Incorporating Legal Claims

College of Law University of Iowa Legal Studies Research Paper Number 14-15 August, 2014 Revised INCORPORATING LEGAL CLAIMS Maya Steinitz University of Iowa, College of Law This paper can be downloaded without charge from the Social Science Research Network electronic library at: http://ssrn.com/abstract=2423541 Electronic copy available at: http://ssrn.com/abstract=2423541 DRAFT. ___ Notre Dame L. Rev. ___ (forthcoming 2015) INCORPORATING LEGAL CLAIMS Maya Steinitz* ABSTRACT Recent years have seen an explosion of interest in commercial litigation funding. Whereas the judicial, legislative and scholarly treatment of litigation finance has regarded litigation finance first and foremost as a form of champerty and sought to regulate it through rules of legal professional responsibility (hereinafter, the ‘legal ethics paradigm’) this Article suggests that the problems created by litigation finance are all facets of the classic problems created by ‘the separation of ownership and control’ that have been a focus of business law since the advent of the corporate form. Therefore, an ‘incorporation paradigm,’ offered here, is more appropriate. ‘Incorporating legal claims’ means conceiving of the claim as an asset with an existence wholly separate from the plaintiff. This can be done by issuing securities tied to litigation proceed rights. Such securities can be issued with or without the use of various business entities. The incorporation paradigm also opens up the possibility of applying practices of corporate governance to litigation governance. Indeed, in certain previously–overlooked real life deals, creative lawyers used securities tied to litigation proceed rights as well as corporate governance mechanisms. The Article analyzes and then expands upon such instances of financial–legal innovation suggesting how various business entities can be used to deal with the core challenges presented by the separation of ownership of and control over legal claims, specifically, the problems of (1) extreme agency problems; (2) extreme information asymmetries; (3) extreme uncertainty; and (4) commodification. In addition, the Article discusses how incorporation of legal claims can reduce various costs that litigation imposes in other transactions, such as mergers & acquisitions. Associate Professor, University of Iowa College of Law. A special thanks to Tom Gallanis, Herb Hovenkamp, Shelly Kurtz, Robert Miller, Todd Pettys, [xxx], and the participants of the Washington & Lee workshop on litigation finance and of the Iowa Legal Workshop. * 7/15/2014 Electronic copy available at: http://ssrn.com/abstract=2423541 2 M. STEINITZ TABLE OF CONTENTS DRAFT Electronic copy available at: http://ssrn.com/abstract=2423541 7/15/2014] INCORPORATING LEGAL CLAIMS 3 INTRODUCTION The law and economics movement has revolutionized our understanding of law by placing economic cost-benefit analysis at its center. One of the achievements of this movement, for better or worse, has been the conceptual commodification of legal claims. Now, we are witnessing one of the most breathtaking consequences of this turn in the history of (legal) ideas: the rise of markets in legal claims, a phenomenon also known as “litigation finance.” Legal claims are being commoditized in the literal sense of the word: they are being traded like other assets. In recent years, legal scholars, regulators, and the media have focused intensely on the visible segment of this new market: new investment firms, such as Burford and Juridica, that invest in litigation by making capital contributions covering litigation costs in return for a share of the litigation proceeds, should any be awarded (hereinafter: “private equity litigation funding” or “PELF”). Indeed, it was the historically-unprecedented going-public of Juridica and Burford1 that has launched the media frenzy,2 academic interest,3 and nation-wide regulatory wave that has washed over the U.S. in recent years,4 even though the trade in legal claims in the U.S. has been ongoing for more than two decades. Unfortunately, because of path dependence, the academic and regulatory analysis has been trapped in what I call a “legal ethics paradigm”: the view that litigation finance, where legal, is an extension of the 1 Caroline Binham, Juridica Attracts Investment as the First Specialist Litigation Fund to Float in the UK, THE LAWYER (Jan. 14, 2008), http://www.thelawyer.com/juridica-attracts-investment-as-the-first-specialist-litigation-fund-to-float-in-uk/130705.article; Elisa Martinuzzi, Burford Capital Amasses 80 Million Pounds in IPO, BLOOMBERG (Oct. 16, 2009), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aM4f5weps7UQ. 2 See, e.g., Mark Cobley, Sparkling Return for Buford as Litigation Investment Comes of Age, FINANCIAL NEWS (Jan. 11, 2014), http://www.efinancialnews.com/story/2013-01-24/burford-capital-results-2012; Jennifer Smith, Litigation Investors Gain Ground in U.S., WSJONLINE (Jan. 12, 2014), http://online.wsj.com/news/articles/SB10001424052702303819704579316621131535960. 3 See, e.g., Geoffrey McGovern, et, al., conference proceedings, Third Party Litigation Funding and Claim Transfer: Trends for the Civil Justice System, UCLA-RAND Center for Law and Public Policy (2009), available at http://www.rand.org/content/dam/rand/pubs/conf_proceedings/2010/RAND_CF272.pdf; Northern Kentucky Law Review Symposium Focuses on Third-Party Litigation Finance, NORTHERN KENTUCKY UNIVERSITY (Feb 2, 2011) http://nku.edu/display_news.php?ID=4307; Clifford Symposium: A Brave New World” Focuses on Litigation Finance, DEPAUL UNIVERISTY COLLEGE OF LAW (Apr. 18, http://depaullaw.typepad.com/depaul_law_school/2013/04/clifford-symposium-a-brave-new2013), world-focuses-on-litigation-finance.html; Symposium, The Economics of Aggregate Litigation, 66 VAND. L. REV 1641 (2013) 4 See infra note 24. DRAFT—DO NOT QUOTE 4 M. STEINITZ contingency fee exception to the champerty doctrine (below) and the consequent regulation of litigation finance via the champerty doctrine and the rules of lawyers’ professional responsibility. This Article offers an alternative theoretical and regulatory paradigm: the “incorporation paradigm” according to which litigation finance should be understood as a pocket of the finance industry, not as an extension of the contingency fee. According to this new paradigm, commercial legal claims can and should be “incorporated” (as defined in subsection 1 below) in order to minimize or even resolve the concerns that both proponents and opponents of litigation finance are seeking to solve through the ethics paradigm. These concerns (detailed in subsection 2) center on conflicts of interest, information asymmetries, risk, and commodification (collectively, the Funding Challenges). Indeed, perhaps the most revolutionary aspect of reframing the debate in this way is that it helps reconceive of the Funding Challenges, which occupy in some form or another most of the scholarship and public debate surrounding litigation finance, as an instance of the familiar problem of the separation of ownership and control; a problem at the heart of corporate law.5 The problem of the separation of ownership and control is the problem of understanding the survival—or in our case, the emergence—of organizations in which important decision agents do not bear a substantial share of the wealth effects of their decisions. 6 Indeed, decision agents may even seek to line their own pockets and engage in selfdealing at the expense of the owners. Since Adam Smith first raised the problem of the separation of ownership and control in The Wealth of Nations,7 more than two centuries ago, the practice and law of business entities has made great strides in understanding and controlling the associated problems (though certainly not eliminating them altogether). The theoretical argument for a paradigm shift rests on a description and analysis of deals that have heretofore been overlooked by scholars in which creative merger and acquisition (M&A) lawyers have incor- Eugene F. Fama & Michael C. Jensen, Separation of Ownership and Control, 26 J.L. & ECON., 301 (1983) (seeking to explain the survival of organizations characterized by separation of ownership and control and characterizing that enigma as “a problem that has bothered students of corporations from Adam Smith to Berle and Means and Jense and Meckling.” Id.). See also, R. Kraakman, 5 et. al, THE ANATOMY OF CORPORATE LAW: A COMPARATIVE AND FUNCTIONAL APPROACH 21 – 71 (Oxford University Press 2004). 6 Id. (1st ed. London 1776) (Cannan ed. 1904) quoted in The Separation of Ownership and Control, supra note 5, at n2, together with the seminal works of Adolf A. Berle & Gardiner C. Means, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932) and; Michael C. Jensen & William H. Meckling, Theory of the Firm; Managerial Behavior, Agency Costs and Ownership Structure, 3, 305 (1976). 7 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 5 porated legal claims and argues that this practice can replace existing practices through which ownership and control of legal claims are traded, in whole or in part, in the litigation finance context. The incorporation paradigm also calls for extending financial regulations, not the regulation of attorneys, to regulate the litigation finance industry. By better solving the Funding Challenges the incorporation paradigm should increase both acceptance of litigation finance and liquidity of legal claims and those, in turn, will increase access to justice. Finally, while the argument focuses on solving problems plaguing litigation finance, incorporating legal claims has important implications in the corporate context for three reasons. First, because it reduces what I call “hidden costs,” sometimes prohibitive, that litigation imposes on mergers, acquisitions and major equity investments in certain (uncommon but important) scenarios. Second, because spinning off large litigations into Special Purpose Vehicles (SPVs) can create accounting benefits for corporations. Third, because simplifying and reducing the costs of litigation finance of large commercial claims by incorporating them may assist corporations and governments to pursue claims that currently go unprosecuted. Part I describes the rise of litigation finance, the ethical concerns it raises, the ethical constraints currently imposed upon it through the legal ethics paradigm, and economic inefficiencies caused by the simultaneous over- and under regulation of litigation funding under the legal ethics paradigm. Part II presents a set of deals in which corporations have used business entities (Delaware statutory trusts) and various types of securities to reduce the hidden costs of litigation and facilitate corporate transactions and two deals where incorporation presented itself in the litigation finance context. After describing these complex and innovative deals, Part III first generalizes from the deals how incorporation can minimize (or exacerbate if misused) the Funding Challenges. It then outlines a broader vision of how corporate entities other than statutory trusts can be used to solve both the problems of the hidden costs of litigation and facilitate efficient and ethical trade in commercial claims. The paper concludes with some remarks on further implications of the incorporation paradigm that can be explored in future works such as the idea of “litigation governance,” modeled on corporate governance, and the question of the proper regulation of litigation finance arrangements understood as securities and, more generally, as financial products. 1. The Legal Ethics Paradigm and its Limitations Currently, liquidity of legal claims is greatly hampered by the fact that the mechanics of claim trading are placed in a strait-jacket woven out DRAFT—DO NOT QUOTE 6 M. STEINITZ of antiquated doctrines and rules (described below) that are aimed at regulating a relationship different in kind. This legal ethics paradigm rests on a flawed analogy between the contingency attorney-client relationship and the financier-financed relationship: Because the similarities between attorney funding and third-party funding are extensive, most of the discourse surrounding litigation funding is characterized by what some economists call an ‘attribute substitution’: a cognitive bias whereby individuals who need to make a complex judgment, here – regarding the desirability of the novel phenomenon of litigation finance, substitute that complex judgment for a more easily calculated heuristic. In our case, the easiest calculation is the desirability of contingency fees. In other words, commentators simply apply their preconceived views of contingency fees to litigation finance.8 The substitution is understandable. As discussed below, there are indeed important similarities between the concerns that arise in the context of the contingency attorney–client relationship and that of the funder–plaintiff, including (1) extreme agency problems (conflicts of interests); (2) extreme information asymmetries; (3) extreme uncertainty; and (4) inappropriate commodification namely, the doing away with nonmonetary relief.9 But while contingency lawyers do provide financing, they primarily provide lawyering services. They are officers of the court, with privileges conferred by the courts and by society at large and corresponding obligations to those constituencies and are therefore subject to an elaborate regulatory regime embodied in the codes of professional responsibility. Conversely, funders are financiers only. The current direct and indirect regulation of litigation finance, through common law doctrines such as champerty (direct) and legal ethics (indirect) should be radically 8 Maya Steinitz, Whose Claim Is This Anyway? Third-Party Litigation Funding, 95 MINN. L. REV. 1268 (2010). These problems as they present themselves in litigation finance have been discussed at length in The Litigation Finance Contract, 54 WM. & MARY L. REV. 455 (2012) [hereinafter The Litigation Finance Contract] (arguing that litigation finance is analogous to venture capital because it is similarly characterized by extreme agency costs, extreme information asymmetry and extreme risk, for similar reasons, and that these problems can be minimized by adapting solutions from venture capital). A detailed discussion of the specific conflicts of interests created by the tripartite attorney – client – funder relationship is available in Whose Claim Is This Anyway? supra note 8. 9 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 7 revised to reflect economic reality.10 That reality, as the deals described below exemplify, is that sophisticated plaintiffs and funders are best understood as co-venturers. Or, in other words, as business partners (as the term ‘partners’ is used colloquially). Consequently, they can adopt existing deal structures, use legal entities and the regulations that govern them, as well as contractual mechanism including corporate governance mechanisms developed through the practices and laws of business entities in order to avail themselves of built-in solutions to the Funding Challenges. These can and should replace the ethics paradigm which both over- and under regulates litigation finance. Legal ethics over-regulates in that it leads to the prohibition of joint ventures (between plaintiffs and funders) that most would find inoffensive, indeed facilitative of access to justice as can most clearly be seen in “David vs. Goliath” disputes between tech start-ups with no resources to pursue patent infringements, on the one hand, and established industry incumbents who infringe, on the other. Legal ethics under-regulates in that it does nothing to deal with the problems of finance e.g., by requiring that funders be adequately capitalized, registered and licensed; mandating appropriate disclosures to the investors in PELF; controlling for the moral hazard that creating litigationbacked securities might create in the future; imposing fiduciary duties and duties to fund, and more. In short, expanding the practice of incorporating commercial legal claims beyond the M&A context to the litigation finance context can help minimize or even solve some of the key problems identified by scholars of litigation finance. Once such problems are addressed, litigation finance—currently suspect by lawyers, judges, legislators and investors— may face less resistance and more expansion allowing more meritorious claims to be litigated than otherwise would be and solving the problem of the value destruction caused to plaintiffs by meritorious claims that go unremedied. Corporations, which are generally conservative about suing, 10 This, in turn implies a normative argument that litigation finance is a positive development. For normative arguments favoring litigation finance, see, e.g., Richard W. Painter, Litigating on a Contingency: A Monopoly of Champions or a Market for Champerty?, 71 CHI-KENT L. Rev. 625 (1995); See also Michele DeStephano, Nonlawyers Influencing Lawyers: Too Many Cooks in the Kitchen or Stone Soup? 80 FORDHAM L. Rev. 2791 (2012). Reasonable minds certainly differ, however. Views opposing litigation funding include e.g., John Beisner et al., SELLING LAWSUITS, BUYING TROUBLE: THIRDPARTY LITIGATION FUNDING IN THE UNITED STATES 3, (Released by the U.S. Chamber Institute for Legal Reform, Oct. 2009), http://www.instituteforlegalreform.com/sites/default/files/thirdpartylitigationfinancing.pdf; Stephen B. Presser, A Tale of Two Models: Third Party Litigation in Historical and Ideological Perspective 27 and; Paul H. Rubin, On the Efficiency of Increasing Litigation, 10-11 (Sept. 24-25, 2009) (unpublished manuscript), (on file with author) available at http://www.law.northwestern.edu/searlecenter/papers/ Rubin-ThirdPartyFinancingLitigation.pdf. DRAFT—DO NOT QUOTE 8 M. STEINITZ currently are experiencing value destruction in the form of un-prosecuted claims. To the extent their claims are not prosecuted because of the difficulty in ascertaining value, the difficulty in ascertaining the likelihood of success prosecuting meritorious claims, negative accounting treatment during claim conduct, unfavorable tax treatment or because of the cost of the capital that would be used to prosecute a claim (including opportunity costs), a more vibrant and liquid litigation finance market may provide access to justice. Sovereigns, domestically as well as foreign, are another type of sophisticated owner of large-scale claims, face the same kind of analysis when having to decide whether to pursue litigation. In addition, in the case of sovereigns such decisions are subject to public scrutiny and using public funds to pursue speculative litigation may not be a popular decision. Here, the value destroyed from having to forgo litigation is foregone public resource. Recognizing the full commodification of claims created by their incorporation and a liquid market in claims, I draw one major limit: I exclude from consideration the incorporation of non-commercial claims.11 Commercial claims, more than all others, involve damages that can be remedied through monetary compensation. When a claim’s natural remedy is monetary, commodification does not distort justice. In all other instances, however, the drive toward commodification can distort justice. While this article will identify ways to ameliorate this dynamic through deal structure at bottom, injuries that call for non-monetary remedies need to be sheltered from commodification. Thus for the purposes of cleanly demarcating the incorporation of claims and its benefits, I exclude noncommercial claims. 2. Incorporation of Legal Claims The market in legal claims is much vaster, and older, than the discourse on commercial litigation finance recognizes. As this paper documents, long before the emergence of PELF, companies advised by creative lawyers have experimented with trading in legal claims by incorporating them. Specifically, by ‘incorporation’ of a claim I am referring to a 11 American litigation finance serves two different markets. One is consumers bringing personal claims sounding, e.g. in torts, matrimonial or workers’ compensation law and who need bridge financing while their attorney delivers a settlement or judgment. The other is corporations, many repeat players already, who want the money to pay the litigation’s expenses so they can free up the capital for operations, or who are faced with a claim too big for them to bring without financing. The public policy concerns are quite different, in that consumers have less bargaining power and sophistication and therefore need more protection; personal claims are not always resolvable with cash alone and; the contracts involved are totally different. Further, consumers can enter form contracts; commercial claims are always negotiated deals. On consumer lending, see consumer lending literature review infra note 18. