What changes may the Coronavirus crisis make in litigation financing?

In their April 28, 2020 article, "How COVID-19 Will Shape Litigation Funding: The Short-Term Effects," Matthew Oxman and Allen Yancy correctly observe that the coronavirus crisis, and the attendant increase in bankruptcy filings that it will undoubtedly bring about, will encourage companies engaged in litigation finance to focus on the creditworthiness of both the plaintiff that has received funding from the company and that plaintiff's defendant in the lawsuit that is being financed.

As to the defendant, there is very little that a funder can do, going forward, except to monitor its creditworthiness. As to the plaintiff, however, there is a great deal that can be done.

At present, litigation finance may be conducted on a secured basis—i.e., by a taking a security interest in the lawsuit that is being financed—or on an unsecured basis. If the lender takes a security interest, and perfects under Article 9 of the Uniform Commercial Code (the statute governing security interests), it will be a secured creditor in the event of the plaintiff's bankruptcy, rather than an unsecured one.

Becoming a secured creditor has two advantages. It may enable the funder to consider a wider range of plaintiffs than it would have considered without such security. Equally important, a security interest will be reassuring to investors who share in the funding, either indirectly, as shareholders or owners of the funding company, or as co-lenders in an individual transaction. This additional step, which may not have been considered essential in better times, is now worth a second look.

What are the practical steps needed to obtain a secured party position in bankruptcy? First, the funder should perform a "UCC search"—i.e., a search of the office of the Secretary of State of the appropriate jurisdiction (in most cases, the state of formation). This search may be performed by a service company, after providing it with some basic information.

If the defendant is a large and nationally recognized company, particularly one engaged in manufacturing, it is not unusual to receive back 800 or more pages of search results that must be reviewed. This should not dissuade further inquiry. In a recent review of one such instance of voluminous search results, nearly all of the filings concerned equipment of various sorts, and only one filing was relevant to the lawsuit.

Having identified any filing(s) that reveal a security interest that might take priority over that of the funder—generally, a security interest in "all assets" of the plaintiff—the funder should now see whether it is possible to contact the filer (frequently, a large bank) to see whether the filer will be willing to relinquish its first priority security interest in the lawsuit being financed by: (1) expressly releasing its security interest in the lawsuit and revising its UCC filing accordingly (the easiest option in terms of documentation) or (2) by agreeing to an intercreditor or subordination agreement (a somewhat more complex alternative).

The funder should not be dissuaded from trying to negotiate a release or intercreditor/subordination agreement by the fact that the entity making the UCC filing is a large bank. Frequently, the large bank (which may not have counted upon the lawsuit in its decision to extend credit) will be persuaded by the argument that a successful result will leave the plaintiff with additional funds to use in its enterprise (and with which, among other things, to repay the bank). (It may be questionable whether a bank's "all assets" filing, and the security agreement to which it points, even covers the lawsuit being financed. Since the searcher will not usually be able to examine the bank's security agreement, however, it is preferable to assume that it may include this asset.)

The second step is to draft a security agreement in which (1) the plaintiff grants the financier a security interest in the lawsuit; and (2) addresses the remedies that the financier may employ, consistent with Article 9 of the Uniform Commercial Code, to recover the proceeds of a successful lawsuit in the event that the plaintiff becomes insolvent (or simply prefers to pay more insistent creditors). In addition to the Article 9 remedies, the funder should focus on the practical considerations: Who is to receive the funds upon settlement? If it is the plaintiff's lawyer, will that lawyer agree to work with the funder so that the funder can be assured of payment? Will (s)he agree to do so even if the client attempts to repudiate its obligations to the funder?

Finally, a financing statement must be filed to perfect the funder's security interest. This is the magic step that protects the funder in bankruptcy. Like the search, the filing can be performed by a service company using the basic information about the debtor initially provided. Although many financiers do not want to publicly disclose the existence of a security interest in a lawsuit, out of a concern that such knowledge may prejudice the outcome, there are various strategies that may be employed in drafting the financing statement to address this concern.

These steps, of course, are not as simple as relying on a straightforward contractual agreement that if the lawsuit is successful, the funded plaintiff will pay. However, given the increased underwriting efforts that will undoubtedly follow in the economic wake of the coronavirus crisis, and the importance of safeguarding the funder's interest in the plaintiff's recovery in the event of the plaintiff's bankruptcy, the advantages of becoming a secured creditor is worth serious consideration.

Sandra Stern (principal of Nordquist & Stern PLLC, NYC) concentrates her practice in secured transactions. She has been a member of the Drafting Committee for each revision of Article 9 of the Uniform Commercial Code.