Collateral: What is it and what do lenders require?

Collateral. Chances are you’ve heard the term if you’ve ever received (or applied) for any type of financing—whether a mortgage, auto loan or credit card.

Consequently, most law firm funders presume you’re well versed as to its meaning and purpose.

While you may have studied the Uniform Commercial Code and security interests in law school, that doesn’t necessarily translate into a working knowledge of the uses of collateral, particularly contingent fees, for the purposes of acquiring funding for your firm.

Here are a few basics.

1. What is it?

Black’s Law Dictionary defines collateral as “[p]roperty that is pledged as security against a debt; the property subject to a security interest or agricultural lien.” But what exactly does that mean?

Collateral is property granted to a financing company to assure them that you’ll fulfill your principal obligations under a funding agreement.

Put simply, collateral gives your funder a supplemental source from which to recover in the event your firm is unable to pay.

Importantly, the value that a financing company gives to your collateral frequently dictates how much financing you’ll receive.

2. What assets can be pledged?

In the U.S., security for financing can be established over all types of assets, including, among other things:

• accounts;
• cash;
• receivables;
• contract rights;
• real and personal property;
• general intangibles;
• equipment and machinery; and
• future/after acquired property.

3. What do law firm financing companies typically require?

Collateral required by law firm funders can vary considerably, but almost always includes some or all of your firm’s earned or unearned contingent fees.

Traditional lenders, like banks and credit unions, or specialty finance companies like Counsel Financial, generally require loans to be collateralized by a blanket lien on all of the assets you and/or your firm possess, including your current and future legal fees (typically considered “future accounts” and/or “general intangibles”). Traditional specialty finance companies, however, usually have more flexibility than a bank or credit union in their ability to adjust the value of the collateral to match the needs of your firm.

Non-recourse specialty financiers are very much the same, except that the lender looks solely to the case collateral and there is no personal guaranty. From the lender’s point of view, that translates into higher risk which means you’ll be charged an exponentially higher rate to match the greater risk to the funder.

In both cases, be prepared to share a case list with estimates of probable recovery as well as timing of expected fees. To the extent that any cases are not yet publicly filed, be cautious when sharing any specific information so as to always protect the attorney/client privilege.

4. Will pledging attorney’s fees constitute fee-sharing?

Many jurisdictions allow attorneys to assign current or future, earned or unearned, legal fees as property to secure a transaction.[1] Accordingly, the courts that have ruled on the issue have held that contracts for legal fees, including fees in pending contingency fee cases, are “accounts” for the purposes of Uniform Commercial Code Article 9.[2]

For example, in In Re: PNC Bank, Delaware v. Berg, a Delaware court concluded “a bank can claim a security interest in the hourly billing and contingent fee contracts of a law-firm debtor even though the underlying obligation, the attorney’s lien for services rendered, is not subject to [UCC] Article 9.”[3]

In the Berg opinion, the Court reasoned:

“[a] law firm is a business, albeit one infused with some measure of the public trust, and there is no valid reason why a law firm should be treated differently than an accounting firm or a construction firm. The Rules of Professional Conduct ensure that attorneys will zealously represent the interests of their clients, regardless of whether the fees the attorney generates from the contract through representation remain with the firm or must be used to satisfy a security interest. Parenthetically, the Court will note that there is no suggestion that it is inappropriate for a lender to have a security interest in an attorney's accounts receivable. It is, in fact, a common practice. Yet there is no real 'ethical' difference whether the security interest is in contract rights (fees not yet earned) or accounts receivable (fees earned) in so far as Rule of Professional Conduct 5.4, the rule prohibiting the sharing of legal fees with a non-lawyer, is concerned. It does not seem to this Court that we can claim for our profession, under the guise of ethics, an insulation from creditors to which others are not entitled."[4] 

Nevertheless, as you’re aware, your local rules govern whether a funder’s secured interest in your firm’s fees will be deemed an unethical fee-sharing arrangement. Before entering into any financing transaction, it’s always a good idea to consult those rules to ensure compliance with ethical rules and professional responsibilities.

[1] See e.g. PNC Bank, Del. v. Berg, No. 94C-09-208-WTQ, 1997 Del. Super. LEXIS 19, 1997 WL 527978 (Del. Super. Jan. 31, 1997); ACF 2006 Corp. v. Merritt, 2013 U.S. Dist. LEXIS 16609, *11-12, 2013 WL 466603 (W.D. Okla. 2013) citing Cadle Co. v. Schlichtmann, 267 F.3d 14, 18 (1st Cir. 2001) (finding that amounts to be paid under contingency fee agreements are accounts under Article 9 of UCC); U.S. Claims, Inc. v. Yehuda Smolar, P.C., 602 F.Supp. 2d 590, 597-600 (E.D. Pa. 2009) (finding that the assignment of amounts owed under contingency fee agreement governed by Article 9 of the UCC); U.S. Claims, Inc. v. Flomenhaft & Cannata, LLC, 519 F. Supp. 2d 515, 521 (E.D. Pa. 2006) (finding that fee contracts created rights to receive payment for services to be rendered by the law firm on behalf of its clients and thus fell squarely within definition of account); PNC Bank, Del. v. Berg, No. 94C-09-208-WTQ, 1997 Del. Super. LEXIS 19, 1997 WL 527978 (Del. Super. Jan. 31, 1997) (finding that an unmatured contingency fee contract is an account under Article 9 of the UCC); Core Funding Group v. McDonald, 2006 Ohio 1625, 2006 WL 832833 (Ohio App. 2006) (contingent fee contracts of a law firm-debtor are subject to Article 9).

[2] Id.

[3] Berg, supra, at fn. 5.

[4] Core Funding Group, LLC, 2006-Ohio-1625, P62, 2006 Ohio App. LEXIS 1523, *31-32 citing PNC Bank, No. 94C-09-208-WTQ, 1997 Del. Super. LEXIS 19, 1997 WL 527978 at fn. 5.