This the the third article of a three-part series. In the previous articles, we provided top 5 tips for securing the best funding terms possible from the market and top 5 pitfalls for the uninitiated seeking litigation finance. In the last of this 3-part series, we look at 5 popular myths about the litigation finance industry.
- Litigation finance encourages litigation
It is sometimes suggested that litigation finance encourages unmeritorious litigation. Indeed, this is one of the arguments often put forward by the notoriously anti-litigation finance Chamber of Commerce (whose most recent lobbying efforts seek an amendment to Rule 26 of the Federal Rules of Civil Procedure to require compulsory disclosure of litigation finance arrangements).
However, ask any reputable funder and you will get the same answer. This is a myth. Funders seek to invest in meritorious claims which, almost by definition, should be brought. It would be a curious business model indeed to invest in bad cases and most funders invest significant time and resource in due diligence precisely to avoid doing so.
- Size really matters
There is a myth that commercial litigation finance is only relevant to the very largest disputes and that “ordinary”, every day commercial disputes between smaller to mid-size businesses.
Like many myths, there is some truth in this. Many of the largest and most well-known funders do indeed target only big-ticket litigation. As the market continues to grow, increasing deployment pressure on the large funds, many are increasing, rather than decreasing, their minimum bite size and seeking portfolio finance opportunities which allow for larger funding commitments than any individual case would require.
However, that is not to say that there are no options for the “mid-market”, meaning commercial disputes of moderate size, with sums at stake which are some way south of the tens of millions threshold required by many funders. For such disputes, the need for litigation finance is often no less acute, but the capital requirements and potential returns available necessitate a different business model to the larger funds.
At this end of the market, litigation insurance, as discussed in our previous articles, can often play an important role. Insurance offers different economics to ‘traditional’ litigation finance. Insurers typically look for lower contingent returns, meaning that the minimum claim value required for a viable deal is much lower than that required by many funders. Insurers are also often able to conclude their due diligence more quickly and efficiently, with less reliance on external counsel. This reduces the transaction cost for all parties and enables insurers to consider seriously proposals where, for example, the insurance coverage is limited to a few hundred thousand dollars of out of pocket costs.
- All funders look for similar returns
Many litigation funders offer relatively comparable IRRs for their investors. However, this does not mean that from the perspective of a business seeking litigation finance for an individual matter or a portfolio of claims, the cost of capital will be the same regardless of the source.
Every claim has unique economics, as well as the potential to produce wildly different financial outcomes for the claim holder. Different funders also have different attitudes and pricing models. Overlaid, this means that in practice, differences between two competing funding offers can translate into a swing of tens of millions of dollars in terms of the plaintiff’s net recovery.
Some funders can also at times be opportunistic in their pricing. The terms offered (and terms eventually agreed) often have less to do with cost of capital calculations and more to do with what the funder thinks the client will agree to, taking into account its need for capital and extent to which there is interest from competing funders.
- It’s a seller’s market
‘Demand outstrips supply’ is a popular myth in relation to litigation finance. In the early stages of the market, this was true – there were few funders operating and few deals being done. However, recent years have seen a boom in the industry, flooding the global litigation market with capital.
However, despite the changes in market conditions, funders have not changed their underwriting criteria, so there are more and more funders competing for a finite pool of fundable cases. This means that a business in possession of a meritorious claim of substantial value should expect to have several funders chasing the deal. This subtle but important shift in market dynamics should be borne in mind by any business contemplating litigation finance.
- Funders are back seat drivers
Litigation finance has made substantial inroads into the corporate market, with numerous examples of major blue chips turning to litigation finance as an alternative to carrying litigation budgets on their own balance sheets.
However, some businesses remain reluctant to engages with litigation finance due to concern that the funder will take over control of the case, including in particular control over settlement. This is rightly a concern and something to consider carefully. Litigation is often about much more than just money changing hands. Where, as is often the case, there are regulatory, reputational or other commercial issues in play, the business needs to retain full and unfettered control over the decision of whether and on what terms to compromise the dispute.
However, it is a myth that most funding agreements require the funded party to cede control to the capital provider in this way. In fact, the vast majority of funding agreements are carefully drafted in order to grant the funder some limited rights to monitor its investment, whilst ensuring that the company retains full, unfettered control. There are important reasons for this. There are few serious attempts made to challenge the legality of litigation finance on the grounds of champerty these days, but cases such as the Delaware lawsuit between Charge Injection Technologies, Inc and EI Dupont de Nemours & Company make it clear that the passive nature of the investment and the lack of settlement control are vital in order to stay the right side of the line.
James Blick, principal of TheJudge and head of its U.S. operations, arranges litigation finance and insurance solutions. Brett McDonald, is a VP and General Counsel in the California office of TheJudge and specializes in litigation and arbitration as well as international business transactions.