litigation finance

As corporate legal operations and law firm pricing professionals know all too well, the Great Recession permanently altered how companies purchase legal services and how law firms manage the pricing of those services. This has put corporate legal operations and law firm pricing professionals in the business of managing legal cost and risk, allowing them to work in ways that are complementary and mutually beneficial. To maximize those synergies, and to achieve better business outcomes, law firms and corporate legal departments are well served by using legal finance.

Legal finance, for those who are unfamiliar, is a tool that shifts the cost and risk of pursuing commercial (non-consumer) disputes from the corporation or its law firm to a third party. Legal financiers do this by providing risk-free capital to companies and law firms involved in meritorious commercial disputes on a non-recourse basis—this means that the capital need be repaid only in the event of a successful litigation outcome.

Legal finance thus enables corporations and their law firms to offload risk and cost to a third party that will neither control the underlying litigation, nor the decision-making related to settlement or strategy. As a result, corporations have the ability to choose the best law firm for a specific case or set of cases, and law firms have the ability to take on matters they otherwise couldn’t.

Given that legal finance has grown at least 237 percent since 2012, it’s critical that legal operations and law firm pricing professionals learn about this tool, develop an understanding of how it is priced and understand how it can be used to protect both corporate wealth and law firm profitability. It is in this spirit that we’ve put together the following guide to legal finance pricing. While not intended to be comprehensive, we hope this will provide an understanding of the principles that guide pricing and how terms can be structured to meet corporate and law firm needs.

The Current Pricing Environment

Before directly addressing legal finance pricing, it is worth painting a picture of the legal environment in which the tool has become necessary and more mainstream.

The Corporate Legal Operations Consortium (CLOC) notes two emerging trends that are driving changes within corporate legal departments: Increasing demand for legal services and increasing pressures on legal budgets and costs. In short, legal departments are being asked to do more with less. That challenge is echoed in 2018 legal finance research that identifies in-house lawyers’ top two challenges as “managing legal risk and uncertainty” and “increased pressure on legal budgets, staffing and spending.”

Responding to these client challenges, law firms have invested in hiring pricing professionals. According to “Thomson Reuters’s Law Firm Pricing Insights” report, just over 70 percent of the Global 100 now employ a pricing officer, “a critical strategic role in creating true partnerships between the buyers and sellers of legal services.”

While legal operations professionals seek to get more for less from outside counsel, law firm pricing professionals seek to create and offer financial arrangements that leave their clients happy, while avoiding race-to-the-bottom pricing and commoditization of services.

Legal finance helps both achieve their intended goals.

A Guide to Legal Finance Pricing

The question of how legal finance is priced lacks a one-size-fits-all answer. Intuitively, this makes sense—the matters being financed (commercial litigation and arbitration) are complex, unique and idiosyncratic. Thus, the pricing of legal finance capital is also understandably complex—it is, after all, based on the underlying matter along with the client’s needs. Plus, different legal financiers address pricing very differently. Moreover, we speak below not for the entire industry, but rather based on our experience.

How risk impacts pricing. Fundamentally, legal finance pricing is based on risk. Legal financiers assume an extraordinary degree of risk, because legal finance is typically provided on a non-recourse basis (i.e., the financier loses its investment entirely if the underlying litigation or arbitration matter is unsuccessful). In addition, legal financiers operate as passive investors where they cannot control settlement or decision-making. Further, very few capital providers outside the legal finance industry have the expertise to assess and assume such risk.

So, how do legal financiers price risk? In many ways they act just like lawyers considering matters to take on contingency but with a more sophisticated modeling system, necessitated by the number and variety of cases financed and the scale of the financier’s business. Legal financiers, recognizing that every case and client is different, consider factors such as:

(1) The merits of the case. Is the case highly meritorious? With the flood of requests for financing, legal finance companies are not in the business of gambling and will only finance claims that—while not necessarily a sure thing—are meritorious.

(2) The stage of the case. If a case is about to be filed or has only recently been filed, the case will be considered higher risk.

(3) The damages. The anticipated financial recovery (rather than the claimed damages) must be realistic and supported by evidence.

(4) Risk diversification. A single-case investment presents a binary risk, versus a matter that is part of a portfolio, where risk is diversified across numerous matters.

