Burford Capital’s high-profile run-in with a short-seller has put litigation funders – and their suitability for listing – in the spotlight. Rachel Rothwell reports

The low down

It was an explosive summer for litigation funding, with the best-known player and poster child for the industry, Burford Capital, at the centre of a storm. Short-seller Muddy Waters launched a brutal attack on Burford’s governance, accounting methods and liquidity. Burford fought back immediately with a robust and detailed response rebuffing the allegations. Headlines in the financial press were dominated by the ongoing battle between the two, and the ensuing fallout, including assertions by Burford that it had found evidence of ‘illegal market manipulation’ (vociferously denied by Muddy Waters). Burford now seems to have weathered the worst of the storm, while the forecast looks promising for the wider industry, which continues to inspire investor confidence.

This summer was an eventful one for litigation funding. The industry, which usually goes about its business largely unnoticed by the mainstream financial press, found itself thrust into the limelight – and not in a good way. The usually quiet August news month was full of headlines covering the twists and turns of a gripping battle between funding giant Burford and its assailant, short-seller Muddy Waters.

The drama started on 7 August, when Muddy Waters sprung a surprise attack on Burford, the biggest litigation funder and poster child for the industry, which has been a darling of the AIM market since listing in 2009. The short-seller’s 25-page report was brutal in its appraisal of the funder’s governance, accounting methods and liquidity. The share price dropped like a stone – having traded above 1,500p in July, it sank to 605p by the end of that day.

Carson Block, founder of Muddy Waters Research

Carson Block, founder of Muddy Waters Research

But the funder punched back hard the next day, with a nine-page riposte seeking to demolish what it described as the ‘false and misleading’ claims, citing ‘many factual inaccuracies’, ‘simple analytical errors’, ‘selective use of information’ and ‘fallacious insinuations’. It sought to calm shareholder jitters with a two-hour conference call.

A few days later it announced governance changes, including a new role for chief financial officer Elizabeth O’Connell, who is married to chief executive Christopher Bogart. The funder also asserted that it had found evidence of illegal market manipulation through ‘spoofing and layering’ – the creation and cancellation of orders to disrupt the supply and demand for shares – at around the time of the Muddy Waters attack. Muddy Waters strongly denies any involvement, stating that it has ‘absolutely no capability to do that’, and, for good measure, tweeting: ‘If [Burford] wants to bring that to court, we will smack [Burford] and any supposed expert down hard’.

Burford has since applied to the High Court to obtain the identities of those who placed allegedly manipulative orders.

The storm raged throughout the month with claims and counterclaims, while Burford’s share price – which at the time of writing has stabilised – reacted to events like a yo-yo pulled on a string. A number of US law firms announced that they would be initiating shareholder actions against the funder, while one investor, Hargreaves Lansdown, revealed that it had dropped Burford from three of its funds. However, in a frank blog post explaining the decision, Hargreaves fund manager Steve Clayton admitted that he did not really know whether Hargreaves ‘may have been wrong’ to drop Burford, ‘or we may have been wrong to have bought in the first place’. Perched on the fence, he noted: ‘Muddy Waters made their name spotting wrongdoing in Chinese-run companies… Since then, their track record isn’t perfect but they have claimed some notable scalps. These situations are always complex… We don’t know whether or not they are right about Burford. We think the company did a pretty good job in demolishing many of Muddy Waters’ claims.’

“If [Burford] wants to bring that to court, we will smack [Burford] and any supposed expert down hard”

Carson Block, Muddy Waters

Crunching numbers

One of the areas where Burford has come under attack relates to its use of ‘fair value accounting’ to attribute a value to cases. The funder published a detailed, 45-page explanation of how this works – and why it is not a problem – on 23 September, noting that ‘history suggests that Burford’s fair value adjustments are reliable and judicious’. But it is clearly an area investors can struggle with.

