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Everything You Ever Wanted to Know About Litigation Finance

Quite understandably, the idea of ‘funding lawsuits’ doesn’t sit well with a lot of people. The notion that a plaintiff might sell a stake in their lawsuit to a third party (thereby transforming the lawsuit into an investable asset) just feels… a bit icky. But the truth is, once people look beyond the ‘ick factor,’ they’re often surprised to learn that not only are their concerns unfounded, but that litigation finance actually benefits individuals and small businesses who are most in need. In fact, one might easily argue that litigation finance helps remove a good portion of the ‘ick’ from our current legal system.

To find out how, let’s take a closer look at what exactly litigation finance is, who uses it, and how it benefits claimants, lawyers, and investors alike.

What is Litigation Finance?

At its most basic level, litigation finance (also called litigation funding) is when a third party provides capital to a plaintiff (or sometimes even a defendant) in return for a portion of any financial recovery from the underlying lawsuit. The capital provided by monetizing a legal claim is often directly applied to the costs of litigation, including attorneys’ fees, investigative fees, expert witness fees and court expenses. A litigation finance transaction is not classified as a loan because it is non-recourse; meaning that if you lose the case, you owe your litigation funder nothing. The funder only receives a payout if the case is won, or if a settlement is reached.

Who Uses Litigation Finance?

While presumably for those who can’t afford the cost of litigation, the truth is that everyone and anyone can benefit from litigation finance. Individuals, class action and mass tort claimants, Fortune-500 companies, universities and businesses of all sizes have taken advantage of the capital security that litigation finance offers.

Now you may be asking yourself, why would a Fortune-500 company seek financing for a lawsuit? Surely they can afford the costs of litigation, so why take money upfront in exchange for giving away a (potentially large) cut on the back-end?

The answer lies in a little-known accounting loophole that affects the balance sheets of publicly traded companies. You see, any time a company undergoes litigation – and companies are always undergoing litigation (According to Norton Rose Fulbright, 90% of U.S. corporations are engaged litigation at any one time) – the expenses of the litigation need to be deducted from the company’s balance sheet. And since B2B litigation moves about as fast as a snail through molasses, those expenses can quickly add up, meaning companies could see millions of dollars in ‘lost capital’ from their balance sheets over the course of several years. And if there’s one thing investors on Wall Street don’t like, it’s lost capital. Sure, you can try to explain that your case is a guaranteed win, or that you’ll settle any day now and see all of your money back plus a hefty payout… but good luck convincing Analysts on the Street to look beyond the numbers. And the worst part is, even if you do win your case or reach a settlement, Wall Street accepts the eventual payout for exactly what it is – a one-time transaction. Which means Analysts discount its significance when assessing your stock valuation going forward.

In short, litigation is a lose-lose for a publicly traded firm. You lose the capital from your balance sheet while the litigation is pending, and even if you win the case, you still lose the opportunity to impress your Stock Market Overlords. It therefore makes sense for publicly traded firms – even cash-rich, Fortune-500 ones – to outsource the costs of their litigation. That way, no capital gets lost on the balance sheet while the litigation is pending. Sure, you don’t get as much payout on the back-end, but you’re also protecting yourself in case of a loss (remember, if you lose the case, you owe the litigation finance company nothing). So in terms of mitigating downside risk, litigation finance can work wonders, even for the big boys.

Some Additional Benefits of Litigation Finance

Balance sheet trickery isn’t the only benefit that litigation finance affords. Check out this laundry list of positives that litigation finance brings to the table: 

  • Helps David Fight Goliath – Hey, even David needed a slingshot, right? Without it, David would likely have been pummeled by the massive Goliath. And that’s exactly what large companies try to do to smaller firms who sue them – pummel the little guys into the ground with motion after motion and delay after delay, forcing legal costs through the roof. Litigation finance provides the Davids of the world with a slingshot: Bring on those endless discovery motions, Goliath, I’m not the one footing my legal bill, haha!
  • Reduces the Risk of a Premature Settlement – No more acquiescing to low-ball offers. Litigation finance provides users with a crucial advantage when entering any litigation: Time. With time on your side, you can scoff at those low-ball settlement offers, and negotiate a much more equitable payout.
  • Unlocks Working Capital Liquidity – What you don’t spend on legal bills, you can now spend on something else (like champagne, for when you make out with a much higher settlement than you would have thanks to your litigation funding agreement!). Or you could go the mainstream route and spend that working capital on employee salaries or marketing for your business. Either way, it’s money you don’t have to spend on lawyers.
  • Affords Access to Top Legal Talent – Litigation finance affords access to capital that claimants might otherwise miss out on, which means they can suddenly afford top legal talent. And much like in the world of sports, when it comes to negotiating a hefty settlement, top talent can make all the difference.

