Claim Based Funding – The Financial and Risk Management Solution

What can a company do when it is the victim of a material commercial wrong and the cost of pursuing a legal solution to fairly remedy the harm will put a significant strain on the company’s financial resources? The solution may be to turn to Themis Legal Capital or a handful of similar companies that have recently entered the US market to offer financial solutions to companies facing the unfortunate reality that, having done nothing wrong, they find themselves involved in complex and expensive commercial litigation.

What is Claim Based Funding?

The essence of Claim Based Funding or CBF is a non-recourse investment in a company with meritorious claims likely to result in a large potential recovery in exchange for a piece of the recovery. The investment is based on a careful assessment of the merits of the company’s claims and the anticipated level of provable and recoverable financial damages that the company has suffered. The provider of CBF typically advances money to fund the cost of the dispute resolution process, including the fees of lawyers, expert witnesses and damages assessment experts. By taking advantage of CBF, the plaintiff company can afford to prosecute its claims in a manner designed to achieve a fair settlement or judgment without disrupting its core business operations by burdening its working capital, cash flow and capital structure. Since CBF is made on a non-recourse basis, the funder only recovers its investment and makes a profit from the amount ultimately realized upon settlement or collection of a judgment.

CBF is a developing financing tool that should and will become an important part of the capital structure of many companies and a product to be considered in most corporate finance discussions. It is well known that the costs of pursuing litigation in the United States and achieving a fair outcome can be very large. A company using CBF can balance the scales of justice with the defendant and optimize the outcome of its claims in litigation even when its opponent has large available resources.

Why do companies need or elect to secure CBF?

There are many scenarios that can lead companies to seek litigation support. Here are a few hypothetical examples:

Suppose that Company A has developed a widget that is different and superior to other available widgets that perform the same function. Company A begins distribution of the product through regional outlets and expands its business at a rate that its working capital capacity will support. A major Big-Box retailer learns about the widget and asks Company A to dramatically expand its capacity to supply the Big-Box retailer. The Big-Box retailer makes various promises of a long term partnership and induces Company A to incur significant debt to increase its production, warehousing and distribution capacity. After a brief honeymoon Company A’s sales to the Big-Box retailer drop off significantly and the company discovers that the retailer has taken Company A’s widget to an off shore supplier to copy the design and deliver the counterfeit widget at 80% of the previous price.
While Company A has suffered tens of millions of dollars of economic harm and may well have a very compelling legal case against the Big-Box retailer, the reversal has put it on the verge of bankruptcy. Company A lacks sufficient liquidity to operate its business let alone pursue its meritorious claims against an adversary with the financial resources to burden any lawsuit with delay, overwhelming document requests and motion practice, which will exhaust Company A’s remaining resources.

Imagine that Company B is owned as a part of a portfolio by a private equity fund. Company B provides logistical support to the transportation industry using patented information systems combining GPS tracking and communications tools in a novel way. Like all portfolio companies of private equity funds, Company B’s balance sheet is leveraged and the sponsor is keenly focused on growing Company B’s EBITDA and gaining market share in the transportation logistics field. While Company B has focused on its core business various large social media companies have noticed Company B’s tracking and communications technology and adapted it to redirecting social interactions. The social media companies begin earning significant advertising revenues from this adaptation of Company B’s technology but naturally fail to pay royalties to Company B with respect to the patented technology that they are exploiting.

When the patent infringement comes to the attention of Company B, its general counsel approaches the PE sponsor for funding to bring a suit to compel the infringers to pay a fair royalty for the use of the technology, which has a present value well in excess of a hundred million dollars. The sponsor, however, cannot justify incurring millions of dollars to enforce the patents. It would be costly to incur additional debt or raise equity in order to pursue the claim but, more importantly the sponsor expects to sell Company B within two years once certain key milestones in its business plan are achieved. As a result the sponsor is intent on preserving EBITDA and does not want to explain an add-back of millions of dollars of litigation cost to a prospective buyer despite the potential for a very large payback in the future.

Picture Company C, which has invested tens of millions of dollars developing mineral resources in a South American country. After extensive investment in infrastructure, Company C was about to commence extraction of the minerals and commercialization of its investment. The present value of the anticipated profits was in the billions of dollars. At about that time, the country’s debt cost began to rise because of economic fallout from the world-wide financial crisis leading to political upheaval and the installation of a populist government. The new regime is motivated by a desire to reclaim its national wealth and to this end moves to nationalize Company C’s holdings.

