Practical Guidance: Litigation Finance Client Types
Contributed by Charles Agee and Gretchen Lowe, Westfleet Advisors
Explore more Bloomberg Litigation Finance resources.
Litigation finance is an umbrella term that covers a wide variety of contractual arrangements. Those arrangements vary in any number of ways: in how much risk and reward the financier takes on, in the number of litigation matters covered, and in whether or how the funding is tranched.
One central variable in any litigation funding relationship is the type of client receiving the financing. This overview compares litigation funding relationships across three different client types: plaintiffs in litigation or arbitration, law firms, and defendants in litigation or arbitration.
[Plan for 2022 and beyond with in-depth analysis of the major trends that will shape the course of litigation in the coming year.]
Plaintiff Financing
What is it?
Plaintiff financing is a transaction in which a claimholder obtains financing that is usually used to satisfy the expense of bringing its claim in litigation or arbitration. It can also be used for other business purposes, or simply to monetize the claim in whole or in part. It is by far the most common form of commercial litigation finance.
Most commonly, law firms are the ones seeking financing for their clients’ matters. The financier’s repayment is secured by a financial interest in the outcome of one or more legal matters brought by the plaintiff. Funders may finance individual cases or portfolios of cases, which mitigates some risk through diversification.
Payment Obligations
All payment obligations to the financier (except in the event of a default by the funded party) are contingent upon a successful outcome in the underlying matter(s). If the funded litigation is unsuccessful for the plaintiff, the financier loses its investment.
Once a recovery is obtained, the financier typically enjoys seniority over distributions to the plaintiff or its counsel until repayment of its initial investment amount. Thereafter, the financier’s return typically follows a waterfall structure in which the plaintiff and its counsel are entitled to receive distributions. This investment return may be structured as a percentage of the recovery, as a multiple of the financier’s investment, or as a hybrid of the two methodologies.
To the extent that a portfolio of claims is used to secure the financing, the financier would typically be cross-collateralized such that a recovery in any one of the claims would trigger a payment obligation to the financier.
Success
Success in a matter financed by litigation funding is nearly always defined as a monetary recovery.
Success can also be defined by non-monetary metrics, but they can be difficult to define in advance. For example, the litigation strategy might be obtaining an injunction in the United States International Trade Commission to prevent the infringing product from being imported into the United States. This can be a significant value to the company, but there is no “monetary” recovery after the injunction is implemented. In situations like these, the litigation finance agreement will contemplate how the funder is to receive its investment return if the plaintiff obtains the injunction.
When is it Used?
Plaintiff financing is appropriate in any situation in which the plaintiff would like to take advantage of “contingency economics”—that is, letting another party absorb the financial burden of the litigation in exchange for an interest in any eventual recovery. Reasons this may be attractive to a plaintiff include:
- A lack of funds sufficient to pursue the case with its preferred counsel;
- A desire to limit the impact of litigation expense on company financial statements during the pendency of litigation (litigation financing is usually “off balance sheet”);
- A desire to hedge risks associated with an adverse outcome in the litigation by partially monetizing the claim at the outset of the litigation; and
- The desire to generate liquidity for some working capital need by leveraging an asset (a legal claim) not reflected on the plaintiff’s balance sheet.
Law Firm Financing
What is it?
Another common type of litigation finance, known as law firm financing, involves a transaction in which a law firm with one or more contingent fee engagements obtains financing. In this situation, the financier’s repayment is secured by an interest in the firm’s recovery on those contingent fee engagement(s).
In this structure, proceeds are often used to fund or to hedge the firm’s investment in its contingent fee cases, which includes costs such as third-party experts, document preparation, travel, and of course lawyer time.
Payment Obligations
Except in cases of default by a financed law firm, all payment obligations to the funder are contingent on a successful outcome in the underlying engagement(s). Once a recovery is obtained, the financier enjoys seniority over distributions to the law firm up to the amount of its initial investment. Thereafter, its investment return typically follows a waterfall structure in which the law firm is entitled to receive distributions. This investment return may be structured as a percentage of the recovery, as a multiple of the financier’s investment, or as a hybrid of these two methodologies.
Many funders are reluctant to structure their returns as a percentage of the firm’s fees due to concerns about fee-sharing prohibitions. To the extent that a portfolio of claims is used to secure the financing, the financier would typically be cross-collateralized such that a recovery in any one of the claims would trigger a payment
obligation to the financier.
Success
In law firm financing, “success” is defined as a monetary recovery.
When is it Used?
Law firm financing transactions are typically used where a law firm seeks to expand or to de-risk its contingency caseload, or where a firm has obtained a large judgment for a client and wishes to monetize a portion of its contingent fee in order to avoid continued deferral of liquidity and to mitigate the risk of reversal on appeal.
