Third-Party Litigation Funding (TPLF) and Ethical Issues In Bankruptcy

Investing in Litigation – The Bankruptcy Code and Third-Party Funding

TPLF may arise when investing in bankruptcy cases.

• Third-party litigation funding can be a pre-petition secured or unsecured creditor— the TPLF source funded litigation and thereby acquired property rights in litigation proceeds or otherwise.
• The TPLF source may be sought to finance post-petition litigation for a debtor in possession (DIP), trustee, or post-confirmation creditor’s trust.

Third-party litigation funding is a recent development in the US, and issues 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. Investing in bankruptcy raises developing legal situations, so this article likely raises more questions than it answers. That said, it is still important to consider them.

I. The “New Game In Town”

Many players are investing billions in litigation, with more to come. For example:

• Bentham IMF
• Burford Capital LLC
• GLS Capital
• Longford Capital Management LP
• Parabellum Capital
• Therium Group Holdings

Love it or hate it, third-party litigation funding is big business with the potential for huge upside. Is it the savior of underdog litigation for those without resources to protect and prosecute rights and claims? Or is it contingency financing on steroids? Either way, particularly in the bankruptcy arena, TPLF is primed for expansion. Debtors and investors must consider the ramifications.¹

II. Brief Historical Context

TPLF in the modern era originated in Australia in the 1990s but didn’t hit the United States until 2006. The underpinnings, the old English legal principles of “champerty” and “maintenance,” are not new.

Before you scramble for your 1968 edition of Black’s Law Dictionary, “Maintenance” is generally assisting another in litigating a lawsuit. “Champerty” is a form of maintenance — maintaining a lawsuit in exchange for a financial interest in settlement or judgment of the suit. Not truly capitalistic, old English law prohibited maintenance/champerty as encouraging potentially fraudulent or baseless litigation.

US states differ in permitting, limiting, or allowing such practices. Canada is outspoken against them.

Now, 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. Investors can fund firms with money secured by the borrower’s accounts receivable. So the victims have their day in court.²

The Financially Distressed Litigant

Combine the high cost of war-of-attrition litigation with financially strapped litigants — add material monetary benefits if the case is won.  Throw in new and inventive ways to finance such litigation. High risks balanced by high economic reward potential make such financing attractive to some. TPLF arises — an industry is spawned.

Where would one more easily find financially distressed litigants than in the bankruptcy arena? There, financially distressed litigants are as common as sick 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 US, before the arrival of TPLF, there were essentially two ways for the financially distressed litigant to prosecute claims:

1. The class action suit, where lawyers were paid a sizable portion of the recovery
2. In smaller matters, the straight contingency fee retention agreement

TPLF has added a new way for litigants to prosecute claims without lawyers taking financial risks. Understandably, lawyers will be keen to utilize this method of financing litigation. ³ Clients are also willing to explore TPLF when part of the recovery pays for a claim they cannot afford to fund. There are numerous TPLF issues related to bankruptcy.  Much depends upon the nature of the TPLF arrangement, specifically control over litigation strategy and related issues like settlements. ⁴, while the TPLF industry disseminates numerous articles refuting any need for additional regulation, scrutiny, or oversight.⁵

TPLF as Insider

If a TPLF is in place pre-filing, there is a possibility of an extremely close connection between sources:

•  Access to confidential information
• Control over the financed litigation
• Communications with counsel 
• Other similar dynamics 

Then, can the TPLF be considered a non-statutory insider, as someone in control of material aspects of the plaintiff? Certainly a possibility for parties looking to challenge a lien or claim of a TPLF in bankruptcy cases.⁶ One can understand why such control is needed to manage the “investment.” However, the ethical and legal overlay makes this particular investment, not the usual cookie-cutter deal to be managed.

Consider access to confidential information. Understandably, prudent third-party litigation funders will complete substantial due diligence before deciding to fund litigation. That involves the exchange of presumably non-public and possibly proprietary information.⁷ While non-disclosure and similar agreements would be common in such due diligence. Once the TPLF decides to fund, and in fact does, it undeniably has access to information and control that non-insiders would rarely be privy to.

Attorney-Client/Work Product Privilege

At least one court has held that a TPLF’s communications with counsel for the plaintiff are protected by attorney-client privilege and work product doctrine.⁸

There may be legal implications of insider status. If characterized as a non-statutory insider,⁹ there are legal implications such as potential subordination of claims, equitable disallowance, longer lookback periods for potential preferences, or increased scrutiny of transactions.