In the ensuing negotiations, the country offers to repay the development cost of the project but refuses to compensate Company C for lost profits that would have been derived from the project. The only recourse for Company C is to pursue an international arbitration to secure a just recovery for the lost opportunity. Unfortunately without access to its expropriated operating assets, Company C has no resources to pay the fees and administrative costs of the arbitration process and to hire lawyers with experience in arbitrating against a sovereign country, economists to testify on damages and other expert witnesses.

What Is At Stake?

What each of these companies has in common is a meritorious claim for substantial economic damages suffered at the hands of a wrong doer. Moreover, each of these companies’ efforts to seek justice is certain to be met with stonewalling and an aggressive counter-offensive designed to wear the company down until it has little alternative but to accept a modest settlement that does not fully address the harm suffered. Without the benefit of CBF, each company lacks or cannot justify the allocation of the necessary financial resources to effectively pursue its claims and resolve the dispute fairly. In situations like this, viable innovative companies might be forced out of business unless they could source the requisite funding to pursue their claims. For such companies, Themis offers creative financial and strategic solutions.

The Themis Case Assessment Methodology

Themis chooses the cases that it invests in carefully. If approached by Company A, Company B or Company C, Themis would conduct a thorough due diligence process to assure that the company indeed has a strong claim for significant damages that can be proven and recovered. Moreover, Themis will satisfy itself that the company’s motivation is to obtain a fair and economic resolution of the dispute. In particular, Themis will avoid partnering with companies that may be motivated by non-commercial objectives such as to inflict harm on a competitor or to engage in a personal vendetta.

Themis’ due diligence process relies upon a proprietary case assessment protocol to identify and elicit the requisite data, to evaluate and sort that data in a systematic manner and to weigh the inputs to effectively assess the strength of the case and the reasonable measure of damages. Themis’ case assessment process is rigorous but also efficient. Themis’ objective is to make the process transparent to the prospective plaintiff as well as comprehensive and analytical for the benefit of our investment committee and our investors.

The process ensures that Themis’ decision to partner with a plaintiff and invest in its case will be based upon thoughtful and disciplined consideration of the following predictors of a successful outcome.

Themis initially evaluates the strength of the case based upon a careful review of the applicable legal principles and of the documentary and testimonial evidence that is available to prove the facts needed to support the claims. The legal theories and the supporting evidence will be developed during a three stage due diligence process that includes document collection and review and interviews with key witnesses, decision makers and counsel. Themis will only finance a case if at the end of this process it determines that the case is demonstrably strong on the merits.

The second factor considered by Themis is the measure of realistic provable damages. Themis does not support litigation brought to prove a point or to induce a recovery of “nuisance value” and, accordingly, Themis would not finance even a strong case on the merits unless the financial damages were sufficiently large to justify the expense and risk associated with pursuing it.

Upon a satisfactory review of the first two factors, Themis will evaluate relevant subjective factors that could affect the outcome of the case, such as peculiarities of the venue where the dispute will be prosecuted, known idiosyncrasies of the judge, any perceived disparity in the skill and resources of the parties’ legal teams, the financial strength of the parties, potential non-economic motivations of either party and similar variables.

The fourth factor that Themis will evaluate is the expected time line of the process and whether it has advanced to a point where there is clearer visibility to the outcome. Themis will look for opportunities to invest in companies with cases that have been underway for some period of time and where the plaintiff needs financial assistance. In these cases, the facts will have been better developed, the time line to resolution shortened and the visibility to the potential outcome enhanced in comparison with new disputes at the commencement of litigation. The differences in the timing and risk of the recovery will have to be evaluated in connection with the investment decision.

Next, Themis will need to consider the case management strategy of the plaintiff and its attorneys before investing. Before taking on any matter, Themis will work with the plaintiff and its legal team to develop a budget for all of the costs of the case. The budget will be segmented by stages of the case such as pre-discovery, discovery, pre-trial, trial and appeal. Themis’ funding will likewise be advanced over the course of the case and Themis will have the right to withdraw in the event of unexpected adverse developments.

