A Primer on U.S. Defense-Side Litigation Finance
- Jason Levine
- Investment Manager and Legal Counsel - United States
Commercial litigation finance companies are best known for funding plaintiffs and their counsel, but there is a burgeoning market for defense-side arrangements as well. Although defense financing is currently rare, its further development will increase the availability of litigation investment capital and can help companies when they are most vulnerable. Creative litigation funders are actively working to develop bespoke defense financing solutions for companies that are the targets of litigation.
Corporate defendants in commercial cases can concretely benefit from non-recourse litigation funding. As discussed below, such financing shifts litigation risk from the defendant to the funder, improves the defendant’s position in settlement negotiations, strengthens its income statement, helps thwart abusive lawsuits filed by larger competitors or class action plaintiffs, and – with the right funder – provides case evaluation and strategic advantages that flow from underwriting and case monitoring. For these reasons, companies and their counsel are increasingly interested in financing their defense of substantial commercial cases.
Types of Defense Financing.
There are three primary forms of defense financing available today: the hybrid portfolio, revenue-sharing, and reverse contingency models. All are non-recourse, meaning the funder is repaid and receives a return only if the case resolves with a success for the defendant. Each model can play a role for the right kind of case, but the reverse contingency applies most broadly to the most types of cases.
In a hybrid portfolio arrangement, the funder includes one or more defense-side cases alongside a collection of typical plaintiff-side cases in a financed portfolio. The funder might receive no return on the defense investment, offset by higher returns on the plaintiff-side cases. A hybrid portfolio is typically suitable for a company with a large docket of affirmative cases to fund, with a one-off defense case. By definition, a hybrid portfolio structure is not a pure defense financing arrangement, and its uses are limited by the need for an accompanying set of plaintiff-side cases.
In a revenue-sharing transaction, the funder’s return comes from a percentage of the revenue stream produced by one or more of the defendant’s assets or lines of business. This format can make sense where litigation seeks to enjoin some or all of a company’s operations. Here, the funder receives an interest in the defendant’s future revenues from the affected aspect of its business until an agreed-upon return is received. Because the arrangement is non-recourse, the defendant pays only if the case resolves successfully. Like hybrid portfolios, however, the revenue-sharing model is not a generally applicable defense financing vehicle. It is designed for cases involving injunctive relief. Further, because the defendant’s affected revenue stream may be inconsistent, payment of the return may take a long time. This suggests a need for a higher time-based return.
Finally, a reverse contingency financing is the inverse of a law firm contingent or “success fee” arrangement. Whether applied through the client or the law firm, the reverse contingency is the most versatile defense financing solution, and it can be tailored to a wide variety of situations.
In the client-facing version, the defendant pays a return to the funder if – and only if – the litigation resolves in its favor. For this reason, the reverse contingency requires careful definition of what events trigger the defendant’s repayment obligation. Examples include winning dismissal or summary judgment, defeating class certification, securing a favorable verdict at trial, and – most commonly – settlement below a set threshold. In any of these scenarios, the defendant repays the funder its deployed capital plus a return.
Another variation involves counsel offering the defendant a discount on its hourly rates, to help the law firm secure the engagement, in exchange for a “success fee” the defendant agrees to pay if it secures a successful outcome. This is a common arrangement in large commercial cases. With the reverse contingency overlay, a litigation funder would pay the law firm some or all of its fee discount – thus reducing or eliminating fee risk to the firm – and the firm would then pay the funder its return from the proceeds of the success fee. Even a modest discount, facilitated by a funder on a non-recourse basis, could make a law firm’s beauty contest proposal more attractive compared with other similarly situated competitors.
Because settlement is the most likely outcome in a commercial lawsuit, the parties to a financing agreement must delineate its role as a “success” in detail, particularly in the client-facing reverse contingency model. The funder and the defendant need to agree up front on an expected value for the litigation, below which a settlement would be considered a victory. This value may change as the litigation proceeds, so the parties may wish to reserve their rights to reset the settlement benchmark at the end of discovery. The funder’s return in the event of a settlement can also be expressed in several ways. For example, it might be a percentage of the difference between the projected value of the litigation and the settlement amount; or it may be the greater of such a percentage versus a multiple of the funder’s investment. The timing of the settlement will usually play a role in defining the applicable return as well. These elements require careful negotiation and realistic expectations at the outset.
In an oversimplified hypothetical example, a defendant sued for $100 million in liquidated damages for breach of contract might agree to pay a funder 20% of any savings below $75 million, plus repayment of defense costs, in exchange for the financier covering those costs up front. If the litigation settles for $50 million after $5 million is spent on the defense, the funder would be repaid its $5 million and earn a return of $5 million (20% of the difference between $100 million and $75 million). The defendant saves $45 million and avoids having spent $5 million up front in defense costs. If the case settles above $75 million, or results in a $75 million+ defeat at trial, the defendant pays nothing toward its defense; the funder bears that cost.
