Third-Party Litigation Funding in Bankruptcy Cases

According to a recent survey of U.S. commercial litigators conducted by the Burford Group, a London-based investment firm that provides third-party financing, in-house general counsels and chief financial officers forecast significant expansion of litigation finance. Fifty percent of AmLaw 200 litigators have had cases that could have used litigation funding, and 18% have a current case that could use funding. Additionally, 59% of general counsels and 71% of chief financial officers say that litigation finance levels the playing field between parties with unequal resources.

The primary concern most often expressed by critics of third-party litigation funding is that it will increase the filing of frivolous lawsuits, but that concern misses the fundamental principle of finance ' to make money. Third-party litigation financiers only invest in cases where the plaintiff's claims are strong and the damages are demonstrable and recoverable. Investing in frivolous cases is bad business. “We are investing in the best claim sets we can find with a fact pattern that we can deconstruct,” noted David Desser, Managing Director of Juris Capital, LLC, a third-party financing firm located in Chicago. “We're not interested in the long odds of venture capital, where a 'home run' counterbalances many 'strike outs.' We target a positive return for more than 70% of our portfolio, with an IRR in excess of 20%.”

Background

Third-party litigation finance in the United States initially took the form of modest investments in personal injury claims intended to provide a financial bridge for claimants while their underlying litigation moved toward settlement or trial. More recently, however, more sophisticated funds have formed to provide capital for complex commercial disputes featuring well-financed corporate claimants seeking damages in the range of tens or hundreds of millions of dollars. And, more substantial players enter the field each year. Today, third-party commercial litigation financiers include hedge funds, banks and even two funds traded on the London stock exchange, in addition to several privately held funds. There are dozens of smaller firms and individuals investing small amounts in personal injury (or similar) claims.

While third-party litigation finance can solve similar problems addressed by contingency fees arrangements ' an allegedly wronged party's inability to pay professionals to remedy the underlying wrong ' more and more, attorneys on contingency fee arrangements are reducing their risk of non-payment or under-payment by securing third-party funding directly or on behalf of their clients.

Third-party litigation finance can take numerous forms and is limited only by the imagination of the investors and their counterparties. Capital may be invested in exchange for an interest in the litigation proceeds equal to the amount of the investment, plus a return ' in some cases three to five times the invested amount. Commonly, the investor expects ongoing representation on a fixed or contingent fee basis (if not already structured in that way).

An alternative arrangement is for the financing party to loan funds directly to the attorney or law firm representing a litigant. Here, the third party will provide an interest-bearing loan, but with this structure the attorney or law firm is the investor's counterparty. These loans may be recourse or “non-recourse,” the later meaning if the underlying lawsuit is not successful, the borrower (law firm) is not obligated to repay the financier. And, most third-party investors disclaim any participatory role in the litigation due to privilege issues and potential attorney-client conflicts.

Third-Party Funding in Bankruptcy Cases

Third-party litigation funding seems like a natural fit for bankruptcy-related litigation. In the typical Chapter 11 bankruptcy case the “hard assets,” e.g., equipment, inventory, receivables, etc., are sold and the proceeds are distributed primarily ' if not entirely ' to the debtor's secured creditor and the estate's professionals. Often, the only assets remaining are causes of action in the form of preference and avoidance actions, breach of contract claims, and breach of fiduciary duty claims which may be difficult and expensive to monetize.

The creditors committee, in the case of an ongoing Chapter 11 bankruptcy case, or the bankruptcy trustee, if the case has been converted to Chapter 7, may have difficulty finding qualified counsel willing to pursue such claims on a contingency basis. The likelihood of retaining qualified counsel would increase, however, if the estate and its retained professionals could hedge the risk associated with the litigation at the outset. Obtaining third-party funding, however, could be perceived by the court as reducing the amount recoverable from the estate's assets and, therefore, require bankruptcy court approval. How bankruptcy courts will treat such arrangements has yet to be seen.

“We don't know of any direct investments in bankruptcy, but it would not be surprise us,” said Desser. “First, third-party litigation finance simply hasn't been around that long in the United States. Second, the investors typically prefer to keep the existence of a financing confidential. We have looked at several opportunities in the bankruptcy context, although we have yet to find the appropriate fit for our fund.”

Although third-party litigation financing seems like a natural fit for bankruptcy-related litigation, the Bankruptcy Code's disclosure requirements may make it less attractive to the ordinarily secretive funds. And, the courts have yet to parse out exactly what amount of disclosure is enough (and what amount is not).

Financing the Bankruptcy Estate 'Directly'

One option would be for the lending party to enter into a funding agreement with the bankruptcy estate via the debtor, the creditors committee or the bankruptcy trustee in exchange for an interest in a specific piece of litigation or all of the existing claims that the estate may own. The estate then has the advantage of a “war chest” to pursue claims for the benefit of its creditors that might otherwise have gone unliquidated and, depending on the terms of the financing, pay other expenses of administering the estate.

