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Incorporating legal claims.


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-world deals, creative lawyers used securities tied to litigation proceed rights as well as corporate governance mechanisms. This 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, this Article discusses how incorporation of legal claims can reduce various costs that litigation imposes in other transactions, such as mergers and acquisitions.
     A. The Legal Ethics Paradigm and Its Limitations
     B. Incorporation of Legal Claims
     A. The Rise of Litigation Finance and the Liquidity in Legal
     B. The Concerns Raised by Litigation Finance
     A. Loose and Strict Incorporation to Reduce Hidden Costs: The
        Winstar Savings & Loans Litigations and Information
        1. Loose Incorporation in the Cal Fed Litigation:
           Participation Right Certificates
        2. Loose Incorporation by Golden State: Litigation
           Tracking Warrants
        3. Loose Incorporation in the Dime/Anchor Savings
           Litigation: Litigation Tracking Warrants
        4. Strict Incorporation in the Coast Savings
           Litigation: Trust Certificates
        5. Strict Incorporation in the Information Resources
           Antitrust Litigation: Contingent Value Rights
     B. Inadvertent Incorporation: Crystallex
     C. The Treca Litigation Financing: Litigation Proceeds Trust
     A. The Problems Solved and the Problems Created in the Real
        world Examples
        1. Corporate Deal-making and Corporate Finance
           a. Reducing the Hidden Costs of Litigation in
              Certain Mergers, Acquisitions, and Large
              Equity Investments
           b. Monetizing Claims that Currently Go
              Unremedied and Litigation Finance as
              Corporate Finance
        2. Litigation Finance
           a. Control and Conflicts of Interests
           b. Information Asymmetry and the Attorney
              Client Privilege.
           c. Uncertainty, Pricing, and Transparency.
           d. Commodification.
           e. Transaction Costs
           f. Investor Protection.
     B. Trusts and Beyond: Using Various Legal Entities for
        Financed or Spun-off Claims
        1. Statutory Trusts
        2. Partnerships
        3. Corporations.
        4. Limited Liability Companies


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. Currently, 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 (private equity litigation funding or PELF). Indeed, it was the historically unprecedented going-public of Juridica and Burford (1) that launched the media frenzy, (2) academic interest, (3) and nationwide regulatory wave that has washed over the United States in recent years, (4) even though the trade in legal claims in the United States 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 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 rather than an extension of the contingency fee. According to this new paradigm, commercial legal claims can and should be "incorporated" (as defined in Section A 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 below in Section B) 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 self-dealing 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 incorporated 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 in turn 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. And third, because simplifying and reducing the costs of litigation finance of large commercial claims by incorporating them may encourage 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 the 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, as well as two deals where incorporation presented itself in the litigation finance context. After describing these complex and innovative deals, Part III 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. This Article 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.

A. 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 straitjacket woven out 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, 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 revised to reflect economic reality. (10) That reality, as the deals described below exemplify, is that sophisticated plaintiffs and funders are best understood as coventurers--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 mechanisms 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 overregulates 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 v. Goliath" disputes between tech startups with no resources to pursue patent infringements, on the one hand, and established industry incumbents that infringe, on the other. Legal ethics underregulates 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 litigation-backed 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 consequently expand, 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, are currently experiencing value destruction in the form of unprosecuted claims. To the extent their claims are not prosecuted because of the difficulty in ascertaining value, the difficulty in ascertaining the likelihood of success in prosecuting meritorious claims, negative accounting treatment during claim conduct, unfavorable tax treatment, and 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, domestic as well as foreign, are another type of sophisticated owner of large-scale claims that face the same kind of analysis when deciding whether to pursue litigation. Additionally, 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 a 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 noncommercial 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 nonmonetary 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.

B. Incorporation of Legal Claims

The market in legal claims is much vaster and older than the discourse on commercial litigation finance recognizes. As this Article 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 practice of giving the claim a legal existence separate from the plaintiff, 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 it is 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 of ownership 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 claims were so large and hard to value that 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 problem was solved by the market's pricing of the shares. That, in turn, allowed strangers to the claim to own the right to some claim proceeds. Claim incorporation was born.

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 multibillion 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.


