Should Your Company Use Litigation Finance For Commercial Disputes?

By Author: Parens Patrice
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Commercial litigation can be costly as well as unpredictable and slow. For many businesses the expense of seeking to pursue a legitimate claim or fighting against one, can exceed the value of the lawsuit itself. Over the last 10 years more and more companies have embraced the financial instrument that was previously only available to large hedge funds and special investors that is called litigation finance. But is it the best choice for your company? It depends on your risk-taking capacity and cash flow requirements, as well as the strength of your argument.

What Is Litigation Finance?

Litigation finance (also known as litigation funding or third-party financing) is a type of arrangement in which an outside investor offers capital to the party in a dispute or arbitration as a payment in return for a percentage of any settlement or judgment. If the case fails the funder usually takes on the losses -- and the company is not liable. This "non-recourse" arrangement is the most distinctive aspect that distinguishes lawsuit finance and a typical loan.

Funders can range from huge publically traded firms that have ...
... billions of dollars of assets under management, to smaller boutique funds that focus in particular areas, like antitrust, intellectual property construction, or antitrust. Funding may be for a single case or a collection of instances, or the ongoing operations of a law firm by using what's called portfolio financing.
How Does It Work in Practice?

The process typically is a series of stages:

Evaluation of the case. The company (often through its counsel in litigation) provides case materials to a funder or a funding broker. It typically includes pleadings important evidence, estimates of damages and a review of legal principles that are involved.

underwriting. The funder's legal and financial analysts review the validity of the claim and the creditworthiness of opposition (since the judgment is only as strong as the defendant's capacity to pay) and the estimated timeframe and the possibility of a settlement.

Terms sheet and arrangement. If the funder decides to proceed, both parties discuss terms- what amount capital will be offered as well as the return for the funder (often constructed as a multiple of amount invested or as a proportion of return, whichever is more) and any milestones that are tied to the distribution.

The case proceeds. The company continues to manage the litigation strategy typically, retaining the counsel of its employees and decision making power and the funder is given regular updates.
Resolution. Upon settlement or judgment, the funder will be paid out of the proceeds in accordance with the agreed formula. The remainder is paid to the company.

It is important to note that in the majority of well-structured agreements the funder doesn't have any control over the litigation itself. It is not able to dictate settlement decisions or dictate the strategy in this manner. It could cause ethical and legal issues in a majority of jurisdictions, so good funders tend to stay clear of it.
Why Companies Consider Litigation Finance

1. Preserving Cash Flow and Balance Sheet Strength
Commercial litigation costs can range from a few hundred thousands dollars to tens of million based on the level of how complex the case is. If a company would prefer to invest capital in growth, operations or payroll, rather than legal costs, funding permits the dispute to go on without consuming working capital. Because it isn't a recourse and non-recourse, it does not appear as a debt at the bottom of the statement the same way that it would if a loan were to be make it, which is attractive for companies that manage credit ratings or debt covenants.

2. Risk Transfer
The litigation process is always uncertain. Even the most successful cases could be lost due to unpredictability of juries, unfavorable rulings or unforeseen evidence. The litigation finance process shifts a part of the risk to a third-party that is specialized in evaluating the risk. If a business wants for a legal claim, but isn't able to accept the idea of spending millions just to get nothing back, litigation finance can make a previously unacceptably risk profile feasible.

3. Leveling the Playing Field
If there's a dispute between a smaller business against a bigger more well-funded competitor, funding can make a difference in the odds. A plaintiff who has a solid financial foundation has a lower chance of being compelled to settle for a shady early settlement due to the fact that it is not able to continue the battle.

4. Monetizing Claims as Assets
Certain businesses view legitimate legal claims as an untapped asset class. Instead of letting claims go unnoticed or settle at a lower value due to cash shortages funding allows businesses to view litigation in the same way it would treat receivablesas something with intrinsic value that could be secured against.

5. Signaling Confidence
Because funders do a thorough due diligence prior to making a commitment to capital, the ability to secure funding could serve as a third-party, independent confirmation of the merits of a claim. This can serve as a helpful signal during settlement negotiations, but companies must be wary regarding how and when the information is shared, given disclosure and privilege concerns that are further discussed.

