In the United States, Litigation funding describes the provision of capital to a claimant in exchange for a portion of the proceeds from a legal claim—whether by settlement or award—where recourse is limited to the proceeds of the claim at issue. Legal claims, as an asset or liability, are like a bond or other financial instrument; once a legal claim “matures” through a judicial award or settlement, it entitles the claim creditor to payment on the prescribed terms. However, unlike a bond it is uncertain as to whether the asset will indeed mature. A bond entitles the holder to payment on its face. A legal claim must survive the legal system’s crucible to hold any value. Thus, an investment in a single legal claim bears substantial risk. Litigation funding redistributes this risk to the party that is most willing and able to bear and manage it. The social benefit of this risk distribution is the allocation of capital resources to their highest and best use; allowing companies to invest in projects that optimize returns and promote general economic growth.
Why Litigation Funding
One of the key benefits of litigation funding for claimants is access to justice. It relieves claimants of the need to fund ligation entirely out of cash flow and permits them to use litigation funding to finance meritorious claims they would otherwise be unable to pursue. This is particularly true in David verus Goliath cases where a smaller claimant takes on a bigger, more powerful defendant. However, there are two additional major benefits of using litigation funding.
First, as litigation funding is typically non-recourse—meaning funders will lose their entire investment if a case they fund is unsuccessful—litigation funders will only fund claims they believe are likely to succeed. Therefore, litigation funders will undertake their own independent and rigorous evaluation of every claim they are asked to fund. Should they refuse to fund a claim on the grounds of merit, claimants may want to reconsider whether their claim is likely to succeed. Additionally, having a funder on board can often lead the defendant in a case to seek a settlement. Knowing that the claimant is well-resourced by a dispassionate third-party who has objectively reviewed the merits of the case and is prepared to invest significant capital on a non-recourse basis can be a very powerful wake-up call.
Second, the use of litigation funding can be highly advantageous from the perspective of corporate accounting. For finance directors and corporate general counsels, litigation is often too expensive and too unpredictable to make good accounting sense. A business with a litigation claim effectively holds a receivable, which is not considered a balance sheet asset under many accounting standards. Further, accounting rules require that litigation costs be expensed, flowing through the P&L, and thereby reducing operating profits. Even when the claim is resolved successfully, the associated income is treated as a one-off item, rather than as operating income. As such, litigation claims rarely assist companies in maximizing profits and/or minimizing expenses. However, by financing claims that would not normally be pursued, litigation funding can help transform corporate litigation teams from cost centers to profit centers.
Considerations for Funding a Case
While no two cases are the same, the characteristics listed below generally make a case a good candidate for litigation funding.
- The case does not turn on a “he-said-she-said” credibility determination.
- There is more than one viable legal theory that could lead to a recovery.
- The legal theory is tested and has good support in statutory or caselaw.
- The case theory makes sense in the commercial context of the transaction or course of dealing.
- The damages theory can be reasonably extrapolated from past performance of the damaged company or there is an established contract, statutory or royalty rate.
- The investment economics do not depend on the case settling early or on obtaining treble damages.
Other factors to consider when evaluating a case include:
- Any potential issues with enforcement of the award or judgment.
- The merits of the claim itself, including jurisdiction, liability, and the facts.
- A reasonable estimate of the quantum, depending on the damages claimed.
- The solvency of the defendant(s).
- Issues relating to the process of the dispute, such as legal or other costs, the likely duration of the case, the rights of appeal, and, if it is an arbitration, the arbitrators involved.
Litigation Funding Structure and Rate of Return
In the United States, litigation funding is for commercial legal claims. It is generally available for substantial cases, where attorney’s fees and/or expenses exceed one million U.S. dollars. Funding can be provided for cases involving commercial torts, bankruptcy, breaches of contract, mass torts, patent infringement, antitrust, and appraisal rights. Funding is also common in international arbitration claims.
The process of tendering for and securing financing is broadly similar for all funders and types of cases. First, the funder undertakes a high-level analysis of all aspects of the claim including obtaining input from lawyers in support of the viability of the proposed action. Preliminary terms of agreement are drawn up between the claimant and the funder. Next, the funder spends a period—typically between three weeks and three months—completing a more thorough investigation of the claims (due diligence), after which the terms of agreement are accepted, modified, or rejected. Funding agreements in the United States are typically accompanied by a non-disclosure agreement to protect the funding agreement from disclosure to the other party in the litigation. No federal rule requires disclosure of a funding agreement, and 49 out of 50 states do not require disclosure in commercial matters.
Funding agreements usually follow a simple formula:
- Estimated cost of case is X.
- Estimated quantum is Y.
- The funder will cover the costs and: (a) if the case is won, the funder receives a multiple of X or a percentage share of Y, or some combination of the two; (b) if the case is lost, the funder absorbs the costs.
The terms of a funding agreement, however, can vary greatly depending on the characteristics of the claim and the funder. For example, the funding agreement may include a time variable whereby the percentage of damages the funder receives increases as time passes and more money is invested in the claim, or a quantum variable which provides for a different percentage recovery for the funder on separate portions of damages.
Types of Litigation Funding
There are two types of litigation funding: single case funding and portfolio funding. As the name implies, single case funding provides funding for one case. Portfolio funding is defined as a single investment in more than one case. In this model, capital is provided to finance multiple matters with a law firm or with a client that has multiple cases with one or more law firms. A portfolio may range in size from as few as two cases to all a firm’s cases on which it is taking some contingency or alternative fee risk. From the funder’s perspective, an ideal multi-case portfolio investment is as diverse as possible, with mostly uncorrelated cases involving different parties, different subject matter, and different courts. As in any investment scenario, spreading risk across a range of matters reduces over-exposure in any one area. Generally, capital will be less expensive on a portfolio basis than financing would be for any single case in the portfolio. A diverse portfolio reduces somewhat the risk of total loss of the investment, thus resulting in opportunities to provide more funding and/or lower pricing.
In addition to different types of funding deals, litigation funding can be provided for both plaintiffs and defendants. In plaintiff-side litigation funding, funding can be used for attorneys’ fees, litigation expenses or both. The funding is generally structured like a contingency fee—where an attorney would receive a set percentage of the recovery if the case is successful, rather than a standard hourly fee. In the event the claim is won, the funder receives a multiple return on committed or deployed funds (for example, between 200% to 500% of the amount of funding provided) or a percentage portion of the returns (for example, between 25% to 50% of the returns). Litigation funding enables the client to pursue its claims with little to no risk of its own capital.
In defense-side litigation funding the funder commits a set amount of money toward the cost of defense, to indemnify the client for a settlement or judgment above a set threshold, or both. In these cases, because there is no monetary return for the client, the client and funder can agree on a definition of a “successful” outcome. As an example, if a client is being sued for $50M, success can be defined as having to pay the claimant less than $10M. If the case were determined to be a success, the funder would be paid an agreed sum based on the difference between what the client paid and what the claimant sought in damages. This allows companies to shift the costs and hedge the risks of litigation.
In any type of litigation funding, the funder is a passive outside investor who in no way alters the attorney-client relationship. The funder has no rights to manage the litigation in which they invest, and they do not seek to stand in the client’s shoes. Nor do they get any rights to control settlement of the litigation, which remains wholly in the client’s purview. However, the funder will monitor the case once it has provided the funding. In monitoring the progress of the case, the funder will usually receive electronic docket notices, review pertinent filings, and track court deadlines. The funder will also track the legal spend and compare it to the stage that the case is in.
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