Quite understandably, the idea of ‘funding lawsuits’ doesn’t sit well with a lot of people. The notion that a plaintiff might sell a stake in their lawsuit to a third party (thereby transforming the lawsuit into an investable asset) just feels… a bit icky. But the truth is, once people look beyond the ‘ick factor,’ they’re often surprised to learn that not only are their concerns unfounded, but that litigation finance actually benefits individuals and small businesses who are most in need. In fact, one might easily argue that litigation finance helps remove a good portion of the ‘ick’ from our current legal system.
To find out how, let’s take a closer look at what exactly litigation finance is, who uses it, and how it benefits claimants, lawyers, and investors alike.
What is Litigation Finance?
At its most basic level, litigation finance (also called litigation funding) is when a third party provides capital to a plaintiff (or sometimes even a defendant) in return for a portion of any financial recovery from the underlying lawsuit. The capital provided by monetizing a legal claim is often directly applied to the costs of litigation, including attorneys’ fees, investigative fees, expert witness fees and court expenses. A litigation finance transaction is not classified as a loan because it is non-recourse; meaning that if you lose the case, you owe your litigation funder nothing. The funder only receives a payout if the case is won, or if a settlement is reached.
Who Uses Litigation Finance?
While presumably for those who can’t afford the cost of litigation, the truth is that everyone and anyone can benefit from litigation finance. Individuals, class action and mass tort claimants, Fortune-500 companies, universities and businesses of all sizes have taken advantage of the capital security that litigation finance offers.
Now you may be asking yourself, why would a Fortune-500 company seek financing for a lawsuit? Surely they can afford the costs of litigation, so why take money upfront in exchange for giving away a (potentially large) cut on the back-end?
The answer lies in a little-known accounting loophole that affects the balance sheets of publicly traded companies. You see, any time a company undergoes litigation – and companies are always undergoing litigation (According to Norton Rose Fulbright, 90% of U.S. corporations are engaged litigation at any one time) – the expenses of the litigation need to be deducted from the company’s balance sheet. And since B2B litigation moves about as fast as a snail through molasses, those expenses can quickly add up, meaning companies could see millions of dollars in ‘lost capital’ from their balance sheets over the course of several years. And if there’s one thing investors on Wall Street don’t like, it’s lost capital. Sure, you can try to explain that your case is a guaranteed win, or that you’ll settle any day now and see all of your money back plus a hefty payout… but good luck convincing Analysts on the Street to look beyond the numbers. And the worst part is, even if you do win your case or reach a settlement, Wall Street accepts the eventual payout for exactly what it is – a one-time transaction. Which means Analysts discount its significance when assessing your stock valuation going forward.
In short, litigation is a lose-lose for a publicly traded firm. You lose the capital from your balance sheet while the litigation is pending, and even if you win the case, you still lose the opportunity to impress your Stock Market Overlords. It therefore makes sense for publicly traded firms – even cash-rich, Fortune-500 ones – to outsource the costs of their litigation. That way, no capital gets lost on the balance sheet while the litigation is pending. Sure, you don’t get as much payout on the back-end, but you’re also protecting yourself in case of a loss (remember, if you lose the case, you owe the litigation finance company nothing). So in terms of mitigating downside risk, litigation finance can work wonders, even for the big boys.
Some Additional Benefits of Litigation Finance
Balance sheet trickery isn’t the only benefit that litigation finance affords. Check out this laundry list of positives that litigation finance brings to the table:
- Helps David Fight Goliath – Hey, even David needed a slingshot, right? Without it, David would likely have been pummeled by the massive Goliath. And that’s exactly what large companies try to do to smaller firms who sue them – pummel the little guys into the ground with motion after motion and delay after delay, forcing legal costs through the roof. Litigation finance provides the Davids of the world with a slingshot: Bring on those endless discovery motions, Goliath, I’m not the one footing my legal bill, haha!
- Reduces the Risk of a Premature Settlement – No more acquiescing to low-ball offers. Litigation finance provides users with a crucial advantage when entering any litigation: Time. With time on your side, you can scoff at those low-ball settlement offers, and negotiate a much more equitable payout.
- Unlocks Working Capital Liquidity – What you don’t spend on legal bills, you can now spend on something else (like champagne, for when you make out with a much higher settlement than you would have thanks to your litigation funding agreement!). Or you could go the mainstream route and spend that working capital on employee salaries or marketing for your business. Either way, it’s money you don’t have to spend on lawyers.
