TPLF may arise when investing in bankruptcy cases.
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.
Many players are investing billions in litigation, with more to come. For example:
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
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
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:
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
If a TPLF is in place pre-filing, there is a possibility of an extremely close connection between sources:
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.
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.
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.
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
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
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:
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
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.
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?
[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):
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. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
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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