Finally, there is little point in pursuing even a strong case, with significant damages, with no unusual negative characteristics and a manageable time horizon if the defendant will be unable to pay a judgment. Accordingly, Themis will review the creditworthiness of the defendant and its insurance coverage as part of the case review and approval process.

What Does The Transaction With Themis Look Like?

For cases that meet its standards, Themis will offer a non-recourse financing package that will typically have the following characteristics:

Themis will pay all of the expense of the case or share the costs with a law firm offering to handle the case on a contingent fee basis. Those costs will be budgeted in advance and Themis’ payment schedule will be capped and correspond to the budget that is worked out among the plaintiff, its counsel and Themis. From the plaintiff’s perspective, not only is the cash burden of financing the litigation mitigated but also the costs funded by Themis will not be treated as expenses for financial accounting, thereby allowing the plaintiff to pursue this valuable asset without eroding EBITDA or affecting debt covenant reporting or other similar financial metrics.

In exchange for funding, Themis will be assigned an undivided portion of the recovery in the case typically between 25% and 40%, with the first recovered amounts being used to repay Themis’ investment. Usually the percentage will be adjusted based on the timing of the payout of the recovery. For example, if the case settles within a few months, the percentage would be lower but if the case extends longer or goes to trial the percentage would be higher. The economics of this structure replicate a typical contingent fee arrangement but they offer the plaintiff the opportunity to select its legal team without being limited to only those law firms that work for contingent fees.

Themis will retain the right to withdraw from the case if subsequent events reasonably lead it to conclude that the initial investment thesis has been discredited. In the event of withdrawal, Themis will retain the right to recover its invested amount if there is a recovery but will typically relinquish some or all of its negotiated portion of any upside recovery. Naturally, this right is not exercised lightly because of the loss of profit potential from the investment. It is necessary, however, because despite the best due diligence, adverse developments do happen occasionally and the parties recognize that the investment thesis can be undermined by such developments. In practice all parties usually recognize that the expectations have changed and all parties typically support the withdrawal from litigation if it turns out to be poorly founded.

Plaintiffs Who Partner with Themis Get More than Funding

Themis is a value added partner in addition to providing funding. The plaintiff and its legal team will provide Themis regular updates with non-privileged developments in the case and Themis will share its insights with the plaintiff and its counsel. As discussed above, Themis does a thorough case assessment before investing in a case. In addition, it updates the assessment throughout the duration of the case. Themis will share the salient elements of the case assessment with the company and its legal team at the outset and as appropriate throughout the duration of the case. Themis’ principals’ years of experience and Themis’ institutional experience contribute to a practical, objective and informed perspective.

Themis has a business focus on the financial issues essential to the litigation process. Themis will evaluate and manage a budget for the entire dispute resolution process, thereby helping to deliver efficiency to the process and manage the cost. An essential element to the decision to proceed and the strategy for the prosecution of the case is a credit analysis of the defendant to assure that there are sufficient prospects for the recovery of a judgment or settlement. Themis’ finance team evaluates these prerequisites to success and offers its insight to the plaintiff and its owners.

Themis has experience with and access to a network of expert witnesses and damages assessment professionals with a broad spectrum of experience and competence. Themis offers to refer experts to the plaintiff and its legal team to support the case. Similarly, Themis has relationships with litigation support service providers offering e-discovery services, document management capabilities and other essential skills that in the right circumstances may contribute valuable support to the plaintiff’s case.

Themis Encourages Settlements

The legal process is, under the best of circumstances, a long one. Typically the parties employ posturing and brinksmanship, which obscures the true merits of their respective positions. Time and disparity in financial resources can wear down a party with a meritorious claim. Litigants, even with the weaker case but, with the advantage of an unlimited time line and superior financial resources often intentionally try to run the clock and drain their adversaries’ resources. Accordingly, litigants without the experience and financial staying power to manage their way through these minefields are almost always forced into disadvantageous settlements that do not fully compensate them for the true harm they have suffered.

The support of Themis and other providers of CBF for litigants with meritorious claims effectively balances the scales of justice by providing those claimants with the financial tools and level headed, experienced support to navigate through the complex stages of litigation. Moreover, Themis believes that when the defendant learns that the claimant has the financial backing of Themis or funder, the defendant is going to have to recognize that the leverage derived from its financial strength has been neutralized. In such a case there is no further tactical advantage to using delay, discovery and motion practice in order to run up the cost of litigation. Accordingly, Themis believes that CBF will, in fact, induce quicker and fairer settlements based on the real merits of the case.

