Litigation funds: The justice league

The battle between Nkosana Makate and his former employers at South African mobile giant Vodacom is a modern tale of David and Goliath. Known as the "Please Call Me" case, the dispute involves a cell phone service - which Makate claims to have invented - that allows pre-pay users who have run out of credit to send a free text message to a friend requesting a call back.

Makate says came up with the idea back in 2000 while working for Vodacom and was promised a share of the profits. Not a cent has been paid. Vodacom, meanwhile, has made millions from the idea. Normally this case - and many others like it - would struggle to see the light of day, but thanks to litigation financiers who were will to stump up the capital needed, David is able to take on Goliath.

In this instance the investor was Commercial Intelligence (CI) Funds Group, currently South Africa's biggest litigation financier, which put up the money in return for a share of the eventual winnings. An outcome is expected this month.

Eye on Asia

CI has been in the business for six years, offering litigation financing through private equity-style funds raised from third-party investors. The firm sees increasing opportunities coming out of Asia. Of its latest vehicle, which has a target of $150 million, nearly 65% will be committed to the region.

"Litigation financing has moved on a lot over the last 10 years," says Michael Shone, a managing partner at CI."The only place it hasn't moved on is in emerging markets."

CI, which also commits around 20% of its capital to distressed debt, is not the only litigation financier interested in Asia. Australia is already home to a handful of industry participants who have been tapping the domestic market, while Hong Kong and Singapore have also attracted investors, including CI, seeking opportunities in the international arbitration space.

So what exactly is drawing litigation funders to Asia and how do the promised returns compare to conventional private equity?

The idea that a law firm could fund clients' claims from its own balance sheet in return for a percentage of the proceeds on a contingency fee basis is well established, especially in the US. However, the practice of bringing in third-party investors to put up the capital is still very much in its infancy.

Australia has widely been credited as the birthplace of litigation financing since the industry was legitimized in 1995. The first litigation financier to set up the in country was IMF Group, which listed on the Australian Securities Exchange in 2001. The Sydney-based firm - still the domestic market leader - focuses on funding litigation claims with a minimum value of A$5 million ($4.6 million) and arbitration claims with a minimum value of A$10 million.

"A cause of action is like any other piece of property," says Hugh McLernon, managing director at IMF in Perth. "It's yours and you are entitled to do what you want with it, whether you sell it, assign it or burn it. That is basically the situation we have in Australia."

In Australia, the US and the UK, litigation financing has flourished as a result of the liberalization of the rules surrounded third-party financing. In UK and Australia at least, the practice was once restricted by an English common-law prohibition against "champerty" and "maintenance," which prevents outside investors from meddling in lawsuits or taking cuts from judgments.

Out of bounds?

While the restriction has since been removed in these two countries - in 1967 for the UK and 1995 for Australia - similar common law prohibitions remain in many Asian jurisdictions rendering most litigation cases out of bounds for potential investors.

However, there are two areas where exceptions can be made: insolvency cases and international arbitration. The latter is particularly attractive because of the large sums involved and also the fact that litigation financiers can concentrate their energies on Asia's two major jurisdictions for international arbitration: Singapore and Hong Kong.

"The reason the rules around international arbitration are somewhat more relaxed is because it tends to be disengaged from local laws when it comes to funding," says Denis Brock, a dispute resolutions partner at King & Wood Mallesons in Hong Kong. "There is no clear authority that says you can have funding in international arbitration."

Insolvent companies, meanwhile, are by definition in need of funding, so it is no surprise that in countries like the UK the assignment of a cause of action to a third party would not run afoul of prohibitions against champerty and maintenance.

In Hong Kong it has been less clear-cut, although two recent cases have shown that the jurisdiction is becoming more open to litigation funding in insolvency cases.

The first is that of Akai Holdings vs. Ernst & Young in 2009. Akai was a Hong Kong-listed electronics manufacturer which had gone into liquidation in 2004. Liquidators launched an action in the Hong Kong High Court against the Ernst & Young, claiming damages for alleged negligence and breach of duty in auditing Akai's accounts from 1997 to 1999. They argued this negligence led to the company's eventual collapse.

The case was significant in that the liquidators are reported to have obtained court approval for the litigation funding from a third party investor - however the identity of the fund remained anonymous.

"Akai is what caught people's attention," says CI's shone. "You had a big liquidation and a horrendously expensive case against a Big Four accounting firm. That's when people realized there were big opportunities in Asia."

The second, and perhaps more landmark ruling in terms of opening up the Hong Kong market, was that of the insolvency of Cyberworks Audio Video Technology. Briscoe & Wong, one of the firm's liquidators, sought sanction to enter into an agreement with litigation funder Remedy Asia, so that it could pursue litigation against various parties in a bid to recover losses.

Cut of the profits

When successful in a case, litigation funders can take anything between 30-60% of a client's financial reward. With potential claims amounting to hundreds of millions, return cans be very lucrative.

"The basic figure we are coming out with is that for every dollar we invest, we get three dollars back," says IMF's Mclernon. "That is over an average of 2.2 years for each case - so it is a tick under a 100% gross return, and from what we can tell that is scalable."

While there is no data readily available on returns for litigation fund investors, industry participants are expecting similarly high returns as IMF's McLernon. London-listed litigation financier Juridica, for example - which has $200 million in assets under management - recently reported a total IRR of 81.97% across all the recoveries in 2012.

But can the same returns be expected in Asia? CI's Shone thinks they can, although he cautions that the nature of the risk requires a sophisticated investor. There is no guarantee that every case will be won - and when one is lost, the fund investor bears the cost.

"It is relatively high-risk strategy where everything depends on your case selection, your management and cost control," he says. "There also a lot of factors beyond your control." CI counts institutional investors and large family office among its LPs.

Given the risks involved, legal experience within team is essential; indeed, many litigation funders come from a legal background rather than an investment one.

IMF's McLernon argues that a strong team can ameliorate the risk. "That is our arbitrage," he says. "It is our view of the risk compared to other people's view of the risk. If we settle eight out of 10 cases, and win half of those that go to court - that is nine out of 10 cases won - how many other business have that kind of certainty?"

While there are few Asia-focused litigation funds to speak of, anecdotal evidence suggests would-be LPs are interested.

Teras Group, a litigation financier based in Singapore, focuses on funding international cases involving Asian claimants that are litigated in US or UK courts. While the firm is currently privately financed it has claims to have received numerous approaches from prospective investors asking about a third-party vehicle.

"There is more interest in the region and more activity and that is a trend that will only continue," says Steven Goodman, Teras' founder. "A lot of people like the space and they like the proposition and the experience we have here. They often ask if we will take outside investment but we are just not ready yet."

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• Topics
• Regulation
• Australasia
• Greater China
• Southeast Asia
• Fundraising
• Fundraising
• Hong Kong (China)
• Singapore
• regulation
• Australia