Litigation financing generally involves a third party investing capital to take an interest in another party’s legal claim. The term “litigation finance” refers to a financial transaction between commercial entities in which repayment is contingent on the outcome of one or more legal matters. When viewed from an investor’s perspective, patent litigation financiers and investors raise capital and provide financing for patent litigations in return for an interest in settlements, damage awards, or licensing fees from the assertion efforts. From the perspective of the patent owner or operating company, patent litigation financing can provide financing that allows the party to bring a claim that it otherwise could not afford to bring or allow its own capital to be allocated to other higher-value purposes.
For patent-rich companies facing cash-flow constraints, justifying investing still more money to protect patents through an enforcement action can be difficult. Over the past decade, patent owners have seen the duration, risks, and costs of patent litigation increase at the same time that fewer licensing deals have been successfully negotiated outside litigation. These forces offer a partial explanation for why many companies are increasingly turning to the use of litigation finance to fund patent litigation matters. This form of financing has become a well-established and sought-after option that offers start-ups, universities, and established companies a way to protect their patented inventions without incurring the cost and the attendant risk of pursuing those claims.
In the early 2010s, the use of third-party litigation financing in the U.S. was controversial. Those who advocated against its use argued that its practice encourages frivolous lawsuits. They also argued that the presence of a third party in a litigation would influence a litigator’s ethical obligations to its patent-owner client, as the litigator would also seek to protect the investments made by its funding partners. Moreover, detractors argued that there is no need to take on third-party financing risks given that contingency fee arrangements are permitted in the U.S.
Those in favor of third-party litigation financing arrangements argue that it provides access to justice for plaintiffs who could not otherwise afford it, as financiers have an incentive to finance only meritorious cases, and the financiers serve as a vetting process by helping litigants see the merits (or lack thereof) of their cases. Advocates for third-party litigation finance also argue that it offers plaintiffs the ability to reduce financial leverage that defendants might gain by outspending plaintiffs.
The use of third-party litigation funding continues to increase in the U.S., although some level of additional regulation or disclosure obligation is possible. Until about 2010, it was uncommon for third parties to fund another company’s commercial litigation. At that time, use of third-party litigation financing was more common in the United Kingdom and Australia. Times have changed, and presently, U.S. courts have accepted the practice. Industry analysts have reported that nearly 60% of chief financial officers (CFOs) at companies with revenues greater than $1 billion said that they were “very likely” to use litigating financing in the near future. These survey results demonstrate that litigation finance is not just a tool for start-up companies, which might need help fending off larger competitors. It is also used by some of the world’s largest publicly traded companies to improve bottom-line performance.
Next, we identify the three categories of funders in the market and explore certain key elements that patent owners should discuss with funders as part of their due diligence process.
The market for monetizing patent infringement claims is primary served by dedicated funders –companies that specialize in funding third-party litigation matters. Dedicated funders are not the only source of capital for patent owners, however. Many hedge funds, private equity funds, and family offices have an appetite for the risk/reward scenario offered by funding meritorious claims.
One key issue that differentiates dedicated funders from their competitors is that dedicated funders focus on providing funding in support of litigation; hedge funds and ad hoc funders tend to pursue multi-strategy investments that employ various investment approaches in different markets and asset classes. This characteristic is important, because dedicated funders, as asset class specialists, tend to be more efficient in assessing risk/reward scenarios, which gives them the potential advantage of deploying capital faster. Unlike a dedicated litigation funder, a hedge fund or ad hoc investor may move more slowly to deploy capital, as it can take them longer to become comfortable with the legal and economic merits of litigation claims, or their structure prevents them from deploying capital until they have presented meritorious claims to their investor pools.
Stout is often asked to advise clients about the financial merits of a legal claim. Through that experience, we have learned that there are key issues funders and patent owners and their counsel generally negotiate: the amount and frequency of the deployment of capital, repayment terms, risk allocation, control over settlement terms, the degree to which a funder can exit its investment, and reserve capital. In the following sections, we summarize our experience regarding those issues.
Funders publicly state that they are interested in investing in opportunities as small as $50,000. However, in our experience, dedicated funders who have an appetite for patent litigation are looking to deploy between $2 million and $10 million for individual claims. This is not to say that smaller cases are not meritorious. However, the median cost to litigate a matter through trial is $2 million to $5 million, which means that small claims do not provide a sufficient return on investment.
Of course, funders often have an appetite for larger litigations; however, these larger investments tend to be reserved for multi-jurisdictional disputes (e.g., district courts, Patent Trial and Appeal Board (PTAB), and International Trade Commission (ITC) matters). Stout has also been involved with larger investments when the funder and the law firm agreed to bundle multiple litigation matters into a single portfolio with each litigation having its own independent value.
The financing might include all litigation expenditures, a particular phase of litigation (e.g., post-Markman hearing trial litigation), expert witness and other ancillary expenditures, or any negotiated combination thereof. Flexibility is one of the key reasons companies value working with litigation financiers. For example, Stout was recently retained to assess the potential damages in a matter that had already progressed through expert discovery, yet the patent owner was unable to afford the anticipated legal fees through trial. The fact that the patent owner was able to turn to a litigation funder at a later stage in the process was an important and valuable consideration for the patent owner, who principally sought to see the matter successfully brought to trial.
