Champerty and Fraud . . . What a Combination!

• Posted on: Mar 8 2023

By: Jeffrey M. Haber

It is not often that we examine a case involving a cause of action for champerty. The last time we did so was on April 23, 2021 (here). We also examined the champerty doctrine in 2020 (here) and 2016 (here).

But what is champerty? Simply, champerty is the prohibited practice of purchasing claims for the purpose of commencing litigation. 

New York’s prohibition against champertous transactions is codified in Section 489 of the Judiciary Law, which provides in relevant part, and with some exceptions, that

No person or co-partnership, engaged directly or indirectly in the business of collection and adjustment of claims, and no corporation or association, directly or indirectly, itself or by or through its officers, agents or employees, shall solicit, buy or take an assignment of, or be in any manner interested in buying or taking an assignment of a bond, promissory note, bill of exchange, book debt, or other thing in action, or any claim or demand, with the intent and for the purpose of bringing an action or proceeding thereon….

The New York Court of Appeals has placed a heavy burden of proof on the party claiming champertous conduct, requiring a showing that the primary, if not the sole, purpose of the transaction was the collection of a claim.¹ 

In Trust for the Certificate Holders of Merrill Lynch Mortg. Investors v. Love Funding (Merrill Lynch Mortg.), 13 N.Y.3d 190 (2009), the Court of Appeals held, in response to certified questions from the U.S. Court of Appeals for the Second Circuit, that a corporation or association does not violate Judiciary Law § 489(1), as a matter of law, when the “purpose in taking [the] assignment of … rights … was to enforce its … preexisting proprietary interest in the [debt instrument]….”² The Court explained that “the critical issue” in assessing champerty is the purpose behind the acquisition of rights that allowed the plaintiff to file the lawsuit.³ The Court made it clear that intent to enforce does not, by itself, constitute champerty.⁴ Because the plaintiff had a preexisting interest in the loan and would suffer the damages of any default on the loan, the Court found that, as a matter of law, it did not violate New York law.⁵ 

While champerty is not a frequent topic for examination by this Blog, claims involving fraud or fraudulent conduct are frequently examined by us. 

To state a claim for fraud, plaintiff must allege “misrepresentation or concealment of a material fact, falsity, scienter on the part of the wrongdoer, justifiable reliance and resulting injury.”⁶ “[T]he circumstances constituting the [fraud] [must] be stated in detail.”⁷ 

One of the elements of a fraud claim that plaintiffs have difficulty satisfying is justifiable reliance. As evident from the reported decisions, the justifiable reliance element is most often used by defendants to secure dismissal of the claim against them.

In Ambac Assur. v. Countrywide, 31 N.Y.3d 569, 579 (2018) (here), the Court of Appeals described the justifiable reliance requirement of a fraud claim as a “fundamental precept” of the cause of action.⁸ As such, the justifiable reliance requirement is considered to be a necessary tool to weed out fraud claims by plaintiffs who “are lax in protecting themselves”.⁹ 

In assessing whether the plaintiff’s reliance was justified, the courts look to see whether the plaintiff’s reliance on the alleged misrepresentation was reasonable.¹⁰ As stated by the Court of Appeals, this means the plaintiff must exercise “ordinary intelligence” in ascertaining “the truth or the real quality of the subject of the representation.”

[I]f the facts represented are not matters peculiarly within the party’s knowledge, and the other party has the means available to him [or her] of knowing, by the exercise of ordinary intelligence, the truth or the real quality of the subject of the representation, he [or she] must make use of those means, or he [or she] will not be heard to complain that he [or she] was induced to enter into the transaction by misrepresentations.¹¹

Whether a plaintiff exercised diligence in ascertaining the truth should not be determined by hindsight. As the Court of Appeals explained, when “a plaintiff has taken reasonable steps to protect itself against deception, it should not be denied recovery merely because hindsight suggests that it might have been possible to detect the fraud when it occurred.”¹² 

Sophisticated parties have a heightened duty to use the means available to them to verify the truth of the information upon which they rely and to use their sophistication to conduct due diligence.¹³ A sophisticated plaintiff cannot establish justifiable reliance on an alleged misrepresentation if the plaintiff failed to make use of the means of verification that were available to him.¹⁴ Thus, to sustain a claim of fraud, sophisticated parties must have discharged their own affirmative duty to exercise ordinary intelligence and conduct an independent appraisal of the risks they are assuming.¹⁵

Moreover, when the plaintiff “has hints” that a representation is false, the courts impose a “heightened degree of diligence” on the plaintiff.¹⁶ Under such circumstances, the courts require the plaintiff to make an “additional inquiry to determine” the “accuracy” of the representation.¹⁷ If the plaintiff fails to make such an inquiry, then the plaintiff will not be found to have reasonably relied on the alleged misrepresentation.

The foregoing principles, among others, were examined by the court in IKB Intl. S.A. v. Morgan Stanley, 2023 N.Y. Slip Op. 30614(U) (Sup. Ct., N.Y. County Mar. 1, 2023) (here).

