updated on 16 January 2018
QuestionWhat are the implications of an increase in litigation funding and what do investors need to consider?
In 2017 there has been an expansion of litigation funding, both in the United States and in the United Kingdom. Over the last 10 years the industry has solidified and matured, and is now seen as a viable investment strategy for many people. The industry has also opened up in recent years, as transparency about the process of litigation funding is seen increasingly as a good thing. For example, Pierce Serginian, a recently opened boutique law firm, is now openly advertising the fact that a large portfolio of its contingency-fee based work is directly funded by a large litigation funder. Recently, one of the most contentious pieces of litigation – the RBS class action suit that dominated headlines – was openly funded by litigation funders. It is seemingly no longer taboo to treat litigation as what for many commercial clients it already was – an investment of money with the hope of an expected return.
Despite this, there are still challenges that the industry, and therefore investors, face. The first is the regulatory void in the United Kingdom, as well as ongoing lobbying to curtail litigation funding in the United States. The second is the intrinsic uncertainty that comes with litigation. Finally, there are real questions about how the move towards funding litigation this way will affect access to justice, and whether it will distort the stated purpose of the court-based process.
It is important to first establish what litigation funding is. In its simplest form, it is the funding of litigation (usually the claimant's costs) by an unconnected third party, which has limited control over the proceedings (eg, not a shell company or parent company).
In exchange for funding the costs of litigation (eg, primarily legal and experts fees, but also court costs) the litigation funder gets a share of the "outcome". This can either be a multiple of the costs which have been funded or a percentage of the total recovery or damages the claimant wins. Due to the nature of the way in which the litigation is funded, it is almost always a claimant who seeks litigation funding, as there has to be some kind of pay-off at the end.
Due to its unregulated nature, a range of different entities offer litigation funding. These range from private limited companies to hedge funds. The main powerhouses are, however, large companies (some of which are publically traded) that have large portfolios of different litigations that they fund, along with similarly high levels of risk and potential reward.
Given the uncertainty of litigation, and the general uncertainty of investing in any market, a key question is how profitable litigation funding actually is for those who put money into it.
One of the key problems is that while transparency is better now than it was, the industry is still reluctant to share information. Some of the larger companies will not disclose which litigation they are funding, limiting potential investors' ability to quantify the risk of each portfolio. This is for a variety of reasons. First, many of the claimants being funded do not want this fact to be made public.
Second, many of the firms involved do not want to spook investors and so restrict their reporting. As these funds are often involved in a range of litigation, much of it high-value, they prefer to provide results about the general state of the fund year-on-year. This limits fallout if one large case is lost, preventing investors from pulling their money.
However, from the data available it is clear that some of the larger funders have historically done very well. In an article written in 2015, three of the larger litigation funders posted high returns:
This trend has only continued, with one publication recently putting the value of the market at £2.7 billion. Clearly there is money to be made in litigation as an investment vehicle.
There are a number of reasons why investors want to put their money into these companies. For one thing, traditional forms of investment are producing very low returns, and people are seeking more esoteric places to generate profit. Second, litigation is unconnected to wider economic forces. Each case will be decided individually on its own merits and so will not depend on wider movements in either the bond or equity markets. While this poses some risks, it can also provide (in some ways) more stability than other forms of long-term investment. Given how litigation often picks up in the wake of large economic crises, investing in litigation funders could be viewed as a hedge against general market movements. If markets collapse, then there will surely be litigation soon afterwards.
Case law (at least in England & Wales) has also been helpful to the litigation funders. In October 2016 in the case of Essar Oilfield Services v Norscot Rig Management Judge HHJ Waksman upheld a decision made by an arbitrator to allow a claimant who had succeeded in an arbitration to recover the costs of the litigation funding. This meant that the claimant was able to recover 100% while the funder also received its agreed amount (which was 300% of the amount it funded) from the defendant. This decision opens up a whole new realm of possibility where claimants seeking litigation funding for arbitration will not even have to bear the cost of paying their funders, making the service even more attractive for both investors (who will have greater certainty about returns) and also those who might want litigation funding.
While the above paints a rosy picture for investors, there are intrinsic considerations that investors and users of the service need to take into account.
The most obvious issue is the lack of specific regulation (especially in the United Kingdom). This is potentially risky for two reasons. First, there are limited protections for investors and a lack of clear rules governing the industry. There is currently a regulatory vacuum in the United Kingdom, which opens up investors and funders to problems generated by quickly moving case law and uncertain legislation (see below on the issues around champerty).
Second, the lack of current regulation means that future regulation could impact the industry in a way that harms the current model. This is best demonstrated in the United States, where the US Chamber of Commerce has lobbied for a variety of rules changes. In 2017 the Chamber of Commerce pressured the US court system to ensure transparency of litigation funding. They argued that if defendants must disclose their insurance funding, then claimants should be forced to disclose litigation funding. In 2015, the lobbying group wanted funders of litigation to post a bond worth 25% of the total claim value, forcing the funders to pay the other sides' attorney fees if their side were to lose (in general, the United States does not operate a ‘loser pays’ system).
Without robust legislation, investors are currently relying on case law and the maintenance of the status quo. While this is a successful model now, any hint of negative legislation could spook the industry, leaving investors exposed.
There are a number of key considerations that litigation funders have to bear in mind when operating in the United Kingdom, and which investors in those companies must also understand.
The doctrine of champerty
Historically, litigation funding was not allowed in the United Kingdom under the common law rules of maintenance and champerty (which were later codified). There have since been changes to those laws and litigation funding is in general allowed, but the doctrine of champerty still applies. This means that litigation funding can be caught by such rules if it is not conducted properly.
To determine if litigation funding is champertous, a court will look at:
The aim is to ensure there is still sufficient distance between the funder and the litigant.
If a court does find an example of funding that is champertous, there are a range of consequences for the funder. The funding agreement itself will be void and unenforceable as a matter of public policy. The funder will be unable to enforce the agreement against the funded party, which is a significant risk if there is any hint of dispute between the funder and the client (or their lawyers).
Perhaps posing more risk, a champertous relationship might result in the litigation funder being ordered by the court to pay for the entire costs of the litigation, not just what was set out in their contract with the client (as pointed out in the judgment of Arkin v Borchard Lines Ltd).
While both of these effects pose challenges for a UK litigation funder, the case law is currently moving in the direction of supporting funders. However, there is no reason why the courts could not start to limit what the funders are allowed to do in the future.
The effect of Excalibur Ventures LLC
This decision also demonstrates how the current English legal regime poses a threat to litigation funders. In this case, the litigation funders were expected to pay (on an indemnity basis) the defendant's costs. Although liability was capped at the amount the funders contributed, this still meant that the litigation funders were doubly out of pocket – once for the costs of the litigation they funded and a second time for the defendant's costs. Given that funders are expected to keep a reasonable arm's length from the proceedings, they have no control over the amounts the defence might accrue, exposing them to potentially large amounts of risk.
While litigation funding is a potentially lucrative investment for those with inactive capital, and offers law firms and their clients new ways to fund litigation, from an investment perspective it must be approached with care.
Litigation is intrinsically risky, even when you have full control over a case as a client or solicitor. Investing as a third party in that process is doubly so, given the rules about how much control you can have over the proceedings as a litigation funder.
While somewhat settled now, the case law and regulatory regime has potential to change and could affect the industry significantly. It is therefore suggested that investors looking to invest in litigation do so with eyes wide open about the risks they face.
Max Rossiter is a trainee solicitor within the professional & financial risks department of RPC.