Third party funding: why Chinese parties should take notice and take advantage?

The Mandarin version of this article is available here.

Over the last decade, the third party funding industry has grown beyond all recognition: where funding was initially deployed in a handful of common law jurisdictions, it has now spread and taken root in new global markets, including Hong Kong and Singapore. A 2018 report from the International Council for Commercial Arbitration (ICCA) indicates that assets available for third party funding may be in excess of USD10 billion and this number is still “rapidly growing”.

As a result of its engagement in global infrastructure projects such as the Belt and Road Initiative, China is beginning to see a major uptick in international disputes across a wide range of sectors. Whilst Chinese litigants are no stranger to risk sharing in the form of contingency fee arrangements in domestic proceedings, the complexity of and large sums involved in cross-border proceedings call for more tailored and sophisticated models of financing. In this article we look at why Chinese parties should actively explore and take advantage of third party funding, as they play an increasingly prominent role in international arbitration.

The basics of third party funding

In essence, third party funding involves an entity (i.e. the funder), which has no prior interest in the underlying legal dispute, providing funds to a party to the dispute (typically the claimant), in exchange for an agreed return payable out of the proceeds of a successful recovery.

Third party funding will generally cover all or at least some of the claimant's own legal costs which include, for example, fees of the arbitrators and the arbitral institution, experts' fees, and so on. In addition, a funder may agree to pay certain other costs associated with pursuing the claim, such as putting up security for costs if the claimant is required to do so, and/or covering the costs of the opponent in defending the claim should the claimant's claim fail. The latter is typically referred to as adverse costs liability and it is generally covered by an insurance policy (known as after-the-event (ATE) insurance) that is often paid for as part of the funding package.

Under most third party funding agreements funds are provided on a “non-recourse” basis, which means that, in the event that the claim does not succeed, the funded party will owe nothing to the funder.

Whilst circumstances and funding needs vary significantly from case to case, in deciding whether to invest in a claim, funders place particular emphasis on a number of factors including: (i) the prospects of recovery (i.e. the creditworthiness of the defendant and the ease of enforcement); (ii) the merits of the claim (prospects of success should typically be 60% or higher); and (iii) a healthy margin between the realistic claim value and the anticipated costs of the arbitration/litigation proceedings (a ratio of 10:1 is a good benchmark). Other factors such as the likely duration of the proceedings, prospects of settlement, the calibre of the legal teams representing the claimant and the availability of insurance to cover the claim will also be taken into consideration.

As a result of the substantial capital committed and high risks involved, parties providing “non-recourse” funding will generally expect to make a significant return, typically as a multiple of the invested capital or a percentage of the sums recovered (either by way of damages or as part of a negotiated settlement), or a combination of the two. It is also common for the funding agreement to link the funder’s return to the duration of the case and/or to the amount of capital that has been drawn down, which means that the funder’s return will be lower if the case settles early but will rise as proceedings progress further.

Why third party funding?

Single case funding

Self-funding an international arbitration matter requires a significant deployment of capital well before any damages are recovered and can be put back into the business. In practical terms, depending on the nature and size of the dispute and length of the proceedings, the total capital outlay throughout the lifetime of an arbitration (and, if needed, any ensuing enforcement actions) can range from several hundred thousand to millions of pounds.

As a result of these very substantial costs, third party funding was historically used as a way of providing financially distressed claimants with access to justice. Whether it is a business already experiencing cash flow difficulties, an insolvent company or an investor which has had its investments expropriated by a foreign state, third party funding provides one (and sometimes the only) viable means of getting a meritorious claim off the ground.

Today, however, third party funding is increasingly being used by large, well-capitalised businesses as a tool to manage cash flow and legal budgets and to control litigation risks. Wary of tying up working capital in fighting costly, lengthy legal battles, company boards naturally prefer to prioritise core activities with a view to growing the business further. Self-funding a legal case is also unattractive from an accounting perspective, since the legal costs have an immediate, negative impact on the company's balance sheet, while potential earnings in the event of success may be booked years later.

Third party funding has the obvious advantage of removing the cost of pursuing a claim from the claimant's balance sheet. Indeed, with a combination of “non-resource” dispute funding and appropriate ATE insurance, pursuing legal proceedings could be effectively “de-risked” for the claimant which would face no financial downside in bringing a case (or losing it), but still stand to benefit significantly from winning (or settling) its claim, albeit with the funder sharing some of the proceeds recovered. As such, third party funding offers corporate claimants the ability to monetise their contingent claims, without negatively impacting their cash flows or balance sheets.

Aside from financial considerations, third party funding also provides a strategic advantage in dispute resolution. The fact that a sophisticated dispute funder is prepared to commit potentially large sums of money to support a legal claim sends out a powerful message to the defendant in relation to the merits of the claim and fact that the claimant will have the means to pursue the claim to judgment/award and through to enforcement, if necessary.

Portfolio funding

Increased competition in the third party funding market in recent years has driven more attractive pricing and an increased level of innovation. One area of innovation which is gaining prominence among corporates is portfolio funding. Unlike the traditional single case financing model, a portfolio funding arrangement is structured around a basket of disputes over a period of time, often with some form of cross-collateralisation, whereby the funder's return is linked to the overall net financial performance of the portfolio of cases as a whole, as opposed to the outcome of each individual claim.

Since the funder's risk is spread across multiple claims, the cost of funding is reduced, and the funded party is typically provided with access to capital more quickly and flexibly than would be the case in a single case funding scenario. In addition, portfolio funding makes it possible to secure funding for cases that could not ordinarily be funded on an individual basis (e.g. small value disputes, defence of cases without a counterclaim, and claims seeking non-monetary relief).

This is particularly significant because portfolio funding enables a corporate to monetise all of its legal disputes (and to secure funding to defend claims), which has the potential to turn in-house teams into profit centres. In view of these significant advantages, Chinese companies involved in cross-border disputes may wish actively to explore and consider portfolio funding, as a number of multinational businesses in the UK and US already have.

Third party funding and COVID-19

The COVID-19 pandemic and the more recent conflict in Ukraine have caused unprecedented levels of disruption to the global economy. For many businesses, the focus throughout this period has been on navigating and surviving huge operational challenges and they have, on the whole, not yet turned their attention to evaluating and pursuing potential legal claims. According to a survey published by EY in April 2021, a third of the companies (32%) and lawyers (34%) surveyed by EY said that they had deferred or stopped investigations of claims that they would ordinarily have pursued, with almost a quarter (24%) citing lack of funds as the reason for such deferrals.

The EY survey also notes a significant increase in demand for third party funding, with the total number of businesses said to be interested in using external funding more than doubling from pre-pandemic levels – 55% of the survey respondents said that they would be willing to use third party funding now or in future, compared to just 26% stating the same before the pandemic.

These results are telling, particularly bearing in mind that the respondents to the EY survey were all large, UK-based companies which would historically have been willing to self-fund claims without much need/appetite for external financing. The fact that many of them now appear keen to use funding illustrates an important shift in the perception of third party funding as a valuable tool for helping businesses protect shareholder value and unlock potential recoveries.

DLA Piper and Aldersgate Funding Limited

DLA Piper has recently established its own independent dispute funding vehicle, Aldersgate Funding Limited (AFL), which is backed by Litigation Capital Management (LCM), a long-established listed funder. AFL offers clients of DLA Piper access to up to GBP150 million of capital for funding litigation or arbitration claims. AFL utilises a portfolio approach which enables it to offer highly competitive pricing to DLA Piper’s clients.

If you would like to discuss this further or have any questions about what we can offer, please do not hesitate to contact us.