The FTX implosion and the role of litigation finance in “black swan”events

Blog - The FTX Implosion and the role of LitFin in Black Swan events
Jason Levine
Investment Manager and Legal Counsel - United States

The recent collapse of cryptocurrency exchange FTX – with its bankruptcy, millions of creditors and damaged investors, and anticipated onslaught of lawsuits – highlights how commercial litigation finance can help claimants recover losses from “black swan” events. This is particularly true for securities and other commercial suits that arise from large-scale shocks to the financial system. Through non-recourse litigation finance, injured shareholders, investors, and policyholders can shift the costs of meritorious lawsuits to a third-party funder, which then is repaid only from the proceeds of successful recovery efforts. Distressed plaintiffs therefore have a way to pursue justice at a precarious time at much reduced cost and risk.

As described by Nassim Nicholas Taleb in his 2007 book The Black Swan, a “black swan” event in financial markets is essentially impossible to predict, has a catastrophic impact when it occurs, and is later explained in hindsight as if it were predictable. Analysis of the FTX debacle bears all the hallmarks of a black swan event. Other recent examples include the 2001 “dot com” crash, the 2008 global financial crisis, and the COVID-19 pandemic. Because these events injured millions of shareholders, investors, and policyholders, they also spawned substantial commercial and securities litigation, and presumably so will the collapse of FTX. 

Corporate plaintiffs facing such complex, costly, and long-lived litigation may benefit from third-party commercial litigation finance. A non-recourse funding arrangement can de-risk the litigation for the plaintiff, preserve its entitlement to the bulk of a damage recovery, compensate counsel, and provide an acceptable return on investment for the finance firm. The most important proviso is that payment to the funder comes only from litigation proceeds upon a successful resolution. If the plaintiff loses its case on the merits, it is not obligated to repay the funder, removing a large portion of the plaintiff’s financial risk.  

If funding is provided directly to a corporate plaintiff to cover its legal fees and costs, a balance can be struck where counsel bills hourly at a discounted rate (often in exchange for a success premium), the financing firm pays the bills, and they all then share in a recovery if one is achieved. In this scenario, the plaintiff will typically receive the bulk of the damages awarded, the law firm will earn extra compensation for its risk-sharing, and the funder will achieve a return on its investment. This arrangement can enable the plaintiff to offload its legal fees and costs, free up its capital for other uses, and shift the downside risk to the funder, while still securing a meaningful recovery in the event of a successful resolution. A corporation in financial distress resulting from a black swan event can therefore hire counsel of its choice to litigate meritorious damage claims that it would not otherwise have the resources to pursue. This is particularly significant given the deep complexity, long duration, and high cost of the litigation generally ensuing after a black swan event.

Similarly, counsel representing a distressed company on a contingent fee basis can receive funding for their litigation work. In this scenario, the financing firm can pay counsel’s out-of-pocket costs and (typically) discounted legal fees, earning a return only from the contingent fee earned from a successful resolution. The plaintiff’s share of the recovery is not part of the arrangement. Counsel can benefit by monetizing and de-risking its contingent fee – realizing a discounted hourly rate instead of taking full risk – without imposing costs on the plaintiff. The availability of litigation finance can therefore enable counsel to offer contingent fees to companies harmed in black swan events, which can expand counsel’s potential client base and provide a compelling advantage if competing for clients.

Relatedly, litigation financing can be beneficial from the perspective of a plaintiff’s corporate income statement. The high cost of pursuing litigation can create a drag on profits.  Under GAAP accounting, litigation costs are booked as an expense in the period they are incurred, yet potential future recoveries, no matter how certain, cannot be treated as an asset on the company’s balance sheet. Compounding this problem, when a recovery occurs, it is usually a one-off revenue event and does not factor into the plaintiff’s recurring revenue. As a result, analysts, investors, and potential purchasers may assign an inaccurately low enterprise value to a company that funds its own litigation in a black swan scenario. With non-recourse litigation financing, however, legal fees and costs are covered by the funder, enabling the company to show higher net income and lower expenses.    

Finally, involving the right litigation finance firm can also provide plaintiffs and their counsel with added 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, as well as to investigate its financial viability and the collectability of a judgment. Through this process, plaintiffs 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, as a financial proposition, and in terms of collectability. This can bolster plaintiff’s and counsel’s confidence in the case and may enhance its settlement value.  Given the complexity of litigation in response to black swan events, the ongoing involvement of an experienced litigation finance firm can add value at no additional cost.

As the global financial system expands and becomes more interconnected, major shocks may become more likely and have more devastating effects. For shareholders, investors, and policyholders injured by such events, commercial litigation finance can enhance their ability to pursue meritorious claims for recovery.

Learn more about legal finance or for information about how we can assist claimants in a variety of commercial disputes, visit our Company Insights and contact us for a consultation to learn about the ways Omni Bridgeway can help unlock the value of your meritorious claims.