The company’s general counsel walks into your office and says, “Boy, have I got a deal for you. We can make a legal claim against Company X, we’re almost certain to win the case, the litigation costs will be only $5 million and our recovery will be three or four times that much.”
The response by you, the CFO, likely is something like this: “Get the hell out of my office! I don’t have budget for $5 million in litigation costs. I don’t care if there might be a profit three years from now.”
You could hire a law firm to pursue the claim on a contingency basis, under which it would collect legal fees only if you win the case. But complex corporate litigation typically requires hiring expert witnesses, conducting electronic discovery and other costly steps that are not included in legal fees. Again it comes back to: Do I want to lay out that cash?
That scenario is, in essence, what’s behind the fairly recent emergence of “litigation finance.” A litigation-finance firm, usually composed of former corporate attorneys, seeks investor funding just as a venture-capital firm does. In turn it provides funding to plaintiff companies (usually) that are attracted by the prospect of lowering their litigation risk and the opportunity to fund lawsuits off the balance sheet.
If the plaintiff loses the case, under most arrangements the litigation-finance firm loses the cash it extended. That makes it imperative for the firm to invest strictly in cases with a high probability of success. As with any investment of venture capital, thorough due diligence is mandatory. If the case is successful, the financing firm takes an agreed-upon share of the plaintiff’s recovery amount.
Litigation financing took hold first some years ago in countries that prohibit contingency-fee arrangements, like Australia, the United Kingdom and Canada. Activity in the United States generally began just three or four years ago, and only now is it becoming more than a tiny niche in the area of corporate litigation strategy.
Research quantifying the growth rate of litigation funding is hard to come by, but signs point north. Several new financing firms have started up operations over the past couple years, including Gerchen Keller Capital, which has raised about $360 million in venture funding. Another fairly new firm, Parabellum Capital, was formed as a spinoff from Credit Suisse in 2012 for purposes of funding litigation in the United States.
The best-known names in the space are Burford Capital — generally considered the world’s largest litigation financing firm — and Juridica Investments, both of which are listed on the London Stock Exchange. Now, though, a “significant majority” of Burford’s business is in the United States, says CEO Christopher Bogart. And it appears to be an almost bizarrely successful business; last September the firm reported that through mid-2013, it had enjoyed a 46 percent return on invested capital since its inception in 2009.
“At the beginning we engaged companies’ general counsel and their outside lawyers,” says Bogart, a former general counsel at Time Warner and a one-time litigator with iconic law firm Cravath, Swaine & Moore. “But the dynamic has changed, especially in the last 12 months. CFOs are becoming increasingly involved in managing the cost of litigation.”
A Critical Mass?
It’s easy to see the appeal of litigation financing to the finance chief of a plaintiff company. CFOs, of course, aren’t fond of costs that aren’t predictable or controllable, as is often the case with litigation costs. But that’s always been true. Why should there be a sudden surge of interest in litigation financing now? For his part, Bogart says he thinks the tipping point occurred as a result of massive litigation costs for some high-profile financial institutions in the past couple of years.
For Kevin LaCroix, the prevalence of such financing now is a direct result of early successes for firms like Burford that have taken a few years to generate a critical-mass effect. “Some of the first movers were U.S. affiliates of publicly traded foreign companies, so it was easy to get information on what they were doing,” notes LaCroix, an attorney with RT ProExec, an insurance intermediary focused on management liability issues. He’s also a blogger who writes often about litigation financing.
Burford recently commissioned its second annual survey of private-practice lawyers, in-house counsel and corporate finance executives about attitudes toward litigation financing. Only 45 finance people responded, and the results should be viewed in that light. The proportion of that group that had never heard of litigation financing declined from 38 percent in the 2012 survey to 25 percent in 2013. Those who said they “know the idea” beyond a limited understanding increased from 25 percent to 35 percent. But still this year, only 3 percent said they had ever used litigation funding, which was equal to the number who said they knew someone else who has.
Bogart acknowledges that 45 respondents is “not a big number” but says the survey results were “consistent with the market feedback I’ve been getting.”
Will Frivolity Reign?
Questions have been raised about potential ethical issues around the practice of litigation financing. One is the possibility that it could generate a profusion of frivolous cases including “strike suits,” or generally baseless claims intended to induce the defendant company to settle rather than pile up legal costs.
“That’s the easiest objection to refute,” says Bogart, because he loses his money if the case is dismissed or the defendant refuses to settle and wins. He notes that in the United States the firm invests an average of $7 million per case, depending on its riskiness and the length of time Burford expects the capital to be tied up. At that monetary level, “they’re not suing because the sidewalk in front of their building crumbled,” he says. “We invest an enormous amount of time and energy in due diligence” to ensure that funds are invested only in meritorious cases with potentially big payoffs.
Bogart’s rationale sounds logical, but LaCroix hedges on the matter. “The problem is, if the litigation financing industry gets better established and publicity about the returns that are available gets out, the field may attract fund sponsors or investors that aren’t as sophisticated or disciplined,” he says. “There’s not an infinite number of great lawsuits, so they may start investing in ones that aren’t so great.”
LaCroix notes that he’s not saying that’s what will happen, just that it is a risk. “Capital isn’t always a disciplining force. We know that,” he says. “With any investment asset class, and that’s what we’re talking about here, there are instances where too much funding is chasing too few opportunities.”
For defendant companies, the risks inherent in the proliferation of litigation financing go way beyond a potentially greater likelihood of strike suits. “If you’re being sued by a plaintiff with third-party financing, the pressure that would ordinarily be on the claimant to settle may not be there,” LaCroix says. “The other side may be able to carry the case longer, meaning additional costs for you.”
But the defendant company ordinarily wouldn’t be able to take that factor into account in deciding how long to fight a case. The plaintiff has no obligation to reveal that its action is being bankrolled.
Litigation finance firms occasionally work with defendant companies, who may also appreciate the ability to fight an extended legal case using off-balance-sheet dollars that don’t create a continuing cash-flow drain. But in this emerging era of litigation financing, the companies that bring the lawsuits are holding more of the cards.