THIRD-PARTY FUNDING FOR CONSTRUCTION LITIGATION DISPUTES
A common construction dispute that we see typically involves an employer failing to pay a contractor for agreed and additional services rendered, leaving the contractor’s balance sheet in a cash negative position. If the contractor considers that they have a good position on entitlement, and assuming all other forms of dispute resolution have failed, then the option to commence litigation or commercial arbitration seems the next step. This, unfortunately, is the usual remedy for reversing the adverse financial position in which the contractor finds themselves. Even if the eventual intention of commencing legal proceedings is to settle before the matter reaches court or a hearing, the costs involved in recouping these monies through litigation or commercial arbitration, can quickly add up.
The readiness to ‘push the button’ on formal legal proceedings however can depend on many factors, a primary one being affordability and whether the contractor can actually operate in a cash negative position for sufficient time, to see out lengthy legal proceedings to final determination and enforcement. There are of course a range of contracting entities and company structures in existence, namely those that can self-fund litigation disputes, due to having adequate cash reserves and those that cannot. The latter could consist of small firms or large firms as part of a joint venture, combined under a special purpose vehicle, neither of which would have been specifically designed or structured to finance litigation, thus, alternative methods of funding a large litigation dispute are sought.
There are a number of financing options such firms may have available to them. Aside from conventional loans, a firm may take out an insurance policy with combined litigation coverage or may even convince a parent company to loan the necessary money. If none of these options are suitable or available to them, then there is also the option of seeking litigation funding from a Third-Party Funder (“TPF”).
THE THIRD-PARTY FUNDER’S APPROACH TO RETURN ON INVESTMENT
In the last couple of decades and in particular, the last few years, there has been a significant rise in the number of firms whose primary purpose it is to provide partial or full funding to support litigation or commercial arbitration disputes. Simply put, in situations where a party (i.e. the claimant) does not have the money to pay for a litigation dispute, a TPF can step in and lend a claimant the money. However, litigation funds are given on a strict basis, one of the most notable conditions being that the TPF will expect a substantial Return On (their) Investment (“ROI”). The percentages of ROI are perceived by some to be remarkably high, but these high returns can be explained on the premise that TPFs essentially work on a risk portfolio model basis, governed by the law of averages. That is to say, in order to ensure an adequate ROI, a TPF will invest selectively in large claims that meet expected threshold criteria, in terms of probability of success and forecasted wins. Just like a commercial bank loans money to a sufficient number of customers to prop up the risk model ensuring adequate coverage against defaulters (applying the law of large numbers), a TPF must also ensure that their recovery from the successful cases, more than covers their costs and any ultimately lost cases, whilst still providing a ROI (i.e. portfolio model). This must be their modus operandi as a TPF has no other vested interest, other than to seek a sizeable ROI by winning litigation disputes.
EVOLUTION OF THE THIRD PARTY FUNDER
The evolution of the TPF, can be divided broadly into four periods of time, namely:
Pre – 2005
Where there were less than 10 TPFs world-wide with an available investment of less than US $30 million. TPFs funded disputes on an ad hoc basis and followed an opportunistic business model. As a result, ROI terms were set at more than 50%.
2005 – 2010
There were less than 30 TPFs world-wide with an available investment of less than US $100 million. TPFs funded on an industry standardisation basis and followed an industry business model. ROI terms were set at 30%.
2010 – 2017
There were less than 40 TPFs world-wide with an available investment of less than US $1 billion. TPFs funded on a risk pricing basis and followed a profession business model. ROI terms were set at 30%-70%.
2017 – Onwards
There were more than 60 TPFs world-wide with an available investment of less than US $10 billion. TPFs funded on a merits-driven basis and followed a specialist business model. ROI terms were set at one to two times the funding amount given, plus a percentage of the damages awarded.
Over the last five years, there has been a paradigm shift from a risk pricing model to a merits driven approach when deciding what to include in a TPF portfolio. Assessing litigation disputes on their merits, meaning their combined strengths and weaknesses, is now proving to be a far better predictor of outcome and one which is more closely aligned with reality. This differs from previous approaches, as it no longer solely relies on statistically assessing the value of risks based on a myriad of common assumptions and factors which in reality, vary between disputes. Even so, portfolio modelling remains important, as it informs not only the terms of a litigation funding agreement between the TPF and the claimant, but equally, it defines a threshold of probability for the ultimate ‘to fund or not to fund’ decision. TPFs have historically needed to set the ROI at a high level, as they have been willing to take on significant risks when it comes to predicting the outcome of a litigation dispute. In contrast, with risk pricing modelling however, which deals in averages, there would always be the possibility that some cases would not fit into this model. With a merits based approach, this issue is circumvented.
