A structured settlement factoring transaction describes the selling of future structured settlement
payments (or, more accurately, rights to receive the future structured settlement payments). People who
receive structured settlement payments (for example, the payment of personal injury damages over time
instead of in a lump sum at settlement) may decide at some point that they need more money in the short
term than the periodic payment provides over time. People's reasons are varied but can include
unforeseen medical expenses for oneself or a dependent, the need for improved housing or transportation,
education expenses and the like. To meet this need, the structured settlement recipient can sell (or,
less commonly, encumber) all or part of their future periodic payments for a present lump sum.
History
Structured settlements experienced an explosion in use beginning in the 1980s.[1] The growth is most
likely attributable to the favorable federal income tax treatment such settlements receive as a result
of the 1982 amendment of the tax code to add § 130.[2] [3] Internal Revenue Code § 130 provides, inter
alia, substantial tax incentives to insurance companies that establish “qualified” structured
settlements.[4] There are other advantages for the original tort defendant (or casualty insurer) in
settling for payments over time, in that they benefit from the time value of money (most demonstrable in
the fact that an annuity can be purchased to fund the payment of future periodic payments, and the cost
of such annuity is far less than the sum total of all payments to be made over time). Finally, the tort
plaintiff also benefits in several ways from a structured settlement, notably in the ability to receive
the periodic payments from an annuity that gains investment value over the life of the payments, and the
settling plaintiff receives the total payments, including that “inside build-up” value, tax-free.[5]
However, a substantial downside to structured settlements comes from their inherent inflexibility.[6] To
take advantage of the tax benefits allotted to defendants who choose to settle cases using structured
settlements, the periodic payments must be set up to meet basic requirements [set forth in IRC 130(c)].
Among other things, the payments must be fixed and determinable, and cannot be accelerated, deferred,
increased or decreased by the recipient.[7] For many structured settlement recipients, the periodic
payment stream is their only asset. Therefore, over time and as recipients’ personal situations change
in ways unpredicted at the settlement table, demand for liquidity options rises. To offset the liquidity
issue, most structured settlement recipients, as a part of their total settlement, will receive an
immediate sum to be invested to meet the needs not best addressed through the use of a structured
settlement. Beginning in the late 1980s, a few small financial institutions started to meet this demand
and offer new flexibility for structured settlement payees.[8]
Process
Pre-2002
Before the enactment of IRC 5891, which became effective on July 1, 2002, some states regulated the
transfer of structured settlement payment rights, while others did not. Most states that regulated
transfers at this time followed a general pattern, substantially similar to the present day process
which is mandated in IRC 5891 (see below for more details of the post-2002 process). However, the
majority of the transfers processed from 1988 to 2002 were not court ordered.[9] After negotiating the
terms of the transaction (including the payments to be sold and the price to be paid for those
payments), a formal purchase contract was executed, effecting an assignment of the subject payments upon
closing. Part of this assignment process also included the grant of a security interest in the
structured settlement payments, to secure performance of the seller’s obligations. Filing a public lien
based on that security agreement created notice of this assignment and interest. The insurance company
issuing the structured settlement annuity checks was typically not given actual notice of the transfer,
due to antagonism by the insurance industry against factoring and transfer companies. Many annuity
issuers were concerned that factoring transactions, which were not contemplated when Congress enacted
IRC 130, might upset the tax treatment of qualified assignments. HR 2884 (discussed below) resolved this
question for annuity issuers.
Federal legislation
In 2001, Congress passed HR 2884, signed into law by the President in 2002 and effective July 1, 2002,
codified at Internal Revenue Code § 5891.[10] Through a punitive excise tax penalty, this has created
the de facto regulatory paradigm for the factoring industry. In essence, to avoid the excise tax
penalty, IRC 5891 requires that all structured settlement factoring transactions be approved by a state
court, in accordance with a qualified state statute. Qualified state statues must make certain baseline
findings, including that the transfer is in the best interest of the seller, taking into account the
welfare and support of any dependents. In response, many states enacted statutes regulating structured
settlement transfers in accord with this mandate.
Post-2002
Today, all transfers are completed through a court order process. As of September 6, 2006, 46 states
have transfer laws in place regulating the transfer process. Of these, 41 are based in whole or in part
on the model state law enacted by NCOIL, the National Conference of Insurance Legislators (or, in cases
when the state law predates the model act, they are substantially similar).
Most state transfer laws contain similar provisions, as follows: (1) pre-contract disclosures to be made
to the seller concerning the essentials of the transaction; (2) notice to certain interested parties;
(3) an admonition to seek professional advice concerning the proposed transfer; and (4) court approval
of the transfer, including a finding that it is in the best interest of seller, taking into account the
welfare and support of any dependents.
