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.
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.
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.
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