OVER THE LAST FIVE YEARS, THERE HAS BEEN A PARADIGM SHIFT FROM A RISK PRICING MODEL TO A MERITS DRIVEN APPROACH WHEN DECIDING WHAT TO INCLUDE IN A TPF PORTFOLIO
INFLUENCING THE RETURN ON INVESTMENT MODEL
Before a TPF will consider whether to invest in a potential litigation dispute, they will want a basic understanding of the parties, the relevant facts of the case, the legal expertise involved, the amount being claimed and the basis of the claim.
When statistically modelled, all possible recovery outcomes of a litigation dispute may be represented graphically. For simplicity, the bell-curve distribution model can be used. The shape of the probability bell curve would be vitally important, as it would inform how probable it would be to achieve a recovery for the TPF, above a defined threshold consisting of funding costs, portfolio losses and required returns.
In the past, a risk pricing model would have captured basic data in advance of the litigation dispute and churned out a probability curve based on systematic and unsystematic risk. This would feed into threshold decisions for the TPF and inform them whether to provide funding or not. Now a merits-based approach requires further analysis of the merits of the case on technical and legal issues. It makes sense, therefore, for technical issues to be examined by relevant subject matter experts, who undertake this type of work regularly, as testifying experts and whom are far better placed to examine the evidence before them. Along with lawyers examining the legal aspects of the potential litigation dispute, this methodology can assist in achieving a better understanding of the bell curve and may, therefore also assist in making better litigation dispute funding decisions.
The competition for ‘winning’ litigation disputes, that is litigation disputes that go in the TPF’s/claimant’s favour, is fierce. This means that marginally positive cases will need to be given more serious consideration at the initial funnelling stages, but equally the marginal losing cases will need to be sifted out. In order to do this, TPFs need to better understand the merits of a dispute and utilising experts that can aptly deal with the technical points – and this is where Aquila Forensics can assist.
TPF’S FIVE STAGE SIFT
In order to better understand how an upfront analysis can help a TPF (or a claimant seeking a TPF), one needs to understand a little more about the sifting out process. There are five stages that feed into this. They are:
1 – All Initial Opportunities Considered – At this point, 100% of the potential litigation disputes will be discussed and considered with the claimant and/or their legal counsel on a non-confidential basis. Over 70% of potential cases will however drop off after this point. The purpose of these initial meetings will be to determine if the case aligns with the TPF’s funding model. The TPF’s focus will be on the expected funding budget and potential amount of money they would be able to recover.
2 – More Detailed Discussions – Only 30% of opportunities make it through to this stage where more of the case facts and merits can be discussed in further detail. At this point, a two-way NDA will be required to be put in place. There is a 55% drop out rate at this stage, as various cases will be deemed not to have merit for proceeding further.
3 – Preliminary Due Diligence – After the TPF has conducted an initial valuation to see if a funding proposal is viable, their findings will feed into an offer for commercial terms once the NDA has been fully executed by both parties. Only 13.5% of opportunities sift down to this stage with a 40% drop out rate thereafter.
4 – Agreeing Terms – The TPF and claimant should come to some form of commercial agreement on the terms for the litigation funding agreement in a term sheet. This will come with an exclusivity period whereby the TPF will be able to review the case in more detail so that parties can ensure they are on the same page in respect of commercial terms. Only 8 % of opportunities sift down to this stage with a 35% drop out rate.
5 – Comprehensive Due Diligence – At this stage, fuller due diligence is carried out by the TPF, after which a litigation funding agreement should be signed by both the TPF and claimant. 5% of opportunities are taken on at this stage with a 30% drop out rate. Overall only 3.5% of all opportunities that are presented to a TPF are actually funded. From those, even less may be awarded the requisite significant damages.
The problem in not using experts to assist with a merits-based approach when funnelling, is that with more and more TPFs coming into the market, extra effort needs to be taken to avoid discounting ‘good’ (winning) cases. TPFs and claimants alike, would also benefit from being informed of possibly hidden (less obvious) counterclaims. If such elements are left to chance, they have the possibility of impinging on overall TPF recovery.
HOW AQUILA FORENSICS CAN HELP YOU
The type and nature of upfront analysis that Aquila Forensics can provide to a TPF or claimant is not too dissimilar to early expert involvement in a litigation or arbitration dispute. Nor is it particularly different to the services Aquila Forensics can provide to an insurer that seeks portfolio project audits and project performance reviews. Aquila Forensics also see alignments between TPFs (like insurance providers), that require a bespoke independent service, which can be rolled out across the portfolio, systematically or that can provide early expert involvement, whilst maintaining independence. The specific services that we can provide bring together our broad, yet detailed, expertise but equally demonstrate our flexibility in dealing with different and changing circumstances. Aquila Forensics can work directly with the TPF or the claimant to help pull together the information required, particularly in respect of preliminary and comprehensive due diligence. We can also assist claimants in achieving improved terms within the litigation funding agreement, once the risks have been clearly outlined.
For more information on upfront analysis for litigation funding by TPFs, please contact Mark Mills at mark.mills@aquilaforensics.com.
