May 2016 edition
The Insider: Litigation financing – Let’s make a deal!
It is a common refrain in legal departments all around the globe: How do we get enough money to do the things we need to do to protect the company? There are always more matters clamoring for money than there is money available. This is especially true with litigation. If your company is being sued, you have little choice other than to spend the money needed to defend your interests (unless you feel a quick settlement is a better call). If the company has meritorious claims, then it often faces the difficult choice of whether to spend the money needed to proceed. If not, valuable claims may be lost. If yes, then money that could be spent on other parts of the business is re-routed to legal fees – and, unfortunately, under accounting rules, money “invested” in a litigation claim is not treated the same as money invested in the business generally. To deal with this, in-house legal departments try a variety of measures to reduce legal expenses, from reduced hourly rates or fixed fees to contingency fees and blended rates or less expensive counsel.
Over the past four or five years, another potential solution has emerged. Depending on which side of the table you are sitting, the solution is either a blessing or the manifestation of supreme evil. The solution is called “litigation financing” and it is something every in-house counsel should be aware of and thinking about.
What is litigation financing?
In its most basic form, litigation financing means a third party agrees to finance your litigation (usually the plaintiff side, but it works for defense side as well) in exchange for a percentage of the recovery (settlement or posttrial) or some other agreed upon return on investment. The financing is usually “without recourse,” meaning that if you do not win your case, nothing is owed to the group financing the litigation; they take all the risk. This is very different from a contingency fee arrangement with a law firm. With litigation financing, your agreement is with a third party, not the law firm. Moreover, the financing can and does cover out-of-pocket costs in addition to legal fees, i.e., depositions, travel, expert witnesses, copies, etc.
The financing can occur at the beginning of the claim, in the middle, on appeal, etc. It can cover legal fees, legal fees and costs, just costs, or half a dozen or so other ways of financing the lawsuit or paying your company for the value of the suit.
How does litigation financing work?
There are a number of litigation financing companies (“LFCs”) operating in the U.S. (and elsewhere) today. These companies tend to manage a large pool of venture capital funding with the objective of investing in litigation. Like any investment company, a litigation financing venture uses a number of tools to analyze cases it may invest in. Some common aspects of due diligence include:
- The nature of the dispute (contract, tort, antitrust, etc.)
- Plaintiff or defendant (the plaintiff side is generally easier to fit in the litigation financing model)
- Where the case is pending (the court, judge, country, state and county – it does make a difference)
- The potential payout (usually focused not on the “face amount” of the claim, but rather the likely amount that can be won at settlement or from a jury)
- The merits (including key evidence such as emails, contracts, etc.)
- The budget (cost in terms of legal fees, experts, and other expenses)
- The likely timeline for the case to get resolved and money to change hands (including appeals)
- The lawyers representing both sides (experience, reputation, results)
- Ability to recover the monies awarded (e.g., Is the defendant good for the money? How easy will it be to get paid or find and attach assets if necessary?)
Many LFCs use a sophisticated statistical model to analyze the above and other factors. The companies then take all of the information and match it up against their risk profile and other parameters. The key is that this is not an educated guess about which cases to take, it is a heavily data-driven exercise. The companies are not looking for frivolous lawsuits, they want lawsuits with merit and high potential recoveries.
Assuming the LFC is satisfied that the case meets its investment parameters, then the parties sit down and negotiate a detailed litigation funding contract setting out the responsibilities and obligations of both sides along with the percentage of the recovery the financing company gets if there is a win. All of which means there is a lot of thought that goes into defining “winning.” How much of the recovery will go to the LFC vs. your company ultimately comes down to how much risk there is in the merits of the case, i.e., how solid is the chance of winning? The less favorable the odds, the higher the percentage of the recovery going to the LFC – the percentage return on investment is directly related to the risk of the investment.
How does it work for defending lawsuits?
