In Depth: Are Large Judgments The Next Target for Hedge Funds?

Aug 12 2015 | 3:46pm ET

By Carrie Tendler & Josh Sheptow, Kobre & Kim

Hedge funds are no strangers to making investments that are sensitive to litigation outcomes. Indeed, from straightforward litigation funding, to appraisal arbitrage to purchasing of claims against a bankrupt firm, hedge funds are currently pursuing (and making substantial money off of) litigation-based investments.  The acquisition of large unexecuted court judgments is the next logical step in hedge funds’ expansion into litigation-sensitive investments.  

Examples of Litigation-Sensitive Investment by Hedge Funds

One well-known and straightforward example of litigation-sensitive investment by hedge funds involves lending directly to plaintiffs in exchange for a percentage of their ultimate recovery.  In this way, hedge funds operate much like attorneys who work on a contingency fee.  Typically, if the plaintiff collects, the fund shares in the profits; if the plaintiff does not collect, the fund loses its investment.   

A less well-known example of litigation-sensitive investment can be found in a type of arbitrage transaction known as “appraisal arbitrage.” 

When Company A acquires Company B, it offers to purchase the stock from shareholders in Company B at a specific price per share.  Shareholders then vote on whether to accept or reject the offer.  If a majority votes to accept, the minority (those who voted against the transaction or who abstained) can bring what is known as an “appraisal action,” asking a court to find that Company B’s fair market value exceeds the offer price.  If the court finds that the fair market value does exceed the offer price, it will order Company A to pay the fair market value for Company B’s shares.  

Against this background, if a hedge fund believes that the announced price at which Company A will pay to acquire Company B’s shares is less than Company B’s fair market value, it can swoop in and buy shares in Company B at or near the offer price prior to deal closing.  The fund can then bring an appraisal action seeking fair market value for its newly-acquired shares.  If successful, the spread between Company A’s offer price and the court-determined fair market value – plus a statutory interest rate of 5% over the Federal Reserve Discount Rate, applied from the date the merger closes to the date the court-determined price is paid – would stand as the fund’s profit.  

A recent case in which funds pursued this strategy involved a challenge to the 2010 merger of 3M and the biometrics firm Cogent.  After the merger was announced – with 3M paying $10.50 per share for Cogent stock – but before the deal closed, several hedge funds including Merion Capital LP and Magnetar Capital Master Fund Ltd., purchased a large block of Cogent shares.  These funds later brought an appraisal action challenging 3M’s price as too low.  

In 2013, the Delaware Chancery Court agreed, finding that Cogent’s fair value when the deal closed was $10.87 per share.  Thus, the hedge funds received a $0.35 premium per share over the offer price, combined with the hefty statutory interest rate for the years the litigation was pending.  

Other recent appraisal actions have resulted in even higher premiums, with the average award between 2010 and 2014 at 61% over the offer price, according to a report published by The American Bar Association.  Notably, appraisal actions have increased in frequency in recent years, with a record 33 filed in Delaware in 2014, and 28 filed in just the first half of 2015, according to a Wall Street Journal report.

A third example of litigation-sensitive investment is the purchase of claims against a bankrupt firm.  When a firm enters bankruptcy, customers and other creditors typically have claims against it – whether for money that had been lent to the firm, contracts awaiting fulfillment, etc.  The value of those claims depends on two primary factors – the priority of the claim versus that of other claims, and the assets that the bankrupt firm has available to pay claims.  These factors are often the subject of significant legal wrangling.  

Hedge funds will sometimes purchase claims against the bankrupt firm from their original holder for a discount off their full value, betting that at the end of the often litigation-heavy bankruptcy process, the claims will be worth more than what they paid for them.  

Indeed, in a recent instance, the hedge fund Baupost LLC purchased the claim that another hedge fund – Fairfield Sentry – had against Bernard Madoff’s bankrupt brokerage firm.  The deal made headlines because only days later, the trustee overseeing the Madoff estate announced a US $7.2 billion claw-back settlement with one of the firm’s prior customers, drastically increasing the assets available for the payment of claims, and thus drastically increasing the value of the claim that Baupost purchased from Fairfield.  The parties are currently in protracted litigation, with Fairfield seeking to unwind the transaction,  but as this case illustrates, the purchase of bankruptcy claims is both well known to hedge funds, and highly sensitive to the relevant litigation outcomes.

Although otherwise unrelated, these examples reflect a broad trend of hedge funds recognizing the profit potential in litigation-sensitive investment.

