INSIGHT: Seven Things You Need to Know Before Investing in Litigation Finance

Financing commercial litigations has become an increasingly popular area of investment in recent years. This novel area of finance provides commercial plaintiffs and law firms with the capital needed to prosecute expensive, complex claims and can reap large rewards for the litigation funder if the litigation is successful. The advances are often non-recourse, however, so if the litigation is unsuccessful, the funder may receive little or nothing in return. Funders mitigate this risk by conducting extensive due diligence on the underlying claim and negotiating large upsides for when the litigation is successful. As the investment returns in this type of financing are uncorrelated with other asset classes, litigation finance is very attractive to alternative lenders and multi-strategy funds looking to build diversified investment portfolios.

Fund managers and investors that are new to the area should understand that litigation finance can be complex. Investors must understand and appreciate several specialized categories of risk that are distinct from those associated with more traditional areas of investment. Not only must the investor evaluate the merits, cost and timing of the underlying litigation (a task foreign to most investors in corporate debt), but there are a number of legal, ethical and practical issues that must be addressed and managed carefully. This article briefly explains some of the more critical issues in litigation finance, focusing on “commercial” litigation finance, which covers the funding of litigation though an agreement with either a corporate plaintiff or an agreement with a law firm representing one or more plaintiffs.

Comprehensive Due Diligence and Case Selection Bias

Frankly, the biggest obstacle currently facing funders is finding good cases to invest in. Unlike more traditional investment products, prospective litigation funding opportunities rarely offer detailed, publicly available information. Cases are found through primary sources (e.g., a funder’s pre-existing relationships with law firms or commercial plaintiffs) or secondary sources (e.g., litigation finance boutiques that specialize in sourcing litigation claims in need of financing). Unfortunately, unless an investor finds a deal through its primary contacts, most secondary sources of supply are likely to finance their most promising cases internally and show prospective funders their least meritorious cases.

It is therefore critical that the funder conduct its own thorough diligence on the cases and not rely too heavily on the opinions of the law firm or funding boutique showing the opportunity. Likewise, those seeking funding may try to take unfair advantage of the flood of new investors that have recently entered the market. Using a trusted, disinterested and unbiased litigation professional to review the case’s merits at the earliest stage of due diligence is imperative to overcome this selection bias.

A Loan or a Purchase?

Litigation funding transactions can be structured in myriad ways. Although funding agreements are typically styled as loan agreements, the underlying economic arrangements freely blend elements of an equity instrument with provisions normally found in a loan. Like some venture capital arrangements, litigation financing arrangements are virtually always non-recourse to the “borrower” and rarely have a fixed rate of interest or a maturity date. Indeed, the aforementioned high returns on invested capital are those one would more typically find in an equity investment, not a loan. As a result, most funding arrangements would probably be better characterized as purchases of rights in the underlying litigation claims rather than as extensions of credit. On the other hand, funding agreements often do include covenants and agreements typical of a loan agreement and sometimes credit enhancements, such as the posting of collateral and third-party guarantees.

As discussed below, how the investment is characterized (as either a loan or as a purchase) can have important implications for how it will be treated under pertinent tax laws, state common law regarding champerty, state usury statutes, and state rules governing legal ethics. But for each area of analysis, a prudent investor must be comfortable with the “characterization risks” inherent in funding arrangements because of the uncertainty as to how a court or regulator will actually view the transaction. Recent history has borne out that, if a court or regulatory authority deems the funding arrangement to be unfair or overreaching, it will probably find a way to characterize the financial arrangement in the way least favorable to the funder.

Tax

Investment managers of hedge funds for offshore investors will generally want to avoid “loan origination,” as doing so could result in the fund being deemed to engage in a U.S. trade or business, with resulting negative tax consequences. Therefore, any fund manager engaging in litigation funding will want to work with its tax advisors in order to ensure that such arrangement does not constitute a loan.

However, there is also uncertainty for offshore investors in arrangements that constitute a purchase. If the purchase is of a portion of the fee of a law firm, the offshore investors may be deemed to receive income effectively connected with a trade or business (the practice of law) in the U.S. If the purchase is of a portion of a claim of a plaintiff, the offshore investors may have to look to the underlying nature of the claim to see if this creates a tax issue for them.

