Lesson 2: Law firms need experienced lawyers in litigation financing deals.
This is the second of four lessons on portfolio litigation finance transactions. The road to success can be long and narrow. Good lawyers on both sides can make all the difference.
Successfully closing a litigation finance transaction requires balance. In a transaction where a law firm pledges its case receivables as security, the deal must be fairly priced and negotiated for the law firm borrower, so that it provides the liquidity that enhances clients' chances of a win; and it must provide a satisfactory risk-adjusted return for the funder and its investors. Further, both lenders and borrowers have third-party stakeholders who are owed important ethical and fiduciary duties: clients who need competent representation and investors who rely on important funder representations about the risk parameters and mandates of the fund.
The key to ensuring the right balance is sophisticated counsel on both sides of the trade. However, in a vast majority of litigation finance trades, the law firm borrowers are not represented by counsel who understand the marketplace and structured finance. This needs to change.
Experienced borrower-side representation is as important to funders as it is to borrowers. When law firm borrowers use their local “go to” business lawyer, or someone who typically papers everyday secured commercial bank loans, or even worse, no lawyer at all, the funder’s counsel is often left educating their counterpart on important parts of the agreement and the mechanics of the financing. This is ethically treacherous, because it raises the specter of giving legal advice to someone who is not your client and wholly adverse; despite standard commercial provisions that asserting that both sides are sophisticated parties with equal opportunity to obtain counsel and negotiate. Even worse, a failure to actually encourage a borrower to have questions answered by their own counsel, and then later relying on the provision at issue in a default or workout, might lead to lender liability claims. Funders and their counsel should want the borrower to have great lawyers so that there is no risk a court will construe provisions against the lender or even render the contract altered or void. However, more importantly, funders should want an educated borrower to avoid the minefield of post-closing issues that often occur in portfolio-backed litigation finance credit facilities. Sophisticated borrower counsel protects the value of the deal overall and reduces the risk of adverse outcomes in any future dispute – for all parties and stakeholders.
Law firm borrowers can be their own worst enemy on this matter, trying to "get by" with minimal representation or a local attorney friend to reduce costs on what is, without a doubt, an expensive trade. Lenders charge their own costs, for diligence and deal documents, to the deal. This means law firm borrowers start the deal with one set of expensive lawyers being deducted from their initial proceeds. This can be jarring to borrowers, but is the norm in alternative asset financing across the globe. But it is exactly because the lender side has experienced finance counsel that law firms need to avoid the tendency to go without lawyers on their side. Even though many plaintiff law firms have never had to retain sophisticated transactional counsel with any regularity, this is the time to act like a business: search for qualified litigation finance lawyers, demand decent pricing (maybe even a flat fee), and monitor counsel to ensure you are receiving value.
Here are a few of the key financial deal terms that law firm borrowers need to understand, but are often caught off guard about as the deal progresses or comes under some stress.
Funder fees: Litigation funders regularly charge a fee, either at close, or upon each draw from a delayed-draw loan facility. These fees are often described as “origination fees” or “underwriting fees” and typically are charged on both the initial advance at closing and any subsequent draws. These fees can range from as little as .5% to as much as 5% of the total facility or each draw made by a borrower. While lender fees are the norm in structured finance, law firm borrowers should understand the financial impact of these fees on the overall financing and negotiate with the funder to a level of comfort, especially if they have already paid a due diligence deposit or are seeing large lawyer and diligence fees deducted from the first proceeds advanced.
PIK Interest: Payment in kind interest, commonly referred to as “PIK Interest” is commonplace in portfolio-backed law firm loans and credit facilities. The headline law firms pay attention to is that payment is only required when fee events occur, but interest on the outstanding balance of the firm’s obligation to the funder is accruing at all times. Transaction documents will typically require the borrower to make either quarterly or monthly payments equal to the accrued and unpaid interest for the specified time period. Practically, this means that if there has not been sufficient law firm revenue during the period to cover the accrued interest the borrower must either elect to pay that interest out of pocket, or more commonly make “payment in kind” to the funder, where the interest is added on top of the money already advanced to the law firm. Law firm borrowers must have a clear understanding of both the legal and financial impact of the compounding effect of PIK interest in litigation finance transactions.
Make-whole/Minimum Interest: Litigation funders almost always have a target rate of return on portfolio financing transactions. Funders will ensure this return by mandating they earn a minimum amount of interest on the amount of the facility, even when it is paid off early or refinanced by another funder. These are called “make-whole” or “minimum interest” provisions, and they can make early payoff or refinancing surprisingly expensive. For example, if a loan has a term of 5 years it may require a minimum of 30 months (2.5 years) of interest paid before termination or refinancing. If a law firm elects to pay off the funder at 18 months it will have to pay 12 full months of interest on the amount outstanding for the privilege to exit the transaction with that funder. While these provisions are common in other forms of commercial financing, law firm borrowers should be aware of their impact on the price of the transaction for early satisfaction and should be negotiated to balance fair burden for law firms with fair reward for funders.
These financial provisions, and at least a half dozen more, can set law firms back years in profit margin and creditworthiness if not clearly understood and negotiated. Law firms considering litigation funding transactions must be represented by counsel familiar with the nuances of these deal structures. And litigation funders should be equally adamant, for the health of their own investment return.