The COVID-19 pandemic thrust law firm bankruptcy practices into the spotlight, with high-profile corporate bankruptcies reaching levels not seen since 2010. For example, over the course of 2020, S&P Global Market Intelligence counted 630 bankruptcies of public companies with either assets or liabilities valued at $2 million, or private companies with public debt and at least $10 million in assets or liabilities. (There were 578 such bankruptcies in 2019.)
At the same time, the disruption coincided with the growth of utilization of litigation finance as a tool for financing litigation. Add a bankruptcy environment where traditional sources of financing by outside lenders, creditors, and law firms may be constrained, it is unsurprising that restructuring attorneys and advisors are increasingly turning to litigation finance.
Litigation finance can preserve or increase estate resources for creditors and enable additional recoveries. Financing can be useful for debtors (or potential debtors), but can also be useful for creditors in intercreditor disputes or other matters and especially useful for a litigation or liquidation trust seeking to prosecute ongoing claims. Fortunately, courts are recognizing that funding can play an appropriate role in bankruptcy proceedings, with two recent district court opinions leaving intact funding arrangements approved by the bankruptcy court.
Lake Whillans has expertise with litigation finance in a variety of distressed situations. Below we describe some of the most common scenarios.
Companies in distress that have significant litigation or litigation-related claims may look to litigation finance to free up, or even increase, cash reserves through financing the costs of prosecuting a claim or by monetizing some or all of a claim. Litigation finance can provide these companies the necessary runway to see through recovery of the business and the realization of litigation proceeds.
Many bankruptcy estates have options with respect to debtor-in-possession (“DIP”) financing from traditional lenders. But there may be instances where the estate’s most valuable assets are litigation claims — in that case it may make sense to discuss potential DIP financing with a commercial litigation funder. Crystallex, for example, secured this very type of financing (in its Canadian bankruptcy proceeding) from a litigation funder to prosecute a $3.4 billion claim against Venezuela for expropriation of a gold mine it had developed. The Canadian court approved the funding agreement finding that “there is a single ‘pot of gold’ asset which, if realized, will provide significantly more than required to repay the creditors.”
A federal district court in the Middle District of Florida recently rejected an appeal challenging the approval of a funding arrangement of this sort in Valley National Bank v. Warren. The chapter 11 liquidating trustee negotiated funding from a third-party to cover the costs of pursuing claims against a bank for aiding and abetting breach of fiduciary duty and for the avoidance and recovery of $3 million in fraudulent transfers. The bankruptcy court approved the arrangement finding that “the agreement best served the Debtors, creditors, and other parties” and that it is “neither champertous nor usurious.” The defendant bank objected to the arrangement arguing that the “financial interests” of the funder could impair settlement negotiations. In its April 2021 opinion, the district court held that the bank lacked Article III standing to appeal the Bankruptcy Court’s decision and failed the “person aggrieved” test that must be satisfied in order to appeal under the Bankruptcy Code.
In some bankruptcies, funding to pursue litigation claims has been provided by creditors to the estate. For example, in the National Events bankruptcy, a “litigation funding DIP” funded by creditors sought to investigate potential claims on behalf of the essentially defunct debtor. A related party also provided funding under DIP provisions in the Welded Construction bankruptcy, seeking to recover funds from a construction dispute. Styled as a litigation funding agreement, the arrangement also resolved some of the claims the funder had against the debtor due to its existing business relationship.
In Dean v. Seidel, a creditor of the bankruptcy estate agreed to advance up to $200,000 to chapter 7 trustee Seidel to fund the cost of litigation against third parties. As approved by the bankruptcy court in the Northern District of Texas in April 2021, the arrangement provided for the following split of any litigation proceeds: (1) pay the trustee’s statutory commission and allowed expenses; (2) reimburse the advancing creditor; (3) pay that creditor a 30% return on investment; (4) distribute the remainder to creditors. On appeal to the district court, debtor Dean challenged the funding arrangement as permitting one creditor to receive a disproportionate share of litigation proceeds relative to similarly situated creditors, in violation of the priority scheme of Bankruptcy Code Section 507. Dean further asserted that any litigation recovery must be “for the benefit of the estate.” The district court noted with some concern the lack of controlling case law regarding an agreement of this type, but applying a clear error standard of review, it affirmed the bankruptcy court. The Fifth Circuit affirmed the district court’s ruling on standing grounds.