In his August blog post, Clayton alluded to the fact that Muddy Waters ‘alleges that Burford is too optimistic in how it revalues its assets’. He added: ‘Burford insists it is not… the only way to settle this argument would be to run down the portfolio, settle the cases for better or worse and see what the eventual value would be. That’s not going to happen, of course, so the argument can run and run, keeping the stock under a cloud’.

Nick Rowles-Davies, executive vice-chair at AIM-listed funder Litigation Capital Management (LCM), points out that fair value accounting ‘is not an evil, but the application of it does matter’. He adds: ‘There are differing ways of adopting fair value accounting and how it is used is ultimately a management team decision… some approaches are more reliant on subjective judgement by management teams than others.’

It’s not that litigation funding is not suited to the public markets – but it is one of the more complex businesses on the public markets

Louis Young, Augusta Ventures

The events surrounding Burford have led many to question whether an industry like litigation funding – where the underlying asset is litigation, which is inherently unpredictable – is really suitable for public listing. But Louis Young, managing director of funder Augusta Ventures, says: ‘It’s not that litigation funding is not suited to the public markets – but it is one of the more complex businesses on the public markets.’

Young draws an analogy with pharmaceutical companies, which might spend four years developing a drug before submitting it for approval. ‘There are a lot of complex businesses out there, and litigation funding is one of them,’ he remarks.

Rowles-Davies adds that there are clear benefits to funders in being publicly listed, which ‘ensures a level of regulation and transparency that the private markets do not have’. LCM moved from the Australian Securities Exchange to AIM in December last year, both to broaden its shareholder base and tap into the mature London market. Rowles-Davies notes that as a listed company, a funder is subject to ‘natural checks’ that are part and parcel of being listed – for example: the risk of investors selling their shares; analysts publishing negative research; and being targeted by short-seller activists. ‘What’s difficult is that there is no formal regulation of the litigation finance sector,’ he adds.

This is the perennial issue that has dogged the litigation funding industry since it began: should it be subject to proper statutory regulation? The industry currently regulates itself through membership of the Association of Litigation Funders (ALF), which has its own code of conduct and financial requirements. But membership is voluntary and many players in the market have not signed up. The ALF and its code was endorsed by Lord Justice Jackson at its launch in November 2011, but the judge’s stamp of approval came with the important caveat that the issue should be revisited when the market expanded. The industry has certainly grown since 2011, so is it now time for the government – most likely through the Financial Conduct Authority – to sweep the funding industry into its remit?

Rowles-Davies suggests that formal regulation of the sector is ‘inevitable in time’ and should be welcomed by respectable funders. David Pipkin, director of the underwriting division at after-the-event insurer Temple Legal Protection, which also provides disbursement funding, has always argued for FCA regulation of the third-party funding industry. ‘Funders should operate within a proper regulatory framework,’ he says. ‘The issues at stake often involve serious matters such as the survival of a company, the bankruptcy of an individual, or someone losing their house. Regulation should be the next step for the market.’

Others worry that regulation could have a detrimental effect on client protection. Mark Roe, a partner who leads on third-party funding at Pinsent Masons, says that at present the courts do a good job of regulating the behaviour of funders. In an industry that is so dependent on reputation, the risk of a funder being on the end of a ‘coruscating judgment’ does much to keep behaviour in check, he suggests.

He adds: ‘I’m not sure what regulation would actually achieve. If you had someone who was trying to do something that breached the regulations, they would simply set up in Jersey or the Cayman Islands. It is better that they are in London, and that the law applies to them.’

All about Money

In April the High Court ruled in a significant case for the third-party funding sector. Davey v Money [2019] EWHC 997 (Ch) addressed the issue of the Arkin cap (a rule based on 14-year-old case law) which funders have used to assert that they are only liable for adverse costs up to the amount that they actually invested in a case. This was highly beneficial for funders in reducing their costs risk.

