Le Moal Olivier
Much of the commentary about litigation focuses on its growth—and it has indeed grown. More interesting than where litigation finance has come from, however, is where it is going. That ongoing evolution reflects many of the persistent pressure points and perennial conflicts in the business of law. What’s ahead for litigation finance—and what does that mean for litigation teams and law firms—in the years to come?
1. GCs will use litigation finance to solve the litigation budget oxymoron
It’s been said that litigation budgets are an oxymoron. Even accounting for dramatic overstatement, this observation reflects a simple, seemingly unavoidable truth: Complex commercial litigation defies the conventional corporate budgeting ethos. The CEO and CFO want quarterly precision and carefully managed outcomes, but the GC—unable to forecast opponent tactics and activity levels, and hard-pressed to predict judicial pace and intensity—dwells in a world of uncertainty. And law firms are no more capable than their clients of reliably predicting how long litigation will take, or how much it will cost; too much depends on the opponent, the court and the idiosyncratic variables present in each unique case.
The problem today is that neither clients nor law firms want to take on the other’s risk. Clients are increasingly seeking economic certainty from law firms, and law firms are increasingly unwilling both to cut costs and also to provide that desired certainty.
Litigation finance can address that dilemma for both clients and firms. By using external capital, GCs can solve the problem they face caused by the inherent unpredictability in litigation spending. In the years to come, litigation finance will increasingly be used in this way, as corporate finance for law or “leasing for litigation”— models with which the business world is already very familiar.
With litigation finance, a capital provider advances funds to cover the cost of commercial litigation or arbitration. Capital is typically provided on a non-recourse basis, meaning that there is no obligation to repay the investor if the underlying litigation is unsuccessful, and often across a pool of cases (including mixed plaintiff and defense cases). In exchange for that, the investor is entitled to a portion of the monies generated if the litigation is successful. And this means that GCs can budget with confidence.
In the years to come, GCs will continue to proactively embrace litigation finance as a go-to tool to manage risk and cost, and to remove the uncertainty of the litigation budget process. Doing so will alleviate one of the perennial headaches faced by corporate legal teams.
2. Portfolio financing will help legal teams move costs off balance sheets—including defense matters—and improve accounting outcomes
Finance provided on a portfolio basis—which follows the model of single-case litigation finance but with financing collateralised by a pool of multiple matters—is already growing, and will continue to do so as legal teams increasingly embrace it as a tool to move legal costs off balance sheets and address perennial C-suite complaints about litigation spending.
A case study exemplifies this trend. A large multinational traditionally paid for litigation out-of-pocket—and suffered negative accounting consequences as a result. Without financing, litigation was impairing its financial performance because of accounting rules regarding treatment of litigation expenses and awards. Legal expenses paid by the company were immediately recorded as expenses, thus reducing its earnings. Exacerbating the situation, litigation recoveries were recorded “below the line” as non-recurring or extraordinary items. That was problematic for the large multinational—as it is for many businesses, particularly for EBITDA-based businesses. The accounting result of a successful claim may result in a permanent reduction in EBITDA, because legal expenses reduce EBITDA but recoveries do not increase it. By self-financing its litigation, the multinational company was reducing its operating profits, and hence sought a solution that would help take legal costs off its balance sheet.
Litigation finance provided that solution in the form of a $45 million financing arrangement backed by a portfolio of pending litigation matters. This transformed how the multinational subsequently managed litigation expense and provided multiple corporate benefits. Not only did the company have the flexibility to use third-party capital either to relieve legal expense budget pressure or for corporate purposes unrelated to the litigation matters, but because the capital was provided on a non-recourse basis, the multinational was entitled to book it as income received, without waiting for the result of the underlying litigation matters.
As this case study suggests, the portfolio approach to litigation finance offers corporate clients many advantages. One of these advantages is a lower cost of capital: Because risk is diversified across multiple claims, financing is less expensive. In addition, portfolio financing is inherently flexible: Capital can be used to finance matters within the portfolio or for broader business purposes.
Even more importantly, portfolios provide a ready tool to finance defense as well as plaintiff matters. That’s significant because managing defense costs is often even more problematic for GCs than managing claimant case costs. When companies are defendants, litigation finance can enable alternative fee arrangements that are even more flexible than what most defense-oriented law firms can or will provide.
Taking that approach to financing on a portfolio basis can enable companies to reinvent their legal departments and budgets, transforming the impact of meritorious litigation from revenue-destroying to profit-enhancing—and that is an area that will undoubtedly drive increased innovation and pickup of litigation finance in the years ahead.
