The Securities Law Disclosure Conundrum for Publicly TradedLitigation Finance Companies

Robert F. Weber August, 2023

Robert F. Weber*

* Associate Professor of Law, Georgia State University. The author acknowledges the assistance of participants at workshops hosted by the Temple University Beasley School of Law and the 2021 National Business Law Scholars Conference. Maya Steinitz and Tony Sebok also deserve recognition for both lighting my way through some of the obscurer realms of litigation finance and commenting on earlier drafts of this article.

Abstract

The Article examines a peculiar legal dilemma—implicating securities law, legal ethics, and evidence law—that arises when litigation finance companies (LFCs) become public companies. LFCs provide funding to litigants and law firms for prosecuting lawsuits in exchange for a share of the lawsuit recoveries. In recent years, LFCs have significantly altered the landscape of the civil justice system in common law jurisdictions. But their assets, which are just rights to proceeds from lawsuits, are notoriously opaque—who really can predict what a jury will do when it comes to liability and damages? When LFCs go public, this opacity frustrates public investors’ legitimate expectations to be able to understand the company’s accounts and operations. The problem is exacerbated by the applicable accounting rules, which outsource the task of valuing the assets to the LFCs themselves, vesting them with significant discretion to build their own financial statements. The resulting lack of clarity about basic valuation matters undermines the two main objectives of securities law: investor protection and market integrity.

From a securities law perspective, the normal solution to an opacity problem is more and better disclosure. However, concerns over the possible waiver of evidentiary protections flowing from the attorney-client privilege and the work-product doctrine complicate matters for LFCs. To avoid the possibility of waiver of privileged, confidential information (which would, in most cases, undermine the cases underlying their assets), LFCs are circumspect when it comes to disclosing any details of the valuation models for their assets, much less relevant details about specific cases. The shadow of privilege waiver thus chills the entirety of LFC disclosure practice, foreclosing it as an effective corrective to the intrinsic opacity of LFC accounts.

After detailing the sources and extent of this opacity problem, the Article explores two case studies. The first, involving the 2015 failure of Juridica Investments, illustrates how opaque LFC accounts can undermine the investor protection objective of securities law. The second, involving the 2019 “short attack” by hedge fund Muddy Waters on litigation funder Burford Capital, shows how the opacity problem can also undermine the market integrity objective. The Article concludes by laying out a framework for reform.

Introduction

For the past decade and a half, litigation finance companies (LFCs) have altered the landscape of the civil justice system in common law jurisdictions. They have empowered thousands of business litigants to vindicate their legal rights, chipped away at inbuilt advantages in settlement negotiations favoring large and repeat players, and catalyzed reform initiatives in areas long considered third rails in professional regulation, such as fee sharing. The continuing evolution of litigation finance is a phenomenon that all lawyers should register. Litigation finance will increasingly shape the institutional arrangements of dispute resolution practices as well as the broader financial and labor economics and ethical regulation of the legal profession.

This Article shifts the lens away from the robust ongoing analysis of the civil procedure,¹ access to justice,² and legal ethics³ implications of litigation finance to analyze, for the first time, how this burgeoning sector intersects with the securities law regime.⁴ When LFCs list their securities on public capital markets, they submit to a complex system of securities law and regulation—a regime oriented to two central objectives: the protection of investors and the preservation of market integrity.⁵

When LFCs go public, they encounter a conundrum resulting from the intrinsic opacity of litigation finance assets. Fundamentally, LFCs are in the business of advancing funds to litigants and their lawyers to finance the pursuit of litigation, in exchange for a return pegged to the proceeds of that litigation.⁶ From the perspective of the LFC, a litigation finance asset can be considered a derivative contract where the underlying asset is a lawsuit.⁷

While there is arguably some room for classificatory discretion on the part of LFC accountants, most publicly traded LFCs take the (probably correct) position that the relevant accounting rules mandate that litigation finance assets be classified as “financial assets.” This position, in turn, requires the use of so-called “fair value accounting” practices. Where the LFC cannot look to any direct market prices nor even any indirect proxy market prices, it must “mark” (or record the fair value of) its assets according to its own internal valuation models. These internal valuation models unavoidably entail some quantum of brute discretion on the part of company management and their accountants. Just as importantly, under applicable accounting rules these “fair value” adjustments, which initially appear as balance sheet phenomena, flow directly through to the income statement.

As such, LFCs wield significant discretion in recording and reporting their assets’ value and operating income. Indeed, LFCs possess significantly more discretion than even other financial companies since adopting fair value accounting would require that all of their assets, lacking as they do any direct or indirect reference market prices, must be marked to internal valuation models. For perspective, it is common for publicly traded LFCs to have more than half of their reported income consist of subjective, discretionary fair value adjustments to their assets, frequently without the asset having yet realized any actual income from settlements or court judgments.⁸

According to the normal logic of the securities laws in the U.S. and elsewhere, the solution to an accounting opacity problem 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, the company’s assessment of the likelihood of success on the merits for some of its larger assets, the litigants’ settlement negotiating leverage for those same assets, and so forth. However, LFCs not only possess uniquely opaque balance sheets, but they also are uniquely handicapped when it comes to producing clarifying, corrective disclosure to remedy that opacity.

This handicap results from concerns over the possible waiver of evidentiary protections flowing from the attorney-client privilege and the work-product doctrine. All of these desired disclosures are informed directly or indirectly by discussions, decisions, and consultations between the funded litigant and its attorneys, occasionally with the involvement of the LFC itself. To be sure, all public companies embroiled in material litigation face difficult trade-offs when balancing the competing directives of the securities laws (which usually demand greater disclosure) and the legal ethics rules and their evidence law adjuncts (which usually demand circumspection, if not outright silence).

The problem is particularly acute in the LFC context because virtually everything that is operationally relevant to an LFC revolves around active litigation—nearly every expected cash flow will originate from an active lawsuit. The risk here is that even a partial disclosure of privileged, protected information might open the door to court-ordered unveiling of materials that will materially prejudice and undermine the financed lawsuit—and the cash flows the LFC expects from it. 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.

Two recent episodes involving publicly traded LFCs serve as case studies for how these dynamics undercut the securities law norms of investor protection and market integrity. The first such case study focuses on the investor protection norm by recounting the collapse of Juridica Investments, Ltd. (Juridica), which in 2007 became the first LFC to go public. By 2015, Juridica had ceased making new investments and was liquidated a few years later. The immediate catalyst for the investor losses was Juridica’s sudden announcement that it would take a total loss on its largest asset, a price-fixing antitrust lawsuit it had previously touted as a potential billion-dollar recovery. The asset, which Juridica had previously recorded at $30 million on a fair value basis, had apparently become worthless. As explained in the case study, Juridica’s unraveling is not a story of fraud. Still, the episode demonstrates the high degree of discretion LFC management has in determining asset marks and the credulousness of both retail and institutional investors concerning those marks.

The second case study recounts the 2019 “short attack” mounted by hedge fund Muddy Waters Research LLC (Muddy Waters) against Burford Capital, Ltd. (Burford), the largest LFC by any metric then and now. This episode illustrates how opaque LFC accounts can undermine the market integrity objective of securities law. Specifically, it presents a (possible) case of a strategic effort to manipulate the market for an LFC’s stock by sowing seeds of doubt about the accuracy of the company’s fair value marks. In a published report, Muddy Waters highlighted the subjective nature of Burford’s fair value marks, comparing the company to Enron, the posterchild for modern corporate accounting fraud.⁹ The Muddy Waters report precipitated steep declines in the market prices of Burford stock and bonds, wiping fifty percent off the company’s market capitalization in a single day.¹⁰

Only the future development of Burford’s portfolio will deliver the final verdict on whether the substance of this short attack was well-founded, as some of Muddy Waters’s past calls have been, or outright market manipulation, a term that some believe best describes Muddy Waters’s general approach to capital markets.¹¹ (It bears mentioning that Muddy Waters made a handsome profit by selling Burford stock short just prior to publishing the report).¹² The fact that, even today, despite the wild gyrations in the market for Burford securities, this uncertainty persists, is evidence of the enduring and structural vulnerability of the sector to market manipulation.

This heightened potential for market manipulation raises obvious investor protection concerns, but its implications are broader. If LFCs present a structural risk of market manipulation, the first-order consequence to be expected is reduced access to public capital markets and lower overall capital inflows to the asset class. Second-order costs include higher bid-ask spreads for the sector, which can spread to other classes of new and existing securities, result in lower trading volumes, and ultimately feed into higher costs of capital and lower returns on investment in the litigation finance sector and neighboring alternative asset classes. In theory, these problems could even lead to less fixed capital spending and economic activity in other unrelated sectors.¹³

As the litigation finance industry grows, so too will the salience of these problems, intensifying the urgency of reform. Over the past decade, four LFCs have listed their shares on stock exchanges in the United States, the U.K., and Australia: Burford, Omni Bridgeway Ltd., Litigation Capital Management Ltd. (LCM), and Manolete Partners PLC (Manolete).¹⁴ Today, the aggregate market capitalization of these companies approaches $3 billion.¹⁵ We should expect more LFCs to look to public markets to meet their capital needs in this rapidly expanding sector. This Article presents not only the initial diagnosis of the problem, but also a framework for reform.

The Article advances six reform proposals, drawing attention to their respective advantages and disadvantages. Four of these proposals are more promising than the others: (1) mandatory direct involvement of external claims valuers in the production and verification of fair value marks; (2) greater deployment of claims valuation expertise in the context of the audit (either external or in-house audit expertise); (3) mandatory disclosure of portfolio-wide sensitivity analysis of the fair valuation marks; and (4) mandatory disclosure of details concerning material litigation assets with accompanying changes to the privilege waiver rules. The first three of these are not only promising, but they are also feasible; efforts to implement the fourth proposal should expect greater headwinds. Two other reform ideas—requiring independent valuation committees for publicly traded LFC boards and promoting markets for litigation assets—are also considered but are likely to be of limited effectiveness, at least in the near term.

Part II introduces the litigation finance industry, focusing on the basic value proposition of litigation finance transactions and describing the sector’s tremendous growth potential. Part II also introduces the publicly traded LFCs and outlines their motivations for accessing public capital markets. Next, Part III explains that the two fundamental objectives of modern securities law and regulation systems are investor protection and market integrity. Part III makes the preliminary case that publicly traded LFCs pose special threats to these objectives on account of the intrinsic opacity of their accounts and the significant discretion management deploys in their preparation and presentation.

Part IV guides the reader through the labyrinthine fair value accounting regime applicable to companies like LFCs that hold large amounts of opaque financial assets. Part IV also explains why the two LFCs adopting fair value accounting and therefore using internal valuation models (Burford and Manolete) are probably correct in determining that they are required to do so. It describes in detail how they implement those rules in practice. If Parts III and IV articulate the fundamental problem, Part V explains why legitimate concerns over privilege waiver prevent securities law from deploying its usual regulatory technology (i.e., more disclosure) as a corrective device. Part VI transitions from the abstract accounting, legal ethics, and evidentiary rules to the conundrum in its practical realities by presenting the Juridica and the Muddy-Watters-versus-Burford case studies. Part VII explores possible reforms, focusing on their respective advantages, disadvantages, and implementation challenges. Part VIII concludes.

II. Introducing the Litigation Finance Industry

Described in the broadest terms possible, LFCs provide financing for law firms and litigants to pursue costly litigation in exchange for a direct or indirect share in the economic proceeds of the litigation. The litigation finance industry is a rapidly growing sector within the broader alternative investment sector, itself part of a broader investment management industry.¹⁶ LFCs thus link together the commercial litigation world with the asset management world. Figure 1 below shows this relationship, with the provisos that (1) the lists of types of asset managers is illustrative and not exhaustive, and (2) LFCs and other alternative asset managers are an overlapping category, as many diversified alternative asset managers are also increasingly deploying capital in litigation finance markets.¹⁷

Figure 1

This Part will introduce the basic features of the litigation finance world. First, the basic value proposition of litigation finance is introduced: the inter-temporal management of a particular type of legal-financial risk. The second section provides a brief description of the sector’s current market conditions, focusing on the present size of the market and the potential for future growth in the coming years. The third section introduces publicly traded LFCs, highlighting both their motivations for going public and previewing the dangers that arise when they do so.

A. The Basic Value Proposition of Litigation Finance

Litigation finance refers to the outside, usually non-recourse,¹⁸ funding of lawsuits by third parties for a profit.¹⁹ In its simplest terms, the basic market opportunity the LFCs exploit results from the temporal mismatch between litigation-related events and litigation-related payouts. Litigation-related events consist of the actionable conduct, the decision to pursue a legal dispute, the pleading stage, dispositive motions, trial, appeal, and so forth. Litigation-related payouts consist of settlements, judgments, and collections. This mismatch creates both risks and opportunity costs. From the litigation finance perspective, litigation is “just a process of moving money from one person to another. Just like any receivable, it has value.”²⁰ The value proposition that LFCs offer is that they stabilize the inter-temporal risk exposure of litigation-related receivables—i.e., the risk inherent in bringing lawsuits with the expectation of an uncertain payout at an uncertain future date.

For example, a plaintiff might calculate that the expected payout, net of expected costs, from a patent infringement claim is $20 million, reflecting its estimation that the claim has a 50% likelihood of success on the merits, in which case it would be entitled to a net payout of $40 million. In the meantime, however, both the plaintiff and its law firm(s) incur direct and indirect expenses in connection with the lawsuit; in other words, those “costs” that we netted out in the first sentence still exist. Direct expenses include legal fees, expert witness fees, court fees, investigative costs, and fees of other specialized consultants brought into the litigation team, such as accountants, bankers, and doctors. Indirect expenses include the distraction to management, which will be diverted from their primary business responsibilities in the case of large-dollar lawsuits. Also, the plaintiff will incur opportunity costs insofar as the temporal mismatch means that the expected payout will materialize months or years later; in the meantime, the plaintiff is not yet in possession of its expected payout and is unable to invest the expected proceeds in the business.²¹

Absent third-party financing, the plaintiff finds itself in a bilateral monopoly game. A bilateral monopoly describes a market scenario with one buyer and one seller. Assuming there is a positive available surplus, it is in the interests of both parties to engage in a trade, but they can trade only with the other party.²² In this hypothetical world without external financing, a plaintiff can only sell its claim to the defendant,²³ which quite frequently also has a greater ability to bear the risk of loss during the pendency of the litigation.²⁴ Accounting rules further complicate incentives for publicly traded commercial plaintiffs; they will recognize expenses associated with pursuing the lawsuit as short-term operating expenses, with no corresponding revenue increase during the pendency of the matter.²⁵ The expense drain can distort the picture of the company’s operational realities. Complicating matters further, even when the litigation results in a payout, the economic impact is reported as non-recurring income and, therefore, liable to be disregarded by investors.²⁶

Further, the law firms that represent the plaintiff usually assume a similar portfolio of risks. Most lawyers in the United States represent plaintiffs on a contingency basis—that is, they are paid out of the lawsuit’s proceeds.²⁷ While contingency fee representation is relatively less prevalent in the business litigation context, it is becoming more common there as well, owing to pressures from corporate clients to reduce corporate legal spending.²⁸ The contingency fee arrangement operates as a risk-transfer mechanism by which the litigant client offloads some of its risk onto the law firm, which, because of its repeat-player status and professional expertise, is thought to be better positioned to bear the risk. Before the lawsuit generates any proceeds, the law firm must pay its expenses—employee salaries, insurance premiums, utility payments, lease payments, and anticipatory distributions of profits to partners (where appropriate). In other words, law firms face relatively high working capital demands and a deficit of patient risk capital to carry multi-year matters through to conclusion.

