When Lawsuits Become Investable Assets: Regulating Litigation Finance in India [Part I]
[Manav and Huzaifa are students at NALSAR University of Law. This is Part I of the two-part article.]
If you have a legal claim against someone or are entitled to damages in a contract, then brace for the resource-intensive and time-consuming process of litigation. Litigating in judicial forums imposes a significant financial burden on parties seeking to enforce meritorious claims. Against this backdrop, third-party litigation funding (TPF) has emerged as an alternative financing mechanism, under which an independent funder bears some or all of a litigant’s legal and procedural costs in return for a share of the proceeds recovered if the claim succeeds. Typically, the funder conducts a merits and recovery assessment before entering into a non-recourse funding agreement, which means that if the litigation fails, the funder bears the agreed financial risk, while a successful outcome triggers its contractual return.
The Indian market for TPF has begun to institutionalise with the emergence of players such as Five Rivers, LegalPay and Singapore-based ELF Partners. This year itself, LegalPay announced a INR 100 crore commitment to fund commercial and insolvency disputes, while Indian banks have reportedly explored using litigation funding for overseas recovery actions.
Against this backdrop, this two-part article evaluates the viability of, and considerations involved in, litigation funding while also conceptualising model guidelines to govern this emerging alternate asset class. Part I explores the current legal framework governing litigation funding in India and the commercial considerations involved for both investors as well as businesses. Part II builds on Part I and discusses global best practices and the practical viability of litigation funding as a model. It utilises this analysis to ultimately conceptualise model guidelines to facilitate the creation of a regulatory framework.
Exploring the Legal Framework Governing Litigation Financing: Permitted but Unregulated
India does not have a current framework through which it prohibits third-party litigation funding; it is only the case that the scheme has been left unregulated, therefore, unexplored. The ruling in Ram Coomar Coondoo v. Chunder Canto Mookerjee betrays India’s comfort with TPF. It was held in this particular case that champertous agreements, wherein a third party funds the legal costs in exchange for a part of the resulting proceeds, are invalid in England due to their conflict with public policy, but the same prohibition does not apply in India in toto. It is only where transactions or agreements which are extortionate and against equity and justice would be prohibited. Much depends upon the quantum of share which the financier has stipulated to get the fruits of his action. For example, it has been held that a stipulation for a 3/4th share in the property, if recovered, would make the agreement champertous and therefore, opposed to public policy.
More than a century and a half later, the Supreme Court in the case of Bar Council of India v. AK Balaji clarified that there is no restriction per se on third parties funding the litigation and getting repaid after the outcome of the litigation, provided the third party is not a lawyer. Further, it also set out the scheme under the Bar Council of India Rules and stated that on a conjoint reading of Rule 18 (fomenting litigation), Rule 20 (contingency fees), Rule 21 (share or interest in an actionable claim), and Rule 22 (participating in bids in execution, etc.) under Chapter VI, Part II, it is clear that advocates in India could not fund the litigant’s case on their behalf. While this distinction accommodates TPF, it also reveals the idea that a financier’s interest should lie in the proceeds, and the litigation strategy should not in any way be affected. If lawyers start financing cases themselves, it will jeopardise the case of the claimant.
Aside from the little jurisprudence on this, the Code of Civil Procedure 1908 (CPC), through several state amendments, recognises third-party funding for litigation. For example, the State Amendment to Order XXV Rule 3 of CPC by Maharashtra empowers the court to implead a third-party litigation financier who acquires an interest in the subject matter of the suit, either as a plaintiff with consent or as a defendant. This has been applied similarly by the State of Madhya Pradesh.
Lastly, Section 6(e) of the Transfer of Property Act 1882 prohibits the transfer of a ‘mere right to sue’. A third-party financier can therefore not purchase a bare cause of action, though it were an ordinary receivable. This is in part because a right to sue is a personal right that only an aggrieved party can exercise to seek a remedy in a court of law, hence it is not assignable. What is permissible, though, is that if a party has a substantive claim and a third party is willing to finance the claim for an agreed-upon return from the proceeds of the outcome, as long as the arrangement is not unfair, oppressive or unconscionable.
The Economics and Commercial Considerations of Litigation Funding
From an investor’s perspective, litigation financing posits an unusual risk-return profile. Contrary to debt, repayment is not primarily dependent upon the borrower’s cash flow. Further, unlike equity, returns are not dependent upon the growth of the business. The investment is instead linked to the probability-weighted value of a legal claim.
