Chief Financial Officer
A good CFO takes enormous satisfaction in controlling costs. And in recent years, many CFOs have been given broad license to keep costs down – or at the very least – to keep costs flat. Despite these efforts, one budget line has continued its unrelenting rise: litigation fees.
Legal costs have long been viewed as a necessary evil, and legal departments are frequently disparaged as corporate “cost centers”. The financial control of legal affairs can be difficult for several reasons. As a general matter, visibility into lawsuits is often clouded by a labyrinth of arcane rules understood only by lawyers. More particularly, outside litigation fees are typically billed on an hourly basis – with little or no certainty given as to when a case will be resolved. For a CFO with ambition for cost control, the situation can be a significant source of concern.
Although unfamiliar to most CFOs, a new solution for addressing uncontrolled litigation fees is at hand. And it’s a solution that should have special appeal for CFOs, as it uses fundamental financial concepts to address the issue. The solution – known as “litigation finance” – is a new field that is quickly emerging in the US and the UK, having taken root in Australia ten years ago. Litigation finance companies treat litigation claims as corporate assets that can be “unlocked” for immediate value. As detailed below, the use of such financing has significant accounting benefits, and, as some companies are finding, can even turn “cost center” legal departments into revenue producers.
The ever-rising cost of litigation
Make no mistake, litigation is a big business. To put the numbers in context, the 200 largest law firms in the US annually bill more than $33 billion in litigation related fees alone; (i) and, as recent industry surveys make clear, the costs of litigation continue to rise.
The 2013 Fulbright & Jarwoski Annual Survey of Litigation Trends in the US and UK reported that 92% of the in-house attorneys anticipate their company will engage in either the same amount or more litigation in 2013. (ii) The survey also made clear that companies are spending more on litigation. In fact, the number of respondents who reported spending US$1 million or more on litigation fees has steadily increased in the past three years, from 46% (2010) to 51% (2011) to 54% (2012). (iii)
Until recently, CFOs and their in-house lawyers have had few options with which to battle these growing fees – none of which offered much satisfaction. Companies could seek to negotiate with top law firms in hopes of receiving discounted fees; they could select lesser quality firms that charged slightly lesser fees; or they could simply forego litigation and write down potentially valuable corporate assets. None of these options, of course, address the core problem. With the bolder solution of litigation finance, however, companies can work with their preferred counsel, and receive other financial benefits at the same time.
What is litigation finance?
The concept of financing litigation is nothing new. In the past, parties involved in litigation have had access to financing from all the usual sources of corporate finance, such as banks, hedge funds, insurance companies and private equity players. But as there were no dedicated players with long-term capital and specialized expertise, what financing did occur was fragmented, unreliably priced, and slow and inefficient in its provision. Over the past two decades, however, a new model for financing litigation began to emerge, first in Australia before gradually shifting to the UK and US. This new model has been driven by specialist financiers like Burford Capital, which are wholly dedicated to financing litigation, and offer a high degree of subject matter expertise and a better ability to assess and price litigation risk.
At its most basic level, litigation finance simply involves providing capital to enable companies to pursue or monetize legal claims. In the classic litigation finance scenario, a claimant has a valuable and meritorious claim but would rather not bear all of the financial risk that large scale litigation entails – or simply lacks the funds to afford counsel of choice. Instead, the company turns to a third-party funder, who puts up the capital to prosecute the case in return for a share of any proceeds. Importantly, such financing is typically non-recourse; if the case is unsuccessful, there is no payment to the funder.
This form of financing is based on the central premise that a legal claim can be treated as a financial asset, the value of which may be unlocked immediately by financing. In essence, the legal claim is serving as security for the investment, just as any other asset might. In more advanced forms of litigation finance, a legal claim may be used to finance something completely separate from the prosecution of that particular claim; for example, it might be used to fund business operating expenses.
