The third degree

In the House of Lords recently, a Liberal Democrat peer pointed out that third-party funding used to be ‘both a crime and a civil tort’. But unusually for a practice that was previously considered illegal, third-party funding is now basking in the warm glow of judicial approval; and while the sun is shining, it is making all the hay it can.

Funders have used their new voluntary code of conduct like a stiff brush to sweep away any prospect of statutory regulation (for a few years, at least). There have been a gaggle of new entrants into the UK funding market; the latest being the world’s largest funder Burford, which has poured an extra £100m or so into the glistening pool of available capital. And next April’s Jackson reforms are expected to provide fertile ground in which funders will enjoy greater yields than ever.

So why is third-party funding so controversial? TPF is essentially the investment in litigation by funders who have no interest in the case, other than to make a profit on their investment. As Liberal Democrat peer Lord Thomas of Gresford pointed out in a February House of Lords debate (in which he was attempting to introduce statutory regulation into the sector through an amendment to the Legal Aid, Sentencing and Punishment of Offenders bill), this used to be considered ‘maintenance and champerty’, which was a crime until 1967. But while champerty still exists as a tort, a 2005 Court of Appeal decision in Arkin brought the sector into the mainstream by establishing that properly structured TPF does not infringe the rules.

Thomas and the three Liberal Democrat peers who backed his LASPO amendment are not alone in their criticism; the US Chamber of Commerce, the world’s largest lobbying organisation, is also a fierce opponent of TPF, claiming that it fans the flames of ‘spurious’ litigation. Funders retort that if the US has a problem with excessive litigation, that is more down to its lack of an adverse costs rule than anything else. On this side of the Atlantic, funders have no interest in bringing cases that they do not think they will win, as they will be hit with the bill for the other side’s costs if they lose.

Thomas’s call for government supervision of the sector largely relates to the potential expansion of TPF into the non-commercial arena, and in particular to divorce cases and personal injury. Clearly the argument for statutory regulation of funders is stronger where the litigant receiving their cash is an individual rather than a corporate entity. Divorce litigation is a small but growing area for TPF, with funders filling a gap left by private banks which have cooled off lending to claimants in high-end divorce disputes. However, as Leslie Perrin, chair of the new Association of Litigation Funders, points out, most funders prefer to steer clear of this litigation because ‘divorce is not economically rational behaviour, which funders have to have’.

Funders also doubt that TPF will ever take off in personal injury. While personal injury claimants are usually on the winning side, and in severe cases they will receive substantial payouts, the amount that could be claimed by funders would be quite limited. A third-party investor’s percentage would have to be based on general damages alone, with no scope for them to take a slice of any future care award, meaning that the claims would not be economically viable for funders.

Commercial imperative

The vast majority of TPF is, of course, focused on commercial litigation. There are two main scenarios in which claimants will seek funding: the David and Goliath situation, where a small business cannot afford to bring the case without the funder’s support, which gives it equality of arms, and the risk-averse client, which is big enough to bring the case unaided but prefers to sacrifice some of its winnings in return for passing the parcel of risk.

But while it is undoubtedly expanding, the funding market is relatively small at the moment. A back-of-envelope calculation by Perrin concludes that there is currently about £350m of capital in the UK funding market, available to finance both litigation and arbitration. That figure includes a £100m boost from the recent arrival of Burford, which entered the UK market in February by buying up after-the-event insurer FirstAssist. It intends to create a funding business on an ‘unrivalled scale’ on this side of the Atlantic, driven by Burford CEO Christopher Bogart’s belief that the UK is now ‘one of the most hospitable environments’ for third-party funding.

Other recent arrivals on the scene include specialist private bank Investec and ‘alternative litigation funder’ Caprica, which is targeting disputes worth a minimum of £50,000 - much lower than traditional funders. In the current economic climate, there are obvious attractions to litigation as an area of investment, as it is not linked to the fortunes of the capital markets. The expectation is that more new entrants will come forth in the coming year, with capital flowing into the sector. Funders are certainly optimistic about the future of their industry.

Neil Purslow of Therium says: ‘We expect to see the market grow in size in terms of the numbers of cases funded, and the amounts of funding being deployed. Therium is seeing a steep increase in interest in funding, year on year. I expect to see more use of funding by substantial corporate clients, trustees, charities and public bodies managing their risk and cashflow. There is also greater awareness of funding in international arbitration, which will be a growth area.’

Ben Hawkins, managing director of Commercial Litigation Funding Ltd, adds that insolvency litigation in particular will be a growth area. He says: ‘Insolvency lends itself well to litigation funding. We have seen a spate of VAT fraud cases and private enforcement of competition claims.’

