Third party litigation finance was originally conceived in Australia to enable distressed companies to pursue valid claims. In that market where lawyers do not work on contingent fees and where the loser risks paying the winner’s legal fees, third party funding offered the only avenue for the distressed company to pursue its claim to resolution. As a result the nascent litigation finance was launched to fill that need. From that beginning, litigation funding has evolved to provide new and different functions in the financial restructuring context.
One prominent example of the use of litigation funding by distressed companies is the case of Chrystallex International Corp. Chrystallex is a Canadian gold mining company which is listed on the Toronto Stock Exchange. Its principal asset was the exclusive right to develop a large gold reserve in Venezuela. After making a substantial investment in the project, the Venezuelan government expropriated the mine without compensation.
Chrystallex was left without its principal asset and with no liquidity to pursue its right to compensation for the expropriation. The company was forced to declare bankruptcy. Although the claim against Venezuela exceeded $1 Billion, the company’s secured creditors sought to liquidate the company and assume the value of the entire claim. That would have left the equity holders out of the ultimate recovery and potentially delivered a windfall to the creditors. In order to protect the interest of the equity holders, the company turned to third party funding to finance the pursuit of its claims against Venezuela.
The court approved financing from Tenor Capital Management to finance the litigation and collection of the ultimate judgment. Over five years and with the bankruptcy court’s approval, Tenor invested $75 Million to pursue the claims. In November of 2017 the bankruptcy judge in Toronto approved a settlement between Chrystallex and Venezuela. When Chrystallex collects on the settlement, the creditors will be paid in full and the equity holders will recover some of their investment.
Chrystallex is an example of the use of litigation finance by the bankrupt company to monetize a claim which is a necessary precondition to the completion of the bankruptcy process and confirmation of a plan of reorganization or liquidation. In the case of many bankruptcies, there are many viable causes of action to pursue which are not central to the operation of the business at it emerges from bankruptcy. These often include claims arising from fraudulent conveyance, preference actions and the like. It is common that such claims would be placed in trust for the benefit of junior creditors. The trust is then free to pursue those claims after the plan of reorganization is confirmed. This approach helps to secure the support of the trust beneficiaries for the plan of reorganization and enables the company to get its plan confirmed more quickly.
In these circumstances, the liquidity required for the trustee to pursue the claims in the litigation trust is typically provided by a cash contribution from the debtor estate. If, however, the trustee arranges litigation financing to reduce or eliminate the cash requirement then more cash would be available for distribution to the creditors upon confirmation while still providing funding to make sure that the trust’s claims will be pursued.
A variation on that use of litigation funding occurred in a litigation trust that arose from the bankruptcy of Magnesium Corporation of America. The principal asset in that trust was an enormous claim against billionaire Ira Rennert and The Renco Group. The defendants were in control of MagCorp prior to its bankruptcy and were accused of manipulating its finances in anticipation of the bankruptcy to divert substantial assets away from MagCorp. The litigation trust was initially funded by the debtor estate but it took nearly 15 years before the trustee won a judgment of $213.2 Million. By the time the verdict was entered the trust had only $670 Thousand in the bank and needed to defend the judgment on appeal against the billionaire. The trustee was able to sell off a partial interest in the judgment to litigation funder, Gerchen Keller Capital, in exchange for $26.2 Million which replenished his coffers to fight the appeal and provided the trust beneficiaries with a guarantee of a recovery even if the judgment was reversed.
In each of Chrystallex and MagCorp the litigation funding had to be approved by the bankruptcy court to assure the fairness of the transaction. In cases like Chrystallex the financing might be structured as DIP financing to provide liquidity to the estate during the duration of the bankruptcy proceeding. DIP financing offers a path for the funder to take a first lien position on the litigation claim proceeds as collateral for its advances. In the case of MagCorp the transaction was structured as a sale under Section 363 of the Bankruptcy Code. Such a sale requires a showing to the court that the transaction was on commercially reasonable terms and advanced the interests of the creditors. In a 363 sale fairness is often demonstrated by utilizing a structured sale process with competitive bidding to market test the terms of the sale.