Synergy Blog

A Response to the SEC Bulletin: The Truth about Factored Structured Settlements as an Investment Vehicle

By Matt Bracy[1] and Jason Lazarus[2]

Every investment vehicle has inherent risks.  This is the tradeoff for the chance to make higher returns.  However, “factored” structured settlements present investors with a unique low risk/high yield opportunity.  “Factored” structured settlements are periodic payments due to a personal injury claimant, paid through a fixed annuity, that have been sold at a discount to a “factoring” company.  Once a factoring company purchases these structured settlement payments, they either bundle the payment streams together in securitized transactions for institutional investors or sell those streams of income to individual investors.  When individual streams of income are sold, they are typically offered by a financial professional to individual investors.  The latter practice is the subject of a recent Investor Bulletin issued by the SEC and FINRA.

On May 13, 2013 the US Securities and Exchange Commission, Office of Investor Education and Advocacy, issued an Investor Bulletin entitled, “Pension or Settlement Income Streams: What you need to know before buying or selling them.” It is the opinion of the authors that this bulletin is misleading and in some cases inaccurate concerning the sale of structured settlement payment streams and factored structured settlements as an investment vehicle.

The bedrock of securities laws, Rule 10b-5, recognizes that partial information and misinformation can be as detrimental to investors as outright falsehoods. In part, the rule makes it unlawful:

To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading (emphasis added)

The SEC bulletin muddles together two distinctly different businesses, pension purchasing and structured settlement factoring.  To make matters worse, the bulletin further muddles the distinctions between the process of purchasing payments from the structured settlement recipient and selling purchased payment streams to investors. What could have been an informative and educational memo for investors to help understand these transactions and investment opportunities instead became a confusing and misleading series of partial truths mixed with some outright misstatements.

The purpose of this article is to add clarity to these issues, at least as it pertains to structured settlement factoring and the use of these payment streams as investments.

Background

Structured settlements and related annuities have been used since the 1970s as a tool to settle personal injury and workers’ compensation claims. Structured settlements are agreements to settle physical personal injury claims through payments over time, using fixed annuities offered by highly rated life insurance companies.  The novelty of structured settlements, and one of their greatest attributes, is that they allow for payment of compensatory damages over time – ideally, payments matched to monthly medical or income replacement needs. The primary advantage of structured settlements is that the payments are completely federal income tax-free to the injury victim.  .

For the vast majority of structured settlement recipients (some estimate as many as 95%), these periodic payments work very well and continue to meet their needs year after year.However, an estimated 5% of structured settlement recipients at some time find that they need liquidity. Structured settlements inherently lack liquidity or the ability to adapt to changed circumstances, since the payments are “set in stone” when the structure is created, and cannot be “increased, decreased, accelerated or deferred”[3]. Considering the difficulty in predicting needs going out 20 years or more, which is common for structured settlements, this low percentage of people needing a change is truly remarkable.

Due to unforeseen changes in life circumstances, such as medical needs, oppressive debt, or positive life-changing opportunities, the structured settlement’s periodic payments may no longer suffice. Beginning in the late 1980s, finance companies began buying part or all of a structured settlement recipient’s rights to receive future payments in exchange for a lump sum payment. By 2002, this process was formalized through state and federal laws, requiring local court approval for all such transfers upon a finding that the transfer is in the best interest of the seller, taking into account the welfare and support of any dependents, among other things.

Prior to the financial crisis of 2008/2009, many finance companies purchasing future structured settlement payment rights were backed by large financial institutions and international banks. Since 2009, with credit tightening, investors began buying structured settlement payment rights from factoring company originators providing necessary capital to the factoring companies.  Many private investors and financial advisors have become attracted to factored structured settlement payment rights due to their relatively high yields and low risk of default. Universal court approval of transfers and good due diligence regarding each transaction have led many to consider this a viable alternative to more traditional investments offering low returns.

Instead of focusing on the real risks, the SEC and FINRA bulletins have combined concerns over factoring structured settlements, pensions and investment in structured settlement payment rights after a factoring company has purchased them.  The bulletin specifically recognizes the attractiveness of these high yields and points out, correctly, that there are commissions associated with the sale of the payment streams.  This is so with almost any financial product sold to investors.  The bulletin also correctly points out that the income streams are illiquid.  Where the bulletin confuses the issues is when it begins to talk about the lack of reliable information about factored structured settlement annuities as investments and its discussion of legal enforceability of a transfer of future structured settlements.

Clearing up the Muddle

Some features of structured settlement factoring that should be clarified:

Always Court Ordered

Contrary to the SEC bulletin’s statement that “the secondary sale of a structured settlement often must be approved by a court, in keeping with the Uniform Periodic Payment of Judgments Act”, the truth is that since 2002 all structured settlement transfers must be court approved. This is so because of the intersection of federal tax law (IRC 5891), providing a punitive excise tax to structured settlement transfers unless approved by a state court, and state laws now in place in nearly all states[4] (and none of them have anything to do with the Uniform Periodic Payment of Judgments Act).