Successful CBF Requires Adherence to High Ethical and Legal Standards

While the merits of CBF as a financial tool for aggrieved companies are quite easy to understand, providers of CBF operate within a regulated judicial system and must respect and observe time proven ethical and judicial standards. In particular, Formal Opinion 2011-2 issued by the New York City Bar Association addressing CBF determined that “It is not unethical per se for a lawyer to represent a client who enters into a non-recourse litigation financing arrangement with a third party lender.” That opinion also offered specific guidance on protecting the role of the attorney as an independent advisor, avoidance of conflicts of interest, maintaining attorney client privilege and confidentiality and ensuring that the litigant maintains control of the proceedings.

Responsible CBF providers such as Themis fully understand and respect that the litigant must maintain ultimate control over the strategic decisions that must be made during the pendency of the case. Moreover, the ethical duty of the litigant’s counsel to form an independent point of view with and to offer independent advice governs the attorney’s relationship with the client. Themis’ contracts are quite clear on these points and Themis has retained renowned experts on legal ethics to guide Themis is its interactions with the plaintiffs it finances. It is also important to note that one of the critical due diligence items for Themis and an important consideration of Themis’ investment committee in approving a transaction is our confidence in the litigant’s counsel and a common understanding among the litigant, counsel and Themis of the litigant’s objectives and realistic expectations.

The “attorney-client privilege” protects most communications between a client and its attorney from discovery by the opposing side in litigation. The rationale for the protection afforded by the privilege is to facilitate free and frank discussions between lawyers and their clients. The “common-interest doctrine” extends the privilege to parties engaged in the joint defense or prosecution of an action. In addition, the “work product doctrine” protects materials prepared by or on behalf of counsel in anticipation of trial from discovery. The applicability, scope and exceptions to these doctrines are determined by the law of the jurisdiction in which the case is proceeding. The scope of these rules as they apply to CBFs is evolving as the use of CBF in litigation expands, but the trend appears to be in favor of protecting its claims to third-part funders. For example, in two Federal District Courts the common-interest doctrine has been held to protect communications between the litigant, its attorney and an involved CBF while a third District Court has ruled to the contrary.

Each of these doctrines provides important protections to the parties engaged in litigation and, accordingly, Themis and any self-interested provider of CBF will always be careful not to undermine the protections they offer. Accordingly, Themis has made a commitment to proceed cautiously when it comes to requesting and reviewing material that might compromise the applicability of these doctrines. Themis works with nationally recognized experts on legal ethics to carefully vet the terms and execution of every investment to assure that the rights of the litigant, the obligation of the attorneys and the actions of the funder are protected.

Themis’ Support Promotes Efficient and Fair Resolution of Meritorious Commercial Disputes.

CBF is a new service offered in the United States legal market and to date only a very few of the thousands of large meritorious commercial disputes have accessed the emerging CBF market. As CBF becomes more widely available, the characteristics of the product will be better understood and its benefits will become more apparent.

In summary, Themis only invests in litigants with cases that are strong on the merits with substantial provable damages. We have developed precise analytical tools to source and evaluate these cases.

Themis’ success depends on adherence to high ethical and professional standards to protect the legal privileges and other ethical and procedural protections afforded by the United States judicial system. Themis and the litigants in whom we invest recognize that this is the best path toward resolution of the dispute.

Themis balances the scales of justice between the parties and makes sure that the partner in which Themis invests has the financial and strategic support to effectively advance its cause toward a fair and efficient resolution. A good settlement is the goal and, once both parties understand that the scales of justice are balanced and there is no tactical advantage for the financially strong litigant to attempt to wear down the financially weaker party, the path to resolution becomes more direct.

Ultimately, CBF is simply a financial tool that is available to companies that have meritorious claims based on the law and the facts. Companies meeting Themis’ funding criteria can access the support of Themis to protect their balance sheets and income statements as they move through the judicial system to achieve redress for the financial harm that they have suffered.

Themis is fortunate to be one of the early movers in the new and exciting field of CBF. With the experience of the Themis team and its commitment to bringing the best practices to this evolving business, Themis is a thought leader helping to move CBF into the mainstream of corporate finance.