Hence the basic litigation finance value proposition: LFCs provide the longer-term capital required to bring the lawsuit to a successful conclusion. The funding can be directly provided to the litigants or their law firms. Investments by LFCs can be structured in multiple ways. Broadly speaking, however, corporate litigants usually obtain financing by agreeing to provide a return to the LFC tied to the success of the underlying claim or portfolio of claims, whether in the form of a right to a specified percentage of the payout,²⁹ or a more bespoke structured contractual arrangement. These arrangements are either undertaken as on-balance-sheet investments by the LFC or as off-balance-sheet investments where the LFC manages private investment funds on which it earns a customary management fee.³⁰

On the other hand, law firms currently face restrictions on sharing fees with nonlawyers, which complicates efforts to provide litigation finance to law firms.³¹ Frequently, LFCs maneuver around the prohibition on fee sharing by simply providing debt-like finance to law firms on a nonrecourse basis, with the firm agreeing to pay to the funder a contractually-specified return, secured by the law firm’s contingency-fee receivables for a financed case or portfolio of cases.³² As a general matter, lawyers face no professional restrictions on borrowing money. A recent trend to liberalize fee-sharing rules augurs greater acceptance of finance arrangements involving LFCs sharing in contingent legal fees directly.³³

This description summarizes the financial and economic logic of litigation finance transactions. It bears note that many LFCs supplement and diversify their business by engaging in adjacent, related business lines such as asset recovery, proprietary strategic litigation seeking to obtain rulings favorable to the litigation finance industry, and financing/monetization of post-settlement litigation receivables.³⁴

B. A Snapshot of the Industry Today

From its modest origins in Australia and the United Kingdom in the 2000s, to its slow-but-steady expansion in the United States in the subsequent decades,³⁵ litigation finance has gradually emerged as a transformational phenomenon for the civil justice system.³⁶ The sector is growing, both in terms of the number of participants and revenue. One litigation finance brokerage currently estimates that litigation funders have over $11 billion either currently invested or ready to invest in U.S. commercial litigation.³⁷

Furthermore, there is unanimous agreement that there is significant potential for the market to grow,³⁸ especially in the United States.³⁹ The total addressable market for litigation finance is difficult to estimate. In the first place, there are two distinct sources of revenue: claims on lawsuit proceeds (in the case of funded litigants) and claims on law firm revenues (in the case of funded law firms). In 2019, IMF Bentham, then a large publicly traded LFC,⁴⁰ attracted attention when it estimated in its Annual Report that the total addressable market for litigation finance in the United States was $85 billion.⁴¹ This estimate was derived from the share of litigation expenses going to plaintiffs’ lawyers, apparently on the theory that that entire amount could become financed.⁴² This estimate is both conservative and exaggerated. It is conservative because it fails to capture financeable defendant opportunities⁴³ and, much more importantly, the direct monetization of claims by business litigants themselves.⁴⁴ On the other hand, it is exaggerated insofar as it is predicated on the industry maintaining a beneficial financial interest in all plaintiff attorneys’ fees, which would hardly be advisable, if it were even possible at all.⁴⁵ While the precise scope of the market opportunity is uncertain, it is clear that litigation finance will remain a fixture, with significant room to grow.

In the meantime, Burford, the largest LFC by any metric, already counts 94 of the “AmLaw 100” law firms, and 90 of the 100 largest global law firms, as its clients.⁴⁶ The 2008–2009 recession provided a special impetus to the law firm finance market, which saw many law firms lose access to bank credit and face increased pressure from corporate clients to transition away from hourly billing as the predominant modality of attorney compensation.⁴⁷ Well aware of the global growth potential, the industry founded its own worldwide trade association in September of last year: the International Legal Finance Association (ILFA).⁴⁸

So much for the demand side. The supply side, consisting of investment fund flows, is in plentiful supply as well, with even traditionally conservative investment institutions like university endowments starting to invest.⁴⁹ First, the low-rate environment has increased investor appetite for non-traditional investments. In this respect, the flow of savings into litigation finance investments is of a piece with investment flows to cryptocurrency, real estate, and commodities. A second factor stoking demand for litigation finance investment is the relatively low correlation of litigation finance returns with the broader economy, which offers investors diversification benefits.⁵⁰ Litigation finance returns are a function of underwriting practices and court timelines rather than consumer spending, commodity prices, corporate investment, etc.⁵¹

C. Publicly Traded LFCs

Currently, more than forty specialized LFCs operate in the United States.⁵² The worldwide number is undoubtedly greater. Yet, only four of these companies are publicly traded worldwide.⁵³ In descending order of current market capitalization, these firms are Burford, Omni Bridgeway, Manolete, and LCM. Burford is incorporated in Guernsey (a small island state in the English Channel that serves as a popular jurisdiction of incorporation) and is listed on the Alternative Investment Market (AIM)⁵⁴ of the London Stock Exchange (LSE) and, as of October 2020, the New York Stock Exchange (NYSE) as well. Omni Bridgeway and LCM are traded on the Australian Stock Exchange; the latter is also traded on the AIM. Manolete is traded on the AIM only. A fifth LFC, Juridica Investments Ltd. (Juridica), was traded on the AIM from 2009 until it was delisted in December 2018.⁵⁵ Together, these four public companies have an aggregate market capitalization as of September 2022 of just under $3 billion.

As with any industry, the public-private distinction has significant implications for how LFCs conduct business. Most obviously, publicly traded LFCs must comply with the periodic and episodic reporting regime imposed by the securities laws. Less straightforward, but equally as important, are the governance implications for an LFC transitioning from a fund model to a public company model. Private investment funds in the private equity, venture capital, and hedge fund sectors operate in an environment where transparency and disclosure expectations are lowered, investors are sophisticated or wealthy (or both), and trust is the predominant cultural norm.

By contrast, investors in public companies expect much more detailed financial and non-financial disclosures than investors in private funds. Moreover, public companies must accommodate the expectations of public market investors for earnings reporting and guidance. This, in turn, affects corporate governance practices. As the saying goes, “if you show me what you count, I’ll show you what counts.” Numbers and accounting practices play a constitutive role; they not only reflect the social world but also help shape it, bringing into existence new practices and routines.⁵⁶ Firms that are not normally in the practice of reporting periodic—and frequently asynchronous, when compared to their investment time horizon—earnings must suddenly not only produce that information, but devote internal resources to deliberating on and projecting future earnings. When Burford, Omni Bridgeway, LCM, and Manolete decided to go public, they opted into a new financial reporting regime and assumed a cluster of anticipated and unanticipated governance implications.

What drives management to take LFCs public? For the most part, the motivations driving LFC managers to list their companies’ shares are the standard set of considerations for all public companies. Most obviously, listed companies have ready access to debt and equity capital.⁵⁷ As noted earlier, the sector is growing and requires capital to fund this growth.⁵⁸ In the LFC context, debt capital tends to fund growth,⁵⁹ and equity capital, being more patient, makes LFCs more resilient to potential liquidity mismatches that pose a threat to all financial institutions that lend long.⁶⁰ By going public, an LFC not only secures equity capital, but it also significantly facilitates the public sale of debt.⁶¹ Further, publicly traded LFCs can freely use their stock as acquisition currency,⁶² as Burford did in 2016 when it acquired litigation finance fund manager Gerchen Keller.⁶³ In this respect, public company status facilitates consolidation and revenue diversification. And publicly traded LFCs are more readily able to compensate management by issuing stock, stock options, and other securities, a practice that is thought to align the microeconomic incentives of managers and other security holders.⁶⁴

An additional motivating factor applies with particular force in the litigation finance industry and provides an entry point into the problem considered in this essay. Specifically, some LFCs have touted the corporate governance benefits flowing from the added transparency that public company status entails. To be sure, securities market professionals have long touted the “branding” and signaling benefits that a company enjoys, particularly if it lists on a reputable exchange with exacting corporate governance listing standards.⁶⁵ However, this general objective assumes heightened importance in the LFC context. In the words of Nick Rowles-Davies, a former Burford executive and current LCM executive vice chairman:

Being listed on any stock exchange ensures a level of regulation and transparency that the private markets do not. . . . As a constituent of a public market, there is pressure to ensure that standards of corporate governance are upheld. Natural checks exist to hold companies to account in the form of selling investors, analysts publishing negative research, and, at the most extreme level, activists or short sellers publicly targeting companies.⁶⁶

Thus, the stock exchange as an institution imposes “natural checks” on possible self-serving behavior on the part of the managers. Yet, this governance story is complicated by the fact that company management—now flush with liquid, tradable securities—has heightened incentives to engage in stock price and earnings management. That is, if stock prices are evaluated in large part by the use of relative valuation techniques like price-to-earnings (PE) ratios,⁶⁷ the incentive exists for management to, as Carson Block—head of the short-only hedge fund Muddy Waters—puts it, “juice the earnings and make up the E.”⁶⁸

Public company status, therefore, is characterized by a tension. On the one hand, the open spigot of liquid company securities to management heightens the temptation to engage in unethical behavior by artificially inflating earnings and other metrics. On the other hand, as Rowles-Davies emphasizes, public companies provide publicity and transparency and invite scrutiny from investment professionals—including activists and short sellers like Muddy Waters.⁶⁹

To a significant degree, this tension is a general structural property of public securities markets; it is observable with all public companies and across all industries and sectors. However, the main argument here is that the intrinsic opacity of LFC financial accounting and reporting practices significantly destabilizes and problematizes the tension, undermining in the process the two main objectives of disclosure-based securities regulation.

III. Publicly Traded LFCs Pose Threats to the
Two Pillars of Securities Regulation

The two main objectives of securities regulation are protecting investors and promoting fair, efficient, and transparent markets.⁷⁰ Efficient capital formation is sometimes added as a third objective, although it is usually thought to be derivative of these investor protection and market integrity grundnorms.⁷¹ More recently, systemic risk is sometimes invoked as an additional objective of the securities laws, although this desideratum has been a shared responsibility for all financial regulators for at least a decade, and is not properly thought of as the core bailiwick of securities regulators. The two central themes, then, of securities regulation over the past century have been investor protection and market integrity. On account of the opacity of their assets, publicly traded LFCs pose threats to both of these objectives.

As discussed in greater length below, litigation finance assets are difficult to value before they result in cash settlements or court judgments. There is no obvious method for how to account for a litigation asset that was purchased for $5 million and could possibly result in recovery scenarios ranging from $0 to $40 million. This uncertainty is even more pronounced when reasonable lawyers and litigation funders disagree about the likelihood of the total-loss and extraordinary-recovery scenarios, and all the alternative scenarios in between. And yet, from an investor’s perspective, the LFC’s enterprise value depends entirely on its ability to generate returns from these opaque assets.

The accounting profession responds to uncertainty of this sort with so-called fair value accounting, which—as discussed in greater detail below—requires reporting entities to report, or “mark,” the values of assets like these according to internal valuation models. The use of such a model entails so-called model risk, which is helpfully defined and discussed by the Federal Reserve in terms that are generalizable even beyond the banking context:

The use of models invariably presents model risk, which is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. . . . Model risk occurs primarily for two reasons: (1) a model may have fundamental errors and produce inaccurate outputs when viewed against its design objective and intended business uses; (2) a model may be used incorrectly or inappropriately or there may be a misunderstanding about its limitations and assumptions. Model risk increases with greater model complexity, higher uncertainty about inputs and assumptions, broader extent of use, and larger potential impact.⁷²

Model risk, when defined in this manner, captures the strategic manipulation of well-designed models, the construction of poorly designed models, and the faulty implementation of all sorts of models. From the vantage point of securities regulation, the opacity and the accompanying model risk creates a twofold problem for the publicly traded LFC, which assumes heightened responsibilities when it comes to disclosure and transparency.

First, it undermines investor protection because the intrinsic opacity of LFC asset valuation complicates the detection of fraudulent or negligent financial reporting, which can lead to investor losses. These problems result from doctrinal considerations and the potential for the confusing presentation of results. As a doctrinal matter, the prevalence of fair value accounting practices among publicly traded LFCs neutralizes much of the accuracy-enhancing effects of securities law antifraud rules. The central feature of securities regulation is a non-waivable, credibly enforceable antifraud remedy that enhances the reliability of disclosure for all companies, leading to more accurate valuations and more efficient capital investment.⁷³ However, judicial insistence on proof of wrongful state of mind,⁷⁴ as well as case precedent restricting the application of the antifraud rules to opinion statements,⁷⁵ attenuate the effectiveness of the antifraud regime as a corrective for the opacity of litigation finance accounts. After all, model risk captures good-faith (and therefore unactionable) errors in judgment, and all valuation models involve the use of inherently subjective and contestable assumptions that are, in an important sense, opinions.

More subtly, the public company financial reporting rules requiring periodic “fair value” estimates of asset values might also cause some retail investors to underappreciate the inherent discretion managers exercise in valuing assets—in good faith or otherwise—and thereby possibly overestimate the reliability of LFC financial statements. Sociologist Nicolas Rose notes that, in modern societies, “[n]umbers are resorted to in order to settle or diminish conflicts in a contested space of weak authority.”⁷⁶ For Rose, the “power of a single figure” is “a rhetorical technique for ‘black boxing’—that is to say, rendering invisible and hence incontestable—the complex array of judgments and decisions that go into a . . . number.”⁷⁷

It is possible to view fair value accounting generally as a second-best solution to the problem of accounting for asset values in highly uncertain environments. Following Rose, there are only “weak authorities” on which to base valuations, so recourse to internal valuation models is arguably necessary. However, reliance on the internal models, which yield single point estimates of value, might in the process “black box” and obscure the complex and ineradicable uncertainty concerning the value of the marked assets. Nassim Taleb has written on this theme in the financial context: “Once on a page or on a computer screen . . . [a] projection takes on a life of its own, losing its vagueness . . . and becoming what philosophers call reified, invested with concreteness; it takes on a new life as a tangible object.”⁷⁸ The prospect of undue investor credulousness leading to investor losses is also part of the investor protection problem regarding opaque assets.

