Covid-19 and Defendant Collectability Risk: What every litigation finance manager should be focusing on …today!
EXECUTIVE SUMMARY
Covid-19 will likely lead to the biggest financial crisis since the Great Depression
The crisis has affected the solvency and viability of corporations and sovereigns
Litigation managers need to re-assess collectability risk, immediately and regularly, of each defendant in their portfolio
INVESTOR INSIGHTS
Diligencing litigation managers should involve a deep understanding of how they assess defendant collectability risk
Defendant collectability risk is an ongoing risk that changes over time, therefore managers need a continuous risk assessment methodology
Investors looking to invest in litigation finance secondaries to take advantage of the current dislocation should avoid single case risk and look to portfolio acquisitions, but must assess collectability risk across the portfolio being acquired
As Covid-19 has taken the planet and the legal community by surprise, I think there are some lessons learned from private equity that can be applied to litigation finance. In short, focus on cash – its collection, generation, distribution and availability.
So, how does this relate to Litigation Finance?
This novel Coronavirus-driven healthcare crisis which has spiralled into a broad-based economic crisis, the likes of which the modern global economy hasn’t seen since the Great Depression, has had the effect of taking otherwise viable, profitable and cashflow positive businesses and stopping them in their tracks. Overnight, certain businesses and industries have performed a complete one-eighty, whereby they went from solvent to being on the precipice of insolvency. For many litigation finance firms, their immediate reaction has and should be to undertake an urgent review of the defendants involved in each and every case in which their portfolios have an investment, in order to re-assess collectability risk, one of the key areas of litigation finance underwriting.
When an economy, especially a consumer driven economy like the US, effectively shuts down overnight, there are few industries and companies that will be spared from a diminution in their value and blockage from access to capital. Former “recession-resistant” and “necessity” businesses have just experienced a new reality, which is that necessity is determined by context. The current context states that the only necessity is feeding, hand washing, shelter and healthcare, and this has had a massive impact on the economy. While this too shall pass, the economic impacts will likely linger for a number of months and years. The hope for a “V” shaped recovery has been dashed, as the crisis has extended beyond initial duration estimates. My personal opinion is that it will at best look like a “U” shaped recovery with the possibility of a double “W”, meaning there will likely be some ups and downs along the way, should the dreaded “C-19” rear its ugly head again going into the next flu season, or should it fail to be contained due to premature ‘return to daily activity’ policy. My hope is that the massive amounts of stimulus that are being pumped into the global economy actually make their way to the most hard-hit regions of the economy, namely ‘Mainstreet’, and thereby mitigate the damage that would otherwise be experienced for many small and medium-sized businesses on which most economies rely.
While we tend to focus on home first, litigation funders should also be mindful that the economy is global. As bad as developed countries think they may have it, fund managers who participate in the international arbitration market, which by definition, involve developing countries and corporations therein, need to be mindful that those defendants in developing countries will likely be even more greatly affected. Yes, even sovereigns.
Those managers that are focused on patent litigation involving start-up technology companies should also ensure the plaintiff is solvent through the end of the litigation, not to mention the collectability risk of the defendant, which may have been negatively impacted.
All of this is to say, that it is in the best interests of litigation finance managers to undertake a re-assessment of collectability risk of each and every defendant in their portfolio, and to do so on a regular basis for the foreseeable future. Managers will need to assess (i) the degree to which the defendant’s industry has been impacted, (ii) the strength of each defendant’s business and balance sheet, (iii) the ability for the defendant (business or sovereign) to access sufficient capital to maintain solvency, (iv) the degree to which the value of such business has declined, (v) a study of the defendants’ behaviour during the last economic crisis, as it relates to litigation ongoing at that time, if any, (vi) determine the extent to which other parties have security and seniority ahead of the plaintiff’s claims and (vii) assess the defendants’ ability to raise capital outside of financing (i.e. asset sales, equity raises, etc.).
Once a determination has been made as to the relative collectability risk, managers will then need to determine next steps with respect to protecting themselves from those cases where the defendant collectability risk has materially changed. This may involve the withdrawal of any further financing provisions (to the extent the financing was milestone-based), partnering with other parties to share the increased risk of the case, or selling all or a portion of a case or a portfolio (although the manager would be selling into a weak secondary market with relatively few participants, which will be reflected in the valuation, if they can secure bids). While the options may not be great, they may be better than investing ‘good money after bad’.