Third-Party Litigation Funding

Despite third-party litigation funding's explosive growth, corporate restructuring/insolvency practitioners in the U.S. are not yet frequent participants in such arrangements. Yet for these professionals, litigation funding could be especially beneficial to provide a new source of capital for otherwise asset-starved estates.

The Typical Litigation Financing Structure and Process

While third-party litigation funding may have “loan” characteristics, the transactions typically (in the authors' experience, universally) do not impose any recourse on the funding recipient absent extraordinary situations like fraud. Rather, the funding is viewed as an “investment” in the successful outcome of a legal proceeding.

The amount that a litigation funder is willing to invest is based on the funder's assessment of the merit and value of the underlying legal claim. Funders may invest in a single cause of action, or may invest in an entire portfolio of claims. And, depending on the particular terms of each investment, the invested funds may be used by the recipient in a variety of different ways including: payment of the litigating attorneys' fees and expenses; payment of the law firm's or underlying business's operating expenses; payments or distributions for other purposes.

The litigation funding process (whether in or out of bankruptcy) typically starts with the litigation funder and the fund recipient (typically a plaintiff) executing a nondisclosure agreement. The funder then analyzes the litigation, subject to certain restrictions on the information disclosed. The litigation funder considers a variety of factors, including the merits of the underlying claims, availability of insurance to the defendant, likely case duration, collection risk, and the probability of one or more appeals

If interested in moving forward, the funder will propose preliminary terms. If terms can be agreed upon, then the funder and the fund recipient will execute a litigation funding agreement. In a bankruptcy case (at least pre-confirmation), of course, such agreement will be subject to bankruptcy court approval.

If the funded litigation results in proceeds coming back to the funding recipient, the funder will be repaid its investment plus the agreed-upon additional return. If, on the other hand, the funding recipient is unsuccessful, the funder gets nothing back on its investment.

The Benefits of Litigation Funding from Plaintiffs' Perspective

The most obvious benefit of third-party financing for a plaintiff is that the funder provides some or all of the funding necessary to pursue the claim. This could be a gating issue for a plaintiff with a meritorious claim, but without the financial ability to litigate that claim.

Even a plaintiff that may be able to afford to finance litigation may want to consider using third-party litigation financing to hedge litigation risk and prevent diversion of capital away from core activities of the business. In this way, litigation funding can help a plaintiff minimize the adverse impact of costly litigation on corporate financial reporting.

Another significant benefit is that the funding due diligence process serves as a reality check as to the merits of the litigation in question: If no litigation funder is interested in funding, that may be telling. A related benefit is that litigation funders typically continue to provide a level of assistance during the litigation (a rare situation in which “back-seat driving” does not have a negative connotation).

On the downside, however, using litigation financing will, of course, reduce a claim's potential upside for the plaintiff. And it will typically require the plaintiff to disclose sensitive and confidential information to the litigation funder during the diligence process. Both the plaintiff and the funder must be on guard against the inadvertent disclosure of attorney-client privileged information during of such due diligence, and throughout the pursuit of the litigation.

A Case for Litigation Funding in the Restructuring/ Insolvency Context

It is not surprising that bankruptcy estates, post-confirmation estates and similar plaintiffs (i.e., receivers and assignees), by their nature, often lack the resources required to hire highly qualified counsel to pursue otherwise viable claims. As a result, valuable legal claims are often settled for far less than full value. Litigation funding offers a mechanism to allow such plaintiffs to pursue these claims from a position of greater strength.

Third-party litigation funding can be used to finance a variety of actions in a bankruptcy case. Plain vanilla avoidance actions are an obvious example. But bankruptcy cases often involve other causes of action, such as those in breaches of fiduciary duty, breach of contract or lender liability. These causes of action are often not subject to a secured creditor's liens, due to the difficulty of obtaining a perfected security interest in commercial tort claims that are often outside the scope of Article 9 of the UCC. Thus, if an estate's only major asset is a pool of litigation claims, litigation funding can be a game-changer.

An obvious point in a Chapter 11 for a litigation funder to become involved is post-confirmation, when liquidating trusts commonly seek to monetize an estate's causes of action.

But what if no plan can be confirmed because there is not enough cash to pay the claims necessary to confirm one? Litigation funding may be the answer, since it can be a means by which to bring sufficient cash into the estate prior to the proposed effective date of a plan. We note, however, our disagreement with at least one commentator who recently argued that litigation funding is likely to provide a means for circumventing a Jevic problem (in Czyzewski v. Jevic Holding Corp. (137 S. Ct. 973 (2017)), the Supreme Court held that a structured dismissal violating the absolute priority rule is impermissible absent impaired creditor consent).

Where litigation funding brings cash into an estate so that litigation can be later brought, the structured dismissal itself will more likely be avoided and a plan confirmed. Thus, the more likely impact litigation funding will have on structured dismissals is that it will result in fewer of them.

