Julia Gewolb, Dave Kerstein, Laina Hammond and Will Marra
When the economy sours, Wall Street’s typical reaction is a wave of “risk-off” selling, moving money rapidly from unstable high-growth securities to safe-haven assets like gold, Treasury bonds or utility stocks.
Corporate America, meanwhile, faces its own challenges, with even strong companies attempting to conserve cash by cutting expenses, some shakier ones trying to save themselves through mergers with better-funded rivals and the weakest, possibly, collapsing altogether.
One profession that often fares better than the rest is the law because litigation is countercyclical – whether the economy is up or down, it will inevitably lead to lawsuits as businesses work to protect their financial interests. The same applies to the comparatively youthful field of litigation finance, in which investors provide funding for plaintiffs to pursue meritorious litigation of their legal claims.
That pattern has held particularly true in the tumultuous years since 2020, when the Covid-19 pandemic shut down huge swaths of the economy and snarled global supply chains. Since then, a labor shortage in the freight industry, a shipping accident that briefly shut down a key trade route, and inflation that touched a 40-year high have only compounded the initial challenges.
Now, with the Federal Reserve trying to bring inflation under control through sharp increases in interest rates and some economists worried about a recession, it’s no longer just the under-funded Davids seeking resources to pursue their claims against Goliaths whose cases are making up the bulk of litigation finance firms’ business. A wider variety of corporations, commercial claimants, inventors and law firms than ever are pursuing funding as a business opportunity.
As they navigate both increasing workloads and budgets tightened by boards and company leaders insisting that they accomplish more with less, many corporate C-suite executives are realizing they can look at litigation as a way to transform their legal departments from a cost center into a profit center, according to investment and underwriting leaders at Validity Finance, a four-year-old firm that now has locations in New York, Houston, Washington, D.C., and Los Angeles.
“What litigation finance teaches, essentially, is that your legal claim is an asset. It's an asset similar to how your inventory, your intellectual property and your real estate holdings are assets,” says Will Marra, a New York-based investment manager at Validity who joined Laina Hammond and Dave Kerstein, both co-founders and managing directors, and Chief Risk Officer Julia Gewolb in a roundtable interview with Lawdragon on the growth of both the firm and its industry during a period of rapid-fire economic shifts.
“It’s always harder to justify pursuing litigation when money's tight,” Marra explains. “When you realize that your legal claim is an asset, you can use litigation finance to secure financing against that asset – including the financing you need to bring your case in the first place.”
But while companies embroiled in economic challenges may be more likely to sue than usual over broken deals and other financial fallout, there’s a flip side: economic challenges tend to make CEOs just as risk averse as Wall Street, an attitude that extends to spending money on litigation where the outcome is unknown.
“When times are good, it may be easier for companies to decide to overlook violations of company rights and move on, but when trying to fight for every bit of revenue, some companies are thinking harder about whether to pursue litigation to enforce their rights,” Hammond says. “The value of litigation funding is companies can do that without having to expend a large amount of capital to pay for outside lawyers and experts.”
Corporate C-suite executives are realizing they can look at litigation as a way to transform their legal departments from a cost center into a profit center.
Lawdragon: One of the things that's really been interesting about the economic uncertainty over the past two years is the breadth of challenges that have materialized. How has that affected the types of cases you're seeing?
Julia Gewolb: Going into Covid, with the economic uncertainty that came with that, there were a lot of questions about how litigation funding would fare. As it turned out, in the first year of the pandemic we saw more, not fewer, opportunities for funding – largely because that same uncertainty incentivized folks to off-load expenses and litigation risk. We were able to grow the portfolio without growing our team, which positioned us well to take on new growth. We’re in a different economic moment today, but even now rising interest rates are presenting an obvious rationale for using funding to handle litigation fees and costs.
William Marra: Lawyers and increasingly companies are aware of litigation funding, and this awareness is coming at a time when companies have an especially high need for it. Ralph Sutton, our CEO and founder, was one of the very first people to do this in the country over 16 years ago. Even when Validity was launched four and a half years ago, a lot of what we were doing was still educating lawyers about funding. That has changed significantly. Law firms have very high awareness of litigation funding. And increasingly, large companies and their general counsel do too. Those GCs need to deal with macroeconomic headwinds, and at the same time, GCs are being asked to do a lot more. For example, companies have to deal with more regulations at the state and federal levels. Those GCs are seeing their budgets cut too. So they’re being asked to do a lot more, what they're being asked to do is more expensive, and they need to do more with less. Litigation is just one of a constellation of issues that GCs need to address, and we enable companies to offload some of the risk and the expense of that.
Laina Hammond: General counsels also continue to be forced to bring a lot of work in-house because of the expense of outside lawyers. That work isn’t necessarily litigation, but GCs are having to handle more legal operations internally.