3. Law firms will use litigation finance to change the subject from alternative fees and discounts
Even a decade after the recession, law remains a buyers’ market, and “alternative fee arrangements” have become the norm—whether that means discounted fees, fixed fees, capped fees or the deferral of fees until and contingent on success. According to the Georgetown Law Centre for the Study of the Legal Profession 2017 Report on the State of the Legal Market, alternative fee arrangements combined with budget-based pricing “may well account for 80 or 90 percent of all revenues” at many firms.
As the head of global disputes for an AmLaw 50 firm commented in the 2016 Litigation Finance Survey, “The legal departments are under pressure. The firms are under pressure... Anything that can relieve that tension is a good thing. Litigation finance… takes the law firm out of the firing line.”
It’s understandable then why law firms should welcome this shift. Law firms are understandably exhausted by unrelenting pressure to defer payment, discount fees, or arguably worse, engage in race-to-the-bottom competitive bids. And because of their cash partnership structure, even contingent fee firms lack the structure to assume an unlimited amount of client risk. They need a way to bridge that gap and “take the law firm out of the firing line.”
For law firm clients, too, alternative fee arrangements can lead to unintended consequences. For example, if a lawyer is good enough to have continued demand for his or her services, pushing compensation levels below the market will result either in that lawyer not wanting the client’s work, or cutting corners performing it. It’s great to be ferocious when it comes to law firm negotiations, but it is generally short sighted if it costs the result in the case. For commodity legal work it might be fine, but not when confronted with more idiosyncratic, business-critical litigation.
Litigation finance can give firms a better way of keeping the focus on providing clients with top tier service. That may mean talking to a client about third-party financing options for a particular piece of high-stakes litigation, or seeking portfolio financing for the firm that will then benefit the client.
Another case study illustrates this point. A leading law firm wanted to expand its litigation practice, offer more aggressive alternative fees to clients and receive the additional upside for taking risk, but could not take additional alternative fee risk onto its balance sheet. A $50 million going-forward portfolio was created to address this challenge. The portfolio was designed to finance five or more potential matters that would be placed into the portfolio as new case opportunities arose. The assurance of having financing available for future matters gave the firm a competitive advantage over other top firms offering alternative fee options and ensured the firm would not have to turn down a strong case or new client simply because the firm could not absorb additional risk. As a result of this flexible portfolio arrangement, the firm was able to expand its practice and increase its opportunity to earn highly profitable success fees, while limiting its exposure to a loss of its time and out-of-pocket cash investment.
4. Litigation finance will be used in more contexts—from M&A to PE to bankruptcy
Corporate litigation teams and law firms will remain the dominant users of litigation finance, but in the years to come, it will increasingly be used in broader business contexts. Arguably, “litigation finance” is evolving as “legal finance”, and “funders” are more like investment banks for law. For example, finance can be used to de-risk or monetise more traditionally “corporate” legal activity, such as tax disputes and M&A. On the simplest level, law firms that work on a “success fee” basis can share some of that risk with an outside finance provider. Stakeholders in M&A can also remove legal risk from the deal itself to advance discussion, or monetize a legal asset to enhance value.
Litigation as an asset
Private equity firms can also use litigation finance to optimize the value of their deals. When private equity firms analyse prospective deals, they consider everything from the industry and the senior management team to the company’s recent and projected financial performance. During what is otherwise an exhaustive diligence process, however, one of the most significant assets of the business is largely overlooked: Litigation. By writing off a company’s pending legal claims as nothing more than a costly, time-consuming liability, private equity firms risk missing out on a potentially valuable asset. However, a growing number of private equity firms are working with legal finance specialists to unlock legal asset value.
Finally, litigation finance will certainly grow in the bankruptcy space. Often, litigation claims are among the most valuable assets held by bankruptcy estates, but trustees face significant obstacles to leverage these illiquid assets. Recently, the bankruptcy trustee for MagCorp demonstrated just how useful litigation finance can be in this context. After a 13-year legal battle against its former holding company yielded a $213 million judgment in its favor, MagCorp was running low on funds needed to see an appeal by the defendant through to its conclusion—and of course faced the possibility of a reversal. In seeking a solution to cash flow issues and in an effort to secure a minimum guarantee to creditors, MagCorp’s trustee and its attorney arranged the unprecedented sale at public auction of an interest in the right to receive litigation recoveries from the judgment on appeal. The $26.2 million sale to a third party enabled the estate to liquidate a portion of a contingent asset, hedge against appellate risk and guarantee a minimum recovery to MagCorp’s creditors. As MagCorp’s attorney noted, “Bankruptcy is ideally suited to capitalize on the benefits that can be provided by litigation finance.”
Christopher Bogart is CEO of Burford Capital, a global finance firm focused on law and the provider of litigation finance.