Champerty Clarified

The Court of Appeals issued the Love Funding decision in response to questions certified by the United States Court of Appeals for the Second Circuit seeking clarification as to the proper interpretation of New York champerty law. Love Funding, 556 F.3d 100, 114 (2d Cir. 2009). The Court of Appeals' decision is critically important to secondary distressed debt and claims market participants because New York law typically governs the documents related to the transfer of distressed debt and claims, including the standard documents promulgated by the LSTA.

The legal doctrine of champerty referred in medieval Europe to a situation in which one party agreed to bear litigation expenses for another, the party to a lawsuit, in exchange for a share of the suit's proceeds. Bluebird Partners, L.P. v. First Fid. Bank, N.A., 94 N.Y.2d 726, 734 (2000). In contrast, in the United States, champerty traditionally was limited to precluding attorneys from buying a cause of action in order to recover costs, which historically included attorneys' fees. See Bluebird Partners, 94 N.Y.2d at 734. Accordingly, New York's early case law and early champerty statutes were limited to proscriptions against champertous acts by lawyers. See Baldwin v. Latson, 2 Barb. Ch. 306 (N.Y. Ch. 1847). See also Bluebird Partners, 94 N.Y.2d at 734. It was not until 1907 that amendments to New York's champerty statute extended its reach to include non-lawyers and corporations. See Bluebird Partners, 94 N.Y.2d at 734. The current statute thus prohibits the “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.” N.Y. Jud. Law ' 489(1). Arguably, therefore, and as the trial court in Love Funding held, the assignment and subsequent enforcement of a debt instrument and rights thereunder could constitute champerty, if the assignee intended to enforce the instrument or rights through a lawsuit. See Trust for the Certificate Holders of the Merrill Lynch Mortgage Investors, Inc. v. Love Funding Corp., 499 F. Supp. 2d 314, 324-25 (S.D.N.Y. 2007).

The Court of Appeals

Nonetheless, the Court of Appeals in Love Funding circumscribed the reach of New York's champerty law and held that an assignment of claim does not violate the New York champerty statute because the statute “does not apply when the purpose of an assignment is the collection of a legitimate claim.” Love Funding, 13 N.Y.3d at 201. Of great importance to the secondary loan and claims trading market was that the Court of Appeals expanded upon this narrow holding, stating 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.” Id. at 200. The Court of Appeals thus clarified that a party need not have a “pre-existing” proprietary interest in a debt instrument to safely purchase a claim for purposes of pursuing an activist and/or litigation strategy. See Id.

The court's decision provides additional certainty for buyers in the secondary loan and claims market, as it is market practice both under the LSTA distressed purchase and sale agreement and many market-standard assignment of claims agreements for litigation rights to be assigned contemporaneously with the underlying debt instrument. The court's ruling also reaffirms the validity of transferred litigation rights, the most important rights in the broad bundle of rights assigned to a purchaser under the LSTA concept of “Transferred Rights.” Finally, the court noted in dicta that the critical issue is not whether the sole or primary purpose of an assignment of litigation rights associated with a debt instrument is to bring a lawsuit, but rather, whether the purpose behind an assignment was to acquire a right in order to make money from litigating it or to enforce the underlying instrument. Id. at 198-99.

The Facts

Love Funding involved a dispute over the origination, pooling and securitization of mortgage-backed securities. Love Funding Corporation (“Love Funding”), a commercial mortgage banking corporation, entered into an arrangement with Paine Webber Real Estate Securities Inc. (“PaineWebber”) (which later became part of UBS) under which Love Funding originated mortgage loans and evaluated buyers, while PaineWebber provided financing and ultimately assigned the loans for securitization. In the mortgage loan purchase agreement (the “Love MLPA”), Love Funding represented that the underlying mortgage loans were not in default. Further, Love Funding covenanted that if that representation was untrue as to any loan, Love Funding would repurchase the loan and otherwise indemnify PaineWebber against any claims arising from the breach of the representation including associated fees and costs.

