Litigation funders are suddenly bumping up against a much tougher economic environment as interest rates climb. Rachel Rothwell reports
The low down
Coming to maturity over a period of rock-bottom interest rates, the litigation funding industry has entered a new, more challenging phase. While funders are well financed, their investors are now expecting higher returns, and funders will face greater competition for cash from more established forms of investment such as private credit, which is enjoying a boom. Meanwhile, the funding sector is braced for a crucial ruling by the Supreme Court that may affect the validity of the agreements that litigation funders draw up with their clients – many of which could become void. Funders have been busy reviewing their documents to try to avoid the potentially disastrous consequences of a negative decision by our highest court.
For the past 15 years or so, the UK has enjoyed ultra-low interest rates. Everything was swimming along nicely for many homeowners, who began to believe low rates were normal and would go on forever. Those low rates also created the perfect habitat for a new concept to emerge and thrive: litigation funding. This new industry could offer investors much bigger returns than they could hope to achieve through traditional investments; and low interest rates meant funders could be relaxed about how long their capital was tied up in cases.
Now those days are over. Just as many homeowners face an unwelcome financial shock as their fixed-term mortgage deals come to an end, the litigation funding market also finds itself in a far more challenging economic environment. It is a complex picture, with some macro factors playing into the hands of funders. But it is clear that this young industry, still only really in late adolescence, suddenly needs to grow up.
The sad reality of the current economic times is that many businesses will find themselves under pressure. But for lawyers and litigation funders that holds a silver lining – a rise in litigation. As Laurence Pipkin, managing director of Temple Legal Protection, says: ‘High inflation is pinching the purse strings of consumers and businesses alike – which means businesses may be more open to litigating now, to protect their financial position.’
On the consumer side, Sentry Funding’s commercial director Tom Webster identifies two claim types in particular that are currently on the rise: business energy claims and housing disrepair. ‘Corporations continue to take advantage of consumers, and new claim types are being proposed all the time to tackle these injustices,’ he says.
Steven Friel, chief executive of funder Woodsford, predicts a rise in group actions brought by shareholders, as the economic climate leads to the exposure of more bad behaviour by companies during the next few years. ‘As the old adage goes, when the tide goes out, you can see who hasn’t got their shorts on,’ he quips.
The boom in legal actions is not the only positive news for the litigation finance industry. Another bonus is its unusual position as an ‘uncorrelated asset’ – not linked to the performance of the main economy and stock markets.
But then we have the bad news. Back when interest rates were low, the profits offered by litigation funders were much higher than most alternatives, albeit for more risk. But now, even very safe options such as bank interest or short-dated index-linked gilts offer much higher returns than previously, while options such as private credit are even better. So the bar against which litigation funders’ returns are judged is now much higher.
This affects the funders’ cost of capital – the minimum rate of return they must earn before generating value. And the longer a funder’s money is tied up in a case, the worse it is for them, because there are other investment options that do not require capital to be tied up for so long. This time pressure has always existed, but now it is much more intense.
'We certainly hear litigation funders talking in worried terms about interest rates and pricing'
Julian Chamberlayne, Stewarts
All this is likely to lead to a significant adjustment in the types of case that funders are interested in. For example, a very strong case that might take seven years to come to fruition may now struggle to attract funding. Meanwhile, we can expect to see greater tensions between funders and lawyers; particularly where funders believe – as is a common industry gripe – that once funding is in the bag, some litigators will march merrily towards a court hearing without really straining themselves to achieve a good settlement and avoid all that expense.
Will all this pressure translate into more expensive funding? ‘We certainly hear the funders talking in worried terms about the interest rates and pricing,’ says Julian Chamberlayne, risk and funding partner at Stewarts. ‘We’ve not yet seen it directly impact the commercial [terms], but we do anticipate we’ll start to see that happening.’
Chamberlayne explains: ‘Timescale is a big issue for funders, and with the current position with interest rates, where cases take longer to come to fruition, that means their investor’s money is out for longer. In a high-inflation regime, their returns compared to other forms of investment may not look as good. Litigation funding is inherently a risky form of investment, so the investors are expecting a pretty high return for that risk; and the shift in interest rates has rather moved the dial on that one.’
When it comes to attracting investors’ cash, the private credit market – where investors such as pension funds and other non-bank lenders provide loans to companies – is probably litigation finance’s biggest competitor. Neil Purslow, UK chief investment officer at funder Therium and chair of the International Association of Litigation Funders, explains: ‘Money is flowing into private credit because the opportunity is there to get returns without the volatility of the private equity market… We are competing for capital in that world.’
