Litigation Outlook
01 December 2007
For a number of years, there have been signs in many quarters of a downward trend in the number of commercial disputes resulting in litigation or arbitration.
To the extent that this trend reflects benign economic conditions, the trend may now be reversed. The direct and indirect effects of the sub-prime crisis have led to losses which, in turn, are likely to lead to disputes.The likelihood of an upturn in litigation may be increased by the availability of new options to fund claims. Claimants who were previously unable or unwilling to pursue claims might now be tempted to do so if they are able to share the cost, and the risk, with a third party.
Together, these developments seem likely to lead to an increase in the number of claims businesses will face in the coming months and years.
MARKET TURMOIL
It is too early to judge with any degree of precision where the collapse of the US sub-prime mortgage market and resulting liquidity crisis will have its greatest impact. From our experience, however, we believe that the following types of claim may well be brought with increasing frequency.
Mis-selling: Investors in what turn out to have been unfavourable investments may naturally look to those from whom they bought the products to see whether there is a case for compensation. Such claims will often face hurdles in overcoming disclaimers and exclusion clauses in the product documentation and there may also be difficulties in establishing a duty of care. However, these are unlikely to deter all claimants, particularly in circumstances where the products sold have become increasingly complex and there is often an imbalance of knowledge between buyer and seller.
Misrepresentation: Where an investor can establish that it made an investment in reliance on false information provided to it, it may have a claim in misrepresentation. Following the collapse of two Bear Sterns hedge funds in July 2007 as a result of exposure to sub-prime mortgages, investors have alleged that the private placing memorandum issued to investors was misleading and that investors were further misled by fund managers during monthly conference calls. It appears to be alleged in both cases that investors were misled intentionally, which sets a high hurdle for the claimant investors. However, allegations of fraud will not always be necessary; a negligent misrepresentation may suffice for a claim in some jurisdictions.
Fraud: Market conditions may trigger fraud claims in other ways. One is where a pre-existing fraud is uncovered. Scams may go undetected in favourable markets. When the downturn arrives and questions are asked they often come out. A second scenario is where the economic environment itself leads to fraudulent activity, for instance dishonest attempts to hide or recover losses.
Mismanagement: In the current market climate some funds will have performed badly, whether or not they were directly exposed to the US sub-prime market. Investors may claim that losses have been incurred due to a manager's failure to take account of or contain risk. In the early 1990s, investors suffered big losses on portfolios invested in mortgage-backed securities. Allegations followed that portfolio managers did not understand the characteristics of the securities in which they had invested, failed to disclose the risk of the strategy they adopted, had no means to control the risk of the portfolios they created, and could not protect against the effects of unpredicted events on
fund performance. Such claims are not difficult to imagine in current market conditions.
Valuation: Hedge funds and others invested in the riskier tranches of collateralised debt obligations face a permanent difficulty in valuing their assets, whether by using broker quotes or internal models. The collapse in liquidity makes matters worse, and may lead to allegations of mis-pricing. Given the complexity and risk profile of these assets, there is scope for widely divergent views. Combined with some significant losses in this area, litigation seems a distinct possibility.
Consequences of the M&A boom: In the highly competitive markets that preceded the current volatility, corners are likely to have been cut in terms of the protections built in to some deals, such as limiting covenants or increasing leverage. In some cases this will have been done with all parties fully aware of the consequences. In other cases it may not, and claims may result. In addition, deals will inevitably have been done to very tight timescales. This heightens the risk of mistakes which may come back to haunt the parties and their advisers.
Claims against rating agencies: Following the collapse of the sub-prime market, some have turned the finger of blame toward the rating agencies. It is said that they should have foreseen (and forewarned of) the risks associated with assets backed by sub-prime mortgages. Investor claims are likely to face high hurdles, such as establishing a duty of care and overcoming disclaimers, but some may be tempted to bring claims in any event.
Claims against directors: Where companies have suffered substantial losses, there is clearly a risk that some will become insolvent. In those circumstances creditors, through liquidators or administrators, will look internally to determine the cause of any loss and whether steps should have been taken to protect more effectively against developments. There is therefore the prospect of claims against directors for any bad decisions, particularly where directors' and officers' cover is in place. And such claims will not necessarily be confined to companies that become insolvent. Any company that has suffered a loss may wish to reflect upon decisions taken by its directors. In an era of increasing shareholder activism, there may be pressure from shareholders to ensure such issues are properly addressed.
