Insider. Damages-Based Agreements: potential or potential pitfall? Don McCue March 2013

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1 Our members review the latest legal developments in their specialist areas of law in an easy-to-read, digestible format. Damages-Based Agreements: potential or potential pitfall? Don McCue March 2013 As part of the Jackson Reforms the much talked about Damages-Based Agreements Regulations 2013 come into force on 1st April Damages Based agreements ( DBAs ) open up the prospect of fees becoming entirely divorced from the actual hours worked on a case. This can lead to much higher fees than those which will arise using the hour-based method, even on a CFA with a 100% uplift. However, there are some potentially serious implications to consider. Don McCue takes a closer look at the potential impact of using DBAs, how they compare to Conditional Fee Agreements ( CFAs ) in different litigation scenarios, and how DBAs relate to the Solicitors Regulation Authority ( SRA ) Code of Conduct. How do DBA fees compare with time-cost and CFA fees? The downside of a DBA or a CFA (unless it is a hybrid) is that if the case is lost the solicitor gets nothing. Traditional time-cost fees do not carry that major risk and for that reason some solicitors will prefer a time-cost arrangement if the client, properly advised, agrees to it. The comparison below focuses on DBAs and CFAs. A solicitor must act in the best interests of each client (SRA Principle 4) and treat his clients fairly (Outcome 1.1, SRA code of Conduct). He must only enter into fee agreements with his clients that are legal and which he considers suitable for the client s needs and take account of the client s best interests (Outcome 1.6). So he cannot just recommend the funding arrangement likely to be the most profitable for his firm. That said, it is entirely legitimate to work out which would be the most profitable, and solicitors will wish to do so. Generally, when the sum recovered by the claimant is above a certain amount a DBA will yield a larger fee than a time-cost fee or a CFA (which is of course a multiple of the time-cost fee). But that amount depends on how long the case takes and therefore how much time cost is incurred. With a quick win a DBA will almost always produce a higher fee for all except the smallest claims. With a case that takes longer a CFA is likely to be more profitable in modest claims. The examples below compare fees receivable on a 50% DBA with those on a 100% CFA in four different types of successful litigation scenarios large claim/quick win, large claim/slow win, modest claim/quick win and modest claim/slow win.

2 For simplicity, participation by a barrister and the effect of VAT are excluded. It is assumed that the base costs (i.e. the total of the representative s time reasonably spent in respect of the claim or proceedings, multiplied by the reasonable hourly rate of remuneration of the representative (DBA Regulations 2013 Reg 1(2)), which will still be recoverable from the defendant on the traditional basis, are taxed down to 70% on assessment and duly paid. Large claim, quick win: defendant caves in quickly and settles at 1million damages. Base costs 10, recovered from defendant. Solicitor s 50% is net of the recovered costs (DBA Regs 2013, Reg 4(1)(b)). The solicitor receives the 7,000 from defendant plus his DBA fee, now capped at 493,000 - a total of 500,000. Client receives 507,000. Solicitor receives the 7000 recovered base costs plus 100% uplift a total of 14,000. Client receives 993,000 (i.e. the 1m award minus solicitor s success fee, which client has to pay because not recoverable from defendant). Large claim, slow win: defendant fights all the way and eventually caves in or loses in court: 1 million damages. Base costs 200, ,000 recovered from defendant Solicitor s 50% is net of recovered base costs. So solicitor receives the 140,000 recovered costs, plus his DBA fee, now capped at 360,000 - a total of 500,000. Client receives award minus the capped DBA fee - 640,000. Solicitor receives 140,000 recovered base costs plus 140,000 success fee, a total of 280,000. Client receives 860,000 (award minus success fee). Note: in this example, solicitor receives the same headline amount of 500,000 but is 60,000 out of pocket compared with example 1 because he has funded the unrecovered base costs (not that he is likely to be heard complaining). Modest claim, quick win: defendant caves in quickly and settles at 200,000 damages. Base costs 10,000; 7000 recovered from defendant. Solicitor receives the 7,000 recovered base costs, plus the DBA fee, now capped at 93,000 - a total of 100,000. Client receives award minus the capped DBA fee - 107,000. Solicitor receives 7,000 recovered base costs plus 7,000 success fee, a total of 14,000. Client receives 193,000 (award minus success fee). Modest claim, slow win: defendant fights all the way and eventually caves in or loses in court: 200,000 damages. Time value fees are 150,000, 70% of which ( 105,000) is recoverable from defendant subject to the indemnity principle. Solicitor receives 100,000, his only entitlement under the DBA. By operation of the indemnity principle defendant only has to pay 100,000 in costs because that is the maximum amount for which he is liable to the solicitor. Defendant pays this and it is paid over to solicitor in satisfaction of his entitlement. Client keeps the whole 200,000 award. Solicitor receives 105,000 recovered base costs plus 105,000 success fee, a total of 210,000. Client receives 95,000 (award minus success fee). The comparison between the two funding regimes thus depends on two variables: the amount recovered and the time the case takes. With a large claim resolved quickly a DBA produces a much larger fee than a CFA. If it takes time to resolve the discrepancy becomes smaller, but the DBA still produces a higher fee than a CFA. That is still the case even with a modest claim, provided it is resolved quickly; but if it takes time to resolve, a DBA may become much less profitable than a CFA. Theoretically, the point beyond which a DBA produces a higher fee than a 100% CFA is where the amount of the base costs incurred in the case is equal to 25% of the amount recovered. Under a 100% CFA the solicitor will then receive 50% of the amount recovered the same as under a 50% DBA. If the amount recovered is larger than this the DBA will produce a larger fee than the CFA. What emerges is that: In general, where the amount likely to be recovered is several multiples greater than predicted base costs, even if the case takes a long time to resolve, a DBA will yield a greater fee than a CFA. When the amount likely to be recovered is less than this, relative to predicted base costs, the time the case takes to be resolved becomes critical to the relative profitability of a DBA and a CFA.

