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Case Budgets: Critical Yet Often Overlooked in Litigation Finance Transactions

One of the most eye-opening aspects of analyzing litigation finance transactions is reviewing proposed litigation budgets. Litigation can be unpredictable, and cases vary in complexity and expense. A patent infringement action, for example, is inherently more expensive than a straightforward breach of contract claim.

Even still, budgets for cases in the same niche — or even the very same case — can vary wildly. Counsel could project the cost of a complaint to be US$50,000, or US$500,000. A complex trial could cost US$1,000,000 total or US$1,000,000 per week.
 
Why is this important? Most litigation finance transactions are predicated on litigation counsel’s budget. The size and pace of legal spend are therefore critical factors that clients should closely examine when evaluating deal terms. But this is often not the case.
 
Instead, clients are far more likely to closely negotiate the amount of a funder’s multiple return or number of contingency points than scrutinize a law firm’s budget. Perhaps it is because clients think that if a litigation funder is footing the bill, the budget is immaterial. Or perhaps it is because clients believe that litigation budgets lack flexibility. Whatever the reason, clients often do not appreciate the potential for incorrectly sized budgets to create misaligned transactions that directly affect their own level of success in multiple regards.
 

The top of the waterfall

At a basic level, single-case (as opposed to portfolio) litigation finance transactions involve a funder committing a certain amount of capital for legal fees and expenses in exchange for an investment return. That return is typically expressed as some or all the following:

  • Multiple on invested capital;
  • Percentage of a successful recovery; and/or
  • Internal rate of return.  

When a case is successful, the funder, client, and often the law firm share in the recovery pursuant to a waterfall. The first level of the waterfall is typically at least the return of the funder’s principal investment. It is not uncommon for funders to receive a multiple of principal on this level (i.e., on a priority basis).

That principal consists of what the funder has invested in legal fees throughout the case. The bigger the budget, the more counsel will tend to bill, and the more case proceeds are likely to be subtracted from the client’s net recovery. After the initial distribution to the funder, it is not uncommon for counsel to recoup any hourly fees it deferred throughout the case.
 

Alignment of interests

Most litigation funders preach the importance of aligning the interests of the funder, counsel, and client in litigation finance transactions. A necessary aspect of alignment is a law firm taking risk, typically by deferring or discounting a portion of its hourly fees (often 30 to 60 percent) in exchange for upside in the event of a successful outcome.
 
Although a transaction may appear to be aligned on its face, that alignment may be rendered illusory by the budgeting process. Larger budgets have a direct effect on the net remaining recovery that is distributed pursuant to the lower levels of the waterfall. If a budget is outsized, there may be little left for a client to recover in low- or mid-recovery scenarios.

In addition, the more conservative the budget, the less actual risk is present. A sufficiently large budget may materially mitigate or even completely de-risk a law firm such that it profits meaningfully regardless of the case’s success.
 
While litigation funders would be wise to scrutinize budgets as a matter of their own investment prudence, the current capital climate has created an observable misalignment of interests. Specifically, due to the recent influx of capital in the litigation finance sector, some funders have urgent deployment needs, and are willing to structure transactions with overly conservative budgets so they can put more money to work more quickly. In addition, a litigation funder may agree to a more favorable budget for the law firm as a means of cultivating a positive relationship that will serve as a future sourcing pipeline.
 

Considerations in evaluating budgets

In light of the potential for misalignment and the funder’s position at the top of the waterfall, clients must critically evaluate budgets to ensure they align with their litigation goals.

Clients have multiple means of countering the potential for misalignment with funders and counsel. Although litigation may be unpredictable, there are many ways to litigate and staff cases, ranging from lean and efficient strategies, on one end of the spectrum, to scorched-earth tactics, on the other. Just because a third party will be financing the legal spend does not necessarily mean the case should be litigated in a more expensive manner.

As an initial matter, clients should evaluate the overall amount of litigation budgets against what they believe would be reasonable in the absence of litigation funding. This can be achieved through the lens of what they would be willing to pay in an hourly, fixed, or other alternative fee engagement. The involvement of a third-party litigation funder should not alter this calculus, nor should the amount of what the law firm has at stake if it is truly taking risk.
 
Clients should also consider the effect of the budget on their likely recovery. When viewed in the context of the waterfall, the budget should not be so large that settlement options may be limited or foreclosed.
 
Finally, clients may consider imposing stage or phase caps on budgets. Interim spending limits control costs, incentivize efficiency, and manage the amount of the client’s net recovery. The same effect can be achieved through flat-fee structures. To account for the unpredictability of litigation, budgets can include “flex” or contingency line items that are activated upon the occurrence of certain events.

In a state court litigation, for instance, the parties may agree to release additional budget in the event of an interlocutory appeal. Similarly, in the patent litigation context, the parties may agree to a certain flat payment upon the filing of a petition for inter partes review, up to a specified number of petitions, with an additional payment made if the petition is instituted.

About the Authors

Andrew LuckingAndrew Lucking is commercial counsel at LiveRamp, a technology company based in San Francisco.

Dai Wai Chin FemanDai Wai Chin Feman is the director of commercial litigation strategies at Parabellum Capital LLC, a litigation finance firm in New York.


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