Second, the structural opacity of the company’s valuation creates conditions ripe for market manipulation through strategies like so-called “short attacks” and “bear runs,” as some believe happened recently with Burford and the hedge fund Muddy Waters. The reference to market manipulation here, and throughout this paper, is intended to capture strategic attempts to create and profit from disjoints between the intrinsic value and the market price of a firm’s securities. What this definition perhaps lacks in specificity it compensates for in its capaciousness. Over a century ago, financial journalist Albert Atwood noted that manipulation “is more easily seen than defined,” but that it “almost invariably conveys the idea of artificiality.” ⁷⁹

This notion of artificiality requires further elaboration. Two central meanings of “artificiality” should be distinguished. On the one hand, a price could be artificial in the sense that it results from artificial tinkering with perceptions and records of supply and demand—from falsely modifying the order flow out of which the price emerges, or is said to be passively “discovered” by market forces. For instance, a group of traders might manipulate a stock price by “spoofing” or “layering” non-bona fide buy orders that they intend to cancel, so as to give the false impression of a surge in demand for a security.⁸⁰ On the other hand, a price could be artificial in the sense that it diverges from what would have been the price absent a flood of bona fide sell orders that were entered solely to affect the security’s market price, with no consideration of fundamental, intrinsic value of the security. An artificial price in this second, broader sense is a price that moves away from its previous level on account of strategic action on the part of the manipulator. It is this latter sense of artificiality that is intended to be captured by the capacious formulation of manipulation adopted here, which is sometimes referred to as “open-market manipulation.”⁸¹

The prohibition on market manipulation in American securities law has been interpreted by courts more restrictively, consistent with a strict interpretation of manipulation and artificiality requiring the stoking of false perceptions about actual supply and demand.⁸² As such, practices like short selling, even when accompanied by aggressive press publicity in the financial press, are legal absent exceptional circumstances.⁸³ In the European Union and the United Kingdom, the Market Abuse Regulation similarly focuses on supply and demand as its overarching principle.⁸⁴ Thus, the sense used here is not only broader, it is also more colloquial and lay than the specialized legal term of art.

The special threat to market integrity arises because the intrinsic opacity of litigation finance assets enables efforts by would-be manipulators to sow seeds of doubt concerning the quality of company accounts. Usually, the sort of “tail risk” represented by Enron-style accounting fraud is remote from the imagination of most investors. However, the more opaque a publicly traded company’s asset portfolio, the easier it is to sow these doubts, making investor fears about tail risk more proximate.

A skeptic of the argument presented here might ask: “Sure, you call it ‘manipulation,’ which sounds mischievous, but where, exactly, is the problem here?” The skeptic might note that litigation finance companies assess the net pros and cons of public company status, including the possibility of a short attack or similar market-manipulative episode. If the company persists in listing, it knowingly assumes this possible downside risk, but impliedly has determined that the benefits outweigh said risks. Framed in this manner, that hardly presents a policy conundrum. However, the specter of market manipulation results in negative externalities from the perspective of the broader capital market.

Consider the following possible series of events. Becoming aware of the structural opacity of LFC fair value accounts, a speculator undertakes to sell the stock short, publicizing its inauthentic “belief” that the LFC’s fair value marks are overly optimistic. In such a circumstance, it can be rational for other investors to sell their shares, creating a positive feedback loop the net result of which is a decline in the price of the LFC firm.⁸⁵ This decline in price can also lead to a decline in intrinsic value, as the price declines operate to increase the firm’s cost of capital and affect its investment policies, in effect ratifying the initially pretextual description of the company’s accounts.⁸⁶ For example, an investment promising an internal rate of return of 20% will be greenlighted by a firm with a weighted average cost of capital (WACC) of 18%, but will be declined by a firm with a WACC of 22% whether the WACC is established on an efficient market or is the result of market manipulation on the part of strategic short sellers.

The effects of market manipulation of this sort reverberate throughout capital markets. Tony D’Aloisio, the former chair of the Australian securities market regulator, lists the parade of horribles that might result from market manipulation of this sort:

Conceptually, the public cost of . . . market manipulation can be expected to be seen in the first instance in a widening in the bid–ask spreads for all trading in the securities in question. This can spill over into widening bid–ask spreads in the market for all securities, an increase in the cost of capital and a reduction in the market price of securities—not only for new and existing issues of the security in question but also for other securities. A reduction in market depth (reflecting reduced willingness to trade) and reduced trading volumes would also be expected. In a dynamic analysis, these higher costs of capital and costs of trading would feed into lower returns on investment, less fixed capital spending and less potential and actual economic demand and activity over the economic cycle.⁸⁷

Despite the evident costs for investors, the incentives persist for would-be manipulators. Unless enforcement is both forthcoming and effective, market manipulators do not themselves incur these economic costs.⁸⁸

These twin injuries to investor protection and market integrity would not pose an acute policy conundrum in the private fund context. In that setting, we might expect that informal norms, reputational considerations, and formal contracts would regulate and manage the uncertainty and opacity that saturates LFC accounts. But once these firms list their securities on public markets, they submit to a new regulatory regime, the objectives of which they can then potentially undermine.

Still, this argument that publicly traded LFCs present heightened risks to investors and market integrity hinges on an important premise: that LFC financial statements are inherently opaque and the product of a higher-than-normal degree of managerial discretion. While some further standardization might be expected in the medium- or long-term, particularly with the advance of predictive legal analytics,⁸⁹ the reality is that today there exists no consensus on how to value litigation finance assets. The following Part will shed light on the significant degree of subjective discretion involved in most LFC asset valuation practices, as well as the potential for abuse that such discretion inevitably entails.

IV. LFC Assets and Fair Value Accounting

The securities disclosure complications for LFCs result primarily from the application of fair value accounting rules to litigation finance assets. This Part will guide the reader through the application of those fair value accounting rules. Accounting rules, along with scripture, are perhaps the only volumes of lexical rule systems that lawyers can push off to another profession. Even for a lawyer, tracing through labyrinthine

accounting rules can be vexatious. Nevertheless, all securities lawyers eventually learn that they cannot avoid engaging with the accounting rules from time to time.

Doing so here reveals a state of uncertainty regarding whether fair value rules do or do not apply to litigation finance assets, with the better argument probably lying in the affirmative position. Next, the Part

examines in detail how the publicly traded LFCs that adopt fair value accounting structure their fair value process and explain it to investors. It highlights in particular the unavoidable quantum of brute discretion that persists in that system, notwithstanding companies’ efforts to center the “objectivity” of their accounts.

A. How Fair Value Accounting Works Generally

One of the principal dilemmas in modern accounting is deciding whether to account for income and asset values by reference to cash flows and historical costs or by reference to current fair values.⁹⁰ The former approach is thought to privilege clarity and certainty at the cost of some economic realism. The latter is thought to privilege economic realism at the cost of introducing discretion and the possibility of strategic manipulation and abuse. Two of the four publicly traded LFCs—Burford and Manolete—classify their litigation finance assets in a manner that requires fair value treatment.

Three of the publicly traded LFCs (Omni Bridgeway, LCM, and Manolete) are subject to the International Financial Reporting Standards (IFRS) regime maintained by the International Accounting Standards Board (IASB).⁹¹ The other (Burford Capital) reported in accordance with IFRS until 2022, when it voluntarily elected to present its 2021 financial statements in its annual report in accordance with the U.S.-based Generally Accepted Accounting Principles (GAAP) accounting regime, maintained by the Financial Accounting Standards Board (FASB).⁹² Given the predominance of IFRS reporting in the industry as presently constituted, this Article focuses on the applicable IFRS rules.

However, fair value accounting is one arena where IFRS and GAAP have substantially converged over the past decade.⁹³ In fact, the IFRS fair value regime applicable to the current cohort of publicly traded LFCs is in most respects substantively identical to that of the GAAP regime, set forth in Topic 820 of the FASB’s Accounting Standards Codification system.⁹⁴ So the U.S.-based reader, likely more accustomed to thinking about accounting in terms of the GAAP regime, is relieved of the burden of wondering how these issues play out in GAAP terms. For purposes of the specific issue with which this Article is concerned—fair value accounting for so-called Level 3 assets—no significant differences exist between GAAP and IFRS. Burford acknowledged as much when it reported its first GAAP-compliant results in early 2022.⁹⁵

The accounting treatment of future contingent cash flows from litigation finance assets begins with “recognizing” the cash flows. This taxonomic project begins with IFRS 9, which governs the accounting treatment of financial instruments, including “financial assets.” IFRS 9 incorporates the definition of “financial asset” from IAS 32,⁹⁶ which includes, among other instruments, any “contractual right . . . to receive cash or another financial asset from another entity . . . .”⁹⁷ If an LFC “recognizes” its litigation finance assets as financial assets, IFRS 9 next makes the precise accounting treatment depend on how the LFC “classifies” the asset.⁹⁸ Chapter 4 of IFRS 9 clarifies that the proper classification of a financial asset, in turn, is a function of the contractual cash flow characteristics of the financial asset.⁹⁹

For litigation finance assets, the relevant provision of Chapter 4 is paragraph 4.1.4. The provision requires that financial assets be measured at fair value through profit and loss where the cash flows related to the asset do not consist exclusively of “payments of principal and interest [on specified dates] on the principal amount outstanding.”¹⁰⁰ In accounting practice, this means that the assets are periodically revalued, with the incremental changes reflected as profit (in the case of an upward fair value adjustment) or loss (in the case of a downward fair value adjustment) on the income statement for the period in which the fair value adjustment occurs. This is significant and potentially confusing, for it means that the idiosyncratic, non-standardized features of litigation finance assets are responsible for fair value movements that directly impact the financial statement responsible for reflecting the operational realities of the business—that is, the income statement.

The specific rules for how to perform fair value accounting are set forth in IFRS 13, which defines fair value, sets out a framework for measuring fair value, and requires disclosures about fair value measurements. IFRS 13 applies when another IFRS standard—e.g., IFRS 9 as discussed above—requires or permits fair value measurements. IFRS 13 defines fair value in terms of a hypothetical exit price:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (ie an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.¹⁰¹

IFRS 13 sets up a tripartite “fair value hierarchy,” with each “level” corresponding to the available set of informational price inputs.¹⁰² The general principle animating IFRS 13 is that fair valuation techniques “shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs.”¹⁰³ Specifically, Level 1 inputs consist of quoted market prices, the most reliable fair-value exit price approximation; they are of the highest priority, meaning that an entity must measure its financial assets according to market prices where such prices are available.¹⁰⁴ Level 2 inputs consist of information other than quoted market prices that are directly or indirectly observable for the asset—for instance, quoted prices for similar assets in active markets.¹⁰⁵ These inputs are of middle priority, and should be used as the basis for measuring financial asset values where they exist, but quoted market prices do not. Finally, Level 3 inputs consist of unobservable information and are the lowest priority; they should be used only where no observable inputs exist.¹⁰⁶

Implicit in this “fair value hierarchy” is the judgment that unobservable inputs are inherently less reliable than observable ones. In the context of Level 3 assets, the term “fair value accounting” is quite ambiguous. It is straightforward enough to determine there are no observable market prices to which an entity might look to value its assets. Still, it is quite different to be able to build an internal, objective informational system as a credible alternative. The same factors resulting in the absence of observable external market inputs—i.e., the absence of reliable market price signals—complicate the generation of reliable, objective internal inputs concerning the value of these assets. When a reporting entity uses internally-generated unobservable inputs to value Level 3 assets—as with internal, proprietary financial models—the risk of strategic manipulation is also heightened.

Unfortunately (but perhaps inevitably), IFRS 13 provides little guidance to reporting entities concerning the production and use of unobservable inputs in fair-value models. It limits itself to insisting that the unobservable inputs, whether generated internally or externally, reflect the assumptions that market participants would use when pricing the asset or liability.¹⁰⁷ But that “guidance” amounts to a tautology; so much was already implicit in the IASB’s specification that fair valuation should seek to approximate an exit sale.¹⁰⁸

In the absence of observable market data, an entity adopting fair value accounting possesses a higher-than-normal degree of discretion that is cabined only by a hypothetical limit set by what other market participants would do: “An entity shall develop unobservable inputs using the best information available in the circumstances. . . . In developing unobservable inputs, an entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market participants would use different data . . . .”¹⁰⁹

Whereas IFRS 13 fails to adopt a prescriptive approach concerning the use of unobservable inputs into fair value models for Level 3 assets, it leans on disclosure principles to provide the context for management’s discretionary choices. Its paragraph 91 sets forth a general principle requiring reporting entities to disclose information that helps users of its financial statements assess the valuation techniques and measurements, as well as the “inputs used to develop those measurements.”¹¹⁰ The principle also provides that entities marking Level 3 assets—i.e., using significant unobservable inputs—must also provide disclosure that explains and contextualizes the effects of the fair value measurements on the entity’s income statement.¹¹¹

Following the skeletal paragraph 91, paragraph 93 fleshes out just what is required. For example, an entity must include a “description of the valuation technique(s) and the inputs used in the fair value measurement.”¹¹² This description must address how an entity decides its valuation policies and procedures and analyzes changes in fair value measurements from period to period.¹¹³ For Level 3 assets, the description should provide quantitative information about the significant unobservable inputs used in the fair value measurement.¹¹⁴

Sensitivity analysis¹¹⁵ is also required, with reporting entities to set forth a “narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement.”¹¹⁶ Further, “if changing one or more of the unobservable inputs to reflect reasonably possible alternative assumptions would change fair value significantly, an entity shall state that fact and disclose the effect of those changes.”¹¹⁷ The entity must also “disclose how the effect of a change to reflect a reasonably possible alternative assumption was calculated.”¹¹⁸

B. Applying Fair Value Accounting to Litigation Finance Assets

If an LFC recognizes its litigation finance assets as “financial assets” under IAS 32, then we have seen how IFRS 9 mandates that they be accorded fair value accounting treatment. Specifically, these litigation finance assets are to be accounted for through the income statement because the cash flows are not exclusively interest and principal payments.¹¹⁹ Once classified as fair-value assets in this manner, the LFCs must look to IFRS 13 for instructions concerning the required fair value techniques and disclosures.¹²⁰

Because litigation finance assets are lawsuit-specific or lawsuit-portfolio-specific,¹²¹ there are no quoted market prices or other indirect observable inputs concerning their fair value. Therefore, IFRS 13 will require them to be classified as Level 3 assets.¹²² In that circumstance, IFRS 13 opens up a significant discretionary space for LFC management to fashion their own valuation models and, in effect, make their own marks. Paragraph B36 of IFRS 13 sets forth some guidance for Level 3 fair value measurements for certain categories of assets, but litigation finance assets are not included.¹²³ Instead, IFRS 13 merely reiterates the default principle that fair value measurements should approximate an exit price.¹²⁴

Note that the foregoing discussion has proceeded on the assumption that LFCs are recognizing their litigation finance assets as “financial assets” under IAS 32 and accounting for them using fair value accounting. Indeed, two of the four publicly traded LFCs—Burford and Manolete—do just that. However, the other two LFCs—LCM and Omni Bridgeway—do not recognize their litigation finance assets as financial assets and, accordingly, do not accord them fair value treatment. Instead, LCM and Omni Bridgeway rely on more tenuous interpretations of IFRS standards that result in accounting treatments favoring more conservative, cash-based accounting over fair value determinations.

