The Power of Litigation Funding: How Social Enterprises and Other Small Businesses Can Use it to Defend Their Legal Rights – And Access Capital
There used to be a David and Goliath problem when legal disputes arose between businesses, particularly in the international context where the option of going to local courts is not always available. Larger companies could freely violate the terms of their agreements with smaller enterprises, safe in the assumption that the smaller party could not effectively enforce their rights under an agreement. The smaller party would simply have to absorb those ever-changing terms in the hopes of retaining the ability to do business with the larger party.
Commercial litigation funding was created to address this issue, by providing resources for claimants who believe they were wronged in a business deal and otherwise might not be able to fund their legal claims. When a company doesn’t have the wherewithal to vigorously enforce their rights, litigation funding enables them to pursue their case using skilled international counsel, funded by external investors. In return, the funders receive a proportion of any eventual award.
Litigation funding is similar to a legal practice that’s common among personal injury attorneys in countries like the U.S., in which individuals who seek compensation after being injured can often find law firms that will take on their case without payment up front, on the condition that the law firm will retain a portion of the awarded damages at the end of the case. This is called a full contingency fee arrangement – where the law firm absorbs all costs until the judgement is paid by the defendant. But most law firms that are sophisticated enough to handle international disputes competently tend to avoid taking on commercial disputes on a full contingency basis, because the complex nature of these cases is often quite different from the generally straightforward fact pattern of personal injury cases. For this reason, the presence of a third-party investor who is willing to inject money into the case in return for a portion of the judgement can prove decisive.
This provides a tremendous tool that impact-focused enterprises and other small businesses can utilize if they believe they’ve been wronged by a commercial counterparty. In the past, large companies could rely on their relative size to bully smaller counterparties in a dispute, coercing them into accepting suboptimal outcomes due to a lack of resources. Commercial litigation funding has leveled the playing field—which is a key issue for social impact companies, since many of them are young organizations that have relatively modest funds available to pursue legal claims.
Below, I’ll discuss how litigation funding works, and how social enterprises and other small businesses working in international markets can leverage it to protect and advance their business interests.
Understanding Litigation Funding
Litigation funding developed during the 1990s in jurisdictions like the U.K. and Australia, once their legislatures chose to ease restrictions involving the centuries-old legal doctrines called maintenance and champerty. These restrictions effectively required parties that provided funding for legal action to actually have a connection to the dispute. These doctrines were originally intended to prevent aristocrats from financing commoners’ lawsuits against other aristocrats. Litigation funding was able to grow once these restrictions were eased.
Before litigation funding, smaller companies that had been mistreated by their larger counterparts generally had to settle for less than they were owed – or work with lawyers that lacked the sophistication or skill to properly enforce their rights. Litigation funding now allows these companies to work with highly-rated global advocates who focus on prosecuting international commercial claims.
For example, let’s say a small company in Ghana wishes to build a factory to produce recycled paper or plastic products. The company purchases equipment from abroad which doesn’t meet the contractual specifications, and as a result, it ultimately is unable to execute its business plan and fails. In the years prior to litigation funding, the company would be left with no resources to pursue a claim against the manufacturer that provided the faulty equipment, and would simply be forced to deal with the consequences of a failed business venture. But today, the company could hire an attorney who specializes in litigation funding to bring a claim against the equipment manufacturer for the damages caused by its failure to deliver proper equipment.
To take a somewhat less extreme example: Let’s say a small-scale manufacturer in Bangladesh receives an order from a customer in the developed world, then expends considerable amounts of time and money working to deliver on the contract. But the purchaser then unreasonably refuses to pay for the products (or only pays a portion of the agreed-upon price) and the business suffers a loss but remains operational. Again, litigation funding could enable this business to hire attorneys to bring a claim for the damages it suffered – provided the damages were sufficiently high.
As these examples illustrate, litigation funding can be applied both in situations where a contractual breach causes the total failure of the business – and in cases where it “only” causes significant damages. It can be extremely useful to businesses in a range of circumstances.
The Process of Obtaining Litigation Funding
The litigation funding process may seem familiar to most startups, as the process of firming up the case for this funding is similar to the process for developing a business plan. A business first assembles relevant pieces of data to demonstrate that the vehicle to be funded has commercial promise to the investor. In this initial phase, the claimants would approach a law firm like mine that focuses on handling these types of international commercial disputes. The lawyers would work with the claimants to confirm they have a case that could result in sufficient damages.
During this phase, the lawyers will want to review the relevant documents, including correspondence, contracts and meeting notes. They will also sit with the claimants’ witnesses to discuss the relevant facts. Once the lawyers have a firm grasp of the facts based on the witnesses’ memories and the hard evidence, they will go through a process of applying the facts of the case to the relevant legal regimes. They would then come to a view as to whether the claims have legal merit.
