Aligned Incentives: The Key Ingredient of Client-Directed Litigation Funding

EXECUTIVE SUMMARY:

• Risk-conscious attorneys are using litigation funding to facilitate more flexible fee structures for undercapitalized plaintiffs with meritorious cases.
• Effective funding arrangements should align the financial incentives of the claim owner, the attorney, and the third-party funder.
• Key agreement provisions can help increase cost certainty for counsel while enabling them to retain the upside of an alternative fee arrangement.

When clients cannot endure the financial strain of litigation, skilled attorneys may be forced to forego involvement in otherwise strong cases. Since most law firms’ business models are based on hourly billing, steep rate discounts may seem too risky, especially for matters that require extensive upfront diligence and analysis. In addition, during the course of the litigation, cash-deficient plaintiffs may feel forced to accept insufficient settlement offers, or they may simply never bring the claim knowing they cannot self-fund the related expenses. As a result, reasonable but risk-averse law firms are unable to work with a substantial portion of potential clients.

Attorneys representing impecunious corporate plaintiffs may, and increasingly do, offer alternative fee arrangements (AFAs) to combat this challenge. However, not all firms are comfortable with the financial risk that AFAs entail. Most traditional lenders are unequipped to underwrite the risk of an unrealized legal claim, and if the case is lost, the lender is still owed principal plus interest on any line of credit. In response, some lawyers have used client-directed litigation funding as a bridge between the hourly billing model they are accustomed to and the flexible fee structure an undercapitalized litigant might require.

These arrangements provide upfront capital to a single litigant, with counsel facilitating case evaluation and acting as the custodian of any funds received. For such transactions to function as intended, the three primary parties involved — the claim owner(s), the attorney, and the litigation funding firm — should consider several factors before executing an agreement. Arguably the most critical element of negotiating a successful three-way partnership, and the focus of this article, is properly aligning the financial interests of the key stakeholders.

A Question of Shared Risk

A litigation finance transaction must be well-structured to serve the needs of claimants and their counsel. This also applies to commercial funders, who commonly offer non-recourse investments of more than $1 million. These arrangements generally state that the recipients owe a funder nothing if the underlying case resolves unsuccessfully.

Litigation funders like LexShares will conduct upfront due diligence to ensure that any claim has strong merits, that the damages model is well-reasoned, and that the planned litigation budget is sound. Once an agreement has been reached, however, most commercial litigation funders make no attempt to influence litigation strategy or settlement decisions — both for practical and ethical reasons. Any legal financing firm agreeing to passive, non-recourse funding not only relinquishes control of tactical decisions, but also risks a complete loss of principal.

Owing to this dynamic, effective litigation funding pacts often encourage attorney-client tandems to remain just as wedded to the case as their third-party backers. At an extreme, an undevoted attorney who walks away from a case could seriously disrupt the case trajectory, and thus the funder’s investment. Offering counsel a stake in a positive case outcome — via a hybrid contingency fee or success fee, for instance — can give all parties ample financial incentive to seek a recovery amount that proportionally benefits all stakeholders.

Likewise, a client who secures litigation funding to reduce their financial exposure to the case cannot view non-recourse capital as an opportunity to “roll the dice” in hopes of securing a larger recovery. From counsel’s perspective, forging strong relationships with carefully selected claimants helps to prevent unforeseen events, such as a client’s demands hindering otherwise amicable and productive settlement negotiations. The attorney-client engagement agreement can help further reduce litigation-related financial risk for the law firm. For example, it may include a clause that ultimately holds the client responsible for legal expenses if and when third-party capital has been exhausted.

Baking Alignment into Litigation Funding Deals

When litigation funding is used, drafting a level agreement is a practical goal that enables more efficient management of the case. Specifically, the following provisions can help extend financial equilibrium to the key parties:

●     Hybrid contingency fee arrangements: Compensation that is at least partly contingent upon the outcome of the litigation ensures the attorney retains financial upside and “skin in the game” and minimizes the chance of a disruptive attorney withdrawal.