LCM, for instance, classifies its assets as contracts with customers, which are covered by IFRS 15. That standard governs the reporting of revenues and cash flows from contracts with customers,¹²⁵ defined as contracts “to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration.”¹²⁶ IFRS 15 and IFRS 9 operate in mutually exclusive fields of application; that is, where one applies, the other by definition cannot.¹²⁷ Therefore, determining whether to apply IFRS 15 or IFRS 9 to litigation finance assets is a highly consequential matter. If an LFC applies the latter, then fair value accounting will apply. If an LFC applies the former, then the LFC will use more conservative cash-based accounting methods where litigation finance assets are recognized at historical cost and revenues are recognized only upon final disposition of the matter.

The appropriateness of an IFRS 15 classification depends on the applicability of a carve-out. The carve-out excludes from the scope of IFRS all contracts in which counterparties “share in the risks and benefits that result from [an] activity or process (such as developing an asset in a collaboration arrangement) rather than to obtain the output of . . . ordinary activities.”¹²⁸ Although their public disclosure does not spell out their classificatory rationale, by using IFRS 15 (and not applying this carve-out) LCM implicitly disclaims that its litigation finance assets involve the sharing of risks and benefits. That determination seems dubious in light of the basics of the litigation finance business model, not to mention LCM’s own description of its value proposition:

By providing our customers with financing solutions to pursue matters which would otherwise be costly, therefore taking on their risk and preserving their capital to pursue their own business opportunities. On successful completion of litigation cases we recover our investment and earn revenue through share of proceeds, performance and management fees.¹²⁹

For its part, Omni Bridgeway avoids fair value accounting through a different taxonomic sleight, classifying its assets as “intangible assets” under IAS 38. This treatment results in the most conservative accounting treatment of all the publicly traded LFCs. IAS 38 sets forth the accounting treatment of intangible assets that are not governed by other specifically referenced standards, including IFRS 15 (LCM) and IAS 32 (Burford and Manolete).¹³⁰ The most important consequence of the classification as intangible assets under IAS 38 is that the assets are carried at cost, with gains recognized on the income statement only at the disposal of the asset.¹³¹ Omni Bridgeway takes the position that a “disposal” of a litigation finance asset occurs (and a gain is recognized) when the financed litigation reaches “successful completion.”¹³²

Furthermore, this classification requires periodic impairment analysis for intangible assets with indefinite useful lives.¹³³ Impairment operates as a one-way ratchet, with downward fair value adjustments being made as necessary in light of regular, periodic assessments, with no provision for accompanying upward adjustments.¹³⁴ As a result, Omni Bridgeway’s accounting treatment is much more conservative than that of Burford and Manolete, and even more conservative, on account of the impairment process, than LCM’s.

In its annual report, Omni Bridgeway explains why it believes IFRS 15 and IAS 32 are inappropriate. As for IFRS 15, it explains that its assets “are not considered contracts with customers as they are collaborative arrangements and there is no vendor-customer relationship established in the contract.”¹³⁵ For reasons discussed above, Omni Bridgeway has the better argument on this score; a typical litigation finance contract provides for too much risk-sharing and revenue-sharing to meet the “contract with customer” definition. As for IAS 32, Omni Bridgeway takes the position that its litigation finance assets are not financial contracts under that standard—which, again, prescribes the treatment for contractual rights to receive cash or other financial assets¹³⁶—because the assets might give rise to proceeds that consist in part of non-financial assets.¹³⁷ Notwithstanding the technical possibility of non-cash consideration, if litigation finance assets are anything, they are “contractual rights to receive cash or another financial asset from another entity,” which should trigger the application of IAS 32 and the fair value rules.¹³⁸ In fact, it is fair to wonder whether the LFCs adopting alternative classifications are doing so due to their repeatedly emphasized strategic preference for more conservative, less discretionary cash accounting systems, notwithstanding the tenuousness of the textual fit between the asset and their preferred IFRS reporting modality.

Table 1 below summarizes the respective accounting conventions and their underlying rationales and ramifications.

Table 1: Summary of Publicly Traded LFC Fair Value
ccounting Practices

Company	IFRS Classification of Assets	Applicable Standard	Rationale for Classification	Resulting Accounting Treatment	Overall Assessment
Burford	“Financial Assets” [IAS 32]	IAS 32 ¶ 11(c)(i)	LF assets are “contractual rights to receive cash or another financial asset from another entity”	FV through profit and loss	Not conservative, but arguably more useful
Manolete	(same as Burford)	(same as Burford)	(same as Burford)	(same as Burford)	(same as Burford)
LCM	“Contracts with Customers”	IFRS 15 ¶ 6	LF assets are “contracts to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration”	Cash-based accounting with no FV impairment	Conservative, but arguably less useful
Omni Bridgeway	“Intangible Assets” [IAS 38]	IAS 38 ¶¶ 3(e), (i); 8	LF assets are intangible assets (i.e., “identifiable non-monetary assets without physical substance”) that are not classifiable as “financial assets” or “contracts with customers”	Cash-based accounting with FV impairment	Very conservative, but arguably less useful

That the four publicly traded LFCs settle on three mutually exclusive accounting treatments for their assets is a testament to the relative novelty and idiosyncrasy of litigation finance as an asset class. One thing to watch for in the coming years is whether a roughly uniform consensus concerning the classification and valuation of these assets emerges within the accounting profession as it becomes more familiar with the asset class.

C. Implementing Fair Value Accounting in the LFC Context:
Burford and Manolete as Case Studies

The two publicly traded LFCs that have classified their litigation finance assets as “financial assets” and therefore adopted fair value accounting—Burford and Manolete—have adopted a constrained fair value approach, revaluing assets only upon the occurrence of certain “objective” verifiable events pertaining to the litigation. Otherwise, they report assets on the balance sheet at their historical cost¹³⁹ unless and until marks are adjusted to reflect the effect of an objective event.¹⁴⁰ Consequently, not all assets are adjusted to fair value; some are reported at historical cost. Relatedly, Manolete and Burford recognize two sources of revenue: (1) unrealized upward fair value adjustments to litigation finance assets based on the objective criteria and (2) actual realized revenue upon the conclusion of litigation finance assets (via settlement or adjudication).¹⁴¹

For the publicly traded LFCs adopting fair value accounting, the fair value component of earnings is significant. In 2020, Burford reported $339 million of total income related to balance sheet litigation finance assets,¹⁴² 46 percent of which ($151 million) consisted of upward fair value marks.¹⁴³ For Manolete, unrealized fair value revaluations comprised an even larger percentage of income, comprising 58 percent ($10.9 million) of the company’s total reported 2020 income of $18.7 million.¹⁴⁴ Burford argues that its marks are conservative by pointing out that only 22 percent of its total realized profits have been previously registered as fair value gains.¹⁴⁵ However, it bears emphasis that in recent periods Burford’s unrealized fair value gains have been concentrated in its so-called “YPF-related assets,”¹⁴⁶ a cluster of claims arising out of the Argentine government’s partial renationalization of the Argentine energy giant YPF S.A. Since 2015, the company has recognized $876 million in unrealized gains related to its YPF portfolio,¹⁴⁷ nearly all of which still awaits an event that would require Burford to recognize the realized gain.¹⁴⁸ In other words, the 22 percent figure does not consider the YPF portfolio, which represents the preponderant part of the company’s unrealized fair value gains.

Hence, over recent reporting periods, we see that these companies’ reported earnings are largely a function of the fair value adjustments that result from internal valuation models. This state of affairs gives rise to the twofold securities disclosure problem introduced earlier. Earnings and cognate concepts like EBITDA are the basis for some of the most popular valuation methodologies.¹⁴⁹ Fair value adjustments impact the balance sheet no less than they affect earnings, with upward adjustments accreting the amount of total assets and, ceteris paribus, stockholders’ equity and book value. This dynamic means that fair value accounting affects other popular valuation methods that use book value multiples. The clear linkages between earnings and book value metrics to popular, widely-used valuation methods underscore the potential dangers to securities law objectives posed by opaque accounts.

To be fair, Burford does not include unrealized gains in its calculation of internal rate of return (IRR) and Return on Invested Capital (ROIC), the primary pro forma metrics by which it touts its financial track record to investors.¹⁵⁰ Over time, an LFC will develop a historical track record of actual realizations that can be compared to its unrealized fair-value marks. However, because most of the companies in this sector, whether public or private, are corporate adolescents, their historical realizations data is relatively unreliable.¹⁵¹ As with any investment firm primarily engaged in deploying capital to achieve returns, realized historical returns on invested capital are the most relevant metrics to which sophisticated investors will ultimately look—but only when there is enough of an operating history to make that data reliable. As these adolescent LFCs mature and demonstrate track records of success in funding lawsuits and generating returns on invested capital, their investors should be more willing to abstract away from any individual assets, however large, and focus instead on the underwriting record itself. The investor will underwrite the LFC itself and have little motivation to separately consider the underwriting decisions pertaining to the portfolio assets. In the meantime, however, fair value marks and flow-through income assume heightened importance.

These problems will be discussed in greater detail below, but their basic features are straightforward. First, the discretion that managers enjoy in Level 3 fair value accounting regimes renders especially problematic their inherent incentive to manage earnings and other financial metrics in an effort to boost their own financial position. Second, this first problem, in fostering the perception of ambiguous accounts, is grist for the mill of would-be market manipulators, who can profit by sowing seeds of doubt regarding the integrity of LFC accounts.

These problems are magnified by the opacity of the fair value modeling process. Burford cautions investors that “[t]he estimation of fair value is inherently uncertain” because “[a]wards and settlements are hard to predict and have a wide range of possible outcomes.” Manolete strikes a similar cautionary note, warning that because:

[l]itigation is inherently uncertain . . . . it is reasonably possible, on the basis of existing knowledge, that outcomes within the next financial year that are different from the assumptions [used in the valuation models] could require a material adjustment to the carrying amount of the . . . investments disclosed in the balance sheet.¹⁵²

Perceiving the tension between the opacity of the valuation process and the goal of transparent disclosure, Burford repeatedly emphasizes in its 2020 annual report the objectivity of its fair value accounting policy:

We hold legal finance assets at initial fair value, which is equivalent to deployed funded cost, until there is some objective event in the underlying litigation that would cause a change in value, whereupon we are required under IFRS to reflect the impact (up or down) of that objective event through a fair value adjustment.¹⁵³

And later on, Burford informs investors that:

We operate under a valuation policy that relies on objective events to drive valuation changes. For the vast majority of our legal finance assets, the objective events considered under the fair value policy . . . relate to the litigation process. When the objective event in question is a court ruling, Burford discounts the potential impact of that ruling commensurate with the remaining litigation risk.¹⁵⁴

Manolete, for its part, makes similar assurances about objectivity, informing investors that it “adjust[s] case fair values depending upon objective case developments, for instance: an offer to settle, mediation agreed, positive or negative legal advice.”¹⁵⁵

For Burford, the “objective events” giving rise to valuation changes are familiar to all lawyers: rulings on dispositive pre-trial motions, judgments, appellate results, exhaustion of rights to appeal, and the issuance of arbitral tribunal awards.¹⁵⁶ Further, Burford sometimes sells portions of its litigation finance assets before their resolution by objective events, and takes into account these transaction prices as Level 3 inputs.¹⁵⁷ After all, the objective of fair value measurement of assets under IFRS is to approximate a hypothetical exit sale at the measurement date from the perspective of a reasonable market participant.¹⁵⁸ Where there are actual exit sales, those prices are obviously relevant. Indeed, most of Burford’s unrealized fair value gains result from Level 3 markups predicated on these dispositions.

And yet, Burford’s disclosure is unavoidably Janus-faced on this score. Notwithstanding all the talk of objectivity, the company also acknowledges that its Level 3 fair value measurements, despite being the current best estimates, are “inherently subjective.”¹⁵⁹ At one point, the company, in seeming exasperation, justifies its valuation policies in terms of a lack of alternatives:

The aggregate of the fair values selected falls within a wide range of reasonably possible estimates. In the Group’s opinion there is no useful alternative valuation that would better quantify the market risk inherent in the portfolio and there are no inputs or variables to which the values of the assets are correlated.¹⁶⁰

Why does Burford’s disclosure close with this ambiguous message that its inherently subjective marks are based on objective markers? And why do publicly traded LFCs using fair value accounting not disclose particularities concerning their valuation models, at least with respect to their highest value assets?

The disclosure and accounting ambiguities referenced so far apply with equal force to all Level 3 fair value accounting systems. To appreciate the answers to the questions posed above, it is necessary to appreciate the further layer of opacity obfuscating publicly traded LFC accounts resulting from privilege and work product rules.

V. The Long Shadows of the Attorney-Client Privilege
and the Work-Product Doctrine

All the while these fair value accounting rules command LFC management to engage in an inherently subjective and discretionary exercise of judgment, the legal ethics and evidence rules command circumspection or even outright silence when it comes to explaining how publicly traded LFCs are exercising that judgment in practice. This dilemma results from waiver concerns under the evidentiary rules relating to the attorney-client privilege and the attorney work product doctrine.¹⁶¹ These concerns significantly restrict the scope of disclosure to public LFC investors.

The focus here is on the United States, but the privilege issues attending LFC disclosure apply similarly in other jurisdictions,¹⁶² especially in common law jurisdictions such as the United Kingdom and Australia. To underscore the special force of the waiver issue in the publicly traded LFC context, this Part will compare the waiver risk these companies face with the risks facing two other categories of actors that are similar, but different in crucial respects: private LFCs and non-LFC public companies. This Part will begin with a brief and general summary of the evidentiary protections flowing from the attorney-client privilege and the work-product doctrine. Next, it will present the comparative analysis referred to above and then conclude with some illustrations of how these protections affect the disclosure practices of publicly traded LFCs.

