Popcorn, soda and the litigation funders

Third parties may agree to meet the litigation costs of one party, receiving upside from the damages payable to the funded litigant if the action is successful. This practice is known as litigation funding. Here, we take a closer look at this dynamic asset class, as law firms seek financing from litigation funders to manage their cash- flow needs and litigation funders turn to institutional investors for debt financing, resulting in a proliferation of market players. We examine "Work-in-progress" (WIP) and/or disbursement and costs advance facilities provided to law firms and also delve deeper into the loans extended to litigation funders and the typical provisions which underpin this esoteric level of funding.

Not many things are as interesting as watching a courtroom drama unfold.

Whether you are at the frontline of the battle or whether you are giving counsel from your living room as the Good Wife, there are many legal dramas you can choose from – you can wear Suits and you can even fly to LA to practice Law. One thing is for certain, real life or television, when there is protracted litigation there is an abundance of costs and expenses.

Just like producing an episode of a legal drama television series, bringing a claim against a defendant can be a costly exercise which often requires external funding. In the UK we are seeing an increase in third party funding being provided by litigation funders, our very own Hollywood "producers". We read about them in the newspapers and we are told that they are funding various high-profile cases such as the case against Volkswagen brought by thousands of car owners in the wake of the emissions scandal; an action brought by shareholders in Lloyds following its acquisition of HBOS; and the action brought against Mastercard and Visa over interchange fees by 27 high street names, including Nando’s and Pret-a-Manger. It all sounds very glamorous but before you settle down with popcorn and soda, in this article we are focusing on the list of credentials at the end of the episode – who is funding the litigation funders and what are the characteristics of their financing arrangements?

The pilot episode: what is litigation funding?

To set the scene, at its most simple, third party litigation funding is the financing of litigation by an uninterested third party.

In return for funding a claim (including legal fees, disbursements, court fees and the costs of expert witnesses) the third-party funder will receive a return from the proceeds of a successful outcome, which is usually either a defined percentage of the recovered costs or a multiple of the amount invested (or a combination of the two). For this reason, the majority of cases sponsored by litigation funders are those brought by claimants, and funders will look carefully at the prospects of success and the likely cost to damages ratio.

While litigation funding is not a foreign concept in the US, Canada, Australia, the Netherlands, Switzerland, Hong Kong and Singapore, there are more specialist litigation funders based in the UK than anywhere else, perhaps not surprising with the UK having a reputation as a global centre for commercial disputes while being the jurisdiction with some of the highest legal costs in the world. Research published by RPC earlier this year suggests UK litigation funders have raised over £1bn in capital to invest in litigation.

England and Wales is also the first jurisdiction to have a code of conduct for litigation funders courtesy of the Association for Litigation Funders (AFL) although this (perhaps controversially) remains voluntary.

Formerly seen as a method for an impecunious claimant to pursue a case it could not otherwise afford, increasingly we are seeing large corporates turn to litigation funders to shift litigation costs from their balance sheets. Companies are also raising funds for working capital with the proceeds of prospective litigation used as security collateral.

Litigation funding is particularly prevalent in the sphere of "class actions", which are likewise becoming more common in the UK, eg alternative lenders such as private equity houses are in some instances financing the costs, in the context of class actions, associated with:

• After The Event (ATE) Insurance (ie an insurance policy which covers a party if that party has to pay its opponent’s costs and its solicitor’s disbursements incurred as a result of that party bringing a legal action); and
• disbursements.

A more recent development in the market is the funding of claims portfolios. A "portfolio" may be a series of homogenous claims, possibly against a single defendant, although this can create additional risk to a funder where a key piece of evidence emerges, knocking out the entire portfolio or if the sole defendant enters into an insolvency process. Alternatively, a business may seek a portfolio arrangement where it has one or two very strong cases alongside smaller, less meritorious claims which would not, on their own, be attractive to a third-party funder.

This has even allowed some companies to raise finance to defend litigation.

There are various other products in the market funding litigation too such as innovative finance Isas (Ifisa) (which is basically an Isa containing peer-to-peer loans instead of cash) where the money invested into the Ifisa is used to fund legal costs.

Law firms themselves are active participants in the market; many offer clients contingent fee structuring packages, such as conditional fee arrangements, where all or part of the law firm’s recovery is contingent on a successful outcome (CFAs) and damages based agreements, where recovery for the law firm is set at a proportion of the recovery from the other side (DBAs). Such law firms are turning to litigation funders in order to maintain their cash flow and meet operating costs while their matters rumble on to completion. Consequently, we are seeing an increasing number of collaborations between litigation funders and law firms, with some funders backing certain law firms’ entire caseloads in specific sectors such as, for example, clinical negligence.

Episode 2: the emergence of a new asset class

Investors (see Diagram 1: "A typical lending structure" below) are increasingly seeing litigation as an attractive asset class due to it being wholly unconnected with the rise and fall of stock prices and the potential for a multiple return on investment. As litigation traditionally increases in times of economic downturn, litigation funding creates investment opportunities during times when more traditional investments are perhaps not performing well.

