Imagine a company that invests in a portfolio of long-term financial assets. This company’s asset portfolio is, relative to the asset management industry, highly concentrated—a circumstance which naturally heightens the appetite of the company’s own investors to know more details of the assets in the portfolio. The company operates in an adolescent industry, and neither the company nor any of its competitors can yet point to an established track record of generating consistent returns on invested capital. This lack of historic performance data combines with the long duration of the company’s assets to increase portfolio uncertainty. The company’s investors can look only to the short-term history of a concentrated portfolio of longer-term financial assets.
Further, imagine that the company cannot tell its investors anything meaningful about any of its most important portfolio assets—even those positions that comprise, say, a full quarter of the company’s balance sheet! In fact, to disclose information about the assets would, in a curious dilemma, chip away at the value of those assets. Separately, to do so might even subject the people responsible for realizing the value of the assets to professional sanctions. As if that were not enough opacity, now imagine that the applicable accounting rules for this company require management to value their assets according to the results of internal proprietary valuation models. Hence, management marks the company’s assets to its own models, reporting any increase as earnings. Oh, and these models also must never be disclosed to investors. In light of all this opacity, a mere rumor about the integrity of the company’s account can cause single-day losses of 70 percent to stock investors, and 30 percent for bond investors.
Introducing the Industry: Third-Party Litigation Finance
The scenario described above is exactly the situation facing investors in publicly traded litigation finance companies (LFCs). The litigation finance industry is a rapidly growing part of the asset management industry that channels funding to litigants and law firms for prosecuting lawsuits in exchange for a share of the lawsuit recoveries. In recent years, LFCs have become a ubiquitous presence in the civil justice system in common law jurisdictions, especially when it comes to certain types of business disputes, such as joint venture or partnership disputes, business torts, breach of contract cases, and class actions. Some experts estimate the total potential annual market for third-party litigation funding to be $50-100 billion, of which the current market is only a small fraction. One estimate puts the current figure at $11.5 billion, with a forecast of nearly 10% year-over-year growth over the next decade. Burford Capital, L.P., the largest provider of third-party litigation finance in the world, has provided litigation financing to 94 of the 100 largest U.S. law firms.
Whatever one thinks of the normative desirability of this integration of third-party litigation finance (and there are good faith arguments on both sides), litigation finance flows are likely to continue to increase, all the while the institutional framework that facilitates and enables those flows will evolve. While some state regulators of the legal profession have tried to curtail its expansion, the clear trend is in favor of greater liberalization. To some extent, litigation finance is an old, hoary technology: plaintiff lawyers have been self-financing their clients’ cases in return for a contingency fee for nearly two centuries. The novelty of the present moment is the emerging awareness that a quantitative change in the amount of third-party financing flowing to litigants and their lawyers amounts to a qualitative change in the relationship between civil business litigation and the capital markets.
At present, most third-party litigation funders are private funds. There are over 40 investment funds dedicated to litigation finance operating today in the U.S., with more in other common law jurisdictions like the United Kingdom and Australia. Still, publicly traded LFCs are taking market share, capitalizing on the advantages public status confers. For the proponents of increased third-party litigation finance, public capital markets offer an attractive, largely untapped, source of funds. And yet, at present, there are only four publicly traded LFCs, which raises the question: why aren’t there more?
The Advantages and Disadvantages of Going Public for LFCs
The relative dearth of publicly traded companies in this field is all the more puzzling because public company status confers two significant advantages for LFCs.
First, the equity funding an LFC obtains in an initial public offering serves as patient capital, making LFCs more resilient to potential liquidity mismatches that pose a threat to all financial institutions that provide longer-term funding. The litigation finance value proposition is that it solves for the inter-temporal mismatch between litigation events and litigation-related cash flows. LFCs provide the funding upfront and assume the risk that the associated cash flows come later than expected, or in smaller amounts, or not at all. More equity capital allows funders to more confidently take on large, high-dollar positions that smaller funders would shy away from, with corresponding increases to expected returns.
Second, by going public these firms submit to securities disclosure regimes, which in turn gives them easy access the public debt capital market. In the litigation finance industry, debt capital usually funds growth.
Over time, these twin advantages should result in publicly traded funders consolidating their competitive position in the sector—a dynamic facilitated further by the ability of public companies to use their stock as acquisition currency, which Burford did in 2016 when it acquired litigation finance fund manager, Gerchen Keller.
As described so far, the funding advantages of going public seem straightforward. Why not go public? The sector is far from mature, which means that attractive marginal returns should be available to those willing to put scarce risk capital to work. And yet, despite these undeniable advantages, publicly traded litigation funders face some special headwinds that help to explain why there are presently only four publicly traded LFCs in the world.
