For the reasons discussed below, we are amending our draft model contract to make the default provision when bridge financing becomes necessary to be good faith negotiations. However, we leave intact, as an alternate, the concepts of Accelerated and Supplement Investments because we continue to believe they have important role when the financing is providing access to justice otherwise unaffordable, as opposed to being simply a method of corporate financing.
Reviewing the Context
The draft model contract is intended for a very specific type of case: a corporate or other sophisticated plaintiff bringing a commercial claim. That does not mean the contract has limited utility; the universe of such potential claims is vast. Indeed, corporate finance and accounting concerns inhibit many companies from bringing meritorious albeit smaller cases, and litigation finance can address those concerns. A recently formed fund emphasized that opportunity when announcing itself. But the sophistication of the players–unlike consumers or injured victims–and the type of harm sued over are important background when analyzing the issues raise by the funding terms of the model contract.
The premise of the model contract’s adoption of venture capital is that a funder can–and should–be able to refuse to further fund a claim at predetermined decision points called “milestones.” As we’ve explained, good milestones are points in time at which the information about the value of the claim has fundamentally changed, such as at the close of discovery, or the entry of a judgment that may yet be (or will certainly be) appealed. We can justify, as a normative matter, a funder’s decision to essentially abandon this type of plaintiff during this type of claim if the decision reflects new information demonstrating the claim is much less meritorious, or much less valuable, than previously known.
If the funder is being used purely for corporate finance reasons, the plaintiff has the opportunity to continue to fund the case itself rather than settle. If the funder is genuinely providing access to justice, and the plaintiff is thus forced to either give up its case or settle on adverse terms because of the decision not to further fund, that result is not per se bad so long as the decision not to further fund reflects new, adverse information.
The world is not so neat and tidy, however, as to guarantee that the moneys provided by funder(s) at the Initial Closing will fund the case through to the Discovery Milestone, or whatever milestone the parties negotiate. When such a gap happens in the venture capital world, the parties simply engage in good faith negotiations to see if they can work out a bridge financing deal. As Elisha Weiner and Kenneth Linzer noted, that approach might be proper in the litigation finance context as well. In that regard they voiced a similar concern to the one raised by Edward Reilly of Themis Capital. To the extent that the funder is simply providing a solution to accounting issues or corporate finance priorities, rather than access to justice, we agree that requiring good faith negotiations is a sufficient contractual provision; in that situation the plaintiff cannot be held up during the negotiations because the plaintiff does not need the money to pursue its suit.
Funding Shortfalls in Access to Justice Cases
When we drafted the model contract, we were more focused on plaintiffs who lacked the resources to sue effectively without financing, true access to justice cases (small corporations suing big ones, wealthy but not mega-rich individuals suing a much deeper pocket). In such cases, the need to negotiate bridge financing a la venture capital can leave plaintiff particularly vulnerable to being “held up”, to use the VC term. That’s in part because the plaintiff in a litigation faces far more systemic constraints and has much less control over the time frame for action than entrepreneurs in the open marketplace do. To protect against such uneven bargaining power, the draft model contract defaults to “Accelerated Investments” and “Supplemental Investments” instead of simply mandating further negotiations.
To understand “Accelerated” and “Supplemental” investments, the concept of “Committed Capital” must be kept in mind. That is, at the outset of the deal, the plaintiff and funder negotiate, based on their estimates of claim value and costs to conduct the claim, the total amount of money a funder is willing to invest to fund the entire claim–the “Committed Capital.” This amount of money is not invested all at once; rather, at the outset the deal is broken into tranches that the funder in good faith intends to invest at the various milestones, unless information developed during the conduct of the claim convinces the funder not to continue funding at such milestone.
An “Accelerated” investment occurs if it seems clear the money invested at the most recent milestone will run out before the next milestone arrives; in that situation, the funder is required to invest some of the capital it had already agreed to invest at a later date. This investment thus does not change the total amount of capital a funder has been willing to commit to a case. While it is true that accelerating some of the investment may ultimately produce a future shortfall, that result is not nearly certain because no one can gauge when settlement will happen.
Imagine, for example, that going through discovery was significantly more expensive than anticipated at the Initial Closing, so that the money invested then will run out before the close of discovery. Requiring additional investment to reach the close of discovery does not necessarily mean that insufficient funds will remain committed to conduct the rest of the case; settlement after the close of discovery is a plausible result, particularly for these types of cases. Indeed, the critical difference between Accelerated Investments and what happens in bridge financing is not that additional capital is invested; the difference is that with Accelerated Investments the price of the capital is not re-negotiated and the further investment is not optional.
(An important caveat is that the Accelerated Investment is not totally mandatory; the funder can terminate the contract at will to avoid Accelerated Investments, with various consequences depending on what the funder does. This discussion assumes the funder does not want to terminate the contract. However we will revisit this issue in Friday’s post, which returns to termination as we start discussing termination for cause.)