A. A Brief Introduction to Privilege Waiver

To appreciate the structuring importance of this privilege issue, a basic understanding of the relevant rules is necessary. The attorney-client privilege is an evidentiary rule providing that neither a client nor the client’s lawyer may be required to testify or otherwise to provide evidence that reveals the content of confidential discussions and disclosures of information between the client and the lawyer in the course of seeking or rendering legal advice.¹⁶³ For its part, the attorney work product doctrine shields from discovery all “tangible material or its intangible equivalent in unwritten or oral form, other than underlying facts, prepared by a lawyer for litigation then in progress or in reasonable anticipation of future litigation.”¹⁶⁴ Two reporters for an American Bar Association Task Force on the Attorney-Client Privilege pithily distill the two protections in the following terms:

It is widely recognized that the attorney-client privilege protects confidential communications between lawyer and client, while the work product doctrine provides qualified protection to writings embodying an attorney’s factual investigations, research, impressions, opinions and conclusions in anticipation of litigation. The attorney-client privilege encourages clients to make disclosures necessary to obtain legal assistance, while the work product doctrine allows lawyers to investigate, prepare and develop strategy relating to litigation without worrying about adversaries obtaining their work and using it against their clients.¹⁶⁵

When litigants disclose confidential information otherwise protected by these rules, they risk waiver of the protections.¹⁶⁶ The upshot of waiver is severe: the otherwise confidential materials may be subject to discovery by adverse parties, such as the adverse defendants¹⁶⁷ in the cases underlying the litigation assets.

Of course, no LFC investor is asking for public disclosure of the central strategy memos written by the lawyers litigating the cases in which the LFC has invested. But the scope of a waiver can be broader than the initially disclosed information that triggers the waiver in the first place. Whenever a client discloses confidential communications to third parties, the disclosure may waive protections not only with respect to the disclosed communication, but also any other communications relating to the same subject.¹⁶⁸ Although the prospect of a broad “subject matter” waiver of this sort is more remote in the work-product context than the attorney-client privilege context,¹⁶⁹ the waiver rule creates a strong incentive for all litigants to take effective steps to protect against even partial disclosure of privileged material, even in nontestimonial settings.

B. A Comparative Analysis of the Risk of Privilege Waiver

1. Publicly Traded LFCs vs. Publicly Traded Non-LFCs

The publicly traded LFC presents an acute case of a broader, usually easy-to-solve, problem. Public companies are always involved in litigation, some of which is usually material for purposes of the securities disclosure regime and must be disclosed to investors.¹⁷⁰ They face competing demands for more disclosure concerning material litigation on the part of investors and for less disclosure (or outright confidentiality and silence) from their lawyers.

The lawyers desire confidential treatment for two basic reasons. First, they want to avoid waiver of the important evidentiary protections flowing from the attorney-client privilege and the work-product doctrine. Second, they want to avoid disclosing strategically important information to adversaries or factfinders in a manner that prejudices their likelihood of success on the merits or diminishes their settlement negotiating leverage. For a non-LFC public company, these competing priorities are activated and weighed against one another every time a company feels pressure to discuss material litigation with investors.

With an LFC, by contrast, litigation is all the company does! Virtually everything that is operationally relevant to an LFC revolves around active litigation. Nearly every cash flow originates from a lawsuit, and ceteris paribus investors would like to understand the LFC’s assessments of its cases—a matter which is informed directly or indirectly by discussions, decisions, and consultations between the funded litigant and its attorneys, occasionally with involvement of the LFC itself. The relevance of these communications can be appreciated by considering the LFC’s use of the information; they also frequently serve as the basic inputs for a publicly traded LFC’s Level 3 valuation models.¹⁷¹ As a result, when compared with the concerns facing public companies outside the LFC sector, the concerns over privilege waiver in the LFC context apply to a much wider range of material disclosures that reasonable investors might otherwise want to see.

2. Publicly Traded LFCs vs. Private LFCs

Whether publicly traded or not, every LFC will expect to review some information bearing on the lawyer-litigant relationship during due diligence and post-investment monitoring of assets. Most of the literature examining the issue of privilege waiver in the LFC context has focused on the issue of inadvertent waiver traceable to these communications.¹⁷² The focus here is instead on the information transfer to investors in the LFCs themselves—a group that Maya Steinitz and Abigail Field helpfully describe as “secondary funders.”¹⁷³ The secondary funders are those that fund the LFCs, and where the LFC is publicly traded, that group includes LFC stockholders, who bring to the secondary funding relationships legitimate and heightened expectations of information disclosure.¹⁷⁴

The risk of waiver arising out of communications from litigants and their lawyers to LFCs (the “primary” funders), while still significant, is lower than it is with secondary funders owing to the potential applicability of the “common interest” exception to the privilege waiver rules.¹⁷⁵ The common interest exception has historically facilitated communications between co-defendants¹⁷⁶ and even defendants and their insurers.¹⁷⁷ The risk of waiver of work-product protections is more remote because waiver only occurs where a litigant effectively provides an adverse party with access to the work product, which would almost never occur in the context of discussions between litigants, law firms, and LFCs.¹⁷⁸ Even in this more liberal disclosure context, litigation funding agreements typically require the LFC to maintain confidentiality of information learned in the course of funding and management of the case.¹⁷⁹

C. The Concrete Effects of Privilege Waiver Concerns on Disclosure Practices

This waiver risk is particularly problematic where an LFC has a highly concentrated portfolio—a not uncommon situation in the sector today.¹⁸⁰ Ideally, investors in a publicly traded LFC could read lawyers’ assessments of strengths and weaknesses of the company’s material litigation assets, or at least those (like Burford’s YPF-related portfolio)¹⁸¹ that constitute an outsize proportion of the company’s balance sheet. To be sure, an investor in a well-diversified—or even a well-enough-diversified—publicly traded LFC would tend to rely more on the company’s track record of producing profits and cash flows over the long haul. In other words, the investor would not expect to conduct its own underwriting analysis of the LFC’s funded lawsuits; after all, that is why the investor is investing in an LFC rather than running one.

But this point should not be drawn too sharply. Each of the publicly traded LFCs is a corporate adolescent, having at most a decade-long history of managing a portfolio of assets that take several years to mature.¹⁸² In theory, over time, a publicly traded LFC will develop a historical track record of actual realizations on which investors will be able to rely. But until that track record materializes, investors would prioritize the shape of the actual portfolio, and even some of the individual assets, during the pre-realization stage. And yet, the specter of waiver of these important privileges is a decisive factor in determining how much—or, really, how little—portfolio information can be disclosed to investors.

The critical point for present purposes is that these evidentiary protections prevent adverse parties and factfinders from learning of significant, relevant information concerning the cases underlying the litigation assets. A detailed study of these privileges—what they are, how they may be waived, and the exceptions to the waiver rules—is well outside the scope of this Article. However, it should be apparent that much of the protected information flows directly or indirectly into the valuation models that LFCs use when deciding whether to invest in lawsuits or considering how to assess the fair value of their litigation assets for financial accounting purposes. And the reason the information is relevant to the lawyers, litigants, and the LFCs themselves is the same reason why reasonable investors would like to see some of it.

In its annual report, Burford insists that concerns over waiver preclude it from disclosing individual asset valuations publicly:

In order to make our underwriting decisions and conduct our ongoing asset monitoring, we receive from our clients confidential and legally privileged information . . . . That sensitive information can lose its protection and become accessible to a litigation opponent if it is disclosed (a concept called “waiver”), which could have catastrophic consequences for the litigant. We are entitled to receive such information but are under a strict obligation to protect it to minimize the risk of waiver. . . . [T]his obligation requires us to tightly restrict access to the information itself and conclusions drawn from it. As an example, the release of individual valuations of ongoing legal finance assets may create a risk of waiver over sensitive information since a court order or other event that might give rise to an asset valuation can only be put in context with the use of privileged information. We thus do not release asset valuations of ongoing matters . . . and are similarly unable to provide other asset-specific information about our portfolio . . . .¹⁸³

As a result of this privilege-imposed risk aversion, publicly traded LFCs provide only high-level, aggregate descriptions of their accounting practices. And they do not provide any meaningful information related to particular assets, even significant ones that comprise an outsized share of their total assets. Moreover, there is virtually no disclosure of middle-level information concerning, for instance, how management generally estimates the likelihood of success on the merits for types of cases, evaluates counterparties’ willingness to settle and ability to pay, and assesses the commercial reasonableness of the litigant and the professional expertise of the counsel involved in the case.¹⁸⁴ The net effect is a chilled communicative environment pertaining to a publicly traded LFC’s core assets.

D. Privilege Waiver in the LFC Context as an Acute Case of a Familiar Securities Disclosure Problem

This tension between legitimate investor expectations to understand the business and company demands to preserve the confidentiality of sensitive corporate information is ubiquitous in the mandatory securities law disclosure regime. Historically, the SEC formally struck a balance between these competing principles through a specific carve-out from the disclosure rules for “otherwise nonpublic corporate information the disclosure of which would affect adversely the registrant’s competitive position.”¹⁸⁵ The SEC eliminated the carveout in 2020 as part of a broader “modernization” reform, insisting that the new emphasis on “principles-based” disclosure would still offer companies flexibility to protect sensitive and proprietary nonpublic information.¹⁸⁶

The carve-out and the subsequent principles-based assurances provided comfort to public companies engaged in businesses like pharmaceutical production. Indeed, an analogy might be drawn between LFCs and pharmaceutical companies engaging in research and development of new drugs. At first blush, the analogy makes a good deal of sense. In both cases, there is a trade-off between investor demand for disclosure and corporate demand for confidentiality. In both cases, the companies regularly make long-term investments, the profitability of which is subject to significant uncertainty.

Nevertheless, the analogy must be qualified in two important ways. First, the LFCs have an added thumb on the scale in favor of confidentiality owing to the privilege waiver rules—that is, it is not just that they want to protect their proprietary valuation models, they also must avoid discussing any litigation altogether. Even more importantly, the fair-value accounting issues require a further qualification to the analogy. The accounting rules for pharmaceutical companies—and, for that matter, technology companies more generally—do not require companies to estimate their projects at fair value. Instead, they recognize intangible assets (if at all) by capitalizing them at the cost of development.¹⁸⁷ The net result is that the securities and accounting rules instruct pharmaceutical and technology companies to “build your balance sheet and income statement conservatively” and “you have flexibility when it comes to disclosing sensitive details of your product pipeline.” By contrast, with LFCs the securities, accounting, and privilege rules combine to say “directly link your balance sheet and income statement to your internal valuations of your investment pipeline” and “by the way, you can’t talk about your pipeline at all.” For this reason, pharmaceutical and technology company financial statements are more conservative and less susceptible to the fraud and manipulation risks highlighted in this Article.

VI. Two Case Studies Illustrating the Two Threats to the Objectives of Securities Law

This Part will describe two recent episodes that illustrate how highly opaque fair value accounting practices at publicly traded LFCs threaten the foundational securities law objectives of investor protection and market integrity. The first case study will recount the failure of Juridica Investments, using it to demonstrate how LFCs can potentially compromise the investor protection objective. The second case study will recount the hedge fund Muddy Waters’s short attack on Burford in August 2019, explaining how the episode alerts us to the special risk of market manipulation when LFCs go public. In each case, the roots of the problems can be found in the opaque fair value marks of litigation finance assets.

A. Undermining the Investor Protection Objective: The Case of
the Juridica Investments Implosion

The rise and fall of Juridica Investments, the first LFC to list its shares publicly, provides an illustrative case study of the potential for confusion and investor losses resulting from opaque marks. To be sure, as will be explained below, the proximate causes of Juridica’s failure were excessive portfolio concentration and bad investment decisions, not misleading fair value marks. Indeed, Juridica’s fair value accounting seems to have depicted economic realities just as well as a cash accounting system would have. Its only shortcoming appears to have been a delayed downward mark on one of its key assets. Still, Juridica’s failure and the resultant significant investor losses provide a useful case study of how LFCs operate, and how they sometimes fail. It also serves as a vehicle through which we can imagine how different applications of the company’s fair value accounting policies could have quite easily deepened the investor losses.

In December 2007, Juridica listed on the AIM, the LSE’s market for smaller issuers.¹⁸⁸ Less than eight years later, stockholders would force the company to cease operations and eventually liquidate after announcing a total write-off of a litigation asset that the company had previously marked up to $30 million.

Juridica, like most LFCs today, underwrote exclusively business-to-business litigation. It developed a special focus on financing antitrust/competition and patent infringement lawsuits. Like Burford and Manolete, Juridica recognized its assets as “financial assets” and implemented fair value accounting consistent with IFRS 9 and IFRS 13.¹⁸⁹ Its description of its fair value process is familiar:

[W]e develop a fair value of a case or investment by discounting its expected terminal value from its expected completion date. We determine our initial expectations on quantum and timing of case results by assigning a probability of various scenarios coming to fruition and applying risk factors that: i) are intrinsic to the specific case; and ii) reflect general risks within and outside of the legal process. Our assumptions behind an investment’s fair value are revisited on a semi-annual basis . . . .¹⁹⁰

In developing the scenarios, Juridica noted that it:

consider[s] the current legal merits of each underlying case, the legal history of the case, the current legal environment, and any other factors we feel are relevant as of the date of our valuation. Working with the lawyers assigned to each case, we develop scenarios of potential outcomes, including the various situations that can generate outsized returns, moderate returns, or a complete loss, and assign each scenario a probability.¹⁹¹

After the company developed the scenarios and assigned them probabilities, it would run a Monte Carlo simulation¹⁹² resulting in a single point estimate of the asset’s fair value.¹⁹³

In late 2008, less than a year after its IPO, Juridica acquired an interest in an antitrust case (which it labeled “8008-L”) brought by several U.S. Fortune 500 companies against a group of non-U.S. liquid crystal display suppliers for an anticipated commitment of $26 million, touting the possibility of a billion-dollar recovery.¹⁹⁴ This particular case was one of six assets comprising an antitrust portfolio that was, at all relevant times, by far Juridica’s largest collection of assets.

