Portfolio Funding, Decoded: An Interview With Iain McKenny of Vannin Capital

By Eric Z. Chang

In the last decade or so, third party funding has entered into the mainstream consciousness of clients, law firms, academics, and policymakers alike. As a relatively new industry, third party funding is evolving at breakneck pace, with ever-more varied and sophisticated products. One of the more interesting developments is the introduction of portfolio funding, where funders provide a funding package that covers a portfolio of cases, rather than an individual case.

As a fairly recent phenomenon, there is not a lot of publicly available information about portfolio funding as a financial product; there is even less discussion about the possible economic, public policy, and ethical implications of portfolio funding.

In order to learn more about portfolio funding and its implications, I spoke to Iain McKenny, General Counsel of Disputes at Vannin Capital, a global third party funder with offices in London, New York and Sydney. Vannin Capital is active in the funding of commercial and investor-state international arbitration disputes, including portfolio funding.

Eric Chang: Iain, can you explain in general terms how portfolio funding works?

Iain McKenny: Portfolio funding exists in two primary forms: (1) a single claimant with multiple claims (typically a large corporate); or (2) multiple claimants with a common cause of action (group action).

Category 1 is the most prevalent form of portfolio funding. It allows large claimants access to a facility to run multiple  disputes, typically a mix of both claimant and defendant work. In this way, the funder takes its security off the claimant work while the claimant obtains relief across its entire legal budget. Owing to the mathematics of the investment, this tends to equate to an elaborate form of partial funding with the claimant effectively seeking to top up their own investment rather than to completely transfer the financial risk of running the dispute on to a third party, but again this depends on the composition of the portfolio.

Category 2 portfolios are less common for us as we do not do a lot of group litigation but we are seeing similar variants arise in the investment treaty realm. The issue with these types of portfolios is whether they are funded as a group action or whether the claims are run individually from a common facility (what we refer to as funding on the back end).  In the context of investment treaty disputes, group actions can raise some jurisdictional hurdles (depending on the treaty). There are now a few examples of treaty claims like this that have successfully cleared the jurisdictional hurdle. These types of group actions usually require some sort of profit share agreement between the claimants. Typically, in this scenario, you would expect the cases to be staggered and information learned from one case used to accelerate or drive deeper in another case under a common interest agreement.

Eric Chang: As relates to Category 1, this would be the case for large corporations who may technically have the cash flow necessary to pay for all of its disputes, but may choose to fully or partially fund the disputes in order to get a better year-end financial statement, or in order to invest the funds in the company (marketing, CAPEX, R&D, etc.)?

Iain McKenny: A better year-end financial statement is the correct way to look at it for a lot of SMEs and even larger corporates.  There is a common misconception that I think some funders are guilty of peddling that it is about converting the legal department from a cost center into a profit center.  This is an over-exaggeration.  The legal department remains a cost center given the nature of its work.  With third party funding, it can just do more without increasing the legal budget.

Eric Chang: I’d like to dig deeper into the possibility of a portfolio that includes both claimant and defendant work. Can you describe how such portfolio funding works? If the facility used across the entire legal budget (claims and defenses), presumably the terms will be different than if a client sought a facility only for claims, correct?

Iain McKenny: You’re right but it still surprises me how often I get asked whether we fund one off defendant or respondent work.  What is the investment hoping to achieve? With claimant work the award in damages is the financial incentive. For respondents, it is very difficult to come up with a structure that makes sense to both the funder and the respondent, economically.  However, respondent disputes embedded in a portfolio of claimant disputes means that the facility a funder provides can sit atop the legal team’s budget allowing drawdown across the entire portfolio while the funders interests are tied to the claimant disputes.  So, for example, let us say there are five disputes in a portfolio, two of which are claimant disputes and three are respondent disputes.  For simplicity, let us say that each dispute has a budget of $3 million USD.  Let us also say that the claimant disputes are claiming $200 million USD and that a quantum analysis suggests that the claimed amounts are realistic.  Subject to the standard investment to damages ratio (1 to 10), the maximum we as a funder would be able to invest is $20 million USD.  Consequently, in this way each of the five disputes can be run for three million apiece, while the funder’s interests are tied to the claimant work. This is a simplified example, and variations tend to lead to partial funding arrangements rather than full funding as mentioned above, but the example is rooted in practical experience.

Eric Chang: What are the criteria you look at as a funder in deciding whether to accept a portfolio of claims, under either category? How is this different (if at all) from the due diligence you would perform on a single claim?

Iain McKenny: It is still an approach that assesses each case on its merits. Vannin doesn’t adhere to a “price the risk” analysis or a “spread betting” model. Commercial terms may still vary, but each claim must be meritorious at its core. Accordingly, a portfolio of claims must still be assessed on their individual merits. This is not to say that Vannin are blind to the gestalt of a portfolio; it is merely that we are conscious of the reputational weight we give to claims that we fund, and we do not wish to dilute that impact for short term gains by funding weaker claims even if they are nestled in a group of stronger claims.

Eric Chang: You are anticipating my next question, which is whether portfolio financing exacerbates the criticism that funders may finance frivolous claims. As you know, this is a common critique of third party funding, one that is also discussed in the ICCA/QMUL Task Force’s Draft Report on third party funding. Funders are able to hedge the risks inherent in any given dispute by pooling resources and investing in a large portfolio of claims, in order to deliver relatively high average returns, assuming that success is achieved on a high enough percentage of the disputes in the overall portfolio. I have heard portfolio investing (done right) described as largely actuarial exercise, with sufficient reliability to achieve substantial returns over time.

