Burford Capital | Winter 2018
Litigation finance is becoming an increasingly important part of the commercial litigation landscape: according to the 2017 Litigation Finance Survey conducted by Burford Capital, the number of lawyers in the US who said their firms had used litigation finance has risen 414% since 2013. Over half (54%) of UK lawyers who have not yet used litigation finance expect to do so within two years.
Nonetheless, some general counsel are still surprisingly uninformed, even sceptical, about litigation finance. This may at first seem rational: litigation finance was once viewed as a last-ditch tool useful only to claimants that could not otherwise pay their legal fees and expenses—and many general counsel serve companies that are not cash constrained and that are far more likely to be defendants rather than claimants.
But these assumptions are based on a limited and outdated understanding of litigation finance. Litigation finance has relevance far beyond this narrow definition, and serves to alleviate the significant burden that litigation imposes on any organisation. Whether the organisation is a claimant or a defendant, litigation is expensive, unpredictable, often protracted and consumes internal resources and management attention. As corporate legal teams are increasingly expected to boost efficiency and improve risk management, litigation finance will increasingly prove to be a vital tool for many general counsel.
Below, we explore five reasons general counsel need to take a closer look at litigation finance.
1) Litigation finance is corporate finance for law
Fundamental to litigation finance is the recognition that a legal asset can be used as collateral for financing. A corporation with a legal asset can secure financing today in exchange for a portion of the proceeds from that asset in the future. Typically, financing will be provided on a non-recourse basis, meaning that the financier’s investment return is contingent upon success.
Businesses use finance every day, when deciding whether to spend their own cash or to use outside capital to pay for goods and services. They make strategic and budgetary decisions about financing all kind of assets – from aeroplanes to office buildings. Litigation finance is no different, except that the underlying assets are legal. Ultimately it gives the business an opportunity to be more profitable because they are spending less of their own money on litigation expenses than they otherwise would. Prioritising their spending according to their goals, and reserve cash for their needs – whether retaining their legal team of choice or preserving capital for other business purposes.
2) Financing helps hedge against rate increases and other future risk
It is a safe bet that interest rates will remain comparatively low in the short term, but interest rate rises in the long term should be expected in both the US and the UK. This makes any form of corporate finance that is not interest-rate-based an appealing option.
History also shows that periods of uncertainty and change—both of which have undoubtedly followed the Brexit referendum—tend to trigger litigation. Not only is the Brexit decision likely to lead to more litigation generally, but because several key regulations will no longer apply to the UK, there are also questions surrounding judgment enforcement and jurisdiction.
For general counsel, litigation finance ‘locks in’ cost and risk regardless of external factors. Litigation finance moves risk off corporate balance sheets and provides capital that is repaid only if the underlying matters are successful. This structure protects against a loss in court, while locking in the financier’s return without any correlation to interest rates or broader economic conditions.
3) It is not just for claimants: litigation finance applies to defence matters as well as transactional areas of law
It is still a little-known fact that litigation finance can provide capital in defence as well as claimant matters – and it is essential to comprehend, because businesses very rarely bring lawsuits but play the role of defendant more often than they would like. As general counsel – and CFOs and CEOs – know all too well, the costs of defending against litigation often interfere with the progress of the business. Defending litigation diverts money from doing things that will advance the business, destroys carefully-planned budgets and hurts the profit and loss (P&L).
Litigation finance can enable alternative fee arrangements with law firms that are more flexible than the options that defence-oriented law firms will provide. When companies are defendants, litigation finance will do exactly what law firms will do with alternative fee arrangements, but with greater flexibility. So, instead of the law firm that feels constrained from going below 70% of usual rates, litigation finance firms will go all the way to 0% of rates. In other words, the litigation finance firm will pay the entire cost of defending against a weak claim, in exchange for the same kind of multiplier or uplift based on predefined success.
Portfolio-based financing, in which a third party provides non-recourse funding for multiple matters on a linked basis, offers even more options for defence-side clients. In this approach, defence matters are pooled with a number of other related or unrelated cases. This is particularly appealing to in-house counsel who are looking to mitigate risk and cost across all the cases within the portfolio, and in this model, they may transform the legal department from a cost centre into a profit centre.
Increasingly, portfolio-based litigation finance is also being used in areas such as tax disputes, mergers and acquisitions, and other ‘success fee’ arrangements.
4) Finance changes the accounting treatment of litigation spend: a huge benefit for public companies
Any general counsel who manages legal spend is aware of the negative impact that litigation has on their company’s balance sheet. The accounting treatment of a litigation claim dictates that claims are not recorded as assets on the balance sheet, and legal expenses paid by a company are not capitalised but rather incurred through the organisation’s P&L – thus reducing the company’s profit for the period.
Additionally, revenue recovered from successful litigation is not returned to the P&L as operating income but is instead recorded ‘below the line’ as a non-recurring or extraordinary item, because the claim is not considered core to the company’s business. This creates a ‘no win’ situation for companies: even if they have winning claims, the accounting impact of those claims can impair the company’s financial performance. This is particularly disadvantageous to companies that are publicly listed and report financial results as they will see a negative valuation impact when pursuing litigation, regardless of their trading metrics.
Litigation finance solves this problem: companies shift the expense drag of litigation by moving it completely off the balance sheet. Under a typical litigation finance arrangement, financing is provided for all the legal fees, expenses and disbursements necessary to mount a legal claim. As the financing is provided on a non-recourse basis, there is no cash flow, accounting or financial impact to the company. The first and only time the litigation impacts the financial statements or the company’s cash flow is when the legal claim succeeds. The entire financial risk, alongside the unfavourable accounting treatment of that risk, is transferred from the company’s books to the litigation finance provider. In turn, the litigation finance provider is remunerated with an agreed share of the proceeds of the claim, if, and only if, the legal claim is successful. This makes litigation finance a particularly powerful tool for public companies – attractive to the CFO along with the general counsel.
5) Finance can convert a company’s litigation department into a profit centre.
General counsel who use litigation finance in the most straightforward way can pursue profit-enhancing claims without adding cost or risk to the business. But general counsel who use litigation finance more ambitiously can potentially zero out the cost of litigation altogether.
For example, a FTSE 20 company used $45m to fund current and future profit-enhancing claims with world-class legal counsel – thereby shifting costs off its balance sheet. Portfolio financing is inherently flexible: capital can be used to finance matters within the portfolio or for broader business purposes, and pricing is generally lower because risk is diversified.