It is easy to see how litigation financing works for the plaintiff side of the equation, but it’s harder to see how it works for a defendant. That said, it does work both ways. This is where litigation funding may have the most value to in-house counsel, because it is likely that defending expensive litigation is a bigger problem for companies than bringing litigation. One key to litigation financing of defense claims is the willingness of the company to pay a premium for success, but still generally paying less than cost of defense otherwise. Much like a law firm “success fee,” this means that if certain parameters are met, the LFC gets a larger return on its investment. If there is no success, then the risk – in terms of the cost of defending the lawsuit – is borne by the LFC. In exchange, the company gets relief from funding the cost of the litigation while it’s pending and, hopefully, a win at trial if it goes that far. Here are some ways where litigation financing can work in the defense context:
- Funding an entire claim – the LFC funds the entire defense cost in exchange for a multiplier or bonus in the event of a “successful” outcome (or hitting a certain level of “success”). Typically, this type of funding hinges on the analysis of “how weak is the claim against the company?” The success fee concept is usually based on a substantial discount upfront on legal fees, e.g., 25%-30% off standard rates. If the case is resolved at X, then the company pays the firm the amount held back. If the case is resolved at Y, then the company pays the firm the hold back plus a bonus/multiplier. This solves a problem with contingency fees whereby most law firms will not go below 70% off of their regular rates, and that may simply not be enough of a discount for the company to proceed. The LFC can step in and fund the entire cost of defense, covering the law firm’s risk (and the firm must still agree to a discount off its rates) as well as that of the company.
- Portfolio funding – the claim(s) for defense are part of a larger portfolio of claims that include claims as “plaintiff” so that the LFC’s risk is diversified across “good cases” and “bad cases.” This means companies need to think about litigation financing across multiple claims vs. just a “one off” claim.
- Reverse contingency fees – The financing company collects a fee that is a percentage of the difference between the amount a third party originally demands from a lawyer’s client and the amount that client must ultimately pay the third party, whether by settlement or judgment.
What are the pros and cons of litigation financing?
Like anything, there are good points and bad points that go with litigation funding. Taking the positive side first, here are several “pros” for litigation funding:
- The cost of the litigation becomes secondary. As noted, the cost of litigation is becoming more and more problematic for in-house legal departments. Litigation funding can reduce or eliminate this problem. Rather than having to pay out of current cash flows and impacting current budgets, the LFC pays the costs of the litigation and the company only pays when the litigation is over, either in terms of a share of the win or some type of success fee tied to defense of the claim. Any payments advanced by the LFC are typically “without recourse.” This means a relatively risk-free reduction or elimination of what is typically the largest and most unpredictable cost in a legal department budget – litigation.
- The CFO will love it. The added benefit of taking the cost of litigation off the company’s books is that the company’s earnings, cash flow, and other measures of financial success are not burdened or diminished by big, hard to predict legal fee payments. While a litigation claim is an “asset” of the company, just like any other receivable, it is not treated the same under the accounting rules. This means costs related to litigation are usually not capitalized, they are expensed – so they hit the bottom line as incurred. Moreover, the unpredictable nature of legal fees, especially in big litigation, can drive problems with earnings for publicly traded companies, as even a penny or two difference off expectations due to unexpectedly high legal fees can negatively impact stock price in a material way. Litigation financing can remove a lot of these problems, keeping legal fees off of the P&L until there is a positive event to report.
- Lawyers of choice. With litigation financing in place, your legal department has more flexibility with respect to choice of counsel as the cost/legal fees become a secondary issue. Your choice becomes more about which law firm you think is best for the case vs. which law firm can do the job within a certain budget. It also removes the battle over how “low” can the law firm go on fees and still be incentivized to work for you or do its best work on your matter. For example, if the fees you are negotiating create a huge incentive for the firm to utilize lower-priced associates, then you may not get the right level of experience for some parts of the project. Litigation financing can better align the interests of the company, the law firm, and the LFC.
- Getting paid. Any “win” is useless if you cannot collect the money owed from the defendant. It can be even more complicated if the other side is a foreign company located outside the U.S. or if you are in arbitration and need to locate assets in countries that accept arbitration awards. An LFC usually specializes in locating assets and collecting damages. This can be a huge benefit to your company in terms of actually getting paid on a judgment or settlement.
Here are some of the negative issues associated with litigation financing:
- Champerty. I remember this term from law school and never thought I’d ever get to write it in a sentence, but here we are talking about “champerty.” Champerty is an old common law doctrine from Medieval England barring third parties from stirring up litigation and financing other party’s claims. The concept actually goes back to the legal systems of the Greeks and Romans. The goal was/is to discourage frivolous litigation and to protect against harassment by wealthy backers of litigation. While the parameters have softened in the U.S. and UK, the doctrine still exists and, as you can imagine, litigation financing appears to fall squarely within the doctrine. Yet, a number of states have relaxed prohibitions on third-party litigation financing. The Delaware Superior Court recently issued a decision upholding third-party financing of claims and finding its laws against champerty did not apply to the facts of the case. Charge Injection Technologies, Inc. vs. E.I. DuPont, C.A. No. N07C-12-134-JRJ (Del. Super. Ct. March 9, 2016). The court found that there is no champerty if the following is true:
Regardless, it is important as part of your research into whether litigation financing makes sense for your company to understand any legal limits, such as champerty, that may exist in your jurisdiction and that the LFC agreement be properly drafted to overcome any obstacles.