In these terms, the highest risk investment is a single matter financed in the early stages of the case where the legal financier is paying all fees and expenses. Because there is only one case, the risk is binary; and because the case has not reached a mature stage, it’s difficult to foresee the entire litigation life cycle and fully assess the potential risk. Such a case represents the upper limits of capital pricing.

Mature finance providers can also fund multi-case portfolios, which have significantly less risk than single-case investments. Portfolios are cross-collateralized, meaning that the financier has multiple matters from which it can earn its return. As a result of such diversification, portfolios offer better pricing opportunities than single-case arrangements.

Creating economic structures to match client needs. Deals are structured to reflect specific client needs. Any engagement between a legal financier and its counterparty should begin with a conversation that allows the financier to offer the right economic structure for that client. An assumption for any deal is that the litigant should receive the bulk of the damages in the event of a successful resolution to the case, and that the law firm should receive fees appropriate for its role in the case.

The most common financing structures exist on a spectrum, with variable returns on one end and fixed returns on the other.

Variable returns. A variable return is comparable to a contingency fee arrangement, where a law firm will advance the cost of litigation out of pocket and then recoup those costs “first-dollar” out of the return, in addition to taking a percentage of the net remaining proceeds. In this arrangement structure, the financier’s return consists of getting its investment back, plus a percentage of the settlement or award. This structure is most attractive to clients when the potential for recovery isn’t inordinately large in relation to the investment commitment. That’s understandable: If the expected recovery is especially large, you would be less happy to give up a percentage of the upside and would prefer instead a fixed return structure.

Fixed returns. At the opposite end of the spectrum is a fixed return structure, where the financier’s return consists of an investment back, plus a multiple (or fixed) return of that investment, as opposed to a percent of the net proceeds.

Hybrid structures. In most cases, the needs of counterparties are such that the return structure falls somewhere in the middle of the spectrum, resulting in a hybrid structure. The financier gets its investment back, some fixed return (albeit a smaller multiple) and then also a percent of the net proceeds (again, likely a lesser amount, given that there is both a fixed return and a variable return element).

Return waterfall. Financiers must also work with clients to structure an appropriate return waterfall—in other words, to lay out the order in which, and the increments by which, they and their counterparties earn returns from matters in which they invest. Each matter is unique, and financiers generally adjust waterfalls to clients’ needs—but the important point to appreciate is that while financiers generally earn their investments back on a first-dollar basis, further recoveries are often split on an incremental basis. In essence, legal financiers and their counterparties “take turns” earning returns.

Understanding term sheets. A critical step in the process of finalizing a legal finance investment is the term sheet, which is the medium in which a legal financier expresses its proposed structure and terms.

We believe that, before a term sheet is offered, it is imperative that the financier has conducted proper diligence on the underlying matter (or set of matters). Without this initial diligence, it is simply impossible to offer an accurate term sheet that offers any substance and guidance to potential counterparties. This is why top legal financiers do not seek exclusivity when performing initial diligence on a case.

Some legal financiers, however, take a different approach, preferring to propose term sheets along with a 60-day exclusivity period at the beginning of the process, before they’ve invested in a significant amount of diligence. While these financiers’ intentions may be good, we caution that their initial proposed terms often change during the diligence process—wasting precious time for the client and the law firm.

If a financier requests exclusivity in order to study the case(s) after just the first or second phone call, beware. Often, that financier will offer a pre-diligence term sheet with a “teaser” rate, which will change dramatically after the exclusivity period (often 60 days or more) expires, leaving the firm and the client in the difficult position of having to start over, or take a bad deal.

Choose the Right Provider

As the use of legal finance grows, in-house legal operations and law firm pricing professionals are uniquely positioned not only to champion its use but also to become experts in selecting the right finance provider. As much as the pricing of legal capital matters, what matters more is ensuring that a legal finance partner is reliable in the short and long term. Financiers with great reputations won’t simply have capital available now, they’ll have permanent capital available for the full duration of a matter, with a staff of in-house lawyers capable of reviewing those underlying matters themselves.

Ultimately, in-house legal operations and law firm pricing professionals are meant to aid one another and work across their organizations—legal finance, in addition to offering cost and risk management benefits, is intended to make that process easier. But remember, not all legal financiers are created equal—a legal financier is only as good as its team—so make sure you choose carefully.

David Perla is a managing director and Rufus Caine is a vice president at Burford Capital.