The Emerging Market for Litigation Funding

A new kind of non-correlated investment class

JOHN PIERCE and DAVID BURNETT, QUINN EMANUEL URQUHART & SULLIVAN LLP

Litigation funding has emerged in recent years as a fast-growing and very attractive asset class. Litigation funding refers to the financing of lawsuits by outside parties, typically small investment funds that are formed for that purpose. It is a small but growing field. Major players include Burford Finance, Juridica Investments, Bentham Capital, and Parabellum Capital. Litigation funding appeals to managers and investors because it is a non-correlated, alternative investment class that offers the prospect of double-digit returns at a time when other asset classes are underperforming. Litigants’ interest in alternatives to hourly-fee legal billing and a recent swell of plaintiff-side, large-scale commercial litigation are driving the sector’s growth. Recent legal opinions have helped clear away the legal and ethical uncertainty regarding the business.

The business model
In private practice, legal services have traditionally been billed in one of two ways: either hourly or on contingency. The hourly model is most common, particularly for defendants, where a party to a lawsuit pays their lawyers by the hour, regardless of the lawyers’ performance or the outcome of the case.

The other payment model is contingency-fee billing, where a client pays no legal fees, or reduced or flat fees, in exchange for sharing any financial recovery arising from the case. This model is typically used in plaintiffs’ litigation, where the plaintiffs are often unable to pay on an hourly basis. Contingency-fee billing provides the plaintiffs free or reduced-fee legal representation. In return, lawyers often receive a third of any judgment or settlement they obtain for their clients. If the case is dismissed, the client pays nothing and the lawyer receives nothing. The lawyer’s financial interests are therefore aligned with the client’s interests, which benefits the client because it incentivises the lawyer to only accept meritorious cases, and to push hard for a favourable recovery.

Litigation funding, as it is typically used, is a variation on the contingency-fee billing model. Funders satisfy a niche in the market for legal representation, where neither the client nor its lawyers wish to (or are able to) bear the up-front costs and risks of financing a lawsuit. Funders typically focus on commercial litigation between sophisticated parties, rather than personal-injury or class-action cases. Institutional plaintiffs often could pay their lawyers’ hourly fees, and the law firms could afford to take the lawsuits on contingency, but both parties choose not to. In a typical scenario, a law firm will offer full-contingency billing to the client (meaning the client pays nothing to the firm, except perhaps incidental costs), while the funder provides periodic payments to the firm to cover its costs and reduce the firm’s financial exposure. In exchange, the funder shares the law firm’s portion of any contingent-fee recovery.

In effect, funders treats legal claims as a corporate asset, able to be quantified and traded in a marketplace. Litigation funders’ return on their investment in lawsuits depends on various factors, including the merits of the claim, the state of the law, the quality of the lawyers, the financing model (lump-sum or drip-fed), and the expected duration of the lawsuit (including time on appeal and time to collect a judgment). Funders perform considerable due diligence on the plaintiff, the legal landscape, and the lawyers before committing to a case. Due diligence can take between 30 and 90 days, depending on the case, followed by negotiation of the deal terms. When funders pick good claims to sponsor, namely meritorious claims that will withstand motions to dismiss and motions for summary judgments, they stand to reap substantial paydays.

Major players
The litigation-funding sector is small but growing. Burford Capital, which was founded in 2009, is the largest fund in the field, with more than $300 million in investment capital. It is publicly traded on the London Stock Exchange. The firm’s total income for 2012 was $54.2 million and pre-tax profit was $34.1 million, both double the 2011 figures. Burford’s co-founder and CEO, Christopher Bogart, is the former general counsel of Time Warner Inc. The other co-founder and chief investment officer, Jonathan Molot, is a professor at Georgetown University Law Center. Burford has retained two prominent experts on legal ethics, both law professors, as ethics counsel to the firm.

Juridica Investments Ltd, another publicly traded investment firm, was founded in 2007. Juridica has over $200 million under management. Juridica’s lifetime gross proceeds through December 2012 were $85 million, and its gross internal rate of return from the investments which have been resolved, as of June 2012, is approximately 85%. The firm typically invests $3 million to $10 million towards legal claims of $25 million to over $100 million in value.

