How to Regulate Legal Funding

We are firm believers in regulation. We believe consumers deserve protection and complex financial products should exist in some sort of regulatory framework. We also believe in innovation - that as new products enter the market, they should be allowed to grow and experiment.

Many of legal funding's opponents favor strict regulation because they know that will put the industry out of business. We've written many times of the tired arguments they deploy: rates are high, consumers are unfamiliar with the product, there are bad actors in the marketplace.

These arguments are often true. They were also true of every new financial product when it was new. They are, in fact, great reasons to let legal funding flourish.

We think a number of states, like Ohio, come close, but others are dangerously paranoid. Policymakers must strike a very tricky balance between protecting consumers and giving legal funders enough freedom that the product is actually useful to those consumers. After all, legal funding is itself a form of consumer protection: it's a free market shield from insurance companies that too often act in bad faith.

Fortunately, smarter people than us are also thinking about these problems. One of these is Larry Summers, former Secretary of the Treasury for President Clinton and Director of the National Economic Council under President Obama. In his lecture at the 2015 Lendit Conference in New York, Summers offered a refreshingly lucid approach to regulating lending marketplaces.

(Disclaimer: legal funding is not a loan, and legal funders are not lenders. But the marketplace is as new as many lending marketplaces, and stands to cause comparable disruption in the financial sector. You could replace "lending" with "funding" anywhere in Summers' speech and it would ring just as true.)

Summers' proposal boils down to four guiding principles for regulating financial marketplaces:

Permission not prohibition: let new business models emerge. Regulators should allow new firms to operate, generating data on the outcomes created by novel business models, before writing new rules. Regulation is necessary but only when necessary.

Insist on transparency and disclosure: then let consumers decide. As new lenders serve parts of the market that have historically not had access to credit, high rates will draw regulatory scrutiny. Regulators should require full transparency and disclosure and see how consumers react to new products and prices before writing rules.

Maintain a level playing field: don't give incumbents an unfair advantage, but discourage business models based on unfair regulatory arbitrage. Regulators should strive to put entrants on equal footing with incumbents, but without sacrificing consumer protection.

Provide workable regulatory frameworks: to date regulatory authorities have generally maintained appropriate attitudes towards innovative lenders. It will be important as the industry evolves and grows that regulators not create overhangs of uncertainty or burden excessively those attempting to innovate.

We admire these principles because they give equal consideration to businesses and consumers. They are far from outlandish - whereas many policymakers cry "consumer protection!" and then make no effort to understand a product, Summers encourages us to nurture innovation. But his push for transparency is just as important: companies should make an effort to be understood, he cautions, so consumers know what they're getting into and regulators know what they're regulating.

"The task of renewal of our financial system," concluded Summers, "is not primarily one for public policy. It is one of entrepreneurial innovation." To view his remarks in full, check out the video below: http://youtu.be/3eUUl-6MZBE

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