- Affords Access to Top Legal Talent – Litigation finance affords access to capital that claimants might otherwise miss out on, which means they can suddenly afford top legal talent. And much like in the world of sports, when it comes to negotiating a hefty settlement, top talent can make all the difference.
Okay, so we know why claimants utilize litigation finance. But what benefit is there for lawyers? Well, plenty as it turns out–
Why Lawyers Use Litigation Finance
- Can Accept Cases from Plaintiffs Who Otherwise Couldn’t Afford the Fees – Much like access to proper medicine, access to justice costs money. And sadly, the legal system is not something most folks can afford. Lawyers love litigation finance because they no longer have to turn away strong cases simply because the claimant can’t afford their fee. Now there’s a means for claimants to seek justice without paying the legal fees. A win-win across the board.
- Enables Flexible Payment Arrangements for Prospective Clients – Sometimes litigation funders don’t just fund a specific case, they fund an entire portfolio of cases. In fact, this practice – known as portfolio financing – is growing more and more common. The result is that lawyers can offer flexible payment arrangements to prospective clients, given the assurance that their costs are already covered by a third party. Yet another means of enticing prospective claimants who might otherwise be scared off by the potential for a massive legal bill.
- Covers Litigation Expenses – This is a big one. If you’re going to bat against the big boys, you’ll need to bring in the experts. And expertise costs money. With litigation funding, you will likely be able to afford all the expertise you’ll ever need. Of course, it depends on the funding arrangement, but remember – the funders want to win the case as well, so they’re typically more than happy to pony up for expert witnesses and investigative costs.
- Helps Achieve Meritorious Recoveries – Basically, litigation finance means that lawyers are likely to see a higher payout when all is said and done. Their costs are covered, and their client is less likely to settle early for a low-ball offer. That makes for one happy legal team.
And guess what? Claimants and lawyers aren’t the only ones who are going gaga over litigation finance. Investors such as hedge funds, private equity funds, pension funds, endowments and family offices are increasingly turning to litigation finance for a litany of reasons.
Why Invest in Litigation Finance?
- The Asset Class is Uncorrelated to Traditional Capital Markets – That’s a ‘financey’ way of saying that investors in litigation finance are looking to diversify their portfolios by investing in a product whose performance isn’t tied to the Stock or Bond Markets. Regardless of how the economy is doing – whether we’re in a bull or bear market, an inflation or recession – there’s always going to be legal claims; someone will always be suing someone else. And the outcome of those claims has nothing to do with how the markets are fairing. So if you’re an investor in those legal claims, you’re not sitting on pins and needles waiting to hear if the Fed will raise interest rates. All of that stock and bond stuff is irrelevant when it comes to litigation finance.
- Outsized Historical Returns – Litigation finance is considered an ‘alternative asset,’ meaning it’s a niche financial product that isn’t classified as a mainstream investment. While such investments typically average higher returns due to their outsized risk portfolios, litigation finance returns are hovering around astronomical. A 2016 quantitative study performed by Professor Michael McDonald on industry ROI showed an average annual return of 36%. Hey, it’s no Bitcoin, but litigation finance is certainly crushing the stock market, and easily topping other alternative asset investments such as agriculture funds and asset-leasing.
- Decent Time to Liquidity – ‘Time to Liquidity’ simply means how long it takes to get your invested capital (plus the returns on your invested capital) back. Real estate, for example, can have a fairly long time to liquidity, since it often takes several years to get your money back (unless you’re one of the stars of ‘House Flippers’). The median time to liquidity for litigation finance is hovering around 24 months, which is moderate compared to other alternative assets such as Venture Capital and other forms of Private Equity.
So those are the reasons why everyone loves litigation finance. Except not everyone does love litigation finance—
The U.S. Chamber of Commerce, for one, is pushing for increased industry regulation, as are several other lobbying organizations across the country. Which begs the question, why all the haters?
Arguments Against Litigation Finance, and Counter-Arguments Against Those Arguments
Argument #1: Litigation Finance Increases Frivolous Lawsuits – This argument is pretty straightforward. With more claimants being able to sue, the likelihood is that we’ll also see an increase in frivolous lawsuits. Hey, if I’m not paying my own legal fees, what’s to stop me from claiming you stole my computer and suing for theft? Except, you know, for the fact that I’m typing this very sentence on my computer… but that’s for a jury to decide!
