Investment Theme – Litigation Financing
With capital moving in search of higher yields, we have witnessed significant interest in alternative forms of investment over the past few years. This has resulted in private funds pursuing opportunities in non-traditional areas of value creation. One such area is that of Litigation financing – a “third party funding’ practice of providing financial resources to a litigant over the course of a commercial litigation or arbitration proceeding. For the purpose of this blog, we aim to discuss the definition of litigation financing, its requirement, and the market available for the same.
What is litigation financing?
Litigation financing involves an arrangement where a third-party financier of a litigant receives returns from the investment either as a fixed percentage of the monetary relief or as interest on the funded amount or the potential relief awarded.
The arrangement of third-party funding itself is an old and established process, having been explicitly recognized and legalized under the Common Law of England and Wales in the 1960s. That said, third-party funding is not yet a well-accepted practice the world over – thanks to concerns over ethicality as it may lead to the possibility that one litigant can essentially outspend the other, and thereby get a favourable award.
Given the concern with ethicality, it is important for one to note that all third-party contracts are executed on a non-recourse basis. Essentially ensuring that the funding party will only receive monetary benefit only if the litigant receives monetary relief pursuant to the proceedings. This affords the litigant the opportunity to match the spending power of the opposing party, free up resources which would have otherwise been tied up and manage the overall exposure to the dispute. Moreover, given the non-recourse structure, the litigant cannot be held liable for expenses incurred by the funding party if claims have not been awarded.
Requirement for litigation financing
While we utilise the term litigation financing, the concept is equally applicable for arbitrations, especially international arbitration proceedings, where the costs can beprohibitive.. As such, requirement for financing exists for both smaller litigants and large corporates to ensure a significant portion of the company’s assets are not tied up in unproductive and time-consuming endeavours.
As an example, a typical dispute would see a corporate incur costs in the following areas:
- Flat fees paid to ICC for hosting the dispute
- Administrative fees (arbitrators fees and expenses)
- Lawyer’s fees (billed on a per day basis)
- Fees payable to any external witnesses
- Overhead costs of senior management
As such third-party funding arrangements have been seeing increasing adoption as companies (and in some cases individuals) get drawn into high value commercial disputes, requiring expensive litigation and arbitration proceedings that might be drawn out over months, and in some cases years.
Market for litigation financing
There exists a large difference between global and domestic awareness and acceptance of litigation financing or third-party funding as there exists some contention on its legality in India. Internationally, several exist in the space and range in size from a few million dollars to a few hundred million dollars, and in some cases over a billion dollars. A survey by Westfleet Advisors estimated that (i) the US litigation funding industry had USD 11.3 billion worth of assets under management in 2020, and (2) third-party funders deployed USD 2.5 billion of capital form mid-2019 to mid-2020 to finance litigations in the US.
The first major player in the third-party funding space to be aware of is Burford Capital. Burford was founded in London in 2009, in the immediate aftermath of the global financial crisis, and was immediately listed on the London Stock Exchange’s Alternate Investment Markets. Today, it has nearly USD 3 billion in assets under management, and is listed on both LSE and NYSE. One major variation that can be observed in the global market is in relation to the nature of the processes being funded. In the UK and in the US, the bulk of the third-party financing activities are to bear the costs of arbitrations. However, in the third best established market for such services, Australia, the bulk of third-party funding flows into litigations.
As mentioned, third-party funding is still a new and contentious concept in India. The general understanding appears to be that third-party funding of legal costs is permitted but might be at risk of judiciary scrutiny on a case-by-case basis.
LegalPay is the only major Indian firm offering third-party funding for litigations and arbitrations. LegalPay was founded by Kundan Shahi in 2019, and finances commercial litigation cases. Its typical ticket size is 25 to 50 lakh per case, which is quite minimal compared to the global players, and practically rules it out from financing big ticket litigations and international arbitrations.
Legal Pay follows a typical AIF model for its revenues, and earns 2% management fee on the capital managed, subject to providing a minimum IRR of 14%, and has publicly disclosed its aim to provide an IRR in excess of 30%. It aims to raise in excess of ₹200 Cr in assets under management by the end of FY2022.
Pros and Cons from an investor perspective
Per a New York Times report, litigation funders in the US were highly profitable, and realized 30% IRR on investments. Sophisticated investors, including pension funds, had included litigation funding in their investment portfolio.
Some of the obvious benefits that an investment in a third-party funder offers to its LPs include:
- Returns that are not directly correlated to the market
- Returns not subject to market-related systematic risk
- Returns that might be inversely correlated to market crashes – an adverse market event often ensures that there will be a higher number of disputes
- Higher degree of diversification – thanks to lower cheque sizes
At the same time some of the obvious demerits are:
- Each investment has a higher-than-average risk of wipeout, as funding is always non-recourse.
- Possibility of long timelines – litigations can take a long time to reach their conclusions as it wends its way through the legal system (particularly in more challenging markets like India).
- Challenges to the proceedings – litigations and especially arbitrations can be delayed because of delay tactics employed by the defendant including by initiating new proceedings challenging the jurisdiction and validity of the first claim.
- Difficulties in enforcement – enforcing the results of arbitration or even litigation awards can be challenging, including as a result of hiding of assets, or through follow-on proceedings initiated by the defendants.
Conclusion
Despite the above-mentioned demerits of litigation financing, there appears good potential for growth in the domestic context. Further, with the increased instances of arbitration and litigation along with the rising costs associated with the same, the option of receiving third party funding will ensure that all associated parties will be on a level playing field. From an investor perspective, while this may not be the ideal place to invest a majority of your portfolio (especially without detailed knowledge of the field), this offers another way to diversify your portfolio given its lack of correlation with the market.