A contract between Ecuadorean villagers suing Chevron and a London firm that finances corporate litigation offers a detailed look at a growing phenomenon in the law: Investing in lawsuits. The contract with a Cayman Islands arm of Burford Group shows the conflicts that can riddle such arrangements, and have  led some states, like Nevada, to ban them outright.

The U.S. Chamber of Commerce condemns outside legal finance entirely, saying it can prolongs litigation and induce people to sue for no reason other than they’re being paid to do it. As the Chamber’s highly paid legal experts say in this report:

The purpose of court proceedings is not to provide a means for third parties to make money by creating,multiplying and stirring up disputes in which those third parties are not involved and which would not otherwise have flared into active controversy.

Proponents of litigation finance note that a) a hedge fund that invests in frivolous litigation won’t stay in business very long and b) litigation finance is rampant already, as this ad for divorce funding shows. Poor litigants get outside financing for personal-injury lawsuits, in the form of contingency-fee arrangements with their lawyers. If they win, they hand 30% to 50% to the lawyer. If they lose, they owe nothing. And insurance companies frequently take ownership of legal claims through the process of subrogation, where they sue to recover money they paid out to one of their customers as a result of, say, a car accident.

The story behind the financing of the Ecuadorean villagers is a bit more complex. As they were closing in on an $18 billion pollution verdict against Chevron last year, the plaintiffs had a problem. Their lead attorney, Steven Donziger, had spent $6 million or so on the case over almost two decades but he had ruptured his relationship his with longtime financial backer, Philadelphia attorney Joseph Kohn, after a series of missteps including inviting a documentary filmmaker to record damaging conversations on camera. With victory in sight, the lawyers were in danger of running out of cash.

So they turned to Burford, a publicly traded company that specializes in financing corporate litigation. Burford is run by experienced corporate attorneys with blue-chip resumes — the chief executive Chris Bogart, is the former general counsel of Time Warner and directors include Geoffrey Hazard of the University of Pennsylvania Law School, considered the dean of U.S. legal ethics and civil procedure.

Normally the contract between Burford and the lawyers suing Chevron would be confidential, but thanks to Donziger’s on-camera antics and an angry federal judge in New York, it got dumped into the public record along with thousands of other protected documents.

The money, up to $15 million, comes from Treca Financial Solutions, a Cayman Islands entity referred to as “The Funder.” The counterparties are “Friends of the Defense of the Amazon,” a non-profit affiliated with the plaintiff attorneys, and some 40 named claimants who theoretically represent thousands of other villagers whose ancestral lands have been polluted with oil and drilling fluids.

Chevron’s attorneys have identified Treca as belonging to Burford. In the contract, Burford agrees to supply the money in three tranches, starting with $4 million on Nov. 1, 2010 and two additional tranches of $5.5 million each.

What does Burford get in exchange? Figuring out the fund’s return requires skipping to several different places in the 75-page agreement. But eventually a careful reader will uncover the terms of the bargain. Burford gets 5.545% of the “Settlement Amount,” which is stated as $1 billion. What if the case settles for less than a bil? Then Burford gets 98.25% of “Net Recoveries” after paying $2.5 million to another outside investor (Donziger’s Harvard Law School friend, J. Russell DeLeon) and certain expenses of other lawyers. But it doesn’t stop there. Should the Ecuadorean villagers decide to accept less than $1 billion from Chevron, another clause two pages away reveals that the “Net Recovery” is deemed to be the “Settlement Amount.” In other words, if the outside funder isn’t happy with the amount the villagers accept, it gets $55.5 million — a 270% return on its money — before the villagers get a dime.

It’s the relationship between the outside funder and the plaintiffs that requires the most careful lawyering in any such contract, said Anthony Sebok of the Benjamin Cardozo School of Law in New York. I ran the contract past Sebok, who has made a sub-specialty of probing the legal and ethical questions surrounding litigation finance. He said it had “nothing unusual from point of view of the litigation finance world.”

Such contracts should be carefully written to state that under no circumstances will the funder make litigation decisions. The plaintiff might want to walk away from the case, for example. “People abandon lawsuits all the time,” Sebok says. Or if the defendant comes in with a nuisance settlement, the plaintiff’s wisest course might be to take it. For these reasons, he said, “it is ill-advised to give settlement control to the fund.”

Indeed, the Burford contract says that both sides agree their “common interest is served by settling the
claim for a commercially reasonable amount,” but that the claimants “may at any time without the consent
of the Funder either settle or refuse to settle the claim for any amount.” Having established the utter independence of the claimants, the agreement then says they must cooperate with Burford’s lawyers, keep them apprised about developments in the case, and agree not to sell any further portions of the case to other investors without their notice. Oh, and a lawyer from Patton Boggs, a Washington law firm with close ties to Burford, must remain in charge of the cash.

The legal terms for sponsoring a lawsuit are  “champerty and maintenance.” They were prohibited in England, Sebok said, after aristocrats abused the court system by hiring their underlings to sue each other for sometimes frivolous reasons. “It became a sport of the upper class,” said Sebock.

About half the states still ban the practice, although the rules are riddled with exceptions. And all states allow plaintiffs to sell their claims outright in a process called assignment, except for personal injury lawsuits, and surprisingly enough, legal malpractice claims.

The central question in any financing contract is whether the plaintiffs have sold their right to make decisions about their own case. This just doesn’t seem right, and courts have called it “officious intermeddling.”

So is Burford’s $50 million payoff if the plaintiffs accept less than $1 billion intermeddling? Technically, no. But it’s a little surprising the firm dove into such a tangled lawsuit with so many plaintiffs and different jurisdictions, when its main business is financing more routine commercial disputes between companies. In those cases, a skilled lawyer can make an expected-return calculation — the odds of winning, times the maximum jury verdict — and extend only that much money in order to avoid depriving the plaintiff having any meaningful stake in the outcome. In the Chevron case, with unsophisticated plaintiffs and a welter of international legal considerations, the calculation is much harder to make.

“It’s not good business sense to lend so much that the plaintiff doesn’t care whether he settles or goes to trial,” Sebok said.  Otherwise, there’s “a very good chance, based on all mathematical models I have seen, your recovery is zero. You don’t want to push the party who has settlement control against a wall.”

By Daniel Fisher, Forbes Magazine