As with any good television plot, there is always a villain and in the case of litigation funding there are various risks associated with investing in this asset class, including the following:

• recovery is almost always contingent on a successful outcome at trial, so if the funded party loses, the funder will not recoup its investment;
• there have been cases where a third-party funder has been liable for a defendant’s costs (see, for example, Excalibur Ventures LLC v Texas Keystone Inc & others [2016] EWCA Civ 1144); and
• as an "asset class", litigation is highly illiquid, and returns, if any, can take years to realise.

Despite these risks, however, we are seeing more alternative lenders entering the market in order to, in the background, produce their very own "funding" episodes.

Episode 3: funding the law firms

While a dispute is continuing, law firms will be building up time and other costs, including court and expert fees, but also the costs of bundling, couriers and other ancillary items on the relevant file. This work-in-progress and the related disbursements are receivables to which value can be attributed, and against which some litigation funders are prepared to lend; loans made to law firms for the purposes of funding such work-in-progress and/or related disbursements are commonly referred to as "WIP & Disbursement Facilities".

"Work-in-progress" (WIP) basically means all amounts recoverable by the law firm in consideration for providing legal services to the client. The "disbursements" are the disbursements paid by the law firm for and on behalf of the client recoverable by that law firm pursuant to the client agreement upon the resolution of litigation.

On the other side of the spectrum, at the end of a dispute, a successful claimant will have the benefit of a costs order, that is, an instruction made by a court or tribunal as to which party should pay all or part of the other party’s costs. As a definite amount (and a receivable) which is legally enforceable, some litigation funders perceive this as relatively low risk to lend against.

Such facilities, commonly referred to as costs advance facilities (CAF Facilities), are therefore an effective means for law firms to leverage their interest in cost orders made in favour of them or their clients (as applicable) to bridge the gap between incurring their costs and waiting to receive payment (pursuant to the cost orders) from the unsuccessful party in the case.

Episode 4: funding the litigation funders

While litigation funders have traditionally raised capital:

• via the issue of corporate bonds;
• on equity markets;
• from institutional investors seeking to diversify their holding and attracted by the potential returns,

there has been an uplift in debt finance transactions which ultimately fund litigation by lending to these litigation funders.

There are many different types of financing facilities currently being made available to litigation funders in the UK market, and the products on offer are becoming more innovative especially with the increased involvement of alternative lenders and insurers.

The lenders financing litigation funders (LF Lenders) consist of a broad mix, including UK banks and alternative lenders such as US-backed funds and private equity houses. In the context of providing financing for CAF Facilities and WIP & Disbursement Facilities, the LF Lenders could take their "cut" simply through interest payments under a loan agreement, in the traditional way and/ or they may seek equity warrants giving them a contractual right (but not an obligation) to subscribe for equity shares in the litigation funder. In the context of funding a class action, however, the LF Lender will receive a percentage of whatever the litigation funder is due to recover in the context of the class action under the arrangements agreed between the litigation funder, the solicitors for the claimants and the working committee.

For the purposes of this article, we are focussing on financing provided to litigation funders so that they in turn can finance:

• WIP & Disbursements Facilities; and
• CAF Facilities.

The main distinction between the two is primarily what stage of the litigation the funding pertains to, and what the borrower provides as primary collateral. Both types are ultimately limited recourse loans and share many of the hallmarks of receivables and borrowing base facilities, but there are various nuances that the parties should be mindful of.

Loans advanced to fund WIP & Disbursement Facilities are perceived to be riskier than those for CAF Facilities. The former presents a greater risk, being advanced at a time when the claimant’s case may still be won or lost. Furthermore, the litigation funder (and therefore the LF Lender) will ultimately have a floating charge from the law firm only; the security package is featured, and discussed further, in Episode 6 below.

Episode 5: the nature of loans

The make-up of the financial covenant package will depend on the type of loan facility and whether it is, for example, a loan extended to a litigation funder in respect of a portfolio of WIP & Disbursement Facilities and/or CAF Facilities.

Loans funding WIP & disbursement facilities

In respect of loans funding WIP & Disbursement Facilities, the focus will be on complying with the "Borrowing Ratio". Essentially, this means the ratio of

• the aggregate principal amount of all outstanding loans owed to the LF Lender to
• the aggregate outstanding amount of all "eligible investments" made by the litigation funder, being the aggregate of (A) the outstanding principal amount of loans made by the litigation funder to law firms plus (B) the aggregate of available and unrestricted cash balances held in segregated accounts and all operating accounts of the litigation funder.