A. 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 private firms that simply did not catch the eye of the financial media or the academy. (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. The first wave of litigation funding, broadly defined, included the law lending industry, also known as consumer litigation funding, and encompassed the financing of personal claims such as personal injury and workers' compensation. (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 International Centre for Settlement of Investment Disputes (ICSID) awards (sovereign debt); (21) and the rise of various forms of alternative funding--including that of class actions--in the pioneering jurisdictions of the United Kingdom and Australia. (22) Lastly, related financial 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 United Kingdom. (23)

The first wave of litigation finance has led to some regulatory efforts--with state-level legislation (24) and some investigations by state attorneys general (25)--as well as an expansion of the market. This expansion included new "asset classes" such as divorces (26) 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 research and development of new financial products by existing and startup litigation funding firms, we are now witnessing a third wave of litigation funding in the United States. One development characteristic of this 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 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 financing (30) and defense financing. (31)

B. The Concerns Raised by Litigation Finance

Most of the literature relating to litigation funding has focused on the ethical challenges and archaic regulations that stand in the way of litigation funding. Such regulations prohibit litigation funding in certain states, and in others, raise its costs and constrain its users into financial arrangements with convoluted structures that operate in a legal gray zone. Concern regarding litigation funding emanates, in part, from the historic perception that litigation is a necessary evil to address personal harms (termed "authentic claims"). (32) The corollary to this perception 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)

Underlying this broad bar are concerns about claim ownership, which is reflected in a focus on whether the funder has received control of the litigation. (36) Much of legal ethics can be explained as creating safeguards that ensure that the client, not the lawyer (especially pertinent in the case of contingency lawyering), ultimately controls the claim. For example, the Model Rules of Professional Responsibility specifically carve out permission for attorneys to make day-to-day decisions; (37) this carve-out 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)

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 contingency fee lawyers and their clients--such as incentives to settle early in order to maximize profits across a portfolio rather than in a particular case, incentives to prioritize reputation over monetary relief, and incentives to prioritize monetary relief over nonmonetary relief (41)--interesting examples of conflicts unique to the funder-client relationship include those that may arise if a funder decides to securitize its pool of litigations (42) 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 repeat-play 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 (that is, splitting the fee between a lawyer and a nonlawyer). (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 law (45) 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 specialists. 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 attorneys' ethical duties to exercise independent judgment, (48) free from funder influence, and to zealously and loyally represent their clients 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 the funder to 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 deals or deal types, namely the doctrines of usury, (51) unconscionability, (52) 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 has been 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 resolution via injunctive or other nonmonetary relief. (55) Again, underlying the tension is the issue of claim control or influence; if the funder has none there is 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--a path focused on avoiding champerty and influenced by the philosophy that there is something vaguely distasteful (56) 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 to contract for control, they are allowed to participate in the management of their investment and the underlying asset, and 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, are generally subject to the various laws and doctrines that address conflicts of interest, and 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 for bringing general principles of corporate law to bear.


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. This hidden cost of litigation imposes major restrictions 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 affects the cost of capital, the hidden costs can dwarf the expense of pursuing a claim.

Additionally, corporations, which are generally conservative about suing, are experiencing value destruction in the form of unprosecuted claims. These too should be included in any analysis of the hidden costs 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 potential for a larger recovery is usually accompanied by higher costs in pursuing the litigation. And accompanying the higher costs are larger downside risks and opportunity costs. Often, the company can employ the funds required to pursue litigation on other activities, such as operations or marketing, with less risk.

Even where valuation is straightforward, 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 earnings before interest, taxes, depreciation, and amortization (EBITDA) calculations. (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 cannot be recognized in the income statement of a company until all contingencies have been resolved. (68) However, even when a claim is resolved favorably, the accounting is not helpful, particularly for EBITDA-based businesses, as the income must be listed as a nonrecurring 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:
      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. (70)

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. (71) 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.

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 costs; (72) and (ii) a solution to the problem of the hidden costs, may all combine to form 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 of them.

While hard-to-value litigation actually threatening a merger or acquisition 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 securities (73) would help their clients overcome the hidden costs. These 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 that "had established trusts for shareholders, assigning them contingent rights in litigation." (74) All of these legal innovations operate in a similar legal gray 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. (75)

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 is transferred to an SPV while the litigation is pending, or whether the SPV issues a litigation-backed security (strict). Each incorporation, whether loose or strict, is always coupled with a formal allocation of control and ownership of the claim, as well as a preemptive resolution of conflicts or a voting process by which such conflicts are resolved.

Specifically, below are (1) examples of both strict and loose incorporation arising 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. (76) The merger-pricing problem arose in a non-Winstar context too. For example, Information Resources needed to spin off its antitrust claim in order to complete a deal in which it was to be acquired and taken private. (2) The Crystallex deal provides a second example, which involves that bankrupt company's massive arbitration claim against Venezuela. (3) A third example is 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.

