Like the traditional non-recourse financing, the model contract provides no security the funder will receive anything if the litigation proves unsuccessful. However, the contract creates security interest(s) in favor of the funder, for after the proceeds exist.
First, the funder is given a security interest in the Proceeds Account, which is set up to hold the proceeds of the litigation, and any after acquired property (the proceeds themselves.) While plaintiff is at risk of an obvious securities fraud claim if the plaintiff receives the proceeds and does not pay out as required by the Litigation Proceed Rights, the security interest is included as a belt-and-suspenders function.
Second, if the funded claim can be considered a “commercial tort” as defined by Article 9 of the U.C.C., then the parties can also create a security interest in the claim and its proceeds. This kind of security interest–which must be perfected by Funder by its filing a financing instrument–should help the Funder if the plaintiff is in bankruptcy when the proceeds are received.
For a claim that is not a U.C.C. “commercial tort,” the security interest challenge is finding a mechanism to put the funder in the tier of secured creditors if the plaintiff is in bankruptcy when the proceeds come in. Frankly, we are not sure how to do this. Edward Reilly of Themis Capital floated the idea that the securities be issued by a bankruptcy-remote special purpose vehicle rather than by the plaintiff directly. The challenge in that scenario, however, is champerty.
Either the claim itself, or the right to receive all the proceeds of the claim, would have to be sold to the SPV. (Surely selling the right to receive all the proceeds to an SPV is the equivalent of selling the claim itself, so either mechanism is a transfer of the claim to the SPV.) As a result, it is not clear that this transaction could be done under the law of New York, which we chose for the model contract. However in jurisdictions with no bar against champerty and with commercial laws that otherwise make such SPVs attractive, such an approach could work. Outside of champerty constraints, the idea of having a bankruptcy remote SPV issue the securities invokes the vast range of possibilities touched on by Michael Kaufman in his guest post.
Here is the language for the security interests:
8.1 The Proceeds Account: Plaintiff hereby irrevocably instructs, and, if further instructions are needed, will instruct, Litigation Counsel to receive any Proceeds Plaintiff becomes entitled to on behalf of the Plaintiff, and to immediately deposit all such Proceeds in the Proceeds Account. The Proceeds Account is governed by the Control Agreement among the Plaintiff, Funder, and [the financial institution the deposit account is located] dated as of [same date or earlier as this Agreement.] As provided in the Control Agreement, Plaintiff may not access the funds in the Proceeds Account until after Funder is paid the value of its Litigation Proceed Rights, whether from the Proceeds Account or from any other source owned or controlled by Plaintiff. The only action the Plaintiff may take with regards to the Proceeds Account prior to the Funder’s receipt of the value of its Litigation Proceed Rights from the Plaintiff is to direct [financial institution party to the Control Agreement] to pay the Funder the value of its Litigation Proceed Rights from the Proceeds Account. As specified in the Control Agreement, the Control Agreement shall terminate upon the Funder’s receipt of the value of its Litigation Proceed Rights.
8.2 Security Interest in the Proceeds Account: To secure its obligation to the Funder represented by the Litigation Proceed Rights owned by Funder, Plaintiff hereby grants Funder a security interest in the Proceeds Account and any and all property therein, whether such property is in the account now or is after-acquired. Such security interest shall terminate at the earlier of Plaintiff paying the Funder the full value of the Funder’s Litigation Proceed Rights or the Conclusion of the Claim, if, at the Conclusion of the Claim, Plaintiff is not entitled to receive any Proceeds from any Defendant.
[8.3 Security Interest in the Claim and its Proceeds: The parties agree that the Claim is a “commercial tort” as defined in Article 9 of the New York U.C.C. at Section 9-102(a)(13). To secure its obligation to Funder represented by the Litigation Proceed Rights owned by Funder, Plaintiff hereby grants Funder a security interest in the Claim and any Proceeds received by Plaintiff from any defendant in the Claim. This security interest shall terminate at the earlier of Plaintiff paying the Funder the full value of the Funder’s Litigation Proceed Rights or the Conclusion of the Claim, if, at the Conclusion of the Claim, Plaintiff is not entitled to receive any Proceeds from any Defendant.]
Again this provision is only relevant if the claim is a commercial tort which many funded claims are not.
8.4 No Other Security Interests: The Plaintiff shall not grant a security interest in the Proceeds Account [or the Claim] to anyone other than Funder without the Funder’s prior written consent.