One of the loans covered by the Love MLPA was a $6.4 million loan to Cyrus II Partnership, secured by a mortgage on an apartment complex (the “Cyrus Mortgage”). This mortgage, along with 32 other Love Funding mortgages, was assigned and sold by PaineWebber to Merrill Lynch under a second mortgage loan purchase agreement (the “Merrill MLPA”). In the Merrill MLPA, PaineWebber made representations substantively similar to those provided by Love Funding in the Love MLPA. Merrill Lynch placed the mortgages into a trust (the “Trust”), which then sold certificates to investors.

When the Trust declared the Cyrus Mortgage to be in default in March 2002, it commenced a mortgage foreclosure action in Louisiana state court with respect to the Cyrus Mortgage (and 32 other loans). The Trust subsequently discovered that Cyrus' principals had committed fraud in obtaining the Cyrus Mortgage. Accordingly, it commenced an action against UBS (PaineWebber's successor-in-interest) claiming the representation that no loan was in default was not true when made and that the fraud had caused the Cyrus Mortgage to be in default from the outset.

On Sept. 13, 2004, UBS and the Trust agreed to settle the case. UBS agreed pay the Trust $19.375 million in settlement of the additional 32 loans, and to take an assignment of UBS's rights against Love Funding under the Love MLPA, including the right to attorneys' fees and costs (the “Assignment”) in settlement of the Cyrus Mortgage. Id. at 196-97.

The Trust then sued Love Funding for breach of its representation regarding the Cyrus Mortgage in the Love MLPA. Love Funding responded that the Assignment violated New York's champerty statute and accordingly was void. The trial court agreed, noting that the Assignment was the only consideration the Trust took in exchange for releasing UBS from the Trust's claims with respect to the Cyrus Mortgage. Love Funding, 499 F. Supp. 2d at 322-24. Thus, the court concluded, the primary purpose of the Assignment was for the Trust to purchase a lawsuit against Love Funding, which the court viewed to be prohibited by the champerty statute. The court dismissed the Trust's action and the Trust appealed.

On appeal, the United States Court of Appeals for the Second Circuit concluded that its decision depended on “significant and unsettled” questions of New York Law; it thus certified three questions to the New York Court of Appeals. Love Funding, 556 F.3d at 103. First, does champerty depend on whether it is the assignee's “primary” intent to enforce the assignment through litigation or must it be the assignee's “sole” intent. Id. at 114. Second, is it champerty if the assignee's purpose is to collect damages on a debt instrument in which it has a pre-existing proprietary interest. Id. And third, is an assignment champertous when an assignee accepts a defaulted obligation as settlement from assignor and seeks to collect more in damages from the obligor than it had in claims against the assignor (and does the answer to this question depend on whether the assignment included the right to indemnification for reasonable costs and attorney's fees). Id. The Court of Appeals answered the second question and both parts of the third question in the negative and deemed first question to be unnecessary. Love Funding, 13 N.Y.3d at 203.

With the benefit of Court of Appeals' responses, the Second Circuit then held that the trial record did not permit a finding of champerty against the Trust. Love Funding, 591 F.3d 116, 122 (2nd Cir. 2010). Accordingly, it reversed the trial court's decision, specifically finding that the Court of Appeals had rejected that court's holding that the Trust had violated the champerty statute because the Trust's primary purpose was to “buy a lawsuit against Love Funding.” Id. at 121-22. The Second Circuit further held that the Trust's actions were not champertous if its purpose was to enforce its rights under the Love MLPA. Id. The trial record could not support a finding that the Trust sued to generate costs; rather it sued to enforce its rights under the Love MLPA. Id. at 122.

Implications for Debt Trading and Bankruptcy Claims Trading

Love Funding should provide significant comfort to purchasers of distressed debt and bankruptcy claims on the secondary market as “trading occurs ' on the premise that the entire bundle of rights held by the original lenders is transferable ' including all the mechanisms for enforcing rights and protecting the holder's interests,” (Amicus Curiae Brief of the LSTA, July 23, 2009). The Court of Appeals' clarification of New York law is particularly important because both the LSTA's standardized transfer documents and typical assignment of bankruptcy claims agreements are governed by New York law.