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 so the transferee takes it free of such status? This is a distinct possibility. In the 9th circuit, for example, a decision states that a claim of an insider, transferred to a non-insider, sheds its characteristic of an insider claim for plan voting purposes.^{10 11} Calls for regulation and disclosure related to TPLF claims would be important information in this situation.

Fiduciary Duty Issues

TPLF is an unconventional DIP financing or post-confirmation exit financing for litigation assets. Rather than being secured by tangible assets, though that is a possibility as well, it is secured by the proceeds of litigation being financed.

Judge Dennis Montali considered, in the Blue Earth situation, an issue with TPLF on a post-petition basis. 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.

The issue is that estate fiduciaries can never abandon their fiduciary duties. TPLF is an unregulated form of post-petition financing — in most cases, associated with huge potential costs. The TPLF’s control over subsequent funded litigation could be viewed as the delegation of the estate’s fiduciary duties.

“With Power Comes Responsibility”

When funded litigation takes an ugly turn and sanctions are assessed, who bears those? If the TPLF is controlling the litigation, should the TPLF source bear sanctions? While never specifically addressed yet in bankruptcy cases, such a situation has arisen in the UK — where TPLF is very common.¹² English courts held that the TPLF source was liable jointly and severally with the litigants. They would be liable for the costs of litigation on indemnity should the litigation not be successful and fees/costs awarded.¹³

Ethical Issues For Counsel

Commentators have noted that TPLF creates potential ethical issues. Issues for counsel proposing it to a client and for the counsel prosecuting the litigation being funded. Who is the client, and with whom does the duty lie?¹⁴

Sharing of Fees with Non-Lawyer Issues

Most states have ethical rules that prohibit lawyers and non-lawyers from sharing fees.¹⁵

Is there a potential conflict of interests between the plaintiff, the attorney, and the 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. But once that happens, who is the attorney’s master? Numerous Model Rules are implicated in the TPLF situation, including these:

• 2.1 requiring a lawyer to exercise independent judgment and render candid advice
• 5.4(c) prohibiting third-party direction of the lawyer
• 1.7(a)(2) prohibiting conflicts of interest
• 1.8(a) regulating the entry into business relationships between lawyers and clients
• 1.8(e) prohibiting financial assistance other than contingency fee arrangements
• 1.8(i) prohibiting lawyers from obtaining a proprietary interest in litigation, other than contingency fee arrangements, which rule has its roots in the prohibition against champerty and maintenance

Take a real-world look at how this plays out between the New York Bar and litigation funding industry. What about the Judge? Judges raise concerns about ethical duties of recusal and the need for TLPF disclosures, another wrinkle created by the third-party funding.¹⁶

Epicenter Partners

For a real-world example of the ethical issues of TPLF for litigation counsel, see the Epicenter Memorandum Decision. As outlined in the complaint, there were issues related to the acquisition of the TPLF proposed by counsel Simpson Thatcher Bartlett — ”STB.” There were issues around STB’s interaction with the TPLF after funding was in place. Judge Wanslee declined to grant a motion to dismiss claims against STB based upon, inter alia, serious ethical concerns about the counsel’s interaction with the TPLF. His interactions were alleged to be detrimental to the interests of the actual client.

Judge Wanslee determined that creditors who acquire insider claims are not automatically themselves insiders subject to defenses and other implications. But if the prior claim holder had been involved in “gross and egregious” conduct, such claims and defenses could arguably be asserted against the new claim holder.

Burford and STB were the two claim holders in Epicenter Partners. Those original claimants held first and second liens against estate assets, respectively. A purchaser, CPF Vaseo Associates (CPF), acquired both claims.¹⁷ The bankruptcy court dismissed claims related to Burford’s pre-petition conduct, and the court denied the motion to dismiss as to the pre-petition conduct of STB. The court found that whether or not STB breached its “ethical duties of loyalty, care and obedience, whose relationship with the client must be one of ‘utmost trust’ ” was a factual matter for trial (Epicenter Memorandum Decision at 24-25).

