By Stephen Pauwels
September 26, 2019
Litigation practices are capital intensive businesses that have always faced unique funding challenges relative to other professional services. In Ontario, plaintiff personal injury lawyers are currently facing a perfect financial storm: aggressive competition, extended claim durations, reduced file settlement values attributable to regulatory changes and emboldened defence positions, and the requirement to spend more and more on expert opinions to achieve them.
This article explores some of these issues from a practice financial management perspective and considers financing alternatives available to law firms to alleviate them.
Even the most successful personal injury law firms must contend with significant unpredictability in their cash flows. These firms wait years on average to realize their contingency fees on successful files while absorbing the losses on the losers. In the interim, they bear the burden of onerous overhead costs: the salaries and wages, rent, marketing and other expenses that keep the lights on and clients walking through the door. If these fixed investments represented a vehicle, then disbursements would be the fuel required to keep the vehicle in motion. These are the thousands or even tens of thousands of dollars that firms must spend to advance each client’s case, which can easily run to hundreds of thousands of dollars of disbursement investments for an individual lawyer’s inventory at any given time.
Clearly, relative to any other professional services businesses, contingency fee-based legal practices require constant access to significant capital to both grow and operate effectively. So where does the money come from?
Retained Earnings. Retained earnings are the accumulated profits after taxes and draws that are recycled back into a practice. The obvious limitation of this source of funding is the requirement that a firm have sufficient excess profits from which to draw in the first place. Further, unless the funds are structured as a loan, there is no tax deductibility of interest, a major disadvantage relative to borrowed capital. Finally, there is the inherent “opportunity cost” of what those same funds could have earned elsewhere, and the complexity of retiring partners wishing to extricate their capital from the practice.
Bank Financing. The most traditional source of funding for other businesses remains the most elusive one for personal injury law firms. Banks’ highly standardized lending models almost entirely discount the inherent value of a contingency fee-based law firm’s active file inventory. As a result, absent the availability of more traditional forms of collateral security such as real estate, or the personal guarantees of partners, bank credit will generally satisfy only a small portion of a firm’s actual funding needs.
Supplier Financing. These are the accumulated “protected accounts”, or the unpaid disbursements held by experts and other support service providers with whom a firm has negotiated deferred payment arrangements. While supplier financing is common in many industries, it typically represents a nominal, short-term funding solution. For example, stretching out accounts payable an extra 60 or 90 days. Personal injury lawyers have taken the concept to a new level, in some cases deferring payment to their experts until settlement years later, and typically with no (or highly negotiable) interest.
Historically, some combination of the above financing sources was adequate to meet the needs of most personal injury practices. This is no longer the case. In Ontario in particular, the perfect storm of market conditions has compressed most firms’ profits to generational lows. Meanwhile, just as lawyers are being compelled to invest more and more in expert opinions to elicit reasonable settlement offers, fewer and fewer of those experts are willing (or can afford) to wait for payment. Most who do now typically require 50% of an invoice to be paid up front – still a hefty outlay, and are imposing hard deadlines (e.g. 1 year) for the balance. Bank credit for personal injury lawyers remains as restrictive as ever.
Fortunately, new sources of funding specifically designed for contingency fee-based law firms are emerging to fill the gap.
Third party disbursement financing for class action and large commercial litigation cases has been available for some time already via the Class Proceeding Fund (in Ontario) and a growing number of private, litigation-oriented investment funds. Its used in personal injury litigation is a more recent development.
Mirroring the broader trend in the credit markets where alternative lenders and “fintech” companies are offering financing to those who fall outside of banks’ limited reach, the litigation finance market is evolving rapidly to service the highly specialized needs of both plaintiffs and law firms.
The growth in the specialized litigation finance market has been fueled by the advent of after-the-event legal expense insurance, or “ATE” insurance, which covers disbursements in unsuccessful claims, thereby insulating both lenders and borrowers from the actual litigation risk. ATE insurance is also evolving with the market, and at least one insurer in Canada is now covering interest on disbursement financing in their policies in addition to the disbursements themselves.
Unlike the disbursement financing arrangements for class actions where investors assume case-specific risk and as compensation therefore require a contingency share in the damages, disbursement financing for personal injury litigation is generally guaranteed by the firm, just like bank debt, and similarly accrues a fixed rate of annual interest irrespective of the outcome of the underlying case(s). As the lawyers’ ‘skin in the game’is not altered by the funding arrangement, it does not jeopardize their contingency fee entitlement.
