Traditionally, small and medium-sized companies with major potential business litigation claims against larger corporations have faced difficult financial decisions. For budget-conscious and cash-strapped companies, the prospect of incurring substantial litigation costs may deter pursuit even of meritorious claims. Larger companies typically have the resources — and often the incentives — to adopt litigation strategies of attrition. In the face of such strategies, the anticipated cash flow and balance sheet impacts for the potential claimant may make the difference in deciding whether to pursue a claim.

Third party litigation funding has emerged as an increasingly viable alternative to traditional funding of litigation claims through internal cash flows. In this model, outside investors — typically a hedge fund or special purpose litigation fund — seek out commercial litigants who have meritorious and substantial claims, but who may be unable or unwilling to make the financial investment required to litigate those claims.

The terms of third party funding vary from case to case, but typically involve a defined non-recourse investment commitment on the part of the funder in exchange for guaranteed returns on success. The success fee generally is measured as a multiple of the amount committed for funding or as a percentage of the proceeds of the litigation, whichever is greater. The funder may ask the law firm handling the case to agree to at least a partial contingency fee arrangement, so that the lawyers also have a stake in the success and efficient handling of the case. Effectively, this model allows a company with a substantial business claim to shift the risks and costs associated with bringing that claim to a third party funder, while retaining much of the potential upside benefit.

This funding model has an established track record in other countries, particularly in the United Kingdom, Germany and Australia. These countries have allowed third party litigation funding while prohibiting or discouraging the alternative approach typical in the U.S., which relies on plaintiffs’ lawyers contingent fee structures. The two models are analogous in the sense that in each case a party other than the litigant is taking the risk of loss, with the difference being whether it is the plaintiff’s lawyer or an outside investor who is assuming that risk.

The U.S. market for commercial litigation funding has grown rapidly in recent years, with the addition of major new market entrants. For example, Burford Capital Limited and Juridica Investments Ltd., both publicly traded on the London AIM, have each announced multi-million dollar funds targeted at supporting major commercial litigation claims in the U.S. Burford Capital has reported $373 million in investment funds committed since 2009. Juridica reports current litigation investments in excess of $230 million. Another recent entrant, Gerchen Keller Capital LLC, reported in April 2013 establishing a $100 million fund that supports both plaintiff and defense side cases. These companies join several other established U.S. litigation funding entities, including Parabellum Capital, a spin-off of Credit Suisse, and 1624 Capital, a targeted fund specializing in high value intellectual property claims.

The growth in the U.S. market for business litigation finance reflects several fundamental themes and corresponding opportunities, as highlighted below.

MISMATCH OF AVAILABLE LITIGATION RESOURCES AND POTENTIAL OUTCOMES

The economic opportunity of litigation funding is maximized in cases where: (1) there are reasonably strong prospects of success, likely resulting in a sizable judgment or settlement; (2) the necessary investment to pursue the litigation can be estimated to a reasonable degree of certainty; and (3) the claimant is not in a financial or strategic position to fund the cash flow expenses of the litigation or take the ultimate risk of loss. For a company considering pursuit of a single claim, even if the anticipated damage recovery is large, the costs and risks may not be worth the potential upside. But for a fund that pools resources and invests in a portfolio of claims, substantial average returns may be delivered as long as success is achieved in a high enough percentage of its funded cases. Thus, if the due diligence process is conducted to a reasonable level of reliability and enough cases are funded, achieving substantial returns becomes largely an actuarial exercise. The model is similar to that employed by insurance companies in pooling risks, except that upside returns now may be assessed, pooled and realized through an actuarial model, rather than simply potential losses.

DISPARATE FINANCIAL POSITIONS OF PARTIES TO BUSINESS LITIGATION

A common scenario for a company seeking litigation financing is in the aftermath of a failed strategic transaction, such as a joint venture or marketing and distribution agreement. Such a case may involve a smaller company bringing a technology or product to market in reliance on the contractual commitments of a much larger multinational corporation. If the larger company fails to meet its commitments, the reliant company may find itself facing major economic harm with a corresponding substantial claim for damages. But that company may lack the resources to commit to the major litigation expenditure required to obtain relief.

