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Third-party funders come to the aid of finance directors seeking to reduce the risk of litigation and control the costs

What is litigation funding? Litigation funding is the financing by one party of litigation brought by another in return for a percentage of any benefits received by the litigant.

What is the problem?
Litigation is a risky business and can seriously damage a company’s balance sheet.

Some companies consider the management of litigation to be a core competence and dedicate significant resources to it.

The pharmaceutical, tobacco, energy, insurance and banking sectors are well-publicised examples of litigious industries, and companies in these sectors often have large in-house legal teams and significant budgets dedicated towards the pursuit (and defence) of litigation.

Claim sizes often run into tens of millions, and in some rare cases the outcome of the judgment may threaten the very survival of the company.

It is therefore not surprising that the management of companies in these industries make it a priority to develop litigation as core skill.

However, for directors of companies operating in a less litigious environment, and where significant actions are infrequent, the prospect of pursuing litigation, either as a claimant or a defendant, can be daunting, particularly given that management may lack the experience to deal with such actions.

Litigation can be a real headache for the finance director, who is expected to manage the financing of what is an inherently uncertain and difficult-to-control expense.

The English legal system is world-renowned for the impartiality of its justice, but it has become one of the most expensive jurisdictions in which to resolve a dispute.

In a 2007 Sunday Times article, the late Sir Hugh Laddie, a British High Court judge, lawyer and professor, attributed the high litigation costs (said to be three to ten times the cost in Germany and the Netherlands) to the labour intensity of cross examination, oral argument, disclosure of documents and witness preparation.

To make matters worse, the English legal system is particularly weighted against the loser, who generally has to pick up the costs of the winner, known as an “adverse costs” award.

This can make the system doubly expensive for the losing party.

What is the solution?
Before the case of Arkin v Borchard Lines Ltd & Others (2005), there was considerable uncertainty over the effect of the medieval laws of “champerty” and “maintenance”, or in common parlance “buying into someone else’s lawsuit”.

However, in this case the Court of Appeal made it clear that third-party financing is a legitimate method of pursuing litigation and thus opened up the litigation funding market in the UK.

However, litigation funding is not the “silver bullet” to all litigation issues faced by companies.

For example, it is usually only financially viable to fund commercial litigation where a claim is for a substantial amount and is more commonly available to a claimant rather than a defendant; however, there are funders who will finance lower-value claims, as well as funders who will finance defendants.

There are, however, some significant advantages, both from a commercial and accounting point of view, to a party that can secure funding.

What are the advantages of litigation funding?
First, and perhaps most importantly, it is possible for the funded party to lay off the financial risk of pursuing a claim in return for giving up some of the upside.

As a result of funding, the risk profile of pursuing litigation changes significantly and the short- to medium-term cash-flow position will be improved.

Once the funder has reviewed the merits of the case and agreed to proceed, they will agree to provide funding for both the plaintiff’s legal costs absolutely and also for the defendant’s costs, where the action is unsuccessful.

Some funders may also require that the claimant enters into a partial conditional fee agreement with their lawyers to secure a reduction in their fees, which the lawyers only recoup if the claimant is successful, together with a success fee; this has the effect of aligning the interests of all the parties – claimant, lawyers and the funder.

Second, some funders, particularly those that employ experienced litigators, are able to offer a well-informed view as to the merits of the case, effectively providing a free second pair of eyes and guidance as to which lawyers are best suited to handle it.

This can be particularly useful for companies with limited experience of litigation.

Third, litigation funded by a third party will have a neutral impact on the financial statements of the company, whereas self-funded litigation can have a negative impact on both the P&L, cash flow and disclosures.

The following simple example illustrates this point. For simplicity the issue of recoverability of costs in the event of success has been ignored because it is very rare for all legal costs incurred to be recovered from the other side in the event that the case is won (and in the event of a loss it is rare to pay all the opposition’s costs).

Case study
A claimant brings a £10m claim with a 75 per cent probability of success, with each side expecting to incur legal of fees of £1m.

Should the company self-finance, the impact will be £1m of legal costs, which will be expensed through the P&L in the normal way.

A contingent asset of £8.25m should be disclosed, consisting of probability-adjusted damages (75 per cent chance of success x £10m = £7.5m) plus the probability-adjusted recovery of legal fees from the defendant (75 per cent x £1m legal fees = £0.75m).

A liability of £0.25m should also be disclosed, consisting of the probability-adjusted liability of the defendant’s legal fees in the event that the case is lost (25 per cent chance of losing x £1m legal fees = £0.25m).

A claimant that brings the same case but secures litigation funding, where the terms stipulate that the funder will take 30 per cent of the damages in the event that the claim is successful, will have a P&L impact of £0 (the funder picks up the legal fees) and a contingent asset of £5.25m consisting of ([£10m potential damages – £3m to litigation funder] x 75 per cent chance of success = £5.25m) and a contingent liability of £0 (the funder pays the defendant’s legal fees in the event that the case is lost).

For a company that runs a great deal of litigation and can afford the finance it is probably worth its while to fund the litigation itself as the cost of the losing cases should be outweighed by those that are won.

However, for a company with only one case and little experience of running litigation, the risks are higher, in that it does not have a portfolio of cases where the winners might outweigh the losers.

Without funding, the claimant is putting £2m at risk to recover £10m. With funding the claimant is risking £0 to “win” £7m.

When litigation is not a developed core competence each corporate litigant will wish to examine at board level which option it prefers and what is the best and most prudent course for the company in the widest sense.

Mark Spiteri, ACMA, CGMA, is a non-executive director of Woodsford Litigation Funding

Photo: Getty Images


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