Litigation Funding for Bankruptcy Litigation Gets a Boost from Recent Appellate Decisions

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Litigation funding has becoming increasingly common for general litigation matters, although its validity will still depend upon applicable state law.  See generally Robert Miller, J.D., Annotation, Enforcement and Funding of Litigation Funding Agreements, 72 ALR 6th 385 (2012).  According to a recent posting by CNBC, there are roughly 40 entities involved in U.S. commercial litigation financing, with assets under management of $9.5 billion.  Its increasing presence, however, has not yet carried into the bankruptcy arena, but two recent U.S. District Court decisions, on appeal from the rulings of two different bankruptcy courts, may change the legal landscape for this type of arrangement in bankruptcy cases.

Litigation funding refers to an arrangement whereby a lender provides funds to a plaintiff in planned or pending litigation, or to the plaintiff's attorney, in exchange for the right to receive an amount out of the proceeds of any realized settlement, judgment, award, or verdict that may be received in the civil lawsuit.  In bankruptcy cases, common plaintiffs include the trustee, a debtor in possession or a creditors’ committee.

In Dean v. Seidel, Civil Action No. 3:20-CV-01834-X, 2021 WL 1541550 (N.D. Tex. Apr. 20, 2021), the United States District Court for the Northern District of Texas affirmed the bankruptcy court’s approval of a litigation funding agreement under which a creditor of the bankruptcy estate agreed to advance up to $200,000 to the chapter 7 trustee for litigation fees to prosecute claims against third parties.  Id. at *1.  The agreement further provided that all recoveries from these claims would be used first to pay the trustee’s statutory commission and allowed expenses, second, to reimburse the advancing creditor, third, to pay it a 30% investment return, and finally, to distribute the balance to creditors.  

The agreement in Seidel was challenged by the debtor as violating the priority scheme of section 507 of the Bankruptcy Code – because it would allow one creditor to receive a disproportionate share of the litigation recoveries as compared to other similarly situated creditors – and also as violating section 550 of the Bankruptcy Code on the theory that litigation recoveries must be “for the benefit of the estate.”  Id. at *1.  The district court did not consider those challenges persuasive, and in upholding the agreement, found it important that the trustee attempted but was unable to negotiate a contingency fee arrangement with attorneys who were approached about taking the case.  Id. at *2.  

Interestingly, the bankruptcy court had approved the arrangement as a term of retention of special counsel under sections 327 and 328 of the Bankruptcy Code, but remarked that it was “a bit like” a section 363 or 364 transaction.  Id.  The grounds for approval were not disturbed on appeal.  Although the district court had some reservations about the litigation funding agreement, due to what it termed “legitimate ethical concerns,” and the “lack of any supporting caselaw,” it affirmed because it was not left with the definite and firm conviction that a mistake had been made,” id., which is the “clearly erroneous” standard of review on appeal. 

The approval of a litigation funding agreement in another bankruptcy case recently withstood challenge on appeal to a district court, but on standing grounds.   In Valley National Bank v. Warren, Case No. 8:20-cv-1777-KKM, 2021 WL 1597960 (M.D. Fla. Apr. 23, 2021), the liquidating trustee in a chapter 11 case sought approval of a litigation funding agreement with a third-party whereby it would finance the fees and expense of litigating an adversary proceeding against Valley National Bank for aiding and abetting breach of fiduciary duty and for the avoidance and recovery of $3 million in fraudulent transfers.  Based on a review of the proceedings, the funding agreement provided that the funder would pay the monthly fees and expenses of the liquidating trustee’s professionals and that from any litigation recovery, would first be reimbursed for those payments and then receive 85% of the recovery.  The funder was also granted a first priority lien and security interest in the cause of action and other collateral. 

The bankruptcy court approved the agreement as a financing under section 364 of the Bankruptcy Code, over the bank’s objection that the funder’s financial interests would impair the good faith efforts of the liquidating trustee in negotiating a settlement with the bank.  Id. at *2.  On appeal, the United States District Court for the Middle District of Florida held that the bank lacked Article III standing to appeal, as well appellate standing under the “person aggrieved” standard for bankruptcy appeals.  Id. at *3-6.  Essentially, the district court held that the bank could not establish a “concrete injury” that was not speculative or remote for Article III standing, and that the bank was not aggrieved because it was not directly and pecuniarily affected by the approval.    

