UK: The View From The Auditors

Last Updated: 3 November 2017
Article by Vannin Capital

Authored by Simon Nicholas, director & Laura O'Sullivan, audit manager, KPMG

You are the chief financial officer of an up and coming high growth company. To paint the picture, it's Friday late afternoon, you are mentally picking out a nice bottle of red to crack open on your arrival home, when the head of product development and chief executive officer walk into your office (uninvited), sit down and kick off with "Houston, we have a problem... sooooo... who would we use if we wanted to take action against a competitor for stealing our IP?".

As they explain further, several thoughts pass through your mind in quick succession: 'seriously, could this not have waited until Monday?'; 'but I have just finished our budgets for next year'; 'cash flow was already tight with the new product launch, how on earth are we going to pay the legal bills?'; 'while I get their argument and we are undoubtedly in the right, if I miss the banking covenants we are in serious trouble so can we really afford to take on this fight?'; and finally 'did these guys save this up all week to ruin my weekend?!'.

Unfortunately this disruption at the end of a long week may be just a tiny portent of what will follow. For, as an audit partner to many growing businesses who unfortunately find themselves involved in litigation, this scenario is increasingly common - certainly in my career I cannot recall a time when my client base has been so distracted by litigation - and recent studies have corroborated what I am seeing. Norton Rose Fulbright1 recently conducted a global survey of corporate counsel which found a clear trend towards the growing litigiousness of the business environment, with 84% of respondents expecting the number of legal disputes (and the spending thereon) to at least remain at the same level; 25% of whom expected increases.

Whether acting as a defendant or claimant, we all know that litigation can carry both operational and financial risks. Potentially costly, time consuming and unpredictable, specifically it can put a colossal strain on management resources, cause reputational damage, prohibit effective budgeting of future financial performance, and bring significant cash flow drawbacks which could span several years. Norton Rose noted that, across all respondents, 75% indicated they had at least one ongoing lawsuit, 42% indicated they had more than five – in many cases individuals or businesses simply do not have access to the financial resources or management bandwidth to undertake such feats. This is ever true given the backdrop of 64% of companies having increased their spend on litigation over the last two years, as found by a recent survey undertaken by Legal Week Intelligence and Vannin Capital.

With ever-increasing capital and solvency pressures faced by businesses today, the threat of legal disputes causes significant uncertainty about the future. We see time and time again the effect that lengthy, unpredictable litigation can have on a business and particularly on its financial position and stability. For regulated businesses, the regulatory environment has led to heavily scrutinised fiscal results and, when paired with significant legal costs and provisions, an increased risk of breaching regulatory requirements – particularly those which may already be close to the limit. This is especially relevant given Norton Rose estimates that more than 39% of legal activity relates to regulatory enquiries and investigations.

There are many examples where share prices are suppressed due to the ongoing uncertainty surrounding material litigation which, once resolved, leads to a healthy spike in the share price. Often the spike in share price is regardless of the result, demonstrating investors' low tolerance for uncertainty.

While analysts are aware of the damaging effect of management distraction, it is very hard to quantify and the hope would be that the organisation has sufficient depth and breadth to weather the storm without impacting strategy implementation. What analysts can quantify, or at least reasonably estimate, is the impact on cash flow and the bottom line of the significant legal costs. 62% of respondents to the Legal Week Intelligence/Vannin survey noted that, on average, commercial disputes they are involved in take over a year to resolve. For a start-up or early growth company this length of uncertainty over cash flow can be quite damaging to future prospects and thus, without funding support, the case will not be pursued as the risks to financial resources are too great. In fact, 56% of companies surveyed noted that, because of this, they do not pursue even meritorious claims.

With interest rates over the past few years at all-time lows, several forms of alternative funding have become prevalent and come to the rescue of many varying sized businesses. From an investor perspective, financial exposure to litigation, while not for the faint hearted, provides welcome diversification within portfolios and the opportunity of healthy returns. One such funding source is litigation funding.

In our industry, following the financial crisis and the resulting surge in corporate distress leading to restructuring, we have seen funding being used by liquidators who are required to obtain the best possible result for the shareholder but who are faced with either illiquid or depleted assets and would otherwise not have the resources to pursue or fight seemingly worthwhile cases.

Litigation funding spreads the risks and lowers the barriers faced by many individuals and businesses that may not have the means necessary to seek justice. Depending on the structure of the funding agreement, engaging a litigation funder could be seen as a win-win for a claimant - retaining the potential upside whilst transferring most, if not all, of the downside risk. We are seeing litigation funding being considered increasingly by our clients as they seek to move from carrying onerous on-balance sheet, costly legal proceedings, to having minor balance sheet and cash flow impacts until a time when a judgment is received resulting in, at worst, the removal of uncertainty at a minimal cost. With the shift of risk from the claimant to the funder the pursuit of large scale litigation is much more accessible if the case is considered to be strong.

Third-party legal financing is growing in popularity for obvious reasons and is not just being employed by small to medium sized businesses. It is frequently preferred by the law firms themselves as it allows them to meet their clients' financial needs, share risk and increase their caseloads.

Third-party funding is still seen by some claimants as novel and untested. With the development and growth of the industry, we do not consider these as concerns. Importantly, seeking to Legitimise the industry through regulation, several key players in the funding industry have sought to improve confidence in this niche area of finance, providing consumer protection to ensure that litigants are engaging with financially stable finance providers with ethical and responsible business practices. This can only be a good thing. One such regulatory body that we work with is the Association of Litigation Funders of England and Wales (ALF), which sets out the rules governing the relationship between a funder and its clients, ensuring transparency on key issues such as case control, settlement and withdrawal and undertakes a rigorous complaints procedure where necessary2. Its members are required to comply with the Code of Conduct for Litigation Funders, first published by the ALF in 2011.

As we have seen, particularly for those operating in financial services, while regulation does bring a burden, for emerging industries it can significantly enhance their growth and impact. I am confident this will be the same for litigation funding - especially given the ever-increasing demand for financial solutions and alternative fee arrangements for those involved in or contemplating litigation.

Footnotes

1 http://www.nortonrosefulbright.com/files/20150514-2015-litigation-trends-survey_v24-128746.pdf

2 http://associationoflitigationfunders.com/

Originally published in Funding In Focus, November 2015

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