States with Transfer Laws in Place
Factoring Terminology
Best Interest Standard
Internal Revenue Code Sec. 5891 and most state laws require that a court find that a proposed settlement
factoring transaction be in the best interest of the seller, taking into account the welfare and support
of any dependents. [11] “Best interest” is generally not defined, which gives judges flexibility to make
a subjective determination on a case-by-case basis. Some state laws may require that the judge look at
factors such as the “purpose of the intended use of the funds,” the payee’s mental and physical
capacity, and the seller’s potential need for future medical treatment. [12] [13]. One Minnesota court
described the “best interest standard” as a determination involving “a global consideration of the
facts, circumstances, and means of support available to the payee and his or her dependents.” [14]
Courts have consistently found that the “best interest standard” is not limited to financial hardship
cases. [15] Hence, a transfer may be in a seller’s best interest because it allows him to take advantage
of an opportunity (i.e., buy a new home, start a business, attend college, etc.) or to avoid disaster
(i.e., pay for a family member’s unexpected medical care, pay off mounting debt, etc.). For example, a
New Jersey court found that a transaction was in a seller’s best interest where the funds were used to
“pay off bills…and to buy a home and get married.” [16]
Although sometimes criticized for being vague, the best interest standard’s lack of precise definition
allows considerable latitude in judicial review. Courts can consider on a case-by-case basis the
totality of the circumstances surrounding the transfer to determine whether it should be approved.
Discount Rate
In the beginning, the factoring industry had some relatively high discount rates due to heavy expenses
caused by costly litigation battles and limited access to traditional investors. However, once state and
federal legislation was enacted, the industry’s interest rates decreased dramatically. There is much
confusion with the terminology “discount rate” because the term is used in different ways. The discount
rate referred to in a factoring transaction is similar to an interest rate associated with home loans,
credit cards and car loans where the interest rate is applied to the payment stream itself. In a
factoring transaction, the factoring company knows the payment stream they are going to purchase and
applies an interest rate to the payment stream itself and solves for the funding amount, as though it
was a loan. Discount rates from factoring companies to consumers can range anywhere between under 9% up
to over 18% but usually average somewhere in the middle. Factoring discount rates can be a bit higher
when compared to home loan interest rates, due to the fact the factoring transactions are more of a
boutique product for investors opposed to the mainstream collateralized mortgage transactions. One
common mistake in calculating the discount rate is to use “elementary school math” where you take the
funding/loan amount and divide it by the total price of all the payments being purchased. Because this
method disregards the concept of time (and the time value of money), the resulting percentage is
useless. For example, the court in In Re Henderson Receivables Origination v. Campos noted an annual
discount rate of 16.8% where the annuitant received $36,500 for the assignment of payments totaling
$63,364.94 over 84 months (two monthly payments of $672.32 each, beginning September 30, 2006 and ending
on October 31, 2006; eighty-two monthly payments of $692.49 each, increasing 3% every twelve months,
beginning on November 30, 2006 and ending on August 31, 2013). However, had the court in Henderson
Receivables Origination applied the illogical formula of discounting from “elementary school math”
($36,500/ $63,364.94), the discount rate would have been an astronomical (and nonsensical) 61%. [17]
Discounted Present Value
Another term commonly used in factoring transactions is “discounted present value,” which is defined in
the NCOIL model transfer act as “the present value of future payments determined by discounting such
payments to the present using the most recently published Applicable Federal Rate for determining the
present value of an annuity, as issued by the United States Internal Revenue Service.” [18] The IRS
discount rate, also known as the Applicable Federal Rate (AFR), is used to determine the charitable
deduction for many types of planned gifts, such as charitable remainder trusts and gift annuities. The
rate is the annual rate of return that the IRS assumes the gift assets will earn during the gift term.
The IRS discount rate is published monthly (link to current rate may be found here). In Henderson
Receivables Origination (above), the court calculated the discounted present value of the $63,364.94 to
be transferred as $50,933.18 based on the applicable federal rate of 6.00%. [18] The “discounted present
value” is a measuring stick for determining what the value of a future payment (i.e., a payment that is
due in the year 2057) is today. Hence, the discounted present value of a payment corrects for inflation
and the principle that money available today is worth more than money not accessible for 50 years (or
some future time). However, the discounted present value is not the same thing as market value (what
someone is willing to pay). Basically, a calculation that discounts a future payment based on IRS rates
is an artificial number since it has no bearing on the payment’s actual selling price. For example, in
Henderson Receivables Origination, it is somewhat confusing for the court to evaluate future payments
totaling $63,364,94 based the discounted present value of $50,933.18 because that is not the market
value of the payments. In other words, the annuitant couldn’t go out and get $50,933.18 for his future
payments because no person or company would be willing to pay that much. Some states will require a
quotient to be listed on the disclosure that is sent to the customer prior to entering into a contract
with a factoring company. The quotient is calculated by dividing the purchase price by the discounted
present value. The quotient (like the discounted present value) provides no relevance in the pricing of
a settlement factoring transaction. In Henderson Receivables Origination (above), the court did consider
this quotient which was calculated as 71.70% ($36,500/ $50,933.18). [19]
