This second installment of our series, “The Life Settlement Industry – Bankruptcy Issues”, will address two related issues:
(1) What type of interest (if any) does an investor-creditor have in a “life settlement” (i.e., a life insurance policy sold by the original owner to a third party for a value in excess of the policy’s cash surrender value, but less than its death benefit), and (2) How is the interest of an investor-creditor in a life settlement generally determined in a bankruptcy case?
The intersection of bankruptcy and an investment in a life settlement can take various scenarios:
- Scenario #1: An individual or business entity purchases a life insurance policy, and then it files for bankruptcy protection. In this scenario, an individual or business entity (a “Purchaser”) buys from a company which is licensed to purchase life insurance policies and resell them to third parties (a “Provider”) a policy insuring the life of Joe Smith (“Smith Policy”). The Purchaser now holds sole title to the Smith Policy as the owner and is listed as both the owner and the beneficiary of the Smith Policy on the books of the life insurance company that originally issued the Smith Policy (the “Insurance Company”). While owning the Smith Policy, the Purchaser files for bankruptcy protection. In this scenario, the Purchaser would possess sole ownership interest in the Smith Policy because the Smith Policy is entirely owned by the Purchaser. Thus, the Smith Policy would be an asset of the Purchaser’s bankruptcy estate.
- Scenario #2: An investor buys a fractionalized “ownership” interest in a life settlement policy, and then it files for bankruptcy protection. In this second scenario, the Purchaser (often, an investment fund) has purchased the Smith Policy from the Provider and sells fractionalized ownership interests (e.g., 20% ownership interest) in the Smith Policy to third parties (the “Fractional Owners”). Similar to the first scenario, the Fractional Owners will be listed on the books of the Insurance Company as the owners and beneficiaries of the Smith Policy. If one of the Fractional Owners files for bankruptcy protection, then its fractional ownership interest in the Smith Policy will become a part of its bankruptcy estate. As we will explain in Part 3 of this series, this scenario also implicates securities laws as it is likely that the life settlement interest is a security.
- Scenario #3: An investor buys a fractionalized “beneficial” interest in a life settlement policy, and then it files for bankruptcy protection. Similar to the second scenario, the Purchaser (an investment fund) buys the Smith Policy from a Provider. However, the Purchaser does not market and sell ownership interests in the Smith Policy to investors. Rather, the Purchaser sells beneficial interests in the Smith Policy. After marketing the beneficial interests to third parties, the Purchaser enters into agreements with several investors (each, a “Beneficial Owner”). The agreements require the Beneficial Owners to pay a certain amount of money that will be used by the Purchaser to pay the premiums on the Smith Policy, and the Beneficial Owners will receive a share of the proceeds of the Smith Policy when it matures (i.e., Smith passes away). Importantly, the Purchaser (not the Beneficial Owners) will be listed as the owner of the Smith Policy on the books of the Insurance Company, whereas the Beneficial Owners typically will have only a contractual right to payment from the Purchaser based upon the terms of their agreement (i.e., the Beneficial Owners do not hold an ownership interest in the Smith Policy). Due to the combination of the Purchaser’s ability at any time to change the names of the beneficiaries of the Smith Policy, and the Beneficial Owners’ lack of a direct ownership interest in the Smith Policy, this scenario is the ripest for fraud and/or investor confusion. Fraud often results in financial shortfalls, leaving it difficult if not impossible for the Purchaser to sustain its business (e.g., pay the premiums on the policies). For the Beneficial Owners, indicators of problems with the Purchaser’s business may include a delay (or failure) in the receipt of payment from the Purchaser when a policy matures, failure of the Purchaser to provide concrete or verifiable responses to investment inquiries, and/or requests by the Purchaser for additional payments or seeking early payment of premiums not yet due. A resultant bankruptcy filing by the Purchaser, either voluntary (i.e., by the Purchaser) or involuntary (i.e., by the creditors of the Purchaser), is not uncommon. Due to the typical complexity and/or ambiguity of the underlying contracts, language differences, and the possibility that the Purchaser made verbal representations during the sale process that may vary from the contract language, this scenario often results in both the Purchaser (now, a debtor) and the Beneficial Owners asserting in the bankruptcy case of the Purchaser identical ownership and/or beneficiary rights in the life settlement policies.
- Scenario #4: An investor buys an interest in a fund that holds life settlement policies as assets, and the fund then files for bankruptcy protection. In this scenario, the Purchaser buys the Smith Policy from a Provider. The Purchaser then places the policy in a trust (“Trust”). A fund (“Fund”) is set up which becomes the beneficiary under the Trust. These Funds tend to be institutional investors, such as hedge funds, pension funds, and mutual funds. In turn, investors (“Investors”) buy interests in the Fund. The Trust is listed as the owner of the Smith Policy on the books of the Insurance Company. The Fund, and/or the Investors, may or may not be listed as beneficiaries on the books and records of the Insurance Company. As the legal owner of the Smith Policy, the Trust may change the beneficiary names at any time. In this scenario, the rights of the Investors would be determined by the shareholder, partnership, LLC or other agreement that controlled the Fund. In the event of a bankruptcy involving the Fund, the treatment of the interests of the Trust, Fund and Investors in the Smith Policy would be governed and influenced not only by bankruptcy law, but by government regulations propagated by, for example, the SEC or the Pension Benefit Guaranty Corporation.
Under any of these scenarios, if an investor-creditor believes that its interest in a life settlement is an “ownership” interest (i.e., the life settlement is not a part of the and the debtor or trustee disagrees, the investor-creditor may need to file an adversary proceeding (i.e., litigation) in the bankruptcy court to obtain a determination of that issue; or the issues may be resolved in the claims resolution process. Depending on the number of life settlements involved, the number of investor-creditors asserting ownership interests in the policies, the number of non-investor creditors and the value of other assets, if any, in the bankruptcy estate, and, most importantly, the willingness of the parties, including the debtor, creditors and trustee (if any) to collaborate on a fair and equitable result for all, the investor-creditors may be able to work out a settlement with the debtor or trustee, subject to approval by the court. Bottom line – These are complex issues and not resolvable by a cookie-cutter approach.
Next up in this series: Are the life settlements viewed as securities under applicable state law?