Opportunities for third-party litigation funding

April 2013 | TALKINGPOINT | LITIGATION & DISPUTE RESOLUTION

financierworldwide.com

FW moderates a discussion looking at third-party litigation funding between Mick Smith, a partner at Calunius Capital LLP, Tom Custance, a partner at Fox Williams LLP, and James E. Tyrrell, a partner at Patton Boggs LLP.

Custance: From an investor's perspective, the returns are potentially very substantial. Typically, the return is based on the higher of a percentage of the damages recovered by the funded party or a multiple of the funds committed. Further, the rate of return increases the longer the funds are committed. So, for example, if it took 18 months for a case to conclude – through determination at trial or earlier settlement – a funder might expect to recover the higher of 25 percent of the damages recovered or three times the funds committed. That is clearly an extremely attractive return. However, the difficulty is getting the success rate right. Litigation is always unpredictable and if the case is lost the funder loses its investment. From a litigant's perspective, there is now an increased awareness of third party funding, compared with two or three years ago. There is also a wider variety of funding options available and the market has matured. There is therefore a greater level of interest from litigants.

Tyrrell: The impetus behind the rise in third-party funding comes from the wide range of benefits found for all parties involved in the transaction – funders, law firms, and clients, whether corporate or individuals. Investors are drawn to litigation as an asset class because litigation thrives during times when many investments under perform. This is because litigation rarely tracks a down economy, since hard times usually result in more litigation. Also, litigation funding, especially in the US, has been around for quite some time now; therefore, investors are more confident in the viability of the industry and motivated by the potential for large returns. Moreover, as the economy continues to recover, larger corporations are pleased to shift the financial risk and cost of litigation off their balance sheets. For individuals or small corporations, litigation funding may be the only practical way to gain access to the courts. Finally, for law firms, financed litigation brings the security of having their fees and expenses paid on a current basis on what might otherwise be a contingency fee based arrangement.

Smith: Litigation funding is becoming increasingly popular because it enables claimants to remove or manage their costs risks. The funder’s return from successful cases normally comes in the form of either a multiple of the sums invested or a percentage of the damages paid. If the claim turns out to be unsuccessful, there is nothing to pay. The bottom line is that third-party funding provides access to justice, especially for small and medium-sized businesses, where, as a practical matter, no such access previously existed. On the investment side, third-party funding is viewed as an alternative asset that can generate returns that are uncorrelated with the returns on other assets. These uncorrelated returns on a portfolio might be as much as 15-20 percent per annum over three to five years. Moreover, the strategy should perform even better in difficult economic times when there is more litigation, and that litigation is harder to pay for, on both the plaintiff and defendant sides.

FW: What features must a case display in order to qualify for third-party funding?

Tyrrell: Because every case is different, a litigant cannot simply look to a checklist to determine whether it qualifies for funding. However, in my experience, third party funders in the commercial litigation arena do maintain some prerequisites before even considering making an investment. They typically only consider investing in ‘business-to-business’ claims, which commonly include patent and intellectual property cases, complex investment disputes, and high-stakes arbitrations. Additionally, for most of these cases to qualify for funding, the amount in dispute must surpass a certain threshold – reaching as high as $25m. Likewise, it is commonplace that the higher the investment sought, the higher the potential amount of recovery must be. Funders will not invest $20m for a case with a ceiling of $25m. Keep in mind, however, that these prerequisites only get a litigant in the door. After meeting these threshold requirements, a case must then pass the funder’s due diligence and underwriting evaluations, which analyse such factors as the merits of the case, the potential for settlement, and all of the attendant risk factors both from a legal and business standpoint.

Smith: Generally, the key factors in a fundable claim are, first, quantum – the realistic claim value should be for a sufficient multiple of the likely costs; second, merits, meaning that the case should have good prospects of success; and third, recoverability – a creditworthy defendant is vital. A fourth consideration is costs; How much will the claimant’s costs be? What is the risk of over-run? How will the adverse costs risk be dealt with? Finally, time is a factor. How long it will take to achieve resolution including the risk of appeal

Custance: First, it must have good merits: funders will generally be looking for prospects of success of 60 percent or above. Second, the defendant must be solvent and able to pay the damages awarded. Third, the likely damages must be sufficiently high so that the economics stack up for both the funder and the funded party – this means that in practice it is very difficult to get funding for a case where the expected damages are not in seven figures. Fourth, the claimant must be 'reliable' and have a decent firm of lawyers on board. The funder cannot be seen to exercise any control over the way the litigation is conducted, so it needs to be satisfied that the funded party will behave sensibly – particularly when it comes to settlement opportunities – and will be properly advised.

