“True Sales” in Litigation Funding Agreements
An issue that keeps some litigation funders up at night concerns the possibility of a claimant filing for bankruptcy after receiving funding and before their underlying case is resolved. Proceeds from the case may become property of the bankruptcy estate and made available to the transferor’s creditors. A carefully drafted litigation funding agreement (“LFA”) can increase the likelihood that the right to receive a portion of litigation proceeds is legally isolated (like the island in the picture above) and beyond the reach of the transferor’s creditors or a bankruptcy trustee.
This Insight refers to the litigation funder as the “purchaser” (since the funder acquires rights to receive a portion of litigation proceeds) and the claimant who received funding as the “seller” of rights to receive a portion of litigation proceeds.
How can litigation funders ensure that the transfer of rights to receive a portion of proceeds resultant of funded litigation (the “Litigation Proceeds”) under an LFA constitutes a “true sale” divesting seller of its property interest in the Litigation Proceeds and not a secured financing whereby the seller is deemed to have borrowed money from the purchaser secured by the Litigation Proceeds?
Determining whether an asset is “property of the estate” of a debtor in bankruptcy is a question of federal bankruptcy law. However, determining whether a property interest held or not by a debtor in bankruptcy is generally a question of applicable nonbankruptcy law, typically state law. As a general matter, “the bankruptcy estate consists of all of the debtor’s legal and equitable property interests that existed as of the commencement of the case, that is, as of the time that the bankruptcy petition . . . is filed.”  If a party has disposed of an asset prior to its bankruptcy petition in exchange for fair consideration, that asset generally will not be the property of the debtor’s estate.
Litigation funding generally refers to an arrangement whereby the funder advances funds to a litigant with a meritorious cause of action who is financially unable or unwilling to underwrite the full costs of the litigation. In exchange, the litigant agrees that the funder is entitled to an agreed-upon portion of Litigation Proceeds resulting from a judgment or settlement. An LFA is typically non-recourse, meaning that if the litigation is unsuccessful and no Litigation Proceeds result, the funder has no recourse to the litigant for the funds used for the litigation.
A carefully drafted LFA with attention to the factors indicated below (among others) and conduct by the purchaser and seller of rights to Litigation Proceeds that supports true sale treatment of the transaction, may increase the likelihood that a litigant’s intervening bankruptcy will not swallow up the Litigation Proceeds. And that in turn might provide the funder with less counterparty risk.
In assessing whether a particular transfer is properly characterized as a sale or a secured financing, courts generally attempt to discern the intent of the parties to the transaction, based on the facts and circumstances underlying the transaction. Courts considering the issue will examine both the stated intent of the parties as documented in the agreement, as well as the parties’ conduct and other objective factors.
Case law reveals that there is no universally accepted set of factors that courts use in determining whether a purported sale should be recharacterized as a financing. However there are numerous factors that various courts have examined; not every court considers or weighs these factors in the same way, and almost always the particular facts and circumstances of the case may influence the significance of the factors considered by courts. As one bankruptcy court decision noted, “the reviewing court will look to the substance of the transaction, rather than the form. It is beyond the scope of this Insight to examine in detail each of the factors from the standpoint of a litigation funding arrangement. Nevertheless, several important true sale factors may be relevant to consideration of these issues in connection with litigation funding.
The principal factors that courts have identified and emphasized in the context of “true sale” analysis include:
Recourse to the Seller. For many courts, the purchaser having a right of recourse to the seller weighs against characterizing the transaction as a true sale. Such recourse can include seller guarantees of collectability and repurchase obligations and similar provisions and structures. Although recourse to the seller is an important attribute indicating a secured loan, there are decisions to the effect that recourse by itself, without other factors indicating a financing, does not require recharacterization. Other courts have held transfers to be sales even where partial or full recourse existed in addition to other factors that are typically indicative of borrowing.
Risk of loss. Related to recourse is which party bears the risk of loss with respect to the asset. Courts have generally held that, where a party does not bear any risk of loss, the result is a debtor-creditor relationship rather than a true sale. By contrast, if the risk of non-collection of the Litigation Proceeds shifted from transferor to transferee, that suggests that the benefits and burdens of ownership of the asset have also changed. Of course, both the funder and the litigant in a funded case would bear the risk of loss with respect to their respective interests in the litigation.
Language of the Contract and Conduct of the Parties. When non-sale factors exist, courts will often examine the language of the agreement governing the transaction as well as the parties’ conduct, i.e. terms such as “security” or “collateral” where other secured loan factors exist, or on terms such as “sell” or “absolutely convey” where sale factors exist. Indeed some courts have suggested that the language in an agreement and conduct of the parties are “the controlling consideration[s]” in the true sale analysis, notwithstanding full recourse provisions.
