Third-party litigation funding (“TPLF”) is, beyond a doubt, here to stay. In bankruptcy cases, TPLF arises in a number of contexts. First is the TPLF as a pre-petition secured or unsecured creditor—i.e., the TPLF source funded litigation and thereby acquired property rights in litigation proceeds or perhaps otherwise as a result.
Second, in a postpetition context, the TPLF source may be sought to finance post-petition litigation for a debtor in possession (“DIP”), trustee or post-confirmation creditors trust. It is a relatively new development in the US and creates numerous issues that are developing in real time.
The focus of this article is the concept of ethical and fiduciary obligation issues that arise from TPLF situations in the bankruptcy context. As these are developing legal and practical situations, this article likely raises more questions than it answers. That said, it is still important to consider them.
Numerous players have entered into the TPLF marketplace, investing billions in litigation with only more to come. For example:
How lucrative is this area? Burford reported $378 million new investments in TPLF in 2016 (up 83%), with total investments in TPLF totaling more than $2 billion. Burford (publicly traded) announced a 75% increase in profits-after-tax for 2016 compared to 2015, and $216 million in cash from investment returns in 2016 (48% increase over 2015). The profitability of the TPLF investments means more players will find new avenues to invest in litigation, putting more eyes on their investments and as a result, the judicial system. With soaring profits, investing in bankruptcy litigation seems to be here to stay, but for every action there is an equal and opposite reaction.
Love it or hate it, it’s big business with the potential for huge upside. Whether it’s the savior of underdog litigation for those without resources to protect and prosecute rights and claims, or contingency financing on steroids, it is here to stay as a practical matter, particularly in the bankruptcy arena. 1
Moreover, the issues identified herein, by no means exclusive, represent real time issues and developments in the law, and are presented in no particular order of priority. As publicized by Burford: “The only limits are your imagination!” But as the litigation investment continues to expand, so do the concerns debtors and investors must consider.
While TPLF is a relatively new concept in the U.S. (originating in Australia about 10 years or so ago), it is something whose underpinnings are not a new concept—the old English legal principles of “champerty” and “maintenance”.
Before you scramble for your 1968 edition of Black’s Law Dictionary, here’s the gist: “Maintenance” is essentially “generally assisting another in litigating a lawsuit”, and “Champerty” is a form of maintenance, and is maintaining a lawsuit in exchange for a financial interest in settlement or judgment of the suit.
Not being true capitalists, old English law prohibited maintenance/champerty because they encouraged potentially fraudulent/baseless litigation. While such prohibition had its roots in old English common/statutory law, in the US states differ in their limitations and allowance, while our neighbor Canada is outspoken against it.
The foregoing notwithstanding, courts have recognized the social benefit of TPLF while noting the need to be mindful of its expansion and impact. Modern litigation is expensive, and deep pocketed wrongdoers can deter lawsuits from being filed if a plaintiff has no means of financing her or his case. Permitting investors to fund firms by lending money secured by the firm’s accounts receivable helps provide victims their day in court.2
Combine the high cost of war of attrition litigation (which may have material monetary benefits if won) with financially strapped litigants, and new and inventive ways to finance such litigation with its high risks, and high possible economic reward for those willing to do such risky financing, and TPLF arises (and an industry is spawned). And where best to find financially distressed litigants than the bankruptcy arena, where finding financially distressed litigants is as common as finding ill people in a hospital! Not only is it common, but it may be incredibly beneficial to overcome problems with dismissals that skip priorities.
In the U.S., before the arrival of TPLF, there were essentially two ways for the financially distressed litigant to prosecute claims—the class action suit where lawyers were paid a sizeable portion of the recovery, or in smaller matters, the straight contingency fee retention agreement. TPLF has added a new way whereby the litigant can prosecute claims where the lawyers are not taking the financial risk. Understandable, lawyers will be keen to utilize this method of financing litigation3, and clients (who already, by necessity, are giving away part of the recovery as the cost of pursuing a claim they cannot afford to fund) are also willing to explore TPLF.
While there are numerous issues related to bankruptcy realm TPLF, presented for the reader’s consideration is the issue surrounding ethical/fiduciary obligations of lawyers and bankruptcy estates when utilizing TPLF. Depending upon the nature of the TPLF arrangement (specifically the issues of control over litigation strategy and related issues, such as settlements), participants in this brave new world need to be mindful of the ethical and fiduciary duties owed by counsel and estate fiduciaries when working with TPLF sources in bankruptcy litigation. Not surprisingly, some industry groups are calling for increased disclosure of TPLF relationships in litigation4, while the TPLF industry disseminates numerous articles and related pieces refuting any such need for such additional regulation, scrutiny or oversight.5
In a situation where a TPLF is in place pre-filing, and given the possibility of extreme close connection between the TPLF source (access to confidential information, control over the financed litigation, communications with counsel, and similar dynamics), can the TPLF be considered a non-statutory insider as someone in control of material aspects of the plaintiff? This is certainly a possibility for parties looking to either challenge a lien or claim of a TPLF in bankruptcy cases6. It is understandable from the TPLF perspective why such control is needed (to manage the “investment”)—that said, the ethical and legal overlay makes this particular “investment” not the usual cookie cutter deal to be managed.
