By: Frederick J. Ufkes | Patrick C. Farber | Peter J. Vodola
As published in Los Angeles Lawyer, March 2010
EVER SINCE CONGRESS AUTHORIZED federal income tax incentives in 1982, the use of structured settlements in catastrophic injury and other personal injury cases has provided financial stability to millions of injured individuals and their families. As an alternative to lump sum payments of settlement proceeds, structured settlements offer settling personal injury claimants the flexibility and tax advantages to resolve a dispute while creating a steady stream of secure income for the injured.(1)
The growth of the structured settlement industry also led to a secondary market of factoring companies that specialize in acquiring, at a discounted price, a structured settlement recipient’s rights to receive future payments. In response to reports of unconscionable structured settlement factoring transactions and the potential for exploitation of accident victims in factoring transactions, 47 states—including California—have enacted structured settlement protection laws that restrict structured settlement factoring. In California, the statute is named the Structured Settlement Transfer Act, but the commonly used term is “structured settlement protection act,” or SSPA.
This legislative trend also led in 2001 to federal tax legislation that reinforced those state laws by imposing a punitive excise tax on factoring companies that acquire structured settlement payment rights without complying with a state’s SSPA. The federal tax code now imposes excise tax on a factoring company unless the factoring transaction was first judicially approved.(2) Thus, state SSPAs typically require court review of factoring transactions, and the federal tax code provides a strong incentive to factoring companies to comply, by penalizing transactions that take place outside of the court approval process. Together, these laws are designed to stem the abuses of structured settlement factoring, to protect the interests of the parties to structured settlement agreements, and to protect the public’s interest in preventing additional dependency on tax-funded social safety nets.
One key feature of most state SSPAs is that they authorize courts to approve a factoring transaction only on a finding that the transaction is in the best interests of the structured settlement recipient. California has revised its SSPA, effective January 1, 2010, to elaborate on the best interests standard, and in doing so has become the first state to provide statutory guidance on the meaning of that term. The changes address some of the concerns raised by recent court decisions, but they also leave other questions unanswered.
Periodic Payment Settlement Act
Traditionally, tort claims were resolved either by way of settlement of a lump sum or payment of a judgment after trial on appeal. Recognizing the special needs of personal injury victims and especially of individuals with long-term disabilities, Congress enacted the Periodic Payment Settlement Act of 1982, creating favorable tax treatment for qualified periodic payments that constitute damages on account of physical injury or sickness.(3)
Although personal injury damages have been excluded from federal income tax for decades,(4) for many years there was some uncertainty about the tax treatment of periodic payments. The 1982 act made it clear that periodic payments for personal injury damages, when the payments are funded by an annuity not owned by the personal injury victim, are excludable from the recipient’s income for tax purposes, if the conditions of the act are satisfied.(5) Structured settlements are generally funded by single-premium annuity contracts held by a party contractually obligated to make the future settlement payments. Also, typically, the annuity issuer, for the convenience of the obligor, assumes responsibility for such administrative duties as ensuring that the scheduled payments are made. The Internal Revenue Code also allows the party with the payment obligation to exclude from its gross income the amount funding the periodic payments, as well as accumulations on that amount.(6)
Fueled by these incentives, structured settlements have become an everyday fact of life in personal injury litigation. Structured settlements are often the settlement vehicle of choice for individuals who have been severely injured and whose healthcare requirements and income streams need to be secured over time. Likewise, they have become popular for use in cases involving injuries to children, as well as matters involving molestation, environmental, and workers’ compensation claims.
The benefits are numerous: The injured individual (or family) is often provided with a stream of income sufficient to cover necessities, including medical and living expenses. Because of the flexibility inherent in the creation of structured settlements, they can be tailored, at the time of settlement, to the specific needs of the individual or family.
With the economic downturn, the financial stability of insurance companies recently came into national focus, but state and federal regulations have long required insurance companies to abide by strict solvency standards to protect their assets. The California Department of Insurance must first approve companies offering structured settlements in California. Those insurers are subject to mandatory annual audits and other financial compliance requirements.(7) The insurance commissioners in California and other states developed these regulations to preserve the solvency of general accounts in which assets are held so that contractual obligations to policyholders are met. These general accounts typically support only the obligations of the insurance companies—and not the obligations of a parent company or other subsidiaries.