3 The problem is that the two variables - the amount that will be recovered and the time the case will take - are both difficult to predict at the outset, when the funding arrangement decision will usually be taken. The solicitor will have to make the most rigorous appraisal he can on the material then available. The amount likely to be recovered may be easier to estimate than the time the case will take. To get a better focus on the latter, it may be sensible, if the client agrees, to postpone a decision as to which funding regime to use (traditional time charge, CFA - either on a full no-win no fee basis or a hybrid no-win low fee basis - or DBA) until the attitude of the putative defendant is ascertained from the initial preaction correspondence. The forthcoming DBA regime also raises a series of unanswered questions, some of which could be potential pitfalls which may result in a spate of satellite litigation to resolve them. The problem of conflict of interest It could be said that there is always a latent conflict of interest in relation to fees but proper explanations and client care letters mediate it perfectly well in the traditional funding situation. CFAs have not thrown up many difficulties to date because the base fee on which the success fee is levied is the same as the traditional time cost fee and for the last thirteen years clients have had no motive to contest success fees because they have been recoverable from the defendant. With DBAs, however, the potential conflict is stark both at the outset and throughout the case: Where a DBA is clearly likely to yield a higher fee than other funding alternatives available, if the merits are strong the solicitor may well wish a DBA to be adopted; but this will be plainly against the interest of the client; Where a DBA is in force the solicitor s interest is best served by a quick resolution so as to minimise the time cost; whereas it will often be in the client s interests to continue. Lord Justice Jackson recommended that clients should receive independent legal advice before entering into DBAs. The respondents to the Government s Consultation Paper were divided almost equally between those who agreed, because of the conflict of interest, and those who were against it on the ground of practical difficulties and cost and felt that the existing regulation of solicitors would protect clients adequately. The Government concluded that independent legal advice was unnecessary. The problem of client reaction A successful claimant who is required by the terms of a DBA to part with a large proportion of his recovered damages to his solicitor may be tempted to seek ways to avoid paying. He might allege that the solicitor negligently and/or in breach of his fiduciary duty failed to explain to him what the consequences of a DBA would be. He might allege undue influence. All these allegations, if proved, would also constitute breaches of the SRA Code of Conduct and would thus lead to disciplinary proceedings. Under the CFA regime since 2000 when defendants had to pay the success fee, they challenged CFAs so relentlessly and unendingly that it was dubbed the costs war. This is not an encouraging portent. How should a solicitor deal with the conflict of interest and the possibility of retrospective complaint by the client? It is suggested that the best way a solicitor can protect himself against these difficulties is by taking steps to render himself bullet-proof in relation to the choice of funding regime, by: giving the client, orally and in writing a full explanation of the alternative funding arrangements available if he is not willing to run the case on any particular funding basis, or not on any except a particular basis, because of his perception of the merits or other reasons, explaining those reasons fully and, perhaps, adding that other solicitors may be willing to enter into other arrangements carefully recording any discussions with and advice given to the client in the course of making the choice of funding arrangement recording the reasons for the percentage chosen recording the choice made, and the reasons for it, in a document signed by both parties. The regulators are stirring. On 15 th February 2013 the Legal Standards Board asked the SRA and the Bar Standards Board to consider whether targeted and proportionate regulation is necessary to minimise any dangers of deliberate or inadvertent mis-selling. Its main concern is that there should be transparent pricing to enable clients to compare providers, especially the less sophisticated clients.