Champerty

Generally speaking, champerty (and its relatives, maintenance and barratry) is a state, common law principal that prohibits the transfer of litigation rights from potential plaintiffs to unrelated third parties under certain circumstances. Although it is a rare litigation funding deal in which the funder takes a full assignment of the claim and actually becomes the plaintiff, one still needs to consider whether a non-recourse financing could be characterized by a court as a champertous purchase of the underlying litigation claim and, therefore, deny the plaintiff the right to bring the claim. Champerty is a creature of state law, and it is not always easy to determine which state law governs the champerty analysis. The trend has been for states to increasingly limit the scope of champerty. Nevertheless, before investing in a claim, one should first consult with counsel, determine which state law applies, and consider whether the specific structure of the transaction is at risk.

Usury

Like champerty, usury is a creature of state law. Unlike champerty, an investor should assume that the investment will be characterized as a loan (as opposed to a claim purchase) when examining this risk and that any return received by the investor will, therefore, be deemed “interest” (or, perhaps, return of principal). To the extent the implied interest rate is in excess of the applicable state law limit, any agreement requiring its payment may be unenforceable and the “lender” may be subject to penalty, including criminal penalties. Although many states provide that loans to non-individuals or loans above a certain threshold amount are exempt from its usury restrictions, it will be important to review the usury laws of the relevant state or states to ensure that you are in the clear.

Legal Procedure and Ethics

Litigation funding also raises a number of litigation-specific issues that may be relevant to counsel representing the plaintiff and the litigation funder.

Preservation of Privilege

During the underwriting process, the investor will review as much information as possible about the litigation, including any documentation that is the subject of the dispute and the analysis and other work product of plaintiff’s counsel and the funder. Unless plaintiff’s counsel can persuasively assert that (i) the means of any communications between lawyers for a party and a proposed litigation funder evidence an intent to maintain confidentiality (e.g., occurred pursuant to a non-disclosure agreement or a common interest agreement in a jurisdiction where the litigation funder is deemed to have a common legal interest with the party seeking funding and not merely a common business interest), and (ii) these communications were in anticipation of litigation (and thus are protected from disclosure by the work product doctrine), a plaintiff’s lawyer risks waiver of the attorney client privilege for sharing privileged information with a proposed litigation funder. This would mean that the shared information could be discoverable in the court proceedings.

In the first instance, the investor should ensure that it is not being provided privileged materials and conclude that it is comfortable conducting its underwriting process in the absence of complete information. Where the investor will not be satisfied conducting its underwriting absent full information, the investor should seek guidance on whether it can receive the information in a privileged context (e.g., pursuant to the work product doctrine or common interest privilege) and minimize the risk of waiver. Carefully designed non-disclosure agreements and common interest agreements can help to bolster an argument that such information is protected.

Funder Control

With much at stake, the funder would naturally like to play an important role in determining strategy for the underlying litigation, especially with respect to deciding between accepting any proposed settlement or proceeding to trial. At a minimum, the funder wants to ensure that a strategy that maximizes the potential return from filing a lawsuit is vigorously pursued. However, any provisions in a litigation finance agreement that give the funder this level of control may be deemed to interfere with the attorney-client relationship – specifically, with the lawyer’s exercise of professional judgment on behalf of the client – and may be rendered unenforceable.

Even an agreement providing for a minimal level of contact and oversight, such as requiring the plaintiff or law firm to keep the funder informed and to consult with the funder prior to making any major strategic or settlement decision, may be unenforceable, and at a minimum risks waiver of any otherwise applicable privilege that would protect the information disclosed to the funder. While it may be prudent to require the applicable law firm to keep the funder informed as to publicly available information (e.g., court pleadings and opinions), the best strategy is to ensure that the financial arrangements set out in the funding agreement motivate the plaintiff and the law firm to maximize the total recovery. That is, be sure that each of these parties retains some upside, as the funder will need to take a hands-off approach once the deal has been struck.