The specific form the investment took was a debt facility provided to Fields Law, a law firm established by the founders of the Juridica enterprise.¹⁹⁵ Under the term of the facility and a related swap agreement, Juridica stood to profit from favorable outcomes of the antitrust lawsuits pursued by plaintiffs represented by Fields Law.¹⁹⁶ Several of the defendants in 8008-L had already been convicted criminally under the Sherman Act for their roles in maintaining a price-fixing cartel in the displays market.¹⁹⁷ From 2011 to 2013, Juridica reported a net positive fair value markup of its antitrust portfolio of $93 million, most of which was attributable to 8008-L, resulting in an unrealized gain of the same amount that flowed directly to the income statement as profit.¹⁹⁸

In 2011, the company marked up its antitrust portfolio¹⁹⁹ by $49.7 million²⁰⁰ and reported comprehensive income of $37.8 million.²⁰¹ The following year, it booked another upward adjustment of $40.3 million,²⁰² and reported comprehensive income of $35.6 million.²⁰³ We can assume that Juridica was marking the assets up on account of what they perceived to be positive developments in the litigation. These two years were by far Juridica’s most profitable years over the company’s history, more than doubling the next most profitable year ($16.5 million in 2009). The upshot is apparent: in terms of income, Juridica’s only good years as a public company were attributable entirely to upward fair value marks on its antitrust portfolio.

Presumably, to prevent privilege waiver, Juridica meticulously avoided disclosing which precise assets were responsible for what proportions of its aggregate fair-value adjustments. Nevertheless, we can obtain a rough idea of the role that Case 8008-L and the antitrust portfolio played in the upward marks during the 2011-2012 period. For instance, we know that the upward marks related to the antitrust portfolio were handled by Fields Law.²⁰⁴ We also know that Case 8008-L comprised an outsize share of the economic value of that portfolio. It was responsible for $26.0 million²⁰⁵ of the initial $62.0 million that Juridica invested in the portfolio.²⁰⁶ It also resulted in an outsize share of the total realized gains associated with that portfolio.²⁰⁷

For perspective, that means the investment had been quite successful for Juridica: an initial investment of $26 million in late 2008 had, by 2015, resulted in nearly $90 million of actual proceeds, representing a nearly 350 percent return on invested capital. The financial statements reflected this favorable asset performance chiefly in a series of upward fair value marks in 2011 and 2012.²⁰⁸ Those upward marks would flow initially to the income statement as recognized, but unrealized, income. Shortly thereafter, as defendants settled (presumably motivated by the same favorable claim developments justifying the upward marks), the unrealized income would result in realized gains when the settlements were agreed. As an accounting matter, the settlements were simply balance sheet phenomena unlinked to the income statement; when Juridica received cash proceeds from settlements, it would simply debit the asset’s carrying value and credit its cash or receivables account. The net impression an investor would receive from this is an emerging and increasingly reliable process of anticipatory revenue recognition followed by a corresponding economic realization in cash terms. That is, until it stopped working like that.

By early 2014, adverse developments in case 8008-L started to belie Juridica’s rosy expectations for the case and the continued reliability of its marks. In April 2014, the company noted that the trial court issued an unfavorable ruling concerning damages but reassured investors that the lawyers working the case had “advised that the adverse ruling is expected to be partially or wholly overturned in [favor] of the Plaintiff . . . .”²⁰⁹ However, to preserve privilege, it provided no disclosure about the lawyers’ rationale. Accordingly, Juridica did not mark the asset down; in fact, its net fair value adjustment for its antitrust portfolio was positive for 2013, checking in at $3.7 million. The following year, the company revealed the case prospects had deteriorated further, with the appellate court affirming the adverse trial court ruling.²¹⁰ The case finally fizzled out in June 2015 when the Supreme Court declined to review the case.²¹¹

When Juridica filed its 2015 semi-annual report in August, it announced that it was writing off the entire remaining 8008-L asset, resulting in a $29.7 million downward fair value adjustment for this asset alone.²¹² This downward mark flowed directly to the income statement as an operating loss. That amount represented 20 percent of the company’s entire balance sheet ($150.1 million at the end of 2014) and 36 percent of its main segment—antitrust, at $82.6 million at the end of the previous year.²¹³ Juridica swung from a loss of $5 million in 2014 to a $49.2 million loss in 2015.²¹⁴ Following a sixty percent decline in its share price during 2015 and pressure from shareholders, the board of directors opted to cease new investments and the business entered run-off,²¹⁵ finally liquidating in 2018.²¹⁶

Table 2 below shows the net fair value marks to Juridica’s antitrust portfolio in relation to various other metrics for the 2010-2015 years. Specifically, the table also shows, for each period, (1) the net fair value adjustment to the antitrust portfolio, (2) the total carrying value for the antitrust portfolio, (3) total assets, and (4) comprehensive income. The fair-value adjustments to the antitrust portfolio do not affect the portfolio’s carrying value on a one-to-one basis. This is chiefly because the carrying value is also impacted by the resolution of cases by settlements or legal judgments (which reduce the carrying values as assets are transformed to receivables and cash) and additional investments in the portfolio (which increase carrying values as cash is invested in the assets). Nevertheless, these data demonstrate a pronounced correlation between the company’s fair value marks on the one hand and its assets and, even more importantly, its income on the other.

Table 2: Select Juridica Financials 2010-2015

Year	Net FV Adjustment to Antitrust Assets	Total Carrying Value of Antitrust Assets	Total Invested Assets	Comprehensive Income
2010	(2.0)	95.1	198.8	(9.0)
2011	49.7	145.4	235.7	37.8
2012	40.0	153.6	255.8	35.6
2013	3.7	129.3	249.5	5.1
2014	(1.4)	82.5	235.3	(5.0)
2015	(35.2)	55.4	126.4	(49.2)

In its first public report disclosing the total write-off of Case 8008-L, the company wistfully recalled its halcyon hopes from just a few years earlier: “Had the case survived the challenges it faced, we believed the case would have generated cash proceeds to the Company far in excess of its US$29.7 million contribution to the Company’s year-end 2014 [balance sheet].”²¹⁷ “If the case had actually gone to trial and prevailed,” the report continued, “damages could have exceeded US$500 million and would have automatically been trebled.”²¹⁸

Until the end, Juridica management clung to hopes for that potential billion-dollar recovery that had tantalized them from the time they issued the press release announcing the initial investment.²¹⁹

The brute facts of Juridica’s abrupt cessation of business and liquidation testify to the reality of investor losses. But, of course, losses are inevitable in the capital markets. The legacy of the Juridica failure and the legal-regulatory lessons to be drawn from it are more ambiguous.

Three preliminary points should be made to clarify matters. First, the use of Juridica here as a case study does not mean that company management or the auditors were engaged in fraud or even negligence.²²⁰ Fair value marks of Level 3 assets are only as good as the models and predictions of the reporting entities, and problems can present even absent misconduct. Hence, the Juridica episode sheds light on the potential for misleading fair value accounting in the litigation finance context in general, whether on account of strategic manipulation and fraud, or as a result of a good faith effort to assess the fair value of these opaque assets accurately.

Second, one of the proximate causes of Juridica’s failure was excessive portfolio concentration. To its credit, Juridica consistently warned of the significant concentration risk it posed. Each of its annual reports included some version of the following warning: “The main concentration to which the Company is exposed arises from the Company’s loan to Fields Law” —that is, the law firm debtor litigating the antitrust portfolio.²²¹ In the five years leading up to the 2015 write-off of Case 8008-L, the antitrust portfolio’s carrying value, which was already highly concentrated,²²² ranged from 54 percent to 76 percent of Juridica’s total investments.²²³ Following the write-off, Juridica disclosed that a single case in the portfolio comprised a whopping 43 percent of its total invested assets.²²⁴

Third, Juridica failed because its investments did not pan out, not on account of the way they were reported. In other words, alongside portfolio concentration, the second proximate cause of the failure was unfavorable investment selection. The starkest illustration of this is Case 8008-L itself: if the courts had accepted the plaintiffs’ damage theory that Juridica had invested in, Juridica’s hopes of a billion-dollar recovery would have been in the realm of possibility. In combination with the portfolio concentration, the denial of certiorari on the damages issue was a sufficient cause of the investors’ losses.

Nevertheless, even if we assume the lack of any fraudulent activity on the part of Juridica’s management and leave aside the special issues attending concentrated portfolios, the Juridica failure should be seen a cautionary tale to investors about fair value accounting by publicly traded LFCs. By adopting fair value accounting treatment, Juridica assumed the burden of periodically valuing its assets based on its own predictions concerning the behavior of judges, juries, and adversaries, as well as other factors that impact asset valuation models, such as interest rates and risk premiums.

It must be acknowledged that Juridica’s internal valuation models performed reasonably well at reflecting the emerging economic realities of its business. Indeed, the Juridica episode seems like an example of fair value accounting done roughly right. The company failed when the largest asset on its highly concentrated balance sheet had to be unexpectedly written off. More than anything else, it is a story about the dangers of portfolio concentration, as well as some combination of bad investment selection and bad luck. However, the episode does provide a window into potential fair value accounting problems in the LFC context.

Juridica initially touted Case 8008-L as a potential billion-dollar asset. It had already produced $90 million in realized settlements and was being carried on the balance sheet at $29.7 million, even after the adverse trial court ruling was upheld on appeal. Recall that following the initial adverse damage ruling, Juridica assured investors that “the adverse ruling is expected to be partially or wholly overturned in [favor] of the Plaintiff.”²²⁵ After the plaintiff lost its appeal and filed its writ of certiorari, Juridica changed its tone: “Uncertainty remains as to whether the requested review by the United States Supreme Court will be accepted.”²²⁶ However, it still did not materially change the carrying value of the asset.²²⁷

This failure to adjust the carrying value downward significantly is the most contestable discretionary decision concerning 8008-L on Juridica’s part. Following the 2014 appellate court ruling, it is difficult to imagine that some partial or total write-down was not appropriate. Such a write-down would have smoothed the otherwise abrupt deterioration from the 2014 loss of $5 million to the 2015 loss of $49 million (as reflected in Table 2). This discretionary call can serve as an entry point to explore the potential dangers with discretionary Level 3 fair value marks. We can imagine how Juridica, by adopting even more aggressive marks, could have delayed the recognition of the emergent problems or increased investor losses.

It is important to note that investors remained credulous of Juridica’s marks of the antitrust portfolio throughout the relevant events. In fact, the stock exhibited very little volatility at all during 2013 and 2014, the period during which the relevant case developments took place. This invites us to consider whether investors would also have been credulous of marks that were inflated through more aggressive modeling, whether done fraudulently or simply foolishly. Lacking access to relevant case-specific information, an investor would have no principled way to maintain an objective basis from which to exercise skepticism concerning the marks.

Imagine that instead of carrying the 8008-L asset at $29.7 million during early 2015, Juridica had maintained a more optimistic mark, consistent with its initial hopes for the billion-dollar recovery. Consistent with its valuation process detailed in its public disclosure, Juridica could have developed (relatively more optimistic) scenarios and/or assigned them (relatively more optimistic) probabilities before churning them through their confidential simulation model.²²⁸ It is easy to imagine the company landing on a valuation of, say, $129.7 million instead of $29.7 million. Given the restrictions on disclosure imposed by the privilege and work product rules, investors would have little reason to question the inflated fair value marks. In the process, investors could have easily lost another $100 million. Crucially, acknowledging as much requires us to confront this possible loss not only as a narrowly avoided hypothetical, but also as a plausible possibility that casts a shadow over LFC capital markets today.

B. Undermining the Market Integrity Objective: The Case of the
Muddy Waters Case Short Attack

The Muddy Waters short attack on Burford demonstrates how market perceptions of opaque accounts can incentivize manipulative strategies that create costly firm-specific and market-wide effects. Muddy Waters, helmed by its founder Carson Block, is a short-only hedge fund. Its business model is to identify overvalued publicly traded securities and to sell them short. Since its founding in 2016, it has achieved an impressive record of success, yielding a 19 percent annualized return for its investors after fees.²²⁹ Its returns are all the more impressive in light of the record bull run among global equity markets during which one might expect that it would be difficult to build a business betting that stock prices will go down.²³⁰

The hedge fund capitalizes on the fit between its organizational principles and the prevailing internet-skeptical zeitgeist.²³¹ Muddy Waters is, if nothing else, skeptical of authority and received wisdom; Block claims his experience working in China taught him to “see the matrix” at play in official-sounding explanatory-speak, and to “question everything.”²³² Block also positions himself as a free speech maverick, a truth-teller in a profession where inertia and sycophancy usually prevail.²³³

In August of 2019, Block and Muddy Waters declared war on Burford.²³⁴ “We are short BUR,” began the fund’s 25-page missive against the litigation finance pioneer.²³⁵ The thesis of the report, acerbic even for salty-tongued short-seller literature, is that Burford’s “Enron-esque mark-to-model accounting” has turned the company into “the biggest stock promotion on the AIM.”²³⁶ While the report sets forth a scattershot list of purported corporate governance failures, Block’s argument is simple: Burford management has elected to mark its Level 3 assets to model, and it has done so in order to strategically profit by exercising its discretion to adopt overly optimistic marks that inflate earnings—and the value of their stock.²³⁷

The report continues to describe Burford’s accounts in the following terms:

[Burford] is a perfect storm for an accounting fiasco. It is a fund that invests in an illiquid and esoteric asset class, which few investors can understand well. By remaining listed on AIM despite being a midcap company, the company’s disclosure requirements are lighter than they would be for the main board—and far lighter than they should be. By choosing to account for its litigation investments as financial assets, [Burford] utilizes fair value accounting for a balance sheet largely comprised of Level 3 fair value assets (i.e., “mark to model” accounting of Enron fame). [Burford] disingenuously blames IFRS for needing to take (outsized) fair value gains when in fact, it was BUR’s choice to adopt this accounting.

The publication of the Muddy Waters report on its own erased half of Burford’s market capitalization (roughly $2 billion) in a single day.²³⁸ The following day saw further bloodletting, with the stock dipping 72 percent below its pre-report levels.²³⁹ On the day of the report, Burford’s bonds also cratered, losing 29 pence to a record-low of 61 pence—i.e., at 61 percent of their principal value.²⁴⁰ 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.²⁴¹

When Moody’s assigned the first-ever credit rating to Burford a few months after the short attack, it rated the company at Ba3, the lowest rating classification in Moody’s category for “non-investment grade” and “speculative” credit investments, just a step above the “highly speculative” category.²⁴² When explaining its rationale, Moody’s cited the familiar fair value accounting opacity that Muddy Waters highlighted:

Burford’s Ba3 ratings also consider the credit challenges associated with the esoteric and illiquid nature of the company’s litigation investments, which have indeterminate realization in terms of both timing and amount, contributing to high expected asset and earnings volatility. About half of the company’s income consists of unrealized gains, which also contributes to volatility and weakens earnings quality.²⁴³

While there is, of course, no way to directly link Moody’s rating decisions to the Muddy Waters short attack, these two roughly contemporaneous developments should be seen as joint evidence of an increasingly skeptical mood settling in among capital markets participants regarding fair value accounting at Burford.

