iCLF is Generally Not a Loan
There are two conceptual ways to think about a CLF transaction. The first is that the funder is loaning money to the fundee where the collateral for the loan is the recovery from the litigation. The second is that the fundee is selling, and the funder is buying, a portion of the future recovery (if any) in exchange for an upfront price or an upfront agreement to cover certain litigation costs. Neither is perfect.
CLF certainly has several hallmarks of a loan. Yet, it lacks others. The bottom line up front on the question is that CLF is neither intended to be, nor is it structured to be a loan. Rather, industry participants typically denominate and structure the contract between fundee and funder as a variable prepaid forward contract. This means that the seller (the fundee) agrees to sell a portion of the future recovery of the litigation being funded at a price that cannot be determined at the time of the agreement.
The Non-Loan Characteristics of CLF
What are the ways in which typical CLF does not look like a loan? First, with limited exceptions, CLF is extended to the fundee on a non-recourse basis. In other words, the funder is paid only if the litigation results in a recovery for the fundee. Loans, in contrast, are usually recourse to a borrower, meaning the lender has the legal right to demand compensation or payment regardless of outcome.
Second, the fundee must use the funds advanced by the funder (the CLF advances) in compliance with a budget or purposes agreed to with the funder. And the overwhelming majority of the CLF advances usually must be used to prosecute the litigation being funded: direct litigation costs, i.e., attorney fees; and “hard costs,” including discovery costs, expert fees, and filing costs (basically anything other than attorney fees).
This is in stark contrast to a typical borrower-lender relationship, in which a lender does not direct how its borrower spends the borrowed funds (for a host of reasons, not the least of which is to avoid later potential lender liability claims). Sometimes, CLF advances do not even pass through the hands of the fundee and, instead, are paid directly to fundee's attorneys or other third parties.
Third, the funder does not typically earn “interest” as such. Rather, in exchange for providing CLF, the funder will get a negotiated portion of the litigation proceeds, which is often tied to a multiple of deployed capital rather than some kind of stated interest rate.
Variable Prepaid Forward Contracts Explained
Generally speaking, a forward contract is an agreement that anticipates the actual delivery of a commodity on a specified future date.
A prepaid forward contract is a type of forward contract where payment is made at the outset, and the delivery of the underlying asset or commodity occurs at a future date. The price of the asset is determined when the contract is created, and the payment is also made at that time. This type of contract is distinguished from standard forward contracts, where the payment and transfer of the underlying asset typically happen simultaneously in the future. Prepaid forward contracts can be used to hedge against the risk of price declines in securities or commodities, while still allowing the owner to benefit from potential price increases.
A variable prepaid forward contract (VPPFC), a specific type of prepaid forward contract, is often used by shareholders with significant stock holdings as an investment strategy. These contracts allow shareholders to receive an upfront payment – usually a substantial percentage of the current market value of the stocks – in exchange for agreeing to deliver a variable number of shares or the cash equivalent at a future date. The contract defines floor and ceiling prices that dictate the number of shares to be delivered, providing protection against downside risk and allowing for some upside potential.
In the context of CLF, the typical deal structure can be likened to a prepaid forward contract. In these arrangements, the funder provides financing upfront to cover legal fees and expenses. In return, the funder receives a portion of the recovery in the future if the litigation is ultimately successful. This structure aligns with the concept of a prepaid forward contract, where the funder (akin to the buyer in a forward contract) pays upfront, and the return (akin to the delivery of the underlying asset) is contingent upon a future event – in this case, the successful outcome of the litigation.
A typical CLF deal meets the definition of a prepaid forward contract in that an initial payment is made (funding the litigation costs), and the return on this investment depends on the litigation's future outcome. Just as in a variable prepaid forward contract, where the return depends on the future value of the underlying asset, in litigation funding, the return depends on the future success of the legal claim. This arrangement allows the fundee to manage the financial risk associated with pursuing the litigation, much like how prepaid forward contracts are used to manage financial risk in other contexts.