“Typically, the claimant directs us to transfer some portion of our investment directly to its attorneys who have committed to a flat fee for litigating the case to closure,” said Desser. “In so doing, the attorneys are pre-paid and the investor recovers from the proceeds of the litigation or from other assets.”

This type of arrangement benefits the bankruptcy estate because it can control the funds, permitting it to retain counsel on an hourly or fixed-fee basis. This may expand the range and quality of law firms available to the estate, since larger firms typically discourage their attorneys from taking cases pursuant to a contingency fee arrangement (and effectively funding the litigation themselves).

“We looked at a case on behalf of a Chapter 7 bankruptcy trustee for an estate of a failed hedge fund,” said Desser. “The trustee was charged with litigating against dozens of recipients of distributions from the fund in an effort to recover and redistribute those funds to the general creditor body. At the end of the day, I believe the trustee obtained less expensive (and recourse) financing, but that's the type of bankruptcy-related situations that would interest a fund like Juris Capital.”

Such “direct” financing is similar to debtor-in-possession (DIP) financing, and presumably would require full disclosure of its terms and prior approval by the presiding bankruptcy court pursuant to Section 364 of the Bankruptcy Code. Additionally, as is the case with traditional DIP financing, the movant would have the burden of proving that the funding is necessary and that less expensive alternatives were unobtainable. This may be difficult ' but not impossible ' in light of the high cost associated with third-party litigation financing and the availability of professionals willing to be retained pursuant to a contingency fee arrangement.

Financing the Bankruptcy Estate 'Indirectly'

As an alternative to funding the estate directly, the third-party funding firm could fund the bankruptcy estate “indirectly” by entering into an agreement with the attorneys retained by the estate. This is especially likely if the attorneys are retained on a contingency basis, as most funders prefer that the attorneys have “skin in the game.” The one obvious downside of this type of arrangement from the bankruptcy-estate perspective is that it eliminates the potential for “surplus” funds which it could other use to pay the expenses of administration.

This form of “indirect” financing also would have to be disclosed to the court pursuant to Rule 2016(b) of the Federal Rules of Bankruptcy Procedure, which requires the disclosure of any agreement by a professional retained by the debtor to share compensation received by the estate with any person not a member of the attorney's law firm. Technically, this provision only applies to professionals retained by the debtor ' not necessarily those retained by a creditors committee or a Chapter 7 trustee. And, this disclosure requirement arguably would not apply if the agreement were drafted so that the funds to repay the third-party financing did not come from payments of the debtor. However, failure to disclose such a relationship, even if technically outside the requirements of Rule 2016(a), could result in a denial of any payments received by the attorney from the debtor. Therefore, as always, disclosure would be highly recommended.

Conclusion

The emergence of third-party litigation funding in bankruptcy cases seems inevitable and may already be more prevalent than public filings would indicate. The ethical “red flags” associated with third-party financing do not appear to be any more disconcerting than contingency fee arrangements, which bankruptcy courts not only tolerate but in certain instances, might favor. Participation in the bankruptcy case by third parties that results in a more efficient and complete liquidation of the debtor's assets for the benefit of its creditors fits soundly within the framework of the bankruptcy code and should be a welcome development.

Maintenance and Champerty

For centuries, common law prohibited limited non-parties from participating in lawsuits by the doctrines of maintenance and champerty. Maintenance is where a non-party provides economic support to a party to an existing lawsuit. Champerty, which is technically a form of maintenance, is where a party acquires an interest in the outcome of a lawsuit to which it is not a party based on economic or other support of one of the parties, typically the plaintiff. The majority of decisions issued in England and the United States discarded dated concerns over maintenance long before litigation finance even existed. More recently, courts and many state bar ethics opinions have held in favor of third-party litigation finance providers and their clients on the basis that, in many cases, third-party financing grants access to justice that financially strapped individuals and corporate litigants might otherwise be denied for purely economic reasons.

Patrick M. Jones is an officer in the Chicago office of Greensfelder, Hemker & Gale, P.C., and a member of the firm's Creditors' Rights and Bankruptcy and Litigation Practice Groups. He represents parties in complex business disputes and corporate bankruptcies, including plaintiffs and defendants, debtors, lenders, creditors' committees and Chapter 7 trustees. Jones can be reached at [email protected] or 312-345-5018.

Third-party litigation financing is a booming form of finance that seems like a natural fit for bankruptcy-related litigation initiated by Chapter 7 trustees, and official committees of unsecured creditors and debtors. Although the disclosure requirements of the bankruptcy code may give the most secretive funds pause, these issues can be managed and should not be a barrier to most participants. Ultimately, third-party litigation finance will assist in the efficient, comprehensive liquidation of bankruptcy estates and provide the maximum benefit for creditors.