LD: Does all of this mean there’s more or less of an interest right now in elective litigation? If the economy's rougher, people might be more concerned about the expense, but if they're using litigation finance, they might see this as an opportunity to leverage more of an asset that they didn't necessarily think of as an asset in times past.
Dave Kerstein: We have seen in the past that our industry can be a bit countercyclical, because as the economy worsens, sometimes there's more inclination to fight over scraps, but yet not want to use your own capital to do so because of how costly that is. So that opens up opportunities for litigation finance companies like ours.
WM: We fund a very small percentage of cases that we see, so we're not encouraging companies to engage in litigation, and we're not encouraging them to pursue weak cases. Whether in good times or bad, companies only want to pursue their strongest, most strategically important litigations – and those are the cases funders want to finance too.
LH: The past couple of years have been a perfect storm because in addition to economic distress, companies have also faced a lot of supply-chain issues, ones we've heard a lot about in the news, and those issues have prompted many companies to be unable to fulfill their contracts.
JG: One interesting trend we saw in the Covid era was an uptick in the number of patent cases. Patent is one obvious area where companies can monetize their IP assets through litigation. If a business holds a lot of patents and realizes other people in the market are making products that infringe on its patents, then enforcing those assets through litigation can be well worth the cost.
Our industry can be a bit countercyclical, because as the economy worsens, there's an inclination to fight over scraps, but not wanting to use your own capital because of how costly that is.
LD: Out of the array of economic issues facing businesses, are there particular ones that have been driving litigation more than others?
JG: They tend to be industry- and location-specific. During Covid, there were a number of insurance claims, for instance, relating to businesses forced to close during Covid. There are a lot of open questions being litigated in the courts right now over insurance policies, which in some instances contemplated pandemics, and in others didn't, because we had never really experienced anything like this before. The uncertainty over how the courts would rule on the issues – as well as the fact that the plaintiffs are businesses coming out of a difficult situation – made it an obvious case for funding.
DK: There’s also a widespread expectation that we’ll see more claims coming out of developments in the cryptocurrency world. There are estimates of a million or more people impacted by the implosion of the FTX crypto trading platform, for instance, and there will probably be legal reverberations from that. We've already seen an uptick in crypto-related funding opportunities over the past year or so. Sometimes they can be hard to fund, however, because while there can be clear evidence of wrongdoing or fraud, collection is often an issue in those cases. But now, with FTX, there is a large-scale bankruptcy that's likely to generate a lot of potentially valuable claims, and I'm sure there will be other things related to that as well coming down the pike.
LD: I’ve been curious about whether the lack of settled law in that area makes it a little more difficult to pursue those claims. If you're touching on bankruptcy or obvious fraud, that's one thing, but there have been many questions over who regulates crypto – the Securities and Exchange Commission, for instance, or the Commodity Futures Trading Commission – and whether it's a stock, a commodity or some kind of currency asset.
LH: The absence of clear laws and regulations governing crypto may make it more challenging for claimants to succeed on claims against crypto companies, particularly for creditors trying to recover money through claims of wrongdoing by the company. A potentially relevant question is whether these crypto companies had any kind of insurance covering employee misconduct or wrongdoing. With fidelity bonds, a company can go to the insurer and ask them to cover the losses that the company suffered because of the high-level employees’ conduct. Because of the lack of clear regulation, however, crypto companies are not likely required to have insurance like that and may choose not to voluntarily purchase it, even if they were able to get an insurer to issue a policy.
LD: It seems like valuation would be another tough issue, because crypto has been so volatile over the past couple of years. And with it being so new, how do you make a substantial claim about how much it’s really worth?
JG: From the underwriting side, all of these issues contribute to litigation risk, which is a great justification for using funding. But it also makes us a little more wary of the risk, too. There's a sweet spot where we're probably a little less risk-averse because we have the cash, and this is what we do, and I think we're pretty good at it. Then beyond that, there’s a spot at which the risk becomes too great for us, too. I've always been a little wary of crypto cases for that reason. When the value of the case is tied to a volatile currency or asset, it raises questions for us as well.
LD: Going back to Covid for a moment, are you still seeing a high volume of related funding requests because of the typical lag time between events and the start of litigation?
WM: There are two significant ways in which the economic challenges and Covid have driven litigation finance. The first is the content of the cases themselves, and there's some of that, but I think that's really a minority of the impact of the downturn. You do have some cases where because of the downturn or because of Covid, some legal dispute arises, and we have invested in some of those cases.
One interesting trend we saw in the Covid era was an uptick in the number of patent cases. Patent is one obvious area where companies can monetize their IP assets through litigation.
A much bigger effect, though, is that in tough economic times, companies are now searching for new solutions to the longstanding problem of how to finance meritorious litigation, and they are now aware that litigation finance is an option. The economic challenges probably do drive a meaningful quantum of our business, even if the matters themselves aren’t related to economic challenges or to Covid.
