The Champerty Doctrine Under New York Law

Champerty, a doctrine with roots in early English law, refers to “an agreement to divide litigation proceeds between the owner of the litigated claim and a party unrelated to the lawsuit who supports or helps enforce the claim.” Black's Law Dictionary (9th 2009). Today, ' 489(1) of New York's Judiciary Law bars champerty, making it a misdemeanor for any person to “buy or take 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.” Recognizing that the historical doctrine may restrict an otherwise robust market for claims trading, in 2004, the New York Legislature added ' 489(2). This safe harbor provision exempts transactions “having an aggregate purchase price of at least five hundred thousand dollars” from the prohibition set forth in ' 489(1).

Since 2000, the Court of Appeals has issued two decisions that limited the application of Judiciary Law ' 489(1) as it relates to modern financial transactions. In Bluebird Partners, L.P. v. First Fidelity Bank, N.A., 94 N.Y.2d 726 (2000), the court found that the champerty doctrine did not apply as a matter of law even though plaintiff had admitted that it had anticipated the possibility of litigation when it purchased the distressed debt. The plaintiff, Bluebird Partners, had purchased certificates issued by the then-bankrupt Continental Airlines and sued the trustee. During discovery, a Bluebird analyst admitted that he had considered suing the trustee for its conduct before it acquired the certificates. The trustee moved to dismiss the case due to champerty. The Appellate Division dismissed the case, concluding that the “record leaves no doubt that [Bluebird's] 'primary purpose' in purchasing those certificates was the maintenance of litigation against the second series trustee.” Id. at 730.

After surveying the historical underpinnings of the champerty doctrine, the Court of Appeals concluded that ' 489(1) prohibited transactions in which litigation was “the primary purpose for, if not the sole motivation behind” plaintiff's acquisition of the certificates. Id. at 736. Because the factual record did not demonstrate that plaintiff's primary motivation was to litigate, the Court of Appeals reversed the Appellate Division, observing that “a finding of champerty as a matter of law might engender uncertainties in the free market system in connection with untold numbers of sophisticated business transactions ' a not insignificant potentiality in the State that harbors the financial capital of the world.” Id. at 739. While the Court of Appeals allowed the case to continue, it did not soundly reject the champerty defense, thereby creating ongoing uncertainty about the outcome of a fact-intensive investigation of a purchaser's intent.

The Court of Appeals expanded on its reasoning in Bluebird Partners and once again interpreted Judiciary Law ' 489(1) in a limited manner in Trust for the Certificate Holders of Merrill Lynch Mortg. Invs. v. Love Funding (Love Funding), 13 N.Y.3d 190 (2009). In response to certified questions from the U.S. Court of Appeals for the Second Circuit, the court explained that “[i]n describing champerty in terms of an acquisition made with the purpose of bringing a lawsuit [in Bluebird Partners], we intended to convey the difference between one who acquires a right in order to make money from litigating it and one who acquires a right in order to enforce it.” Id. at 200. The former, according to the court, constituted champerty, while the latter did not. The Love Funding decision did not address the ' 489(2) safe harbor, however.

Justinian Capital v. WestLB

The combination of the creation of the ' 489(2) safe harbor in 2004 and the Court of Appeals decisions in Bluebird and Love Funding seemed to free the distressed debt market from any concerns about the champerty doctrine. However, Justice Kornreich's recent decision in Justinian Capital v. WestLB AG rekindled this issue. In April 2010, Justinian Capital bought two series of mortgage-backed securities notes issued by Cayman Islands segregated portfolio companies after the financial crisis left the notes worthless. Justinian Capital, 952 N.Y.S.2d at 727-28. Pursuant to the terms of a stock purchase agreement (SPA), the seller, Deutsche Pfandbriefbank AG (DPAG), conveyed to Justinian the notes and all related rights and claims. Justinian agreed to pay DPAG $1 million and granted DPAG a substantial reversionary interest in the net proceeds of any settlement or judgment resulting from collection or litigation efforts. Under the contract, Justinian agreed to remit 80% of the net proceeds (after paying contingent attorneys' fees) to the seller if Justinian had paid the $1 million fee but would remit 85% of the net proceeds if it had not paid the initial fee. DPAG retained a security interest in the notes to guarantee the amounts it would receive. It appears that Justinian had not paid the $1 million fee to DPAG, but this non-payment was not deemed to be an event of default under the contract.