NEW FUNDING OPTIONS
New ways of funding commercial litigation have emerged on the scene. Until recently, there were few funding options for a party with a major commercial claim it wished to pursue in a number of jurisdictions around the world, including the UK and Europe, where (unlike the US) lawyers generally cannot act in return for a share of the proceeds. The claimant had to engage lawyers and pay them on the basis of agreed hourly rates. If successful, it would be likely to recover a proportion (but by no means all) of what it had spent. If not, it would be out of pocket not only for its own legal fees but, in most cases, also for a proportion of its opponent's costs. If the claimant did not have the means to fund the litigation, then it simply could not pursue it.
This seems to be changing, at least in some European jurisdictions such as the UK and Germany. New and innovative forms of funding have become available, which until fairly recently either did not exist or could not be obtained for major commercial cases. Most straightforward is professional funding, in which an independent third party funds the claimant's costs in return for a percentage of any damages awarded. More complex is litigation risk hedging, in which a claimant sells a percentage of its claim in return for a fixed sum, which can be used in part to fund the case. This allows the claimant to offset not only the costs risk but also some of the outcome risk if the case is lost - at a price, obviously. It is also available to defendants who can in effect cap their losses in return for a premium.
In the UK, parties may also have the option of after the event (ATE) insurance, which covers a party's risk of paying the opponent's costs and its own disbursements if the claim is unsuccessful, in return for a premium. To date it has not generally covered a party's own lawyers' fees, although products are becoming available which include some contribution toward those costs. ATE insurance has traditionally been associated with smaller claims, especially for personal injury. In recent years, however, the level of indemnities that insurers are prepared to offer has increased so it is now available in larger commercial cases.
The options for claimants have therefore increased. Claims which might previously not have been brought, because of a lack of funds or lack of risk appetite on the part of the claimant, may now be pursued. A further consequence may be the development of ‘class action' style group litigation in Europe. Typically in class actions each claimant's individual loss is small, although the overall claim may be substantial. Such cases are traditionally very difficult to get off the ground in Europe, not least because lawyers cannot act in return for a share of the proceeds as in the US. If third-party funders are willing to take on such cases, this gap may be filled.
More litigation funding seems likely to result in more litigation. Indeed, fears have been expressed that litigation funding will lead to spurious claims against defendants with deep pockets and the spread of the ‘litigation culture' which is so entrenched in the US. This risk may be overplayed. Funders are looking to make a return on their investment. They are only likely to support cases which have a good prospect of succeeding rather than investing in speculative claims - particularly in jurisdictions where they may be liable for some of the opponent's costs if a claim fails. However, for a large enough share of the proceeds, some funders may be prepared to make riskier investments in weaker claims, relying on the law of averages to see that they make an overall return. Much will depend on the risk appetite of those who enter the litigation funding market, and how competitive that market becomes.
The question remains just how much these new methods of funding will change the commercial litigation landscape. Will the impact be limited to those who would otherwise not be able to fund litigation privately, such as individuals and insolvent (or near insolvent) companies? The instinctive question for litigation lawyers is: if a client can afford to fund the litigation itself, why would it want to give up a significant proportion of its damages to get someone else to pay the bills? But litigation is an expensive and risky business. Fees can escalate and even the most solid of cases can unravel at trial. A claimant may well be keen to share some of the risk even if it also means sharing the ultimate rewards.
If both the upside and downside of litigation become more predictable through alternative methods of funding, parties may be more likely to litigate. In our view, such funding methods are likely to grow in popularity. The regular reports in the legal press of new entrants to the funding market suggest others agree. To name just one development, Allianz, the German insurer, has expanded its litigation funding business to London. Having funded cases for a number of years out of its Munich office (in the German, Austrian, Swiss and English courts, as well as international arbitration elsewhere) it has now opened a London office. It will be interesting to watch how this business develops.
CONCLUSION
It is impossible to predict the extent to which litigation will result from current market conditions and the availability of new methods of funding. It seems likely, however, that the combination of these factors will result in an increase in the number of cases brought. It may be time for businesses, and their liability insurers, to review their procedures and prepare themselves for claims that may soon appear over the horizon.