Uncertainty as Litigation Strategy
Why do sophisticated parties litigate under clouds of (easily resolvable) jurisdictional uncertainty?
In our recent essay (available here), we argue that some sophisticated litigants do not raise obvious jurisdictional defects so that they can use jurisdictional uncertainty as a litigation strategy. Our paper examines, in particular, federal statutory interpleader disputes involving securitized financial instruments (SFIs).
In a federal statutory interpleader action, a custodian of money or property can bring multiple parties into federal court to sort out competing claims. In order for federal courts to have subject matter jurisdiction over these actions, parties must deposit the disputed amount with the court. Interpleader works particularly well in some contexts, like life insurance, where an insurer can deposit insurance proceeds with a court and force competing beneficiaries to sort out their differences in court without the insurer’s involvement.
The financial crisis put old tools, like federal statutory interpleader, to new uses. Post-crisis, federal statutory interpleader has been used to sort out multi-billion dollar contract disputes between the holders of different tranches of an SFI. In these disputes, SFI security-holders disagree about whether there has been an event of default that triggers early liquidation of the SFI. Faced with competing claims—to liquidate or not to liquidate—the SFI’s trustee initiates a federal statutory interpleader action to force the security-holders into federal court to resolve their issues. But SFI disputes are not quite like life insurance disputes. In an SFI dispute, parties do not always deposit the disputed amount with the court. Because the deposit requirement is not met, courts do not appear to have subject matter jurisdiction over these cases. Cases do continue in federal court—but they are litigated under a cloud of jurisdictional uncertainty.
Surprisingly, no one raises the jurisdictional defect. Any party can raise a subject matter jurisdiction defect at any time, even after losing the case (which would cause the case to be dismissed to state court and potentially restarted). A court can also raise a defect on its own initiative. What accounts for parties’ and courts’ puzzling silence?
In our essay, we consider reasons parties stay silent about the jurisdictional defect. In particular, we focus on junior security-holders, who do not want to liquidate the SFI. At first blush, junior security-holders have every incentive to raise a jurisdictional defect. Because of the way SFIs are structured, junior security-holders are unlikely to be paid if there is an event of default and the SFI is liquidated. Raising a defect would stall the case, and therefore stall liquidation. Moreover, because a party can raise a jurisdictional defect even after it has lost the case, junior security-holders have an extra incentive to raise a defect after losing the case, so that a case can be restarted in state court.
We posit that savvy junior security-holders may choose not to raise a jurisdictional defect, and instead to use jurisdictional uncertainty as a litigation strategy. For example, a junior security-holder could threaten to raise a jurisdictional defect to force a favorable settlement from senior security-holders. Senior security-holders, faced with the prospect of restarting the costly litigation in state court, may be highly motivated to settle.
Repeat playerism may also help to explain parties’ puzzling silence. In SFI disputes, the players—financial institutions—may switch positions. The holders of a bottom tranche in one SFI may own top tranches in other SFIs. Taking an aggressive bottom-tranche position may diminish repeat players’ rights in the next SFI dispute.
Our essay discusses these and other reasons for parties’ puzzling silence, and uses these disputes to show how litigants may use uncertainty to motivate bargaining and settlement.
The preceding post comes to us from Cathy Hwang, Resident Academic Fellow at Stanford’s Rock Center for Corporate Governance, and Benjamin P. Edwards, Assistant Professor at Barry University Dwayne O. Andreas School of Law. The post is based on their recent paper, “The Value of Uncertainty,” which was published in the Northwestern University Law Review Online and one of four 2015 Online essays selected for reprint in the Northwestern University Law Review. It is available here. This post has also been featured in the Columbia Blue Sky Blog.
 SFIs are often structured so that when they mature or are liquidated, senior-tranche security-holders are paid in full first. Remaining funds are then distributed to the second-senior holders (until they are paid in full), then to the third-senior holders (until they are paid in full), and so on down the line. As a result, these disputes are often initiated by a relatively senior holder, who approaches the trustee alleging an event of default and demanding an early liquidation. If liquidated, the senior holder would collect payment while lower-tranche holders might get nothing. For this reason, junior holders generally prefer not to liquidate.
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