Similar disparities may arise where small and mid-sized technology companies have developed intellectual property that is infringed by major industry players. Even when facing strong claims, large defendants in patent cases often employ a strategy of attrition, seeking to outspend and outlast plaintiffs who frequently lack the resources to maintain large-scale patent litigation that can easily cost upwards of $3 to $5 million per case. In those scenarios, the playing field may be leveled if a third party litigation funder provides the necessary financial resources to pursue the claim, thus making it more likely that a meritorious outcome will be obtained. Indeed, in its broadest sense, litigation funding is about access to justice for companies that otherwise may lack the financial wherewithal to vindicate their rights.

FINANCIAL IMPERATIVES TO REDUCE LITIGATION COSTS AND EXPOSURE

Companies and their in-house counsel are under ever-increasing pressure to reduce litigation costs. Legal fees paid to outside counsel for litigation are reported as current expenses, with resulting negative income statement impacts. Whether as plaintiffs or defendants, the use of third party financing to fund litigation can serve to remove those costs from the books, a welcome result for corporate officers seeking to meet company financial targets.

UNASSERTED LITIGATION CLAIMS AS CORPORATE ASSETS

Companies also are beginning to recognize that potential litigation claims can be viewed as a category of corporate assets subject to appropriate investment analysis. Where a company has deferred action on a potential claim due to litigation cost concerns, the availability of third party funding may unlock potential returns that otherwise would be unrealizable, resulting in the opportunity for positive contributions to the company’s bottom line.

Several general categories of disputes may present strong opportunities for litigation funding. These include:

  • Environmental contamination and damages claims;
  • Business claims arising from breached contracts or failed transactions;
  • Patent infringement, intellectual property and trade secrets cases;
  • False Claims Act (qui tam) claims alleging fraud on the U.S. government;
  • Claims of bankruptcy estates seeking recovery from third parties under breach of contract and fraudulent conveyance theories; and
  • International arbitration proceedings.

THE IMPORTANCE OF EFFECTIVE DUE DILIGENCE

The third party funding model is inherently dependent on effective and reliable due diligence. A funder accepting a case takes on a substantial or even complete risk of loss; it will only achieve long term returns if the outcome in enough cases across its portfolio exceeds a multiple of the amount invested. Accordingly, a premium is placed on the quality of the due diligence that is conducted. The due diligence team must carefully explore the full range of issues that ultimately will determine the outcome of the case, including an objective understanding of the underlying facts and law; the credibility of the witnesses; the quality of the documentary and demonstrative evidence on each side; the importance and credibility of expert testimony in light of the claims in issue; the nature and attributes of the forum (and potential for changes in venue); and intangible factors such as the relative equities of the parties in the broader context of the dispute.

Moreover, once the funding decision is made, litigation funders typically do not play an active role in managing the cases they finance. In most cases, funders are essentially walled off from determining strategy and from making decisions on trial tactics or settlement negotiations. Therefore, they are dependent on getting the due diligence assessment right in the first instance.

Given these factors, a company seeking third party litigation funding must prepare a compelling and well documented due diligence package. They also should retain a strong legal team to handle the case, and ensure that the team members are well prepared to discuss the merits, their proposed strategy, and the estimated legal costs. Only a small percentage of cases presented are selected for funding. Thus, these preparatory steps are critical to achieving a successful funding request outcome.

NAVIGATING ETHICAL CONSTRAINTS

The framework for obtaining third party litigation funding can raise important ethical considerations affecting lawyers and their clients contemplating third party funding arrangements. A number of these considerations were summarized in a 2011 Formal Opinion of the New York City Bar Association.1 The specific ethics requirements will vary depending on the jurisdiction, so the applicable laws and guidance must be analyzed in each specific situation. In particular, a lawyer advising a client in connection with a funding agreement must take care to avoid any conflict of interest, particularly where the same lawyer also will be retained to handle the litigation. It may make sense in such circumstances for the client to seek an independent opinion regarding the fairness of the arrangement. In addition, as a general matter the lawyer may not receive a referral fee from the funder; the lawyer must provide candid advice regarding whether the arrangement is in the client’s best interest; and the lawyer should confirm that the client in fact has other alternatives for pursuing the litigation if it so chooses, i.e., that the client is not effectively forced into the arrangement.

Moreover, applicable state laws must be researched to ensure that the proposed funding arrangement does not violate prohibitions on “champerty and maintenance,” common law principles that historically barred buying into or otherwise participating in an unrelated party’s legal claims.

While these prohibitions have been repealed in many states, their potential applicability must be determined. Navigating these legal and ethical constraints is a critically important aspect of the litigation funding process, and ideally should be comprehensively addressed by lawyers with extensive experience and knowledge in the area.