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 9 practice of giving the claim a legal existence separate from its plaintiff, and thus making it an asset that can be sold. There are two archetypical ways to incorporate claims which I will call loose and strict. ‘Loose incorporation’ means embodying the value of the litigation in a security which until claim resolution derives value solely from the expected value of the litigation and at claim resolution has a fixed value that is conveyed to the security holders. Placing the claim in the “corpus” of a security is “incorporation” in a loose, literary sense only. “Strict incorporation” involves creating an SPV to embody the claim and/or its proceeds, and is a literal usage of “incorporation,” though not intended to connote that corporations are the only, or even most appropriate, legal entities for this purpose. When strictly incorporating, the SPV may issue securities, but that is not a definitional constraint. Claim incorporation can address the issues raised by separation and control in two basic ways: by contract, and by the statutory and common law that come with the different forms of SPV. Regardless of which of the possible forms the incorporation takes, claim incorporation forces the transparent allocation of ownership and control as people will not buy a litigation-backed security without disclosure as to how the litigation will be managed. Even without a security, SPVs by their nature require structuring the funder-plaintiff-claim relationship. Examples of both loose and strict incorporation are discussed in Part II. Nearly all of the examples are of deals done in the 1990s to solve merger pricing problems created by litigation. In those deals the claim was so large and hard to value the parties could not agree on what the target was worth. So the target spun-off the value of the claim to its shareholders, and the deal priced without consideration for the claim. The spun-off securities traded on the Nasdaq12 (for the most part), and thus the target’s shareholders were able to realize immediate value and the pricing problems was solved by the actual market pricing the shares. That in turn allowed strangers to the claim to own the right to some claim proceeds. Claim incorporation was born. See infra Part III. In addition, some litigation finance firms are publically traded: The Australian IMF is traded on the Australian exchange and Juridica and Burford are traded on London’s AIM exchange. John O’Doherty, Litigation Fund Poised for AIM Debut, FIN. TIMES (London), Oct. 17, 2009, at 14. As such, conceptually, their shares are securities of pools of litigations. Interestingly, Professor Stephen Yeazell used the idea of “a NASDAQ for legal claims for lawsuits” in his argument in favor of pricing transparency in the market of civil suits’ settlements. Stephen C. Yeazell, Transparency for Civil Settlements: NASDAQ for Lawsuits?, CONFIDENTIALITY, TRANSPARENCY AND THE U.S. CIVIL JUSTICE SYSTEM (Joseph Doherty & Robert Reville eds., 2012). 12 DRAFT—DO NOT QUOTE 10 M. STEINITZ While most of the deals arose in the M&A context, each explicitly contemplated the possibility of issuing additional securities to finance the litigation and their structures are well-suited for usage directly for litigation finance.13 In addition, two other examples of strict incorporation come directly from the litigation finance context. One was contractually agreed to but apparently never created. The other came about in the legally distinctive bankruptcy context and the claim’s incorporation in that case was inadvertent rather than intentional. It is appropriate to speak of that claim as incorporated simply because the facts leading to the bankruptcy so stripped the company of value that its sole remaining asset was its multi-billion dollar claim. Importantly, that litigation finance deal involved the formal allocation of ownership and control through the medium of both the plaintiff’s corporate form and by contract. I. LITIGATION FINANCE AS A SQUARE PEG IN A ROUND HOLE AND THE INHIBITION OF LIQUIDITY IN LEGAL CLAIMS 1. The rise of litigation finance and the liquidity in legal claims Recent years have seen an explosion of academic interest in commercial litigation funding which is regarded as a new phenomenon in the United States.14 The timing of the public awareness in academia and in the financial, trade and general media is probably due to the launch of two publically-traded litigation finance firms—Juridica in 2008 and Burford in 2009.15 It appears, however, that some private entities have been funding commercial cases in the United States for at least a couple of decades, either ad hoc, in the case of certain hedge funds, or through specialized 13 Whether it is possible to do an IPO, rather than a spinoff, of litigation proceeds-backed securities is an open question, as underwriters may reject participating in such a deal. However, securities could still be privately placed. See Richard Painter, The Model Contract and The Securities Laws, Part IIV, A MODEL LITIGATION FINANCE CONTRACT, supra note 16. 14 See, e.g., Steven Garber, Alternative Litigation Financing in the United States, RAND CORP. (2010) (occasional paper), http://www.rand.org/content/dam/rand/pubs/occasional_papers/2010/RAND_OP306.pdf.; Jonathan T. Molot, Litigation Finance: A Market Solution to a Procedural Problem, 99 Geo. L. J. [xx] (2010) Stephen Gillers, Waiting for Good Dough: Litigation Funding Comes to Law, 43 AKRON L. REV. 667 (2010); Deborah Hensler, Financing Civil Litigation: the US Perspective, NEW TRENDS IN FINANCING CIVIL LITIGATION IN EUROPE (Mark Tuil & Louis Visscher, eds., 2010). See IMF (AUSTRALIA) LTD, http://www.imf.com.au/ (last visited Mar. 21, 2013); JURIDICA CAPITAL MANAGEMENT LTD, http://www.juridica.co.uk/about.php (last visited Mar. 23, 2013); BURFORD, supra note Error! Bookmark not defined.. 15 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 11 private firms that simply did not catch the eye of the financial media nor the academe.16 Since the high-profile launch of Juridica and Buford a number of privately-held litigation firms have emerged including Bantham Capital, BlackRobe Capital, Fulbrook Capital, Themis Capital and Gerchen Keller Capital LLC, to name a few.17 Moreover, the current commercial litigation funding industry, variously referred to as third party funding, alternative litigation funding, litigation investment, and more was preceded by a number of closely-related practices. A first wave of litigation funding, broadly defined, includes the law lending industry, also known as consumer litigation funding, and it encompasses the financing of personal claims such as personal injuries and workers’ compensation claims.18 Also included in this wave was the rise of the so-called IP-trolls;19 a market in bankruptcy claims (corporate debt);20 a market in ICSID awards (sovereign debt)21 and; the rise of various forms of alternative funding—including that of class actions—in the pioneering jurisdictions, the UK and Australia.22 Lastly, related financial 16 This is based on communications this author received in associating with her web-based research project The Model Litigation Finance Contract, supra note 9. See BANTHAM ASSET MANAGEMENT, http:// http://www.benthamam.com/; FULBROOK CAPITAL MANAGEMENT LLC, http:// http://www.fulbrookmanagement.com/; THEMIS LEGAL CAPITAL. http:// http://www.themislc.com/; GERCHEN KELLER CAPITAL LLC, http:// 17 http://www.gerchenkeller.com. Susan Lorde Martin, Financing Plaintiffs’ Lawsuits: An Increasingly Popular (and Legal) Business, 33 U. MICH. J.L. REFORM 57, 79–83 (1999); Susan Lorde Martin, Litigation Financing: Another Subprime Industry that Has a Place in the United States Market, 53 VILL. L. REV. 83, 86–87 (2008); Susan Lorde Martin, The Litigation Financing Industry: The Wild West of Finance Should Be Tamed Not Outlawed, 10 FORDHAM J. CORP. & FIN. L. 55, 68 (2004); Julia H. McLaughlin, Litigation Funding: Charting a Legal and Ethical Course, 31 VT. L. REV. 615 (2007). 18 19 See e.g. Peter N. Detkin, Leveling the Patent Playing Field, 6 J. MARSHALL REV. INTELL. PROP. L. 636 (2007). 20 Drain, Robert D & Elizabeth J. Schwartz, Are Bankruptcy Claims Subject to the Federal Securities Laws?, 10 AM. BANKR. INST. L. REV. 569 (2002). 21 An industry described in PROFITING FROM INJUSTICE: HOW LAW FIRMS, ARBITRATORS AND FINAN- ARE FUELLING AN INVESTMENT ARBITRATION BOOM available http://www.tni.org/sites/www.tni.org/files/download/profitingfrominjustice.pdf. CIERS at See generally, Tuil & Visscher, supra note 14,and CIVIL JUSTICE COUNCIL, THE FUTURE FUNDING OF LITIGATION– 22 ALTERNATIVE FUNDING STRUCTURES 54 (2007), http://www .civiljusticecouncil.gov.uk/files/future_funding_litigation_paper_v117_final.pdf. DRAFT—DO NOT QUOTE 12 M. STEINITZ products such as litigation insurance for plaintiffs and after-the-event insurance for defendants have been available in foreign jurisdictions for some time including, respectively, Germany and the UK.23 The first wave of litigation finance has led to some regulatory efforts—with state level legislation24 and some investigations by states attorneys general25—as well as an expansion of the market. This expansion included new ‘asset classes’ such as divorces26 and the rise of dedicated commercial funders (including publically-traded ones) described above. With public awareness and attendant growing demand for litigation funding, as well as a lot of R&D (research and development) of new financial products by existing and start-up litigation funding firms, we are now witnessing what can be termed the third wave of litigation funding in the United States. One development characteristic of the third wave is that commercial funders are emboldened to seek overt control and not mere influence over the litigations they invest in.27 Under this revised business model funders seek to enhance the value of their investment by actively managing them, as is done in more traditional asset classes. Another characteristic is that new market entrants have positioned themselves as Marie Gryphon, A Loser-Pays Model Would Make the Civil Courts System a Winner, MANHATTAN INST. FOR POLICY RESEARCH DAILY J., Dec. 5, 2008. 23 24 Legislation to regulate at least some types of litigation funding is currently pending before three state legislatures - Indiana, Oklahoma, and Mississippi. S.B. 378, 2013 Gen. Assemb., Reg. Sess. (Ind. 2013); S.B. 1016, 54th Leg., 1st Sess. (Okla. 2013); H.B. 503, 128th Leg., Reg. Sess. (Miss. 2013) and S.B. 2378, 128th Leg., Reg. Sess. (Miss. 2013). A 2010 Delaware House Bill passed out of committee, but went no further. H.B. 422, 145th Gen. Assemb. (Del. 2010). Three other states—Maine, Ohio, and Nebraska—have already passed legislation regulating litigation financing. An Act to Regulate Presettlement Lawsuit Funding, 2007 Me. Laws 394 (codified at ME. REV. STAT. tit. 9-A, §§ 12-101 to -107 (2007)); H.B. 248, 127th Gen. Assemb., Reg. Sess. (Ohio 2008) (codified in OHIO REV. CODE § 1349.55 (2008)); L.B. 1094, 101st Leg., 2nd Sess. 25 Several consumer financing companies doing business in New York State have entered into a stipulation with the Attorney General of New York that requires the law lending firms who are members of the American Legal Finance Association to follow certain guidelines. See Eliot Spitzer, Att’y Gen. N.Y., Assurance of Discontinuance Pursuant to Executive Law § 63(15), (Feb. 17, 2005). See Binyamin Appelbaum, Taking Sides in a Divorce, Chasing Profit, N.Y. TIMES, Dec. 5, 2010, at A1. 26 See Selvyn Seidel, Time to Pass the Baton? COMMERCIAL DISPUTE RESOLUTION MAGAZINE, Nov.-Dec. 2012, available at http:// http://www.fulbrookmanagement.com/2012/11/01/time-to-pass-the-baton. Sean Coffee, the principal of the litigation funding firm BlackRobe (now dissolved) termed this “litigation 2.0”. His explanation for the shift is that when Juridica and Burford sought to go public their deal advisors were unsure that funding which involves control of the litigation is permissible and so those entities sought a more conservative approach than the privately-held entities that followed in their footsteps. John (Sean) Coffey Presentation at the Institute for Law & Economic Policy’s 19th Annual Symposium on The Economics of Aggregate Litigation, Naples, Fl. (April 2013). 27 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 13 providing methods of corporate finance for businesses that could otherwise afford to bring claims,28 and incumbent market participants have added such products to their offerings.29 Other new financial products include law firm financing30 and defense financing.31 2. The concerns raised by litigation finance Most of the literature relating to litigation funding has focused on the ethical challenges posed by litigation funding, on the one hand, and on archaic regulation that stands in the way of litigation funding, on the other. Such regulations prohibit litigation funding in certain states, and in others, raise its costs and constrain its users into financial arrangements with convoluted structures which operate in a legal gray zone. One set of concerns arises from the historic perception of litigation as a necessary evil to address personal harms which are perceived, in the words of one scholar, as ‘authentic claims.’32 The corollary is a historic distaste of ‘officious intermeddling’ by nonparties, especially for a profit.33 The broadest prohibition designed to avoid such intermeddling and to ensure that only authentic claims are brought to the courts is the doctrine of champerty, which bars profiting from financing lawsuits, and related (though functionally different) prohibitions against claim assignment.34 Champerty and assignment limits can apply regardless of claim type, serving to prohibit both commercial and consumer claims.35 See generally What We Do, GERCHEN KELLER CAPITAL,http://www.gerchenkeller.com/what-wedo; specifically for plaintiff services at http://www.gerchenkeller.com/what-we-do/claimholders. 28 29 As this Article goes to print an innovative form of funding in which the funding firm provided a plaintiff with a conventional recourse loan with a contingent value right to receive a portion of an arbitration award has been announced. The funds were to be spent on the plaintiff-corporation’s business needs, rather than litigation costs. See http://www.burfordcapital.com/wp-content/uploads/2014/06/2014-06-03-BUR-Rurelec-press-release-Final.pdf and; See Jan Wolfe, Burford Touts 73% Return on Arbitration Case, THE LITIGATION DAILY, June 3, 2014. See http://www.burfordcapital.com/how-we-help/for-law-firms/; ler.com/what-we-do/law-firms. 30 http://www.gerchenkel- Gerchen Keller Capital describes its defense products at http://www.gerchenkeller.com/whatwe-do/defendants. 31 32 Anthony J. Sebok, The Inauthentic Claim, 64 VAND. L. REV. 61 (2011). 33 See, e.g., definition of “champerty” in BLACK’S LAW DICTIONARY (9th ed. 2009). 34 See N.Y. JUDICIARY LAW §489 (prohibiting buying claims). Each state’s doctrine varies and certain exceptions can be made. For example, New York allows the free assignment of claims that are sufficiently large or of certain types. See Anthony Sebok, 35 DRAFT—DO NOT QUOTE 14 M. STEINITZ Underlying this broad bar are concerns about claim ownership, which is reflected in a focus on whether or not the funder has received control of the litigation.36 Much of legal ethics can be explained as safeguards that ensure that the client, not the lawyer (especially pertinent in the case of contingency lawyering), ultimately controls her claim. For example, the Model Rules of Professional Responsibility specifically carve out permission for attorneys to make day-to-day decisions;37 this carveout is necessary as a deviation from the rule that the client ultimately controls her case. In contrast, only the client can make key decisions with the most privileged decision being the decision to settle, including the option to abandon the litigation.38 Because litigation funding has generally been discussed as an extension of the contingency fee—the best known and the most important of the exceptions to champerty—there is a natural tendency to assume that funders should similarly have no control over the litigation generally and over settlement specifically (though influence is permissible).39 Incorporating The Claim, A MODEL LITIGATION FINANCE CONTRACT, (Feb. 4, 2013 7:59 AM), http://litigationfinancecontract.com/incorporating-the-claim. 36 A Texas Appellate court listed as factors potentially creating a problematic transfer of control: “permitting appellees to select counsel, direct trial strategy, or participate in settlement discussions, [or] to look to [ ] trial counsel directly for payment.” See Anglo-Dutch Petroleum Int'l, Inc. v. Haskell, 193 S.W.3d 87, 104 (Tex. App. Houston 1st Dist. 2006). A Florida District Court concluded a funder had so much control of the litigation it was the real party in interest. See AbuGhazaleh v. Chaul, 36 So.3d 691, 693 (Fla. Dist. Ct. App. 2009); see also the landmark Australian case, Campbells Cash and Carry Pty. Ltd. v Fostif Pty. Ltd. (2006) 229 CLR 386 (Austl.), in which the Australian High Court permitted the funder to have broad control, and the English Court of Appeals equally groundbreaking decision in, Arkin v. Borchard Lines Ltd., [2005] EWCA (Civ) 655 (Eng.), in which it established that third-party funding is acceptable, even desirable, to increase access to justice, but fell short of sanctioning the transfer of control to funders. See also N.Y.C. Bar, Formal Op., at Section E (notes that a client may agree to permit a financing company to direct the strategy or other aspects of a lawsuit including whether and for how much to settle, similarly acknowledges the potential value of funder involvement but leaves it to private contracting rather than interpret the law as allocating any control to the funder). MODEL RULES OF PROF’L CONDUCT R. 1.2 (authorizing the attorney in part to “take such action on behalf of the client as is impliedly authorized to carry out the representation.”). 37 38 Id., saying in part “A lawyer shall abide by a client’s decision whether to settle a matter.” See N.Y.C. Bar Opinion, infra note 40, ABA Comm. on Ethics 20/20, White Paper on Alternative Litigation Financing (2011) (draft), available at http://www.americanbar.org/content/dam/aba/administrative/ethics_2020/20111019_draft_alf_white_paper_posting.authcheckdam.pdf. But cf. The Litigation Finance Contract, supra note 9, at [xx] (arguing that sophisticated plaintiffs in commercial cases should be allowed to sell control in exchange for a control premium). 39 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 15 A related concern is conflicts of interest as the introduction of a financier into the attorney-client relationship can produce conflicts or reinforce existing ones.40 In addition to conflicts that are similar to those that exist between a contingency fee lawyer and her clients—such as incentives to settle early in order to maximize profits across a portfolio rather than in a particular case; incentive to prioritize reputation over monetary relief; and an incentive to prioritize monetary relief over non-monetary relief41—interesting examples of conflicts unique to the funder-client relationship include those that may arise if a funder decides to securitize its pool of litigations42 or to invest on both sides of the “v.” Conflict concerns are often also concerns about control. Instead of overt control, like formal settlement authority or the right to dictate choice of counsel, conflicts can generate hidden forms of control. For example, any repeatplay relationship between funder and the litigation counsel gives funder informal but significant influence over the conduct of the case. As is already implied, litigation funding both affects and is affected by attorneys’ ethics. Therefore, attorneys’ professional responsibility duties function as indirect regulation of litigation funding. Like authentic claim issues, one such duty is a broad bar: the prohibition on fee-splitting 40 See Whose Claim Is It Anyway?, supra note 8 at 1291–92, 1323–25, and The Litigation Finance Contract, supra note 9, at 481–88. Specifically, N.Y. State Rules of Prof’l Conduct R. 1.2(d); 1.6(a); 1.7(a); 1.8(e), (f); 2.1; 2.2; and 5.4(c). More generally, the MODEL RULES OF PROF’L CONDUCT R. 1.0(E) (informed consent), R. 1.6–1.11 (confidentiality of information; conflict of interest: current clients, specific rules; duties to former clients; imputation of conflicts of interest: general rules, special conflicts of interest for former and current government officers and employees), R. 2.1 (counsel as “advisor”), and R. 2.3 (counsel’s evaluation of a matter for use by a third party). These are the rules addressed in the New York City Bar’s formal 2011 opinion on the ethics of third party litigation finance. See N.Y.C. Bar Opinion from October 2011 n. 10 and accompanying text. The American Bar Association’s has draft opinion on the ethics of third party litigation financing, discussing the practice in light of the model rules. See ABA Comm. on Ethics 20/20, supra note 39. HERBERT M. KRITZER, RISKS, REPUTATIONS, AND REWARDS: CONTINGENCY FEE LEGAL PRACTICE IN THE UNITED STATES 9 (2004) (applying modern portfolio theory to contingency fee practice and, among other things, analyzing the conflicts that a portfolio of contingency fee cases creates); Whose Claim Is It Anyway?, supra note 8(analyzing the effects of portfolio management to litigation finance.). 41 For an analysis of the conflicts that may arise if funders ever securitize litigation see Whose Claim Is It Anyway?, supra note 8 at 1312. 42 DRAFT—DO NOT QUOTE 16 M. STEINITZ (that is splitting the fee between a lawyer and a non-lawyer).43 This prohibition prevents business models that make economic sense,44 and it distorts contractual relationships among lawyers, plaintiffs and funders. The same is true of the prohibitions on the unauthorized practice of law45 and on multidisciplinary practices (i.e. the practice of law and other professions, such as accounting, in a single firm).46 Each of these in isolation and in combination means, for example, that finance or accounting specialists cannot partner up with lawyers in a single firm that engages in the practice of law. (However, litigation finance firms are firms in which former attorneys partner up with such finance specialist. They must therefore be careful not to overstep the bounds and engage in the practice of law.)47 Another set of ethical regulations again relates to control: an attorney’s ethical duty to exercise independent judgment,48 free from funder influence, and to zealously and loyally represent her client even if it means being in conflict with the funder.49 These obligations, combined with the fee splitting prohibition, for example, limit a direct engagement between the funder and the attorney for the financing of litigation and require that funder contract directly with the client. Finally, attorneys’ ethical duties also limit or prohibit specific financial arrangements between the attorney and funder such as paying referral fees.50 In addition to industry-wide challenges such as champerty and attorney ethical duties, other doctrines challenge the terms of individual 43 MODEL RULES OF PROF’L CONDUCT R. 5.4. Victoria Shannon, The Funder as Co-Counsel: A glimpse Into the Future of Law Firm Ownership, A MODEL LITIGATION FINANCE CONTRACT, http://litigationfinancecontract.com/thefunder-as-co-counsel-a-glimpse-into-the-future-of-law-firm-ownership/. 