Interest in litigation finance is growing rapidly. This product is moving beyond the domain of law firms and in-house legal teams as CFOs begin to understand the broader benefits it can deliver.
Litigation finance involves a third party taking on all or some of the legal costs and risk involved in running a case in return for a share of any proceeds of a successful outcome (whether it be by way of settlement of the claim or by a judgment in the claimant’s favour). This finance and risk transfer is provided on a non-recourse basis. It has traditionally been a way for claimants to fund their cases when they don’t have sufficient financial resources to do so.
Litigation finance can also deliver important benefits for well-resourced corporations. So, what are these benefits and why should CFOs be interested in litigation finance.
Protecting the value of the business from the cost impact of litigation
Litigation is expensive and the costs of running a case are generally treated as an expense on a company’s profit and loss statement. This adversely impacts the operating profit of the company for the duration of the case (which can be years). There is also an opportunity cost in deploying the company’s funds into litigation rather than into the profit generating operations of the business.
These litigation costs negatively impact the EBITA of the company which in turn has a negative impact on value (particularly where the company may be valued on a price to earnings multiple).
For a company involved in litigation, there is potentially a once-off financial return if the claim is successful. However, that return is not recognised as an asset in the accounts until the year that the payment is received. There is no amortisation of the future benefit of a successful claim across the years that the case is being pursued. Also, any financial return ultimately received from the litigation is not treated as operating income, but rather as an extraordinary item below the line and as such, does not positively impact on the valuation of the business. This unfavorable accounting treatment results in a company’s litigation budget creating a significant and unnecessary burden upon profitability.
If the same case was financed by a third-party funder, then the business will not carry these legal expenses. Rather, these expenses will be paid by the funder, removing this significant item from the company’s balance sheet. The operating profit in each year will be higher and the accounts will be a more accurate reflection of actual business performance. Further, once the claim is successful, the company will be able to include the proceeds as profit which has been generated at zero cost.
Protecting the business from significant litigation risk
Litigation is inherently risky as it is extremely difficult to predict a successful result. For many businesses, this risk is too great, and they choose not to pursue meritorious claims.
Litigation finance is provided on a non-recourse basis. This means that the assets of the business are protected and cannot be claimed by a third-party funder as collateral. The funder carries 100% of the financial risk involved in pursuing the claim and if the claim is unsuccessful, the funder will receive nothing.
In some jurisdictions (such as Australia and the UK) the rule that a losing party must pay the successful party’s costs presents an additional risk for claimants. There is also potentially a requirement to pay security for costs. This is an order that a claimant provide security for the defendant against the possibility that the claimant is ultimately ordered to pay the defendant’s costs.
Litigation finance can include the offer of an indemnity against adverse costs and an agreement to meet an order for security for costs. This means that the litigation funder carries all of the cost and risk of the piece of litigation which becomes from the claimant’s perspective, risk free.
Using third-party litigation finance also removes uncertainty in forecasting legal spend, which can be highly variable and difficult to predict. A client can choose how much of their legal spend is funded and be assured that they will not be required to spend anything other than what has been agreed.
Insulating the business from unexpected claims
Litigation brought against a company is an unwelcome consequence of doing business. These claims are almost always unexpected, unbudgeted and require action. The party against whom a claim is made does not have a lot of control over how or when costs are incurred. This often leads to CFOs being required to divert resources from other business activities, further impacting operating profit and EBITA and for no foreseeable financial gain.
If a business has a number of different cases this will present a substantial drain on working capital if they are all pursued. A litigation funder can provide a funding package for a group of claims (for and against the company) that is collateralised against successful outcomes of the cases in that pool. This “portfolio” based approach to funding lowers the risk for the funder (and as such, lowers the cost of the finance). But importantly it offers the corporate client the opportunity to offset the costs and risks involved in defending claims, as well as allowing the business to apply its capital into growth operations rather than on uncertain litigation.
Unlocking the value that resides in claims
As with any other source of potential revenue, litigation that a corporate can pursue is an asset of the business to the extent that it will potentially yield a return. Litigation finance presents a way of unlocking the value in that asset by meeting the costs required in order to realise the claim. In exchange the corporate client foregoes a proportion of a future financial gain (which in any event, is not guaranteed).
Litigation finance allows companies to recognize the value in a piece of litigation at a time which suits them best. For example, if a company is looking at achieving an EBITDA which is below expectations for a specific period, but the company also has a claim which is likely to be realised in a subsequent period, litigation finance can provide funds to the company secured against the “asset” which the company has (i.e. the piece of litigation). These funds provided to the company can “plug the gap” in expected EBITDA at no cost to the company.
The benefits of litigation finance are clear, even for well-resourced corporates.
It allows for the entire financial risk of litigation to be shifted to an external third party.
Litigation finance can eliminate the drain on working capital that occurs when companies fund their own litigation. When litigation finance is in place, the balance sheet is unaffected by litigation costs.
Litigation finance helps to optimise capital allocation and allows companies to focus on their core business and use their financial resources for value-creating activities. The use of litigation finance means a company’s valuation will not be adversely impacted by the movement of cash into supporting litigation costs. This is an especially desirable benefit for listed companies who are under scrutiny from capital markets.
Litigation finance is more than just a channel to justice for impecunious claimants. It is rapidly becoming an important corporate finance tool – and CFOs need to understand its application for their businesses.
Susanna Taylor is a Senior Investment Manager at ASX-listed litigation funder LCM. If you want to know how litigation finance might be utilised by your business, please contact Susanna at firstname.lastname@example.org