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Litigation. Costly liability, or Untouched asset? – Lexology

Litigation. Costly liability, or Untouched asset? – Lexology

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For many companies, litigation is a negative word, and for most it’s a last resort, only to be considered once all other options have been exhausted.

Litigation is viewed in this way because it’s normally very expensive, and one of the reasons for this is because lawyers typically charge by the hour, regardless of the result. In addition, litigation diverts the key resources of a company (whether that’s people, time or money), away from creating profit and growth for shareholders/owners. And finally, the law is complicated, justice systems around the world vary enormously and litigation can be a long and drawn out process.

Litigation as an asset

Litigation can be an asset to a business.  Law firms who are willing to share the risk with their client () can do so by way of creative retainers. Further, Damages-based agreements – whereby the payment of fees is contingent on the success of a case and the amount paid is determined by the scale of the result – were made legal in the UK in 2013.  In addition, agreements with external litigation funders (sharing the risk between the law firm and an investor) are also now legal.

Fundamental to law firms who are willing to share risk (through creative retainers) is the recognition that a legal asset can be used as collateral for financing. A corporation with a piece of litigation (a legal asset) can secure financing today in exchange for a portion of the future proceeds from that asset. Typically, the retainer and financing will be provided on a non-recourse basis, meaning that the financier’s investment return is contingent upon success.

Every day businesses decide whether to spend their own money or to utilise outside capital to pay for goods and services. They make strategic and budgetary decisions about financing all kinds of assets – from software to foodstuffs, and litigation is no different, except in this case the underlying assets are legal. This provides the business with an opportunity to be more profitable because they are spending less of their own money on litigation expenses than they otherwise would, and at the same time allowing them to prioritise their spending according to commercial objectives.

One of the main reasons why businesses dislike litigation is that it takes time.  Research shows that in the UK, a litigation case that goes to trial takes at least 18 months.  Most cases take between 2-3 years from start to finish.  Furthermore, litigation is almost never straightforward.  Any General Counsel (GC) or Finance Director (FD) who manages legal spend is aware of the negative impact that litigation has on their company’s balance sheet. The accounting rules surrounding a litigation claim dictates that claims are not recorded as assets on the balance sheet, and legal expenses paid by a company are not capitalised but rather incurred through the organisation’s P&L – thus reducing the company’s profit for the period.

Additionally, revenue recovered from successful litigation is not returned to the P&L as operating income but is instead recorded ‘below the line’ as a non-recurring or extraordinary item. This creates a ‘no win’ situation for companies: even if they have winning claims, the accounting impact of those claims can impair the company’s financial performance. This is particularly disadvantageous to companies that are publicly listed and report financial results, as they will see a negative valuation impact when pursuing litigation, regardless of their trading metrics.

The solution

Creative retainers and the creative attitude of your lawyers can solve these problems: companies shift the expense drag of litigation by moving it completely off the balance sheet. Utilising creative retainers and a fee sharing arrangements, financing can be sourced that pays the legal fees, expenses and disbursements necessary to mount a legal claim. As the financing is provided on a non-recourse basis, there is no cash flow, accounting or financial impact to the company. The first and only time the litigation impacts the financial statements or the company’s cash flow is when the legal claim succeeds. The entire financial risk, alongside the unfavourable accounting treatment of that risk, is transferred from the company’s books to the law firm and/or litigation funder. In turn, the lawyers and/or funder are remunerated with an agreed share of the proceeds of the claim, if, and only if, the legal claim is successful. This makes litigation finance a powerful tool for companies – attractive to the CFO along with the General Counsel.

The reason why creative retainers should change the minds of FDs, CFOs and GCs is that they are able to transform litigation into a financial asset: the law firm can share risk with its client, a funder can provide financing against a particular form of contingent asset being the proceeds of the litigation.  Without the burden of financing the litigation and potentially through raising the funds that would have been attributed to the case as working capital, the company can benefit by generating cash flow for other uses and from improved financial metrics.  To date businesses have been able to raise money not just for the costs of litigation they are bringing but also to defend claims against them or even fund unrelated projects.

 



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