“True Sales” in Litigation Funding Agreements

The following article was contributed by John Hanley and Douglas Schneller of Rimon Law, P.C

An issue that keeps some litigation funders up at night concerns the possibility of a claimant filing for bankruptcy after receiving funding and before their underlying case is resolved.  Proceeds from the case may become property of the bankruptcy estate and made available to the transferor’s creditors.  A carefully drafted litigation funding agreement (“LFA”) can increase the likelihood that the right to receive a portion of litigation proceeds is legally isolated (like the island in the picture above) and beyond the reach of the transferor’s creditors or a bankruptcy trustee.[1]

This Insight refers to the litigation funder as the “purchaser” (since the funder acquires rights to receive a portion of litigation proceeds) and the claimant who received funding as the “seller” of rights to receive a portion of litigation proceeds.

How can litigation funders ensure that the transfer of rights to receive a portion of proceeds resultant of funded litigation (the “Litigation Proceeds”) under an LFA constitutes a “true sale” divesting seller of its property interest in the Litigation Proceeds and not a secured financing whereby the seller is deemed to have borrowed money from the purchaser secured by the Litigation Proceeds?

Determining whether an asset is “property of the estate” of a debtor in bankruptcy is a question of federal bankruptcy law. However, determining whether a property interest held or not by a debtor in bankruptcy is generally a question of applicable nonbankruptcy law, typically state law. As a general matter, “the bankruptcy estate consists of all of the debtor’s legal and equitable property interests that existed as of the commencement of the case, that is, as of the time that the bankruptcy petition . . . is filed.” [2]  If a party has disposed of an asset prior to its bankruptcy petition in exchange for fair consideration, that asset generally will not be property of the debtor’s estate.

Litigation funding generally refers to an arrangement whereby the funder advances funds to a litigant with a meritorious cause of action who is financially unable or unwilling to underwrite the full costs of the litigation. In exchange the litigant agrees that the funder is entitled to an agreed-upon portion of Litigation Proceeds resulting from a judgment or settlement. An LFA is typically non-recourse, meaning that if the litigation is unsuccessful and no Litigation Proceeds result, the funder has no recourse to the litigant for the funds used for the litigation.

A carefully drafted LFA with attention to the factors indicated below (among others) and conduct by the purchaser and seller of rights to Litigation Proceeds that supports true sale treatment of the transaction, may increase the likelihood that a litigant’s intervening bankruptcy will not swallow up the Litigation Proceeds. And that in turn might provide the funder with less counterparty risk.[3]

In assessing whether a particular transfer is properly characterized as a sale or a secured financing, courts generally attempt to discern the intent of the parties to the transaction, based on the facts and circumstances underlying the transaction.[4] Courts considering the issue will examine both the stated intent of the parties as documented in the agreement, as well as the parties’ conduct and other objective factors.[5]

Case law reveals that there is no universally accepted set of factors that courts use in determining whether a purported sale should be recharacterized as a financing.[6]  However there are numerous factors that various courts have examined; not every court considers or weighs these factors in the same way, and almost always the particular facts and circumstances of the case may influence the significance of the factors considered by courts.  As one bankruptcy court decision noted, “the reviewing court will look to the substance of the transaction, rather than the form. It is beyond the scope of this Insight to examine in detail each of the factors from the standpoint of a litigation funding arrangement.  Nevertheless, several important true sale factors may be relevant to consideration of these issues in connection with litigation funding.

The principal factors that courts have identified and emphasized in the context of “true sale” analysis include:

Recourse to the Seller. For many courts, the purchaser having a right of recourse to the seller weighs against characterizing the transaction as a true sale. Such recourse can include  seller guaranties of collectability and repurchase obligations and similar provisions and structures.[7]  Although recourse to the seller is an important attribute indicating a secured loan, there are decisions to the effect that recourse by itself, without other factors indicating a financing, does not require recharacterization.[8] Other courts have held transfers to be sales even where partial or full recourse existed in addition to other factors that are typically indicative of borrowing.[9]

Risk of loss. Related to recourse is which party bears the risk of loss with respect to the asset.  Courts have generally held that, where a party does not bear any risk of loss, the result is a debtor-creditor relationship rather than a true sale.[10] By contrast, if the risk of non collection of the Litigation Proceeds shifted from transferor to transferee, that suggests that the benefits and burdens of ownership of the asset have also changed.  Of course, both the funder and the litigant in a funded case would bear the risk of loss with respect to their respective interests in the litigation.

