A New Litigation Financing Solution Is Available to Law Firms

There is a new, cheaper, and more client-friendly financing solution to support law firm alternative fee arrangements, or AFAs, that involve partially or fully contingent fees—a commercial loan from a bank or credit fund coupled with an insurance policy that de-risks the recourse feature of the loan.

AFAs require tremendous investment over a lengthy period with no certainty of recovery. Sometimes law firms self-fund this investment or seek their own external capital. Other times clients seek external capital to fund the investment.

Law firms lack the full range of capital solutions available to other businesses. In most jurisdictions, Rule 5.4 prohibits non-lawyer equity capital, so firms must rely on funding via recourse or nonrecourse debt.

A recourse credit facility from a commercial bank or credit fund is the simplest and cheapest external funding source. This type of commercial loan isn’t secured by specific cases—it’s a general obligation on the firm—and repayment isn’t contingent on case outcomes.

Traditional Funding

Firms focused on personal injury or class actions often are comfortable assuming some recourse obligations. But most other firms have historically avoided using commercial loans to fund AFAs.

The main reason for this avoidance is that firms are risk-averse and unwilling to use billable hour revenue to repay a commercial loan, which they must do if the firms’ plaintiff-side AFA matters yield inadequate recoveries.

So firms often resort to nonrecourse litigation funders. According to a new Westfleet Advisors survey on the nonrecourse commercial litigation finance market, these funders committed $2.3 billion to new litigations last year, with almost 40% of it going to matters involving the largest 200 law firms.

But the survey results also showed a drop in total commitments compared with prior years, reflecting a “tighter” capital market for nonrecourse funding.

Nonrecourse funders cover the out-of-pocket costs and some of the legal fees to litigate cases involving AFAs in exchange for a right to repayment contingent on a successful case outcome. Firms thus avoid having to possibly use billable hour revenue to repay the funding facility, if the funded cases are unsuccessful.

These are real benefits for law firms and their clients, but they come with downsides. Funders in nonrecourse facilities assume risk—they face a total loss. They mitigate this risk with rigorous due diligence, which can be lengthy and exacting. And they price their capital to reflect the high risk, which can make the facility expensive.

A New Option

Firms may now instead consider a cheaper and newer option: a de-risked recourse credit facility from a bank or credit fund. This is a two-step process.

Step 1: The law firm obtains, or better yet uses, an existing commercial loan from a bank or credit fund to cover hard costs and a portion of its hourly equivalent fees as they accrue on cases subject to AFAs.

This capital would be comparatively cheap. The lender would have recourse to the firm for repayment of the principal and interest—and no contingent right to benefit from successful case outcomes.

The law firm and client would therefore retain the benefit of a large recovery. And given the recourse feature, the lender is less likely to put firms and their clients through rigorous case due diligence.

Step 2: The firm de-risks the recourse feature of the commercial loan.

It does this by separately securing a contingent risk insurance policy that insures the projected (and/or already accrued) hard costs and a portion of the projected (and/or already accrued) hourly fees on a portfolio of insured AFA cases.

In other words, the policy provides the firm with a right to recover from the insurer the costs and a portion of the fees accrued on insured AFA matters if the firm doesn’t instead recover those costs and fees from the insured cases.

The policy may even be expandable, allowing the firm to add coverage—and thus financing—for future cases onboarded after securing the policy.

The maximum limit on this policy could match or exceed the amount the firm would owe under the commercial loan. If the firm’s contingency fee recovery exceeds the policy limit, the insurer pays nothing. If the firm recovers less than the policy limit, the firm makes a claim on the policy and the insurer pays out up to the policy limit.

The firm either recovers sufficient fees on the AFA cases to easily repay the inexpensive commercial loan or, if the cases end poorly, makes a claim on the insurance policy and uses the insurance proceeds to repay the commercial loan. The policy therefore de-risks the recourse feature of the loan.

Array of Benefits

Through this structure, law firms unlock multiple benefits.

They tap cheaper and more flexible bank or credit fund capital to support AFAs. They and their clients retain the substantial financial upside on AFAs, which nonrecourse funding often requires firms or clients to forfeit.

And because a commercial loan isn’t secured by specific cases, it is arguably not “litigation funding,” which could exempt it from litigation funding-related discovery considerations.

What’s more, law firms using this structure may have a competitive advantage in servicing existing clients and engaging new ones.

After securing the insurance, the firm could later add coverage, subject to insurer approval, for the costs and a portion of the fees to litigate a new matter for an existing or prospective client.

The firm then could finance the new matter with drawdowns on the commercial loan, which the firm de-risked with the added insurance coverage. This would create an efficient and economical funding solution to offer clients in need of AFAs.

In contrast, competing firms might require those same clients to either wait as the firm decides whether to assume the full risk of the AFA or endure the possibly lengthy and demanding process of securing expensive nonrecourse funding.

These advantages, among others, may increasingly motivate firms to finance AFAs with a de-risked commercial loan.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Bob Koneck is a senior vice president at Atlantic. He previously worked at a leading commercial litigation funder and practiced as a commercial litigator.

Richard Butters is an executive director at Atlantic. He previously worked in structured finance as a director at Barclays Bank.

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