Litigation funding - An innovative solution to costly construction disputes
This article is intended to assist those considering using litigation funding for a construction dispute. It provides an overview of the main criteria a funder considers when assessing construction cases for funding and the likely return on their investment that a funder will seek.
Introduction
Construction disputes can be expensive. If a dispute has arisen, not only will a party (whether an Employer, Contractor or Sub-contractor) likely have incurred significant losses, it will also face the prospect of incurring substantial costs to recover those losses by commencing arbitration or litigation proceedings (and, if bonds are involved, frequently both in parallel). Such costs, can, and often do, run into millions of dollars.
As a result, companies have started to turn to innovative litigation funding solutions to finance the costs that arise in pursuing such claims. Litigation funding is an alternative source of financing, where a company uses the asset value of its litigation or arbitration claims to secure capital from a third party to finance the dispute. The litigation funder provides capital to pursue legitimate claims which otherwise might be settled unsatisfactorily or left unpursued. The primary benefits of litigation funding to a company are to remove the downside cost risk of claims (freeing up capital to deploy for other business purposes), and to move the cost impact of running an arbitration onto the balance sheet of the funder.
Typically, the funder will cover all of the costs associated with litigation or arbitration. In return, the funder typically receives a proportion of the recoveries made or any settlement which is reached. However, if the claim is unsuccessful, then the funder loses their investment, without any recourse to the company or its assets for the recovery of its investment. Litigation funding is therefore described as “non-recourse” finance.
To help make the economics of funding viable, the lawyers often agree to share the funder’s risk, by accepting a discount to their usual fees, in return for an uplift in the event of a successful settlement or recovery. The uplift is often paid from the funder’s return on their investment.
Assessing a construction case for funding
There is no “hard and fast” set of criteria for obtaining litigation funding for a construction dispute. Ultimately, it is about identifying a funder which is willing to invest in a claim based on its commercial assessment of the investment potential of the case. All sizes and types of construction disputes can be financed (although realistically funders tend to be more interested in the larger claims, certainly where funding is sought for a single case) and different funders have different funding profiles, risk tolerance and track records, which will determine whether or not they are prepared to make the investment. However, funders do share a focus on certain common criteria when carrying out their commercial assessment. It follows that it will both assist and expedite a funder’s review of a claim if the potential claimant and its advisors have considered those criteria in advance and are able, at the outset, to address those issues in writing.
1. Spreading the risk
The first point is that, generally, in the context of construction disputes, funders prefer to invest in a portfolio of multiple cases. That is because, in a typical construction dispute, there will be both claims and counterclaims, and significant cost outlay, with the consequence that an investment in one claim is likely to be regarded as high risk. However, if a construction company has a number of claims (as is often the case in the industry), the funder can spread its risk across a number of claims and recover any losses from one claim from the recoveries made in a successful claim. This spreading of risk also enables the funder to provide better commercial terms than it would be willing to provide for a single case funding.
Contrary to the approach of most lawyers, experts and clients, a funder’s first area of focus tends to be on the identity of the defendant/respondent and whether they have sufficient assets in amenable jurisdictions to satisfy any award rendered against them. If, for example, a defendant is insolvent or only has assets in jurisdictions which are regarded as high risk, these will be very significant obstacles for any funder, before they even begin to look at the merits of the claim.
2. Initial claim analysis
In terms of the claim itself, it must be quite clear that the potential claimant is likely to be the net winner (bearing in mind that construction disputes frequently involve counterclaims). If not, given legal finance is non-recourse, the funder will lose their investment, so any claims which are of questionable merit (for example, where the prospects of success are less than 60%) are unlikely to be funded.
Generally, in the context of a complex construction dispute - involving extensions of time claims, prolongation, disruption, head office overheads, variations and termination - before approaching funders, claimant’s counsel will need to carry out an initial analysis (with the involvement of appropriate experts) of both the legal, technical and factual elements of the claim and, based on the information available, provide a preliminary opinion on the likely prospects of success and also importantly, the range of damages that may be awarded. This initial analysis may require a significant investment of time and costs, though both law firms and experts are increasingly willing to invest some risk in this part of the process, which can reduce the cost. If a funder does decide to invest in the case, these costs may be reimbursed by the funder upon closing the agreement.
The credibility and expertise of the law firm carrying out the review is an important factor here. While the funder will carry out its own due diligence in due course, for the preliminary commercial assessment at least, the funder will initially consider the analysis that the law firm provides. It follows that a reputable law firm with specialist contentious construction expertise and a strong track record will help provide assurance to the funder that the likely range of damages is an objective and sensible estimate.
3. Engaging credible experts
In addition, in carrying out that detailed review, it is helpful (although not always essential) to have at least the initial views of a credible expert, in particular in relation to any extension of time (“EOT”) claims, but also potentially quantum or technical issues too. A funder will draw confidence where a claim is backed up by a preliminary analysis from a credible expert. When assessing an EOT claim (especially where the project has been built), it is also important that a credible assessment of delay by reference to a retrospective method of delay analysis is utilised, in particular if the claimant is seeking to recover prolongation costs. A claim for prolongation costs based on a Time Impact Analysis, which produces hypothetical results that only relate to potential entitlements to EOT and should not be used to demonstrate prolongation costs, is likely to be inadequate. As a result, some clients may pay an expert for an initial analysis and seek reimbursement upon completion of financing documentation. It may be possible to seek some upfront finance from a funder for that preliminary work, but this is much more difficult to achieve.
