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Structured Settlement Factoring: Panacea or the Road to Ruin?

By: Edward O. Burke
Arizona Attorney, March 2008

Your darling two-year old daughter, Sarah, has a potentially life-threatening condition as a result of medical malpractice during her birth. Your personal injury attorney settled Sarah’s claim against the doctor and hospital for $1,048,000. Acting in what you believed to be in Sarah’s best interest you arranged for $787,000 of her settlement to be structured in a life contingent annual payment annuity over 26 years (an average payment of $25,500 per year) beginning at age 18, subject to termination upon her death.
As sometimes happens during the teenage years, Sarah rebelled, left home without graduating from high school, and moved in with Fred, a methamphetamine addict currently on probation for selling drugs. They now have three children under age 5 and neither has a job. Sarah has received her first 5 annual annuity payments and life is a financial struggle.

Late one night Fred sees a television ad placed by Rapacious Factors, L.L.C., a factoring company offering lump sum payments for structured settlement annuities. The next morning Fred excitedly tells Sarah how they can solve their financial woes. He convinces Sarah to accompany him to Rapacious’ office that day. Rapacious tells a delighted Sarah and Fred that it will give her $145,000 in cash for her settlement. All she has to do is sign some papers, talk to a lawyer, and appear briefly with them in court to obtain approval.

The paperwork discloses that in return for the $665,400 annual payments left on her annuity, Sarah will receive $237,000. It also reveals that from her $237,000 share, Sarah will have to pay $91,650 for a paid up $665,000 life insurance policy to protect Rapacious (in case she does not survive the term of the annuity), and a $500 processing fee, leaving her with a net of $145,350. With visions of a new car, down payment on a house, and paid-off bills dancing in her head, Sarah eagerly signs the papers while Fred happily looks on.

Rapacious even recommends an attorney for Sarah to consult about the arrangement. Sarah telephones the recommended lawyer who listens to her briefly, asks her if she’s sure she wants to do this, and tells her it is a good deal.

A month later Sarah appears in Superior Court with Rapacious’ lawyer to obtain approval of the arrangement pursuant to A.R.S. §12-2903. Sarah testifies that she and her fiancé Fred, have a lot of bills and want to buy a new car, make a down payment on a house, and invest the rest for their children’s educations. Fred sits in the back of the courtroom thinking about how much fun it will be to spend the money. The kindly judge asks Sarah if she realizes that she is giving up $428,000 and that she will have another $91,650 taken from her share to pay for a life insurance policy. The judge also asks Sarah if she has discussed this arrangement with an attorney. Sarah replies affirmatively to both questions. When the judge asks her if her parents know she is doing this she quickly snaps: “No, I’m over 18 and I don’t have to tell them!” When the judge asks Sarah how she will make the payments on the house she plans to buy Sarah hesitates and then tells her she’ll probably have to get a job.

The disclosure statement given to Sarah states that the discounted present value of her $665,000 annuity at 5.60% is $365,867. After deducting the $91,650 insurance premium and the $500 processing fee, Sarah will receive 39.6% of the discounted present value of her annuity in cash. Sarah will receive her money at an effective annual discount rate of 18.46%. On a gross undiscounted basis, Sarah will receive only 21.8% of her remaining annuity payments. Should the judge approve this arrangement?

Does this scenario happen in real life? In the first eight months of 2007, 176 applications for approval of these sales were filed in the Maricopa County Superior Court. That is a 66% increase over the same period in 2006. The applications were filed under the Structured Settlement provisions of A.R.S. §12-2901, et. seq. The questions this article will address include: What is the purpose of this act? Whom does it protect? And what standard should courts apply in evaluating these contracts?

History of Structured Settlement Acts.

A structured settlement is “an arrangement for periodic payment of damages for personal injuries or sickness that is established by settlement or judgment in resolution of a tort claim or for periodic payments in settlement of a workers’ compensation claim “1. They are normally funded by an annuity contract purchased and held for the claimant’s benefit by an insurance company.
Structured settlements are attractive to liability insurance carriers. “In addition to providing the payee with a secure source of income, structured settlements also provide insurance carriers with a less expensive means of settling a personal injury claim because it allows them to pay the obligation over many years,…”

Structured settlements do benefit the injured person. When structured properly, the full amount of the future payments, including the interest earned on the annuity, are excludable from the claimant’s gross income under § 104(a) of the Internal Revenue Code. Thus a structured settlement can be substantially more valuable to a claimant than an all cash payment.

