This article first appeared in Financial Director and is available here.
Most finance executives shy away from court and try their best to avoid the company of lawyers. In truth, who can blame them?
But commercial disputes are part of the complex and volatile business environment in which finance executives operate and it is essential to the role of the Chief Financial Officer to appropriately manage the financial impact of litigation risk.
High performing organizations have demonstrated that collaboration between the CFO and the legal department yields substantial financial benefits and helps mitigate risks.
With Brexit predicted to bring increased litigation due to the greater uncertainty, embracing innovative new ways of managing litigation spend and litigation risk in 2017 and beyond needs to be a priority for all CFOs and Financial Directors.
It is important to first acknowledge that litigation is a burden to any organization. Whether the organization is a claimant or a defendant, litigation is expensive, unpredictable, often protracted and consumes internal resources and management attention.
From the CFO or FD’s perspective, litigation poses an even bigger burden, as the unfavorable accounting treatment of litigation in the company’s financial statements makes pursuing litigation close to punitive.
It’s important to first understand why the accounting treatment of litigation claims is so punitive.
Starting with its impact on the balance sheet, a pending litigation claim is essentially a financial claim. If the company has brought legal action against a counterparty, for instance to recover damages from a supplier or after a failed joint venture, management expects the company will realize the monetary value of that claim. Management also expects the company will spend resources to pursue that asset, likely in the form of legal expenses, fees and disbursements.
In ordinary course, financial claims generate an asset on the company’s books in the form of a receivable, which would be the case if the company was owed money by a counterparty. Furthermore, as the company expends money in pursuing the claim, those expenses will be added to the claim as they are capitalized rather than expensed through the profit and loss statement (P&L).
But that is not the case for litigation claims. The unfavorable accounting treatment of litigation dictates that claims are not recorded as assets on the balance sheet, and money spent to realize them is not capitalized but rather incurred through the organization’s P&L – thus reducing the company’s profit for the period.
If the company succeeds in making a recovery on its litigation claim, it is penalized again when the claim is not treated as operating income on the P&L but appears ‘below the line’ as non-operating income or a one-off item, because the accounting standards do not view it as the company’s core business.
This unfavorable accounting treatment leads to a "no-win" situation. When the company has a valid legal claim against a counterparty, the ongoing costs will negatively impact the company’s P&L statement as they reduce the profit line. Then, when the company is successful and realizes the recovery, the recovery is pushed “below the line” as non-operating income.
This is particularly disadvantageous to companies that are publicly listed and report financial results or to companies that are subject to financial maintenance covenants in borrowing arrangements.
Publicly listed companies will see a negative valuation impact when pursuing litigation, regardless of their trading metrics.
The on-going expense of litigation reduces net profits and EBITDA, negatively impacting companies which trade on a P/E or an EV/EBITDA multiple.
Companies which trade on book value are negatively impacted by the reduction in book assets, as cash is spent to pay for legal fees and expenses, without creating a corresponding asset. When the litigation is successful, it is classified as non-recurring and the company typically sees no valuation impact.
Companies under customary borrowing arrangements see negative impact too, as the ongoing litigation expenses reduce ratios under their maintenance covenants.
This unfavorable accounting treatment is, in many companies, coupled with a near-constant pressure to reduce legal spend, creating a disincentive to pursue viable, NPV positive, legal claims.
Those in the legal profession encounter countless companies that dismiss NPV positive legal claims because their decision is clouded by the accounting impact of pursuing litigation.
This leads companies to miss out on financial gain, when actually, by utilizing litigation finance, companies can move legal expenses completely off balance sheet. Under the typical litigation finance arrangement, financing is provided for all the legal fees, expenses and disbursements necessary to mount a legal claim.
As the financing is provided on a non-recourse basis, there is no cash flow, accounting or financial impact to the company. The first, and only, time the litigation impacts the financial statements or the company’s cash flow is when the legal claim succeeds.
The entire financial risk, alongside the unfavorable accounting treatment of that risk, is transferred from the company’s books to the litigation finance provider.
In turn, the litigation finance provider is remunerated with an agreed share of the proceeds of the claim, if, and only if, the legal claim is successful.
There is undoubtedly a growing knowledge amongst CFOs and FDs when it comes to litigation finance, however, the collaborative approach between the legal department and the finance function, albeit sometimes challenging, can be improved in many companies if they aim to manage the cost of litigation effectively.