Access to confidential information: Understandably, prudent TPLF will do substantial due diligence before deciding to fund a litigation. That will involve the exchange of material, presumably non-public (and possibly proprietary) information.7. While non-disclosure and similar agreements would be common in such a due diligence process, once the TPLF decides to fund, and in fact does, it is undeniable it has access to information and control that the non-insider would rarely be privy to.
Legal implications of insider status: If characterized as a non-statutory insider9, there are legal implications such as potential subordination of claims, equitable disallowance, longer lookback periods for potential preferences, increased scrutiny of transactions, etc.
Can such status, if present, be “cleansed” through a transfer of the claim? If the pre-petition TPLF is an insider, can the claim be transferred such that the transferee takes it free of such status? This is a distinct possibility. In the 9th circuit, for example, there is a decision that states (in an analogous situation) that a claim of an insider, transferred to a non-insider, sheds its characteristic of an insider claim for plan voting purposes.10 11 The calls for regulation (and disclosure) related to TPLF claims would be important information related to TPLF claims in this regard.
TPLF is at its core an as yet unconventional DIP financing or post-confirmation exit financing for litigation assets—rather than being secured by tangible assets, though this is a possibility as well, it is “secured” by the proceeds of the litigation being financed.
Related to all of these issues, and as underscored by Judge Montali in the Blue Earth situation discussed above, an issue with TPLF on a post-petition basis is who controls the litigation and directs counsel once the TPLF is in place? DIP/Trustees are of course fiduciaries. The terms of certain TPLF agreements give control and discretion to the TPLF (perhaps understandably given the risky nature of the investment in uncertain and costly litigation).
Herein lies the issue in that estate fiduciaries can never abandon their fiduciary duties. Because TPLF is a relatively new, unregulated form of post-petition financing in most cases with huge potential costs associated with it, the TPLF’s control over the subsequent funded litigation could be viewed as a delegation of the estate’s fiduciary duties.
On a related note, to the extent the funded litigation takes an ugly turn, and sanctions are assessed, who bears those? If the TPLF is controlling the litigation, should the TPLF source also bear sanctions? While never specifically addressed as of yet in bankruptcy cases, such a situation has arisen in the UK (where TPLF is very common).12 (English court held the TPLF source was liable, jointly and severally with the litigants, for the costs of litigation on indemnity should the litigation not be successful and fees/costs were awarded).13
Finally, many commentators have noted that TPLF creates potential ethical issues for counsel proposing it to a client, as well as the counsel prosecuting the litigation that is being funded. Who is the “client”, and to whom does the duty lie? 14
Most states have ethical rules that prohibit the sharing of fees between lawyers and non-lawyers.15
Potential conflict of interests between plaintiff, attorney and TPLF source? The practical and economic pressure on counsel is real. Contentious litigation can be economically burdensome on counsel, and the prospect of TPLF that will result in cash flow to counsel is appealing to say the least. But once that happens, who is the attorney’s master? Numerous Model Rules are implicated in the TPLF situation, including rules:
You can also take a real world look at how this plays out between the New York Bar and litigation funding industry. But what about the Judge? Judges raise the concern of their ethical duties of recusal and need for TLPF disclosures, yet another wrinkle created by the third-party funding.16 TPLF makes this dynamic a bit murky.
For a real world example of the ethical issues attendant in TPLF for litigation counsel, see the Epicenter Memorandum Decision. As outlined in detail in the Epicenter Complaint, there were issues related to the acquisition of the TPLF proposed by counsel (Simpson Thatcher Bartlett—”STB”), and STB’s interaction with the TPLF after such funding was in place. Judge Wanslee declined to grant a motion to dismiss with respect to claims against STB based upon, inter alia, serious ethical concerns in the way counsel interacted with the TPLF (which was alleged to be in detriment to the interests of the actual client). While Judge Wanslee determined that the creditor who acquires insider claims are not automatically themselves insiders (and thereby subject to the defenses and other implications of that), if the prior claim holder had been involved in “gross and egregious” such claims and defenses could arguably be asserted against the new claimholder.
