Legal Funding is Not a Lawsuit Loan

While many perceive legal funding as a loan, it needs to be said that such a claim, while seemingly logical, is inaccurate. Legal funding is actually an investment in a legal case. When one asks the question of what the difference between a loan and an investment is, it can be said that the answer to that question is – risk. It is the existence of substantial, actual risk that distinguishes a loan from an investment. On that note, many agree that legal funding is an investment precisely because it involves a substantial amount of actual risk.

When it comes to lawsuits, it can be said that it’s strange to think of them as something that can be assigned, sold or bought; the fact to the matter is that they can be, much like stocks or even real estate. Regardless of the circumstances, loans must be paid back with interest, because they are regarded by the law as financial obligations. For example, only if the litigant settles or wins their case are legal funding investments paid. Much like company owners, who take on the risk of losing their investment if their company fails, legal funders are also at risk of a lawsuit failing.

Because of the fact that consumer loans are subject to very strict regulation in the great majority of states, dramatic consequences can occur if legal funding becomes misclassified as a loan. For instance, companies who deal in loans to consumers are required to comply with strict state usury laws; these laws are responsible for capping the rate of return, which is charged on the consumers. Now, compared to some other types of investments, loans are considered relatively less risky; this means that the rates of return (that are required in order to make a profit) are somewhat lower than for legal funding, for example, as well as other types of finance that carry more risk. In order to ensure a profit, legal funding companies are required to charge higher rates because they are at risk of the lawsuit failing. Therefore, if one was to subject legal funding as an activity to usury laws, the model simply wouldn’t work.

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In the great majority of states, the definition of a usurious loan has 4 main elements:

• An agreement that features lending money
• The existence of an absolute obligation of the borrower to repay (the loan), with the addition that such an obligation is not contingent on any other event
• A rate of repayment that exceeds the statutory maximum
• An intention to receive a greater payment than allowed by the usury law

Out of these four, it can be said that the most important and critical element, in terms of this debate, is the second element; its focus in on the way in which a loan is specifically defined.

When you look at the surface of things, it seems as though the critical second element is not triggered by legal funding transactions at all. After all, they are, in essence, non-recourse cash advances that are made contingent after a court award or settlement. In other words, until or unless a lawsuit has succeeded, the consumers are under no legal obligation to pay anything. That being said, legal funding agreements tend to spell this out in very precise, obvious and easily understandable terms.

Here’s how you should look at it – an attorney contingency fee is also not contingent on the outcome of the case, if legal funding isn’t, as well. In other words, attorneys and legal funders who are working on contingency are pretty much the same in this sense: until you get paid, they don’t get paid either.

When it comes to the definition of legal funding, the debate over whether it should be considered a loan or an investment is one over which people just can’t seem to agree. It was established by all jurisdictions that legal funding transactions are investments because of the existence of risk. However, therein lies another problem: what about contingencies?

Well, numerous arguments can be heard about how contingencies of a mere hypothetical character just aren’t enough. In other words, the existence of a substantial risk that something might not actually happen is required in order for an outside event to really be perceived as contingent. For instance, if you have a situation where an agreement to pay is conditioned by the sun rising the next morning, it cannot be said that such an agreement is really contingent. When you consider the fact that the best legal funding companies have a tendency to invest only in those claims that they feel have a good chance of winning or even settling, it’s understandable why many argue that these companies aren’t under substantial risk to make an obligation contingent in the true meaning of the word.

On the other hand, when you look at the practical side of things, it becomes apparent that legal funding actually is a true contingency. For example, when it comes to the default rates for traditional lawsuit loans – a great number of funding companies tend to report default rates that are much higher than the aforementioned ones. While the reasons for this cannot be specified, there is a great chance that it’s because of the sheer number of variables that exist when it comes to investing in something as volatile as litigation. Legal funding is far from certain and the following reasons give some insight as to why that is:

• The great majority of plaintiffs have a habit of seeking legal funding right after being involved in an accident. It doesn’t take a rocket scientist to figure out that it’s much less speculative to invest in cases later than it is to invest early on

• For the most part, the extent of the injuries sustained is what the case is typically based on. There’s a risk for the legal funding companies that revolves around investing in a case that’s based on an injury committed by the defendant; the risk is in the fact that it might turn out that the defendant wasn’t responsible for causing the injury at all, in addition to the possibility that the injury was caused way before the accident

• The lack of control over a case. Just like a minority shareholder in a small business who doesn’t enjoy a large degree of control, a legal funder also cannot influence a case significantly. Out of the blue, plaintiffs can decide to drop meritorious claims or settle for small amounts

• Not being first in line when it comes to getting paid. Following a successful case, the plaintiff can be in a situation where holders with a greater priority need to be paid first, like having medical liens, owing child support and being in bankruptcy. Not to mention the fact that various other costs, including attorney’s fees, need to be paid prior to the actual plaintiff and legal funding company

• Winning a case doesn’t automatically mean collecting. When a plaintiff receives legal funding and wins their case in court, there could be obstacles that prevent the plaintiff from collecting. For example, being “judgment proof” is often what many defendants are, which means that the plaintiff is denied collecting on their judgment

Many traditional lenders consider legal funding to be too risky. In fact, the only time when it really makes sense to defend a legal claim is either when there’s a chance to reduce the award significantly, or when the party is convinced that they have a chance of winning the case. When it all comes down to it, the belief that the contingency is real is what the defendants are actually investing their own money in. When you think about it – the defendants would never waste any time on legal fees if there was no risk of a plaintiff losing; the goal then would be to settle as soon as possible.

If you would like to know more or would like to submit an application with Pegasus Legal Funding LLC, we are here to help. Submit an online application or call today for a free evaluation.