I recently spoke on a virtual roundtable organized by Bryan Cave Leighton Paisner on legal finance in the insolvency context, with a focus on how corporate trustees can recover value for creditors through an insolvent company’s litigation assets. The rise in bankruptcy litigation has led corporate trustees to explore all financing options. In turn, legal finance has become increasingly prevalent in the corporate trust industry.
Below are key takeaways.
Bankruptcy litigation is on the rise
Indenture trustees are increasingly called upon to bring more claims on behalf of noteholders. This has led to an increase in the use of legal finance to manage the associated litigation cost and risk.
Parties on all sides of bankruptcy litigation are becoming more aggressive in protecting their interests; the secured creditors are becoming more aggressive in locking up all available collateral and sponsors are increasingly siphoning off assets that should be available to pay off the creditors.
In recent years, following the infamous Caesars bankruptcy, the phenomenon of directors, officers and sponsors of insolvent entities engaging in systematic fraud to take assets out of the reach of bondholders has become more prevalent. It was alleged in Caesars that the sponsors protected their own financial interests by methodically siphoning off properties to other entities from the highly leveraged bankrupt company, to the detriment of all creditors (secured or unsecured). The emergence of several similar cases of largescale fraud has led to an increased interest in litigation addressing that trend.
Alongside the boom in bankruptcy litigation, noteholder concerns regarding litigation cost and expense have contributed to the increased use of legal finance.
How legal finance works in the bankruptcy context
A legal finance provider pays the legal fees and expenses necessary to bring a case. If the case ultimately settles or is adjudicated successfully, only then would the finance provider get its investment back plus some agreed upon entitlement. If the underlying case is not successful, the finance provider has no recourse to recoup its investment thereby bearing the risk of the underlying litigation. Although a relatively new industry—having grown largely out of the ashes of the last recession—legal finance has become much more prevalent in recent years.
Legal finance providers view investment opportunities on bankruptcy claims like any other litigation claim. A financier will analyze and diligence the merits, likely duration, counsel and potential damages of the claims.
There are certain type of claims arising from the bankruptcy context that lend themselves to financing better than others. For example, accusations against the lawyers and accountants of an insolvent entity involve a high hurdle of gross negligence in New York and similar jurisdictions and are therefore difficult to finance. Conversely, as was the case in Caesars, matters with allegations of systemic fraud, fraudulent conveyances and the like lend themselves extraordinarily well to litigation finance. However, there are any number of commercial claims that arise out of a bankruptcy and litigation finance investors will consider all of those claims, oftentimes as a basket or portfolio of multiple claims that the estate needs financed.
Legal finance is a business development tool for bankruptcy lawyers
Prior to the advent of legal finance, bankruptcy-related litigation would have been pursued either by using estate funds to finance hourly litigation with upfront cash or by engaging contingency counsel.
Legal finance now provides a clear third option that can be used in conjunction with contingency fees or without. Bankruptcy lawyers typically exist in large law firms, which have a historical hostility to contingent arrangements. Therefore, if the corporate trustee is forced to conduct the litigation on a pure contingency basis then it would exclude bankruptcy lawyers at traditional hourly fee firms from retaining that business.
By using third party capital, the corporate trustee can engage their counsel of choice without having to use a large portion of the estate funds to do so.
Investigating legal finance options is part of the role of a corporate trustee
The role of an indenture trustee in a distressed situation is to act as a prudent person would act in the conduct of their own affairs. This means trustees always have an obligation to defend their actions as being in the best interests of the noteholders. This also means they should explore all potential financing options for outstanding claims—including legal finance.
For example, securing counsel on a contingency basis may result in the noteholders having to give away up to 40% of the litigation proceeds. In high value claims, this often means that legal finance is cheaper than paying a law firm’s contingency fee rate.
From the corporate trustee’s perspective, engaging a legal finance provider also helps to demonstrate to the opposing counsel that the claim is well funded, they are prepared for the long haul and they are not going to be bullied into an early and cheap settlement.
Ultimately, corporate trustees in today’s world should at the very least consider legal finance when exploring causes of action as a means to recover value for their noteholders.