When a purchaser evaluates a potential acquisition of a bankruptcy claim or a loan on the secondary market, its valuation and risk/benefit analyses focus in part on the bundle of rights embodied in the LSTA concept of Transferred Rights, which in relevant part includes “any and all of [s]eller's rights, title, and interest in, to and under the [l]oans ' and, to the extent related thereto, the following ' all claims (including 'claims' as defined in the [b]ankruptcy [c]ode ' 101(5)), suits, causes of action, and any other right of [s]eller ' . against [the] [b]orrower.” Similarly, assignment of bankruptcy claims agreements typically include language providing that the “Transferred Rights” include any legal rights or claims including suits or causes of action (whether known or unknown) against the debtor. Love Funding reinforces this powerful right of a purchaser vis-'-vis borrowers and direct and indirect upstream sellers “to assert a claim to protect [its] investment ' to the greatest extent possible for losses arising from a borrower's default or misconduct in the underlying credit transaction,” (Amicus Curiae Brief of the LSTA, July 23, 2009) and breaches of representations and warranties in the upstream transaction documents. If market participants were forced to calculate whether and to what extent the likelihood of recovery through litigation could be impacted by principles of champerty, the secondary loan and claims markets likely would experience both price depreciation and diminished trade volume. The Love Funding decision will permit buyers in the secondary loan and claims markets to more precisely assess their potential for recovery on a claim, which in turn will facilitate market volume and, as a result, provide essential liquidity to the system.

Lawrence V. Gelber is a partner and David J. Karp is Special Counsel in the Business Reorganization Group at Schulte Roth & Zabel LLP. Erik Schneider, an associate in the Business Reorganization Group, assisted in the preparation of this article.

Participants in the secondary distressed debt and bankruptcy claims markets rely heavily on the notion that assignments of distressed bank debt or claims include the rights to enforce the underlying obligation and to bring litigation against any previous owner(s) (i.e. the upstream seller(s)) of the debt or claims for breach of a representation or warranty that impairs the purchaser's recovery. This concept is formalized in both the standardized distressed bank debt purchase and sale agreement, promulgated by the Loan Syndication & Trading Association, Inc. (“LSTA”), and typical bankruptcy claims assignment agreements, which provide that the purchaser succeeds to all of the seller's rights against the original borrower and any upstream sellers.

No Violation of Champerty

In a decision of great significance to secondary market distressed debt and claims purchasers, the New York Court of Appeals (the “Court of Appeals”) recently held that this type of “standard” assignment of claim does not violate New York's champerty statute, N.Y. Jud. Law ' 489(1). Trust for the Certificate Holders of the Merrill Lynch Mortgage Investors, Inc. v. Love Funding Corp. , 13 N.Y.3d 190, 201-02 (2009) (“ Love Funding “). The statute forbids the assignment of litigation claims if the purpose of the assignment is to collect damages by means of a lawsuit for losses on a debt instrument. N.Y. Jud. Law ' 489(1).

The Court of Appeals issued the Love Funding decision in response to questions certified by the United States Court of Appeals for the Second Circuit seeking clarification as to the proper interpretation of New York champerty law. Love Funding, 556 F.3d 100, 114 (2d Cir. 2009). The Court of Appeals' decision is critically important to secondary distressed debt and claims market participants because New York law typically governs the documents related to the transfer of distressed debt and claims, including the standard documents promulgated by the LSTA.

The legal doctrine of champerty referred in medieval Europe to a situation in which one party agreed to bear litigation expenses for another, the party to a lawsuit, in exchange for a share of the suit's proceeds. Bluebird Partners, L.P. v. First Fid. Bank, N.A. , 94 N.Y.2d 726, 734 (2000). In contrast, in the United States, champerty traditionally was limited to precluding attorneys from buying a cause of action in order to recover costs, which historically included attorneys' fees. See Bluebird Partners, 94 N.Y.2d at 734. Accordingly, New York's early case law and early champerty statutes were limited to proscriptions against champertous acts by lawyers. See Baldwin v. Latson , 2 Barb. Ch. 306 (N.Y. Ch. 1847). See also Bluebird Partners, 94 N.Y.2d at 734. It was not until 1907 that amendments to New York's champerty statute extended its reach to include non-lawyers and corporations. See Bluebird Partners, 94 N.Y.2d at 734. The current statute thus prohibits the “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.” N.Y. Jud. Law ' 489(1). Arguably, therefore, and as the trial court in Love Funding held, the assignment and subsequent enforcement of a debt instrument and rights thereunder could constitute champerty, if the assignee intended to enforce the instrument or rights through a lawsuit. See Trust for the Certificate Holders of the Merrill Lynch Mortgage Investors, Inc. v. Love Funding Corp. , 499 F. Supp. 2d 314, 324-25 (S.D.N.Y. 2007).

