The following article was first published by The Recorder, a Law.com media property, on April 24, 2020. The article was co-authored by Matthew Oxman, LexShares’ Vice President of Business Development & Investments, and Allen Yancy, LexShares’ Director of Investments.
The far-reaching reverberations of COVID-19, the most disruptive pandemic in more than a century, have sent shock waves throughout the legal industry. Courts across the country have temporarily closed or suspended trials. Proceedings that would normally occur in person instead take place over video conference calls, governed by policies that evolve frequently. Law firms and in-house legal departments have implemented headcount reductions, salary cuts, or both. Finding itself in a position that was unthinkable just a few months ago, and with the disruption showing no signs of abating soon, the legal industry must now contend with a “new normal.”
When the 2008 financial crisis rocked the global economy, the fallout for the legal industry quickly became apparent: litigation increased, and liquidity-challenged plaintiffs needed financial resources to pursue their claims. These realities, further exacerbated by tight credit markets and escalating legal costs, sparked a swift expansion of commercial litigation finance in the United States.
With widespread work stoppages fueling another economic downturn today, we anticipate a similar surge of undercapitalized plaintiffs seeking financial liquidity, risk reduction, and judicial access. Many commercial claimants with pending or ongoing litigation have already begun to explore their funding options. Others have just started to file cases that directly stem from the pandemic. What, then, lies ahead for the litigation finance industry? We lean on a mix of history, macrotrends, and our in-house experience in identifying four factors that will influence commercial litigation funding patterns in the months ahead.
Small Businesses and Law Firms Will Need Working Capital
COVID-19 has triggered a breathtaking economic downturn, with 22 million U.S. jobless claims made in the four weeks since broad restrictions were first implemented. Small businesses are especially vulnerable to the cash flow delays caused by the pandemic response. A recent U.S. Chamber of Commerce poll found that 24% of small businesses fear they will be forced to close permanently in the next two months. Furthermore, Chapter 11 bankruptcy protection and restructuring is often too expensive, time-consuming, and risky for small businesses to seriously consider.
Law firms, which may encounter cash flow delays even under normal circumstances, face similar financial pressures as clients make cost-conscious spending decisions or struggle to stay current on their hourly fees. Looming requests for discounts and the restructuring of alternative fee arrangements threaten to pin law firms between the need to address accounts receivable and the desire to remain empathetic toward distressed clients. The rapid declines of attorney travel and in-person court appearances, now replaced by inconsistent remote work arrangements, may make previous hourly billing rates tougher to justify. For contingency law firms with limited access to traditional credit, or none at all, the ever-present need to address operating expenses while cases await resolution remains, as well.
In March, when the pandemic’s effects were first felt in the U.S., LexShares saw its inbound funding inquiries increase 100% over three weeks.
Recently, more small business plaintiffs and law firms have inquired about litigation funding as they seek to bridge the financial gaps caused by COVID-19. In March, when the pandemic’s effects were first felt in the U.S., LexShares saw its inbound funding inquiries increase 100% over three weeks. Other funders, including Burford Capital and Omni Bridgeway, have observed similar growth. Many such requests come from plaintiffs looking to address short-term working capital needs–such as business operation expenses, attorney fees, expert witness fees, and court costs–in anticipation of accumulating accounts receivable and worsening economic conditions. Portfolio financing and direct funding arrangements can also provide law firms with greater liquidity and flexibility, ensuring short-term financial stability and even broadening the scope of cases a firm might represent on contingency.
Breach of Contract and Insurance Cases Will Proliferate
There is mounting evidence that COVID-19 business interruptions will drive increased breach of contract and insurance litigation. Force majeure clauses will be key points of contention. To what extent does a pandemic excuse contract fulfillment? Businesses in hard-hit industries may now face this unusual question. The growth of telecommuting, a provision not commonly covered in union contracts, could additionally lead to contractual disputes involving such issues as timekeeping, network security, and the protection of confidential information. At the same time, opinions on what constitutes an “act of God” vary across jurisdictions, with some defining it solely as forces of nature. The varied wording of force majeure clauses further complicates matters; contract language may or may not include a blanket provision specifying “any other like events” beyond the control of a party.
Insurance claims are already surging as businesses feel the adverse impact of canceled events, closed manufacturing facilities and storefronts, and other affected sources of revenue. We also expect an increase in claims filed by insurers against their re-insurers, as providers seek to insulate themselves against a flood of pandemic-related claims. Across the country, courts must address whether the contract language of the insurance policy covers pandemic-related business disruptions. The variability of this language makes it uncertain whether many pandemic-related insurance claims will hold up in court. Some providers, for instance, are positioned to argue that business interruption coverage is not designed to apply in the case of a virus due to the specific terms of their agreements.
Due to the unprecedented nature of COVID-related insurance and breach of contract claims, we can expect litigation funders to apply especially rigorous underwriting standards to these matters.
Business Solvency Will See Increased Scrutiny
There is little doubt that demand for bankruptcy and restructuring counsel has grown as companies struggle to meet payroll, repay creditors, and maintain debt covenants. Moreover, stalled commercial activity can turn previously creditworthy plaintiffs and defendants into credit risks. Litigation funders closely examine a defendant’s financial strength when underwriting any case because it affects the likelihood and speed of judgment collection. A bankruptcy filing typically stays all pending litigation. Even in the event of a positive outcome, the plaintiff will become a judgment creditor in bankruptcy without a security interest in a valuable asset, with rights similar to other non-priority unsecured creditors–thereby significantly hindering collectability.
Stalled commercial activity can turn previously creditworthy plaintiffs and defendants into credit risks.
Potential shifts in creditworthiness will naturally affect a funder’s investment decisions. In some instances, questions about the defendant’s financial viability will compel funders to reject otherwise meritorious case investment opportunities. The financial condition of plaintiffs is also a critical consideration given the added risk of a funder becoming involved in a plaintiff’s bankruptcy, were that to happen during litigation. Between these solvency concerns and a general uptick in litigation finance inquiries, which would create a larger pool of potential investments for funders, we expect funders to be more selective in their underwriting process.
Investor Interest in Litigation Finance Will Remain Robust
Investments in litigation-related assets are generally not correlated with public capital markets. This holds significant appeal for investors hoping to hedge portfolio risk against prevailing economic turbulence. Investors have relied upon third-party funding to generate strong historical returns shielded from systemic risk, and our firsthand observations lead us to believe that will remain true moving forward.
Earlier this month, LexShares’ online marketplace investors funded a $1.5 million breach of contract case in just a few hours. More recently, we fully funded a $2 million case in which nearly 20% of participating investors were new to the platform, potentially representing a fresh cohort of investors looking to diversify into litigation finance. Thus, we believe institutional and individual investor interest in litigation finance will remain healthy for dedicated funders with strong historical track records. This level of engagement can ultimately facilitate a reliable source of non-recourse capital for the plaintiffs and attorneys who may soon require it.
COVID-19 has changed life for millions of business and legal professionals, who suddenly find themselves searching for new sources of capital and stability. Litigation’s counter-cyclical nature is no secret, and the coming deluge of legal claims promises to make equitable access to justice a chief concern for plaintiffs. In the right situations, commercial litigation funding can allow attorneys and clients to gain financial clarity and flexibility amid great uncertainty. By converting illiquid legal claims to non-recourse capital that can be deployed in the coming months, law firms, corporations, and businesses that survive the ongoing crisis may position themselves to emerge stronger when it ends–just as some did following the 2008 recession.
For a closer examination of third-party funding, view LexShares' complimentary Litigation Finance Guide, which covers case underwriting criteria, current regulations, the investment process, and more.