Research recently announced by Thomson Reuters revealed that the litigation spend amongst the FTSE 100 reached £26.2bn this year. This came after the five-year high in 2016, when the number of cases the FTSE were involved in more than doubled in one year.
This is a trend we can expect to continue. History shows that periods of uncertainty and change—both of which have undoubtedly followed the Brexit referendum—tend to trigger litigation. Not only is the Brexit decision likely to lead to more litigation generally, but because several key regulations will no longer apply to the UK, there are also questions surrounding judgment enforcement and jurisdiction.
The most significant changes may open the door for increased litigation relating to commercial contracts that are subject to force majeure clauses. A force majeure clause excuses a party from performing their obligations under a contract following events outside their control.
The impact and cost of this increased litigation will only further exasperate already heightened tensions among CFOs, FDs and their in-house counsel. That tension stems from a simple fact—that litigation is extremely expensive—but also a little-known aspect of how litigation is accounted for on corporate balance sheets. Due to accounting practices, litigation has a negative influence on the balance sheet, which means that whether the organisation is a claimant or a defendant, pursuing litigation can be close to punitive.
In essence, the costs of litigation claims are not handled the same way other financial claims are. In ordinary course, financial claims generate an asset on the company’s books in the form of a receivable, which would be the case if the company was owed money by a counterparty. Furthermore, as the company expends money in pursuing the claim, those expenses will be added to the claim as they are capitalised rather than expensed through the profit and loss statement (P&L). This makes sense for receivables and for the money spent to capitalise them, as it is money the company is owed. Many other assets work similarly.
But that is not the case for litigation claims. The unfavourable accounting treatment of litigation dictates that claims are not recorded as assets on the balance sheet, and money spent to realise them is not capitalised but rather incurred through the organisation’s P&L – thus reducing the company’s profit for the period.
Furthermore, if the company succeeds in making a recovery on its litigation claim, it is penalised again when the claim is not treated as operating income on the P&L but appears ‘below the line’ as non-operating income or a one-off item, because the accounting standards do not view it as the company’s core business.
This creates a ‘no win’ situation for companies, however valid their legal positions. The costs for legal action will negatively impact the P&L, and when monies are recovered after a successful action, they will remain off the P&L statement as non-operating income.
For companies that are publicly listed, this has a negative impact on valuation if they trade on a P/E or an EV/EBITDA multiple. This is an issue which could very possibly make a bad situation worse for the more domestic-seated FTSE250, with its house builders, construction and finance companies, perhaps more than the internationally-focused companies (such as the mining giants) which make up the FTSE100.
Not only has this unfavourable accounting treatment had major disincentive effects on companies in pursuing viable claims, it has also put FDs under constant pressure to reduce legal spend even when claims are worth pursuing. With these pressures on FDs and GCs, innovative ways of managing litigation will therefore require both to work even harder in resolving the burden that litigation places on the balance sheet.
Managing the impact of this unfavourable accounting treatment is why an increasing number of companies are turning to litigation finance. According to Burford Capital’s 2017 Litigation Finance Survey, 88% of UK corporates say that the ongoing impact of legal expenses on financial results is a major business challenge, and 37% agreed that the financial reporting and accounting benefits of litigation finance are a major trigger for its use.
It’s easy to see why. Litigation finance—in which outside capital is provided by a third party with repayment tied to successful outcomes—reverses the negative valuation problems. Costs do not travel out of the company’s P&L margin, and therefore the company’s profitability is preserved in the wake of legal action. In fact, the first time a financial statement is impacted is when the company wins a claim and receives the cash income.
A typical litigation finance arrangement provides the finance for the fees, expenses and disbursements that are needed to pursue a claim on a non-recourse basis. This means that FDs can pursue worthwhile NPV positive claims without worrying about the accounting impact because there is no cash flow.
Litigation finance instead leaves the balance sheet untouched and transfers the risk to the litigation finance provider. This transfer of risk will ultimately make the legal process more efficient. The immediate result is that the unfavourable accounting treatment never arises as an issue. In return, the litigation provider is compensated by an agreed share of the proceeds of claims. This remuneration occurs if, and only if, the legal claim is successful.
This approach has been successful in America for as long as a decade and is continuing to expand. In the UK, Burford Capital already have in place one such arrangement with a FTSE 20 company, encompassing a portfolio of cases.
With the rising cost of litigation, a collaborative approach between FDs and the legal department is necessary to formulate a legal spend strategy that preserves company valuation and undoes the litigation burden. With a litigation finance arrangement, an FD can now ensure their General Counsel get the green light to pursue worthwhile claims, whilst simultaneously reversing the negative impact on the balance sheet.