●     Time-based multiples: Because drawn-out litigation adds financial risk, the funder, law firm, and client should be incentivized to pursue their claim efficiently and with financial discipline. This can be accomplished through a return structure that increases the multiple owed on the funding received as time to resolution increases. Expedient resolutions can support cost-conscious decision making, which benefits the client, and limit the law firm’s lifetime financial exposure to a single matter.

●     Tiered return waterfall: The waterfall is the order in which each party to the funding agreement receives their owed portion of any potential damages recovered. Specifying this order at the outset mitigates any misunderstanding about who receives a payout, and in what order, if and when that occurs. Most funding agreements designate that the funder recoups its investment first, followed by the attorney and then the client.

●     Follow-on funding: The arrangement may allow for additional capital to be provided by the funder once an agreed-upon interval of time has passed or the case has reached a certain procedural milestone — provided no material adverse events have occurred prior. These deferred investments are sometimes referred to as tranches, and they can allow each party to better balance its financial risk as the case progresses.

Consider a hypothetical example. Litigation funders typically invest no more than 15% of the estimated total damages. An attorney seeks $4 million in damages on behalf of a client who cannot afford full hourly rates. In exchange for a stake in a successful litigation outcome, the funder provides $400,000, which covers all estimated litigation-related expenses (such as discovery and expert witness costs) as well as attorney’s fees at a 50% discounted rate. The attorney, who normally charges $300 per hour, would instead receive $150 per hour until approximately 1,300 hours are billed (totaling $200,000), as well as $200,000 to pay for expenses.

In this scenario, the law firm pays no legal expenses out-of-pocket, receives partial compensation for the billable hours incurred, and achieves greater cost certainty. In addition, the attorney is entitled to a 20% hybrid contingency fee upon successful resolution of the case. Let us assume the claim owner is awarded the estimated $4 million in damages 48 months after funding was received. A typical distribution of the final recovery might look like this:

●     In addition to already receiving $200,000 for fees throughout the course of litigation, the attorney receives remaining fees owed of $200,000 and a 20% success fee of $800,000 (total: $1,200,000)

●     The litigation funder receives a 3.0x return on its investment ($1,200,000)

●     The balance goes to the plaintiff ($1,800,000)

Want more attorney-focused insights and content like this? Follow LexShares on LinkedIn.

The Entrepreneurial Attorney: Weighing Costs and Benefits

In the theoretical framework above, an attorney would receive greater compensation on the hybrid contingency agreement than she would on traditional hourly billing, which — if we continue with the $300 per hour assumption — would have netted her roughly $390,000 at 1,300 billable hours, minus any legal expenses the firm might have paid on behalf of its undercapitalized client. If the litigation does not result in a successful recovery, the attorney in the funding example still receives $200,000 in fees and pays no expenses out-of-pocket.

Pairing this type of litigation funding with a hybrid contingency arrangement entails less compensation certainty than an hourly billing arrangement. Yet there is also more cost certainty thanks to the non-recourse nature of the third party’s investment. Attorneys considering litigation funding should therefore be comfortable with analyzing a claim’s merits through the lens of a contingency practice. This may require additional analysis of the potential case value and in some cases a reevaluation of the overall strength of the arguments presented.

Contingency practices “invest” in a case only if the merits and potential value justify the required time and effort — which can be substantial for certain claim types and jurisdictions. The same can be said for litigation funders, who commit valuable time and human capital to properly diligence a legal claim. The merits of the legal claim, its potential value, and the ability to collect from the defendant are chief considerations. The two parties may reach similar conclusions about the strength of a claim, thereby reinforcing the attorney’s confidence, or the funder may ask questions that highlight weaknesses in the arguments being presented.

Ultimately, aligning three parties with potentially varying interests in a legal claim requires tact, a willingness to compromise, and a keen awareness of the client’s financial needs. With the proper protections and good-faith negotiations, however, litigation finance may make the representation of under-resourced clients more viable for the right law firms.

Gain an even deeper understanding of our growing industry by downloading the free Attorney’s Guide to Litigation Finance.