Bloomberg Law: Litigation Finance in Corporate Bankruptcy

May 8, 2020

Overview, May 2020
David Kerstein and Wendie Childress
Reprinted with permission from Bloomberg Law Litigation Finance in Focus

Litigation can be essential to corporate restructurings or liquidation proceedings. However, the capital available to claim holders in the context of a corporate bankruptcy has traditionally been limited, offered on unfavorable terms, or both. Litigation finance provides an alternative way for debtors, trustees, creditors and creditors’ committees to finance their claims.

Litigation in Bankruptcy

In corporate bankruptcy, litigation can be a central mechanism for recovering assets, maximizing the value of the estate, and determining the distribution of assets among competing stakeholders. Litigation can include the pursuit of valuable claims that originated prior to or during the bankruptcy, and claims related to the restructuring or liquidation process, such as preference litigation.

A lack of adequate capital hinders a claim holder's ability to fully litigate claims, and can force the claimant to settle for less than a claim is worth—sometimes far less—rather than face a protracted and uncertain court battle. Litigating against a deep-pocketed defendant who can afford to wage a war of attrition only amplifies the pressure to settle.

Being short on cash also restricts a trustee or claim holder's choice of counsel and the amount of any recovery she will be able to retain for the estate. She may find herself obliged to select counsel from among firms willing and able to take cases on contingency, which may not include her first-choice lawyers. A cash- strapped claim holder will also have less negotiating power with respect to the fee structure, forcing her to surrender more of any eventual recovery than she would like.

Litigation Finance in Bankruptcy Proceedings

Litigation finance is available for virtually any type of commercial case that may arise during the course of a corporate bankruptcy. In a litigation finance transaction, a funder provides non-recourse capital to litigate a case or set of cases and takes a pre-negotiated return from any settlement or damages award—usually calculated as a multiple of the amount invested or as a percentage of the eventual recovery.

Court Approval

Depending on the stakeholder and the stage of litigation, court approval may be required. For example, if a funder is entering the picture before plan confirmation, the stakeholder would likely need court approval (and should try to get buy-in from the debtor and other stakeholders if possible). However, it's possible for litigation claims to be sent into litigation or liquidation trusts, and for the trust instrument to be drafted in such a way to allow the trustee, perhaps with the consent or approval of a board of overseers, to enter into a litigation funding agreement without court approval.

If court approval is necessary, what is required to be disclosed to the court also varies. In some cases, the entire proposed term sheet or funding agreement must be disclosed. Other times, redacted versions will suffice. In still other cases, a summary of the key terms may be all that is necessary.

Advantages of Litigation Finance

From the perspective of a claim holder in bankruptcy, litigation funding offers advantages over other sources of financing.

First, and perhaps most importantly, because the capital provided is non-recourse, the claim holder can litigate without spending its own cash or putting its other assets at risk. The prospective settlement or damages award acts as collateral for the funder's investment. If the case loses or otherwise fails to meet the agreed-upon success metrics, there is no repayment obligation. This can be a significant advantage over other types of finance, which require ongoing payments during the bankruptcy or even after the process has concluded—regardless of whether the case has yielded a recovery.

Second, the capital gives the claim holder the resources to pursue the optimal litigation strategy with the counsel it chooses, rather than with the counsel it can afford—as well as the flexibility to choose how to compensate lawyers and experts (i.e. on an hourly basis or with contingency arrangements.) A litigation finance transaction aligns the interests of the claim holder, counsel, and funder. Each is incentivized to maximize the recovery, which means the claim holder has the team and the funds to litigate meritorious claims to their full extent.

Litigation finance can also be a helpful source of “working capital” or funds to manage the estate. Although a funder's investment is based on its assessment of the litigation's likely outcome, the recipient is not always required to spend the money exclusively on the fees and costs related to litigation. In some cases, the money can be used for any legitimate business purpose, including, for example, paying costs related to administering the debtor's estate or to the debtor's ongoing business.

Claim Monetization

It may also be possible for a claim holder to monetize a significant portion of a judgment that is either on appeal or in an enforcement process, through negotiation with an individual funder or a public auction process. See Overview – Monetization of Claims. Meritorious legal claims against solvent defendants are financial assets. Monetization allows a claim holder to recognize the value of litigation assets, according to the claim holder's own needs and timing. Monetization provides immediate access to liquidity and de-risks the process of further litigation to uphold or collect on a judgement. As with other forms of litigation finance, monetization transactions are non-recourse—if the claim holder doesn't ultimately recover, the funder doesn't either.

Portfolio Finance

Litigation funding is available for single cases, but claim holders in the bankruptcy context, and trustees in particular, are often well-positioned to take advantage of the benefits of portfolio finance because in most instances they are dealing with a high volume of litigation.

A portfolio typically consists of at least three cases, but it can include up to several dozen or even several hundred claims. The funder conducts diligence on the cases in the proposed portfolio, although each funder approaches the process differently. Some may conduct diligence on each case, depending on the size of the proposed portfolio. Others may verify the basic information of the cases, but reserve more comprehensive diligence for the most valuable cases. The bottom line is that through diligence, the funder assesses the potential returns of the portfolio as a whole and provides capital based on that assessment. See Overview – Constructing a Portfolio.

Funding a portfolio has a number of advantages over single-case financing. First, the process of constructing a portfolio helps the trustee consider the holistic risk profile of the current and potential litigation in partnership with a funder who can provide an objective third-party assessment of likely outcomes.

Second, funding a portfolio rather than a single case provides access to a larger capital pool, allowing the recipient to reduce or even eliminate out-of-pocket legal costs, or to access a potentially significant amount of capital for needs related to estate administration or other business activities.

Third, portfolio finance can provide capital to pursue higher-risk, higher-reward litigation strategies in some circumstances, and can permit the funding of cases—including defense cases—that would be difficult to fund on an individual basis.

Finally, portfolio finance may offer a trustee or other claim holder more attractive financial terms than either single-case funding or contingency representation from a law firm. In both of the latter types of funding, the risk to the funder or firm is higher, which usually means the claim holder must surrender a higher proportion of any eventual settlement or damages award to compensate for the risk. By contrast, the number and volume of cases involved in a portfolio finance transaction lowers the overall risk of the investment for the funder. This is particularly true with portfolios that consist of diverse cases against different defendants, or based on different facts or legal theories. The risk-lowering effect of portfolio finance can save the funding recipient a significant amount of money as cases resolve, as compared to other sources of finance.

The Bottom Line

Litigation finance provides a new suite of financing options for corporate debtors. The solutions litigation funders offer can give claim holders—particularly trustees handling a lot of litigation—the resources and flexibility to fully litigate claims rather than being forced to accept low-ball settlement offers; to work with the counsel and experts of its choice; to accelerate payment in certain cases, thus controlling the timing of the estate's recognition of value; to de-risk litigation and collections; and to access significant working capital for the administration of the estate.