Keeping your shareholders happy
IMF Investment Manager, Simon Dluzniak discusses the benefits to businesses, big and small, of taking the risk of litigation off balance sheet to free up capital for use elsewhere.
Commercial litigation, despite the best efforts of the legislature and the Courts, remains an expensive and protracted affair. It is widely acknowledged that the cost to companies of seeking to enforce their rights via the Courts (whether those rights be contractual, intellectual property or other) remains prohibitive for many. Legal fees incurred by businesses involved in complex commercial disputes can run to millions of dollars, with the cases usually taking anywhere between two to five years to resolve.
There is also, of course, the risk that the litigation does not succeed and the company bringing the claim will be required to pay the other side’s legal costs, known as “adverse costs”. Adverse costs are typically awarded by Courts on a party-party basis and this means that the losing litigant ends up paying about 65-70% of the legal costs incurred by the defendant.
In light of the above, it is certainly arguable that companies, whether they are big or small, public or private, will benefit where they are able to have their litigation funded by an external entity such as a litigation funder. The principle reasons for this are:
1. Its frees up cash the company can then use for other working capital purposes.
2. It takes the litigation “off balance sheet”.
Freeing up cash
A company which litigates will usually be liable to pay the costs associated with the case along the way. This means that solicitors, barristers and expert witnesses must be paid (often significant amounts) by the company on a monthly basis over a long period of time.
The funds required for this purpose could arguably be more effectively utilised by the company for business-related and forward-looking purposes, for example to fund necessary capital works, or an acquisition.
The accounting perspective
As well as actually freeing up cash for working capital purposes, from an accounting perspective it also makes sense for a company to take litigation “off balance sheet”.
A litigation claim, which in a legal sense has the status as an asset, or a “chose in action”, is however not classified as an asset for accounting purposes. It will not be found in a company’s financial statements other than noted as a contingent asset, or as a note to the accounts. Further, where the case is successful, any income that the company derives from it is not treated as operating income, but rather is treated “below the line” and accounted for as non-operating revenue, or a one-off item.
In contrast to this accounting treatment of litigation income, the costs that a company incurs in litigating will have a meaningful and direct effect on its profit and loss statement, as these costs are not capitalized as you might expect, but rather are classified as expenditure. This has the effect of flowing through to the P&L and reducing the company’s operating profits whilst litigation is on foot.
So, as you can see, it is arguable that companies that litigate suffer through the course of the litigation from both a cash flow and a balance sheet perspective.
This is where a litigation funder can assist. For a contingent fee, a funder will in the usual course, pay on behalf of a company all of the costs it incurs in running a case, and will indemnify the litigant for any adverse costs payments it its ordered to make if it loses. This frees up cash for the company and also means that none of the litigation costs flow through to its P&L. Where a funder is involved, the only time the litigation affects a company’s accounts is if/when it is successful and when it does, it creates a positive cash flow - and that is a scenario which should keep the company’s shareholders happy.
If you would like to discuss a potential matter for funding with one of our Investment Managers, please contact us by visiting www.imf.com.au/contact for contact details.
Commercial litigation, despite the best efforts of the legislature and the Courts, remains an expensive and protracted affair. It is widely acknowledged that the cost to companies of seeking to enforce their rights via the Courts (whether those rights be contractual, intellectual property or other) remains prohibitive for many. Legal fees incurred by businesses involved in complex commercial disputes can run to millions of dollars, with the cases usually taking anywhere between two to five years to resolve.
There is also, of course, the risk that the litigation does not succeed and the company bringing the claim will be required to pay the other side’s legal costs, known as “adverse costs”. Adverse costs are typically awarded by Courts on a party-party basis and this means that the losing litigant ends up paying about 65-70% of the legal costs incurred by the defendant.
In light of the above, it is certainly arguable that companies, whether they are big or small, public or private, will benefit where they are able to have their litigation funded by an external entity such as a litigation funder. The principle reasons for this are:
1. Its frees up cash the company can then use for other working capital purposes.
2. It takes the litigation “off balance sheet”.
Freeing up cash
A company which litigates will usually be liable to pay the costs associated with the case along the way. This means that solicitors, barristers and expert witnesses must be paid (often significant amounts) by the company on a monthly basis over a long period of time.
The funds required for this purpose could arguably be more effectively utilised by the company for business-related and forward-looking purposes, for example to fund necessary capital works, or an acquisition.
The accounting perspective
As well as actually freeing up cash for working capital purposes, from an accounting perspective it also makes sense for a company to take litigation “off balance sheet”.
A litigation claim, which in a legal sense has the status as an asset, or a “chose in action”, is however not classified as an asset for accounting purposes. It will not be found in a company’s financial statements other than noted as a contingent asset, or as a note to the accounts. Further, where the case is successful, any income that the company derives from it is not treated as operating income, but rather is treated “below the line” and accounted for as non-operating revenue, or a one-off item.
In contrast to this accounting treatment of litigation income, the costs that a company incurs in litigating will have a meaningful and direct effect on its profit and loss statement, as these costs are not capitalized as you might expect, but rather are classified as expenditure. This has the effect of flowing through to the P&L and reducing the company’s operating profits whilst litigation is on foot.
So, as you can see, it is arguable that companies that litigate suffer through the course of the litigation from both a cash flow and a balance sheet perspective.
This is where a litigation funder can assist. For a contingent fee, a funder will in the usual course, pay on behalf of a company all of the costs it incurs in running a case, and will indemnify the litigant for any adverse costs payments it its ordered to make if it loses. This frees up cash for the company and also means that none of the litigation costs flow through to its P&L. Where a funder is involved, the only time the litigation affects a company’s accounts is if/when it is successful and when it does, it creates a positive cash flow - and that is a scenario which should keep the company’s shareholders happy.
If you would like to discuss a potential matter for funding with one of our Investment Managers, please contact us by visiting www.imf.com.au/contact for contact details.