At the moment, for example, investors can lend cash to strong, stable corporates and expect an annual return of around 12-13%. This private credit industry is considered to be having a ‘golden moment’ – Morgan Stanley estimates it to be worth $1.5 trillion. Meanwhile the litigation funding market is far smaller, estimated by Swiss Re to be worth over $17bn in 2022. Technically, litigation funding is itself classed as part of the private credit market, although this is a source of debate.
The knock-on effect of all this competition is that investors that choose litigation funding over other options now expect higher rewards than when interest rates were low and the alternative options were not as attractive.
‘We’re competing with everyone,’ remarks Purslow. ‘It doesn’t matter when you raised the money, because your investors are looking at the opportunity in front of them now, and they won’t be very happy with you if you say, “Well I raised the money a while ago and I said I’d give you a lower return, so I’m giving you a lower return”.’
EU clampdown ‘could stifle the sector’
In June last year, German MEP Axel Voss, a longstanding critic of litigation funding and a member of the European Parliament’s legal affairs committee, published a damning report on the funding sector that called for a host of controls and restrictions over funders operating in the EU. These included imposing a 40% cap on the damages that funders can take and obliging claimants to disclose that their cases are supported by litigation funders. In a blow to the industry, the parliament officially adopted an updated version of Voss’s report last September, and called on the European Commission to act on its recommendations.
Last month, the International Litigation Funders Association (ILFA) published its own report, warning that the plans to regulate Europe’s legal finance industry could stifle the sector and undermine the EU’s own legislation, the Representative Actions Directive, which aims to protect the collective interests of consumers. To the relief of the funding industry and its clients, the commission has said it plans to conduct a mapping study of the European litigation funding landscape before rolling out new rules.
ILFA chair Neil Purslow says that it would be wrong to assume this means the issue has been kicked into the long grass. He added that the ‘mapping study is helpful, because it shows the European Commission engaging with the discussion and trying to do this properly. So it’s thoroughly positive from that perspective.’
Woodsford’s CEO Steven Friel observes: ‘The Voss report itself is a Frankenstein’s monster. You really get the impression that people with very little experience of litigation funding, very little real-world understanding of the access to justice benefits of litigation funding, and without really appreciating that this is a multi-billion-dollar industry that has been in existence for 15 years in most major jurisdictions without any real problem, they sit down and they look at all the theoretical risks in litigation funding, and effectively create a problem… The defendant lobby uses the protection of claimants as a fig leaf. But claimants can’t be protected if they can’t bring the claim in the first place.’
Null and void?
The industry is contemplating another major headache: an imminent Supreme Court ruling that could affect the validity of litigation funding agreements (LFAs). PACCAR Inc and others v Road Haulage Association Ltd and another was heard in February and judgment is due on Wednesday next week.
The ruling is part of two mammoth class actions being brought against truck manufacturers in the Competition Appeal Tribunal (CAT). The issue before the Supreme Court is whether, as truck manufacturer DAF contends, LFAs should be classed as damages-based agreements (DBAs). This is important because if they are indeed DBAs, they will need to comply with the DBA Regulations 2013. In PACCAR, the parties have agreed that the LFAs do not currently comply with these rules. But the implications reach well beyond this case, to LFAs more broadly, many of which could potentially be rendered invalid depending on the Supreme Court’s decision in PACCAR.
So with the court decision now looming, the litigation funding industry has adopted the wise approach of ‘hope for the best, prepare for the worst’. Stuart Carson, competition litigation partner at Stewarts, says: ‘Months and months ago, the funders [were] already taking pre-emptive measures to amend all of their agreements, such that if the Supreme Court rules on the side of DAF those agreements won’t be null and void.’
Most LFAs allow for funders to be paid in one of two ways: as a percentage of damages, or as a multiple of the amount they invested (usually a multiple of three). It is the percentage share that potentially triggers the DBA regulations.
Carson says: ‘The way of [ensuring that LFAs are not caught by the DBA regulations] is that, if you have a percentage agreement at the moment, swap it out for a multiple and include a severance clause to make sure that that multiple stays instead of a percentage. The difficulty is, do the funders want that – are they and the class representative content with a multiple?’
Under the Competition Act 1998, DBAs are not enforceable in opt-out collective proceedings. So depending on which way the Supreme Court rules, funders may have to swap to a multiple rather than a percentage in opt-out claims. This will then avoid the LFA being classed as a DBA.
For other ‘opt-in’ claims, there may not be as much of a problem as first thought.
