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AxiaFunder To Cover £500,000 In Losses

People who invest through AxiaFunder's online platform are funding claimants' legal cases. Investors typically take huge profits when these claims are won – sometimes even projected to earn 2-3 times the amount invested – albeit with substantial downside risk when cases are lost.

Most cases through AxiaFunder* are batched together by the dozens through partner law firms. Those firms choose cases to take on, approaching AxiaFunder to get the funding.

One of those law firms that AxiaFunder worked with, McDSL, has now gone bust. It had taken on seven portfolios of cases through AxiaFunder up to the end of December 2022, involving just over 600 cases.

Of those cases, about £1.5 million had already been – or will very probably soon be – paid out to investors from nearly 350 settled claims. But that will still leave them £520,000 short.

The most important immediate point is that AxiaFunder has decided to cover all these investor losses out of its own pocket. I think it's very likely to be able to afford to do so out of its profits. The direct impact will therefore be limited to investors making no return on the portion of their money that was in any of these portfolios of cases.

It's likely that the regulator will need to approve any such payout to investors, but history shows that it surely will.

This is far from the first time such action has been taken by an investment provider in the broader online investment industry that is covered by 4thWay. That's especially in their earlier years, where they usually make their biggest mistakes.

But that's not reason to be complacent. Because we have seen providers make big mistakes and either not learn from them or they simply had too many other weaknesses or problems to deal with on top.

So you will want to know: what actually went wrong here, what could have been done better, and what is being done to prevent this or any other such calamitous event happening again? Is that sufficient?

And you'll want to know: what does this mean for the future of AxiaFunder, those investing through its online platform, and what the overall level of risks really are?

I'll try to publish a lightly edited transcript of my lengthy interrogation with AxiaFunder* CEO Cormac Leech at some point, which will interest those of you who are comfortable reading lots of jargon (because I won't have time to translate that interview into simpler words.)

However, here are all of the important details in 4thWay's usual style.

What happened at AxiaFunder?

McDSL was the first ever law firm that AxiaFunder partnered with to get funding for large numbers of cases in batches. Prior to that, AxiaFunder took on larger, individual cases. AxiaFunder agreed to fund McDSL without taking the strongest legal security against the funded claims on investors’ behalf.

While McDSL's cases seemingly went pretty smoothly, the law firm itself was far too bent on growth at all costs.

In short, it went from a very small operation to taking on what must have been many thousands of claims in just a few short years, largely through other funding providers, not AxiaFunder.

It also took on types of cases – again not funded by AxiaFunder – that were likely more problematic, in one way or another.

When it collapsed just days ago, AxiaFunder had little or no recourse to collect on the resolved claims that were already in the last step of being costed and paid out to AxiaFunder investors.

Nor does AxiaFunder have good prospects of recovering much on the McDSL claims that are still in progress. That's even though those claims will continue being handled by someone, after being disbursed to other law firms, most likely by the Solicitors Regulation Authority (SRA).

While it's still possible AxiaFunder will get something back, the other, larger funders of McDSL legally sit in a much better position. They will get their money back first. And yet even they could struggle, as they might well have funded some of the more problematic types of cases that McDSL was working on.

Failing any recoveries, the collective total loss that AxiaFunder* has now committed to cover on behalf of investors using its online platform will be £520,000.

The initial rough estimate is that, without AxiaFunder paying out, lenders in the oldest batch of cases would probably have made low single-digit losses. However, those in the newest batch might have lost around 50%. Depending on which of the seven batches you were in, the newer ones had more claims still outstanding and so more that is now forever unrecoverable.

Aren't investors supposed to take all the risks?

You absolutely should expect to take losses yourself when they occur and for whatever reason they occur. That's why you invest when you believe the positive returns will easily offset whatever risks and losses are involved and still leave you with satisfactory returns relative to those risks.

You probably will sometimes suffer substantial losses on some cases through AxiaFunder, even total losses on some claims, which will somewhat knock back the very high returns that are made on the majority of cases.

Yet, by its own admission, AxiaFunder should have emphasised this particular risk – involving losses across multiple batches of claims – more strongly. More importantly, it should have ensured it had better legal security over the funded claims on behalf of investors.

I’ll explain more about what security was needed and how it protects investors lower down.

But the lack of it meant that, in this exceptional situation, it was a reasonable course of action for AxiaFunder to cover the cost itself.

What is AxiaFunder doing about it?

AxiaFunder* has sufficient profits to cover the payout to investors. I expect it will continue to be increasingly profitable, not least since it is dealing with this situation swiftly, transparently and sensibly.

But the steps it's taking to reduce the risk of anything even remotely like this happening again are especially important. Because it's not likely to cover investor losses again – regardless of how they occur.

I'm going to split this section on what AxiaFunder is doing into two.

The first part is on the changes it already made after it had signed up McDSL – which had already been applied to all future law firm partners but not McDSL itself.

The second part is the changes it is now making after the event to reduce this and similar risks from ever happening again.

