Companies in court

Yet not all forms of information can be correctly or even adequately priced. Legal matters are a case in point. For example, once we learn a company has a contractual dispute, what value or risk do we attach to it? What about the reputational damage that could come from an executive’s criminal charge? Is it ever even possible to know what is happening in patent litigation? And how might we factor a long-running fraud investigation into our assumptions about a company’s future value?

Eventually, most long-term investors will encounter some type of litigious information asymmetry. Unfortunately, even companies find it hard to quantify the accompanying risk, as much as a chief executive might press his or her general counsel or law firm for a definitive, cold number. Even if you view legal risk as a necessary part of doing business – alongside currency swings, the occasional asset impairment and insurance – there may come a time when investing means making a mini-judgement of your own.

Expert opinion

Then again, it is possible to profit from special situations where legal disputes are involved. For proof, one only need look at a share price chart for Burford Capital (BUR), one of the London Stock Exchange’s true success stories of recent years.

For those who haven’t been briefed, Burford is the largest provider of investment capital to lawyers and clients engaged in major litigation and arbitration. In particular, Burford offers funding for companies with a civil litigation case they might be unable to pursue for either financial reasons or due to time constraints, in return for a cut of the amount awarded by the courts in the event of a successful legal outcome. Some of Burford’s cases are enormous. Following the acquisition of Gerchen Keller Capital last year, the group has been bankrolling a £14bn claim against Mastercard on behalf of British payment cardholders. Its stake in the Petersen Group’s $3bn (£2.2bn) lawsuit against Argentina has already generated more than $100m in cash profits, following its disposal of 25 per cent of its entitlement in the case to date. Income, as the chart opposite shows, is increasing at a clip.

Law firms are generally restricted from this kind of financing, for various reasons to do with professional guidelines, liability and the capital structure of partnerships. Litigation funding exploits this gap between two illiquid parties. Burford’s success in this field lies in the ability of its investment advisers and former litigators to treat a dispute as an asset, quantify the risk, and underwrite the case. Its senior directors universally hail from the in-house legal teams of giant multinationals and the world’s most prestigious law firms, where they developed the experience to navigate complex, high-stakes disputes.

Unfortunately, ordinary investors may struggle to replicate this slick model. Even those with legal backgrounds will be denied access to the evidence on which cases will hinge, and knowledge of the grounds on which a defence, appeal or claim will be attempted. But that doesn’t mean legal matters should, or can, be excluded from an investment decision. In some instances, they will be critical.

In this feature, we look at five ongoing cases where the presence, legacy or possibility of legal action is likely to have a material impact on the valuation of a UK company, and what approaches – however speculative – investors can take to estimate risk. 

When justice meets politics

It would be remiss to talk about corporate legal risk without mentioning banking. According to research from Boston Consulting, banks have shelled out a whopping $321bn (£241bn) in fines since the financial crisis first hit a decade ago – blunting earnings, dividends and growth in the process. As anyone who was invested in the sector at the peak of this castigatory bonanza will know, annual and interim reports read more like confessions than business updates.

One set of fines has been particularly punishing: the penalties connected to the packaging, securitisation and sale of the toxic residential mortgage-backed securities (RMBS) that precipitated the global financial crisis. The sheriff in this round-up has been the US Department of Justice (DoJ), and the sums have been enormous. In 2013, JPMorgan was slapped with a $13bn fine. A year later, Bank of America paid out $17bn. Citigroup followed, coughing up $7bn, and last year Goldman Sachs and Morgan Stanley shelled out $2.6bn and $5bn, respectively. European banks have not escaped the firing squad: in January, Credit Suisse settled for $5.3bn, eclipsed by Deutsche Bank’s $7.2bn payment.

Note the absence of two British financing houses from that list: Barclays (BARC) and Royal Bank of Scotland (RBS). The former has refused to settle and is now being sued by the DoJ, while the latter is close to an agreement that includes “further material settlement costs”, as per its half-year results. This deal, it should be noted, is separate to a $5.5bn (£4.2bn) July agreement with the Federal Housing Finance Agency, also related to RBS’s underwriting of retail mortgage-backed securities and which sacrificed 6 percentage points from RBS’s liquidity coverage ratio.

