Should We ‘Second’ That? A ‘Top Ten’ Due Diligence Checklist for the Litigation Finance Secondaries Market
Given the recent growth of the secondaries market in the litigation finance space, Secondary Investors should consider how to best approach their review of potential transactions. In addition to the economics of a given investment, there are key legal issues Secondary Investors should consider.
A secondary transaction is any transaction where an interest in a previously consummated investment is acquired from the Original Investor. The secondary investment could take the form of an investment in all or a portion of a single original investment, a portfolio of original investments, or the equity interests of the Original Investor.
This article will use the following terms to reference the various parties involved in a secondary transaction, regardless of the structure of the original investment or the secondary transaction:
The “Debtor” is the entity (most often a law firm or litigant) with which the original investment was made by the Original Investor. The original investment between the Debtor and the Original Investor may have been structured as traditional debt or another investment structure, such as a prepaid forward.
The “Original Investor” is the entity that made the original investment with the Debtor. The Original Investor may have acted as lender, buyer, funder or the like, depending on the structure of the original investment. Alternatively, the Original Investor may have been acting as an agent for a group of such investors.
The “Secondary Investor” is the entity that transacts with the Original Investor to invest in all or a portion of the original investment.
Before entering into a secondary transaction, it is essential to undergo a comprehensive legal due diligence review of the original investment. In this article, we share our “Top Ten” due diligence items to consider.
1. Assignment Provisions
To assess whether a sale or assignment of the original investment is permitted as a secondary transaction, a Secondary Investor must look at key provisions in the underlying transaction documents from the original investment. Secondary Investors and their counsel should review those transaction documents to ensure the Original Investor can sell or assign its rights and obligations. If so, does the Debtor have a consent right? Are there any inclusions on the “restricted funders” list that could prevent the Secondary Investor from acquiring an interest?
If a Secondary Investor is entering the deal by acquiring an equity interest in the Original Investor, the Secondary Investor should review the relevant terms to assess whether the acquisition trips any restrictions on change of control for the Original Investor or is itself deemed an assignment. Secondary Investors should also consider what consents are required in light of any applicable restrictions.
2. Organizational Documents
In the case of an investment in a portion of the equity interests of the Original Investor, a Secondary Investor will need to understand its rights under the organizational documents of the Original Investor, and consider whether to propose any amendments to those organizational documents in connection with the closing of the secondary transaction.[1] The Secondary Investor’s review of the organizational documents of the Original Investor should be especially attuned to any rights of the Original Investor to take action on key topics without the prior written consent of the Secondary Investor, including any amendment to the organizational documents, any issuance of additional equity that would dilute the Secondary Investor’s investment, the granting of any lien by the Original Investor on the Original Investor’s assets, and any amendment to the underlying transaction documents from the original investment. With respect to those underlying transaction documents, the Secondary Investor should look to protect itself from scenarios where the Original Investor, without the Secondary Investor’s prior written consent, enters into amendments that could impact the Secondary Investor’s investment, including any changes to the investment commitment, any changes to the investment return or investment waterfall, and any changes to the collateral.
3. Lien Searches
Regardless of the structure of the transaction, a best practice is to run lien searches against both the Original Investor and the Debtor. Secondary Investors should run lien searches against the Original Investor to determine whether the Original Investor has already granted liens on the investment it wants to assign. Although the Original Investor most likely ran searches on the Debtor when the original investment was arranged, Secondary Investors should also run independent lien searches against the Debtor, especially if a meaningful amount of time has passed since closing of the original investment. If any issue is uncovered, Secondary Investors should confirm with the Original Investor if and how such issue was addressed during the original investment. If the secondary transaction involves the acquisition of equity of the Original Investor, Secondary Investors should also run lien searches on the sellers of the equity, in addition to the searches on the Original Investor and the Debtor.
If the searches find any problematic liens that were not addressed or did not exist when the original transaction closed, Secondary Investors should assess the risk and how to best address it. Next steps might involve collateral releases, payoff letters, intercreditor arrangements, or a combination of these options.
4. Retainer Agreements
Secondary Investors should review the retainer agreements between the litigant and the law firm representing the litigant in the underlying litigation to confirm that the economics between the litigant and law firm (i.e., the success fee and any monthly fee obligations) align with what is reflected in the transaction documents from the original investment.
Where the original investment was with the litigant, Secondary Investors should examine the transaction documents from the original investment to determine what acknowledgments or agreements were made by the law firm representing the litigant. This might include an acknowledgment by the law firm of the Original Investor’s interests in the litigation and/or an amendment to the retainer agreement to establish that the proceeds of the litigation will ultimately be distributed in alignment with what is provided in the transaction documents.
5. Commitments
Depending on when a Secondary Investor consummates the secondary transaction in relation to the progress of the original investment, the Secondary Investor may have ongoing funding obligations to the Debtor. If so, it is important to assess whether the remaining amounts are fully committed or if funding is discretionary, and to determine the duration of any ongoing commitment obligations.
