Quantum of solace for hedge funds?

Originally published in the November 2008 issue

We live in extraordinary times. Many fund values are seeing as rapid a descent in value as they did a meteoric rise. The current financial crisis and liquidity problems are a wholly different animal to typical market turbulence. For many, the impact on fund value is not necessarily a lack of judgement by fund managers but rather a consequence of the mistakes of others. During the last recession, pursuing claims through the courts was an expensive exercise. For some, the cost of litigating and the associated risks of losing often tipped the balance in favour of simply writing off losses altogether. For others, litigation was the only way to survive, although cost proved to be an insurmountable catch 22.

Litigation is generally the option of last resort. There are exceptions, in particular where it is necessary to freeze assets quickly before the opponent can dissipate. In addition to financial considerations, the sheer distraction of management time carries an opportunity cost in itself. But when other methods to mitigate fail, litigation becomes inevitable. Fortunately, it is not all doom and gloom, fund managers can take some solace from the financial options now available if pursuing litigation.

In the last two months there has been an unprecedented rise in applications for litigation funding from lawyers on behalf of hedge funds, and in some cases by funds directly, regarding current or contemplated litigation. The types of cases are diverse, ranging from fraud actions to defamation proceedings against the financial press as a result of alleged misstatements and their effect on fund values. Claims brought by funds against investment banks also appear to be increasing. For example, the collapse of Lehman Brothers has sparked a raft of asset recovery claims, as has the demise of a number of other investment banks.

The seismic shift in referrals to TheJudge from hedge fund claimants can be attributed, in part, to the increased awareness among law firms of ways in which their clients can mitigate the cost risk involved in pursuing litigation. In today’s unprecedented times, it is possible to hedge the cost risk of litigation. Ironically, litigation risk transfer options have developed during a decade of a booming economy, when litigation levels remained largely stagnant. Much of the stress-testing of this market has been undertaken during a relatively flat litigation period, which is fortuitous. The risk transfer market is better placed now than ever before to respond rapidly as litigation levels soar.

Third Party Funding (TPF) has hogged the headlines but, in truth, TPF is merely the little brother of a burgeoning litigation insurance industry. The products available in this most developed of litigation risk transfer markets offer a life raft to financial sector businesses caught in a perfect storm. England and Wales is now arguably the most attractive jurisdiction in which to litigate because of the availability of litigation insurance, funding and commercial conditional fees.

Using litigation risk transfer tools
A litigation insurance policy is a policy of indemnity. It does not provide interim financing, save for paying any interim cost orders which may arise during the course of proceedings, rather it gives an indemnity for legal costs if the case fails. Typically, a policy will indemnify the client’s liability for adverse costs, their own disbursements (including counsel’s fees) and potentially a proportion of the client’s own solicitor’s fees. Whilst a 100% cost transfer is possible, typically somewhere in the order of 50-75% is achievable from the insurance markets; much depends on the size of the case. The interesting feature, and the real solace for fund managers contemplating litigation, is that this hedge on risk is available at no upfront cost, no cost if the case fails and, if the case succeeds, the cost of the policy should be recoverable from the opponent. This is true whether the cost ofthe litigation is modest or significant.

Provided a client has sufficient cash flow to pay some of the interim costs involved in pursuing litigation, safe in the knowledge those costs are ultimately insured in the event of a loss, it is, potentially, possible to transfer up to 100% of the financial risk at no cost whatsoever. Too good to be true? No, it is a fact and has been so for some years now. The message has been slow to filter through to clients because of the inability of some lawyers to understand how this risk transfer tool works. Some continue to be out of touch with the market and others still treat the ‘economics’ of litigation as a secondary consideration, when it ought to be a primary point of discussion.

Third party funding (TPF) is a slightly different risk transfer model to insurance. TPF provides interim cash flow for a case as well as carrying the risk of failure. However, this hedge comes at a substantially increased cost. In exchange for providing interim financing, a TP funder will expect to receive a share of the case proceeds, often anywhere from 20-50% of the case value or 2-5 times the amount funded. Unlike insurance, the cost of this hedge is payable by the client and cannot be recovered from the opponent.

For some litigants, in particular those with limited or no assets, knowing they have complete indemnity from an AA Rated insurance company is not sufficient if they do not have the liquidity to pay the interim expenses to enable the litigation to progress. For those litigants, TPF is undoubtedly a key ingredient in their risk transfer mix. However, for a well-resourced asset-rich client the notion that “it’s better to have 50-70% of something than 100% of nothing” needs to be considered against “why give away 30% when you can retain 100%?” Where TPF is employed, a hybrid package is often negotiated to combine litigation insurance within the deal. The notion of pure TPF-xfinanced litigation is likely to be very short-lived.

The point to remember for those involved in or contemplating litigation is that a significant proportion of the cost risk can, potentially, be offset at no cost whatsoever. Also, as well as having the support of a major insurer, TP funder or indeed both, the fact of having a litigation funding package in place sends a powerful message to an opponent that others agree your case is likely to succeed.

James Delaney is Director, The Judge Ltd, Independent Risk Transfer Brokers