The Importance of Diversification in Commercial Litigation Finance

Presented by Balmoral Wood | Litigation Finance

Why is diversification so important in commercial litigation finance?

In a word, RISK. Lack of diversification in a commercial litigation finance portfolio increases the portfolio’s risk substantially. Now, the same can be said for many asset classes, but in this asset class the risk is more acute because of the quasi-binary risk (see explanation below) nature of litigation.  The quasi-binary risk stems from a series of underlying risks related to a single piece of litigation.  The more significant risks (setting aside legal representation risk) of a single piece of litigation can be summarized as follows: (i) legal risk, (ii) counterparty risk, (iii) judiciary risk, and (iv) plaintiff risk.

In part 1 of this article, we’ll look at the legal and counterparty risks to commercial litigation finance. In part 2, we’ll examine the judiciary and plaintiff risks, as well as the potential discrepancy in deployed vs. committed capital that is so unique to this asset class. We’ll then wrap things up with an explanation of the reward for successfully investing in commercial litigation finance (spoiler alert: the returns are huge!).

Legal Risk

Legal risk is a catch-all for a variety of legal considerations inherent in a piece of litigation.  These could include the risks associated with the legal counsel’s and litigation finance manager’s interpretation and assessment of the legal merits of the plaintiff’s case.  This risk is more significant when investing in the earlier stages of a case due to fewer facts/disclosures being available when a financing decision is necessary. However, such risk can also be mitigated through milestone financing, pursuant to the funding contract such that the funder does not risk too much capital when limited information is available.

There could also be risk associated with litigation reform, or adverse jurisprudence related to the specific case type being financed.  As an example, patent reform has had a significant impact on the ‘patent trolling’ industry, hence very few litigation finance firms will consider those opportunities.  The question for a financier is whether the case type which they are financing could be the subject of reform, or adverse jurisprudence before the settlement or court process is finalized, which could have a material impact on the outcome of the case.

The other aspect of legal risk is jurisdictional in nature, in terms of the legal jurisdiction or the forum (i.e. court or arbitration panel).  Different courts and judges can maintain distinct biases and interpretations which effect the outcomes of cases. With respect to arbitration, if it is binding in nature, the plaintiff and the financier lose the ability to appeal the panel’s decision, which makes that venue more restrictive on one hand, yet more definitive on the other.

The variety of legal risks inherent in litigation – some objective, some subjective – makes it that much more difficult to underwrite in a systemic way that results in a series of reliable and recurring outcomes.

Counterparty Risk 

With respect to counterparty risk, this too can take many forms.  The core component being that even if the plaintiff were to win its case, the plaintiff may not be able to collect the award or settlement.  In some cases, the defendant has the financial resources to pay the award, but due to the jurisdiction of the case, the plaintiff may not be able to enforce and collect its award (because, for example, the legal jurisdiction may not match the jurisdiction in which the defendant owns most of its assets). This can also be referred to as “collection risk”, but ultimately has to do with the characteristics of the counterparty (or defendant). Typically, litigation funders are very focused on this risk early in their underwriting process, and if there is no clear path to collection, the litigation funder will typically pass on the opportunity.

The other counterparty risk is behavioural/cultural in nature and may be assessed through the past performance of the defendant in a similar set of circumstances. A plaintiff may be in dispute with a corporation that has a predisposition to fight each dispute ‘to the bitter end’ even though that may not be an economically rational decision.  This behavior is often rooted in a corporate culture that encourages strength in litigation, in order to prevent future potential plaintiffs from engaging in similar litigation, and maintain a pristine reputation.  In this way, the corporation believes that ‘a strong defense is the best offense,’ which ultimately results in long-term savings, as it serves to deter future costly litigation.

Other corporations take a more practical approach and treat litigation as a cost of doing business, thus making economically rational decisions to minimize the costs of litigation (legal costs, discovery costs, settlement costs, etc.).  These organizations are generally more likely to enter into a settlement agreement.

Ultimately, the counterparty and their philosophical approach to litigation will have a significant impact on the outcome of a case, so whatever can be accomplished upfront to assess their likely approach will benefit the party’s outcome. Having said that, each case is unique, and each successive executive team may harbor different beliefs, so it becomes inherently difficult to consistently assess and anticipate counterparty behaviour given these ever-changing variables.

Judiciary Risk

Judiciary risk is simply the risk that despite a meritorious claim with ample supporting evidence, the judiciary will make an unpredictable or incorrect decision that results in a loss to the plaintiff.  This risk will differ depending on the nature of the forum (court or arbitration) and the nature of the judiciary (judge, jury or panel), not to mention the individual making the decision. The only remedy in this situation is success through an appeal, but that option may not be available, and typically the chances of a successful appeal are less than 50%.

