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20 August 2020
The COVID-19 pandemic is forcing businesses of all shapes and sizes to pursue alternate sources of funding to ensure the advancement of pending claims, bring new claims arising out of the pandemic and enhance cash flow where possible to survive. Understanding the range of dispute funding options available is critical to assess whether and, if so, how such funding can be leveraged to help a business weather the current COVID-19 environment and what is yet to come.
Many businesses have experienced a dramatic reduction in cash flow and working capital as a result of the recent global economic shutdown. Insolvency is on the rise, as is bankruptcy. While some losses experienced during this period will lie where they fall, many have already and will continue to give rise to disputes. A meritorious claim in the hands of a nearly insolvent company may well be a vital part of its return to financial health. Similarly, a meritorious claim in the hands of a bankrupt party may represent the only asset capable of ensuring a meaningful recovery for creditors.
Third-party arbitration funding (TPF) is the process whereby a third-party funder, which has no direct interest in a dispute, funds the legal costs for one of the claimants. It is rare for defendants to obtain funding, although sometimes this is made available – for example, as part of funding a portfolio of claims and defences. TPF often works alongside its insurance brethren, before-the-event (BTE) and after-the-event (ATE) legal costs insurance, which insure the risk of adverse legal costs faced by claimants. Many funders require funded parties to obtain such insurance and, in some instances, also require their external legal counsel to work on a conditional fee arrangement in order to share some of the risk.
TPF is usually provided to claimants on a non-recourse basis, meaning that if the claim is unsuccessful, the funder loses its investment and has no recourse against the funded party. If the claim is successful, the funder recovers its investment as well as a success fee (usually calculated as either a multiple of the sum invested or a percentage of the damages awarded, whichever is higher). Many funders also offer products designed to alleviate strain on working capital. For example, a business with a meritorious claim or holding an award may 'monetise' the claim or award. This involves a funder advancing payments in tranches or a lump sum to the business, usually consisting of non-recourse capital, and securing its return by taking an interest in the claim or award. Funders have already reported an increase in requests for this type of funding since the outbreak of COVID-19.
BTE legal costs insurance covers the risk of the legal costs of a potential arbitration in exchange for a premium paid in advance, while ATE legal costs insurance covers the risk of the legal costs of arbitration after a dispute has arisen. Businesses that had BTE insurance in place before the outbreak of COVID-19 may be better positioned to manage their disputes risk arising out of the pandemic than those businesses with no such protection in place. BTE will commonly fund the following costs of bringing or defending a claim:
For businesses without BTE insurance which face disputes arising out of the pandemic, ATE insurance may offer some protection. This type of insurance provides cover against an adverse costs award or non-recovery of a party's own costs up to the limit of indemnity and is usually paid for by a contingent premium (ie, a premium which is paid only if the claim succeeds).
Although most third-party funders disclaim the application of any particular formula in sizing up a potential dispute, there are several common factors that funders consider material to accepting (or not accepting) a matter. Many of these factors are unaffected by the COVID-19 pandemic.
One of the key factors is proportionality of costs to likely recovery of damages. Some third-party funders maintain minimum claim value thresholds in order to ensure that any recovery is adequate to cover both the funder's return and a meaningful return for the claimant. In some jurisdictions, this may be necessary to ensure the enforceability of the funding agreement. They will also factor in any other elements that affect this ratio, such as likely counterclaims.
Third-party funders also seek to fund only meritorious claims. The merits of a dispute and any counterclaims are likely to be assessed from several different angles, including the stability and predictability of the laws of the jurisdictions that are potentially applicable to the claim (including the governing law of the dispute as well as laws of the forum or seat of arbitration). An absence of documentary evidence or fact witnesses who are able and willing to testify can also lead to an adverse assessment. Funders generally tend to prefer claims where no significant facts are in dispute, as this adds to the complexity of the matter and complicates the assessment of the likely outcome. A claim that is premature or, conversely, at too advanced a stage may also be assessed as having less merit than a claim that is about to be commenced or is still in its early stages.
