Investors Fund Lawsuits and Take a Share of Whatever Is Won

The Problem It Addresses

Litigation is expensive and time-consuming. A plaintiff with strong arguments against a large opponent can still lose by attrition because the opponent can afford to prolong the proceedings and the plaintiff cannot

This asymmetry means that results depend in part on resources rather than merit which is a real defect in access to justice rather than a theoretical one

Asymmetry also determines which cases are filed. A company weighing whether to file a claim treats legal fees as a cash cost that affects current profits versus a recovery that may come years later and may not come at all so meritorious claims are dismissed for reasons that have nothing to do with their merit. Funding changes that calculus by removing the cost from the claimant's own budget

How the Funding Works

A funder pays legal costs in exchange for a portion of any recovery. Financing is without recourse: If the case is lost the funder receives nothing and the claimant owes nothing

How the Return Is Priced

The price usually takes the form of the greater of two quantities: a multiple of the capital actually deployed or a percentage of the recovery. Which one depends on how the case turns out and the interaction is where plaintiffs are often most surprised

Take for example a funder who commits 10 to costs and is entitled to three times his capital or 30 per cent of the recovery whichever is greater. In a recovery of 100 three times the capital is 30 and 30 per cent is 30 so the two match and the claimant is left with 70

In a disappointing recovery of 50 the percentage would give 15 and the multiple would give 30. The multiple joins together the funder keeps 30 and the claimant takes 20 of a won 50. Therefore a partial victory is much worse than proportionally worse for the claimant because the funder's floor does not decrease with the result

The multiple also typically increases over time so a case that settles in the second year has a different price than one that settles in the sixth year. That's not a shame. It reflects the following arithmetic

Why the Multiple Has to Be That Large

A return of three times sounds exorbitant expressed as a number and stops sounding that way once duration and failure rate are included

Three times the capital returned after four years is an annualized return of about 31.6 percent. The same three times after seven years is about 17 percent. After two years it would be about 73 percent. The multiple holder says almost nothing until the holding period is attached and litigation timelines are long and beyond anyone's control

Then apply the losses. The funder earns that return only on the cases that win and earns nothing on those that don't even though it has paid all the costs for them. A portfolio in which a significant portion of the cases return zero requires winners to pick off the losers before any returns reach the funder's own investors

Put them together the price is much less notable than it seems. It is the pricing of an equity stake in a binary outcome with an unpredictable duration of several years and no cash flow in between which is close to the least attractive combination of characteristics that an investment can have

The Investment Characteristics

The lack of correlation is the main attraction for institutional investors. Whether a court rules in favor of a plaintiff has nothing to do with interest rates or stock markets

The difficulty is the shape of the returns. Cases are resolved unpredictably many settle for less than projected and building a portfolio requires enough cases so that those that fail are absorbed. That requires scale which is why the industry consolidated toward larger funders

The absence of interim cash flow creates a reporting problem worth understanding especially for listed funders. Because a case can go on for years without producing anything the value of the position must be estimated in the meantime and favorable events such as surviving a strikeout request or receiving a positive ruling are recognized as profits before money has changed hands

Those profits are genuine in the sense that the asset is actually more likely to generate profits and they are not verifiable in the sense that only the bottom line settles the issue. Therefore a funder may report years of increasing profits from revaluations and then discover that cases are settled for less than book value. This is the same measurement problem that appears anywhere where an illiquid asset is flagged by the person who owns it and that is why the cash actually received from the casesconcluded is a more informative line than declared earnings

Funding a Portfolio Rather Than a Case

The answer to that concentration problem changed the shape of the industry and that is where most of the capital now goes

Instead of funding one claim a funder funds a group of cases often a set held by a single law firm and recovery from any one of them is available to pay for the entire service. Cross-collateralizing in this way turns a set of binary bets into something closer to a diversified exposure and offers better prices for the client because the funder's risk is lower

It also changes who the counterparty is. A portfolio agreement with a law firm is both a credit relationship with that firm and a claim on any individual case which introduces the firm's own creditworthiness and its incentives into the analysis

The same logic applies on the business side. A company with several claims can fund them as a group deduct the legal costs from its own bottom line and treat the entire matter as an asset rather than an expense. That framework more than access to justice is what has driven adoption among large well-funded plaintiffs who could very well have paid for the litigation themselves

