Written by Zac Hall, Bramden Investments
While the benefits of litigation funding are increasingly understood by lawyers, its valuable benefits from the perspective of financial directors are rarely discussed. Zac Hall, an investment manager of Bramden Investments, the private equity company that invests in Vannin Capital, explores litigation funding as a new, lucrative form of cost risk mitigation and investment potential.
Notwithstanding that it is a foreign emotion for the stereotypical accountant, the group of people who are perhaps most likely to get excited about litigation funding are finance directors.
By partnering with a litigation funder, a claimant can entirely de-risk the financial costs of litigation, transforming it from an exercise with an unknown cash commitment for an unknown period of time (an accountant's worst nightmare) to one with zero cost outlay and only upside potential.
Litigation is expensive
It is also an unfortunate truth that litigation is now an accepted part of modern business. As companies grow, they will inevitably undertake litigation and, in all likelihood, the amount and cost of that litigation is likely to increase in proportion to the growth in size of the company.
According to the 2014 Litigation Trends Survey by Norton Rose Fulbright, the percentage of large US companies spending $1million or more per annum on litigation increased from 53% in 2012 to 71% in 2013.
Further, the percentage of larger companies ($1bn+ revenues) spending $10m or more annually on litigation increased for the second consecutive year to 43% (2012: 33%, 2011: 19%).
With the ever increasing costs associated with pursuing litigation, coupled with the fact that businesses have never been under more pressure to reduce outgoings, even a claim with strong legal merit must be subjected to a cost/benefit analysis to determine whether a company can afford to pursue its right to justice.
Costs and Risks
Anyone who has ever been involved in litigation will attest that despite the best attempts of lawyers to budget and timetable, the process will invariably cost more and run longer than first predicted.
In addition to the cost uncertainty, the following must always be considered:
- the outcome of litigation is never certain so, even those with the most meritorious claims are not guaranteed that their expenditure will result in a successful resolution;
- the amount of management time that will be devoted to monitoring the claim and debating the merit of the ongoing expenditure may well be better used leading and growing the underlying business; and - if the claim is lost, the claimant is likely to be required to reimburse the defendant for the legal costs they have incurred in defending the claim.
No finance director finds it comfortable to request his board to release funds in order to pursue a claim in the knowledge that there may be no return as well as further cash exposure if the case is lost.
However, by utilising the services of a litigation funder, a company can eliminate all of the above risks surrounding the pursuit of litigation.
Working under strict confidentiality obligations, a funder will use litigation experts, including solicitors, barristers, judges and other experts to validate the merits of a claim, the likelihood of success and the anticipated quantum to be recovered.
If the claim is considered strong enough, the funder will present the client with an offer to fund all fees related to the claim on an agreed profile that is matched to the anticipated life cycle of the case, meaning zero cash flow exposure for the claimant for the duration of the litigation. The funder will also arrange insurance or an additional facility to cover any adverse costs exposure in the event of an unsuccessful claim.
The first and most obvious benefit of such an arrangement is that by removing all the claimant's obligations for legal fees and adverse costs, a claimant can pursue litigation without fear of EBITDA or cash erosion. Furthermore, all liabilities, including contingent liabilities for adverse costs remain completely off balance sheet.
In addition to the financial benefits, funding offers:
- free, independent validation of the legal and commercial merit of a claim from highly qualified and experienced practitioners;
- access to an additional team of litigation experts who will monitor the progress and tactics of a claim at no cost. With completely aligned interests, the funder and its team will hold lawyers to account and be on hand to provide additional views on the course the litigation is taking. However, at no time will they (nor indeed are they permitted to), take control of the litigation. This control is sacrosanct and always remains with the claimant; and
- the ability to make the defendant aware that funding has been obtained. It not only indicates that the claimant is sufficiently capitalised to see a claim through to trial, it shows that an experienced third party has reviewed and validated the merits of the claim.
Another major advantage of third party funding is that it gives the claimant the opportunity to augment or improve its legal representation. The importance of hiring appropriate professionals cannot be overstated. The litigation process both prior to and during trial is a niche and highly specialised area and, as a result, is heavily influenced by the lawyers involved. It is vitally important to have a legal team which is adequately resourced and appropriately experienced so that it not only 'keeps up' but instead leads and influences the course of proceedings.
When you partner with a litigation funder you know that they are motivated to ensure that the best legal team with the necessary specialism is instructed to achieve a mutually beneficial outcome from the litigation.
Cost Centre / Profit Centre
Corporate legal teams are under growing pressure to improve their efficiency and reduce costs. A January 2015 survey of Fortune 1000 companies by Consero Group found that 72% of respondents reported increased pressure to manage legal spend.
Savvy finance directors, especially those whose employers are often subject to litigation or who have an existing portfolio of claims, will also see an opportunity to turn legal teams/litigation departments from cost centres into potential profit centres. By utilising funding, management can redirect a large amount of allocated expenditure toward additional growth projects that would otherwise have been shelved, perhaps indefinitely. If and when the funded litigation is successful, the claimant is still able to reap a reward for the rights it has been able to enforce.
Clearly a litigation funder itself is in business and requires a return on what is a high risk capital investment. That cost is typically the return of capital invested plus either three times the amount spent or 25% to 40% of the quantum recovered, whichever is the greater. However, this cost won't have any adverse impact on the claimant's P&L as it is only incurred if the case is successful and if the quantum is recovered. One major issue in the litigation process that is often overlooked is that even if your claim is successful, you are reliant upon the defendant actually being able to pay the judgment. Again, by utilising the capital of a third party funder, that risk is eliminated. If the defendant cannot be made to pay through the enforcement process, it is the funder that loses out, not the claimant.
To fund or not?
From the perspective of a finance director, the decision of whether to use funding is very simple. Do you completely de-risk the litigation and make the pursuit of your rights risk and cost free? Or, do you spend the next three, four, five or more years constantly reallocating cash from elsewhere in the business whilst still carrying the risk of a negative outcome? Prudency suggests that you should use funding whenever possible.
A company is deciding whether to embark on a £30m claim which its lawyers' have advised has a 60 per cent probability of success, with each side expecting to incur legal of fees of £2m.
If the company was to self-finance, the legal costs of £2m will be expensed in the P&L every month and year that they occur and thus reduce the company's EBITDA. In addition, a contingent liability may need to be disclosed in the accounts to cover the defendant's costs in the event the case is lost. If the case is successful, due to the accounting treatment of litigation the recovery is recorded "below the line" as a non-recurring or extraordinary item.
If the company brings the same case but secures litigation funding, where the terms stipulate that the funder will take the greater of x3 the funding advanced or 30 per cent of the damages in the event that the claim is successful, it will have a P&L impact of £0 (the funder picks up the legal fees) and no requirement to disclose a contingent liability (the funder pays the defendant's legal fees in the event that the case is lost).
In this instance, management will weigh up whether to risk £4m and suffer years of EBITDA impact to possibly recover £30m or to risk nothing with the potential to recover £21m.
Zac Hall is an Investment Manager at Bramden Investments, the private equity owner of Vannin Capital. With almost a decade of experience working in the City of London as both a finance lawyer and a corporate banker he is assisting a growing number of finance teams to appreciate the benefits of dispute resolution funding.
Originally published in Funding In Focus, May 2015
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.