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How to maintain budget certainty and manage risk when engaging external counsel

In a guest column for GC magazine, James Delaney, director at specialist litigation finance and insurance broker The Judge, discusses strategies for optimising risk and reward when faced with pending litigation.

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It is a familiar tension when engaging external counsel to pursue a legal claim: in-house counsel desire budget certainty and the ability to control expenditure, but that can’t come at the expense of quality. While cost control is key, in-house counsel will still expect their case to be handled by the best team. Cutting the budget too far, only to be left with less experienced lawyers managing the case, is rarely a palatable compromise.

Large enterprises with strong balance sheets will always be attractive clients to law firms. However, a multibillion-dollar balance sheet rarely translates into a limitless war chest to pursue legal disputes. Some lawyers can, nevertheless, be accused of failing to look beyond the client’s balance sheet to the general counsel’s position on a human level – having justified to their financial controllers that a claim should be pursued, a GC will be under pressure to deliver a well-managed and cost-effective project.

In the early days of the third-party litigation funding market, many lawyers in top-tier law firms would take the approach of ‘our clients have very deep pockets and so cost is not an issue for them’. Few would endorse such a statement today. Any law firms that thought the move away from open-ended billable hour retainers in favour of capped fees and other alternative remuneration options was a short-term blip have had their eyes opened. Instead, it is clear that the demand for such alternatives is increasing. Creative and risk-bearing retainers now form part of the standard menu for even the largest and most conservative law firms – and competition is fierce.

Of course, ‘humanising’ the in-house/external relationship works both ways. Just like the general counsel, a partner in a large international law firm will be under internal pressure to meet billing and realisation targets, limited by the constraints of the firm and by their own need for self-preservation.

Delivering true budget certainty is difficult and advisers will argue that litigation is unpredictable. It’s impossible to know how an opponent will fight a case or what issues may arise along the way. While requesting discounts or fee caps might seem like a soft negotiation item for those in-house, it can belie the significant pressure that fee-earners face. Any discount immediately impacts on that lawyer’s realisation rate. Furthermore, in the event of an unsatisfactory outcome, there can be fee write-downs, leading to a second hit on the final realisation.

It is known that some large law firms will offer fee deals that mean the case is being run at a loss. While this might be a reflection of an increasingly competitive environment, it cannot be in the long-term interest of the firm or the client.

But the divergence of interests between internal and external counsel need not be insurmountable. Options exist which can significantly reduce the shared pressures. A market of financial services to manage litigation risk has emerged and developed with immense speed since the mid-2000s but, until recently, blue chip companies have not been as active in utilising the benefits as claimants in more financially distressed situations. This is partly due to a lack of awareness. Many general counsel rely on their external lawyers to keep them abreast of what options are available, but they’re often not fully versed in the different directions that financing can take.

Applying third-party finance – a reality-check

The litigation finance market is one option available to help manage risk. A third-party investor finances the legal fees in exchange for a share of the claim proceeds. The financing is provided on a non-recourse basis, with the funder’s return secured only against the claim. For illiquid clients, this can be a lifeline and, often, the only way of obtaining justice.

Third-party funding has become prominent in many jurisdictions and the industry has been successful in raising the profile of this ‘off-balance-sheet’ financing solution. The marketing focus of the major litigation funds today is centred around the blue-chip market, seeking to recategorise third-party funding as mainstream corporate finance, moving away from the market’s origins in financial distress.

Third-party funding may indeed be an interesting way for corporate entities to hedge risk without compromising on legal team quality, and there are several high-profile examples of this trend. However, many businesses with good liquidity and strong balance sheets may not be comfortable with the returns required by the litigation finance market. As one lawyer recently remarked, there could be moral drivers too. He represented various blue-chip clients seeking a recovery for their investor base following a misrepresentation by a major bank in their prospectus. Giving a significant share of any proceeds to external financiers would not feel like a victory for their investors, whom they would hope to retain as clients.

Some general counsel will also be reluctant to engage with external third-party financiers due to concerns over control. Although third-party funders generally do not (and in most common law jurisdictions cannot) take control of the case and the client’s decision-making, they will still expect some level of input and reporting. It might feel too alien to a major corporate to allow any external party a seat at the table, especially where non-monetary factors, such as reputation management, may feed into the client’s strategic decision-making.

A more traditional solution to manage risk and address mutual tensions

For many of our own blue-chip clients, risk management is the key driver as opposed to the need for cash flow financing. A more appropriate solution is often litigation insurance. This provides an effective alternative to third-party funding, but is less well-known and is often overlooked entirely, even by law firms experienced in the use of litigation finance.

Litigation insurance sits behind a traditional billing arrangement. The insurer provides an indemnity to the claimant for the fees and expenses paid to the external legal team. If the case is lost or a judgment cannot be enforced, the insurer reimburses the company for the agreed level of fees insured. The premium is often contingent upon success, which means that if the case loses, the insured pays no premium and the insurer pays a claim.

Litigation insurance differs from third-party funding in a number of important respects:

Firstly, the premium charged by the insurer in the event of success is a fraction of the cost of a third-party funding success fee (reflecting the fact that the insurer does not pay cash out during the life of the claim). The premium is linked to the amount of cover provided by the policy and not to the claim value, meaning that there is a fixed, quantifiable cost of insurance in the event of success, as opposed to a large percentage of damages. This enables insurance to be used in cases where the economics would be unworkable for third-party funding.

Conceptually, insurance may sit more comfortably within the financial culture of the business. The carriers are typically large international A and AA rated insurance companies, from whom the client may already buy general liability insurance. Insurance is also typically more passive than third-party funding in terms of the level of input and reporting required by insurers.

From the perspective of external counsel, tabling insurance as an option when budgeting the case or when pitching for business can be highly beneficial. While third-party funding is generally well-known, many general counsel are still unfamiliar with the existence of insurance or how it can be used. Providing some indicative insurance options upfront can materially soften the impact of the litigation budget, without the need for the law firm to cut its rates too leanly and compromise on quality. Similarly, where litigation or fee fatigue sets in midway through a case, insurance can potentially be put in place to mitigate cost risk going forward, or retroactively insure expenditure to date.

In the long term, whether the billable hour has a limited shelf life compared to more value-driven models remains to be seen. However, the competing tensions that arise from such a model can at least be mitigated in today’s market, provided both parties communicate openly about the pressures they each face. Litigation insurance or litigation finance might not be suitable for all cases, but they do offer useful alternatives to help in-house and external counsel agree upon a mutually beneficial and sustainable fee structure.

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