4 The problem of setting the percentage When a range of percentages is permitted with no guidance as to how the parties should fix it, there is likely to be concern that the court might interfere ex post facto by lowering the rate, as has been done with CFAs by dint of taxing masters routinely taxing off CFA success fees in excess of certain (increasingly modest) percentages. This is unlikely to happen with DBAs. Procedurally it would be difficult because the percentage of a DBA, not being an amount payable by the other party, will not be within the scope of any detailed assessment. Furthermore, the formal requirements for DBAs prescribed by the DBA Regulations 2013 are modest, perhaps as a result of the torrent of litigation which ensued from the much more complex CFA Regulations 1998 allied to costs liability of defendants (the costs war), which was only stopped by abolishing the Regulations. Reg 3 provides that every DBA must specify: a. the claim or proceedings or parts of them to which the agreement relates b. the circumstances in which the representative s payment, expenses and costs, or part of them, are payable; and c. the reason for setting the amount of the payment at the level agreed.. Provided the reason for setting the percentage is clearly specified e.g. the chance that the claim will fail it is hard to see how the court could hold the DBA to be noncompliant. Thus the indication is that the percentage will be set between solicitor and client as a matter of negotiation. Some firm may well adopt a fixed policy as to percentage, and, if the client is treated in a way compliant with the SRA Code of Conduct, it is hard to see that this could be criticised. If the amount of the percentage arises as an issue it will probably be in the context of negligence actions by former clients. The problem that a hybrid DBA will not be available This is extremely surprising. Hybrid CFAs, also known as no-win, low fee agreements, have proved popular because they mitigate the severity of the risk the lawyer is asked to take. They typically provide for a payment of an amount representing a percentage discount on the normal charging rate if the claim fails, and payment of the normal rate plus the same percentage if it succeeds; but there are many variations. The Civil Justice Council s DBA Working Party recommended in 2012 that hybrid DBAs should be permitted. However, although the statute (Section 58AA of the Courts and Legal Services Act 1990 as amended by LASPO section 45) would permit hybrids, the draft DBA Regulations 2013 would not; that is the effect of the definition of payment in Reg 1(2) together with the wording of Reg 4. Leading commercial firms have pointed out that this omission is surprising and unwelcome; most commercial litigators in the USA, they said, use hybrid agreements. It may be that this is the result of a drafting error by the MOJ rather than a settled intention not to permit hybrids. If that is so the draft Regulations may be amended. Currently the Bar Council is suggesting amendments to the draft DBA Regulations. It is likely that these include amendments to permit hybrid DBAs. The problem of inflexibility: what if the prognosis changes? Estimates of the two variables the amount which will be recovered and the time it will take frequently change substantially as the case proceeds. What if it becomes clear, for a reason not known at the time the DBA was agreed, that the amount which will be recovered is much less than had been thought, so that, for example, the most the solicitor can possibly get from the case has reduced to a negligible sum. Can the solicitor terminate? Conversely, what if it becomes clear to the client, for the same kind of reason, that recovery will be rapid and substantial and he would be much better off under a traditional time-based charging arrangement. Can he terminate? It is hard to see how this risk can be avoided. If the DBA were to be worded to permit either side to revisit the terms in the light of information not available at the date of the contract, certainty of outcome would be lost and the DBA, arguably, would not be worth entering into. On the other hand, a client being forced to stay with a solicitor and a funding contract he no longer wanted, or a solicitor being forced to carry on conducting a case for a negligible fee, are both unattractive prospects.

5 Conclusion Whether or not as a result of the costs war experience, the revolutionary funding arrangement represented by DBAs has been introduced with surprisingly little formal regulation. This is welcome in some respects, but there is still likely to be litigation, at least in the early days, as authoritative answers are sought to some of the problems. It remains to be seen to what extent DBAs will be taken up, and by what segment of the commercial litigation market in large claims, by sophisticated clients, or in a small claims by unsophisticated clients signing up to a one-size-fits-all DBA offered by volume providers or both? Don McCue is a commercial litigator with wide-ranging experience in commercial and chancery litigation and domestic and international arbitrations. He has authored previous 11 SB publications on Partnership law and LLPs (with Edward Cohen) and on SRA investigations and Solicitors Disciplinary Tribunal proceedings. He is a mediator with ADR Group. 11 SB is a commercial / chancery set with a strong expertise in commercial, company, insolvency, civil fraud, professional negligence, banking & finance and real estate disputes. Our clients value the fact that we offer a large number of barristers who have expertise across several disciplines. Given that nowadays many disputes involve more than one practice area this adds value to the service we provide and enhances our ability to deal with very complex cases. For more information on Don McCue or 11 SB, please visit call on or us on clerks@11sb.com.