This type of litigation finance is an alternative asset class that has experienced rapid growth in the U.S. in the past decade. Explained in its its simplest form, a third party provides capital to a claimant to cover or supplement the cost of litigating a claim or to hedge against an adverse outcome. The third party purchases a portion of a claimant's recovery, less attorneys' fees and costs. The financing is almost always provided on a non-recourse basis, i.e., the claimant is not liable to the third party if the underlying lawsuit is unsuccessful.

Significant Expansion

According to a recent survey of U.S. commercial litigators conducted by the Burford Group, a London-based investment firm that provides third-party financing, in-house general counsels and chief financial officers forecast significant expansion of litigation finance. Fifty percent of AmLaw 200 litigators have had cases that could have used litigation funding, and 18% have a current case that could use funding. Additionally, 59% of general counsels and 71% of chief financial officers say that litigation finance levels the playing field between parties with unequal resources.

The primary concern most often expressed by critics of third-party litigation funding is that it will increase the filing of frivolous lawsuits, but that concern misses the fundamental principle of finance ' to make money. Third-party litigation financiers only invest in cases where the plaintiff's claims are strong and the damages are demonstrable and recoverable. Investing in frivolous cases is bad business. “We are investing in the best claim sets we can find with a fact pattern that we can deconstruct,” noted David Desser, Managing Director of Juris Capital, LLC, a third-party financing firm located in Chicago. “We're not interested in the long odds of venture capital, where a 'home run' counterbalances many 'strike outs.' We target a positive return for more than 70% of our portfolio, with an IRR in excess of 20%.”

Background

Third-party litigation finance in the United States initially took the form of modest investments in personal injury claims intended to provide a financial bridge for claimants while their underlying litigation moved toward settlement or trial. More recently, however, more sophisticated funds have formed to provide capital for complex commercial disputes featuring well-financed corporate claimants seeking damages in the range of tens or hundreds of millions of dollars. And, more substantial players enter the field each year. Today, third-party commercial litigation financiers include hedge funds, banks and even two funds traded on the London stock exchange, in addition to several privately held funds. There are dozens of smaller firms and individuals investing small amounts in personal injury (or similar) claims.

While third-party litigation finance can solve similar problems addressed by contingency fees arrangements ' an allegedly wronged party's inability to pay professionals to remedy the underlying wrong ' more and more, attorneys on contingency fee arrangements are reducing their risk of non-payment or under-payment by securing third-party funding directly or on behalf of their clients.

Third-party litigation finance can take numerous forms and is limited only by the imagination of the investors and their counterparties. Capital may be invested in exchange for an interest in the litigation proceeds equal to the amount of the investment, plus a return ' in some cases three to five times the invested amount. Commonly, the investor expects ongoing representation on a fixed or contingent fee basis (if not already structured in that way).

An alternative arrangement is for the financing party to loan funds directly to the attorney or law firm representing a litigant. Here, the third party will provide an interest-bearing loan, but with this structure the attorney or law firm is the investor's counterparty. These loans may be recourse or “non-recourse,” the later meaning if the underlying lawsuit is not successful, the borrower (law firm) is not obligated to repay the financier. And, most third-party investors disclaim any participatory role in the litigation due to privilege issues and potential attorney-client conflicts.

Third-Party Funding in Bankruptcy Cases

Third-party litigation funding seems like a natural fit for bankruptcy-related litigation. In the typical Chapter 11 bankruptcy case the “hard assets,” e.g., equipment, inventory, receivables, etc., are sold and the proceeds are distributed primarily ' if not entirely ' to the debtor's secured creditor and the estate's professionals. Often, the only assets remaining are causes of action in the form of preference and avoidance actions, breach of contract claims, and breach of fiduciary duty claims which may be difficult and expensive to monetize.

The creditors committee, in the case of an ongoing Chapter 11 bankruptcy case, or the bankruptcy trustee, if the case has been converted to Chapter 7, may have difficulty finding qualified counsel willing to pursue such claims on a contingency basis. The likelihood of retaining qualified counsel would increase, however, if the estate and its retained professionals could hedge the risk associated with the litigation at the outset. Obtaining third-party funding, however, could be perceived by the court as reducing the amount recoverable from the estate's assets and, therefore, require bankruptcy court approval. How bankruptcy courts will treat such arrangements has yet to be seen.

“We don't know of any direct investments in bankruptcy, but it would not be surprise us,” said Desser. “First, third-party litigation finance simply hasn't been around that long in the United States. Second, the investors typically prefer to keep the existence of a financing confidential. We have looked at several opportunities in the bankruptcy context, although we have yet to find the appropriate fit for our fund.”

Although third-party litigation financing seems like a natural fit for bankruptcy-related litigation, the Bankruptcy Code's disclosure requirements may make it less attractive to the ordinarily secretive funds. And, the courts have yet to parse out exactly what amount of disclosure is enough (and what amount is not).

