Many companies shy away from enforcing their legal claims in court because they are unwilling or unable to take on the costs and risks of a legal dispute, which are difficult to calculate. Professional litigation financiers can remedy this situation and help companies to avoid taking major financial risks and unnecessarily burdening their balance sheet.
Dr Stephan Klebes is Senior Legal Counsel at Deminor, one of the top 10 litigation funders worldwide. He is admitted to the bar in Germany and has extensive experience in conducting and supporting cross-border litigation before international arbitral tribunals and state courts. A particular focus of his practice is the financing of general commercial disputes and capital markets damages disputes. Prior to joining Deminor, he was an associate at an international law firm specialising in litigation, where he focused on advising companies in various arbitration proceedings as well as extensive investor claims before state courts.
The following article was originally published on REthinking: Finance in their December edition (see end of article).
The litigation financing business model
Litigation financing is based on a fundamentally simple business model that benefits all parties involved.
The litigation financier bears the costs of the proceedings, for example for lawyers, the court and experts. The company therefore benefits from the fact that it can disregard the cost risk of the court proceedings, as this is borne entirely by the litigation financier. In return, the financier (only) receives a share of the proceeds of the proceedings as commission if the case is successful. The litigation financier therefore invests in the prospects of success of the legal dispute.
In this way, companies can secure financing for the enforcement of a legal claim and at the same time receive a large part of the proceeds from this claim without having to fear recourse from the litigation financier in the event of failure (so-called "non-recourse"). This is actually a normal financing process in any company - the object of the investment just seems unusual at first glance because legal claims are intangible assets. However, management also regularly makes financing decisions with regard to tangible company assets, such as fixed assets. Litigation financing enables the management to secure capital in the same way by drawing on company assets - because a promising claim also represents an asset that must first be realised.
Litigation financier acts as a passive investor
Litigation financing is superior to conventional financing processes not only because the remuneration of the litigation financier is purely success-based, but also because the company does not have to provide any collateral for the capital or relinquish control over the legal dispute. This is because litigation funders act as passive investors. As financiers, they do not provide legal advice to their clients themselves, but primarily provide the capital to assert the claim. This is another reason why litigation financing is so attractive for companies, compared to credit financing, for example.
As the litigation funder is remunerated on a purely success-based basis and provides money largely without any direct influence on the proceedings, it first needs a legal analysis of the case in order to realistically assess the risk profile of the matter and make an appropriate investment decision. To do this, he usually draws on the assessment of the law firm mandated by the client. On this basis, the financier evaluates the legal and economic prospects of success of the legal dispute and often models the various possible courses and outcomes of the proceedings. This due diligence is decisive for pricing and also for the final investment decision. However, the company and the law firm mandated by it remain responsible for enforcing the claim during the course of this claim assessment and thereafter.
The result of the due diligence also influences the structure of the performance-related remuneration of the litigation financier, which generally depends heavily on the individual case. It is usually calculated either as a percentage of the proceeds of the proceedings or as a multiple of the capital invested by the financier. Average contingency fees start at around 20% of the proceeds of the proceedings and are often not static, but vary depending on various factors such as the amount of the proceeds and the duration of the proceedings. This value is necessary to economically secure the litigation financier's risk investment. After all, if the legal dispute is lost, the financier's money is also lost completely and without replacement. From the perspective of the litigation financier, any proceeds from successful disputes must therefore also cover any losses from other proceedings.
By using Litigation Funding the financed process is off-balance sheet
Litigation financing is also a good way for companies to keep their own balance sheet free of costs already incurred or future costs, as the costs of enforcing claims are borne by the litigation financier and not by the company. As a result,
companies that use a litigation funder do not have to recognise a provision for the risks borne by the funder.
The costs and risks of enforcing claims in court are often a significant factor, not least for a company's financial accounting. Without litigation funding, legal disputes can have a lasting negative impact on a company's financial performance due to the accounting rules for the treatment of litigation costs and proceeds. Costs paid by the company for legal proceedings are immediately recognised as an expense and thus reduce profits. At the same time, the proceeds from legal disputes are often recognised as one-off or extraordinary items. This also has a negative impact on the EBITDA result. This is because the accounting result of a successful enforcement of a claim can lead to an effective reduction in EBITDA, as the costs of legal action reduce EBITDA, while litigation proceeds often do not increase it. As EBITDA often also has an impact on the company's credit rating, financing costs may also increase - a doubly negative effect. The involvement of a litigation financier can eliminate these negative effects on the balance sheet profit from the outset and enable companies to neutralise the cost burden of legal disputes.
Litigation financing protects against external risks
Litigation financing can also help to protect companies from external risks. The increasingly uncertain economic environment resulting from various (geo-)political crises is already a burden for many companies. By using a litigation financier, companies have the opportunity to reduce the risk to their balance sheet by using external capital to realise their legal claims, which only has to be repaid if the underlying legal dispute is successful. With this approach, they not only protect themselves against a loss in court, but can also utilise external capital without any correlation to interest rates, currency fluctuations or other economic conditions.
Typical cases of Litigation Funding application: Commercial individual actions and group proceedings following antitrust or capital market law violations
Traditionally, the option of litigation funding in Germany was primarily used by financially weak consumers who were dependent on third-party funding to enforce their rights. This has now changed considerably. Financially strong companies in particular have now recognised the opportunity to protect themselves against litigation risks and thus avoid unnecessarily burdening their balance sheet.
In principle, all commercial law disputes are suitable for litigation financing as long as they fulfil a few basic requirements. Firstly, there must be a positive prospect of success in enforcing the law. In most cases, however, the law firm commissioned by the company already has an assessment of this at an early stage, so that no additional expense is incurred. Even complex cases can be considered for financing. However, it must be possible to record the case with a reasonable amount of effort and to convert it into a reliable risk assessment. In addition, the claim should be for the payment of a sum of money or the surrender of assets whose market value can be reliably determined. This is the only way to realise appropriate compensation for the financier from the proceeds of the legal dispute.
However, it also happens that financiers actively acquire claimants themselves after examining the prospects of success of a potential case, conclude financing agreements with them and then hand the case over to a cooperating law firm for processing. This reverse procedure applies in particular to group proceedings following infringements of antitrust or capital market law. For example, the capital investor test case against Volkswagen in Braunschweig is based on the actions of numerous institutional and private investors, most of whom are supported by litigation funders. In these proceedings, the plaintiffs accuse Volkswagen of failing to properly and promptly inform the capital market about the Group's misconduct in connection with the diesel scandal.
Cartel damages claims could also often not be enforced economically without the involvement of a litigation funder. This is also the case, for example, in a prominent damages case against the so-called 'truck cartel'. The EU Commission had imposed a fine of almost four billion euros on various truck manufacturers for cartel offences because the truck companies concerned had agreed sales prices with each other between 1997 and 2011. However, the EU Commission had left open whether the buyers of the lorries had suffered any damage as a result of the cartel. The lorry manufacturers deny this, but the buyers of the allegedly overpriced lorries - mostly medium-sized haulage companies - are demanding a nine-figure sum from them as compensation. These companies, which are smaller in comparison to the respective opponent, would normally lack the time, money, legal expertise and nerves for a costly individual legal dispute against a supposedly overpowering group. In such situations in particular, the use of a litigation financier is often the only way to legally enforce an existing claim, as the costs of the proceedings would otherwise be disproportionate to the potential proceeds of the proceedings.
Written by:
Dr. Stephan Klebes
Senior Legal Counsel
