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How to Properly Structure a Litigation Finance Investment Fund Avoiding Common Mistakes and Serious Missteps January 17, 2012 Slide 2 Faculty: Steven Huttler, Partner, Sadis & Goldberg LLP Eddie Stone, President, Stone Capital Assets, Inc. Kirk Van Brunt, Partner, Locke Lord LLP 2 Slide 3 Steven Huttler Steven Huttler is a partner in the firms Financial Services and Corporate Groups. Mr. Huttler has extensive experience in corporate, finance, investment fund and securities matters, including the representation of U.S. and foreign investment funds, underwriters, and private clients in various registered public and private offerings of debt and equity securities totaling in excess of $10 billion. As part of his investment fund practice, Mr. Huttler has served as corporate counsel to many private investment funds and partnerships based in or domiciled in the United States and in international and offshore jurisdictions such as the Cayman Islands, Bermuda, the British Virgin Islands, Ireland, Luxembourg, Isle of Man, Jersey, Guernsey, Cyprus, Mauritius, United Kingdom, Austria, Russia, India and Gibraltar. Mr. Huttler's legal practice has exposed him to diverse fund clients with an exceptionally wide range of investment programs and structures, including large mutual funds and hedge fund complexes, private equity firms, real estate partnerships and funds, venture capital funds and funds focused on specialty finance assets. He has also counseled small start-up hedge funds and financial industry entrepreneurs. His practice has included structuring and establishing start-up funds and managed accounts, and structuring investment funds to benefit from U.S. double taxation treaties. He has advised management companies and fund managers on compensation structures, restructured and reorganized funds, structured, negotiated and documented fund trades, negotiated seed, joint venture and start up agreements, and advised on a range of sophisticated transactions. He has also represented financial services providers, such as brokerage firms (including proprietary trading broker-dealers), fund administration firms and third party marketing firms in structuring their operations, reorganizations to achieve tax benefits, advising on disputes with clients, and in the development of forms for their pension, investment, trading, administration and other services to investment funds, equity, debt and option traders and other clients. 3 Slide 4 Mr. Stone is the President of Stone Capital Assets, consultants and advisors in the specialty finance and insurance industries. He was previously a Managing Director at Plainfield Asset Management, LLC and President and Chairman of Caldwell Funding Corporation, a Plainfield portfolio company in the insurance finance business. He is an attorney at law admitted to practice both in New York and Connecticut and an expert in esoteric asset securitization. Mr. Stone has first hand experience in building new funding companies and structures for emerging asset classes such as structured settlements, lotteries, viatical and senior settlements, litigation funding companies and casino awards. Eddie Stone 4 Slide 5 Kirk Van Brunt Kirk Van Brunt is a tax partner with over 25 years of experience with the taxation of financial institutions and products, with a particular focus on insurance companies and insurance products. Within the insurance arena, Mr. Van Brunt has substantial experience with bank/corporate owned life insurance (BOLI/COLI) and is very active within the life settlement and structured settlement industry. Mr. Van Brunt also has substantial experience in the tax treatment of asset-backed securities and derivative financial instrument, and in-bound tax issues for the foreign investor. Mr. Van Brunt is widely published and frequent speaker at industry conferences and seminars 5 Slide 6 Structuring a Litigation Finance Fund: Relevance To investors: to ensure sufficient transparency and understanding of investment, optimize tax results (avoid confiscatory levels of 70% or more) and provide best opportunities for maturation of assets To managers: for reasons stated above (i.e., to attract and retain investors) and to try and achieve their own goals, including reporting and operational efficiencies and optimized tax results on fees 6 Slide 7 Setting the Stage Structuring from legal side is like