44 45 MODEL RULES OF PROF’L CONDUCT R. 5.5. 46 See Shannon supra note 44. 47 The line can be blurry the more financiers seek to be active funders who monitor and seek to actively enhance the value of their investment. See the back and forth discussion here http://litigationfinancecontract.com/funders-as-lawyers/, here http://litigationfinancecontract.com/funders-as-lawyers-a-response/, and Maya Steinitz, Funders As Fiduciaries, http://litigationfinancecontract.com/funders-as-fiduciaries/. 48 MODEL RULES OF PROF’L CONDUCT R. 5.4. 49 MODEL RULES OF PROF’L CONDUCT R. 1.3, comment. 50 See A Model Litigation Finance Contract, supra note 9 at 30 (referrals and repeat play). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 17 deals or deal types namely, the doctrines of usury,51 unconscionability52 and abuse of process.53 All but the last of these doctrines focus on potentially exploitative financing terms, and as a general matter, are raised by consumers rather than plaintiffs involved in the large commercial deals conducted pursuant to bespoke contracts. Nonetheless when a commercial plaintiff seeks to invalidate a deal because it does not like the financing terms in hindsight—after the claim resolved—such arguments have come up.54 A final set of concerns arising from litigation finance include the pressure to commodify claims by resolving them all with money, as opposed to with injunctive or other non-monetary relief.55 Again, underlying the tension is the issue of claim control or influence; if the funder has none there’s no pressure to commodify the claim. Claim commodification reflects perhaps the purest tension between the justice and economic/finance models of litigation and is the reason why financing of certain categories of claims, e.g. torts or claims arising under public international law, should proceed with great caution and may require different regulation than financing of commercial claims. *** In sum, path dependency—an evolutionary path focused on avoiding champerty and the greater philosophy that underlies this doctrine according to which there’s simply something vaguely distasteful56 51 Susan Lorde Martin, Litigation Financing: Another Subprime Industry that Has a Place in the United States Market, 53 VILL. L. REV. 83, 86–7 (2008). 52 Julia H. McLaughlin, Litigation Funding: Charting a Legal and Ethical Course, 31 VT. L. REV. 615, 643 (2007). See LISA BENCH NIEUWVELD & VICTORIA SHANNON, THIRD-PARTY TIONAL ARBITRATION (2012) (discussing the abuse of process doctrine). 53 FUNDING IN INTERNA- 54 S&T Oil Equipment & Machinery, Ltd. v. Juridica Investments Ltd. (S.D. Tex. 2011) is an example of a financed large commercial claim in which a remorseful buyer—the plaintiff—tried to invalidate the financing arrangement. See Anglo-Dutch Petroleum Int'l, Inc. v. Haskell, 193 S.W.3d 87 (Tex. App. Houston 1st Dist. 2006)[] at 95-101 (usury argument), 101-103 (unregistered securities argument), 103-105 (discussing public policy); See also Anglo-Dutch Petroleum Int’l, Inc. v. Smith, 243 S.W.3d 776 (Tex. App. Houston 14th Dist. 2007) (noting the arguments made by the plaintiff that the funding was a usurious loan, or an unregistered (and thus invalid) security, or void as against public policy). 55 See infra note 59. Michael Herman, Fear of Third Party Litigation Funding Is Groundless, TIMES ONLINE (Oct. 25, 2007) (“Detractors [of third party litigation funding feel that]… there is something distasteful, some say unethical, about a third-party that has no involvement in a legal dispute being allowed to profit from it”). This is the notion underlying Anthony J. Sebok, The Inauthentic Claim, 64 VAND. L. REV. (2011). See also W. Bradley Wendel, Alternative Litigation Financing and Anti-Commodification 56 DRAFT—DO NOT QUOTE 18 M. STEINITZ about litigation funding—has obscured a simple fact. The fact is that some plaintiffs have come to regard their claims as assets they wish to monetize i.e., sell in whole or in part.57 To the extent that they wish to sell parts of the asset they are bringing in business partners. Business partners are a known beast: they are allowed contracting for control, they are allowed participating in the management of their investment and the underlying asset, in certain circumstances they owe and are owed fiduciary duties (if structured as a partnership) or at least a duty of good faith,58 they must avoid self-dealing and are generally subject to the various laws and doctrines that address conflicts of interest, they can request to review books and records, and more.59 In other words, there is an entire area of law, as law students learn as soon as they commence their legal education, that has evolved during modern times, since the advent of limited liability, to deal with these kinds of commercial relationships: the law of business entities. There is no good reason to prevent parties to litigation funding arrangements from availing themselves of the mechanisms, laws and practices that have evolved in the law of corporations to deal with these very same problems. Some concrete examples are provided in Part III. But first, the next Part demonstrates that these issues of ownership and control can be directly addressed when issuing securities tied to litigation proceeds, either directly or through an SPV, or when using an SPV to embody and distribute the value of the claim to the SPV’s owners, rather than to litigation proceed-backed security holders. Understanding how control and conflicts were addressed in these deals will lay the foundation to bringing general principles of corporate law to bear. Norms, DEPAUL L. REV. (Forthcoming) (theorizing the “ick factor” that is often cited in discussions of Alternative Litigation Finance). 57 As is recognized by the literature on claim assignment. See Michael Abramowica, On the Alienability of Legal Claims, 114 YALE L. J. 697 (2004); Sebok, supra note 56. 58 Anthony J. Sebok & W. Bradley Wendel, Characterizing the Parties’ Relationship in Litigation Investment: Contract and Tort Good Faith Norms, 66 VAND. L. REV. (forthcoming 2013). 59 See infra Part IV. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 19 II. CLAIM INCORPORATION AND LITIGATION GOVERNANCE IN THE EXAMPLES OF WINSTAR, INFORMATION RESOURCES, CRYSTALLEX AND TRECA60 Legal claims are notoriously difficult to value.61 Consequently, they are very difficult to account for on a corporation’s books. 62 And when a claim is materially large relative to a plaintiff company’s value as a going concern, legal claims can, and have, become insurmountable obstacles to pricing a merger, acquisition, or major equity investment. I call this kind of problem a “hidden cost” of litigation. Hidden costs are major restrictions imposed on a business simply because a large legal claim exists.63 Importantly, when litigation causes difficulties in entering into mergers or acquisitions, transacting into large equity infusion or effects the cost of capital the hidden costs can dwarf the expense of pursuing a claim. 60 I thank Abigail C. Field for her assistance with this section. Her many insights have been invaluable to its development. Maya Steinitz, Pricing Legal Claim, 16 VAND. L. REV 1890, 1903-1906 (2013) spp. and especially the literature review nn. 56-89. See also, Jonathan T. Molot, A Market In Litigation Risk, 76 U. CHI. L. REV 367 (2009). 61 62 A note on individual plaintiffs: While beyond the scope of this paper, individuals have an access to justice problem as well as a problem in valuing legal claims and receiving accounting and tax benefits on causes of action and pending litigation, as opposed to on damages they received. These are beyond the scope of this paper but I hope to see others investigate them. Jonathan Molot introduced a similar idea in the defense context dubbing it the “tertiary cost” of litigation and concluded the solution was a market in legal defenses: 63 “[I]n some instances, litigation’s largest expense may stem from the ‘tertiary’ effects that pending litigation may have on litigant conduct. A $50 million lawsuit against a company can easily prevent that company from raising $250 million or even $500 million in debt or equity to finance new, productive business activities. At the very least, the uncertainty surrounding a significant potential liability may increase a company’s cost of capital by depressing its stock price or increasing the interest rate it must pay on its debt. Where litigation risk interferes with an equity investment, a debt refinancing, or a merger or acquisition the tertiary costs of litigation can dwarf the primary costs.” A Market In Legal Claims at 374 -75. For empirical work on the effects of litigation on a company’s stock price see David M. Cutler & Lawrence H. Summers, The Costs of Conflict Resolution and Financial Distress: Evidence from the Texaco-Pennzoil Litigation, RAND J. OF ECON., Vol. 19, No. 2, pp. 157-172, (Summer 1988) (estimating that the Texaco-Pennzoil litigation had reduced the combined equity value of the two companies by about $2 billion and that further losses may have been incurred by Texaco’s bondholders). DRAFT—DO NOT QUOTE 20 M. STEINITZ In addition, corporations, which are generally conservative about suing, currently are experiencing value destruction in the form of un-prosecuted claims. These too should be included in any analysis of the hidden cost of litigation to the extent that claims are not prosecuted because of the difficulty in ascertaining value, the difficulty in ascertaining the likelihood of success prosecuting meritorious claims, negative accounting treatment during claim conduct or unfavorable tax treatment. Potential corporate plaintiffs face a decision to dedicate significant sums to cover litigation fees and costs in return for an outcome that is uncertain.64 The larger the potential recovery, the higher usually are the costs of pursuing the litigation and with those the larger the down-side risk and the opportunity costs. Often, the funds required to pursue litigation can be employed by the company with less risk on other activities such as operations or marketing. Even where valuation is straight forward, accounting treatment can be unfavorable from the plaintiff corporation’s perspective, deterring the corporation from bring meritorious claims. For starters, all the costs of litigating are accounted for as expenses, a negative impact that particularly hurts EBITDA businesses.65 Next, accounting rules do not allow recognition of the potential upside while the claim is pending. The Financial Accounting Standards Board (“FASB”) prohibits evaluating and listing a claim as an asset on a balance sheet.66 In addition, as paradigmatic examples of gain contingency,67 pending court cases and legal claims can- 64 Id. See Financial Acumen--Taking Litigation Off the Balance Sheet, BURFORD, http://www.burfordcapital.com/casestudies/financial-acumen-taking-litigation-offthe-corporate-balance-sheet/#sthash.ppJmSBlw.dpuf. (last visited Mar. 21, 2013) 66 Selvyn Seidel & Sandra Sherman, Corporate Governance Issues regarding “Stock Price Manipulation” and “Insider Trading”, (and other matters) are coming to in Third Party Financing, (forthcoming) (discussing FIN. ACCOUNTING STANDARDS BD. No. 5). 67 Defined in FASB ASC 450 “an existing condition, situation, or set of circumstances involving uncertainty as to possible gain (referred to as a ‘gain contingency’)… to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.” 65 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 21 not be recognized in the income statement of a company until all contingencies have been resolved.68 Last, even when a claim is resolved favorably, the accounting is not helpful, particularly for EBITDA businesses, as the income must be listed as a non-recurring item.69 The accounting difficulties are likely the reason why banks do not consider legal cases to be assets and why they do not lend based on the value of contingent fees, no matter how large the potential contingency:70 Most business can turn to banks for help, but law firms are often stuck. Banks don’t consider legal cases to be assets and won’t lend based on the value of ‘contingent fees’ since there’s no guarantee of getting them. So the only way to get a bank loan is for the partners to borrow money personally or use their credit cards. But besides being costly and putting the partners’ own money and assets at risk, the interest on personal loans is not tax deductible. Also, until the case is finished, attorneys can’t deduct the enormous legal case expenses that are incurred.71 In addition, banks do not invest in litigation financing because it is financing provided upfront with no expected cash flow for an extended period of time.72 Last but not least, funding litigation can pose business conflicts for banks. This problem on the plaintiff side is analogous to the difficulty that litigation poses to defendants’ ability to raise debt and equity. Sovereigns, domestic as well as foreign, are another type of sophisticated owner of large-scale claims that face the same kind of analysis 68 [Accounting for Contingencies at 2]. Disclosure of such gain contingencies can be made when the probability that it will be realized are high but “care should be exercised to avoid misleading implications as to the likelihood of realization.” Id. Consequently, “it is unusual to find information about contingent gains in [a] financial statement." Id. 69 See supra note Error! Bookmark not defined.. 70 See Jonathan D. Epstein, An Unusual Financial Niche: Lending Money to Lawyers, BUFFALO NEWS, Sept. 30, 2007, at C1. See also, Ben Winograd, Specialized Lenders Help Fill Financing Void for Law Firms, AM. BANKER, Nov. 2, 2006, at 3 (“No matter how large the potential verdict, banks generally will not make loans beyond the existing assets of a firm or its attorneys.”) Both discussed in Nora Freeman Engstrom, LAWYER LENDING: COSTS AND CONSEQUENCES (forthcoming) at n.56. 71 See Epstein, supra note 70. See also, Winograd, supra note 70. 72 I thank Victor Goldberg for this comment. DRAFT—DO NOT QUOTE 22 M. STEINITZ when having to decide whether to pursue litigation. In addition, such decisions are subject to public scrutiny and using public funds to pursue speculative litigation may not be a popular decision. Here, the value destroyed from having to forgo litigation is a foregone public resource. The reconceptualization of legal claims as assets that the American legal world is currently undergoing, combined with (i) the newfound purchasing power of corporations and their consequent ability to lower their legal costs73; and (ii) a solution to the problem of the hidden costs, may all combine to a new reality in which corporate and sovereign plaintiffs are able to monetize the value of all their meritorious legal claims, rather than forgo some. While the existence of hard-to-value litigation that actually threatens M&A is an unusual situation, it arose several times in the 1990s, and some innovative lawyers correctly concluded that incorporating and trading in legal claims through the use of securities74 would help their clients overcome the hidden costs. Those are most of the deals described below. There is some evidence that these deals are not sui generis. For example, preceding the Winstar deals described below were deals by banks which “had established trusts for shareholders, assigning them contingent rights in litigation.”75 All of these legal innovations operate in a similar legal gray 73 See Jonathan D. Glater, Billable Hours Giving Ground at Law Firms, N.Y. TIMES, Jan. 30, 2009, at A1, available at 2009 WLNR 1784153 (“‘Clients are more concerned about the budgets, more so than perhaps a year or two ago.’” (quoting Evan R. Chesler, presiding partner, Cravath, Swain & Moore LLP)). 74 On issuing securities as a mechanism for litigation funding for reasons other than those discussed herein, see A Model Litigation Funding Contract, supra note 16. There, a co-author and I suggested issuing Litigation Proceed Rights, a kind of privately placed, heavily restricted security, in order to implement the idea that litigation finance can be modeled on venture capital. In that context start-up companies issues securities that compensate the venture capitalists for their investment. We suggested that, just as in venture capital, securities can be used to effectuate staged funding which allows for minimizing the extreme uncertainty, information asymmetry and agency costs that characterize litigation as an investment. While we did not use the incorporation paradigm to describe that security, the deal we proposed would constitute a “loose incorporation” of the claim. Professor Richard Painter commented on some of the securities laws implications of using such securities. See Richard Painter, The Model Contract and The Securities Laws, Part I-IV, A MODEL LITIGATION FINANCE CONTRACT, supra note 16. See Margaret Cronin Fisk, ‘Winstar’ Litigants Bet on Future Damages Awards, NATIONAL LAW JOURNAL, Jan. 11, 1999, at A19 (going on to note that “this was rare, and you couldn’t buy or sell these rights” (quoting Victor Lewkow, partner, Cleary, Gottlieb, Steen & Hamilton LLP)). Another early financial instrument tied to litigation proceeds were the Tabaco settlement bonds. These too implicated the issues of control and conflicts of interests. See, e.g. Jody Sindelar and Tracy Falba, Securitization of Tobacco Settlement Payments to Reduce States’ Conflict of Interest, HealthAffairs, July (“the issue [raised by securitization] is lack of commitment to tobacco control by states. Further, securitization can mitigate states’ conflict of interest between keeping tobacco companies fiscally healthy to ensure their [Master Settlement Agreement] payments and reducing tobacco 75 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 23 zone as the financial innovation that is litigation finance, for the same underlying reasons. Consequently, these efficient and commonsensical market solutions seem to be very rarely used.76 This section describes litigation proceed-backed securities tied to six claims, and then a litigation finance deal that involved regular corporate securities as part of a secured lending litigation finance deal for a bankrupt plaintiff. I classify the claim incorporation as ‘loose’ or ‘strict’, depending on whether the plaintiff issues a security directly (loose) or the claim/right to receive all proceeds of the claim are transferred to an SPV while the litigation is pending, whether or not the SPV issues a litigation-backed security. Each incorporation, whether loose or strict, is always coupled with a formal allocation of control and ownership of the claim, as well as a pre-emptive resolution of conflicts or a voting process by which such conflicts are resolved. Specifically, below are (1) examples of both strict and loose incorporation that arose from litigation against the federal government filed in the mid- and late-1990s by failed or nearly failed Savings and Loans, collectively known as the Winstar cases, after the case name in the U.S. Supreme Court decision determining the government’s liability. The merger pricing problem arose in a non-Winstar context too. Information Resources needed to spin off its anti-trust claim in order to complete a deal in which it was acquired and taken private. (2) The Crystallex deal, which involves that bankrupt company’s massive arbitration claim against Venezuela. (3) An example of a trust contemplated in connection with the funding of transnational mass tort litigation known as the Chevron – Ecuador litigation. The trust incorporation contemplated in this funding arrangement would have been a strict incorporation. sales for health reasons. States should not align with tobacco companies with the common interest of keeping tobacco companies fiscally healthy”). 76 The author was only able to identify the Treca, Winstar, IR and the Crystallex examples. A special thanks to Abigail C. Field for bringing to my attention the IR deal. In researching these deals, I have found no instances in which such transactions ended up being challenged through litigation on issues such as champerty. Two deals were involved in litigation, both while the plaintiff company in bankruptcy. The creditor status attached to being a Dime warrants holder was litigated in Washington Mutual’s bankruptcy, as discussed below, and in the debtor-in-possession financing deal for Crystallex, which was a litigation funding deal, was challenged by dissident Crystallex bondholders who wanted the bankruptcy judge to accept their debtor-in-possession financing deal instead. Neither litigation sought to void the transactions on the basis of litigation finance concerns. DRAFT—DO NOT QUOTE 24 M. STEINITZ 1. Loose and Strict Incorporation to Reduce Hidden Costs: the Winstar Savings & Loans Litigations and Information Resources In the 1980s, following the S&L crisis, the federal government facilitated mergers between failing institutions and relatively healthier ones. A crucial deal point was regulators’ blessing that ‘goodwill’ associated with the transactions could be counted as part of the merged S&L’s required capital and written off over decades. In 1989, Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), that attempted to both prevent future S&L failures and facilitate accountability for the one that had happened. One part of FIRREA focused on making S&Ls sounder by forcing them to be better capitalized.77 One capitalization-related change imposed by FIRREA was that the S&Ls were forced to write down the “supervisory goodwill” much faster, with an immediate and major impact on the balance sheets of the merged companies. Many such companies sued the federal government on both breach of contract and constitutional bases. In its July, 1996 decision upholding the government’s liability on the breach of contract claims,78 the U.S. Supreme Court gave this recitation of the history: The impact of FIRREA’s new capital requirements upon institutions that had acquired failed thrifts in exchange for supervisory goodwill was swift and severe… Despite the statute’s limited exception intended to moderate transitional pains, many institutions immediately fell out of compliance with regulatory capital requirements, making them subject to seizure by thrift regulators. 