U.S. Commercial Litigation Finance Industry - Call To Association!
There is no other way to express it; the US commercial litigation finance industry is under assault from a variety of different interest groups and the industry lacks a homogenous voice to counter the opposition and to communicate its strong benefits.
No doubt, many industry participants are well aware of the recent report by a hedge fund short- seller against the industry’s largest participant. While the report raises many issues for consideration, it is also symptomatic of a multi-pronged attack on the industry, whether organized or purely by coincidence. This article is a call for the industry to unite and create an association to represent interests of the various participants and beneficiaries of the industry (lawyers, plaintiffs, funders and investors).
Why now? Let’s look at the current litigation finance environment.
US Chamber Institute for Legal Reform
The single biggest opponent to the litigation finance industry has been the US Chamber of Commerce (“USCOC”), through their affiliate entitled U.S. Chamber Institute for Legal Reform (“ILR”). The USCOC is the largest lobby group in America and the ILR has chosen litigation finance as one of its favourite punching bags.
While the USCOC boasts 3 million members , large and small, it is important to note that according to an article published by U.S. News entitled “The Chamber’s Secrets”, more than 50% of their contributions came from 64 donors. The article suggests that much of the funding for the USCOC comes from large corporate interest in legacy industries (tobacco, firearms, fossil fuels, banking, etc.). Accordingly, based on their funding sources, it should be no surprise that they are opposed to litigation finance. In fact, the article goes on to state that many of the smaller businesses which used to be members of the USCOC are partnering to create alternative organizations like the American Sustainable Business Council to look after their best interests. Perhaps litigation finance should align itself with these splinter groups as there is likely a high commonality of interests vis-à-vis commercial litigation finance.
So, what does this all mean for litigation finance? Well, the ILR has been lobbying the government hard to increase disclosure requirements related to litigation finance, and is espousing that litigation finance is a scourge that needs to be eradicated as it serves to promote frivolous lawsuits and increase the cost of litigation. Their position is both inaccurate, and fails to serve the needs of all ILR members. While certain members of corporate America would like to keep the proverbial litigation finance ‘genie’ in the ‘bottle’, we all know that litigation finance serves the interests of small corporate America particularly well by levelling the playing field through the provision of capital to pursue meritorious claims mainly for small corporations, the very constituency that the USCOC purports to represent. Of course, as the litigation finance industry pushes into providing portfolio financing to larger corporations (witness recent moves by Burford and Litigation Capital Management), it could very well be the case that the USCOC may no longer represent the best interests of its larger contributors.
Nevertheless, in light of the organized effort to denigrate the need and value of litigation finance by the ILR, the commercial litigation finance industry needs a unified voice to educate the market and our elected officials about the benefits of litigation finance, and to ensure that legislative changes support access to justice and continued industry growth.
Disclosure, Disclosure, Disclosure
The single biggest complaint from the USCOC relates to disclosure which is being raised with increasing frequency in litigation where litigation finance is being used. Recently, a favourable decision in U.S. District Court for the Northern District of California was issued whereby Judge Illston held that the discovery of the identity of the litigation funder was irrelevant. This decision somewhat contradicted a previous decision by the same judge which compelled disclosure, although in one case relevance was conceded whereas in the other it was not. While it remains unclear to what extent disclosure is being requested and when disclosure is applicable and relevant, the issue is an active one. While it does appear that there is a strong bias by the judiciary against disclosure; that according to a study conducted by Westfleet Advisors entitled “Litigation Funding and Confidentiality: A Comprehensive Analysis of Current Case Law”, it is incumbent on the industry to ensure disclosure is appropriate for the circumstances.
If disclosure relates to the existence of a third-party litigation finance provider in a case, many in the industry have said they would not necessarily be opposed to that level of disclosure. However, a panelist at a recent industry conference made an astute observation, suggesting that if the defense is even aware that a litigation funder is involved, the very knowledge of its involvement may influence the outcome of the case, which may be prejudicial to the rights of the plaintiff. Sometimes there is value in silence.
If, on the other hand, disclosure encompasses the name of the funder and the amount and terms of the funding contract, this would clearly be prejudicial to the interests of the plaintiff as it provides the defense with economic knowledge about the funding terms which it could use to its advantage.
Either way, it is important for judicial authorities to understand the pros and cons of disclosure in the context of litigation finance so that they can rule in a way that is not prejudicial to either party in the case. This is an area where education and lobbying by the industry could be an important determinant of standards for disclosure.
Legislative Trends in Consumer Litigation Finance
On the consumer side of the litigation finance market (predominantly personal injury settlement advances in the US), there have been a series of measures taken by various state legislatures that have served to limit and sometimes effectively eliminate the practice of settlement advances. While these actions have been taken under the guise of consumer protection, the reality is that those states that have effectively eliminated the practice of consumer litigation finance have left thousands of injured parties in a very precarious position. While legislators may have had the best of intentions in creating consumer protection legislation, the unintended consequences may be worse than the problem they were trying to solve.
My biggest concern is that litigation finance becomes a political platform issue that results in legislative reform that ultimately harms consumers more than it helps, and then those same reforms make their way into the commercial side of the market. This is an area where a strong association liaising with other closely aligned associations can combine their resources to protect their collective interests.
Don’t Forget the Investors!
The recent Muddy Waters report accusing Burford Capital of significant governance and financial reporting shortcomings should be another call to action for the industry. These accusations have the potential to be a serious setback for the industry given the stature of Burford in both the litigation finance industry as well as from a capital markets perspective.
