REUTERS | Edgar Su

Is litigation funding expensive?

No commercial litigation solicitor bats an eyelid to the principle of a 100% uplift in a conditional fee agreement (CFA). They are taking the risk of losing all their work in progress if the case is unsuccessful and a 100% uplift is just reward.

Those solicitors brave enough to embrace damages based agreements (DBAs) see 30%/40% of the damages as perfectly reasonable for the risks they assume (and that’s only if the realistic damages are sufficiently large enough to generate a significant monetary return). In reality, few cases are large enough for DBAs, but given the reticence of lawyers as a breed to assume financial risks, it’s unlikely that even with a large enough claim, many would seriously consider a DBA whatever the percentage on offer.

While those solicitors who use litigation funding to great effect (in particular to help their clients pursue claims and winning work for them in the process) accept the traditional cost of funding, the “greater of 3 times the invested capital or 30%/40% share of the award”, why is it the case that the market still perceives the cost of litigation funding to be overly expensive?

Sparkle Capital offers a fixed interest rate product with a first year interest rate of 35%, to which some solicitors still react with a sigh of disgust, labelling such interest rates as akin to “unjustifiable credit card rates”. One of course never hears the same groans from solicitors about the effective 100% interest rates charged under a CFA with a 100% uplift, or the fact that credit card risk has the possibility of personal recourse in a way that litigation funding doesn’t.

The above is not a criticism of lawyers but a reflection of the lack of knowledge and context of broader financial market pricing, and a historic reliance on gut instinct rather than rational reasoning in pricing litigation funding. One obvious reason for this (and the most common criticism of lawyers by non-lawyers) is the reluctance to look at market comparables beyond law, without which there is no de-mystification or contextualisation of the cost of litigation funding.

A natural defence to “expensive” pricing is that the market price simply reflects the basic principles of demand and supply, or simply where two parties are willing to transact. But this seems wholly unsatisfactory if one believes (as some do) that there is a cartel-like dynamic at play, which in turn adds weight to the notion that litigation funding is overly expensive.

The reality is that litigation funding pricing may seem intuitively expensive. However, the risk assumed by funders who fund litigation cases is often seen in the narrow veins of legal merits and not the broader context of financial economics, which show that litigation funding is in fact reasonably priced.

Litigation funding is comparable to Series A venture capital pricing

One way to look at pricing is from a probability of default-based pricing methodology. This was set out excellently in a series of blogs by Adrian Chopin, a managing director at the mainstream litigation funder Benchwalk Advisors. And as a fellow peer of investment banking derivative days gone by, this author agrees with much of what Adrian explained.

However, one obvious hurdle to this approach is the starting point based on “prospects of success”, which seems much more like a gauge of wind speed and direction than a qualifiable figure. It also comes with substantial variability, so much so that one litigation funder, Balance Legal Capital, ran a survey around interpretations of “prospects of success” which highlighted this precise substantial variability.

This doesn’t undermine this “debt” pricing methodology in itself, especially if pricing is articulated in interest rate terms. But it does pose the question of whether an equity approach might be more suitable, given the market tends to price on a time-insensitive multiple of returns, or share of the award.

Consider a venture capital fund that makes a Series A investment, namely an investment into an early stage company that has a “minimum viable product” but needs further investment to take the matter further. Typical Series A investments range from US $5 million to US $15 million for up to approximately 30% of the equity, with a high expectation of failures to generate an exit (read “a crystallisation of returns”), although when they do, the returns are astronomically high such that a Series A return is expected to average approximately 3x.

If this sounds familiar enough, the parallels don’t stop there. “Minimum viable product” reads “a litigation matter developed sufficiently enough that a reasonable prospect of success can be given”. “The uncertainty of how the product and market evolves” reads “uncertainty of how a case and the law may develop”. “The uncertainty of exit” reads “the uncertainty of final amount awarded and recoverability”. “The possibility of failure” reads “the possibility that the case may be lost”. “30% of equity” reads “30% of the share of the award”. “Average return of 3x” reads “a 3x multiplier”.

