What is Arbitration Funding?

Preface

This report on Arbitration Funding, authored by David Walker of Deminor Litigation Funding and originally published in the Delos Guide to Arbitration Places (GAP) 2nd Edition, examines the funding options available in international arbitration today.

Arbitration funding has evolved from a tool for impecunious claimants to a financial instrument used by companies of all sizes. Organisations now use funding to manage litigation costs whilst preserving working capital for business operations. This transformation has created a diverse market with multiple funding structures.

The report analyses six main funding types: classic third-party funding, portfolio funding, co-funding and sub-funding, purchase of future proceeds, assignment of claims, and law firm funding. For each structure, it explains operational mechanics, typical contractual provisions, and remuneration models.

Whether you are corporate counsel evaluating funding options for a potential claim, a law firm partner advising clients on financing alternatives, or an arbitration practitioner seeking to understand this increasingly important aspect of modern practice, this report offers valuable insights into the current state and future direction of arbitration funding.

GAP REPORT: ARBITRATION FUNDING

A potential litigant faces various challenges, including the need to cover legal costs and disbursements, especially in an (international) arbitration. To address this issue, several alternative financing options have developed in the market such as third-party funding (TPF), Damages-Based Agreements (DBAs), Conditional Fee Agreements (CFAs), and Alternative Fee Arrangements (AFAs).

These financing structures emerged initially to facilitate access to justice by offering solutions to parties with a meritorious claim but without access to the necessary funds. Over the years, however, these financing structures have become more and more popular. They are still utilised by under-resourced litigants, but they are also popular with those unwilling to allocate money to litigation when they could put it to better use elsewhere, such as in developing their business. As a consequence, litigation and arbitration cases can now be considered as real assets that can be monetized and not simply as liabilities. With this monetization of claims, a real litigation financing market has developed with more competition and players continuously looking to offer new financing alternatives.

DBAs and CFAs are special fee arrangements between a client and their lawyer where the lawyer's compensation is contingent on the success of the case. Under a DBA, the attorney will receive fees in the event of success based on a predetermined percentage of the recoveries. With a CFA, on the other hand, the lawyer is paid at a discounted rate compared to the normal fee that he or she would usually charge, with the difference only being paid in case of a success, along with a further success fee.

Finally, AFAs cover all other fee arrangements between a lawyer and their client that are not based on the classic hourly billing model. They include, for example, flat fees, capped fees, and blended hourly rates.

Third party funding, or litigation funding, is a different financing model as it involves a third party – the funder – who provides the financial resources to the client to pursue claims. The funder pays all or part of the costs of the litigation/arbitration (including lawyers' fees, expert fees, arbitration costs, etc.) in exchange for a success fee if the client achieves a recovery. Litigation funding originally emerged in common law countries, but it has gained a lot of traction in continental Europe recently, especially for commercial and investment treaty arbitrations.

The increasing interest in third party funding has led market players to constantly adapt their offerings to make it attractive and appropriate for the different stakeholders. We can no longer discuss only "classic" litigation funding, but rather we have to deal with many different funding structures like portfolio funding, co-funding and sub-funding, law firm funding, and many more.

The classic funding structure

A classing funding agreement is concluded between a funder and the funded party whereby the funder will cover all or part of the costs of one litigation case on behalf of its client.

After conducting due diligence on the case successfully, the funder undertakes to pay the costs and fees related to the case up to a certain amount (the funded amount). Provisions in the litigation funding agreement (LFA) usually cover the following:

• The funding amount: the LFA will generally define the maximum commitment of the funder, the specific items that are included in the budget (legal fees for first instance and appeal, expert fees, adverse party costs, etc.) and the conditions to draw down from the budget. To avoid budget overruns, and depending on the type of case, funders may work with capped amounts per item or stage of the proceedings.
• Exposure to counterclaims: the LFA will specify whether the funding covers the costs of defending a counterclaim and whether the funder will cover any financial exposure to a counterclaim.
• The exchange of information: correspondence between the client and his or her lawyer, and any written material drafted for the client, are protected by attorney–client privilege. The lawyer, therefore, cannot disclose any of this to the funder without the client's express consent. Consequently, the LFA will regulate the exchange of information between the client, the lawyer, and the funder. This enables the latter to be kept abreast of the progress of the case and to monitor its investment.
• Control or consent rights: to protect its investment, the funder will generally seek to have some degree of control over important decisions in a case, such as filing appeals, terminating proceedings, or accepting settlements.
• Termination rights: in addition to termination for material breach, the funder and the client may also agree on a right for the funder to terminate the LFA if an event occurs that negatively impacts the prospects of the case or makes the case commercially unviable. The LFA may even allow for termination for convenience.

