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Valuing Indemnity Protection Investment Returns in Litigation Finance

The following article is part of an ongoing column titled ‘Investor Insights.’ 

Brought to you by Ed Truant, founder and content manager of Slingshot Capital, ‘Investor Insights’ will provide thoughtful and engaging perspectives on all aspects of investing in litigation finance. 

Executive Summary

  • Indemnities are not costless instruments; they are akin to securities options, but without a stated option value
  • Approaches to determining cost of indemnity include: Probability weighted outcome approach, Opportunity Cost Approach and Approach based on empirical evidence
  • Implications for Portfolio Returns are that improper assessment of indemnity returns may materially skew return results of a portfolio

Investor Insights

o   Indemnities have a cost and their cost should be used to determine investor returnso   Depending on how indemnity performance is measured, it has the ability to skew portfolio performance

Some litigation finance providers offer a product called indemnity protection (please don’t call it insurance), which is a product designed to protect plaintiffs against adverse costs in certain jurisdictions (Canada, Australia and the UK, for example) where the plaintiff may be found liable for defense costs should the defendant win the case.  Indemnity protection is prevalent in product class action and securities class action cases.

What makes indemnity protection challenging is the process of estimating the returns inherent to providing the protection.  Indemnities differ from traditional litigation finance, in that the latter requires the funder to finance hard costs (legal counsel, court costs, expert witness costs, etc.), while the former only pays out once a case is lost by the plaintiff, and subject to the court’s determination regarding the application of adverse costs.  In the event the plaintiff is successful, the indemnity provider shares in the contingent proceeds and is not liable for any payout.

However, in the event the defendant is successful, the indemnity provider must pay the indemnity amount and forego any prospective proceeds.  In a normal rate of return calculation, the numerator (i.e. gains or proceeds) and denominator (dollars deployed to finance costs) help determine a Return on Invested Capital (“ROIC”) or Multiple of Invested Capital (“MOIC”). However, with indemnities there is no denominator; in the event the plaintiff wins the case and hence there is no “cost”.

Or is there?

I think most people in finance would argue strongly, and rightly so, that there is indeed a cost.  I liken the analysis to that of a securities option.  In the context of a securities option (a put or call option, for example) one pays an upfront amount (i.e. the option price) to attain the right to benefit in either the reduction or increase in the underlying stock price.  The value of the option is based on the market’s view of the weighted average probability of the event taking place (i.e. achieving the strike price in a given period of time).

In the case of an indemnity, there is no cost to providing the indemnity (other than out of-pocket contracting costs) even though the opportunity has value to the indemnity provider.  The value of the indemnity for the investor is inherent in the pay-out they expect to receive on success, which is offset by the likelihood of having to pay out under the indemnity.  Essentially, it is a costless option.  The upside produces infinite returns, while the downside produces a total loss.

Approaches to Valuing the Indemnity Protection

As we all know, nothing is “costless”. Instead, I would suggest that an investor in an indemnity needs to determine a theoretical cost for that investment.

One approach is to look at the litigation funder’s underwriting report and economic analysis to determine the probabilities associated with various negative outcomes pertaining to the case, and probability-weight the negative outcomes to determine a theoretical cost of capital. Of course, these need to be looked at in the context of the risks of the various case types in the relevant jurisdiction, in addition to the risks of the case through the various stages of the case, as adverse costs can have multiple pay-out points throughout the case.  As an example, securities class actions in Australia and Canada, when certified by a court, have an extremely high success rate (meaning that they typically settle quickly after the certification).

Another approach might be to look at the alternative to utilizing that same capital in an investment with a similar risk profile, where the potential outcome could be the same and the risk of loss is similar.  As an example, if the opportunity cost of providing an indemnity was to buy a securities option with a similar risk profile, then you could use the market cost of the option as a proxy for the cost of the indemnity.

Yet another alternative would be to study the outcomes of a large sample of identical indemnities to try and determine the probability of a negative outcome and apply it to the indemnity amount to determine a notional cost.  Unfortunately, much of this information remains in the private domain, as most cases which use indemnity protection tend to settle.  In time, it may be that there is sufficient data to make this approach realistic, but as it stands, there is insufficient data to make this a viable alternative.

