Litigation Finance – Quickly Evolving Beyond ‘Traditional’ Uses

Ed. note: Litigation finance is transforming the fields of both law and finance. To help our readers gain a better understanding of what litigation finance entails, we’ve partnered with Lake Whillans to present a new series so you can better understand how litigation funding works, its pros and cons, and its past, present, and future.

In its early days (not so long ago), litigation finance entailed a straightforward proposition.  A claimholder with a meritorious claim, but without the resources to litigate it, would seek funding from a litigation finance provider.  The funder would conduct due diligence on the claim and negotiate investment terms.  If the claim succeeded, the funder would recoup its principal, plus a return; if it failed, the claimholder would walk away with no liability.  Funder and claimholder had no particular expectation of any longer-term partnership.

This type of one-off, single-case funding is still going strong today.  But the field of litigation finance has expanded considerably, and funding now comes in a variety of flavors.  A growing proportion of funding deals involve neither a single case nor a poorly-resourced claimholder.  Today, entities seeking funding are often more concerned with managing risk than with acquiring sufficient resources to litigate.

This article will explore three growth areas in the current funding landscape: (1) deals involving funding for larger corporations, (2) law firm portfolio funding, and (3) acquisition of claims by litigation funders.  Lake Whillans has extensive experience investing in each of these structures.

Large corporate deals

At first glance, it may not be obvious why a well-resourced corporation would be interested in litigation funding.  Can’t a big company finance its own litigation?  Well, the fact that it likely could doesn’t mean that it should.  For any corporation, regardless of the strength of its balance sheet, there is an opportunity cost to paying litigation expenses: resources that could be spent on building the company’s core business are instead diverted to litigation.  Optimal resource allocation is particularly critical in this time of economic uncertainty, when most executives — including general counsel — are under pressure to trim their budgets, mitigate risk, and maximize resources.

Even in the most stable economy, large corporations find value in litigation finance as a risk management tool.  Every lawsuit, no matter how meritorious the underlying claim, is costly and to some degree unpredictable both in terms of outcome and timing.  Even if the decision to pursue the claim was entirely rational, skeptical corporate stakeholders may not see it that way in the wake of an unforeseen loss.  Litigation finance removes this risk because funding is structured as a non-recourse investment: if the claim fails unexpectedly, the company owes nothing.

Another risk/reward analysis that favors using litigation funding by corporations of any size arises from the accounting treatment given to litigation expenses and recoveries.  Expenses incurred in litigation directly reduce the corporation’s profits because they must be reported on the company’s statement of profits and losses.  The corporation cannot offset this profit hit by recognizing the expected future value of a favorable outcome.  Realizing the return on litigation expenses may take years.  And even when the company achieves a litigation victory, the value of the recovery must be reported as an “extraordinary event” that doesn’t improve the market’s view of its profitability or valuation.  By externally funding its litigation expenses, the company can improve profitability and ultimately its valuation in two ways: (i) remove the legal expense drain on its profits,which will directly improve its balance sheet and (ii) put capital that otherwise might have been used for legal costs towards uses that drive performance and revenue. (And in some cases, a litigation finance transaction may even increase the company’s available capital with an up-front monetization).

Litigation finance deals involving larger corporations often depart from the familiar single-case model.  A large company may have several current or potential litigation matters proceeding at any given time; often the company will be on the claimant side in some matters and the defense side in others.  Such a corporation has the option to negotiate funding for a portfolio of cases all at once.  This enables it to obtain funding at a lower cost than in a single-case scenario because a portfolio of distinct cases carries less risk for the funder than a single-case investment.  A portfolio funding agreement can also include infusing the company with capital that can be used to support defense-side cases, thereby reducing the legal department’s spending across the full range of cases involving the company.

Law firm portfolio funding

A growing number of funding agreements do not directly involve claimholders at all.  Rather, the funder enters into an agreement with a law firm that represents claimholders on contingency.  In a law firm portfolio deal, the funder provides capital to the firm in exchange for a portion of the future contingent fees that the firm will eventually recoup from the portfolio of cases.  The capital is generally used to support the cases in the portfolio and bridge the gap for the firm until the cases are monetized.  Contingent fee cases can be lucrative, but cash flow from these matters is often choppy and unpredictable both in terms of amount and timing.  As in standard claimholder funding, a law firm portfolio funding deal is a non-recourse investment; the funders’ recourse is limited to the fees achieved in the agreed-to portfolio.

Portfolio funding is especially useful for law firms that are expanding their volume of contingent fee cases, particularly where resolution of those cases is likely to take years.  A funding arrangement can support a case acquisition strategy where more funding is released as the firm acquires clients and files cases.  A portfolio funding agreement gives the firm the security of consistent, predictable short-run cash flow, in exchange for a somewhat reduced upside on its contingent fees.

Claim acquisition

In the traditional funding model, the funded claimholder continues to litigate its claim, and the funder acquires a minority stake in the anticipated proceeds from the claim.  However, in certain situations, it can be more sensible for the claimholder to sell its entire interest in the claim to a litigation funder.  This is especially attractive in the bankruptcy context: a bankruptcy estate is permitted to sell litigation claims in the same way that other assets are sold in the bankruptcy process.  It may be advantageous for the bankrupt entity (and its creditors) to monetize such claims immediately, rather than incurring the uncertainty and delay of a years-long litigation process.  A company’s monetizable claims may include both unique claims and claims arising as members of a class action.

A similar dynamic may prevail for a claimholder that, while not bankrupt, is experiencing severely constrained cash flow.  With a growing number of companies now finding themselves in this situation due to the economic effects of the pandemic, claim acquisition is becoming increasingly common.

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Litigation finance continues to evolve and be used in unique and complex ways.  Lake Whillans is well-positioned to discuss the individual circumstances of a company or law firm, drawing on its years of experience structuring similar deals.  The best way to determine if your company or firm could benefit from litigation finance is to contact us.