The following post was contributed by Guido Demarco, Director & Head of Legal Assets of Stonward.
In March 2021, the European Parliamentary Research Service published a study on Responsible Private Funding of Litigation. This study was later supplemented by a draft report prepared by the European Parliament’s Committee on Legal Affairs in June 2021. Both documents, the study, and the draft report, contain certain recommendations to regulate litigation funding and criticize the economic costs that these funds impose on their clients by referring to them as “excessive”, “unfair” and “abusive”.
Specifically, on the issue of fees, the study suggests setting a 30% cap on funders’ rates of return, while the draft report recommends that LF agreements should be invalid if they foresee a benefit for the claimant equal to or less than 60% (unless exceptional circumstances apply). In other words, a cap of 40%.
While this might be viewed as a logical measure to make litigation finance more affordable, what needs to be considered is that the funders’ expected return is simply a consequence of the risks and costs that arise from litigation, not the other way round.
The costs
Let us take the case of a foreign national, ‘Citizen Kane,’ who makes an investment in the energy sector in Ruritania[1]. Let us imagine that a bilateral treaty between Mr. Kane’s country of nationality and Ruritania protects Citizen Kane’s investment. The Republic of Ruritania suddenly indirectly expropriates Mr. Kane’s business without due compensation. To claim damages, Mr. Kane will start an arbitration through the International Center for Settlement of Investment Disputes (ICSID). The total cost of the dispute will depend on the complexity and the duration of the case, including the number of pleadings, experts, hearings, and the time incurred by the attorneys. Only the first advance to ICSID can be circa $150,000.
If Citizen Kane estimates damages of $30 million, the costs of such a dispute could easily amount to $3 million or more. In investor-state arbitration, the mean costs for investors are about $6.4m and the median figure is $3.8m. The mean tribunal costs in ICSID arbitrations is $958,000 and the median $745,000.[2]
Therefore, after years suffering arbitrary measures and pursuing fruitless disputes in local courts, Citizen Kane will now have to invest an additional circa $3 million to file a claim for damages with a completely uncertain outcome. Even if Citizen Kane wins, Ruritania may not be willing to follow the award voluntarily, and he will have to incur more expenses to enforce the judgment.
The risks
Aware of the prohibitive costs of litigation, Ruritania may play the long game, unnecessarily prolonging the dispute to financially drain the claimant while expecting a future administration will be in office to foot the bill down the road. This might be challenging even for a financially healthy company, as litigation costs are often considered an expense on the profit and loss statement and therefore CFOs are increasingly looking for alternatives to preserve working capital for the company’s main activity.
How long will the proceeding take? What will be the final amount of the damages awarded? Will the other party voluntarily follow the award? What if, in the end, I lose? These questions have no exact answers because the answers depend on third parties, including how a judge or tribunal interprets the law and the facts of case, as well as the performance of experts and lawyers in pursuing the claim.
The litigation budget and estimated damages will play a key role in the investment decision, together with the merits of the case, liquidity, and reputation of the respondent, as well as the reputation of the law firm chosen by the client. Analyzing the risk is not easy, considering the latest figures that show that investors prevail in only 47% of cases, and that the median amount of damages claimed vis a vis damages awarded is 36%.
However, the main factor in determining risk is the structure of non-recourse litigation finance loans. This is not just a typical loan, but a mechanism to transfer risk. It is normal that the greater the risk assumed by the funder, the higher the return expected.
Conclusion
Limiting a funder’s expected return will not reduce financing costs for clients, and therefore will fail to make litigation more affordable, which is the aim of the EU’s regulation proposal. Funders will not grant funding if they perceive the risk/reward of a case is not worth the given circumstances. However, a cap on the return could have a direct effect on the number of cases taken up by funders – which is already low – since there will be cases in which the combination of factors described above will not make the investment worthwhile, considering the risk tradeoff. Unfortunately, there is a cost floor shared by both large and small cases, and complex claims like Citizen Kane’s expropriation case would be made all the more challenging to finance. A cap could therefore limit Mr. Kane’s litigation options.
Should funders charge any profiteering fee? No, but a cap to the fees may not be the solution. In the end, the direct beneficiaries of the proposed regulation could end up being certain states such as Ruritania, which act as defendants in arbitration or judicial cases, rather than the individuals that the EU is attempting to protect. Ironically, states finance their legal firepower with taxes, the same taxes that Citizen Kane has paid for years to the Republic of Ruritania.
[1] Ruritania is a fictional country used as a setting for novels by Anthony Hope, such as The Prisoner of Zenda (1894). Jurists specialising in international law and private international law use Ruritania when describing a hypothetical case illustrating some legal point.
[2] 2021 Empirical Study: Costs, Damages and Duration in Investor-State Arbitration, British Institute of International and Comparative Law and Allen & Overy, available at: Costs, damages and duration in investor-state arbitration – Allen & Overy.