Five months after purchasing the notes, Justinian sued the sponsor and asset manager for the notes, WestLB AG (WestLB), for breach of contract, fraud, and other claims. WestLB moved to dismiss Justinian's claims for lack of capacity to sue under CPLR ' 3211(3), arguing that Justinian did not actually own the notes and, even if it did, its claims violated Judiciary Law ' 489. (Arguably, this argument reflected an affirmative defense of lack of standing, not a claim that Justinian lacked the capacity to sue). WestLB accused Justinian of pretending to purchase the notes when, in reality, it had agreed to litigate on DPAG's behalf for a fee. To support its argument, WestLB provided the court with an undated Justinian marketing presentation. The presentation stated that any seller of distressed assets to a Justinian entity would retain “ultimate control and ownership” of the assets. Furthermore, the Justinian presentation referred to a few law firms as its “litigation partners” who would work with it on a contingency fee basis. Notably, the presentation did not in any way describe or refer to any transaction with DPAG.

In analyzing WestLB's champerty argument, Justice Kornreich first noted that New York courts applied Judiciary Law ' 489 cautiously. The court justified this cautious approach because “[t]he financial industry is critical to New York's economy, and its courts are rightly wary of fomenting uncertainty in its vibrant secondary markets by exposing the purchasers of debt instruments to charges of champerty.” Id. at 732. Moreover, the court noted that an expansive application of ' 489 would improperly encourage obligors of distressed instruments to announce an intent to default so that any lawsuit by a future purchaser would be subject to a champerty defense. Id.

Notwithstanding this cautious approach, the court concluded that Justinian's purchase of the notes may be champertous. The court held that the ultimate issue was whether “Justinian bought the instruments as a bona-fide investment (which would properly include the ability to enforce rights through litigation) or if the purchase was merely a pretext for conducting litigation by proxy in exchange for a fee.” Id. at 733. If Justinian had in fact partnered with a law firm to purchase debt instruments to profit from the litigation itself, as WestLB alleged and as arguably suggested by Justinian's marketing materials, the court reasoned that Justinian's purchase of the notes would be champertous. The court concluded that questions of fact surrounded Justinian's intent when it purchased the notes, leading it to stay the case pending limited discovery on the issue of champerty. Id. at 734.

Notably, the court rejected Justinian's argument that ' 489(2)'s safe harbor applied even though Justinian had purchased the notes for a promise to pay $1 million. Because Justinian promised to remit the majority of the proceeds to DPAG, the court reasoned that the SPA may “not really [be] an agreement for the sale of the [notes],” but instead an agreement whereby DPAG “subcontract[ed] out this litigation to Justinian.” Id. In so ruling, the court did not accept the SPA's plain language at face value. Apparently, the court believed that a bona fide purchaser would not have agreed to such an arrangement.

Analysis and Likely Effects of Justinian v. WestLB

The court's decision in Justinian represents a significant departure from recent jurisprudence concerning the champerty doctrine. The court's rejection of the ' 489(2) safe harbor is remarkable because this exemption removes transactions from the intent-based analysis otherwise governed by ' 489(1). Ironically, the court determined that the parties' likely intent rendered the safe harbor inapplicable. Significantly, the court seemed troubled by the fact that the debt seller received at least 80% of the net proceeds after paying attorney's fees. However, the amount of the contingent fee was negotiated by sophisticated parties who had to assess the murky likelihood of success of the underlying claims. The court's conclusion that no bona fide seller of debt would have agreed to those terms is debatable. In any event, the court's decision may have the unintended result of increasing uncertainty and justifying higher fees by claims traders.

Perhaps the court's analysis would have been different had there been evidence that Justinian had actually paid the $1 million set forth in the SPA. While the decision does not refer to the existence or non-existence of that payment, proof of actual payment may have reduced the strength of the champerty defense. It is also not clear whether the court would have reached a different result but for Justinian's problematic marketing slides. Of course, it seems that there may have been far more probative indicia whether DPAG still considered itself the owner of the notes than Justinian's marketing materials.

Finally, the court's disdain for the role played by Justinian's then-counsel, Reed Smith, seems misplaced. The court went so far as to state that the firm had “aided and abetted” a potentially illegal transaction. Id. at 733. The court seems to have reacted strongly to Justinian's brochure, which listed Reed Smith as one of its three “litigation partners.” But there is no evidence that the firm helped structure or negotiate the SPA, which Justinian could have done on its own. Nor is there any evidence that Reed Smith solicited the seller. Rather, it seems that the firm's role was no different than as a garden-variety contingent-fee attorney.