- The financing agreement does not assign ownership of the claims to the financier;
- The financier does not have any rights to direct or control the litigation; and
- The plaintiff retains an unfettered right to settle the litigation at any time for any amount
- Attorney-client/work-product privilege. Any time privileged information is shared with a third-party, i.e., anyone other than the law firm and the client, there is a risk of waiver of the privilege. That risk certainly exists in the context of litigation funding where the LFC will want to get as much information as possible in order to evaluate your claim and set the “price” of the funding. The law in this is area is still very unsettled. In the Carlyle Investment Management L.L.C. v. Moonmouth Company S.A., No. 7841-VCP, February 24, 2015, the Delaware Court of Chancery held that communications between a claimant and the LFC, and the claimant’s attorneys and the LFC are protected by the work-product doctrine. Regardless, since the law is unsettled in this area, it is wise to take precautions with respect to any information you seek to share with the LFC, such as:
- Provide documents that are not privileged (e.g., pleadings);
- Provide what you expect to turn over to the other side through the discovery process; and
- Weigh risk of disclosure against the need for funding and provide privileged documents understanding the risks
- Legal ethics. Under the rules of legal ethics in the U.S. and the UK, your outside counsel owes a duty of loyalty and independence to you, the client. The funding relationship cannot interfere with that duty, and this must be crystal clear upfront with your LFC. In fact, as noted in the Charge Injection Technologies case above, such a level of independence is necessary to prevent a successful claim of champerty. Three key points here:
While you should retain all of these key rights in managing your litigation, don’t be surprised if the economic terms of the financing agreement encourage certain behaviors and decisions, i.e., if you terminate counsel, the LFC may retain the right to back out of the case, or if you settle for less than $X amount, the LFC gets a certain payment, etc.
- You must retain the right to hire and fire counsel;
- You retain sole right to decide whether or not to settle and for what amount; and
- You and your counsel direct litigation strategy and decisions; the LFC is completely passive
What are my next steps?
You may be thinking that litigation financing sounds a little “sketchy” and not something you would necessarily be involved in. My thought is that every in-house counsel needs to investigate the issue further. The industry exceeds $1 billion and is growing rapidly. National firms like Bartlit Beck, Kirkland & Ellis, and Sidley Austin are already working with LFCs. If you have any material litigation spend (plaintiff or defense) or otherwise pass on (or not see through to completion) valuable claims because they are too expensive to prosecute, you owe it to your company to make an informed decision as to whether litigation financing makes sense or not. At a minimum, you should involve your CFO/finance team in the review as some of the most positive impacts come on the accounting/budget side of the equation, including preservation of/other uses for the company’s capital. On the other hand, if you (or C-suite or board) are absolutely opposed to the concept and feel that your company’s interests are harmed by the availability of such financing, then you should know that there are efforts underway in Congress to investigate the industry and potentially pass litigation regulating litigation financing. See August 27, 2015 Wall Street Journal. You may wish to encourage Congress or state governments to act.
Like it or not, it appears that litigation financing is here to stay and is only going to become more prevalent. As in-house counsel, you need to be up to speed on this issue and be able to provide guidance to the company and the senior management about whether it is something the company should explore further. There is a lot of information online, including an in-depth review of litigation financing in the December 2015 issue of American Lawyer. The websites of the large financing companies (some of the largest are Gerchen Keller Capital, Burford Capital, Harbour Litigation Funding (UK), and Vinson Litigation Finance) also contain additional information that will assist you as you look into this.
About the author
Sterling Miller spent over twenty years as in-house counsel, including being general counsel for Sabre Corporation and Travelocity.com. He currently serves as Senior Counsel for Hilgers Graben PLLC focusing on litigation, data privacy, compliance, and consulting with in-house Legal Departments. You can follow his blog “Ten Things You Need to Know as In-House Counsel” at www.TenThings.net and follow him on Twitter @10ThingsLegal. His first book, The Evolution of Professional Football, was published in December 2015 and is available on Amazon and at www.SterlingMillerBooks.com.