Claim Investments as Private Equity or Hedge Fund?

April 08, 2015

Does an investment in the litigation claim asset class have the profile of a private equity or a hedge fund investment?  Perhaps the answer lies in the rather antiquated way we are forced to frame the question. 

At its most fundamental level, an investment in a litigation claim is an investment in a money-making project. The project includes a claimholder, who owns the claim to be pursued (analogous to a building, a patent, or a productive piece of machinery).  If the person against whom he holds the claim refuses to honor it or reach some accommodation (like paying money for the infringed rights), the claimholder will ordinarily hire a lawyer and file litigation.  If the lawyer is willing to risk some of his compensation in the project to pursue the claim, he will agree an arrangement with the claimholder where the lawyer is paid some or all of his compensation in the form of a contingent fee—a percentage of recoveries paid only if there are any. 

Viewed in this way, the prosecution of many claims in arbitration and litigation actually are joint ventures between two partners—lawyer and claimholder—each working toward monetization of the claim in a project where they contribute their time, skill and resources in return for a share of an uncertain outcome in a project defined by time and investment.  This is the classic “black letter” definition of a joint venture, nothing more than a form of business partnership to make money. 
But this particular form of joint venture partnership has some unique characteristics, and it operates in a very special market.  It is unique because, at least technically, the claim holder is supposed to make all the key business decisions (according to the lawyer-partner’s rules of professional ethics), while the lawyer makes routine decisions about the day-to-day running of the litigation.  The claimholder is like the board, and the lawyers, the management. 

The joint venture operates in a special market because the joint venture is not selling its product—the claim and its value—to the general public, but rather to a special part of the public: the defendant, for one, or a tribunal (arbitrator, judge, mediator), for the other.  How could this be, you might ask, that the transaction where the joint venture earns its revenue is in a market of only two buyers, tribunal and/or defendant?  Because the outcome of the litigation is binary: either the defendant will buy what the joint venture has to sell in an exchange of the claim for money or other value (e.g., a settlement), or (if the parties cannot bargain a settlement) the tribunal will order a settlement, where the claimholder is forced to sell his claim for an amount of money or money’s worth, and the defendant is forced to buy it (sometimes, for nothing in return).  This market also is special because in litigation there is always an exit in this peculiar binary market, one that is rarely influenced by the external marketplace or other macroeconomic factors. 

What this simplistic paradigm says about investments in claims and the claim asset class generally is that a third-party’s investment in a litigation joint venture project closely resembles a garden variety venture capital or private equity investment.  The essentials are all there: a team with a common business relationship and common goals who are building information and strategies to market their product to a defined and sophisticated audience that is believed to be motivated to buy that product.   But unlike private equity or venture capital, in litigation an exit for the investor is guaranteed, and thus time-to-return is ultimately bracketed by the length of time to trial in the chosen forum. 

Enter a fundamental distinction between hedge fund investments (high risk investments in business shares with lower liquidity and an approximate four-year time-to-return on investment) and private equity, which has an average six-year time-to-return profile.  Which is more apposite to investments in litigation joint ventures, hedge fund or private equity?  Unfortunately the investment world is still scratching its head, even after the claim asset class first emerged in 2007 (when Juridica was launched).  Eight years on investors still do not know how to apply their somewhat anachronistic taxonomy to these assets, because litigation statistically takes between three and five years, straddling the expectations of hedge fund and private equity investors.  

Perhaps it’s time for a new taxonomy on Wall Street.  No other asset class has a defined, assured exit uncorrelated to any micro- or macro-economic conditions.  Certainly neither traditional private equity nor hedge funds.  No other private equity investment has such a confined, linear development pathway, where the joint venture project proceeds through a five-hundred-year-old conduit call the court system, forced along the way to monetization (or worthlessness) by the pressure of other litigation projects pushing from behind.  No other private equity investment has so few variables and is so insulated from atmospherics, not to mention market and social vicissitudes, that the outcomes are essentially binary.  Few private equity investments have the certainty of investment amount and the ability to avoid stranded investments by pushing risk onto the lawyer-partner, who is ultimately managing the enterprise and its budget. 

Does an investment in the litigation claim asset class have the profile of a private equity or a hedge fund investment?  Happily, neither.

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Contingent Fees in Camelot

Timothy Scrantom

January 17, 2014

The recent introduction in England of U.S.-style contingent fees, where a lawyer invests sweat equity in a case for a percentage of the winnings, is a curious milestone in the seven hundred-year history of English lawyers.  It is also an epoch event in the rivalry between the law industries in the U.K. and the U.S. and in the way the multi-billion dollar global litigation industry is financed. 