Language of the Contract and Conduct of the Parties. When non-sale factors exist, courts will often examine the language of the agreement governing the transaction as well as the parties’ conduct, i.e. terms such as “security” or “collateral” where other secured loan factors exist, or on terms such as “sell” or “absolutely convey” where sale factors exist.[11] Indeed some courts have suggested that the language in an agreement and conduct of the parties are “the controlling consideration[s]” in the true sale analysis, notwithstanding full recourse provisions.[12]

Restrictions on Alienation. Courts have found that a provision that restricts purchaser’s right to resell the purchased assets is inconsistent with a true sale of such assets.[13]  The purchaser of the rights to Litigation Proceeds should be able to pledge or encumber the rights without the consent of the seller and the seller should not be able to pledge or encumber the rights to Litigation Proceeds at all.

True Sale on Organizational Books and Records.  If the purchaser of rights to Litigation Proceeds, and the seller of such rights, each treats the transaction as a true sale on their respective organizational books and records, a court may be less likely to recharacterize the transaction as a financing.

Although the considerations above may be important in structuring a litigation funding agreement, there are several aspects of a typical litigation funding that may be at odds with true sale analysis. For example, in a true sale, buyer acquires all rights to the asset, including the ability to control the use and nature of that asset, while seller retains no, or occasionally minimal, ability to act in respect of the asset (for example, to collect and forward payments on the asset that belong to buyer).[14]  By contrast, in litigation funding the litigant, not the funder, controls the prosecution of the litigation; indeed the ultimate value of any Litigation Proceeds will depend on the litigant’s ability to prove its case or motivate a favorable settlement (acknowledging, however, that the funder provides financial means to enable litigant to do so).[15]

In conclusion, and as noted above, there are no reported controlling judicial precedents directly on point, and the authors have not identified any judicial decisions that state that an agreement by a litigation funder and litigant is a true sale, and we have not located statutory or decisional law interpreting specific contractual provisions identical to those contained in “typical” LFAs.  The cases referenced above are only indicative to illustrate the approach some courts have taken with respect to true sale analysis. Generally, the presence or absence in a transaction of one or more of the particular attributes noted above will not, alone, necessarily be dispositive of a court’s conclusion that a sale, or alternatively a secured borrowing, has occurred. Nevertheless, true sale analysis may offer useful concepts and cautions for parties to litigation funding arrangements to consider.

 

[1] Note that this Insight does not address tax or regulatory issues that may be implicated by litigation funding, including whether there may be tax or regulatory consequences if a litigant or funder were to treat a transaction under an LFA as a sale.

[2] 5 Collier on Bankruptcy ¶541.02.

[3] An examination of the various complications that may result for a litigation funder from a litigant’s bankruptcy filing is beyond the scope of this Insight.

[4] See, for example, Major’s Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538, 543-45 (3d Cir. 1979); Bear v. Coben (In re Golden Plan of Cal., Inc.), 829 F.2d 705, 709 (9th Cir. 1986).

[5] See, for example, Paloian v. LaSalle Bank Nat’l Ass’n (In re Doctors Hosp. of Hyde Park), 507 B.R. 558, 709 (Bankr. N.D. Ill. 2013) (noting that “the reviewing court will look to the substance of the transaction, rather than the form. Therefore, it is important to focus on whether the transaction is arms length and commercially reasonable as well as in proper form and subsequent acts actually treat the sale as real” and listing the following factors as relevant: recourse; post-transfer control over the assets and administrative activities; accounting treatment; adequacy of consideration; parties intent; a seller’s right to surplus collections after the buyer has collected a predetermined amount; the seller’s retention of collection and servicing duties; and lack of notice to the account debtor or others of the purported sale).

