A Guide to Legal Finance in Aggregate Claims
November 2, 2020
When a claim-holder cannot economically justify pursuing their claim, and a class-action is either not possible or desirable, claims aggregation may be the answer.
Acquiring small commercial claims – either in whole or in part – may enable the aggregator to achieve a “Critical Mass” of combined potential returns that would enable the acquirer to pursue enforcement of this pool of rights. This structure is typically used with breach of contract claims against a single defendant and/or its affiliates.
In many jurisdictions, purchasing even an undivided percentage of such a commercial claim gives the aggregator the right to prosecute both the acquired portion of the claim as well as that portion of the claim retained by the original owner. This right typically also includes the right to decide whether to enforce the terms of a successful resolution of such matters.
If only a partial claim is acquired, the claims aggregator will pay the original claim owner some nominal consideration at acquisition. It should also simultaneously grant the original owner a perfected security interest in the proceeds, if any, to which the claims aggregator is entitled as security for the payments due to the original owner under the waterfall. Of course, the original owner must represent and warrant that the acquired claim will be free and clear of all liens and security interests.
The purchase agreement must also provide that the claims aggregator will continue its efforts to aggregate similar claims in order to see if it has reached the required “Critical Mass.” Determining the aggregate value of those claims requires the use of a contractually approved method for valuing each claim individually. Given the risk that sufficient claims may not be aggregated, as well as the lack of precision frequently inherent in this type of calculation, the original claim owner must expressly approve this valuation mechanism while granting the claims aggregator the right to unwind its purchases by conveying the acquired claim to each original owner against their payment of the nominal consideration they received at closing. Alternatively, the claims purchase agreements could be held in escrow after they have been executed by the original claims owner, but only executed by the claims aggregator if and when “Critical Mass” is achieved. While this latter approach would save the economic opportunity loss involved in actually advancing the down payments, it may also permit the original claims owners an easy right to terminate their offer to sell.
Claims aggregation requires careful attention to applicable state law. For example, the claim aggregator’s failure to simultaneously pursue all of the legal theories attributable to the original claim may prevent her from raising those claims later. In some other jurisdictions, the defendant may have the right to offer a settlement early in the litigation process and thereby limit the amount of legal fees that might ultimately be recovered by the claims aggregator. Understandably, this tactic may drive the claims aggregator’s fee arrangement with its counsel to include some combination of a portion of the payment, if any, made to the claims aggregator with some mutually agreeable offset of some or all of the legal fees that are ultimately received.
The claim purchase agreements should have an expiration date outside the timeline to final resolution projected by the counsel for the claims aggregator, but it should also provide for with automatic extensions thereafter as a prudent cushion. The claim purchase agreement may terminate earlier upon the occurrence of any of the following: (i) a final, non-appealable resolution of the prosecution; (ii) the written agreement of the claims aggregator and all of the original claim owners; or (iii) a written notice from the claims aggregator that it has either not reached “Critical Mass” or has not obtained the needed alternative legal finance facility. Key obligations in the claims purchase agreement (such as indemnification, confidentiality and non-circumvention) should survive expiration or such earlier termination. In this way, the claims aggregator retains the option to negotiate a separate agreement with interested original claim owners to enforce and/or simply monitor the defendant’s compliance with a successful resolution.
Including all of the necessary provisions in the claims purchase agreement may present a drafting challenge, since claims aggregators typically want to use a simple, one-page agreement that will not intimate the owners. Balancing this goal with carefully including the economics of the transaction as well as the requirements of both the claims aggregator and the legal finance source will be much easier when both parties understand that they each want to include several key structural points – such as prohibiting the claims aggregator from making any distributions to the original owners until all of the defendant’s appeal rights have lapsed.
THE ALTERNATIVE LEGAL FINANCE COMPONENT
Assuming that this litigation will be long and costly, the claims aggregator may seek alternative legal finance for its projected litigation expenses. Therefore, the claims purchase agreement should provide that obtaining such financing on terms acceptable to the claims aggregator must be secured or the claims aggregator may unwind the prior purchases. This enables the legal financier to deal with one party in the negotiation and administration of the legal finance facility.
Initial analysis of this potential legal finance arrangement is generally the same as implemented in all similar analyses. The financier must carefully analyze applicable state law and the possible ethical constraints imposed on counsel for the claims aggregator. If legal finance remains a viable financing option after this initial assessment, the claims aggregator, its counsel, and the legal theories underlying the aggregate claims must be assessed as well. However, given the number and potentially low value of any individual claim, the financier source may elect not to incur the cost of conducting a detailed due diligence review of all individual claims. In the interest of saving those expenses, the financier may analyze only a subset of these claims and bear the additional risk that the results from this limited review may not be representative of the value of the balance of claims.