Consider the plight of Natasha, a 50 year old Russian widow with an eighth grade education, a poor command of English, and no job skills or experience, whose husband is killed by the negligence of another driver. A structured settlement of her $333,000.00 settlement paid her, after costs and attorneys’ fees, $71,000 in cash and an $180,000 lifetime annuity payable in monthly payments of $500, which, with her social security survivor’s benefits, will help her live out her life with a modicum of comfort.

By 1997, many states had enacted statutes to protect claimants. Even so, participants in the structured settlement industry were expressing concern that lump sum damage awards were being dissipated fairly quickly. 3 Concerns were also being expressed about the increasing involvement of factoring companies in purchasing structured settlements from financially unsophisticated and unsuspecting persons. In the June, 2000, issue of the American Bar Association Journal Phillip Corboy, a well knownIllinois trial attorney, said:

‘Recently a growing number of factoring companies have used aggressive advertising, plus the allure of quick and easy cash, to induce settlement recipients to cash out future payments, often at substantial discounts, depriving victims and their families of the long-term financial security their structured settlements were designed to provide….

Because the underlying purpose of a structured settlement is not only to compensate an injured party but also to protect that party from his own improvidence, a number of commentators, courts, and legislatures have become concerned by the growing number of companies, sometimes called ‘factoring companies,’ that purchase structured settlements from a personal injury victim by paying him immediate cash for the right to future payments under the settlement. Recipients are induced to sell, even though these transactions are a clear breach of their structured settlements agreements’ and ‘[t]he advance payment companies exploit their customers to sell at unconscionable rates that would be deemed usurious if the transactions were treated as loans.’

Congress took note and on January 23, 2002, amended the Internal Revenue Code to impose “on any person or entity who acquires directly or indirectly structured settlement payments rights in a structured settlement factoring transaction a tax equal to 40 percent of the factoring discount.” A statutory exception was created for any transfer of structured settlement payment rights that is approved in advance by a qualified State court order.

The order must expressly find that the proposed transfer does not contravene any federal or state law, regulation, or order, and that the sale “is in the best interest of the payee, taking into account the welfare and support of the payee’s dependents…”

Currently 46 states, including Arizona, have enacted statutes regulating the transfer of structured settlement payments and requiring court approval of any such transfer. Many of these acts are entitled: “Structured Settlement Protection” acts. This leads to the question: Who is being protected, i.e. the injured annuitants from their own folly or the factoring companies from the 40% federal excise tax?

Many structured settlement contracts contain an anti-assignment clause. In finding that the payee had waived that clause a Texas appellate court said:
‘It appears that the various legislatures have determined that the solution is not to prohibit the assignment of structured settlements payments, but to require certain precautionary mechanisms that will safeguard recipients from possible abuse by factoring companies.’

Arizona’s statute was enacted in 2002. The minutes of the House Appropriations Committee reflect that only one person spoke on the bill – – a representative of the Alliance of American Insurers, who said:
“The bill will require a court process to make sure the recipients of structured settlements receive the benefit of the value they secured through the court process.” In response to a question he said: “Congress passed a law last year that says all structured settlement transactions must have court approval. States were given a small window of time to implement similar legislation. If settlements are sold without going through the court process, an excise tax is imposed. Having the courts involved in the process will help prevent the potential fleecing of victims.”

In the Senate hearing he said:
“The intent is to make sure that the long-term interests of the participants are carried out and protected.”

Arizona’s law, like the others, requires that eight items be provided to the proposed payee at least three days before the payee signs the transfer agreement. A payee must be advised in writing by the factor to seek independent professional advice regarding the transfer and must either have received the advice or knowingly waived the advice in writing.

What Standards Should the Court Apply?

Natasha, our Russian widow, who spent her $71,000 cash payment in 4 years, also responds to a Rapacious ad and is offered $18,250 for $54,000 of her annuity payments. The discounted present value of the payments at 5.6% interest is $30,820. From her proposed payment of $18,250, Natasha will have to pay $11,000 for a life insurance policy on her life for Rapid, leaving her with $7250 or 13.4% of the gross value of her annuity. She wants to use the money to purchase more equipment for her business which grosses $25,000 per year. Does Arizona’s law protect Natasha? Should a court approve her application?

