Posted by By Michael Lent, 21st November 2018 on 08/23/2018

What are the risks facing an investor in litigation funding?

We examine the nature of the risks facing investors in litigation, using AxiaFunder, in this article.

It is now well established in the Courts of England & Wales (although not the Republic of Ireland) that third party funding of litigation i.e. by a person or corporate body that has no connection with litigation between other parties is no longer illegal. Indeed, within certain constraints, the Courts have welcomed it, not least, as a means of creating access to justice to those litigants who would not otherwise be able to fund their litigation.

In this article we are only dealing with the cost of funding the costs of the litigation itself, e.g. the solicitors’ and barristers’ fees, Court fees, expert’s fees. A third party funder can invest in the litigation by agreeing to pay for, typically, part of these costs of the litigation on behalf of the party who it is persuaded will win, in exchange for a return that will be paid from the damages recovered by the successful party.

What is the risk of the investment itself?

This investment in the litigation is usually provided as a loan on a “non-recourse” basis which means that if the case is lost at trial, the third party investor will recover nothing.

Therefore, in common, with many investments, the investor stands to lose all of their investment.

Of course, the great majority of cases settle early, (conservatively at least 70%) and even if a case is not going as well as hoped, a settlement may be achieved which does not provide for all of the originally agreed return but will provide either a reduced return as well as the return of capital or possibly just a return of some capital.

Litigation is, by its nature, unpredictable and if a case goes to trial the result is binary. However, it must be borne in mind that if care goes into selecting the cases for investment, the downside risk of losing the complete investment can be much reduced because in a carefully chosen portfolio of say 10 cases, 7 of those will settle and of the 3 that proceed to trial, 2 will win and 1 will lose.

Are there any additional risks?

In addition to the risk of losing all of the original investment, there is a risk of having to pay the successful opponent’s costs, if the claimant themselves lacks the capital to pay these costs.

As a Third Party investor, you may question how this could be, since you are not actually a party to the litigation. But Courts in England & Wales have very wide powers to make “Non party costs orders”. These orders do what they say on the tin and entitle a Court to order an appropriate person to be ordered to contribute to the costs of litigation that they have supported financially, where they have done so with a view to financial gain. Clever corporate structures and trusts designed to confound the ability of the Court to make such orders will only have the opposite effect to make the Court more determined to ascribe liability.

Following the case of Arkin v Borchard Lines, a decision of the Court of Appeal (which is the final arbiter of issues relating to costs in England & Wales), it was held, in effect, that a third party funder could only be liable to the successful party for their costs up to the amount that the funder had invested in the litigation i.e. if the funder contributed £10,000 to litigation then the maximum the funder could be required to pay, was £10,000 to the opponent’s costs.

A more recent decision also confirmed that if a Court had ordered costs to be paid on an indemnity basis, then such costs were indeed to be included in the funder’s liability albeit subject to what is now known as their “Arkin” limit.

Although this Judge in his judgment queried, as an aside, whether the ruling in the decision of Arkin was correct, he did not depart from it.

Thus, in addition to the possibility of losing the entire investment, a third party funder could, in theory, be liable to double their loss.

How is the Arkin risk managed/avoided?

The simple answer is ATE (“After The Event”) insurance – either Standard or Non-Avoidable ATE. This is an insurance product that the third party funder insists (in the case of AxiaFunder) is taken out by the funded/claimant. For both Standard and Non-avoidable ATE insurance, the policy provides protection against the liability to pay the adverse costs of the opponent if the case is unsuccessful. However, it should be noted that Standard ATE insurance has some conditions which could enable the insurance to avoid paying out if for example the claimant misrepresented their claim or their solicitor was found to be negligent.

Non-Avoidable ATE insurance is written on the basis that the insurer will not exercise any grounds to avoid or vitiate the terms of the policy, for an additional premium. Therefore, if the case is lost, say, because the Court determined that the funded/insured had been untruthful in giving their evidence, the policy would still pay out (the insurer’s reserving their right to recover their losses from the insured personally) thus protecting the third party funder.

Where adverse cost risk exists, AxiaFunder will seek to ensure that a suitable amount of Non-Avoidable ATE insurance has been put in place before making the case available for funding.

However for certain cases where the adverse cost risk is viewed as low and Non-Avoidable ATE insurance is not available, AxiaFunder will rely on Standard ATE insurance. We believe that in the vast majority of cases, Standard ATE insurance provides adequate cover. AxiaFunder will always clearly state the type of ATE cover that is in place for each case.

Is even Non-Avoidable ATE insurance a complete answer?

There are extremely rare events which could prevent it from being so. For example, the insurance company might become insolvent. AxiaFunder protects against this risk by only using insurers that are investment grade or that have a Solvency Capital Ratio of at least 110% for the ATE insurance cover. Given the stringent requirements of Solvency II, the chances of an insurer’s insolvency at this level are very low. Further if the insured is an individual, they (and the third party investor) will largely be protected by the FSCS (Financial Services Compensation Scheme) up to a limit of 90%[1].

Another possibility is that the level of ATE cover is inadequate to meet the opponent’s costs recovery entitlement.

During the course of litigation in England & Wales, the litigants are obliged to provide and have approved by the Court, their costs budget for the litigation which will, of course, be used to ensure that the levels of ATE insurance cover are adequate.

It is only in extreme situations that a Court would allow a party to recover more than their budgeted costs; indeed, one of the arguments for refusing to allow a party to exceed their budget would be that it might exceed the ATE insurance obtained on their behalf.

Therefore, it can be seen that the Arkin costs risk, whilst real, is an identifiable and manageable risk which is extremely low and should not, of itself, deter those investors who are interested in seeking the projected returns that this type of investment may be able to offer, as part of a balanced portfolio of investments.

By Michael Lent, AxiaFunder Case Originator and Assessor 

[1]For the avoidance of doubt, the crowd funded investment itself does NOT benefit from FSCS coverage.