Gaining Experience to Navigate Risks 

Of course, there are significant risks in connection with each of the litigation-sensitive investments set forth above.

  • With respect to direct lending to plaintiffs, the plaintiffs could lose their case outright, or they could settle for an amount that does not enable the fund to recoup its investment.  
  • With respect to appraisal arbitrage, a court could determine that the target company’s fair market value was less than the original offer price.  In that case, the fund would still receive fair market value for the shares it purchased – only now it would be less than the offer/purchase price, and the fund would lose money on the transaction.  
  • With respect to the purchase of claims against a bankrupt firm, a party may lose a dispute regarding priority, or the trustee may not secure sufficient assets to pay claims at the anticipated rate.

In light of these risks, any hedge fund considering a foray into these and other litigation-sensitive investments must have – and many do have – sufficient legal as well as financial expertise to properly evaluate the likelihood of success or failure.  

Where Do Hedge Funds Go From Here?

As hedge funds have begun integrating legal expertise into their operations, in part to pursue investment strategies such as those discussed above, they will inevitably be on the lookout for other, litigation-sensitive investments.  

Indeed, hedge funds confront a landscape of historically low interest rates and equity markets that many believe have peaked.  In view of this, they are likely turn their attention, among other things, to untapped, litigation-sensitive investment opportunities that offer the possibility of high returns with varying degrees of risk.  A prime candidate for those investment dollars are large, unexecuted judgments.   

When a court issues a judgment against a defendant for money damages, the battle is often not over.  The plaintiff must then collect on the judgment.  Defendants have had years since the litigation began to establish complicated asset protection plans.  Accordingly, a judgment creditor may have to invest significant time and expense to locate and (if they exist) seize the judgment debtor’s assets.  Confronting these obstacles, a creditor may prefer to sell the judgment at a discount to a third party, in return for cash up front.  The buyer would effectively be betting that she would collect enough from the defendant to exceed the purchase price and related costs, thereby making the transaction profitable.   

This is where hedge funds come in.  

Leveraging the legal and financial expertise that they have drawn on in past forays into litigation-sensitive investments, hedge funds can turn to asset tracing and judgment enforcement professionals to model the likelihood of collecting on a judgment, the amount likely to be recovered, as well as the cost for doing so.  Funds can then use these models to set a price at which they would be willing to purchase a judgment.  If the models are well-done, a fund could make a substantial profit after investing in a number of large judgments.  

Beyond their ability to evaluate the prospects of collection, hedge funds are in a unique position to invest in large judgments for a number of reasons:

1.  Many holders of large judgments are members of a class of plaintiffs whose claims have been aggregated against one or more defendants. These are often individual investors or consumers who would prefer to convert their claims into cash quickly, rather than wait as their attorneys pursue the defendants’ assets with uncertain chances of success.  Many hedge funds, in contrast, are in the opposite position – they have cash available and are seeking medium to long-term investment opportunities. This mutuality of interests may enable the funds to purchase claims at a significant discount.  Indeed, at least one hedge fund has already pursued this strategy, and has begun purchasing claims from a class of plaintiffs who recently secured a US $1.8 billion judgment against the government of Iran. 

2.  Apart from classes of plaintiffs, large judgment holders also include corporations with judgments against other corporations.  While the two may have squared off in litigation, the plaintiff corporation may seek to conduct future business with the defendant.  This may be hindered if the plaintiff is relentlessly chasing the defendant’s assets.  Accordingly, the plaintiff corporation may find it more economical to sell their judgment to a third party, such as well-capitalized hedge fund, than to try to collect on it.  

3.  As there is no public database that tracks large judgments, nor any official measure of the market for large judgment investment, finding investment opportunities is yet another way that hedge funds can leverage their legal and financial expertise.

For these reasons, large judgments may represent the next wave of litigation-sensitive hedge fund investment.


About the Authors:

TendlerCarrie A. Tendler is a partner with Kobre & Kim in New York where she focuses her practice on international judgment enforcement and offshore asset recovery. She has extensive experience representing major corporations and funds in developing global asset recovery strategies for judgments and arbitration awards in the hundreds of millions of dollars, often involving hedge funds and other financial institutions with worldwide assets and complex asset protection plans. 

Josh Sheptow is an associate with Kobre & Kim in Miami where he focuses his practice on international judgment enforcement and complex commercial litigation. 

His recent experience includes matters involving asset recovery in Asia involving elements of fraud and embezzlement.


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