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Elena S Rey

Brown Rudnick, London

esrey@brownrudnick.com

Tobias Plowman

Brown Rudnick, London

tplowman@brownrudnick.com

Litigation funding

The past two decades have seen litigation funding increase from a few isolated cases into a US$39bn global sector. The growth of litigation funding as a new asset class has been fuelled by a combination of relatively poor returns from traditional investment asset classes such as securities or real estate which are more susceptible to macroeconomic and political changes, along with a more distressed and litigious environment.

This combination has captured the attention of the investment sector with hedge funds, asset managers, banks, family offices and other institutional investors steadily increasing their allocation to this new alternative asset class. Litigation funders appear in every shape and size driving different investment criteria, expectation of return and risk appetite for different contentious matters. In addition to the funds focused exclusively on funding litigation, distressed and loan trading funds are now building litigation finance teams. Family offices are also newcomers to the sector, often focusing on litigation in higher risk markets to which they may have familiarity such as Russia/CIS, Asia or Latin America.

Investment return analysis

As the litigation funder’s return is inextricably linked to the success of the case, strict investment criteria must be applied when assessing the merits of funding a case. Each fund will approach their decision with different strategies and criteria, but the most important will include:

1. the ability of a defendant to pay an award if the litigation is successful;
2. the minimum realistic monetary value of the claim, ie, whether the pay-out is worth the time and effort;
3. the maximum legal budget for the case and whether the funder has sufficient capital committed to cover it (the illiquid nature of this asset class can cause funds to fail where they overstretch their capital and receive slower than expected returns);
4. the merit and the legal value of the claim; and
5. the length of the trial and any enforcement risk.

Structural issues

The course of litigation contains a number of procedural milestones and situations when the interests of a funder and the funded party may diverge, which can cause differences of opinion to arise regarding how to best proceed with the litigation. Independent legal counsel can assist by assessing the merits of the claim and advise on enforceability of any litigation funding arrangement at the outset of the opportunity, structure an appropriate security package, provide ongoing advice on key milestones (eg, settlement opportunities), test the litigation approach and strategy, structure legal costs to minimise the funder's exposure, maintain control over the litigation process and advice on the enforcement risk. A number of such situations are set out in more detail below.

Funding

Parties should consider how the funds are advanced to the funded party. Where possible, it is preferable to advance funds directly to the legal counsel for the funded entity rather than to the account of the funded entity itself. If the funds are disbursed directly to the funded entity’s bank account, the funder should consider taking security over this bank account.

It is also worth considering the cost of funds to the funder itself and when and how these costs are payable. If funds are advanced in a single drawdown this may not be an issue but it is common practice to advance the funds in multiple drawdowns throughout the course of the litigation against legal invoices. This can cause issues where the funder needs to pay the cost of funds for the total amount to be funded.

Additional finance requirements

The funder should incorporate protections where additional funding is required due to legal costs overruns (eg, relating to extensive disclosure, multiple jurisdictions or additional parties joining the claim). In this event, the funder should seek:

1. the right of first refusal to consider injecting any new funds into the case (though it should be made clear that this is not an obligation to provide additional funds);
2. the right to syndicate its funding obligations or involve another funder provided that any new funder sings up to the existing litigation funding documentation; and
3. a renegotiation right in respect of the amount or structure of its return/success fee depending on how much additional funding is required and the reason for it (this allows the funder to reassess if the case has become riskier).

Termination rights

Funders should detail their rights to stop funding upon agreed circumstances in the funding documentation (eg, where the funded entity commits a material breach, makes a misrepresentation, breaches relevant reporting requirements or a fails to assist in the proceedings) or in the event of a material and detrimental change of circumstances. Parties often agree that whether a change in circumstances of this nature has occurred must be confirmed by a legal opinion of an independent lawyer stating that the prospects of the litigation success have materially diminished.

It may be appropriate to negotiate an obligation of the funded party to repay back part of the funded amount and pay part of the success fee to the funder where the funding arrangement is terminated under certain circumstances.

