In Part 1, I discussed the purpose and creation of security interests in claims. In this part, I will examine the additional steps required to perfect a security interest, thus making it effective in the event of payment default by the plaintiff or another eventuality that either obfuscates or frustrates collection of the settlement proceeds.
As a general matter, the mere creation of a security interest in a claim gives the provider certain preferential rights over other stakeholders, while also imposing duties on the plaintiff granting that security. However, despite the lien’s primary validity, additional steps must be taken to enforce the security against third parties and settle prioritization of competing security interests.
Imagine a situation where your firm has invested significant capital in a commercial claim. You signed an agreement with the plaintiff, received a security interest in return, and perhaps even restricted the plaintiff from granting any future security interests in the same claim to other investors. When the case settles for much less than expected, you are surprised to learn that three other investors received similar security interests from the plaintiff around the same time. There is not enough money to pay everyone. What is the priority of payments in this scenario?
A security interest may be perfected by three methods, depending on the type of asset and the nature of the transaction. These methods are not mutually exclusive and therefore may be used concurrently. They include:
- physical possession of the secured asset;
- notice to the fundholder; and
- statutory registration.
Possession of Settlement Proceeds is Not Practicable
In the legal finance context, immediate possession of future settlement proceeds, an unliquidated right, is not directly possible. What is possible is to create the expectation (and obligation) of all parties to the transaction that all proceeds from any settlement will be directed to an escrow account that is controlled either by the provider or an escrow agent who will scrupulously follow the letter of any investment agreement specifying how the proceeds should be distributed. To this end, many investors will seek to bind the plaintiff and his or her attorney to deposit any settlement proceeds paid by the defendant directly into a third-party escrow account controlled by the provider. From a practical standpoint, however, this is difficult to achieve. For this to work, the defendant must be notified before the settlement takes place and must also agree to deposit any settlement proceeds into an escrow account. Many plaintiffs and attorneys are reluctant to disclose the existence of a legal finance arrangement to the defendant and may refuse to do so. Moreover, many attorneys expect to be paid first and are disinclined to allow their fee to be deposited into an account which they do not control.
Since possession is often not practicable, most investors rely on a combination of notice to the attorney and UCC registration to perfect their security interests.
Notice to Plaintiff’s Attorney
The majority of transactions in legal finance are assignments of proceeds, occurring with the expectation that the plaintiff’s attorney will serve as the escrow agent or fundholder in the event proceeds are recovered from the claim. As a general rule, most attorneys are bound by the rules of their state bar associations governing the safekeeping of property belonging to third parties. Specifically, a majority of states have adopted the American Bar Association’s Model Rule 1.15, which requires that a “lawyer shall promptly deliver to the client or third person any funds or other property that the client or third person is entitled to receive and, upon request by the client or third person, shall promptly render a full accounting regarding such property.” For attorneys to be bound by this requirement, however, they must receive notice of the assignment. For this reason, most providers will include an attorney acknowledgement section as part of their funding agreement, requiring the attorney to sign a confirmation that he or she has received notice of the assignment and agrees to distribute any settlement proceeds in accordance with the funding agreement.
Once notice of assignment has been given, the priority of liens is typically decided by prevailing lien law, which is usually “first in time is first in right.” Exceptions do arise, however. As we shall see, a Uniform Commercial Code filing is one of them.
Even if notice is sufficient to perfect a security interest, not all notice is created equal for purposes of establishing priority of payment rights. A security interest may be also perfected by filing a UCC-1 financing statement under the Uniform Commercial Code. This form is filed to give public notice that there is a right to certain assets for repayment of a specific obligation with a certain priority. It is generally filed with the secretary of state or other agency tasked with UCC liens, in the state where the lawsuit is pending.
According to the UCC, the first stakeholder to file a UCC-1 statement has a priority payment right trumping all other similar rights (except certain statutory liens. See Part 3, Perfecting Security Interests: Exceptions and Enforcement). Under UCC § 9-406(a), a notice of assignment is effective and binding as to the account debtor, in our case the defendant, and also provides legal notice to the fundholder (the plaintiff’s attorney), if the notification is signed by either the assignor or the assignee, and sets forth that the amount due or to become due has been assigned and that payment is to be made to the assignee. After receipt of the notification, the defendant and the plaintiff’s attorney may only discharge the obligation by paying the assignee; paying the assignor will not discharge the obligation.
In this way, a UCC lien is the most effective method of perfecting a security interest. For example, if two similarly situated providers invest in the same claim, on the same date, both giving notice to the Plaintiff’s attorney, the first party to file a UCC lien gets paid first. Similarly, even if the parties invested on different dates and the investor who came later filed a UCC lien first, that second investor still gets paid first. Therefore, lawsuit investors who neglect to file a UCC lien as part of their investment process risk subordinating their interests to other stakeholders, even those who come after them.