Over time, due to the rapid growth in the availability of litigation finance, more and more cases involve a minimum of three stakeholders: a litigant, a funder and an after the event (ATE) insurer. A pre-condition of any litigation finance arrangement is that ATE insurance is purchased by the claimant, in the claimant’s own name; that by necessity creates a three-party relationship. Of course, where the legal representative is acting on a conditional fee agreement (CFA) or damages-based agreement (DBA), that makes at least four stakeholders (or five if counsel is acting on any form of contingency agreement).
In any situation where there are more than just two stakeholders, it is helpful to have a “Priorities Agreement” (often called a “Waterfall Agreement”) to regulate the distribution of proceeds derived from the litigation. A written commitment from all stakeholders to share the proceeds in a pre-agreed order is designed to prevent disputes over limited recoveries but it also assists the litigation strategy by ensuring all parties know where they stand in relation to potential settlements.
However, very often these arrangements are put together after two of the three parties have already spent substantial amounts of time agreeing a deal. The introduction of a third party at a late stage can lead to lead to a situation where the precise terms of a Priorities Agreement can cause a deal to fall over and usually because of disagreements over how to cope with some extreme scenarios, rather than typical situations. After all, the precise terms of Priorities Agreements are only really acute where the proceeds are not sufficient to cover all of the stakeholders’ investments in the case. Most people are prepared to compromise on their share of the profits in the event of unforeseen circumstances that could expose them to real downsides were they not to compromise, but where stakeholders are left making a loss, they will look to the contract first.
With the above in mind, it is worth considering some scenarios that can lead to negotiations between the stakeholders becoming rather tense, very often in the final stages of a deal being completed.
1. Interim proceeds, recycling and breakaway settlements
Where interim proceeds are recovered, the question is whether any of the component parts are expressly captured by the Priorities Agreement. Sometimes, interim proceeds are not expressly catered for and the stakeholders are at odds over whether costs, damages or both should be treated as if they were final proceeds or whether something different should happen. It can arise where claimants or lawyers expect to be able to recycle the proceeds back into the litigation to avoid drawing down so much expensive third-party funding.
If an ATE insurer has paid an interim adverse costs order, then the ATE insurer will expect their claims payments to rank parri passu pro-rata with the funder’s outlay. This is not normally controversial, but what can be awkward is that commercial ATE policies generally contain an “offset provision” which means the insurer is only liable for future adverse costs orders after recoveries have already been used to extinguish their liability under the policy.
This can cause a headache because technically interim proceeds cannot be distributed without the insurer’s consent as they may be required to extinguish a future liability for adverse costs. In some instances, interim proceeds sit in an escrow or are held on trust for this reason. Increasingly, Priorities Agreement make this expressly clear.
The constitutional documents of a group action should prevent such issues arising but sometimes, members of a group who settle their claims early are unhappy that their damages are held back in an escrow account until the position with the “last member standing” is resolved.
2. Funder preferred returns, interest rates or admin fees
Some funders will want a priority over not just their deployed capital but also a rate of interest or equivalent. This is the cause of some eyebrow raising with other stakeholders who are out of the money until after this rate of return is collected.
The relative profits between funders and ATE insurers generates a lot of discussion. Contingent ATE insurance premiums tend to be a quarter of the size of a litigation funder’s success fees. This is a very rough estimate and it depends entirely on the arrangement but it would not be surprising for a contingent ATE premium to be a rate equivalent to 50% to 70% of the limit of cover if the case reaches trial, whereas the funder would be in line for 200% to 300% of the funded sums to get to trial, possibly more. The relative rates of return can lead to insurers complaining that a parri passu pro-rata arrangement between their contingent premium and the funder success fee is not fair on the insurer. Funders will argue that many insurers are paid an upfront deposit premium which they have had to fund, and which the insurer retains no matter the outcome of the litigation, so funders are 100% cash out at risk until the end, unlike insurers.
3. Solicitors’ base fees incurred under CFAs
Solicitors’ fees have often been directed to the bottom of the pile, just above the claimant, but the base fees that solicitors have put at risk are a form of risk capital that the firm has invested. Blockages can arise between the parties when there is no meeting of minds over the comparative treatment of so called “soft” time costs versus “hard” costs that have been funded such as disbursement bills. Generally, the solicitors’ unpaid base fees incurred under a CFA are higher up the waterfall than the CFA success fee. However, quite often, the base fees are not treated equally to funder capital and the success fee is not treated equally to the funder’s return. That can come as a shock to lawyers who are asked to review a Priorities Agreement in the final stages of a deal, especially when the substantive terms of ATE and funding have been agreed and the claimant is ready to sign-off and get cracking on the case.
It is easy to say that the best approach is to cater for as many scenarios as possible in the Priorities Agreement, but that is not always straightforward. The best thing to do is discuss the order of distribution in detail at an early stage, so that there is time to iron out the scenarios that are most likely to actually occur in the case, and which of those scenarios are most likely to lead to a stakeholder walking away from the deal before it gets to the eleventh hour.