I. Overview
Litigation Finance involves lending to either (a) plaintiffs and their representatives who are seeking payment on a claim or (b) defendants and their representatives who are seeking to reduce or avoid payment.
Note that litigation finance is different from the practice of lending to law firms whereby credit quality is derived from the operating income of the law firm.
Considerations for investors/lenders/funding sources (collectively “funders”) include the certainty of payment, the timing of payment, the diversification of claims, the reputation and prior experience of the parties involved, and other factors.
The purpose of this installment is to provide an overview of the area.
II. Plaintiff-based Funding
Legal claims are typically awarded to the plaintiff based on losses (or damages) incurred. To establish such claims the plaintiffs can undergo a trial or settle before trial.
Typically, funds borrowed by the plaintiff are used to finance a case’s legal-related expenses.
Advances typically are made on a non-recourse basis. That is, in the event of non-recovery, there is no claim against the law firm or the plaintiffs. Hence, a thorough review of the quality of the claims is essential.
In the case of a trial, the award might be challenged via an appeal. In this case, the manifestation and timing of the payment is less certain. Therefore, plaintiff-focused funders would typically advance a smaller proportion of funds than they would otherwise.
Key considerations for plaintiff-focused funders:
Status of the Claims – what is the status of the claim; refers to whether the claims have been fully litigated. Common terms are 'pre-settlement' and 'post-settlement.'
Defendant’s Ability to Pay – are they able to pay the claims and if so, when.
Diversification – the level of diversification of the claims. A high level of diversification is advantageous.
Future Obligations – if additional investment is needed to realize cash from the claims, such claims might be disallowed by the funders.
III. Defense-based Funding
Defendants and their representatives may seek funding to cover their legal-related expenses. The practice is often called “reverse contingency financing."
Funding can be tailored to a wide variety of situations. In the client-facing version, the defendant pays a return to the funder if – and only if – the litigation resolves in its favor. For this reason, the reverse contingency requires a careful definition of what events trigger the defendant's repayment obligation.
Examples include winning dismissal or summary judgment, defeating class certification, securing a favorable verdict at trial, and –most commonly – settlement below a set threshold. In any of these scenarios, the defendant repays the funder its deployed capital plus a return.
In another structure, a law firm offers the defendant a discount on its hourly rate in exchange for a “success fee” if it secures a successful outcome. In a reverse contingency, a funder would pay the law firm some or all of its fee discount – thus reducing risk to the law firm – and the law firm would then pay the funder its “success fee.”
IV. Settlements
Generally, the least risky form of financing is based on claims that have previously been litigated and the injured parties are simply waiting for payment. In this case, assuming litigation has been fully exhausted, the main issues are (i) ascertaining the validity of the settlements and (ii) assessing the credit quality of the obligor(s) and the certainty of payment.
V. Structure of Funding; Lending Base and Advance Rate
As is the case in many private transactions, structure is important. Typical issues might be…
- Characteristics of eligible claims
- Advance rates
- Term of the overall transaction
- Expense allocation
- Diversification levels
- Material changes in the litigants
- Maximums and minimums for the pool
- … and other factors
Both plaintiff-based and defendant-based financing might be included in the overall pool.
A key step is using the aforementioned items to estimate the available resources (aka the lending base) to repay funders. Below is a sample matrix for such calculation for defendant-based lending:
In the above simple example (most change to many pools are 15 or more cases), Case A can be considered a claim with high credit quality as it is post-settlement, and the payment should be forthcoming in approximately 24 months. Using a similar analysis for the various cases resulted in a “Lendable Base” of $16.5M on which a typical lender might advance only a portion, in this case, $10M. (Note, typically the amounts of cases and the corresponding total are much greater than those indicated above.)
VI. Defining Success
Because settlement is the most likely outcome in many lawsuits, the parties to a financing agreement must delineate its role as a "success" in detail, particularly in the client-facing reverse contingency model. The funder and the defendant need to agree upfront on an expected value for the litigation, below which a settlement would be considered a victory.
This value may change as the litigation proceeds, so the parties may wish to reserve their rights to reset the settlement benchmark at the end of discovery. The funder's return in the event of a settlement can also be expressed in several ways. For example, it might be a percentage of the difference between the projected value of the litigation and the settlement amount; or it may be the greater of such a percentage and a multiple of the funder’s investment. The timing of the settlement will also play a role in defining the return. These elements require careful negotiation and realistic expectations at the outset.
In an oversimplified hypothetical example, a defendant sued for $100 million in liquidated damages for breach of contract might agree to pay a funder 20% of any savings below $75 million, plus repayment of defense costs, in exchange for the financier covering those costs upfront. If the litigation settles for $50 million after $5 million is spent on the defense, the funder would be repaid its $5 million and earn a return of $5 million (20% of the difference between $75 million and $50 million). The defendant saves $45 million and avoids having spent $5 million upfront in defense costs.
If the case settles above $75 million, or results in a $75 million+ defeat at trial, the defendant pays nothing toward its defense; the funder bears that cost. Extending the same hypothetical example to the law firm “success fee” variation, suppose the law firm agreed to a 50% discount on its $5 million in fees in exchange for a success fee that grosses it up to 100% plus a 50% premium for success (totaling $7.5 million in fees). A litigation funder then covers some or all of the law firm’s $2.5 million discount. In the event of a successful resolution, the defendant pays the law firm its $2.5 million in deferred fees plus an additional $2.5 million – the 50% premium. This is essentially the cost of having de-risked its success fee discount.
VII. Credit Rating
An assessment of the corresponding rating is based on several factors as mentioned at the onset. Nonetheless, a significant factor is likely to be the advance rate (i.e., the amount borrowed which is $10M in the above example) compared to the Lending Base (i.e., $16.5M above). Arrange a call at egan-jones.com/book for a more granular view.
VIII. Market Rating
Regarding the transactions being completed in the market currently, for the most part, they are in the less-risky areas; that is the claims have already been litigated and the claim holder wants to realize proceeds from those claims. Additionally, at times, the claims are "wrapped" via support from a third party providing assurances regarding the payments of the claims.