Litigation Finance: An Indispensable Tool for Insolvency Professionals | USA

Liquidators are hiring. Like the red robin’s harbinger of spring or the coal mine canary’s portent of doom, liquidation firms hiring insolvency professionals is a sign of the cyclical rise in insolvency, liquidation and bankruptcy activity. Global financial stress from rising interest rates, the end of COVID-19 monetary policies and economic structural instabilities from geopolitical events such as Brexit, the war in Ukraine and Sino-Western friction have pushed many companies and investment funds into wind-down. This will result in a large uptick in liquidation proceedings in offshore jurisdictions, especially in the Caribbean, as well as onshore bankruptcy and insolvency actions in the USA and UK; hence the hiring surge.

While some of these insolvency actions will result in value back to creditors and investors, there will be insufficient assets to make stakeholders, especially investors, whole. For those left behind, the only avenue to recovery will be through litigation against third parties. Dispute resolution is expensive and time-consuming, however, and the debtor is unlikely to have the capital needed to prosecute asset recovery claims, nor are creditors likely to self-fund such actions; enter litigation finance.

The last insolvency cycle, brought on by the liquidity and credit crisis 15 years ago, has been instructive. Companies and funds, particularly offshore hedge funds in the British Virgin Islands and the Cayman Islands, found themselves with insufficient assets to continue operations, locked-up investments and devastating losses. Most of these funds were placed into liquidation, usually involuntary liquidations commenced by investors. Liquidators appointed by the courts found themselves in an impossible position; namely, they suspected malfeasance on the part of fund managers, fund administrators, accounting firms, financial consultants and others, yet they did not have sufficient liquid assets to hire global professionals who could investigate and document the reasons behind the economic failure.

There was often pushback from institutional investors on the creditors’ committees, mostly large European banks, insurance companies and pension funds, when any amount of cash was directed towards investigation or dispute resolution as opposed to returns of capital to those investors. In essence, limited partner investors did not want to see “good money thrown after bad” since they had taken huge losses already and needed liquidity for other purposes.

Faced with the above dynamic, insolvency professionals began to seek out law firms which would represent the debtor on a contingent or success fee basis. While this approach bore some limited fruit in pursuing former fund managers or specific institutions which may have participated in fraud or misrepresentations, it was far from an ideal solution and netted only limited returns. In many instances, the debtor had global operations or investments and needed legal and other professional assistance in multiple jurisdictions – eg, New York, London, Dublin, Geneva, Hong Kong, Singapore, etc. Engaging a contingency lawyer in New York did little to assist with asset recoveries in the other jurisdictions; further, legal contingency representation did nothing to mitigate the hard costs of dispute resolution associated with investigators, experts, administrative fees, litigation support and cost security. In essence, legal remedies, which were valuable assets of the debtor, were neglected for lack of resources. The mainstreaming of litigation finance since the credit crisis provides a solution for this next cycle of insolvency.

Bespoke litigation finance products have been developed to assist insolvency professionals who find themselves in the above dilemma. So-called seed funding can be made available such that insolvency practitioners can hire the appropriate professionals to investigate possible claims against third parties. Typically, this initial funding tranche is structured as a non-recourse priority loan which can be converted into an equity investment in future litigation brought by the debtor. Once the scope of possible claims becomes clear, the litigation funder has a right of first refusal to finance global recovery efforts by the liquidator or trustee. Often, this entails making a large pool of capital available to pursue claims in various jurisdictions, hence avoiding the pitfalls of the single contingency law firm noted above. As actions monetise, the resulting cash flow is funneled through the agreed-upon waterfall such that the litigation funder receives partial returns on its investment, and the company or fund can distribute the remainder to its creditors or investors.

While, ultimately, the litigation funder will retain a portion of the overall recoveries, the debtors and its stakeholders will have monetised litigation assets that would have otherwise been abandoned. There is no need for investors, who have already realised a loss on the asset, to put further capital into the debtor to fund recovery efforts, and there is no risk to the investors if the litigation fails. Thus, litigation funding is a “win-win” for the insolvency practitioners and the investors.

Litigation funding for insolvent entities can act as a force multiplier even where sufficient capital exists, essentially providing leverage to the debtor in claw-back actions, asset recovery claims, global discovery/disclosure applications, and litigation against a host of wrongdoers around the world. Insolvency professionals who fail to investigate the availability of funding do a disservice, not only to the debtor, but to its creditors and investors as well. A well-thought-out litigation finance plan, created in conjunction with a reputable funder, can provide access to justice for stakeholders who are looking to prosecute claims to recover losses without further commitment of capital. Finally, where court approval for affirmative litigation is required, the presence of a financial backer to the claims demonstrates the strength of the litigation strategy to the court and the fiduciary cost-sensitivity of the insolvency practitioners overseeing the process.

In short, liquidators and trustees should not ignore litigation funding, which was not generally available during the last crisis, and should make it a regular part of the insolvency toolbox.