In other words, counsel guided negotiations with the TPLF that counsel recommended and then interacted with the TPLF. That created potential liability for counsel under ethical rules and under 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 report is aimed at lawyers advising clients about seeking TPLF, but does not intend, by its own scope, to deal with the many issues that may arise from TPLF.

Conclusion

TPLF is a financing mechanism in uncharted territory — contingency fee financing without the usual regulation. It is contingency fee financing in an arena on steroids. The arena is bigger and more aggressive, with the potential for huge returns, all with uncharted ethical constraints. As TPLF 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?

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• Commercial Litigation Funding 
• Legal Ethics: Bankruptcy Edition

This is an updated version of an article originally published on December 5, 2017, and previously updated on March 2, 2021. It was recently edited by Maryan Pelland]

©2022. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.

1. See McDonald, “A Rising Tide Lifting Seaworthy Boats In Litigation Finance,” Above The Law (August 15, 2017)
2. See, e.g. Lawsuit Funding, LLC v. Lessoff, Index No. 650757/2012, 2013 WL 6409971, at *6 (N.Y. Sup. Dec. 9, 2013) (litigation funding “allows lawsuits to be decided on their merits, and not based on which party has deeper pockets or stronger appetite for protracted litigation.”); Hamilton Capital VII, LLC, I v. Khorrami, LLP, No. 650791/2015, 2015 WL 4920281 at *5 (N.Y. Sup. Aug. 17, 2015) California is not as restrictive.  See, e.g. Del Webb Communities, Inc. v. Partington, 652 F.3d 1145, 1156 (9th Cir. 2011) (“‘Champerty’ generally refers to an agreement in which a person without interest in another’s litigation undertakes to carry on the litigation at his own expense, in whole or in part, in consideration of receiving, in the event of success, a part of the proceeds of the litigation.  […]  The consistent trend across the country is toward limiting, not expanding, champerty’s reach.”)  [Citations and internal quotation marks omitted.]; Abbott Ford, Inc. v. Superior Court, 43 Cal. 3d 858, 885 (1987) (“California… has never adopted the common law doctrines of champerty and maintenance.”); Pac. Gas & Elec. Co. v. Bear Stearns & Co., 50 Cal. 3d 1118, 1136, 791 P.2d 587 (1990) (“In fact we have no public policy against the funding of litigation by outsiders.  […] Our legal system is based on the idea that it is better for citizens to resolve their differences in court than to resort to self-help or force. It is repugnant to this basic philosophy to make it a tort to induce potentially meritorious litigation.”)
3. See, e.g. “Burford Clinches Portfolio Funding Deal With UK Law Firm”, Law 360 (July 31, 2017); “The Role Legal Finance Can Play In Firm Year-End Collections”, Law 360 (October 5, 2017).; “Using Litigation Finance: 12 Leading Lawyers Weigh In—Parts I and II”, www.BurfordCapital.com/blog/leading-lawyers-discuss-litigation-finance (October 3 and November 2, 2017).
4. See “Renewed Proposal To Amend Fed. R. Civ. P 26(a) (1) (A)” at pp. 2-7 (June 1, 2017), a letter from numerous groups to the Secretary of the Committee On Rules of Practice and Procedure of the United States Courts (hereinafter the “Chambers Letter”). The Chambers Letter was sent by the following groups: US. Chamber Institute for Legal Reform, the Advanced Medical Technology Association, the American Insurance Association, the American Tort Reform Association, the Association of Defense Trial Attorneys, DRI – The Voice of the Defense Bar, the Federation of Defense & Corporate Counsel, the Financial Services Roundtable, the Insurance Information Institute, the International Association of Defense Counsel, Lawyers for Civil Justice, the National Association of Mutual Insurance Companies, the National Association of Wholesaler-Distributors, the National Retail Federation, the Pharmaceutical Research and Manufacturers of America, the Product Liability Advisory Council, the Property Casualty Insurers Association of America, the Small Business & Entrepreneurship Council, the U.S. Chamber of Commerce, the Michigan Chamber of Commerce, the State Chamber of Oklahoma, the Pennsylvania Chamber of Business and Industry, the South Carolina Chamber of Commerce, the Virginia Chamber of Commerce, Wisconsin Manufacturers & Commerce, the Las Vegas Metro Chamber of Commerce, the Florida Justice Reform Institute, the Louisiana Lawsuit Abuse Watch, the South Carolina Civil Justice Coalition, and the Texas Civil Justice League.
