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Businesses in every industry defend against litigation, and manydo so routinely. As such, companies have well-traveled paths formanaging defense costs, which are often covered by insurance. Thesame cannot be said for affirmative litigation: Companies sometimesare reluctant to pursue it; insurance doesn't cover it; and whencompanies do pursue it, they are often forced to shouldersignificant cost and risk.

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When companies bring legal claims, they create novel issues forCFOs, treasurers, and risk managers. Companies filing suit face therisk that their spending of, potentially, millions of dollars onlegal fees will not result in the desired judgment. In addition,because legal fees show up on corporate income statements, anexpensive case will place a notable drag on reported earnings. Andeven if the company seems likely to win a particular case, it willstill have difficulty predicting the tactics of its opponents andthe pace of judicial review. In a world that wants precisebudgeting of quarterly inflows and outflows, complex litigation cancreate frustration and doubt.

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Over the past decade, legal finance—also known as “litigationfinance” or “litigation funding”—has emerged in the United Statesto help address these problems. The tool, which reduces the costand risk of litigation, remains poorly understood by corporates.Unsurprisingly, it is also underused.

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In Burford Capital's latest research, 68 percent of in-houselawyers reported that their companies have forgone meritoriouslegal claims due to the perceived impact on the bottom line. And 59percent said that their company has uncollected awards andunenforced judgments valued at $10 million or more. With so manycompanies abandoning millions in recoveries, and in an increasinglycompetitive global landscape, corporate treasury and finance teamsshould develop an understanding of legal finance.

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What Is Legal Finance?

In the U.S., legal finance arose in the wake of the GreatRecession, largely to address the rising cost of litigation and lawfirms' desire to serve clients that were not prepared to pay legalfees out of pocket. The legal finance industry has evolved sincethen, but its entry-level product—single-case financing—remains acommon solution that is instructive to understanding legal financebroadly.

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In the single-case scenario, a company typically has a strongclaim that it is unwilling or unable to self-finance. To obtainthird-party financing, the company approaches a legal financier,which conducts due diligence on the matter. This can occur at anystage of the legal process. If the financier agrees to fund thematter, it will extend capital on a non-recourse basis. This meansthat the financier will receive a portion of any potential award orsettlement, and in exchange will assume all downside risk. Neitherthe company filing suit, nor its law firm, will owe the financiermoney if the case loses.

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This financing is a passive investment. Legal financiers do notexert control over litigation strategy or decision-making, andlegal finance arrangements are designed accordingly. Althoughfinancing arrangements may stipulate terms regarding how capital isused, all parties agree upon those terms at the outset. Terms varydramatically from agreement to agreement, and they should take intoaccount the need for flexibility as the case progresses. Once afunding agreement is in place, the company's law firm keeps intouch with the legal financier, which may act as an advisor to thelegal team.

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Due to the idiosyncratic natureof lawsuits and legal risk, no two legal financing arrangements areidentical. Financiers tend to offer variations of three basicreturn structures: variable returns, fixed returns, and hybridreturns. A variable return is comparable to a contingency feearrangement, where a law firm will advance the cost of litigationout of pocket, then recoup those costs “first-dollar” out of thereturn, in addition to taking a percentage (such as 30 to 40percent) of the net remaining proceeds. In fixed-return structures,the financier's return consists of receiving its investment back,plus a multiple of that investment (or a predetermined amount), asopposed to a percentage of the net proceeds. In most cases, thereturn structure includes characteristics of both variable andfixed returns, resulting in a hybrid structure.

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Ultimately, single-case financing arrangements enable corporatesto pursue high-value claims with certainty around risk exposure,even in the worst-case scenario. This enables claimants with riskor liquidity concerns to proceed with legal matters they would nototherwise bring. Increasingly, corporate finance teams are usinglegal finance out of choice, not necessity. One law firm partner inBurford's 2018 survey remarked: “We are seeing more companies whowant to use [legal finance] not because they cannot affordthemselves to finance the litigation, but because they see a way tomonetize an asset that sits on their balance sheet or to de-riskthe funding of litigation.”

