Litigation focus | Investment culture: The future of third-party funding

Third-party funding is an area of high risk and high reward. In order to apply the traditional third-party funding model a claim has to have three key elements. First, it has to be high in value. Second, it must have good prospects of success and third, it must have a defendant who can afford to pay.

The very high returns that can be made in litigation funding are more likely to be found in the world of hedge funds and given the rewards it is no surprise that this is an area of fast growth in the UK. As a result there has been a substantial increase in the number of firms offering to fund cases in the last 12 months. However, nearly all of these organisations have a threshold for claim value that is in excess of £1m. Most, will say that £5m is the lowest value they will consider. The reason for this is simple mathematics. These funders seek a high return for their high-risk investment. Litigation is not a science and it can be unpredictable so funders will be looking for a minimum of their money back plus three times their investment as a return. Others will look for a straight percentage of the proceeds of the case and that may work out to be far more.

We have funded one-off cases of that level just to prove it works in the past. However, there is no real market at the moment for funding lower value claims. It may change.

Trial and error

Historically, there were various methods of funding which were open to solicitors. Some have gone by the wayside, partly in disgrace, others have simply been too risky or too expensive for one side or the other.

Of the historic methods, one of the first financing models used a consumer credit agreement (CCA). A client would borrow money from a finance house on a term of three years or less. An ATE insurance policy was used to insure the loan. The money was drawn to pay solicitors disbursements, with the lawyers working on a full CFA. This model had very high interest rates and was used at the consumer end of the market, primarily in personal injury cases. It went out of favour when the claims companies that were inextricably linked to these sorts of financing packages caused mayhem in the market place, went bust and left huge losses for insurers who insured the loans.

Another, a simpler model that followed after the CCA route became unpopular (with clients and the SRA), was the direct lending route. Solicitors took on the debt themselves. Following the huge losses insurers took after agreeing to pay back the balances on the consumer credit loans, they decided they would no longer insure the debt. The result was that the only way for lawyers to obtain finance was to borrow the money themselves, or at least underwrite the clients’ borrowings. This allowed solicitors working on a CFA and to use the borrowing to pay disbursements.

So historically there have been ways to fund low-value cases. However, more recently those methods have been less than attractive to lawyers or clients. The advent of the reforms being put into place by LASPO and Jackson mean that methods for funding and running lower value cases will have to change. ATE premiums are necessary in lower value civil and commercial disputes, indeed any solicitor that did not recommend one would probably be negligent and in any event would fall foul of the SRA’s conduct rules. However, they are no longer going to be recoverable. This presents a problem. If premiums are not recoverable there is no reason for insurers to make them contingent and defer the payment of them. They will therefore need paying by someone. Law firms doing volume work with an insurer, and with a good track record of success, may well be able to reach accommodating terms with insurers. Those that do not will struggle to insure one off cases other than with a premium payable up front.

In the coming years, the funding of lower value claims may be done in a number of ways. The advent of ABSs could provide an answer. Already law firms are being considered for investment from private equity. It is an easy step for those investors to extend their facilities so that law firms can offer terms to clients that are attractive to them and the firm. The additional opportunities that law firms offer to investors under the ABS umbrella are endless, and funding cases is just one of the money-making opportunities. ABS structures, may interest some investors but not all.

Funders work on a portfolio approach to their investments. They like to have a range of cases in value and term. The wider they spread their risk, the more likely that that one individual failure will cause them a real financial problem in the long run. Insurers have managed to pick a winner in around 80 per cent of cases during the period that the ATE market has been running, so realistically there is no reason why funders cannot operate with the same sort of success rate, if they apply similar principles. If that is what they do then they will make significant money and that will continue to provide a popular asset class for investors ?at the high value end.

Many investors are used to receiving ?a minimum of 20 per cent per annum as a return and like a regular return on their investment. High value litigation funding does not support that methodology, but lower value higher volume funding does. By this I am not suggesting a return to the early part of the century and the mass personal injury funding. However, a well-managed (and insurance-backed) scheme with a law firm receiving a regular amount of money per case for disbursements and work in progress across a range of cases could work well for funders, lawyers and investors. These schemes are already ?being launched.

Low-risk portfolios

A figure of around 20 per cent per annum is not an unrealistic interest rate for specialised unsecured lending against cases. It is still a high-risk investment opportunity but with reasonably good returns. There will be no shortage of potential investors.

One thing is obvious. The method used for traditional third-party funding does not work for all lower value cases. The budgets for these cases are large and capital adequacy requirements brought in by the Code of Conduct and set down by the Association of Litigation Funders means that significant sums of capital are tied up, potentially, for a long period of time with no return. Funders are used to waiting for their returns but they expect them to be large. That does not work in the lower value market. But there is hope.

With the increase in popularity of litigation funding in the UK, traditional funders may find that the increased competition drives down their returns. Currently that is less likely than commentators predict because there remain far more cases available for funding, than there is capital to fund those cases. ?However it will come eventually.

What is more likely is that funders will realise that the key to dominating the funding market, when it is a competitive one, is ensuring that when the best cases are available, they are offered to them first. Clearly, relationships with lawyers and clients, a good reputation and competitive pricing will be key to that, but having a range of products which includes a facility for lower value cases can only help. Put simply, if you can fund a law firm’s lower-value cases, when the firm has a high value one, they will come to you. It is claims capture that is the key to success and funding high and low value cases will assist with that.

Traditional funders will soon work out that there are significant opportunities for them at the lower levels of quantum

There is a general increase in investment in the funding market. This increase will eventually drive down the very high returns available and require funders to look for ways to spread their risk and increase their ability to secure the best cases. One way to do this will be to provide facilities to fund lower value claims at a lesser but more regular return. That will take some time and the existing players may choose not to take that approach given the opportunities available for very large returns at the top end of the market in other jurisdictions.

However, traditional funding remains high risk. While investors from the venture capital world are used to risks, the portfolio approach to providing facilities to lawyers to fund lower value cases is a much lower risk. The investment itself will be insured, but the returns are regular and higher than other asset classes.

Venture capital is coming into the funding world at all levels but the lower value end of the market could provide rich pickings for those investors and remains, for now, an untapped opportunity.