Litigation: the newest corporate finance tool

September 2014 | PROFESSIONAL INSIGHT | LITIGATION & DISPUTE RESOLUTION

Financier Worldwide Magazine

As company CEOs and CFOs search for new ways to de-risk liabilities and unlock hidden asset value, they are increasingly finding solutions in an unexpected place: the general counsel’s office.

Long viewed solely as a cost centre, a company’s legal department now can leverage its litigation docket to play a significant role in improving the organisation’s financial health and creating shareholder value. There are also more tools available for corporate GCs to better manage exposure to legal liabilities and more efficiently monetise legal claims.

This new opportunity is largely due to financial solutions developed by investment firms such as ours that provide capital collateralised by litigation claims and other legal and regulatory processes and outcomes. So-called ‘litigation finance’ firms are changing the way organisations view legal claims, which historically have been unrecognised assets, leaving few mechanisms for companies to tap their often significant embedded value.

“Litigation claims frequently present compelling opportunities for companies that seek innovative approaches to manage risk and generate revenue. ”

Long a fixture in the United Kingdom and Australia, litigation-related investment firms are becoming more prevalent in the United States. More recently, these firms have broadened the allowed uses of funds they deploy, enabling companies to expand working capital or raise financing for general corporate purposes – and morphing ‘litigation finance’ funds into more traditional capital providers.

Financing arrangements tied to commercial litigation can take many forms. The most traditional, sometimes called ‘third-party litigation funding,’ allows a company to initiate or continue litigation without any out-of-pocket cost. An investor’s capital covers the legal fees and expenses associated with the lawsuit, in exchange for an investment return if the case is successful.

Using this approach, companies can avoid the accounting consequences of paying for litigation. In other words, they can maintain a suit without adding to their quarterly legal spend (and thereby reducing earnings). In the United States, accounting rules require companies to record attorneys’ fees and other litigation costs as expenses, instead of capitalising those amounts when they spend dollars to harvest the value of legal claims. A litigation finance transaction defers some or all expenses until the litigation generates the proceeds to pay them.

Particularly when legal budgets are already allocated to fight wars of necessity – such as defending the company against lawsuits and fighting various regulatory battles – litigation capital offers immense value by dramatically expanding a company’s ability (and appetite) to pursue valuable claims. When successful, claims that otherwise would have sat dormant can add tens or hundreds of millions of dollars to the bottom line.

Some investment firms allow their capital to be used for any business purpose, not just for expenses related to the litigation – meaning companies can convert their legal positions into immediately available funds. For example, if a lawsuit has produced a trial court judgment that now must survive multiple appeals, the investment firm’s capital allows the prevailing company to de-risk a portion of the award in exchange for agreeing to pay a premium on the de-risked amount from the ultimate settlement or judgment proceeds. Thus, companies convert a contingent, intangible and unrecognised asset into cash that can be redeployed into more productive uses, while simultaneously removing all legal and duration risk from the monetised portion of the award.

These financial arrangements are not unique to plaintiffs. A company that is a litigation defendant and wishes to delay legal expenses or realign incentives with counsel can use litigation funding, as well. Most frequently, the investment firm will convert a company’s cost of defence from a monthly expense into a one-time lump sum, payable only in the event of success at the end of the underlying litigation. In this way, companies (and ultimately their shareholders) pay only when lawyers deliver a favourable outcome, and any recognised expenses arrive as a one-time payable rather than a recurring drain on earnings. The investment firm also can reduce a company’s exposure to a crippling damages award in exchange for an investment return if the case resolves successfully.

In addition to these situations, all of which involve ongoing litigation risk, some funds will accelerate litigation-related receivables when the principal legal issues in a case have already been resolved. In some instances, a litigation settlement agreement provides for delayed or staggered payments, but the plaintiff or defendant company wants to move those payments into a particular accounting period. At other times, the parties are still at the settlement table but have different tax or accounting needs, creating a role for a funder to spread the payments over time or create one lump-sum payment, each as the parties desire.

In all of these scenarios, litigation finance providers typically link investments exclusively to the outcome of the underlying litigation. In other words, the transactions are not loans and do not create a corresponding liability; a company that obtains financing faces no repayment obligations unless the underlying litigation is resolved successfully. In the meantime, the company stays in the driver’s seat: many investment firms do not take control of the litigation or acquire any contractual right to dictate strategy or settlement terms.

As the above examples show, litigation claims frequently present compelling opportunities for companies that seek innovative approaches to manage risk and generate revenue. That is welcome news, given that commercial litigation activity continues to increase. A recent survey of US and UK corporate legal officers at public and private companies found that one in four large companies had recently initiated a lawsuit with more than $20m at stake. Nearly 400,000 cases were filed in the US federal courts alone in 2013—a 6.3 percent increase over the previous year.

Despite these statistics and the many ways capital can be deployed in connection with litigation, banks and other traditional capital providers are not addressing market needs. Without experts who understand law as well as finance, investment firms are simply unable to price litigation-related risk, leaving them ill equipped to invest capital in the asset class.

Litigation-related financial firms stand ready to fill the void. The Economist recently estimated that the global litigation finance industry manages more than $1bn. Because companies continue to seek solutions that manage increasing legal costs and monetise valuable claims, that number will only continue to grow.

Adam Gerchen co-founded Gerchen Keller Capital and serves as Chief Executive Officer. Mr Gerchen is a former portfolio manager at Alyeska Investment Group, a Chicago-based market neutral hedge fund, where he specialised in risk arbitrage and event driven investing. Before joining Alyeska in 2008, Mr Gerchen was an investment banker at Goldman, Sachs & Company. Mr Gerchen graduated from Brown University and received his JD from Harvard Law School. He can be contacted by email: arg@gerchenkeller.com.

Ashley Keller co-founded Gerchen Keller Capital and serves as a Managing Director. Mr Keller is a former partner at Bartlit Beck Herman Palenchar & Scott LLP. He previously was a law clerk for Judge Richard Posner at the US Court of Appeals for the Seventh Circuit and Justice Anthony M. Kennedy at the Supreme Court of the United States. Most recently, Mr Keller was an analyst at Alyeska Investment Group. Mr Keller graduated from Harvard College and received an MBA and JD from the University of Chicago. He can be contacted by email: ack@gerchenkeller.com.

Travis Lenkner serves as a Managing Director at Gerchen Keller Capital. Mr Lenkner was a senior counsel at The Boeing Company and was a litigation and appellate attorney in the New York and Washington, DC offices of Gibson, Dunn & Crutcher LLP. Mr Lenkner also served as a law clerk for Judge Brett M. Kavanaugh of the US Court of Appeals for the DC Circuit and Justice Anthony M. Kennedy of the Supreme Court of the United States. Mr Lenkner graduated from Kansas State University and earned his JD from the University of Kansas School of Law. He can be contacted by email: tdl@gerchenkeller.com.

Gerchen Keller Capital, LLC