As litigation funders are much more cognizant of the inherent value of a firm’s work in progress, they will generally extend more credit to a firm than banks will. Another key distinction between bank and litigation financing relates to repayment terms: where banks will always require regular monthly servicing on their loans, litigation financing is directly tied to the pace of a firm’s settlement activity: disbursement loan repayments correspond to the resolution of the underlying files and thereby perfectly match the firm’s cashflows.
The question of who ultimately pays the cost of the disbursement financing is an important one to consider. This is not to be confused with who pays the disbursements themselves, which in the majority of cases will be the lawyer on their client’s behalf. The question is: who ultimately pays the cost to finance the disbursements? Interestingly, the answer tends to vary by region.
In Ontario, lawyers have traditionally absorbed the full cost of disbursement financing. They are entitled to charge their clients interest on those disbursements so long as the amount is “fair and reasonable and disclosed in a timely fashion” to the client[1]. However, the Law Society of Ontario cautions lawyers from profiting from the arrangement[2]. In essence, this means that lawyers can pass along to their clients the full cost of third party disbursement financing – whether the interest is charged by a bank, an expert or a litigation funder, and so long as it is disclosed and reasonable - but not more[3].
Of interest, historically only a small minority of law firms in Ontario have elected to charge interest to their clients on disbursements. This was presumably out of fear of a competitive disadvantage relative to other firms who self finance, and also attributable to small role that third party disbursement financing has played in the past. Both of these factors appear to be changing under current market conditions.
In British Columbia, it is standard practice for personal injury lawyers to charge interest to their clients on disbursements, irrespective of whether third party financing costs were incurred. Similar to Ontario, lawyers in British Columbia are allowed to do so where the amount charged is “fair and reasonable and disclosed in a timely fashion”[4]. Unlike in Ontario, however, there is no rule in British Columbia restricting lawyers from profiting from the practice. As a result, many personal injury lawyers there have adopted a liberal interpretation of what is “fair and reasonable”, with most charging their clients interest on disbursements of between 1.0% to 2.0% per month (12% to 24% per annum).
As in Western Canada, law firms in Eastern Canada routinely reference their ability to charge interest themselves (or pass along third party interest) on disbursement financing in their retainer agreements. For example, the Law Society of New Brunswick recently updated their Code of Professional Conduct such that a lawyer who pays for disbursements on behalf of their client is not considered to have lent the money to their client, even if they charge interest on such an expense[5].
Eastern Canada is notable as the only region in Canada where financing costs incurred by the plaintiff to pay for disbursements were determined by the court (on appeal) to be fully recoverable from a defendant[6] in LeBlanc v. Doucet. In that decision, the Chief Justice of New Brunswick found that the interest was “a reasonable expense, necessarily incurred”. In further support of his decision, he extensively referenced the comments of Supreme Court Justice MacLachlin:
“[36] The importance of access to justice in our society is a theme the Chief Justice of Canada addresses on a regular basis in her public interventions, excerpts of which are reproduced in Bourgoin v. Ouellette et al. (2009), 2009 CanLII 27242 (NB QB), 343 N.B.R. (2d) 58, [2009] N.B.J. No. 164 (Q.B.) (QL):
[TRANSLATION]
The privilege of living in a peaceful society where the principle of the rule of law applies brings with it for us, who are the key players in the legal field, an added obligation. This obligation is the civic duty to maintain, inCanada, public confidence in the legal institutions, and especially in the legal system. In order to maintain confidence in our legal system, it must be, and must be seen to be accessible to Canadians. Yet the time and cost it takes to get a matter to trial is moving beyond the resources of the average Canadian. We cannot allow this to continue.
[...]