[6] See for example Reaves Brokerage Co. v. Sunbelt Fruit & Vegetable Co., 336 F.3d 410, 416 (5th Cir. 2003) (“the distinction between purchase and lending transactions can be blurred” and therefore the outcome of any case will depend on the precise facts of the case and the manner in which it is argued in court); Savings Bank of Rockland County v. FDIC, 668 F. Supp. 799, 804 (S.D.N.Y. 1987), vacated per stipulation, 703 F. Supp. 1054 (S.D.N.Y. 1988) (“The cases that address whether or not certain transactions are to be considered loans or sales do not lay down a clear rule of law on the issue.”); In re Commercial Loan Corp., 316 B.R. 690, 700 (Bankr. N.D. Ill. 2004) (discussing the difficulties of determining whether a transaction is a sale or a secured borrowing).

[7] See, for example, In re Woodson, 813 F.2d 266 (9th Cir. 1987) (seller’s purchase of insurance policy to insure buyers of participations in mortgages against loss an important factor in holding the assignment was a disguised loan); People v. Service Institute, Inc., 421 N.Y.S.2d 325, 327 (Sup. Ct. 1979) (transaction characterized as a loan where assignor had right of full recourse and did not assume risk, charging of interest plus service charge, no notification of account debtor as to the assignment, assignee’s right to withhold payments on accounts until 60 days had expired and right to commingle moneys collected with assignor’s own, and assignor’s offer to help collect the accounts receivable); Aalfs v. Wirum (In re Straightline Invs.), 525 F.3d 870, 880 (9th Cir. 2008) (purported “sales” of receivables were actually disguised loans where seller guaranteed full repayment and correspondence between parties referred to payments for the receivables as “advances”) .

[8] See, for example, Lifewise Master Funding v. Telebank, 374 F.3d 917, 925 (10th Cir. 2004) (holding that, under New York law, the term “recourse” in an agreement refers to the liability of a seller of receivables to the buyer if the underlying obligors fail to pay the receivables and that a repurchase obligation for breach of representations and warranties does not convert a nonrecourse assignment into a recourse assignment).

[9] Broadcast Music, Inc. v. Hirsch, 104 F.3d 1163 (9th Cir. 1997) (assignment of future royalties to two creditors sufficient to divest assignor of property interest, therefore tax lien did not attach to royalties, even where assignment did not extinguish debt and assignment could be terminated following repayment of debt).

[10] See, for example, Woodson, 813 F.2d at 270-72 (debtor relieved the investors of all risk of loss; permanent investors were paid interest regardless of whether original borrower paid Woodson; “[s]imply calling transactions ‘sales’ does not make them so. Labels cannot change the true nature of the underlying transactions.”); and In re Major Funding Corp., 82 B.R. 443 (Bankr. S.D. Tex. 1987) (promising investors a set return on their investment regardless of rate on assigned note, as well as a repurchase of prior lien upon default, indicating that the investors did not have any risk related to ownership and resulting in a finding that the transactions were loans by investors, not sales).

[11] Golden Plan, 829 F.2d at 709, 710 n. 3 (provision in assignment agreement “without recourse” suggests sale where other countervailing factors are not present); Palmdale  Hills  Property,  LLC v. Lehman Comm. Paper, Inc., 457 B.R. 29, 44-45 (B.A.P. 9th Cir. 2011) (parties’ manifestation of intent that transaction constitute a sale evidenced in their use of terms “buyer” and “seller,” “purchase date,” and “all of seller’s interest in the purchased securities shall pass to buyer on the purchase date”); Paloian, 507 B.R. at 709 (“[w]hether the documents reflect statements that the parties intend a sale” is a relevant factor to consider in determining if the transfer of healthcare receivables constituted a true sale); Goldstein, 89 B.R. at 277 (“orders, assigns and sets over” language supported sale treatment); In re First City Mortg. Co., 69 B.R. 765, 768 (Bankr. N.D. Tex. 1986) (contract language coupled with preexisting debtor-creditor relationship indicated loan).

[12] In re Financial Corp. (Walters v. Occidental Petroleum Corp.), 1 B.R. 522, 526 n.7 (W.D.Mo. 1979), aff’d. sub. nom., Financial Corp. v. Occidental Petroleum Corp., 634 F.2d 404 (8th Cir. 1980) (“While this repurchase agreement had many attributes of a secured loan, there was nothing in the record to indicate that this transaction was intended to effectuate a security interest.”).

