Litigation Financing and the Securities Laws

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Eighteen years ago I urged that outside investors be allowed – indeed encouraged – to fund plaintiffs’ lawsuits in return for a percentage of the recovery. Litigation financing could provide plaintiffs with an alternative to contingent fee lawyers charging inflexible and sometimes excessive rates. Litigation financing could unbundle litigation financing and insurance, on the one hand, from legal services, on the other, bringing costs for both to competitive levels. Few such litigation funding arrangements, however, were available for plaintiffs, and lawyers perhaps predictably looked upon them with disfavor. See Litigating on a Contingency: A Monopoly of Champions or a Market for Champerty?, 70 Chicago-Kent Law Review 625-697 (1995) (Symposium on Fee Shifting).

Back then, the litigation financing industry was in its infancy and the principal worry was that common law prohibitions on champerty stood in the way to its success. Since then enormous strides have been made by litigation financing companies, plaintiffs’ lawyers who work with litigation finance companies and academics such as Maya Steinitz who study these financing arrangements. Common law prohibitions on champerty turned out to be a problem that most litigation finance companies could work around, and plaintiffs’ lawyers have figured out how to take advantage of the services of these companies. Indeed the relationship is sometimes too close, and the ABA is addressing conflicts of interest that arise when plaintiffs’ lawyers work with litigation insurers and sometimes recommend them to clients. See ABA 20/20 Commission, Issues Paper Concerning Lawyers Involvement in Alternative Litigation Financing (November 23, 2010).

Now, a critical question is how litigation finance companies can raise enough money to fund the vast amount of litigation that needs financing.

It is here that federal and state securities laws come into play. Litigation finance companies that raise money from outside investors must observe laws, including disclosure requirements, designed to protect their investors, while at the same time protecting interests, including confidentiality interests, of clients whose litigation is being financed.

There are several alternatives for a litigation finance company to consider.

First, the easiest option probably is to raise money privately. The advantage of private placements is that they are exempt from registration with the SEC under Section 3(b) or 4(2) of the 1933 Securities Act and/or SEC Regulation D. There is thus no fixed template for the disclosure package provided to investors. Disclosure can be as much, or as little, as the promoter wants, and investors will agree to accept. There is one very important caveat: the seller of the securities and anyone else involved in the offering process must tell the complete truth about the issuer and its securities. Disclosures must be completely accurate and once disclosures are made, other disclosures may need to be made in order for what was said not to be materially misleading. A litigation finance company that chooses to disclose statistical data about its recoveries and settlements in litigation, for example, cannot cherry pick the data and disclose only favorable results. Misleading statements in connection with the sale of any securities, including private placements, constitute securities fraud that is actionable both civilly and criminally under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5.

This “negotiable” disclosure regime for private placements allows litigation finance companies to balance disclosure needs of investors with confidentiality needs of clients. If disclosing information about strategy or settlement prospects could be harmful to litigation underlying a financing arrangement, investors could be persuaded that the disclosure is not necessary. Alternatively, the number of investors could be so few in number that the information could be disclosed to them privately, conditioned upon a promise of confidentiality (warning: attorney-client privileged communications and attorney work product should never be disclosed to investors or other outsiders, because these privileges could be waived as a result; indeed disclosure by litigants or their lawyers to the litigation finance company itself could constitute waiver of a privilege).

Congress in the Jumpstart our Business Startups (JOBS) Act of 2012 mandated that the SEC relax its rules on solicitation of investors in private placements. Whereas before the JOBS Act investors in Regulation D private placements could not be solicited (they had to ask to receive proposals for private placements), under the JOBS Act promoters and their bankers will be allowed to ask qualified investors – referred to as “accredited investors” – for an investment (the SEC is still finalizing many of its rules under the JOBS Act).

A second option is for litigation financing companies to use one of several exemptions from 1933 Act registration requirements that are available for public offerings. The JOBS Act has also expanded the options here significantly.

One new option is “crowd funding” — raising relatively small amounts of money from individual investors who are each limited in the amount they can invest. In sufficient number, a “big crowd” of such investors can contribute a lot of capital to an enterprise. Although the SEC has yet to promulgate the crowd funding rules mandated by the JOBS Act, this will be a very promising option for litigation financing firms that can reach a large number of investors, particularly people who might be motivated by their interest in, or ideological commitment to, a particular type of litigation.

For more on crowd funding see this article in Forbes.

Another option is a public offering under the SEC’s Regulation A, which previously only allowed offerings up to $5 million, but pursuant to the JOBS Act will now be available for offerings up to $50 million. Regulation A offerings require a filing of an offering circular with the SEC – and there are some detailed disclosure requirements, although not as much as for a registered offering.

Finally, there is the option of a full blown registered initial public offering (IPO) followed by other offerings if additional capital is required. These transactions do require a registration statement under the 1933 Act. Detailed disclosures are required concerning the issuer’s management, business operations, pending and threatened litigation, and other matters, and audited financial statements must be included with the registration statement. Registered offerings are expensive because of the required work of investment bankers, lawyers and accountants for due diligence and preparation of the registration statement. Finally, if there is an error in the registration statement, the issuer, the issuer’s directors and the underwriters, among others, can be sued not only under the securities fraud statutes, but under Section 11 of the 1933 Act. Under Section 11 the issuer is liable to investors for any misleading disclosures in the registration statement regardless of who was at fault, and the other defendants have to prove a due diligence defense in order to avoid liability.

Many litigation finance companies may choose to avoid a registered public offering of securities for a number of reasons, including concern that the required disclosures are inconsistent with a business plan built around some degree of confidentiality, as well as their potential exposure to Section 11 liability if disclosures in a registration statement are incorrect. On the other hand, litigation finance companies that have already tried and succeeded with private placements and various types of unregistered public offerings may find that they have a large number of shareholders to whom they must provide periodic disclosure (after enactment of the JOBS Act, companies with over 2000 shareholders must file annual and quarterly disclosure reports with the SEC). When these companies want to raise additional capital, they will not necessarily find the burdens associated with a 1933 Act registration statement to be so onerous that they want to pass up the opportunity to do a fully registered deal.

Most important, a litigation finance company that uses any method to raise capital from outside investors will want to make sure that its investors cannot later claim to have been misled about the profitability of the scheme, applicable legal constraints on litigation finance in the states where it does business, potentially troublesome conflicts of interest that the company may have with members of the bar, or anything else. Companies doing a registered offering will want to invest the time and effort to make absolutely sure the registration statement is accurate. Raising capital to fund plaintiffs’ litigation can be a good business plan, but missteps can quickly make new defendants out of the litigation finance company, its directors and anyone who helps it sell securities.


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