Fee structures

Multiple potential structures and fee arrangements exist for litigation funding. The structure chosen will be driven by the nature of the dispute, the borrower and the investment mandate of the funder. It is common that deductions made to cover the drawdown amount which should be repaid to the funder, insurance premium and applicable tax payments are given priority in the payment waterfall. The balance is then split in the agreed proportions. The agreed split is often variable, depending on the level of recoveries made and may include a ‘springing success fee’, where the percentage recovered by the claimant is increased after a certain threshold.

Counsel should also be able to structure additional protections to limit or mitigate the funder's liability and cost exposure. In particular, it is advisable that a cap on the indemnity of the funder to contribute to the legal costs of the other party if the litigation is lost is negotiated and all legal costs and expenses are disbursed pursuant to a pre-agreed budget. Furthermore, there are now a number of various ‘after the event' insurance structures that help to minimise the funder's overall cost exposure.

Security structures

A thorough due diligence of the funded entity and its group should be carried out to determine the best security package to fit the case and reflect its particular risks. The following options should be considered besides the standard security over the assets of the funded entity:

1. the possibility of assigning the claims upon a trigger event should be considered and weighted against the Champerty rules in particular jurisdiction;
2. an undertaking from the legal counsel of the funded entity could be a helpful way to have more control over the cash flows during the litigation process and on receipt of a successful award; and
3. in additional to traditional security over the asset of the funded entity, a share charge over the claimant and or over its bank accounts should be considered.

In certain cases, it may be appropriate to incorporate a poison pill in the claimant's corporate documents which can be triggered upon a change of control or a hostile event and which provides the funder with control over the board of the claimant. This concept again should be checked against applicable Champerty rules (see below).

Tax implications

The funder should seek tax advice prior to structuring any funding arrangement in order to prevent success fees becoming invalidated or any increase in the funder’s tax exposure. By way of example, in certain jurisdictions success fees must be structured as a gain from an asset rather than as an interest on the loan. Where the funded entity is incorporated in the UK, advice should be taken to minimise the UK withholding tax risk.

Transfer rights

The right of the funder to assign or ‘syndicate’ its obligations under the litigation funding documentation (eg, in the event of a costs overrun or a material detrimental change in circumstances) is an important right to be incorporated into the documentation. Assignment rights of both parties are particularly relevant in the context of the developing market for the sale of arbitration awards.

Regulatory requirements – disclosure

Protections can be put into the documentation to protect the identity of the funder in sensitive litigation cases, high risk jurisdictions or to limit their exposure for third-party costs. Disclosure and transparency have been key market trends in the litigation space, particularly in the UK and the US where litigants have recently been required to disclose to court if their litigation is being funded by third parties and the funders may also be required to disclose their capital adequacy and the source of funds to ensure proper funding of the claim.

Regulatory requirements – Champerty

The litigation funding documentation must be carefully drafted to balance the desire of the funder to maintain input regarding any key litigation decisions versus the risk of triggering the Champerty concept which can invalidate the litigation funding agreement and relevant success fee provisions where the funder has too much influence/control over the litigation strategy and process. The question of whether a funding arrangement falls foul of the rule against maintenance and Champerty will be vary case by case and depend on various factors, including:

1. the level of control the funder has over the litigation;
2. the level of communication between the funded party and the solicitor;
3. the extent to which the funded party is provided with information and is able to make informed decisions about the litigation;
4. the amount of any return that the funder stands to receive relative to the total damages claimed;
5. whether there is a risk of inflaming damages or distorting evidence; and
6. the funder's rights to withdraw funding.

The future of litigation funding

With approximately US$1.3bn of funds raised in the past year alone, it is evident that the litigation funding sector will continue to grow with an increasing number and diversity of entrants to the market, financing a wide range of disputes across numerous jurisdictions. Legal documentation remains bespoke and complex for each particular dispute but an expanding legal framework and developing guidelines for participants is assisting the progress of litigation funding in becoming an increasingly credible asset class, delivering potentially greater returns for investors as well as removing the costs and burden from litigants.

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