Pricing Legal Claims Part I: The Valuation Challenge

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The difficulty in valuing a given litigation is well known, but it is important to recognize the three different sources of uncertainty. First is the basic question of the amount in controversy and all the ways that the judge, jury and law can affect that amount. Second are the impact of transaction costs–the cost of litigation–on the amount in controversy. And third is the sequential nature and nonmonotonic value of the option to settle. The latter is almost universally overlooked. In this series of posts we explain why, given especially this third characteristic, staged funding is a better way to deal with valuation difficulties than the common approach.

These challenges have taken on added importance because of the modernization of litigation finance. Pre-modern litigation finance, the only parties who deeply cared about a claim’s value were the litigants and any contingency fee attorney involved. In today’s world, to varying degrees in the U.S., U.K., and Australia, the parties seeking to value a claim may include third party litigation funders; the investors in such funders, whether LPs or shareholders; investors in publicly traded law firms; and non-lawyer investors in privately held firms. For law firm investors, valuation issues are most important when the firm does substantial amounts of contingency fee work.

Third party litigation funders have developed a basic form of phased capital infusion to deal with the valuation problem. (This basic form follows in the footsteps of contingency fee practices). However the approach fails to fully capture either the change in claim value throughout the litigation or new information about value revealed throughout the course of the litigation for the following reasons. First, in the basic approach the percentage of proceeds purchased with each tranche of capital is fixed at the beginning, as is the amount of capital that will be invested with each tranche.  Second, in the basic approach, the money runs out when it runs out; without pegging the tranches (and repricing) to milestones, funding decisions may not be timed to reflect the revelation of valuation information. Third, the fact that the tranches are not pegged to milestones exacerbates the vulnerability of plaintiffs to de-funding, as we discussed earlier on this site, and may worsen the risk of litigation over a funder’s decision to refuse to continue investing.

The model contract/full staged financing approach deals with litigation’s uncertain value more effectively. First, repricing to capture revealed valuation information is built in. Second, funding is strictly or at least loosely pegged to milestones, depending on whether the plaintiff is an access to justice or a corporate finance plaintiff. With these mechanisms, funders can manage their risk, and plaintiffs can maximize the fairness of the financial bargain.

 

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