Using Securities as the Financing Instrument

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As has been mentioned in the comments, the transaction at the core of the model contract is not the typical financing approach. While it is hard for an outsider to define “normal” since public reports about financing emphasize the variability of arrangements and most deals (outside the consumer context) are secret, the deals that come to light involve non-recourse loans. In addition, deals can involve a dollar value minimum lender recovery (provided the lawsuit is a winner). By applying the venture capital analogy to the financing mechanism, the model is different in both respects. In this post we want to highlight some of the advantages, and at least one disadvantage, that results from financing through securities.

The advantages of having the plaintiff issue proceed securities are flexibility and increased certainty. By flexibility, we mean securities can have many features that reflect the parties’ priorities and work to preserve the economic bargain, as well as ease participation by multiple funders. By increased certainty, we mean that issuing securities limits “buyers’ remorse” lawsuits to invalidate the transaction (above and beyond the model contract’s “plaintiff minimum”), and further that incentives for the plaintiff to truthfully and fully disclose material information are increased. The biggest disadvantage (that we are aware of to date) is the investor’s rights in case the plaintiff goes bankrupt and the litigation’s proceeds become part of the estate.

Flexibility

Securities can be structured, ex ante, to  preserve the economic bargain as much as possible. For example, anti-dilution rights can be included that have triggers keyed to the claim’s ultimate value, as the model proposes, or to time, as Prof. Rhee proposed, or to any other deal point that the parties negotiate. In addition, although the model does not so provide, litigation proceed rights could be assigned a minimum value (provided any proceeds ultimately exist), analogous to the minimum payout for the funder. We do not support such a value in addition to the anti-dilution provisions because we believe that giving the funder more than those would provide could only mean that the plaintiff minimum recovery is voided, which we believe creates some unconscionability risk.

Another way securities provide flexibility is that they ease the participation of multiple funders. In a non-recourse loan transaction, successive funders need to be subordinated or buy out the original lenders entirely. However with Litigation Proceed Rights securities, issues of seniority/priority do not come into play. All rights holders have equal rank. Similarly, in venture capital early funders want preemptive rights, such as a right of first refusal when more “shares” are being offered, that can discourage others from investing. Litigation proceed rights holders do not need such rights, because preserving a pro-rata position throughout the litigation is not necessarily as important. The caveat is that to the extent a funder is actively participating in the case, it may want pre-emptive rights to preserve its influence, as Edward Reilly noted).

In theory, issuing securities can also facilitate secondary markets vis a vis financing via secured loan. However, as we oppose secondary financing of most types, the model securities are relatively hard to transfer. Further, issuing securities can also create secondary market complications given that the “shares” are privately placed with Accredited Investors and subject to the restrictions imposed by the Securities Acts of 1933 and 1934.

Certainty

Securities increase certainty in a few ways because the anti-fraud provisions of the securities laws apply. First, the securities must be honored as issued: once the proceeds are in, the plaintiff must pay according to their terms.   The plaintiff cannot claim usury as the security is not a loan, and huge profits from securities are typically praised, not considered unconscionable. While a plaintiff could try to invalidate the securities it issued by claiming the securities were themselves against public policy, if the securities are not champertous, it’s hard to see how that hypocritical argument wins. Certainly during the course of the litigation the plaintiff can try to re-trade the deal and persuade the funders to exchange one set of litigation proceed rights for another, it is hard to know what leverage the plaintiff could exert to get funders to participate if the new securities materially reduced the value the funders could earn.

The anti-fraud provisions of the securities laws should also give comfort to the investors that the plaintiff is in fact disclosing all the material information necessary to assess the claim. If the plaintiff has lied or withheld material information it seems (to us at least) that a 10b-5 violation would have been committed. If financing is staged as in the model, the anti-fraud provisions should provide an ongoing incentive to ensure accurate disclosures about the claim so that no material misrepresentations exist at the time the new securities are sold. This protection does not mean the contract should not provide other remedies for breach of the representations and duties regarding disclosure. Rather, it is an advantage conferred by using securities as opposed to a non-recourse loan.

One disadvantage with financing by security has to do with bankruptcy. Secured creditors are at the head of the line; litigation proceed rights holders would not be so privileged. However, in VC liquidation rights are often negotiated into the security, and neither of us knows enough bankruptcy law to know what protections our security buyers could negotiate.

In addition, there may be significant accounting advantages to taking the non-recourse loan approach, as debt financing gains favorable treatment as a general matter. Whether or not litigation proceed rights could be characterized as debt for accounting purposes is beyond our expertise, and more generally, we lack sufficient accounting expertise to assess those tradeoffs. Nonetheless we suspect that not all plaintiffs would care about the issue. Those plaintiffs who simply engage in litigation finance as a type of corporate finance, not because they could not otherwise bring their claims, would surely care. Those plaintiffs who can only access justice through litigation finance are much less likely to worry about the accounting.

We are very interested in your thoughts on advantages and disadvantages posed by financing by issuing securities instead of non-recourse loans.

2 thoughts on “Using Securities as the Financing Instrument

  1. Professor Steinitz writes, “with Litigation Proceed Rights securities, issues of seniority/priority do not come into play. All rights holders have equal rank.” I wonder if the issuance of senior and junior proceed rights might provide several advantages.

    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.

  2. Maya,

    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

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