In addition to being the law of over a quarter of the nations of the world, English common law has always been the preeminent law of international trade and commerce.  English courts and more recently, London-based arbitrations, have been where many if not most transnational civil disputes were decided.  In the early days of globalization, English lawyers were only hourly fee-paid sponsors of British dispute resolution, waving litigants into the London coliseums of common law litigation and arbitration.  Now they are positioned to be real champions, bowing from the center ring in their own prize fight for a share of the spoils.  Among their implements is the law that now permits outside investment in British law firms, and the prospect law firm shares can be listed on stock exchanges. 

The notion of lawyers as champions conjures heroic images.  One is of medieval trial by combat, where a nobleman litigant could send a brute in his place to fight for recompense, rights or honor (in biblical lore, “Goliath” was one such champion).  From the French “champion” and other Norman feudal concepts the Saxon-exiled Britons brought back to the Emerald Isles in 1066, the word and practice called champerty evolved.  In the Fourteenth Century champerty, where one liege lord would purchase land claims against a rival intending to use the court system to cripple him, was prohibited by statute.  The King’s courts were clogged with injudicious lawsuits that his Lords were using as a surrogate for jousts and combat, and so he banned the practice altogether.

The true legal and etymological origins of champerty (acquiring an interest in another’s claim for a share) are as faded and mythical as Camelot itself, but the concept nonetheless lingered untouched for centuries.  It remained a chief reason why lawyers in England could not fight their client’s cause in return for a piece of the spoils.  This held true from the 1330’s (about the time lawyers emerged as a profession) until April, 2013, when new U.K. regulations permitted professional lawyers to, in effect, practice champerty.  They are latecomers to the game.

Early American state lawmakers and lawyers, separated from the English system at birth following a rather traumatic labor in 1776, often dusted off the feudal relic of champerty as they rummaged old English common law and statutes for things of use to them.  Sometimes they just tossed it into the mix for good measure.  For a time in the 1960s, enterprising Southern legislators even criminalized champerty for the singular purpose to stop civil rights activists from funding and sponsoring blacks’ discrimination lawsuits.  A suitable solution to preserve their own brand of feudalism.

As they went about snatching bits of English law here and there to patch together their legal systems, lawmakers and judiciaries across the U.S. applied the champerty prohibition, if at all, only to non-lawyers.  While the original English system applied the champerty prohibition equally and to everyone—lawyers included—American state legislatures took a more discriminating approach.  Mysteriously and often without any basis in law or history (certainly not the history of the English common law), U.S. states exempted lawyers working on a contingent fee basis from the prohibitions against champerty.  But pure champerty it was.

For over a hundred and fifty years U.S. lawyers have been permitted to charge legal fees as a percentage of litigation recoveries (Abraham Lincoln even worked on litigation “on the come” in his private practice).  The vanguard of the U.S. litigator-investor field is the so-called “plaintiffs’ bar,” that uniquely American invention--lawyers who exclusively represent plaintiffs, connotatively on a contingent fee basis.  In America, it was believed, lawyers and no one else could invest in a litigation case.  American lawyers, the logic must have gone, were the only ones who could be trusted as venture partners in their clients’ lawsuits.

England has never had a plaintiff’s bar per se.  The lawyers in their “split profession” of barristers and solicitors traditionally represent either side without discrimination.  This ambidexterity is in part a market-driven response to their never having been allowed to charge contingency fees; the same market phenomenon that encouraged the one-dimensional American-lawyer business model practiced by the plaintiffs’ bar.  But there are other factors influencing the differences between the two legal systems.  England, the birthplace of human liberty and its only sure defender, the Anglo-Saxon trial by jury, got rid of jury trials in almost all civil cases well over a hundred years ago.  The system obviously believed that royal judges could operate just fine without taking every random trial to a democratic vote of twelve jurors.  England is also the liege lord of the eponymous “English Rule,” which requires the loser of litigation to pay all of the winners’ costs and legal fees.  All this judicial discipline (no contingent fees; no juries; cost risk if you lose) had a price:  access to justice was believed to be effectively denied to those without money. 