Factual Background

Plaintiff IKB SA was a commercial bank incorporated in Luxembourg. IKB SA purchased a number of certificates (“Certificates”) for residential mortgage-backed securities (“RMBS”) from Morgan Stanley, allegedly in reliance on misrepresentations that Morgan Stanley made in its offering documents. In particular, Morgan Stanley allegedly made misrepresentations to IKB SA’s investment managers, Standish Mellon and BlackRock, including misrepresentations regarding loan-to-value (“LTV”) and combined loan-to-value (“CL TV”) statistics, owner-occupancy status of borrowers, and adherence to the originators’ own underwriting guidelines. 

The value of the Certificates collapsed during the onset of the financial crisis as the poor quality of the underlying loans and resulting increased credit risk became apparent. Ultimately, IKB SA was placed into liquidation as part of the German government’s bailout of IKB SA’s parent, IKB AG.

In November 2008, IKB SA sold the Certificates to IKB AG. Two weeks later, IKB AG sold the Certificates to a newly created Irish special purpose vehicle called Rio Debt Holdings (Ireland) Limited (“Rio”). As part of the sale of Certificates to Rio, IKB AG became a junior lender to Rio and also became a portfolio administrator to Rio.

IKB AG and Rio subsequently executed an assignment agreement on May 9, 2012, in which Rio assigned to IKB AG “all the rights of action and claims against any other party with respect to the Securities it may have obtained in connection with its purchase of the Securities from IKB Deutsche Industriebank AG … except rights of action and claims for the receipt of interest and principal on the Securities” (“2012 Assignment”). In exchange, IKB AG agreed to provide Rio “a sum equal to the proceeds of any recovery stemming from a resolution of claims relating to the Assigned Rights, net of all agreed costs, taxes and expenses, which shall be set out and governed by a separate agreement to be executed by the Parties”.

IKB AG contended that under a supplementary deed and other governing documents, the parties agreed that 80% of the net litigation proceeds would revert to IKB AG. Rio and IKB AG executed the supplementary deed on January 11, 2013 – after Plaintiffs filed the summons in the action – but gave it retroactive effect from May 9, 2012.

After the 2012 Assignment, IKB AG filed the action. The complaint alleged causes of action for fraud, fraudulent concealment, aiding and abetting fraud, and negligent misrepresentation. 

Defendants moved to dismiss the complaint, in part for lack of standing, arguing that the 2012 Assignment of the fraud claims to IKB AG was void as champertous. The court denied the motion, finding that Defendants had not shown that “IKB AG’s primary or sole purpose [for the assignment] was not to enforce a legitimate claim, or that the claim was not acquired as part of a larger transaction or for leverage in other disputes between the parties”. The court determined that IKB AG’s intent in the 2012 Assignment was a factual question which required further development of the record. However, the court dismissed the causes of action for fraudulent concealment and negligent misrepresentation.

Thereafter, Defendants moved for summary judgment, claiming that the action should be dismissed on the basis of champerty. Defendants additionally argued that the complaint should be dismissed because Plaintiffs failed to establish justifiable reliance on their fraud claim. 

We examine the court’s decision with respect to the champerty and fraud causes of action.

Champerty

The court held that the 2012 Assignment was not champertous because IKB AG had a preexisting proprietary interest in the subject matter. The court explained that to finance the initial assignment of the Certificates to Rio in 2008, IKB AG and Rio entered into a loan agreement. Pursuant to the 2008 loan agreement, IKB AG, as junior lender, was entitled to 80% of the profits from the assets. Although the loan had been paid down, the court found that, unlike other champertous assignments, the 2012 Assignment did not involve a “stranger” to the transaction. Instead, it involved a party with a prior interest.

The court also held that Defendants failed to establish that the sole purpose for the 2012 Assignment was to profit off of litigation, to the exclusion of all other purposes. As noted by the court, an assignment is not champertous merely because the parties enter into the assignment “for the purpose of collecting damages, by means of a lawsuit”.¹⁸ The purpose of the assignment must be “to make money from litigating it” for it to be champertous.¹⁹ “[A]cquir[ing] a right … to enforce it” is not champertous.²⁰ The court found that Plaintiffs provided evidence that they were still entitled to 80% of the future cash flows under the 2008 loan agreement with Rio because the loan was not paid off entirely – even though it was paid down almost in its entirety. Therefore, concluded the court, regardless of whether the 2012 Assignment’s primary purpose was litigation, Defendants failed to provide sufficient evidence to establish that the sole purpose, to the exclusion of all other purposes, was to profit off of litigation. As such, said the court, Defendants failed to establish that the 2012 Assignment was void as champertous. 

Fraud

Defendants additionally moved for summary judgment on the basis that Plaintiffs failed to establish actual and justifiable reliance for their fraud cause of action. The court granted in part and denied in part the motion.