Judiciary risk encourages many to believe that litigation risk is “binary”, which is to say that a plaintiff will either win or lose its case, but rarely is there a judicial outcome somewhere in the middle.  I would argue that the asset class, when viewed through the lens of a large diversified portfolio, possesses “quasi-binary” risk, as described below.

During the earlier stages of a case, there is uncertainty on either side of the dispute because a lack of disclosure has taken place, and so the counter-parties’ confidence in their respective cases relies solely on what they know about the case (both sides, of course, appreciate that there may be much they do not know). When you look at two parties in a dispute that have equivalent economic resources, the parties quickly turn their attention to focus on the merits of the case and the probability weighted potential outcomes of the case if it were to proceed to a judicial process. This uncertainty, married with the concept promoted by litigation finance of ‘level the playing field,’ creates a breeding ground for settlement. When you consider the large variety of potential outcomes in the context of a negotiated settlement, the possibilities are infinite. It is this series of potential outcomes that make a piece of litigation much less binary during the pre-trial period.

The reality of litigation is that the lion’s share of resolutions is derived through settlement (90-98%, depending on the data source). Hence, a commercial litigation finance portfolio is not as binary as one might think.  However, in the context of a single piece of litigation, there is the possibility that it gets resolved through a judicial decision and hence there is an element of binary risk inherent in any single piece of litigation. Since most commercial litigation is settled, and since there is binary risk associated with a single piece of litigation that reaches the judiciary, the application of portfolio theory decreases the binary risk inherent in a portfolio of cases.

Plaintiff Risk

Most jurisdictions prevent a third party from influencing the plaintiff with respect to their case.  “Officious intermeddling” is a reference to a third party interfering with the plaintiff’s decision, and is a component of the definition of the legal doctrine of ‘champerty’, which is still relevant in many jurisdictions.  Accordingly, when a litigation funder takes on a case, they must ensure that the plaintiff will be an economically reasonable decision-maker, which is difficult to assess, as the injured party typically wants to exact revenge for the damage done to them. There are ways in which a litigation funder can construct its funding contract to make the plaintiff act economically rational, but the provisions are more ‘guard rails’ than a ‘podium’.  Good litigation funders will spend time with the plaintiff to assess their economic rationality, but ultimately the funder is adopting an element of plaintiff risk when funding a new case.

Commitment vs. Deployment 

In addition to the risks outlined above, the other characteristic of the commercial litigation finance asset class that merits comment relates to deployment rates. In this asset class, there is a distinction between the amount the litigation funder ‘commits’ to a case, and the amount they ‘deploy’.  The former is the amount that the financier is willing to commit to fund based on a set of assumptions, milestones and limitations. The latter is the amount that is actually funded.

Since litigation funders cannot possibly know (particularly in early stage cases) how much of their commitment they will ultimately deploy, it becomes that much more difficult for fund managers to design diversified portfolios.  As an example, if I manage a fund with a 15% concentration limit based on aggregate committed capital, and my entire fund deploys 75% of its aggregate committed capital throughout its term, then my concentration limit is effectively 20% (15%/75%) of deployed capital.  If that same fund has 2 investments that have hit the fund concentration limit, then the returns of the fund will mainly be dictated by 2 cases representing 40% of the deployed capital.  When you layer on single case binary risk, you quickly come to understand how inappropriate the concentration limit is for the fund, and how difficult it can be for a fund to overcome a loss related to 1 large case investment and still produce strong absolute returns.

The Reward

Given that many of these risks exist in a single piece of litigation, the economic return must be significant to justify assuming these risks, which is why the industry has the perception of being an expensive source of capital. In addition, the industry does have the potential to achieve outsized returns depending on the funding contract and timelines, but these are typically driven by single cases and are extremely difficult to underwrite and predict. While the industry risks are numerous, many of them are manageable and diluted in the context of a diversified portfolio, and many investors believe the rewards are well worth the risk.

So, when an investor looks at the risks and rewards of a single piece of litigation in the context of a large diversified portfolio, it is easy to conclude that the application of portfolio theory (i.e. diversification) is necessary to achieve appropriate risk adjusted returns. Diversification can take many forms (fund managers, geography, case size, case type, counterparty, industry and legal representation) and it is important to have a mix of each within the portfolio to reduce risk, while obtaining the overall benefits of the absolute returns inherent in the asset class.

 

About the Author: Edward Truant is a principal of Balmoral Wood Litigation Finance, a litigation finance fund manager based in Toronto, Canada.  The author can be reached at edwardt@balmoralwood.com.

Didn't Meet ExpectationsMet ExpectationsExceeded Expectations (No Ratings Yet)
Loading...