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Litigation Finance Investments Are Not Risk-Free Loans

By Wendie Childress and William C. Marra

When it comes to litigation, perhaps the only certainty is that the outcome is uncertain. There are many roads to defeat, and your fate rests with unpredictable and fallible humans: juries, judges, lawyers, and witnesses.

This is why claimholders and lawyers frequently share litigation risk with litigation funders. And it is why courts have held that usury laws do not prohibit litigation finance agreements. Usury laws apply only to loans, which have an absolute requirement that the borrower repay. Litigation funders are repaid only if the plaintiff wins.

In short, investing in litigation bears little resemblance to loans like mortgages, where any homeowner can tell you payments come due each month no matter what.

Last week, a California-based federal appeals court asked New York’s highest state court to enter this fray and decide whether a unique type of litigation funding transaction violates New York’s usury laws.

The case, involving small-dollar consumer funding, is unlikely to affect the legality or prevalence of standard commercial litigation funding in New York or elsewhere. Nevertheless, it presents an important opportunity for the New York Court of Appeals to affirm the consensus among courts: litigation finance transactions are not loans subject to rate caps. A contrary ruling would misapply usury laws to hobble investments these laws were never designed to regulate, and would impair access to funding that New York courts have recognized help cash-poor litigants access the courts.

Fast Trak Investment Company v. Sax involves a dispute over whether Fast Trak’s funding agreement with attorney Richard Sax and his clients violates New York’s usury laws. Fast Trak provided funding backed by contingent case proceeds payable to both Sax and his clients, across a portfolio of at least 18 cases. When Sax failed to pay Fast Trak after obtaining recoveries in several cases, Fast Trak sued Sax.

Sax argued the funding agreements were usurious because they were loans with interest in excess of the statutory rate. Although New York’s law usury laws do not apply to nonrecourse investments where the investor’s principal is at risk, Sax argued that Fast Trak’s particular portfolio was so robust that it “predictably and effectively guaranteed repayment.” A federal district court rejected Sax’s argument. On appeal, the United States Court of Appeals for the Ninth Circuit certified to the New York Court of Appeals the question whether a funding agreement qualifies as a “loan” when the funder’s return comes from both the client’s recovery in one litigation and the lawyer’s recovery in unrelated litigation.

Whatever the New York Court of Appeals decides should not implicate commercial litigation finance transactions. First, New York’s civil usury law does not apply to transactions of $250,000 or more, and most corporations cannot raise a usury defense. (The criminal usury law does not apply to transactions of $2.5 million or more.) Usury laws are not addressed to sophisticated corporate parties. Second, the Ninth Circuit did not appear to question that most funding arrangements should not be reclassified as loans. The court distinguished from Sax’s case a New York state court appellate decision, Cash4Cases, Inc. v. Brunetti, holding that usury laws did not apply to a funder’s investment in a single matter because the funder’s return was contingent upon an uncertain case outcome.

Nevertheless, the New York Court of Appeals should affirm what most courts to address the issue have held: litigation funding agreements are not subject to usury laws because the funder’s return is contingent on the outcome of litigation. As the Georgia Supreme Court explained in 2018, litigation finance provides a poor fit for usury laws because the “obligation of repayment attache[s] only upon the successful resolution” of a case, such that funding resembles an investment, not a loan. Courts across the country, including in New Jersey, Florida, Texas, and lower courts in New York, have reached the same conclusion.

Sax’s argument centers on the claim that Fast Trak invested in a particularly robust portfolio of claims, which Sax claims presented lower risk than a single-case investment (or, presumably, riskier portfolios). But portfolios, no less than single cases, present substantial risks, which is why litigants and law firms look to share that risk with funders. If the cases do not succeed, the funder will lose its entire investment. If a case were a slam dunk, chances are the defendant has already settled, the litigant or a law firm will bear all the risk, or the claimholder will secure lower-cost funding elsewhere in the market. Indeed, several cases in Sax’s portfolio were unsuccessful.

Just last year, scholar J.B. Heaton wrote a law review article contending that litigation finance is unlikely to be profitable for most investors because litigation is simply too uncertain. “Litigation is far more complex and random than most investors understand,” Heaton argued. Courts should hesitate to declare nonrecourse litigation finance a risk-free endeavor.

Of course, in hindsight everything can look certain, whether it’s funding a winning portfolio or buying Amazon stock circa 1999. Usury disputes like Sax’s typically arise after funded cases resolve favorably and there is money to fight over. Courts must resist this hindsight bias.

Finally, ruling that the usury laws might apply to some portfolio investments may cause the market to shift more towards a single-case funding model. This would only hurt claimholders. Some funders, including Validity Finance, where we work, offer better pricing for portfolios than single-case investments, meaning a shift to single-case investments will only drive up prices for litigants and law firms.

Claimholders and their lawyers should hope the New York Court of Appeals gets it right: litigation finance investments are not loans subject to usury laws.

Wendie Childress and William C. Marra are portfolio counsel at Validity Finance, a litigation finance company. Wendie can be reached at wendie@validity-finance.com. Will can be reached at will@validity-finance.com.