Fee-Splitting

Lawyers are prohibited from sharing legal fees with nonlawyers. Generally the ethics rules prohibit business arrangements between lawyers and nonlawyers in which a nonlawyer’s compensation is directly based on the receipt of legal fees, or a percentage of the legal fees received. The prohibition has obvious implications for litigation funding arrangements where a funder provides financing to a lawyer or law firm in connection with representing clients in litigation.

On July 30, 2018, the New York City Bar Committee on Professional Ethics issued an opinion making plain that the prohibition applies where payments to a funder are contingent on the lawyer’s receipt of legal fees or on the amount of legal fees received by the lawyer in one or more matters. According to the opinion, funding arrangements involving a non-recourse loan secured by legal fees (where the lawyer will make future payments to the funder only if the lawyer recovers legal fees in one or more matters), or where the amount of the lawyer’s payments to the funder vary with the amount of legal fees received in one or more matters, are prohibited under the pertinent ethics rule. This interpretation is premised on the concern that if nonlawyers have a stake in the legal fees from particular matters, they have an incentive, and moreover, an ability, to improperly influence the lawyer.

At the same time, this ethics opinion is advisory, does not necessarily reflect how a court will address the issue, and seemingly is contrary to recent decisions by New York courts, which have upheld funding arrangements that Opinion 2018-5 would suggest are prohibited. When considering a non-recourse law firm financing, qualified counsel in the relevant jurisdiction should be consulted.

Disclosure

Finally, courts and state legislatures have focused on whether a party that obtains financing from a litigation should have an obligation to disclose the fact of the funder’s involvement. Most courts have been accommodating to litigation funders and have not required disclosure. But a few district courts have required disclosure to the defendant of the financing arrangement, sometimes analogizing disclosure of the financing arrangement to mandatory insurance disclosure rules.

In addition, Wisconsin recently passed a law requiring disclosure of third-party financing in certain types of litigation. In particular, the U.S. Chamber of Commerce has aggressively lobbied for federal legislation requiring such disclosure. It is as yet unclear what effect such disclosure might have on the final outcome of a litigation, but part of the funder’s diligence of a case should include looking at the current disclosure requirements of the relevant jurisdiction and, if relevant, being prepared for the possibility that the financing arrangement will become part of a public court proceeding.

Timing and Counterparty Credit Risk

A funder with an investment in even the most meritorious litigation must manage the risk that it will not receive its anticipated return. Firstly, this could be due to the litigation/settlement process taking much longer than anticipated, thereby dramatically reducing the funder’s effective rate of return on invested capital. For this reason, before making an investment, it is just as critical that the funder diligence the litigation to determine the likely timing of any distributions – or the likelihood of different distribution timing scenarios – as it is to evaluate the merits of the litigation. This is especially true in the case of litigation in jurisdictions outside of the U.S. Again, a good funding agreement that provides an economic incentive for the plaintiff and law firm to conclude the litigation expeditiously can be of great help to mitigate this risk.

Secondly, even a windfall payout from the defendant does not help the funder that is unable to subsequently collect its share from the plaintiff or law firm counterparty to the funding agreement. This failure to pay may be a result of the receiving party’s financial distress and various encumbrances on any funds it receives, or simply because the receiving party is having second thoughts about complying with its contractual obligations now that it is sitting on a pile of cash. To mitigate these risks, funders should think carefully about requiring credit enhancements at the time the original deal is reached. Specifically, having the funding counterparty post collateral or personal guarantees to protect against insolvency, fraud, or willful misconduct can go a long way to protect the funder’s rights.

Conclusion

For multi-strategy investors, litigation funding is an exciting new, non-market correlated investment area to explore. The amount of capital entering the market is enormous with some estimates showing up to $5 billion of capital now committed to the U.S. commercial litigation market. And with the vast amount of commercial litigation in the U.S., there appears to be little risk that the supply of eligible cases will run out. However, it is critical that investors move carefully and retain capable counsel to guide them through the myriad of potential pitfalls before committing capital to this high risk/high reward area of investment.