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How Are Companies Using Legal Finance?

Companies use legal finance in myriad ways. The most common usecase, as described above, is to pursue financing of a single claim.Another common scenario involves a company monetizing a legalasset, such as a large unpaid judgment debt, in which the companywon a claim but it remains unenforced. And perhaps the mostsignificant trend in legal finance is the rise of portfoliofinancing arrangements for companies with several meritoriousclaims.

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The portfolio financing strategy makes sense when a company hasmultiple pending claims that merit in-depth consideration.Financing of a legal portfolio follows the same general rules assingle-case financing: The investments are non-recourse, and thefinancier must determine that the claims are meritorious in orderto move forward. In certain arrangements, the client may addadditional suits on an ongoing basis.

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In a portfolio-financing arrangement, the claims arecross-collateralized—meaning that if one case loses, the capitalprovider can recoup its investment when it collects its share ofreturns from the portfolio's claims that are successful. Becausethe financier has multiple paths to collect on its investment,portfolios might reduce the client company's cost of funding.Increasingly, companies are also including defense matters andsmaller claims in portfolio arrangements. They are extracting valuefrom their large meritorious claims and using it to fund otherlegal activities.

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Although defense claims are most often financed throughportfolios, some organizations are using legal finance to funddefense in a single case. Defense efforts may be financed as aone-off when the company has a strong counterclaim or when theclaim against the company is weak. In such an arrangement, thefinancier's return would be predicated upon achieving a mutuallyagreed-upon definition of success.

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Accounting Impacts of Legal Finance

Ordinarily, companies' legal costs are expensed on the profitand loss statement (P&L) during the period in which they'reincurred, and the spending is not capitalized. This means thatself-financed litigation reduces an organization's reported profit.Even if a claim is eventually successful, the accounting disparityis not corrected. Any recoveries from a legal judgment are recordedbelow the line as non-operating income. Thus, the P&L reductionthat companies experience as they pursue meritorious claims—whichmay knock their market value if they are publicly traded—is neverreversed, regardless of the final outcome of the claim.

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In contrast, when a company finances its litigation, legal feesand expenses do not have to hit its P&L. In the context of alegal finance arrangement, the counterparty—the entity that willactually receive the inflows of financing—will either be thecompany pursuing the claim or its law firm. When the company's lawfirm acts as the counterparty on a financing agreement, it receiveslegal capital directly on the client's behalf, thereby handling theaccounting treatment of the capital on its own balance sheet. If,instead, the company chooses to serve as the counterparty—andreceive the financing directly—it is afforded discretion in how toaccount for legal finance on its balance sheet.

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In either case, legal finance improves the accounting outcomesconnected to affirmative litigation.

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The Role of Treasury and Finance

The management of a company's legal assets remains theresponsibility of the in-house legal department. Nevertheless,CFOs, treasurers, and treasury teams have an obligation toshareholders and the board, within their fiduciary duties to theircompany, to explore opportunities to recover on meritorious legalclaims. They should be looking for ways to minimize the impact oflegal actions on both corporate financial statements and theworking capital available to fund the company's ongoingoperations.

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Not every meritorious claim is financeable, but for companieswith strong claims, it makes sense to consider having themevaluated by a legal capital provider. Too often, companiesneedlessly abandon legal claims that they could win, or elseshoulder a heavy financial burden to pursue them. Legal finance cansolve both problems. As business competition intensifies, itbehooves treasury teams to learn about the potential workingcapital and accounting benefits of legal finance so that they canhelp their companies unlock the millions they may otherwise end upleaving on the table.

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Elizabeth O'Connell,CFA, is the CFO of Burford Capital, a litigationfinance firm whose clients are among the world's largebusinesses. With over 25 years of experience in finance,O'Connell was previously managing director and CFO of GlenavyCapital LLC and CFO of Churchill Ventures Limited.  Shespent more than a decade in investment banking at Credit Suisse andSalomon Brothers (later Citigroup) after commencing a career infinance selling foreign exchange at Bank of America.

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