Extending the same hypothetical example to the law firm “success fee” variation, suppose the law firm agreed to a 50% discount on its $5 million in fees in exchange for a success fee that grosses it up to 100% plus a 50% premium for success (totaling $7.5 million in fees). A litigation funder then covers some or all of the law firm’s $2.5 million discount. In the event of a successful resolution, the defendant pays the law firm its $2.5 million in deferred fees plus an additional $2.5 million – the 50% premium. The law firm in turn repays the funder the deferred fees that it covered, plus an agreed return from the $2.5 million premium – essentially, the cost for having de-risked its success fee discount.
Benefits of Defense-Side Financing.
Of course, as the models and examples above show, defense-side funding involves a return to the funder and thus imposes added cost on the defendant if it succeeds in the litigation. The same is true for “success fee” arrangements between defendants and law firms, as a common form of risk-sharing. Involving a litigation finance firm presents specific benefits that the defendant may well decide are worth the cost.
Most crucially, defense financing shifts up-front litigation risk from the defendant to the funder. If the outcome does not meet an agreed definition of success, the defendant pays nothing for its defense. This is particularly valuable for uninsured or uninsurable litigation claims, such as fraud or antitrust violations. Defense financing can also improve the defendant’s position in settlement negotiations, because shifting the expense of trial to a funder – which the funder alone will bear in the case of a defeat – may let the defendant more credibly threaten going to trial.
Litigation financing is beneficial from the perspective of a defendant’s corporate income statement as well. The cost of defending litigation creates a drag on profits. Under GAAP accounting, litigation costs are booked as an expense in the period they are incurred. With litigation financing, however, legal fees and costs are covered by the funder, letting the company show higher net income and lower expenses. Financing also frees up the defendant’s resources for other purposes, reducing the opportunity cost of litigation. By the time repayment to the funder is due, if the case resolves successfully, the defendant’s ability to use its capital for investment and business purposes (rather than day-to-day litigation costs) may generate revenue or stock appreciation that exceeds the cost of the funder’s return.
Further, defense financing can help thwart or minimize abusive litigation. In a David-and-Goliath type of commercial dispute, a larger company may assert dubious or inflated claims against a smaller rival that seems to be an easy target. Defense financing can help put the smaller company on an even footing and enable it to file counterclaims it otherwise lacked the resources to fund up front. Defendants’ access to litigation financing may also help reduce frivolous or nuisance lawsuits, particularly “strike suit” class actions. With financing, defendants can better withstand the ongoing cost of these suits, and thus better resist the pressure to settle rather than fight weak claims. In both scenarios, financing can help a defendant secure a better result than it would have otherwise achieved.
In addition, involving the right litigation finance firm can provide defendants and their counsel with analytical and consultative benefits that flow from the financing process itself. Before agreeing to invest in a matter, a reputable funder will conduct its own rigorous due diligence investigation. This is intended to identify the strengths and weaknesses of the case on the merits, in legal and evidentiary terms. Through this process, defendants and their lawyers receive additional insights into the case from experienced litigators who work for the funder or are hired to perform third-party due diligence. Moreover, because reputable funders are highly selective, acceptance of a case signals its evident strengths on the merits. This can bolster the defendant’s and its counsel’s confidence in the case and may enhance its settlement value. Although the funder does not control the litigation or serve as counsel, it will typically offer advice and feedback as the matter proceeds, which can also add value at no incremental cost.
Distinctive Elements of Defense Financing Arrangements.
The key distinguishing feature of defense-side financing is that – unlike plaintiff-side financing – the defendant itself will need to repay the funder. Unless the defendant asserts and wins a counterclaim, there will be no damage award or settlement proceeds from which the return is paid. For this reason, as noted above, parties considering a defense financing arrangement must carefully consider and agree on the expected value of litigation and return structures. Moreover, the defendant must be able to pay the expected return, which may necessitate heightened financial due diligence by the funder and involve a repayment period instead of a lump sum.
Relatedly, given the myriad possible outcomes for a defendant, the parties must agree on a detailed definition of “success,” with returns accounting for different scenarios that could evolve during the litigation. Ideally, “success” will be defined broadly, to reduce risk and thus permit lower rates of return. A broad definition, along with covenants of good faith, can also help mitigate the risk of a defendant settling for a figure barely above an agreed point of “success” to escape from paying the funder a return. It may also be desirable to consider re-negotiating the definition of “success” as the litigation proceeds, as previously noted. Finally, if an extended repayment period is contemplated, the parties will need to agree on a timetable with specified remedies for breach, if not liquidated damages.
In short, defense financing requires sophisticated parties and a bespoke approach. Structured correctly, such an arrangement can provide tangible financial and risk-management advantages to corporate defendants and law firms operating under success fees in commercial cases. Creativity, flexibility, and experience are crucial to successful defense-side financing.
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