Legal gold

While bankers and investors wonder when the credit squeeze triggered by the US subprime mortgage crisis is going to end, for litigation lawyers the work is only just beginning. Navigant Consulting, a US-based firm specialising in risk mitigation analysis for companies, attributes a total of 278 US lawsuits filed in 2007 to the subprime debacle, of which 38 had been dismissed by April 2008, with a further 170 filed in the first quarter of 2008. This suggests a marked acceleration in the number of cases being brought.

Few of these disputes have yet reached court, but much can already be deduced. The scale of legal action may be greater than seen in previous financial scandals, such as the dot-com bubble, because of the size of losses incurred and the sheer number of institutions caught up in the crisis. In addition, a growing number of specialist firms willing to provide third-party funding or adverse cost insurance for large damages claims could begin to level the playing field for smaller investors pursuing investment banks that have significant resources to spend on defence lawyers. Indeed, as the credit crunch prompts a surge in legal disputes, investing in litigation itself may prove a rare growth area in a time of falling asset prices.

Predatory lending

Clearly, some cases are more speculative than others. To date, class actions by borrowers against subprime mortgage originators for predatory lending practices constitute the largest slice of litigation (see figure 1 below).

Although some of these origination firms are already in severe financial difficulties that make them less than appealing targets for damages claims, they may be owned or taken over by the largest universal and investment banking groups, such as Bank of America or ­Goldman Sachs. And bankruptcies among mortgage originators could be just the leading edge of a wave of financial distress, if the credit crunch fuels a wider economic downturn.

Where insolvency is unavoidable, creditors or ­liquid­ators sometimes take action against the bankrupt company’s servicers – including auditors and banks – alleging professional negligence. This is all the more likely if fraud has contributed to the company’s financial meltdown – one obvious example might be large-scale falsification of mortgage applications.

The extent of property market declines and mortgage defaults in the US is also provoking some much more unusual cases against household lenders. The City of Cleveland, for example, has launched a claim against lenders for creating a “public nuisance” through predatory lending, since parts of the city are blighted by mass home repossessions. Another municipality, Baltimore, is alleging racial discrimination against several banks, on the basis that racial minorities whose financial position could have qualified them for better packages were erroneously categorised as subprime borrowers, thereby subjecting them to higher interest rates on repayments.

Originators may be vulnerable to such claims because they received commission fees as a proportion of the interest rate on the mortgage, giving them an incentive to increase sales of higher-risk products. Even so, Ernest Patrikis, partner in the regulatory practice at US law firm Pillsbury, and a former member of the legal department at the New York Federal Reserve, believes “economic damage” claims will be difficult to litigate, taking the courts into untested areas of law.

“These cases have a nuisance value that may cause the defendant to settle, especially if the plaintiff defeats motions to have the case moved out of the state courts,” says Mr Franklin.

Seller beware?

A more direct threat to the major Wall Street banks is likely to come from investors suing for losses suffered. These include funds and individuals that bought subprime-linked assets such as collateralised debt obligations (CDOs) or mortgage-backed securities (MBS) – or default protection on these assets – from the distributing investment banks. They also include shareholders of the banks themselves, who have seen the value of their holdings plummet as subprime losses were unveiled.

“Almost every major financial institution that is a public company that has any involvement in subprime assets, broadly defined, has been sued by their own shareholders, on the basis that the bank or entity lost money or had to write down assets, and had issues that should have been disclosed earlier – either risk exposures or accounting disclosures,” says William Dodds, litigation partner at Dechert in New York.

By contrast with previous financial market losses, he adds, institutional investors such as pension funds or corporate treasuries have been ready to take the lead in litigation, despite the need to maintain wider relationships with the banking sector. “Historically they didn’t want to get into litigation, they would handle it commercially out of court, but this time there is just too much money at stake, and too much illiquidity for these institutions to do nothing – or they are worried that if they don’t take action now, the bank may be in trouble later,” says Mr Dodds.

Historically, the bar for claims to succeed in the Federal courts has been relatively high, with the need to prove particular acts of fraud by the bank, says Mr Franklin. However, the Sarbanes-Oxley legislation, post-Enron, doubled the time limit for bringing a case to two years, allowing litigators more time to develop a sophisticated case. “And there has been a raft of lay-offs. Plaintiffs’ lawyers will interview former employees and they may well find someone who will ‘finger’ specific managers within the bank,” adds Mr Franklin.

