How Litigation Funding Shifted in the Pandemic

EXECUTIVE SUMMARY:

• Commercial litigation finance has continued to grow and evolve despite initial fears in 2020 of drastic disruption of the legal sector from the COVID-19 pandemic.
• Changes stemming from regulatory developments, macroeconomic trends, and more have spurred a number of key industry shifts in recent months.
• The LexShares team examines how third-party funding has changed since March 2020, including the trends litigators should consider heading into 2022.

When the pandemic first uprooted the legal industry nearly two years ago, law firms’ financial outlooks appeared bleak. Fears of layoffs, pay cuts, and insolvency abounded as offices emptied.

Today, seemingly a lifetime later, a thriving legal market has reversed the narrative almost entirely. Through the first nine months of 2021, law firm revenues are up 14% on average, compared to 6.3% in 2019. Profits per partner have spiked to all-time records for several Am Law 100 firms.

Much has changed in the legal world since March 2020, and commercial litigation finance is no exception. The industry continues to grow and evolve, spurred by regulatory developments, macroeconomic movements, and more. With third-party funding experiencing a number of key shifts in recent months, litigators should take note of the following trends in 2022.

Post-Covid 19 Economic Factors

When making investment decisions, commercial funders always assess the defendant’s ability to pay. Early in the pandemic, defendant solvency was under scrutiny, as certain sectors such as retail, hospitality, and travel experienced severe financial stress.

Plaintiffs may have had greater difficulty obtaining funding given the industry’s concerns over collectability. A faster-than-expected economic recovery, however, has significantly lessened these concerns.

In addition, the post-pandemic litigation landscape looks unlike what many expected. Business disruption claims filed against insurers since March 2020 have been mostly one-sided, with insurers successfully dismissing a large majority of these cases.

Going forward, litigation funders will likely focus more on disputes arising from supply-chain breakdowns. Cross-border breach of contract claims related to manufacturing and delivery delays, for instance, can be expensive and complex, and are therefore good candidates for funding.

Lastly, rising inflation rates coupled with the war for legal talent will drive law firm expenses higher— just when some firms are no longer benefiting from pandemic-era cost savings on travel, office upkeep, and in-person events. This could make litigation funding more attractive to mid-sized law firms and boutique firms that did not share in Big Law’s record profits last year.

Disclosure of Funding Agreements

Funding skeptics argue that disclosure of litigation finance agreements is needed to achieve transparency. Advocates counter that broad mandates issued by courts and regulatory bodies needlessly impede judicial access when defendants hold financial superiority.

The recent New Jersey federal court decision to mandate disclosure was nominally a win for the skeptics, and perhaps a step toward practices adopted in the United Kingdom and Australia, where disclosure is more common.

We have seen few public divulgences, however, of funding arrangements in the U.S.—even after New Jersey Local Rule 7.1.1 took effect this year. Current case law supports this observation: Westfleet Advisors found that U.S. courts did not allow for significant discovery in 43 of 52 cases analyzed. While additional disclosure regulations are possible, attempts to establish uniform federal rules have stalled as recently as October.

Preferred Partnerships

Since 2008, the number of commercial funders in the U.S. has risen from six to 46, nearly eightfold. As the industry expands, law firms may have a greater ability to prioritize funders with strong investment track records and an interest in establishing long-term relationships.

In June, the U.S. saw its first major publicized commercial funding pact when Willkie Farr & Gallagher reached a $50 million agreement with Longford Capital. The deal gives Willkie a ready source of capital for plaintiff-side clients who desire or require outside funding.

Across the pond, international firm Mishcon de Reya struck a similar £150 million funding deal with Harbour Litigation Funding this year. We expect to see more preferred partnership transactions next year, as they facilitate client-friendly alternative fee arrangements without placing full financial risk on the firm.

Law Firm Ownership Rules

Arizona’s elimination of Ethics Rule 5.4 allows non-lawyers to own law firms in the state, and two litigation funders recently expressed interest in such arrangements. The topic has generated buzz as other states, including California, New York, and Illinois, reconsider their ethics rules. Utah has gone a step further, implementing a pilot program to license nonlawyer-owned firms in the state. Yet many hurdles remain.

For instance, states could take vastly different positions on firm ownership, as Florida did in unanimously voting against amendments to ER 5.4. Another complicating factor: Non-compete agreements remain ethically unenforceable, as they restrict a lawyer’s right to practice law. Partners who sell equity to a non-lawyer could then leave the firm—an outsized risk for potential investors, as legal talent is a law firm’s principal asset.

Minority investments could become feasible, and they have taken place in the U.K. (Burford Capital last year acquired 32 percent of a London litigation boutique.) For now, however, firm leaders will likely view law firm funding as their preferred financing alternative. Portfolio deals have become more popular in recent years and will likely remain so, as firms can directly obtain funding for growth initiatives and working capital without assuming traditional recourse debt.

Available Capital

The funding market’s influx of institutional capital is well-documented. Pension funds and university endowments are among the various asset allocators that have begun to embrace litigation finance. Steep inflation and prospective tax hikes could make alternative assets even more attractive to these investors as pressure for market-bearing returns intensifies.

With a growing supply of deployable capital, funders are increasingly equipped to support larger individual claims, transact directly with corporate legal departments, and dedicate significant funds to preferred partnerships.

Looking ahead, as rising attorney wages put pressure on firm leaders to make cost-conscious decisions, 2022 could be a breakout year for law firms formalizing their funding relationships and leveraging outside financing for their largest cases.