Structured settlements are subject to noteworthy restrictions. To qualify for the desirable income tax benefits, the recipient cannot accelerate, defer, increase, or decrease the payments. The payments also must be fixed and determinable at the inception of the settlement, and the money used must come from a party or its insurer in an amount no greater than the original liability.(8)Most structured settlements are designed by professional consultants who are themselves licensed.(9) Also, many individuals have been certified as structured settlement consultants, pursuant to a program of the National Structured Settlement Trade Association (NSSTA).(10) This professional program trains licensed individuals to assist insurance companies, banks, and other institutions with organizing and running structured settlement programs. The NSSTA certification program has included instruction in needs-based evaluations, tax implications, special needs trusts, guardianship rules, loss reserving, Medicare set asides, and claim valuations. After completing the course, an individual may become a Certified Structured Settlement Consultant.(11)
Beginning in the late 1980s, a new wrinkle emerged in structured settlements. Entities known as factoring companies targeted individuals who had structured settlements, buying the future structured settlement payment rights for a discounted lump sum, usually a fraction of the overall settlement figure. For the structured settlement payee, the transaction represented instant cash, free of the structured settlement’s restrictions on acceleration, albeit at a substantial cost.
Many payees sold their settlement payment streams without fully realizing the financial ramifications of their actions. Throughout the 1990s, significant abuses by factoring companies were reported,(12) leading to SSPA regulation of factoring transactions. Under California’s SSPA,(13) court oversight is now required for individuals who wish to sell their structured settlement payment rights.(14)
The California SSPA is comparable to those enacted in other states and is based on model legislation recommended by the NSSTA. The statute has three key components. First, a structured settlement payment recipient, or payee, must receive from the factoring company a set of disclosures about important financial and other terms of the proposed transaction. Second, the factoring company must initiate court review, providing notice and copies of the court-filed papers to all interested parties. Third, a court must review the transaction, and may approve the transfer only based on findings satisfying the statutory conditions.
California’s disclosure requirements are more extensive than those of any other state. The factoring company must provide the disclosure statement at least 10 days before the payee signs any agreement with the company. (15) The disclosure must identify the dollar amount of the payments being sold, the present value of those payments (based on a federally established rate for valuing annuity interests), the amount being paid to the payee, and the interest rate calculated as if the transfer were a loan and not a sale of the payment rights.(16) The factoring company must advise payees that they should get professional advice from an attorney or accountant and must explain in the disclosure statement that the payee may cancel the transaction at any time before court approval.17 Unlike other state SSPAs, the California SSPA also requires that certain disclosures be included in the agreement signed by the payee and the factoring company.(18)
The California SSPA’s court filing requirements are also more extensive than those of most other states. Factoring companies must file and serve on interested parties copies of the structured settlement agreement and annuity contract, along with the disclosure statement and other required documents.(19) Factoring companies also must send documents—including copies of any order that approved the structured settlement at its outset—to the California attorney general.20 The attorney general and interested parties (including the payee, the annuity issuer, the structured settlement obligor, and persons who are entitled to receive payments in the event of the payee’s death) must receive notice of the court proceeding and of the hearing that the court is to hold on the factoring company’s request for court approval.(21)
Court approval is necessary for any structured settlement to be valid, so if a transaction does not receive court approval, the payee may walk away with no obligation to the factoring company.22 The California SSPA authorizes a court to approve a transfer only upon specific factual findings, including that the transfer of the structured settlement payments is in the best interest of the individual, taking into account the welfare and support of any dependents, that the transfer meets the standards of the statute and does not contravene any other court order, and that the payee reasonably understands the terms and conditions of the transfer agreement.(23)
The California SSPA statute also calls for independent professional advice, requiring that the payee be advised to “obtain independent professional advice regarding any federal and state income tax consequences arising from the proposed transfer, and that the transferee may not refer the payee to any specific advisor for that purpose.”(24)
The California SSPA is similar to many other state SSPAs that require that payees be advised to obtain advice, but California goes further, requiring the factoring company to pay up to $1,500 to the payee’s chosen adviser.25 California is also among a small number of states whose laws provide that a violation of the state’s SSPA is also a violation of the state’s unfair business practice laws.(26) Despite these statutory demands, some courts have been critical of the quality of disclosures in matters presented for judicial approval. Some recent California decisions examined some of these issues, as well as the public policies underpinning California’s SSPA.(27) For example, in 321 Henderson Receivables Origination LLC v. Sioteco,(28) the court reviewed a string of superior court orders denying petitions for approval of transfers.