For Woodsford’s Jonathan Barnes, Lord Justice Jackson’s plans to scrap recoverability of after-the-event insurance premiums could provide a new role for funders. ‘The end of recoverability will be significant,’ he predicts. ‘Under the contingent/deferred model, all ATE insurance premiums are ultimately paid by losing defendants. ‘When recoverability goes, insurers may want premiums paid up front, as with all other types of insurance. Solicitors who previously ran cases on 100% conditional fee agreements coupled with contingent/deferred ATE insurance will have to find a funder to pay the cash cost of the premium, or to indemnify the client in respect of the adverse cost risk.’

Hawkins adds: ‘If the LASPO bill does remove recoverability of ATE premiums and success fees, we expect to see funders competing on cost and developing innovative models to ensure that those deductions from damages are minimised.’

Others believe TPF will become accessible for a greater volume of cases. Solicitor and former Law Society president Michael Napier says: ‘As the market matures, the threshold that funders currently apply to cases will gradually reduce from its current high level (usually seven figures) to lower-value claims, particularly as lawyers become more creative in blended fee arrangements and offering fixed fees. The other factor of course is the yet-to-be-seen impact of alternative business structures, with the skills to commoditise even the resolution of commercial disputes.’

The use of TPF may be on the up, but it is hard to tell just how many disputes are actually being backed by funders at the moment, as they rarely publicise their involvement in a case to the outside world. Often this is because of the client, who does not want publicity in relation to their dispute; but funders are also wary of being subject to an application for security for costs if their involvement becomes public. This lack of transparency does little to improve the somewhat opaque image of the sector.

Shadowy image

What has done much to clear away the shadowy image of third-party funding, however, has been the launch last November of a new code of conduct to shine a light on how funders must operate. A new Association of Litigation funders (ALF) was set up, along with the voluntary code to which all members of the association must adhere. The code of conduct is intended to pin a badge of respectability on the sector and, as Harbour’s Susan Dunn said at its launch, shows that third-party funding has finally ‘emerged from the shadows’.

Crucially, the contents of the code were endorsed by Lord Justice Jackson at its launch. The judge is an advocate of TPF, which he believes can be ‘beneficial’ to access to justice, provided safeguards are in place. Jackson had called for a voluntary code of conduct for funders in his final report on civil justice reform, suggesting that the heavier tool of statutory regulation should not be considered until this nascent market matures. In the House of Lords in February, justice minister Lord McNally rejected Thomas’s call for the government to regulate TPF, saying that it preferred to see how the voluntary code developed first. So the code has successfully shielded the industry from government regulation that might have stifled its development, and it seems unlikely that government will revisit this approach for a few years. But while ALF has now issued applications for membership, it has yet to appoint its first member; this development is expected soon.

Those involved in the industry are highly supportive of the new code, which they believe will give solicitors more confidence in selecting a funder. Peter Smith, managing director of FirstAssist, adds: ‘It’s worth noting that the adoption of the code is one of the first Jackson reforms to be implemented; the private sector has responded swiftly.’ But while the code is undoubtedly a benefit for TPF, it took a lot of blood, sweat and tears to bring it into existence. Negotiations on its wording, chaired by Napier on behalf of the Civil Justice Council, began as far back as 2008, and the code went through 12 drafts in the six months running up to its publication - with final changes being made right up to the day before it was launched at the Royal Courts of Justice.

While the US Chamber of Commerce argues that the code is merely voluntary and has no real sanction for non-compliance, in practice all the main funders are expected to sign up to it, and risk being thrown out of the ALF if they fail to adhere to it; which would be distinctly bad for business. With Jackson’s approval so crucial to the code’s success, the final version gave the judge everything that he was looking for (see box). It ensures a funder has enough cash to fund a case for three years, restricts the circumstances in which it can pull out of litigation, and prevents it from taking control of the case.

But funders are conscious that the capital adequacy requirements imposed on them by the code will place them at a disadvantage once solicitors start using damages-based agreements from next April. When a solicitor acts under a DBA, they will effectively be a funder of litigation; but unlike third-party funders, they will not have to prove that they have the finances in place to fund their cases.

Matthew Amey of broker TheJudge says: ‘Funders will be competing with solicitors who, assuming they embrace the opportunity to fund cases through DBAs (which is quite an assumption), will effectively be indistinguishable from funders. But from the funders’ perspective, solicitors will have a number of advantages, in that they control the client; they will not be liable for adverse costs (unlike funders); and they won’t be subject to capital adequacy requirements.