To explain this simply, the investment metric can be expressed as the given formula:
Expected Return = (Probability of recovery x Expected recoverable amount) – Total funding cost
For example, assume a funder finances litigation involving a claim worth INR 100 crore. If the funder estimates a 70% probability of successful recovery and expects the Claimant to recover INR 80 crore if the they succeed, while incurring INR 20 crore in total funding costs, the expected return would be:
Expected Return = (70% x INR 80 crore) - INR 20 crore = INR 36 crore.
Therefore, although the underlying claim is worth INR 100 crore, the funder’s probability-adjusted expected recovery is INR 56 crore before funding costs, resulting in an expected net recovery of INR 36 crore.
The exact return the investor would get depends on the specific contractual formulation. This can play out in two different ways in practice. First, the investor can directly get a percentage of the expected return. This percentage would generally be proportionate to the percentage of the total funding costs contributed by the investor. Assuming this as 30% in the present hypothetical, the investor’s return would be 30% of INR 36 crore, which would be INR 10.8 crore. Since this is generally proportionate to the funding contribution, it would mean that the investor in this case had invested 30% of INR 20 crore, which is INR 6 crore, thereby resulting in an 80% return on investment (ROI).
The second and more common contractual formulation would be to give the investor the agreed upon share of the expected recovery, before deducting the funding costs, which would again, generally be decided in proportion of the funding cost agreed to be contributed by the investor. In the given situation, this would mean that 30% of INR 56 crore, amounting to INR 16.8 crore is the return of the investor on an investment of INR 6 crore, thereby making the ROI 180%.
These computations are subject to a few caveats that exist in practice. First, the two types of calculations are dependent upon the exact contractual formulation and there exists the possibility that a different mode of computation is agreed upon that falls outside these two methods. Second, although the returns might seem high in percentage terms, the expected-return formula is a static probability-weighted net present value with no discounting for duration. Generally, the final ROI percentage is calculated with reference to the internal rate of return (IRR) and in fact, duration risk is arguably the single largest driver of realised IRR variance in this asset class. Without an IRR, the accurate ROI cannot be computed because the actual ROI will reduce with the passage of time. In India, litigation at times can extend for even over multiple decades and considering this time benchmark, a 180% ROI is extremely sub-par, even when it is compared to a basic fixed-deposit earning account which pays an interest of around 7% a year, with the interest proceeds reinvested. Third, in real-world contractual agreements, a “greater of” structure is generally used instead of a flat percentage. For example, a clause which gives the investor the higher of a capital multiple like 2-4x or the percentage of proceeds, whichever is greater. Therefore, the computations presented might be an oversimplification but they substantively depict how a litigation fund operates in practice and what makes it different from a simple debt or equity investment. This is also a riskier investment because if the decision is against the said party, the investor would lose the entirety of their investment amount, which is starkly different from losses in the equity market scenario.
In practice, a sophisticated investor can diversify their investments across varied cases, jurisdictions, sectors, and legal causes of action. An investment portfolio comprising several independent claims can largely reduce idiosyncratic risk, similar to the risk-reduction strategy in traditional alternative investments and equity or equity-linked instruments.
On the other side of the spectrum, for Indian business, the proposition is equally attractive. A company might possess a INR 500 crore contractual claim but be unwilling to commit INR 20 crore over several years to pursuing it. Litigation funding enables it to monetise part of the economic value of that claim without immediately selling it or waiting years for its cash realisation. This is particularly relevant for large contractual disputes in sectors including infrastructure, engineering, procurement, and construction, insolvency, and tax, where claims can be substantial in practice but the timelines of litigation remain uncertain and often stretched.
Additionally, the resultant capital-allocation benefit is potentially more important than liquidity itself. A company that funds litigation itself in effect internally ties up capital that could otherwise be deployed into other uses like working capital, acquisitions or expansion. Therefore, litigation finance effectively converts legal expenditure from an operating cost into an externally financed investment. Consequently, a company can move litigation costs off its own profit and loss account.
However, the same characteristics that make it attractive, create significant risks. In practice, litigation outcomes are difficult to model with uncertain judicial timelines, unpredictable damages, and sub-par enforcement which might differ materially from the probability of merely winning a case. For example, a claimant might get a favourable INR 100 crore award against a counterparty who is incapable of paying the sum in the first place. Therefore, while making an investment decision, an investor does not merely have to ask the “Will the claimant win?” question. The correct question to ask is instead “Will the claimant win, recover the amount, and make this recovery within an economically viable timeframe?” It is because of these considerations and complications that litigation finance cannot be regulated merely as another form of lending.
[Continued in Part II]