FW: Do you believe your jurisdiction’s ethical rules alleviate or perpetuate the common criticisms of litigation funding?

Smith: With the exception of the odd US lobby group, there is little criticism in England and Wales; just a judicially endorsed commitment to promote best practice. Technically, there are no specific ethical rules applicable to litigation funding but the Association of Litigation Funders of England and Wales (ALF), a body set up – with judicial and government support – to bring greater credibility and transparency to the world of third-party funding, has developed a code of conduct. The ALF, and its code of conduct, promote best practice and ethical behavior amongst litigation funders operating in the English courts.

Custance: There is no getting away from the fact that there is a tension between the lawyer's duty to act in the best interests of the client and his – and also often the client's – wish to ensure the funder is happy with the way the case is progressing. This is not least because it is the funder who will be paying most of the lawyer's fees, and the funding agreement will allow the funder to pull out in certain circumstances. The funder will therefore, in practice, have a degree of influence over the conduct of the case. Although this tension cannot be ignored, the high standards of ethical rules – in England – governing the lawyer's duties to the client and the court do minimise the scope for conflict between the client's interests and those of the funder.

Tyrrell: All too often critics of third party litigation financing attack the industry without considering whether a jurisdiction’s ethical rules safeguard against the harm they are complaining about. For example, litigation funding is commonly criticized for improperly shifting control over the litigation from the attorneys and the litigant to a third party. But this criticism falls short because it assumes that the attorney in the case will ignore his or her ethical obligations. Under the Model Rules of Professional Conduct in the United States, attorneys are obligated to exercise ‘independent professional judgment’ and to prohibit third parties who pay the attorney to ‘direct or regulate’ the attorney’s decision-making. Because of these ethical rules, sophisticated litigation funders are aware that attorneys are professionally obligated to ensure that litigation authority remains with the attorney and client, and that no third party may compromise that attorney’s independent professional judgment. But since that doesn’t fit their narrative, the critics ignore it.

FW: Could you explain the current legal and regulatory framework relating to third-party litigation funding in your region?

Custance: The Association of Litigation Funders of England and Wales has produced a code of conduct for its members. This is a brief, two-page document, covering such matters as maintaining adequate financial resources to meet the funder's obligations under the funding agreement, and not seeking to influence the lawyers acting for the funded party to cede control or conduct of the case to the funder. In general, funders are understandably content with this limited and voluntary self-regulation.

Smith: Litigation funding in England and Wales remains subject to the prohibition on champertous contracts which, in reality, means adhering to public policy and ensuring that the claimant retains control of the litigation. A key aspect of this public policy adherence comes from the ALF code of conduct, which was endorsed by the Jackson Civil Litigation Costs Review. The code provides specific rules on capital adequacy, termination of funding and control of cases. In essence, it is designed to ensure that third-party funders commit to a case for the duration and do not seek to take control of the dispute or settlement negotiations. The code thus helps users to identify the reputable players, which benefits the sector.

FW: Is the litigation funding market currently facing any major regulatory and/or compliance issues? Can we expect to see any rule changes in the near future?

Smith: While greater comfort and assurance is provided by the ALF and code of conduct, funders still face an uncertain period into 2013. As part of Jackson’s reforms, contingency fees are to be introduced, enabling solicitors to earn their fees through damages-based agreements with clients. It raises the prospect of solicitors no longer requiring funding for their fees, as they will have the opportunity of running a dispute and hoping to take a share of the damages, provided they can fund the disbursements. Furthermore, the liabilities and restrictions on funders appear to exceed those felt by solicitors. The regulations do not appear to provide for ‘partial’ or ‘hybrid’ DBAs – for instance where the lawyer is partially funded by the traditional method and partially by reference to a percentage of damages. This omission has surprised some commentators. It remains to be seen whether the market will interpret the omission as a prohibition on such partial DBAs.