For conventional asset-backed loans, lenders typically turn to physical assets, such as inventory, machinery, or real estate, in determining loan size and terms. The borrower grants a security interest in these assets to the lender as collateral against the loan. IP-backed loans are similar to their tangible asset-backed counterparts. For tangible and intangible assets, asset-based lenders assess credit risk, at least partially, based on the value and liquidity of the underlying collateral, and typically require unconditional repayment of the principal plus interest.
Unlike conventional asset-backed financing arrangements, litigation financing agreements are “non-recourse,” in that the plaintiff repays the funder only with the proceeds of a successful lawsuit – owing nothing if the judgment is unfavorable. The contingent nature of these non-recourse loans is one of the primary benefits to borrowers associated with litigation finance. The patent owner not only defers the costs associated with a successful outcome but also may further avoid costs entirely if the case is resolved unfavorably. Many patent professionals are familiar with this approach, as it is similar to the type of engagement taken on by litigators when they are retained on a contingency fee basis.
Depending on the merits of the underlying litigations, certain funders may prefer that the claimholder and counsel share in the risk of the case. To the patent owner, this means that the patent owner would have to pay some portion of the litigation fees and expenses side-by-side with the funder. From the perspective of outside counsel, the litigators may be asked to take on a partially contingent stake. For example, the funder may agree to pay the hourly cost of the attorney’s time so that the firm can cover payroll expenses in exchange for paying a multiple on unrealized fees. Although it may not be possible to structure all deals with a risk-sharing objective in mind, risk-sharing may be among a funder’s requirements.
It is well-known that patent litigations can take several years to complete. This means that companies should be asking their funding partners whether they have a track record of supporting cases over a lengthy period and whether they have experience with other multi-year investments. One of the key diligence questions patent owners can ask is whether the funder has sufficient committed capital to fully fund the litigation, and whether the funder holds some or all of the investment amount in reserve.
Litigation funding providers generally play a passive role in management and decision making regarding the underlying legal claims. There are certain prohibitions against interfering with the representing lawyer’s ability to exercise its own independent professional judgment. However, patent owners should understand whether, and to what extent, there are conditions that allow the funder to stop financing the litigation. For example, a funder might be able to contract for a right to exit if there is a material negative ruling (stay pending PTAB resolution, negative discovery ruling, adverse claim construction ruling, etc.). Terms like this could leave the patent owner and outside counsel in a tough situation. Other funders may establish control over the decision to accept a settlement by negotiating terms that increase the cost of the funding if a plaintiff rejects a reasonable settlement offer.
One of the primary benefits of working with a litigation financier is the reduction in risk of uncontrolled and potentially unpredictable expenses. This issue may be important for general counsel, whose job it is to overcome internal budget challenges to allocate capital to pursue commercial disputes. According to industry surveys, this is an issue not only for cash-strapped start-up companies but also for larger companies whose shareholders who have quarterly earnings expectations and expect that company executives will prioritize investment of capital in core business activities – not in risky litigation.
The main advantage of litigation finance for litigators is that they can structure deals such that the litigators are paid even if the claim is resolved unsuccessfully. As a product of these benefits, certain law firms have used litigation finance as a business development tool to differentiate themselves from their competition. In addition, if the matter is successfully resolved, then the litigators may be able to earn a return on their investment that is a multiple of their unrealized fees.
Law firms are also in the unique position to bundle portfolios of ongoing, or yet to be filed, litigations. Portfolio deals may include multiple matters and can result in larger investments from litigation financiers. Certain funders may prefer these types of bundled transactions because a diversified portfolio spreads the risks associated with each lawsuit.
The primary disadvantage of litigation funding is that it reduces the potential upside for an otherwise meritorious claim. The non-recourse feature of litigation funding might present a burden because the payment terms are structured such that the funder is paid first with interest. Given the risk and cost associated with patent verdicts these days, certain litigation funders can charge patent owners a high interest rate which, when spread out over multiple years, can become very expensive – eating into the potential upside for the litigator and the patent owner.
Other forms of financing, such as asset-backed collateral financing, are generally stable, and lenders often have readily available market information to assess the value of the underlying assets. However, because patents are generally more difficult to value and to liquidate, patent owners and potential funding partners require a lengthy valuation diligence process that allows all parties involved to understand the risk/reward scenarios. For example, Stout can prepare financial pre-case (or early case) assessments within approximately three to five weeks that lay out the likely damages scenarios.
This brings us to risk of disclosure of confidential information. As part of due diligence, the patent owner, the funder, or both need to work with independent economic and valuation professionals who attempt to collect relevant information associated with the financial, legal, and technical aspects of the case. This is necessary because, in most cases, the litigation has not yet proceeded through fact discovery, yet the litigation financier must work with the patent owner to vet the merits of the liability and damages claims. Although some clients have readily accessible historic and pro-forma profit and loss statements that they are willing to share, other companies have to be ready to open their books for third-party review.
Demand for legal finance is growing, particularly in the intellectual property (IP) space, where patent owners face uniquely high costs and risks of monetizing their legal claims. Understanding the benefits of legal finance and how to obtain it can be the key to unlocking the value of IP through licensing or patent enforcement campaigns. As non-recourse financing depends on successful outcomes, each litigation undergoes a rigorous diligence process to assess the strengths of the liability and damages claims. Although certain funders conduct this underwriting process internally, others prefer to operate with a lean deal team and outsource the financial diligence process to trusted damages experts, valuation professionals, and legal and technical experts. The benefits of the underwriting process can help claim holders and financiers better assess case merits and weaknesses. A thoroughly vetted case can make for better investment and litigation strategy decisions.