A. Loose and Strict Incorporation to Reduce Hidden Costs: The Winstar Savings & Loans Litigations and Information Resources

In the 1980s, following the savings and loan (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) (77) that attempted to both prevent future S&L failures and facilitate accountability for the crisis that had happened. One part of FIRREA focused on making S&Ls sounder by forcing them to be better capitalized. (78) 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, (79) 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. (80)

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:
   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. (81)

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 California Federal Bank (Cal Fed), Dime, and Coast Federal issued litigation proceeds-based securities, as discussed below, (82) liability in those cases had not been determined. Only Golden State's security issuance was founded on established liability. (83) 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.

1. 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. (84) Cal Fed filed suit in 1992, but its case was stayed while the Winstar cases were litigated. In July 1995, prior to the Supreme Court decision in Winstar, Cal Fed issued the first of two securities (called Participation Right Certificates) related to its supervisory goodwill claim. (85) These Participation Right Certificates entitled holders to a share of approximately 25% of the net proceeds if ever realized, (86) 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. (87) 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. (88) 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. (89) 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, shareholders were only given something they were always entitled to--the right to receive the value of 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 was 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. (90)

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. (91) 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 to $17.92 In April 1999 the court awarded Cal Fed a mere $23 million, and the certificates plummeted in value. (93)

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. (94) In October 2005 the $23 million Cal Fed judgment became final when the U.S. Supreme Court denied certiorari. As a result, Citigroup notified the Cal Fed certificate holders they would get nothing. (95)

2. 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, while negotiations were ongoing, Golden State declared that 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 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 Cal Fed-like certificates that could be redeemed for cash to avoid the income tax consequences of the Cal Fed approach. (96)

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. (97) 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." (98) The warrants gave the companies a "market mechanism" to resolve the dispute, namely a "collar." (99) 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." (100) 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.

      "It certainly removes a major stumbling block" in the event of
   an acquisition.... "Now we can value it on its earnings and
   franchise." (101)

The LTWs were issued in May 1998 to holders of Golden State common stock on a "one share, one LTW basis." (102) 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% was to be retained by Golden State. The warrants came without voting rights, liquidation preferences, dividend or other distribution entitlements, (103) and were freely tradable, being registered on the NASDAQ. (104) If Golden State underwent future mergers, the LTWs would be exercisable against the surviving company's common stock on the same terms. (105)

How many shares could be purchased upon a triggering event could only be determined at the time such an event occurred as there were two unknowns--first, the amount of net proceeds received, and second, the market price of Golden State stock. (106)

The prospectus made clear that Golden State owned and controlled 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 [Golden
   State] and [Golden State] intends to pursue the Litigation with the
   same vigor as it has in the past.

   [Golden State] reserves the right, however, to terminate the
   Litigation in any manner it deems appropriate to serve [Golden
   State's] best interest. (107)

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. (108)

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 claim and Cal Fed's claim. (109) The litigation management agreement created two committees, 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 with regard to the respective litigation. The litigation management agreement further provided that two Golden State executives, knowledgeable of the underlying facts, would be employed by the company as "Litigation Managers" for both cases, reporting to both committees. (110) 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. (111)

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. (112) 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. (113)

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--the LTWs not only solved the merger pricing problem but also forced a change in the accounting of a second merger, (114) had a role in the mechanics of a third merger, (115) and were part of the consideration of the redemption of some preferred securities, (116) all of which occurred before the Cal Fed deal closed. The merger between Golden State and Cal Fed closed in September 1998. (117) Ultimately, Citigroup, as part of its November 2002 merger with Cal Fed, assumed the litigation and the warrants tracking it. (118) As a result, Golden LTWs became exercisable for shares in Citi if a triggering event occurred, which it did in 2005.

On March 15, 2005, the government paid Citi $381,538,695 to satisfy damage and costs judgments in the Golden State/Glendale litigation. (119) Those proceeds, after netting, resulted in an adjusted litigation recovery of $153,776,991. (120) 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 a 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. (121) The total cash value of each LTW on the day the distribution was determined was $1.7931, (122) which compares favorably with the $1.38 to $1.75 trading range of the LTWs in the first quarter of 2005. (123) However, that amount was well below the $6 and 11/16 valuation on the close of the first day of trading after issuance. (124) 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.
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Title Annotation:commercial litigation funding governance; Introduction through II. Claim Incorporation and Litigation Governance: Winstar, Information Resources, Crystallex, and TRECA A. Loose and Strict Incorporation to Reduce Hidden Costs: The Winstar Savings & Loans Litigations and Information Resources 2. Loose Incorporation by Golden State: Litigation Tracking Warrants, p. 1155-1183
Author:Steinitz, Maya
Publication:Notre Dame Law Review
Date:Feb 1, 2015
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