Custance: The greater the growth of the litigation funding market, the more pressure there will be for some form of external regulation. Being cynical, at some point there will be a scandal involving a 'rogue' funder who does not have the financial resources to meet its commitments, or who seeks to pull out of a funding agreement without good reason, or who puts improper pressure on the client's lawyers. That would probably be the catalyst for external regulation.

FW: What, in your view, will be the major impact of the ‘Jackson’ ruling on litigation funding?

Custance: The Jackson report has endorsed third-party funding as a means of promoting access to justice. The main changes flowing from the Jackson report are unlikely to impact litigation funding directly. The fact that solicitors will shortly be able to enter into damages based agreements (DBAs) is unlikely to pose any real threat to funders, as very few law firms are structured in a way which would make it practicable for them to compete with funders. There are too many issues to resolve concerning cash flow and allocation of profits between partners over different years. The non-recoverability of after the event (ATE) insurance premiums may make funding more attractive, as the only way in which ATE may be affordable is as part of a package provided or arranged by a funder. Another bonus for funders is that the publicity around contingency fees (DBAs) – something which lawyers in England have not previously been able to enter into – will raise the general awareness of litigation funding.

Smith: On first inspection you could say that the introduction of DBAs will be the most seismic change, but we wonder if, in the longer term, it might be that cost capping and control measures which limit adverse exposure will have more impact. Certainly, the DBA lawyer has a privileged position. He is not subject to adverse costs orders, whilst funders are. Nor is he subject to the same capital adequacy strictures as funders. So DBA lawyers in enterprising firms have an opportunity to structure very attractive fee agreements. However, with this potential reward comes significant risk and, at the very least, it may be that law firms will continue to use third party funding in order to fund WIP and disbursements.

FW: In your opinion, do investor groups conduct sufficient due diligence prior to investment?

Tyrrell: Speaking from my experience working with the premier investors in the commercial litigation markets, there is no doubt that those investors are conducting ample due diligence prior to investing. This is evidenced by the high rates of return the top funders are yielding on these investments. Simply put – the top litigation funders are looking to maximise returns and the only way to do that is to be selective and thorough in the evaluation process. As the litigation market grows out of its infancy, due diligence is no longer about just finding a high priced case with good legal merits. Investors now are analysing various legal, political, social, and business concerns that come along with a case. As a result, investors often commence a two-three month due diligence process, which includes exhaustive risk analysis, engaging independent legal review, and implementing proprietary underwriting guidelines; all done to ensure they are investing in a meritorious legal claim that also makes proper business sense.

Custance: This varies between funders. As a general rule, the larger the organisation, the more internal procedures and checks and balances there are, although this does not necessarily mean that more due diligence is undertaken. There is often a tension for funders between satisfying a client's desire for a quick decision on funding and the time it may take to go through a proper due diligence process, particularly if the funder is in a race to secure the case before the client accepts terms from another funder. In practice, therefore, a funder may choose to rely to a greater degree than it would wish on the judgment of the client's lawyer, particularly if that lawyer is known to and respected by the funder.

FW: Do you anticipate a rise in alternative fee arrangements between corporations and law firms? If so, what are some examples?

Smith: Yes, we anticipate an increase. Claimants are looking for a combination of cost savings, cost certainty, and alignment of law-firm interests with corporate interests in avoiding an excess of hours billed. Shifting the fee risk to the law firm aligns the law firm’s incentives with the client’s and reduces the risk to the client. In addition, clients who lack the financial resources to pursue important but expensive litigation are provided the opportunity to pursue such matters by having their law firm invest in the case alongside the client. DBAs structured properly should also make lawyers agnostic towards the timing of settlement. Funders try to structure their deals so that it does not matter when a case settles. DBAs can similarly remove the historic inertia of paid-by-the-hour lawyers toward early settlement. So, we expect to see more billing arrangements with caps in return for a modest percentage entitlement in the proceeds, provided the new regulations permit this.

Custance: It has been well publicised that general counsel of corporates are under increasing pressure to curb legal expenditure. So, alternative fee arrangements are attractive to corporations if they are perceived as delivering lower overall fees. One of the main drivers for corporations is certainty, so anything which means there are no surprises and gives general counsel confidence that budgets will not be exceeded is likely to appeal. Fixed or capped fees for each major stage of the case are examples. A significant benefit of litigation funding is that it can remove any cash flow or provisioning issues for financing litigation, provided of course that the corporation is prepared to give up a proportion of its winnings. It is currently unclear how much take up there has been for this method of financing claims.

