Can Litigation Funding Thrive on Bankruptcy?

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By Stephanie Cumings

Aug. 19 — Litigation financing has been gaining popularity in the U.S. in recent years, and a new venture is hoping that momentum will carry over into the field of bankruptcy. Burford Capital, one of the country's biggest providers of litigation funding, has teamed up with Chilmark Partners, a bankruptcy and restructuring firm, to create Bankruptcy Litigation Funding LLC.

The joint venture, which was launched in July 2015, intends to “provide financing services for claims brought in connection with US bankruptcies, including providing funding and advisory services to litigation trusts,” according to the company's website.

The current way in which these litigation trust operate creates inefficiencies and a “misalignment of interests” financiers hope to capitalize on, industry insiders told Bloomberg BNA.

“We look forward to transforming this market—just as we have transformed other areas of litigation,” Burford’s Chief Investment Officer Jonathan Molot said in a July 28 press release. Molot is co-chairing the venture along with Chilmark’s Managing General Partner David Schulte.

Litigation financing involves the funding of lawsuits by a party otherwise unrelated to the case in exchange for a share of the proceeds.

The practice has flourished in the U.S. in some areas of law, like individual tort claims and commercial claims for damages, while it has stagnated in others, like class action litigation. But Schulte and Molot are betting that bankruptcy will be a good fit.

Rise of Litigation Financing

“The legal funding industry began circa 1997, with a few small companies providing legal funding to plaintiffs with personal injury claims,” according to the American Legal Finance Association's (ALFA) website.

“Over the past ten years, a number of larger, well-capitalized companies formed, and developed more robust underwriting standards which provided the ability to offer lower pricing to the consumer.”

ALFA—comprised of 31 legal funding companies—seeks to establishing “industry standards” in and “increasing awareness” of the legal funding industry.

Litigation financing has become increasingly popular among bigger corporations and law firms. Burford, which focuses on funding large-scale commercial litigation, has experienced both high-profile success and failure in this arena, but overall their investments are paying off.

For the first half of 2015, the company reported that operating profits were up 56 percent to $28.4 million and income was up 48 percent to $40.6 million. The company also reported that this period “saw Burford’s largest recovery to date—$61 million in gross proceeds on a $25 million investment.”

Several big name law firms, including Simpson Thacher & Bartlett, King & Spalding, and Latham & Watkins, have been involved in Burford-financed cases.

Financing for Litigation Trusts

One of Bankruptcy Litigation Funding's main goals is to provide outside financing to bankruptcy litigation trusts.

Litigation trusts are vehicles created by a debtor's bankruptcy plan to pursue causes of action that belong to the debtor's estate for the benefit of creditors. These trusts are a “relatively new creature, [but] they are becoming more common as a category of litigants because their sole purpose is to pursue litigation and their activities are generally funded by an initial cash allocation from the bankruptcy estate,” according to the American Bar Association's website.

Chilmark's Schulte claims that the current model for litigation by these trusts creates a “misalignment of interests.” Schulte told Bloomberg BNA in an interview Aug. 11 that trustees and lawyers for litigation trusts usually benefit from protracted litigation in the form of professional fees, to the detriment of creditors.

Schulte said litigation trusts are typically allocated between $5 million and $50 million dollars from the bankruptcy estate to fund the litigation, and trustees and lawyers have no incentive to spend less than what they've been given.

So they're more inclined to “swing for the fences because they're playing with house money,” he said.

‘Skin in the Game.'

Schulte also noted that these trusts don't usually report publicly, only to their beneficiaries, making them a “dusty corner” of the legal world. He said that many practitioners are “appalled” by the inefficiency of these trusts.

“The system will work better if creditor interests are more closely aligned with the conduct of post-confirmation litigation,” Schulte said in the July 28 press release. “We intend to fill that void by bringing capital and quality management to the process.”

“By providing outside financing to litigation trusts, Bankruptcy Litigation Funding will obviate the need for the bankruptcy estate to fund the trust, leading to greater cash recoveries for creditors upon confirmation,” the company's website states.

“By virtue of having ‘skin in the game', everyone’s interests will be aligned with those of the trust beneficiaries.”

Potential to Catch On

“I think it has the potential to really catch on for two main reasons,” James L. Bromley, the leader of Cleary Gottlieb's restructuring and insolvency practice in New York, told Bloomberg BNA Aug. 19. Bromley said that because litigation trusts have been around for years and require ample resources, there is “both precedent and inventory” to support the company's goals.

“Second, the question of how to finance these litigation claims post-emergence can be a dicey one,” Bromley said.

“Retaining distributions from creditors to pay lawyers is one method. Hiring law firms with contingency arrangements is another,” he said.

“Either way, the question of funding such litigation claims has caused and continues to cause problems. Providing a third legitimate option in the form of litigation funding strikes me as a terrific idea.”

‘There Might Be Value Here.'

“Applying Burford's model to bankruptcy cases could make sense,” Richard Levin, a member of the bankruptcy, workout and corporate reorganization practice at Jenner & Block, New York, told Bloomberg BNA in an Aug. 11 interview. Levin is also the Chair of the National Bankruptcy Conferece.