It’s also notable that litigation finance was becoming mainstream right as Covid hit. That probably has increased the number of requests we've received. We can fund at any stage of the case, and we’ve had people come to us in the middle of a case saying, "I've been paying my lawyers by the hour, but I can't afford to do so any longer. I have better uses for this money." I don't know if we've actually funded a lot more because of that, but it has resulted in more requests.
LD: In terms of the industries or economic sectors from which you're seeing cases come, are there particular ones that stand out?
WM: One difference that we've seen is in the size of the business. Historically, litigation funding has been the domain of Davids versus Goliaths – we were funding the impecunious litigants that otherwise can't afford to bring a case. You could think of them as liquidity-constrained. They just don't have the money. Without litigation funding, they couldn't move forward.
But this past year, we have had signed term sheets with companies that have a billion dollars or more in annual revenue. It's not that these companies cannot afford the litigation, it's that they are thinking about this as just another way to share the risk, the same way that they would go to the capital markets to fund research and development or to start a new business line. Large companies are thinking about this in a way that they may not have five years ago.
With a venture-backed company, for instance, if your investors give you $5 million a year, they don't want you spending $2 million on your lawyers for litigation that's going to resolve five years from now. They want you to invest it in your company’s core products. These are basic business principles that these companies have already embraced in other contexts, and it goes to the point that general counsels are being asked to be more business-minded, not just come to the table with legal ideas, but also to approach legal problems as business problems. This way, they can come to the table not only saying, "Hey, this is hugely important for us,” but also, “This is how we can pay for it.”
LD: If GCs are bringing more work back in-house, do they sometimes turn to litigation finance when they want to pay for retaining experts in certain matters?
WM: We had one deal we were looking at with a company that was doing a lot of their litigation in-house, but funding was a way to go out and hire outside counsel for some cases. While some companies make a strategic choice to handle litigation in-house, often that choice is made because of cost savings.
LH: In general, for large-scale, bet-the-company cases that cost millions of dollars in fees and costs to pursue, companies must hire outside counsel, and they want to hire the best. They don't want to have to hire a specific lawyer or law firm simply because that's what fits within their legal budget. Funding is a great way for companies to obtain that capital, use it to hire the top counsel, and not have to exhaust their budgets to do it.
JG: That's the obvious case for funding. Also, historically, corporate counsel have viewed their litigation budgets more as a way to fund defensive action than going on the offensive and unlocking value. They're thinking about how to manage their cash to defend in lawsuits. They may not even be thinking very hard about what litigation assets the company has that they could enforce, and funding is a great way for them to get in that mindset. If they win, that’s additional cash flow to the company and so the general counsel’s office is actually generating value, which is something a lot of in-house litigation attorneys don’t think about. And if they lose, it doesn’t affect their balance sheet because the funder takes the case on a non-recourse basis. It is in many ways a no-brainer.
There’s a widespread expectation that we’ll see more claims coming out of developments in the cryptocurrency world.
LD: Going forward, over the next two to five to 10 years, are there particular areas of focus for Validity in terms of taking advantage of the growth and expanding awareness of the industry?
JG: I think we're going to continue to do what we've been doing, which is search out the most meritorious domestic litigation, commercial opportunities and patent matters. There are a lot of exotic places funding could get into, but we as a company feel like there's a lot of untapped growth and potential even in the bread-and-butter commercial disputes that we've specialized in, and probably will continue to specialize in.
LH: We hope to further expand our team in key geographic markets where we're seeing a lot of litigation and an increased interest in and demand for litigation finance. And we’ll try to go deeper into the markets that we already are servicing. As lawyers and companies become more aware of litigation finance, I think there are going to be a lot of opportunities for us and other funders to finance the types of commercial litigation that we've been financing all along. I don't know that there's going to be a real need to expand out into riskier types of investments, at least not in the short term, but that type of expansion may ultimately be on the horizon, too.
DK: I think we'll also focus a little bit on underserved markets, where we might not necessarily have full-time people, places where funders don't necessarily have boots on the ground right now, but there are still great lawyers that likely have great cases that could be ripe for funding.
WM: In the end, we anticipate funding really becoming a third standard way of pursuing litigation. Everyone is familiar with the vanilla and chocolate of how to pay for litigation: You pay your lawyers by the hour, or your lawyers take the case on a full contingency. The problem is that not every company can afford to or wants to pay their lawyers by the hour, and not every law firm has the risk appetite to take cases on full contingency. We offer a third model. We pay a portion of the legal fees, we pay a portion of the costs, and there's risk-sharing with the law firm and litigant. For the law firm, it looks like a hybrid or a partial contingency. For the client, it looks like a full contingency. And there are a lot of ways in which this third model better suits the risk appetite and the desires of both the client and the law firm. This didn’t really exist more than 15 years ago, but I think increasingly it's here to stay. Especially in this economic environment, this third model makes a lot of sense.