There are, of course, the usual disadvantages to public company status, such as compliance costs and the legally mandated disclosure of potentially sensitive competitive information. However, LFCs going public must confront an additional set of problems owing to the opaque nature of their accounts.
To be sure, the opaque LFC accounts are just an acute case of a problem afflicting other asset management businesses that hold illiquid assets, such as venture capital and private equity. For these and similar companies, the norms of trust overshadow the norms of audit and compliance.
But three factors conspire to heighten the opacity problem with publicly traded LFCs. First, these firms are corporate adolescents operating in a relatively young industry, which means that investors cannot yet rely on a demonstrated record of litigation underwriting performance. In the asset management field, investors underwrite management, not the individual assets in which management invests. But in this context, management cannot yet command the trust of public company investors as fully as can other publicly traded asset managers with multi-decade track records, such as KKR,TPG, or Apollo.
Second, the fair value accounting rules grant significant discretion to management to set the reported values of assets. While the accounting mechanics are characteristically byzantine, the upshot is simple: the rules require management to mark their assets to their internal valuation models. Even more importantly, in a public capital market with eyes fixated on earnings, under applicable accounting rules these “fair value” adjustments, which initially appear as balance sheet phenomena, flow directly through to the income statement. Management marks the assets to model, and books any increase as earnings.
The third and final element of this puzzle relates to legal ethics and evidence rules regarding the attorney-client privilegeand the work-product doctrine. According to the normal logic of the securities laws in the U.S. and elsewhere, the solution to an accounting opacity problem of the sort described here would be enhanced disclosure concerning the assets and the models used to value them. Investors in a publicly traded LFC might like to know about the company’s specific valuations for particular assets, or the company’s assessment of the likelihood of success on the merits for some of its larger assets, or the litigants’ settlement negotiating leverage for those same assets, and so forth. Even generalized disclosures about the company’s valuation methodologies and models would clarify the accounts in non-trivial ways. However, LFCs not only possess uniquely opaque balance sheets, they also are uniquely handicapped when it comes to producing clarifying, corrective disclosure to remedy that opacity.
This handicap results from concerns over the possibility of privilege waiver. All these desired disclosures are informed directly or indirectly by discussions, decisions, and consultations between the funded litigant and its attorneys, occasionally with involvement of the LFC itself. In fact, virtually everything that is operationally relevant to an LFC revolves around active litigation—every expected cash flow originates from an active legal dispute. The risk here is that even a partial disclosure of privileged, protected information might open the door to court-ordered disclosure of materials that will undermine the financed lawsuit—and the cash flows the LFC expects from it. Further, the lawyers responsible for generating the recoveries could be subject to professional sanctions if they do not carefully protect the confidentiality of the privileged information. As a result, concerns over privilege waiver cast a shadow over LFC disclosures, and this shadow chills efforts to speak frankly about LFC assets, even at the aggregate portfolio level.
The evidentiary and ethical concerns over privilege waiver thus entrench the opaque accounts issue as an ongoing feature of the disclosure practice for publicly traded LFCs. This dynamic is grist for the mill for short-selling hedge funds, who can sow doubts about the company accounts, precipitate a collapse of company securities, and then profit. The shorts might be right, or they might be manipulating the market. Either way, they profit. This specter of market manipulationlayers on yet another problem for capital formation for these companies.
As a result, honest LFCs confront a “market for lemons” problem: investors struggle to discern honest LFCs using conservative valuation models from LFCs using unrealistic, opportunistic valuation models, and therefore assume everyone is dishonest. The 2019 Muddy Waters short of Burford Capital is a case study for how these problems can manifest.
The Muddy Waters Short Attack on Burford Capital
On August 7, 2019, the short-only hedge fund Muddy Waters – led by its bear-minded but bull-tempered founder, Carson Block – published a 25-page report on Burford Capital. By the end of the day, Burford’s market capitalization had halved, resulting in a single-day loss to Burford stockholders of nearly $2 billion. The following day saw further bloodletting, with the stock dipping 72 percent below its pre-report levels. On the day of the report, Burford’s bonds also cratered, losing nearly a third of their market value. The panic and uncertainty gripped both retail and institutional investors; GAM, the Swiss asset manager and then Burford’s largest bondholder, liquidated its entire position in response to the report. Why did the report cause such chaos in the market for Burford securities? This was Burford Capital, after all. It was the oldest and largest of the publicly traded litigation finance firms. If litigation finance is an adolescent industry, Burford was at least the big kid in the back of the bus.