Counter-Argument Against That Argument – As we just said, the above argument is very straightforward. In fact, it’s too straightforward. The argument fails to reason that no funder worth their paycheck would ever finance a case they felt was frivolous. Remember, these are non-recourse investments; if the case is lost, the funder recoups absolutely nothing. So why on earth would a funder invest money in my ludicrous claim that you stole my computer?
In fact, funders are more likely to be even stricter with the merits of a case than a typical lawyer, since they’re approaching each case from the perspective of an investor. Many funders even turn down meritorious cases, simply because they can’t make the numbers work. So the idea that they would start funding frivolous cases is a bit… well… frivolous.
Argument #2: If Third Parties Fund Lawsuits, They Will Influence the Outcomes – Hey, if I’m investing in your lawsuit, you can bet your bottom dollar I’m going to be standing over your shoulder, critiquing every move you make, acting like the worst backseat driver on Planet Earth (we all know that guy). And that presents a thorny ethical issue: No one should control the decisions of a case except the claimant and the legal team, especially not some outside party whose only concern is making a payday on its investment. What could anyone possibly have to say to counter that?
Counter-Argument Against That Argument – All of that is 100% true. We don’t want third parties to influence lawsuits. That would be unethical, and would present a dangerous slippery-slope. Perhaps that’s why all litigation funders remain PASSIVE INVESTORS.
Yes, that’s right – part of the rules of being a litigation funder is that you cannot make decisions on the part of the claimant or legal team. A litigation finance company has zero legal input into the case (unless the claimant wants to ask their opinion, in which case they’re allowed to give it). Otherwise, funders just sit there – like a quiet introvert on a long car ride through a gorgeous mountain terrain – and wait for an outcome. Heck it’s even written into their contracts… they are expressly forbidden from making legal decisions unless the claimant asks them for advice.
So nice try, haters—
Argument #3: Litigation Finance Increases Trial Times – When a claimant has access to funding, they’re less likely to settle, which means longer trial times. Ugh!
Counter-Argument Against That Argument – Ummm… what exactly is the problem here? You’re telling me that claimants should be forced to settle early because of time constraints? Sorry, but if I deserve a hefty payout, I kind of couldn’t care less that our justice system’s biological clock is ticking.
Regardless, there is little (read: zero) evidence that litigation finance increases the time to settlement. In fact, the practice may even streamline cases and decrease the time to settlement by limiting the delay tactics that are so often utilized to bleed claimants dry.
Argument #4: Litigation Finance Means More Lawsuits Overall – Our court system is already clogged, adding litigation finance would be like flushing cement down the toilet…
Counter-Argument Against That Argument – This one is technically true, in that litigation finance is likely to increase the volume of claims. As claimants have access to financing, they are more likely to bring lawsuits forward (again, those lawsuits will likely be meritorious, but they’ll still be taking up valuable legal real estate nonetheless).
The thing is… is really that so terrible? I mean, isn’t that the point of having a justice system in the first place; that anyone who’s legitimately wronged should have the ability to bring their case and receive justice? In fact, I’d argue that more legal claims are actually a good thing. Sure, it might mean clogging up our courts a bit in the short run, but if companies and individuals begin to fear the repercussions of litigation finance – that is to say, that they might be sued for malfeasance and won’t be able to drag the case out and force a lowball offer – maybe, just maybe, they’ll be less likely to commit the malfeasance in the first place. And wouldn’t that be the best result of all?
Conclusion
Ready for a tough pill to swallow?
We don’t all have the same access to the legal system. Those with money have more access than those without. Litigation finance allows claimants without money to have the kind of access to justice that those with money currently enjoy. Obviously, that threatens some (like the moneyed folks who won’t be able to bully their way through the system anymore), but for the rest of us, litigation finance should be celebrated as a means of achieving equality of opportunity when it comes to preserving our legal rights. It will likely take some time, but eventually the idea of financing a lawsuit will be as common as financing a car (which ironically won’t be so common, since in the future we’ll be all be driven around by half-chimpanzee/half-robot cyborgs).
Also in the future, our legal cases will be handled speedily and cost-free by some omnipotent, AI version of Judge Judy. But until that glorious day, let’s all appreciate litigation finance for exactly what it is: a way to make the justice system just a little more accessible.
