The Crazy Reason Even Rich Corporations Consider Litigation Finance

Suppose you’re a rich corporation.

You have plenty of money. You can afford to pay to prosecute a case. And a litigation finance firm would take a big cut of the likely settlement (or verdict).

Why might that rich corporation nonetheless consider having a firm finance big litigation?

Because the accounting rules, and the stock analysts, encourage big corporations to do things that make no economic sense.

Bear with me for a moment. Here’s the essential backstory:

Stock analysts care only about the operating results of a public company. If you spend (or recover) a lot of money, but the loss (or gain) is a one-time event, unlikely to recur, then analysts don’t care about it. Analysts exclude that one-time loss (or gain) from their models; analysts assess your company only on the basis of on-going operating results.

Think about a big lawsuit that will cost $20 million to prosecute and likely yield a $100 million settlement (or an even bigger verdict). Perhaps an IP case fits the bill, or maybe it’s just complex commercial litigation. And assume that every $2 million that you spend will reduce your company’s operating results by a penny a share.

If you pay to prosecute the lawsuit, you will spend $20 million and depress your operating results by ten cents a share over time. The analysts will pick up on that, and your share price will be ten cents lower.

Then you settle the big case, and you recover $100 million! That was money well spent, and you’re a hero!

Not quite.

The accounting rules require that you call out as one-time events (not reflected in operating income) all recoveries in excess of a certain dollar value. The dollar value varies by company, but assume that your company must call out as a one-time event any recovery that exceeds, say, $30 million.

You recover the $100 million, but the analysts yawn. You’ve called that out as a one-time recovery, unlikely to be repeated in the future. That isn’t operating income. Analysts exclude the recovery from their models, and your stock price gets no benefit.

Thus: You depressed your company’s share price while you prosecuted the lawsuit — because the attorneys’ fees you incurred were operational expenses. But you did not increase your company’s share price with the recovery — because the accounting rules require you to call out the recovery as a one-time event, and analysts don’t care about one-time events.

Economically, what you did makes perfect sense. You maximized your corporation’s return on investment.

But under the accounting rules (and analysts’ treatment of them), you’re a fool. You depressed your company’s share price and never made up for that.

Litigation finance to the rescue!

Instead of paying for prosecuting the case yourself, you let a third party finance the litigation at no expense to you. Presto! You’re no longer depressing your company’s share price with your litigation expense.

You can give away any portion of the recovery to the litigation finance firm — twenty percent, thirty percent, forty percent, whatever. Suppose you give away forty percent of the recovery. When your case settles for $100 million, you give the litigation finance firm $40 million and pocket $60 million. You’ve still won your case, and you’ve still pocketed a little dough. Congratulations!

Notice that this makes no sense economically. If you paid $20 million to prosecute the case and recovered $100 million in settlement, you’ve netted $80 million.

If you’ve done the deal I proposed with a litigation finance firm — prosecute the case for free, but give away forty percent of the $100 million settlement — you’ve netted only $60 million.

You’ve chosen to give away $20 million, which doesn’t seem like a good idea.

But you’ve appeased the analysts, and maximized the share price, and done other worthy things, I suppose.

In any event, that’s the crazy reason why even rich corporations consider litigation finance.

And why someone should think hard about the drawbacks of being a public company. Or the crazy way analysts value public companies.

Or something.

Because this is a truly crazy reason for considering litigation finance; this is nuts.

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Mark Herrmann spent 17 years as a partner at a leading international law firm and is now responsible for litigation and employment matters at a large international company. He is the author of The Curmudgeon’s Guide to Practicing Law and Inside Straight: Advice About Lawyering, In-House And Out, That Only The Internet Could Provide (affiliate links). You can reach him by email at [email protected].