In response, Burford defended the integrity of its accounts and impugned Muddy Waters’s motives.²⁴⁴ On this latter point, it claimed that Muddy Waters had already closed out its short position within a few days of publishing the report, booking a healthy gain flowing directly from the stock’s precipitous—and, in Burford’s estimation, artificially induced—decline.²⁴⁵ It also scrambled to make various corporate governance changes. Burford replaced its Chief Financial Officer (who was married to the then- and current CEO Christopher Bogart),²⁴⁶ doubled down on planned executive stock purchases,²⁴⁷ and deepened the level of disclosure about its fair value accounting practices.²⁴⁸

In its lengthy press release published on August 8, Burford chastised Muddy Waters for engaging in market manipulation:

Short attacks such as this are a fundamental menace to an orderly market and to the value inherent in long-term investing companies such as Burford that are revolutionising industries. Burford is well-equipped to investigate and pursue market manipulators, and as stewards of investor capital, we are exploring doing so here, cognisant of the substantial losses our investors have suffered. Our early investigation already shows the hallmarks of market manipulation.

Of course, even if we credit Burford’s description of its revolutionary role, not all vanguard companies report earnings on a fair value basis, and therein lies the rub. Something about LFCs and their accounts makes them especially susceptible to short attacks.

A key weapon in Burford’s defense was its argument that Muddy Waters had engaged in so-called “spoofing” and “layering”—that is, creating and canceling a large volume of limit orders that distorted the supply and demand for a security.²⁴⁹ It asked the London Stock Exchange (LSE), which operates the AIM market on which Burford stock trades, to investigate the matter and provide confidential trading data that would identify the investors responsible for the order flow at the time of the Muddy Waters report.²⁵⁰ After LSE ceased its investigation and refused to turn over the trading data, Burford sued LSE in the Commercial Court division of the High Court of Justice of England and Wales, seeking a court order compelling the disclosure.²⁵¹ It made a similar inquiry with the Financial Conduct Authority (FCA), the primary U.K. capital markets regulator.²⁵² These efforts were ultimately unsuccessful, as the FCA informed the company it found no evidence of market manipulation.²⁵³ The court denied the petition to compel LSE to disclose the trading data.²⁵⁴

In the end, whether to credit Block’s accusations of accounting fraud or Burford’s market manipulation story is a question that the company’s future operating history will resolve. Over the next decade or so, as a half dozen or so of its asset vintages mature and it develops a more established track record, one of these opposing narratives will be vindicated.

However, it is not necessary to resolve this matter to appreciate the disclosure problems that a conflict like the one between Muddy Waters and Burford presents. Whether or not Muddy Waters is engaged in an opportunistic and manipulative scheme, a short attack of this sort is only possible because the target company is using fair value methods to account for opaque Level 3 assets. More fundamentally, it is not only possible, but it is an omnipresent threat for these companies, particularly when they lack an extensive operating history that ratifies their accounting policies. The crucial point is that the publicly traded LFC will face great difficulty explaining their fair value marks at any given time, given existing privilege waiver rules. As a result, it will have a hand tied behind its back when would-be market manipulators attack it. It should also be pointed out that the threat applies on the upside and the downside. While the Muddy Waters attack, involved a short-only fund talking down a stock, it is possible for manipulation to occur on the upside too, which can also disrupt the normal course of corporate governance, albeit in different ways.²⁵⁵

For so long as it is possible to evaporate half of a company’s market capitalization in a single day simply by running to the rumor mill, the LFC industry will face higher volatility, higher trading costs, higher capital costs, lower security prices, and even decreased capital investment.²⁵⁶ Furthermore, this dynamic also undercuts the investor protection objective of securities regulation, since part of the resultant volatility—that relating directly to stock movements—creates a systematic set of winners (the manipulators) and a systematic set of losers (everyone else).

VII. Possible Reforms

As more LFCs consider listing their shares to expand in this growing sector, the special problems that publicly traded LFCs pose will only acquire greater salience. This concluding Part will propose several reforms that might help redress these problems, drawing attention to their respective advantages and disadvantages. As securities regulators and accounting standard setters acknowledge the problem and consider reform proposals, the following materials can serve as a rough checklist for possible reforms. A checklist, but not a blueprint; it is unlikely that adopting all of these proposals is possible, or even desirable. Still, adopting a limited combination, or even an isolated single proposal, will go some way to remediate the problems examined here.

Four of these proposals are more promising than the others: (1) mandatory direct involvement of external claims valuers in the production and verification of fair value marks; (2) greater deployment of claims valuation expertise in the context of the audit (either external or in-house audit expertise); (3) mandatory disclosure of portfolio-wide sensitivity analysis of the fair valuation marks; and (4) mandatory disclosure of details concerning material litigation assets with accompanying changes to the privilege waiver rules. The first three of these are not only promising, they are also highly feasible; efforts to implement the fourth proposal should expect greater headwinds. Two other reform ideas—promoting markets for litigation assets and requiring independent valuation committees for publicly traded LFC boards—are less promising, but still worthwhile projects to consider. This Part will begin with these latter two proposals and then move to discuss the four more promising initiatives.

A. Promoting the Development of Markets for Litigation Assets

The problems associated with valuing Level 3 assets result from what has repeatedly been referred to here as the intrinsic, structural opacity of the assets. This situation could also be described as a high degree of uncertainty clouding the fit between the reported value and the asset’s intrinsic value. Resort to mark-to-model fair value accounting is, as the IASB has stressed, an imperfect but workable way to intelligibly bridge the gap between these two values. Indeed, under IFRS and GAAP “fair value hierarchies,” recourse to internal models is only permissible if there are neither quoted prices for the asset nor direct or indirect observable data concerning the asset’s price.²⁵⁷

One way to improve the accuracy and reliability of the reported asset values is to bump them up the fair value hierarchy by developing markets that generate quoted prices or other observable inputs. Others have argued in favor of developing markets for claims to pursue other goals, such as improving settlement outcomes,²⁵⁸ increasing access to justice,²⁵⁹ or legal risk management.²⁶⁰ The goal here, however, would be to generate more reliable informational inputs to use in the fair value process. One of the main benefits of decentralized capital markets, in contrast to bank credit or state finance, is the phenomenon of price discovery. Price discovery refers to the “efficient and timely incorporation of the information implicit in investor trading into market prices.”²⁶¹ Price discovery is the process by which market efficiency can be, such as it is present in any market, achieved. And efficient markets, in turn, facilitate efficient capital formation. Indeed, the suboptimal efficiency of the LFC capital market is half of the policy problem with which this Article is concerned.²⁶²

Burford’s efforts to stimulate a market for its YPF-related assets are instructive. As noted earlier,²⁶³ Burford has sold a portion of its YPF-related assets to third-party investors for a total of $144 million. For these assets, the company takes those sales prices into consideration for valuation purposes:

In a small number of instances, the Group has the benefit of a secondary sale of a portion of an asset. When that occurs, the market evidence is factored into the valuation process; results on portfolios with multiple fair value factors are presented based on whether the portfolios are in an overall positive or negative fair value position. The more robust the market testing of value is, the more weight that is accorded to the market price.²⁶⁴

Given these transactions’ relative paucity and infrequency, Burford’s characterization of these transactions as “market evidence” adopts a liberal sense of the term. Even with that “market evidence,” however, Burford still treats the assets as Level 3 assets; in other words, the market evidence is taken into account not as observable inputs, much less quoted asset prices, but as unobservable inputs under IFRS rules.

Although, in principle, this is a constructive response to the disclosure problems, marketizing a sufficient portion of litigation finance assets to generate meaningful inputs to use in fair value calibrations is unlikely to prove effective, at least anytime soon. Before purchasing a litigation finance asset, capital markets investors will expect to review the relevant information. Concerns over confidentiality, and the possible waiver of privilege and work product protections, impose strict limits on the practical ability of this information to flow freely between the claim holder and the investor. Burford’s YPF assets remain a special case because most of the details concerning the case are already public.²⁶⁵

Burford’s use of market-like data in asset valuation models is only an initial step in commodifying and marketizing legal claims. More aspirational proposals advocate for the large-scale securitization of commercial legal claims.²⁶⁶ That is, a claimant would form a special purpose entity, capitalize it by contributing one or more lawsuits, and arrange for the SPE to issue securities that derived their value from the underlying litigation.²⁶⁷ These securitized lawsuits could then be publicly traded. The capital market for litigation finance would bifurcate, with primary and secondary markets for direct claims existing alongside the publicly traded LFC market in which investors could gain indirect exposure to the asset class. The direct market would possess several advantages as a coordinating and signaling mechanism—for instance, clearing of supply and demand based on the collective, inter-subjective information set of a decentralized group of agents. We might imagine publicly traded LFCs looking to this market to form reasonable expectations concerning the riskiness and future cash flows of their own assets and portfolios. This comparative inquiry would formally take place in the context of an improved Level 3 asset valuation process or even a step up the fair value hierarchy to a Level 2 process.²⁶⁸

However, this type of direct secondary market in securitized litigation assets would also be frustrated by the familiar privilege waiver and work product problems. As Professor Maya Steinitz explains as a matter of financial history and corporate law, there is nothing particularly exotic about securitizing a lawsuit.²⁶⁹ However, whether maintaining a public market in that lawsuit communicates any meaningful information to the owners of similar lawsuits is another matter altogether. For instance, if Burford was seeking to value an asset deriving from Lawsuit A, how would it even know that Lawsuit B, which was securitized and publicly traded, was sufficiently similar to Lawsuit A to make it an acceptable proxy observable input under IFRS 13? The SPE could not disclose any relevant details concerning Lawsuit B to its security holders without waiving privilege.

Capital markets perform their signaling function by aggregating a multiplicity of opinions and expectations concerning the relevant inputs impacting an asset’s valuation, and clearing at a single, individual price. The problem is that an aggregate of investors, lacking any relevant information concerning the underlying merits of the litigation asset on account of the confidentiality restrictions, would not have any intelligible basis on which to formulate such opinions and expectations concerning a particular asset. This epistemic gap (between what an investor would like to know and what an investor can practically expect to know) is particularly pronounced in the early stages of litigation, narrowing later on as information about the matter is made publicly available.²⁷⁰

Pooling individual assets into tradable portfolios would diversify away much of the idiosyncratic risk of particular assets, such that the market price might be thought to express aggregate expectations concerning the development of particular types of litigation assets (e.g., patent claims). However, even crediting this possibility, the market prices of the tradable portfolios would lack any clear advantage as a fair value input over the subjective internal models that LFCs currently use. While they might contribute an incremental informational input about market perceptions concerning the asset class, the internal models would still possess the important advantage of being able to incorporate information actually relevant to the claim.

In conclusion, marketization is unlikely to solve the disclosure problems on its own. Burford’s efforts to develop secondary markets for specific assets is handicapped by the incompleteness of the “market,” such as that term can even be credibly employed. Further, marketization through the development of publicly traded, securitized litigation assets face the same privilege waiver issues that any involvement of public investors in a capital market for litigation risk inevitably entails.

B. Requiring an Independent Valuation Committee for Publicly Traded LFCs

An independent committee of the board of directors with the primary responsibility for approving fair valuation practices and fair value marks might also contribute positively to the perception of reliability of LFC fair value marks. Such a strategy would focus internally on modifying the publicly traded LFC’s corporate governance infrastructure. Securities regulators could require the establishment of such a committee as a precondition to listing on an exchange. The independence requirement would be met in the typical securities law fashion: that is, by restricting membership to the members of the board who are otherwise unaffiliated with the company.²⁷¹ In this way, the valuation committee would resemble the independent audit committee.²⁷² It would amount to an independent corporate organ with specialized oversight—in this case, over the fair value accounting function.²⁷³ If securities regulators also require some third-party valuation checks,²⁷⁴ the valuation committee would also be responsible for overseeing how those reviews are taken into consideration by management and reflected in the financial statements.

Burford already has established a “valuation committee,” although it differs in crucial aspects from the type of committee envisaged here. Burford’s valuation committee is responsible for reviewing and approving any fair value marks, but it is a management committee, not a board committee.²⁷⁵ Crucially, it is not an independent committee, but is instead composed of senior managers performing the vital task of monitoring the value of the assets in the firm’s portfolio. The involvement of senior management in the fair valuation process makes sense; once the LFC adopts fair value accounting, it could hardly be otherwise. While Burford does stress that its independent, board-level audit committee oversees the fair value process, audit committee oversight necessarily entails a more general level of scrutiny of the fair value process rather than granular attention to the assumptions underlying valuations of specific assets.

While the valuation committee might initially seem a promising antagonistic agent, a closer look justifies some skepticism. The reasons for this skepticism emerge more clearly if we deconstruct the analogy between an independent valuation committee and an independent audit committee. The independent audit committee oversees the audit process, which is, by definition, operationally and logically distinct from a company’s business. The auditor checks and reviews the financial reports that management compiles, as well as the adequacy of the internal processes and controls that produced those reports. The price of the audit committee’s independence is some distance from the operational realities of the business. Here, however, the expertise to value the assets is highly specialized and the management team possesses it in overwhelming, if not exclusive, proportions. In other words, although independent directors likely possess the ability to oversee an auditor’s work, it is unlikely that such independent directors possess adequate skills and expertise to assume authority for valuing the LFC’s assets. After all, that is management’s core value proposition along the life cycle of the litigation funding transaction, from the underwriting decision to the settlement terms.²⁷⁶

C. Requiring Use of External Claims Valuers

Another possible incremental solution to the fair value disclosure problems is the use of external certified claims valuers. If the independent valuation committee would represent an internal validation strategy operating at the corporate governance level, outside claims valuation would represent an external validatory tool. A cadre of valuation advisory teams, both standalone firms and units within larger diversified advisory firms, have developed alongside the LFCs to provide valuation advice to improve underwriting and fair value accounting. In the United Kingdom, LFCs also retain some solicitors to provide claim valuation advice.²⁷⁷ When considering whether to underwrite a litigation asset, an LFC reviews the valuation assessment of the selling litigant or law firm and conducts its own valuation process. Sometimes, it also involves a third party as a sort of “sanity check” on the process.²⁷⁸ Manolete currently incorporates third-party claims valuation in its fair value accounting process. At the conclusion of each reporting period, it takes a sample of its cases and obtains written valuation assessments from external solicitors.²⁷⁹ This type of independent third-party valuation certification is common with Level 3 fair value assets like illiquid securities and derivatives.²⁸⁰ So far, the practice has yet to become standard in the publicly traded LFC context.