Restrictions on Alienation. Courts have found that a provision that restricts the purchaser’s right to resell the purchased assets is inconsistent with a true sale of such assets. The purchaser of the rights to Litigation Proceeds should be able to pledge or encumber the rights without the consent of the seller and the seller should not be able to pledge or encumber the rights to Litigation Proceeds at all.
True Sale on Organizational Books and Records. If the purchaser of rights to Litigation Proceeds, and the seller of such rights, each treats the transaction as a true sale on their respective organizational books and records, a court may be less likely to recharacterize the transaction as a financing.
Although the considerations above may be important in structuring a litigation funding agreement, there are several aspects of a typical litigation funding that may be at odds with true sale analysis. For example, in a true sale, buyer acquires all rights to the asset, including the ability to control the use and nature of that asset, while seller retains no, or occasionally minimal, ability to act in respect of the asset (for example, to collect and forward payments on the asset that belong to buyer). By contrast, in litigation funding the litigant, not the funder, controls the prosecution of the litigation; indeed the ultimate value of any Litigation Proceeds will depend on the litigant’s ability to prove its case or motivate a favorable settlement (acknowledging, however, that the funder provides financial means to enable a litigant to do so).
In conclusion, and as noted above, there are no reported controlling judicial precedents directly on point, and the authors have not identified any judicial decisions that state that an agreement by a litigation funder and litigant is a true sale, and we have not located statutory or decisional law interpreting specific contractual provisions identical to those contained in “typical” LFAs. The cases referenced above are only indicative to illustrate the approach some courts have taken with respect to true sale analysis. Generally, the presence or absence in a transaction of one or more of the particular attributes noted above will not, alone, necessarily be dispositive of a court’s conclusion that a sale, or alternatively a secured borrowing, has occurred. Nevertheless, true sale analysis may offer useful concepts and cautions for parties to litigation funding arrangements to consider.
 Note that this Insight does not address tax or regulatory issues that may be implicated by litigation funding, including whether there may be tax or regulatory consequences if a litigant or funder were to treat a transaction under an LFA as a sale.
 5 Collier on Bankruptcy ¶541.02.
 An examination of the various complications that may result for a litigation funder from a litigant’s bankruptcy filing is beyond the scope of this Insight.
 See, for example, Major’s Furniture Mart, Inc. v. Castle Credit Corp., 602 F.2d 538, 543-45 (3d Cir. 1979); Bear v. Coben (In re Golden Plan of Cal., Inc.), 829 F.2d 705, 709 (9th Cir. 1986).
 See, for example, Paloian v. LaSalle Bank Nat’l Ass’n (In re Doctors Hosp. of Hyde Park), 507 B.R. 558, 709 (Bankr. N.D. Ill. 2013) (noting that “the reviewing court will look to the substance of the transaction, rather than the form. Therefore, it is important to focus on whether the transaction is arms length and commercially reasonable as well as in proper form and subsequent acts actually treat the sale as real” and listing the following factors as relevant: recourse; post-transfer control over the assets and administrative activities; accounting treatment; adequacy of consideration; parties intent; a seller’s right to surplus collections after the buyer has collected a predetermined amount; the seller’s retention of collection and servicing duties; and lack of notice to the account debtor or others of the purported sale).
 See for example Reaves Brokerage Co. v. Sunbelt Fruit & Vegetable Co., 336 F.3d 410, 416 (5th Cir. 2003) (“the distinction between purchase and lending transactions can be blurred” and therefore the outcome of any case will depend on the precise facts of the case and the manner in which it is argued in court); Savings Bank of Rockland County v. FDIC, 668 F. Supp. 799, 804 (S.D.N.Y. 1987), vacated per stipulation, 703 F. Supp. 1054 (S.D.N.Y. 1988) (“The cases that address whether or not certain transactions are to be considered loans or sales do not lay down a clear rule of law on the issue.”); In re Commercial Loan Corp., 316 B.R. 690, 700 (Bankr. N.D. Ill. 2004) (discussing the difficulties of determining whether a transaction is a sale or a secured borrowing).
 See, for example, In re Woodson, 813 F.2d 266 (9th Cir. 1987) (seller’s purchase of insurance policy to insure buyers of participations in mortgages against loss an important factor in holding the assignment was a disguised loan); People v. Service Institute, Inc., 421 N.Y.S.2d 325, 327 (Sup. Ct. 1979) (transaction characterized as a loan where assignor had right of full recourse and did not assume risk, charging of interest plus service charge, no notification of account debtor as to the assignment, assignee’s right to withhold payments on accounts until 60 days had expired and right to commingle moneys collected with assignor’s own, and assignor’s offer to help collect the accounts receivable); Aalfs v. Wirum (In re Straightline Invs.), 525 F.3d 870, 880 (9th Cir. 2008) (purported “sales” of receivables were actually disguised loans where seller guaranteed full repayment and correspondence between parties referred to payments for the receivables as “advances”) .
