Litigation Finance, Litigators, Money

Variety Fuels Billion-Dollar Litigation Finance Funds Of Tomorrow

Litigation funding is an unsettled environment, and there's plenty of room for innovation and new ideas.

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gavel money law finance litigation financeInvestment structures in many areas of finance are pretty standardized at this stage. Companies raising capital can generally go into a fundraising round looking for equity or debt and have a good sense for what the structure of a funding arrangement will entail. Litigation finance has far less consistency and certainty around it, and that’s what makes it so interesting.

Much like any other area of finance, funding needs in litigation can take many different forms; some participants are looking for single-case funding, others might seek portfolio funding, disbursements funding, or enforcement funding.

The need for litigation finance is driven by high and rising legal fees and court costs in many jurisdictions. Traditionally, these costs on the plaintiff side have been borne by the client or in some cases by a law firm with great faith in the merits of the case. Thanks to high costs, though, some otherwise meritorious cases are not feasible for plaintiffs or law firms to bring on their own any more. The key benefit offered by third-party funding is that it provides a litigant access to a key part of the justice system that might otherwise be unavailable due to those cost pressures.

From the investor’s standpoint, claims on cases are potentially an uncorrelated asset, and in a world where growth is scarce and investment returns vary greatly, litigation finance offers a unique opportunity. Given that, and the newness of the space, it’s probably not surprising that different investors and investment firms have different approaches to investing.

One common type of third-party funding is the non-recourse structure. This type of funding arrangements is common in many cases, and is probably the most basic type of single-case funding arrangement. With non-recourse funding from professional investors, a fundee can completely offset all or substantially all financial risk associated with a claim with no risk in the event that the case is lost. Funders will typically take on all or the majority of the costs incurred in pursuing the action, with their return on investment dependent entirely on the success of the action that it is funding.

Since the funding is a type of non-recourse debt, litigation funding creates a lack of incentives for the funded parties once the investment closes. That’s why such funding contracts need to be written very carefully to avoid agency problems. Historically, this structure appealed to, and was primarily utilized by, the impecunious litigant. However, that’s starting to change. According to one investment manager I spoke with recently, “as the corporate world begins to appreciate the financial benefit available, more and more finance directors are accessing third-party funding in order to de-risk their balance sheets, lower litigation expense, and reduce the time management spent away from growing their business.” In other words, corporations are coming around to the benefits of litigation financing.

The other key benefactor of third-party funders is the lawyers themselves. Lawyers are increasingly under pressure to agree to contingency-fee arrangements or damages-based agreements. This leads to them effectively taking risk on the litigation which they are backing. This risk does not sit well with all lawyers, and many do not have the business model or balance sheet to carry large amounts of such risky assets – let alone for litigation that can take many years to resolve. External finance is an obvious way to deal with this issue.

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Non-recourse debt is only one of the many structures available – in some cases, particularly with funding to law firms, deals can be structured as partial recourse, where the law firm is responsible for repaying a portion of the investment if the suit should fail. In other cases, litigation funding comes in tranches based on the funded party meeting certain metrics. Indeed, in a few cases, funding deals can even be done on as a form of equity in the law firm itself, though this is really only available in one jurisdiction in the U.S. due to current laws around external law firm ownership.

Broadly speaking, the point is that litigation funding is very much an unsettled environment. There is plenty of room for innovation and new ideas in the space. Investment firms and individuals that put in place the best ideas today are likely to be the ones that see their firms grow to be billion-dollar industry leaders tomorrow.

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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