In the preceding examples, related parties presumably provided funding because they had the most to gain from successful litigation. However, an unrelated litigation funder could instead have funded the claims in coordination with the debtor and creditors of the estate. Engaging a litigation funder could be appealing if related parties and creditors are unwilling or unable to provide additional funding. It is also possible that a litigation funder — specialized in assessing litigation risk — may be able to provide funds at the lowest cost of capital.
Sale of Litigation Assets
A bankruptcy estate can sell a stake in its litigation or litigation-related claims much in the same way that it sells other assets in its bankruptcy process.
Many companies hold litigation-related assets, for example, in large class actions, and these can be sold like a traditional asset in a bankruptcy. Numerous companies have sold claims in the Visa Mastercard class action (In re Payment Card Interchange) through bankruptcy asset sales. (See, for example, Shopko’s motion to sell its claim for $2.2 million during its bankruptcy process last year.)
Bankruptcy estates may also have more traditional litigation claims available for monetization during a bankruptcy process (including claims stemming from the bankruptcy itself). These claims are much harder for the estate to value and their continued prosecution often requires expense and resources of the bankrupt entity or its representatives. A bankruptcy estate may wish to sell or monetize a portion of its litigation claims to accelerate cash recoveries for the estate, reduce or offset estate expenses (including funding the litigation), and hedge its risk of loss in the litigation. The most significant example of this type of sale was the 2016 sale of a judgment resulting from a jury award in the Magcorp bankruptcy pending an appeal following an intensive bidding and auction process. A litigation funder paid $26.2 million to acquire a $50 million interest in the judgment, which allowed creditors to be paid sooner, off-load some risk of a loss on appeal and to fund the appeals process itself.
Litigation or liquidation trusts
Litigation trusts and liquidation trusts can also be prime candidates for litigation funding. The establishment of these trusts generally allows for the confirmation of a plan of reorganization while litigation claims that may take years to play out continue to progress. The litigation trusts typically benefit unsecured creditors who might otherwise end up with little or nothing from the bankruptcy. These trusts sometimes receive seed funding from the estate or from beneficiaries of the trust or rely on contingency arrangements with law firms, but because the assets they hold are litigation-related, and because funds expended on the fees or expenses of litigation might otherwise be returned to creditors if not used for litigation, these trusts make excellent candidates for litigation funding.
The General Motors Avoidance Action presents a prime example of how this funding can be used. The long-running dispute stemmed from the alleged improper repayment of GM’s term lenders during the automaker’s bankruptcy. This intercreditor dispute centered on whether the term lender’s security interest had been terminated prior to repayment and, if so, how much of the funds paid to the term lenders should have gone to other creditors. The action proceeded with $1.6 million in “seed” funding from the estate, but that amount and additional amounts provided by various funding sources, including the U.S. Department of Treasury and Export Development Canada and a private funder, were exhausted after lengthy litigation. Finally Lake Whillans (through an SPV) provided a $10 million facility in anticipation of trial. Eventually, the matter settled for $231 million, an amount that would certainly not have been possible without funding for the protracted and costly litigation that took nearly 10 years to resolve, and included a two-week representative trial that narrowed the issues between the parties.
To underscore how valuable this type of funding can be for a standalone litigation trust consider the Tropicana matter. After the casino operator went bankrupt in 2008, the estate eventually formed a litigation trust to pursue claims (backed largely by investor Carl Icahn) in an adversary proceeding against its former CEO. More than a decade later, those claims survived a summary judgment motion, which wouldn’t have been possible without an additional cash infusion from Icahn and other funders in 2016.
As more restructuring professionals become aware of bankruptcy and district court decisions approving litigation funding in distressed situations, we expect litigation finance will be used with increasing infrequency in the bankruptcy context. Litigation finance provides a creative tool for companies to consider as they plan for what may be long-running and cost-intensive litigation.
* * *
If practitioners have questions about employing litigation funding in a bankruptcy situation, Lake Whillans would be happy to discuss the particular circumstances of your case. We invite you to contact us.