How a Case Is Underwritten

Diligence is the product and is not as much like legal work as the name suggests

The evaluation of the merits is the obvious part and is usually supported by the opinion of an attorney independent of the team handling the case since the attorneys who will be paid to litigate are not the appropriate people to evaluate whether to litigate

In practice damage modeling matters more than the question of liability. A claim that has a good chance of success and produces a modest award is a worse investment than a large contested claim because the funder's costs are virtually the same either way and only the recovery increases

Then there is the budget which is where funders lose money without losing cases. Litigation costs are overrun opponents make procedural requests that were not in the plan and a funder who has committed to pursuing a case is exposed to expenses it did not cover. Credits are therefore drawn up in stages according to defined milestones rather than being paid up front allowing the funder to reassess as the case develops and giving the funder the practical leverage discussed below

The ratio that governs the entire decision is the expected recovery versus the total committed costs. Funders generally want a large multiple before proceeding precisely because the estimate of both numbers will be incorrect and the direction of the error is not symmetrical

Collecting Is a Separate Problem

An underestimated risk is that it is not pay to win. A judgment against a defendant without accessible assets or in a jurisdiction that will not be enforced is worth little

Enforcement can take years beyond the original case and it can be extremely difficult to collect from sovereign defendants in particular. Assessments that focus on the legal merits without evaluating collectability have produced victories that turned up nothing

The discipline this imposes on underwriting is that the defendant's balance sheet is scrutinized as closely as the legal argument. A strong claim against a weak defendant is a bad investment and a weak claim against a solvent one may be worth its liquidation value which is a way of thinking about litigation that has more in common with distressed credit than with the law

The Downside Is Not Always Zero

Lack of recourse describes what the claimant owes the funder. In jurisdictions where the losing party pays the winning party's costs it does not describe what the claimant owes the other party

That exposure is real and can be large so cases in those jurisdictions are typically backed by insurance taken out against the risk of losing and the premium itself is often deferred and paid only in the event of a win. The funder then underwrites the case the risk of execution and the cost of securing an adverse order with each layer taking a cut of what is recovered

Courts in some jurisdictions have also held that a funder can be directly liable for the costs of an unsuccessful plaintiff based on the reasoning that a party that funded litigation for profit should bear the consequences of losing it. Where this applies the disadvantage to the funder in an unsuccessful case is worse than losing its capital and the exposure must be provisioned

The Control Question

The central ethical question is who conducts the litigation. A lawyer's duty is to the client not the payer and a funder with money at stake has an obvious interest in settlement decisions

Most jurisdictions restrict funders' control of strategy and settlement. In practice enforcement is difficult because a funder with the right to withdraw funds exerts influence regardless of what the agreement says about control

There is a real tension here. A claimant may want to settle early for certainty while the funder prefers to proceed for greater compensation and their interests really diverge at that point

The pricing structure makes that divergence more stark than it appears at first glance. Because the funder's claim has a floor set by a multiple of its costs a modest settlement can leave the claimant with very little while still fully satisfying the funder. The two parties are not simply disagreeing about optimism. They are looking at the same offer and seeing genuinely different results and no amount of wording in a control clause makes that go away

Disclosure

It is actively contested whether the existence of financing should be revealed to the court and the opposing party

The argument in favor of disclosure is that courts should know who has an interest in the outcome that conflicts can be controlled and that costs orders may need to reach the funder. The argument against is that it reveals a litigation strategy and invites satellite disputes over funding rather than the claim

The direction of travel in most jurisdictions is toward greater disclosure particularly in class actions where funders' share of recovery affects what class members actually receive

Class actions are where the issue is most acute because the people to whom the money belongs are absent. An individual claimant negotiates his own funding terms and accepts the consequences. A class member is represented by lawyers he did not choose in a case funded on terms he did not see and the deduction comes out of his pocket in the end. Courts in several jurisdictions have responded by directly reviewing the funder's performance and reducing it when it appears disproportionate to the risk actually assumed which is a form of regulation ofprices that come through the judiciary and not through legislation

The Bottom Line

Litigation financing allows claimants to pursue cases they otherwise could not pursue valued as an equity stake in an uncertain binary outcome rather than as a loan. The investment risks are duration collectibility and concentration; the systemic questions are who really controls the case and whether the courts should be informed that the funder exists. The number worth understanding before signing something is not the multiple but the one produced in the face of a disappointing outcome because that is where the claimant discovers that the funder's profitabilityIt has a floor and its own does not