[13] See In re Criimi Mae, Inc., 251 B.R. 796, 805 n. 10 (Bankr. D. Md. 2000) (“[A] restriction on alienability is inconsistent with [the] claim that the Repo Agreement accomplished a complete transfer in ownership of the Disputed Securities.”)

[14]   See for example Southern Rock v. B & B Auto Supply, 711 F.2d 683, 685 (5th Cir. 1983) (noting that the retained right of assignor to receive proceeds, coupled with a “Security Agreement” and assignment of “collateral security” defeats claim of absolute assignment); and Petron Trading Co, Inc.. v. Hydrocarbon Trading & Transport Co., 663 F. Supp. 1153, 1159 (E.D. Pa. 1986) (no absolute assignment of right to payment under contract where assignor continued to prepare invoices for contract payments, did not notify account debtor and retained rights under contract to petition account debtor for price adjustments).

[15] See, for example, Hibernia Nat’l Bank v. FDIC, 733 F.2d 1403, 1407 (10th Cir. 1984) (participation agreement permitting the loan originator to, inter alia, release or substitute collateral and to repurchase the loan, did not transfer ownership of the loan to participating bank; grantor/originator retained complete discretion to deal with the loan); and Northern Trust Co. v. Federal Deposit Ins. Corp., 619 F. Supp. 1340, 1341-42 (W.D. Okla. 1985) (because loan participation agreement gave participant little input into grantor’s management of the participated loans and collateral backing such loans, court held the participation “did not create or transfer any ownership or property rights” in the participated loan).

Commercial

View All

Computer Weekly Provides In-Depth History of Post Office Horizon Inquiry

By Harry Moran |

The Post Office Horizon IT scandal represented not only one of the most significant cases of institutional malpractice and miscarriage of justice in British history, but also catapulted the use of litigation funding into the public spotlight.

An article in Computer Weekly provides an in-depth summary of the statutory public inquiry into the Post Office Horizon IT scandal, giving readers a detailed account of all the key revelations that emerged across the last three years of the inquiry’s work. The feature breaks down these revelations on a chronological basis, starting in May 2022 with ‘phase one’ of the inquiry’s hearings and going all the way through to ‘phase seven’ in September 2024.

The feature explains how each of these seven phases gathered evidence on different aspects of the scandal, beginning in 2022 with phase one hearing testimonies from the victims, and the phase two investigation into the Horizon IT system itself.

Phase three saw the examination of the Horizon system over the subsequent year, whilst phase four switched focus to assess the activities of lawyers and investigators who participated in the subpostmasters’ prosecutions. Finally, the feature guides us through the inquiry’s work this year, with phases five and six putting the behaviour of directors, politicians and civil servants in the spotlight, before concluding with phase seven that took a broader look at the Post Office’s present and future.

Within the feature, readers can find links to individual articles that provide deep dives into each of these individual phases, cataloguing the most important pieces of evidence unearthed by the inquiry’s hearings. 

Community Spotlights

Community Spotlight: Dr. Detlef A. Huber, Managing Director, AURIGON LRC

By John Freund |

Detlef is a German attorney, former executive of a Swiss reinsurance company and as head of former Carpentum Capital Ltd. one of the pioneers of litigation funding in Latin America. Through his activities as executive in the insurance claims area and litigation funder he gained a wealth of experience in arbitrations/litigations in various businesses. He is certified arbitrator of ARIAS US and ARIAS UK (AIDA Reinsurance and Insurance Arbitration Society) and listed on the arbitrators panel of DIS (German Arbitration Institute).

He studied law in Germany and Spain, obtained a Master in European Law (Autónoma Madrid) and doctorate in insurance law (University of Hamburg).

Detlef speaks German, Spanish, English fluently and some Portuguese.

Company Name and Description:  AURIGON LRC (Litigation Risk Consulting) is at home in two worlds: dispute funding and insurance. They set up the first European litigation fund dedicated to Latin America many years ago and operate as consultants in the re/insurance sector since over a decade.

Both worlds are increasingly overlapping with insurers offering ever more litigation risk transfer products and funders recurring to insurance in order to hedge their risks. Complexity is increasing for what is already a complex product.

Aurigon acts as intermediary in the dispute finance sector and offers consultancy on relevant insurance matters.