My question is thus two-fold: first, if a funder’s overall portfolio is composed of smaller portfolios of claims, does this increase the risk of financing frivolous claims? Second, if I understand your position correctly, in addition to the due diligence you will perform on each claim in a portfolio, the reputational risk means that funders such as Vannin will avoid the risk of funding frivolous claims nested within a portfolio?

Iain McKenny: In order to answer those questions properly it is important to explain that I think that we are currently in a second paradigm shift of third party funding.  The first exposed a difference between ad hoc third party funders and professional third party funders.  Case law such as the now-infamous Excalibur case helped distinguish between these two models of funding by finding that ad hoc funders doing next to no due diligence, providing no adverse costs cover, etc., and funding unmeritorious claims may very well be found to be at least partially liable to the successful defendant for the costs incurred.  That’s the first paradigm shift from ad hoc to professional third party funders.

The second paradigm shift is between competing models under the umbrella of professional third party funders. Specifically, there is a lawyer driven model and an insurer driven model. The latter effectively spreads bets knowing that if they fund say twenty claims for example that statistically with high enough commercial terms on each case they only need to win on a few to make money.  This sort of funding by numbers requires light touch due diligence and indeed I think can lead to investment in unmeritorious claims, because it is not the merits of each case that is driving the investment decision.  This tends to treat the legal system like another financial market.  However, the problem with this approach is that the primary function of the legal system is not the compensation of loss, but the dispensation of justice.  The compensation of loss is merely a consequence of the dispensation of justice.  By contrast, the lawyer-driven model, which Vannin champions, dictates that each claim is invested in on its merits. The distinction between these models should answer both your questions. The lawyer-driven model adds value to the legal system by effectively helping to filter out unmeritorious claims and lends weight to funded claims.  I believe that the second paradigm shift to a lawyer-driven model will result in positive regulation, whereas the insurer driven model is likely to result in negative regulation.

Eric Chang: You raise an interesting point, and I’d like to expand on that: do you think regulation of third party funding is inevitable?

Iain McKenny:  I think regulation arises either as a response to a problem (negative regulation) or to help achieve something (positive regulation).  This is important, because in the second paradigm shift of third party funding it is not yet clear to me whether we are looking at negative or positive regulation. Imagine this: a couple of judges go out to lunch and after a few glasses of claret one turns to the other and says that their case docket has increased dramatically over the last few months. The other judge concurs and says that the majority are unmeritorious too, just clogging up the courts. The first judge concurs and adds that he has noticed that many of these unmeritorious cases are using third party funding. Say this conversation spreads and grows amongst the judiciary to the point where TPF is perceived to be a problem. This type of scenario could lead to negative regulation, hence the importance of the second paradigm shift towards a lawyer-driven model. Under a lawyer-driven model of third party funding, I still think that regulation is likely, but it may be more focused on increasing access to justice and drawing third party funders closer to the legal community, and thus likely to be positive regulation.

Eric Chang: Going back to commercial considerations, what happens if you have a situation where one or more claimants come with a portfolio, which includes one very weak claim, but insist on maintaining the claims together? Would you negotiate to keep only the strong claims? Pass up on the opportunity?

Iain McKenny: The simple answer is that under the lawyer-driven model an unmeritorious claim is an unmeritorious claim. I would, however, want to understand why the claimants wanted to pursue a very weak claim at all. I think you’re getting at something more complicated than that, so let’s go there. Even under a lawyer-driven model, complexity arises where the claims might be inherently connected such that without the weak claim the other stronger claims could not be brought forward. It then becomes a philosophical question on what constitutes meritorious.  As of yet, that situation has not arisen, but it is certainly worth further thought and consideration.

Eric Chang: Last question, and one I think is burning on a lot of people’s minds. Can a client expect economies of scales in the cost of funding for a portfolio, as opposed to funding the claims individually? What sorts of savings could one expect on the back end contingency that a funder will negotiate?

Iain McKenny:  A claimant with a portfolio of claims can indeed expect that the increased diversification decreases the risk and therefore leads to better commercial terms.  Unfortunately, I cannot give you a formula for such calculations, as it is still very case specific. What may be slightly more interesting is a variant of portfolio funding called bundling. This is where different claimants with individual claims are sufficiently similar on either the facts or law, that they can be bundled in a common interest and cost sharing agreement. By that, I mean efforts on one case can be directly applicable to the other cases and consequently the costs of running the other cases in the bundle are decreased – i.e., no one needs to reinvent the wheel. In those circumstances, I would expect economies of scale because the cost of running each dispute is decreased.  This bundle could then be taken to a funder who could put in place a facility to run each of the claims individually. But owing to the common interest and cost sharing agreements, the size of the facility is decreased while the risk remains diversified, which in turn is reflected in better commercial funding terms. So let us take some of the photovoltaic ECT claims currently against Spain as an example. The facts are undoubtedly very similar, the legal analysis is very similar, the industry is very similar. There is sufficient overlap in these claims that make them ripe for bundling. Each claim can be run individually but there is nothing to suggest that research and analysis on one claim cannot lighten the burden on another. As a consequence, the legal budget for running each should be reduced, leading to more favorable third party funding terms.

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