Creating and Perfecting Security Interests in a Claim: Part I, Purpose and Creation

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Many lawsuit funding deals involve the plaintiff assigning a portion of his or her future recovery to a funder in exchange for an upfront investment. Investors who bet on the outcome of litigation make money by collecting from the proceeds of any settlement or judgment. This seems simple in concept, but ensuring that those proceeds will be available for collection can be a challenge. With the majority of transactions occurring when all parties are strangers to one another, the practicalities of administering settlement payments are central considerations for lawsuit investors, requiring constant vigilance.

In a typical scenario, payments made by defendants to settle their claims are deposited into attorneys’ escrow accounts and disbursed to all the lien holders according to their priority. Quite often, however, plaintiffs, attorneys, and funders will have divergent views about how the settlement proceeds should be divided. Clients may be eager to receive funding but reluctant to pay investors all or part of their contractual obligation once the underlying claim is resolved. Moreover, investments in lawsuits can span a number of years without any interim payments, hazarding the risk that proceeds become encumbered over time. Attorneys who are responsible for distributing the settlement funds may have a number of competing stakeholders vying for a share of the settlement. How does an investor prove that he or she should receive a portion of the proceeds? What if the plaintiff sells another participation right in the lawsuit to someone else? How will the other party’s rights affect the original funder’s investment? Who should be paid first?

In these situations, litigation to resolve the rights of the parties may ensue and courts will be asked to determine the legality of legal finance transactions and the priority of payments to the claims’ stakeholders. As of now, legal finance has been allowed to proceed by the majority of states. However, despite significant progress in the past decade, the United States still lacks a transparent and comprehensive regulatory regime for legal finance. There is currently no federal law regulating this industry. Rather, the states themselves regulate the industry through a diverse patchwork of case precedent, common law doctrines, state bar ethics opinions, state statutes, and agreements with regulatory bodies.

Unlike mainstream financial instruments, investments in lawsuits are unfamiliar to most people, and the rights created through them are not immediately apparent. Funding providers must, therefore, affirmatively stake their claim to the proceeds of the lawsuit by securing those assets for collection once the claim is resolved. They must broadcast to the world that those lawsuit assets belong to them – and no one else. This is achieved contractually by creating and perfecting a security interest in the proceeds of the underlying litigation, giving the investor certain preferential legal rights in the disposition of secured assets.

Language creating a security interest is usually part of the investment agreement. It may be a separate page or section of the funding documents that describes the nature of the lawsuit, the parties involved, which assets or payment streams are covered, and the method of calculating any future payments to the investor. For a security interest to attach to an asset, it must have a valid and recognizable basis in law. In other words, prudent investors must know where state laws permit investing in lawsuits. They need to know whether the assignment of lawsuit proceeds is permitted in various states. They may be concerned with state licensing requirements, as well as the current legislative and regulatory efforts that could become policy in the states where they invest. In a sizable minority of jurisdictions, how courts would interpret legal finance deals remains fairly uncertain. Each state has its own unique perspective of how investment in lawsuits should be treated.

Next: Part 2, Perfecting the Security Interest: Notice to the Attorney, and the Uniform Commercial Code.

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