Carson says: ‘For the market generally, there are a lot of agreements out there that could be void – but [in fact] I doubt there are that many outside of the CAT that would actually be void. If they use a percentage, that’s fine as long as the agreement doesn’t frustrate the DBA regulations.’
One key provision in the DBA regulations, for example, is that the payment should not exceed 50% of damages. But Carson says these cases could be very rare. ‘I’d hope those agreements are very few and far between. I think there was a lot made at the Supreme Court hearing of the wider ramifications of the ruling, but in practice I think it’s potentially not as profound as one initially thought. It just requires some careful reviewing of the agreements to make sure they aren’t null and void.’
One point to note, however, is that the requirement for payments not to exceed 50% of damages will also include the fees of solicitors and counsel acting on a conditional fee agreement with success fee, as well as the funder’s cut. And past agreements, where the funder has already been paid, will also be affected. So an adverse decision by the Supreme Court could inadvertently give birth to a cottage industry in which a law firm targets clients who received funding and offers to check if the fees paid amounted to more than the 50% limit, and if so, offers to sue the funder.
All this will of course be irrelevant if the Supreme Court rejects the truck manufacturer’s assertion that the LFAs should fall within the DBA rules. Chamberlayne notes: ‘If you think back to Lord Justice Jackson’s review of costs [in 2010]… there was no suggestion at all that he intended litigation funding to be caught within the DBA regime, which was focused on what lawyers charge.
‘He was also keen not to constrain the fledgling litigation funding market.’
Access to justice
The reason why that fledgling industry was seen as something to be nurtured back in 2010 was due to its potential role in helping litigants achieve access to justice. But the economics of litigation mean that all too often funders end up fighting one another for the biggest, strongest cases, while smaller claims struggle to attract any interest at all. Pipkin notes: ‘The middle market – cases where the client wants an indemnity [or funding] of £100,000 to £500,000 in value which might be similar in damages – that area is really under-resourced in funding, and also in after-the-event insurance. There’s scope there to offer better products.’
One market player seeking to make funding available at the lower-value end is Sentry, which works with a variety of funders. Webster notes that the issue of financing lower-value claims is something that is often discussed within the industry. ‘I haven’t seen dramatic action by the wider market,’ he reflects. ‘But the funders on our panel have made solid commitments to support lower-value claims.’
Technology holds the key to cracking this particular nut, Webster suggests. ‘Artificial intelligence opens up a world of possibilities for funders,’ he enthuses. ‘I can see AI playing a bigger part in decision making as the confidence in the technology grows and data becomes more readily available.
‘At Sentry we process thousands of funding applications, and to help us manage these efficiently we are integrating AI tools that will check documents uploaded by law firms. The clever part is how it uses a “human-in-the-loop” process, whereby the AI will check the document against set criteria that our case handlers would manually check for. If the AI is not confident it fits the criteria, it will ask a human to interject; and the AI learns from the human input, so it will know better next time it sees the same issue.’
'Artificial intelligence opens up a world of possibilities for litigation funders. I can see AI playing a bigger part in decision making'
Tom Webster, Sentry Funding
From the access to justice perspective, litigation funding’s greatest success has been in group actions, where funders have a crucial – and judicially acknowledged – role to play in getting claims off the ground and supporting them throughout the life of the case. But while many funders were initially very keen to throw their weight behind group claims, there are signs of some cooling off, particularly given how long such claims can take to achieve a financial result, and the teething problems experienced in the CAT.
Chamberlayne explains: ‘The funders are concerned. Some of them were burned during Lloyd v Google [an opt-opt class action dismissed by the Supreme Court in November 2021] as they had actually invested quite heavily in data privacy cases. So they are a bit cautious about backing too many really big opt-out cases in the CAT until they can see some winners coming through, and the system working better.
‘Also, [there are] too many of what they may view as a similar class of case, or similar type of defendant – particularly Big Tech and Big Pharma cases. Funders may be happy to do one or two of those, but once they’ve signed them up, they don’t really want to do four or five of those cases. These are really high-cost cases as well – a major opt-out claim is going to be serious eight-figure budget. So there’s appetite, but it’s cautious appetite.’
Up for a fight
In conclusion then, after enjoying a somewhat cosseted childhood of low interest rates and a steady inward flow of cash for the past 15 years, the litigation funding industry now finds itself in a playground tussle with more established and mainstream investment options. But having raised sizeable sums during those boom times, it enters that contest with full war chests, an expected rise in the number of plum cases available to pick from, and a proven track record. In the fight for investors’ money, the industry is already mature enough to take on the big boys.
Rachel Rothwell is editor of Gazette sister publication Litigation Funding