Conflicting information

Investors suing banks for alleged misselling of structured credit products may have more points of access. According to Philip Young, a partner at commercial dispute specialists Masseys in London, bankers often constructed each new CDO by adding extra contracts and schedules to an existing template. As a result, the legal structures sometimes became as complicated as the cash-flow and risk/reward profiles that caught out so many investors. “These products were not designed with the risk of litigation in mind,” says Mr Young.

Litigators in the US are finding similar points of access in the complexity of structured products. Rick Antonoff, insolvency and restructuring partner at Pillsbury, was involved in a smaller round of disputes over residential mortgage-backed securities (RMBS) in the wake of the Long-Term Capital Management hedge fund collapse in 1998, but says the market has changed beyond recognition since then. “In 2001 this was a $128bn market. By the end of 2007 it had grown to $1300bn, half of it originated in 2006. And the structures have become so much more complex. It used to be long-term investors seeking mortgage cash flows; now we have waterfalls of payments through CDOs.”

As with shareholder litigation, claimants will also be looking to prove inconsistency between offering documents and other information available in the bank. According to Mr Franklin, the structuring of MBS and CDO products into different risk tranches poses a particular problem for distributing banks, as high-yield investors further down the capital structure may have been given more detailed information on risks for the underlying asset pool than the investors in senior tranches.

Institutions that warned their investment advisory clients to exit subprime securities while continuing to distribute them through structured product sales teams could be especially vulnerable, and the size of the institutions themselves is only a weak defence. “In cases I’ve seen, the court aggregated the knowledge of offices in New York, London and Dublin. The whole of the bank was taken to know everything across those three offices,” says Sean Upson, partner at Masseys in London.

Slow boat across the Atlantic

European institutions have certainly not been immune from the financial consequences of events in the US, but the tide of litigation is taking time to cross the Atlantic.

US cases can be almost entirely financed by the plaintiff’s lawyer through contingency fee agreements, where the attorney charges nothing up-front but takes a percentage of the winnings if the claim succeeds. Moreover, in the US, juries decide cases and can award punitive damages far beyond the actual losses to the plaintiff, which is again different to the system in Europe.

Given these factors, even shareholders in French bank Société Générale considering action over late disclosure of losses by rogue trader Jérôme Kerviel are apparently looking at ways to bring the claim in the US rather than France. “As most of these banks have international business, it is often possible to use the US class action. The US courts don’t want to be an international policeman, but it is hard to resist the tendency,” says Mr Nyssen.

In addition, whereas there is a specialised plaintiffs’ bar in the US, claimants in Europe would find many of the largest and most experienced commercial law firms already have multiple relationships with the very banks that might be defendants. This makes most of the major partnerships reluctant to take on litigation against leading financial institutions.

That reluctance is likely to intensify after reports surfaced in June 2008 that JPMorgan had dropped legal giant Linklaters from its panel of advisers, apparently because the law firm was acting for Barclays Bank against Bear Stearns, which was accused of failure to disclose losses at two of its hedge funds. The case started in December 2007, well before JPMorgan had announced any intention to rescue the stricken Bear Stearns.

But judges in Europe may be as unsympathetic to claimants as the large law firms are, if recent decisions are any indication, says Tom Custance, head of dispute resolution at Fox Williams in London. He acted for Belgian investment group IFE Fund in an unsuccessful attempt to sue Goldman Sachs over an alleged failure to disclose an audit report on a company for which the bank was arranging finance. IFE lost the case in the Court of Appeal in 2007.

In a similar case, a judge ruled in favour of JPMorgan in June 2008 when it faced misselling claims from an investment vehicle called Springwell Navigation Corporation. Courts have put the burden of proof on sophisticated institutional investors, and upheld the legal strength of disclaimers and exclusions inserted into contracts by the banks.

But Mr Custance believes those attitudes could soften a little in the current climate. “There was perhaps a feeling that the City of London works; the courts didn’t want to over-regulate because that would make it a less attractive destination for doing business. All that has now changed, because we can see how damaging any form of malpractice can be, how it affects the whole economy, so it is actually a good thing if corporate governance is closely scrutinised.”

New possibilities through litigation funding

Another central obstacle to litigation against deep-­pocketed defendants in the UK, however, has traditionally been the cost. In Germany, lawyers’ fees are fixed by statute for each case type, whereas UK lawyers charge hourly rates, driving up costs the longer a dispute drags on. The predictability of the fixed-fee system in Germany has facilitated a long-standing market for prozess finanz, or litigation finance, in which upfront funding of legal costs is provided in return for a share of the payout if the claim is successful.