Company Website: www.aurigon-lrc.ch

Year Founded: 2011, since 2024 offering litigation risk consulting  

Headquarters: Alte Steinhauserstr. 1, 6330 Cham/Zug Switzerland

Area of Focus:  Litigation funding related to Latin America and re/insurance disputes

Member Quote: “It´s the economy, stupid. Not my words but fits our business well. Dont focus on merits, focus on maths.”

Read More

Manolete Partners Releases Half-Year Results for the Six Months Ended 30 September 2024

By Harry Moran |

Manolete (AIM:MANO), the leading UK-listed insolvency litigation financing company, today announces its unaudited results for the six months ended 30 September 2024. 

Steven Cooklin, Chief Executive Officer, commented: 

“These are a strong set of results, particularly in terms of organic cash generation. In this six-month period, gross cash collected rose 63% to a new record at £14.3m. That strong organic cash generation comfortably covered all cash operating costs, as well as all cash costs of financing the ongoing portfolio of 413 live cases, enabling Manolete to reduce net debt by £1.25m to £11.9m as at 30 September 2024. 

As a consequence of Manolete completing a record number of 137 case completions, realised revenues rose by 60% to a further record high of £15m. That is a strong indicator of further, and similarly high levels, of near-term future cash generation. A record pipeline of 437 new case investment opportunities were received in this latest six month trading period, underpinning the further strong growth prospects for the business. 

The record £14.3.m gross cash was collected from 253 separate completed cases, highlighting the highly granular and diversified profile of Manolete’s income stream. 

Manolete has generated a Compound Average Growth Rate of 39% in gross cash receipts over the last five H1 trading periods: from H1 FY20 up to and including the current H1 FY25. The resilience of the Manolete business model, even after the extraordinary pressures presented by the extended Covid period, is now clear to see. 

This generated net cash income of £7.6m in H1 FY25 (after payment of all legal costs and all payments made to the numerous insolvent estates on those completed cases), an increase of 66% over the comparative six-month period for the prior year. Net cash income not only exceeded by £4.5m all the cash overheads required to run the Company, it also exceeded all the costs of running Manolete’s ongoing 413 cases, including the 126 new case investments made in H1 FY25. 

The Company recorded its highest ever realised revenues for H1 FY25 of £15.0m, exceeding H1 FY24 by 60%. On average, Manolete receives all the cash owed to it by the defendants of completed cases within approximately 12 months of the cases being legally completed. This impressive 60% rise in realised revenues therefore provides good near-term visibility for a continuation of Manolete’s strong, and well-established, track record of organic, operational cash generation. 

New case investment opportunities arise daily from our wide-ranging, proprietary, UK referral network of insolvency practitioner firms and specialist insolvency and restructuring solicitor practices. We are delighted to report that the referrals for H1 FY25 reached a new H1 company record of 437. A 27% higher volume than in H1 FY24, which was itself a new record for the Company this time last year. That points to a very healthy pipeline as we move forward into the second half of the trading year.” 

Financial highlights: 

