We don't typically quote French philosophers from the 1700's, but Sidore Marie Auguste Fran̤ois Xavier Comte has a famous quote that is worth breaking convention for. He famously said, "Know yourself to improve yourself."
The best legal funding companies should look at themselves honestly to try and improve in order to get more business and improve margins. Much of our content is geared towards providing ways to improve sales, operations, and underwriting, for example.
Today, we wax a little more theoretical to help legal funders better understand their product.
One of the biggest misconceptions about legal funding is that because funders sometimes charge rates of return that may appear high, funding companies are all backing their trucks up to the bank. In fact, it's not so. Legal funding is a good business, but not as lucrative as some may think. This is especially true of late, as rates charged to plaintiffs have dramatically decreased over the past decade due to innovation and the free market working as intended.
Understanding why legal funding rates are higher than might be expected is important because:
- You need consistent, clear, thoughtful responses when plaintiffs and attorneys ask why funding's expensive
- Regulators are examining the industry and considering rate caps
- It's valuable information for understanding your business and how to improve it
1. Risk of LOSS without recourse
Unlike loans or other types of debt, legal funding is an investment and there is no recourse against the plaintiff if the case loses. This increases the default rate for legal funding companies. While funders typically only fund meritorious cases, many times funding companies get involved early in the cases when the party seeking the money is most in need. The earlier it is in the case, the harder it is to evaluate the exact value of a case.
Also, even if a case wins, that doesn't mean a legal funder gets paid. Legal funding is considered double contingency. There needs to be a successful outcome, followed by proceeds to the plaintiff that aren't already eaten up by other liens, such as attorneys fees, medical bills or even unexpected child support payments.
From a plaintiff's perspective, even when traditional financing is available and less expensive, they may choose legal funding since it protects their downside by eliminating the risk of going into debt. It transfers risk to a third party. For example, if a litigant took out a loan from their credit card or bank, she would have to pay back the loan, even if the case lost or the settlement was far lower than the litigant expected. Plaintiffs may rather pay a higher rate of return in order to eliminate that possibility.
2. Legal expertise is expensive
Legal funding requires someone to analyze the lawsuit, and that requires specialized skills and time.
When applying for a loan, it's relatively easy to access someone's credit score, or see how much their house is worth. In fact, many banks offer an automated approval system to let people know on the spot if they qualify. But analyzing someone's lawsuit requires much more work and specialized knowledge.
Most funders employ staff just to collect the many necessary documents related to the lawsuit, and then employ attorneys to evaluate the cases to see whether they would be good investments. In addition, some legal funders report that only 5-10% of cases they see end up being funded, and some legal funding companies are even more selective than that. This is generally a much lower approval rate than traditional financiers. Part of the large rate of return that legal funders charge is a direct result of the time and money it takes to evaluate the cases that are never funded.
3. Relatively small investment sizes
Many legal funding investments are relatively small, often as low as $500 to help someone pay their rent while they are recovering from an accident. If a funding company charges a return of 50% per year, they would get just $250 in profit per year. While that may be a huge rate of return as expressed in percentages, as a total sum, $250 is probably not enough to even cover the underwriting and other costs associated with the funding.
Therefore, while the percentages may seem high, the gross amount paid to the investor can be relatively small.
4. High operational costs
One result of the average funding size being very small is that the amount of fundings a funder would need to originate in order to have a sizeable business needs to be large. For example, a funder whose average investment is $4,000 would need to originate 250 fundings a month - about 10 a business day - to invest $1M a month. In order to do 250 fundings a month, a funder may have to source over 1,000 applications.
Doing intake, document collection, underwriting, and then regularly tracking and servicing 1,000+ cases is no small feat.
Companies need to be operationally efficient to make tough decisions as to where they should invest their time and money.
5. Vintages are long and undefined
Basic economics tells us that competition forces prices to decrease. I've seen this happen in legal funding over time. But the very nature of legal funding investments makes prices decrease a bit slower than other industries.
