The coronavirus chaos spreading through the financial markets is driving some hedge funds and other private funds to shut down.1 During this tumultuous time, managers tasked with liquidating funds must nonetheless dutifully conduct value realization due diligence. This note is intended to aid affected managers by providing considerations for the disposition of certain illiquid assets—specifically, the selling of future securities class action (and related legal) recovery claims.
The information may also be useful for funds continuing as a going concern but still have a need for returning outside capital.2 In any event, selling the rights to legal claims can aid fund managers by providing immediate liquidity while lessening ongoing administrative burdens. Fund stakeholders can likewise benefit by receiving adequate compensation without incurring the downside risk of a prospective claim.
Though COVID-19 is causing unprecedented financial woes, veteran hedge fund managers know that fund shutdowns are commonplace.
Though COVID-19 is causing unprecedented financial woes, veteran hedge fund managers know that fund shutdowns are commonplace.3 In fact, hedge fund closures notably outpaced launches in 2019. According to industry tracker Hedge Fund Research, 738 hedge funds closed, while only 480 new funds launched.4 Because wind-downs have been an integral part of the hedge fund business, a niche industry has developed for assisting managers with value realization at the final stage. Though liquidating publicly traded securities may not require the aid of an advisor, monetizing alternative or illiquid assets may necessitate the assistance of a specialist. In addition, there may be hidden value beyond the assets listed on the fund’s balance sheet. Specifically, an inquiry should be made into whether assets have securities litigation claims of any worth. Before delving into how to make such an assessment, it is useful to first understand how a future securities claim derives its value.
Simplistically, a typical securities fraud class action alleges that (a) an issuer and/or its executives made material false statements that inflated a company’s stock price, (b) certain investors purchased the stock during the period when the price was inflated, (c) an event occurred exposing the fraud and causing the stock price to decline, and (d) under securities laws, investors have a claim for the losses suffered as a result of the fraud. When a securities lawsuit results in a monetary award, impacted investors can make a claim for their respective portion. Therefore, if a hedge fund is in the affected class, it may ultimately receive money for its claim… or it could sell that prospective claim today for real dollars.
To locate dormant securities claims, the search should begin in a fund’s historical trade records. Even if a fund had a minimally diversified portfolio, odds are good that it has a cognizable legal claim. Approximately one in 18 companies listed on U.S. exchanges was the subject of a securities class action in 2019.5 The likelihood that U.S. exchange-listed companies were subject to a securities class action increased for a seventh consecutive year, from 2.6 percent in 2012 to 5.5 percent in 2019.6 Further, securities class action filings against S&P 500 firms in 2019 occurred at a rate of 7.2 percent.7
A vast number of such lawsuits result in monetary settlements to compensate damaged investors. Over $105 billion, comprising more than 1,800 successful cases,8 has been awarded since 1996.9 In 2019 alone, there were 101 approved settlements filed in the U.S. valued at $3.17 billion.10 At present, there are more than 500 securities class actions still awaiting settlement or some other final outcome.11 Consequently, securities class action claims can represent substantial value added for a portfolio that once traded public securities.
1 in 18
Approximately one in 18 companies listed on U.S. exchanges was the subject of a securities class action in 2019
Class action settlement awards, however, are not limited to investors trading common stock. Funds may likewise have claims for a variety of other financial instruments in their portfolio. Market manipulation and antitrust class action lawsuits have yielded billions of dollars in recoveries for products including, among other things, currencies, forwards, futures, options, rates, and swaps. A few recent examples include (a) a $2.3 billion settlement for investors who traded Foreign Exchange (FX) Instruments,12 (b) a $590 million settlement for investors who traded instruments tied to U.S. Dollar LIBOR,13 and (c) a $505 million settlement for investors who transacted ISDAfix instruments.14 Even digital assets and cryptocurrencies have been in existence long enough for some class action legal claims to have been resolved. For example, in early 2020, a $25 million settlement was announced on behalf of investors who participated in the Tezos initial coin offering.15
Neither are shareholder claims limited to U.S. courts or investments. A growing number of countries have developed investor protection laws allowing monetary recoveries. At least 44 securities class actions were filed in Canada over the last five years.16 Outside of North America, approximately 290 securities litigations were filed since 2015.17 Ongoing litigation for which there may be future claim recoveries truly spans across the globe and industries, such as shareholder actions against Volkswagen in Germany, Danske Bank in Denmark and Petrobras in the Netherlands.18
By understanding the breadth and depth of future legal claims a portfolio might contain, a manager can more fully appreciate the virtue of monetizing such claims when liquidating. To exact value, however, a fund manager needs a reputable buyer. Lake Avenue Capital, LLC is one of a few such firms that buys future securities class action settlement claims from private funds that are closing or returning capital to investors.19 Following are highlights from a recent conversation with the firm’s founder, Shane Kinahan, who provided firsthand knowledge of the claim buying process.
