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

• Specialization has occurred and will continue to occur in the legal finance market.
• Public Sector Entities represent a unique plaintiff type which merits specialization
• Damages can be significant for PSE claims, which has implications on rewards and case duration
• Litigation finance for PSE plaintiffs is timely due to budget constraints exacerbated by the economic effects of the coronavirus.

INVESTOR INSIGHTS

• PSE claims are unique enough that specialization makes sense;
• Specialization by plaintiff type is unique and mitigates systematic risk attributable to specialization related to specific case types
• Investors need to be aware of duration risk associated with PSE claims due to claim size
• Investors need to ensure there is good alignment of interests and contractual arrangements between the PSE and their economic goals

While much of the specialization that has occurred to date has to do with claim type (e.g. patent claims) or risk type (collection risk in post-settlement cases vs. litigation risk in pre-settlement cases), few funders have decided to focus on plaintiff type.  One such funder, Arran Capital, has decided to do so mainly because its principal, Grant Farrar, has had hands-on experience as a result of being Corporation Counsel at the City of Evanston, Illinois, as well as serving as outside counsel to governments across the US.   Through countless high stakes litigations and transactions, he evaluated risk and outcomes that were specific to governments and their constituents.  Grant and I have agreed to co-author this article to inform readers about the Public Sector Entities space, the increasing need for litigation finance therein, and some of the attributes that need to be considered by commercial litigation finance funders and public sector entities (“PSE”) that are unique to the PSE plaintiff. Background Public sector affirmative litigation of all shapes and sizes across the country is increasing.  PSEs with different demographics and economic circumstances want to ensure their right of access to the courts. This article discusses state and local governments’ (which will continue to be identified as PSE) assumption of their leading role in shaping policy and litigation priorities in the United States.  When this context is viewed through the prism of post-Covid imposed budget stress, legal financing may be uniquely positioned to provide a creative budget and policy solution for PSE.  Concerns expressed relative to PSE legal finance resemble similar objections to private sector legal finance.  These objections merit consideration, but a full treatment of these points exceeds the scope of this discussion. Lastly, impact investing mandates may generate significant new investment opportunities for PSE legal finance. PSE Market Size and State of Play There are approximately 90,000 units of local government.  This number is broken out in approximate numbers as follows:

• 35,000 cities, towns, villages, townships;
• 3,000 counties;
• over 52,000 special districts (such as airport, harbor, water and/or sanitary districts); and
• the remainder are school districts and other miscellaneous units.

Combined government spending for PSE is $3.7 Trillion, which is 9% of US Gross Domestic Product, and double the spend of the US federal government.  Given the size and differing compositions of PSE, it is hard to pinpoint with exactitude PSE legal spend.  According to the US Census Bureau 2017 Census of Governments (released in summer 2019), PSE legal spend in 2017 approximated over $10B for the 90,000 units of local government. Another data point is found in a dedicated survey of city legal department spend, the Governing Magazine 2016 Study of the Top 20 Largest Municipal Legal Budgets, which indicated the total annual median expense was $12M. Median annual litigation expense was $3.5M, but it is important to note that this sum excluded staff costs.  To be sure, surveys of this enormous market with differing budget data points and nomenclature cannot capture the many millions of dollars in litigation expenditures by public client law firms retained by PSE.  These litigation expenditures may either conform to traditional fee arrangements, or increasingly common alternative fee structures such as modified contingencies or hybrid hourly rate/recovery models. Given the sizable differences In PSE entities, and the varying affirmative litigation strategies across the US, no comprehensive data set or analytics currently exists to definitively measure case duration, settlement amount or damages profiles of cases.  However, certain data points confirm the upswing in scope and return on PSE affirmative litigation.  For example, the following settlements in the last 2 years provide context: 2018 – State of Minnesota settlement of PFAS environmental cases for $850 million.  Note, litigation by local governments regarding PFAS in that state is recently underway, and not impacted by this settlement. 2019 – Cuyahoga and Summit County, Ohio settlement of opioid claims for $260 million. 