RBS has had several years to record provisions for these fines, and still has around £3bn earmarked for RMBS fallout from the DoJ probe. At first blush, this would appear fairly meagre; some analysts’ estimates have previously reached £9bn. The bank has also cautioned that “further substantial provisions and costs may be recognised and, depending upon the final outcomes, other adverse consequences may occur”. However, no additional RMBS-related provisions have been made since RBS set aside a further £3.1bn in the first quarter of 2017. At the time, Cenkos Securities’ Sandy Chen suggested this could be taken positively, implying “that RBS must have convinced its auditors that it had reasonable grounds to take further provisions, and that a deal with the US authorities is within sight”.

For RBS’s investors, there are other reasons for optimism. Unlike the aforementioned banks, RBS is the only institution to be taxpayer owned. Even if those taxpayers are British, a punishment on the scale of Bank of America’s or JPMorgan’s could be seen as politically toxic, and one Whitehall will be trying hard to mitigate. Then again, it is difficult to imagine the mighty DoJ – or for that matter RBS’s peers already on the naughty step – will want anything less than their pound of flesh. Accordingly, our preference is to avoid the shares, out of concern that a settlement could provide a damaging hit to book value. Once a final figure is known, the market can have some confidence on the path ahead. Meanwhile, Barclays’ decision to go its own way could come back to haunt it.

A legal comedown

From an investor’s perspective, banking investigations and their associated costs have been unusual. The penalties have been part of a broader, somewhat inevitable settlement with society. More commonly, legal issues arrive suddenly, and for unforeseeable reasons.

UK pharmaceutical group Indivior (INDV) provided a recent example of this tendency. The group is going after a big market: clamouring demand to treat the opioid addiction crisis gripping the United States. Its flagship drug, Suboxone, although not without its own controversies, is recognised as an effective treatment for heroin and prescription painkiller addicts.

This month, it received a potentially lethal dose of news. The US District Court for the District of Delaware decided that an unbranded version of Suboxone – made by Indian pharma company Dr Reddy’s – should not be considered a breach of Indivior’s patent for the treatment. In one fell swoop, 31 per cent was wiped off the UK company’s shares, as the path for lower-priced competition was cleared. Indivior directors warned that the arrival of Dr Reddy’s generic competition could take two-thirds off the top line within a matter of months. The company has vowed to appeal the judgement, which blindsided both management and investors, who had been encouraged by several favourable judgements in separate patent disputes. This was despite a contraction in Suboxone’s leading share of the opioid treatment market, following intensifying competition from drugs developed by Mylan, Actavis and Teva.

Since the news, the shares have recovered some ground, backed by a positive stance from analysts. Numis analyst Paul Cuddon “sees little chance of Dr Reddy’s launching in 2017”, reiterating his buy call on the stock and confidence that the impending launch of a monthly injection treatment of Suboxone could rebuild market share.

We view things differently, and contend that persistent and costly legal battles, together with growing competition from generic rivals, paint a murky outlook for earnings. Although Dr Reddy’s has yet to receive US Food and Drug Administration approval for its drug, this appears to be a matter of when, not if. Moreover, it’s hard to remain bullish when the legal status of a piece of intellectual property is called into question. We see little reason for investors to second-guess this judgement; consequently, we think Indivior shares are too high.

A reputational call

Legal issues beget legal issues. BT (BT.) is learning this the hard way, despite its decisive and immediate response to the discovery of an accounting scandal in its Italian business. In January, the group uncovered “a complex set of improper sales, purchase, factoring and leasing transactions”, which the company blamed on senior executives in the country. An initial estimated write-down of £145m quickly ballooned to £530m.

The whiff of book-cooking tends to draw in a crowd. According to the Financial Times, Italy’s tax police have been sifting through the evidence of potential fraud, and earlier this year raided BT Italia’s office and key suppliers. BT itself has filed a criminal complaint against its former employees. Meanwhile, the US law firm Quinn Emanuel and litigation funder Bentham Europe are assembling a group of institutional shareholders, apparently with a view to bringing a claim.