The court concluded its decision by suggesting that the legislature had the power to strike down the champerty laws in their entirety. Id. at 734. While that is true, the harsh result in Justinian may be overturned on appeal, or future courts may distinguish it as applicable to the particular facts at issue and apply the statutory safe harbor instead. In the meantime, claims traders should take extra care marketing and structuring potential transactions when they buy claims that are likely to lead to litigation.

Jeffrey Gross is of counsel and Nathaniel J. Palmer is a senior associate at Reid Collins & Tsai LLP. They are resident in New York and Austin, respectively, and may be reached at [email protected] and [email protected].

A recent New York case demonstrates that the common law doctrine of champerty still poses a threat to the market for distressed debt. Historically, this doctrine barred litigation brought by assignees. In recent years, New York courts and the Legislature have restricted its ambit, thereby encouraging the development of secondary debt markets. This more limited application of the champerty doctrine has enabled buyers of distressed debt to pursue litigation, if necessary, as assignees.

But the champerty doctrine is not dead yet. In Justinian Capital, SPC v. WestLB AG , 952 N.Y.S.2d 725 (Sup. Ct. N.Y. Cty. Aug. 15, 2012), a New York trial court stayed a claims trader's causes of action pending further discovery about the merits of a champerty defense. On what it deemed to be an issue of first impression, the court characterized plaintiff's claims as a “scheme” to wage “litigation by proxy in exchange for a fee.” Id. at 733. Whatever the outcome of future discovery in this case, this decision is noteworthy for participants in the market for distressed debt.

Origins and Efforts to Limit the Champerty Doctrine

Champerty, a doctrine with roots in early English law, refers to “an agreement to divide litigation proceeds between the owner of the litigated claim and a party unrelated to the lawsuit who supports or helps enforce the claim.” Black's Law Dictionary (9th 2009). Today, ' 489(1) of New York's Judiciary Law bars champerty, making it a misdemeanor for any person to “buy or take 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.” Recognizing that the historical doctrine may restrict an otherwise robust market for claims trading, in 2004, the New York Legislature added ' 489(2). This safe harbor provision exempts transactions “having an aggregate purchase price of at least five hundred thousand dollars” from the prohibition set forth in ' 489(1).

Since 2000, the Court of Appeals has issued two decisions that limited the application of Judiciary Law ' 489(1) as it relates to modern financial transactions. In Bluebird Partners, L.P. v. First Fidelity Bank, N.A. , 94 N.Y.2d 726 (2000), the court found that the champerty doctrine did not apply as a matter of law even though plaintiff had admitted that it had anticipated the possibility of litigation when it purchased the distressed debt. The plaintiff, Bluebird Partners, had purchased certificates issued by the then-bankrupt Continental Airlines and sued the trustee. During discovery, a Bluebird analyst admitted that he had considered suing the trustee for its conduct before it acquired the certificates. The trustee moved to dismiss the case due to champerty. The Appellate Division dismissed the case, concluding that the “record leaves no doubt that [Bluebird's] 'primary purpose' in purchasing those certificates was the maintenance of litigation against the second series trustee.” Id. at 730.

After surveying the historical underpinnings of the champerty doctrine, the Court of Appeals concluded that ' 489(1) prohibited transactions in which litigation was “the primary purpose for, if not the sole motivation behind” plaintiff's acquisition of the certificates. Id. at 736. Because the factual record did not demonstrate that plaintiff's primary motivation was to litigate, the Court of Appeals reversed the Appellate Division, observing that “a finding of champerty as a matter of law might engender uncertainties in the free market system in connection with untold numbers of sophisticated business transactions ' a not insignificant potentiality in the State that harbors the financial capital of the world.” Id. at 739. While the Court of Appeals allowed the case to continue, it did not soundly reject the champerty defense, thereby creating ongoing uncertainty about the outcome of a fact-intensive investigation of a purchaser's intent.

The Court of Appeals expanded on its reasoning in Bluebird Partners and once again interpreted Judiciary Law ' 489(1) in a limited manner in Trust for the Certificate Holders of Merrill Lynch Mortg. Invs. v. Love Funding ( Love Funding ), 13 N.Y.3d 190 (2009). In response to certified questions from the U.S. Court of Appeals for the Second Circuit, the court explained that “[i]n describing champerty in terms of an acquisition made with the purpose of bringing a lawsuit [in Bluebird Partners], we intended to convey the difference between one who acquires a right in order to make money from litigating it and one who acquires a right in order to enforce it.” Id. at 200. The former, according to the court, constituted champerty, while the latter did not. The Love Funding decision did not address the ' 489(2) safe harbor, however.