While approaches will differ by fund manager and investor, the important point is to eschew the concept that an indemnity is a costless financial instrument, as to do so would skew the results inherent in a fund manager’s track record where indemnities are an important part of their strategy.  This same result can also occur in more traditional litigation finance cases where there is a settlement shortly after the funding contract has been entered into, and which did not necessitate the drawing of capital.  In this case, the returns are also infinite, but perhaps there should have been a theoretical cost of capital based on the probability of the funding contract being drawn upon.

Investor Insights: When assessing the rates of return on an indemnity, my approach is to determine a weighted average probability of loss outcomes and apply them to the Indemnity amount in order to determine a notional cost for the indemnity.  This analysis becomes extremely important when assessing portfolio performance because most often fund managers do not assign a notional cost to their indemnities when providing their investment track records, and hence positive indemnity outcomes make their overall portfolio performance seem more impressive than one might otherwise assess.  A simplified example of the potential for an indemnity to skew portfolio performance based on approach is as follows:

Assumptions:

Case Type:                             Security Class Action

Indemnity Amount:             $1,000,000

Damage Claim:                      $10,000,000

Contingent Interest:              10%

Contingent Interest Award:  $1,000,000

Probability of Loss                $ Loss*

Loss at Summary Judgement:                  10%                     $100,000

Loss at Certification:                                   5%                       $50,000

Loss at Trial:                                                 25%                     $250,000

Notional Cost of Indemnity:                                                  $400,000

* calculated as probability of loss multiplied by Indemnity Amount.

  1. Return Calculation applying a theoretical cost to the Indemnity in a win scenario:

ROIC: =       $600,000 ($1,000,0000-$400,000) = 150%
$400,000

MOIC:                  $1,000,000 = 2.5
$400,000

  1. Return Calculation applying no cost to the indemnity in a win scenario:

MOIC &
ROIC:          $1,000,000 = Infinite
$0

Edward Truant is the founder of Slingshot Capital Inc. and an investor in the consumer and commercial litigation finance industry. Slingshot’s blog posts can be accessed at www.slingshotcap.com.

Commercial

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Announcements Commercial Regulatory Issues

More Than 100 Companies Sign Letter Urging Third-Party Litigation Funding Disclosure Rule for Federal Courts Ahead of October Judicial Rules Meeting

By Harry Moran |

In the most significant demonstration of concern for secretive third-party litigation funding (TPLF) to date, 124 companies, including industry leaders in healthcare, technology, financial services, insurance, energy, transportation, automotive and other sectors today sent a letter to the Advisory Committee on Civil Rules urging creation of a new rule that would require a uniform process for the disclosure of TPLF in federal cases nationwide. The Advisory Committee on Civil Rules will meet on October 10 and plans to discuss whether to move ahead with the development of a new rule addressing TPLF.

The letter, organized by Lawyers for Civil Justice (LCJ), comes at a time when TPLF has grown into a 15 billion dollar industry and invests funding in an increasing number of cases which, in turn, has triggered a growing number of requests from litigants asking courts to order the disclosure of funding agreements in their cases. The letter contends that courts are responding to these requests with a “variety of approaches and inconsistent practices [that] is creating a fragmented and incoherent procedural landscape in the federal courts.” It states that a rule is “particularly needed to supersede the misplaced reliance on ex parte conversations; ex parte communications are strongly disfavored by the Code of Conduct for U.S. Judges because they are both ineffective in educating courts and highly unfair to the parties who are excluded.”

Reflecting the growing concern with undisclosed TPLF and its impact on the justice system, LCJ and the Institute for Legal Reform (ILR) submitted a separate detailed comment letter to the Advisory Committee that also advocates for a “simple and predictable rule for TPLF disclosure.”

Alex Dahl, LCJ’s General Counsel said: “The Advisory Committee should propose a straightforward, uniform rule for TPLF disclosure. Absent such a rule, the continued uncertainty and court-endorsed secrecy of non-party funding will further unfairly skew federal civil litigation. The support from 124 companies reflects both the importance of a uniform disclosure rule and the urgent need for action.”