That same team paired up in a class action against Volkswagen, to sue the German automaker for its role in the emissions scandal. To date, VW has set aside €22.6bn (£20.3bn) to cover the total legal fallout, although there are good reasons to believe that the damage will not be nearly as painful or far-reaching for BT. For a start, the group has already settled with two large shareholders – Deutsche Telekom and Orange – for £225m. This removes the threat of litigation from the telecoms pair, which were issued a warranty to protect them from a slump in BT’s value as part of the deal to sell EE to BT for £12.5bn in 2015. While a painful charge, it seems unlikely that Deutsche Telekom and Orange would have accepted the deal if they believed they could realistically claim significantly more.

What’s more, large institutional shareholders considering joining a class action will have to balance the risk that a successful lawsuit could bring to their existing holdings. Few of the funds that hold BT are likely to welcome further provisions and lower earnings projections.

Finally, there is no indication thus far that the scandal goes beyond Italy, or a small band of executives. This is reassuring, as it suggests additional regulatory or investigatory oversight might be capped. BT has plenty of issues on its plate, not least of which is a lumbering business model in a world of fast-moving media and telecoms upstarts. But barring a major setback, we think BT is on track to contain these legal issues, and reverse the short-term reputational hit.

Confidence in treaties

Of course, not all legal disputes involve companies in the dock. Sometimes they are the claimants. For several years, Cairn Energy (CNE) has had two focuses. One has been exploration, particularly its hunt for oil and gas off the coast of Senegal. The other has been its sprawling dispute with India’s tax authorities.

India’s revenue has claimed it is owed $477m, and blocked Cairn’s disposal of the residual 10 per cent stake it holds in Cairn India, the division the company sold to Vedanta Resources for $6.5bn in 2011. Conversely, Cairn says it has been unfairly impacted by the freeze in the 10 per cent stake, and the dividends owed from it.

Such he-said-she-said cases can be hard for investors to judge, but in this instance Cairn has assured the market that it has a “high level of confidence” it can claim compensation of $1.1bn plus costs in the matter: a figure largely absent from Cairn’s valuation.

The matter has reached international arbitration under the UK-India Investment Treaty, and will be heard in The Hague next year. Although any judgement could be mired in lengthy counter appeals, we see this as a decent risk-reward trade on a binary legal decision, and put stock in Cairn’s repeated assertions of confidence that its claim will be awarded.

Mining recoveries

Complex disputes are rarely welcome, but sometimes they may be the only solution. We have written a lot about the crisis engulfing gold digger Acacia Mining (ACA) this year, and the remedial efforts to keep itself afloat. Unfortunately, this trajectory cannot continue indefinitely, and at some point remedy may have to be substituted for legal action. This still distant but growing prospect could someday present investors with an opportunity.

First, the back story. In March, the Tanzanian government announced a ban on exports of gold concentrate, effectively cutting off 30 per cent of Acacia’s revenue stream. Since then, and despite ongoing discussions between the government and Acacia’s majority shareholder, Barrick Gold, matters have deteriorated. President John Magufuli has publicly accused the gold miner of under-reporting or failing to declare the precious metals in its concentrate shipments. The bill for unpaid taxes, penalties and interest charges stands at a scarcely believable $190bn. A 3 percentage point increase in royalty and clearing payments is being paid under protest.

Recent efforts to protect cash generation have resulted in a decision to gradually close concentrate production from the Bulyanhulu mine, and the purchase of options to sell 210,000 ounces of near-term output at a strike price of $1,300 an ounce. As all of Acacia’s operations are located in Tanzania, the company has little chance but to hunker down – for now. It is in the miner’s interests to settle things amicably, as it has publicly acknowledged. But events are fast-moving, and if cash outflows cannot be stemmed, the company may have to sue the government, having already served notice of arbitration in London in July.

If that happens, Acacia would have a reasonable case under the bilateral treaty between Tanzania and the United Kingdom, which covers concessions to “extract or exploit natural resources”. Such action would of course be complicated by the fact that the majority of Acacia’s asset base is within Tanzanian borders. Then again, with the shares trading at around 50 per cent of the $1.9bn net asset value recorded at the end of June, the market has already made its own heavy impairments. So, while initiation of formal arbitration proceedings could further hurt the share price, it might at least pave the road for shareholders to recoup some of the £1.5bn in lost market value. The prospect of legal action may turn out to be Acacia’s last hope.