Small Litigation Funders And Purchasers Of Distressed Debt Beware – Champerty Is Alive And Well In New York

• Posted on: Nov 9 2016

Champerty. Most people have never heard of the word, and, even if they did, it is more likely they do not remember what it means. The same is probably true for most lawyers, who most likely encountered the doctrine when they studied for the bar exam.

So what is champerty? Black’s Online Law Dictionary (2d ed.) defines champerty as: “A bargain made by a stranger with one of the parties to a suit, by which such third person undertakes to carry on the litigation at his own cost and risk, in consideration of receiving, if he wins the suit, a part of the land or other subject sought to be recovered by the action.” In plain English, this means that champerty occurs when a person or entity agrees to finance someone else’s lawsuit in exchange for a portion of the judicial award.

The prohibition of champerty dates back to the middle ages. Martin, Syndicated Lawsuits: Illegal Champerty or New Business Opportunity?, 30 Am Bus LJ 485 (1992). Some commentators believe that the doctrine go back to ancient Greece and ancient Rome. E.g., Jason Lyon, Revolution in Process: Third-Party Funding of American Litigation, 58 UCLA Law Review 571, 580 (2010). Regardless of its origins, champerty was considered to be against public policy – a person who has nothing to do with the matter being litigated should not be able to profit from it.

Over time, however, the prohibition on champertous transactions began to decline. Today, the states are split on the enforcement of the prohibition. Some jurisdictions strictly enforce the doctrine, others enforce it less strictly, while the remainder have abolished the doctrine.

The Law in New York:

New York continues to enforce the prohibition of champerty. See Judiciary Law § 489(1). Judiciary Law §489(1) provides, in pertinent part:

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. In Bluebird Partners v. First Fid. Bank, 94 N.Y.2d 726, (N.Y. 2000), the Court noted that it had been historically “hesitant to find that an action is champertous as a matter of law….” Id. at 735-36. Indeed, prior jurisprudence showed that “a mere intent to bring a suit on a claim purchased does not constitute the offense; the purchase must be made for the very purpose of bringing such suit, and this implies an exclusion of any other purpose.” Id. at 735 (quoting Moses v. McDivitt, 88 N.Y. 63, 65 (1882)).  Thus, “in order to constitute champertous conduct in the acquisitions of rights, …the foundational intent to sue on that claim must at least have been the primary purpose for, if not the sole motivation behind, entering into the transaction.” Id. at 736. In Bluebird Partners, the Court found that the record did not support a finding of champerty as a matter of law, because it could not be determined that profiting from litigation was the primary motivation behind the acquisition of the certificates at issue.

Almost a decade later, the New York Court of Appeals had the opportunity to further comment on the requirements needed to find champerty. 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 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]….” Id. at 201-02.  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. Id. at 198-99. The Court made it clear that intent to enforce does not, by itself, constitute champerty. 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.”). 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. Id. at 202.

After Love Funding, many considered champerty to be a dead doctrine in New York, except in the rare case where the facts and evidence truly reflected a champertous transaction. Indeed, cases in the lower courts confirmed this view. E.g., Seomi v. Sotheby’s, 27 Misc.3d 1231(A) (Sup. Ct. N.Y. Cnty. 2010); IRB-Brasil Resseguros v. Inepar Invs., No. 604448/06, 2009 WL 2421423, at **19, 20 (Sup. Ct. N.Y. Cnty. July 31, 2009) (holding that an assignment of the rights of a noteholder was not champertous where the assignee had purchased $14 million worth of notes itself, and was a signatory to the subject notes); Nat’l City Commercial Capital v. Becker Real Estate Servs., 24 Misc. 3d 912 (Sup. Ct. Suffolk Cnty. 2009) (holding that the defendant failed to demonstrate that champerty was the primary purpose behind the plaintiff’s acquisition of a financial lease).

On October 27, 2016, in Justinian Capital SPC v. WestLB AG, 2016 NY Slip Op. 07047, the Court of Appeals reminded everyone that the champerty doctrine is alive and well.

Justinian Capital SPC v. WestLB AG:

The Facts:

In 2003, non-party Deutsche Pfandbriefbank AG (“DPAG”) invested nearly 180 million euros (approximately $209 million) in notes (the “Notes”) issued by two special purpose companies, Blue Heron VI Ltd. and Blue Heron VII Ltd. (collectively, the “Blue Heron Portfolios”). The Blue Heron Portfolios were sponsored and managed by the defendant WestLB. By January 2008, the Notes had lost much (if not all) of their value. Slip op. at 2.

In the summer of 2009, DPAG’s board of directors approved the filing of a lawsuit against WestLB, a German bank partly owned by the German government, to recover the losses caused by the devaluation of the Notes. Both DPAG and WestLB were receiving substantial support from the German government at the time. Because of these relationships, the DPAG board feared that pursuing a lawsuit against WestLB would result in the loss of government support for the bank. Consequently, the DPAG board determined to have a third party bring the lawsuit and remit a portion of any proceeds to DPAG. In February 2010, DPAG discussed this option with the plaintiff Justinian Capital SPC (“Justinian”), a Cayman Islands shell company with little or no assets. Id. at 2-3.

In April 2010, DPAG and Justinian entered into a sale and purchase agreement (the “Agreement”) pursuant to which DPAG assigned the Notes to Justinian for a base purchase price of $1,000,000 (representing $500,000 for the Blue Heron VI notes and $500,000 for the Blue Heron VII notes). Justinian did not, however, pay for the Notes. Under the Agreement, the only consequences of Justinian’s failure to pay appeared to be that interest would accrue on the $1,000,000 and that Justinian’s share of any proceeds recovered from the lawsuit would be reduced from 20% to 15%. At the time of the appeal, Justinian had not paid any portion of the $1,000,000 purchase price, and DPAG had not demanded payment. Id. at 3.

