Beyond a Reasonable Return
By: Mark Goad & Adam Voorberg
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Alternative Litigation Financing
Litigation financing for those unable to fund their own proceedings has been an untapped opportunity for Ontario investors, until now. Alternative litigation finance (ALF) or ‘third-party’ finance refers to financiers unrelated to the legal dispute at hand contributing to the costs of litigation in exchange for a share of any potential proceeds. Additionally, ALF offers insurance against adverse cost awards, where the challenging party is forced to cover their counterparty’s legal costs. Stringent regulations in Ontario have historically prohibited third party investors from taking part in class action suits, while other jurisdictions have spawned a market for these investments. Firms allowed to participate, such as New York’s Burford Capital, achieved a 91% return on capital, making $32 million from a mere nine cases. In such a market, litigants and law firms have access to third party financiers to whom they can sell a portion of their suit, transferring returns to savvy investors willing to accept the risk. One’s capacity to afford litigation will never again impede access to justice. A capital market like this could soon be available for the 40 class action suits launched annually in Ontario, a market worth an estimated $325 million. Today, ALF is practiced in the US, Britain, and Australia and could soon be widely practiced across Canada.
The Canadian Landscape
Private litigation financing has been restricted in Canada since 1897 under laws prohibiting officious intermeddling, known as champerty. Policy makers feared that outside investors would have a material impact on the lawsuit proceedings they had invested in. But, after more than a century of stern enforcement, the Canadian judiciary has begun to lift restrictions in order to promote greater access to the justice system. The first notable step on the path towards ALF was the abolition of restrictions surrounding legal contingency fees, an arrangement where claimants pay their counsel a percentage of awarded damages and are not obligated to pay in the case of a loss. The majority of class actions, for example, are financed and insured using credit extended by the counsel in the form of a contingency arrangement.
The Class Proceedings Fund (CPF) was the first ALF fund in Canada, created to increase potential claimants’ access to justice. It operated as a government-run fund with a monopoly on the legal finance credit market for over twenty years. Created in 1992, the fund has provided financing to cover legal disbursements in exchange for a 10% commission from any recovery or settlement. The fund started with $500,000 of seed capital in 1992 and over the next 20 years earned $24.24 million on 30 successful lawsuits and a further $1.86 million from interest payments. Of the 30 successful suits, exactly half were consumer protection class actions, of which 11 cases involved consumer groups filing against corporations or banks for finance related crimes, including charging criminal rates of interest or not disclosing certain fees. Only 11 of the fund’s claimants have ever lost their proceedings in court; accordingly, the fund paid out $7.47 million in adverse awards to defendants. In aggregate, the fund’s balance is currently $7.82 million, representing a compounded fund growth rate of 14.74% per annum, exceeding the 6.7% growth of the S&P/TSX Composite index over the same period.
The future of ALF policy regulation has yet to be determined. The Canadian judiciary has allowed precedent to evolve over the past 20 years and is just now beginning dialogue on access to justice, ALF, and the adverse cost regime in Ontario. Recent reviews by the Law Foundation of Ontario and the Ontario Attorney General have affirmed the value of the CPF to enhance class litigants’ access to justice, however, only the legislature has the authority and power to guarantee the fund’s future. As long as financing mechanisms continue to promote public good as opposed to focusing on exploitive profits, the potential for ALF is promising. While the future is still uncertain, ALF through the CPF has performed well and provided Canadians access to the justice system when they would otherwise have been shut out because of cost. As judicial comfort grows with the concept of ALF, there is a significant opportunity for private funders to enter the market.
Investing in Justice
For investors, litigation financing is a unique investment alternative. ALF returns behave much the same as private equity investments, but with little correlation to the broader market and economy. Like private equity, the time horizon for realizing returns is relatively long; the average CPF case took 7.5 years to pay out. However, somewhat unlike private equity, there is a further downside, as investors can lose more than 100% of their original investment if they insure against adverse costs. ALF opportunities differ from private equity investments in that the information disclosed to investors is limited and investors are not allowed to influence any decisions made in relation to the proceedings of the case. That said, the performance of the CPF is very compelling and provides healthy compensation for these investment risks.
