THE EVOLUTION OF THE SECONDARY MARKET FOR STRUCTURED SETTLEMENTS A LONG AND WINDING ROAD

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1 THE EVOLUTION OF THE SECONDARY MARKET FOR STRUCTURED SETTLEMENTS A LONG AND WINDING ROAD By: Andrew S. Hillman, Esq., President and CEO, Specialty Asset Advisors, Inc., for Seneca One Finance, LLC May 2015 Scope of this Article One of the most complicated and misunderstood financial transactions to reach the consumer finance marketplace in the last two (2) decades is a transaction in which future structured settlement payments are purchased in exchange for an immediate payment of cash (a factoring transaction ). This service to consumers is an animal that is different from traditional loans such as a mortgages, automobile loans or credit cards with which most consumers are familiar. Factoring transactions have existed for almost 20 years and during that time there has been a proliferation of companies (factoring companies) that offer this service. At their core, factoring transactions are consumer finance transactions and, as such, factoring companies have moral and legal obligations to ensure that consumers are protected and adequately informed of the impact these transactions could have on their lives and the lives of their families. In order to provide context around this development, this article will provide a brief history of how the structured settlement factoring industry ( secondary market ) has evolved. In the Beginning It s Been a Hard Day s Night In the beginning (around 1996), there was born from a theretofore misunderstood financial asset called a structured settlement, a service to consumers in need of immediate cash. This service became known as a factoring transaction. Initially, the basics of this service were difficult to comprehend. Factoring transactions were widely misunderstood by the limited public who were aware of such transactions, the paucity of consumers who understood what a structured settlement was, personal injury attorneys, and insurance companies whose obligations would be fundamentally altered from the paradigm for which structured settlement annuities were intended: to be utilized by personal injury attorneys and insurance companies to settle personal injury lawsuits and provide for their clients future financial security. As context for the development of the factoring transaction, it should be pointed out that there existed at that time a robust market in the healthcare financing space; the factoring of Medicare receivables. It was common practice for healthcare providers (e.g., doctors, dentists and hospitals) to sell, or assign to their creditors the payments of receivables due from Medicare as security or for repayment of their obligations. Since by federal law Medicare receivables were not assignable, lock- boxes were set up that were controlled by creditors or funders to receive those Medicare payments at the direction of the 1

2 healthcare providers. These payments were not sold or assigned ; they were redirected. The first factoring transactions were developed using this construct. Sellers of annuity payments (sometimes referred to in this article as annuitants ) would notify insurance companies of a change of address to a lock- box to which to remit (redirect) annuity payments. These lock- box accounts were controlled by and provided sole access and control by the factoring company so that the factoring companies received directly from the insurance companies, rather than the annuitant, the payments they purchased. But, here was the rub: structured settlements are set up in a paternalistic fashion so as to prevent annuitants from selling the payments (purportedly for the benefit and protection of an injured annuitant). So, the fact that these payments by the terms of the lawsuit settlement documents could not be sold or assigned added a layer of complexity to, scrutiny of, and opposition to such practices by those companies that profited handsomely by setting up structured settlements in the first place, to wit: insurance carriers and brokers. At this point, it may be helpful to describe what a factoring transaction is and come back to its evolution later. The Anatomy of Structured Settlements and a Structured Settlement Factoring Transaction - Who Are You? A structured settlement is a mechanism that includes a personal injury plaintiff, an annuitant and a defendant liability insurance company in which the annuitant agrees to settle a lawsuit in exchange for payments to be made in the future by the liability insurance company. The liability insurance carrier then buys an annuity policy from a highly rated life insurance company to make those payments to the annuitant on behalf of that liability insurance company. The payments are structured in the sense that they are to be paid periodically over time to assist an annuitant to plan for their financial future and ensure that an annuitant, through the imposition of non- assignability clauses, does not squander a one- time lump sum payment. Structured settlements are a popular method for settling personal injury lawsuits and wrongful death cases. A structured settlement factoring transaction is the selling of future structured settlement payments. People who receive structured settlement payments may decide at some point down the road that they need money immediately rather than wait until future payments are made. The reasons for this need vary but can include unforeseen medical expenses for themselves or a loved one, the need for improved housing, for education costs, or to start a new business. To meet this need, an annuitant can sell all or part of its future payments for a present lump sum of money. In order to do this, an annuitant must seek approval from a judge to do so. We left our discussion of the evolution of the secondary market where lock- boxes were being utilized by factoring companies to collect structured settlement annuity payments under the radar, at least initially, of unsuspecting insurance carriers. This is where things start to get interesting between the primary and secondary markets. The Battle Is Joined - I Can t Get No Satisfaction 2

