Applications Of Litigation Finance
Single Case Financings
The main application of commercial litigation finance is quite simply what is was designed to do - provide plaintiffs who believe they have been economically disadvantaged by another company the necessary capital to pursue their case and potentially obtain damages either through a settlement or a judgment. Since many of the companies seeking financing are smaller corporate entities (the “Davids”), that are suing larger, much more well-capitalized companies (the “Goliaths”), having access to financial and professional resources is imperative to levelling the playing field. Third party litigation finance is therefore an economic tool enabling them to seek restitution in a fair and equitable way against a system that has been geared to favor the deep-pocketed. The genesis of the industry was single case financing.
Portfolio Financings
Instead of using third-party financing on a single case basis, industry participants (law firms and corporations) have wisely applied it to the financing of a portfolio of cases. The cross-collateralization of the portfolio thereby diversified and reduced the funder’s risk, which enabled the portfolio owner to substantially reduce their overall cost of capital. In essence, it represents a risk transfer from the funder to the law firm or corporation that has the portfolio, which attracts a lower cost of capital but still represents excellent risk-adjusted returns for the litigation funder.
Hedging
Litigation finance offers plaintiffs a way to hedge their financial exposure against an adverse outcome by shifting some of their financial risk onto a third party in exchange for a cash payment and a reduced economic interest in any potential reward. Often this decision is economically-driven, as opposed to outcome-driven. The outcome of any case - irrespective of the merits – is always subject to some element of irrationality and uncertainty (judicial bias, jury bias, jurisdictional bias, etc.). By selling a piece of their claim to a third party in exchange for financial assistance, the plaintiff reduces its psychological and financial stress. While this will result in reduced upside potential, it also reduces downside risk.
Off-Balance Sheet Financing
The senior executives of some corporate entities, especially those that are publicly listed or owned by a private equity fund, have a fiduciary responsibility to maximize the outcome for every dollar they invest. Some would argue that to pursue a single case litigation is not a good use of a company’s finite financial resources due to binary and idiosyncratic litigation risk as opposed to using those same financial resources to re-invest in the growth of the business. Even if victorious, a one-time legal win can never accrue the same long-term equity value as that which can be achieved through an increase in recurring income and profitability.
For these stewards of capital, they are more apt to look for a source of off-balance sheet capital to finance their litigation. Not only does it have an element of hedging, as discussed above, there is also an accounting and financial benefit in that the legal fees are not impairing operating earnings and equity value. In addition, any financial windfall resulting from a successful outcome must be reported ‘below the line’ (below the operating profit line) providing no sustainable positive impact to the firm’s equity value (other than the after-tax cash that is added to the balance sheet as a result of a win).
Life Cycle Funding
While most of the litigation finance industry is geared toward pre-settlement financing (i.e. an active piece of litigation that has not yet settled), there are other applications in terms of pre-appeal and post-settlement.
Pre-Appeal funding is where a case has been won by a plaintiff but is now set for appeal. Using litigation funding at this stage of the case may allow the plaintiff to take some ‘chips off the table’ as a hedge in case the initial ruling is overturned on appeal and do so at a valuation that is generally better than in a pre-settlement scenario. From an investor’s perspective, pre-appeal financing has a different risk/reward outlook and duration is much lower than pre-settlement.
Post-settlement funding is essentially the funding of the receivable between the plaintiff and the defendant after a settlement or judgment has been achieved but before the monies have been transferred. From an investor risk perspective, post-settlement funding has more to do with collection risk, procedural risk, and timing than it has to do with litigation risk, hence the cost of capital is significantly lower.
Other applications could include the factoring of law firm receivables related to completed cases, but this type of financing starts to cross into commercial finance as it no longer involves litigation risk.