As a private ALF funder, a firm would not have to follow the same investment prospectus as the CPF and could be more selective, leaner, and ultimately more effective. With a different mandate than the CPF, private ALF funders would be able to service litigants who were previously unable to secure financing. Further, private ALF funders would provide an alternative, often at a lower required commission, as private ALFs have historically demanded 7-9% of awards versus the 10% CPF demands. With firms in the US making significant returns, and CPF in Canada demonstrating financial feasibility, Canadian investment funds should look to capitalize.
Class-ifying the Opportunity
For law firms, litigation financing represents access to capital funds that have traditionally been elusive in the legal sector. Law firms are privately held entities that are forbidden from raising capital from non-partners and thus have a decidedly finite pool of resources to extend by way of financing or indemnity, especially to class actions. Plaintiffs who cannot convince a firm to represent their claim because the firm cannot afford the litigation or is unwilling to accept the exorbitant risk of an adverse cost award may not be able to pursue legal action, even if they have a legitimate claim. With more legitimate claims than financing available to pursue them, class actions seem like the ideal target for ALF investors.
Members of the Canadian judiciary have reasoned that the lack of credit available to Canadian civil litigants, especially class actions, represents an unacceptable limit to their access to justice, and that third-party financing agreements are legal, notwithstanding legislation regarding champerty. This reasoning has been recognized in all successful ALF applications; see Dugal v. Manulife Financial; Fehr v. Sun Life; and Baynes et al. v. Kinross. Despite strong support from the Canadian judiciary, ALF agreements are still uncharted territory in the Canadian legal system. Focusing on class actions, where legal challenges to ALF are less likely to succeed, seems like the logical strategy from a legal perspective as well.
Partnering with Partners
Deregulation of the Canadian legal finance market has created a legitimate opportunity for investors to diversify their portfolios and share in the upside of civil litigation. Alternative or event-driven hedge funds have pre-existing mandates to diversify market risk through alternative investments. These funds are the best-positioned financiers to capitalize on this opportunity because they have the adjacent competencies in their resources, expertise, and organizational impetus. These alternative or event-driven funds should partner with small to medium size law firms who lack large capital reserves, especially those specializing in class action suits, in order to facilitate the arrangement of alternative financing agreements. These funds will likely need to hire key employees that have the legal experience to properly perform due diligence on cases; determining the appropriate amount of financing to extend and what percentage commission on the award the fund must demand to compensate for their risk.
Funds will need to ensure a supply of high-quality class action suits to invest in, thus an essential dimension of this strategy includes establishing long-term relationships with these law firms. The motivation for law firms to engage in this relationship is twofold: to expand their funding base and spread capital risks. As private entities, Canadian law firms are comparatively less liquid than ALF firms that have the ability to raise capital in financial markets. This is especially true for small- and mid-sized law firms who can be prohibited from taking a case because they simply do not have the money to finance the litigation. Incorporating third party financiers to raise this needed capital represents a solution to this lack of liquidity and will enable law firms to take on cases they would not have been able to under the previous financing regime. Further, even large law firms with more substantial capital reserves can benefit from incorporating a third party financier, thereby diffusing the inherent risk involved in litigation. This could be accomplished through joint financing agreements or by allowing financiers to cover the credit spread on class actions that are perceived to carry risk higher than what many law firms will accept.
The relationship between investor and counsel would be long-term in nature. Both parties must accept that the process of litigation is defined by substantial risk. There is a high degree of speculation surrounding whether a suit will be successful, how long it will take to reach a court decision, and even higher uncertainty regarding how much the final award will be worth. Furthermore, significant trust must be established as limited information is disclosed to ALFs and they must look to the firms they have partnered with to make key decisions.
The Future of ALF
The ALF investment opportunity was born from amendments to century old legislation aimed at empowering the average Canadian to pursue legal claims they once could not afford. Today, ALF is practiced in many large Western economies, and with sentiment changing in the Canadian judiciary system, it will be a significant opportunity for Canadian investors. For ordinary Canadians, ALF represents a tremendous solution to illiquidity for class litigants. For investors, ALF presents the opportunity to create long-term relationships with law firms and generate substantial returns for shareholders. While the dust has yet to settle over the policy debate, it is certain that ALF will continue to be a viable investment opportunity for years to come.