One of the reasons investors may be so attracted to structured settlement payment streams is that the court order clearly approves the transfer and orders the annuity issuer to make the designated payments to a specified transferee.[5]  Accordingly, the bulletin is not completely accurate when it suggests that there could be legal challenges to the purchase of future payments of a structured settlement by an investor.  If a structured settlement factoring transaction complies with federal and state structured settlement transfer laws, the risk of a challenge is relatively small.  While there is some risk, having an independent legal evaluation of the transaction to make sure all laws were properly complied with lessens this risk greatly.  In addition, the legal evaluation provides the necessary background information regarding the structured settlement annuity and the issuer so that an investor knows exactly what he or she is getting.  The information is reliable and readily available as part of the closing process of the sale of a factored structured settlement to an investor.

No Negative Tax Consequences to the Seller

The payee of a structured settlement is the personal injury claimant, or his/her heir or estate. Clearly, they receive the payments federal income tax free.[6] What about when these payments are sold?

Because the SEC bulletin combines so many divergent topics, it is not clear who or what situation they are addressing when they write, “The lump sum payment you collect may be taxable.” The IRS long ago clarified[7] that the seller of structured settlement payment rights does not suffer any adverse tax consequences from the sale, but rather receives the lump sum purchase price federal income tax free, just as they received the payments being sold. Investors who subsequently purchase future periodic payments from a factored structured settlement annuity will have gain and should consult a tax professional about proper reporting of taxable income.  However, that is normal recognition of taxable income as one would have with any other taxable investment vehicle.

Investors’ Rights

There is no better example of the muddling confusion of this bulletin than this statement:

Your “rights” to the income stream you purchased could face legal challenges. It may not be legal to purchase someone’s pension. And it may be difficult to legally force the original owner of a pension or structured settlement to forward or assign their income to a factoring company or investor.

Again, this article is focused on the structured settlement world, and we leave the nuances of the pension purchasing process to those more knowledgeable of it. Our focus is on the second sentence above, and the impressions that it creates. First, no one involved in structured settlements or structured settlement factoring are interested in “forcing” anyone to assign their payments. Willing sellers of such payments, motivated by whatever pressing financial need is in their lives, decide to sell this valuable asset in return for a lump sum. Once the terms are agreed upon, a judge decides whether or not the sale is in their best interests, and whether the transfer laws have been complied with (written disclosures about the terms of the transaction are delivered prior to the contract being signed, the seller is advised to seek independent professional advice, etc.).

Significantly, once the order is signed, the annuity issuer is now bound to send the payments to the factoring company or investor as directed in the court order. Legal enforcement of a court order is relatively straightforward, should it be needed. If the court order designates the factoring company as the payment recipient, and the payment rights are subsequently assigned to an investor, enforcement of that assignment is also relatively straightforward.

The Real World

Despite the inaccuracies and misleading information, the SEC bulletin makes a few good points — not unique to structured settlement payment rights, but good points nonetheless: Investors should learn about what they are buying, investigate the company they are doing business with, and hire professionals for help and guidance. Structured settlement payment rights have become popular with many investors because they realize the relative stability of this asset and opportunity for making a good return. As the bulletin’s garbled message makes clear however, it is not always easy to understand how this works and the process is somewhat complicated. Education about this product becomes more difficult however when partial information, or misinformation, are spread.

Ultimately, an investor must work with professionals who do the proper due diligence as it relates to the factored structured settlement investment opportunities.  Having an independent legal evaluation of each transaction is critical to the process of making sure the investment vehicle is “clean”.  The independent legal evaluation will answer most of the questions identified in the SEC bulletin as being critical for the investor to analyze.  In the end, each investor will have to decide based upon the real facts whether this is an appropriate vehicle or not.  However, a low risk high yield investment opportunity shouldn’t be avoided or discredited without complete and accurate information.  Hopefully this article has provided some clarity to the cloudy picture painted by the SEC’s bulletin.


[1] Matt Bracy is a partner with the law firm Nesbitt, Vassar & McCown, LLP in Dallas, Texas. Matt was the General Counsel of Settlement Capital Corporation, a structured settlement factoring company, for over 10 years, is the past president of the National Association of Settlement Purchasers, and is a frequent commentator on structured settlement factoring issues for the Legal Broadcast Network.

[2] Jason Lazarus is a founding principal and CEO of Synergy Settlement Services in Orlando, Florida.  He is also the managing partner of the Special Needs Law Firm which provides legal services related to public benefit preservation, MSP compliance and complicated health care liens.  Jason is a frequent lecturer regarding complex settlement related issues and has been published many times over.

[3] Pursuant to IRC 130, the tax code section that provides tax benefits for structured settlement recipients and the insurance companies setting up the structure.

[4] 48 states currently have transfer laws. Transfers are governed by the law of the state where the payee resides. For states or US jurisdictions without transfer laws, federal law provides that the transfer can be brought under the law of the state where the annuity issuer or owner reside.

[5] Practices vary regarding who the “transferee” is under the approval order. In some cases it is the factoring company originator, or a specified and identified investor, or an entity created to hold the interest.

[6] See IRC 104(a).

[7] See IRS PLR 1999-36030

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