Securities regulators could require publicly traded LFCs to undertake an external review of a portion of their fair value marks. The regulators could then require the external valuer either to certify the reasonableness of the marks to investors in the disclosure, or, more modestly, to prepare a report to LFC management to the same effect. External certification of investor disclosure is a common feature of securities disclosure, most obviously in the case of the independent audit requirement. Late last year, the SEC permitted the boards of directors of investment companies and small business development companies to appoint a “valuation designee” to make fair value determinations for the fund.²⁸¹

A certification requirement would at once be more and less than an audit: less than an audit because the external certifier would only assess a portion (the fair value marks) of the accounts, but more than an audit because it would perform independent valuation of assets. A full-blown certification requirement would be costlier than a more modest report to management, but would further enhance the credibility of the accounts. The increased cost would correspond to the reputational and financial risks the external valuers would assume in consenting to the inclusion of their expert reports in securities disclosure materials.²⁸² On the other hand, if the external valuer simply provided a report to management and the auditor, no securities law liability would attach absent extenuating circumstances. The report would doubtless impact the audit too, providing the auditor with more data and information concerning the appropriateness of the fair value marks. How to weigh the burdens of preparing reports for management or for public disclosure to investors against the anticipated increase in account reliability is outside the scope of this Article. However, these certification requirements should be considered as part of any regulatory reform effort in this space.

D. Leaning on the Audit Profession to Develop Heightened, Standardized Verification Practices Concerning the Accuracy of Fair-Value Marks

Broadly speaking, the programmatic, normative function of a modern public company’s independent audit is to produce increased confidence in the reliability of financial statements, improving the efficiency of capital markets in the process.²⁸³ The public company audit is a process punctuated by the delivery of an audit letter expressing an opinion concerning the fairness of the presentation of the company’s financial accounts. In the lead-up to the delivery of the audit letter, the audit process consists of samples, checklists, and analytical methods designed to provide assurance to the auditor, and eventually the investors, of the financial reports as prepared by company management.²⁸⁴ This Article is hardly the place to summarize the operational, functional, and aspirational realities of public company audit practice. However, some brief recommendations can be made concerning how audit practice might meet the challenges posed by fair value accounting in the litigation finance sector.

The Public Company Accounting Oversight Board (PCAOB), the governing body for the U.S. public company audit function, publishes general guidance for public company audits. Its Audit Standard 2501, titled Auditing Accounting Estimates, Including Fair Value Measurements, sets forth the assurance expectations for public company auditors regarding a company’s fair value marks.²⁸⁵ When evaluating a company’s fair value mark, that standard requires the auditor to “us[e] some or all of his or her own methods, data, and assumptions to develop an expectation of the estimate for comparison to the company’s estimate.”²⁸⁶ In a subsequent note, the standard notes that:

[i]n developing an independent expectation, the auditor should take into account the requirements of the applicable financial reporting framework and the auditor’s understanding of the company’s process, including the significant assumptions used by the company, so that the auditor’s expectation considers the factors relevant to the estimate.²⁸⁷

The standard also clarifies that auditors should assume that the risk of material misstatements of stated fair values are higher in the context of Level 3 assets.²⁸⁸ And yet, the guidance is ambiguous precisely where it is most needed. When the auditor is reviewing Level 3 asset marks, it “should obtain an understanding of how unobservable inputs were determined and evaluate the reasonableness of the unobservable inputs[.]” In doing so, it should take into account (1) “[w]hether modifications made to observable information generally reflect the assumptions that market participants would use when pricing the financial instrument, including assumptions about risk”; and (2) “[h]ow the company determined its fair value measurement, including whether it appropriately considered the information available.”²⁸⁹ The first specification here basically copies-and-pastes the fair-value accounting rules, and the second amounts to a directive to use common sense; together, they do nothing to empower the auditor to scrutinize the substance of the fair value marks.

If an LFC auditor were to engage a valuation specialist to review some portion of the LFCs’ fair value marks, it would obtain greater assurance over the reliability of the marks and the broader integrity of the company’s accounts. The PCAOB has published a general standard governing the use of such specialists.²⁹⁰ Such specialists might come from a separate team within the audit firm itself (frequently called the “valuation team”) or a third-party provider. For instance, the “big four” accounting firms maintain specialist valuation teams that, among other engagements, assist their audit colleagues.²⁹¹

Greater involvement of valuation expertise in the audits of publicly traded LFCs would be a welcome development. The impetus to mandate or encourage the involvement of a specialist in the audit could come from the applicable securities regulator, the PCAOB, or the American Institute of Certified Professional Accountants (AICPA). The AICPA publishes interpretive guides for auditors concerning particular industries and particular types of transactions, providing localized advice and guidance for audit professionals.²⁹² While the size of the litigation finance industry probably would not justify a standalone industry guide, special treatment for LFCs might be indicated in the AICPA’s existing guidance for auditing derivative investments, hedging activities, and investments in securities.²⁹³ The PCAOB could also expand on its guidance concerning Level 3 assets, perhaps by encouraging the use of internal or external valuers to assist the auditor in assessing the reliability of the fair value process.

E. Requiring Sensitivity Analysis of Valuation Models

Sensitivity analysis is an analytical tool that can enhance user understanding of financial models and accounting policies, demystifying the isolated point estimates that are usually the standalone end products. When conducting sensitivity analysis, the analyst moves isolated input parameters in valuation models or accounting policies by a unit amount to reveal how “sensitive” the relevant output metrics are to the changes. In the context of Level 3 litigation finance assets, the relevant output metrics are straightforward: the reported fair values, with the associated flowthroughs to profit and loss. The relevant inputs, as discussed below, are considerably messier.

The SEC has recently shown its willingness to make sensitivity analysis part of the standardized disclosure materials for public companies. In December 2020, as part of its significant suite of amendments to the Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) disclosure requirements, the SEC mandated that public companies conduct sensitivity analysis regarding certain “critical accounting estimates.”²⁹⁴ An accounting estimate is “critical” for these purposes if it “involve[s] a significant level of estimation uncertainty and ha[s] had or [is] reasonably likely to have a material impact on the [company’s] financial condition or results of operations.”²⁹⁵

The amended Item 303(b)(3) of Regulation S-K reworks the MD&A requirements concerning these critical accounting estimates. Among other disclosures, it requires an analysis of the “sensitivity of the reported amount to the methods, assumptions and estimates underlying its calculation.”²⁹⁶ By requiring this sort of sensitivity analysis, the SEC acknowledges the significant subjectivity and contestability underlying many accounting policy choices and their quantitative byproducts. For instance, revised Item 303(b)(3) would provide important information to investors regarding a swap contract that receives a $50 million fair value mark, but would be worth $10 million if the benchmark interest rate were to rise, say, fifty basis points. The utility of this information from the perspective of financial statement users is apparent.

The fair value accounting rules do mandate footnote disclosure of some basic sensitivity analysis for Level 3 assets. For instance, IFRS 13, paragraph 93(h) requires:

a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs if a change in those inputs to a different amount might result in a significantly higher or lower fair value measurement. If there are interrelationships between those inputs and other unobservable inputs used in the fair value measurement, an entity shall also provide a description of those interrelationships and of how they might magnify or mitigate the effect of changes in the unobservable inputs on the fair value measurement.²⁹⁷

In practice, however, the sensitivity analysis conducted by Manolete and Burford to date has been less than illuminating. Burford simply imagines a 10 percent increase or decrease in the aggregate value of its Level 3 assets while holding all other inputs constant.²⁹⁸ Investors could perform this back-of-the-envelope calculation on their own.

Not to be outdone, Manolete’s sensitivity analysis is even less availing—indeed, it is nonexistent. The company appears to ignore paragraph 93(h) altogether: “Sensitivity analysis has not been included, due to the vast amount of inputs and number of variables which are inherently specific to each case, making it impossible to provide meaningful data.”²⁹⁹ The company is onto something, but not everything, here. The number of inputs involved in litigation finance asset valuation are not vaster than that of any other complicated financial asset.

However, Manolete is correct in its observation that the variables in litigation finance asset valuation models are especially asset-specific. It is undoubtedly more difficult to mechanistically toggle input variables to produce useful, even intelligible, sensitivity analysis of a litigation finance model than it is with a financial model for an interest rate swap or collateralized debt obligation. That is not to say that it is impossible.

We might imagine, for instance, an LFC that reports an aggregate fair value of its litigation assets of $100 million. That estimate derives from aggregating individual asset values, each of which is arrived at through a modeling analysis using case-specific assumptions concerning the likelihood of success on the merits, the expected future cost outlays to maintain the litigation, the likely case duration, the probable settlement amounts or judgment awards, and the likelihood of recovery. Such an LFC could report to investors how the $100 million figure would decrease if, for instance, its expected recoveries for all, or those for a portion of its high-value assets, were decreased by, say, 25 percent. Or if its assumed recovery rate decreased from, say, 90 percent to 75 percent. Or if the likelihood of success of its two largest assets were halved. Or all three of these input adjustments.

This sort of analysis permits some rough extrapolation of the valuation models and techniques without disclosing case information in a manner that would result in privilege waiver or revealing proprietary information that would erode the LFC’s competitive position. Any reform effort to combat the disclosure problems incident to publicly traded LFC should consider including mandatory sensitivity analysis as a securities disclosure matter, building off the existing, but presently ineffectual, accounting rules.

F. Mandating Standardized Disclosure of Material Asset Valuations and Amending Privilege and Work-Product Waiver Rules

The most straightforward way to remedy these problems would also be the most controversial: requiring publicly traded LFCs to disclose significantly more details about their asset portfolios, perhaps even case-specific financial and strategic information. Such a requirement would need some filtering mechanism to structure the disclosure. For instance, it could include a materiality threshold, such that disclosure would be provided only for significant matters likely to be of interest to reasonable investors.³⁰⁰ It could instead be calibrated quantitatively according to percentage of total LFC assets (e.g., “any asset the reported value of which exceeds 5 percent of the registrant’s total assets”) or a specified number of the LFC’s largest assets (e.g., “the 5 largest assets by reported value”). For U.S.-listed LFCs like Burford, the S.E.C. could even sensibly determine that no formal rule change is required and publish a release interpreting its existing Regulation S-K to require the disclosure.³⁰¹

The controversy would arise because of the familiar attorney-client privilege and work-product concerns, which presently cast a shadow on publicly traded LFC disclosure that at present chills almost all case-specific information.³⁰² The privilege waiver issue is more pressing than setting the precise scope of the disclosure burden, or its precise location within the securities law compendium. If securities regulators wanted to maximally promote this sort of transparency, they would have to create litigation finance carve-outs from the privilege waiver rules. The challenge in crafting such a carve-out is in achieving two goals at once: allowing meaningful information flows to investors sufficient to combat the twofold securities disclosure problems discussed here while also protecting the confidentiality of privileged communications between funded litigants and their counsel.³⁰³

To implement any approach, the securities regulators should work collaboratively with professional bar associations, courts and, other judicial bodies responsible for evidentiary rules, and legislatures to craft the carve-out. Alternatively, in the United States at any rate, securities regulators could seek congressional approval to preempt state privilege laws with new federal securities rules.³⁰⁴ Whatever political-institutional strategy for legal adoption is preferred, as a technical matter different approaches are feasible.

First, legal authorities could clarify that the general disclosures required by the securities laws would not open the door to broader “subject matter” waivers of the documents to which those general disclosures refer or from which they draw.³⁰⁵ Such an approach would in effect adopt a version of the “selective waiver” doctrine, under which disclosure to a government agency does not waive the privilege vis-à-vis other parties.³⁰⁶ Here, the criterion for selectiveness would be scope of content, not the identity of party obtaining disclosure. Disclosure would only waive privilege with respect to the specific matters disclosed and nothing that underlies or contextualizes them.

Second, the carve-out could be designed as an exception for “disclosures required by securities law set forth in [the relevant statute or regulation requiring the disclosures].” A broader carveout for “disclosures required by securities law” would be inadvisable because there might be cases where an issuer—even a non-LFR operating company—voluntarily discloses information in its securities disclosures that should amount to waiver.

Even assuming the privilege waiver issues are solvable, mandatory case-specific disclosure will still prejudice the LFC’s funded litigation clients—and, for the same reason, the LFC itself—by disclosing otherwise confidential information that could be used strategically in settlement negotiations. For instance, if an LFC discloses that it values a financed plaintiff lawsuit at $22 million, then the defendant might sensibly view that as a ceiling above which it is unwilling to pay. Thus, there are benefits to confidentiality apart from the privilege issues that should be taken account of in any balancing of competing pros and cons. As a number of leading law firms put it in a joint memo concerning the privilege issue in the context of a similar regulatory setting (bank examiners divulging privileged information to Congress):

[A]s a practical matter the value of privilege is diminished in correlation to the number of people who have access to the privileged information. The candor that the privilege is intended to promote is undermined when the communications are subject to public or even private view regardless of whether the communications are used directly or indirectly in a legal proceeding.³⁰⁷

In other words, privilege rules do not apply outside courtrooms. Strictly speaking, they, along with the other rules of evidence, delimit the information set that factfinders can consider when applying the law to facts.

If a litigant involved in settlement negotiations believes that its case on the merits is flimsy, but its settlement leverage rather substantial, it offers no comfort that a leak of memo in which it describes its view of the case cannot be introduced later as evidence in a courtroom. It will by that point already have foundered the settlement talks, not to mention affected the adversary’s strategic posture to the conduct of the litigation. Even more importantly, this hypothetical example draws our attention to possible deeper ramifications for the future availability of litigation finance: if the securities regime pushes too far, the transactional logic of litigation finance itself will come under pressure, at least for those companies considering listing on a public stock exchange. In that scorched-earth circumstance, securities law would solve a problem by eliminating publicly traded LFCs from public markets altogether.

VIII. Conclusion

In concluding, I want to underscore a detail from the Muddy Waters short attack on Burford that was mentioned only in passing above. Within a week of Muddy Waters announcing its short, GAM, a Swiss asset manager with over $140 billion in total assets under management,³⁰⁸ liquidated its entire £80 million position in Burford bonds.³⁰⁹ A sophisticated institutional investor if there ever was one, GAM was sufficiently affrighted, virtually overnight, to abruptly unravel one of its largest positions. While steep declines in stock prices are par for the course following a short attack, such hair-trigger nervousness on the part of institutional debt investors is both remarkable and telling. One can almost imagine the GAM investment manager going around the table, inquiring if any colleagues knew anything about the real composition of Burford’s case portfolio, and receiving only a few shoulder shrugs in response. If one hopes for the continued expansion of the industry through the deployment of funds from public capital markets, one should also hope for more confident responses to the manager’s inquiry the next time around. The reform framework sketched here offers a place to start building that confidence.