Insurance giant Allianz is one of the leading players in this field in Germany, but Christian Stürwald, who began extending the group’s business into the UK in 2007, says costs for equivalent cases can be five to 10 times as high in the British market, complicating the pricing calculations for funders. More importantly, in stark contrast to the US, claimants in the UK are also required to pay the defendant’s costs if the claim fails – so-called adverse costs, which could be very high for a wealthy defendant that took on a large legal team.

The market is gradually getting to grips with these challenges, and there are growing opportunities for claimants to spread or hedge out some of the costs and risks of litigation. These were further stimulated by a case in the Court of Appeal in 2005, Arkin versus ­Borchard Lines, which established that litigation funders would not be liable for adverse costs, provided they had not taken a role in initiating or directing the claim itself.

The Arkin case involved a claimant whose company had gone into liquidation, and the legal framework for insolvency practitioners to use litigation funding is already well established. This is unsurprising, as bankrupt companies by definition do not have the financial means to fund actions against their advisers or auditors. Even where the bankrupt firm’s creditors include major banks with substantial funds of their own, the banks’ shareholders may be reluctant to finance litigation on their own balance sheet and risk pouring good money after bad, says Stephen Cork, head of restructuring and recovery in the accountancy department of Smith & Williamson in London.

One of the original players in the funding field, IMLF, recently suffered a setback when a £90m ($168m) claim it was financing for a trading company in liquidation, Stone & Rolls, against its auditor Moore Stephens, was struck down in the Court of Appeal. The liquidators could yet seek leave to appeal to a higher court, the House of Lords, but this would increase costs for the funders.

But larger players are able to build a more diverse portfolio of cases to back, spreading the risk of failure in any individual case. “The lesson to be learnt from Stone & Rolls is that third-party funding is risky, and you have to choose your cases wisely. This is not about the merits of litigation funding, it is about the merits of each case in law,” says Mr Cork at Smith & Williamson, which launched a litigation funding initiative last year.

His firm finances claims with its own resources, and has a distinctive position, because it combines accountancy and fund management companies with a private banking licence. Not only does this provide a source of potential cases from the restructuring team, but also the minimum capital adequacy requirement of a bank serves to reassure clients and their lawyers. Allianz Prozess­Finanz similarly benefits from the regulated solvency of a large insurance group.

Targeting the deep pockets

The more experienced funders are now moving outward from insolvency into other cases, wherever the defendants have known means to pay, legal precedents are fairly clear and the supporting evidence is strong – preferably based more on documents than on individual witnesses who might falter in court.

Peter Horrocks co-founded IMFL in 2002, initially focusing on his existing contacts among liquidators, after a legal career that included heading the corporate recovery team at Lovells. Since then, the team has backed more than 50 cases. “Between 2002 and 2005, about 90% of our cases were insolvency. Since 2005, the balance is changing and we now have about 40% general commercial cases,” he says.

Several of the categories of cases now attracting funding could easily be relevant to the subprime crisis, including professional negligence or misfeasance, white-collar fraud and misselling of financial products, and breach of contract or insurance disputes. These often involve large claims that make the risk/reward ratio attractive for a funder.

Litigation finance brokerage Calunius Capital is currently working on a funding package for a small class of private investors, seeking more than £60m over an alleged fraudulent investment scheme. Not all of the clients are able or willing to pay their own share of the high legal costs for the action, so the case might not progress without the package.

Mark Wells, partner and co-founder of Calunius, who worked in investment banking for about 20 years, says third-party funding could also come into its own for an asset management firm suing a bank over alleged misselling of financial products, as asset managers have fiduciary duties to their investors. “If an open-ended fund has lost money on structured products, investors buying into the fund only after the loss occurred would not want their money used to help finance litigation on behalf of those investors who lost out. This is where litigation funding makes sense,” observes Mr Wells.

A question of cost control

Even in the US markets, where contingency fees and the absence of adverse costs limit the downside for claimants, litigation funding is a growth industry. Juridica, founded by members of the plaintiffs’ bar in the US, raised £80m in a listing on AIM in December 2007, mostly from institutional investors such as Artemis, Henderson and Invesco Perpetual. Juridica chairman Richard Fields explains that the US model tends to involve the funder smoothing the cash flow of the lawyers themselves, who will not receive their contingency fee payment until a case is concluded, but will have to meet the expense of expert witnesses and research along the way.

