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
- 3 Phases of Risk:
- De-Risking
- Optimum Resolution
- Re-Risking
- Optimum risk-adjusted zone is when information is maximized and trial has yet to begin
- Once a trial begins, outcomes become binary in the absence of a settlement
- Diversification is critical to investing in the litigation finance sector
Investor Insights
- In assessing portfolio performance, it’s crucial to determine the extent of trial outcomes
- Assess settlement performance in the context of industry settlement rates
- Generally, a high percentage of cases are settled
- Certain case types have lower settlement rates, so there is not a ‘one size fits all’ approach to analyzing portfolio performance
I was speaking recently with a local litigation finance manager about the value of a piece of litigation in the context of litigation finance. As I thought more about the discussion and the implications for settlements and maximizing outcomes, I felt compelled to relay the thoughts in an article for other industry participants to consider and argue. Keep in mind that this is a simplistic view of a piece of litigation, as most litigation has layers of complexity that influence valuation, not to mention precedents in other jurisdictions.
Value
The intrinsic value of a piece of litigation is made up of a number of components that lawyers, plaintiffs and litigation finance managers assess as they underwrite their investment decision, which typically consist of the following:
| merits of the case | defense counsel effectiveness |
| collectability of damages | defendant’s conduct re: previous litigation |
| quantum of damages | plaintiff counsel effectiveness |
| justice considerations (judiciary and jurisdiction) | |
For the purposes of this article, we will mainly reference early stage, pre-settlement cases.
Editor’s note– the following contribution appears with illustrative graphs and charts here.
Value is not a static concept in litigation. Nevertheless, litigation fund managers have to determine approximate value; or a value range at the very early stages of a case when there is a relatively high degree of uncertainty, relatively few facts and little to nothing in terms of judicial proceedings. In the context of litigation, value varies with time (while time may add value in the short term by virtue of contributing to the amount of information that can be gathered on the case, the longer a case drags on past the point where maximum information is available, the less valuable time becomes due to the time value of money). Value also varies proportionately – or perhaps disproportionately – with risk, which is in turn influenced by information. That is to say, unknown data may come to light that becomes beneficial or harmful to the merits of your case and may influence its outcome and/or quantum. As an example, the ‘certification’ process of a class action in certain jurisdictions has a meaningful impact on whether the class proceeds with the action, and ultimately is a strong determinant of success, typically through settlement.
Of course, in all jurisdictions, another major contributing factor is access to capital so plaintiffs can finance the pursuit of their meritorious claims to the point of collection of damages – enter litigation finance. We will assume for the remainder of this article that all cases have the appropriate amount of financing.
As discussed, the value of a case is determined by two factors: risk and time. All cases start where risk is at a maximum, as there is relatively little information known about the case and hence a great degree of uncertainty about its outcome. As plaintiff and counsel build their case and proceed through discovery, the case generally becomes ‘de-risked’ as the plaintiff team grows more comfortable about the merits of their case and the quantum of damages. As we move through the case, we enter the zone of ‘optimum resolution’. However, ‘optimum resolution’ is not necessarily a value maximizing concept, but rather a concept of risk-adjusted value maximization. The risk-adjusted aspect stems from the fact that both sides have about equal information concerning the dispute, and are now able to make a rational decision as to the possible outcomes and damage quantification. At the point where the process moves past the Optimum Resolution phase, the parties enter into a new phase of risk which is reflective of the binary risk nature of litigation, whereby the outcome is determined by a third party judiciary.
As the plaintiff gathers more information regarding his or her case, the case generally increases in value as risk diminishes. However, at the point where a judicial process commences (and assuming a settlement doesn’t occur between the start of the process and the decision), the investment bifurcates into two potential outcomes on the assumption that there is no resolution after the start of the trial – generally, either a win or a loss outcome. In certain jurisdictions where they have “adverse costs” or “loser pays” rules, the plaintiff will have to pay the defense costs, and so there is a real financial cost in addition to the lost opportunity associated with a positive outcome.