The corporate letter advances a number of additional reasons why TPLF disclosure is needed in federal courts:

Control: The letter argues that parties “cannot make informed decisions without knowing the stakeholders who control the litigation… and cannot understand the control features of a TPLF agreement without reading the agreement.” While many funding agreements state that the funder does not control the litigation strategy, companies are increasingly concerned that they use their growing financial leverage to exercise improper influence.

Procedural safeguards: The companies maintain that the safeguards embodied in the Federal Rules of Civil Procedure (FRCP) cannot work without disclosure of TPLF.  One example is that courts and parties today are largely unaware of and unable to address conflicts between witnesses, the court, and parties on the one hand, and non-parties on the other, when these funding agreements and the financial interests behind them remain largely secret.

Appraisal of the case: Finally, the letter reasons that the FRCP already require the disclosure of corporate insurance policies which the Advisory Committee explained in 1970 “will enable counsel for both sides to make the same realistic appraisal of the case, so that settlement and litigation strategy are based on knowledge and not speculation.” The companies maintain that this very same logic should also require the disclosure of TPLF given its growing role and impact on federal civil litigation.

Besides the corporate letter and joint comment, LCJ is intensifying its efforts to rally companies and practitioners to Ask About TPLF in their cases, and to press for a uniform federal rule to require disclosure. LCJ will be launching a new Ask About TPLF website that will serve as a hub for its new campaign later this month.

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Commercial People Moves

Mesh Capital Hires Augusto Delarco to Bolster Litigation Finance Practice

By Harry Moran |

In a post on LinkedIn, Mesh Capital announced the hiring of Augusto Delarco who has joined the Brazilian firm as a Senior Associate, bringing a “solid and distinguished track record in complex litigation and innovative financial solutions” to help develop Mesh Capital’s Litigation Finance and Special Situations practices. 

The announcement highlighted the experience Delarco would bring to the team, noting that throughout his career “he has advised clients, investors, and asset managers on strategic cases and the structuring of investments involving judicial assets.”

Delarco joins Mesh Capital from Padis Mattars Lawyers where he served as an associate lawyer, having previously spent six years at Tepedino, Migliore, Berezowski and Poppa Laywers.

Mesh Capital is based out of São Paulo and specialises in special situations, legal claims and distressed assets. Within litigation finance, Mesh Capital focuses on “the acquisition, sale and structuring of legal claims, covering private, public and court-ordered credit rights.”

Case Developments Commercial

Delaware Court Denies Target’s Discovery Request for Funding Documents in Copyright Infringement Case

By Harry Moran |

A recent court opinion in a copyright infringement cases has once again demonstrated that judges are hesitant to force plaintiffs and their funders to hand over information that is not relevant to the claim at hand, as the judge denied the defendant’s discovery request for documents sent by the plaintiff to its litigation funder.

In an article on E-Discovery LLC, Michael Berman analyses a ruling handed down by Judge Stephanos Bibas in the United States District Court for the District of Delaware, in the case of Design With Friends, Inc. v. Target Corporation. Design has brought a claim of copyright infringement and breach of contract, and received funding to pursue the case from Validity Finance. As part of its defense, Target had sought documents from the funder relating to its involvement in the case, but Judge Bibas ruled that Target’s request was both “too burdensome to disclose” and was seeking “information that is attorney work product”.

Target’s broad subpoena contained five requests for information including Validity’s valuations of the lawsuit, communications between the funder and plaintiff prior to the funding agreement being signed, and information about the relationship between the two parties.

With regards to the valuations, Judge Bibas wrote that “while those documents informed an investment decision, they did so by evaluating whether a lawsuit had merit and what damages it might recover,” which in the court’s opinion constitutes “legal analysis done for a legal purpose”. He went on to say that “if the work-product doctrine did not protect these records,” then the forced disclosure of these documents “would chill lawyers from discussing a pending case frankly.”

Regarding the requests for information about the relationship between Design and Validity, Judge Bibas was clear in his opinion that these requests were disproportionately burdensome. The opinion lays out clear the clear reasoning that “Target already knows that Validity is funding the suit and that it does not need to approve a settlement”, and with this information already available “Further minutiae about Validity are hardly relevant to whether Target infringed a copyright or breached a contract years before Validity entered the picture.”The full opinion from Judge Bibas can be read here.