In today’s declining market amid rising insolvencies, investors are inevitably paying attention to the uncorrelated returns offered by litigation financing, says Mr Mirchandani at Lovells. Hedge fund MKM Longboat hired Susan Dunn from IMFL to set up Harbour Litigation Funding in 2007, and Mr Cork says Smith & Williamson would certainly consider allowing its asset management clients to invest in its litigation funding activities if the demand emerged. Mr Fields at Juridica also sees opportunities to invest in areas such as intellectual property, competition law, and large insurance claims.

However, the model does not fit every investor. “Litigation could typically take two to three years to reach a conclusion, international arbitration could take four years on average. This does not sit well with hedge funds that have regular liquidity needs or monthly redemptions, it is more suited to a private equity or closed-end model, or a fund with side-pockets,” says Mick Smith, partner and co-founder at Calunius.

And most banks that consider entering the market directly tend to step back, says Mr Mirchandani, due to concerns over reputational risks and conflicts of interest if they are asked to back cases against existing corporate clients.

Allianz ProzessFinanz also has to juggle these difficulties, as part of a diversified financial services group that includes Dresdner Bank. “If a case against a bank is above a certain claim value, we would need to check with our colleagues in the banking division: would you be affected by something similar if it were directed against you, do all banks have the same issue?” says Mr Stürwald.

Of course, says James Delaney, a director at litigation finance brokerage The Judge in London, there is nothing to stop banks as clients seeking third-party funding options themselves. These might include formulae for the defendants – Calunius has worked on exposure swaps designed to hedge out part or all of the risk of litigation against a client, and insurance giant AIG has offered a “litigation buyout” service for some years.

But for either side, funding is often on a first come, first served basis, Mr Delaney warns. “Funders and insurers don’t like going up against each other – it means someone else in their business has taken a look at the other side’s case, and thinks it has a good chance of success.”

And for litigants who already have the financial means to pay the cash flow of a case upfront, the litigation funding arrangement may not be the most cost-effective means of proceeding. “It is an embryonic market. Funders with financial understanding must then move to understanding litigation risk – and in the case of international arbitration, you might need to add political risk. This all makes it hard for funders to price their product,” says Sonya Leydecker, head of litigation and arbitration at law firm Herbert Smith, which first began examining the model last year.

In addition, says Mr Horrocks of IMFL, little data has been compiled on the size of the market or success rates. Consequently, funders will typically take upwards of 30% of the eventual award – and sometimes more than 50% in a long case that goes all the way to trial.

In this context, says Mr Delaney, going-concern ­companies should look closely at the alternative of after-the-event (ATE) insurance policies that can cover both the claimants’ costs and a set sum of adverse costs. Typically, these involve a sizeable premium of about 20% or more of the amount insured, but unlike a funding deal, the insurance premium can be charged to the defendant if the claim is successful. Moreover, the largest ATE players now offer deferred, contingent premiums, explains Matthew Williams at Brit Insurance. This means the premium is only paid when the case ends, and is waived altogether if the claimant loses.

“It’s remarkable, like an insurer waiving your car insurance premium if you write the car off,” says lawyer Michael Green at Addleshaw Goddard. He is currently pursuing a claim for clients who have been offered a choice of partial or full litigation funding combined with ATE insurance.

Even for clients who have the means to pay, professional litigation funders have another attraction, says Mr Green. “The funding agreement is drawn up in advance, so solicitors have to make an accurate estimate of their costs on the case right at the start to know how much the funders need to commit. Typically, lawyers charging hourly rates have not been very good at this.” In this context, Addleshaw Goddard has included litigation funding as part of a wider offering called “Contro£”, which promises better management and more visibility on the costs of litigation. The firm expects it to appeal to financially savvy commercial clients.

In addition, even the largest UK law firms are now starting to offer conditional fee agreements (CFAs) for commercial cases, rather than just personal injury claims. Under CFAs, clients pay as little as 50% of legal costs if the case fails, with an uplift of up to 100% to the lawyers’ fees if the case succeeds.

This set of innovations could transform the UK ­litigation market, says Mr Delaney. “A combination of CFA, ATE and third-party funding means you have nothing to pay up front, and your liabilities for costs can be clearly defined at the start of the case, which could make the UK one of the most attractive jurisdictions in which to litigate.”

UK-based banks should be warned.

Subprime-related US Federal court filings
First quarter 2008