The Trade-Offs and Risks

Litigation finance isn't a free loan and isn't the best choice for every scenario.

Cost of Capital

Funders face a lot of risk and their expectations of return reflect this. Funders usually look for returns between two and four times their investment or a significant portion of the profit and sometimes both and the funder will take whichever is higher. If a recovery is substantial this could be a sign of giving up a substantial portion of the final profits. It is essential for companies to think about various scenarios for settlement and court cases to determine what they'll take home after repayment to funders costs, legal fees, and tax.

Disclosure and Discovery Risk
The issue of whether or not litigation financing arrangements need to be disclosed to the opposing parties or even the court is dependent on the jurisdiction, and is a constantly evolving subject of law. In certain U.S. federal courts and states disclosure of funding agreements is becoming more common or even mandatory in some situations. Counsel opposing to the disclosure may utilize the existence of funds or its terms -as a target for discovery or as a lever for tactical use in arguing that it is relevant to settlement or credibility of witnesses. Businesses should consult with counsel in order to fully understand regulations regarding disclosure in the pertinent region prior to signing an agreement.

Loss of Some Control (or the Perception of It)
Although reputable funders do not direct strategies for litigation, financing agreements usually contain reporting requirements, consultation rights for major decisions, such as settlement, and in some cases approval rights that are tied to significant modifications to the case strategy. It is important to read these clauses carefully, because even minor rights to consult can cause conflict if the motivations of the funder differ from those of the company at an important time -for instance in the event that a company wishes to settle quickly in order to ensure certainty, while the funder would prefer to pursue more money.

Not Every Case Qualifies

Funders are very selective. The estimates of industry experts suggest that they approve of only a tiny percentage of cases they look at which is often between 5 and 10 percentage. They prefer cases that have clear liability, quantifiable, and significant damages, and the defendant is able to pay an amount in a judgment. Cases with smaller disputes, unclear liability, or claims against defendants who have a judgment are less likely to get funding, which is why the tool isn't available everywhere, even to businesses that need it.

Attorney-Client Privilege and Work Product Concerns

Sharing case material with a funder in underwriting poses the question about whether confidentiality or work product protection can be waived. Many practitioners design these disclosures in joint-defense or common-interest agreements as well as confidentiality clauses to reduce the danger, but this is an aspect that requires careful handling by the law instead of a universal notion of security.

Questions to Ask Before Pursuing Litigation Finance

Does the claim sound enough to get funds at reasonable rates?

If underwriters are not enthusiastic, the terms they offer might prove to be not worth the price.

What would an actual net return look in an array of scenarios?

Run the numbers in a scenario of a reasonable settlement that is not just an ideal-case scenario.

What are the obligations to disclose in the jurisdiction of your choice?

Understand what opposing counsel and the court might find out about the contract.

What rights does the funder have over settlement and strategy decision-making?

Negotiate these carefully Do not assume that all agreements are identical.

Does the business has a legitimate cash flow or risk-tolerance motive for funding, or is it just because funds are readily available?

Just because a case is eligible doesn't mean that funding is the best choice -in some cases, self-funding or a contingency fee arrangement with counsel accomplishes the same goals at a lower cost.

How trustworthy is the person who funds it?

Track record, capital reserves, as well as references from other firms or law firms are important. A poorly funded funder that is unable to keep its promises mid-case introduces a risk of its own.

Bottom Line

Litigation finance could be an effective option for businesses with solid claims with high value that want seek justice, without having to tie up capital or carrying the burden of risks of litigation that are not covered in their own balance sheets. It's especially beneficial for companies with well-funded competitors or those who see the claim as a feasible asset instead of as a cost center that needs to be reduced.

However, it's not a decision you can take lightly or without consideration. The capital cost is real, and disclosure rules are still being formulated and not every case is eligible for. Parens Patrice Firms considering this route must engage experienced litigation counsel before they begin, and run the economics in a variety of scenarios, and evaluate potential funders as thoroughly as they do any other financial partner. If handled with care it can transform an otherwise challenging dispute an easy, and even strategic business decision. If not used properly, it could increase the complexity and expense of litigation already complex enough.

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