2019 – Several California counties settlement of lead paint abatement litigation for $305 million. 2018 – City of Chicago settlement with Uber and Lyft for over $10 million. 2020 – United Kingdom Revenue and Customs Department obtaining a very large share of a £22.5 million recovery on an insolvency claim, such claim which was financed by a litigation funder. Covid-19 economic dislocation and cost burdens associated with the public health response imposed severe budget impacts and revenue loss on PSE in 2020, and this impact will continue to unfold over the years to come.  Economic dislocation and related revenue decreases erode ability and capacity to pursue and sustain affirmative litigation.  Several policy organizations recently provided the following statistics to capture the amount of reduced PSE revenues, with such shortfalls constituting the biggest cash flow crunch since the Great Depression.  The National Association of Counties identified current budget shortfalls of $434 billion for states, $360 billion for municipalities, and $202 billion for counties.  The Brookings Institution estimates state and local revenues will be reduced 5% in 2020, 7.5% in 2021, and 8% in 2022.  With the prospect of divided federal government in 2021 and beyond, federal relief of this budget stress is unlikely. Aside from the economic reality of PSEs during and subsequent to the current pandemic, there are a lot of good practical reasons for PSEs to align themselves with litigation finance managers. Significant benefits exist for PSEs to partner with commercial litigation funders due to their perspective on the commercial aspects of a given case, which will be important for PSEs to ensure they are delivering value to their constituencies.  Funders also represent a ‘second set of eyes’ to determine the commercial prospects of a case (merits, collection, counsel insight, judiciary insight, counsel recommendations, case strategy, etc.), the probability of winning a case and the likely costs and timing associated with its pursuit. The other perspective for PSEs to consider is using litigation finance as a financial hedge against other actions where they may be listed as the defendant.  If the PSE does not actively consider plaintiff side claims, they are missing an opportunity and exposing their constituents to downside risk associated with defense side litigation without benefiting from the upside inherent in plaintiff side litigation.  However, the PSE doesn’t have to assume this risk alone.  Instead, PSEs should consider partnering with litigation financiers to share the risk associated with plaintiff side litigation. Implementing Legal Finance for PSE With budget and resource scarcity juxtaposed alongside policy consensus in many PSE jurisdictions supporting affirmative litigation strategies, PSE could benefit from an infusion of investment capital to ensure public access to the courts and a level litigation playing field.  The complex cases being maintained by PSE, such as opioid claims, public nuisance claims regarding alleged environmental harms, or whistleblower actions, often require a sustained and intensive budget and legal resource commitment.  This commitment is required regardless of whether these cases utilize outside counsel, staffing a case(s) with additional government lawyers, or some combination of the two.  Given shrinking state and local budgets and the growing list of potential big-ticket claims, legal finance in the public sector could offer budget flexibility to public servants, just as it offers flexibility to private sector businesses.  Financing could permit governments to exercise a newfound ability to fund strong, effective legal counsel.  In the alternative, governments could fund operations if they have the capacity to prosecute litigation with internal legal staff.   By law, PSE budgets must be balanced every year, during a time where revenue shortfalls typically reflect 10-30% downturns.  Thus, PSE have a statutory mandate to address budget and policy allocations in a very tight time frame.  This creative new optionality could address and overcome budget and operational pressures resulting from these severe revenue shortfalls. Legal finance could address the asymmetrical funding gap between PSE and corporate defendants.  Irrespective of the merits of their defenses, many corporate entities in high stakes PSE affirmative litigation have the means, the money, and the motivation to hire the best legal talent money can buy to wear down their opponents.  Returning to the inherent optionality of legal finance, a PSE is in a new position to get exactly the law firm it wants, not just the law firm that can take a matter on contingency.  With a financing option in place, a specialist law firm that may have a long-standing relationship with a PSE could in fact offer better value, dedication and results than a volume dependent, contingent fee practicing law firm.  However, as is the case in the private sector legal market, this does not necessarily present a downside risk for law firms.  The law firms with a public client practice, with possibly a burgeoning desire to expand their contingent fee practices, can benefit from financing which supports firm liquidity and client retention goals.  