The parallels, though, don’t exist by design. Litigation funders price because that is their cost of funds and that’s how their business model works. Yet, the fact that litigation funding pricing closely mirrors Series A investments would suggest that perhaps litigation funding is in fact fairly priced when compared to similar investments outside of law.

Lawyers are the best gauge

In a recent roundtable of a number of lawyers, it was suggested that after the event (ATE) insurers should consider lowering their hurdle rates of prospects of success to below 60% if they wanted to attract more commercial ATE business. However, this overlooked the fact that law firms could, but shouldn’t (and don’t), take on cases on a CFA or DBA basis that have lower prospects either.

The point is that lawyers are often the best gauge of the legal merits of a case and their willingness to offer a CFA or DBA is in itself a useful benchmark on where pricing should be.

For Sparkle Capital’s fixed interest product, a 35% first year interest, which rises to 65% (gross) if repaid in year two and 90% in year three, compares very favourably to a solicitor’s 100% uplift on a CFA. Sparkle Capital’s 1&20 product, with a 1% per month interest rate and 20% share of the award (both deferred and contingent upon success), reflects favourably against a DBA. And a traditional funder’s “greater of 3x or 30%/40% share of the award” is comparable to a DBA entitling the law firm to 30%/40% of the damages.

If law firms themselves are pricing at those rates (and one can look back to significant precedents in the US to show that DBA rates are not new (think the PG&E litigation Hollywood-ized by Erin Brockovich) and considering that third-party litigation funding is often cited as the funding option of last resort (after CFAs and DBAs), then it would follow that the current pricing of litigation funding products available in the market are in fact reasonably priced in the eyes of the lawyers themselves.

Property development as a benchmark

Comparing litigation funding to every other businessman’s second hobby might provoke some consternation amongst those in the legal industry. But property development is a useful benchmark because it is underpinned by a long-established, efficient market for residential and commercial mortgages, with rates at the levels that the users of litigation funding products would eventually like to see.

Of course, litigation funding cannot be compared to those rates. Residential and commercial mortgages are both secured by way of legal charge to an underlying asset of value which, even in a significant market downturn, retain significant value. So any comparison here would be misguided. But property development, which sits at the beginning of the real estate cycle, is very relevant.

Large-scale property developers are able to fund the equity investment required in a development themselves. In the same way, large corporates or wealthy individuals are able to self-fund a litigation matter from start to finish. But at the non-institutional end of property development are property developers who often need to find external equity investors to kick-start a project. This is the parallel to claimants with the inability to fund a litigation case unless they are able to secure third-party litigation funding to pursue their claim.

A standard and widely accepted external equity investor deal in property development often involves the external equity investor funding all the costs in return for 50% of the profit. The return reflects the fact that an equity investor is buying into the credibility of the property developer (read “the credibility of the claimant”), taking the risk on recognising a significant profit (read “the prospects of success”) and all the things that might go wrong (read “the variables that influence the direction and outcome of any given litigation matter”).

The parallels then become very clear. A property developer A claimant who is otherwise unable to pursue a good property developer opportunity a meritorious litigation matter is willing to pay up to 50% of his or her profit  40% of his or her damages for the funding, at the risk that the property development project fails the litigation matter is unsuccessful.

If an established and efficient market like real estate sees similar pricing levels on a regular basis to those seen in litigation funding, it would be fair to argue that litigation funding is in line with other markets beyond law.

Summary

Much like real estate though, litigation comes in various shapes and sizes. The large complex matters that the traditional litigation funders all chase have a degree of complexity and risk that warrants the “30%/40% share of the award” pricing models. On the simple, single issue litigation matters that often typify the small and medium size claim market that Sparkle Capital focuses on, the relatively smaller risk profile is reflected in the lower pricing that is available.

The broader point, however, is that litigation funding is risky business and that is why litigation funding is priced accordingly in a way that many interpret as expensive. But to conclude as such based on gut instinct would be misguided because, clearly, litigation funding is comparable to pricing rates seen in other markets.

Even if one disagrees with this statement, however, the hope is that greater knowledge and context of pricing should empower lawyers better to negotiate funding rates for claimants as well as leading to greater long-term accuracy in pricing that better reflects the true commercial risk of any litigation matter.

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