Litigation funders are seeing opportunities for big returns in bankruptcies.

Litigation funders like Legalist's Eva Shang are anticipating another wave of bankruptcies as government stimulus winds down.

Yoonji Han
4/14/2021
Original Article

More than a year into the global coronavirus pandemic, businesses across the United States are still filing for bankruptcy at high rates. Investors who make bets on litigation are eyeing the economic turmoil with visions of big returns.

Commercial Chapter 11 bankruptcy filings spiked by 29% in 2020 with 7,128 filings compared to 5,518 in 2019, according to data from Epiq, a legal services company. Although Chapter 11 filings for 2021 Q1 fell by 25% compared to the same period in 2020, experts anticipate the numbers to surge again as government stimulus measures wind down.

As businesses file for bankruptcy, litigation finance firms see opportunity for investment. These firms make their money by up- fronting the costs of third-party lawsuits in exchange for a percentage of the financial outcome. The business is considered countercyclical rather than acyclical: litigation funders have more investment opportunities when other businesses are in a crunch.

There hasn't been a "juicy" moment this ripe for litigation funding since the 2008 financial crisis, according to Connor Murphy, director at Burford Capital, which finances larger litigations requiring an average of $10 million in investment.

Burford committed $99 million to insolvency and bankruptcy-related matters in 2020 — up around 20% from approximately $83 million in 2019.

How bankruptcies create opportunities for litigation funders

Bankruptcies can be complicated legal procedures: some of the best opportunities for investment returns come out the litigation they create.

A distressed company's "most valuable asset may be a litigation claim, but may not have assets to afford high-quality representation to pursue that claim," said Matthew Oxman, vice president of business development and investments at litigation finance firm LexShares. "To avoid having to settle for a small amount, litigation finance enables them to hire quality counsel and to pursue their claims vigorously."

LexShares, whose typical investment size ranges from $200,000 to $4 million, has recently seen an uptick in bankruptcy claims they've been asked to fund.

Most litigation funders lend cash to both debtors and creditors in bankruptcy proceedings.

Oxman said the nature of the business — providing capital to keep companies afloat — makes litigation finance more "appropriate" for debtors. Extra funds can help a bankrupt company maximize financial recovery for itself and creditors, according to Oxman.

Litigation funding can also be used to help litigation trusts, which typically benefit creditors. With additional capital, a trust can prosecute legal action against the auditors that drove the company to reorganize, enabling a faster and larger recovery for creditors, according to Stuart Grant, cofounder and managing director of Bench Walk Advisors, another litigation finance firm.

Funds are often provided on a non-recourse basis, meaning the recipient of the funding doesn't have to repay the litigation funder if it loses the case.

The pandemic could launch a 'cottage industry' for litigation claims

The US government's economic stimulus packages have pumped additional liquidity into struggling industries like retail, initially keeping the brunt of bankruptcies at bay. But litigation funders expect a surge in bankruptcy filings and related litigation as business conditions return to normal.

"Everybody's watching to make sure that creditors throughout the capital structure are protected and that assets aren't being spun out of the company or spun away to a specific group of creditors or equity holders. And those are the kinds of things that tend to lead to litigation," said Emily Slater, managing director at Burford.

In a sign of litigation funders' growing appetite for making bets in bankruptcy, Legalist, a startup that uses AI to make high-volume investments in smaller court cases, announced in March that it closed its first-ever bankruptcy fund with $50 million, which will be used for debtor-in-possession (DIP) financing to small businesses. Shang said Legalist chose to target DIP financing because it's one of the lowest-risk forms of bankruptcy financing, but isn't widely available for many small businesses that are its core client base.

"Some of the most prominent defenders are large distressed funds that have recently raised billions of dollars. They're not going to be making $3 or $5 million DIP loans to Main Street businesses that are in bankruptcy," said Legalist cofounder Eva Shang.

Things are only going to get busier for litigation funders. The need for legal finance tends to linger a few months after bankruptcy filings, and Slater from Burford said she expects to see even more demand for third-party funding in 2021.

"I think there'll be law firms and advisors who are now a little more opportunistic after seeing a lot of claims fall by the wayside," said Bench Walk's Grant. "The availability of litigation funding may well spawn a cottage industry of those who can look for meritorious claims."