It will also be interesting to see what develops as litigation funding becomes more prevalent. Debtors (and funders) will inevitably look for more ways to bring (or deploy) capital into bankruptcy estates. We may next see funders looking to come onto the scene as DIP lenders, seeking approval of detailed funding agreements whereby the funders not only provide working capital to the estate, but also specific funds to tackle estate causes of action. In exchange, they may seek not only a portion of the litigation recoveries, but also the special treatment and protections routinely provided to DIP lenders.

In these early days of litigation funding involvement in bankruptcy cases, there is not yet a clear process or mechanism by which practitioners are seeking authority, or courts are reviewing and approving requests, to use litigation funding. For example, in the post-confirmation context, a liquidating plan or trust agreement may appear to provide sufficient authority to allow a trustee to enter into a litigation funding agreement, yet trustees have nonetheless filed comfort motions seeking express authority to proceed. See In re Superior Nat'l Ins. Grp., 2014 Bankr. LEXIS 64 (Bankr. C.D. Cal. Jan. 7, 2014); In re Complete Retreats, LLC, 2011 Bankr. LEXIS 1417 (Bankr. D. Conn. Apr. 14, 2011). But in another example, a trustee sought authority to proceed under Section 363, framing the proposed transaction as a sale of estate assets, presumably because the estate was looking to transfer a portion of any litigation recovery to the funder. See In re DesignLine Corp., Case No. 13-31943, Dkt. No. 689 (Bank. W.D.N.C., Sept. 9, 2016).

The appropriate path depends both on whether the transaction is structured as a sale of estate assets under section 363 or as a loan to the estate under section 364, and also on the point at which the funder enters into the case (whether pre- or post-confirmation). Regardless of what authority a debtor or trustee cites for the request to enter into a litigation funding agreement, the court carefully will look at the terms of the proposed funding. And bankruptcy professionals considering using litigation funding should be able to demonstrate an economic justification for seeking that outside funding and the reasonableness of its terms. In all instances, just as outside bankruptcy, the estate or trustee (i.e., the plaintiff), rather than the funder, should maintain control over the litigation.

Matter of Magnesium Corp.: Creative Deployment of Litigation Funding Capital

There has already been at least one creative deployment of litigation funding capital, outside of the scope of a plain vanilla funding of ongoing litigation, in the Magnesium Corp. bankruptcy proceeding. In September 2016, Gerchen Keller Capital (GKC) was involved in a deal in which MagCorp's Chapter 7 trustee auctioned off a piece of a $213 million judgment that the estate had received against Ira Rennert and The Renco Group for fraudulently transferring cash from the debtor prior to its 2001 bankruptcy.

GKC paid $26.2 million to acquire a $50 million interest in that judgment, which provided the cash-strapped estate with the liquidity necessary to defend against the pending high-profile appeal of the judgment and the need to pay ever-accumulating estate costs. In March 2017, the Second Circuit affirmed the estate's judgment against Rennert and Renco. Matter of Magnesium Corp. of Am., 682 F. App'x 24, 27 (2d Cir. 2017), cert. denied sub nom. Renco Grp., Inc. v. Buchwald, No. 17-228, 2017 WL 3456824 (U.S. Oct. 10, 2017). Ultimately, GKC received a return of more than 90% on its investment.

Public Policy Concerns Still Exist

Practitioners should be aware, however, that bankruptcy courts have not universally approved all litigation funding agreements placed before them. For example, in In re DesignLine Corp., 565 B.R. 341 (Bankr. W.D.N.C. 2017), the bankruptcy court refused to approve a proposal that a portion of litigation proceeds be sold to a funder in exchange for the funder advancing legal costs and expenses. The court found that the arrangement violated North Carolina's public policy, because the funder was given excessive control over the litigation.

Even outside of bankruptcy, the use of third-party litigation funding is not without controversy on public policy grounds. Some believe that litigation financing will help shrink the widening gulf many face in accessing justice, especially where a drastic disparity exists in the financial means between parties. Yet, concerns abound regarding fostering speculative lawsuits, conflicts of interest and potential interference from investors.

While concerns over claims of champerty, an old common law doctrine that prohibits third parties from “stirring up” others by financing possibly frivolous lawsuits, are on the wane in several states, the law remains strong in others. Practitioners looking to make use of litigation funding must be aware of the status of the champerty law in the applicable jurisdiction.

Conclusion

Third-party litigation funding is not only here to stay, but primed to expand. And bankruptcy professionals should routinely evaluate whether financing costly litigation could benefit their clients.

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Jonathan Friedland and Elizabeth Vandesteeg are partners with Sugar Felsenthal Grais & Hammer LLP. They represented GKC in its purchase of the $50 million stake in a bankruptcy estate's judgment discussed in this article.