To avoid being steamrolled by an aggressive debtor, DIP lender or plan sponsor, unsecured creditors must be well represented and able to quickly respond to a fast-moving bankruptcy case. Early in the case, plan support agreements, also known as “lock up” agreements, unabated by creditor opposition may be used to circumvent the chapter 11 plan process with limited input and limited notice to the creditor body. Later in the case—after a section 363 sale for example—unsecured creditors must keep a careful eye on the debtor or trustee to make sure they are efficiently carrying out their fiduciary duties. Since unsecured creditor recoveries come from the unencumbered asset pool, these stakeholders are understandably concerned with the buildup of priority claims and, importantly, keenly interested in maximizing the value of all assets, including contingent assets like litigation claims.
Bentham IMF can partner with unsecured creditors throughout the bankruptcy process, providing bespoke financing solutions at every stage. To learn more about the benefits of litigation financing as a tool during the insolvency process, we spoke with Bentham’s Ken Epstein, who is responsible for leading the company’s investments in bankruptcy-related matters.
In general terms, how does litigation finance benefit unsecured creditors?
KE: When a bankruptcy filing occurs, unsecured creditors often find themselves on the outside looking in, trying to piece together the true story of what led to the demise of the bankrupt company. They push back, but usually from a defensive posture and with little leverage. Senior creditors are not inclined to look into past conduct, or in less obvious places for value, especially when their efforts only benefit junior creditors and may cause a delay in the plan process.
Litigation is a tool used to slow things down to allow time for unsecured creditors to unpack a complex situation. Later in the case or even post-confirmation, litigation can be critical to unsecured creditors’ ultimate recoveries. Money is often needed to investigate potential wrongdoing, develop the evidence to support case theories and litigate worthwhile claims. The incentives are not there for senior creditors to lead in this area, or for that matter, management.
The question is: How do you fund necessary litigation when the debtor or creditor body does not have sufficient resources, or does not wish to risk their fixed recoveries. Litigation financing is one way to get this done, either on its own, or in conjunction with contingency law firms.
How does a litigation funding strategy in a bankruptcy work, and how does this differ from a more typical funding arrangement in a non-bankruptcy context?
KE: Outside the bankruptcy context we provide individual case financing where we work side-by-side with lawyers willing take partial risk on a case. We also provide portfolio financing where it’s possible to bundle together and finance multiple cases. Portfolio deals are less risky to the funder, as the returns are cross collateralized by a group of cases. In the bankruptcy context, the same option exists for a debtor, a chapter 11 trustee, a post-confirmation trust or a creditors committee authorized to prosecute actions on behalf of the debtor. The party with multiple cases, or their advisors, uses their contingent returns to secure financing on better terms.
Can you provide an example of when a portfolio financing would be better for the client?
KE: In a typical contingency arrangement, the lawyers take a percentage of the litigation recoveries when a case is resolved, which can be 40% or higher. With a portfolio financing, a third-party capital provider can take a multiple of its deployed capital, leaving the rest of the litigation proceeds for the client. Depending on the size of the potential recoveries and percentages involved, paying back a multiple on deployed capital can be beneficial for the estate and the unsecured creditors.
Take for example a situation where a trustee has 5 claims to pursue, it will cost $5 million to prosecute them, and the recovery will be $100 million. Paying 40% contingency fee will leave $60 million in the estate. However, if the client pays a funder 3x its deployed capital amount, the estate gets to keep $85 million. In this example the lawyers receive their full hourly rate, the funder gets its contractual return, and the client gets to keep a higher percentage of the litigation recoveries.
What types of claims would you cross collateralize?
KE: Chapter 5 of the Bankruptcy Code and various state laws allow the debtor and/or its creditors to pursue and avoid pre-petition transfers that unfairly advantaged one creditor over another. In addition, an estate representative can pursue other claims or recovery actions to bring money into the estate, like when a dispute arises over insurance coverage or pre-petition tax payments are subject to recovery. A trustee might bring dozens of preferential transfer and fraudulent transfer claims in a given case. This bucket of claims can be used to cross-collateralize and fund other sources of recovery. Any of these could be eligible for litigation financing.
Are there other benefits for creditors?
KE: Litigation finance is non-recourse, so other trust or company assets are not at-risk when a litigation recovery is pursued. If the case succeeds, the creditors get the benefit of the funding. If the case fails, they owe nothing to the funder. Many people don’t realize or think of financing as a solution for existing litigation. For example, if a case is taking longer than anticipated, a corporate client needs working capital, the lawyers or financial advisors are deferring their fees and covering costs, and/or the parties are fatigued and wish to offload some of the financial burden, funding can be a good option.
How beneficial is it to have the funder evaluating these claims for investment?
KE: Litigation funders specialize in evaluating litigation and assessing litigation value. Stakeholders can benefit from this knowledge and take comfort that the claims being contemplated or pursued are likely to be meritorious if someone is willing to invest in them. At Bentham IMF, every Investment Manager is also a lawyer with significant legal experience, so an additional benefit, should it be of interest to the client and lawyer, is our ability to make recommendations about the case. We also have an extensive network of relationships so, should we be asked to do so, we can help identify strong consulting and testifying experts. Remember that we are aligned with the client and counsel in our cases. We benefit from a successful outcome and are incentivized to maximize the value of the litigation.
Do you see litigation funding becoming an even more common part of the bankruptcy process?
KE: Yes, absolutely. Litigation is a critical tool in bankruptcy. It’s used to settle disputes between debtors and their creditors, between and among creditors, and to aid the company in bringing value back into the estate. With much of the recovery work being done these days post-confirmation through a trust structure, creditors of all stripes will find litigation financing a useful option.
Do you have any additional advice for companies or firms?
KE: For bankruptcy practitioners, I suggest talking to a litigation funder early on, even before a bankruptcy case is commenced, if there is a litigation or prospect of litigation on the horizon. When drafting a plan of liquidation or reorganization, be explicit about the estate representative’s authority to engage a litigation funder. Must the estate representative get bankruptcy court approval, or is it sufficient that the post-confirmation debtor or trust governing body approve the transaction?