Funding Agreements: The Devil is in the Details

Recovery efforts in some countries outside the U.S. have proven challenging, with some of the successes there smaller than expected. Whether clients see much from these recoveries frequently depends on the terms of the organizer’s funding agreements and, more specifically, the amount of expenses reimbursed before funds are distributed to group members.

Registration documents, including funding agreements, can be dense and complex, sometimes exceeding 150 pages of legalese. They’re drafted by case organizers (lawyers and funders) trying to both protect and maximize returns on their investments of time and capital. Having read hundreds of these agreements, we appreciate that the devil is often in the details.

Here we offer some general observations, particularly on the importance of funding agreement “waterfalls” – terms specifying the priority of payments from recoveries – and how prosecution costs and the types of expenses reimbursed can affect both the percentage share and absolute amounts from recoveries received by claimants. We offer these comments not to discourage client participation, which we fully support, but to ensure clients join with fully informed expectations.

The Fundamentals of Funding Agreements

Clients should understand the basics of funding agreements and their potential impact on future resolutions and clients’ bottom lines. Most important is the difference between gross and net recoveries.

• Gross recovery is the full consideration paid by defendants after settlement or judgement.
• Net recovery is the gross recovery less case expenses taken ‘off the top,’ plus any other priority payments made to case organizers before the remaining balance is shared among the claimant group.

If prosecution costs are high, the variance between gross and net recovery can be substantial, resulting in a larger share of recoveries to case organizers than is suggested by the percentage success fees in litigation funding agreements. We encourage clients to model potential outcomes, particularly for small recoveries in countries where the gross/net variance may be significant due to high prosecution costs.

Case organizers front-load returns on their investments. Under the waterfall provisions in funding agreements, they are paid first and in doing so, recover more when recoveries are small and expenses are high. For example, if the gross recovery is $10M, and there are $2 million in costs along with a 25% success fee to the funder, then the net amount to claimants is $6M. ($10M minus $2M minus 25% of $8M).[1] This results in a 40/60 split between case organizers and claimants. If, however, prosecution costs are twice as much – $4M instead of $2M – case organizers receive $5.5M while claimants get $4.5M, a 55/45 split. In other words, most of the recovery goes to the organizers.

Organizers would likely argue it’s unfair to lump together expense reimbursement and commissions when considering recovery splits. However, not all expenses involve cash outlays to third parties. Many represent returns on the organizers’ time and capital paid as cases progress. For example, costs for investigations, book building, and pre-filing settlement attempts are paid from litigation budgets. Counsel gets a substantial portion (e.g., 75%) of their hourly rates as suits proceed. Funders often charge fees for managing litigation and instructing counsel. They may earn interest on invested capital.

Funders may also capture a larger share of recoveries if their success fees are multiples of invested capital. For example, funders may receive 2-3x their invested capital upon success. This may be their sole compensation method, or it may establish a floor on the percentage success fees. When settlements are small, the multiple on invested capital approach can consume far more of the recovery than suggested by a straight percentage commission rate. For the examples above, if the funding agreement specified success fees equal to the greater of 25% or 2x invested capital, the organizer/claimant split would be 55/45 rather than 40/60.

Understanding Funder Incentives

Across cases we’ve seen many variations, some better and some worse for claimants. However, there is always one constant. Funders have dual incentives: they want to protect their invested capital and earn a return on it, and they want to settle for the greatest amount they can (entitling them to a higher amount in success fees). When cases are strong, there is limited tension between the two. But when recovery prospects decline – e.g., due to weakening case merits or collectability issues – organizers may have different incentives. They may prefer settling for lesser amounts to ensure they recoup their investment and earn a small return, rather than continue investing more capital if the chances for a better outcome have diminished.

In all cases, the organizers’ capital bet is hedged. In most cases, they will get their principal back, since every case has some settlement value even if it’s only nuisance, namely the amounts companies anticipate having to spend on defense that they would prefer to pay earlier to avoid those costs and buy peace.

Since expenses are paid first, ‘off the top’ of any recovery, their investment is reasonably secured. Certainly more so than their success fees, which are contingent on the success of the case, much as bondholders bear less risk than equity holders when company fortunes decline. The tension between capital protection and the prospects for success fees is greatest in countries where prosecution costs are high, like the U.K. and more recently Germany, as the organizers have more invested capital to protect.

The combined assurance of case costs getting paid first, and the receipt of some compensation as cases proceed, means organizers have more incentive to organize and pursue matters than they would if their returns were wholly based on success and pari-passu (on equal footing) with returns to investors. They also have greater incentive to settle for smaller amounts when the prospects for success diminish.

The degree to which organizers control resolutions varies by country and matter. However, funding agreements always allow them to stop further investment if recovery prospects diminish to the point where they determine the case is no longer viable; and they often partially or fully control the settlement process, including approval. So, in practice, claimants are beholden to the funders’ incentives and choices.

Key Takeaways for Investors

For investors, there are six main points to bear in mind. Capable vendors with experience reading funding agreements can assist you in understanding the devilish details in specific registration documents and funding agreements.

• Consider country prosecution costs: When modeling recovery outcomes for countries with high prospection costs, increase the percentage you assume will go to cost reimbursement. In other words, assume a substantial variance between gross and net recoveries.
• Understand payment waterfalls in funding agreements: Consider who and what gets paid before claimants, and whether expenses represent cash outlays by case organizers to third parties or compensation to themselves during proceedings. These are distinct from funder success fees.
• Consider past recoveries: The track record for recoveries in countries may be limited or vary greatly by matter. Model an average recovery rate (g., 20% of estimated losses) and a small recovery rate (e.g., 5% to 10%), particularly if there is a history of modest outcomes in that jurisdiction.
• Be wary of funder returns based on multiples of invested capital: As discussed above, if upon success funders receive a multiple of their invested capital, this can significantly reduce the claimants’ share of recoveries.
• Consider group size: After expense reimbursements and priority payments, the remaining amounts typically get divided pro rata among group members based on their estimated losses at the start of suit.  What claimants get back in absolute dollars depends both on the net recovery amount and how widely it must be spread.  A $10M net recovery goes three times further if there are $100M in group losses than if they are $300M.
• Set appropriate loss thresholds: Consider adjusting your minimum loss thresholds per country to ensure absolute dollar amounts are meaningful even in small recovery situations, particularly if there’s a history of them there. Countries with high prosecution costs are often the same as those that impose significant participation burdens on claimants.  We’ve found that nothing is more frustrating for clients than doing a lot of work to get little or nothing in the end.

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[1] In some cases, funder success fees may be a percentage of gross rather than net recoveries, further increasing organizer shares.