Publication | ThinkSet
Litigation Finance 101: What You Need to Know
Bob Craig, Daniel Ryan, and Larry Tedesco
It’s growing fast, but does that mean more frivolous lawsuits? And how does it change corporate legal strategy?
If you’re working in the corporate legal space, you’ve likely encountered litigation finance. But while many in-house attorneys have seen cases against them funded by third parties, most legal departments still aren’t using it themselves. And plenty of executives still aren’t sure what to make of it.
Does using litigation finance, also commonly known as litigation funding, encourage frivolous litigation, or does it level the playing field? Does it change the way in-house counsel think about legal strategy, or does it help them convert legal claims into value-generating assets?
The answer to each of those questions is the same as the answer to so many legal queries: It depends. That is, it depends on whom you ask, on the form of litigation funding and on the facts of the matter itself.
Our aim is to offer a few thought-provoking perspectives to anyone grappling with corporate legal costs or seeking to generate value in their legal departments; a simple guide to the advantages of using litigation funding; and an honest assessment of the reasons why some folks remain circumspect.
Common concerns with litigation finance funds
CORPORATIONS DON’T NEED LITIGATION FINANCE.
That might have been true 20 years ago. But a recent Thomson Reuters survey shows that controlling outside counsel costs has become a general counsel’s top priority. On top of that, today’s GCs are often tasked with turning their legal departments into value-generation engines. In the drive to generate revenue, claims against other entities can be a GC’s most effective tool. In the last decade, we’ve seen some incredibly successful efforts, most notably DuPont’s Global Recoveries Initiative, a concerted revenue campaign that generated $1.5 billion in recoveries over six years.
Enter litigation funding, which can be a powerful means to extract revenue from legal claims while also holding down outside-counsel costs. While it’s not clear that GCs have widely adopted this thinking, it seems likely that many will move toward using funding as legal departments are increasingly held to the same budgetary and value-generating standards as other corporate functions.
Funding can also provide independent validation, enabling the GC to file a claim that could bring a big payoff but would be expensive to litigate—a complex patent prosecution, for example—and requires buy-in from elsewhere in the C-suite. CEOs and CFOs don’t always grasp completely the risks and rewards in those scenarios, and they may want assurances of success that the GC can’t provide. Obtaining funding suggests that an outside expert has positively assessed the claim and potential damages, which may help sway the C-suite.
IT ENCOURAGES MORE AND FRIVOLOUS LITIGATION AMONG COMPANIES.
That’s half-true. Litigation finance can generate more lawsuits by allowing companies to file claims where they might not otherwise—that’s the point, after all. But those cases are anything but frivolous. Because funders shoulder significant levels of the risk, they don’t invest in cases unless their due diligence shows that the claims have merit. The authors of an Arizona State Law Journal article put it this way: “Frivolous litigation makes for a worthless investment.” If anything, litigation funding leads to more high-quality litigation.
It also propagates litigation by resolving an issue bedeviling many law firms: pressure to accept more contingency arrangements. Corporate clients increasingly want their outside firms to share the risk of lawsuits, but law firm balance sheets can only handle so much of that risk. Litigation funding spreads some of the risk to a third party, allowing law firms to revert to their customary hourly fee structure or other fee arrangement that allows regular income. And in many cases, the lawyers will take a reduced hourly fee to share in the upside, meaning they also have skin in the game.
The cost of capital for litigation funding appears steep—if you don’t consider the risk to the funders. Most funding comes in the form of nonrecourse financing. The funder, and often the attorneys, takes a fairly large cut—typically around 40 percent—from potential proceeds in exchange for covering funded costs. If you lose, you owe the funder nothing.
Plenty of general counsel who understand the litigation-funding calculus still often prefer to finance their strongest claims themselves, rather than give up a portion of the proceeds. But there are situations, especially for publicly traded companies (more on that below), when it makes more sense to defer the costs of litigation and shift some of the risk, even with claims that have obvious merit.
IT’S NOT CLEAR WHAT THE RULES ARE.
American lawyers and judges don’t look kindly on nonlawyers and nonparties taking a financial interest in lawsuits. In summer 2018, the New York City Bar Association issued guidance indicating that ethical rules don’t permit law firms to finance portfolios of cases, an increasingly common practice. That isn’t binding, and it’s being hotly debated, but it’s an indication of the unease among the profession.
