When the fallout from failed intellectual-property litigation collides with bankruptcy, the complexities may be dizzying enough, but when the emerging practices and imperatives of litigation financing are imposed on those complexities, the situation might be likened to three-dimensional chess. But in the court of one veteran bankruptcy judge, the complexities were penetrated to reveal that elementary errors and oversights can have decisive effects.

The debtors in the Chapter 7 case in the Northern District of California[1] (“Debtors”) had previously engaged in protracted intellectual-property litigation (the “IP Action”) against Qualcomm Inc. using the services of three law firms, and the Debtors lost spectacularly--Qualcomm even obtained a judgment against them for attorneys’ fees of “several million dollars.”[2] The Debtors financed the litigation with two litigation funders to the tune of more than $3 million, securing the loans with their anticipated recoveries in the litigation.[3]

In the bankruptcy case that followed (which began as a Chapter 11 case that was converted to a Chapter 7 case), the trustee asserted malpractice claims against the law firms that had represented the Debtors in the IP Action and settled with two of them, producing a pot of cash.[4] The IP Action having failed to produce a recovery to be the litigation funders’ collateral, they asserted that the proceeds of the Trustee’s malpractice claims against the law firms were also their collateral (and therefore not property of the Chapter 7 estate available for unsecured creditors including, notably, Qualcomm for its attorneys’ fees judgment in the IP Action).

No, said Bankruptcy Judge Dennis Montali. While the collateral description in the litigation funding documents was very broad in terms of form and venue, it could not be stretched to include the proceeds of malpractice claims against the Debtors’ law firms in the IP Action.[5] There was simply no expression, however general, of an intention of the parties to include malpractice claims against the Debtors’ law firms and the proceeds thereof in the collateral. Perhaps an additional dozen or so words would have been sufficient to expand the collateral description beyond the proceeds of the IP Action to also include the proceeds of related malpractice claims. “Were it contemplated in any way that malpractice by any of Debtors’ counsel would be a source of recovery [for the litigation funders], the documents would have reflected that possibility,”[6] but they did not. Business oversight? A lawyer’s drafting error? We don’t know, and it didn’t matter.

Furthermore, if a malpractice claim may be collateral for a debt at all, it must be a “commercial tort claim.”[7] It is elementary in secured transactions law that, while most other types of collateral may be described generally by type in the parties’ security agreement, commercial tort claims must be at least reasonably identified.[8] While there may be fair arguments about how much detail is required to reasonably identify a commercial tort claim, these litigation funding documents were so bereft of any description of the malpractice claims that there was no shred of reasonable identification.[9]

Complex transactions and litigations often require specialized knowledge of arcane areas of law and business, but, as seen so often, neglect of business and legal nuts and bolts can have decisive consequences.