“It was the best of times, it was the worst of times…”
The above quote from Charles Dickens aptly describes the current environment for the legal industry.
Currently, the world economy and the legal profession are under tremendous financial pressure due to the impact of the novel coronavirus. This has already resulted in layoffs, reduced salaries general poor short-term outlook for the global legal services market. However, there are two bright spots, namely bankruptcy and insolvency and litigation services. So what does this mean for pension funds and other institutional investors which may be invested in or contemplating an investment in litigation finance?
Litigation should thrive in uncertain economic times as executives and shareholders make difficult decisions to protect the value of their entities, perhaps at the peril of counter-parties to agreements, which will ultimately culminate in disputes. As evidence, commercial lawsuits in the U.K. increased by 10 per cent in 2009. And in the U.S., in 2008 alone, 576 new cases related to subprime mortgages were filed against financial institutions.
Accordingly, this current downturn should similarly drive activity for the commercial litigation finance market, but there are some complex dynamics at play. During financial dislocations, psychology and cashflow play heavily into the actions of plaintiffs and defendants. Whereas in good economic times a plaintiff might be more inclined to fund a claim and the defendant may be inclined to actively defend, during financially difficult times the same plaintiff may not have the financial resources and the defendant may be more inclined to postpone or settle to minimize legal costs. Further, in the unprecedented case of coronavirus, we also have a situation where the court system itself has ground to a halt which will naturally delay cases. However, when cases do settle, this may occur more quickly than they would otherwise and at lower settlement amounts given both plaintiff and defendant are financially constrained.
The other dynamic at play is that during economic hardship, executives explore the value of all assets in their business to try and monetize under-utilized assets like litigation. But a business would only be able to do so if it had resources to spend, which are scarce during a financial crisis. Similarly, some plaintiff firms have approached litigation finance firms to monetize their existing portfolios (i.e. sell an interest in their contingent fees) or to provide funding for their portfolios (including their legal fees). Astute lawyers are also ensuring their clients are informed of the availability of litigation finance to ensure their client doesn’t walk away from a meritorious claim as a result of their own financial hardship.
Law firms that are under financial pressure are also now looking at their internal portfolios and engaging with litigation funders to determine how their portfolios can either be monetized or where funders could provide capital and share risk to assist law firms.
In each of these scenarios where there is either existing litigation or potential litigation, plaintiffs and law firms will be looking to litigation finance managers to fund their claims more than ever before, which should be a positive for the litigation finance industry, although perhaps with an increase in risk.
In terms of how this all nets out for the funders’ portfolio’s return profile, each of the dynamics referenced above will have consequences. Quicker resolutions will likely result in lower settlements and less profit, but duration will also be shorter so while their multiple of capital may suffer, their internal rates of return may benefit.
A shuttered court system will result in longer duration, but since most litigation finance contracts have economic entitlements that scale with time, they may see improved multiple of capital (however IRRs could suffer if the case goes on too long and the settlement may ultimately represent a larger portion of a smaller ‘pie’).
A plaintiff that has been negatively impacted may also look to litigation finance to increase its financial support for the case, which may change the risk-reward characteristics of the case for the litigation finance firm. Further, there could also be legislative changes to counter the potential for insolvency claims that impact both existing and new cases and therefore litigation finance related thereto.
Overall, I expect there will be an increase in demand for litigation finance with this demand being significant and sustained. Hence, I expect to see litigation finance managers undertaking fundraising initiatives before the end of their current investment periods. Additionally, litigation finance managers should also take this opportunity to look through their own portfolio and reassess defendant collectability risk. Since this risk has changed significantly in the last 30 days, fund managers need to determine whether to reduce or eliminate their support for existing cases and the extent to which they can do so without breaching funding contracts. Investors in litigation finance should be asking their fund managers about the process they have undertaken to assess defendant risk in the context of the current crisis and whether they expect the fund performance to be impacted as a result.