Even when the legal finance source agrees to advance expenses to the claims aggregator, it may want reduced funding obligations as well as termination or sale rights if the prosecution does not progress as desired and/or if ongoing expenses exceed the initial budget. The claims aggregator, on the other hand, will resist any attempt to reduce this steady source of expense payments and may, in fact, argue that subsequent legal finance advances should be risk-adjusted and the waterfall modified accordingly if the case is progressing well.
Without question, the waterfall must provide both the claims aggregator and its legal financier with sufficient potential return in order to justify this investment of time, energy and expense. The metrics for the split of net resolution proceeds between those parties and the original claim owners is always a negotiated point based, at least in part, on the legal financier’s analysis of the amount and timing of projected expenses, the projected value of an acceptable resolution, and the financial hurdle required by the ALF’s investment committee for such investments. Some claims aggregators may approach the original claim owners with the belief that since they cannot justify pursing their individual claims, “half a loaf is better than none,” thereby leading to their acceptance of a lesser percentage of net resolution proceeds. Perhaps, but in any event it seems likely that allocating the net proceeds available to all of the original claim owners must rely on the assessment of their relative individual values that was established in order to enable the aggregators to determine whether to seek to enforce the claims.
Security for repayment of these advances and the payment of the required return to the legal financier may also present a challenge. Original claim owners should agree in the claims purchase agreement to direct counsel to deposit all resolution proceeds in an account that is subject to a perfected first lien security interest in favor of the legal finance source prior to any distributions under the waterfall. As a trade-off for this agreement, original claim owners may be granted a perfected second lien position on those funds, which would include the proceeds to which the claims aggregator is entitled pursuant to the waterfall as discussed above. The legal finance agreement should anticipate the use of this mechanism and work in lockstep with the claims purchase agreement for the simultaneous release of these security interests in conjunction with the distribution of net proceeds pursuant to the waterfall.
In addition to the provisions of shared interest discussed above, the legal finance source and the claims aggregator should also require the original claim owner to confirm the following: (i) the prosecution of the original claim may not be successful or the proceeds, if any, may not provide the original claim owner with any payment; (ii) no one associated with the claims aggregator or its legal finance source has made any assurances regarding the outcome of this prosecution or has solicited legal work from the original claim owner; (iii) the results of the valuations discussed above are final and the original claims owner will not challenge them things, (iv) no party other than the claims aggregator has any right, title or interest in or to the acquired claim; (v) the original claim has merit but the original claim owner could not have sought redress without the assistance of the claims aggregator; (vii) the original claim owner may need to pay its own counsel to represent it in all future depositions, (viii) the original claim owner has not engaged or retained any counsel to prosecute the original claim and (ix) the original claim owner’s counsel has fully described its past, current or potential relationships, with the claims aggregator, the legal finance funding source and/or any of their respective legal counsel.
Similar drafting challenges arise in including original claim owner covenants that both the claims aggregator and its legal financier need in the claims purchase agreement: (i) to provide the claims aggregator and its financier with a complete set of all relevant agreements and information relating to the original claim; (ii) to cooperate with the claims aggregator counsel in both this enforcement action and in the claims aggregator’s efforts to aggregate similar claims; (iii) subject to the requirements of applicable law, not to discuss the original claim or the claim purchase agreement with anyone other than the claims aggregator and its counsel; (iv) if contacted by the defendant and/or its counsel, to direct each to the claims aggregator’s lead litigator and to promptly tell him or her about that contact; (v) not to attempt to circumvent the payment due to the claims aggregator, its counsel and/or its financier under the waterfall and/or the legal finance documents; (vi) not to initiate or participate in any separate prosecution of, and/or settlement discussions relating to, the original claim; and, (vii) not to take any action (such as selling, assigning, gifting or pledging the retained portion of the original claim) that could reduce the value of the aggregate claims and/or the amount of, or manner of paying, proceeds from a successful resolution.
LEGAL FINANCE & CLAIMS AGGREGATION: A SUMMARY
Enforcing a portfolio of aggregated claims represents both a potentially attractive return for savvy claims aggregators as well as the essence of alternative legal finance since it gives legitimately aggrieved parties a vehicle to “level the playing field” against larger defendants. Clearly outside the realm of the traditional legal-financed “bet the company” case, such as intellectual property infringement, financing this type of dispute could enable a legal finance provider to diversify its investment portfolio as suggested by modern financial portfolio theory. As a result, both potential claims aggregators and alternative legal finance sources should keep this structure and opportunity in mind for use in future ventures.