Loans funding CAF Facilities

LF Lenders usually have specific requirements regarding the litigation funder’s CAF Facility loan book; for example, some LF Lenders will only fund CAF loans that meet the following criteria:

• the law firm has been instructed on a CFA or DBA basis;
• a judgment or order for costs has been made in favour of the law firm’s client against a defendant and sealed by a court;
• the costs award is payable by a defendant or a qualifying body (eg HMRC, the NHS, the FCA or authorised insurance companies) on behalf of a defendant;
• a costs firm has been instructed;
• the litigation funder has first-ranking fixed security over the amounts payable by the defendant; and
• the costs firm must issue a notice of assignment requiring payment of the receivable directly into a blocked account.

In the case of loans provided to fund CAF Facilities, "Availability" (this is in essence the amount available for drawing by the litigation funder) will be calculated with reference to a borrowing base certificate that has to be produced periodically and on each drawdown date. It will, for example, be calculated as follows: (the total advances made to law firms + accrued interest and fees due from law firms) – (write-offs and law firm advances outstanding for more than 120 days) = total eligible borrowing base x 75% = gross availability, less reserves and less debit balances on ledger = "Availability".

Other typical financial covenants include an adjusted net tangible assets test and a cash cover test.

Common features

In respect of facilities financing both WIP & Disbursement Facilities and CAF Facilities, it is common for LF Lenders to impose concentration limits, as they do not want the litigation funder to be over-exposed to a single law firm for more than, for example, 10% of the then outstanding total amount of all law firm loans.

Given the risks involved in each type of loan facility, clearly there are additional protections LF Lenders will require alongside the more typical covenants, representations and undertakings. Below we have identified a few of these protections, but of course this list is by no means exhaustive:

• LF Lenders will place strict controls on the types of matters that may be financed from the proceeds of their loan facility. The facility agreement will hardwire concepts of "eligible" and "ineligible investments" with stipulations such as, among other things, relating to jurisdiction, type of borrower/claimant, currency, quantum and a prerequisite that ATE insurance is in place;
• litigation funders will be required to deliver various documents to the LF Lenders as part of the due diligence process, including copies of their investment assessment procedures and their template loan and security documentation to be entered into with the law firms; any material deviations from the process and template forms would then require LF Lender consent;
• LF Lenders will require monitoring rights, either via regular audits or where a default is anticipated or suspected. Some will appoint a verification agent who is permitted access to, for example, credit/ investment committee materials and may report back to the LF Lender. The costs for such monitoring are invariably for the account of the litigation funder;
• LF Lenders typically require step-in rights in order to ensure that, in an enforcement scenario, they are able to step in and run down the litigation funder’s loan book;
• LF Lenders will look closely at the operational side of the litigation funder’s business. Many litigation funders use bespoke software packages to manage their law firm loan portfolios, which also provide a useful "dashboard" for them to ensure facility compliance.
• The software packages will also be the subject of various representations and undertakings to ensure they are properly licensed and protected and that, in the event the LF Lender ever needs to step-in to the business, can be effectively used and/or sold by the LF Lender; and
• some LF Lenders may consider imposing a requirement for the litigation funder to adhere to the AFL code of conduct.

Episode 6: the security package

The scope of the LF Lender’s security package will be a key consideration and will be shaped by the nature of the loan facility being provided to the litigation funder.

The LF Lender will want to make sure that its borrower (ie the litigation funder) has taken proper security from the relevant law firms and that the LF Lender in turn has a valid and effective assignment of such security package granted in favour of the litigation funder.

If it is a WIP & Disbursement Facility, the LF Lender would expect the litigation funder to obtain a floating charge from its borrower law firms (the benefit of which would in turn be assigned to the LF Lender). If it is a CAF Facility, the expectation would be first ranking fixed security over the amounts payable by the defendant, with a subsequent assignment in favour of the LF Lender.

LF Lenders would also look to take security over any key software and other intellectual property rights associated with the litigation funder’s business, key contracts (including any contracts with servicers), insurance policies and bank accounts.

Depending on how the litigation funder’s business is structured, if it obtains financing from different LF Lenders for different financing products or if the same underlying law firms provide security to multiple litigation funders, there may be a need for intercreditor arrangements. Any intercreditor issues will bring an additional layer of complexity as the different LF Lenders would have to agree priorities between themselves.

Other points to consider will include the bank account provisions and payment waterfalls, which will be bespoke to the commercial deal agreed between the LF Lender and litigation funder.

Season finale

As litigation funding becomes an established part of the UK legal landscape, law firms are finding they need to be fluent in the different types of funding arrangements available to them and their clients. At the same time, litigation funders can now finance themselves from an ever-growing number of players in an increasingly complex and proliferating market, deploying capital streams from various sources. As with all financing arrangements, however, it is important to understand the underlying asset class and the risks associated with funding the same.

Keeping track of all third party funded class actions and the various financing products available in the litigation funding space provides for compelling viewing (with or without popcorn), and based on the current activity levels in the market it does seem as though litigation funders and LF Lenders will remain on the credit roll of a large number of UK courtroom productions for the foreseeable future.

This article originally appeared in the August 2018 edition of Butterworth’s Journal of International Banking & Financial Law.