Editor’s Note: The information contained in this article is for informational purposes only and should not be considered legal/financial advice.
Most litigation funders use the “traditional” funding model by providing non-recourse capital to a law firm or claimholder in exchange for a share of any recovery. The funder’s return, if any, is typically calculated by charging a specified interest rate, applying a multiple of invested capital, as a percentage of proceeds, or some combination of the three.
Due to the uncertainty inherent in litigation, non-recourse debt is priced based on the risk associated in the transaction. In many circumstances, using a combination of insurance and funding is a more efficient, flexible, and cost-effective solution.
Insurance can remove or mitigate outcome variability, thereby making the cost of funding less onerous. Additionally, companies and law firms are turning to insurance to protect work in progress and judgments which they may or may not seek to monetize.
In 2022, the majority of funding transactions looked the same as they did in 2010: single-case deals with pricing based on an interest rate, multiples of invested capital, or a percentage of the recovery. More total dollars go to law-firm portfolio deals, which offer better pricing because of cross-collateralization; however, those deals are just a scaled-up version of the base paradigm, not something wholly different.
In other words, the industry has grown, but what it is offering has not fundamentally evolved.
If companies and law firms want more efficient options, they should look toward insurance as a way to remove outcome risk, thereby making capital more accessible and efficient. This paradigm allows stakeholders to win more by risking less.
So, how does this alternative model work, and how does it compare to other funding methods? The best way to understand it is to see how different funding models—one with insurance, and one without insurance, i.e., a typical litigation funding approach—operate when applied to a common fact pattern and showing the expected costs and net proceeds under each scenario.
Law Firm represents a Plaintiff corporation in a commercial dispute. In order to prosecute the suit, Law Firm needs $5 million to cover legal fees and third-party expenses. Potential damages for the case are $40 million, likely to be recovered in five years.
Under traditional funding, and assuming a multiple of invested capital model, the law firm or company would incur funding costs—i.e., interest—of approximately $15 million during the pendency of the litigation, which is equal to approximately 3x the invested capital provided by a litigation funder ($5 million funding x 3 = $15 million). The implied interest rate on this arrangement is approximately 32%.
While this protects the law firm and company in the event of a total loss, the cost of capital is relatively expensive as the risk is uncertain and the debt is non-recourse.
Using Work in Progress (WIP) Insurance & “Synthetic” Litigation Funding
Instead of going to the funding market first, companies or law firms can look to insurance to remove the outcome risk. Just like with a litigation funder, the risk goes through an underwriting process but this time, by insurance underwriters who specialize in creating litigation insurance solutions for known, threatened, or pending litigation.
In exchange for a fixed premium, the company or law firm can obtain downside protection to prevent a total loss of expenses or attorneys’ fees (WIP) incurred in the prosecution of litigation. By removing the risk of loss, the cost of litigation funding capital reflects the new paradigm. The risk for a funder has now been substantially mitigated as the insurance policy can be pledged to the funder thereby providing downside protection to the funder in the event the case is not successful.
By providing this downside protection, the risk is reduced and therefore, there is a corresponding reduction in the expense the funder will seek. Further, the number of funders willing to participate in the transaction expands as potential funders will look to the insurance policy for collateral rather than underwriting the underlying litigation, which many funders are not equipped to do, creating a more competitive process which further reduces costs.
So, the same $5 million in funding need would most likely now only cost a total of approximately $5.4 million—$882,000 for the insurance premium and approximately $4.5 million in interest costs—which represents a 64% savings in total costs or approximately $10 million. Using insurance also would increase the expected net proceeds by nearly 50%.
An added benefit is that the cost of insurance is financed as part of the overall insurance and funding package. This way, the stakeholders save significant costs without any additional out of pocket expense.
Summary of Calculations
By using insurance in combination with funding, the Law Firm and Plaintiff can achieve a better overall combination of risk-avoidance, cost-of-capital, and upside potential than they can by using the traditional litigation funding model.
So, when deciding how to finance plaintiff-side litigation, it is important to know that there are options. But those options do not all result in optimal results. One option in particular—combining insurance and funding—is often the far more efficient and superior option.
This article originally appeared on bloomberglaw.com in September 2023.