Benefits of Not Being a Loan: Tax Benefits
Because CLF transactions are generally treated as prepaid forward contracts (and provided the IRS does not successfully challenge that treatment), any profit a funder makes from its share of litigation proceeds if held for the requisite holding period is taxed as capital gains instead of ordinary income – a distinct tax advantage for the funder and its investors.
This treatment is also beneficial to the fundee from a tax perspective for two reasons: first, like a loan, a prepaid forward contract structure enables the fundee to avoid taking the CLF advances into income. Rather, the taxable event for the fundee does not happen unless and until it receives litigation proceeds. Second, the structure avoids the potential cancellation of debt income (CODI) that results in the forgiveness of a loan (whether the loan was recourse or not).
Usury
The position that a CLF transaction is not a loan is an essential underpinning for the industry because loans are often subject to usury laws, and the imputed rates of return for successful CLF transactions are typically far in excess of the limits imposed by such laws, where applicable.
The non-recourse nature of CLF is the basis on which courts have universally ruled that most CLF agreements are, in fact, not loans and, thus, not subject to usury law (see, e.g., Cash4Cases, Inc. v. Brunetti, 167 A.D.3d 448, 449 (N.Y. App. Div. 2018) (“Assignment agreements such as the agreement at issue here are not loans, because the repayment of principal is entirely contingent on the success of the underlying lawsuit”). This can be the result even in the context of consumer litigation finance (see, e.g., Anglo-Dutch Petroleum Int’l, Inc. v. Haskell, 193 S.W.3d 87, 96 (Tex. Ct. App. 2006) (same).
CLF vs. Consumer Litigation Finance
Consumer litigation financing is to CLF as Chapter 7 bankruptcy practice is to Chapter 11 corporate bankruptcy practice: they have similar names and share some baseline concepts, but that’s where the similarities end. They serve different markets and have fundamentally different characteristics.
Target Fundees
CLF is aimed at fundees that are involved in complex commercial litigation, such as breach of contract disputes, patent infringement cases, or securities fraud lawsuits. Consumer litigation financing, on the other hand, is aimed at individual plaintiffs who are involved in personal injury lawsuits, employment discrimination cases, or other types of consumer litigation.
Use of Advances
As stated in our first article in this series, CLF Advances are used overwhelmingly for direct litigation costs and sometimes do not even touch the fundee’s bank account, instead being paid directly to the fundee’s litigation attorney and other experts and service providers. Consumer litigation financing advances, on the other hand, typically are paid directly to the fundee for the fundee to use personally, never for litigation costs.
Size of Claims
CLF typically involves larger claims, with funding amounts that can range from tens of thousands to millions of dollars. In contrast, consumer litigation financing typically involves smaller claims, with funding amounts that are generally in the range of a few thousand to tens of thousands of dollars.
Underwriting and Due Diligence
CLF Funders generally conduct very thorough due diligence and risk assessment of the likelihood of success on the litigation to be funded before agreeing to provide funding. In contrast, the likelihood of success or failure in consumer litigation is generally easier to assess, both because the matters are less complex and because the financing is typically provided much later in the litigation as compared to CLF, which is typically provided very early in the litigation (and often before litigation is even filed). Moreover, consumer litigation financers rely on portfolio math to reduce overall risk, meaning they involve themselves with a greater amount of cases in order to reduce the impact of any one of them.
Repayment Terms
In stark contrast to CLF, consumer litigation finance is commonly structured as a cash advance or a loan, which must be repaid regardless of the outcome of the case. As stated above, CLF Funders are only paid in connection with a successful outcome. In addition, consumer litigation finance sometimes involves the outright sale of the claims themselves, which is rare in the context of CLF.
Regulatory Environment
The regulatory environment for CLF is far more permissive than for consumer litigation financing as CLF typically involves sophisticated parties represented by counsel, while consumer litigation financing may involve less sophisticated and unrepresented parties who sometimes need regulatory protection from bad actors.