Okay, so we know why claimants utilize litigation finance. But what benefit is there for lawyers? Well, plenty as it turns out–

Why Lawyers Use Litigation Finance

  • Can Accept Cases from Plaintiffs Who Otherwise Couldn’t Afford the Fees – Much like access to proper medicine, access to justice costs money. And sadly, the legal system is not something most folks can afford. Lawyers love litigation finance because they no longer have to turn away strong cases simply because the claimant can’t afford their fee. Now there’s a means for claimants to seek justice without paying the legal fees. A win-win across the board.
  • Enables Flexible Payment Arrangements for Prospective Clients – Sometimes litigation funders don’t just fund a specific case, they fund an entire portfolio of cases. In fact, this practice – known as portfolio financing – is growing more and more common. The result is that lawyers can offer flexible payment arrangements to prospective clients, given the assurance that their costs are already covered by a third party. Yet another means of enticing prospective claimants who might otherwise be scared off by the potential for a massive legal bill.
  • Covers Litigation Expenses – This is a big one. If you’re going to bat against the big boys, you’ll need to bring in the experts. And expertise costs money. With litigation funding, you will likely be able to afford all the expertise you’ll ever need. Of course, it depends on the funding arrangement, but remember – the funders want to win the case as well, so they’re typically more than happy to pony up for expert witnesses and investigative costs.
  • Helps Achieve Meritorious Recoveries – Basically, litigation finance means that lawyers are likely to see a higher payout when all is said and done. Their costs are covered, and their client is less likely to settle early for a low-ball offer. That makes for one happy legal team.

And guess what? Claimants and lawyers aren’t the only ones who are going gaga over litigation finance. Investors such as hedge funds, private equity funds, pension funds, endowments and family offices are increasingly turning to litigation finance for a litany of reasons.

Why Invest in Litigation Finance?

  • The Asset Class is Uncorrelated to Traditional Capital Markets – That’s a ‘financey’ way of saying that investors in litigation finance are looking to diversify their portfolios by investing in a product whose performance isn’t tied to the Stock or Bond Markets. Regardless of how the economy is doing – whether we’re in a bull or bear market, an inflation or recession – there’s always going to be legal claims; someone will always be suing someone else. And the outcome of those claims has nothing to do with how the markets are fairing. So if you’re an investor in those legal claims, you’re not sitting on pins and needles waiting to hear if the Fed will raise interest rates. All of that stock and bond stuff is irrelevant when it comes to litigation finance.
  • Outsized Historical Returns – Litigation finance is considered an ‘alternative asset,’ meaning it’s a niche financial product that isn’t classified as a mainstream investment. While such investments typically average higher returns due to their outsized risk portfolios, litigation finance returns are hovering around astronomical. A 2016 quantitative study performed by Professor Michael McDonald on industry ROI showed an average annual return of 36%. Hey, it’s no Bitcoin, but litigation finance is certainly crushing the stock market, and easily topping other alternative asset investments such as agriculture funds and asset-leasing.
  • Decent Time to Liquidity – ‘Time to Liquidity’ simply means how long it takes to get your invested capital (plus the returns on your invested capital) back. Real estate, for example, can have a fairly long time to liquidity, since it often takes several years to get your money back (unless you’re one of the stars of ‘House Flippers’). The median time to liquidity for litigation finance is hovering around 24 months, which is moderate compared to other alternative assets such as Venture Capital and other forms of Private Equity.

So those are the reasons why everyone loves litigation finance. Except not everyone does love litigation finance—

The U.S. Chamber of Commerce, for one, is pushing for increased industry regulation, as are several other lobbying organizations across the country. Which begs the question, why all the haters?

Arguments Against Litigation Finance, and Counter-Arguments Against Those Arguments

Argument #1: Litigation Finance Increases Frivolous Lawsuits – This argument is pretty straightforward. With more claimants being able to sue, the likelihood is that we’ll also see an increase in frivolous lawsuits. Hey, if I’m not paying my own legal fees, what’s to stop me from claiming you stole my computer and suing for theft? Except, you know, for the fact that I’m typing this very sentence on my computer… but that’s for a jury to decide!