The bar against renegotiation is justified both by the disproportionate bargaining power issue above and by the fact that nothing has changed to justify altering the terms. Specifically, at the last profound change in information about claim value (as opposed to claim cost)–the last milestone–the funder made the decision to invest on certain terms. As the next milestone has not yet been reached, and thus the informational landscape of claim value not significantly changed, the return earned by the new purchase of Litigation Proceed Rights should have a similar–indeed, because of the time value of money, greater–return as the Rights bought at the earlier milestone. That seems commercially reasonable.
The mandate to invest is justified both to protect the plaintiff from being held up and because our courts are a public good and are currently tremendously overburdened. If funders could walk away from a claim before reaching a point at which the information about claim value has materially changed, they could “claim shop.” That is, funders could initially invest in many claims, and then abandon many even though new information about claim merit/value has not emerged to divert resources into a subset of those investments. (According to some, this happens with some contingency law firms that invest in a large portfolio of cases). In this scenario, the claims they would continue funding would be the ones that were moving along fastest, at lowest cost, or the ones in which plaintiffs offered the best possible deal; not necessarily those that were most meritorious or most potentially valuable to all parties. Indeed, funders would have an incentive to always under invest at the initial closing. This outcome would be less problematic in the venture capital context, but in the litigation context it is normatively undesirable. (Again, plaintiffs that are using funders for accounting reasons do not face the bargaining power problem and these concerns are not significant.)
In sum, the concepts of Accelerated Investments and even Supplemental Investments help prevent funders from abusing the system by forcing them to honor their commitment to the plaintiff through to a point where all parties have new information that justifies reassessing going forward and/or what the terms of a fair settlement are.
Admittedly, supplemental Investments are somewhat different, in that they occur after all the Committed Capital has been spent. Nonetheless, if the funder has not already decided to exit, whether by ceasing funding at a milestone, lining up a replacement funder, or simply walking away and cutting its losses, the funder is affirming that in its view the case is meritorious and should be pursued. Because Supplemental Investments require the investment of new capital, the contract imagines the funder will want a premium, and it suggests one. The point of doing that negotiation at the outset is simply to limit the transaction costs and bargaining power disparity when the committed capital runs out; the premium has already been negotiated.
When we first unveiled the idea of Accelerated and Supplemental Investments, Edward Reilly objected based on the idea that the funder is absorbing the risk of cost overruns without itself causing the overruns. Indeed, while many reasons can drive the overruns, as partially sketched by Kenneth Linzer and Elisha Weiner, only a poorly conceived litigation budget (or a strategic decision pushed by the funder) could be even partially attributed to the funder. There are two kinds of responses to Mr. Reilly’s concern.
One, the allocation of risk is appropriate because it is on the party most able to bear it, one that (in the case of Accelerated Investments) has already indicated a willingness to invest the capital in the claim. We acknowledge, however, that Supplemental Investments are very different than Accelerated Investments, even in access to justice cases, as they involve the provision of new capital.
Finally, Weiner and Linzer also suggest that Accelerated Investments and Attorney Waste would push funders to use litigation counsel that are repeat players so that the funders can exert more influence on the Litigation Counsel. That concern seems to us to be a bit overstated, simply because funders are already heavily incentivized to work with repeat Litigation Counsel to get that influence. That is, it may be true that the terms increase that incentive but it is not clear to us that the increase is meaningful given the strength of the underlying incentive.
Here is the revised contract language:
[5.4 Funding Shortfall: If a Funding Shortfall occurs, Litigation Counsel shall so certify to [the/each] Funder and the Plaintiff. Within  days of receiving such certification, the parties shall negotiate in good faith to finance the Claim until the next Milestone; such negotiations may involve the sale of additional Litigation Proceed Rights or any other financing mechanism not prohibited by law.]
[5.4 Accelerated Investment: If an Acceleration Event occurs, Litigation Counsel shall so certify to [the/each] Funder. Within  days of receiving such certification, [the/each] Funder shall purchase [a pro-rata share of]  Litigation Proceed Rights at the Litigation Proceed Right Purchase Price used at the Closing immediately prior by depositing the Funder’s total purchase price into the Litigation Account. This Accelerated Investment shall not represent a new capital commitment; instead it is the acceleration of a portion of the capital intended for investment at the next Closing. The number of Litigation Proceed Rights sold at an Acceleration Closing shall reduce the number of Litigation Proceed Rights offered for sale at the [Discovery Closing/at the next Milestone Event Closing] by a like amount.
[5.5 Supplemental Investment: If a Supplemental Investment Event occurs, Litigation Counsel shall so certify to [the/each] Funder. Within  days of receiving such certification, [the/each] Funder shall purchase [a pro-rata share of]  Litigation Proceed Rights at [the Litigation Proceed Right Purchase Price used at the Closing immediately prior/at a price [10%] less than the price used at the Closing immediately prior] by depositing the Funder’s Supplemental Investment into the Litigation Account.]
Funding Shortfall: The balance of the Litigation Account falls below [$ ] and the Litigation Counsel in good faith reasonably believes the amount remaining in the Litigation Account is insufficient to finance the conduct of the Claim through to the Milestone Event marking the next Closing.