What treasury needs to know about legal finance

October 12, 2019

Elizabeth O'Connell, CFA

Businesses in every industry defend against litigation, and many do so routinely. As such, companies have well-traveled paths for managing defense costs, which are often covered by insurance. The same cannot be said for affirmative litigation: Companies sometimes are reluctant to pursue it; insurance doesn’t cover it; and when companies do pursue it, they are often forced to shoulder significant cost and risk.

When companies bring legal claims, they create novel issues for CFOs, treasurers, and risk managers. Companies filing suit face the risk that their spending of, potentially, millions of dollars on legal fees will not result in the desired judgment. In addition, because legal fees show up on corporate income statements, an expensive case will place a notable drag on reported earnings. And even if the company seems likely to win a particular case, it will still have difficulty predicting the tactics of its opponents and the pace of judicial review. In a world that wants precise budgeting of quarterly inflows and outflows, complex litigation can create frustration and doubt.

Over the past decade, legal finance—also known as “litigation finance” or “litigation funding”—has emerged in the United States to help address these problems. The tool, which reduces the cost and risk of litigation, remains poorly understood by corporates. Unsurprisingly, it is also underused.

In Burford Capital’s latest research, 68 percent of in-house lawyers reported that their companies have forgone meritorious legal claims due to the perceived impact on the bottom line. And 59 percent said that their company has uncollected awards and unenforced judgments valued at $10 million or more. With so many companies abandoning millions in recoveries, and in an increasingly competitive global landscape, corporate treasury and finance teams should develop an understanding of legal finance.

What Is Legal Finance?

In the U.S., legal finance arose in the wake of the Great Recession, largely to address the rising cost of litigation and law firms’ desire to serve clients that were not prepared to pay legal fees out of pocket. The legal finance industry has evolved since then, but its entry-level product—single-case financing—remains a common solution that is instructive to understanding legal finance broadly.

In the single-case scenario, a company typically has a strong claim that it is unwilling or unable to self-finance. To obtain third-party financing, the company approaches a legal financier, which conducts due diligence on the matter. This can occur at any stage of the legal process. If the financier agrees to fund the matter, it will extend capital on a non-recourse basis. This means that the financier will receive a portion of any potential award or settlement, and in exchange will assume all downside risk. Neither the company filing suit, nor its law firm, will owe the financier money if the case loses.

This financing is a passive investment. Legal financiers do not exert control over litigation strategy or decision-making, and legal finance arrangements are designed accordingly. Although financing arrangements may stipulate terms regarding how capital is used, all parties agree upon those terms at the outset. Terms vary dramatically from agreement to agreement, and they should take into account the need for flexibility as the case progresses. Once a funding agreement is in place, the company’s law firm keeps in touch with the legal financier, which may act as an advisor to the legal team.

Due to the idiosyncratic nature of lawsuits and legal risk, no two legal financing arrangements are identical. Financiers tend to offer variations of three basic return structures: variable returns, fixed returns, and hybrid returns. A variable return is comparable to a contingency fee arrangement, where a law firm will advance the cost of litigation out of pocket, then recoup those costs “first-dollar” out of the return, in addition to taking a percentage (such as 30 to 40 percent) of the net remaining proceeds. In fixed-return structures, the financier’s return consists of receiving its investment back, plus a multiple of that investment (or a predetermined amount), as opposed to a percentage of the net proceeds. In most cases, the return structure includes characteristics of both variable and fixed returns, resulting in a hybrid structure.

Ultimately, single-case financing arrangements enable corporates to pursue high-value claims with certainty around risk exposure, even in the worst-case scenario. This enables claimants with risk or liquidity concerns to proceed with legal matters they would not otherwise bring. Increasingly, corporate finance teams are using legal finance out of choice, not necessity. One law firm partner in Burford’s 2018 survey remarked: “We are seeing more companies who want to use [legal finance] not because they cannot afford themselves to finance the litigation, but because they see a way to monetize an asset that sits on their balance sheet or to de-risk the funding of litigation.”

How Are Companies Using Legal Finance?

Companies use legal finance in myriad ways. The most common use case, as described above, is to pursue financing of a single claim. Another common scenario involves a company monetizing a legal asset, such as a large unpaid judgment debt, in which the company won a claim but it remains unenforced. And perhaps the most significant trend in legal finance is the rise of portfolio financing arrangements for companies with several meritorious claims.

The portfolio financing strategy makes sense when a company has multiple pending claims that merit in-depth consideration. Financing of a legal portfolio follows the same general rules as single-case financing: The investments are non-recourse, and the financier must determine that the claims are meritorious in order to move forward. In certain arrangements, the client may add additional suits on an ongoing basis.

In a portfolio-financing arrangement, the claims are cross-collateralized—meaning that if one case loses, the capital provider can recoup its investment when it collects its share of returns from the portfolio’s claims that are successful. Because the financier has multiple paths to collect on its investment, portfolios might reduce the client company’s cost of funding. Increasingly, companies are also including defense matters and smaller claims in portfolio arrangements. They are extracting value from their large meritorious claims and using it to fund other legal activities.

Although defense claims are most often financed through portfolios, some organizations are using legal finance to fund defense in a single case. Defense efforts may be financed as a one-off when the company has a strong counterclaim or when the claim against the company is weak. In such an arrangement, the financier’s return would be predicated upon achieving a mutually agreed-upon definition of success.

Accounting Impacts of Legal Finance

Ordinarily, companies’ legal costs are expensed on the profit and loss statement (P&L) during the period in which they’re incurred, and the spending is not capitalized. This means that self-financed litigation reduces an organization’s reported profit. Even if a claim is eventually successful, the accounting disparity is not corrected. Any recoveries from a legal judgment are recorded below the line as non-operating income. Thus, the P&L reduction that companies experience as they pursue meritorious claims—which may knock their market value if they are publicly traded—is never reversed, regardless of the final outcome of the claim.

In contrast, when a company finances its litigation, legal fees and expenses do not have to hit its P&L. In the context of a legal finance arrangement, the counterparty—the entity that will actually receive the inflows of financing—will either be the company pursuing the claim or its law firm. When the company’s law firm acts as the counterparty on a financing agreement, it receives legal capital directly on the client’s behalf, thereby handling the accounting treatment of the capital on its own balance sheet. If, instead, the company chooses to serve as the counterparty—and receive the financing directly—it is afforded discretion in how to account for legal finance on its balance sheet.

In either case, legal finance improves the accounting outcomes connected to affrmative litigation.

The Role of Treasury and Finance

The management of a company’s legal assets remains the responsibility of the in-house legal department. Nevertheless, CFOs, treasurers, and treasury teams have an obligation to shareholders and the board, within their fiduciary duties to their company, to explore opportunities to recover on meritorious legal claims. They should be looking for ways to minimize the impact of legal actions on both corporate financial statements and the working capital available to fund the company’s ongoing operations.

Not every meritorious claim is financeable, but for companies with strong claims, it makes sense to consider having them evaluated by a legal capital provider. Too often, companies needlessly abandon legal claims that they could win, or else shoulder a heavy financial burden to pursue them. Legal finance can solve both problems. As business competition intensifies, it behooves treasury teams to learn about the potential working capital and accounting benefits of legal finance so that they can help their companies unlock the millions they may otherwise end up leaving on the table.