Capital is the lifeblood of the industry, and to the extent negative accusations effect the outlook for an industry, they also impact the industry’s ability to attract capital. Accordingly, in addition to codes of conduct and industry best practices, an association should also bear in mind the best interests of those that provide the fuel to move the industry forward – namely, investors. In this vein, an association should be providing best practices in financial disclosure and reporting to ensure that the industry is well understood by investors, and that financial results are clearly explained and standardized across managers, both in public and private markets. An association should also be liaising with securities and accounting professionals to ensure they understand the industry and the limitations associated with fair value accounting in a market which exhibits both idiosyncratic and binary risk. Existing guidelines and principles from groups like the Institutional Limited Partners Association could also serve to benefit association members and investors.
From a capital markets perspective, I believe the industry needs to position itself as a Socially Responsible Investing (“SRI”) asset class. What other investment do you know of where you have the ability to change corporate behaviour for the better by providing capital to level the playing field. Litigation finance is in the business of profitable social justice and the industry should ensure the investment community is aware of this fact. A strong industry association can undertake the necessary steps to ensure the investment community is aware of the social benefits associated with the asset class and positions the asset class appropriately in the context of investor portfolio construction.
Industry is at a Critical Juncture
The US commercial litigation finance industry has been estimated by some as a $5-10B industry, although much of the industry’s capital sources are opaque and not well-tracked. While the absolute number is not important, it is fair to say it is a relatively small market in the context of the US economy. However, it is also a fast-growing market. As markets gain notoriety and generate strong absolute returns, they can also be attractive for undesirable market entrants. The industry is now large enough to be organized and capitalized in a manner that is meaningful and at a point in time in its evolution that will make it effective in ensuring that ‘undesirables’ don’t enter the market, to the benefit of all market participants.
Self-Regulation
While the benefits of an industry association are generally well known, the commercial litigation finance industry also stands to benefit mainly through its own self-regulation. The world of litigation finance is a relatively new area of finance and is one that is relatively complex, both from the perspective of capital provisioning, as well as the terms of the financial reporting of outcomes. Further, commercial litigation finance solutions are highly customized for the case or portfolio of cases, and so the application of a ‘cookie cutter’ regulatory framework could be dangerous. The last thing the industry needs is to be regulated by someone unknowledgeable about litigation finance. The potential for unintended consequences, similar to what has happened in certain states on the consumer side, is a great example of why the industry should self-regulate.
In addition, the legal profession is already highly regulated. The profession itself has numerous rules covering ethics and rules of civil procedure. One could argue that the last thing the profession needs is another rule. I think what is more important to the consumers of litigation finance is transparency about how it works and an internal monitoring function to ensure adherence with existing rules. These are best crafted by those involved in the daily workings of commercial litigation finance.
Keep Calm and Organize!
It’s times like these when an industry needs to come together to create a strong association to represent its interests, before succumbing to the pressure of interest groups with opposing objectives and motivations. The commercial litigation finance industry is on the precipice of either sharp decline or its next growth phase, and the outcome may lie in its efforts to create an association to protect its interests and espouse the benefits of litigation finance. The industry needs a unified voice to speak on behalf of and to the benefit of the collective community (be they funders, plaintiffs, lawyers or investors) and across geographic borders to ensure global alignment, to the extent viable. While an Association can benefit from support by some of the larger funders in the community, their support, while very much welcome, should not prohibit the industry from moving ahead with an association, given that all funders will eventually join out of necessity.
While the consumer side of the litigation finance industry has astutely created both the American Legal Finance Association (“ALFA”) and the Alliance for Responsible Consumer Legal Funding (“ARC”) to represent its best interests, it does not appear the same can be said for the larger commercial litigation finance market. ALFA and ARC have proactively created a code of conduct, and have organized efforts to lobby, where appropriate, at the state and federal levels. ALFA’s mandate includes being “committed to promoting fair, ethical, and transparent funding standards to protect legal funding consumers”, whereas ARC’s mandate includes advocating “…at the state and federal levels to recommend regulations that preserve consumer choice”. In short, they are organized and they will benefit as a result of such organization despite increasing pressure on the industry at the state level. In other jurisdictions where commercial litigation finance is more mature, industry associations have been created and are actively representing participants’ best interests, including the The Association of Litigation Funders of Australia and The Association of Litigation Funders of England and Wales.
In addition to fostering strong relationships with other global associations, the commercial litigation finance industry also needs to form strong bonds with consumer oriented associations, as the issues faced by both are often similar and arguably the consumer side can be viewed as ‘the canary in the coal mine’ for the broader industry as it provides financing to consumers which is often a more sensitive area of the market from a regulatory perspective.
The commercial litigation finance industry has a fantastic story to tell, it just needs someone to communicate it with passion!
For my part, I am discussing the concept with a variety of funders and intermediaries in the industry, and would like to hear from interested parties who are supportive of the creation of a US commercial litigation finance association. I encourage readers to also read a recent article entitled “Litigation Finance Can and Should Protect its Reputation” (subscription required) written by Charles Agee of WestFleet Advisors, recently published in Law 360.
Investor Insights
When reviewing fund manager results one should look closely at the composition of the portfolio to understand what portion is being derived from portfolios compared to single cases. It will also be important to note the trending in these case types. If the manager is scaling its operations, as many currently are, their motivations are to deploy large amounts of capital quickly in large portfolios with lower risk. While this is a prudent approach for the manager, one then has to determine whether the historic return profile based on a portfolio of single case exposures is indicative of a future portfolio which will be mainly comprised of portfolio financings. The portfolio financings will have a different risk-reward dynamic and so investors will need to model their return expectations accordingly. Either way, I expect the return profile for litigation finance to remain robust both in the areas of single cases and portfolios and continue to believe that diversification is a key success factor to prudent investing in the commercial litigation finance asset class.
Edward Truant is the founder of Slingshot Capital Inc., and an investor in the consumer and commercial litigation finance industry.