Improvements it made to its processes after partnering McDSL

So let's go back in time to when McDSL was running cases already and AxiaFunder wanted to sign up more law-firm partners. Some of the following changes that it had already made back then might potentially have been through chance, rather than planning, but regardless AxiaFunder is certainly now thankful for all them.

Here are some of the changes it had already made:

Security for investors as a first legal charge

In contrast to its funding of McDSL, with the portfolios of cases going through all AxiaFunder's other law-firm partners, AxiaFunder now ensures that the cases being funded are secured for investors by having a first legal charge on them.

This is rather like how your mortgage provider takes a legal charge on your home, so that it is in poll position in getting its money back. With these charges, it means that, when the cases are repaid after a law firm goes bust, the money doesn't get spread around to all the other companies that were owed money by the law firm. It comes back to you instead.

(Unknown to 4thWay currently is whether AxiaFunder can prevent its existing law-firm partners from getting second – junior – charges on the same batches of cases. Even junior charges can still increase the overall risk, because it can in some cases put more financial pressure on the law firm. For the same reason, you need your mortgage lender's permission before getting a second charge on your home.)

If AxiaFunder had had first legal charges on McDSL cases, it estimates it probably would have recovered at least an additional £200,000 within the next few months alone. Plus, at a minimum, collected roughly £300,000 more after other law firms were passed the outstanding cases and gradually resolved them.

However, the administrators running down McDSL would take fees out of those payouts and you should assume those would be hefty.

More contact with the owners and managing partners/directors

AxiaFunder* speaks to all its other law firms at least once a week in 30- to 60-minute calls. It goes through their portfolios and ensures that any unsuccessful claims are being replaced with fresh claims at no cost to AxiaFunder or investors, as per their agreements.

The call is also to ensure that AxiaFunder receives payouts quickly.

In contrast, the verbal communication with McDSL was often through a broker during the funding stage, and not the law firm itself. AxiaFunder won't tolerate that now.

Paced draw down of agreed funding

The money is being drawn down more slowly with current law firms, meaning they don't get all the funds up front.

McDSL might have raised and received £250,000 in one go from AxiaFunder investors. With the current law firms, they will get funding each week based on the actual pre-vetted case load coming in.

Engaged an extra corporate lawyer to draft stronger contracts with law firms

After signing McDSL, AxiaFunder engaged a specialist corporate lawyer to improve its contracts with law firms.

I shall presume, in the absence of exceptional evidence to the contrary, that this lawyer has not had much direct experience in arranging contracts for litigation finance companies specifically, as it's very niche.

Still, clearly it’s an improvement that these contracts were worked over. It might count for something that the firm is in the Legal 500 for its work in the broader area of structuring asset-backed lending. (That means, designing and organising the legal and financial framework for a loan that is secured by assets.)

Sometimes AxiaFunder restricts law firms from growing too fast

AxiaFunder* is “increasingly” putting contract terms called covenants in place that restrict the total amount of funding that a law firm is allowed to get from all businesses that provide it with funding for cases.

This way, they can't grow at a rate that is faster than AxiaFunder is comfortable with. (4thWay doesn't yet have details on how AxiaFunder sets those limits or how often these covenants are not included in their contracts with law firms.)

Working with smaller law firms that AxiaFunder can control

AxiaFunder is “much keener” to work with small law firms that it can monitor and have greater control in terms of putting brakes on any dangerous speed of growth. Bigger firms rely on other funders and it's those funders that control the firms.

Law firms pushed to work with claims-management companies that are regulated

Anyone reading the money pages over the past 15 years will have often read about scandals involving claims-management companies (CMCs). There are good ones and bad ones. So when law firms are receiving lots of cases from a CMC, AxiaFunder obviously needs to keep an eye on the quality of those cases.

After signing up McDSL, AxiaFunder has increasingly pushed its partner law firms to work with CMCs that are regulated by the Financial Conduct Authority, which might reduce the risk.

Improved monitoring of the law firms

For law firms after McDSL, AxiaFunder regularly logs into their systems and has real-time access to their claim portfolios. It sees their correspondence on each file, establishing whether it’s performing well or not.

If, on logging in, AxiaFunder finds a case is not performing, it can insist on it being replaced as quickly as possible, for free, with another case.

It did also log in to McDSL's systems, and request cases are replaced, but this was irregular and less often – perhaps every month or six weeks.

On a weekly basis, AxiaFunder gets an Excel file from the other law firms, which shows the overall portfolio that it cross checks and audits. Then it agrees which claims need to be monitored and tracked until they are replaced.

AxiaFunder* also gets management accounts on a quarterly basis to track all its existing law firms' financial position.

Personal guarantees from the law firm's owners and managing directors/managing partners

It has taken personal guarantees from the owner of one law firm, which is the biggest one it works with. This means that if the firm is unable to meet its obligations to AxiaFunder investors, AxiaFunder can go after the personal cash and property of the owner.

As 4thWay users may know, none of us value personal guarantees until they are proven, but it certainly can't hurt to have them.

New changes that AxiaFunder is implementing

The good news is that all the above, which AxiaFunder is already doing with existing law firms, would have been sufficient to reject working with McDSL today.