The Fresno County superior court judges had been critical of factoring company 321 Henderson’s petitions, pointing to omissions in the submissions, perceived violation of the independent counsel requirements, and violations of the anti-assignment clauses in the annuity contracts.(29) At least one trial court indicated that the company had engaged in a pattern of judge shopping, by filing petitions but dismissing them on receipt of adverse tentative rulings.(30) When 321 Henderson attempted to dismiss new petitions, the court declined to enter the dismissals.(31)
The court of appeal reversed the lower court decisions, concluding that requests for dismissal must be granted if made prior to the commencement of trial (or, in this case, hearings on the petitions).(32) As to petitions in which “trial” had commenced, the court of appeal concluded that, absent objection by an interested party, a contractual anti-assignment clause does not prohibit factoring, and further that the evidence did not support the trial courts’ findings of systematic violations of SSPA requirements.(33) To be sure, the appellate court acknowledged shortcomings in the filings, but those might be cured on remand, by amendment of the petitions, or were otherwise too intertwined with issues that required reversal.
Amending California’s SSPA
As cases moved through the courts, California’s legislature examined the adequacy of the California SSPA, and in 2009 adopted additional safeguards in order to better protect consumers who wish to transfer their structured settlement payment rights.(34) Revisions effective January 1, 2010, provide that, when making the best interest determination, a court should look to the “totality of the circumstances.”(35) The statute supplies a nonexclusive list of criteria that include, among other things:
• The payee’s age, mental capacity, legal knowledge, and apparent maturity level.
• The payee’s stated intended uses for the money to be received from the factoring company.
• The payee’s “financial and economic situation.”
• The terms of the transfer agreement.
• Whether the payments were intended to be used for medical care due to the payee’s original injuries, and whether the payee still needs the payments for such purposes.
• Whether the payee needs the payments for future medical expenses.
• Whether the payee lacks insurance or other resources to cover medical expenses for the payee’s original injuries.
• Whether the payee has sufficient resources to cover financial obligations for the support of the payee’s dependents.
• Whether the payee has previously transferred, or attempted to transfer, some payments.
• If any previous transfers were denied within the past five years.
• Whether the payee received independent financial advice about the transfer.
• “Any other factors or facts that the payee, the transferee, or any other interested party calls to the attention of the reviewing court or that the court determines should be considered.…”(36) California is the first state to codify the factors relevant to the best interests examination.(37)
Notwithstanding the restrictions set forth in the California SSPA, most factoring transactions receive court approval. While the economy over the past two years has affected factoring companies, and the Fresno County cases have also had an impact on the number of transactions in California, there is little reason to believe that the situation has changed greatly since 2004, when the California attorney general issued a detailed report on factoring of structured settlement payment rights. The dollar value of structured settlement payments purchased by factoring companies grew from $10.6 million in 2001 to $53.7 million in 2003.(38)
The 2004 report revealed that 21 companies were in the structured settlement factoring business, purchasing structured settlement payments in California, with two companies involved in more than 80 percent of the transactions. The attorney general’s report observed that the average effective annual discount rate charged by factoring companies—that is, the equivalent interest rate that the factoring company would charge if the transaction were treated as a loan—was 19 percent.
The attorney general also reported that, of the 632 decisions on California petitions from January 2002 through September 2003, 541 (85.6 percent) were approved by the courts, one was approved with a change, 66 (10.4 percent) were withdrawn, and 24 (3.8 percent) were denied.(39) Since 2002, one factoring company alone had secured judicial approval of more than 2,000 structured settlement transfers.(40)
One likely reason for routine approval of transfer petitions is that they are rarely opposed. The payee typically joins the petition, and objections are infrequent. Before 2009, a single unpublished appellate decision interpreted the California SSPA, and that was in a case in which the structured settlement obligor and annuity issuer objected, for various reasons, to a factoring transaction. (41) The focus of that opinion was the anti-assignment provision, which the appellate court held validly precluded any transfer—precisely because the structured settlement obligor and annuity issuer had exercised their contractual and statutory rights to object and prevent the transfer. This contrasts with the Sioteco court’s conclusion that, because no party had exercised its rights to object under the antiassignment provisions, those contractual prohibitions on transfers did not bar the transactions.
The public policy embodied in the California SSPA—as with other state SSPAs and the federal tax provisions that reinforce those state laws—reflect a decision to protect the benefits provided by structured settlements. Those protections extend to payees, the primary beneficiaries of the statutes. But payees are not the only parties whose interests are at stake, and safeguarded, by protection acts. The dependents of payees, for example, are also a focus of the protections—and the 2010 version of the California SSPA includes new provisions aimed at arming courts with information needed to take appropriate actions in favor of the dependents. Other interested parties, and the public as well, benefit from the protections. But in many regards, the protections are only effective when enforced, in the day-to-day decisions by judges in hundreds and even thousands of SSPA proceedings.
The courts have been tasked to ensure that structured settlements continue to serve as the financial safety net that they were intended to be when they were first devised more than 25 years ago. The newly revised California SSPA adds important protections designed to assist the courts in doing their job of protecting those for whose benefit the structures were originally made. It will be up to California’s judiciary to make sure those safeguards work in practice.
