Who Cares If A Litigation Finance Contract Is A Security?

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This post is drawn from the following article: Wendy Gerwick Couture, “Securities Regulation of Alternative Litigation Finance,” Securities Regulation Law Journal (forthcoming).  To download the full article, please click here.

As I discussed in my first post, a litigation finance contract may qualify as an “investment contract” subject to a federal securities regulation.  In my second post, I argued that a litigation finance contract arguably implicates the securities laws’ interest in full and fair disclosure because of information asymmetry between the funder and the claimant.  In this post, I discuss two of the major implications of the classification of a litigation finance contract as a security.

First, under § 5 of the Securities Act, securities cannot be offered or sold absent exemption or registration.  This provision ensures that potential investors have the opportunity to make informed decisions.  An investor has the right to rescind a non-complying transaction under § 12(a)(1) of the Act, and the S.E.C. is authorized to seek to enjoin the sale and advertising of unregistered securities and to bring an action for civil penalties against those who violate § 5.  The current litigation finance marketplace probably does not implicate this aspect of securities regulation because litigation finance contracts are generally private transactions, subject to exemption under § 4(a)(2) of the Act and/or Rule 506 promulgated thereunder.

As this industry evolves, however, parties to a litigation finance contract should beware lest the transaction inadvertently violate § 5.  For example, if the world of funders were expanded to include non-accredited investors, Rule 506’s disclosure and investor sophistication requirements would be triggered.  The failure to satisfy an exemption from registration would likely destroy the investment.  For one, the S.E.C. could enjoin the non-complying transaction, interfering with the potential investment.  Second, a non-complying transaction would raise the specter of liability for rescission.  The rescission remedy is available only to investors, so the claimant could not use it to undo a transaction.  The in pari delicto defense would probably bar a litigation finance company that was heavily involved in structuring the transaction from seeking rescission from the claimant.  Other investors whose involvement in structuring the transaction was less extensive could seek recourse from the claimant, however, potentially preventing the continued funding of the litigation, at the expense of the interests of both the claimant and the litigation finance company.  Scariest of all, under Pinter v. Dahl, 486 U.S. 622, 647 (1988), the litigation finance company might even be viewed as a “seller” for purposes of the rescission remedy if it “solicit[ed] the purchase, motivated at least in part by a desire to serve his own financial interests or those of the securities owner,” and thus the company, along with the claimant, could be on the hook to fellow investors.

Second, the securities laws include broad antifraud provisions, including a private right of action afforded to purchasers and sellers of securities by § 10(b) of the Securities Exchange Act.  Any litigation finance contract that qualifies as a security should thus be negotiated in the shadow of potential securities fraud liability.  For one, litigation finance companies, as purchasers of the securities, could rely on the antifraud provisions to redress misrepresentations made by claimants seeking financing, and the potential for this liability should help combat claimants’ incentive to exaggerate the merits of their claims.  Additionally, claimants, as sellers of the securities, could assert fraud claims against the funders for misrepresentations about the terms of the transaction, thus providing a potential remedy for predatory lending.  Finally, the S.E.C. has the power to seek to enjoin practices that violate § 10(b) and to bring an action for civil penalties against violators of § 10(b).  As in the context of the sale and advertising of unregistered securities, the potential for S.E.C. involvement may be the most meaningful effect of the securities regulation of litigation finance.

In sum, the securities laws cannot be ignored.  If a litigation finance contract cannot be structured to fall outside the scope of the definition of an “investment contract,” the parties should retain securities counsel to ensure that the transaction is exempt from registration and that the parties’ disclosures are complete and accurate.

One thought on “Who Cares If A Litigation Finance Contract Is A Security?

  1. so does that mean that an investment in ALF, if it is a security but exempt from registration, still must file a Form D? And if a Form D must be filed, who would file this? The litigation claimants? If a Form D must be filed, then this document would be public, which may hurt the litigants advantage over the defendants, assuming that the funding is needed years before the litigation claims are filed.

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