Regulation of Lawsuit Loans – Is It Important?
Calls for lawsuit loan regulation come as no surprise in today’s business environment. Politicians are always looking for an excuse to enter into the private affairs of individuals. This post will consider the costs associated with lawsuit loan regulation and what possible consequences, intended or otherwise, could arise from this interference in the free market.
Lawsuit Funding Background
The lawsuit loan is a financial transaction where a lawsuit funding company advances money to a plaintiff prior to settlement. In other words, the plaintiff gets money now and he/she assigns a portion of the case’s ultimate recovery. The lawsuit funding business arose out of an ever increasing need for immediate cash to meet the pressing financial obligations many plaintiffs were facing.
The most common example is a plaintiff who is injured, due to the negligence of another, and whose injuries prevent him from financially supporting himself. With nowhere else to turn for funds (many typical lawsuit funding clients have poor credit or would otherwise not qualify for a personal loan), lawsuit funding companies offer relief to these individuals. The relief comes in the form of immediate cash for plaintiffs to use at their discretion.
The business gained traction in the mid 1990’s and also the attention of insurance companies who often paid lawsuit proceeds on behalf of their insureds. With their influence, state legislatures began investigating the business. Since that time, calls for lawsuit loan regulation were consistently heard.
Consider an article from 2018 written by then New York State Senator, Robert Ortt, entitled, It’s Time for New York to Crack Down on the Lawsuit-Loan Wild West originally published here. The article deems the industry “predatory” and calls for regulation based upon some polling numbers and a few examples where plaintiffs paid sometimes 10x of the advance amount.
Many states have lawsuit loan regulatory measures in place. And in New York, some sort of legislation may ultimately be passed. Will the consequences be worth it? We consider that question below.
For Your Protection – Of Course
The whole argument for lawsuit loan regulation is normally to protect the public – in this case from unscrupulous lenders who prey on the dire financial situation of their applicants. And most of these arguments revolve around the issue of price. In fact, the NY Post article states that “in some instances”, fees could reach the equivalent of 200% per year. Of course, this seems outlandish on its face. However, as with most things, we need to delve a little deeper for the truth.
Pricing Confusion
While we do not know the “reports” the NY Post refers to, we can envision a situation where this statement can be misleading. For example, many lawsuit loan companies charge interest in six (6) months increments. The rub is that if the case is settled anytime during the period, the entire amount of interest is still owed. So if a pre-settlement loan is taken at 30% interest every six months, at first blush the interest rate is 60% per year.
But this is true ONLY if the cash advance is paid on the last day of the second six (6) month term. If the amount of the loan is paid in three months, then in effect the annual percentage rate is actually 120% because 30% interest was paid in three months. Multiply 30% by four (4 three month periods = 12 months) and you get 120%.
Processing and Other Fees
Other examples might include the charging of process, origination, and underwriting fees. These amounts are not paid up front by the client. Instead, they are essentially financed since they are added to the contract amount.
The client receives the contract amount minus the fees but the lawsuit funding rate (use fee) is applied to the total contract amount. Because of this, the true rate of return can be far more than advertised especially on smaller advances.
For example, a lawsuit funding company could charge a $300 processing and application fee on a one thousand dollar advance. That is a 30% charge upon execution and does not include the “interest” charged on the funding. As a percentage, these fees could be considered outlandish relative to the amount of the advance.
Of course, the lawsuit funding business did not invent the use of fees on financial products. This practice existed long before the lawsuit funding business emerged. Fees of this type are common on car notes, mortgage loans, or home equity lines of credit (HELOC). These are simply the business costs to originate, underwrite and advance money to plaintiffs. These costs, like all business costs, must be passed along to the consumer.
You will notice heavy regulation in the consumer loan business in almost every jurisdiction. Yet loan origination, process and underwriting fees are still charged in these business models.
Unique Financial Product Risk
Moreover, lawsuit funding transactions are not loans in the traditional sense of the word, which implies repayment at some point in the future. Since the lawsuit cash advance is not repaid if the case is ultimately unsuccessful, these contracts are called “non-recourse” financing. This fact alone justifies the higher charges and fees because of the added risk to capital.
Lawsuit Loan Regulation – Missing the Point
Unfortunately, discussing interest rates and transaction fees misses the point entirely. Justifying the cost is simply taking the bait since the issue of fairness goes through a public debate. This is playing right into the hands of the lawsuit loan regulators since the real issue is whether there should be any interference in the litigation finance market at all, not the nature and extent of the interference.