As for the funder's remuneration, this will depend on the type of claim, its chances of success, enforcement issues and the duration. The longer it takes, the more expensive the funding is likely to be. It is also possible to receive partial funding (covering, for example, only the security for costs or the lawyer's fees) if the client seeks to limit the funder's involvement and limit the funder's remuneration.

The funder's remuneration can be either a percentage of the recovered amounts, a multiple on the funded amount, or a combination of both. Usually, the multiple and the percentage will evolve over time on a periodic basis.

Portfolio funding

Portfolio funding consists of funding a number of claims at the same time, either several claims for the same client, or several claims for different clients instructing the same law firm. All types of litigation can be included in a portfolio and, depending on the size of the portfolio, an in-depth due diligence may or may not be required on each individual case.

The main advantage of this structure is that it allows for the cross-collateralization of the litigation assets upon which a return is obtained from those that are successful.

If the portfolio contains several claims held by the same client, it also allows for the inclusion of less promising or less certain cases in the portfolio because they are balanced with more meritorious cases. Taken alone, the less promising case would not have made it to funding. However, thanks to a portfolio structure, the risk to the funder is spread over many claims and terms can thus be more flexible.

A funded amount will be determined for each case in the portfolio and the funder's return might either be calculated on the entire portfolio or per case depending on how different the cases are.

Another type of portfolio is where the same law firm seeks funding for several clients with similar claims but with each claim being an individual case (i.e., not a class/group action). For example, funding was provided in France to several business owners in their pursuit of indemnification from insurance companies for losses suffered due to the closure of their restaurants during the COVID 19 pandemic. The exact number of cases which would be included in the portfolio was not known at the outset. The structure was therefore built on an estimate of the number of claims to be funded for clients working with the same law firm. A fixed amount of fees was agreed upon in advance with the lawyer to be paid per case by the funder and the lawyer would also, in case of success, be entitled to a success fee.

In this type of portfolio funding, it is almost impossible to know the exact number of cases to be funded in advance (although there should be an estimate). It is also not possible to conduct due diligence on each individual claim. Typically, a few cases amongst the existing portfolio will be chosen randomly for due diligence, and the results of that can be duplicated on the others. This is, however, only possible if all the cases are very similar in terms of who the defendant is, the facts, and the applicable law. A budget will be created on an individual case basis (generally including a success fee for the lawyer if permitted) and the same level of funder's remuneration will apply to all cases.

The main advantage of this structure is that the funder's due diligence is very efficient as it will focus on a limited number of cases. The success rate can be very good because the same arguments will be raised across the board. This means that if there is already a track record when the portfolio is presented to the funder, it is likely that the same outcome will apply for most of the cases.

If the portfolio involves only one law firm, the relationship between the lawyer(s), the clients, and the funder is very important. This type of portfolio usually takes time to reach a conclusion. Depending on the size of the portfolio, the funding is likely to last longer than a classic funding as the cases will be spread over time, meaning that the duration of the funding is more difficult to discern at the outset.

Finally, should the funding be disclosed were the portfolio concerns the same defendant, the chances of settlement may sometimes increase as a result of the mass effect perception that a funded portfolio may trigger on the defendant.

Co-funding and sub-funding

With the aim of diversification and mitigation, a co-funding structure allows for liabilities and potential risks to be shared amongst two or more funders. Co-funding might be an option, for example, if the funder who initially reviewed a case has reached its capacity in a specific claim type, or if it is simply willing to share the risks on a case.

All co-funders will be parties to the funding agreement with the client. They will all be entitled to be paid a portion of the proceeds.

The LFA will need to determine the extent of each funder's participation in the payment of the costs and the allocation of the proceeds, if any. It will also be important to define the role of each funder and its role in monitoring and case management to avoid unnecessary delay in the process.

When co-funding is considered for a claim, it is important to discuss this at an early stage of the due diligence process. Consent must be obtained from the client to work with several funders, but stakeholders also need to work efficiently during the due diligence process to ensure that all funders are proceeding at the same pace and with the same timetable in mind.

As the co-funding process involves more than one funder, there can be a concern in the market over potential delays in the due diligence process. To address this concern, one alternative is sub-funding which is now used more and more frequently. This structure allows only one funder to sign the LFA, complete due diligence and act as the liaison for the client and the law firm. However, the funder can also limit its exposure by sharing the risks with another funder via a participation agreement where the sub-funder undertakes to fund part of the costs in exchange for part of the proceeds in the event of success by the main funder.