The competence of legal counsel retained by the party seeking funding is another important factor. A meritorious claim in the hands of counsel with no prior experience in the subject matter may lead to the rejection of an application for funding. Funders are often staffed with former dispute resolution lawyers who are familiar with leading members of the legal profession in different fields. They will also have an eye to how counsel have historically analysed and presented the merits of claims to funders, potentially preferring those with a track record of presenting meritorious claims.
However, in the present environment, many funding decisions are likely to turn on the third-party funder's assessment of the likelihood of recovery of any award for damages, including the defendant's solvency. The same phenomenon that is causing businesses to seek out disputes funding is forcing funders to proceed with caution and to closely scrutinise not just the defendant's present solvency, but also its likely future solvency. Predictions of global economic recession suggest that businesses that have survived the COVID-19 crisis will not necessarily be out of the woods once pandemic restrictions have been lifted. More generally, a third-party funder will assess the ease of enforcement, including:
The nature of the funder and its source of investment capital is also a factor in its investment appetite, as discussed below.
According to commentators, in any given year, more applications for TPF are rejected than accepted. In the present period of economic uncertainty and disruption, this is unlikely to change. Businesses in certain sectors suffering from multiple shocks, such as oil and gas, may face a greater challenge in making the case for TPF due to uncertainties such as the price of oil. This uncertainty may make it more difficult for funders to gauge the merits of a claim – in particular, the value of any likely recovery and the solvency of the defending party (whether a private company or a state) and therefore the likelihood of recovery of an award.
Similarly, changes in law in response to or in connection with the pandemic may affect a funder's merits assessment. States may adopt changes to the legal framework applicable to a contract or an investment, leading to uncertainty in respect of the status of a company's rights and their vindication. Inconsistent judgments or awards on contract interpretation, such as in respect of force majeure clauses and other doctrines (eg, frustration of contract), may also create uncertainty.
For companies seeking to pursue TPF, careful consideration of the above factors and due diligence prior to applying for funding will assist in ensuring a company's best chances of success. Legal counsel with experience in TPF and the type of claim being considered can help to guide a company in weighing its options and preparing its best case for funding, as well as identifying appropriate funders. The nature of the funder and how and from where its investment capital is raised is another key piece of the puzzle. Funders backed by private equity and those which have just completed significant capital raising rounds are more likely to be actively pursuing opportunities for investment and may therefore have a higher risk tolerance.
As many third-party funders are seeking to shift their investments to portfolios, there may also be an opportunity for multiple claims to be included within a portfolio. Portfolios enable funders to spread their risk by cross-collateralising claims: the more diverse the claims, the lower the risk to the funder. The criteria for this type of funding is similar to the criteria discussed above in respect of individual claims but within a portfolio, a funder may be more willing to take on a higher risk claim if it is balanced by a diverse set of other matters, lowering the overall risk presented to the funder and potentially lowering the cost to the funded party. There is also the potential of including defences in addition to claims.
Finally, claimants seeking funding must also undertake their own careful due diligence on potential funders, including:
Some capital is generally paid in the future on a rolling basis, so claimants must be confident that the capital will be available to them when needed. The terms of funding should also be carefully negotiated to ensure, for example, that the funder is firmly bound to provide the capital and to reasonably limit the opportunity and terms on which they may exit the funding arrangement.
Once a successful application for funding has been made, careful consideration of proposed funding terms is essential not only to ensure funding can and will deliver the relief that a company needs but also to address other matters. For example, it is critical that a funded party understand how and when payment of the funder's fee and investment will be made. It is also important that the funder and funded party agree an appropriate level of involvement for the funder (legally as well as practically) throughout the matter, including in respect of any settlement discussions. Issues of privilege and confidentiality must also be carefully considered both at the outset when funds are sought and during the subsequent funded period.
For further information on this topic please contact Alison G FitzGerald or Alexa Biscaro at Norton Rose Fulbright's Ottawa office by telephone (+1 613 780 8661) or email (email@example.com or firstname.lastname@example.org). Alternatively, contact Martin J Valasek at Norton Rose Fulbright's Montreal office by telephone (+1 514 847 4747) or email (email@example.com). The Norton Rose Fulbright website can be accessed at www.nortonrosefulbright.com.
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