Litigation funding as a risk hedging tool
26 July 2016
Litigation funding is the, non-recourse, financing by one party of litigation brought by another in return for a share of any financial benefits recovered. To date it has generally been seen as a means whereby a party without the financial resources to bring a claim can nevertheless gain access to justice. Now it is increasingly recognised that litigation funding can play a valuable risk management role for companies with significant financial resources.
Litigation is a risky endeavour and can seriously damage a company’s balance sheet. In extreme cases the outcome may threaten the very survival of the business.
Some companies consider the management of litigation to be a core competence and dedicate significant resources to it. The pharmaceutical, tobacco, energy, insurance and banking sectors are well-publicised examples of litigious industries where claim sizes routinely run into tens of millions. Companies in these sectors often have large in-house legal teams and significant budgets dedicated towards the pursuit (and defence) of litigation.
However, for directors of companies operating in a less litigious environment and where significant actions are infrequent, the prospect of pursuing litigation, either as a claimant or a defendant, can be daunting. Management may lack any real experience of dealing with such actions and they can be a real headache for the finance director, who is expected to manage the financing of what is an inherently uncertain and difficult to control expense. The English legal system is world renowned for the impartiality and quality of its justice, but it has become one of the most expensive jurisdictions in which to resolve a dispute. In a 2007 Sunday Times article, the late Sir Hugh Laddie, a British High Court judge, lawyer and professor, attributed the high costs (said to be three to 10 times the cost in Germany and the Netherlands) to the labour intensity of cross examination, oral argument, disclosure of documents and witness preparation. To make matters worse, the English legal system is particularly weighted against the loser, who generally has to pick up the costs of the winner (known as an ‘adverse costs’ award). This can make the system doubly expensive for the losing party.
Before the Arkin case in 2005, there was uncertainty over the continuing effect of the medieval laws of ‘champerty’ and ‘maintenance’, or in common parlance “buying into someone else’s lawsuit”. However, the Court of Appeal made it clear that, provided the funder doesn’t control the claim and the claimant keeps the greater financial interest, third-party financing is a legitimate method of pursuing litigation. This opened up the litigation funding market in the UK.
While litigation funding is not the answer to all litigation issues faced by companies (for example, it is usually only financially viable to fund a claim for a substantial amount) there are some significant advantages, both from a commercial and accounting point of view, for a party that can secure funding.
Once the funder has reviewed the merits of the case and agreed to proceed, it will normally agree to provide cash funding for the claimant’s own litigation costs and also address the potential liability for the defendant’s costs should the action be unsuccessful. Some funders may encourage the claimant to enter into a partial conditional fee agreement with their lawyers to secure a reduction in their fees, which the lawyers only recoup if the claimant is successful together with a success fee. This largely aligns the financial interests of the parties – claimant, lawyers and funder.
The first and perhaps most important advantage of funding is that it is possible for the funded party to lay off the financial risk of pursuing a claim in return for giving up some of the potential upside. As a result of funding, the funded party’s risk profile changes significantly and the short to medium-term cash-flow position will be improved.
Second, some funders, particularly those that employ experienced litigators, are able to offer a well-informed view of the case, effectively providing a free second pair of eyes and guidance e.g. as to which lawyers are best suited to handle it. This can be particularly useful for companies with limited experience of litigation.
Third, litigation funded by a third party will have a neutral impact on the financial statements of the company, whereas self-funded litigation can have a negative impact on both the P&L, cash flow and disclosures. The following example illustrates this point. For simplicity the issue of recoverability of costs in the event of success has been ignored because it is very rare for all legal costs incurred to be recovered from the other side in the event that the case is won (and in the event of a loss it is rare to pay all the opposition’s costs).
A claimant brings a £10m claim with a 75 per cent probability of success, with each side expecting to incur legal of fees of £1m. Should the company self-finance, the impact will be £1m of legal costs, which will be expensed through the P&L in the normal way. A contingent asset of £8.25m should be disclosed, consisting of probability-adjusted damages (75 per cent chance of success x £10m = 7.5m) plus the probability-adjusted recovery of legal fees from the defendant (75 per cent x £1m legal fees = £0.75m). A liability of £0.25m should also be disclosed, consisting of the probability-adjusted liability of the defendant’s legal fees in the event that the case is lost (25 per cent chance of losing x £1m legal fees = £0.25m).
A claimant that brings the same case but secures litigation funding, where the terms stipulate that the funder will take 30 per cent of the damages in the event that the claim is successful, will have a P&L impact of £0 (the funder picks up the legal fees) and a contingent asset of £5.25m consisting of ((£10m potential damages – £3m to litigation funder) x 75 per cent chance of success = £5.25m) and a contingent liability of £0 (the funder pays the defendant’s legal fees in the event that the case is lost).
For a company that runs a great deal of litigation and can afford the finance it may generally be worth its while to fund the litigation itself as the cost of the losing cases should be outweighed by those that are won (assuming they all have merit). However, even for such companies, in the light of the costs involved in either English proceedings or international arbitration, there will be categories of case where it can make sense to share the risk with a third party funder. For a company with only one case and little experience of running litigation, the risks are higher, in that it does not have a portfolio of cases where the winners might outweigh the losers.
Without funding, the claimant is putting £2m at risk to recover £10m. With funding the claimant is risking £0 to “win” £7m. When litigation is not a developed core competence each corporate litigant will wish to examine at board level which option it prefers and what is the best and most prudent course for the company in the widest sense.
There are, however, significant advantages, both from a commercial and accounting point of view, to a party that can secure funding.