Counter-Argument Against That Argument – As we just said, the above argument is very straightforward. In fact, it’s too straightforward. The argument fails to reason that no funder worth their paycheck would ever finance a case they felt was frivolous. Remember, these are non-recourse investments; if the case is lost, the funder recoups absolutely nothing. So why on earth would a funder invest money in my ludicrous claim that you stole my computer?

In fact, funders are more likely to be even stricter with the merits of a case than a typical lawyer, since they’re approaching each case from the perspective of an investor. Many funders even turn down meritorious cases, simply because they can’t make the numbers work. So the idea that they would start funding frivolous cases is a bit… well… frivolous.

Argument #2: If Third Parties Fund Lawsuits, They Will Influence the Outcomes – Hey, if I’m investing in your lawsuit, you can bet your bottom dollar I’m going to be standing over your shoulder, critiquing every move you make, acting like the worst backseat driver on Planet Earth (we all know that guy). And that presents a thorny ethical issue: No one should control the decisions of a case except the claimant and the legal team, especially not some outside party whose only concern is making a payday on its investment. What could anyone possibly have to say to counter that?

Counter-Argument Against That Argument – All of that is 100% true. We don’t want third parties to influence lawsuits. That would be unethical, and would present a dangerous slippery-slope. Perhaps that’s why all litigation funders remain PASSIVE INVESTORS.

Yes, that’s right – part of the rules of being a litigation funder is that you cannot make decisions on the part of the claimant or legal team. A litigation finance company has zero legal input into the case (unless the claimant wants to ask their opinion, in which case they’re allowed to give it). Otherwise, funders just sit there – like a quiet introvert on a long car ride through a gorgeous mountain terrain – and wait for an outcome. Heck it’s even written into their contracts… they are expressly forbidden from making legal decisions unless the claimant asks them for advice.

So nice try, haters—

Argument #3: Litigation Finance Increases Trial Times – When a claimant has access to funding, they’re less likely to settle, which means longer trial times. Ugh!

Counter-Argument Against That Argument – Ummm… what exactly is the problem here? You’re telling me that claimants should be forced to settle early because of time constraints? Sorry, but if I deserve a hefty payout, I kind of couldn’t care less that our justice system’s biological clock is ticking.

Regardless, there is little (read: zero) evidence that litigation finance increases the time to settlement. In fact, the practice may even streamline cases and decrease the time to settlement by limiting the delay tactics that are so often utilized to bleed claimants dry.

Argument #4: Litigation Finance Means More Lawsuits Overall – Our court system is already clogged, adding litigation finance would be like flushing cement down the toilet…

Counter-Argument Against That Argument – This one is technically true, in that litigation finance is likely to increase the volume of claims. As claimants have access to financing, they are more likely to bring lawsuits forward (again, those lawsuits will likely be meritorious, but they’ll still be taking up valuable legal real estate nonetheless).

The thing is… is really that so terrible? I mean, isn’t that the point of having a justice system in the first place; that anyone who’s legitimately wronged should have the ability to bring their case and receive justice? In fact, I’d argue that more legal claims are actually a good thing. Sure, it might mean clogging up our courts a bit in the short run, but if companies and individuals begin to fear the repercussions of litigation finance – that is to say, that they might be sued for malfeasance and won’t be able to drag the case out and force a lowball offer – maybe, just maybe, they’ll be less likely to commit the malfeasance in the first place. And wouldn’t that be the best result of all?

Conclusion

Ready for a tough pill to swallow?

We don’t all have the same access to the legal system. Those with money have more access than those without. Litigation finance allows claimants without money to have the kind of access to justice that those with money currently enjoy. Obviously, that threatens some (like the moneyed folks who won’t be able to bully their way through the system anymore), but for the rest of us, litigation finance should be celebrated as a means of achieving equality of opportunity when it comes to preserving our legal rights. It will likely take some time, but eventually the idea of financing a lawsuit will be as common as financing a car (which ironically won’t be so common, since in the future we’ll be all be driven around by half-chimpanzee/half-robot cyborgs).

Also in the future, our legal cases will be handled speedily and cost-free by some omnipotent, AI version of Judge Judy. But until that glorious day, let’s all appreciate litigation finance for exactly what it is: a way to make the justice system just a little more accessible.