 See, for example, Lifewise Master Funding v. Telebank, 374 F.3d 917, 925 (10th Cir. 2004) (holding that, under New York law, the term “recourse” in an agreement refers to the liability of a seller of receivables to the buyer if the underlying obligors fail to pay the receivables and that a repurchase obligation for breach of representations and warranties does not convert a nonrecourse assignment into a recourse assignment).
 Broadcast Music, Inc. v. Hirsch, 104 F.3d 1163 (9th Cir. 1997) (assignment of future royalties to two creditors sufficient to divest assignor of property interest, therefore tax lien did not attach to royalties, even where assignment did not extinguish debt and assignment could be terminated following repayment of debt).
 See, for example, Woodson, 813 F.2d at 270-72 (debtor relieved the investors of all risk of loss; permanent investors were paid interest regardless of whether original borrower-paid Woodson; “[s]imply calling transactions ‘sales’ does not make them so. Labels cannot change the true nature of the underlying transactions.”); and In re Major Funding Corp., 82 B.R. 443 (Bankr. S.D. Tex. 1987) (promising investors a set return on their investment regardless of rate on assigned note, as well as a repurchase of prior lien upon default, indicating that the investors did not have any risk related to ownership and resulting in a finding that the transactions were loans by investors, not sales).
 Golden Plan, 829 F.2d at 709, 710 n. 3 (provision in assignment agreement “without recourse” suggests sale where other countervailing factors are not present); Palmdale Hills Property, LLC v. Lehman Comm. Paper, Inc., 457 B.R. 29, 44-45 (B.A.P. 9th Cir. 2011) (parties’ manifestation of intent that transaction constitutes a sale evidenced in their use of terms “buyer” and “seller,” “purchase date,” and “all of the seller’s interest in the purchased securities shall pass to buyer on the purchase date”); Paloian, 507 B.R. at 709 (“[w]hether the documents reflect statements that the parties intend a sale” is a relevant factor to consider in determining if the transfer of healthcare receivables constituted a true sale); Goldstein, 89 B.R. at 277 (“orders, assigns and sets over” language supported sale treatment); In re First City Mortg. Co., 69 B.R. 765, 768 (Bankr. N.D. Tex. 1986) (contract language coupled with preexisting debtor-creditor relationship indicated loan).
 In re Financial Corp. (Walters v. Occidental Petroleum Corp.), 1 B.R. 522, 526 n.7 (W.D.Mo. 1979), aff’d. sub. nom., Financial Corp. v. Occidental Petroleum Corp., 634 F.2d 404 (8th Cir. 1980) (“While this repurchase agreement had many attributes of a secured loan, there was nothing in the record to indicate that this transaction was intended to effectuate a security interest.”).
 See In re Criimi Mae, Inc., 251 B.R. 796, 805 n. 10 (Bankr. D. Md. 2000) (“[A] restriction on alienability is inconsistent with [the] claim that the Repo Agreement accomplished a complete transfer in ownership of the Disputed Securities.”)
 See for example Southern Rock v. B & B Auto Supply, 711 F.2d 683, 685 (5th Cir. 1983) (noting that the retained right of assignor to receive proceeds, coupled with a “Security Agreement” and assignment of “collateral security” defeats claim of absolute assignment); and Petron Trading Co, Inc.. v. Hydrocarbon Trading & Transport Co., 663 F. Supp. 1153, 1159 (E.D. Pa. 1986) (no absolute assignment of right to payment under contract where assignor continued to prepare invoices for contract payments, did not notify account debtor and retained rights under contract to petition account debtor for price adjustments).
 See, for example, Hibernia Nat’l Bank v. FDIC, 733 F.2d 1403, 1407 (10th Cir. 1984) (participation agreement permitting the loan originator to, inter alia, release or substitute collateral and to repurchase the loan, did not transfer ownership of the loan to participating bank; grantor/originator retained complete discretion to deal with the loan); and Northern Trust Co. v. Federal Deposit Ins. Corp., 619 F. Supp. 1340, 1341-42 (W.D. Okla. 1985) (because loan participation agreement gave participant little input into grantor’s management of the participated loans and collateral backing such loans, court held the participation “did not create or transfer any ownership or property rights” in the participated loan).
John J. Hanley focuses his practice on litigation finance, first and second lien financings; private placements of debt and equity securities; and the purchase and sale of loans, securities, trade claims, and other illiquid assets. His clients include litigation funders, claimants, business development companies, specialty lenders, investment banks, hedge funds, actively managed CLOs, special purpose vehicles, and other financial institutions. Read more.
Douglas Schneller handles a broad range of complex transactional matters involving bank finance and lending; restructuring, bankruptcy and insolvency; intercreditor and subordination arrangements, including for mezzanine, leveraged, multi-lien and unitranche financings; claims analysis and reconciliation; and purchases and sales of par and distressed assets such as bank loans, notes, accounts receivable, trade claims, bankruptcy claims, and equity interests. Read more.
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