79 Three S&Ls were involved in that case, and the claim of one of them, Glendale Federal Bank, became the focus of one of the litigation securities discussed herein. As the Court noted: 77 See United States v. Winstar Corp., 518 U.S. 839, 857 (U.S. 1996). 78 Glendale filed its suit in 1990 and won its partial summary judgment motion on the contract claims in 1992. See Glendale Federal Awarded Damages in Supervisory Goodwill Suit Vs. U.S. Government, BUSINESS WIRE, April 9, 1999. The government won its appeal to the Federal Circuit, but Glendale won an en banc rehearing in August 1995. Winstar Corp. v. United States, 64 F.3d 1531 (Fed. Cir. 1995). 79 United States v. Winstar Corp., 518 U.S. 839, 857-58 (U.S. 1996). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 25 Respondents Glendale Federal Bank, FSB, Winstar Corporation, and The Statesman Group, Inc., acquired failed thrifts in 1981, 1984, and 1988, respectively. After the passage of FIRREA, federal regulators seized and liquidated the Winstar and Statesman thrifts for failure to meet the new capital requirements. Although the Glendale thrift also fell out of regulatory capital compliance as a result of the new rules, it managed to avoid seizure through a massive private recapitalization. 80 Importantly, while Winstar established the idea that the government could be liable—and was liable to Glendale, whose parent Golden State Bancorp eventually issued securities tied to that litigation—the various S&L deals involved different language and facts and thus liability could not be assumed in all S&L cases. Thus, when Cal Fed, Dime, and Coast Federal issued litigation proceeds-based securities, as discussed below, liability in those cases had not been determined. Only Golden State’s security issuance was founded on established liability.81 In fact, when Cal Fed issued its securities, the Winstar Supreme Court decision quoted above had not yet been issued. These deals thus highlight that the tremendous risk inherent in litigation, particularly early stage litigation, is not itself a bar to issuing securities, even ones that trade on public markets. Because Cal Fed was the first issuer, I begin with its deal. A. Loose Incorporation in the Cal Fed litigation: Participation Right Certificates The Cal Fed case arose from its acquisition of four thrifts in 1982 and 1983.82 Cal Fed filed suit in 1992, but its case was stayed while the Winstar cases were litigated. In July 1995, prior to the U.S. Supreme Court 80 Id. With regard to Glendale, it agreed to take over a failed Florida thrift in 1981 and regulators allowed it to offset bad loans with “supervisory goodwill” that it would then write off over the next 40 years. When FIRREA passed, Glendale Federal still had $565 million in supervisory goodwill remaining. To compensate for the FIRREA requirements, Glendale said it was forced to decrease its assets by more than $10 billion. See Deborah Adamson, Glenfed Parent Announces Earnings Up, Trading Plan Byline, DAILY NEWS OF L.A., October 29, 1997. 81 See Coast S-4 “The Litigation—Related Cases” at [SEC page 17 / internal page no. 11]. U.S. Court of Appeals Rules Golden State Bancorp May Seek Damages For Lost Profits In Cal Fed Supervisory Goodwill Case, BUSINESS WIRE, April 3, 2001. 82 DRAFT—DO NOT QUOTE 26 M. STEINITZ decision in Winstar, Cal Fed issued the first of two securities (“Participation Right Certificates”) related to its supervisory goodwill claim.83 These Participation Right Certificates entitled holders to a share of approximately 25% of the net proceeds if ever realized,84 and were issued directly by Cal Fed, with Cal Fed retaining control of the claim. Thus the Participation Right Certificates represent a partial, and “loose” incorporation of Cal Fed’s claim. The first Cal Fed issuance was not done to solve a hidden cost problem; some speculated it was done purely to line the pockets of the executives and directors at the expense of shareholders.85 Nonetheless the market price of that first security was used to value the claim when Cal Fed entered a merger agreement with First Nationwide Holdings, and the second litigation security was issued as part of the terms of that merger to resolve the hidden cost problem.86 That second security was similar to the first, in that holders were entitled to a fraction of any net cash recovery after other claims, such as those of the first security’s holders, had been paid. Because both securities were redeemable for cash, they had negative tax consequences for the shareholders who initially received them.87 Both securities traded on the NASDAQ. From both a champerty and privilege waiver perspective, it is nigh impossible to see an issue created by Cal Fed’s approach. From the champerty perspective, all that has happened is that shareholders were given something they were always entitled to—the right to receive the value of 83 California Federal Bank Goodwill Participation Securities Declared Effective; Record Date Set, PR NEWSJune 28, 1995. WIRE, 84 Id. Kurt Eichenwald, INVESTING IT: INVESTMENT GRADES; No Toasters at This Bank. It’s Giving Away a Lawsuit, N.Y. TIMES, March 26, 1995. (also explaining that “if markets work the way they should, for every penny the shareholders receive in this new security, they should lose a like amount in their Cal Fed shares… Some Cal Fed executives say they don't buy that. Instead, they assert that, by shedding 25 percent of a potential asset, the share price of the company could actually go up. The way the logic goes, creating the new security could force the market to come to grips with the possible value of a lawsuit once kissed off as negligible.”) 85 For the valuation of the suit using the first security’s trading value, see the unaudited pro forma financial data reflecting the financial condition of the proposed merged company at page P-4 attached to the AMENDED AND RESTATED AGREEMENT AND PLAN OF MERGER dated July 27, 1996, filed as an exhibit to the 8-K announcing the closing of the merger filed with the SEC on January 3, 1997. For a discussion of the secondary security issued as part of the merger, see Article I of the Merger Agreement. 86 See Nantahala Capital Partners, LP v. Wash. Mut., Inc. (In re Wash. Mut., Inc.), 464 B.R. 656 (Bankr. D. Del. 2012) (Discussing the development of litigation tracking warrants to avoid the taxation issue posed by certificates that could be redeemed for cash.) See also Ferve Ozturk, Nantahala: Litigation Tracking Warrants Are Equity, Not Debt 31-4 ABIJ 22 May 2012. 87 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 27 the claim. True, by trading the certificates to people who were not shareholders of Cal Fed, investors who were ‘strangers’ to the litigation stood to profit if the litigation were successful. Nonetheless they had not actually financed the litigation; Cal Fed did not receive payment in those transactions. Finally, no claim transfer occurred; the plaintiff retained full control of its litigation. From a privilege perspective, the company simply did not reveal any privileged information to shareholders or certificate holders, and no funder or other party was inserted into the attorney client relationship.88 The Cal Fed-First Nationwide merger closed in January, 1997. Later that year Cal Fed began merger talks with Golden State, setting in motion that S&L’s spinoff of its Winstar litigation, discussed below. Cal Fed was the surviving company in that transaction, which closed in 1998. That year Cal Fed’s litigation securities were trading as high as $16-$17.89 In April, 1999 the court awarded Cal Fed a mere $23 million, and the certificates plummeted in value.90 In 2002, Citigroup acquired Cal Fed, and thus it absorbed both Cal Fed’s goodwill claim and Golden State’s, and their related securities obligations.91 In October, 2005 the $23 million Cal Fed judgment became final when the U.S. Supreme Court denied cert. As a result, Citi notified the Cal Fed certificate holders they would get nothing.92 B. Loose incorporation by Golden State: Litigation Tracking Warrants In 1997 Glendale Federal’s parent, Golden State Bancorp, announced its intention to merge with Cal Fed Bancorp. In October, 1997, 88 Disclosure is one of the interesting challenges regarding claim-based securities. While these deals suggest the securities laws’ command to disclose material information can be met without disclosing privileged information, it is possible to imagine a claim that involves privileged information that investors would find material if they knew it to exist. On the possible operation of securities regulation see Wendy Couture, Securities Regulation of Alternative Litigation Finance, (forthcoming). Paul Sweeney, INVESTING; How to Win Big in Court And Never See a Lawyer, N.Y. TIMES November 1, 1998, § 3, at 10, Col. 5. (at the time of the article, the first issuance traded at $16.125 and the second one traded at $17.75). 89 90 Richard B Schmitt, Investors Betting On Judgment For Thrift Take A Hit In California Federal Ruling, WALL ST. J., April 20, 1999, at B11. Laura Mandaro, In Brief: Citi Closes Purchase of California Federal (Citigroup Inc. acquires California Federal Bank) (Brief Article), AM. BANKER, Nov. 15, 2002. 91 Citibank (West), FSB, Announces Supreme Court Action in California Federal Bank v. United States, BUS. WIRE, Oct. 4, 2005. 92 DRAFT—DO NOT QUOTE 28 M. STEINITZ while negotiations were ongoing, Golden State declared it would issue Litigation Tracking Warrants (warrants, LTWs or Golden LTWs) tied to the Glendale claim. The Golden LTWs were a ‘loose incorporation’ of the Glendale claim because they were issued by Golden State instead of a Special Purpose Vehicle (SPV). Control of the litigation remained with Golden State. If the Glendale claim ever resulted in proceeds, the warrants allowed holders to purchase shares of Golden State common stock with an aggregate value pegged to the value of the proceeds received. The spinoff of the Glendale claim was done this way instead of via CalFedlike certificates that could be redeemed for cash to avoid the income tax consequences of the CalFed approach.93 The warrants were issued to solve the hidden cost problem. Golden State asserted the claim’s value was $1.5 billion, a number that would be material in many deals even today. 94 The Chairman of Cal Fed explained that the “two sides had been unable to agree on how much Glendale is really worth once the anticipated damages on its goodwill suit against the federal government are factored out of its stock price.”95 The warrants gave the companies a “market mechanism” to resolve the dispute, namely a “collar.”96 Specifically, if “Glendale’s stock is worth $32 or less in a specified period after the goodwill litigation tracking warrants have been issued, its shareholders get 55% of the combined company. At $33 or more, they get 58% of the company.”97 Market analysts reacted favorably: “[According to analysts,] the warrants make it easier for the thrift to be taken over since it separates the company’s legal claims against the government from the company’s core business because it certainly removes a major stumbling block in the event of See Wash. Mut., Inc., 464 B.R. 656; See also Ferve Ozturk, Nantahala: Litigation Tracking Warrants Are Debt, Not Equity 31-4 ABIJ 22 May 2012. 93 In its pleadings, Glendale asserted damages of $1.5 billion, and indeed publicized its offer to settle for that amount a month after announcing its intention to issue the warrants. See Brad Finkelstein & Brian Collins, Glendale Offers to Settle its Goodwill Lawsuit, NAT’L MORTG. NEWS, Dec. 1, 1997, at 17. 94 Snigdha Prakash, Despite Deal's Complexities, CalFed Really Is the Buyer, AM. BANKER, Feb. 12, 1998, at 22. 95 96 Id. 97 Id. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 29 an acquisition… Now we can value it on its earnings and franchise.” 98 The Litigation Tracking Warrants were issued in May, 1998 to holders of Golden State common stock on a one-share, one LTW basis.99 If a ‘triggering event’ occurred, meaning, if sufficient litigation proceeds were received, warrant holders were entitled to purchase Golden State common stock for $1 per share up to an aggregate value of 85% of the net proceeds. The remaining 15% were to be retained by Golden State. The warrants came without voting rights, liquidation preferences, dividend or other distribution entitlements,100 and were freely tradable, registered on the NASDAQ.101 If Golden State underwent future mergers, the LTWs would be exerciseable against the surviving company’s common stock on the same terms.102 How many shares could be purchased upon the receipt of sufficient proceeds to be a triggering event could only be determined at such time as it involved two unknowns—first, the amount of net proceeds received, and second, the market price of Golden State stock.103 The prospectus is clear that Golden State owns and controls the litigation: [Golden State] will retain sole and exclusive control of the Litigation and will retain 100% of the proceeds of any recovery from the Litigation. The Litigation will remain an asset of the Bank and the Bank intends to pursue the Litigation with the same vigor as 98 Adamson, supra note80 (internal quotation marks omitted). Golden State Bancorp Inc., Current Report (Form 8-K) (April 21, 1998) available at, http://www.sec.gov/Archives/edgar/data/1019508/0000898430-98-001724.txt Golden State Bancorp Inc., Current Report, (Form 8-K & Press Release) (May 5, 1998). Golden LTWs were also held in reserve to be distributed to those who had the right to Golden State common stock via convertible securities but had not yet exercised that right as of the record date. No other LTWs were to be issued. See Warrant Agreement section 2.1, available at, http://www.sec.gov/Archives/edgar/data/1019508/0000898430-98-001506.txt, exhibit 3. 99 100 Id. at 9. 101Id. at 4. 102 Id. 103 The formula is described in Golden State Bancorp Inc., PROSPECTUS, at 6 (May 22, 1998). DRAFT—DO NOT QUOTE 30 M. STEINITZ it has in the past. The Bank reserves the right, however, to terminate the Litigation in any manner it deems appropriate to serve the Bank’s best interest. 104 Golden State was similarly clear that the resulting conflict between it and the LTW holders was resolved in its favor: The LTW(TM) Holders will not have any rights against the Company or the Bank for any decision regarding the conduct of the Litigation or disposition of the Litigation for an amount less than the amount it has claimed in damages in the ongoing trial in the Claims Court, regardless of the effect on the value of the LTW(TM)s. Although the Bank currently intends to continue prosecuting the Litigation and to seek a cash recovery in the amount claimed, there can be no assurance that the Bank will not make a different determination in the future. 105 Perhaps to reassure LTW holders that the claim conduct would be managed well, Golden State and Cal Fed entered a ‘litigation management agreement’ to govern the conduct of the two goodwill claims, Golden State’s and Cal Fed’s.106 The litigation management agreement created two committees of the board of directors, one for each of the Glendale (Golden State) and Cal Fed cases, and vested in those committees the full power of the board of directors of the merged company in each committee as regards the respective litigation. The litigation management agreement further provided that two Golden State executives with knowledge of the underlying facts would be employed by the company as ‘Litigation Managers’ for both cases, reporting to both committees.107 Subject only to the ultimate authority of the committees, the Litigation Managers could retain or fire counsel, hire agents, and take all steps appropriate relating to both litigations and the associated litigation securities.108 104 Id. 105 Id. 106 Golden State Bancorp Inc., Current Report, (Form 8-K Exhibit) (Feb. 17, 1998). Litigation Management Agreement by and among the Registrant, Glendale Federal Bank, A Federal Savings Bank, Stephen J. Trafton and Richard A. Fink Article I. The Cal Fed committee had the power to reduce the Litigation Managers control of that case, but the Litigation Managers would still be paid as if they were managing that case. 107 108 Id. Article II. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 31 Even though the Litigation Managers were to be employees of the merged company (Executive Vice Presidents) reporting to committees of the boards of directors, and even though the company owned the litigation and stood to receive substantial financial benefit from a successful conclusion of both cases, including expense reimbursement and 15% of the value of the proceeds, the litigation management agreement imposed a duty to cooperate on the merged company.109 The litigation management agreement further provided that the company would not merge or otherwise effect a change of control unless the rights of both the Litigation Managers’ and the LTW holders were unaffected.110 Just as with the Cal Fed security, this loose incorporation approach poses no problems from either a champerty or privilege waiver perspective. Indeed, with the LTWs the distance from champerty is even greater, as the litigation proceeds are simply a reference number, like LIBOR, and do not have a direct connection to the securities. Golden State retains the claim and 100% of its proceeds. Because the legal claim was now reified—incorporated in the sense of having a legal identity separate from the plaintiff—it not only solved the merger pricing problem but rather the Golden State LTWs also forced a change in the accounting of a second merger,111 had a role in the mechanics of a third merger,112 and were part of the consideration of the redemption of some preferred securities,113 all of which occurred before the Cal Fed deal closed. The merger between Golden State and Cal Fed closed in September 1998.114 Ultimately the litigation and the warrants tracking it were assumed by Citigroup as part of its November, 2002 merger with CalFed.115 As a result Golden LTWs became exerciseable for shares in Citi if a triggering event occurred, which it did in 2005. 109 Id. at 2.2. 110 Id. at 3.1(a). Golden State Bancorp Announces Change in Accounting for Acquisition of CENFED Financial Corp., BUS. WIRE, Jan. 27, 1998. 111 See California: News And Insight On Business In The Golden State; The State / Banking; Golden State Bancorp Plans Stock Buyback Byline, L.A. TIMES, May 20, 1998, at D2. 112 113 Golden State Bancorp to Redeem Series A Preferred Stock, August 19, 1998. 114 California Federal Bank and Glendale Federal Bank Complete Merger, BUSINESS. WIRE, Sep. 11, 1998. Laura Mandaro, In Brief: Citi Closes Purchase Of California Federal (Citigroup Inc. acquires California Federal Bank) (Brief Article), AM. BANKER, Nov. 15, 2002. 115 DRAFT—DO NOT QUOTE 32 M. STEINITZ On March 15, 2005 the government paid Citi $381,538,695 to satisfy damage and costs judgments in the Golden State/Glendale litigation. Those proceeds, after netting, resulted in an Adjusted Litigation Recovery of $153,776,991.116 The impact of costs and taxes is clear: 85% of the gross proceeds would have been $324,307,890.75, more than double the amount the LTW holders were entitled to. In the end, each LTW was exercisable for 0.02302 share of common stock of Citigroup and $0.6725 in cash, with the result that Citi would distribute up to 1,944,415 shares of Citigroup common stock and $56,802,378, depending on how many LTWs were redeemed.117 The total cash value of each LTW on the day the distribution was determined was $1.7931,118 which compares favorably with the $1.38-$1.75 trading range of the LTWs in the first quarter of 2005.119 However that amount was well below the $6 and 11/16 valuation on the close the first day of trading after issuance.120 The initial, much higher valuation in 1998 and the very close to accurate valuation in 2005 demonstrate the impact of information challenges on litigation valuation. Early in the litigation—but after an initial liability determination—the market price wildly overstated the securities’ value. But when sufficient information was revealed—by the quarter prior to claim resolution—the litigation was more accurately valued through a market mechanism. C. Loose Incorporation in the Dime/Anchor Savings litigation: Litigation Tracking Warrants Anchor Saving’s claim was based on eight acquisitions of failing S&Ls in 1982-85, four of which were facilitated by regulators.121 When FIRREA was enacted in 1989, Anchor’s books still carried over $500 million of related capital, including the ‘goodwill.’ As a result, Anchor claimed it Citigroup Inc., Prospectus Supplement (Sept. 2, 2004), available at http://www.sec.gov/Archives/edgar/data/831001/000104746905009106/a2154892z424b3.htm. 116 117Citigroup Announces That the 60-Day Exercise Period for Its Litigation Tracking Warrants Commenced Today, BUSINESS WIRE, April 5, 2005. 118 Citigroup Inc., supra n. 90, at S-6. 119 Id. at S-3. 