In the report, Muddy Waters accused Burford of engaging in “Enron-esque mark-to-model accounting,” fraudulently propping up the litigation funder’s stock price through opaque earnings management and “egregiously misrepresenting” its return on invested capital. Muddy Waters describes itself as “a pioneer in on-the-ground, freely published investment research.” In one sense, it was true that the research was free. The report was obtainable by any interested investor with a web browser and a search engine. However, the report did not result from some altruistic motivation on the part of Muddy Waters to monitor the integrity of Burford’s accounts. The hedge fund had taken out a large short position on Burford, which meant that it stood to profit handsomely on the trade once markets digested the report’s substance.
While music aficionados should be forgiven for imagining the legendary Mississippi bluesman, Muddy Waters actually takes its name from a Chinese proverb: “muddy waters make it easy to catch fish.” The hedge fund has transformed the proverb into a short-only investment management business model, adapting it as a capital markets mantra: “opacity creates opportunities to make money.”
The Muddy Waters allegations were in one sense familiar, and in another sense not. The gist of the report evoked a standard trope of corporate governance literature over the past half-century: that management was manipulating the stock price by inflating earnings, raking in tens of millions of dollars of profits in the process by selling their own stock. But less familiar was the specific type of opacity from which Muddy Waters was attempting to profit. As we have seen, reported LFC asset values and operating income present a unique type of uncertainty.
Lessons to Be Learnt
Two and a half years later, the lessons to be drawn from the Muddy Waters Burford short are as opaque and ambiguous as Muddy Waters says Burford’s accounts are. And that is precisely the problem. As of April 2022, the company’s stock price has not recovered from the short-inflicted wound in August of 2019. In the year following the short, Muddy Waters published a few pithy follow-up reports reaffirming its negative opinion of Burford’s management. Burford, for its part, has adopted some corporate governance improvements in the aftermath of the episode. The hedge fund and the LFC have, for now, settled into a sort of détente, formally enemies but now engaged in a lower stakes war, with Muddy Waters admiring its 2019 profit and Burford managing its business in relative quiescence. (Weirdly enough, Muddy Waters’ main Burford-related focus these days is Block’s crusade against Columbia Law School professor Josh Mitts, who served as Burford’s expert witness in an ultimately unsuccessful U.K. lawsuit seeking to pry open the London Stock Exchange’s records to reveal manipulative trading by Muddy Waters in August 2019).
In the meantime, there is still little clarity on the most serious allegations in the report—those alleging Burford was strategically manipulating its valuation models to inflate its net assets and reported earnings. Even if the stock price has more or less settled for now, Burford and its stockholders are no doubt acutely aware that another short attack, whether from Muddy Waters or someone else, could happen again. The same is true for other publicly traded LFCs like Litigation Capital Management and Omni Bridgeway. Equally as important, we can only speculate how many LFCs might be dissuaded from tapping public capital markets altogether to avoid the risk of an opportunistic short attack.
It is perhaps not a coincidence that, since the Muddy Waters attack on Burford, there’s been only one attempt to tap retail investors to invest in litigation finance: a crowdfunding portal called Ryval is offering digitized stakes in lawsuits for sale to unaccredited investors. I will leave for another blog post the question of whether this is a bona fide attempt to democratize access to this emergent asset class, or a smoke-and-mirrors show opportunistically riding the crypto-wave to lure unprepared investors into buying preselected bad litigation assets that sophisticated funders declined to finance.
For the time being, the lack of robust public capital market funding for litigation finance might not be a problem for the sector, inasmuch as private capital is, if nothing else, in plentiful supply these days. But as we have seen, access to public capital markets provides quick and easy access to sources of equity funding (to fund concentrated portfolios and riskier lawsuits) and debt funding (to fund growth more generally). Moreover, litigation finance will always be a miniscule part of capital markets, and the private market’s appetite for litigation risk will exhaust itself at some point, or at least result in adverse pricing mechanics as the market approaches capacity. At that point, the risks associated with public company status will operate as a real constraint to capital formation in the sector.
Whether or not this is a policy problem worth solving depends on one’s opinion of litigation finance—and, again, reasonable arguments exist on both sides. Those in favor of continued expansion of litigation funding markets would do well to think about some solutions to the opacity problems discussed here before private capital markets begin to dry up.
Robert F. Weber is an Associate Professor of Law at Georgia State University
This post is adapted from his paper, “The Securities Law Disclosure Conundrum for Publicly Traded Litigation Finance Companies” available on SSRN.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.