Bentham Capital is the US subsidiary of IMF (Australia) Ltd, an experienced commercial funder. IMF reports that the cases it has under management have a claim value of $1.2 billion. The firm is run by Ralph Sutton, who previously helped establish the litigation funding group at Credit Suisse. Others in the litigation finance team from Credit Suisse spun off to found Parabellum Capital in 2012, which has raised $200 million. Most recently, in April 2013 a new firm, Gerchen Keller Capital, announced that it has raised $100 million to invest in commercial litigation between large institutions, with both plaintiffs and defendants. On the other hand, BlackRobe Capital, a litigation funder that was founded in 2011, recently announced that it is closing due to an inability to attract sufficient outside capital.

Deal structures and risk profile
Like asset managers in other fields, litigation funders seek a diversified portfolio of investments, spread along a continuum of risk and reward. On the one hand, funders might make relatively small investments in lawsuits, or might invest in lawsuits with relatively small losses, where the expected recovery is modest, or the funders might invest in relatively low-risk lawsuits with a good chance of success, where their financing terms are less lucrative. On the other hand, a fund might also make larger and riskier bets on lawsuits whose outcome is less certain, but where a successful judgment or settlement will yield enormous recoveries. Funders are likely to demand more favourable terms before agreeing to fund lawsuits with untested legal theories or long-shot arguments with known pitfalls. Relatively conservative investments are meant to provide a steadier source of revenue while the fund waits for outside returns from more speculative investments.

Litigation funding can be structured in many ways, and can accommodate awide range of clients and financial needs. Funding can be applied to multiple stages of a lawsuit, from pre-filing to post-judgment and appeal. Given the number of variables in play – the claims, the parties’ goals, the applicable legal and professional restrictions that could apply – and given the relative newness of this asset class, there is great variation among deals. Sometimes funds invest in individual lawsuits, but given the time and costs involved in due diligence and negotiation, funders more commonly agree to invest in an entire portfolio of claims held by a client or law firm. The fund either makes a single lump-sum payment or periodic payments to the law firm, in exchange for a portion of any settlement or judgment. Or the funders might invest directly with the plaintiffs, providing capital to parties with pending cases or trials. The funders might even purchase interests in legal claims, particularly patents, at which point they can prosecute claims as plaintiffs.

Here is an example. Imagine an institutional investor which sues an investment bank for $200 million in losses on mortgage-backed securities. The lawyers negotiate a full contingency fee agreement with the client. The lawyers separately agree to split the contingency payment with a litigation fund in exchange for $5 million in periodic payments to the law firm. Assume the court denies the defendants’ motion to dismiss, the case proceeds to discovery, and the defendant ultimately settles for $50 million. The law firm receives a 30% contingency fee, $15 million, and pays half to the funders. The funders realize a $2.5 million profit on their investment, a 50% return. If the court dismisses the case, however, or the plaintiffs only obtain a small settlement, the funders could lose some or all of their investment in the case.

Types of cases
Litigation funding can be applied to a wide variety of lawsuits, all typically commercial litigation among large institutions. Funders often focus on high-stakes financial litigation and intellectual-property litigation, involving highly sophisticated lawyers and claim-holders with high-value claims. For example, our firm, Quinn Emanuel Urquhart & Sullivan, LLP, has used litigation funding to help finance multiple claims brought by large clients. Funding can also be applied to bankruptcy claims, insurance claims, contract disputes, and domestic and international arbitration. Funding is typically on the plaintiffs’ side, although funding could be used by defendants to cover their legal costs in exchange for repayment and a success fee if the case is dismissed, for example.

Development of litigation funding
The growth of litigation funding coincides with litigants’ growing interest in alternatives to conventional hourly-fee legal billing. Given the enormous costs of legal representation, which can run to millions of dollars a month in large cases, and corporations’ belt-tightening following the recent recession, litigants are seeking creative ways to reduce their legal costs. Some clients seek partial or full-contingency billing arrangements, in exchange for sharing any recovery with their lawyers. Another option is flat-fee billing, with fees billed by project or by phase of the litigation, which is meant to provide greater predictability in billing. Quinn Emanuel can be seen as a pioneer in providing contingency-fee billing to large corporate clients. Litigation funding compliments contingency-fee billing by injecting additional capital, and therefore further flexibility in billing and financing, for all parties involved. Funding frees up capital for litigants and law firms to allocate elsewhere while a lawsuit is pending.

