The challenges that litigation can present are familiar to many IPs. At times there are insufficient funds to launch a claim. Litigation funding can unlock those claims, but the economics do not always add up, especially if claims are too small for funders or if the costs-to-claim value ratio is too tight to accommodate the funder’s multiple. At other times there can be litigation against the estate, or the prospect of a judgment in favour of the estate being reversed on appeal, which hampers an IP’s ability to use or distribute funds. However, the full range of potential solutions to those challenges are usually far less obvious. The litigation insurance industry is much less publicised than funding but is growing in size and sophistication and can provide ways to overcome these problems, either alone or in combination with litigation funding.
The way litigation risk is allocated among the various parties who form the disputes ecosystem is evolving rapidly. Litigation funders are increasingly looking to obtain principal protection insurance for their portfolios to de-risk and lower their cost of capital. Law firms and IPs are taking more cases ‘on risk’ because the market is demanding it of them and, perhaps to a lesser extent, because they are starting to see the opportunity to increase profits. Investors have a lot of appetite to apply their capital to alternative asset classes such as litigation, which can provide uncorrelated and high returns in times of market uncertainty and low interest rates.
Litigation insurance exists to meet the needs presented by all of these stakeholders, and the following products can be part of the IP’s toolkit.
Judgment Preservation Insurance
This allows an IP to ‘lock in’ a favourable court judgment or arbitral award and, if that judgment or award is successfully appealed or set aside by the other party, the insurance will pay out to put the estate in the position it was in when it had the favourable ruling. This can allow the IP to safely use funds for other purposes or make distributions to creditors, in the knowledge that the legal outcome of the case is secure. The policy covers the legal risk of loss of the award, not the collection risk if the insured is successful in court but cannot enforce.
Once a judgment is insured, it becomes a more concrete asset and the IP has a number of options to ‘monetise’ it by accelerating payment, and thereby avoid having to wait years to be able to benefit from the result. In the simplest situation, the judgment could be sold, and often for a higher amount when there is no appeal risk attached to it. However, sale of a judgment even if insured will inevitably involve a significant ‘haircut’ on the face amount.
IPs also have the option to monetise by retaining the insured judgment and borrowing against it. Cash can be obtained on a loan basis, secured against the insurance policy, much more cheaply than capital from litigation funders. The loan in these arrangements would typically be ‘non-recourse’ (like litigation funding), with the lender taking the risk of the IP not being able to collect on the judgment, provided that collection risk is low. Raising cash in this way can open up many possibilities to IPs, including being able to pay outstanding legal fees, pay for the pursuit of other litigation or make distributions to creditors.
Adverse Judgment Insurance
This can provide a solution where an estate is the defendant in an existing or potential claim that has a low risk of prevailing but still blocks the IP from getting on with his or her duties. For instance, there could be a trust claim over all of the funds in the estate, which causes paralysis. If insurance takes the risk on that claim, the IP can safely deal with the funds and assets in the estate. Alternatively, there may be an outstanding claim that is weak, but still prevents distributions to creditors until it is resolved. If the risk of paying out on that claim is transferred to insurers, distributions can safely be made years earlier.
If an IP has a good claim but does not have the cash to pursue it and does not want to pay a litigation funder’s returns, insurance can enable lawyers and the IP to take fee risk on the case with the comfort that they are not taking an all-or-nothing bet on the case winning.
Lawyers can act on the claim on a DBA (damages-based agreement) basis, under which they charge nothing upfront but take a percentage of the case recoveries. The lawyers will record their time (or work in progress/WIP) on an hourly basis as usual and, if the case loses, the insurance pays an agreed percentage of the accrued WIP. Law firms in this country are not generally accustomed or set up to take full fee risk on cases and the insurance can enable them to get comfortable taking on a case that they otherwise would not. In time, law firms are likely to use WIP insurance on a portfolio basis to grow the part of their litigation businesses that is high risk/high reward, as a complement to the part of their business that is more stable. IPs can also insure the fees they incur on litigation in the same way, to allow them to take significant reward if it succeeds, but mitigate downside if it fails.
Where litigation needs to be brought but an estate does not have cash or does not want to use its own cash, the alternative options of creditor funding, litigation funding and law firms and IPs taking fee risk can be modelled out and presented to creditors so that the best option can be chosen. If needed, cash flow can be obtained for the law firms and IP on a loan basis, secured on the insurance (in the same way as with judgment preservation insurance) or litigation funding can be used, particularly for disbursements.
Most IPs are familiar with ATE insurance for opponent’s costs; however, the possibility of using ATE to cover own costs is often overlooked. Sometimes an estate has the funds to pay lawyers and the IP on an hourly basis but there is no desire to risk wasting those costs if the case loses. In that situation, the incurred costs can be insured so that most of them are paid by an insurer if the case loses. This enables the IP to avoid giving away significant upside if the case wins, without risking returns for creditors.
Combining Insurance with Funding
Insurance and funding often go hand in hand. Funding and ATE for adverse costs is the most obvious combination, but insurance premia for judgment preservation insurance and adverse judgment insurance can be put up by a litigation funder if needed. Where law firms and IPs act on contingency, disbursements can be paid for with funding.
Cross-Undertakings in Damages
Insurance can potentially be available for cross-undertakings in damages where estates do not have funds to cover these but need to obtain injuctive relief.
In addition to pure, ‘live’ litigation risks, IPs are often confronted with other situations where there is another form of contingent risk that could result in liability for either the estate or the IP personally. Such risks can take the form of potential tax claims by the authorities, ‘woodwork’ claims being made late in the day, etc. Those claims ought not to stand in the way of distributions to creditors but where there is scope for one to arise an IP has to be cautious. Insurance for those types of risk has been used for many years but is often overlooked as a possibility.
This is the same sort of insurance that is used in M&A transactions where a buyer does not want to take on a risk and a seller wants a clean exit and does not want to reduce price or escrow cash. In that sense, M&A and insolvency have many considerations in common. Contingent risk insurance is available from the M&A insurance markets along with tax and warranties and indemnities insurance, which can also be of particular use to IPs when they are disposing of businesses and assets but are unable to vouch for what is being sold in the same way as a ‘normal’ seller would.
In conclusion, creative and bespoke solutions are available to address litigation and contingent risks that IPs face and these solutions can optimise returns to creditors and help to streamline the winding up of estates.
Contact our M&A and Transaction Solutions experts to find out more:
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+612 9253 8443
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This article was first published in Recovery, Summer 2022, R3 Association of Business Recovery Professionals.