The practice of “litigation financing” has become a source of great controversy in the legal industry. If you almost fell asleep reading that sentence, put on a pot of coffee. The terminology may sound antiseptic, but the business of litigation finance—and the scandal brewing around one of its leading companies—are more interesting than the name suggests.
Litigation financiers provide funding that allows litigants (corporate plaintiffs, mostly) to bring expensive lawsuits that can, in some instances, take years to resolve. In exchange, financiers take a stake in any recoveries earned at trial or through settlement. The business model is little different than venture capital or other risk-based investing: The plaintiffs get money to move forward with their cases; the financiers, meanwhile, are betting on receiving returns in excess of their investments.
Critics like the U.S. Chamber Institute for Legal Reform, an arm of the U.S. Chamber of Commerce, complain that litigation funding incentivizes frivolous lawsuits and complicates settlement negotiations, driving up costs. So far, though, pioneers in the sector have been relatively free to play in what the Chamber estimates to be a $100 billion niche in the investment market.
New developments surrounding one of litigation financing’s leading players, however, are putting a microscope on the industry.
Last week, the short-selling investment house Muddy Waters laced into Burford Capital Ltd. with allegations that the litigation funding firm “heavily” manipulated performance metrics (such as internal rate of return and return on invested capital) to inflate its profitability. Muddy Waters didn’t mince words in a 25-page report laying out its position on Burford’s stock, which trades on the AIM sub-market of the London Stock Exchange. In the document, Muddy Waters charges Burford with using so-called mark-to-market accounting to place overly generous values on pending litigation, and booking profits before the cases are even completed.
“For years, [Burford] was the ultimate ‘trust me’ stock,” Muddy Waters said. “Thanks to a light disclosure regime, the esoteric nature of its business, and unethical behavior by its largest shareholder, Invesco, it turned Enron-esque mark-to-model accounting into the biggest stock promotion on the AIM.”
Burford fired back with a defense of its accounting and insinuations of “illegal market manipulation” by its short-selling critic. Nevertheless, Muddy Waters’ call to short the stock sent shares tumbling and reportedly left other litigation financiers scrambling to calm investors’ fears over their asset valuation methods in the fallout.
It has all been very messy. Then again, so is Burford’s “byzantine” corporate governance, according to Bloomberg Opinion columnist Chris Bryant. Among other issues, institutional investors aren’t thrilled with the fact that Burford’s CFO is married to CEO Christopher Bogart.
The marital status of Burford’s C-suite probably doesn’t matter that much to public companies, but the phenomenon of litigation finance should. A number of sophisticated plaintiffs’ law firms could be tapping litigation finance for resource-intensive 10b-5 securities fraud cases, whistleblower suits, and appraisal rights. To the extent that the industry gets over the hurdle of the Burford story, corporate defendants can expect that the growth of litigation finance will increase the war chests of their adversaries.
And when a litigation financier inevitably decides to go public on a U.S. stock exchange, it will raise tough questions about how players in this emerging line of business should report their financials. The Burford drama could motivate regulators to start working out the answers now.