Implications of Usury in Third-Party Litigation Funding

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Published in A Model Litigation Finance Contract, Litigation Funding in Theory and Practice.

Implications of Usury in Third-Party Litigation Funding

A funded litigant may not always be happy to return to the financier the amount owed after securing a favorable settlement, judgment or arbitration award. In such situations, the funded party may seek an order from a local court to invalidate the funding agreement.

One approach the funded litigant may take is to argue that the financing constitutes a loan with an extremely high interest rate in violation of the laws against usury. The rationale behind usury legislation is “to protect borrowers from the outrageous demands often made and required by lenders.” 44B Am. Jur. 2d Interest and Usury § 6.

In the United States, usury laws vary from state to state and the legal lending interest rate is usually regulated by state statutory law. For example, in the state of New York, the maximum rate of interest is 16% per annum. N.Y. Banking Law, § 14-a (McKinney). Similarly, in the District of Columbia the maximum rate of interest is 24% per annum. D.C. Code, § 28-3301. Most states that have usury statutes envisage exceptions to the general rule, such as excluding transactions in which the borrower is a corporation (and thus is allowed to borrow at a higher interest rate than the general limit) or when the amount of the loan surpasses a certain amount. As an example, in Missouri business loans over US$ 5,000 are not subject to limits on the interest rate provided certain conditions are met. Mo. Ann. Stat., § 408.035 (West). On its part, in Ohio the restrictions do not apply in certain situations, including when dealing with loans over US$100,000 or with business loans. Ohio Rev. Code Ann., § 1343.01 (West). Some states, such as Nevada, Idaho, New Hampshire, Oregon and Wyoming, have abandoned usury prohibitions entirely.

As early as 1830, the U.S. Supreme Court stated the elements of a usurious transaction in Lloyd v. Scott, 29 U.S. 205 (1830). Today, generally the elements of usury are: (1) a loan or forbearance of money; (2) an absolute obligation to repay the principal (not contingent on any event); and (3) greater compensation for the loan (i.e., interest to be applied on the principal) than is allowed under statute. Some courts have also considered the intent with which the act is done as an important ingredient.

At first look, usury appears irrelevant to litigation funding. Litigation funding agreements usually share five common requirements: (i) a cash advance; (ii) made by a non-party; (iii) in exchange for a share of the litigation or arbitration proceeds; (iv) whether in settlement or judgment or award; and (v) payable at the time of recovery if, and only if, such recovery takes place. This last feature facially excludes litigation funding agreements from the restrictions against usury.

Indeed, state courts have considered contingent fee agreements, whether with a lawyer or third party (i.e., a litigation funder), to be investments and not loans because there is no absolute obligation to repay. 9 Williston on Contracts § 20:18 (4th ed.). The underlying rationale is the inherent contingent nature of such contracts or, more precisely, the risk born by the lender. Such risk, however, must be substantial and thus a mere colorable hazard will not preclude excessive interest charges from being usurious. The lender must be subject to some greater hazard than the mere risk that the borrower might fail to repay the loan or that the security might depreciate in value. See id. In this regard, many courts have recognized that any litigation proceeding or appeal involves a substantial amount of risk.

It follows that a third-party funder, as long as the funding agreement is of a truly contingent nature, will be exempt from compliance with statutory limits on interest rates and usury will not be a valid defense to void such litigation finance agreement. However, the contract’s terms may not be dispositive of the contingent nature of the investment; the facts of the case to be funded and the context of the investment may be highly relevant. Looking at such factors, some state courts have found litigation funding agreements void under the usury laws.

For instance, a lower court in New York found that “a strict liability labor law case where the plaintiff is almost guaranteed to recover” involves “low, if any risk”. Echeverria v. Estate of Lindner, 7 Misc. 3d 1019(A) (Sup. Ct. 2005), at *8. Therefore, the funding agreement was best understood as a loan and void because the funder charged an interest beyond the usury limit. Another illustrative case is Lawsuit Fin., L.L.C. v. Curry, 261 Mich. App. 579 (2004). The Michigan Court of Appeals ruled that the agreements were usurious because, before any agreement was entered into between the parties, the defendant in the funded lawsuit had admitted liability and the jury had returned a verdict in the amount of US$27 million. Id. at 588-590. Therefore, the risk of no recovery was non-existent.

In some states the terms of the usury statute can apply to litigation funding even if the court agrees that the financing is not a loan. As an example, the Court of Appeals of North Carolina held that contingent litigation funding investments were “cash advances” covered by the relevant usury statute, which specifically prohibited both usurious “advances” and loans. Odell v. Legal Bucks, LLC, 192 N.C. App. 298, 311-312 (2008). The court differentiated between loans – which are to be repaid unconditionally – and advances – which, “while similar to a loan, do[ ] not require unconditional repayment of the principal.” Id., at 312-313. For the court, any conditional or contingent recovery was a covered “advance,” including the funding agreement at dispute.

A lower court in the state of Colorado took a similar view. Oasis Legal Fin. Grp., LLC v. Suthers, No. 10CV8380, slip op. at 5 (Colo. Denver Dist. Ct. Sept. 28, 2011). However, there is a very wide exception in the state of Colorado: the rate of interest shall be deemed to be excessive of the usury limit only if it could have been determined at the time of the stipulation by mathematical computation. Colo. Rev. Stat. Ann., § 5-12-103 (West). Therefore, litigation financiers may structure their investments as a percentage of the amount litigated and thus fall within the safe harbor.

In conclusion, in order to verify whether the defense of usury is available in a particular state, one should first analyze the applicable statute in force with special emphasis on the interest thresholds and safe harbor provisions. If the relevant transaction exceeds the usury interest limits and does not fall within any of the exceptions, one should then analyze the level of non-recovery risk involved to determine whether the funding agreement would be considered a loan or an investment. If the transaction can be considered as an investment due to the risk involved, the funder should usually be on the safe side. Nevertheless, this should be analyzed on a case-by-case basis.

As an additional layer of security, the funding agreement should include provisions acknowledging the level of risk involved in the transaction and explicitly recognizing that the deal is to be considered an investment and not a loan of any nature. Of course, terms such as “loan”, “principal”, “interest”, etc. should be avoided in the corresponding litigation funding agreements.