The Current Regulatory Framework of Lawsuit Loans

Consumer litigation funding is the Wild West of investment vehicles.

Lots of trailblazers and few lawmen. Still largely unregulated, the industry has seen some movement toward more oversight and legislation to ensure that the consumer litigant gets a fair shake and unscrupulous funding companies are weeded out. Much of the friction comes out of a fundamental difference in characterization of lending and investment products. The legislatures that have taken up the issue generally grapple with whether these are transactions that should be subject to lending restrictions. The industry argues that these are not loans, but rather opportunities for investment that carry with them real risk of loss. Some interests, such as the US Chamber of Commerce, lobby in favor of this “loan model” arguing that from the perspective of the consumer the fees charged by litigation funding agreements are too high and the agreements too hard for the average consumer to digest.

Most people are familiar with consumer lawsuit funding through company commercials on radio and television, which are as ubiquitous as the ads for the law firms who bring the lawsuits. These ads are directed at individuals who have brought a personal injury suit against a company or a government entity. They are often unemployed or experiencing health issues and find themselves in need of cash to handle their basic expenses until their cases are resolved. The transaction amounts in consumer cases are generally limited to the low five figures, although they can range up to $100,000 or more depending on the case’s value. The advances in a consumer case are designed to pay for specific basic needs, like rent or mortgage, food, transportation, and in some cases medical expenses. In return, the consumer agrees to pay back the advances out of the settlement or judgment proceeds. A plaintiff who doesn’t receive any money at the end of the case doesn’t reimburse the advances because the funding company takes on the risk of loss.

Not surprisingly, consumer advocates attempt to characterize consumer funding contracts as loan agreements that take advantage of unsuspecting or desperate plaintiffs by charging usurious rates. The litigation funding companies don’t agree. They argue that the transaction are not loans because the consumer doesn’t have to pay back the advances if he receives no award. They also contend that the agreements clearly spell out the consumer’s obligations, and the fees reflect the considerable risk of loss the funding company incurs if, in the end, the plaintiff loses the case or settles for less than it received in funding advances. Furthermore, the funding companies argue that the agreements are non-recourse, and therefore investments that should not be subject to state or federal lending regulations.

The issue may ultimately be decided by the courts. In 2018 the Georgia Supreme Court held that a consumer lawsuit funding contract was not a loan subject to state laws designed to protect the public from unscrupulous lenders. The court based its holding on the non-recourse nature of the agreement and the lack of risk to the plaintiff.

Some funding companies have found themselves defending their agreements against a pair of old English principles called maintenance and champerty, which were designed to discourage third parties from inciting litigation for profit. Maintenance occurs when someone not involved in a controversy encourages the aggrieved party to bring a lawsuit. Champerty is when a third party puts up money in exchange for a financial interest in litigation. Some states have never had prohibitions against maintenance and champerty. A few continue to take a hardline view and insist that litigation funding fits the definition of champerty. In those states, litigation funding has not fared well. Courts in Pennsylvania, New York, and a federal appellate court interpreting Kentucky law have all held that litigation funding agreements are champertous.

Some states have narrowed the application of maintenance and champerty in light of a more modern ethics framework and doctrines like abuse of process and malicious prosecution. Modern litigation funding has largely avoided the champerty label by maintaining that, while they have an interest in the outcome of the litigation, the funding companies make no attempt to control the course of the lawsuit. Rather, they leave the strategizing and decision making to the plaintiff and the plaintiff’s legal team, as evidenced by clear prohibitions written into the agreements themselves.

As court actions continue, state legislatures have made some headway in passing regulations to address concerns like proper disclosures and fee caps. As a whole, the litigation funding industry does not oppose the imposition of reasonable regulations. State action can work to the industry’s advantage. A statutory framework addressing litigation funding lends a measure of legitimacy to a misunderstood industry. It also provides the principled funding companies an even playing field and less competition from unscrupulous operators that charge exorbitant rates and offer misleading terms.

Fewer than a dozen states have made any attempt to pass legislation to regulate funding transactions. Those that have generally require that litigation funding companies be licensed, cap the amount of charges or fees the consumer will be required to pay and provide for certain disclosures similar to ones required under consumer lending statutes.

Recently enacted regulations in Nevada cap the fees a litigation funder can charge at 40% per year. The statute requires detailed disclosures, including a summary of all charges and fees, and requires that funding company to include a payment schedule listing all dates and the amount due at the end of each 180-day period from the funding date until the contract reaches its maximum.

Legislation enacted in Indiana is similar. Its maximum yearly rate is 36% and caps the document fee at $500 if the amount funded is more than $5,000. Indiana goes a step further by specifically stating that these transactions are not loans, thereby sidestepping state statutes governing consumer lending products. Declining to define the transaction as a loan can have a significant advantage for the consumer. It exempts the transaction from certain banking regulations and federal tax obligations on any amounts the funder would write off if the consumer lost the case or settled for less than the total amount owed on the funding agreement.

As of February 2020, lawmakers in Utah, Florida, and New York are considering similar measures. So far, the only attempts at regulation on the federal level are directed at disclosure of litigation funding agreements during discovery in certain class action or multi-district lawsuits brought in federal court.