Discovery & Disclosure Series: Disclosure of funding in bankruptcy cases

By Amy Geise 

In this series, we delve into the rules surrounding discovery of litigation funding information in three specialty areas: bankruptcy, international arbitration, and patent law. In these contexts, discovery rules may deviate from the general rule that litigation funding documents are not discoverable – a concept that has been reiterated by courts in numerous jurisdictions. (See eg, our previous posts featuring the most recent decisions following this general rule from the Northern District of California, the District of New Jersey, and the Western District of Pennsylvania).

Case in point: disclosure is typically recommended, if not required, in bankruptcy cases. Like any post-petition financing outside the ordinary course of a debtor’s business, litigation financing for a debtor is typically subject to standard notice and hearing requirements. Disclosure requirements may be less exacting for post-confirmation trustees, creditors, or other stakeholders, but often even these constituents find it advisable to obtain court approval. Thus, best practice dictates that restructuring professionals carefully consider what steps should be taken to consummate a funding arrangement in a bankruptcy case.

An increasingly frequent role for litigation funding in a bankruptcy case is as a source of DIP funding, partially because debtors are eager to capitalize on valuable litigation assets that often remain unencumbered by a prepetition secured lender’s UCC liens. Various code provisions may be implicated in a DIP funding transaction—including sections 105 (equitable authority of bankruptcy court), 363 (use of estate property), and 364 (obtaining credit). In this sense, the process for a debtor seeking litigation financing resembles the process of obtaining a traditional DIP loan.

For example, in the Welded Construction bankruptcy,¹ the debtors sought approval of a Litigation Funding and Cooperation Agreement that would grant a litigation funder a lien on the proceeds of a lawsuit against a former contract counterparty. The debtors attached a copy of the proposed agreement as an exhibit to a motion for approval pursuant to Sections 105(a), 363(b), and 364(c) of the Bankruptcy Code and Rules 2002, 4001, 6004, and 9014 of the Federal Rules of Bankruptcy Procedure. After 14 days, the debtors submitted a certificate of no objection and the court entered an order approving the transaction.

Of course, debtors’ efforts to secure litigation financing aren’t always uncontested. In the National Events bankruptcy,² the debtors’ court-appointed receiver negotiated a DIP loan to fund investigations into potential fraud by the debtors and certain insiders. The receiver sought approval of the agreement pursuant to sections 105, 361, 362, 363 and 364 of the Bankruptcy Code and sought to allow liens, security interests and superpriority claims in favor of the funder. The debtors faced objections from their prepetition secured lenders and certain unsecured creditors, who argued that they had not been properly noticed of the proposed transaction—underscoring the importance of proper disclosure in a bankruptcy case. After an interim order and a 20-day waiting period, the court entered a final order approving the transaction over all remaining objections.  

Unencumbered litigation assets may also be a valuable resource for unsecured creditors’ committees investigating estate actions on behalf of creditors. Like debtors, official committees seeking litigation funding must comply with standard notice and hearing requirements prior to consummating a transaction that would encumber property of the estate. However, creditors are not necessarily bound by these requirements when securing funding for their individual, non-estate claims.

Litigation funding can also be used to monetize estate claims through a 363 sale. In this context, the terms of a funding agreement must be disclosed because the funder is acting as a prospective purchaser in a competitive bidding process. The MagCorp bankruptcy³ provides a prime example of this kind of transaction. In MagCorp, the chapter 7 trustee orchestrated a 363 sale of the debtors’ interest in a $213 million judgment pending appeal. The trustee explained that the sale would hedge the estates’ downside exposure and provide needed liquidity. The court agreed, and ultimately approved the sale of a $50 million interest in the judgment to a funder for $26.2 million. Click here to listen to our Beyond Hourly podcast episode featuring the attorney who coordinated the sale, Nick Kajon of Stevens & Lee LLP.

Another popular use of litigation funding in bankruptcy arises post-confirmation, when a trustee or other estate representative may seek litigation funding to pursue claw-back litigation or other claims on behalf of trust estate beneficiaries. Depending on the language in the plan, notice requirements for a representative seeking litigation funding may be substantially relaxed. For maximum flexibility post-confirmation, practitioners should craft plan and confirmation order language that specifically addresses the post-confirmation representative’s authority to enter into funding agreements, and ideally, removes or reduces the need for court approval. Some examples of post-confirmation estate litigation funding transactions can be found in the Paragon,⁴ GM,⁵ and Tropicana⁶ bankruptcies.

It bears repeating that the prevalence of litigation funding disclosure in bankruptcy cases deviates from the norm, which is that a party’s funding information is not discoverable, often on both relevancy and privilege grounds. Such exceptions exist in other specialty areas, as well. The next segment of this series will address one such area—discoverability in IP cases.