‘While co-funding and other co-operative strategies will develop with the introduction of DBAs, there is a possibility that contingency fees will slow down the growth of the third-party funding market. In practice though, there is probably room for both in the short- to medium-term.’

Deciphering the code

The Code of Conduct of the Association of Litigation Funders

All funders who sign up to the voluntary code must:

• Take reasonable steps to ensure the litigant receives independent advice on the terms of the funding agreement, which can be from the solicitor instructed in the dispute;
• Not take any steps that may cause the solicitor or barrister to breach their professional duties;
• Not seek to influence the solicitor or barrister instructed in the dispute to cede control to the funder;
• Maintain adequate financial resources to meet its funding obligations for at least 36 months;
• Ensure the funding agreement sets out the extent to which a funder may provide input into settlement discussions;
• Only terminate its agreement if it reasonably ceases to be satisfied about the merits of a dispute; reasonably believes that the dispute is no longer commercially viable; or reasonably believes there has been a material breach of the agreement by the litigant; and
• If there is a dispute between the funder and litigant about a settlement or termination of the agreement, a binding opinion will be obtained from a QC jointly instructed or nominated by the chair of the Bar Council

Others see DBAs in a different light, believing them to be more opportunity than threat as far as funders are concerned. Hawkins says: ‘DBAs will move the UK funding model further towards the US, and we see this as potentially a good thing. What is often overlooked is that the idea of a DBA involves solicitors "funding" the cost of disbursements and insurance.

‘At a simple level, this could suggest a drop in business for funders, as law firms compete to fund their own cases. But every firm has a threshold at which it will become uncomfortable with work-in-progress exposure, so solicitors' firms will become our clients, and funders are more likely to get involved in portfolios rather than single cases.’

The prospect of spreading the risk of a DBA or funding up-front ATE premiums or expenses, and the comfort of knowing that a funder has signed up to a transparent code of conduct, may lead to more solicitors choosing to engage with funders. But funding is not necessarily that easy to come by.

The first point to note is that third-party funders are pretty cautious about the type of case they will take on. They will typically look for 70% prospects of success; but given the intrinsically uncertain nature of litigation, percentages are not that helpful. Funders like disputes where liability is strong, and the argument is over quantum. Perrin, who is chair of funder Calunius Capital, says it is not necessarily about wanting a case that will win in court.

‘We would look at whether the case looks like it will settle; are the dynamics there that would lead to an early settlement?’ he says. Positive indicators might be a situation in which the defendant does not gain any financial benefit from delaying proceedings, or where there is a business relationship that needs to be resuscitated.

It is a ‘wide spectrum of factors’, he says, adding that funders will often get involved in arbitration rather than litigation, as law firm arbitration partners tend to be more open to the concept of funding. Once funding has been secured, there are other pitfalls that should be avoided in dealing with funders.

Amey says: ‘Some funders insist on exclusivity periods in order for them to complete their due diligence. In principle, this is a legitimate request where the funder is genuinely going to spend hard cash on investigating the case. However, exclusivity periods are requested and accepted too readily.

‘Legal representatives need to carefully consider whether it is in a client’s best interests to exclude alternative options, especially where there is time pressure, given the time it takes to complete due diligence.

‘Moreover, approaching funders and insurers consecutively may not be a great idea from a presentation point of view, as a prior rejection will perturb would-be funders. A simultaneous search of the funding market is always the safest option for clients, at least until such time as an exclusivity period is clearly justifiable.’

Purslow adds that exclusivity ‘can backfire on a live piece of litigation if the funder decides not to proceed’. Clients tend to focus too much on the ‘headline commercial arrangements’, suggests Hawkins, without considering how the funders plan to interact with the legal team and insurers.

He says: ‘What happens, for example, if the budget needs to increase, or a solicitor moves firms? Funders’ experience of these issues is just as important to the smooth running of a case as their ability to devise commercial terms at the outset.’ With endorsement from the senior judiciary, up-front ATE premiums and the introduction of DBAs, the stars are aligned to suggest a bright future for TPF; and solicitors will have every reason to get closer to the industry.

As Perrin says: ‘The sector is going to expand. It will either be driven by lawyers’ own business acumen, or, as awareness increases, it will be driven by client demand. Ultimately, clients will force their lawyers to develop a sophisticated understanding of funding.’

Rachel Rothwell is editor of Litigation Funding magazine, which provides in-depth coverage of third-party funding and costs. LF publishes an up-to-date list of funders and insurers