a matrix, inputs are nature of asset, investor type and activities, and output that emerges is structural alternatives Structuring from the reporting and due diligence perspective are key issues for investors and thereby managers 7 Slide 8 Important Definitions for Discussion What are litigation finance assets? Most commonly: participation in certain types of legal claims: Personal injury Mass torts Commercial litigation Intellectual Property Sub-specialties: Sexual harassment, employment, etc. 8 Slide 9 Definitions: Whose Interest is Being Acquired? Litigant, generally plaintiff (but not always, e.g., IP cases) Law Firm Other Party (e.g., lenders, creditors, trustees in bankruptcy) 9 Slide 10 Definitions: Timing of Investment Pre-settlement Funds are advanced to the litigant/law firm prior to a settlement Post-settlement Funds are advanced after a settlement has been reached, but prior to the time when settlement proceeds become fixed and payable (akin to bridge financing) Structured settlement Purchase of future structured settlement payments that a litigant is entitled to receive under a structured settlement Counter-intuitive point: structured settlement typically has longer duration than post-settlement Counter-intuitive point: post-settlement still has meaningful risk of loss: e.g., individual seeks certification as member of a class, might not get it 10 Slide 11 Structured Settlements: Explanation/Diagram Structured Settlement Diagram Post Settlement 11 Slide 12 Structured Settlements: Explanation/Diagram Structured Settlement Diagram Pre Sale 12 Slide 13 Structured Settlements: Explanation/Diagram Investor Structured Settlement Diagram Post Sale Investor Claimant Originator Unsold payments All payments Purchased payments New Lock Box Account Annuity Company 13 Slide 14 Definitions: Schematic of Commonly Held Assets - Litigant Pre-SettlementPost-SettlementStructured Settlement Personal Injury Mass Torts Commercial Litigation Intellectual Property 14 *Assets can include participations in cases, rather than direct interest in them *Assets can also include baskets of cases, rather than individual ones Slide 15 Definitions: Schematic of Commonly Held Assets Law Firm Pre-SettlementPost-SettlementStructured Settlement Personal Injury Mass Torts Commercial Litigation Intellectual Property 15 * Recourse vs. non-recourse * Relevant specifically to law firms Slide 16 Implications of Definition of Assets Tax ramifications different structures for domestic and offshore investors Reporting and due diligence implications 16 Slide 17 Next Essential Input: Nature and Locations of Proposed Manager and Investors First question fund attorneys ask: who are your proposed investors and where are they located Generally, overall 3 categories U.S. taxable individuals and entities, U.S. non-taxpayers (pensions, etc.) Offshore In particular, what jurisdictions are the offshore investors from? Generally, two categories from standpoint of U.S. tax treaties: (1) Investors from US/North America/Other Tax Treaty Jurisdiction, and (2) everyone else Where does the manager intend to conduct its business? 17 Slide 18 Identifying Central Tax Issues Foundation question: What is the asset? Debt? In many cases, this may be the best answer, but in many other cases, it isnt Something else: Equity of some type e.g., partner or joint venture with the litigant/law firm? UFO (unidentified financial object)? e.g., purchase of a life contingent structured settlement payment not really debt or equity, but then what is it? 18 Slide 19 Identifying Central Tax Issues (cont.) Complicated by fact that industry participants have needed to take different positions on these points in other contexts: Usury laws: its not debt Rules against participating in legal fees, torts like champerty etc.: its not equity Taking inconsistent non-tax and tax positions can be troubling, lack of industry consensus 19 Slide 20 Identifying Central Tax Issues (cont.) Does profit from the asset constitute capital gains or ordinary income? Generally need to show a sale or exchange of a capital asset If the asset is debt, then profits generally will be interest taxable as ordinary income If the asset is not debt, then it depends on what the asset is If the asset is some type of equity that is being effectively redeemed when advances are repaid, maybe its capital gain 20 Slide 21 Identifying Central Tax Issues (cont.) For the