Best Interest Standard On Factoring Terminology On Structured settlement factoring transaction. Internal Revenue Code Sec. 5891 and most state laws require that a court find that a proposed settlement factoring transaction be in the best interest of the seller, taking into account the welfare and support of any dependents. “Best interest” is generally not defined, which gives judges flexibility to make a subjective determination on a case-by-case basis. Some state laws may require that the judge look at factors such as the “purpose of the intended use of the funds,” the payee’s mental and physical capacity, and the seller’s potential need for future medical treatment. One Minnesota court described the “best interest standard” as a determination involving “a global consideration of the facts, circumstances, and means of support available to the payee and his or her dependents.”
Courts have consistently found that the “best interest standard” is not limited to financial hardship cases. Hence, a transfer may be in a seller’s best interest because it allows him to take advantage of an opportunity (i.e., buy a new home, start a business, attend college, etc.) or to avoid disaster (i.e., pay for a family member’s unexpected medical care, pay off mounting debt, etc.). For example, a New Jersey court found that a transaction was in a seller’s best interest where the funds were used to “pay off bills…and to buy a home and get married.”
Although sometimes criticized for being vague, the best interest standard’s lack of precise definition allows considerable latitude in judicial review. Courts can consider on a case-by-case basis the totality of the circumstances surrounding the transfer to determine whether it should be approved.
Discount Rate
In the beginning, the factoring industry had some relatively high discount rates due to heavy expenses caused by costly litigation battles and limited access to traditional investors. However, once state and federal legislation was enacted, the industry’s interest rates decreased dramatically. There is much confusion with the terminology “discount rate” because the term is used in different ways. The discount rate referred to in a factoring transaction is similar to an interest rate associated with home loans, credit cards and car loans where the interest rate is applied to the payment stream itself. In a factoring transaction, the factoring company knows the payment stream they are going to purchase and applies an interest rate to the payment stream itself and solves for the funding amount, as though it was a loan. Discount rates from factoring companies to consumers can range anywhere between 8% up to over 18% but usually average somewhere in the middle (link to a discount rate calculator can be found here).
Factoring discount rates can be a bit higher when compared to home loan interest rates, due to the fact the factoring transactions are more of a boutique product for investors opposed to the mainstream collateralized mortgage transactions. One common mistake in calculating the discount rate is to use “elementary school math” where you take the funding/loan amount and divide it by the total price of all the payments being purchased. Because this method disregards the concept of time (and the time value of money), the resulting percentage is useless. For example, the court in In Re Henderson Receivables Origination v.
Campos noted an annual discount rate of 16.8% where the annuitant received $36,500 for the assignment of payments totaling $63,364.94 over 84 months (two monthly payments of $672.32 each, beginning September 30, 2006 and ending on October 31, 2006; eighty-two monthly payments of $692.49 each, increasing 3% every twelve months, beginning on November 30, 2006 and ending on August 31, 2013). However, had the court in Henderson Receivables Origination applied the illogical formula of discounting from “elementary school math” ($36,500/ $63,364.94), the discount rate would have been an astronomical (and nonsensical) 61%.
Discounted Present Value
Another term commonly used in factoring transactions is “discounted present value,” which is defined in the NCOIL model transfer act as “the present value of future payments determined by discounting such payments to the present using the most recently published Applicable Federal Rate for determining the present value of an annuity, as issued by the United States Internal Revenue Service.” The IRS discount rate, also known as the Applicable Federal Rate (AFR), is used to determine the charitable deduction for many types of planned gifts, such as charitable remainder trusts and gift annuities. The rate is the annual rate of return that the IRS assumes the gift assets will earn during the gift term. The IRS discount rate is published monthly (link to current rate may be found here).
In Henderson Receivables Origination (above), the court calculated the discounted present value of the $63,364.94 to be transferred as $50,933.18 based on the applicable federal rate of 6.00%. The “discounted present value” is a measuring stick for determining what the value of a future payment (i.e., a payment that is due in the year 2057) is today. Hence, the discounted present value of a payment corrects for inflation and the principle that money available today is worth more than money not accessible for 50 years (or some future time). However, the discounted present value is not the same thing as market value (what someone is willing to pay).
Basically, a calculation that discounts a future payment based on IRS rates is an artificial number since it has no bearing on the payment’s actual selling price. For example, in Henderson Receivables Origination, it is somewhat confusing for the court to evaluate future payments totaling $63,364,94 based the discounted present value of $50,933.18 because that is not the market value of the payments.
In other words, the annuitant couldn’t go out and get $50,933.18 for his future payments because no person or company would be willing to pay that much. Some states will require a quotient to be listed on the disclosure that is sent to the customer prior to entering into a contract with a factoring company. The quotient is calculated by dividing the purchase price by the discounted present value. The quotient (like the discounted present value) provides no relevance in the pricing of a settlement factoring transaction. In Henderson Receivables Origination (above), the court did consider this quotient which was calculated as 71.70% ($36,500/ $50,933.18).
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