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Commercial

The Importance of Diversification in Commercial Litigation Finance

Presented by Balmoral Wood | Litigation Finance Why is diversification so important in commercial litigation finance? In a word, RISK. Lack of diversification in a commercial litigation finance portfolio increases the portfolio’s risk substantially. Now, the same can be said for many asset classes, but in this asset class the risk is more acute because of the quasi-binary risk (see explanation below) nature of litigation.  The quasi-binary risk stems from a series of underlying risks related to a single piece of litigation.  The more significant risks (setting aside legal representation risk) of a single piece of litigation can be summarized as follows: (i) legal risk, (ii) counterparty risk, (iii) judiciary risk, and (iv) plaintiff risk. In part 1 of this article, we’ll look at the legal and counterparty risks to commercial litigation finance. In part 2, we’ll examine the judiciary and plaintiff risks, as well as the potential discrepancy in deployed vs. committed capital that is so unique to this asset class. We’ll then wrap things up with an explanation of the reward for successfully investing in commercial litigation finance (spoiler alert: the returns are huge!). Legal Risk Legal risk is a catch-all for a variety of legal considerations inherent in a piece of litigation.  These could include the risks associated with the legal counsel’s and litigation finance manager’s interpretation and assessment of the legal merits of the plaintiff’s case.  This risk is more significant when investing in the earlier stages of a case due to fewer facts/disclosures being available when a financing decision is necessary. However, such risk can also be mitigated through milestone financing, pursuant to the funding contract such that the funder does not risk too much capital when limited information is available. There could also be risk associated with litigation reform, or adverse jurisprudence related to the specific case type being financed.  As an example, patent reform has had a significant impact on the ‘patent trolling’ industry, hence very few litigation finance firms will consider those opportunities.  The question for a financier is whether the case type which they are financing could be the subject of reform, or adverse jurisprudence before the settlement or court process is finalized, which could have a material impact on the outcome of the case. The other aspect of legal risk is jurisdictional in nature, in terms of the legal jurisdiction or the forum (i.e. court or arbitration panel).  Different courts and judges can maintain distinct biases and interpretations which effect the outcomes of cases. With respect to arbitration, if it is binding in nature, the plaintiff and the financier lose the ability to appeal the panel’s decision, which makes that venue more restrictive on one hand, yet more definitive on the other. The variety of legal risks inherent in litigation – some objective, some subjective – makes it that much more difficult to underwrite in a systemic way that results in a series of reliable and recurring outcomes. Counterparty Risk  With respect to counterparty risk, this too can take many forms.  The core component being that even if the plaintiff were to win its case, the plaintiff may not be able to collect the award or settlement.  In some cases, the defendant has the financial resources to pay the award, but due to the jurisdiction of the case, the plaintiff may not be able to enforce and collect its award (because, for example, the legal jurisdiction may not match the jurisdiction in which the defendant owns most of its assets). This can also be referred to as “collection risk”, but ultimately has to do with the characteristics of the counterparty (or defendant). Typically, litigation funders are very focused on this risk early in their underwriting process, and if there is no clear path to collection, the litigation funder will typically pass on the opportunity. The other counterparty risk is behavioural/cultural in nature and may be assessed through the past performance of the defendant in a similar set of circumstances. A plaintiff may be in dispute with a corporation that has a predisposition to fight each dispute ‘to the bitter end’ even though that may not be an economically rational decision.  This behavior is often rooted in a corporate culture that encourages strength in litigation, in order to prevent future potential plaintiffs from engaging in similar litigation, and maintain a pristine reputation.  In this way, the corporation believes that ‘a strong defense is the best offense,’ which ultimately results in long-term savings, as it serves to deter future costly litigation. Other corporations take a more practical approach and treat litigation as a cost of doing business, thus making economically rational decisions to minimize the costs of litigation (legal costs, discovery costs, settlement costs, etc.).  These organizations are generally more likely to enter into a settlement agreement. Ultimately, the counterparty and their philosophical approach to litigation will have a significant impact on the outcome of a case, so whatever can be accomplished upfront to assess their likely approach will benefit the party’s outcome. Having said that, each case is unique, and each successive executive team may harbor different beliefs, so it becomes inherently difficult to consistently assess and anticipate counterparty behaviour given these ever-changing variables. Judiciary Risk Judiciary risk is simply the risk that despite a meritorious claim with ample supporting evidence, the judiciary will make an unpredictable or incorrect decision that results in a loss to the plaintiff.  