120 In Brief: Warrants Fall, DAILY NEWS OF L.A., May 6, 1998. WASHINGTON MUTUAL: Goodwill Lawsuit Over 4 Acquisitions Pending, LLOYD'S CORP. LITIG. REP, .Oct. 3, 2008. 121 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 33 faced severe limitations on its activities and was forced to liquidate valuable assets at fire-sale prices.122 In 1994, Anchor and Dime Savings Bank agreed to merge. In January, 1995 Anchor filed the suit against the government. Shortly thereafter, the merger closed, and as a result of the merger, Dime became entitled to the proceeds.123 Because filing the claim did not disrupt the merger pricing previously negotiated by Anchor and Dime, Anchor had no motivation to issue litigation securities at that point. However, a later deal did face the pricing problem. In early 2000, North Fork Bank attempted a hostile takeover Dime. Dime found a white knight in Warburg Pincus. As Dime and Warburg did not agree on the value of the litigation, that major equity investment faced the hidden cost issue. As a result, Dime issued Litigation Tracking Warrants on December 29, 2000.124 Again, because these were issued directly by Dime they represent a “loose” incorporation. Dime retained control of the litigation. The Anchor/Dime LTWs were conceptually similar to the Golden State LTWs and were similarly worth stock representing 85% of the net recovery. Also like the Golden State LTWs, the Dime LTWs traded on the NASDAQ and, because of merger, were ultimately redeemable for shares in a different company than Dime. In 2001 Dime announced its intention to merge with Washington Mutual, and that deal closed in 2002.125 Not much happened until 2008, when the trial court awarded $356 million in damages.126 The decision was appealed.127 Later in 2008, regulators seized WaMu and sold most of its assets to JPM Chase.128 The hollowed out parent company filed for bankruptcy the next day.129 In 2010 the appeals court remanded for further WASHINGTON MUTUAL: Broadbill Asserts Claim Over Breach of Contract, 14 TROUBLED CO. REP., May 28, 2010. 122 123 Id. See Warburg Pincus, Dime Announces Major Investment, BUS. WIRE, July 6, 2000; Randi Feigenbaum & Tami Luhby, Dime's Move May Quash Rival's Bid, NEWSDAY (N.Y.), July 7, 2000, at A55. See Dime Announces Distribution of Litigation Tracking Warrants, BUS. WIRE, Dec. 18, 2000. 124 125 See Washington Mutual to Extend National Banking Franchise With $5.2 Billion Merger With Dime Bancorp, BUS. WIRE, June 25, 2001; Washington Mutual Completes Acquisition of Dime Bancorp, BUS. WIRE, January 7, 2002. See WASHINGTON MUTUAL: Court Declares LTWs as Equity, Not Debt 16 TROUBLED CO. REP February 9, 2012. 126 127 Id. 128 Id. 129 Id. DRAFT—DO NOT QUOTE 34 M. STEINITZ damage calculations, suggesting the damages should be $63 million more.130 Shortly thereafter LTW holders began negotiating with the WaMu estate. One group decided to settle, and received some cash, some stock in a reorganized WaMu, and some “Run-off Notes”.131 Other LTW holders sued, seeking a declaration of their rights and creditor status above equity holders. In 2012 the court ruled the LTWs were equity, and the litigating LTW holders were assigned such status and their related claims subordinated.132 As a result of that decision, $337 million in proceeds were released into the estate.133 D. Strict Incorporation in the Coast Savings litigation: Trust Certificates Coast Savings Financial took over the failed Central Savings and Loan Association from regulators in 1987, in a deal that involved a $298 million ‘capital credit’ that was wiped out by FIRREA in 1989.134 Coast filed its goodwill claim in July, 1992.135 The litigation was stayed while the Glendale/Winstar litigation went all the way to the U.S. Supreme Court, and was not scheduled to be tried until 1999 at the earliest.136 However, in 1997 Coast began negotiating merger terms with H. F. Ahmanson & Co. Again, litigation’s valuation difficulty created hidden costs. As part of the merger agreement executed in October 1997, Coast Savings announced it would spinoff the value of its claim immediately pre-merger. Coast effectuated its claim spinoff via a “strict” incorporation approach: it created a trust to receive the value of the claim, the trustees of which 130 Id. L. John Bird, Decision in Washington Mutual, Inc. holds that litigation tracking warrants are equity instruments, ASS’N OF CORP. COUNSEL, Feb. 23, 2012, http://www.lexology.com/library/detail.aspx?g=3f6bcffd-8198-492c-9677-4ea62b7434e8. June 19, 2012. 131 Nantahala Capital Partners, LP v. Washington Mut., Inc. (In re Washington Mut., Inc.), 464 B.R. 656 (Bankr. D. Del. 2012). 132 WASHINGTON MUTUAL: Judge Approves Deal With Warrant Holders 16 TROUBLED CO. REP., Mar. 12, 2012. (ISSN: 1520-9474). 133 Coast Federal Litig. Contingent Payment Rights Trust, Registration of Securities, Business Combinations (Form S-4) at 11 (Jan. 13, 1998). 134 135 Id. at 10. 136 Id. at 12 explains that before the Coast trial could happen the Court of Claims had scheduled several other S&L cases. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 35 controlled the litigation, and then the trust issued Contingent Payment Right Certificates to Coast’s pre-merger shareholders. The basic structure of the deal was as follows. A trust was formed with certain powers, approximately $20 million (earmarked for litigation expenses), and an asset called “the Commitment.” Securities embodying the right to receive a part of payments made pursuant to the Commitment were issued to existing Coast Savings shareholders. Coast Savings merged into H.F. Ahmanson and Ahmanson, as successor to Coast Savings, owned the claim and the right to receive the proceeds. If proceeds were ever received, Ahmanson would be required by the Commitment to give them to the trust. Monies received by the trust were to be paid to certificate holders, net of certain costs. More specifically, on January 8, 1998 the Coast Federal Litigation Contingent Payment Rights Trust (CPR Trust) was created, with the powers and limitations conferred upon it by an Amended and Restated Declaration of Trust signed by Coast Savings (as Sponsor), Bankers Trust Company (as Trustee),137 and the CPR Trust (through its four Litigation Trustees). On January 13, 1998 the CPR Trust registered Contingent Payment Rights Certificates (CPR Certificates) with the Securities and Exchange Commission. 138 On February 13, 1998, moments before the merger closed, Ahmanson entered the Commitment Agreement with the CPR Trust, contributed approximately $20 million to the CPR Trust to fund the Litigation, and the CPR Trust issued the CPR Certificates to Coast shareholders.139 This transaction is the purest strict incorporation of a claim I have found, although the Treca Trust (discussed below) would be equally pure if it were ever created. That is because the Litigation Trustees were given complete control of the claim; Ahmanson, which nominally owned the Because the CPR Trust is a Delaware Statutory Trust, Banker’s Trust wears two trustee hats: “Institutional Trustee” and “Delaware Trustee”. Banker’s Trust’s real power comes from its Institutional Trustee status. For simplicity I simply speak of “Trustee”. 137 Coast S-4, supra note 81, available gar/data/1052801/0000950150-98-000043.txt 138 at http://www.sec.gov/Archives/ed- 139 See [the deal documents re the steps]; for the date see e.g., Coast Litigation Trust Announces Judge's Entry of Order Regarding Government Liability, PR NEWSWIRE, Mar. 25, 199. While innovative in being used for litigation, contingent payment rights, as a financial instrument, are old. E.g., a U.S. Supreme Court case ruled on the correct tax treatment for a contingent payment right in 1931. See David Hasen, Financial Options In The Real World: An Economic And Tax Analysis, 37 FLA. ST. U.L. REV. 789, 797 (2010). DRAFT—DO NOT QUOTE 36 M. STEINITZ claim and showed it on its books, had none.140 Moreover, the trustees’ primary loyalty was to the trust, that is, to certificate holders, even at the expense of Ahmanson, the claim owner.141 Thus in every sense except the most formal, the CPR Trust embodied the claim. While it is true that the litigation trustees were former executives of Coast with knowledge of the litigation’s facts, putting them in charge of the litigation in this manner, rather than via a management agreement like Golden State entered, creates unnecessary issues under the legal ethics paradigm. From an ethics perspective the Coast Savings deal created an ambiguity as to whom litigation counsel represents: the trustees, who controlled the litigation and who had duties to maximize the claim’s monetary value on behalf of certificate holders, or Ahmanson, who nominally owned it? Similarly unclear is the implications of the answer to the latter question to the application of the attorney-client privilege. Also, do the trust and Ahmanson share a common legal interest that protects privilege regardless of who the client actually is?142 And how should this structure be viewed from the champerty perspective? Ultimately, the Court of Claims entered a judgment of no damages in 2001 so the CPR Certificates were worthless.143 The CPR Trust appealed and won at the Federal Circuit in 2002,144 but then the Government sought and won a re-hearing en banc.145 In 2003 the full court upheld the The Coast S-4/Prospectus explains at 15/11 under “Formation of the CPR Trust”: A more detailed list of the Litigation Trustees’ power to control the litigation is in the Trust Agreement appended to the prospectus at B-22 and B-23 “Article VI Management of the Litigation.” 140 141 The Trust Declaration states: “any attorneys, experts, advisors, consultants and investigators retained by or at the direction of the Litigation Trustees …shall be authorized by this Declaration to accept directions from the Litigation Trustees with respect to the Litigation, notwithstanding any conflict of interest that may arise by reason of such directions with the interests of any party to this Declaration. The Litigation Trustees shall have no duty to [Coast/Ahmanson] to consider any interest [such entity] may have with respect to the Litigation.” See Trust Declaration at Section 6.2(a) at B-23 (emphases added). The Trust Declaration flatly states that communications among the trustees, Ahmanson and counsel are privileged, see Section 6.2(a) on B-23, but parties cannot create privilege by agreement where the law does not afford it. 142 Coast Litigation Trust Announces Claims Court Entry of Judgment for Government, PR NEWSWIRE, Oct. 29, 2001. 143 144 Coast Litigation Trust Announces Appellate Court Decision in Favor of Coast Federal Bank, PR NEWSOct. 9, 2002. WIRE, Coast Litigation Trust Announces Order Granting Government Petition For Rehearing of Appellate Court Decision, PR NEWSWIRE, Feb. 15, 2003. 145 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 37 Court of Claims’s judgment of no damages,146 and the CPR Trust decided not to appeal to the U.S. Supreme Court.147 The CPR Trust terminated and the CPR Certificates were de-listed on May 23, 2003.148 E. Strict Incorporation in the Information Resources Antitrust Litigation: Contingent Value Rights In July of 1996 Information Resources sued The Dun & Bradstreet Corp and others, alleging antitrust claims. Information Resources alleged damages exceeding $350 million, prior to trebling.149 The suit came nearly three months after the European Union had begun formal proceedings against the defendant for abusive practices. Three months after the suit was filed, the defendant entered into an agreement with the European Union to end its abusive practices.150 A trial was scheduled for September, 2004.151 However, in 2003 Information Resources was negotiating a merger with Gingko Corporation and the litigation posed the hidden cost problem. To solve the problem, Information Resources formed a special purpose [statutory] trust which issued ‘Rights Certificates’ tied to the proceeds of the antitrust claim. Unlike the Coast deal, however, Information Resources did not transfer control of the claim to the trust. As a result it is more accurate to say the trust received the monetary value of the claim rather than the claim. In some jurisdictions, the distinctions between (a) transferring the value of the claim versus the claim itself and/or (b) transferring control over the claim versus the value of the claim differentiated between a void champertous transaction and a valid non-champertous transaction.152 Instead, a separate contract governed the conduct of the claim. Under that contract the company that survived the merger (and 146 Coast Litigation Trust Announces Appellate Court En Banc Decision in Favor of Government, PR NEWSMar. 25, 2003. WIRE, 147 Coast Litigation Trust Announces Decision Not to Seek Supreme Court Review and Termination of Litigation, PR NEWSWIRE, April 24, 2003. 148 Coast Litigation Trust Announces Termination of Designation of CPR Certificates for Trading on NASDAQ and Termination of the Trust, PR NEWSWIRE, May 23, 2003. Info. Res. Litig Contingent Pymt Rights Trust, Registration of Securities, Business Combinations, (Form S-4), at 8 (Sept. 8, 2003). 149 150 Id. at 17. 151 Id. at 2. E.g., New York distinguishes, at least to some extent, between claim transfer and claim proceed transfer. See Model Litigation Finance Contract at [xx]. 152 DRAFT—DO NOT QUOTE 38 M. STEINITZ thus owned the claim) retained control of the settlement decision as well as influence over major strategic choices. Nonetheless, executives from the pre-merger claim owner retained significant influence over major strategic decisions. The Information Resources transaction was a more complicated deal overall than the CPR Trust, largely because several investors/companies were coming together to form a company that would merge into the publicly traded Information Resources and take it private. Thus there were more parties and more steps to the overall transaction. In addition, the privately held status of the surviving company and the newness of the trust created in the deal meant that the certificates it issued could not be listed on the NASDAQ, although they were tradable over the counter.153 (Complicating the discussion of the deal further, the surviving entity retained the name “Information Resources” while becoming a wholly owned subsidiary of Gingko. To facilitate this discussion, when speaking of the post-merger entity, I use the term ‘pmIR’; pre-merger, it is simply ‘IR’; and because the trust was created and certificates issued pre-merger, they are the ‘IR Trust’ and the ‘IR Rights Certificates.’) The most important aspect of the IR deal, for the purposes of expanding the analysis of how claim incorporation can address the ethical issues raised by litigation finance is how the deal addressed control of the litigation. Thus the agreement laying out those terms will be the focus of the discussion below. Within our narrow focus, certain core elements of the deal are the same: A Delaware statutory trust was created via Declaration (IR Trust Agreement) among the acquirer, target, trust and three trustee types— litigation, institutional, and Delaware. The main asset of the trust was the merged company’s parent’s contractual commitment to pay proceeds of the litigation. The trust was given an initial endowment by the acquiring company to fund the litigation, after which the trust had to raise funds on its own by selling certificates or borrowing funds.154 The litigation itself was “owned” by the acquiring company and appeared on its books as a contingent asset.155 The trust issued the certificates immediately before the merger closed, the certificates were tradable but highly speculative and See SEC Declares Registration Statement for CVRs Effective; CVRS to Be Quoted on OTC Bulletin Board on Completion of the Offer for Information Resources, Inc. by Gingko Acquisition Corp., PR NEWSWIRE October 30, 2003. 153 154 Info. Res. Litig Contingent Pymt Rights Trust, supra note 149 at 3. 155 Id. at 15. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 39 came with very limited rights. And, if the claim was successful, the certificates could be redeemed for cash based on the amount of net proceeds received.156 However, the control of the litigation is crucially different than in the Coast deal. Under Coast Savings, the Litigation Trustees controlled the litigation, and conflicts with the claim owner were resolved in favor of the trust. In contrast, the IR Litigation Trustees were only empowered to raise funds for the litigation by selling more certificates or borrowing money; to enforce the Contingent Value Rights Agreement and the IR Trust Agreement; to ensure the IR Trust’s compliance with the securities laws; and to undertake various trust/certificates related tasks. 157 To manage the litigation, the parties entered into a contingent value rights agreement (“rights agreement”) that both governed the conduct of the litigation and contained Ginko’s promise to pay the trust when/if litigation proceeds came in. 158 The rights agreement provided that five rights agents would manage the litigation.159 Two would be appointed by IR (the “CVR Rights Agents”), two by Gingko (the “Parent Rights Agents”), and one chosen by the other four (the “Independent Rights Agent”). The rights agreement explains the breadth of the control granted: (c) The Rights Agents shall have the sole power and duty to direct and supervise all matters involving the Litigation (including trial strategy and planning and settlement strategy) on behalf of Parent, the Company, the Company Subsidiaries and their Affiliates; provided that all decisions and determinations with respect to the Litigation (including, without limitation, any Settlement Decision or Strategic Decision) shall be made in accordance with Section 3.1(d) hereof. 160 And that as a general matter, the appointees of IR—the original, pre-merger plaintiff—will have day to day litigation management: 156 Summary- The Contingent Value Rights Agreement, Id. at 1. 157 Id. at A-13-14. See the IR Prospectus, available at http://www.sec.gov/Archives/edgar/data/1260946/000104746903034778/a2119115zs-4a.htm. 158 159 See generally the form of Contingent Value Rights Agreement appended to the Prospectus as Exhibit B at Article III-The Rights Agents at B-11. 160 Rights Agreement 3.1(c) at B-11. DRAFT—DO NOT QUOTE 40 M. STEINITZ Either one or both of the CVR Rights Agents (as they may mutually decide in their discretion) shall have primary responsibility for the dayto-day direction and supervision of the Litigation and may, without the approval of any of Parent, the Company, the Company Subsidiaries or any of the other Rights Agents, make decisions and determinations in accordance with Section 3.1(d) hereof with respect to the dayto-day conduct of the Litigation and such decisions shall be deemed to made on behalf of all of the Rights Agents.161 Nonetheless, the rights agreement explained, the two IR appointees/CVR Rights Agents’ power was not unlimited because certain decisions required the approval of at least three of the five rights agents: Notwithstanding the foregoing, (i) the approval of a majority of the Rights Agents (including the Independent Rights Agent) shall be required for any Strategic Decision and (ii) the approval of a majority of the Rights Agents (other than the Independent Rights Agent) shall be required for any Settlement Decision;162 That is, for “Strategic Decisions” either the Independent or Parent Rights Agents could provide the third vote, but for settlement decisions, the Parent Rights Agents had to agree. Through this majoritarian provision the claim owner, the parent, is retaining ultimate control of the litigation. This delegation of authority is akin to the way legal ethics allow attorneys to make day to day decisions for their clients, but unlike legal ethics—and like business entities—it creates a voting mechanism for resolving conflict between the parties and tailors the voting mechanism to allocate influence and control much more finely than attorney ethics does. In fact, the rights agreement contained a further constraint on the rights agents’ discretion by dictating what they had to consider in making litigation decisions of any kind:163 [T]he Rights Agents shall act in good faith with a view to maximizing the present value of the Litigation Proceeds to the Company, the Company Subsidiaries and the CVR Trust. Without limiting the generality of the foregoing, in connection with any Settlement Decision, the Rights Agents shall consider: 161 Id. 162 Id. 163 Id. at 3.1(d) at B-11 to B-12. