Securitization and Secondary Financing Under the Model Contract

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For the reasons in our essay on securitizing claims, the model contract draft prohibits securitization. However, as pointed out by Edward Reilly of Themis Capital in a comment to yesterday’s post, securitization poses unique issues not raised by arms length deals between funders and secondary investors. The model contract draft does not bar such secondary market deals the way it bars securitization. However, the model does restrict secondary financing. Specifically, the model restricts the transfer of Litigation Proceed Rights, and further requires plaintiff’s consent before the funder could provide a potential secondary funder with the information it would need to do due diligence. That latter restriction limits resales of the right to the value of some or all of a funder’s Litigation Proceed Rights that is short of an actual transfer of the rights.

We impose these restrictions because of the following concerns:

1. Protecting Privilege.

Secondary funders are likely to want to do due diligence on the claim; as a result, merely engaging in the negotiations for secondary funding can create privilege waiver, even if the primary funder has been found to have a sufficient common legal interest to preserve privilege. Reinsurers, under NY law, do not automatically have a common legal interest with insurers and their insured, and to our view secondary funders in the litigation finance context are akin to reinsurers.

2. Protecting the Plaintiff’s Control of its Claim and Confidential Business Information.

If secondary funders wish to do due diligence on the claim, be informed about the progress of the claim, or be active in the claim, all of which would require access to the plaintiff’s and Claim’s sensitive information, the Plaintiff should know who the secondary funders are before they gain that informational access and have the ability to say no ahead of time. Due to the significant conflicts of interest in litigation finance, Plaintiffs cannot rely on funders to protect plaintiffs’ interests in their secondary financing deals.

3. Risk Transparency

Plaintiffs should have a right to know the level of risk their funder has regarding their claim. A funder who has less at stake (because it has been bought out) in a given claim may be more (or less) likely to have litigation goals that conflict with the plaintiff’s. For example, a funder who has offloaded its risk might be more willing to take a long term view of the claim; on the other hand, a funder who has offloaded its risk might become less interested in the claim and more likely to divert its resources to other claims in its portfolio. The plaintiff should know the funder’s level of risk so that it can factor the information in to the its analysis of the funder’s advice.

Reflecting these concerns, the draft model contract prohibits securitization and limits the direct transfer of litigation proceed rights. In addition, the draft model contract requires the funder to represent that is entering the deal not having already started negotiations to transfer its interest. The draft contract does not, presently, include any restrictions on secondary financing that does not involve the transfer of the proceed rights themselves and that does not involve the disclosure of confidential or privileged information.

As a result, a funder could sell shares in itself, or a derivative financial product based on its entire portfolio, and not face any restrictions under the draft model contract. Finally, if the funder could find a secondary market investor willing to purchase a derivative tied to the proceed rights without using confidential information, nothing prohibits that transaction either. (Though, securities laws might prohibit such transactions if disclosure would be considered inadequate without sharing confidential information about the plaintiff or claim).

Note, this discussion of secondary financing is different than the situation in which a funder seeks to exit completely by arranging a replacement funder. In that scenario, the model requires the replacement funder to be sufficiently creditworthy and make other commitments. If the funder seeks to be fully replaced in the transaction, then the contract

With that background, here are the provisions and definitions relevant to secondary financing (some of which have been shared before; emphasis added for this post):

2.2.7 Secondary Market Financing: Funder represents that as of the date of this Agreement it has not sold or entered negotiations to sell part or all of its interest in the Claim or the Proceeds to anyone. Funder will not securitize its interest in the Claim or the Proceeds.

Litigation Proceed Right Certificate: a document in the form of Exhibit [ ] (i) reflecting ownership of a certain number of Litigation Proceed Rights; (ii) bearing a legend stating that the certificate and the rights it represents may not be transferred without the express, written consent of the Plaintiff and then only if the transferee becomes a party to this Agreement; (iii) acknowledging the rights and obligations created by Section 5.6 of this Agreement; and (iv) certifying the existence of a perfected senior security interest in the Proceeds Account [and any other security interest negotiated] sufficient to secure the Litigation Proceed Rights reflected in the certificate. Notwithstanding section 4.2, Funder and its Representatives shall not disclose any Common Interest Material to anyone without prior written consent of Plaintiff. For the avoidance of doubt, this prohibition prevents disclosure without prior written consent to Funder’s investors and/or any party to whom the Funder wishes to transfer part or all of its interest in the Claim. If consent is given, Funder shall enter into an agreement with such secondary recipients to preserve the confidentiality of the Common Interest Material on terms no less restrictive than those set forth in this Agreement for Confidential Information. This provision shall survive the termination of this Agreement and remain in effect until the Conclusion of the Claim.

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