Within days after the Agreement was executed, and shortly before the statute of limitations was to expire, Justinian filed a summons with notice against WestLB. The subsequently filed complaint alleged causes of action for breach of contract, fraud, breach of fiduciary duty, negligence, negligent misrepresentation, and breach of the covenants of good faith and fair dealing, all in connection with WestLB’s purchase of ineligible assets for the Blue Heron Portfolios. Id.

WestLB moved to dismiss the complaint on champerty grounds. The court found questions of fact with respect to the champerty defense and instructed the parties to conduct discovery on that issue. Following the close of this limited discovery, WestLB moved for summary judgment. Id. at 3-4.

The motion court dismissed the complaint, concluding that the Agreement was champertous because Justinian had not made a bona fide purchase of the Notes and was, therefore, suing on a debt it did not own. The motion court also concluded that Justinian was not entitled to the protection of the safe harbor under Judiciary Law § 489(2) because Justinian had not made an actual payment of $500,000 or more. Id. at 4 (citing 43 Misc. 3d 598 (Sup Ct, N.Y. Cnty 2014)). On appeal, the Appellate Division, First Department, affirmed, largely adopting the rationale of the motion court. Id. (citing 128 A.D.3d 553 (1st Dep’t 2015)). The Court of Appeals granted leave to appeal, and affirmed the holding of the lower courts, though for somewhat different reasons. Id.

The Court’s Ruling:

In a 5-2 ruling, the Court concluded that Justinian’s acquisition of the Notes represented a “sham transaction” that was designed to put Justinian in a position to champertously sue WestLB:

Here, the impetus for the assignment of the Notes to Justinian was DPAG’s desire to sue WestLB for causing the Notes’ decline in value and not be named as the plaintiff in the lawsuit. Justinian’s business plan, in turn, was acquiring investments that suffered major losses in order to sue on them, and it did so here within days after it was assigned the Notes…. [T]here was no evidence … that Justinian’s acquisition of the Notes was for any purpose other than the lawsuit it commenced almost immediately after acquiring the Notes.… Here, the lawsuit was not merely an incidental or secondary purpose of the assignment, but its very essence. Justinian’s sole purpose in acquiring the Notes was to bring this action and hence, its acquisition was champertous.

(Internal quotations and citations omitted.)

The Court also ruled that the transaction did not come within the statutory safe harbor. Judiciary Law § 489(2) exempts the purchase or assignment of notes or other securities from the restrictions of Section 489(1) when the notes or other securities “hav[e] an aggregate purchase price of at least five hundred thousand dollars.”

In concluding that the transaction did not come within the safe harbor, the Court found that because the $1 million purchase price listed in the transaction documents “was not a binding and bona fide obligation to pay the purchase price other than from the proceeds of the lawsuit,” Justinian’s acquisition of the Notes did not satisfy the safe harbor’s requirements:

The record establishes, and we conclude as a matter of law, that the $1,000,000 base purchase price listed in the Agreement was not a binding and bona fide obligation to pay the purchase price other than from the proceeds of the lawsuit. The Agreement was structured so that Justinian did not have to pay the purchase price unless the lawsuit was successful, in litigation or in settlement. The due date listed for the purchase price was artificial because failure to pay the purchase price by this date did not constitute a default or a breach of the Agreement. The Agreement permitted Justinian to exercise the option to let the due date pass without consequence and simply deduct the $1,000,000 (plus interest) from its share of any proceeds from the lawsuit.

The Court explained that its finding was consistent with the legislative history and the purpose of the safe harbor provision:

The legislative history reveals that a purchase price of at least $500,000 was selected because the Legislature took comfort that buyers of claims would not invest large sums of money to pursue litigation unless the buyers believed in the value of their investments. This comfort is lost when a purchaser of notes or other securities structures an agreement to make payment of the purchase price contingent on a successful recovery in the lawsuit; such an arrangement permits purchasers to receive the protection of the safe harbor without bearing any risk or having any skin in the game, as the Legislature intended. The Legislature intended that those who benefit from the protections of the safe harbor have a binding and bona fide obligation to pay a purchase price of at least $500,000, irrespective of the outcome of the lawsuit.

That is precisely what is lacking here….

(Internal quotations and citations omitted.)

Two justices dissented, arguing that the majority decision depended upon reaching conclusions about the intent and motivation of the parties, which, they said, are not issues to decided on summary judgment.

Takeaway:

The Court’s decision will have broad implications for small litigation funders and distressed debt purchasers. See, e.g., Reuters, New York’s Top Court Clamps Down On Shoestring Litigation Funders, dated October 28, 2016).  As a result of the Court’s decision, these financiers must have “skin in the game” when they enter into transactions that do not exceed $500,000. That means that they must ensure, among other things, that the payment obligations set forth in the transaction papers are bona fide – that is, the purchase price will be paid on a date certain or contemporaneously with the execution of the agreement, and the payment will not be contingent or revocable. It also means that transactions involving disallowance provisions, consideration without apparent or facial value, complex financing arrangements, or other provisions that indicate the buyer does not actually hold at least $500,000 in the investment will be closely scrutinized.  Consequently, these companies and purchasers will have to document and retain records showing that the primary intent and purpose of the transaction comports with the Court’s ruling. Otherwise small funders and debt purchasers will learn that the champerty prohibition is alive and well in New York.

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