Law Firm Financing on the Stand: Controversial Financing Enables Firms to Withstand Long-Term Litigation
Litigation involving hundreds or thousands of clients can take years to resolve, putting a financial strain on law firms working on a contingency basis. While banks are willing to provide loans based on a firm’s hard assets, law firm finance companies are willing to lend based on anticipated fees, account receivables and other assets. Attorney Kelly Anthony explains this new type of specialty lending and defends it against industry detractors.
In 2006, an established legal practice based in Georgia started to retain clients who suffered serious injuries from surgical mesh devices, commonly
referred to as transvaginal mesh. What began as a small number of cases against a single manufacturer exploded into litigation involving thousands of cases against multiple big-name pharmaceutical companies, including Johnson & Johnson, Endo International and Bard. The surge in clients resulted in millions of dollars in expenditures for the law firm, which had to more than double its staff, pay sizeable court filing fees and incur
additional expenses associated with prosecuting and processing thousands of claims. However, thanks to a loan from a company specializing in law firm financing, the firm was able to successfully maintain its leadership role in the litigation and to negotiate hundreds of millions of dollars in settlements on behalf of its clients.
The story of that Georgia firm is not uncommon. Plaintiffs’ attorneys who serve as counsel in personal injury cases and class action litigations typically have contingency fee arrangements with their clients — only receiving payment for their services and case-related costs if they win the lawsuit. So as these lawyers pursue long-term financial viability by acquiring more clients, in the short-run, their firms can suffer severe economic strains. Law firm finance loans are designed to ease that strain.
Contingent Fees as Assets
In November 2000, a group of attorneys with more than 50 years of collective litigation experience created a specialty finance company, Counsel Financial, to solve the cash flow gaps inherent to a contingent-fee practice. Since the founders were attorneys, they recognized that while traditional lending institutions, like banks, extended loans to law firms, the principal amounts of the loans were almost always limited to the hard assets of the firm or its partners — leaving owners of plaintiffs’ firms without an adequate source of capital.
Unlike a bank, law firm financing companies can provide attorneys with larger lines of credit because they are willing to include the potential value of a contingency fee award as part of the risk versus reward evaluation. These firms employ experienced attorneys to review each borrower’s future earnings potential based on anticipated fees. At the review, the lender’s counsel meets with the principal partners at the borrower law firm to discuss pending and settled cases. Then the attorney from the law firm financing company works with the attorneys from the applicant firm to estimate the value of the firm’s total unrealized case revenues. Based on the assessment, the company will grant the law firm a line of credit that is collateralized by these anticipated fees.
Loans granted by law firm lenders are generally secured by personal guaranties as well as a perfected security interest in substantially all of the assets of the law firm, including its accounts receivable, furniture, fixtures and current and future legal fees. The terms of the loan also are typically flexible to account for the unpredictable, and oftentimes longer than anticipated, time it takes for attorneys to resolve civil lawsuits.
Law Firm Financing vs. Litigation Financing
Not all companies that provide funding related to lawsuits are the same. In fact, the term “third-party litigation financing” encompasses many different types of business models. The three most common are: complex commercial litigation funding, consumer litigation funding and, the subject of this article, law firm financing.
Complex commercial litigation funding usually involves a business entity that invests in a claim as a plaintiff or defendant. The funder, generally a hedge fund or private investor, buys a portion of a business’ future monetary interest in a lawsuit settlement or award at a discount, and then receives an often-significant premium if the case is resolved in favor of the business. Complex commercial litigation transactions are mostly non-recourse — meaning that the recipient of the financing does not have to pay back the funder if the case is lost.
Consumer litigation funding is also mainly provided on a non-recourse basis, but to individuals. In a standard financing arrangement, a plaintiff or plaintiffs’ attorney receives a lump sum payment from a funder while a case is ongoing or while they await payment from a settled case. In return, the funder takes a lien on the plaintiff’s proceeds from the case and, if the lawsuit is won, is repaid the amount that it advanced to the individual, plus a fee.
Conversely, law firm lending is a recourse transaction much like a traditional bank loan. The law firm has an absolute obligation to repay the lender the principal amount plus all interest and fees. Upon an event of default, the lender can collect from the firm and all of its assets, as opposed to limiting the recovery to the proceeds of one particular case.
Whether it is news about U.S. tort reform or a billionaire’s bankrolling of Hulk Hogan’s $140 million judgment against Gawker, third-party litigation financing has recently drawn some negative attention from the press and scholars. Opponents of the industry, like the U.S. Chamber of Commerce’s Institute for Legal Reform, frequently argue that it poses “a major threat to the integrity of the legal system” — exploiting justice for profit, drumming up frivolous lawsuits and creating conflicts of interest.
However, this argument fails to hold up when you consider the funding provided by litigation financing companies is based on cases being successfully resolved, since that is the principal source of repayment. If a loan or advance is made toward a meritless lawsuit, then the company will not recoup a return on their investment.
Similarly, if a conflict of interest arises between an attorney and his or her client as a result of a funding relationship, then the funder would be adversely affected. Lawyers are subject to rules of professional conduct, which prohibit third parties from interfering with a lawyer’s professional judgment in the rendering of legal services to a client. Litigation financing companies are careful to preserve the attorney-client relationship because, if it is breached, the attorney will be subject to discipline, and repayment of the money advanced would be exponentially more difficult or impossible.
The last criticism — that litigation financers exploit justice for profit — is primarily aimed at commercial and consumer litigation funders.
Unlike law firm lenders, they are able to charge high interest rates and fees because their transactions are non-recourse. The usury laws of most states, which govern the rates a lender can charge, typically do not apply if there is not an absolute obligation to repay the amount advanced. Since the litigant in a non-recourse transaction does not have to pay anything if the case is lost, the funder can ask for rates and fees that are above state usury limits. Nevertheless, the reason a vast majority of these non-recourse funders require significant rates of return under their contracts is because of the high risk associated with investing in a single case without a remedy if the lawsuit resolves unfavorably — a risk that law firm financing companies avoid by lending against all of a borrower’s assets. Further, because the law firm is obligated to repay a law firm lender from any source, the rates are generally subject to state usury limits, and thus, it is even less likely that law firm financing companies are exploiting their borrowers as the U.S. Chamber of Commerce suggests.
In June, Volkswagen established a $10 billion fund to resolve the individual claims of current and former owners and lessees of its vehicles arising from the highly publicized emissions scandal. In July, a jury awarded a $70 million verdict to a male teenager who developed female breasts after taking the antipsychotic drug Risperdal, manufactured by a subsidiary of Johnson & Johnson. In August, Pfizer reached a $486 million settlement in a securities class-action lawsuit where shareholders alleged they sustained large losses because the company concealed safety risks associated with its Celebrex and Bextra pain-relieving drugs.
In the past five years, the need for law firm financing has risen because of the monumental expenses a plaintiffs’ firm must advance in a lawsuit to achieve multi-million and billion dollar settlements like those cited above. In the past, most firms self-funded, but that is no longer a feasible option for attorneys who represent hundreds or thousands of plaintiffs in a single litigation that could take years to resolve.
Plantiff firms need working capital for case-related costs and other operating expenses. Because much of their potential earnings are tied to fees that are contingent upon the outcome of the case, firms are often unable to access the capital they need without the help of a law firm financing company. This is the reason this segment of specialty lending was created. As cases arising from injuries related to medical devices, pharmaceutical drugs, environmental disasters, consumer products and securities fraud continue to be pervasive, so, too, will the need for law firm lending.