Pricing Legal Claims III-Staged Funding and the Link to Options Analysis

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A paradigm shift is underway regarding claim valuation, from viewing claims as assets to real options. The asset approach, while accurate and workable at a basic level, oversimplifies the reality of litigation by treating all the decisions involved as essentially two: the decision to file suit, and the decision to settle. In reducing litigation this way, the assumption is that the litigators and litigants are essentially passive investors, and that a fixed commitment to full funding has been made at the point of filing suit. This paradigm is most appropriate when the perspective is that of a plaintiff who pays out of pocket for legal fees and costs. Such a plaintiff will, as the asset approach imagines, sue only if the expected return is more than the expected costs, and go to trial only if her perception of a potential judgment is so much greater than the defendant's that it exceeds her expected costs of litigating through to judgment.

The real options approach, by contrast, assumes active managers of the litigation who can calibrate their financial commitment in response to case developments. These active managers can plow more or less resources into a case without committing to full funding or pulling the plug on the investment entirely. This framework is most relevant when analyzing the decision-making processes of repeat players who have portfolio concerns. Given the rise of third party litigation funding, or when considering contingency fee firms, this approach is more accurate and useful than the asset approach.

Unsurprisingly, since it reflect a third party investment in a litigation, the model contract embodies the real options analysis approach. The VC analogy underlying the model contract also suggests that active management of the law suit, i.e. decision – making based on new information, can be as or even more valuable than the capital contribution funders provide. By selling interests in the litigation's proceeds in stages, at prices that can be negotiated at every stage, the model enables the funder(s) to play the role of active financial managers. Indeed, the securities approach of the model provides the most flexibility possible, in that it enables various anti-dilution rights or other methods of customizing the deal's financial terms to reflect contingencies.

However the essence of the model–venture capital-style staging of investment pegged to the revelation of an uncertain potential asset's value–could be done without a formal securities approach, as the simple forms of sequencing currently in the funding marketplace suggest. That is, full staging would be more nuanced and complex than the current approach, but like the current approach, the investment could be styled as a non-recourse loan.

Either way, the point is the same: full staging of litigation finance provides the flexibility sought by the active investment managers assumed by the real options approach.


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