There was evidence for this belief even though, for centuries, a somewhat socialistic interpretation of Magna Charta led the Kingdom to benevolently provide that access to courts of civil justice by impecunious common folk would be paid for under government-funded programs.  Yes, the government paid lawyers for legal aid even to prosecute civil (non-criminal) cases.  Her Majesty’s government finally wised up:  instead of the government paying for civil litigation, why not let outside capital invest in claims to provide that money.  And let the funders charge a share of the recoveries, like the U.S. plaintiffs’ bar.  So came “third party litigation funding,” embedded in 2007 law reform legislation emanating from, no less, the House of Lords.  Through their early mischiefs the Lords had invented champerty.  Morally, it was up to them to forbid it

The third-party funding alternative for government-funded litigation was, with characteristic English aplomb, celebrated as a success rather than mumbled about as a remedy for a failure:  champerty was a silly old notion and Twenty-First Century London capital markets should be allowed participate in the Sport of Kings, the Lords recommended to the Queen.  And so, seven hundred years on, champerty in England was marched to the gallows, and a modern litigation finance industry was born.

For the ensuing seven years (2007-2013) U.K. lawyers were still prohibited from taking contingent fees in most cases by the old doctrine of champerty, now effectively dead in the U.K. as to all but the lawyers.  In America the direct opposite appeared to be true.  How curious: when it comes to litigation investing, in the U.S. lawyers were oligarchs effectively operating a monopoly, but in England, they wore a scarlet letter, since it was believed they could not be trusted as co-investors with their clients.  Watching the growth of the third party funding phenomenon and wondering what it ultimately meant for them, the American plaintiffs’ bar sat on this side of the Atlantic like a cat with a canary in its mouth.  At least the U.S. Chamber of Commerce had a new tort-reform whipping boy, they must have sighed.  The canary wiggled.

English lawyers, for their part, had spent many decades deriding the American legal system for its litigiousness, and particularly its contingent fees.  They, too, feared being branded hypocrites and naturally had trouble admitting that the stigmas they had fostered about contingent fees might be, well, passé.   Still, for most British people, lawyers appeared to be the last people one could trust to responsibly own a contingent fee in a case.  The British lay public and regulators remained concerned that lawyers could not responsibly manage the natural conflicts of interest inherent in being their clients’ own joint venture partners in a case.  To get around this, English lawyers still had to eat a bit of crow with the British public.

There is more than curious history, irony and paradox in all this.  Like it or not, the tit-for-tat between US and UK litigation “law markets” has now yielded a fulsome variety of ways to finance litigation—lawyer contingent fees almost world-wide; various forms of ATE and capital-protection insurance; outside equity and debt capital.  For the consumer large and small this means choice.  And what card-carrying capitalist can really argue against the availability of investment options? Or insurance against litigation risk (almost an oxymoron)?  Choice is, after all, the watchword of democracy, modernity and even globalization.

But wait, one might say: we are not talking about making trains and building canals and selling tea.  The Industrial Revolution was one thing, but we are talking about the justice system. Is this the place to instigate the competitive ardor for a new transatlantic revolution between the Mother country and her young common law upstart?

The more rational conclusion is that modern (not archaic) court procedural rules, capital market discipline, choice, risk-sharing techniques and competition are what will cure broken litigation systems, both in the U.S. and in the U.K.  Among them, lawyers putting their money where their mouth is: if they want to be paid to bring a case, they better take some risk on their fees and maybe even on their out-of-pocket costs.  Insurance companies taking risk of adverse costs awards, even if their insured can’t recover the cost of the premiums.  Smart capital sources bringing the discipline of financial due diligence, interest alignment, investment valuation, time-to-return analysis and risk-adjusted return models to investments in claims.  Consumer choice, and the imprimatur of case-backing where the claim has been underwritten by insurers, investor-lawyers and outside capital.  There’s a system that should work, at least for sophisticated business claim holders and their commercial disputes.

Doesn’t it make sense that if a lawyer suggests bringing a case he at least be willing to take some risk that he doesn’t get paid if it is unsuccessful?  Isn’t it common sense that lawyers investing in cases alongside smart private equity capital will kill frivolous lawsuits? And along the way, won’t this logically provide the best and widest choices for consumers facing the arcane world inside the courtroom, a world which, after all, lawyers themselves have been happy to quarantine behind shrouds in their temples for a thousand years?

If the American legal system is the orphan child of the English common law, the English system is the elder who becomes, again, the child.  Contingent fees in England are not bad or good.  They are rational, and in effect, they are hardly new.  Oddly, their introduction has hardly been attacked or applauded by the British public.  This must be the new normal in the world of litigation finance. 

Timothy D. Scrantom
Lawyer and barrister

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