In Davey, however, Mr Justice Snowden declined to apply the Arkin cap. He said: ‘What has become known as the Arkin cap is, in my judgement, best understood as an approach which the Court of Appeal in Arkin intended should be considered for application in cases involving a commercial funder as a means of achieving a just result in all the circumstances of the particular case. But I do not think that it is a rule to be applied automatically in all cases involving commercial funders, whatever the facts, and however unjust the result of doing so might be.’

The judge said he was ‘not persuaded’ by the ‘policy argument’ that if he did not apply the Arkin cap in Davey, ‘commercial litigation funders would be discouraged from providing funding in the future, essentially because my decision would signal that they might have an “open-ended” exposure to adverse costs’.

Is the ruling likely to have a significant effect on the funding market? Mark Roe, partner at Pinsent Masons, suggests not. ‘Most third-party funders already insist that after-the-event insurance is taken out to cover their [adverse costs] risk,’ he notes. ‘This may make them a bit more cautious to ensure everyone is insured, but I do not think it will have a big impact.’

State of the market

Beyond raising questions about the regulation of third-party funding or the suitability of funders to be stockmarket-listed, what wider impact has the Burford saga had on the sector? Has it deterred clients from wanting to involve funders?  ‘We haven’t seen any drop-off since the [Burford] news broke,’ reports Adam Strong, funding committee partner at HFW. ‘I think a lot of people are waiting to see what happens next; the jury is still out.’

There have been a number of recent positive developments in the market that suggest the industry has not lost its sheen for investors. Last month, funder Vannin was purchased by New York investment manager Fortress Investment Group. Augusta, meanwhile, managed to bag a further $115m from an existing investor – an asset manager for large institutions with a ‘multi-million-pound balance sheet’.

Young explains that the $115m investment had been in negotiation for some six to eight months, but was still not concluded when the Muddy Waters report hit the headlines. ‘It was a bit like someone throwing dog dung over the fence, and we had to deal with that,’ remarks Young. ‘We had to answer questions [from the investor] about what did we think of [events relating to Burford], how do we compare. But we were able to deal with that.’

With the investor satisfied that it still wanted to commit, the timing of Augusta’s investment announcement was ‘serendipitous’, notes Young.

In July Augusta also unveiled arrangements with two separate law firms which could mark the start of the next big trend for the industry. It has negotiated a deal with both Pinsent Masons and HFW, which will see the clients of each firm given access to a £25m funding ‘facility’ from Augusta, at a preferential rate.

Pinsent Masons

Roe comments: ‘Some funders are financing “portfolio” arrangements with law firms, where the firm will take a share of the profit. We felt uncomfortable with that idea. We feel you are building in a conflict of interest between the lawyer and client.’

He adds that Pinsents’ funding facility arrangement with Augusta is a good alternative to portfolio funding: ‘It’s a preferred supplier arrangement. A bit like a travel agent, we have used our buying power to get a better price…  The rate is significantly less than the open market would offer them.

‘It’s not exclusive, so if a client wants us to test the market or work with another funder we would do so. We have no financial interest in any third-party funding arrangement between Augusta and our client.’

Young adds that the arrangements ‘took a while to set up’, because each side had to do extensive due diligence on the other. ‘As we’ve mitigated the risk, we can reduce the cost,’ he adds, with a ‘softening’ of the due diligence needed for cases using the facility. The initiative has already attracted the attention of other firms: ‘We’ve been approached by four or five already that want to engage with us on that basis,’ reports Young. ‘There’s a lot of mileage to be had.’

Despite the summer storm that hit the funding industry’s best-known player, the sector has come a long way. Growth looks set to continue regardless of recent setbacks. As Roe describes it: ‘Funding is a bit like mediation was 30 years ago. Then, mediation was novel, whereas now there is a UN treaty on it. Third-party funding is going through the same process. It started out almost a bit racy, a touch dubious, like gambling… But now it is becoming much more acceptable.

‘I would feel no discomfort on a big arbitration in saying that “this case is funded by a third-party funder”; whereas previously, one might have been rather coy about it.’

Rachel Rothwell is editor of Gazette sister publication Litigation Funding.