CT Bankruptcy Court Invalidates Lawsuit Funding Agreement

Lawsuit funding companies have routinely filed claims as creditors in tort plaintiffs' bankruptcy actions when the debtor has failed to repay litigation funding advances. Whether bankruptcy courts will enforce lawsuit funding agreements depends on the applicable state law.

Creditors should take note of recent cases invalidating or upholding state regulation of lawsuit funding agreements. For example, in Global Injury Funding, LLC v. Knight (In re Knight), 538 B.R. 191 (Bankr. Conn. 2015), a bankruptcy judge in Connecticut recently invalidated a lawsuit funding agreement. The court focused on the applicable state law in rejecting the lawsuit funding company's (Global) attempt to enforce the following provision of its agreement with Jesse K. Knight, a personal injury claimant, to whom it had advanced funds:

Purchaser's interest [is] to be described as an asset of Purchaser (and not as a debt obligation of Claimant in any oral or written communications, including, but not limited to, any schedule or other document filed in connection with said case or proceeding. Claimant agrees, absolutely, irrevocably and without condition, to notify the Bankruptcy court and/or other relevant court that Purchaser owns a portion of any potential recovery from said claim and Purchaser is entitled to notify the court of the same. Accordingly, in light of the fact that the funds advanced herein by Claimant are an investment and not a loan, Claimant's obligation will not be discharged or reduced as a result of any Bankruptcy or Insolvency proceeding.

Id. at 199

Rejecting these agreement terms, the court held that Global's advance to the debtor created a debt that was subject to the debtor's discharge in the bankruptcy case, and any assignment of the personal injury proceeds arising under the agreement was unenforceable.

The court also held that Global had no equitable lien on the proceeds because Connecticut law did not provide for such liens. The court said that the bankruptcy trustee could assert a claim to the proceeds of the personal injury lawsuit and that the court would determine what rights the estate had in those proceeds at a later time.

Knight obtained funds from Global in anticipation of Knight's recovery through a settlement or award in a pending state court personal injury action. The agreement obligated Knight to repay Global a sum, plus fees from settlement or award proceeds.

Nondischargeability

The court held that Global failed to establish by a preponderance of the evidence many of the requisite elements for a determination of nondischargeability pursuant to ' 523(a)(2)(B). Quoting Grogan v. Garner, 498 U.S. 279, 286-87, 111 S. Ct. 654 (1991) and other key cases, the court said that a determination of nondischargeability requires the plaintiff to establish each of the elements for a nondischargeability determination as enumerated in ' 523(a)(2)(B). The court focused on the elements that Global Injury Funding failed to establish.

Regarding the first element, which requires the Plaintiff to establish that the statements were materially false, the court said that Knight's statement that he had not filed bankruptcy within the past seven years or consulted attorneys concerning filing bankruptcy was false.

But the court also found, regarding the next element ' materiality ' that Knight's statement was not material. Quoting Bethpage Federal Credit Union v. Furio (In re Furio), 77 F.3d 622, 624 (2d Cir. 1996) for the proposition that a statement must be both false and materially false, the court concluded that Knight's false statements about his past bankruptcy filings did not affect Global's decision to grant credit to Knight.

Global also failed to meet a third required element of ' 523(a)(2)(B), which required it to establish that the statements reflected the financial condition of Knight or related to the financial condition of Knight. The court said that there is disagreement concerning whether a statement of financial condition is limited to a specific type of financial statement that purports to represent a person's overall net worth or a person's overall ability to generate income, or extends to any written communication that has a bearing on the debtor's financial position. The court quoted Schneiderman v. Bogdanovich (In re Bogdanovich), 292 F.3d 104, 112 (2d Cir. 2002) for the proposition that courts have adopted both broad and narrow interpretations of the term “financial condition” for nondischargeability purposes.

Knight's statement that he had not filed bankruptcy within the past seven years (or consulted a bankruptcy attorney), although false, “did not inform Global concerning his assets or liabilities, his income,” or his financial condition. Moreover, the court concluded that it was clear “that the singular financial issue that concerned Global was whether the personal injury claim held by Knight was likely to bring a financial recovery sufficient to enable Knight to repay” Global's advance, “plus earn it the hefty fees” specified in its agreement with Knight. The agreement provided that the only source of recovery for the advance was the proceeds of the personal injury action. The court concluded that the “potential for a recovery by Global of the Advance, the interest due thereon, and payment of additional fees, was not in any way dependent upon Knight's own financial ability to repay the Advance.”