Levin said that Burford's model could act as a substitute for contingency counsel, like in cases where contingency isn't an available option. He noted that how much money a litigation trust receives from a bankruptcy estate to fund the litigation is “heavily negotiated and fought-over,” with the money usually coming from the secured creditors' collateral.

“In those circumstances, if there is this independent source of funding that can be considered, pursued, analyzed, and agreed upon during the case, it could obviate the need for the litigation trust funding from the secured lender's collateral to facilitate the exit from bankruptcy,” Levin said. “You can see that there might be value here.”

Levin added that he's not sure what the benefit of third party litigation funding would be if contingency counsel was a viable option.

Comparisons to Claims Trading

“Litigation financing is a trend that will accelerate just like claims trading has in the last decade,” Dan Dooley, CEO of MorrisAnderson, told Bloomberg BNA Aug. 5. MorrisAnderson is a financial and operational consulting company that often works with distressed companies. Dooley is also a board member at the American Bankruptcy Institute.

Dooley said that bankruptcy litigation has “significantly increased in the last few years for a variety of reasons,” including the fact that “hedge funds are a much larger investor group today in distressed companies and are much more litigious by nature than other investors.”

“That being said, hedge funds providing financing for bankruptcy litigation is nothing more than a variation on claims trading,” Dooley said. “An investor puts up cash to buy or fund a claim or potential claim in exchange for what the investor sees as a large payout down the road. Creditors who hold the claim generally believe they will see a relatively small recovery percentage, but most importantly they don't anticipate getting cash out of that claim for years. The creditors are willing to take a heavily discounted bird in the hand today versus two in the bush with a much higher recovery with a multi-year wait and the uncertainty and frustration of a process where they have virtually no control.”

Dooley added that “many bankrupt estates have little cash and it takes some cash to pursue complicated litigation even using a contingency law firm due to needed experts and other litigation costs.”

Response to Criticisms

But the practice of litigation financing is not without its detractors. Few critics have been as vocal in their opposition to litigation financing as the U.S. Chamber of Commerce’s Institute for Legal Reform.

“Third party financing is problematic in bankruptcy for the same reasons it is problematic in other litigation: it encourages abusive litigation by removing risk, hands the reins of decision-making to the funders, and takes a large chunk of the proceeds, in this case from creditors,” Lisa Rickard, the group's president, told Bloomberg BNA Aug. 12.

“This multi-billion dollar industry is unregulated in any corner of the world, and federal rules in the U.S. should require it to be transparent. We continue working to build support in Congress for introducing a bill to bring this activity out of the shadows,” she said.

The claim that litigation funding leads to an increase in frivolous litigation is a typical criticism of the industry. But Schulte says that the new venture won't create more litigation, it will merely make the litigation trusts that are already being created pursue their claims more efficiently.

A spokesperson for Burford added: “Backing frivolous lawsuits—whether related to a bankruptcy or any other commercial claim—is not good business. Burford is exposed to the economic risk of a case not settling, and to the possibility that a case will not prevail at trial. So we back only those cases that we believe will be meritorious at trial.”

Conflicts of Interest?

The Institute for Legal Reform's website also claims that litigation financing creates “numerous ethical conflicts, starting with the fact that funders have no ethical obligations to safeguard the interests of the claimants.”

“Significantly, it is a fundamental rule of ethics that lawyers have a fiduciary duty to their clients,” the website states. “But when [litigation financing] investors get involved in a case, they often front the fees of the claimants’ lawyer. In that case, will the lawyer act in the best interests of their client, as they are supposed to do, or in the interests of the third party funder paying the legal fees?”

But Schulte argues that Burford's new venture, rather than creating conflicts of interest, will actually correct a misalignment of interests that already exists for litigation trusts.

One of the goals of the venture is to “[a]lign the process with the interests of creditors—creating an incentive for efficient and timely resolution, and for better selection and evaluation of meritorious claims and the best lawyers to assert them,” according to the company's website.

Regulation and Lack Thereof

The legal financing industry remains largely unregulated.

The American Bar Association released a report in 2012 examining the practice of litigation financing and outlining some of its risks, but it didn't suggest that the practice should be curtailed, nor did it call specifically for more regulation.

ALFA entered into a voluntary agreement with the Attorney General of New York State in 2005 to regulate the conduct of the legal funding industry within that state.

Professor Terrence Cain of the University of Arkansas at Little Rock William H. Bowen School of Law told Bloomberg BNA Aug. 17 that Maine, Nebraska, Ohio and Oklahoma are currently the only states to regulate litigation funding by statute.

“The federal government does not regulate [litigation finance companies] at all, thus, in forty-five states and the District of Columbia, there is no oversight of [litigation finance companies],” Cain said.

Cain suggested that either the Consumer Financial Protection Bureau or the Federal Trade Commission could be well-suited to regulate litigation funding, but both agencies would likely only regulate litigation funding in the context of consumer borrowers as opposed to commercial clients.

Cain added that although bankruptcy is not his area of expertise, he was sure that Burford “would not fund bankruptcy cases unless the profit potential from those cases is in the tens of millions.”

“Simply put, Burford Capital would not enter into the bankruptcy litigation finance market unless it was certain that it could be as successful in that arena as it has in funding large scale commercial litigation and international arbitration,” Cain said.

To contact the reporter on this story: Stephanie Cumings in Washington at sacree@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com