Litigation finance has a bad name in many circles. Industry groups often oppose it, and in consultations with prospective investors, I have found some feel it is unethical – akin to “ambulance chasing.” Yet there is an important caveat in litigation finance that many do not realize: litigation finance can be used by both plaintiffs and defendants.
Litigation finance is broadly broken up into two categories: personal injury and commercial claims. The defense-side funding that is done is almost exclusively commercial in nature. There may be opportunities for defense-side work in the personal injury space in the future, but so far there are no firms prominently advertising it as an option. For those not familiar with personal injury litigation finance and its comparisons to commercial, I wrote previously about the topic here, and I would recommend Bridgeway Legal Funding’s primer on the subject here. The firm provides plaintiff advances on personal injury cases.
Litigation finance for the defense side of the aisle is more complex conceptually than plaintiff funding. Basically the way the process works is a defendant submits their claim to a litigation finance firm. If the litigation finance firm wants to take on the case, they assign an expected loss or damages amount to the case. Then any amount below the expected damages is the value generated by the litigation finance firm, which gets a portion of that value.
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For example, perhaps firm ABC is being sued and after an analysis, it is found that the expected cost of the case including legal fees is $10 million. The litigation finance firm might agree to fund the upfront legal expenses associated with the defense of the case in exchange for a multiplier or uplift based on any savings the firm can achieve compared to the $10M expected cost. If the litigation finance firm can bring the case to a close for $4M, for example, they might be awarded half of the savings versus the expected initial cost, or $3M.
This type of arrangement is certainly less common than typical plaintiff funding, but it does exist and it’s done by large industry players. Burford Capital and its recently acquired peer, Gerchen Keller Capital are involved in defense-side litigation finance, for example.
Litigation funding on the defense side helps put to rest the old chestnut that it is somehow ethically questionable – funding that is available for either side in a case is simply a means to ensure a level playing field. Now, of course, not all cases will qualify for funding on the defense side, just as many cases will not qualify on the plaintiff side.
Defense-funded litigation finance highlights two important lessons for the industry:
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- Quantitative methods matter – you can get a good attorney to make a judgement call about how a case is going to go from the plaintiff side and the probability of success. It’s almost impossible to accurately and effectively measure expected losses from a defense perspective without a more objective system, though. So far, many litigation finance firms are resistant to such thinking.
- Litigation finance is still evolving as a field, and new investment structures are a major opportunity.
For example, there is currently no way to “short sell” a legal case as one can short a stock or even a bond. Yet conceptually there could be. For example, what if a litigation finance firm got paid upfront in exchange for covering the loss in a litigation? This is in essence similar to a credit default swap on a bond – it’s a method of betting that a lawsuit has no merit. Such an arrangement is also different than conventional insurance in the same way that a put option is.
Whether it is a good idea or a bad idea to allow short-selling in litigation is a different matter, as is the legality of the type of investment described here. That’s not the point, though. Instead the point is that new kinds of litigation finance are being developed each year, and they are creating new opportunities in a market that is rapidly evolving. Investors and funders need to be thinking about how these new structures create opportunities as they consider their portfolio allocations going forward.
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 [email protected].