“The first step for us is the execution of a non-disclosure agreement to give the fund assurance that all trading information will be handled appropriately,” said Kinahan. Once executed, the claim buyer should provide all necessary details on the scope and format of the data needed to conduct the analysis. The private fund will then deliver its historical trade data to the claim buying firm. Lake Avenue frequently works with a fund’s custodian or administrator if sufficient trade records are not internally available. “Accessing complete trade records benefits everyone. It speeds up the process and ensures the fund receives the best possible offer,” stated Kinahan.
The next step is for the claim buyer to analyze a fund’s portfolio for securities claims. Lake Avenue declined to disclose the details of how its proprietary valuation model works. Kinahan did, however, relay that the essential analysis is matching a fund’s portfolio against the hundreds or thousands of securities class action matters where a settlement is pending or may occur. “After determining the potential eligibility for future settlement claim payments, Lake Avenue assigns a dollar value to all future claims in the portfolio. We then make a fair purchase offer, sometimes in less than a week from when we started the trade analysis,” said Kinahan.
Once a purchase agreement is executed, a claim buyer should be willing to allocate the payout according to the fund’s specifications. Lake Avenue, for example, can provide a schedule breaking down payment amounts for each relevant account and then wire the respective proceeds directly to each account. Lastly, after confirming the money has transferred correctly, the transaction should be complete.
Upon receiving a future claims purchase offer, a liquidating hedge fund should consider its options. A key consideration for many funds is whether keeping a fund operational for the purpose of self-filing claims makes economic sense. On the one hand, a fund could hold on to the claims and monitor whether settlements are reached, and damages paid out at the anticipated maximum amount. On the other hand, it could sell the claims now and achieve immediate liquidity, but possibility at a discount.
If a liquidating fund decides to keep its claims, it should be aware that settlements can take years to materialize, if ever. “In doing this for more than a decade, we’ve found that the average securities class action settlement takes a little more than four and a half years from the initial complaint filing to a claims administrator making a payout,” said Kinahan.20
Final class action settlement amounts, and individual claimant amounts, can also be unpredictable. For example, even if a class action settlement is reached by the parties, a judge has the power to alter or void the agreement. Moreover, an anticipated settlement disbursement plan of allocation may encounter unforeseen issues that impact the recoveries investors receive. One scenario in which that situation could arise is if more investors file claims than estimated, thus causing individual claims to receive a smaller proration of the total settlement amount.
Another crucial consideration for the fund is to understand the scope of what it is selling. Lake Avenue, for example, typically purchases the entire portfolio unless the fund requests otherwise. “We believe this simplifies the process for the fund and maximizes the purchase offer,” said Kinahan. Even so, a fund should evaluate whether selling certain claims might impact any legal matters in which it is involved. Carving out a specific claim or security from a purchase agreement may be necessary. Similarly, restricting the sale to a portion of a portfolio might be optimal for managers returning outside capital but still trading their own capital. For example, a fund transitioning to a family office might only sell rights related to outside capital and then internally manage its own claims going forward.
Finally, funds that have historically used a third-party legal services vendor to file securities class action claims should confirm the claims buyer has a plan for a seamless transition.21 Importantly, a buyer should have a process that accounts for submitted but not yet disbursed settlement recovery claims. If applicable, the buyer should be willing to coordinate with the vendor in a manner that minimizes the fund’s obligations. “At least for Lake Avenue, to the extent there is overlap, we always want to honor existing agreements between a fund and its legacy claims filer,” said Kinahan.
Closing a fund can be complex. Managers often have the difficult job of shutting down promptly while ensuring stakeholders are distributed all possible value. The selling of legal claims could aid managers in this situation by reducing ongoing administration costs, and at the same time, providing liquid cash when it might be most desired. Therefore, as part of the fund wind-down process, managers should consider selling future securities class action and other legal claims contained in its portfolio.