Plaintiff’s fraud claim was based on three purported misrepresentations: (1) LTV and CL TV statistics; (2) owner-occupancy status of borrowers; and (3) adherence to originator underwriting guidelines. The court denied Defendants’ motion as to the first two categories.

With regard to the issue of actual reliance,²¹ the court found that Plaintiffs raised questions of fact as to actual reliance on the purported LTV /CL TV and owner-occupancy misrepresentations.

In particular, investment manager testimony and write-ups that the investment managers issued, said the court, “clearly reflect[ed] that LTV /CL TV and owner-occupancy were at least among the factors that they considered in recommending Certificates.”²² In addition to the write-ups, noted the court, “the preliminary term sheets prepared by Morgan Stanley reflect[ed] that CL TV/LTV and owner-occupancy [issues] were clearly significant parts of [Plaintiffs’] due diligence.”²³ 

Additionally, the court held that Defendants failed to show that Plaintiffs did not justifiably rely on the LTV /CL TV and owner-occupancy representations.²⁴ Focusing on the question of whether there were “hints of falsity”, the court held that Defendants failed to establish that there were such facts and circumstances.²⁵ “The core problem underlying” the hints of falsity identified by Defendants, said the court, was “that they almost entirely relate[d] to indications that the sub-prime housing market and the associated RMBS in general were deteriorating rather than indications that Morgan Stanley may have misrepresented particular facts relating to the securities at issue here”.²⁶ The failure to establish hints of falsity with respect to particular representations relating to the Certificates, concluded the court, was fatal to Defendants’ motion.²⁷

The court noted that “[e]ven if Defendants … established that Plaintiffs were on notice of a general economic downturn, Defendants [had] not shown that the systemic concerns [that were] raised … gave any hint of falsity of particular representations relating to these Certificates.”²⁸

The court also held that Defendants failed to establish “that Plaintiffs’ reliance was not justifiable because of their undisputed status as sophisticated investors.”²⁹ Though sophisticated parties must undertake steps to protect themselves from fraud, the court held that “Plaintiffs were not required to ‘retrace’ Defendants’ steps for their reliance to have been justifiable.”³⁰

As to originator underlying guidelines representations, the court found that Defendants met their burden. The court agreed with Defendants that “there [was] no evidence in the record concerning Morgan Stanley’s representations about underwriting guidelines on which the investment managers could have relied ….”

Footnotes

1. Bluebird Partners v. First Fid. Bank, 94 N.Y.2d 726, 736 (2000).
2. Id. at 201-02.
3. Id. at 198-99.
4. Id. at 200 (noting that “if a party acquires a debt instrument for the purpose of enforcing it, that is not champerty simply because the party intends to do so by litigation.”).
5. Id. at 202.
6. Basis Yield Alpha Fund (Master) v. Goldman Sachs Group, Inc., 115 A.D.3d 128, 135 (1st Dept. 2014) (internal citation omitted).
7. CPLR § 3016(b).
8. See ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043, 1051 (2015) (Read, J., dissenting on other grounds).
9. Id.
10. Epifani v. Johnson, 65 A.D.3d 224, 230 (2d Dept. 2009).
11. Schumaker v. Mather, 133 N.Y. 590, 596 (1892); see also ACA Fin. Guar., 25 N.Y.3d at 1044; DDJ Mgt., LLC v. Rhone Group L.L.C., 15 N.Y.3d 147, 154 (2010).
12. DDJ Mgt., 15 N.Y.3d at 154.
13. McGuire Children, LLC v. Huntress, 24 Misc. 3d 1202 (A), at *12 (Sup. Ct., Erie County), aff’d, 83A.D.3d 1418 (4th Dept. 2011).
14. Id.
15. Id.
16. Centro Empresarial Cempresa S.A. v. América Móvil, S.A.B. de C.V., 17 N.Y.3d 269, 279 (2011) (quoting, Global Mins. & Metals Corp. v. Holme, 35 A.D.3d 93, 100 (1st Dept. 20016)).
17. Id. (citation and internal quotation marks omitted).
18. Slip Op. at *8 (quoting, Universal Inv. Advisory SA v. Bakrie Telecom Pte., Ltd., 154 A.D.3d 171, 180(1st Dept. 2017)).
19. Id.
20. Id.
21. To establish actual reliance, a plaintiff must establish that the alleged fraud was a “substantial factor in inducing [the plaintiff] to act in the way that they did.” Aronoff v. Ernst and Young, 1999 WL 458779, at *3 (Sup. Ct., N.Y. County Apr. 26, 1999 (citing, Curiale v. Peat, Marwick, Mitchell & Co., 214 A.D.2d 16 (1st Dept. 1995)); Abu Dhabi Commercial Bank v. Morgan Stanley & Co. Inc., 888 F. Supp. 2d 431, 462 (S.D.N.Y. 2012)).
22. Slip Op. at *12-*13.
23. Id. at *13.
24. Id. at *14.
25. Id.
26. Id. at *16.
27. Id. (citations omitted).
28. Id.
29. Id. at *17.
30. Id.