Investing in litigation

A Chicago Federal Court will soon consider a multimillion-dollar dispute that represents a new frontier in the march of global capitalism, a lawsuit between Miller UK, a heavy equipment manufacturer based in England, and Caterpillar, the American construction-equipment giant that was once Miller’s biggest customer. The themes of Miller UK v. Caterpillar are classics of the intellectual property genre of litigation drama: greed, betrayal, bloodlines.

Miller’s method of funding its side of the production, however, is something new. Rather than paying its lawyers out of pocket, Miller has turned to a private firm to front the money for its legal costs, Illinois-based Arena Consulting. If Miller loses, Arena gets nothing. If Miller wins, Arena will get a share of the proceeds, which could run well into the tens of millions of dollars.

Litigation Financing a new way to buy a lawsuit

This new form of lawsuit funding is called “litigation finance” which celebrates ingenious mercantilism in America, as demonstrated by our penchant for turning everything from church raffles to mortgages into marketable securities to be chopped up, bundled, and resold.

Like the celebrity bonds backed by royalties and popularized by David Bowie during the 1990s, litigation finance represents the expansion of securitization into hitherto virgin territory. Those involved in the practice argue that it allows smaller companies like Miller to afford a day in court. Detractors worry that it could give rise to a litigation arms race, with speculative money aggravating the already high costs of the American legal system.

Litigation funded by outside financiers barely existed outside a shadow realm inhabited only by some of the most successful “rainmakers” of the Plaintiff personal injury bar until the mid-2000s, but is growing rapidly, driven by increasingly permissive laws, the promise of high returns and hourly billing rates that run $500 to $1,750 or more for the largest and most sophisticated law firms.

Between 2013 and 2014, Burford Capital, a public company traded in Britain, increased its lawsuit investments from $150 million to $500 million. During the same period, its profits rose by 89%, with a 61% net profit margin. Two-year-old Gerchen Keller, one of the industry’s youngest funds, manages more than $840 million. With investor-backed war chests, plaintiffs are crossing borders to find the most favorable jurisdictions, and sometimes enlisting the help of foreign governments.

Like equities and mortgages, lawsuits are making a transition from a private arrangement to a fully monetized asset class. The “portfolio” held by IMF Bentham, an Australia-based investment group, consists of 39 cases, which the firm values at just over $2 billion.

Larger companies, even those with their own in-house counsel, are selling off pieces of lawsuits to smooth out cash flow and offload risk.

Using future awards as a credit line

The questionable social utility of these investments is exemplied in the reported comments by Richard Fields, chief executive of Juridica Investments, a Miami-based fund with $650 million under management and where actions involving Fortune 500 companies make up 80% to 85% percent of its investments. Fields claims, perhaps accurately, that outside funding helps align the interests of plaintiffs’ lawyers with those of their clients. “You want the largest recovery, in the shortest time, with the least uncertainty.” Smaller companies can use litigation financing to finance growth by using their future award as a credit line.

The social utility of litigation

Over the last century, many have come to see lawsuits as a means of expression, a political weapon and a powerful deterrent against those who might do wrong. Indeed public interest litigation has advanced the cause of civil rights for almost 100 years and environmental common law equity litigation has improved environmental quality throughout the Biosphere.

Conventional litigation seeking money damages, however, is a zero-sum industry — every dollar in damages taken home by the winner, minus fees, must be wrung out of the loser.

Traditionally, in common law countries such as the United States, Great Britain, Canada, and Australia, litigation often establishes legal precedent, defining the terms under which civil justice may be sought. There is no question that bringing billions of dollars in investment capital will not change the system of civil justice; certainly in America and perhaps in the remaining common law countries of the world. The only question is how and when this change will occur.

Average working men and women who have good jobs making $100,000 a year may consider themselves middle class, but they are effectively shut out of the American legal system, that is unless they run afoul of the government and are charged with a crime. These middle class Americans cannot afford to pay the legal fees of time billing lawyers or advance the operating costs of a “big” case. This had been true since the rise of industrial mercantilism following the War between the States and by the end of World War I, when a small group of dedicated lawyers began to represent the victims of negligence and industrial neglect who would not be able to have their day in court without a lawyer willing to work on a contingency—“No recovery; no fee!”

Litigation finance: the origins

Despite the hypercapitalist spirit of its rise, litigation finance actually has its roots in antiquity. According to Max Radin, a historian of ancient city-states, members of Athenian political clubs would back each other in lawsuits against their rivals. During the age of Pericles, Athens was a highly litigious society. The philosophers we remember today, Socrates, Plato, and Aristotle, as well as countless rhetoricians who learned the skill of argument at their feet, tried cases before juries. Apollodorus, a wealthy son of a banker bought shares of lawsuits and hired professional orators — some of the earliest lawyers in Western history — to write his court speeches.

The Romans tolerated the practice in some cases until the sixth century, when it was banned by Emperor Anastasius. The Roman taboo on litigation finance, Radin writes, sprang from the idea that “a controversy properly concerned only the persons actually involved in the original transaction,” not self-interested meddlers.

