This post is drawn from the following article: Wendy Gerwick Couture, “Securities Regulation of Alternative Litigation Finance,” Securities Regulation Law Journal (forthcoming). To download the full article, please click here.
Maya Steinitz and Abigail Field make the compelling case in “A Model Litigation Finance Contract,” forthcoming in the Iowa Law Review and available for download here, that the future of litigation finance lies in claimants’ issuance of securities (in the form of Litigation Proceed Rights) to funders. One anticipated criticism of Steinitz and Field’s approach is that securities regulation might impede the development of litigation finance. This criticism ignores, however, that litigation finance contracts in their current iteration are also arguably securities within the scope of the securities laws. In this post, I analyze this more immediate question of whether a litigation finance contract, as entered into between a claimant and a funder in the current marketplace, is a security and thus subject to securities regulation.
The most likely suspect is the “investment contract,” which serves as a catch-all category of security and brings a variety of novel instruments within the reach of the securities laws. As defined by the Supreme Court in S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946), and progeny, an investment contract contains four elements: (1) an investment of money; (2) the expectation of profits; (3) solely from the efforts of the promoter or a third party; and (4) a common enterprise. Funders who invest in litigation finance undoubtedly satisfy the first two elements, but latter two elements merit further analysis.
In the current market, funders are probably sufficiently passive to satisfy the “solely from the efforts of the promoter or a third party” element. The circuit courts have unanimously declined to treat the word “solely” literally, instead merely requiring that “the efforts made by those other than the investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Funders have the incentive to exercise control over the litigation in order to protect their investments, and such control by experienced funders might even add value. Most funders expressly disclaim any control over the litigation, however, likely out of fear that their control would interfere with the claimant’s attorney’s independent professional judgment and force the attorney to withdraw. Therefore, most funders currently do not exercise significant control over the litigation, and the efforts of the plaintiff’s attorney, as the agent of the plaintiff, are the “undeniably significant ones.”
The relationship between a funder and a claimant probably satisfies the “common enterprise” element in those jurisdictions that apply a vertical commonality test. The circuit courts are split on the definition of “common enterprise,” with various circuits adopting a horizontal commonality test, a broad vertical commonality test, and/or a narrow vertical commonality test. Horizontal commonality requires that investors’ fortunes be pooled, and thus, in the current market, where the funder is ordinarily a single litigation finance company, the horizontal commonality test would fail. Vertical commonality, on the other hand, centers on the relationship between the investor and the promoter, rather than the relationship among investors. Broad vertical commonality requires that the investor’s fortunes depend on the promoter’s efforts, and narrow vertical commonality requires that the investor’s fortunes be intertwined with those of the promoter. Litigation finance contracts probably satisfy both versions of vertical commonality because the passive funder’s fortunes depend on the plaintiff’s attorney’s efforts and because the funder’s fortunes are intertwined with those of the claimant.
In sum, litigation finance contracts in their current iteration arguably satisfy the elements of an “investment contract,” thus qualifying as securities under federal law, with one caveat. The Supreme Court in Marine Bank v. Weaver, 455 U.S. 551, 556 (1982), declined to treat an agreement that arguably satisfied the Howey test as a security because the instrument did not need the protection of the securities laws. Therefore, before concluding that litigation finance contracts, even in their current iteration, are securities, I must consider whether they implicate the policies underlying the securities laws. For a discussion of this issue, see my next post, titled “Does Litigation Finance Implicate the Policies Underlying the Securities Laws?”