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As confidence returns to transactional markets, some companies involved in, considering or the target in an M&A deal may fear being encumbered by impending litigation hanging over their business. There are ways, however, to restrict that risk.

During the past few years an evolution has occurred in litigation risk management. Commercial claimants (or plaintiffs) whose cases enjoy good prospects of succeeding no longer need to bear the cost risk of the litigation. A new market is developing globally which enables claimants to mitigate their cost exposure through a variety of financial instruments.

In the US some law firms may be prepared to accept instructions on a contingency fee basis or, more realistically, a partial contingency with the client paying a proportion of costs on a standard basis. In the UK there has been a rise in the use of conditional fee agreements with a typical structure being employed by leading city firms that offers clients, for example, somewhere in the order of a 30 percent discount in fees if the case loses but with a success fee uplift should the case succeed.

Commercial litigation insurance (also known as ‘after the event’ insurance) has also seen a sharp rise in the past three years.

Claimants can now buy an insurance policy which insured their legal fees if their case loses with the additional benefit that the premium for the policy is typically only payable if the client wins their case. If the case is lost the insurer pays the liabilities and does not collect a premium. Once a product designed for the civil litigants, these policies are increasingly being used by blue-chip claimants.

In addition to the creativity being applied via law firms’ retainers, together with the rise of litigation insurance, the past two years has also seen the emergence of third-party litigation funders. These funders are independent companies willing to finance a claimant’s legal fees in exchange for a share of the damages if the case succeeds. With increasing sophistication these various instruments can be used independently or brought together in a variety of combinations to provide the plaintiff with a definitive hedge on their legal fees exposure. So all is looking good for the claimant/plaintiffs but what of the defendants?

Hedging risk for a defendant is typically more cumbersome, particularly where the defendant knows it is unlikely to have an outright defendable position. That being said, options do exist to mitigate the risk for defendants.

Once a product designed purely for the M&A sector, Litigation Buyout Insurance (LBI) or Litigation Containment Insurance as it is sometimes described, is an insurance product designed to hedge the costs and/or liabilities associated with a pending claim. The origination of the product was designed to bridge the gap in a merger acquisition where one of the companies has a pending litigation claim(s) being brought against them. Litigation liabilities can be difficult to cap, even more so where, for example, there is a possibility of punitive damages or perhaps multiple claims. LBI provides a mechanism to hedge or cap the exposure and therefore, hopefully, appease the concerns of an acquirer enabling the transaction to proceed.

LBI policies are highly bespoke to the requirements of the insured. For example, cover can be purchased to indemnify the damages award, defence costs or potentially both. The justification for purchasing an LBI can vary. Whilst the purchasing rationale within the M&A field is often obvious, outside of the M&A arena the reasons for buying an LBI can vary. The company might not hold any liability insurance which will respond to the claim they are facing or perhaps the level of their primary liability policy is insufficient to pay the claim. It might even be that the claim being pursued against the company falls within the company’s insurance excess and therefore the company wishes to explore the possibilities of mitigating their uninsured exposure.

There are two principle mechanisms through which LBI can be employed:

A full litigation buyout – In this instance the LBI insurer will charge a premium which will be akin to, if not slightly higher than, the realistic estimated exposure the insured faces in the litigation. In accepting the premium the insurer becomes liable to manage the litigation and run the risk of the liabilities exceeding the original sum. Because this form of buyout requires a cash payment similar to the actual likely exposure the applicability, and indeed attractiveness, of this product is likely to be limited. In a full buyout scenario the insurer will also likely expect to have full control over the management of the litigation. For some this could be deemed as a positive as the insurer will doubtless be highly experienced in managing these risks, which enables the management team of the policyholder to concentrate on what they do best. However, the option to buy a liability cap on exposure is more than likely to have greater appeal for many companies defending a claim.

Liability cap – Essentially this works like a stop-loss insurance policy. For example, Company X is facing an $80m suit but realistically expects to be able to settle the case with a maximum exposure of $30m. The LBI policy would seek to insure the $50m in excess of the $30m with the company retaining the first $30m of risk. This excess or liability cap is the most versatile of LBI products in that it could, in theory, apply to most large-value cases being brought against defendant C. The crucial negotiating issue will be agreeing the realistic settlement exposure and the insured’s retention.

Whilst LBI policies have been developed initially to deal with the M&A transactional problem of one party having outstanding liabilities, there is no reason for the products to stay within this sphere. Indeed, any law firm representing a defendant client who faces a sizeable claim ought to be advising on the potential availability of this type of policy.

The limit of indemnity available under an LBI policy will always be subject to the risk appetite of the insurers. Most insurers will usually want to limit their individual exposure to a maximum of circa £20m ($32m). co-insurance arrangements can therefore be common (i.e. where multiple insurers share the risk of a given opportunity).

The pricing of LBI policies is also highly bespoke. A critical factor in the premium rating will be the level of retention by the policyholder; typically, the higher the retention by the insured the lower the premium.

A common feature of all the financial products discussed is that they can all respond to assist clients with known or pending liabilities.

This runs contrary to traditional insurance principles whereby the policyholder is insuring some unknown future event which may not materialise. As such the risks are much greater to the insurance companies and funders operating in this sector. Their ultimate success is determined by the quality of their due diligence in being able to speculate on how a particular piece of litigation will conclude.

James Delaney is a director at TheJudge. He can be contacted on +44 845 257 6058 or by email: james.delaney@thejudge.co.uk.