October 5, 2016
Edward M. McNally
Delaware Business Court Insider

The business of third-party funding of litigation is said to be rapidly growing. Typically, the entity putting up the money (a funder) signs a contract with a plaintiff to pay the costs of a lawsuit in return for a percentage of any recovery. While once thought to be impermissibly champerty, this practice is now widely recognized as permitted so long as the plaintiff retains control of the litigation. But in a recent twist on the business of funding, a Delaware court has denied a funder any fees. The decision raises a caution that funders should note.

In Judy v. Preferred Communication Systems, Del. Ch. C.A. 4662-VCL (Sept. 19), the court denied a fee application by Preferred Spectrum Investments (PSI) notwithstanding that PSI's funding of litigation had arguably set in motion a series of events that led to a $60 million recovery by its litigation target, Preferred Communication Systems Inc. (the company). While the facts of the Judycase are very unusual, the principles it stands for have potentially far-reaching consequences.

Briefly, PSI was created to use litigation to take over the company. A series of suits were filed, including a books-and-records case and an action to compel a stockholders' meeting where the backers of PSI hoped to elect directors under their control. The plaintiffs found this effort financially viable because the company held potentially valuable wireless telephone licenses. After much travail, the company's duly elected board was able to sell those licenses for $60 million. PSI then filed its fee application, asking for a $20 million cut of the pie.

The Delaware Court of Chancery denied PSI's application entirely for multiple reasons. Most easily understood, the court reasoned that as a potential acquiror in a takeover bid, PSI was not entitled to any fee award under existing Delaware law. Thus, a party using litigation in support of its takeover effort is not entitled to a fee award, even if another bidder appears and prevails at a higher price. Note that this rule is limited to the actual potential acquiror; it does not bar a fee to the lawyers for a stockholder plaintiff whose litigation efforts led to an improved acquisition price.

The Court of Chancery also denied PSI's application because PSI's litigation-based efforts did not actually cause the $60 million sale, and therefore it could not prove the causation required to win a fee. Additionally, PSI's quantum meruit argument failed because of its own disclaimers of any expectation it would be paid for its efforts. Those rationales are consistent with prior law.

More potentially significant, however, the Court of Chancery also denied PSI any fees because it "was neither the plaintiff nor plaintiff's counsel." Exactly how far that holding goes is important. For example, a funder may choose to support litigation that by its very nature will not generate a substantial monetary recovery for the plaintiff but that generates a sufficiently large recovery to a class of stockholders to justify the funder's investment. Almost all stockholder litigation filed by individual stockholders might fall into that category, even if the named plaintiff does not receive a large sum. If the funder is limited to its agreed-upon share of its client's recovery, it will not lend in those circumstances.

The Judy decision offers a potential solution to the problem. It suggests that PSI should have entered into an agreement with the plaintiff to split a fee award and it was the absence of such an agreement that doomed PSI's application because then it was a "gratuitous volunteer." But, is that really a solution?

Plaintiffs themselves are not the recipients of a fee award. Rather, it is their counsel who gets the fee. But, can counsel then split that fee with a litigation funder? The splitting of attorney fees with a nonlawyer is generally not permitted under the Rules of Professional Conduct. Therefore, the Judydecision may effectively bar litigation funding in any case where the individual client is not going to recover his own, substantial damages.

Is that a good policy? On the one hand, it can be argued that there are plenty of plaintiffs' lawyers willing to take contingent fee cases and there is therefore no need for litigation funding. But if that is so, why is there a growing business of doing just that funding? Presumably, litigation funding exists to meet a real need.

Moreover, it is also true that litigation funding of lawyer fees is going on already. Plaintiffs lawyers occasionally take out loans they expect to repay out of the contingent fee that they will receive if they win a case. While the lawyers are personally responsible for those loans, the reality is they are splitting their fees with their lenders when the loan is repaid out of a fee the lawyers earn. This is not quite the same thing as borrowing money to pay the rent during a period of low cash flow.

The dividing line between funding that is ethical and funding that is unethical may well be whether the lawyer is personally liable to pay the funder no matter how the litigation turns out and whether the amount to be paid turns on the amount of the recovery. It remains to be seen if a no recourse loan is ethical. If the amount to be paid is dependent on the amount of the recovery (such as by payment of a fixed amount if the recovery exceeds a predetermined threshold), the loan may pass muster. But until this issue is resolved, litigation funding of litigation that is dependent on a fee award to pay the funder will be suspect.

Delaware Business Court Insider |  October 5, 2016