The growth of litigation funding is also linked to the fall-out from the 2007-08 financial crisis. Beset by enormous losses and prompted by substantial evidence of wrongdoing, hundreds of institutional investors have brought suit against the Wall Street banks that structured and marketed mortgage-backed securities, collateralized debt obligations, and other complex financial instruments. More recently, litigation funders have also explored financing arrangements for claims arising from banks’ alleged manipulation of the LIBOR rate. Oftentimes investors would like to bring suit but they are reluctant to pay hourly legal fees for discretionary lawsuits (as compared to defense-side work, where companies have no choice but to defend themselves in court or settle). Law firms, meanwhile, are reluctant to forgo all revenue from the lawsuits while they are pending, particularly if the firm represents the client in multiple lawsuits, given the carrying costs of law firms and the risk of dismissal. As the litigation funding market grows, it has attracted interest from prominent white-shoe law firms, which are helping to make the asset class more familiar and acceptable.

Litigation funding is also popular with investors because it is a non-correlated asset class. Indeed, legal claims are often counter-cyclical with general economic conditions, as illustrated by the legal fall-out from the financial crisis.

The legal and ethical environment
“Champerty” is a medieval legal doctrine that prohibited the sharing of litigation proceeds between a litigant and a third party, while “maintenance” restricted a third party from assisting a litigant in prosecuting or defending a case. In the US many states like California have rejected these doctrines, finding them outdated. Other states, like Minnesota and Ohio, have voided litigation funding contracts, finding them void and unenforceable under these doctrines. The parties to litigation funding must take applicable laws into account when agreeing on funding agreements.

Recent legal opinions have upheld the permissibility of litigation finance. An April 2013 report to an ethics committee of the New York State Bar Association noted a number of recent court decisions and bar opinions condoning the use of litigation fund. The report found that third-party financing of commercial litigation is becoming an increasingly common way to pay for commercial lawsuits in the US. Courts are extending legal protections to funders, as well. For example, in October 2012, a federal court held that litigation funders may review privileged documents without risk of disclosure to opposing counsel, since the documents were protected as attorney work product. The court found that litigation strategy would be revealed if the documents were produced. The court also declared that the materials were protected by attorney-client privilege, since Burford and the plaintiff had a “common interest in the successful outcome of the litigation which otherwise [the plaintiff] may not have been able to pursue without the financial assistance of Burford.”

Litigation funders are keenly aware of the ethical and legal sensitivities surrounding their industry. They employ top ethics advisors and stay abreast of legal developments, and they analyse the legal and ethical aspects of each investment before funding it. They also take steps to insulate themselves from critique, like avoiding direct contact between the funders and the party to litigation. Funders prefer to contract with the law firm.

Advocates argue that litigation funding benefits the legal system because it can level the playing field for underfunded litigants. Given the considerable costs of high-quality legal representation, all too often the most well financed party wins a case or obtains a favourable settlement. As explained by Christopher Bogart, the CEO of Burford, “Companies with meritorious claims can be drained by litigation or outspent by better financed adversaries. With financing, the case is about the merits, not about the bank accounts.” Litigation funding can also benefit litigants by applying sophisticated economic analysis and due diligence to assessing their claims.

The US Chamber of Commerce has criticized the industry, claiming that funders can inappropriately influence the outcome of cases because they are driven by economics rather than legal judgment or clients’ best interest. The response is that the funders should not have a direct say in the direction of the litigation, and therefore improper influence is not an issue. And if financing is structured properly, the economic interests of the claim-holder, their lawyers, and the funders should be aligned.

The Chamber of Commerce also worries that litigation funding will encourage frivolous litigation by plaintiffs with no financial risk in bringing suit. It is true that, by increasing the financing options for claim-holders and their lawyers, thereby making certain claims economically feasible to bring, litigation funding may expand the ranks of plaintiffs. Certain lawsuits may be financially unattractive or impossible without funding. But even as litigation finance reduces claim-holders’ financial investment in cases, it increases the funders’ investment. The funders have a great interest in ensuring a successful outcome for cases they bankroll, so in practice funders would not finance frivolous claims.

Looking ahead
The market for litigation funding should continue to grow, as plaintiffs and law firms look for creative ways to balance legal costs with successful outcomes, and as financiers look further afield into alternative investments. In a December 2012 survey, Burford concluded that “Litigation finance has a clear use in the US market, and lawyers and general counsel expect this type of financing to grow in commercial litigation over the next 18 months.” In their survey, 69% of litigators said they expect the use of litigation finance to grow and 51% of litigators said they have had a case that would benefit from outside financing. Nonetheless, the long-term growth for litigation funding and its impact on the legal marketplace remain to be seen. The sector depends on plaintiffs’ appetite to sue, and on the willingness of litigants and their lawyers to share any settlement or judgment. But given the vast size of the US legal market – the amount spent by litigants is estimated to be $200 billion – there is enormous room for growth.