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 41 (A) the aggregate amount of After-Tax Litigation Proceeds to be received in connection with the proposed settlement; (B) the benefit to the Company and the Company Subsidiaries of any agreements, commitments or undertakings to be made in connection with such settlement that restrict future anti-competitive or allegedly anti-competitive conduct by one or more parties to the Litigation; [and the potential value of a future settlement if the current offer is rejected, discounted to reflect the time value of money.]164 The criteria in (B) is striking and reflects the fact that while the IR Certificate holders would prefer (A) to be the only consideration—that is, maximum cash—the anti-trust nature of the litigation means that any remedy of type (B) could be far more valuable to pm-IR. (B) is a contractual requirement to put the interests of pm-IR ahead of the certificate holders. This allocation of power and preference to pm-IR/Gingko is further underscored by the settlement veto the parent has per the provisions discussed above. Combined, they illustrate how the commodification of claims that seems at first blush inescapable can actually be avoided, and by preemptively and transparently resolving the conflict of interest through both (B) an the settlement veto. The prospectus makes this dynamic explicit and counsels potential IR Certificate purchasers that: The interests of Gingko Corporation in any settlement of the antitrust litigation will not necessarily be aligned with the interests of the rights certificate holders. For example, Gingko Corporation may prefer a settlement that includes, in addition to cash payments, agreements by the defendants to refrain from future unlawful anti-competitive conduct over an alternative settlement that includes no such agreements, even if the alternative settlement offers higher cash payments. On the other hand, the rights certificate holders… presumably would prefer the alternative settlement offering higher cash payments, which would result in correspondingly higher payments on the rights certificates. In those circumstances, however, the rights agents appointed by Gingko Corporation would be able to veto the alternative 164 Id. at 3.1(d)(C), (D) and (E). DRAFT—DO NOT QUOTE 42 M. STEINITZ settlement, and any veto of that settlement alternative would be final and binding.165 On other key strategic issues, Gingko lacks a veto but gains influence because 3 of the 5 Rights Agents must agree, and Gingko has two of the five, and those two have an equal say in a third. Those key strategic issues in which the merged corporation (successor to the claim) retains influence though not control are: the appeal of any aspect of the antitrust litigation; the addition of any claim or party; changing legal counsel or the basis for payment of attorneys’ fees; any admission of liability with respect to any claim against Information Resources in the antitrust litigation; and any other proposed decision or determination that …would represent a material change or development in strategy … and result in a substantial likelihood that the recovery or receipt of any amount of antitrust litigation proceeds …will be delayed;.166 Because the selection of counsel and the retainer agreement is one of the aspects of the litigation that the claim owner (Gingko) no longer controls, champerty and attorney ethics may be implicated. Regardless the situation is not as extreme as the CPR deal because of the retained influence on those decisions and because of the claim owner’s relationship to the entity its shares control with. Unlike the CPR deal, the trust is not the source of Gingko’s loss of control. Instead, it is the way the IR deal attempts to preserves the corporate DNA of the pre-merger IR: Gingko split control with the ghost of a company that was now its subsidiary. Champerty and attorney ethics concerns seem very distant in this situation. The issue of preventing privilege waiver is also simplified in the IR scenario. Since the litigation managing Rights Agents are not beholden to the trust: The Rights Agents shall be deemed to be agents of [Gingko] and [IR/pm-IR] for all purposes relating to evidentiary privileges, including attorney-client privileges.167 165 Id. at 11 (emphasis added). 166 Id. at 20. 167 Id. B-13 3.1(i). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 43 The IR litigation settled on February 16, 2006 for $55 million. On May 16, 2006 the IR Trust announced the net share to be received by the trust and disbursed to certificate holders was $23,051,687, and that payment would begin on June 15. Each Rights Certificate was worth $0.7152.168 2. Inadvertent Incorporation: Crystallex Crystallex International Corporation169 is an example of a strictly incorporated claim that is striking in many respects, not least its inadvertent nature. Crystallex is a gold mining company currently in bankruptcy in the Canadian court system, because Venezuela voided its rights to operate a massive mine in that country. As a result of Venezuela’s action, Crystallex’s single major asset is a multi-billion dollar international arbitration claim against Venezuela.170 The claim is the company. As part of the bankruptcy process, Crystallex received “debtor-inpossession” financing. Normally such financing is intended to enable a company to restructure itself and emerge from bankruptcy. In this situation, however, nearly all of it served as litigation funding.171 The money came from a specialized investment fund that agreed to provide four tranches of capital, tied to milestones (some of which were pegged to litigation developments),172 in exchange for control rights, a commitment See, Information Resources, Inc. Litigation Contingent Payment Rights Trust Announces Commencement of Distribution Process for Holders of Contingent Value Rights Certificates, May 16, 2006, http://www.sec.gov/Archives/edgar/data/1260946/000110465906035301/a0612014_1ex99d1.htm. 168 Crystallex International Corporation v. Bolivarian Republic of Venezuela, ICSID Case No. ARB(AF)/11/2. 169 170 Tenth Report of the Monitor at ¶ 59-60, In re A Plan of Compromise or Arrangement of Crystallex International Corporation, Ontario Sup. Ct. (June 4, 2013) (No. CV-11-9532 00CL), available at http://documentcentre.eycan.com/eycm_library/Project%20Gem/English/Monitor's%20Reports/Final%20Crystallex%20-%20Tenth%20Report%20of%20the%20Monitor.pdf (calling the arbitration the company’s “main asset” and noting that other than “minimal surplus mining equipment”, the company has no assets other than the arbitration). 171 Id. at paragraphs 7-10 (pp 3-4 for the description of what the DIP budget was based on: funding the arbitration, covering the costs of the bankruptcy proceedings (including litigation and negotiation with bondholders), paying the lender’s expenses, and revenue from selling excess mining equipment. Id. at ¶ 7-10 (describing what the DIP budget was based on: funding the arbitration, covering the costs of the bankruptcy proceedings (including litigation and negotiation with bondholders), paying the lender’s expenses, and revenue from selling excess mining equipment). 172 DRAFT—DO NOT QUOTE 44 M. STEINITZ to repay principal and interest,173 and a substantial slice of any eventual arbitral proceeds. The Credit Agreement174 gave control rights to the funder through two vehicles: issuance of a special class of stock that empowered the funder to nominate directors of the company, and contractual requirements to get the assent of the funders’ directors to certain steps within the litigation. Specifically, the funder was issued 100 Class A preference shares, Series 1. Upon the trigger—drawing the second tranche—the funder had the right to nominate two of the company’s five directors,175 and to conominate a third director who was given “sole and ultimate authority” over the bankruptcy proceedings, the rights of the parties under the funding agreement, the management incentive plan, and the retention of professionals for any of those purposes.176 While this power generally gave the funder significant influence over the company, more specific powers were conferred as well. For example, the assent of a funder-appointed director was necessary for board approval of transactions involving affiliates, certain types of executive pay, retention of certain advisors, and a redacted term.177 Further, at least one of the two funder directors had to agree before the company could remove the arbitration counsel.178 In addition to those powers, at least one funder appointee’s assent is needed for the company to take actions or decisions described in several redacted provisions.179 Beyond to the indirect control of the claim that the funder gained by having significant influence and control over the company itself, the funder gained certain direct control and influence over the conduct of the 173 See Senior Secured Credit Agreement dated April 23, 2012 (pp. 72-156) at 78, In re A Plan of Compromise or Arrangement of Crystallex International Corporation, Ontario Sup. Ct. (May 31, 2013)(No. CV-11-9532-00CL) available at http://documentcentre.eycan.com/eycm_library/Project%20Gem/English/Motion%20Materials/CCAA/Redacted%20Motion%20Record%20returnable%20June%205,%202013.pdf 174 See Senior Secured Credit Agreement, available at http://documentcentre.eycan.com/eycm_library/Project%20Gem/English/Motion%20Materials/CCAA/Redacted%20Motion%20Record%20returnable%20June%205,%202013.pdf (providing the agreement and its amendments, attached as an exhibit) Secured Credit Agreement at 6.13a(1); see id. at 108, available at http://documentcentre.eycan.com/eycm_library/Project%20Gem/English/Motion%20Materials/CCAA/Redacted%20Motion%20Record%20returnable%20June%205,%202013.pdf 175 176 See Secured Credit agreement at 6.14 and 6.15. 177 Id. at 6.16. 178 178 179 Id. at b(iii). See Credit Agreement at 6.16 (a)(iv); 6.16 (b)(i), (b)(ii); and (b)(v), all of which are redacted. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 45 arbitration. For example, the Credit Agreement requires the company to get the funder’s written consent before it decides not to follow any material advice of its arbitration counsel, and before it agrees settle for so little that the proceeds would be insufficient to repay the funder its principal and interest.180 While the various redacted terms make it impossible to fully assess how Crystallex and its financier allocated control of the company and the claim, certain terms—needing funder permission to reject counsel’s advice, change arbitration counsel, or accept a small settlement—are problematic under the current legal ethics paradigm perspective (though trading in bankruptcy claims is a . A final set of financing provisions applied only if the arbitration were successful, and were designed to give the funder flexibility with respect to how it received its payout. One approach involved direct payments, however these were limited in amount each year to avoid criminal usury; the alternative would allow the funder to convert its right to proceeds into equity in Crystallex, special shares with voting, dividend and preference rights.181 As of this writing, the Crystallex arbitration is ongoing. 3. The Treca Litigation Financing: Litigation Proceeds Trust In October 2010, Buford Capital (‘Burford’) invested in the socalled Chevron-Ecuador dispute182 (the ‘Burford Ecuadorian deal’183), an on-going mass-tort litigation brought by Ecuadorians against Chevron over oil drilling-related pollution. Two facets of this deal are relevant to the incorporation discussion. 180 180 181 Id. at 7.16a. Id. at Ex. G. Aguinda v. ChevronTexaco, App. Ct. of Ecuador, Case 11:1150 (2012) available at http://chevrontoxico.com/assets/docs/2012-01-03-appeal-decision-english.pdf. 182 183 This deal, and specifically the underlying contract, is discussed in great detail in The Litigation Finance Contract. The financing contract was by and between Treca Financial Solutions and Claimants (including Friends of the Defense of the Amazon), dated October 31, 2010 (“Treca Agreement”). Treca was created solely to invest in the litigation. See Settlement Agreement, April 15, 2013, by and among Chevron, the Burford Parties (Burford Capital and related entities), and Ecuadorian Ventures, LLC. (herein “Burford Settlement Agreement”) Section 4. (a)(vi) (page 6) In addition to Treca, the Burford Ecuadorian deal involved other SPVs. One is a Guernsey company called Nugent Investments Limited (“Nugent”), which is Treca’s largest shareholder, and until December 30, 2010, was its only shareholder. Id. On that date Nugent sold four of the 15 shares of Treca that it owned to Ecuadorian Ventures LLC, an Illinois limited liability company ("Ventures"). Id. at recitals, Section 4(a)(v), Section 4(b)(iv). Through Treca, Burford was the major funder of the litigation, although a number of other funders participated as well. See The Litigation Finance Contract, supra note 9 at 494 & nn. 174-75. DRAFT—DO NOT QUOTE 46 M. STEINITZ First, Burford made use of a number of SPVs and received partial control over the conduct of the claim; however Burford’s investment did not constitute claim incorporation under my taxonomy. These SPVs were not devices created by the plaintiff to embody the claim (in whole or in part) but simply were created and used by the funder to further the funder’s financing objectives. This function can be seen in both the investment mechanism, which was indifferent to whether the funder was Burford or the SPV,184 and in the funder’s partial control, i.e. influence over counsel, 185 which would also have been the same regardless of whether the funder was Burford or the SPV. 186 Given that the powers granted the contracting SPV were not different than those that Burford would have negotiated for itself directly, the SPV approach was presumably used because doing so gave Burford tax, accounting or other advantages unrelated to its relationship with the Ecuadorian plaintiffs or their counsel. Second, the financing contract contemplated a later, strict incorporation of the claim. Specifically, the parties agreed a trust would be created, and that the claim and any value due or received for it would belong to the trust.187 Until such time, the trustee would have the sole right to For example, the financing contract called upon the funder to invest $4 million immediately, and tentatively committed it to invest another $11 million split evenly into two more tranches. See The Litigation Finance Contract, supra note 9, at 467. Burford itself could have simply given the initial $4 million to the Ecuadorian plaintiffs; its use of an SPV to do so related to its own purposes, not the plaintiff’s financing needs. 184 Burford gained partial control by installing Patton Boggs, a firm with close ties to Burford, as an “Active Lawyer” shaping the litigation and as the “Nominated Lawyers” who controlled the purse strings. Going forward, the plaintiffs could replace Active Lawyers as they wished, but replacing the Nominated Lawyers would require the SPV’s/Burford’s approval. Regarding the relationship between the firms, see PATTON BOGGS, ATT’Y WORK PROD., PATH FORWARD: SECURING AND EN-FORCING JUDGMENT AND REACHING SETTLEMENT (report authored by plaintiffs’ counsel, setting out the details of their enforcement strategies), 185 http://www.earthrights.org/sites/default/files/documents/Invictus-memo.pdf (last visited Feb. 27, 2012). See The Litigation Finance Contract, supra note 9, at 497 & nn182-88. Regarding the role of the Active and Nominated lawyers and how they could be replaced, see the Treca Agreement at Subsection 2.3; Section 3; Subsections 5.1, 5.2, 5.4, 5.5, 6.1, 7.6, 7.7, 7.9, 8.5(c), 10.2 (10.2 is interesting because it treats disclosure to the Nominated Lawyers as equivalent to disclosure to the Funder/Burford), 13.1, 13.5, Schedule 1; and Schedule 3, including definition of “Nominated Lawyers”. Burford invested several months after the law firm of Patten Boggs began advising the Ecuadorian plaintiffs; absent Patten Boggs’s involvement, Burford would not have invested. As a result, it is hard to imagine Burford would have negotiated different terms regarding the Nominated and Active lawyers had Burford been directly investing. See Roger Parloff, “Litigation finance firm in Chevron case says it was duped by Patton Boggs” FORTUNE.COM; and Jan Wolfe, Patton Boggs Accuses Burford of Betrayal in Chevron Case, LITIG. DAILY, June 21, 2013. 186 187 Treca Agreement at 8.1(a). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 47 control the conduct of the claim and the enforcement of any judgment, except that the trustee would itself be controlled, either by certain of the plaintiffs’ lawyers or by a ‘board of managers,’ a term which was not defined.188 It is possible that a trust was contemplated because the Ecuadorian judgment required that any funds paid by defendants would be placed in a trust. The judicially contemplated trust, in turn, appears to be a solution devised to deal, at least in part, with agency problems which may emerge when non-monetary relief (remediation, in that case) was involved. The Ecuadorian judgment ordered that a trust be established for the benefit of an NGO purporting to act on behalf of the class (the Amazon Defense Front, or ADF), or those the ADF designates, and that Chevron pay the damages awarded to that trust. The judgment further “directed that the trust’s board of directors be made up of the “representatives of the Defense Front”… and provided that the board would choose the contractors who would perform the remediation.””189 (This kind of litigation governance through the use of legal entities, especially common law trusts, may be expanded to structured settlements, but I leave an elaboration of this idea for another day). Regardless of whether the claim was ultimately incorporated, this investment has not gone well. At first, it looked like a winner: an Ecuadorian judge awarded the plaintiffs a $19 billion USD judgment for compensatory and punitive damages in February 2011.190 However, Chevron contends that the judgment was fraudulently obtained and is currently fighting its enforcement on that basis. As of this writing, the judgment is subject to an appeal in Ecuador, an ICSID arbitration, an anti-enforcement injunction in the United States, and numerous enforcement actions around the globe.191 In addition, Chevron has sued the lead plaintiffs’ lawyers alleging RICO and other violations in connection with alleged fraud and corruption through which the judgment was allegedly obtained. It has recently won the action (which is subject to an appeal)192 Patton Boggs 188 Treca Agreement at 8.1(b). Chevron Corp. v. Steven Donziger, et al., case 1:11-cv-00691-LAK-JCF [at pg. 180-1 of the 497page PDF] available at http://www.theamazonpost.com/wp-content/uploads/Chevron-Ecuador-Opinion-3.4.14.pdf [hereinafter: Chevron Corp.] 189 Roger Parloff, No-show Judge Bolsters Chevron's Attack On $19 Billion Judgment, FORTUNE.COM, http://features.blogs.fortune.cnn.com/2013/05/17/judge-chevron-ecuador-2/ (last visited May 17, 2013). 190 All discussed in Manuel A. Gómez, The Global Chase: Seeking The Recognition And Enforcement Of The Lago Agrio Judgment Outside Of Ecuador (forthcoming). 191 192 See generally Chevron Corp. DRAFT—DO NOT QUOTE 48 M. STEINITZ was named as a “co-conspirator” but not a defendant in that suit and has settled it.193 In April, 2013 Burford, Chevron and others entered a settlement agreement under which Burford renounced its right to receive any proceeds of the litigation, and Chevron and Burford agreed to release each other from any claims relating to the Chevron/Ecuador litigation.194 Burford also agreed as part of the settlement to dissolve the primary SPV, Treca Financial Solutions, through which the funding was effectuated.195 Beyond illustrating funder financing tactics and a possible form of claim incorporation, this deal illustrates the very features of litigation finance that render bringing corporate law and practices, especially corporate governance practices, obviously beneficial for both funder and funded. First, it exposes the high degree of risk funders face. Burford may very well have been defrauded by the plaintiffs and the controlling lawyers it selected. The jury on that is, quite literally, still out.196 But even if it has not been Burford has faced great cost and reputational harm for having made this particular investment. And since it has become, de facto if not de jure, a real party in interest to the Chevron / Ecuador litigation through its investment, it has gotten enmeshed as a (potential) party in the underlying litigation. Second, it exposes the extreme information asymmetry characterizing litigation funding deals. And, third, in Burford’s re-alignment with Chevron and renouncement of the plaintiffs, while an unusual Roger Parloff, Chevron Seeks To Sue Patton Boggs For Fraud And Deceit, FORTUNE.COM. (May 13, 2013, 6:16 AM), http:// http://features.blogs.fortune.cnn.com/2013/05/13/chevron-seeks-tosue-patton-boggs-for-fraud-and-deceit. 193 Burford Settlement Agreement. Burford, through Treca initially invested $4 million thereby purchased the right to receive 1.48% of the proceeds. See Treca Agreement at Schedule 1, Section 3(h). Although it refused to make further investments and later terminated the funding contract, it retained the right to that percentage until renouncing it in the settlement. See Burford Settlement Agreement, supra note 183, at recitals and Section 1; Treca Agreement at Section 7 and Subsection 11.3. 194 Although Burford’s settlement agreement with Chevron is not explicit on this point, it appears that Nugent (Treca’s largest shareholder and originally, sole sharedholder) exists for reasons beyond the Chevron/Ecuador investment because the agreement does not require Burford to dissolve Nugent though it does require Burford to dissolve Treca. Burford Settlement Agreement Section 4.(a)(vi) (page 6). Similarly suggestive but unclear is the Settlement Agreement’s reference to other companies as part of the “Burford Parties” namely, Litigation Risk Solutions, a Delaware LLC, and a company identified only as “Glenavy.” Glenavy is defined in the recitals as one of the Burford Parties and is identified in one of the recitals as having received a subpoena from Chevron as part of its RICO suit against the Ecuadorian plaintiffs, but otherwise does not appear in the document, nor is there any indication of where it was formed or whether Glenavy is its full name. 195 196 Chevron Corp. at [page 175/497 in PDF version]. DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 49 scenario, we find an illustration of the types of conflicts these arrangements may give rise to.197 III. THE INCORPORATION PARADIGM: USING LEGAL ENTITIES TO ELIMINATE THE HIDDEN COSTS AND GOVERN LITIGATION 1. The problems solved and the problems created in the real world examples As discussed at the outset, the use of securities tied to litigation proceeds, the use of an SPV, and at times both, is a single mechanism that can both resolve certain hidden costs of litigation and assist in managing the ethical challenges implicated by litigation finance. The following paragraphs generalize and elaborate on how they do so beyond the deal-specific analysis in the previous Part. A. Corporate deal making and corporate finance (i) Reducing the hidden costs of litigation in certain mergers, acquisitions and large equity investments. As illustrated by the discussion of the deals above, both loose and strict incorporations can and have been used to solve company valuation problems when a claim’s value is material relative to the value of the company, but not so large that the claim becomes the company, and the company wants to merge, be acquired, or receive a large equity investment. Without incorporation of the claim, the difficulties in valuation have made it very difficult or even impossible to undertake such transactions creating the problem of the hidden cost of litigation – a cost which may well dwarf the apparent costs of litigation namely attorneys’ fees and legal expenses. (ii) Monetizing claims that currently go unremedied and litigation finance as corporate finance. The ability to cabin off a litigation in an SPV, the liquidity that can be provide by embodying a litigation in a security (with or without an SPV),198 and the ability to raise funds directly for the pursuit of a litigation On extreme information asymmetry, extreme risk and extreme agency costs (conflicts of interests) as characteristics of litigation as an asset. See generally The Litigation Finance Contract, supra note 9. 