This risk will differ depending on the nature of the forum (court or arbitration) and the nature of the judiciary (judge, jury or panel), not to mention the individual making the decision. The only remedy in this situation is success through an appeal, but that option may not be available, and typically the chances of a successful appeal are less than 50%. Judiciary risk encourages many to believe that litigation risk is “binary”, which is to say that a plaintiff will either win or lose its case, but rarely is there a judicial outcome somewhere in the middle.  I would argue that the asset class, when viewed through the lens of a large diversified portfolio, possesses “quasi-binary” risk, as described below. During the earlier stages of a case, there is uncertainty on either side of the dispute because a lack of disclosure has taken place, and so the counter-parties’ confidence in their respective cases relies solely on what they know about the case (both sides, of course, appreciate that there may be much they do not know). When you look at two parties in a dispute that have equivalent economic resources, the parties quickly turn their attention to focus on the merits of the case and the probability weighted potential outcomes of the case if it were to proceed to a judicial process. This uncertainty, married with the concept promoted by litigation finance of ‘level the playing field,’ creates a breeding ground for settlement. When you consider the large variety of potential outcomes in the context of a negotiated settlement, the possibilities are infinite. It is this series of potential outcomes that make a piece of litigation much less binary during the pre-trial period. The reality of litigation is that the lion’s share of resolutions is derived through settlement (90-98%, depending on the data source). Hence, a commercial litigation finance portfolio is not as binary as one might think.  However, in the context of a single piece of litigation, there is the possibility that it gets resolved through a judicial decision and hence there is an element of binary risk inherent in any single piece of litigation. Since most commercial litigation is settled, and since there is binary risk associated with a single piece of litigation that reaches the judiciary, the application of portfolio theory decreases the binary risk inherent in a portfolio of cases. Plaintiff Risk Most jurisdictions prevent a third party from influencing the plaintiff with respect to their case.  “Officious intermeddling” is a reference to a third party interfering with the plaintiff’s decision, and is a component of the definition of the legal doctrine of ‘champerty’, which is still relevant in many jurisdictions.  Accordingly, when a litigation funder takes on a case, they must ensure that the plaintiff will be an economically reasonable decision-maker, which is difficult to assess, as the injured party typically wants to exact revenge for the damage done to them. There are ways in which a litigation funder can construct its funding contract to make the plaintiff act economically rational, but the provisions are more ‘guard rails’ than a ‘podium’.  Good litigation funders will spend time with the plaintiff to assess their economic rationality, but ultimately the funder is adopting an element of plaintiff risk when funding a new case. Commitment vs. Deployment  In addition to the risks outlined above, the other characteristic of the commercial litigation finance asset class that merits comment relates to deployment rates. In this asset class, there is a distinction between the amount the litigation funder ‘commits’ to a case, and the amount they ‘deploy’.  The former is the amount that the financier is willing to commit to fund based on a set of assumptions, milestones and limitations. The latter is the amount that is actually funded. Since litigation funders cannot possibly know (particularly in early stage cases) how much of their commitment they will ultimately deploy, it becomes that much more difficult for fund managers to design diversified portfolios.  As an example, if I manage a fund with a 15% concentration limit based on aggregate committed capital, and my entire fund deploys 75% of its aggregate committed capital throughout its term, then my concentration limit is effectively 20% (15%/75%) of deployed capital.  If that same fund has 2 investments that have hit the fund concentration limit, then the returns of the fund will mainly be dictated by 2 cases representing 40% of the deployed capital.  When you layer on single case binary risk, you quickly come to understand how inappropriate the concentration limit is for the fund, and how difficult it can be for a fund to overcome a loss related to 1 large case investment and still produce strong absolute returns. The Reward Given that many of these risks exist in a single piece of litigation, the economic return must be significant to justify assuming these risks, which is why the industry has the perception of being an expensive source of capital. In addition, the industry does have the potential to achieve outsized returns depending on the funding contract and timelines, but these are typically driven by single cases and are extremely difficult to underwrite and predict. While the industry risks are numerous, many of them are manageable and diluted in the context of a diversified portfolio, and many investors believe the rewards are well worth the risk. So, when an investor looks at the risks and rewards of a single piece of litigation in the context of a large diversified portfolio, it is easy to conclude that the application of portfolio theory (i.e. diversification) is necessary to achieve appropriate risk adjusted returns. Diversification can take many forms (fund managers, geography, case size, case type, counterparty, industry and legal representation) and it is important to have a mix of each within the portfolio to reduce risk, while obtaining the overall benefits of the absolute returns inherent in the asset class.   About the Author: Edward Truant is a principal of Balmoral Wood Litigation Finance, a litigation finance fund manager based in Toronto, Canada.  The author can be reached at edwardt@balmoralwood.com.