  • Total revenues increased by 28% to £14.4m from H1 FY24 (£11.2m) as a result of the outstanding delivery of realised revenues generated in the six months to 30th September 2024.
    • Realised revenues achieved a record level of £15.0m in H1 FY25, a notable increase of 60% on H1 FY24 (£9.4m). This provides good visibility of near-term further strong cash generation, as on average Manolete collects all cash on settled cases within approximately 12 months of the legal settlement of those cases
    • Unrealised revenue in H1 FY25 was £(633k) compared to £1.8m for the comparative H1 FY24. This was due to: (1) the record number of 137 case completions in H1 FY25, which resulted in a beneficial movement from Unrealised revenues to Realised revenues; and (2) the current lower average fair value of new case investments made relative to the higher fair value of the completed cases. The latter point also explains the main reason for the marginally lower gross profit reported of £4.4m in this period, H1 FY25, compared to £5.0m in H1 FY24. 
  • EBIT for H1 FY25 was £0.7m compared to H1 FY24 of £1.6m. As well as the reduced Gross profit contribution explained above, staff costs increased by £165k to £2.3m and based on the standard formula used by the Company to calculate Expected Credit Losses, (“ECL”), generated a charge of £140k (H1 3 FY24: £nil) due to trade debtors rising to £26.8m as at 30 September 2024, compared to £21.7m as at 30 September 2023. The trade debtor increase was driven by the outstanding record level of £15.0m Realised revenues achieved in H1 FY25.
  • Loss Before Tax was (£0.2m) compared to a Profit Before Tax of £0.9m in H1 FY24, due to the above factors together with a lower corporation tax charge being largely offset by higher interest costs. 
  • Basic earnings per share (0.5) pence (H1 FY24: 1.4 pence).
  • Gross cash generated from completed cases increased 63% to £14.3m in the 6 months to 30 September 2024 (H1 FY24: £8.7m). 5-year H1 CAGR: 39%.
  • Cash income from completed cases after payments of all legal costs and payments to Insolvent Estates rose by 66% to £7.6m (H1 FY24: £4.6m). 5-year H1 CAGR: 46%.
  • Net cashflow after all operating costs but before new case investments rose by 193% to £4.5m (H1 FY24: £1.5m). 5-year H1 CAGR: 126%.
  • Net assets as at 30 September 2024 were £40.5m (H1 FY24: £39.8m). Net debt was reduced to £11.9m and comprises borrowings of £12.5m, offset by cash balances of £0.6m. (Net debt as 31 March 2024 was £12.3m.)
  • £5m of the £17.5m HSBC Revolving Credit Facility remains available for use, as at 30 September 2024. That figure does not take into account the Company’s available cash balances referred to above.

Operational highlights:

  • Ongoing delivery of record realised returns: 137 case completions in H1 FY25 representing a 18% increase (116 case realisations in H1 FY24), generating gross settlement proceeds receivable of £13.9m for H1 FY25, which is 51% higher than the H1 FY24 figure of £9.2m. This very strong increase in case settlements provides visibility for further high levels of cash income, as it takes the Company, on average, around 12 months to collect in all cash from previously completed cases.
  • The average realised revenue per completed case (“ARRCC”) for H1 FY25 was £109k, compared to the ARRCC of £81k for H1 FY24. That 35% increase in ARRCC is an important and an encouraging Key Performance Indicator for the Company. Before the onset and impact of the Covid pandemic in 2020, the Company was achieving an ARRCC of approximately £200k. Progress back to that ARRCC level, together with the Company maintaining its recent high case acquisition and case completion volumes, would lead to a material transformation of Company profitability.
  • The 137 cases completed in H1 FY25 had an average case duration of 15.7 months. This was higher than the average case duration of 11.5 months for the 118 cases completed in H1 FY24, because in H1 FY25 Manolete was able to complete a relatively higher number of older cases, as evidenced by the Vintages Table below.
  • Average case duration across Manolete’s full lifetime portfolio of 1,064 completed cases, as at 30 September 2024 was 13.3 months (H1 FY24: 12.7 months).
  • Excluding the Barclays Bounce Back Loan (“BBL”) pilot cases, new case investments remained at historically elevated levels of 126 for H1 FY25 (H1 FY24: 146 new case investments).
  • New case enquiries (again excluding just two Barclays BBL pilot cases from the H1 FY24 figure) achieved another new Company record of 437 in H1 FY25, 27% higher than the H1 FY24 figure of 343. This excellent KPI is a strong indicator of future business performance and activity levels.
  • Stable portfolio of live cases: 413 in progress as at 30 September 2024 (417 as at 30 September 2023) which includes 35 live BBLs.
  • Excluding the Truck Cartel cases, all vintages up to and including the 2019 vintage have now been fully, and legally completed. Only one case remains ongoing in the 2020 vintage. 72% of the Company’s live cases have been signed in the last 18 months.
  • The Truck Cartel cases continue to progress well. As previously reported, settlement discussions, to varying degrees of progress, continue with a number of Defendant manufacturers. Further updates will be provided as concrete outcomes emerge.
  • The Company awaits the appointment of the new Labour Government’s Covid Corruption Commissioner and hopes that appointment will set the clear direction of any further potential material involvement for Manolete in the Government’s BBL recovery programme.
  • The Board proposes no interim dividend for H1 FY25 (H1 FY24: £nil).

The full report of Manolete’s half-year results can be read here.

Read More