Instances of avoided or deferred litigation would be reduced if a PSE felt it had access to new financial tools to undertake litigation. While this discussion focuses only upon legal finance as applied to the affirmative litigation environment, this author believes there is a significant potential for legal finance in a defense context as well. So how might legal finance work in the new PSE market? The competitive landscape in the litigation financing market is siloed, and concentrated in the plaintiff/consumer or private sector commercial litigation worlds.  PSE can benefit from funders that are conversant with the public sector, informed by subject matter expertise and a national network. Tapping into this niche requires relational and subject matter expertise to understand, approach, negotiate, and close deals in the public sector entity market. While the existence of a funder’s direct contract with an entity is likely disclosable under relevant government Freedom of Information Act laws, this may not necessarily constitute a market negative outcome for the legal funder that already understands such an outcome going into prospective deals.  First, the contents of the litigation funding agreement should be exempt from full disclosure pursuant to applicable statutory exceptions exempting production of confidential, proprietary, or trade secret information.  Second, an agreement between a funder and a law firm representing a PSE (not the PSE itself) should be exempt from production as it is privileged, and also not a public record.  Third, it may actually be a net positive outcome, because if a defendant knows a public entity cannot be outspent, or that it will succumb to financial pressure exerted by a free-spending defendant, a more open and positive case settlement dialogue may occur sooner rather than later.  This author understands from first-hand experience over numerous 7 and 8-figure litigations in his career, that defendants bank on “outspending” and “burying” public sector entities with litigation costs. Quicker, fairer settlement outcomes can relate back to what the Federal Rule of Civil Procedure 1 states, that there is a goal of the “just, speedy and inexpensive resolution of every proceeding”. Fed. R. Civ. P 1. Legal financing will interject a new component into media coverage of PSE litigation. Newly conferred budget and operational flexibility is an attractive counterpoint to the standard narrative of reciting how public entity funds are being depleted during litigation.  This type of budget flexibility promotes organizational stability for elected officials, chief financial officers, and the legal team. There could also be more dollars potentially available in a recovery that could be directed to the public good.  Depending on deal terms and the waterfall, there may be more flexibility in litigation resolution returns, meaning, more dollars returned to taxpayers, as opposed to the recoveries obtained under the traditional contingent fee model.  On any deal involving legal financing, there may be concern over the amount of returns recovered by a funder on a successful outcome.  Funders should be mindful and respectful of the intrinsic nature of operating in this space, and simply put, not seek too much.  Also, some jurisdictions, like the state of Ohio, have statutorily mandated fee schedules with a hard cap on recoveries paid to non-governmental entities.  Of course, the PSE needs to be mindful that this is an investment that requires a return that cannot be measured off of the outcome of a single investment, but rather must be viewed in the context of the funder’s portfolio (including write-offs included therein). PSE Legal Finance and the Public Interest Several concerns and arguments against legal finance for PSE exist, which closely resemble arguments interposed against contingent fee lawyers and law firms maintaining public sector affirmative litigation.  Many of these arguments are discussed at great length in law review articles and legal symposia.  As such, thoughtful consideration of those points far exceeds this forum. At top of mind, however, is the contention that legal finance may deprive elected officials of their constitutional and statutory power to control public expenditure, or that legal finance processes may be non-transparent.  However, as local democratic citizen participation on budget matters makes clear, and which is repeatedly expressed in “Zoom” or in-person Council/Board meetings, those objections may run into trouble in the public forum.  The vast majority of law firm retentions must and do comply with applicable public sector procurement regulations, which typically implicate public bidding or a lengthy Request for Proposal (“RFP”) process.  In the end, this review and approval process regarding expenditure of public funds is usually publicly approved by the governing body, and requires the passage of some time.  In some states and localities, legal financing arrangements between a funder, and a PSE as a counterparty, will likely be subject to an RFP or bidding process.  