Regulation in Consumer Litigation Finance
The litigation finance industry has been referred to as "the wild west of finance." You’ll find many articles on the web pointing to interest rates in excess of 100%. You may be asking yourself one, isn’t that usury and two, why would anyone in their right mind pay that much? Well it’s not technically usury. Under the current laws usury applies to loans and since repayment is contingent upon the outcome of a lawsuit, it’s not considered a loan. People are willing to pay this much to borrow money because they have no other options. If you’ve been in an accident, are out of work, have no savings and a low credit score what other options are there? Also, when the plaintiff repays the amount owed, it comes from the proceeds of their lawsuit so they don’t feel it as much as if it were coming from their paychecks.
So if the current laws don’t apply and the people borrowing are desperate, then the government should step in to prevent companies from preying on these people, right?
Wrong. The litigation finance industry is largely self-regulated. They have formed a trade organization called the American Legal Finance Association or ALFA. ALFA lobbies for the industry and sets industry best practices in their code of conduct. Each member of ALFA agrees to adhere to the standards in their code of conduct.
Examples that Benefit the Consumer
- Each member agrees to obtain written acknowledgement from the plaintiff’s attorney before funding their case.
In every case the attorney must sign off on the contract. This ensures that the attorney acknowledges that there is a lien on the case to be paid before the client is paid. The attorney also usually reads the contract more carefully than the client and can advise them on the terms.
- Each member agrees that their transaction with their client shall constitute the entire agreement between the member and their client. Each member agrees that they will not take any step to:
Acquire ownership in their client’s litigation
Interfere or participate in their client’s litigation, and/or attempt to influence their client’s litigation
In some litigation financing the lender buys a portion for X amount of dollars and receives X percent of the proceeds of the settlement. For example I give you $10,000 for 10% of your settlement. Your case settles for $1,000,000, therefore I’m entitled to $100,000. ALFA’s rule does not allow this.
- Each member agrees that they will not intentionally advance their client money in excess of their client’s needs at the time the advance is completed.
The plaintiff should only be advanced to meet their needs. If the client asks for $10,000, but could survive on $1000 a month then they would pay less on the monthly stipend vs the lump sum.
- Each member agrees that they will not intentionally over-fund a case in relation to their perceived value of the case at the time of such advance.
The client should be left with the lion’s share of their settlement. If the company over-funds a case then the client may be left with little or nothing at the end. Typically a funding company will advance only 10-15% of their perceived value of the case.
- Each member agrees that they will not advertise false or intentionally misleading information.
This is extremely important for plaintiffs to trust the industry. However, beware that 3% compounded monthly is 43% a year.
- Each member agrees that they will not offer or pay commissions or referral fees to any attorney or employee of a law firm for referring their clients to the member.
Attorneys can’t be incentivized to refer a client to a specific funding company. It creates a conflict of interest and incentivizes the attorney to recommend the company with the highest commission rather than the lowest rate.
What about Rates?
Remember that 100% we mentioned before? Well it’s not so accurate. Maybe in the past rates were closer to 100%, but not anymore. For certain advances it is possible rates approach 100% in the first year with fees included. Usually companies charge in the neighborhood of 36% per year. Some charge simple rates and some charge compound rates.
Some states, like Indiana and Arizona, have limits on rates that companies can charge, which cap rates at 36% per year. Caps don’t hurt competition as companies can charge lower if they wish. However, caps will hurt plaintiffs with riskier cases that require a higher rate of return from investors. If a plaintiff has a case with a lower chance of success and an investor demands 45% a year then the plaintiff has no alternative.
What about Licenses?
Illinois requires a license for non-recourse consumer lawsuit funding companies to do business in the state. Alabama and Vermont have bills pending to require a license in their states. Licenses may or may not add any value to the already self-regulated industry. Licenses do create a barrier to entry for firms willing to do business in the state. If more firms cannot do business in the state due to licensing red-tape, consumers will pay higher prices and have less choices.
While government regulation has good intentions, the outcomes do not always benefit consumers. Regulation of the industry creates barriers to entry. Many potential entrants will not be willing to jump through the necessary hoops. Those new entrants would of course charge lower rates and improve the quality of service in an attempt to gain market share. Regulation would actually have the opposite effect it intended to have by reducing competition and increasing prices for consumers. If rate caps are introduced, then certain plaintiffs will lose access to funding because their case is deemed too risky.
Right now barriers to entry in litigation finance are extremely low. Anyone with a phone and a pile of cash can make advances to plaintiffs. The number of ALFA member companies has grown from 21 to 37 since 2010 (a 76% increase). If plaintiffs and their attorneys are willing to shop around for the best option they will be better off than if the government tries to put controls on the industry.