And even outside the US, in jurisdictions where litigation funding has been widely used for nearly a decade, the International Centre for Settlement of Investment Disputes recently proposed a series of rule changes that would require litigants to disclose third-party funders in order to gauge potential conflict of interest for the arbitrator. Similar disclosure rules have been put forward in the US Congress, and the US Chamber of Commerce persistently clamors for more transparency.
But litigation funding has a powerful wind at its back: investors seeking market-beating returns that aren’t correlated to stocks and bonds. Perhaps the strongest indicator of this is the recent entry of institutional investors—including Fidelity International and the Employees Retirement System of Texas, according to the Wall Street Journal.
Compelling reasons to use litigation finance companies
IT LETS LAWYERS FOCUS ON LAWYERING.
Under the traditional hourly rate setup, once the law department chooses an outside law firm, GCs can look forward to months or even years of scrutinizing billing statements and quibbling over budgets during the litigation process. None of that has anything to do with the law degrees hanging on their walls.
Securing litigation funding, however, typically reduces many of those burdens for an in-house team, allowing it to focus on collaborating with its law firm on legal strategies and tactics. And because the law firm isn’t financing the case itself, the GC can worry less about the outside team cutting corners or pushing for premature settlements. Funding typically isn’t unlimited, so costs still must be managed, but adding a financing partner helps shift the balance back toward lawyering.
EXPERT DAMAGE ASSESSMENTS.
Litigation funders bring a significant level of discipline and professionalism to damage assessment, because their business depends on it.
In this regard, litigation funding is analogous to the broader movement to outsource non-core corporate functions—web hosting, IT, property management, etc.—to specialized vendors as part of a quest for efficiency and agility.
Calculating legal damages requires a great deal of specific litigation knowledge and experience. While this is in the in-house lawyer’s wheelhouse, using a litigation funder adds an element of independent scrutiny, lowering the risk of being led into expensive, inadvisable legal battles by overzealous managers or law firms.
IT CHANGES THE MATH ON LITIGATION EXPENSES.
Under Generally Accepted Accounting Principles, litigation costs must be recorded as operating expenses, charged to selling, general and administrative (SG&A) costs. But proceeds from a successful outcome are usually treated as other income, not from operations. So litigation can reduce a company’s cash balance, operating income and earnings in the short term. For a publicly traded company, that can mean a hit to the stock price in the short term. For private companies, inflated SG&A may have adverse consequences as well, such as where interest rates are tied to SG&A in loan covenants. Neither lenders nor analysts are likely to recognize the value of the potential recovery until it is in the bank.
Litigation finance can help dull, if not nullify, the short-term financial hit. If the litigation funder, or some combination of funder and law firm, covers most of the litigation costs, the company’s financial statements are unaffected; resulting proceeds, while reduced by the funder’s payout, amount to a bottom-line windfall.
Here, again, litigation funding provides an innovative tool that can help relieve potential tension between GCs and CFOs. It allows the legal department to pursue a meritorious claim without drawing resources away from the core business.
While litigators and in-house lawyers are still showing some apprehension about litigation finance, investors are rushing in with abandon. It’s not just a shiny new thing, but also one that’s truly uncorrelated to other asset classes and has lately outperformed them as well. Even within a single funder’s portfolio, cases are uncorrelated—a unique and enticing attribute for investors. Litigation funding firms are having no difficulty attracting the world’s highest-net-worth investors and institutional investors.
Unsurprisingly, the demand is giving rise to more funding firms, which promises to create greater competition for meritorious claims and thus more attractive pricing for the claimants. And those firms are on a hiring binge, attracting some impressive talent from law firm litigation teams. “The roles are seen as more entrepreneurial than those at rigid, bill-by-the-hour firms,” the Wall Street Journal has reported, noting recent hires from Arnold & Porter Kaye Scholer, Latham & Watkins, Proskauer Rose and others.
More funders means more funding activity. In just five years, the share of law firms (working for and against corporate America) using litigation finance has risen from 7 percent to 36 percent, according to a 2017 survey by Burford Capital. That pace can’t continue forever, but there’s still plenty of room to grow—and plenty of reasons for in-house counsel to give litigation funding a close look.
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