26 September 2018

Litigation finance: Could law firms remodel to take on hedge funds?

Hedge funds are making sizeable returns from the proceeds of litigation. But could law firms play them at their own game?

There has been a lot of press on the growth of the litigation funding market with funders posting record profits and a stream of new entrants seeking their piece of the pie. The industry’s global expansion has had a significant impact on how high value legal disputes are financed and many believe that the market has not yet reached its full potential. Whilst litigation funding can be the obvious, though by no means the only, solution for clients looking for assistance with their legal spend, it can come at a hefty price. The funder’s success fee will often be circa three times their investment plus the repayment of the original capital. This begs the question for how long will law firms sit back and allow hedge funds to make sizeable returns from their cases before they adjust their own models to ensure the proceeds of their success largely stay with them? Will the landscape shift to see a marked rise in law firms competing against funders through the increased use of alternative fee arrangements such as contingency fees?

Tensions in the market

Several signs demonstrate that a tension already exists between lawyers, clients and funders with the former feeling like they are being forced to jump through hoops to obtain funding and are being held to ransom through high success fees. Yet funders would argue that they need to operate a selective approach combined with high returns to write sustainable business. It’s not all about the price, however. Many clients would simply prefer to negotiate a different arrangement with their lawyer than have the added complexity of a third-party funding arrangement. Whilst many clients believe funder fees are high, their concerns about litigation funding do not end there. Additional concerns include their fear of losing control of the case, a perceived hindrance in their ability to make quick decisions, privilege issues and the leaking of information. 

Marked shift in the way law firms work

This has contributed to a marked shift in the way law firms win work, with more clients operating tender processes for their matters. Having the flexibility to offer alternatives to the hourly rate is becoming increasingly important. Most clients are not interested in a race to the bottom approach as it often means compromising on quality. Increasingly, the mandate will be won by the law firm that offers a sustainable fee arrangement that demonstrates their trust in the claim and protects the client’s down side without the need to involve a third-party funder, even if it means the lawyer receives a significant success fee. As a result, law firms are under increasing pressure to take a share of the risk in good cases either on a conditional or contingency fee basis or by agreeing a deferred fee arrangement.

WIP insurance

Many lawyers will have encountered cases that would have been ideally suited for a contingency fee, however, the economic reality of risking their full fees is often too much for the law firm to stomach. In other instances, the firm may already have reached its maximum contingent fee exposure and be unwilling to take on more. A recent solution to this problem is the development of WIP insurance.

Proving popular

WIP insurance is a policy taken out by the law firm to cover a portion of the firm’s fee risk under a contingency fee arrangement. This type of insurance is proving popular on both sides of the Atlantic. However, it has the added benefit in England and Wales, where hybrid contingency fee arrangements are unlawful, of enabling the firm to offer a full contingency arrangement to the client whilst ensuring the law firm receives some fee income, regardless of the outcome of the case. If the case is lost, the insurer reimburses the law firm for an agreed portion of the fees incurred, typically 50%. If the case is successful and the firm recovers its contingency fee, the law firm pays the insurer a premium from the contingency fee collected. The premium is only payable if the case succeeds and generates sufficient fee income for the firm. WIP insurance, therefore, provides law firms with budget certainty when forecasting revenues and provides the comfort needed to offer contingency fee agreements in return for significant success fees. 

Contingent fees

It is not envisaged that law firms will adopt the contingent fee approach to the extent that will spell the death of the litigation funding market any time soon. And, indeed, the two products need not be mutually exclusive. The firm could have the benefit of WIP insurance and still arrange funding to finance the disbursements or to provide some cash flow to the firm. It is likely, however, that a combination of client pressure, the prospect of attractive returns and the comfort of WIP insurance will lead to law firms taking on more contingency fee arrangements. As their confidence grows, they may begin to encroach on the litigation funders’ sweet spot of high value claims and this could put pressure on funders to change their model to offer a more palatable suite of products to a wider range of cases or to accept that, going forward, they will have to fight harder for market share.

Verity Jackson-Grant is the Director of Business Development at The Judge