Implications
The purpose of this analysis is to focus the plaintiff on the fact that on a risk-adjusted basis, the zone of Optimum Resolution is the most advantageous point in the litigation process to resolve the case, as it reflects the point of most knowledge and least risk. This is the point in time to cast aside all emotional elements of the case and the impact of damages incurred, and focus on a realistic outcome that can be achieved through negotiation and settlement, regardless of whether it makes the plaintiff “whole” or not. Of course, as the old saying goes, “it takes two to tango”, and so, if the defense is not of the same opinion, or their analysis is skewed, they may have a very different perspective on the appropriate settlement amount. In the case of insurance companies as defendants in cases, they may have other considerations such as statutory reserve requirements or corporate strategic reasons to delay as long as possible (time value of money and the impact on their insurance reserves and investment returns). Nevertheless, the concept applies to both defense and plaintiff, which is the reason for high settlement rates in most litigation in all jurisdictions.
From an investor’s perspective, there should be a recognition that as each case in their portfolio extends beyond the zone of Optimum Resolution, the risk to their portfolio increases. Accordingly, if you are an institutional investor buying a secondary pool of litigation finance assets, you want to be sure you are not buying a series of old cases where the binary risk is high and you are not getting an appropriate discount to assume the risk. Of course, there are always exceptions to this rule. The reason a case has extended for a long period of time may be because the plaintiff has had successive wins at various levels of judiciary and the risk has started to shift away from binary litigation risk toward collection and enforcement risk (Burford’s investment in the ‘Petersen claim’ is a prime example of this phenomenon).
Needless to say, litigation is not a formulaic science, and because of the large degree of human interaction and case complexity, it will be relegated into the “arts” category for the time being. Perhaps artificial intelligence can add a scientific element to determining value and litigation outcomes, but until the vast knowledge of settlement data becomes publicly available, the industry will depend on ‘gut instinct’ and litigation experience in making its decisions. From an investment perspective, the important point is that diversification is critical to capture the upside inherent in the asset class, while minimizing the downside inherent in the inevitable losses that will be experienced.
Important Considerations
Other important factors to consider are the use of contingent fee arrangements and litigation finance, and the impact those characteristics have on the ultimate value of a piece of litigation. Some in the litigation finance community will argue that they will only consider providing financing to cases where the lawyer is providing their services on a 100% contingent basis (there could be jurisdiction specific constraints to the use of contingent fee arrangements), as this fosters alignment between plaintiff and lawyer to maximize the value of the claim. Certainly, the alignment argument makes intuitive sense. However, not every funder is convinced of this fact, and unfortunately, there is not a broad set of data that is definitive in this regard. Accordingly, until the data determines there is a strong correlation between contingent fee arrangements and outcomes, it remains to be seen. On one of the panels at the September 2019 LF Dealmakers conference, a litigation funder stated that the company’s empirical data suggests there is no correlation, and hence contingency fee arrangements are not a significant feature to their underwriting process. Yet it’s worth pointing out that many funders feel strongly that the alignment argument is a good one, so they refuse to invest in a case without at least some level of legal counsel fee contingency.
Then there is the existence and use of litigation funding itself. One could argue that the very existence of a plaintiff’s use of a litigation funder to pursue its case will shift the balance of power and ‘level the playing field’ between the plaintiff and the defendant, especially in a David v. Goliath situation where the defendant is ‘deep pocketed’ and the plaintiff relatively impecunious. As an investor in the industry, not only do I subscribe to the theory, I have seen the results. While many would suggest it is difficult to parse the effect of litigation funding from the effect of good legal representation and a meritorious claim, I look at the results of relatively small financings and I can see a correlation between success and short duration, which I, in large part, ascribe to the existence of litigation finance.
Investor Insights:
As a consequence of the above, when I review track records for fund managers one of the metrics I look at is how often the realized outcomes are dependent on a judicial decision (bench, trial or arbitral) as compared to an outcome determined through settlement. Overall, the data concerning litigation outcomes illustrates that a high percentage of cases (90%+) are settled prior to a judicial decision and so we need to view the results in the context of industry settlement rates. Generally speaking, and depending on the case type and jurisdiction, I have a strong preference for fund managers that have a disproportionate number of settlements in their realized portfolios as opposed to outcomes that were derived from a judicial decision, given the binary nature of those outcomes. In certain jurisdictions, litigation funders are able to have some influence on the settlement discussions which may tend to favour higher settlement rates, so this issue and my approach to it is not identical in every jurisdiction. Another influencing factor on settlement rates is case types and case sizes. Generally speaking, I have noticed that outcomes dependent on judicial/arbitral decisions are correlated with larger cases and certain case types (as an example, International Arbitration cases would be one area where settlement is less likely and hence arbitral outcomes more prevalent).
Edward Truant is the founder of Slingshot Capital Inc., and an investor in the consumer and commercial litigation finance industry.