3 From the period 1995 to early 2001, eager entrepreneurs envied the profits (sometimes with rates at or above 30%) being made by the pioneers of the secondary market and wanted a piece of the action. With more and more entrants into the secondary market came a hue and cry and a not insubstantial push- back by primary market brokers and insurance companies. Insurance companies were increasingly burdened by additional administrative costs associated with change of address requests. Moreover, some annuitants committed fraud on the factoring company by telling insurance companies to redirect to them those payment purchased by factoring companies. Invariably, the factoring companies would obtain judgments against the sellers and armed with those judgments demand from insurance carriers those payments, thus potentially causing the insurance company to have made the redirected payment to the lock- box and another one to the factoring company that was defrauded. This potential double payment liability problem was something the insurance companies could not abide. Moreover, personal injury lawyers and structured settlement brokers became concerned that the secondary market might somehow shed an unfavorable light on the structuring of lawsuit settlement pay- outs thereby raising scrutiny on the structured settlement model itself. In their minds, the lucrative primary market was under attack by profit- hungry miscreants. It soon became clear to the insurance companies that the factoring industry would not go away. The pioneers of the industry were smart and tenacious and saw an industry with tremendous profit and public service potential. Sellers of payments were able to access otherwise not available to get immediate cash for exigent life needs. Litigation among and between factoring companies, insurance carriers and class action lawyers ensued. A few States Attorneys General joined the fray as well. Insurance carriers argued that the payments could not be sold (remember those tricky and bothersome non- assignment features). Different states had differing laws on the assignability issue and no one really knew what the general state of the law was. Class action lawsuits were filed by plaintiffs lawyers representing sellers of these payments on the basis, among other things, that their clients were being taken advantage of by ruthless loan sharks and were being robbed of their security and long- term financial stability by selling payments they would need in the future. Attorneys General argued that consumers were being duped and defrauded and their futures stolen from them. Neither side would retreat from their entrenched positions. It was feared that the distraction and expense incurred because of the litigation and general tumult could deleteriously impact both the primary and secondary primary markets. Something had to give! The Compromise I Want to Hold Your Hand Cooler heads began to prevail and secret discussions between certain primary and secondary market participants began. Secret, because any such discussions would surely, if disclosed to primary and secondary market participants, scuttle any effort directed at compromise between the antagonists. There were there (3) major players in this game: (i) the National Structured Settlement Trade Association (NSSTA), the well- funded trade association representing virtually all major life carriers at the time with a substantial amount of political clout, (ii) the National Association of Settlement Purchasers (NASP), a nascent, disparate group of factoring companies, and (iii) the National Conference of Insurance Legislators (NCOIL). The idea was to resolve differences and determine whether the NSSTA 3