Yet it clearly needs to learn and do more.

AxiaFunder is just at the very beginning of its assessment of what happened and it's just starting to learn from it, so even more changes are to come. But this is what we know so far.

Watch growth even more closely

AxiaFunder said that one major item it needs to learn from is the growth rate of McDSL. “That should have been a red flag for us.”

We'll need a lot more details, but so far it has said they would no longer fund a large firm growing as quickly. (All other firms it currently has are smaller and growing more slowly.)

Even more monitoring

It's now planning to start monitoring the financial position of its law firms much more closely.

A senior equity research analyst (someone who assesses public listed companies, predominantly to estimate a fair share price) is going to start regularly reviewing the latest accounts from each law firm.

He will insist on seeing the bank statements, so that they can be cross-referenced with the management accounts.

Robust audit process with direct communication only

All communications should be exclusively through the law firm, not third parties, in future.

Sometimes these companies can operate in a relaxed way. So there will be granular detail with AxiaFunder probably requesting evidence to verify every statement.

For example, if a law firm says it has 10 employees available to do the job, AxiaFunder now thinks it will want to see the signed job contracts for those individuals.

Leech admitted to the mistake that “to some extent I've been relying on SRA registration for them to be reliable people, but I think we need to be much more careful and sceptical of that.”

Improved security for investors

It seems that the legal charges, as well as the covenants that AxiaFunder sometimes gets to control the growth of law firms, are not sufficient. Because it also wants to try to get law firms to agree to debentures.

A debenture is basically securing the invested amounts on all the assets (including cash) in the partnership. That will be on top of the specific legal charge on the cases themselves that it already gets.

Debentures might help recoveries somewhat – although perhaps less than you might think. To give you an idea, debentures might perhaps typically help you recover an additional 20% of outstanding amounts in a standard business loan of this kind. Although it varies widely and that is before any administrator fees.

AxiaFunder is currently more optimistic than me, stating “I suspect that it would have enabled us to cover all the money we lost” on McDSL.

But the main point of a debenture is perhaps not to increase recoveries, but rather to increase control.

Other funders will find AxiaFunder's law-firm partners less attractive to work with if they see that AxiaFunder already has a debenture. This could therefore help to contain the speed of the law firms' growth.

The flip side is that you don't want to hurt the law firm's financial position by restricting it too much. So it will be a delicate balance to work out and negotiate.

What this means for investors in future

Firstly, I'd like to point out that this a huge reminder that serious losses are possible when doing these kinds of investments, as there are all sorts of risks that might occur.

At a minimum, you'll want to take your own steps to spread your AxiaFunder investments across investment offers that have different law firms behind them.

But what should AxiaFunder* do?

For investment providers we cover that aren't doing bread-and-butter lending with 100+ years' direct experience on their team, I expect mistakes. And that the biggest mistakes will occur earlier on.

This kind of funding for legal cases is still a niche field in development. AxiaFunder, like others in this space, are not starting with a huge amount of experience. Plenty of legal experience and support, yes, in terms of assessing cases, but not in terms commercial, partnerships etc, and in terms of having long, deep datasets on outcomes in the way that lenders with thousands of completed loans do.

Two further examples of risk came up as a result of my investigation into this. While these didn't impact AxiaFunder and I currently see no reason why they will, they serve just to show that there are a lot of risks to prepare for. These are that firms like AxiaFunder have to take action on the right types of claims to make money. And that the claims have to be pursued correctly by the law firms leading the action in order for them to work out – and to work out swiftly enough for the participants.

Again, those examples aren't relevant to AxiaFunder, as I'm thinking of some other companies that messed up in those ways, but it just shows you how deeply AxiaFunder needs to go to prepare for as many possible risks as possible.

The question for AxiaFunder is whether we can rely on it to act appropriately now, learning specific lessons and appropriately applying them more broadly across the many other potential risks that might occur.

Long-term 4thWay users will know I have 10 years’ experience and learnings in deeply interrogating investment providers, which is one of many methods that all fit together in a web to help sort fact from fiction. (Hence the exceptional results we've had.)

On that basis, I was impressed but not surprised by Leech's responses. Not surprised because it fits to his character as I see it and his sense of doing the right thing.

Impressed because the depth of, and manner of, the response was appropriate, as well as its speed. Most importantly, that the process of learning from this is going to be a big investment for them over the coming weeks.

Certainly, AxiaFunder has work to do to reassure investors and to do a new, thorough review of all the risks. I want to see an updated, rules-based, non-arbitrary approach to setting standards similar to how money lenders set credit policy.

For example, establishing what specific signs mean that a firm is growing fast, what level of growth is too fast and why? Or for what reason and why would AxiaFunder continue to work with a law firm that uses CMCs that are not regulated, and what data or analysis stands behind that? And how is it arranging things so that it can extricate itself from law firms as soon as possible when those law firms no longer meet AxiaFunder's latest standards? And so on.

Yet that is exactly Leech's cup of tea. If anyone was running a niche investment opportunity for you of this extremely complex kind, you would want Leech running it.

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