Outside Funders Fuel Bankruptcy Lawsuits

After winning a court battle for control of the business, Benefit Street now faces a different fight—to keep the extra payoff it expects to receive for financing the litigation. The disputed litigation loan could deliver returns of more than 2,000%, according to rival investors that have sued to challenge it.

Bankruptcy courts nationwide have seen more such funding deals in recent years, as distressed companies and their creditors sell the rights to pursue lawsuits in exchange for upfront cash. With the pace of corporate defaults picking up, litigation funding could fuel more disputes in bankruptcy court that can alter creditors’ recoveries.

“We’re seeing a recognition of litigation assets as another source of value for companies and their unsecured creditors in a more robust way than we have in the past," said Ken Epstein, investment manager and legal counsel at litigation funder Omni Bridgeway, which isn’t involved in the Sanchez case.

Benefit Street and three other investment firms put up nearly $5.6 million to bankroll a lawsuit on behalf of unsecured bondholders of Sanchez, which exited bankruptcy in 2020 under the new name Mesquite Energy. Earlier this month, a bankruptcy judge ruled that 70% of the company belongs to unsecured creditors, rather than to its former bankruptcy lenders Fidelity Investments and Apollo Global Management.

Benefit Street and the three other asset managers negotiated for 90% of the lawsuit’s proceeds in return for their financing. That means only 10% of the recent award would be spread among all the company’s unsecured creditors. One of them, Lake Whillans Capital, sued earlier this month to challenge the litigation loan, saying that a court-appointed creditor representative signed away too much of the lawsuit’s value.

Lake Whillans, which began acquiring $340 million in Sanchez bonds after the energy company exited bankruptcy, said the chance to provide funding should have been marketed more widely. Fidelity and Apollo, which lost the lawsuit, have made similar arguments. Despite being an established litigation financier itself, Lake Whillans was never approached as a funding source, according to its lawsuit filed in the U.S. Bankruptcy Court in Houston.

Benefit Street and Lake Whillans do agree on one thing: Litigation financing has taken root in bankruptcy proceedings as investors sense opportunity in corporate defaults and reorganizations. Payoffs from litigation investments, a risky asset class that isn’t tied to broader financial markets, can be so large that they are giving rise to new disputes between creditors.

Assets under management in all types of U.S. commercial litigation funding, including for antitrust and patent cases, were $13.5 billion as of June 2022, according to litigation finance consultant Westfleet Advisors. That compares with $12.4 billion, $11.3 billion and $9.4 billion in the immediately preceding years, according to its reports, which don’t have specific numbers on litigation funding in bankruptcies.

“We’ll continue to see an increase in litigation funding at a moderate pace," Westfleet Chief Executive Charles Agee said, while noting that predictions of bigger increases over the years haven’t materialized.

The market has gotten the attention of the U.S. government, however. Last year, a U.S. Government Accountability Office report found that litigation funding has several advantages, “such as giving underfunded plaintiffs resources to litigate cases against well-funded defendants and allowing plaintiffs to transfer litigation risk."

Litigation funding “also can be costly to plaintiffs and defendants, and may create incentives for parties not to reach settlement," the GAO found.

Because litigation funders can lose everything if a lawsuit they finance fails, they demand higher returns than in other asset classes. Lake Whillans said the litigation loan negotiated by Benefit Street could deliver sky-high returns because of the appreciation of equity in Texas-based Mesquite Energy since 2020. After selling some oil and gas properties this year, Mesquite now has $959 million more in assets than it owes in liabilities, according to a company balance sheet filed in court last week.

Benefit Street declined to comment on Lake Whillans’s lawsuit, which seeks to reallocate the 70% equity award among all of the company’s unsecured creditors, including Lake Whillans. Delaware Trust, the creditor representative that borrowed the litigation loan, said it acted in its limited capacity as appointed by the bankruptcy court.

When companies are trying to exit from bankruptcy, they want to pay creditors and operate their businesses, said Chris Bogart, chief executive of litigation funder Burford Capital. They don’t necessarily want to spend millions of dollars pursuing legal claims, even when they believe they have significant value, and can view litigation funders as a way to unlock the value of legal claims that are time consuming and costly to pursue.

In June, a litigation trustee controlling the remnants of several bankrupt hospital entities in four states won court approval to use Omni Bridgeway funding to pursue legal claims against former principals, several laboratories and marketers over alleged fraudulent billing. Australia-based Omni has been expanding its U.S. operations since entering the market in 2011, including earlier this year by hiring a restructuring lawyer from powerhouse law firm Weil Gotshal & Manges in Miami.

Among the largest lawsuits backed by outside funding is bankrupt Petersen Energia Inversora’s claims against Argentina and state oil giant YPF. Earlier this year, a U.S. court held Argentina liable to Petersen, a YPF shareholder, for breaching an obligation to buy back the YPF shares held by Petersen, which went bankrupt. Burford, the funding source for the lawsuit, could get a large cut of the damages.

Last year, the remnants of grocery chain Great Atlantic & Pacific Tea and its unsecured creditors committee got bankruptcy-court permission to enter into a financing arrangement with litigation funder Woodsford Group as they try to claw back roughly $68 million paid to McKesson. The drug company has said in court papers that it shouldn’t have to repay the money.

“The funding agreement is necessary to maximize the value of the claims," according to a court filing by Great Atlantic, which operated under A&P and other brands. Without outside financing, the legal proceedings would “likely need to be abandoned," to creditors’ detriment, the company said.

Litigation financiers can also simply buy creditor claims in bankruptcy cases. In 2021, Burford acquired antitrust claims related to broiler chickens in the bankruptcy case of food distributor Maines Paper & Food Service. Last week, Burford was named the winning bidder for claims that bankrupt Cox Oil could pursue against a shipowner that crashed into its oil platform.

“It’s a somewhat complicated piece of litigation, and it’s going to be expensive," Burford CEO Chris Bogart said.

In 2015, the bankruptcy trustee winding down Magnesium Corp. of America won a $215 million judgment against billionaire investor Ira Rennert with funding from Burford. After an $88 million contingency fee for the trustee’s lawyers, and more than $26 million to cover Burford’s initial investment and provide it with a return, the company’s bondholders received $47 million.

Burford, which did its first U.S. bankruptcy work in 2010, expects to see more activity in those courts as the pace of bankruptcies rises. After a long period of muted restructuring activity, U.S. corporate defaults are now on the rise, largely due to higher interest rates.

“We’re being asked to look at more cases than we have in the last couple of years," Bogart said.

Write to Becky Yerak at becky.yerak@wsj.com