Litigation Funding Contract Didn't Violate Ethics Rules

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By Samson Habte

Aug. 25 — A class action law firm can't invoke ethics rules to void a litigation funding agreement that gave a hedge fund a security interest in the firm's accounts receivable, the New York Supreme Court, New York County, held Aug. 17.

The ruling allows Hamilton Capital VII to go forward with a $12 million lawsuit seeking repayment of principal and interest and damages for unjust enrichment from the law firm, which was given a revolving line of credit under the parties' agreement.

Justice Shirley Werner Kornreich said defendant Shahin (Shawn) Khorrami and his law firm, Khorrami LLP, failed to show that the credit agreement—which allowed the firm to borrow $20 million in working capital from Hamilton—amounted to an improper fee-sharing agreement with a nonlawyer, in violation of New York Rule of Professional Conduct 5.4(a).

“[C]ourts have expressly permitted law firms to fund themselves in this manner,” Kornreich wrote.

The court also rejected Khorrami's argument that a security provision in the loan contract, which required the firm to pay Hamilton 10 percent of its gross revenues for three years after the loan's closing date, transformed the agreement into one that gave Hamilton an equity stake in the firm, in violation of Rule 5.4(d).

Congressional Interest

Kornreich's ruling is one of just a handful of court opinions that address the ethical propriety and enforceability of third-party litigation funding agreements. Such agreements, one expert has noted, are “very quickly becoming of particular concern … in mass tort and class action lawsuits,” the focus of Khorrami's California-based practice. See Thurbert Baker, Paying to Play: Inside the Ethics and Implications of Third-Party Litigation Funding, 23 Widener L.J. 229 (2013).

Just last month, one of the major players in the world of litigation funding, Burford Capital, was notified by the Senate Judiciary Committee that the committee is looking into “what impact the rapid expansion of third party litigation financing is having on our civil justice system.”

Committee Chairman Sen. Charles Grassley (R-Iowa) and Sen. John Cornyn (R-Tex.), chairman of the Constitution subcommittee, asked Burford to supply extensive information about its business, including what law firms it has financed, which cases, whether it has any referral agreements with law firms, how much Burford loaned and how much it got back on its investments in the last five years.

Rise and Fall

Khorrami LLP and Hamilton entered the agreement that gave rise to this action in 2009. The contract allowed the firm to borrow against a $7 million “revolving credit facility” to finance its cases. In addition to principal and interest, the firm agreed to pay Hamilton 10 percent of its gross revenues—later increased to 15 percent—for three years after the end of the loan.

Hamilton alleged that over six years Khorrami LLP borrowed just over $20 million against the credit facility and repaid $23.6 million, but still owed $6.28 million.

According to the complaint, although Khorrami LLP boasted on its website “that it has recovered more than $2.5 billion” in litigation “against some of the country's largest companies,” the firm experienced “severe financial difficulties” and defaulted on its payments.

Hamilton sued for breach of contract, seeking $6.28 million in outstanding debt and $5.2 million for unjust enrichment.

The court subsequently placed the law firm in temporary receivership. On Aug. 26, California bar authorities filed a 19-count disciplinary complaint against Shawn Khorrami, alleging trust account violations, misappropriation and failure to respond to client inquiries.

Not New

The defendants filed a motion to dismiss Hamilton's lawsuit. They argued that the provision giving Hamilton an interest in Khorrami LLP's gross revenues, in addition to principal and interest payments, contravened Rule 5.4(a) and was thus “unenforceable as violative of public policy.”

Khorrami said that clause distinguished the contract from those that have withstood ethical challenges and been deemed enforceable in the few cases in which courts have considered the issue.

“[T]his financial arrangement is directly tying a nonlawyer’s profit to the successfulness of a legal business,” Khorrami's counsel said during oral argument. “It is essentially ownership,” he added.

Kornreich disagreed. “This is not an issue of first impression,” she said in her opinion. “[T]he case law cited by defendants does not support the proposition that a credit facility secured by a law firm's accounts receivable constitutes impermissible fee sharing with a non-lawyer.”

Kornreich said the “most on point and persuasive” case supporting Hamilton was Lawsuit Funding, LLC v. Lessoff, 2013 BL 343470, No. 650757/2012 (N.Y. Sup. Ct. Dec. 4, 2013). That unpublished decision quoted PNC Bank v. Berg, No. 94C-09-208-WTQ (Del. Super. Ct. Jan. 31, 1997), which stated: “[T]here is no real ‘ethical' difference whether the security interest is in contract rights (fees not yet earned) or accounts receivable (fees earned) in so far as … [Rule 5.4] is concerned.”

The court also rejected Khorrami's argument that the agreement violated Rule 5.4(d) on nonlawyer stakes in law firms. That rule states that a lawyer may not practice in an entity if a nonlawyer “owns any interest therein” or “has the right to control the professional judgment” of the lawyer.

“Unless the credit agreement provides for equity (for instance, by issuing convertible bonds), the loan results in debt, not equity,” Kornreich said. “Under the Transaction Documents, Hamilton has no right to control any aspect of the Law Firm's cases.”

Kornreich said public policy considerations also militated in favor of upholding the financing agreement:

Providing law firms access to investment capital where the investors are effectively betting on the success of the firm promotes the sound public policy of making justice accessible to all, regardless of wealth. 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. This laudable goal would be undermined if the Credit Agreement were held to be unenforceable. The court will not do so.

‘Wild West.'

Lucian Pera, a partner in Adams and Reese LLP in Memphis, Tenn., who has represented a litigation funding company, told Bloomberg BNA he believes the court made the right decision.

Pera said he wasn't persuaded that Khorrami LLP's financing agreement was distinguishable from those upheld in other cases simply because it included a security provision that gave Hamilton an interest in the firm's revenues “that lived past the life of the loan.”

“Ownership means ownership,” Pera said, rejecting the notion that the clause gave Hamilton an equity stake in Khorrami LLP.

While most cases addressing the enforceability of litigation financing agreements have involved loans secured by an interest in anticipated recoveries from specific cases, Pera said the black letter of Rule 5.4 doesn't provide much support for arguments to invalidate agreements that are tied to a firm's general revenue.

Pera also said the litigation financing industry is evolving, and that third-party funders are increasingly willing to bet on firms rather than specific cases.

“Lenders are doing very different things,” he said. “It is still somewhat of a Wild West.”

Steven J. Shore of Ganfer & Shore LLP, New York, represented Hamilton Capital. Perry S. Fallick of Morelli Ratner Law Firm, New York, represented Khorrami and Khorrami LLP.

To contact the reporter on this story: Samson Habte in Washington at shabte@bna.com

To contact the editor responsible for this story: Kirk Swanson at kswanson@bna.com

Full text at http://www.bloomberglaw.com/public/document/Hamilton_Capital_VII_LLC_v_Khorrami_LLP_No_6507912015_2015_BL_265.

The complaint in this case is available at http://op.bna.com/mopc.nsf/r?Open=kswn-a22nh3

The credit agreement is at http://op.bna.com/mopc.nsf/r?Open=kswn-a22s96

Khorrami's motion to dismiss is at http://op.bna.com/mopc.nsf/r?Open=kswn-a22njw

Hamilton's opposition to the motion to dismiss is at http://op.bna.com/mopc.nsf/r?Open=kswn-a22nkj

Transcript of the oral argument is at http://op.bna.com/mopc.nsf/r?Open=kswn-a22nkx

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