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Structured settlement factoring transaction
Structured settlement - information for buying or selling structured settlements : cash settlements and otherwise: structuredsettlementinfo.net
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Structured settlement
factoring transaction
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]
References
[1] Daniel W. Hindert et al., Structured Settlements and Periodic Payment
Judgments § 1-14–1-17 (Law Journal Press 2000).
[2] I.R.C. § 130.
[3] Adam F. Scales, Against Settlement Factoring? The Market In Tort Claims Has
Arrived, 2002 Wis. L. Rev. 859, 868 (2002).
[4] Scales, supra note 3, at 869.
[5] Robert W. Wood, Taxation of Damage Awards and Settlement Payments 7--16 (Tax
Institute 1991).
[6] Hindert, supra note 1, § 1-30.
[7] Adam F. Scales, supra note 3, at 876.
[8] Adam F. Scales, supra note 3, at 899.
[9] Hindert, supra note 1, § 8A-3.
[10] I.R.C. § 5891.
[11] I.R.C. § 5891; See, e.g., Model State Structured Settlement Protection Act
§4; See also, Tex. Civ. Prac. & Rem. Code §141.
[12] In re Petition of Settlement Capital Corp., 774 N.Y.S.2d 635,638-39 (N.Y.
Sup. Ct., 2003)
[13] Settlement Capital Corp. v. State Farm Mut. Auto. Ins. Co., 646 N.W.2d 550,
556 (Min. Ct. App. 2002).
[14] Id.
[15] Barr v. Hartford Life Ins. Co., 2004 NY Slip Op 50980U, 3, 4 (N.Y. Sup. Ct.
2004).
[16] In re Transfer of Structured Settlement Rights by Joseph Spinelli, 803 A.2d
172, 175 (N.J. Super. Ct. 2002).
[17] Henderson Receivables Origination, LLC v. Campos, 2006 N.Y. Slip Op.
52430(U) (N.Y. Sup. 2006).
[18] TX Revised Civil Statute Annotated § 141.002(4).
[19] Henderson Receivables Origination, LLC v. Campos, 2006 N.Y. Slip Op.
52430(U) (N.Y. Sup. 2006).
Structured settlement - information for buying or selling structured settlements : cash settlements and otherwise: structuredsettlementinfo.net
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