Growing recognition of the value of litigation finance
CFOs are slowly starting to gain awareness of litigation finance. In the US, a November 2012 survey found that 62% of responding CFOs had heard of litigation finance. (This number stands in stark contrast to other parties surveyed – 93% of litigators and 96% of general counsel indicated they were familiar with litigation finance). In the UK, where the practice of litigation finance is more mature than in the US, one can safely assume slightly greater appreciation of litigation finance amongst CFOs.
While many CFOs are just becoming familiar with specialty litigation finance, the US survey results indicate that they are keenly interested in the topic. The majority of CFOs thought the use of litigation finance would increase over the next 18 months; (iv) while 22% said that their company had in the past had at least one case that could have benefit from financing; and 11% said they have an active case that could benefit. The results clearly point to a need for CFOs to further explore the application of such financing to their businesses, and to receive further education on the subject.
Litigation finance brings considerable accounting advantages
Amongst its many benefits, litigation finance can serve as a valuable accounting tool, allowing companies to litigate valid claims without impacting corporate balance sheets. Without the benefit of financing options, legal expenses paid directly to law firms are immediately recorded as expenses. That is, any legal fee paid results in a reduction from pro?ts – a reduction likely to be substantial and to last for years in a commercial case of any complexity. To make matters worse, if and when a company receives a recovery, it is often recorded “below the line” as a non-recurring or extraordinary item. That is an unhappy result for many businesses, and it is particularly unpleasant for EBITDA-based businesses, as the accounting result of pursuing a successful claim can perversely be a permanent reduction in EBITDA (because legal fees paid reduce EBITDA but recoveries occur below the EBITDA line). Clients can avoid these negative accounting effects by pursuing claims through litigation ?nancing.
Litigation finance can turn legal departments into profit centers
As noted above, in-house legal departments are often regarded as a necessary cost of doing business; in truth, they are actually capable of becoming profit centers in their own right. Companies such as DuPont in the US, and Michelin in Europe, are leading the way in this regard.
In the mid-1990s, DuPont faced a massive upswing in litigation costs as the number of cases each year grew from the hundreds to the thousands. As the cases multiplied, DuPont reevaluated its legal strategy and eventually developed the DuPont Legal Model. Under the Legal Model, DuPont’s legal team has a consistent process for assessing the merits and economics of each case. Perhaps most interestingly, the DuPont approach has lead it to focus on smaller claims – litigation “assets” if you will – that it might have otherwise ignored as too small to pursue. (Such claims include breaches of contract, stolen IP, damaged goods, and tax assessment.) By entering into innovative arrangements with outside counsel, these claims are now being brought and are helping to unlock revenue that would otherwise have gone wasted. In 2010, for example, DuPont recovered US$454.7 million from 198 separate cases, with the individual sums ranging from less than US$16,000 to almost US$185 million. (v)
In Europe, the legal team at Michelin has taken this concept one step further. They too have seen the value of pursuing legal claims that traditionally they would have foregone. But they have chosen to have the fees for the pursuit of such claims funded by a litigation financier. In so doing, they transfer all of the litigation risk to the financer, while standing to gain a significant upside.
Given the very public success of both the DuPont and the Michelin programs, one can assume other large corporations will soon explore a similar path, if they have not begun to already.
As CFOs look to lessen the financial pressures on their corporate balance sheets, litigation fees are clearly an area that merits close attention. The new solutions provided by litigation finance may be among the best and most efficient tools for the task. As the offerings are better understood and appreciated by those responsible for corporate finance, it is clear that interest in this new form of financing will continue to grow. And as the accounting and risk transfer benefits are better understood, it seems inevitable that more companies will avail themselves of litigation finance.
The best CFOs are continually on the look-out for new strategies to help their company’s bottom line. If that sounds like you, perhaps you should raise the topic of litigation finance when you next speak to your General Counsel. You both may be glad you did.
Chief Financial Officer
Miriam Connole is Chief Financial Officer of Burford Capital, a litigation funding firm based in the UK and US and listed on the London Stock Exchange. She was previously Group Finance Director of UK insurer Friends Life Group.