197 198 On the significance of the possibility of a market in shares as a significant upside of organizational law generally see, e.g., H. Hansman, R. Kraakman & Richard Squire, Law and the Rise of the Firm, 119, Harvard L. Rev. 1333, [xxxx] (2006). DRAFT—DO NOT QUOTE 50 M. STEINITZ and do so on an ongoing basis (by issuing additional securities), may induce corporations, governments and other sophisticated actors to pursue legal claims that currently go unremedied. As the risk of incurring the hidden costs of litigation are reduced the incentive to commence and pursue (as opposed to settle too early at a discount) meritourious claims increases. (Depending on one’s view of the desired level of litigation in society this is either a benefit or a detriment).199 B. Litigation Finance (i) Control and conflicts of interests As discussed above, the primary concern raised by both critics and proponents of litigation finance is that funders may obtain control of the claim and use it to further their interests at the expense of the interests of the authentic owners of the claim, the plaintiffs. As also discussed, this is the well-familiar problem of the separation of ownership and control. Shareholders often have little control over how their companies are managed. Shareholders have little ability to propose alternative directors,200 to shape executive compensation,201 and otherwise control their agents. Because this problem is both profound and old, corporate law has developed mulitple responses. “[F]ive legal strategies that the law employs [] address [agency] problems… Some legal strategies are regulatory insofar as they directly constrain the actions of corporate actors: for example, a standard of behavior such as a director’s duty of loyalty and care. Other legal strategies are governance-based insofar as they channel the distribution of power and payoffs within companies to reduce opportunism. For example, the law may accord direct decision rights to a vulnerable corporate constituency, as when it Steven Shavell, The Fundamental Divergence Between the Private and the Social Motive to Use the Legal System, 26 J. LEGAL STUD. 575 (1997); Steven Shavell, The Level of Litigation: Private Versus Social Optimality of Suit and of Settlement, 19 INT’L REV. L. & ECON. 99 (1999) (the privately determined level of litigation can depart from the socially optimal level in either direction because litigants do not take into account either the negative or positive externalities their litigation creates. Corrective social policy may help to remedy the divergence). 199 See Key Issues: Proxy Access, PWC.COM http://www.pwc.com/us/en/corporate-governance/proxy-access.jhtml. 200 Jesse Eisinger, In Shareholder Say-On-Pay Votes, More Whispers Than Thoughts, DEALBOOK, NYTIMES.COM (Jun. 26, 2013, 12:00 PM. 201 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 51 requires shareholder approval of mergers. Alternatively, the law may assign appointment rights over top managers to a vulnerable constituency, as when it accords shareholders - or in some jurisdictions, employees - the power to select corporate directors. Finally, the law may attempt to shape the incentives of managers or controlling shareholders, as when it regulates compensation or prescribes an equal treatment norm such as the rule that dividends must be paid out ratably.”202 Lets illustrate how to apply these strategies to the incorporation of legal claims. Among the most fundamental mechanisms are the fiduciary duties that directors and officers owe shareholders, namely the duty of care and the duty of loyalty.203 These duties aim to prevent self-dealing, bad faith, and actions against the corporation’s and shareholders’ best interest. Under certain structures, the use of an SPV could mean that funders become officers, with fiduciary duties, not only owners. Further examples of how corporate governance principles can inspire litigation governance can be gleaned by turning to the area of incentive alignment through executive compensation.204 For example, compensating executives with options has become a popular practice on the theory that it aligns the managers’ interests with those of the owners. As the limitations of this method became evident, it has been refined.205 For example, some corporations require executives to hold on to some or all of 202 H. Hansmann & Reinier Kraakman, Agency Problems and Legal Strategies, [at SSRN Abstract] in R. Kraakman, et. al, THE ANATOMY OF CORPORATE LAW: A COMPARATIVE AND FUNCTIONAL APPROACH (Oxford University Press 2004). The authors detail ten strategies that generally comprise the law’s methods of dealing with agency problems, four regulatory and six governance-related. Since these are general strategies all can be applied to the regulation and governance of incorporated legal claims. See, e.g., Fiduciary Duties and Liabilities of Directors and Officers of Financially Distressed Corporations, http://apps.americanbar.org/buslaw/newsletter/0003/materials/tip3.pdf; § 4.01 Duty of Care of Directors and Officers; the Business Judgment Rule, Principles of Corp. Governance § 4.01 (1994); § 5.01 Duty of Fair Dealing of Directors, Senior Executives, and Controlling Shareholders, Principles of Corp. Governance § 5.01 (1994). See, Anthony J. Sebok & W. Bradley Wendel, Characterizing the Parties’ Relationship in Litigation Investment: Contract and Tort Good Faith Norms, 66 Vand. L. Rev. [xx] (2013) (good faith rather than fiduciary duties). 203 For a review of various approaches to aligning executive compensation with the interests of the corporation see Wulf A. Kaal, Contingent Capital in Executive Compensation, 69 WASH. & LEE L. REV. 1821 (2012). 204 On the promise of using restricted stock options, see Sanjai Bhagat & Roberta Romano, Reforming Executive Compensation: Focusing and Committing to the Long-Term, 26 YALE J. on Reg. 359, 363 (2009). On the shortcomings of using options and other equity approaches to compensate executives see Kaal, supra note 204, at 1828-29 (citing Regulating Bankers’ Pay, 98 GEO. L.J. 247, 249 (2010), at 249-50, Lucian A. Bebchuk, Alma Cohen & Holger Spamann, The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, 27 YALE L. J. ON REG. 257 (2010), at 259. 205 DRAFT—DO NOT QUOTE 52 M. STEINITZ their options, have ‘skin in the game,’ to disincentivize short-termism. Another option is claw-backs: contractual rights to have compensation returned in case of under-performance in the long run.206 Similarly, funders can be required to hold on to some or all of their litigation proceed rights until the litigation is concluded.207 There are other efforts to address agency problems that tend to be embedded in corporate practices and are executed via contracts rather than statutes. In two of the deals, potential agency problems were resolved via contracts that specified principles of litigation governance in detail. As part of the Golden State-CalFed merger, both the Golden State LTWs and the Cal Fed participation rights were governed by the litigation management agreement, which demarcated precisely how the litigation would be managed. That contract also spelled out whom the agents reported to, and how the agents could be removed.208 The IR deal similarly involved a litigation management contract which allocated control of the litigation, giving some of it to the pre-merger company, and some—including settlement—to the post-merger parent company.209 Litigation governance contracts like these, which specify who has how much power to take which decisions, are perhaps the most direct way to resolve the agency issues. Where an SPV is used the constitutional documents of the entity can also be used to define the purpose of the entity and the obligations of its officers in a manner that minimized conflicts. Thus, a single SPV may be used for multiple litigations should a plaintiff and funder choose to join forces on more than one suit. In such a case, an SPV would reduce the transaction costs of negotiating a separate contract for each litigation.210 206 L. A. Bebchuk & J. M. Fried Pay without performance: Overview of the Issues, Journal of Applied Corporate Finance (2005). Indeed, the Coast Litigation Trustees had to retain at least 50% of their certificates during their tenure as Litigation Trustees. See Coast Amended and Restatement Declaration of Trust, Ex. B to the Coast S-4, at Section 3.7(b) at B-11. 207 Golden State Bancorp Inc., Current Report, (Form 8-k Exhibit) (Feb. 17, 1998). Litigation Management Agreement by and among the Registrant, Glendale Federal Bank, A Federal Savings Bank, Stephen J. Trafton and Richard A. Fink At Articles I and II, The Litigation Management Agreement designated litigation managers for each case, who reported to committees of the board of directors specifically create for each case and were vested with the power of the board as regards the litigation, including rights to remove the litigation managers for cause. 208 209 See generally the form of Contingent Value Rights Agreement appended to the Prospectus as Exhibit B at Article III-The Rights Agents at B-11, and specifically at 3.1.at B-11 through B-12. 210 The question of what legal entities add to mere contracts, given that at core they can be understood as standard contracts, is an important question when selecting between loose and strict incorporation and a question that has received substantial treatment in corporate legal theory but a full treatment of it is beyond DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 53 Using an SPV can also help clarify the duties of the attorney in the attorney-client-funder triumvirate thus resolving or minimizing the set of conflicts between the client and its attorney that are created once a third party, the funder, pays the attorneys’ bill and, especially if that funder– attorney relationship is a repeat–play relationship.211 Now, the SPV can be the client of the attorney and, so long as the funder is either a director or officer of the SPV and thus owes it fiduciary duties, those conflicts can be regulated. Using an SPV to manage funder-funded conflicts would fail, however, if the funder does not have such a duty to the SPV. The continuum described in Part III—of transferring no control, some control, or total control of the claim when incorporating it—represent different modalities of dealing with the agency problems that arise once ownership and control are separated in the context of a financed or spun-off litigation. Loose incorporation always resolves these tensions by contract. In the context of a publicly issued security, whether as a spin off or, if an underwriter were willing, through a litigation-funding IPO, control stays with the original plaintiff. The claim ownership rights embodied in the security are too fragmented for a security holder to be given any control, and in any case, the security holders only enter the transaction after its terms are set. If the security were done via private placement to a single funder or a very small number of funders, one could imagine them contracting for partial or full control transfer. Middle ground is possible, where a plaintiff sets the terms of its security and then markets its private placement via a road show to a much larger number of qualified investors. Such investors need not be PELF investors and may not seek much control.212 The legal ethics paradigm treats these permutations differently because of its focus on the degree of control transfer, and would be more approving of a funding IPO than the arms’- length negotiated deal with a PELF. A close examination, however, reveals that this approach is suboptimal in terms of promoting public policies. If underwriters were willing the scope of this paper. Some of some answers to this question include H. Hansmann & R. Kraakman, The Essential Role of Organizational Law, 110 Yale L. J. (2000) (“organizational law permits the creation of patters of creditors’ rights that otherwise could not practicably be established”); H. Hansmann, R. Kraakman & R. Squire, Corporation and Contract, 8 American L&E Rev. 1 (2006) (explaining why publicallytraded corporations rarely deviate from the default terms of state corporation law in their charters); See, Vicki Waye, TRADING IN LEGAL CLAIMS: LAW, POLICY & FUTURE DIRECTIONS IN AUSTRALIA, UK & US (2008) at [xx]; Whose Claim Is It Anyway? supra note 8, at 1280; N.Y.C. Bar Opinion supra note 39; A.B.A. Comm. on Ethics 20/20 supra note 39. 211 See Painter, supra note 16; and Maya Steinitz & Abigail C. Field, The Model and The Securities Laws, Coda, A MODEL LITIFATION FINANCE CONTRACT, http://litigationfinancecontract.com/the-model-and-the-securities-laws-coda/. 212 DRAFT—DO NOT QUOTE 54 M. STEINITZ to issue litigation funding IPOs, such originate-and-distribute deals could create a moral hazard (investing other peoples’ money and shifting the risk to buyers of the securities) and, consequently, a risk to the court system by flooding it with non-meritorious claims.213 This is much less socially desirable than a PELF deal even though the separation of ownership and control is greater in the latter. The incorporation paradigm in contrast, allows us to clearly see that such a preference for an IPO over a PELF deal would be undesirable. If securities are involved, the potential for tension between ownership and control is greatest with the strict incorporation approach, as evidenced by the Coast Savings example. But that tension need not exist if ownership of the claim as well as control of it are transferred to the SPV. If the entire claim is transferred to the SPV—Coast Federal without Ahmanson’s continued claim of ownership and accounting for the claim, or the Treca trust if created—then not only is the tension absent, but by structuring ownership, the bylaws and roles within the SPV, control can be allocated among the parties however they wish without necessarily raising any agency issues. The Crystallex deal illustrates some of the possibilities. The Board of Managers envisioned by the Treca Agreement would perhaps have been another such vehicle. One can envision such Board of Managers as including plaintiff representatives analogous to lead plaintiffs in class action, as well as their litigation counsel and a funder representative. The Board of Managers’ membership, like the IR Rights Agents, could have voting powers that give a settlement veto to the plaintiffs, but nonetheless give funders a vote and thus influence. The IR deal itself reflects the overall flexibility of the incorporation paradigm. The trust features that made its issuance of the proceed right certificates more deal appropriate than having pm-IR or the new parent, Gingko, issue them could be realized, but control transfer could be finely customized by contract. Again, the legal ethics paradigm approaches these deal structures differently, but its touchstone—claim control—seems to be simply one of the central, negotiated deal points, rather than the sine qua non deal point excluded from negotiation amongst sophisticated actors by operation of Bar Association regulation.214 An incorporation paradigm more appropriately assesses the deal as a business transaction. The judgment of these deals should use the standards for deal making and decision-making developed in the business law context. 213 Whose Claim Is This Anyway? supra note 8 at [xx] (on the prospect of securitizing legal claims and the potential attendant dangers). 214 See, Anthony J. Sebok, Should the Law Preserve Party Control? Litigation Investment, Insurance Law and Double Standards (forthcoming). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 55 ii. Information asymmetry and the attorney-client privilege. The funder–funded relationship is characterized by information barriers, predominantly the fear of waiving attorney–client privilege by communicating with funder,215 and extreme information asymmetry due to the fact that the plaintiff has better, private information. Funders may also have material private information. Information barriers and asymmetry can be addressed using securities structures, whether loose or strict, to the same extent they can be in the more typical non-recourse loan scenario, so long as the securities issuance is an arms-length private placement. That is, so long as it is practical to enter confidentiality agreements that preserve work-product protection information asymmetry about the facts of the case can been minimized.216 However, if a publicly traded security is used, information asymmetry becomes reinforced rather than mitigated. That is, the plaintiff will not want to publicly disclose any information that would result in work product or privilege waiver. Instead, the disclosures will resemble those of the Coast Trust’s, namely, announcements of case developments otherwise in the public record. If a strict incorporation approach is used that positioned both the funder and the plaintiff as officers of the SPV, privilege issues for communications between them would evaporate as they would be co-representatives of the SPV client for all dealings with counsel. Privilege issues could also be resolved under loose incorporation structures if the funder’s litigation managers were subject to sufficient control by the plaintiff, as in the Golden-State example. Whether a funder would agree to such control is a different question. Also unclear is whether entering a litigation management agreement of the type used in the IR example would preserve privilege when the parties are not parties to a merger but are instead engaging in a joint venture, which is the essence of claim incorporation in the litigation finance, rather than hidden costs, context. Perhaps the agreement could serve to demonstrate the common legal interest necessary to preserve privilege.217 Though in at least some US jurisdictions that risk is greatly minimized through the operation of the attorney work product doctrine. For a discussion of both see A Model Litigation Finance Contract, supra note 9at 487. 215 See The Model Litigation Finance Contract, supra note 9 at 487 (analyzing the extent to which the work product doctrine can be preserved despite the introduction of a funder and the extent to which it overlaps, in scope of protection, with the attorney-client privilege). 216 217 An exception to the doctrine that disclosure to a third party waives attorney client privilege is called the common interest doctrine. The contours of the doctrine vary by state, and can be incoherent even within a state. Importantly, while parties must agree the common legal interest exists, DRAFT—DO NOT QUOTE 56 M. STEINITZ (iii) Uncertainty, pricing and transparency. By embodying the value of a litigation in a security which is capable of trading, litigation—notoriously difficult to value because of the nonmonotonic and discontinuous nature of settlement values218 and because of the absence of comparables and a of transparent market219—becomes subject to pricing via markets. Furthermore, the ability to issue additional shares in the future allows plaintiffs to avoid over-selling (i.e. sell a larger portion of the claim than they have to) at the outset and/or sell at a steep discount when their bargaining position is the weakest.220 Instead, as more information is revealed about the value of the litigation through the litigation process, risk is reduced, and additional shares can be priced accordingly. If a robust market develops, the accumulation of transparent pricing data, currently absent with respect to legal settlements, can reduce pricing problems across deals. Finally, by avoiding uncertainty as to whether any given deal is champertous or not a risk factor that is currently raising the cost of financing for plaintiffs will be removed. (iv) Commodification. Embodying a claim in a security, whether in connection to a strict or loose form of incorporation, is commodification in its purest form. However, steps can be taken to mitigate the implications. The most potent is the approach taken in the IR deal, namely to provide explicit direction requiring certain types of non-monetary relief to be sought and prioritized even at the expense of a reduced monetary award, coupled with a disclosure of this arrangement to the proceed right holders. One can imagine a litigation finance contract that funded an antitrust claim containing similar their agreement alone cannot give rise to such an interest because the parties cannot create privilege by agreement when it otherwise does not exist. A challenge normally for funder-funded relationships is that a common commercial interest is easy to establish, but a common legal one is not. See A Model Litigation Finance Contract, supra note 16at [xx]. However, if the parties are contractually agreeing to co-manage a litigation for a common purpose as defined in the litigation management agreement—the IR agreement, e.g., lays out how settlement offers are to be evaluated—then their relationship seems much closer than simply that of co-defendants agreeing to cooperate in their defense, which is the situation the common interest doctrine arose from. Thus a privilege preserving common legal interest would plausibly exist. The idea is simply too novel, however, for any on-point precedent. See Joseph A. Grundfest & Peter H. Huang, The Unexpected Value of Litigation: A Real Options Perspective, 58 STAN. L. REV. 1267, 1272––73 (2006); Robert J. Rhee, The Effect of Risk on Legal Valuation, 78 U. COLO. L. REV. 193 (2007). 