Muddy Waters: Will Regulation Follow?

Will the Burford/Muddy Waters saga increase the likelihood of regulation for the litigation funding industry?

It is not often that litigation funding makes the national, let alone international news, but the recent allegations made by Muddy Waters in respect of Burford Capital’s accounting practices have even captured the interest of many mainstream media outlets. Whether the accusations stem from a lack of understanding about the risks involved in this incredibly niche market, or whether they have substance, is for investment analysts and the investment community to debate. But we can be sure that headlines such as these will always attract scrutiny by those looking for reasons to denounce litigation funding. Such detractors will link any negative news about the industry to the need for regulation and greater oversight.

Since 2011, self-regulation has prevailed over a fast-growing market in the UK. The Civil Justice Council published the Code of Conduct for Litigation Funders, and The Association of Litigation Funders (ALF) was set up by the funding community as an independent body responsible for overseeing the self-regulation of litigation funding in England and Wales.

The Code of Conduct sets out rules governing the relationship between a funder and its client, as well as the capital adequacy requirements of funder members. It also provides clarity and best practice guidance on issues such as case control, settlement and withdrawal. The membership of ALF is intended to provide a quality kite mark and gives comfort to the legal community and potential counter-parties investigating their options. Some long-standing and well-known names of the industry are members of ALF, including Burford. TheJudge is a broker member of ALF. We believe that ALF has been a force for good in legitimising the market and helping establish important principles that most of us operating in the market will work to by default. Essentially, it has helped construct the market’s DNA, in the UK and probably further afield, so that whilst the market has evolved very rapidly, it has done so in a way that has made it far more difficult for the less scrupulous to abuse those who would rely on it. There have been a few bad actors, as with any financial sector, but ALF has set the rules of the game, in a practical way, for solicitors, financiers and entrepreneurs to follow.

It also worth mentioning that as this competitive market of capital providers investing in litigation cases expands, so too has the volume of players who are not members of ALF who are perfectly credible sources of capital. Despite a lack of membership, such funders will often still use the ALF Code of Conduct as a reference point and tune their behaviour to comply.

So, what does this latest story say about self-regulation? Answer: nothing.

ALF is designed to help protect the counterparty in funding agreements. It is not focused on protecting the investors of the funds themselves. The Code is virtually irrelevant to the issues now facing Burford. ALF does not stipulate how a litigation funding business should value its assets. So, the arguments being made by the short-sellers now would not have been pre-empted by the Code of Conduct. As mentioned, there are capital adequacy provisions within the Code (and they are quite stringent ones at that). However, they don’t compel a funder to subscribe to specific accounting methodologies when it comes to apportioning value to contingent returns; nor should it. Those are matters for the managers and the investors.

Is ALF or any other regulatory body really going to delve into how its members forward project the value of their live litigation/arbitration investments? It’s unlikely that any single fund can say they truly have enough book data to determine the right methodology. While the funding market has been active for a good ten years, that is still a very limited amount of book experience. In the early days, the volume of deals concluded would have been too small to draw any conclusions. It’s only been in the last four or five years that the funding market has started to be considered a “normal” part of the litigation landscape.

If there is a reliable trend that has been observed by the industry as a whole, it is that the projected legal costs to fund a case will often prove to be underestimated, as will be the timeframe forecast to make a financial recovery. The latter shouldn’t be understated. Many of the funders will have very strong books made up of litigation cases that will eventually lead to funder returns. However, the timeframe to realise those gains has led many funders to rethink their expectations over how their books will mature.

Self-regulation has not failed because of a disagreement over the value of a listed company in the sector. However, the need for some regulation over capital adequacy, in the form of the current self-regulation at least, is real. Burford’s stratospheric rise pulled the rest of the industry up with it, enticing investment into the sector from parties who may never have considered investing in litigation funding. The vast majority of capital providers in this niche market are not listed funds; many may now be put off listing in the short term. Private companies are by their nature less transparent. Some of those capital providers have been substantial international grade investors and some have been nothing more than intermediaries, posing as funders.

The concern from a client protection perspective is that the past few years have seen an increase in several market entrants purporting to be funders, but once you scratch below the surface, it quickly becomes apparent that some of these entities do not have the requisite legal and financial experience, or the necessary capital required to deliver on their promises to their clients. Such “faux funders” (as one funder described them) can be disruptive and destabilising for the growth of the market. They bring an increased risk that the claimant might be left without funds mid-claim. They also introduce a false level of competition that could have a serious impact on the deal flow for other funders that are following best practice. Clearly, regulation would act as a natural deterrent to some of these rogues by making the market less attractive from the outset, as well as enabling redress for claimants affected by those that have gained regulated status but do not follow best practice thereafter.

However, client and shareholder protection must be balanced against any effect that more wide-reaching regulation would have on the funding community’s ability to offer products that meet the needs of the claimants requiring their services. Regulation may well act as a barrier to entry to the market. It may also stifle innovation and product development. A reduction in the number of funders in the market could decrease competition. The extra work required to meet regulation could increase the funders’ operating costs. These factors could potentially drive prices up, or at least reduce the downward pressure that funders are currently facing given the growth of the market in recent years.

There is no doubt that litigation funding provides access to justice in a world in which legal fees can be grossly expensive. It also provides a logistical solution for law firms seeking to run multi-claimant cases where individually billing each claimant would cause a significant process headache and increased costs (assuming they can pay without the assistance of a funder, of course). Of equal importance, a funding friendly market attracts international litigation and could be a key factor in our legal system retaining its prominence in the international disputes arena post-Brexit. For these reasons, we must be vigilant to spot negative trends but allow more time for the market to develop, once the data is available for market participants to calibrate their offerings based on appropriate margins, before injecting a whole layer of regulatory cost and complication beyond the important principle enshrined in the ALF Code of Conduct.

A delicate balancing act exists between giving the market the freedom to grow and providing adequate protection for both claimants and those funders that are following best practice. However, the Burford v Muddy Waters argument is not the reason to advance any future debate with regards to regulation.

This article was first published on the Practical Law Dispute Resolution blog here.

Verity Jackson-Grant