Finding that Knight's false statements were not statements respecting the Debtor's financial condition, the court held that Global was not entitled to a determination of nondischargeability pursuant to ' 523(a)(2)(B).

Reasonable Reliance

The court also found that Global failed to establish the reasonable reliance element of ' 523(a)(2)(B). Stating that a creditor's reasonableness should be judged objectively, the court said that Global failed to establish that in advancing funds to Knight, it reasonably relied on Knight's statements. The court found authority for the proposition that partial creditor reliance on the debtor's representations as a contributing factor is sufficient to create debtor liability to the creditor (discussing and quoting Barristers Abstract Corp. v. Caulfield (In re Caulfield), 192 B.R. 808, 821 (Bankr. E.D.N.Y. 1996)).

The court said that Global presented no evidence that Knight's disclosure of bankruptcies “would have resulted in Global walking away from the Agreement.” No evidence established whether Global would have rejected Knight's application for funds if Global had known of the bankruptcies, the court found.

CO Supreme Court Approves Funding Agreement Regulation

Courts in Colorado have also held that these lawsuit funding agreements create loans that are debts in bankruptcy proceedings. Rejecting the lawsuit funding companies' characterization of their advances as “asset purchases,” the Colorado Supreme Court recently held that lawsuit funding loans are subject to Colorado's consumer finance statutes. Oasis Legal Finance Group, LLC v. Coffman, 2015 C.O. 63 (Colo. 2015).

The Colorado Supreme Court said in Oasis that the funding agreements created debt for purposes of Colorado's Uniform Consumer Credit Code, even though the agreements did not impose an unconditional obligation on personal injury claimants to repay the funders.

The court found that the funding agreement obligations increased “with the passage of time, another characteristic of a loan.” The litigation funders required claimants to repay more than the amount advanced and the agreements correlated the amount of the claimants' repayments to the time the advances were outstanding:

Oasis denominates this rate of increase a “multiplier” while LawCash calls it a “monthly use fee,” but in both cases the charges function as interest. This growth in the repayment obligation over time is a finance charge and a hallmark of a consumer loan under the UCCC.

Funding Agreement Enforced Under NJ Law

Under New Jersey law, however, lawsuit funding agreements like those in Knight and Coffman are enforceable. In re Brown, 34 B.R. 100 (Bankr. N.D. W. Va. 2006) (applying New Jersey law). The Brown court held that the lawsuit funding agreement in that bankruptcy proceeding met the three statutory requirements necessary for a valid assignment ' The agreement: 1) provided that the debtor transfer to Atlas Legal Funding his right to receive a portion of any settlement proceeds that he would be entitled to receive in the future from his personal injury claim in exchange for a cash payment from Atlas Legal Funding; 2) set forth a description of what was assigned ' in this case contingent settlement proceeds; and 3) made the assignment irrevocable.

The lawsuit funding agreement gave the debtor a five day “cooling off” cancellation period. The court held that this contingency did not change the irrevocable nature of the assignment itself after the expiration of that five-day period.

The Brown court also held that, in a bankruptcy proceeding, the transfer of a cause of action originally belonging to the debtors back to the debtors in consideration for a payment of money to their bankruptcy estate did not violate any state public policy prohibition against champerty or maintenance.

Conclusion

There are three key takeaways from these cases: Creditors evaluating the enforceability of a lawsuit funding agreement must: 1) review the agreement's choice of law provision to determine which state's law applies to the agreement; 2) determine if the bankruptcy court is likely to defer to the parties' agreement concerning the applicable state law and their interpretation of those provisions; and 3) determine whether the applicable state's statutes, rules of professional responsibility, or common law doctrines of champerty and maintenance have been interpreted to make those agreements unenforceable.

John B. Spitzer practices law in Pennsylvania, edited several editions of The Fundamentals of Bankruptcy Law, serves on the board of a condominium association, and has worked with bankruptcy attorneys in several states.