218 See Yeazell supra note Error! Bookmark not defined.(while there are numerous legal settlements, the legal claims market is unusual in that there is no available information about their values because most settlements tend to be confidential). 219 220 See Model Contract supra note 9 at [xx – yy] (discussion of the “hold-up”). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 57 language. That said, the commodification inherent in reducing claims to securities, tradable or not, is the reason this approach is inappropriate to claim types other than commercial claims owned by corporations, wealthy individuals or, in certain cases, sovereigns. (v) Transaction Costs. The transaction costs of doing a private placement of securities need not be materially larger than negotiating a more typical funding contract, unless a private placement involving a formal offering memorandum and a road show. Then the costs are much higher. However, if retaining full control of the claim is a crucial deal point and the claim is large enough that litigating it will be so costly that financing is attractive, these costs may be justified. Similarly, if a claim is embodied in a publicly traded security, the costs are high. These are all the costs of drafting and registering the prospectus, and ongoing compliance costs.221 These costs are even higher if a trust or other SPV is used in conjunction with the public security, because then there are the additional costs of creating the SPV, its own compliance costs, and the compensation of the SPV’s directors, officers, or trustees. Investor protection. Currently, there is a lack of clarity as to whether (some or all) litigation finance contracts are securities.222 By following well-recognized deal patterns, whether and what kind of security is involved and what kind of securities regulation applies becomes much easier to discern. In sum, incorporating legal claims is a practice that holds the potential of significantly minimizing the Funding Challenges as well as carries additional benefits such as improving investor protection. 2. Trusts and Beyond: Using Various Legal Entities for Financed or Spun-off Claims Accepting the idea that the funding of a commercial claim is a joint venture brings to stark relief at least two key features of litigation finance. One, is the key difference between the funder–plaintiff relationship—which is that of co-venturers—and the contingency lawyer–client relationship—which is an attorney-client relationship. What follows from this difference is that while allocating control over key decisions to an attorney may not be appropriate allocating control to a co-owner is appropriate in certain circumstances. The other, related difference is the fact 221 Painter, supra note 74. 222 See Wendy Couture, supra note 88. DRAFT—DO NOT QUOTE 58 M. STEINITZ that conflicts of interests run both ways in the funder-plaintiff relationship. While the funder may be tempted to maximize its profits at the expense of its JV partner, the claimant, the latter may also try to take advantage of its JV partner, the funder. Yes, the funder may push for an early settlement in order to re-invest in other litigations in its portfolio.223 But the claimant may push to over-invest in its case either because it is heavily concentrated in it or because the claimant may be more emotional about it case.224 These conflicts of interest are a direct result of the separation of the ownership and control of the claim. Business law has developed (partial) solutions to these problems over the years.225 These solutions are embodied in (1) the different types of business entities, understood as sets of organizational choices which have evolved over time to produce internal coherence226 and; (2) principles of corporate governance. The rest of this section looks at a few illustrative examples of business entities, with an emphasis on the different forms of corporate governance they offer, to see how they might address the separation of ownership and control in the context of litigation finance and litigation governance. The section compares them along a few dimensions, including relative complexity and formality, access to capital, and ease of transfer of interests. This section seeks only to illustrate how choice of entity can influence issues implicated by the separation of ownership and control. It is not intended to be an exhaustive survey of either the entities that can be used nor of the important dimensions of entity selection analysis.227 In addition, while the question of what it is that legal entities add to mere contracts, given that at core organizational forms can be understood as For an elaborate discussion of the conflicts created by the fact that funders invest in portfolios of litigations see The Litigation Finance Contract, supra note 9. 223 224 “Litigants litigate not just for money, but to attain vindication; to establish precedent; ‘to express their feelings’… their decisions to settle or litigate may be affected by… [their] self-serving biases concerning the fairness of their position, habit, unyielding conceptions of justice, and myriad other factors.” Russell Korobkin & Chris Guthrie, Psychology, Economics, and Settlement: A New Look at the Role of the Lawyer, 76 TEX. L. REV. 77, 79–81 (1997) (surveying the empirical literature establishing same). See LEE A. HARRIS, CASES AND MATERIALS ON CORPORATIONS AND OTHER BUSINESS TIES: A PRACTICAL APPROACH (2011) [hereinafter Corporations and Other Business Entities]. 225 226 ENTI- Riebstien, infra note 236. 227 For in depth analysis of the considerations that go into entity selection see generally, e.g., H. Hansmann, R. Kraakman & R. Squire, The new Business Entities in Evolutionary Perspective, [xxx]; H. Hansmann, Firm Ownership and Organizational Form in R. Gibbons et. Al (eds.), THE HANDBOOK OF ORGANIZATIONAL ECONOMICS; L. E. Ribstien, Why Corporations, 1 Berkley Bus. L. J. 183 (2004); Larry E. Rib- stien, THE RISE OF THE UNCORPORATION (2010). DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 59 standard contracts is an important question when selecting between loose and strict incorporation (and a question that has received substantial treatment in corporate legal theory) a full treatment of it is beyond the scope of this paper.228 It is also important to note that from a deal-specific perspective, additional and possibly idiosyncratic, considerations may come into play. For example, key deal–specific considerations as to which legal entity to use are likely to be the tax and accounting consequences of the structure in the context of the claim and claimant. Such deal-specific considerations are also outside the scope of this paper. (i) Statutory Trusts Two of the spinoff deals discussed used statutory trusts as security-issuing entities to which claim proceeds and perhaps control were transferred. Among the various available forms, these entities have certain advantages. They are rigid, passive and well understood. Simultaneously, their rigidity does not eliminate flexibility, in that the powers of the trustee, the corpus of the trust, and the terms of the securities can be customized. In addition, they are routinely used for financing and security issuance. Access to capital is limited solely by the attractiveness of the terms of the certificates the trust issues, and transferability of the certificates can be customized within the bounds of the securities laws. To leverage trust doctrine to minimize or resolve the conflicts of interest between the funder and the funded, defining the trustees’ powers is key. The IR and Coast Federal deals show the tension; the certificate holders want maximum financial return, which may or may not be what the Plaintiff wants. IR resolved the conflict by retaining control of the litigation, so it could pursue non-monetary relief freely, and simply told certificate holders that the conflict was resolved against them. Coast Federal resolved the conflict in favor of the certificate holders, and informed Ahmanson (the claim owner) accordingly. One could imagine the optimal use of a trust to finance a claim and resolve conflicts of interest would be a deal in which the plaintiff and funder(s) were both trustees and certificate holders, the claim involved only monetary remedies, the trust corpus was the right to receive the net 228 Some of some answers to this question include H. Hansmann & R. Kraakman, The Essential Role of Organizational Law, 110 Yale L. J. (2000) (“organizational law permits the creation of patters of creditors’ rights that otherwise could not practicably be established”); H. Hansmann, R. Kraakman & R. Squire, Corporation and Contract, 8 American L&E Rev. 1 (2006) (explaining why publically-traded corporations rarely deviate from the default terms of state corporation law in their charters); H. Hansmann, Firm Ownership and Organizational Form in R. Gibbons et. Al (eds.), THE HANDBOOK OF ORGANIZATIONAL ECONOMICS; L. E. Ribstien, Why Corporations, 1 Berkley Bus. L. J. 183 (2004) (corporate form facilitates regulation). DRAFT—DO NOT QUOTE 60 M. STEINITZ proceeds of the claim, and the trustees controlled the litigation. This approach would impose fiduciary duties on both the funder and plaintiff, binding them to the same commercial goal (maximizing the net proceeds). Funders are unlikely to find the fiduciary duty attractive, but it is possible to imagine allocating decisional power among the trustees gave the funder comfort that the fiduciary duty would not force it to act too strongly against its own interest. In addition, the ability to raise additional funds by issuing certificates to other funders without making those second-wave funders trustees could be quite appealing. Similarly, to the extent a funder could sell some or all of its certificates while retaining (or even relinquishing) trustee status/litigation control, a funder might find the trust attractive. (ii) Partnerships Perhaps the oldest and simplest business form is the partnership. Partnerships resolve mutual conflicts of interest by imposing a reciprocal fiduciary duty,229 do not involve the separation of ownership and management, and allocate management responsibility laterally by agreement. Unlike with corporations, management is not stratified into a board of directors and an officer tier.230 The greatest downside of partnerships—liability for other partners’ acts—is a relatively minor issue in the litigation finance context because most actions of the partnership are not directed toward external clients/customers the way most businesses are. The simplicity of partnerships and the relatively low liability risk makes this arrangement theoretically the most effective, efficient way to resolve the funder-funded conflicts. However, the general historical trend has been away from the partnership form due to the restrictive nature of both the fiduciary duty and the joint and several liability. For the same reasons it is likely that both funders and clients may wish to restrict their reciprocal duties and limit their liability.231 A final consideration is that partnerships’ ability to raise capital is limited to the partners’ assets and borrowing ability, i.e. they draw on a For a discussion of fiduciary duties in partnerships, see Michael Haynes, Partners Owe to One Another A Duty of the Finest Loyalty . . . . or Do They? An Analysis of the Extent to Which Partners May Limit Their Duty of Loyalty to One Another, 37 Tex. Tech L. Rev. 433, 434 (2005). 229 230 Corporations and Other Business Entities, supra note 225, at [xx]. On the historical shift away from partnerships and towards corporations and uncorporations and, within the latter category, especially towards the LLC see, e.g., Riebstien. 231 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 61 limited reservoir.232 This issue is less pressing in the litigation finance context because most funders take on cases assuming they will fund the case themselves, or through syndicates they have put in place, and thus presumably could bring sufficient capital to the table. Finally, partnership interests are difficult to transfer. One can imagine that funders may lean in favor of ease of transfer while plaintiffs may be better served by requiring funders to maintain ‘skin in the game.’ A notable consideration is that heavily restricted securities do not lend themselves to securitization, a restriction that is beneficial for plaintiffs.233 However, some funders express the opposite concern, wanting to insure plaintiffs have skin in the game in the form of retained ownership. (iii) Corporations Most corporations are entities that involve a complete separation of ownership and control for most decisions. While shareholders have the last word at certain points, for the most part control is vested in a Board of Directors, and through them, Officers, some or all of whom may also be shareholders. The exception to this basic structure is the “close corporation,” which is a privately held entity that can give shareholders or third parties topic-specific Director or Executive level powers (and duties), and can in fact eliminate the board of directors entirely, effectively incorporating a partnership. 234 Like partnerships, however, close corporations have been trending down. Corporate law has long recognized the conflicts of interest created by separating ownership and control, and has used both statutory and common law fiduciary duties and governance theories to minimize them. 232 Id. at [xx]. Securitization involves the transfer of the right to receive future payments to a trust that then issues a security backed by those payments. If the right to receive litigation proceed payments cannot be transferred to the trust, the trust cannot use litigation proceeds to issue its own securities. On securitization and its moral hazards see, e.g., Kevin Dowd, Moral Hazard and the Financial Crisis, 29 CATO J. 141, 142 (2009). Securitization of litigation is not only undesirable from a public policy prospective, because it will likely encourage the funding of unmeritorious claims, but also from the plaintiffs’ perspective because of its inherent moral hazards. On the risks to the public and to plaintiffs from creating litigation – backed derivatives see Whose Claim Is It Anyway?, supra note 8 at [xx]. 233 234See, 11 Del. J. Corp. L. 383. A corporation with such few shareholders could be best styled as a close corporation because of the flexibility gained. Further, a close corporation could flatten management by eliminating the board of directors, increasing efficiency. In these ways close corporations could mimic the advantages of partnerships while adding the benefit of limited liability. See, 11 Del. J. Corp. L. at 395-96. DRAFT—DO NOT QUOTE 62 M. STEINITZ Managers must be loyal and avoid self-dealing, while pursuing the company’s—shareholders’—best interests. Governance theories have involved aligning financial incentives through compensation structures, easing accountability by making directorships all expire at the same time, increasing transparency and accountability by having independent directors and members of compensation and audit committees, and similar efforts. Finally, Congress and regulators have taken some steps to increase shareholders power versus management.235 All that said, corporate misconduct continues to make headlines and trigger shareholders suits, demonstrating that all these measures simply reduce rather than eliminate the problems created by separating ownership and control. So while a corporate structure could be used to impose various duties, and director and officer roles allocated among funder and claimant to structure decision-making power and authority to minimize conflicts, unless the funder and the claimant held all or essentially all the shares of the corporation the conflict minimization would be imperfect at best. (iv) Limited Liability Companies. These entities are far newer, and far more flexible than corporations. The flexibility extends to the degree of separation of ownership and control. Flexibility in LLCs also means that intra-company relationships can be structured relatively free from significant statutory and case lawimposed fiduciary duties and other requirements. The de facto de-regulatory effects of the LLC form accounts for its popularity in recent years.236 The great flexibility to embrace or reject the conflict-minimizing duties and doctrines that come with more traditional business forms, however, places in doubt the likely effectiveness of this form in minimizing the problems created by the separation of ownership and control beyond what sheer bargaining power already affords contracting parties. While the rise of the LLC and the high likelihood that this business form will be popular in this context as it has increasingly been in others raises questions about the effectiveness of business entities to minimize problems arising from the separation of ownership and control, it is important to note that the type of entities used and their internal governance arrangements in the litigation finance context can be dictated or at least affected by court orders as to the form of settlement structure where a settlement is court-supervised. Court supervision, in turn, is likely to play an increasingly important role as defendants and judges become 235 See supra note 24. On the rise of the LCC see generally, Larry E. Ribstien, THE RISE OF THE UNCORPORATION (2010). On LCC’s de-regulatory effects as a main reason for this rising tide see Id. at [xx]. 236 DRAFT 7/15/2014] INCORPORATING LEGAL CLAIMS 63 more aware of litigation finance and seek, respectively, to bring the fact of financing to light and to submit finance arrangements to court scrutiny. CONCLUSION The legal ethics paradigm, while superficially very attractive given certain similarities between contingency attorneys and funders, proves, upon closer consideration to fall woefully short in explaining and addressing the economic reality of litigation finance. Consequently, it leads to both over- and under regulation of the practice and falls short in recognizing and addressing the problem of the separation of ownership and control of legal claims. The legal ethics paradigm also masks the full spectrum of possible deal structures that market players are already experimenting with in the marketplace that is the focus of this Article: commercial claims brought by sophisticated plaintiffs such as corporations, sovereigns and wealthy individuals. A better view would replace litigation-finance-as-champerty as the organizing idea in the literature and jurisprudence with litigation finance as…finance as the organizing idea. What follows, dubbed here “the incorporation paradigm,” better fits the realities of deals actually undertaken by various market participants and brings a centuries old paradigm of thought on how to address, i.e. minimize or even solve (but if mismanaged exacerbates), each and every problem that stems from what is now reframed as the problem of the separation of ownership and control of legal claims. These problems are, in a nutshell, (1) extreme conflicts of interests; (2) extreme information asymmetries; (3) extreme uncertainty; and (4) inappropriate commodification. In addition, the incorporation paradigm simplifies the analysis of the application of securities regulation to litigation finance arrangements. In addition to this transformation of litigation finance scholarship and practice, the discussion of incorporation of legal claims contributes to the scholarship on corporate law. As we have seen, most of the claim incorporation deals have taken place in the context of mergers, acquisitions or large equity investments. In those cases, claim incorporations have been undertaken in order to resolve the hidden cost of litigation— the barriers that pricing legal claims can place on such transactions because of the difficulty in valuing legal claims. These hidden costs, where they apply, dwarf the visible costs of litigation i.e., attorneys’ fees and legal expenses. Finally, incorporating legal claims may also provide accounting benefits and may play a role in corporate finance by allowing corporations (or governments) to monetize claims that currently go unprosecuted. DRAFT—DO NOT QUOTE 64 M. STEINITZ Fully commodifying commercial legal claims and providing for enhanced liquidity through public trading of securities in the open market, on security exchanges, can open up additional horizons beyond those this paper explores or those alluded to in the preceding paragraph. More analysis can be done on the accounting and tax implications of the use of different types of business entities and securities and on how different legal entities may lend themselves to different forms of corporate governance cum litigation governance. The full implications of understanding litigation finance contracts as financial products and spun-off litigation from a regulatory perspective, is a rich field to mine and there can be little doubt that the analysis herein will launch experimentation by market players and new scenarios for courts to opine on. DRAFT