The court is required to find that the sale “is in the best interest of the payee, taking into account the welfare and support of the payee’s dependents.” Which of the following questions should a court weigh:

  • Is the standard paternalistic?
  • Is this strictly an economic test?
  • If so, where should the court draw the line on the proposed discount rate?
  • Should the court consider that Arizona has no usury law in evaluating whether a discount rate is unconscionable?
  • Should the court evaluate the facts as though the payee is incompetent?
  • What weight, if any, should the court give to prior applications by the payee?
  • How important is economic hardship or the dire straits of the applicant?
  • What is the standard for independent financial advice or a knowing waiver thereof?
  • Should it matter to the court that the “independent professional” is an attorney recommended by the factor?
  • Should the court inquire as to who paid the attorney?
  • Can the court consider that a payee who recently turned 18 has not advised her parents of the application?
  • Is the court obliged to point out to the payee that there is a developing market in this area and s/he might get a better deal by looking on the Internet?
  • Should the court consider the amount of the annuity that will remain if the application is approved?
  • Can the Court ask the payee to explore other financial means of solving a current financial situation?
  • How does the court weigh the welfare and support of the payee’s dependents?
  • How to balance the payee’s long-term financial security against alleged immediate needs?
  • Should the court require or review the payee’s business plan for the money?
  • Does the proposed payee have the financial sophistication to obtain a return on her funds equal to the discount rate she will pay by accepting the offer.

There is scant appellate guidance in this area, none inArizona, undoubtedly because of the cost of an appeal, there really is no one to contest an approval, and a claimant who is denied can simply apply again to another judge.

Texas, New Jersey, and Pennsylvania courts have characterized their obligation as paternalistic. 16 A Pennsylvania judge denied an application reasoning:
“To date, Bendowski has sold $330,000.00 worth of structured settlement payments for $158,600.00 in cash payments. The instant petition represents her third request in slightly more than two years and, if approved, will result in the aggregate sale of $480,000.00 in structured settlement payments for $208,850.00 in cash. On each occasion, 321 Henderson Receivables has offered Bendowski fewer cents on the dollar. By way of illustration, 321 ‘Henderson Receivables’ payments in March 2004 and June 2005 constituted 79.7% and 62.4% respectively of the discounted present value of the annuity payments purchased. The latest offer of $50,250 .00 represents a mere 57% of the discounted present value of the structured settlement payments to be acquired.

An offer to purchase structured settlement payments for 57% of their discounted present value is unconscionable under the Structured Settlement Protection Act.” The court concluded: “absent exigent circumstances justifying a compelling need for immediate cash, such as a pending ejectment action following a mortgage foreclosure judgment or possible or actual incarceration for failure to make court-ordered child or spousal support payments, a parsimonious offer of 57% of the discounted present value should not be sanctioned by the court.”

A New York trial court said: “… the State Legislature in enacting the SSPA,…did not intend for the courts to be mere rubber stamps.”

Another New York Court emphasized the impact of structured settlement factoring on persons of color and persons of limited income saying:

“This case involves a significant, yet often overlooked, statute which appears to have a disproportionate impact on persons of color and persons of limited income….

…. Not surprisingly, in virtually all the cases throughout the State in which the standard has been applied and the court has chosen to publish its reasoning, the court has denied the petition on the ground that the proposed transfer did not serve the best interest of the payee….

The primary reasons for the denials are twofold. First, the discount rate offered by the factoring company is so significant that the payee is oftentimes selling his payment rights for a fraction of their value, contrary to his ‘best interest.’ Secondly, the payee oftentimes lacks a viable, concrete plan for the use of the funds, or a more viable alternative exists which better serves his interests.

… In a transparent attempt to satisfy the statutory requirement that the factoring company advise the payee to seek ‘independent professional advice’ about the sale, the petition was also accompanied by a pro forma letter from an attorney to the petitioner professing that the attorney had discussed the details of the proposed transaction with Mr. Martinez and ‘believes Pedro understands and agrees.’”