Lack of insight into how and when a funder's portfolio of investments will return oftentimes freezes new investment, or at the very least, chills their willingness to rapidly decrease price.
While the average legal funding investment is typically less than two years, many cases won't return for four, five, or even six years. That's because our legal system is slow, and legal funders are the ones shouldering that burden for plaintiffs.
If a legal funder has a number of "long tail" cases that are not returned, it's impossible for that person to truly know his return and then adjust his rates to re-enter the market competitively.
6. Unexpectedly high attorney risk
Consumer legal funders only invest in plaintiffs who have an attorney already representing them. There are a number of reasons and benefits for this, including unprecedented consumer protection for the plaintiff, a generally valuable additional data point on case quality, and the fact that attorneys act as fiduciaries over the settlement, distributing proceeds to funders directly and before the plaintiff receives theirs.
Or at least, they're supposed to. If only life were so easy!
Plaintiffs' attorneys have been known to forget liens, negotiate reductions (sometimes by flatly lying), threaten funders even though they themselves signed an agreement, and have liens on the books that they didn't report at the time of funding. It doesn't happen in most cases, but it happens more often than industry outsiders would expect.
That uncertainty adds a risk premium to any funding where the funder isn't highly confident that the attorney is solid. Those tactics used by attorneys may sometimes help one-off plaintiffs, but overall it hurts the field by adding risk to investments which forces funders to increase rates across the board.
7. High cost of capital
Although consumer legal funding has been around for over a decade, it is still quite nascent and not as widely accepted by capital markets as other financial products. There is a limited secondary market, no easy way to securitize, and overall, a lack of awareness on Wall Street about the product.
This will surely change over time. However, as long as the cost of capital remains high, the pricing floor will remain high, too.
One of the ironies of legal funding is that Republicans, who generally see regulation as an impediment to free markets and competition, are the ones pushing for legal funding regulation. This has decreased competition in some states - like Tennessee - and seeded uncertainty in others. Both have the effect of inflating prices.
In states where legal funding is a codified practice, regulators have frequently required funders to register, which many have not. The effect, of course, limits the number of competing companies. In other states, the prospect of regulation means money spent on lobbying, and the uncertainty leads to lack of investment in the short-term.
CONCLUSION: Legal funding often pays more than it costs
So there you have it - my list of why legal funding rates will likely never be as low as mortgage rates or bank loans. But an important caveat: not everything that's expensive is a bad deal. And legal funding should be the poster child for that expression.
As we all know, many consumers are empowered when they have the money to make better decisions. They decide not to take a lowball settlement offer from an insurance company because of financial stress. They decide to get that surgery their doctor says they need. They pay rent and bills that help prevent debt spirals. In these ways, legal funding isn't "expensive" at all.
Here is what one former funder said about this dynamic that I love:
"People say legal funding is expensive, and they're right. They're also wrong. Let me explain. Imagine I offer to sell you a piece of pie for one million dollars. That's expensive, right? Yes, the answer's yes, it's very expensive, don't buy that. But imagine I offered to sell you the same slice for the same one million dollars, with the proviso that my friend Tim would then buy it from you for four million dollars. Much more attractive, right?
I think this is pretty straightforward—how something that seems expensive given imperfect information can actually be quite negligible when you have the full story. It's the same with legal funding. Although investors charge a return that might seem like a lot, it's only a fraction of the increased settlement that legal funding makes possible. Or, in pastry terms, yes, the pie is expensive, but with legal funding you can buy a small piece of a small pie and turn it into a big piece of a much bigger pie. I think that's a price worth paying."
I think this is right. Legal funding, in most every instance, is a good deal.
Written ByJosh Schwadron
Chief Executive Officer
About the author
Joshua is a lawyer and tech entrepreneur who speaks and writes frequently on the civil justice system. Previously, Joshua founded Betterfly, a VC-backed marketplace that reimagined how consumers find local services by connecting them to individuals rather than companies. Betterfly was acquired by Takelessons in 2014. Joshua holds a JD from Emory University, and a BA in Economics and MA in Accounting from the University of Michigan.
About the reviewer