foreign investor: Does the fund (or other investment) vehicle engage in a trade or business in the U.S.? For offshore investors (including U.S. investors forced to invest offshore), this can result in a severe US Tax burden Answer can depend on what the asset is once again Are offshore investors assets subject to withholding? (typically 30%) 21 Slide 22 Identifying Central Tax Issues (cont.) For the foreign investor: Treaty benefits: Interest vs. dividend vs. other income Avoiding a US permanent establishment Satisfying the limitation on benefit rules If asset classification is uncertain, adopting a structure for the foreign investor that qualifies for treaty benefits may be a way to manage US tax es 22 Slide 23 Specific Tax Issue: Season and Sell Conundrum If the asset is viewed as debt, a special US trade or business issue may exist for the foreign investor Regular lending to US borrowers may give rise to a US trade or business even if nothing is being done in the US except through independent contractors This is a broader issue than litigation finance; many shadow banking funds have been established in last ten years Liquidity crisis since 2008, alternative source of funds needed by many businesses around the country (+ internationally) Since debt and equity markets have traded sideways over last 10 12 years, many investors have found these specialty finance or alternative alternatives markets to provide enticing returns and risk-reward opportunities 23 Slide 24 Specific Tax Issue: Season and Sell Conundrum (cont.) U.S. tax authorities have been active recently in pursuing this trade or business issue, where money is from offshore, or offshore fund is involved One approach many auditing firms and tax practitioners have adopted: the season and sell structure e.g., fund organizes two side-by-side funds, one offshore, one domestic, and sells the loan from the domestic to the offshore at a later date, and assuming real risk so domestic fund doesnt look like an agent to the IRS 24 Slide 25 Recurring Issues: Open- vs. Close-ended Architecture Focus on the core issues: ease of valuation and liquidity of underlying asset pool If either is not present, it is not realistic to adopt open ended architecture People sometimes think I will value assets conservatively and this will solve problems This is not really true, as there is no true conservative valuation methodology. Your method always hurts either departing or remaining investors. 25 Slide 26 Key Due Diligence Issues in the Litigation Funding Context Fund Manager Issues: Background and relevant experience Track Record Risk Factors Reporting Skin in the Game Conflicts of Interest Originator, Fund Manager and Servicer all the same Fund Structure and Taxation Onshore/offshore Tax treatment of investment How to Align Interests Liquidity issues 26 Slide 27 Key Due Diligence Issues in the Litigation Funding Context (cont.) Litigation Finance Company due diligence: The underlying assets. Strength of Underlying Case (or Cases) Creditworthiness of the Defendant Track Record of the Firm Politics, Regulatory and Legislative Issues Headline Risk Law Firm Funding Issues: How are underlying loans structured and sized? Documentary review Usury concerns and choice of law issues in lending arrangements Forum non conveniens as a defense 27 Slide 28 Key Due Diligence Issues in the Litigation Funding Context (cont.) Law Firm Funding Issues (cont.) : Licensing and reporting requirements Enforcement challenges when loans go South Counsel arrangements can get sticky The return of Champerty, Maintenance and Barratry Ethical prohibition against sharing fees with non-lawyers Secondary and Tertiary Market Issues How to evaluate and structure an investment in an existing portfolio Who are the Crooks and How Do You Avoid Them? 28 Slide 29 Sadis & Goldberg LLP If you have questions, please contact: Steven Huttler Sadis & Goldberg LLP 551 Fifth Avenue, 21 st Floor New York, NY 10176 212.573.8424 shuttler@sglawyers.com 29 Slide 30 Stone Capital Assets, Inc. If you have questions, please contact: Eddie Stone Stone Capital Assets, Inc. 500 West Putnam Avenue, Suite 422 Greenwich, CT 06830 203.504.8425 eddie@stonecapitalassets.com 30 Slide 31 Locke Lord LLP If you have questions, please contact: Kirk Van Brunt Locke Lord LLP 701 8 th Street, N.W., Suite 700 Washington, DC 20001 New York, NY 10176 202.220.6959 kvbrunt@lockelord,com 31 Slide 32 32