This article was first published in Corporate Counsel and is available here.
In just a few short years, litigation finance has become an important part of the commercial litigation landscape. The number of lawyers who said their firms had used litigation finance jumped four-fold between 2013 and 2016. And in the same 2016 survey, 75 percent of in-house counsel predicted that the use of litigation finance will continue to grow.
However, some GC’s remain skeptical of the practice. On its face, this disinterest seems rational. Many GCs still perceive litigation finance as nothing more than a tool to help undercapitalized claimants pay legal fees and expenses. And many or most GCs serve companies that face no immediate cash shortage and litigate more often as defendants than plaintiffs.
But these observations are based on a limited and outdated definition of litigation finance. A broader understanding reveals at least five reasons why litigation finance can become a relevant tool for in-house counsel in various corporate circumstances:
#1. Litigation finance is corporate finance for law.
The core concept of litigation finance is the recognition of a legal asset as collateral for financing. A corporation with a legal asset can secure financing today in exchange for a portion of the proceeds from that asset in the future, typically on a nonrecourse basis (meaning that the financier’s investment return is contingent upon success). Businesses do this every day when making strategic and budgetary choices about when to spend their own cash versus seeking outside capital. They do it with all kinds of assets, from airplanes to office buildings. Litigation finance allows GCs to secure capital based on corporate legal assets just as their C-suite colleagues do across all other areas of the business.
#2. Financing helps hedge against rate increases and other future risk.
The financial markets seem sure that the Federal Reserve will raise interest rates in the next month, and possibly twice more in 2017. Although it’s probably a safe bet that rates will remain comparatively low in the short term, interest rates may rise longer-term, which makes any form of corporate finance that is not interest-rate-based a far more appealing option. For GCs, that means an increased use of legal finance, which moves risk off corporate balance sheets by providing capital that need only be repaid if underlying matters are successful. This structure protects against a loss in court while locking in the financier’s return without any correlation to interest rates or broader economic conditions.
#3. It’s not just for plaintiffs. Legal finance applies to defense matters as well as transactional areas of law.
Legal finance can provide capital in defense as well as plaintiff matters, along with other contexts completely unrelated to litigation. So, although many businesses rarely—if ever—bring lawsuits, most are defendants in litigation more often than they would like. When a company is a defendant, litigation finance can enable alternative fee arrangements with law firms that are more flexible than the options that defense-oriented law firms can or will provide. Portfolio-based financing (in which a third party provides non-recourse funding for multiple matters on a linked basis) can offer even more options for defense-side clients. Increasingly, portfolio-based litigation finance is also being used areas such as tax disputes, mergers and acquisitions, and other “success fee” arrangements.
#4. Finance changes the accounting treatment of litigation spend—a huge benefit for public companies.
GCs who work closely with their CEOs and CFOs to control the legal spend will recognize the accounting problems litigation presents. Without financing, litigation can permanently impair financial performance because of accounting rules regarding the treatment of litigation expenses and awards. Legal expenses paid by a company are immediately recorded as expenses, thus reducing earnings. Even worse, litigation recoveries often are recorded “below the line” as non-recurring or extraordinary items. That is an unhappy result for many businesses—particularly for EBITDA-based businesses: the accounting result of a successful claim can be a permanent reduction in EBITDA, because legal expenses reduce EBITDA but recoveries do not increase it. Litigation finance removes that hit to profits, enabling companies to remove the expense drag of litigation—a particularly powerful tool for public companies.
#5. Finance can convert a company’s litigation department into a profit center.
GCs who use legal finance in the most straightforward way can pursue profit-enhancing claims without adding cost or risk to the business. But GCs who use legal finance more ambitiously can potentially zero out the cost of litigation altogether. By leveraging litigation finance on a portfolio basis, GCs can obtain nonrecourse financing for multiple matters. They may be plaintiff- or defense-side, existing or anticipated matters, from as few as two to a company’s entire portfolio. For example, a FTSE 20 company recently used $45 million to fund current and future profit-enhancing claims with world-class legal counsel—and thereby shifted all of the costs off its balance sheet. Portfolio financing is inherently flexible: capital can be used to finance matters within the portfolio or for broader business purposes, and pricing is generally lower because risk is diversified.
As the legal market increasingly scrutinizes financing options to boost efficiency and improve risk management, general counsel will need a greater understanding of the benefits of litigation finance. The examples set forth here are just a few of the ways corporate legal departments can harness the power of legal finance tools to generate results and improve the bottom line.