April Fools’ Day 2013 sees the arrival onto the changing legal landscape of Damages Based Agreements (“DBAs”). In simplistic terms these allow lawyers to enter into arrangements with their clients that result in the client not paying legal fees during a piece of litigation, but which offer the lawyer an agreed percentage of damages on a successful outcome (in commercial litigation up to 50%).
These arrangements offer enterprising law firms the chance to recover something approaching a “value based” reward for their efforts, but the risks are also obvious.
I want to focus here on two forms of capital – first capacity and then capability – essential for law firms to play in the DBA market that will emerge in post April 2013.
Mind the gap
The capacity of a law firm to engage in DBAs in litigation cases will to a large extent be determined by its financial strength and access to capital. The demise of some large law firms like Halliwells and Cobbetts has demonstrated that even these big practices are financially vulnerable. Financial management is critical in any business, but more so in a business that is engaged in delayed gratification.
So how will law firms manage with the shortfall in cashflow while waiting for the eagerly anticipated victory in a DBA case or better still its portfolio of DBA cases?
The answer lies in the financial engineering and management of the law firm. It’s inevitable that firms on low profit margins with weak balance sheets are going to struggle to play in the DBA space. The opportunity seems far richer for those who have already recognised the fundamental need to change the shape, business model, cost base and indeed the very business of the law firm. If the client is not paying profit costs for the duration of the DBA-funded case the need to bear down on costs through the use of technology, lower operating costs and a more flexible cost base will be the priority. So I return to my soapbox about the need for law firms to change and suggest that they accept the challenge from Alan Kay who said “the best way to predict the future is to invent it”.
But the process of re-invention will not happen overnight and so there is likely to be a funding gap between the current state business model of a law firm and the desired future state. Of course this is the stuff of the management consultant working with its client – the determination of the desired objective or outcome, the understanding of the present position and the acceptance of the resources needed to make and survive the change process.
There are well known sources of capital in the shape of banks and of course the partners of the firm. Litigation funders have also begun to throw their hats into the ring. The latter not just in funding cases but also in considering funding firms with cases. It remains to be seen whether other financial products will emerge to securitise the bets placed by lawyers.
Getting the right people on the bus
The second significant consideration that falls from the recognition of the capacity challenge is to assess the capability of the firm to deliver owners returns on capital through DBAs.
Lawyers are generally intellectually able, but this does not of itself deliver the expertise and experience that will be needed to manage a DBA litigation portfolio. I guess what I am saying is that lawyers are not financial engineers, they are not asset or fund managers. In addition, the law firm failures point to the potential absence of “proper” risk management within law firms or as a core competency in their business planning processes.
I suggest that considering behaviours in other markets might assist lawyers in determining what capability they have and what they need to get. DBAs appear to me to be a simple investment proposition. The underlying asset is the claim itself and the price of achieving the return on the asset is the costs to run the litigation. The role of the lawyer is to assess the merits of the claim and then through skill and experience to maximise the return for the client using the litigation process as the toolkit. But the DBA requires a further range of skills in origination, finance and risk management. Read across then to the world of the investment fund manager. At the high level they are considering countries or asset types or both; considering likely future performance and return on investment; assessing risk at macro and micro economic levels and then forming a balanced view to assist in decision-making on what to buy, hold and sell. I suggest that the skill set of asset managers will be needed within law firms to consider and determine the portfolio mix by type, claim size, costs and expected duration.
An investment management committee might be a useful way of applying firm wide discipline, control and management to DBA’s. Such a committee would bring together litigators with finance managers and risk managers within law firms, but importantly would add in asset managers – collectively mandated to have the ultimate decision on which cases to undertake on DBAs.
Perhaps there is also a deeper linkage that could be developed here. Funds investing in law firms that do DBAs placing their fund managers on the investment committee to assist in decision-making. Not only a skill set but a potential source of funds in much the same way as a private equity investor puts some of its team on the board of its investments.
It seems at least sensible for law firms intending to offer DBAs to consider how they will decide which cases to back with DBAs, how they will capitalise to sustain themselves in the leaner times, how they will satisfy the SRA that they have adequate capital or access to adequate capital. More importantly than all these considerations how will they satisfy their owners that they have robust disciplines in place in relation to DBAs.
SRA meet FSA
I have referred above to the adequacy of capital. Law firms are under an obligation to run their businesses “effectively and in accordance with proper governance and sound financial and risk management principles” (Mandatory Principle 8 of the SRA Code of Conduct 2011). Look across again at the world of financial services, which after all experienced outcomes-focussed regulation before its migration to legal services. The FSA’s approach to stability in financial services calls for businesses to maintain reserves of “ring-fenced” capital to satisfy regulators of their ability to “weather storms”. Only yesterday (27 February 2013) Lord Turner, chairman of the FSA announced that such capital requirements applied to banks would in future differentiate existing players from new entrants or so called “challengers”. Now imagine two things – the first a requirement for law firms engaged in certain activities – say betting on litigation, deferred gratification or DBAs or call it what you will – be required to hold capital to satisfy SRA of their stability and prudence and to demonstrate in a tangible way their compliance with Principle 8. Then go on to imagine that in some way challenger new market entrants experienced lower capital hurdles. Is it so unimaginable when we look at the implications of DBAs and the weakness of firms of all sizes? One could argue that new challengers come to the market with an inherent advantage in the absence of legacy systems and out-dated thinking, but to add lower costs of capital would generate some heated debate!
There’s gold in them there hills
So DBAs are not for the faint-hearted firm. Leaders need to satisfy themselves that in financial and human capital in the shape of both capacity and capability before taking a decision to enter the world of the investment banker.
Owners, investors, partners, regulators and most importantly clients should demand that firms undertaking DBAs can demonstrate they have the processes, people and capital essential to win in the DBA market. For those that can it won’t be fools’ gold.