In medieval England, litigants could hire “champions” to represent them in “trial by battle,” By the late 13th century, these strongmen were being compared to prostitutes, and the shortage of fighting men to advance the interests of the Crown hastened the transfer of dispute resolution from the lists and the battlefield to the courtroom. Lawyers not warriors became the champions of the parties engaged in civil dispute.

During the Middle Ages, the concept of “champerty” — assisting another person’s lawsuit in exchange for a share of the proceeds — emerged as part of the larger ecclesiastical taboo against usury. Though the word was associated with feudal land grabs, Radin notes that in practice, champerty was used by rich lawyers “on behalf of propertied defendants.”

In 1787, Jeremy Bentham, the political philosopher, mocked prohibitions on champerty as a holdover from feudal days, where courts were beholden to ‘‘the sword of a baron, stalking into court with a rabble of retainers at his heels.”

At least 28 states now explicitly permit champerty, as long as the investors do not act out of malice, back frivolous lawsuits, or exert too much overt control over trial strategy.

Out of the Recession; corporate champerty

Hedge funds, banks and insurance companies have long been quietly funding the occasional lawsuit, but no major United States commercial investment company specialized in the practice until Juridica was founded in 2007. The industry’s early growth was driven in part by the recession, which made lawyers at big companies eager to hand off risk and also increased the demand among investors for opportunities that could pay off no matter what was happening in the world’s markets. Today the industry seems to have become a permanent part of the financial landscape, with shares of prominent funders trading every day on stock exchanges in London and Sydney.

Anthony Sebok, a professor at Cardozo Law who advises Burford, says he sees the practice as part of a broader trend toward the financialization of the law. “Why can’t I promise a stranger some piece of the game?” I’m commodifying my rights? Bentham says these legal rights are our property. Why shouldn’t we be able to sell them?”

Jonathan Molot, a professor at Georgetown Law who serves as Burford’s chief investment officer and has written that stock offerings by law firms could improve morale, lower rates and help lawyers focus on maximizing long-term profits. Like lawsuits, the firm itself should evolve into an asset.“It’s a mistake for lawyers to hunker down and say we’re different, we’re excluded, we’re not part of the economy,” he said.

Inherent conflicts of interest in litigation financing

Often the interests of financiers and plaintiffs are not always well aligned. Depending on the structure of the deal and the ultimate payout, plaintiffs sometimes walk away with only a few crumbs after the investors and lawyers take their share.

One such outcome happened in 2007, when Altitude Capital, invested $8 million in an intellectual-property suit filed by DeepNines, a small network security company, against McAfee, a much larger competitor. The case was settled for $25 million, but after expenses ($2.1 million), lawyers’ fees (roughly $11 million) and Altitude’s cut ($10 million), DeepNines took home only $800,000, a little over 3% of the settlement. Then, Altitude claimed that DeepNines should not have deducted its own expenses before calculating contingency fees and sued its former partner for $5 million more!

At the conclusion of a successful investor financed contingency lawsuit, plaintiff’s can find themselves facing another large well-financed opponent in the courtroom— their former champion.

The Institute for Legal Reform, a Washington-based lobbyist associated with the United States Chamber of Commerce, argues that litigation finance will prompt courts to award damages so large that they hurt American businesses. Lisa Rickard, the Institute president, calls litigation finance “the biggest single threat to the integrity of our justice system.”

Transforming legal disputes into business deals

For years, observers of the legal profession have criticized how the market economy erodes its ethical obligations, pushing private advantage over public good and billable hours above all.

Only the truly rich can afford to hire a professional who will zealously and exhaustively defend their interests. When litigation financiers talk about expanding access to justice and standing up for the little guy, they generally mean helping millionaires pursue claims against billionaires.

If champerty is “a hoary doctrine” as one federal judge proclaimed and the financial dealings of plaintiffs with their investors are irrelevant, as they “have nothing to do with the claims or defenses in the case” and the specifics of how a plaintiff is financing their lawsuit are confidential, the day is approaching when lawsuits become transferable and therefore marketable commodities. More and more lawyers will find themselves being paid by people whose interest in the outcome is speculative, not personal.

Litigation as a tool for short selling

In the wake of a provision of the America Invents Act that went into effect in September 2012 and created a procedure known as Inter Partes Review (IPR) making it easier and faster to file a patent challenge, investor Kyle Bass and his hedge fund, Hayman Capital are filing IPR challenges and shorting the stock of the company they challenge because the news about a challenge to the patent for a big-selling drug can rattle investors.

On average, an IPR can cost about $300,000 and take up to 18 months, while conventional litigation needed to invalidate a patent may cost $3 million or more and take years. An IPR filing is a much more cost effective and efficient way to challenge a patent than conventional litigation. Of the 2,536 challenges filed since the law passed in 2012, 383 were filed against chemical and biotechnology patent holders and 87% of IPR filings challenging pharmaceutical patent claims have, so far, been successful.

Apparently this practice is not considered “insider trading” by regulatory authorities even though Mr. Bass and members of his hedge fund are the only investors aware of the lawsuit about to be filed and can immediately profit with a well-timed short sale coincident with their filing.

As his technique of reducing risk on short sales is further refined by Kyle Bass, other hedge fund managers may see the value of investing in such intellectual property challenges.