The two claimholders in Epicenter Partners were Burford and STB. Those original claimants held first and second liens against estate assets, respectively. A purchaser acquired both claims (CPF Vaseo Associates—”CPF”).17 The Bankruptcy Court dismissed the claims related to the Burford pre-petition conduct, but denied the motion to dismiss as to the pre-petition conduct of STB, finding it was a factual matter for trial whether STB breached its “ethical duties of loyalty, care and obedience, whose relationship with the client must be one of ‘utmost trust'”. Epicenter Memorandum Decision at 24-25. In other words, counsel’s actions in guiding the negotiations with the TPLF (that counsel recommended), and then interacting with the TPLF, created potential liability for counsel (under both ethical rules, and also the “gross and egregious” standards for equitable subordination under bankruptcy law).
According to an ABA Report: In February 2012, the ABA weighed in on the ethical issues inherent in TPLF (referred to as “alternative litigation finance”, or “ALF”) with respect to lawyers advising clients considering TPLF.
As set forth in the Executive Summary:
“The Informational Report should not be interpreted as suggesting that alternative litigation finance raises novel professional responsibilities, since many of the same issues discussed below may arise whenever a third party has a financial interest in the outcome of the client’s litigation.”
The ABA Report was the result of a working group whose purpose was limited in scope. Specifically:
“The Working Group was directed to limit its consideration to the duties of lawyers representing clients who are considering or have obtained funding from alternative litigation finance suppliers. It did not consider social policy or normative issues, such as the desirability of this form of financing, or empirical controversies, such as the systemic effects of litigation financing on settlements (except insofar as this has an impact on the ethical obligations of lawyers), or the effect that alternative litigation finance may have on the incidence of litigation generally, or unmeritorious (“frivolous”) lawsuits specifically. Nor did the Working Group consider legislative or regulatory responses to perceived problems associated with alternative litigation finance in the consumer sector, such as excessive finance charges or inadequate disclosure. However, to the extent a lawyer is representing a client and advising or negotiating with respect to an ALF transaction, the duties considered in this Informational Report are applicable.”
The ABA Report is aimed at lawyers advising clients on seeking out TPLF, but does not intend (by its own scope) to deal with the many issues that may arise from TPLF.
TPLF is in many respects a financing mechanism in uncharted territory—contingency fee financing without the usual regulation. It is, in the end, contingency fee financing in an arena on steroids—bigger, more aggressive, the potential for huge returns, all with uncharted ethical constraints. As it unfolds and evolves, the legal issues surrounding it will develop as well.
In the words of Guns N’ Roses: “Where do we go now?” Where do we go, indeed?
©All Rights Reserved. March, 2021. DailyDACTM, LLC
See, e.g. “Critics Pushing Back On 3rd Party Funding Disclosure Rule”, Law360 (June 21, 2017); Chock, Harrison and Pai, “Big Business Lobby Tries To Hobble Litigation Finance, Again”, Law360 (June 6, 2017) (“The Chamber raises several supposed concerns about litigation finance to justify its overbroad proposed rule, which is rather obviously meant to reveal a plaintiff’s ability to withstand protracted litigation.”). See also Letter of Bentham IMF in response to Chambers Letter dated September 6, 2017 (“The Chamber’s radical proposal to invade parties’ financial privacy and their attorneys’ work product is inconsistent with the underlying purpose of the federal rules “to secure the just, speedy, and inexpensive determination of every action.”… The Chamber attempts to tag litigation funding with “problems” that largely either do not exist, or are in truth benefits. “Frivolous litigation” is the Chamber’s principal whipping boy. Nothing suggests that litigation funding causes cases of little or no merit to be filed in federal court, or that the Chamber’s automatic disclosure proposal would head off such filings. Litigation funding in fact encourages careful assessment of litigation prospects and costs—the antithesis of “frivolous litigation”—and therefore discourages frivolous litigation and promotes fair settlements, both in theory and in practice… Litigation funding represents only one of many ongoing developments in the evolution of litigation and dispute resolution. These developments include increased reliance on technology to perform tasks that formerly only lawyers performed, increased use of private resources in resolving disputes, increased control of litigation by the parties themselves, and increased focus on the resource constraints for litigation. These developments are largely beneficial. The Chamber’s proposal is an ill-disguised attempt to thwart perhaps the most significant and salutary of them all, namely litigation funding, and we urge the committee to reject it.”).
Thomas Salerno is a bankruptcy attorney at Stinson LLP. He brings thirty-five years' experience to resolving complex issues in commercial corporate restructurings and recapitalizations, advising lenders, distressed companies, committees and acquirers of assets in both out of court restructurings and in bankruptcy cases.
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