The history of the Bar Association and of the judiciary in Canada is that of the struggle to provide Canadians with an efficient and affordable justice system. However, the cost of legal services today is unfortunately a factor which limits access to justice for many Canadians. For the wealthy, and for large companies, access to justice is not a problem. The same applies to the very poor: despite the shortcomings which exist in some regions, they have access to legal aid… Rather, it is the most numerous group, that of middle-class Canadians, which is most affected. This is because these people have a certain income. They have a few assets, maybe a small house, and this disqualifies them for legal aid. The choices they have are none too encouraging: they can exhaust the family assets in a trial, represent themselves, or simply give up. The cost of justice, which could represent taking out a second mortgage on the house or using money saved for retirement or for the children’s education, should not be so high. [paras. 60-61
Conclusion
Contingency fee-based legal practices are capital intensive business who face greater financing challenges than any other professional services businesses. In Ontario, plaintiff personal injury lawyers are currently facing a perfect financial storm. Years of regulatory reforms and the scorched earth tactics of the insurers benefiting from them are requiring plaintiffs and their lawyers to invest more and more time and money into their claims, only to be receive less in damages than previously.
Navigating this storm will require many firms to alter the way they have operated traditionally, while availing themselves of new sources of financing that have emerged where traditional sources are disappearing.
The tradition in Ontario of lawyers both funding and financing disbursements is an unsustainable one under current market conditions for all but a few firms with very deepest pockets. Firms who have yet to recover some or all of any third-party disbursement financing costs from their clients will likely have to consider doing so in the future. The sample language below reflects how some firms are reflecting the arrangement in their retainer agreements:
“[Law firm] may, at its discretion, finance any reasonable and proper disbursement and expense which exceeds [$ ] through a Third Party Financing Company of its choice. Interest accumulated as a result of the aforementioned Financing will be at the rate required by the Third Party Financing Company. The interest charges will be treated as a reasonable and proper disbursement and expense as if part of the original invoice. Upon conclusion of the claim, total disbursements owing to [law firm] will include accrued interest on disbursements and expenses financed by the Third Party Financing Company which I will be responsible for.”
Ideally, with the right fact situation, the courts in Ontario will be favourable to the recovery of such necessary financing costs from defendants in keeping with the decision in LeBlanc v. Doucet and in the spirit of the comments of former Chief Justice McLaughlin regarding access to justice. Such a decision would signal a welcome break in the clouds that have threatened Ontario’s personal injury litigation market now for too long.
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[1] Rule 3.6-1 of the Rules of Professional Conduct: “A lawyer shall not charge or accept any amount for a fee or disbursement unless it is fair and reasonable and has been disclosed in a timely fashion.”
[2] “Lawyers and paralegals should not profit from disbursements charged to the client. Any expense that you pay on behalf of the client should be billed to the client for the same amount.” (Source: https://lso.ca/lawyers/practice-supports-and-resources/topics/managing-money/fees-and-disbursements/fees-and-disbursements)
[3] The Solicitors Act (Ontario) refers to invoices including “fees, charges or disbursements” (emphasis added) does not define “charges”.
[4] Rule 3.6-1 of the Code of Professional Conduct for British Columbia: “A lawyer must not charge or accept a fee or disbursement, including interest, unless it is fair and reasonable and has been disclosed in a timely fashion.”
See also Part 8 – Lawyers’ Fees of the Legal Professions Act (British Columbia) where “charges” is explicitly defined to include “interest on fees and disbursements”
[5] See Rule 3.4-33A of the Law Society of New Brunswick Code of Professional Conduct: “For the purposes of rule 3.4-33 and subject to section 3.6, the payment of necessary expenses in a legal matter that the lawyer is handling for the client shall not be deemed to constitute the lending of money to the client, whether the lawyer charges interest to the client or not.” (emphasis added).
See also Rule 3.6-1 of the Law Society of New Brunswick Code of Professional Conduct: “A lawyer must not charge or accept a fee or disbursement, including interest, unless it is fair and reasonable and has been disclosed in a timely fashion.” (emphasis added). This same provision appears in the Nova Scotia Barristers’ Society Code of Professional Conduct (Rule 3.6-1), Code of Professional Conduct (The Law Society of Newfoundland and Labrador) (Rule 3.6-1) and Law Society of Prince Edward Island Code of Professional Conduct (Rule 3.6-1).
[6] SeeLeBlanc v. Doucet and the New Brunswick Power Corporation, 2012 NBCA 88 (CanLII) (“LeBlanc v. Doucet”) where the plaintiff borrowed funds to finance disbursements in his personal injury action. At the time of the accident, the plaintiff was a 17-year-old student living with his parents and therefore had little to no other means to pay for disbursements other than to borrow from a third party funders as bank financing was not available to him.