4. Estimating arbitration costs and recovery prospects
As highlighted above, a funder will expect there to be an estimate of the range of damages likely to be recoverable, as well as a preliminary estimate of the costs of the arbitration from commencement to enforcement, so that the amount of funding sought can be specified and the funder knows how much capital it needs to invest. The real likelihood of recovery is key: a claimant may adopt a maximalist position claiming very high sums, but the funder relies on a serious and candid estimate of what is likely to be actually recovered. The funder will use those two figures (the estimated recovery and the cost of pursuing the claim) to assess whether the claim represents a viable investment. Typically, the funder will be looking for the ratio between the likely recovery and the amount of funding required to be 10:1 in a single case scenario i.e. if USD7 million of funding is required, then the funder will expect the estimated recovery to be at least USD70 million. A ratio of this magnitude not only allows for the funder to make an acceptable return on its investment, but more importantly it also allows for the claimant to recover a satisfactory level of damages after the funder takes its return. Many funders will refuse to invest if the ratio is such that the client will receive less than 50% of the damages awarded.
5. Sufficiency of assets and creditworthiness of both parties
As the funder only receives its invested capital and return when the claimant is paid its award or settlement, then another key criteria will be the creditworthiness of the respondent, the size of its assets, and where they are located. If the respondent is insolvent or has insufficient assets, the value of which do not meet the damages claimed, then it is unlikely a funder will make an investment, even if the merits of the claim are strong. Similarly, if the majority of the enforceable assets are located in a jurisdiction with an unpredictable or inefficient domestic court system when it comes to enforcing an award, then that may raise red flags with the funder, not only as to the likely recoverability of proceeds but the delay to recovery. As part of their commercial assessment funders will consider the amount of recoverable and enforceable assets and during the diligence process may also require a report from professional asset recovery advisors to identify the same. This is especially the case in the Middle East where often, there is a lack of transparency on a company’s financial records.
There are also additional factors which the funder will consider. These include the financial status of the claimant itself. If there are serious concerns about a claimant’s solvency, then this may be a give a funder cause for concern, particularly where the claimant is incorporated in a jurisdiction which does not have a sophisticated insolvency legislation regime. That is because the funder will wish to avoid a situation where the funding agreement is unwound or treated as a nullity by an insolvency practitioner or the court, or where its entitlement is given a low ranking in the order of priority in any insolvency of the claimant.
Another claimant-related risk on which the funder will need comfort is the claimant’s goals and motivations in bringing the arbitration. That is because, notwithstanding that it is the funder’s investment which is at risk, it is the claimant, and not the funder, which retains full control over the proceedings, including when and if to settle and at what amount. As a result, while the funder and claimant’s interests are likely to be generally aligned in wanting to resolve the dispute for a fair settlement, the funder will want to assess whether the claimant’s goals and motivations are realistic.
6. Negotiating the commercial terms
Once the funder has had an opportunity to review the analysis of the merits, the likely damages together with the prospects and timeline of recoverability and the legal budget, the funder may provide indicative commercial terms of funding in a non-binding Letter of Intent (“LOI”) or similar document. At this point, a funder will usually want to agree a period of exclusivity with the claimant, which would typically be for 8 weeks or so. The LOI is not a binding contract but allows the claimant and funder to explore the terms of a funding agreement for the dispute and provides time for the funder to carry out a more detailed due diligence exercise and obtain any necessary internal approvals before making the investment. The exclusivity means that, during this period, the claimant would not be able to engage in discussions with any other funder. If, after signing the LOI, the funder decides not to fund the dispute or wishes to change the terms of its proposed funding, then typically no fees would be payable by the claimant to the funder. However, if the claimant decides not to go ahead, then the funder may have negotiated a break fee, which typically covers the costs which it has incurred in conducting due diligence and documenting the funding agreement.
7. Pricing litigation funding
In terms of the likely costs of litigation funding, there is no fixed pricing model. The cost of funding is the result of commercial negotiations between the claimant and funder and is informed by the funder’s assessment of the risk profile of the case and the risks posed by an investment. Pricing models may differ and could be calculated by the funder’s entitlement to reimbursement of the investment and costs expended together with a percentage of the balance of the amounts recovered (typically in the region of 30%). Another alternative is reimbursement calculated by reference to an agreed multiple of the capital the funder has invested (rather than committed). The level of multiple is to be negotiated, although increasingly funders offer a “sliding multiple” model, whereby a multiple increases as time passes, to reflect the time value of money.
While litigation funding may seem expensive, one has to bear in mind the wide array of risks the funder assumes, which mean that the returns from litigation funding investments must be comparably higher than other forms of high yield or private equity finance. The fact that the funding is non-recourse and the inherent unpredictability of legal disputes make litigation finance a high risk business. In relation to the latter, there are a number of litigation-specific risks, for example where the merits of a case worsen as evidence is uncovered, where the damages awarded are lower than estimated, and where the time to recovery is delayed by unforeseen events.
Conclusion
In summary, litigation funding can be an extremely helpful alternative source of financing for construction companies which either need financial assistance to pursue claims, or otherwise see the benefit both of offloading the downside risk of litigation and of using third party finance to fund outstanding claims, allowing them to use their own finance to invest in their core business. Given this, it is unsurprising that litigation funding plays an increasing role in the resolution of construction disputes. This is evidenced by the number of funders that are continuing to enter the market and provide innovative solutions to cost constrained companies. DLA Piper also launched an independent funding company (Aldersgate Funding Limited) to meet this need and offer clients access to GBP150 million for funding large-scale litigation and arbitration.
With that said, obtaining litigation funding for complex construction disputes (and particularly single cases) is, not a straightforward process. The funder has to have sufficient information to predict the outcome with a reasonable degree of certainty and to carry out a cost-benefit analysis, and this takes time and effort. It is key that claimants engage an experienced law firm which is able to navigate the funding process efficiently and negotiate the best terms for their clients. Often, experienced firms have strong relationships with funders, making every aspect of the process smoother.
