Contracting parties often suffer from information problems, lack of expertise, and limited cognitive abilities. They sometimes make decisions under stressful conditions. There are always others happy to exploit these phenomena to make extra profits. One sphere in which such exploitation has attracted much attention since time immemorial is usurious interest rates. In their fascinating empirical study, Ronen Avraham and Anthony Sebok shed new light on this phenomenon in an expanding new market for credit—namely, Litigants Third-Party Funding (LTPF). These are nonrecourse loans, given by commercial firms to individual tort plaintiffs, which are then repaid from the proceeds of the lawsuit.
Avraham and Sebok obtained a unique dataset of about 200,000 plaintiffs’ applications for loans handled by one of the largest firms that engages in such funding. The dataset comprised both approved and refused applications. Among other things, it included the personal details of each applicant; the name of the attorney representing him or her; a description of the case; the amount sued for; medical and insurance reports on the accident; an independent legal assessment of the lawsuit’s likelihood of success and potential value; and information about existing liens on the award that the plaintiff might receive. With regard to approved applications, the dataset included also the amount funded; the monthly interest rate; the length of the legal proceedings; the amount owed when the case was resolved; and the amount actually repaid. (Pp. 6–7.)
The article offers rich and very lucid descriptive statistics of the data, and discusses the policy implications of the findings. Among other things, it was found that only about half of the applications were actually funded, and that the average loan was around 7% of the estimated case value. (P. 10.) The interest was calculated on a monthly basis, with a median interest of 3% per month. In the great majority of cases, the interest was compounded on a monthly basis. In most of the contracts, there was a minimal period for which interest was charged, regardless of the actual length of the funding—usually three months. Beyond this period, the compounded interest was commonly calculated using interest buckets—namely, minimal periods (usually of three months) for which interest was charged, even if the loan was paid back before the end of that period. (Pp. 15–16.) The average period of the loans was 14 months. Most borrowers took only one loan per case, but a considerable minority received two, three, or even more loans per case. (P. 9.) Only applicants whose requests had been approved were charged a processing fee, which was paid along with the principal and interest at the end of the loan period (subject to the same compound interest and buckets). The most frequent fee for the first funding request was $250, with an additional fee of $75 for each additional request in the same case. (Pp. 19–21.) The average total amount of the funding was around $7,000, and the median—around $2,250.
Given what we know about people’s limited literacy, innumeracy, and lack of legal and financial expertise, one could reasonably surmise that most borrowers believed that the effective annual percentage rate (APR) was somewhat higher than 36% (the stipulated monthly rate multiplied by 12). In fact, due to the complex calculation described above, the median APR was 101%! Twelve percent of the borrowers paid back only the principal, or even less than the principal, and many more paid only part of the sum due, as the lender had not insisted on repayment in full (so-called haircuts). Consequently, the median effective APR collected by the lender was approximately 44%. The article shows that the contractual terms offered to borrowers and the haircuts they got ex post depended on whether the borrower’s lawyer had an ongoing relationship with the lender. (Pp. 24–29.)
The article offers a unique, large-scale empirical analysis of the LTPF market, which is crucial for any regulation thereof. It elucidates the relationships between lenders, borrowers, and the borrowers’ lawyers at the formation and performance stages of the contract, and offers insightful policy recommendations.
The authors place much emphasis on the effective APR of 44%. They note that it is considerably lower than some previous estimates (Pp. 4–5), and close to the statutory cap proposed in negotiations between the LTPF industry and its critics (P. 8). However, one might question this framing of the data. First, caps on interest rates refer to the contractual terms, rather than their ex post enforcement by lenders. Gaps between contractual terms and suppliers’ reliance on them serve important functions, but they also have troubling, and potentially harmful implications. As the data shows, while most borrowers get considerable haircuts, 34% pay the full amount due, and 5% apparently pay more than the amount due. (Pp. 21–24.) Those who pay back the full amount will find little comfort in the fact that others do not repay the loans at all, or get considerable haircuts—and from a societal perspective, the redistributive effects of this practice (exacerbated by the existence or absence of an ongoing relationship between the lender and the client’s attorney) are troubling.
It should be noted that the high median APR of 44% cannot be explained or justified by the risks LTPF lenders take, because this figure already embodies loans that have not been repaid in full or at all. The authors argue persuasively that their findings call for regulation. Their key recommendation—which I find very compelling—is that regulation should neither be content with setting default rules or disclosure duties (both of which may well be futile), nor imposing caps on interest rates (which firms may creatively bypass). Rather, the law should prohibit any contract terms that impinge upon the APR more than a simple interest rate (that is, ban all compounding interest, minimal periods, buckets, and fees paid upon repayment of the loan). (Pp. 34–37.)
One question that must be answered when considering regulation of the LTPF industry is to what extent it enhances access to justice for poor people—a potential major justification for its existence. My own impression is that LTPF has little to do with litigation funding. Since the great majority of tort plaintiffs hire their attorneys on a contingent fee basis (P. 32), they do not need additional funding for the litigation. Presumably, then, they are taking out the loans to finance daily needs that may have risen due to the accident and its possible adverse effect on their earnings. Thus, the expected recovery from the lawsuit serves primarily as collateral. Indeed, the fact that these are nonrecourse loans provides an important advantage to borrowers whose net recovery is smaller than the amount due. However, the contingent nature of repayment (including the payment of the processing fees) may actually allow LTPF lenders to charge much higher APR than otherwise possible. Since repayment is contingent upon the success of the claim, borrowers may view it as protecting them from a possible loss—and loss-averse people are willing to pay much for such protection (just as they are in the context of attorneys’ contingent fees).
Avraham and Sebok’s beautifully executed study lays the groundwork for further empirical work, theoretical analysis, and legal policymaking (further empirical research would be useful because the LTPF market is fraught with traditional and behavioral market failures—hence there may be considerable variance among firms). However, none of my quibbles detract from the important empirical research and thought-provoking analysis that it already offers. More generally, the reality of the LTPF market—apparently a distinctively American phenomenon—should give one pause about the current U.S. economy and its legal system.