Financing the Bankruptcy Estate 'Directly'

One option would be for the lending party to enter into a funding agreement with the bankruptcy estate via the debtor, the creditors committee or the bankruptcy trustee in exchange for an interest in a specific piece of litigation or all of the existing claims that the estate may own. The estate then has the advantage of a “war chest” to pursue claims for the benefit of its creditors that might otherwise have gone unliquidated and, depending on the terms of the financing, pay other expenses of administering the estate.

“Typically, the claimant directs us to transfer some portion of our investment directly to its attorneys who have committed to a flat fee for litigating the case to closure,” said Desser. “In so doing, the attorneys are pre-paid and the investor recovers from the proceeds of the litigation or from other assets.”

This type of arrangement benefits the bankruptcy estate because it can control the funds, permitting it to retain counsel on an hourly or fixed-fee basis. This may expand the range and quality of law firms available to the estate, since larger firms typically discourage their attorneys from taking cases pursuant to a contingency fee arrangement (and effectively funding the litigation themselves).

“We looked at a case on behalf of a Chapter 7 bankruptcy trustee for an estate of a failed hedge fund,” said Desser. “The trustee was charged with litigating against dozens of recipients of distributions from the fund in an effort to recover and redistribute those funds to the general creditor body. At the end of the day, I believe the trustee obtained less expensive (and recourse) financing, but that's the type of bankruptcy-related situations that would interest a fund like Juris Capital.”

Such “direct” financing is similar to debtor-in-possession (DIP) financing, and presumably would require full disclosure of its terms and prior approval by the presiding bankruptcy court pursuant to Section 364 of the Bankruptcy Code. Additionally, as is the case with traditional DIP financing, the movant would have the burden of proving that the funding is necessary and that less expensive alternatives were unobtainable. This may be difficult ' but not impossible ' in light of the high cost associated with third-party litigation financing and the availability of professionals willing to be retained pursuant to a contingency fee arrangement.

Financing the Bankruptcy Estate 'Indirectly'

As an alternative to funding the estate directly, the third-party funding firm could fund the bankruptcy estate “indirectly” by entering into an agreement with the attorneys retained by the estate. This is especially likely if the attorneys are retained on a contingency basis, as most funders prefer that the attorneys have “skin in the game.” The one obvious downside of this type of arrangement from the bankruptcy-estate perspective is that it eliminates the potential for “surplus” funds which it could other use to pay the expenses of administration.

This form of “indirect” financing also would have to be disclosed to the court pursuant to Rule 2016(b) of the Federal Rules of Bankruptcy Procedure, which requires the disclosure of any agreement by a professional retained by the debtor to share compensation received by the estate with any person not a member of the attorney's law firm. Technically, this provision only applies to professionals retained by the debtor ' not necessarily those retained by a creditors committee or a Chapter 7 trustee. And, this disclosure requirement arguably would not apply if the agreement were drafted so that the funds to repay the third-party financing did not come from payments of the debtor. However, failure to disclose such a relationship, even if technically outside the requirements of Rule 2016(a), could result in a denial of any payments received by the attorney from the debtor. Therefore, as always, disclosure would be highly recommended.

Conclusion

The emergence of third-party litigation funding in bankruptcy cases seems inevitable and may already be more prevalent than public filings would indicate. The ethical “red flags” associated with third-party financing do not appear to be any more disconcerting than contingency fee arrangements, which bankruptcy courts not only tolerate but in certain instances, might favor. Participation in the bankruptcy case by third parties that results in a more efficient and complete liquidation of the debtor's assets for the benefit of its creditors fits soundly within the framework of the bankruptcy code and should be a welcome development.

Maintenance and Champerty

For centuries, common law prohibited limited non-parties from participating in lawsuits by the doctrines of maintenance and champerty. Maintenance is where a non-party provides economic support to a party to an existing lawsuit. Champerty, which is technically a form of maintenance, is where a party acquires an interest in the outcome of a lawsuit to which it is not a party based on economic or other support of one of the parties, typically the plaintiff. The majority of decisions issued in England and the United States discarded dated concerns over maintenance long before litigation finance even existed. More recently, courts and many state bar ethics opinions have held in favor of third-party litigation finance providers and their clients on the basis that, in many cases, third-party financing grants access to justice that financially strapped individuals and corporate litigants might otherwise be denied for purely economic reasons.

Patrick M. Jones is an officer in the Chicago office of Greensfelder, Hemker & Gale, P.C., and a member of the firm's Creditors' Rights and Bankruptcy and Litigation Practice Groups. He represents parties in complex business disputes and corporate bankruptcies, including plaintiffs and defendants, debtors, lenders, creditors' committees and Chapter 7 trustees. Jones can be reached at [email protected] or 312-345-5018.