Your points are well taken and I assume that you will post the contract language tomorrow.

I think it would be helpful to distinguish between the type of large scale securitization that you are addressing and a private transaction that might transfer a preferred interest in a portfolio. By using a privately negotated transaction with a sophisticated buyer, a funder could effectively leverage a portfolio but transferring a senior interest in the pool of recoveries in exchange for a fixed return. A transaction like that could be an excellent source of liquidity to the funding industry and offer a high and fairly dependable return to the counterparty.

For instance, the issuance of senior proceed rights with fixed returns (similar to senior bonds) would provide an opportunity for (relatively) lower-risk investments. Funds managing a portfolio of litigations would want access to some lower risk assets. As a default rule, the plaintiff should retain the residual interest, similar to common equities. Under this arrangement, the plaintiff retains the incentive to maximize return on the litigation, as all senior proceed-right holders would need to get paid off first. As a corollary to this arrangement, senior bond holders should only have passive control over the litigation; this probably provides an end-run around a lot of champerty issues. In jurisdictions where champerty is not a problem, plaintiffs could retain the senior interests and leave the residual interests to funders. The funders could gain control over the litigation. In this case, plaintiffs would receive a fixed return (so long as the total value of the senior interests was covered by the settlement award or litigation award) and the funders, holding the residual interest, would receive all the award over and above the total needed to compensate the fixed return, senior rights holders.

This arrangement could, hypothetically, allow for multiple classes of proceed rights (especially multiple classes of bond-like, fixed return proceed rights). Of course, this division potentially dis-aligns incentives for the various players on the plaintiff’s side: senior investors only need a certain settlement or award to cash in provide the expected return. However, as previously mentioned, those improper incentives can be ameliorated by leaving ultimate control in the hands of the residual-right holder (as a default rule). Finally, each class of proceed rights would have different discount rate, based on risk, and could therefore provide a broader set of investment opportunities for funders.

If the funder believes that the claimant may pose a bankruptcy risk in the future, the right to receive the proceeds of the claim could be transferred to a special purpose subsidiary which would issue the securities. That structure should serve to insulate the claim from the claimant’s creditors.

The security structure poses the tax question of whether it would convert all of the gain to capital gains which would be attractive. I wonder if anyone has some insight on that issue.

There may also be accounting advantages to the security structure because it is non-recourse so there should be no expense running through the claimant’s income statement.

Ed

The venture capital portfolio typically consists of many failures and a small number of very big winners. In a recent FastMoney article, Harvard Business School lecturerer Shikar Ghosh reports that 75% of venture backed companies do not return money to their investors based on a survey of more than 2000 venture backed companies. Our observation and the published results of the publically traded companies that finance large commercial litigation cases demonstrate that the percentage of sucessful outcomes on litigation investments is in the range of 75% to 80% of cases funded. Much higher than in the venture capital world. In addition, IMF’s results have clearly demonstrated that by monitoring the progress of the case and exercising withdrawal rights in those cases where adverse developments occur, the losses in those cases can be controlled. Specifically, as of June 30, 2012, IMF reported that out of 137 completed cases, 32 cases with adverse results and IMF withdrew from 27 of those cases with an average cost per withdrawn case of about $70,000. IMF only lost 5 of the 137 cases at trial.

Similarly, while venture investments have the potential to achieve Facebook sized valuations, the recoveries from litigation are typically bounded by the high and low end of a range of provable damages. In that sense the outcomes of litigation are relatively predictable.

At Themis, we manage the risk that the plaintiff will run out of funding by establishing budgets for each phase of the case and allocating portions of our aggregate funding commitment to each phase. Accordingly, if there is a cost overrun at the discovery stage, there is still funding allocated to, and available for, the pre-trial, trial and post-trial phases. We also require that the engagement letter between the plaintiff and its counsel addresses which party will bear the risk of cost overruns and how they will be financed as a condition to our financing.

Indeed, buyer’s remorse is a big concern. The model deals with it to some extent by setting a plaintiff minimum recovery, which is itself a percentage of the ultimate proceeds. The plaintiff’s minimum is designed to help with both buyer’s remorse and unconscionability. Even so, the model does not eliminate the risk because it tries to preserve the funder’s “expected value” of its “shares” via a type of anti-dilution provision that kicks in if the actual claim value proves much less than originally anticipated. As a result a funder can ultimately capture a much higher percentage of the proceeds than it purchased, limited only by the plaintiff’s minimum recovery.

The issue is more acute (I imagine) in the funding you do both because the plaintiffs are much less sophisticated/less able to assess risk and cost, are more likely to be emotionally vested because injury is involved, and may be more desperate for a certain recovery amount.

Thanks again for the thoughtful contributions.

Your observations on the preemptive rights issue are fair. There is no reason that a funder needs a preemptive right to preserve the percentage interest in the recovery represented by the purchased units. It is also fair to say the the claimant has little incentive to commit to give the incumbent funder a first refusal on future issuance. Such a preemptive right might discourage another funder from doing its due diligence to bid into the next round of funding.

The funder may, however, want to bargain for this right because 1) having made a significant iinvestment in due diligencing the case, the funder may want the first option to put additional money to work as the case progresses and 2) since funders often endeavor to influence the claimant’s strategic decisions along the way, the funder may prefer to preempt another funder with a different strategic perspective from getting involved with the case.

The preemptive right provision might be one to footnote into the model agreement as an alternative for the parties to consider.

Ed