6. Mechanics
When considering the funding and borrowing mechanics of the original investment, Secondary Investors should determine how and when the Debtor can request funds, the cutoff times by which payments need to be made, and the minimum amounts that must be requested to confirm that the Secondary Investors can operationally comply with all such provisions.
If there are mandatory repayment provisions, Secondary Investors need to understand the amortization schedule and maturity, if applicable, and ensure that the waterfall reflects the economics of the deal the Original Investor marketed to them.
Secondary Investors should also assess whether optional prepayments are allowed, and if so, whether they are permitted in whole or in part and whether they are permitted only after a specific date. Secondary Investors will also want to know the prepayment fee amount, if applicable, and when it applies.
7. Collateral
Secondary Investors must review the underlying collateral. Is the original investment secured by an all-assets lien, or is the lien limited to certain cases or portfolios and their proceeds? Regardless of the collateral package’s scope, Secondary Investors must make sure that the Original Investor’s lien on the collateral was properly perfected. A UCC-1 Financing Statement will cover perfection for most personal property. Secondary Investors can use the lien search results to make sure a UCC-1 Financing Statement was properly filed and is still effective.
With respect to law firm transactions, control agreements may also be in place, especially for those bank accounts into which litigation proceeds are being directed. Secondary Investors should confirm whether existing control agreements can be assigned or if there are restrictions on a change of control of the Original Investor. If any such restrictions exist, the Original Investor and the Secondary Investor should work with the depository bank to obtain its approval of the secondary transaction.
If the Secondary Investor is acquiring all of the equity in the Original Investor or taking a full assignment of the original investment, the Secondary Investor should track when the UCCs need to be continued and plan accordingly to file the necessary UCC-3 Continuation Statements. If the Secondary Investor is taking a full assignment of the original investment, the Secondary Investor must also ensure all related UCC-1 Financing Statements are assigned to the Secondary Investor as the “Secured Party” and, as a belt-and-suspenders approach, should consider filing a new UCC-1 Financing Statement against the Debtor naming itself as the “Secured Party”.
8. Other Investors
Understanding the rights and obligations of other investors is another important due diligence step. For instance, if a Secondary Investor is acquiring a deal in full, the Secondary Investor should understand the rights of any existing participants. Do those participants share equally in all funding obligations under the original investment? What obligations will those participants owe to the Secondary Investor once it steps into the shoes of the Original Investor? Do any other existing investors have any consent rights with respect to Secondary Investors joining? Do any existing investors have tag-along rights? If so, Secondary Investors should consider how those rights affect the economics and mechanics of the secondary investment. And if the Secondary Investor will be acting as agent, the Secondary Investor should determine its obligations to the other investors.
With respect to voting, Secondary Investors should look at the “required lender/funder” definition to determine how much control they will have and how much control other investors have.
9. Insurance Policies
As is becoming more evident in today’s market, insurance providers want a stake in the litigation finance world. As a result, Secondary Investors need to be on the lookout for insurance policies that may be insuring the original investment. If the Original Investor obtained an insurance policy to protect the original investment, Secondary Investors should review the insurance policy for the following: (a) change of control provisions, (b) assignment provisions, (c) any requirements for notice or consent upon an amendment to the investment agreement, an amendment to any retainer agreements or any changes to the other transaction documents, and (d) any delivery requirements of the insured, such as updates with respect to the litigation. The delivery requirements related to litigation updates are particularly important in complete equity purchases whereby the Secondary Investor will be stepping into the shoes of the Original Investor under the insurance policies and will, therefore, be required to take over these delivery requirements.
If the Secondary Investor’s right to recovery is protected by an insurance policy, even if just a portion thereof, the Secondary Investor needs to review the policy to ensure that the consummation of the secondary transaction does not trigger a default under the policy.
10. Exit/Assignment Provisions
Secondary Investors should remember to think about their ability to exit a deal. The assignment provisions become relevant again when a Secondary Investor considers selling all or a portion of its investment later down the line. It is important that Secondary Investors be aware of the Debtor’s consent rights, restricted lender/funder lists, and voting rights. Secondary Investors should consider if any such provisions could impact their ability to exit a deal in full or in part.
If you have any questions about secondary transactions or other litigation finance transactions, please don’t hesitate to reach out. LP is one of the nation’s leading providers of transactional services in the burgeoning area of litigation finance. We represent prominent litigation finance firms, hedge funds, and other investors in entering into single-case financing transactions with plaintiffs, as well as financing transactions with law firms that are collateralized by pools of contingency fee matters or, alternatively, all assets.
[1] This topic is typically not significant in the context of a purchase of 100% of the equity interests of the Original Investor, as the Secondary Investor will usually have free rein to amend the organizational documents after closing of the secondary transaction.