The Court of Appeals

Nonetheless, the Court of Appeals in Love Funding circumscribed the reach of New York's champerty law and held that an assignment of claim does not violate the New York champerty statute because the statute “does not apply when the purpose of an assignment is the collection of a legitimate claim.” Love Funding, 13 N.Y.3d at 201. Of great importance to the secondary loan and claims trading market was that the Court of Appeals expanded upon this narrow holding, stating 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.” Id. at 200. The Court of Appeals thus clarified that a party need not have a “pre-existing” proprietary interest in a debt instrument to safely purchase a claim for purposes of pursuing an activist and/or litigation strategy. See Id.

The court's decision provides additional certainty for buyers in the secondary loan and claims market, as it is market practice both under the LSTA distressed purchase and sale agreement and many market-standard assignment of claims agreements for litigation rights to be assigned contemporaneously with the underlying debt instrument. The court's ruling also reaffirms the validity of transferred litigation rights, the most important rights in the broad bundle of rights assigned to a purchaser under the LSTA concept of “Transferred Rights.” Finally, the court noted in dicta that the critical issue is not whether the sole or primary purpose of an assignment of litigation rights associated with a debt instrument is to bring a lawsuit, but rather, whether the purpose behind an assignment was to acquire a right in order to make money from litigating it or to enforce the underlying instrument. Id. at 198-99.

The Facts

Love Funding involved a dispute over the origination, pooling and securitization of mortgage-backed securities. Love Funding Corporation (“Love Funding”), a commercial mortgage banking corporation, entered into an arrangement with Paine Webber Real Estate Securities Inc. (“PaineWebber”) (which later became part of UBS) under which Love Funding originated mortgage loans and evaluated buyers, while PaineWebber provided financing and ultimately assigned the loans for securitization. In the mortgage loan purchase agreement (the “Love MLPA”), Love Funding represented that the underlying mortgage loans were not in default. Further, Love Funding covenanted that if that representation was untrue as to any loan, Love Funding would repurchase the loan and otherwise indemnify PaineWebber against any claims arising from the breach of the representation including associated fees and costs.

One of the loans covered by the Love MLPA was a $6.4 million loan to Cyrus II Partnership, secured by a mortgage on an apartment complex (the “Cyrus Mortgage”). This mortgage, along with 32 other Love Funding mortgages, was assigned and sold by PaineWebber to Merrill Lynch under a second mortgage loan purchase agreement (the “Merrill MLPA”). In the Merrill MLPA, PaineWebber made representations substantively similar to those provided by Love Funding in the Love MLPA. Merrill Lynch placed the mortgages into a trust (the “Trust”), which then sold certificates to investors.

When the Trust declared the Cyrus Mortgage to be in default in March 2002, it commenced a mortgage foreclosure action in Louisiana state court with respect to the Cyrus Mortgage (and 32 other loans). The Trust subsequently discovered that Cyrus' principals had committed fraud in obtaining the Cyrus Mortgage. Accordingly, it commenced an action against UBS (PaineWebber's successor-in-interest) claiming the representation that no loan was in default was not true when made and that the fraud had caused the Cyrus Mortgage to be in default from the outset.

On Sept. 13, 2004, UBS and the Trust agreed to settle the case. UBS agreed pay the Trust $19.375 million in settlement of the additional 32 loans, and to take an assignment of UBS's rights against Love Funding under the Love MLPA, including the right to attorneys' fees and costs (the “Assignment”) in settlement of the Cyrus Mortgage. Id. at 196-97.