The sub-funder will not, however, have direct contact with the case and, in the event of success, it will only be paid by the main funder once the latter has received its remuneration. The arrangement therefore requires a high degree of trust between the relevant funders. Indeed, while the main funder remains the debtor of the full funding amount towards the client, it is also the direct beneficiary of the entire remuneration.

With this structure, the client is satisfied that it has only one interlocutor during the due diligence process and one partner during the litigation. However, the funder has made it possible to onboard the case by sharing its risks internally with another funder.

Purchase of future proceeds

In this structure, the funder purchases a portion of future proceeds against payment of certain expenses and disbursements associated with the pursuit of the claim. The purchase price will be defined as the total amount effectively funded. It will be paid in several instalments throughout the litigation depending on when costs are incurred, so that the final purchase price will be known only at the end of the litigation, once all costs are paid. At the signature of the LFA the purchase price is thus only estimate with a defined maximum purchase price, equivalent to the maximum approved funding amount.

The client remains the owner of the claim during the litigation, as in a classic funding structure, and the transfer of the proceeds only occurs if and when there is a success. If a success materializes, the amount of proceeds to be transferred to the funder will be calculated based on a formula similar to the one usually applied for the calculation of a funder's return: a multiple of the purchase price; a percentage of the total proceeds; or a combination of both.

This structure is very similar to a classic funding structure and frequently used in Italy, known as "Cessione di Credito Futuro" or "Vendita di Cose Future".

Assignment of claims

On the occasion of certain events such as an insolvency, restructuring, business reorganization, sale or merger, a company or its trustee may be interested in selling a claim. Moreover, it can also be appealing to a claimant which has already paid significant litigation costs to obtain a final decision or arbitral award. If the judgment or award is likely to require costly enforcement proceedings, the client might be willing to remove this litigation form its balance sheet and sell it to a funder.

In such cases, the client and the funder sign a sale agreement under which the funder pays the client a purchase price for its claim. The ownership of the claim transfers from the client to the funder in exchange for the payment of a discounted price compared to the value of the underlying litigation.

Through this mechanism, the client transfers its ownership of the claim and is no longer involved in the litigation from the moment the sale agreement is executed. From then on, the claim is solely the funder's property and the funder will take all decisions regarding future litigation, strategy, or settlement.

The financial risk for the funder is higher compared to other types of funding due to the additional upfront cash payment. However, if the case is successful, the return is likely to be higher too as the funder will be entitled to recover the entirety of any damages obtained.

When considering this structure, careful attention should be paid to the applicable law. Many jurisdictions (at least in continental Europe) allow a debtor in certain circumstances and defined conditions to extinguish its debt by paying the beneficiary of the assignment an amount equal to the price it paid to purchase the claim (retrait litigieux). Without entering details on this particular issue, the application of this principle has led to many discussions under French law leading to disputed case law from the French Supreme Court.

Law firm funding

One final structure that is becoming increasingly popular is law firm funding. In this scenario, the funder provides funding to the law firm rather than the litigant.

In jurisdictions where lawyers and law firms are permitted to act under CFAs or DBAs, the law firm takes both a credit risk and a litigation risk. First, while a case is ongoing, the law firm will have to carry some or all of its own costs in pursuing the litigation or arbitration. That could mean a running financial cost over a period of years which law firms are not traditionally set up to deal with. This is especially true in the case of DBAs where the law firm will not be receiving any payment from the client until the case is resolved. Second, the law firm is also taking on the risk that the outcome of the case might be unfavourable to its client, so that it would not receive any payment or only a reduced amount at the end.

The success fees payable pursuant to DBAs and CFAs are designed to compensate the law firm for those risks, but law firm funding also allows law firms to reduce that risk further by offloading it to a funder.

A funder can enter into an agreement with a law firm pursuant to which the funder will pay the law firm a proportion of its fees incurred on a regular basis. If the claim succeeds and the law firm is paid its success fee, it will then share the same with the funder. If, on the other hand, the case outcome is negative then the law firm will not be paid any success fee but it will still have received remuneration from the funder as the case progressed.

This model can be utilised on single cases or as part of a portfolio of cases run by the same law firm. Such funding also allows law firms to build significant books of smaller claims where the law firm's running costs can be split across a number of cases.

Other forms of law firm funding are also emerging in the market where funders in some jurisdictions are providing capital to law firms for expansion, for the acquisition of other firms or cases, or for launching new practices of claim types. The funder can get a return from the law firm's profits or from the future proceeds of cases which are due to the law firm. For the law firm, this offers a chance to obtain financing from an entity like a funder which is acclimatised to both litigation risk and law firm structures.

Author: David Walker, General Counsel UK