There have been other bankruptcy decisions that have approved of litigation funding arrangements on their merits, but not as a form of financing under §364 of the Bankruptcy Code.   In Realan Investment Partners, LLLP v. Meininger (In re Land Resource, LLC), 505 B.R. 571 (M.D. Fla. 2014), the chapter 7 trustee entered into a litigation funding agreement with a surety that had issued bonds for the debtor’s benefit prior to the bankruptcy filings.  Under the agreement, the surety agreed to fund up to $750,000 for the fees and costs of certain fraudulent transfer litigation brought by the chapter 7 trustee and, in exchange, was to receive a sliding scale percentage of the recovery proceeds after reimbursement of the amount funded.  Id. at 576.  The percentages started at 80% of the net recovery up $1 million and gradually declined to 35% of any net recovery in excess of $3 million.  Id.  The agreement was approved by the bankruptcy court as a settlement under Fed. R. Bankr. P. 9019, over the objection of the defendants in the fraudulent transfer action, and its approval was affirmed on appeal on that basis.  Id. at 587.

In affirming the bankruptcy court, the district court found most important the testimony of the chapter 7 trustee’s counsel that the litigation could not continue without the funding, while adding its recognition that the real reason for the objection and appeal by the defendants was for them to be free of the litigation.  Id. at 587.  The district court also rejected arguments that the agreement should have been reviewed under the standard for a sale of assets under §363 of the Bankruptcy Code or as a financing under §364 of the Bankruptcy Code.

In In re Ashford Hotels, Ltd., 226 B.R. 797, appeal dismissed 235 B.R. 734 (S.D.N.Y. 1999), the bankruptcy court approved a litigation funding agreement between a chapter 7 trustee and Allied Irish Bank (“AIB”), a major creditor of the estate, whereby AIB would pay $25,000 toward administrative expenses of the estate and fund the fees necessary for the trustee to defend an action against the debtor which sought to nullify an indemnity agreement in its favor.  Id. at 800-01.  The indemnity agreement, if enforceable, would require the indemnitors to pay AIB’s outstanding loan to the debtor, and would allow for a successful recovery on the indemnity in a related action before England’s High Court.  Id.  In the event of a recovery, AIB would remit to the trustee the lesser of $500,000 or five percent of the net recovery.  Id.  at 801.

The agreement was presented, analyzed and approved as a settlement under Fed. R. Bankr. P. 9019, which, at bottom, requires approval if the settlement “does not fall below the lowest point in the range of reasonableness.”  Id. at 804.  The bankruptcy court had no trouble finding that the agreement met that standard, even though the parties who sought recission of the indemnity agreement offered $50,000 to the estate to drop the litigation’s defense.  The court reasoned that it was the trustee’s decision that was being reviewed and that it met the standard for approval of a settlement under Rule 9019 particularly since it allowed “for a potential future recovery of additional monies” for the estate, whereas the indemnitors’ offer “close[d] the door to future recoveries.”  Id. at 804.

The decision in In re 8 West 58th Street Hospitality, LLC¸ Case No. 14-11524, 2017 WL 3575856 (Bankr. S.D.N.Y. Aug. 4, 2017) involved an unusual arrangement whereby the landlord of the chapter 11 debtor’s place of business agreed to fund litigation against a party that had defaulted on its obligations to take an assignment of the debtor’s under-market lease of the premises, which had been approved by the court on the debtor’s motion for assumption and assignment of the lease.  Under the agreement, if the action against the assignee for surrender of the lease was successful, the landlord would buy the lease from the debtor for $1,250,000, and if the action was unsuccessful, the debtor and its principals would assign their claims against the assignee of the lease, which included a contempt proceeding, to the landlord for $1 million.  Id. at *2.

The court approved the agreement as a transaction outside the ordinary course of business under section 363(b) of the Bankruptcy Code, which employs a business judgment standard, id. at *3, after it was clarified that the landlord would not have veto power over any settlement or other disposition of the litigation.  Id. at *5.  The court also rejected the argument that the agreement should be analyzed as a financing transaction under section 364 of the Bankruptcy Code, citing Ashford, as well as the argument that receiving fees from a third party would present a conflict for debtor’s counsel.  Id. at *6-7.  

As can be seen, litigation funding agreements for bankruptcy litigation have not received uniform analysis in bankruptcy cases, but they have been approved on various grounds.  Given the more limited resources that are commonly found in bankruptcy cases, and as bankruptcy decisions approving these types of agreements become more widely known, it can be reasonably expected that they will be used more frequently as the litigation funding business continues to expand.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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