Consider this example: a law firm has a portfolio of contingency fee cases but has been waiting for those cases to resolve for a long time. While the law firm knows that it will eventually recover on these cases, it wants to unlock some of its expected fee now rather than waiting for the cases to resolve. Such a law firm could use litigation finance to de-risk some of its contingency fee and advance the payment of a portion of its expected fee award.
Similarly, the law firm that would like to take a case on contingency but has met its internal threshold for taking on contingency cases could use litigation finance as a tool to help the law firm expand its contingency fee practice when it otherwise would not have had the risk tolerance to do so.
Defendant Financing
What is it?
It is important to note that while defendant financing does exist, it is exceedingly rare. While there are a few different types of defense-side financing, we will discuss “pure” defense-side financing. This occurs in cases where the funder is purely financing the defense of the case; there are no counterclaims present that a funder could secure its investment against. Notably, there are cases where the defendant has a strong counterclaim and seeks litigation financing for prosecuting that counterclaim and defending against the plaintiff’s allegations. Given the similarities between this type of financing and plaintiff-side financing, we did
not want to discuss it in-depth here.
In this scenario, defendant financing relates to the potential exposure the defendant faces from the litigation. It involves a transaction where the defendant obtains financing to defend itself in a legal action and the financier’s payment is secured by a financial interest in the defendant’s outcome in one or more legal matters. This type of financing is meant to replicate a law firm’s reverse contingency fee arrangement. Much like a reverse contingency fee agreement, the funder’s recovery is based on the difference between the amount the plaintiff demands from a lawyer’s client (the defendant), and the amount ultimately obtained from that client, whether by settlement or judgment.
Success
In these structures, “success” is less tangible than in plaintiff financing, in which a monetary recovery is typically made. Here, success is defined by the differential between a benchmark of the defendant’s exposure in the litigation (that is, an initial estimate of what the litigation will cost the defendant) and the actual amount paid by the defendant to resolve the claim through settlement or judgment.
For example: a defendant has been sued by a plaintiff for allegedly breaching a contract to manufacture television screens. The plaintiff seeks to recoup the amount it paid under the contract, $10 million, and an additional $40 million in lost profits.
While the defendant can pay for the defense of the case and the ultimate award, it does not want to due to current budget restrictions. Moreover, since the lawsuit is only for breach of contract, there is no insurance coverage available.
In this case, the defendant could seek financing from a litigation finance company to pay for the defense of the case. At the outset, the funder and defendant agree that “success” is defined to mean only repayment of the $10 million under the contract. The parties also agree that, if the plaintiff recovers any lost profits, then the litigation was not “successful.” The parties determine that, if the lawsuit is successful, then the defendant must pay the funder two times the investment amount plus 25% of the difference between the amount actually paid by the defendant to the plaintiff, and the parties’ definition of success, which is a payment of $10 million.
Payment Obligations
All payment obligations to the financier (again, except in the event of a default by the funded party) are contingent upon a successful outcome in the underlying matter(s). That is, the financier will only be paid if the actual cost to the defendant is less than the initial cost estimate or benchmark. If the outcome is unsuccessful, the financier loses its investment and the defendant will have effectively avoided the legal costs typically associated with an unsuccessful defense.
In this situation, once the underlying claim is resolved, the repayment of the financier’s investment plus its return typically follows the same waterfall structure as in plaintiff financing. That is, the financier’s return increases along with the differential between the defendant’s actual payout and its pre-defined exposure in the case. This investment return may be structured as a percentage of this differential, as a multiple of the invested amounts, or a hybrid of these two methodologies.
Using the example above, assume the financier pays $2 million in defense costs. Ultimately, the case goes to trial and the defendant is only required to pay $2 million. Under this scenario, the defendant would owe the financing company $6 million (two times the $2 million investment, plus 25% of $8 million, which was the difference between the definition of success and the $2 million owed to the plaintiff) at the successful conclusion of the litigation. If, however, the defendant were required to pay $11 million to the plaintiff at the end of the litigation, then it would be considered unsuccessful, and the defendant would not have to repay the $2 million expended by the financier in defending the lawsuit.
When is it Used?
As we have already discussed, defendant financing is rarely used (though that may change in the coming years as new metrics for measuring success are developed). Theoretically, it may be used in any situation in which the defendant prefers to tie its expenditures to defend a claim to an agreed-upon level of success achieved in that defense.
What Else Is Out There?
There is currently much discussion throughout the litigation finance industry of corporate plaintiff portfolios, which operate very similarly to plaintiff financing, but on a larger scale. The difference is that corporate legal departments are the ones seeking funding for their own matters, rather than going through their outside law firms. It operates as a tool for corporations to generate consistent revenue from pending pieces of litigation rather than receiving all of the proceeds from a piece of litigation at one time. This can result in significant benefits for a corporation’s balance sheet.
There is also talk throughout the industry about the introduction of sophisticated insurance products for parties who seek the risk-management benefits attendant to litigation financing but do not need liquidity and do not want to bear the costs associated with obtaining it.