5. 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.”).
6. According to the Chambers Letter, “Bentham’s own 2017 ‘best practices’ guide contemplates robust control by funders. Specifically, it notes the importance of setting forth specific terms in litigation funding agreements that address the extent to which the TPLF entity is permitted to ‘[m]anage a litigant’s litigation expenses’, ‘[r]eceive notice of and provide input on any settlement demand and/or offer, and any response’, and participate in settlement decisions.” Chambers Letter at 16-17. According to Bentham:  (1) the Chamber mischaracterizes Bentham’s Code of Best Practices; (2) Bentham’s Code does not provide that a funding agreement should give the funder control over the litigation or settlement, but only that a funding agreement should be clear about whether or not the funder has control over the litigation; and (3) Bentham’s funding agreement expressly provides that it does not have control over the litigation or settlement.  In any event, regardless of broad policies, extent of control will be a function of the actual TPLF agreement.
7. See, e.g. Shang, “The Future Of Litigation Finance Is Analytics”, Law360 (July 17, 2017) (discussing “the moneyball effect in litigation finance.”)
8. See In Re International Oil Trading Company, LLC, 548 B.R. 825 (Bankr. SD Fla. 2016) (litigation in which Burford was the TPLF); Innes, “Litigation Funding: Key Considerations”, Global Insolvency & Restructuring (March 21, 2017) (hereinafter “INSOL Article”)
9. The concept of non-statutory insider (as opposed to statutorily defined insiders) is accepted. See, e.g. In re The Village of Lakeridge, LLC. , 814 F.3rd 993 (9th Cir. 2016). See also “A Sui Generis Approach To ‘Insider’ Status In Bankruptcy”, Chapman Insights (February 18, 2016).
10. See In re The Village At Lakeridge, LLC, 814F.3rd 993 (9th Cir, 2016) (currently on appeal to the Supreme Court); Memorandum Decision Granting In Part And Denying In Part Defendant’s Motion To Dismiss Adversary Complaint dated June 2, 2017, Epicenter Adversary (hereinafter The “Epicenter Memorandum Decision”) (Bankr. D. AZ. Case No. 2:16-bk-05493-MCW) (Dkt. 77).
11. Judge Wanslee’s Epicenter Memorandum Decision held that a claim secured by estate assets by Burford sold pre-filing to a subsequent transferee, was “cleansed” by transfer to the non-insider, relying on Village of Lakeridge. The decision is interesting in that the creditor (CPF Vaseo Associates. LLC—”CPF”) purchased two claims (secured by first and second liens on the estate asset). The first was the Burford TPLF claim, in first position. The second was a claim of the prior litigation counsel (Simpson Thatcher Bartlett—”STB”) for unpaid legal fees, secured by a second lien on the assets. The Epicenter Adversary was filed to characterize the claims as insider claims, equitably subordinate and disallow the two secured claims held by CPF. The Court dismissed the claim seeking to characterize (and subordinate) the CPF claim related to the prior Burford TPLF claim, but did not do so as to the STB secured claim that essentially arose from the same pre-filing litigation, and also acquired by CPF. Arizona has no law related to ultimate enforceability of TPLF claims as violative of champerty/maintenance laws.  In re Enron Corp., 379 B.R. 425 (SDNY 2007) (holding transferee of insider claim may still be subject to equitable subordination type claims that could have been brought against the insider/transferor);  In re KB Toys, Inc., 470 B.R. 331 (Bankr. D. Del. 2012), aff’ed 736 F.3rd 247 (3rd Cir, 2013) (transferees take subject to claims/defenses assertable against transferor).
12. See Excaliber Ventures LLC v Texas Keystone Inc. & Ors (2014).
13. See INSOL Article.
14. See, e.g. Steinitz, “Whose Claim Is It Anyway? Third Party Litigation Financing”, 95 Minn. L. Rev. 1268, 1291-1292 (2011); Decker, “A Litigation Finance Ethics Primer, Above The Law (March 9, 2017) (an article interestingly sponsored by a TPLF, Lake Whillans).
15. See Chambers Letter at 13-15; Model Rules Of Prof’l Conduct, R. 5.4(a) (hereinafter “Model Rules”).
16. See, e.g.  Pribisich; Chambers Letter at 14-15.
17. See discussion in note 12, supra.