4 and NASP could co- exist, using NCOIL as the vehicle to effect some type of regulation/legislative compromise which all the parties could accept. It was David and Goliath re dux. Efforts to regulate the secondary market had been attempted before. In 1996, this writer, on behalf of a factoring company, approached numerous state regulatory entities to determine whether the product/service it was offering to consumers was one that fell under the umbrella of any one specific financial instrument state regulator. Curiously, none of the agencies deigned to take on the regulation of factoring because no regulator could figure out exactly what kind of animal it was. Was it a security, a loan or other financial instrument? After meeting with various Attorneys General, the factoring company determined that this was a consumer financial product that could be modeled around consumer protection laws and regulations. As we shall see later, this concept became the foundation for a legislative fix. After over a year of negotiating, cajoling, and meeting with industry negotiators, lawyers and lobbyists, the basis for a model act that would be passed in the states was agreed upon. The Model Act (as it came to be referred to) provided roadmap to be followed by a factoring company in order to obtain a judge s approval of a potential factoring transaction. The Model Act mandated implementation by the factoring companies of certain consumer protections and that a seller of payments demonstrates to a judge that the transaction is in the best interests of a seller and his dependents. It was an arduous process to say the least to achieve such a sea change in the primary and secondary markets. The primary market correctly assumed that factoring was here to stay and that it had to in some way accommodate the secondary market without seeming to explicitly endorse its practices. The secondary market for its part correctly assumed that rather than impinge on the profitability of its endeavors through costly and burdensome litigation, it would be better to agree to subject factoring transactions to some kind of judicial oversight in the courts. And, in the bargain, both sides were able to foster and support the provision of an important service that those who needed funds urgently for basic living needs and to enhance their lives. The Legislative Fix How To Mend A Broken Heart Now that the Model Act was written it, or some version of it, had to be adopted in states where factoring companies wanted to do business, i.e., purchase annuity payments from residents of those states. A flurry of lobbying began with representatives of NSSTA and NASP who testified before state judiciary committee meetings to explain the Model Act and why it should be adopted in that state. This in and of itself was expensive and time- consuming but the parties were invested in it. And, it worked. To date all of the states but one have adopted some version of the Model Act ( SSPAs ). It would be too time consuming here to explain the nuances of the differences of some of the SSPAs provisions in the various states. Suffice it to say that each of the SSPAs provides basic consumer protections and safeguards: i.e., financial terms disclosures, notice to certain parties to object if they desire, admonitions to sellers to seek professional advice, and a finding by a judge that the transaction is in the best interests of the seller and their dependents. To buttress this process and apply teeth to these consumer protection provisions, a new section to the federal tax law had to be adopted to allow for favorable free tax treatment to annuitants who sell their annuity payments and to maintain insurance companies tax 4

5 incentives for writing structured settlement annuities. This tax provision dovetails with the SSPAs by mandating that those consumer protections afforded to annuitants set forth in the SSPAs must be adhered to or an excise tax of 40% will be imposed by the I.R.S. on factoring companies. Thus, insurance companies and factoring companies became bound together legislatively, creating a paradigm within which the secondary market could operate. The Future- Whatever Will Be Will Be As of this writing, the primary and secondary markets warily co- exist. The SSPAs are working, with the emphasis now on whether the transaction is in the best interest of the seller and its dependents and the actual cost of the transaction to the seller. New entrants into the secondary market have emerged and the average approval rate for transactions remains around 90%. This is due, in part, because competition in the marketplace has had a salutary impact on the costs of these transactions. That said, unfortunately there are some rogue factoring companies that attempt to stretch the limits of what is permissible under the SSPAs. These companies are decried by NASP and other reputable factoring companies. Recently there also have been rumblings by primary market participants that the secondary market needs to be put in check. Business in the primary market has waned over the past few years and that industry is compressing, thereby raising concerns that the use of structured settlements is being impinged by factoring. There is no empirical evidence of that however. Notwithstanding this, efforts by some in the primary market and their representatives continue to try to chip away at the court approval process by raising procedural and legal issues against a proposed transaction. The service afforded by the secondary market is alive and well and gaining popularity with those who are in need of it. It remains to be seen whether the current peaceful co- existence will remain so or whether there will new attempts to degrade or scuttle the secondary market. It could be posited that the SSPAs do not really regulate the secondary market; rather, that they merely provide an orderly roadmap with which to obtain court approval of factoring transactions. (A couple of states do require that factoring companies register to do business in those states however). As was noted earlier, the attempt to seek the certainty of regulation fell on deaf ears. Nature abhors a vacuum. It may be time for level headed participants in both the primary and secondary markets not only to suggest improvements to the SSPAs but also to seek reasonable regulation that would provide more certainty and fewer squabbles among market participants resulting in less cost to the consumer. Andrew S. Hillman is President and CEO of Specialty Asset Advisors, Inc., ( a consulting firm that provides a full array of services to the advance funding industry. Seneca One Finance, LLC ( is one of largest specialty finance companies in the U.S. that purchases structured settlement annuity payments, assignable annuities, lottery winnings and other prizes. 5