Frederick J. Ufkes is a partner in Hinshaw & Culbertson’s Los Angeles office and represents chemical, pharmaceutical, and manufacturing companies in product liability and environmental litigation. Patrick C. Farber is a structured settlements broker at Ringler Associates in Southern California. Peter J. Vodola is a Connecticut-licensed attorney and partner at Seiger Gfeller Laurie LLP who represents clients in litigation regarding SSPAs. He represented the appellants in Rapid Settlements, Ltd. v. Symetra Life Insurance Company.
1 In 2005, sales of structured settlement annuities reached $6 billion. See Daniel W. Hindert & Craig H. Ulman, Transfers of Structured Settlement Payment Rights: What Judges Should Know about Structured Settlement Protection Acts, 44 JUDGES’ J. 19 (2005).
2 See 26 U.S.C. §5891.
3 See Pub. L. No. 97-473, 26 U.S.C. §130.
4 See Revenue Act of 1918, §213(b)(6), 40 Stat. 1057, 1065-66 (1919).
5 See 26 U.S.C. §§104(a), 130.
6 26 U.S.C. §130.
7 See INS. CODE §§729-736, 900-925.4, and 10 CAL. CODE REGS. tit. 3.
8 See 26 U.S.C. §130(c).
9 See INS. CODE §§1631 et seq.
10 See http://www.nssta.com.
11 See id.
12 See, e.g., P. Corboy, Structured for a Reason, A.B.A. J., June 2000, at 116.
13 See Structured Settlement Transfer Act, codified at INS. CODE §§10134 et seq. (also referred to as the California Structured Settlement Protection Act or the California SSPA).
14 Cf. 26 U.S.C. §5981, INS. CODE §§10134 et seq.
15 See INS. CODE §10136.
16 The California SSPA also applies to factoring transactions structured as a loan to the payee, with payments paying off the loan in installments. See INS. CODE §10134(n) (defining transfer within the scope of the statute as “any sale, assignment, pledge…or other form of alienation or encumbrance” of structured settlement payment rights). Most structured settlement factoring transactions are based on documents drafted by factoring companies that describe the transaction as a sale or assignment of the payment rights and not a loan. Some payees have challenged this terminology and alleged that the factoring transaction was a loan and that the interest rate violated state usury laws. See, e.g., 321 Henderson Receivables Origination LLC v. Sioteco, 173 Cal. App. 4th 1059 (2009). These challenges have generally fared poorly. See id.
17 INS. CODE §10136.
18 INS. CODE §10136(c).
19 INS. CODE §10139.5.
20 INS. CODE §10139(a).
21 INS. CODE §10139.5.
22 Id. See also INS. CODE §§10139.3, 10136.
23 See INS. CODE §10139.5.
24 INS. CODE §10136(a)(9).
25 INS. CODE §10139.5(h).
26 See INS. CODE §10139.4.
27 See, e.g., 321 Henderson Receivables Origination LLC v. Ramos, 172 Cal. App. 4th 305 (2009); 321 Henderson Receivables Origination LLC v. Red Tomahawk, 172 Cal. App. 4th 290 (2009); 321 Henderson Receivables Origination LLC v. Sioteco, 173 Cal. App. 4th 1059 (2009); Rapid Settlements, Ltd. v. Symetra Life Ins. Co., 2007 WL 1576437 (Cal. Ct. App. 4th Dist., June 1, 2007).
28 Sioteco, 173 Cal. App. 4th 1059.
29 Id. at 1067.
30 See Red Tomahawk, 172 Cal. App. 4th at 299.
31 See id. at 297; Sioteco, 173 Cal. App. 4th at 1068; see also Ramos, 172 Cal. App. 4th at 312.
32 Red Tomahawk, 172 Cal. App. 4th at 303.
33 Sioteco, 173 Cal. App. 4th at 1074-79.
34 S.B. 510 (2009), legislative digest.
35 INS. CODE §10139.5(b).
36 Id. These criteria are similar to those that have been identified in court opinions in California (as well as in other states, particularly New York) as important to the best interest determination.
37 INS. CODE §10139.5(c).
38 See Office of the Attorney General Public Rights Division/Consumer Law Section, Impact of Prior Court Approval on the Transfer of Structured Settlement Payments Rights, submitted to the California Legislature pursuant to INS. CODE §10139.5(e) (Mar. 2004).
40 321 Henderson Receivables Origination LLC v. Sioteco, 173 Cal. App. 4th 1059, 1066 (2009).
41 See Rapid Settlements, Ltd. v. Symetra Life Ins. Co.,
2007 WL 1576437 (Cal. Ct. App. 4th Dist., June 1, 2007).