The difficulty in making these decisions was described by a Connecticut judge in a case where the payee proposed to transfer her rights to an asset with a discounted present value of $31,039.83 for $10,019.88, which amounted to paying the factor interest at a rate of approximately 20% per year. He said:
“Masotta is a thirty-eight-year-old mother of three minor children. She is separated from her husband. She is currently employed as a waitress and earns approximately $10,000.00 per year. She informed the court that she needs the money to help payoff some of her debt and she wants to use some of the money to send her daughter to college. She also informed the court that she is having other financial difficulties, specifically mentioning that her car is in disrepair and that she needs the money to make the vehicle drivable.

Masotta’s testimony was credible. This court is therefore faced with the dilemma of either approving a transfer that appears to be a bargain for Seneca (the factor) and an incredibly poor deal for Masotta; or depriving Masotta of an opportunity to resolve her financial predicament, send her daughter to college, and to provide reliable transportation for her family.

It is with great difficulty that this court comes to the conclusion that the totality of the circumstances as presented to this court leads it to believe that, upon taking into account the welfare and support of Masotta’s dependents, the transfer is in her best interests. ”

On the other hand, a New Jersey court had no difficulty approving the sale of structured settlement payments by a payee who had exhausted his savings during his cancer treatments and planned to get married and buy a house. The payee had a business degree, had worked as a licensed financial advisor in Wall Street investment firms, had shopped around for price quotes, and received financial advice from persons he had worked with on Wall Street. The court did note that the same conclusion would not be reached for payees lacking his financial acumen.

Of the 162 applications filed in Maricopa County in 2006, 142 were approved; 19 were voluntarily dismissed and 1 was denied. Through August, 2007, 4 applications have been denied and 15 have been dismissed. One payee, who turned 18 in 2002, and is the beneficiary of a structured settlement of more than $13,000,000, filed four applications in less than two years. Her first two applications, seeking the sale of a total of $1,300,000 in structured payments for $508,076, were approved by two different judges. Her next two applications, seeking approval of the sale of $1,753,427 in structured payments for $446,360, were denied by two other judges. The law does not require the factor or the beneficiary to disclose that prior applications have been filed or the rulings on those applications.

This article asks more questions than it answers. Without A.R.S. § 12-2901, et.seq. factors wanting to do purchase of structured settlements from Arizona residents would seek approval in other states that have acts to avoid the 40% federal excise tax on the factoring discount. The legislative history indicates that the reason we have A.R.S. § 12-2901, et. seq. is to allow factoring companies to operate in Arizona without the 40% federal excise tax penalty.

The legislation was sold to the Arizona Legislature as placing the courts in the position of protecting annuitants from “potential fleecing.” Personal injury and other attorneys who use structured settlements for their clients should counsel them carefully about the benefits and detriments of selling their structured settlements and encourage them to obtain competent and thorough financial analyses of all factoring proposals.

One potential area of abuse is repeated applications by claimants to sell their future payment rights. This has been addressed by some courts. Three New York trial courts have directly addressed this issue, expressing concerns that a claimant had systematically eroded his structured settlement and suggesting in another case that the claimant’s dependents were being deprived because the judge was not told of prior depletions of the structured settlement. 25 One Arizona judge, the Hon. F. Pendleton Gaines addressed this issue in denying an application by ordering that: “If Peachtree makes any other application to any court anywhere in the United States in reference to Ms. Jones’ annuity in this case, they are to supply the Judge in the new case with a copy of this order.” In Re Settlement Funding, L.L.C. (Dasha Jones),MaricopaCountySuperior Court No. CV 2007-008144, June 29, 2007, Minute Entry. Unfortunately Judge Gaines only had the power to bind one factor and others could make an application without disclosing Ms. Jones’ history.

A solution to this problem would be for the Arizona Supreme Court to adopt a Rule of Civil Procedure requiring applicants in these cases to disclose all prior applications and the results thereof in their applications so that judges will be more fully informed. This is the approach Pennsylvania has taken. See Pa. R. Civ. P. 229.2 (f), effective September 1, 2007.

Arizona courts should carefully examine structured settlement factoring applications and inquire about prior applications to prevent annuitants from throwing away their financial futures.

Sarah and Natasha are fictional persons, of course. Applications with somewhat similar facts have been denied in Arizona’s Superior Courts.