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Risky Business: Why Usury Doesn't Apply to Legal Funding (original)

January 30, 2011
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4min read

Insurance companies and other critics of legal funding allege that it is a usurious practice, and they are wrong for a very simple reason we've discussed at length: legal funding is not a loan but an investment.

As an investment, it is indeed more expensive than a traditional loan -- for good reasons -- and it probably couldn't exist otherwise. The primary reason for this is that a legal funding transaction involves no absolute repayment -- if the plaintiff loses, she owes nothing back to the funder. But the argument has been made, in and out of the courts, that some cases have such a low risk of losing that investments in those cases must be considered loans.

A similar allegation was leveled against attorneys when they introduced the contingency fee. Critics argued that it was unethical for attorneys to charge such high fees in cases when there was little risk of losing. Though it still has its critics, few would argue that the contingency fee allows plaintiffs to pursue worthy cases they otherwise could not afford. So how do we categorize legal funding -- and the contingency fee -- in cases that have negligible risk of failure? Is it an investment, or a loan? 

This tiny man wants to invest in your lawsuit.[/caption] The judiciary has generally avoided this analysis, likely due the difficulty in retroactively assessing risk. In one famous case, Rancman v. Interim Settlement Funding, the Ohio Supreme Court completely eschewed that conundrum entirely. Noted legal theorist Lester Brickman writes in his critique of the contingency fee that "strenuously" avoiding any discussion of risk "allowed the court to simply ignore the issue of whether charging a one-third standard-contingency fee in a 'sure winner' case violates the ethical requirement that fees must be 'reasonable.'"

But what if a court didn't ignore the issue? In a 2013 Cardozo Law Review paper, attorney Sheri Adler offers a new model for the courts. She draws a parallel to tax law, which distinguishes between transactions that are "more akin to debt, created when a loan has occurred, or equity, created when a non-loan transaction has taken place." The distinction extends further between lenders, who expect timely returns regardless of a venture's success, and shareholders, who assume a venture's risk with the expectation of high returns if it is successful. 

Sometimes, taking a risk is as simple as flying a balloon, toward an eagle, in an eldritch colorless world.[/caption] Adler's argument is nuanced and well-made; she takes the reader through ten factors used by courts in the Eleventh Circuit to determine whether a business's transactions create debt or equity. She applies them to legal funding, asking whether it looks like a loan in each given context. More often than not, it doesn't. Here are some key factors in Adler's multi-factor test:

Name Given to the Certificate

"In the tax context," Adler writes, "courts often look at the type of certificate issued to evidence a transaction in order to distinguish between debt and equity."

Stock certificates indicate equity; bonds, debentures, and promissory notes indicate debt.

Legal funders don't use any of the above. In most cases, rather, they issue "purchase agreements," "funding agreements" or similarly-titled contracts to plaintiffs who treat the transaction as a sale or an advance: the product is a stake in a legal claim's proceeds.

This agreement resembles a stock certificate more closely than a promissory note, and signifies that funding is not a loan.

Presence or Absence of a Fixed Maturity Date

Adler writes that "Courts look to the presence of a fixed maturity date in an instrument as an indication that the borrower is unconditionally obligated to repay loan principal, an important characteristic of debt." The absence of a fixed maturity date, however, suggests that repayment "depends on the fortune of the business" - in this context, the lawsuit.

Legal funders do not set a fixed maturity date, making legal funding "more analogous to a capital contribution than a loan."

Right to Enforce Repayment

Adler observes that "Where an obligation to repay is definite, it follows that the funder has the right to enforce repayment, and a loan is indicated. Conversely, where parties have discretion over whether to enforce repayment, an absolute obligation to repay does not exist, and an equity contribution is indicated."

It is true, though, that sometimes the right to enforce repayment is contingent on events whose occurrence is uncertain.

But in such cases, the uncertainty "must be a question of when the events will occur, rather than whether they will occur." So while legal funders indeed have a right to enforce repayment, a case's success is not a matter of when - it is a matter of whether.

Intent of the Parties

Similar to the "Name Given to the Certificate," this factor deals simply with the "objective intent" of those involved in the transaction. This is an important factor in tax cases because when corporations make deals across a table, a written agreement might not quite "reflect the true substance of the transaction" - whereas corporations negotiating with large groups of shareholders at arms-length must write agreements that more accurately represent that substance.

Legal funding contracts are arms-length agreements, and their form does reflect the true intent of the funder: to invest in worthy lawsuits.

Interest Payments

Lenders are indeed concerned with interest, and Adler is right that the "high premiums" charged by legal funders are well-earned critique of the industry. But, she goes on, there are a few things that make legal funding fees "look like something other than traditional interest charges for a loan." Chief among these is that the any payment made to the funder comes from the settlement, and settlement is never guaranteed; therefore the funder cannot be certain what percentage of the fees it will recoup. 

What look like fixed fees are thus fundamentally un-fixed.

Moreover, the plaintiff makes no payments before the lawsuit is concluded - she must only pay the fees upon successful resolution. Again, the legal funder more closely resembles an investor than a lender.

Ability to Obtain Loans from Outside Lending Institutions

One powerful signal that a transaction is a loan is that the borrower could have obtained it from other creditors: for instance, a bank. In the case of legal funding, banks do not (yet) offer non-recourse loans to borrowers whose collateral is a lawsuit. If they did, the legal funding industry probably wouldn't exist. In this context, funders appear more like speculators than lenders. 

 Adler's argument is more nuanced than we can justly cover here, but her ultimate conclusion is firm: "In accordance with the legal maxim that if a transaction is not a loan, it cannot be usury... usury caps should not be applied to alternative litigation financing advances."

Photo credits: beX out loud, JD Hancock, h.koppdelaney via Compfight.

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