The Trust then sued Love Funding for breach of its representation regarding the Cyrus Mortgage in the Love MLPA. Love Funding responded that the Assignment violated New York's champerty statute and accordingly was void. The trial court agreed, noting that the Assignment was the only consideration the Trust took in exchange for releasing UBS from the Trust's claims with respect to the Cyrus Mortgage. Love Funding, 499 F. Supp. 2d at 322-24. Thus, the court concluded, the primary purpose of the Assignment was for the Trust to purchase a lawsuit against Love Funding, which the court viewed to be prohibited by the champerty statute. The court dismissed the Trust's action and the Trust appealed.

On appeal, the United States Court of Appeals for the Second Circuit concluded that its decision depended on “significant and unsettled” questions of New York Law; it thus certified three questions to the New York Court of Appeals. Love Funding, 556 F.3d at 103. First, does champerty depend on whether it is the assignee's “primary” intent to enforce the assignment through litigation or must it be the assignee's “sole” intent. Id. at 114. Second, is it champerty if the assignee's purpose is to collect damages on a debt instrument in which it has a pre-existing proprietary interest. Id. And third, is an assignment champertous when an assignee accepts a defaulted obligation as settlement from assignor and seeks to collect more in damages from the obligor than it had in claims against the assignor (and does the answer to this question depend on whether the assignment included the right to indemnification for reasonable costs and attorney's fees). Id. The Court of Appeals answered the second question and both parts of the third question in the negative and deemed first question to be unnecessary. Love Funding, 13 N.Y.3d at 203.

With the benefit of Court of Appeals' responses, the Second Circuit then held that the trial record did not permit a finding of champerty against the Trust. Love Funding, 591 F.3d 116, 122 (2nd Cir. 2010). Accordingly, it reversed the trial court's decision, specifically finding that the Court of Appeals had rejected that court's holding that the Trust had violated the champerty statute because the Trust's primary purpose was to “buy a lawsuit against Love Funding.” Id. at 121-22. The Second Circuit further held that the Trust's actions were not champertous if its purpose was to enforce its rights under the Love MLPA. Id. The trial record could not support a finding that the Trust sued to generate costs; rather it sued to enforce its rights under the Love MLPA. Id. at 122.

Implications for Debt Trading and Bankruptcy Claims Trading

Love Funding should provide significant comfort to purchasers of distressed debt and bankruptcy claims on the secondary market as “trading occurs ' on the premise that the entire bundle of rights held by the original lenders is transferable ' including all the mechanisms for enforcing rights and protecting the holder's interests,” (Amicus Curiae Brief of the LSTA, July 23, 2009). The Court of Appeals' clarification of New York law is particularly important because both the LSTA's standardized transfer documents and typical assignment of bankruptcy claims agreements are governed by New York law.

When a purchaser evaluates a potential acquisition of a bankruptcy claim or a loan on the secondary market, its valuation and risk/benefit analyses focus in part on the bundle of rights embodied in the LSTA concept of Transferred Rights, which in relevant part includes “any and all of [s]eller's rights, title, and interest in, to and under the [l]oans ' and, to the extent related thereto, the following ' all claims (including 'claims' as defined in the [b]ankruptcy [c]ode ' 101(5)), suits, causes of action, and any other right of [s]eller ' . against [the] [b]orrower.” Similarly, assignment of bankruptcy claims agreements typically include language providing that the “Transferred Rights” include any legal rights or claims including suits or causes of action (whether known or unknown) against the debtor. Love Funding reinforces this powerful right of a purchaser vis-'-vis borrowers and direct and indirect upstream sellers “to assert a claim to protect [its] investment ' to the greatest extent possible for losses arising from a borrower's default or misconduct in the underlying credit transaction,” (Amicus Curiae Brief of the LSTA, July 23, 2009) and breaches of representations and warranties in the upstream transaction documents. If market participants were forced to calculate whether and to what extent the likelihood of recovery through litigation could be impacted by principles of champerty, the secondary loan and claims markets likely would experience both price depreciation and diminished trade volume. The Love Funding decision will permit buyers in the secondary loan and claims markets to more precisely assess their potential for recovery on a claim, which in turn will facilitate market volume and, as a result, provide essential liquidity to the system.

Lawrence V. Gelber is a partner and David J. Karp is Special Counsel in the Business Reorganization Group at Schulte Roth & Zabel LLP. Erik Schneider, an associate in the Business Reorganization Group, assisted in the preparation of this article.