Finance And Law: Litigation Finance ETFs
Exchange-traded funds could address litigation finance's problem of a limited investor base.
Two of the biggest trends in finance in the last decade are the shift from active to passive management and efforts across much of the finance industry to find ways to offer innovative investment products within the confines of the Investment Company Act of 1940 (40 Act). These trends have led to the rise of exchange-traded funds, or ETFs, and the shift by many major hedge funds to offering 40 Act-compliant vehicles in an effort to increase assets under management. Despite all of the innovation of the last decade, there are still multiple asset classes and investing themes that remain unavailable to most investors. Unfortunately, litigation finance is one of those limited opportunities.
Litigation finance vehicles are generally available only to qualified investors at this stage, and in practice, even that subset of groups is mostly limited to sophisticated institutions or well-connected individuals with a background in law. There are certainly some smaller litigation funding platforms out there that will let individuals directly invest in lawsuits, but these often have some significant limitations, including the limited ability to diversify across investments.
The limited investor base for litigation finance is a problem currently for both the nascent industry and for attorneys. In the same way that limited and restricted capital markets choke off growth in conventional industries, a limited litigation finance industry chokes off growth within the legal industry. Plenty of otherwise promising cases fall by the wayside because of funding issues and the risk of any single individual (or single investor) funding the suit. Likewise, investors in existing litigation funding vehicles are generally substantially hurt by the lack of a liquid secondary market.
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ETFs are one solution to the litigation financing issue that capitalizes on both of the trends discussed earlier. ETFs are becoming broader and more diverse as an asset class all the time. For instance, ETFs have traditionally been a passive investment vehicle, but in recent months, several asset management firms have begun offering actively traded ETF vehicles, such as Eaton Vance’s new NextShares product. Similarly, hedge funds have begun packaging previously unavailable investment strategies like managed futures into 40 Act-compliant vehicles. Real estate crowdfunding platform Fundrise is offering several direct commercial real estate ETFs. Against this backdrop, litigation-oriented ETFs are a clear opportunity in the market.
Certainly a litigation funding ETF would have to be very carefully structured to avoid problems with the 40 Act and with SEC compliance expectations. Based on work I have done with the SEC, it is clear that the compliance expectations around esoteric investment products are becoming stricter rather than more lax (a trend that should be welcomed by securities attorneys given the opportunity to add more value for clients). Nonetheless, a litigation finance ETF is feasible given other parallels in the market.
In some respects, the current situation in litigation funding is similar to the market for bank loans 30 years ago, before the rise of syndicated loans and the secondary market for those products. Today, senior bank loans are offered through ETF vehicles, there is a liquid secondary market including independent platforms that help buy and sell the instruments, and syndicated bank loans are one of the most commonly used financing tools among major corporations. Perhaps the future of litigation finance holds similar opportunity.
If you’re interested in discussing more about ETFs and how they could work with litigation finance, feel free to contact me at M.McDonald@MorningInvestmentsCT.com.
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Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.
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