The bottom line is there is a need for this service and there are entities willing to fill this need. Ideally, that should be the end of the discussion. But there is the way it should be, and the way it actually is. Regulation is part of the present business environment – for better or for worse.
To sell any regulation, lawmakers must argue the measures will benefit the citizenry. Since one person’s benefit must come from someone’s detriment, there will be some winners/losers when lawsuit loan regulation is passed. Thus, an examination of the likely winners and losers is in order.
Lawsuit Funding Regulation Winners and Losers
The lawsuit funding business historically derived its inventory (dollars) from hedge funds and private investors. A large reason why lawsuit funding outfits could not secure bank financing was because there simply was not enough profitable history to justify traditional bank participation in the industry. As you can probably surmise, investors required a greater return on these “risky” investment pools than commercial banks were demanding.
Lawsuit loan regulations such as capping charges (fees and rates) will likely quell competition since many sources of funds are not available at bank rates. Yet, interest rates are simply one line item to be factored into the cost of providing lawsuit funding to clients.
Winners
Quite likely, existing lawsuit funding operations with cheaper cost of money expenses would benefit since those with higher expenses could not compete on price. This is basic business. Limiting competition would ultimately leave only a few players in the game. And the power in the industry would be consolidated accordingly. Those few entities which remain will have the luxury of funding only the best cases.
Losers
The losers then become those applicants who have lawsuits which do not fit into the funding models of the big players. This means many plaintiffs, who nonetheless face severe injuries and are unable to earn a living, will be less able to secure lawsuit loan approvals and obtain funding. Available money for plaintiffs with cases such as products’ liability, medical malpractice, and legal malpractice would be reduced dramatically. These cases are often more difficult and costly to litigate. Since the loss ratios may not justify the risk involved in providing the “non recourse” advance, this may be just one (unintended?) consequence of lawsuit funding regulation.
Currently, many plaintiffs obtain cash against their lawsuit. Cases with subjectively marginal proofs are also funded because investors are willing to take on this risk. Lawsuit loan regulation which caps interest rates essentially removes these investors from the arena. Thus, plaintiffs will be at the mercy of the funding tastes of the few players whose cost of money is small enough for them to turn a profit.
The Market – the Best Lawsuit Loan Regulation
The lawsuit loan business grew rapidly in the mid 1990’s. At that time, some pre-settlement loan companies charged 10% per month on their advances. Presently, clients can obtain lawsuit loans at considerably lower rates. And this is not due to any lack of greed on the part of the funding companies. Instead, the reduction is primarily caused by the business showing a historical return on investment and increased competition for “fundable” cases in the marketplace.
Legal loans are repaid at the end of a pending lawsuit. And lawsuits usually take from 1-4 years to reach their conclusion. Once a couple of litigation cycles elapsed, enough data was compiled to show potential investors a historical return on capital. This meant more money available for pre-settlement loans and at lower rates.
Profitability usually attracts new players. Although the cost of money savings might not have otherwise been passed along to the consumer, an increase in competition caused a reduction in pricing. In fact, the number of funding companies has exploded in recent years. Lenders simply were forced to lower rates to capture the business. Currently, lawsuit funding companies advertise advances with rates as low as 2% per month or 20% per year.
And the market did what it was supposed to do – become more efficient.
Politicians call for “reform” because they are lawmakers. That is what they do. Yet laws that hinder the free market all come at someone’s expense. Consider Senator Ortt’s statement: “it is because I so strongly support the free market that I believe reforming this system and closing the lawsuit-lending loophole is paramount.” Such a contradiction shows a basic misunderstanding of free-market principles. There is no loop hole. There are only parties, mutually agreeing to contract, each with their own interests in mind.
Will Lawsuit Funding Regulation Help?
Unfortunately, lawsuit loan regulation will do little to help those it tries to protect. Instead, it will block available relief for many.
Lawsuit funding clients sometimes find themselves in the unfortunate position of needing liquidity and needing it fast. The policy argument is to “save” these unfortunate individuals not from the lawsuit funding industry – which is willing to risk capital on even marginal cases – but from themselves.
The question then becomes: who is in a better position to understand the risks and rewards of the transaction – a plaintiff faced with foreclosure on their home or other immediate need, or a legislator trying to do the right thing?
Thank you for your interest in lawsuit funding regulation.
