Litigation Finance, Litigators, Money, Wall Street

Contingent Value Rights Offer A Model for Litigation Finance

As litigation finance continues to evolve, new models of valuation will be required in order to help expand the market.

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money question mark value valuationFor an industry that is growing rapidly and attracting a lot of smart people, the litigation finance field is still missing one crucial element – consensus about valuation techniques among participants. While other investments from stocks and bonds to options and CDS all have clear methods of valuation, litigation finance does not.

As the litigation finance industry continues to evolve, new models of valuation will be required in order to help expand the market. At this stage the industry faces two related problems: (1) limited demand for litigation finance investments among major asset managers, and (2) limited willingness by many attorneys and plaintiffs to sell the most lucrative case rights. There are other structural problems in the market, of course, but they are probably not as severe as the demand and supply constraints mentioned previously.

Both of these two problems can be partially solved through effective empirical asset valuation methods. The problem with such quantitative methods is that there is a lack of widespread agreement about the right method to use. Contingent value rights may help ease these worries by providing a template that is useful for investors in the litigation funding space.

Contingent value rights (CVR) are derivative securities whose value is tied to a future outcome. They started in the pharmaceutical space, but have spread well beyond that today.

Consider the following: a drug company has a promising new drug that it is in the process of developing. The drug company does not want to take on all of the risks associated with developing that drug and waiting for FDA approval on its own. Instead it would like to spread that risk out among various investors. Contingent value rights can let the firm do that. Those CVRs can be sold to investors as a security that will pay the investors certain dividends if the drug hits certain milestones. For instance, if the drug is approved by the FDA, CVR holders might be entitled to a $1 per CVR dividend. Then if the drug hits $1 billion in annual sales, perhaps the CVR pays another $2 dividend. If the drug hits $5 billion in annual sales, a third $5 per CVR dividend might be guaranteed.

The precise structure of the CVR varies based on the specific circumstances, but it is easy to see the analogy with lawsuits. Like large lawsuits, the outcome from drug trials and the eventual payoff is uncertain. Investors and companies can use CVRs and similar digital options to hedge particular risks or participate in a broad pool of investments.

Perhaps the most well-known large pool of CVRs came from the Sanofi/Genzyme merger a few years ago – in that case, the CVR payouts were worth an estimated $3.8 billion. The size of that payout caused Sanofi to allegedly look to chisel investors of their rights, according to a lawsuit; this of course reflects the same type of contractual and moral-hazard risks that one sees in litigation funding. In that sense, CVRs parallel both the good and bad of litigation funding.

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CVRs are not well known, nor are they a large asset class. But they are a tradeable security with a reasonable secondary market. Moreover, the methods for valuing CVRs and other digital options are well understood and agreed upon by economists. All of this would be a major step forward for the litigation funding market, which is still struggling to move beyond simply being an illiquid niche asset class. A broadening and deepening of the litigation funding market would benefit both investors and “issues” alike, just as it has benefited corporations that use CVRs today.

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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