Tyrrell: In light of the recent economic downturn, it is only logical that we should see a rise in alternative fee arrangements between corporate clients and law firms. Corporate America is tightening its belt and, as a result, law firms are receiving enormous pushback against the billable hour. For example, we may see more fee structures trading equity instead of cash in return for legal services, which is common where start-ups or small companies have been shut down by improper copyright and patent enforcement. Or, firms and clients can utilise a sliding scale of compensation based on anticipated recovery or damage minimisation – thereby allowing the results to dictate the amount of fees due. Incentive based arrangements, such as the ‘sliding scale,’ aligns a client’s and attorney’s interests because the client won’t pay as much for ‘low-percentage’ strategies and the attorney will still be rewarded for good lawyering.

FW: How do you predict the litigation funding market will develop over the next 12 months and beyond?

Custance: The market will grow as lawyers and their clients become increasingly knowledgeable about litigation funding. However, this is still outside the comfort zone of a lot of lawyers, and that is an impediment to clients receiving proper advice about the options. The potential returns will continue to attract more investors to the market. We will see greater flexibility and sophistication in the products being offered, as funders seek to differentiate themselves from each other. The really interesting challenge will be to see whether the economics can be made to work for medium value cases. If it can, that should significantly increase the overall size of the market. Finally, some form of external regulation is highly likely, although probably not in the next 12 months.

Tyrrell: Moving forward, I expect significant growth in the litigation finance market. Litigation funders have now proven they can survive the life of a litigation, provide law firms and clients with substantial value-added, and generate significant returns for their investors. I think we will also see hedge-funds become more active in the litigation funding arena as they witness traditional litigation funders achieve great success. Additionally, I anticipate a rise in defence-side litigation funding. Nowadays, corporate defendants litigate with their own resources and their insurance carrier, while the plaintiff has hundreds of individual lawsuits in a mass tort cases or large class actions, multiple plaintiff law firms pooling resources and capital, and third party litigation funders to fund these actions. But, this imbalance provides motivation and opportunity for the defence to turn to third party funding to help alleviate the financial burden and pursue strategies it may not have otherwise considered because of cost.

Smith: The financing of litigation is not new. For years it has been available on an ad hoc basis from sources of finance, such as specialist units of the big banks, hedge funds, insurance companies and private equity. However, in the last five years the market has come of age and worldwide specialist financiers have emerged in public. They offer users a high degree of subject-matter expertise and a more transparent and predictable underwriting process. This publicly available litigation funding market is now a $1bn industry and is likely to grow by at least another $1bn in the next two to three years.

Mick Smith is a partner and co-founder of Calunius Capital LLP. Mr Smith studied Mathematics and then Law at Cambridge University, and qualified as a solicitor at Freshfields in 1996. Subsequently he worked in finance in a variety of investment banking roles. He is responsible for origination and transaction execution at Calunius, sourcing and analysing investments in litigation and arbitration claims. Mr Smith can be contacted on +44 (0)20 3142 8339 or by email: mick.smith@calunius.com.

Tom Custance is a partner in the litigation and dispute resolution department of Fox Williams LLP. He has extensive experience in all aspects of the litigation, arbitration and mediation processes across a broad range of commercial disputes, primarily in the financial services sector. Much of this has been in the insurance field, where he has acted in several substantial policy coverage disputes, as well as advising on policy wording issues. Another particular area of expertise is employment-related disputes. Mr Custance can be contacted on +44 (0) 207 614 2508 or by email: tcustance@foxwilliams.com.

James E. Tyrrell, Jr is the managing partner of the greater New York/New Jersey offices of Patton Boggs, national chair of the Firm’s Toxic Tort and Product Liability practice groups, and a member of its Executive Committee. Mr Tyrrell’s experience includes toxic tort, product liability, intellectual property (IP), antitrust and general commercial litigation. Mr Tyrell is a member of numerous associations, and has served on the Federal Legislation Committee. He currently serves as chairman of the Board of Directors of the Reflex Sympathetic Dystrophy Syndrome Association of America. He can be contacted on +1 973 848 5600 or by email: jtyrrell@pattonboggs.com.

THE PANELLISTS

Mick Smith

Calunius Capital LLP

Tom Custance

Fox Williams LLP

James E. Tyrrell

Patton Boggs LLP