Assuming the claims do have legal merit, there are a few other points that the lawyers might want to consider at this initial stage, to ensure the matter would be attractive to potential funders. These issues include: the expected budget and timetable for bringing the claims; the likely damages which would be awarded; the ability of the defendant to pay the awarded damages; and the potential for the parties to reach a settlement (which can be an attractive outcome because it avoids the uncertainty of a hearing). Just like when making a business plan, an enterprise doesn’t simply need to demonstrate that its business idea has merit. It has to perform a risk assessment to take account of potential factors that could cause an otherwise good business idea to encounter difficulty.
To assist in this process, good lawyers will ask hard questions to the claimant early on, to properly test the case before introducing it to funders. It’s important for the lawyers to form a complete view of the case beforehand, because first impressions truly matter. A business needs to be sure that its lawyers are proposing a fully fleshed-out claim that it can stand behind. And importantly, lawyers often act as guardrails to ensure that litigation funders are not inundated with unmeritorious cases.
At the end of this initial assessment process, the lawyers will come to a view on whether a claim would be attractive to litigation funds. If they believe the claims have merit and would be attractive to funders, they will then begin the process of soliciting funding from litigation funds. Many lawyers have relationships with various litigation funds, which helps the process along – particularly since they understand the key issues that different funders prioritize.
When a funder decides that it is interested in potentially funding an attractive claim, it will offer the claimants a term sheet—similar to the term sheet phase during startup funding rounds. The term sheet will outline how much the funder is willing to invest, and the level of return it expects to receive if the claim is successful.
Litigation funding is generally a non-recourse loan, which means the funders only receive a return on their investment when the claimant recovers money from the defendant. This is why so much effort is invested in confirming the case is strong. When a business obtains a traditional loan to invest in a project, the lender is entitled to repayment regardless of whether the project is successful. A litigation funding arrangement is much closer to an equity investment by a venture capital investor, since payment to the funder is contingent on the success of the venture.
Once the term sheet is executed, there usually begins an exclusivity period lasting a few weeks, during which the funder looks deeply into the case. The funder has not yet made a definitive decision to fund at the term sheet phase – it only makes a firm decision after conducting its due diligence during the exclusivity period. During this due diligence phase, the fund might ask to review all relevant documents, speak with the witnesses and lawyers on the case, or solicit input from outside counsel on specialized areas of the law. At the end of the due diligence process, the litigation fund generally presents the matter to an investment committee within the fund that makes the final decision on whether to provide funding.
Throughout these processes, as with most transactions, the parties’ interests must continually be aligned so that everyone has a stake in a successful outcome. Oftentimes, the law firm is asked to take on the case on a partial contingency basis—in which case it would not recover all of its legal fees unless the claim is successful—putting the law firm in the same position as the funder and claimant. No single party should be overly favored, and it is the lawyers’ duty to ensure they are advocating in the best interest of their client.
Litigation Funding as a Tool for Social and Emerging Markets Enterprises
Litigation funding can ensure that enterprises in emerging markets have legal recourse when business relationships go wrong – while also providing a new source of funding for these companies. But if those enterprises have a social impact focus, they must take a unique set of concerns and goals into account during any commercial dispute, given their multiple-bottom-line approach.
For this reason, it is crucial for these enterprises to clarify their goals and priorities with the funder at the outset. Litigation funds generally operate from the principle of maximizing financial returns, without regard for other bottom-lines. This is why it is helpful to have legal counsel that is familiar with these multiple-bottom-line concerns, and that can highlight any potential issues for the parties early on so that they can be adequately addressed.
There are some litigation funds that have a focus on providing funding for impact litigation or other purpose-driven ventures. This is a niche in the litigation funding market, in which certain funders are actively trying to provide funding for cases that generate social impact as well as financial returns for investors. For example, these funds might support a group of garment workers in filing a wage-theft suit against a multinational employer, where a successful outcome would likely result in financial returns for the investor (through the damages recovered by the claimants) and may also generate social impact by cautioning other multinationals against similar misconduct.
But whether they’re traditional or impact-focused, small businesses in both developed and emerging markets should be aware of these options for litigation funding, since even the most promising of business relationships can eventually end in conflict.
Disclaimer: The information in this article is provided for informational purposes only. You should consult with an attorney before you rely on this information. This information should not be seen as legal advice and does not create an attorney-client relationship. This article is meant to be a general discussion and may not include all relevant information regarding the issues covered.
Photo courtesy of Jesse Loughborough.