However, in cases where a funder and the law firm are the counterparty, public bidding and review may not occur, as the transaction remains by and between those two entities.  RFP and bid responses typically remain confidential as proprietary business information, with the caveat that some public entities may publish a proposer’s winning bid/response as a policy custom or statutory practice. And, in some states and localities, legal finance may never be utilized as it might be disallowed under the same laws that prohibit contingent fee law firm public client work.  All told, the opportunity costs implicated by the different characteristics of the PSE marketplace can be fairly weighed against the market size and opportunity. It is asserted that legal finance could promote the de-evolution and ceding of prosecutorial authority to funders.  Yet it is hard to imagine an ethically rigorous funder who assumes the obligations of operating in the public environment, with documents maintaining any say in legal strategy or case control.  PSE contracts with affirmative litigation firms and applicable procurement statutes typically state in black letter law that PSE maintain strategic primacy, and retain full and final settlement authority in litigation.  Legal finance is complementary to, not a driver of, PSE affirmative litigation.  Other objections stating that legal finance is a clumsy way to resolve questions that should be the sole province of legislatures or city councils, do not necessarily focus an objection upon PSE legal finance, but rather a more comprehensive objection to affirmative litigation itself. ESG / Impact Investing Opportunities in PSE Legal Finance A corollary consideration relevant to the possible upswing in PSE legal finance is the intersection it may have with impact investing, or Environmental, Social, or Corporate Governance (“ESG”) investing. The uncorrelated nature of legal finance coupled with the ongoing emphasis for certain institutional investors to make sustainable investments, will likely open up the market for PSE legal finance.  Investors can broaden their portfolios and their allocation strategies into this “niche of a niche”.  PSE financing advances a central thesis of all litigation, the aspiration to see the rule of law upheld.  This aspiration is a shared goal of all citizens, regardless of partisan or political persuasion. One specific litigation area that will continue to fall into the impact investing orbit is the PFAS/PFOS water contamination cases filed across the US and the world.  This subject matter garnered new attention following the fall 2019 release of the motion picture, “Dark Waters”.  The existence and toxicity of PFAS “forever chemicals” in drinking water in the state of Minnesota triggered the settlement of state claims against 3M for $850 million in 2018.  In the months since, other states such as New Jersey, New Hampshire, North Carolina, Michigan, and Ohio, have filed suits which may potentially result in recoveries running into the billions of dollars.  Litigation funders and their investors are bound to take a close look at these cases, and those to be filed in the years to come, through the prism of ESG allocations and their potentially attractive return profiles. Conclusion PSE are in the forefront of addressing and resolving policy and litigation issues in the US.  Legal funders, prospective litigants, and law firms will likely work together to unlock this previously unrealized PSE legal market.  Investors looking for a compelling new alternative investing strategy can expect to pay attention to this niche in the years to come. Investor Insights The PSE sector is a vast segment of every country’s economy and litigation funders should be aware that significant opportunities may exist in the public sector given the sheer size of these organizations and the claims they may attract.  While PSE motivations may be different than commercial entities, PSEs should understand that commerce lies at the core of litigation finance and that investors need returns commensurate with the risk they assume to ensure the long-term viability of the asset class. Disclosure and RFP processes may be problematic in the context of litigation finance given the nature of the financing, and so this issue needs to be dealt with early on in the process.  PSEs should think about litigation funders not just as sources of capital, but trusted advisors that can add value above and beyond the capital they may provide.  For litigation funders, PSE claims would likely qualify as ESG investing activities, given the social benefits that are derived from these activities.  Edward Truant is the founder of Slingshot Capital Inc., and an investor in the litigation finance industry (consumer and commercial).  Ed is currently designing a new fund focused on institutional investors who are seeking to make allocations to the commercial litigation finance asset class.  Grant Farrar is the founder and managing director of Arran Capital Incorporated, which is currently raising capital to create the first fund specifically dedicated to investing in the PSE sector.