Justinian Capital v. WestLB

The combination of the creation of the ' 489(2) safe harbor in 2004 and the Court of Appeals decisions in Bluebird and Love Funding seemed to free the distressed debt market from any concerns about the champerty doctrine. However, Justice Kornreich's recent decision in Justinian Capital v. WestLB AG rekindled this issue. In April 2010, Justinian Capital bought two series of mortgage-backed securities notes issued by Cayman Islands segregated portfolio companies after the financial crisis left the notes worthless. Justinian Capital, 952 N.Y.S.2d at 727-28. Pursuant to the terms of a stock purchase agreement (SPA), the seller, Deutsche Pfandbriefbank AG (DPAG), conveyed to Justinian the notes and all related rights and claims. Justinian agreed to pay DPAG $1 million and granted DPAG a substantial reversionary interest in the net proceeds of any settlement or judgment resulting from collection or litigation efforts. Under the contract, Justinian agreed to remit 80% of the net proceeds (after paying contingent attorneys' fees) to the seller if Justinian had paid the $1 million fee but would remit 85% of the net proceeds if it had not paid the initial fee. DPAG retained a security interest in the notes to guarantee the amounts it would receive. It appears that Justinian had not paid the $1 million fee to DPAG, but this non-payment was not deemed to be an event of default under the contract.

Five months after purchasing the notes, Justinian sued the sponsor and asset manager for the notes, WestLB AG (WestLB), for breach of contract, fraud, and other claims. WestLB moved to dismiss Justinian's claims for lack of capacity to sue under CPLR ' 3211(3), arguing that Justinian did not actually own the notes and, even if it did, its claims violated Judiciary Law ' 489. (Arguably, this argument reflected an affirmative defense of lack of standing, not a claim that Justinian lacked the capacity to sue). WestLB accused Justinian of pretending to purchase the notes when, in reality, it had agreed to litigate on DPAG's behalf for a fee. To support its argument, WestLB provided the court with an undated Justinian marketing presentation. The presentation stated that any seller of distressed assets to a Justinian entity would retain “ultimate control and ownership” of the assets. Furthermore, the Justinian presentation referred to a few law firms as its “litigation partners” who would work with it on a contingency fee basis. Notably, the presentation did not in any way describe or refer to any transaction with DPAG.

In analyzing WestLB's champerty argument, Justice Kornreich first noted that New York courts applied Judiciary Law ' 489 cautiously. The court justified this cautious approach because “[t]he financial industry is critical to New York's economy, and its courts are rightly wary of fomenting uncertainty in its vibrant secondary markets by exposing the purchasers of debt instruments to charges of champerty.” Id. at 732. Moreover, the court noted that an expansive application of ' 489 would improperly encourage obligors of distressed instruments to announce an intent to default so that any lawsuit by a future purchaser would be subject to a champerty defense. Id.

Notwithstanding this cautious approach, the court concluded that Justinian's purchase of the notes may be champertous. The court held that the ultimate issue was whether “Justinian bought the instruments as a bona-fide investment (which would properly include the ability to enforce rights through litigation) or if the purchase was merely a pretext for conducting litigation by proxy in exchange for a fee.” Id. at 733. If Justinian had in fact partnered with a law firm to purchase debt instruments to profit from the litigation itself, as WestLB alleged and as arguably suggested by Justinian's marketing materials, the court reasoned that Justinian's purchase of the notes would be champertous. The court concluded that questions of fact surrounded Justinian's intent when it purchased the notes, leading it to stay the case pending limited discovery on the issue of champerty. Id. at 734.

Notably, the court rejected Justinian's argument that ' 489(2)'s safe harbor applied even though Justinian had purchased the notes for a promise to pay $1 million. Because Justinian promised to remit the majority of the proceeds to DPAG, the court reasoned that the SPA may “not really [be] an agreement for the sale of the [notes],” but instead an agreement whereby DPAG “subcontract[ed] out this litigation to Justinian.” Id. In so ruling, the court did not accept the SPA's plain language at face value. Apparently, the court believed that a bona fide purchaser would not have agreed to such an arrangement.

Analysis and Likely Effects of Justinian v. WestLB

The court's decision in Justinian represents a significant departure from recent jurisprudence concerning the champerty doctrine. The court's rejection of the ' 489(2) safe harbor is remarkable because this exemption removes transactions from the intent-based analysis otherwise governed by ' 489(1). Ironically, the court determined that the parties' likely intent rendered the safe harbor inapplicable. Significantly, the court seemed troubled by the fact that the debt seller received at least 80% of the net proceeds after paying attorney's fees. However, the amount of the contingent fee was negotiated by sophisticated parties who had to assess the murky likelihood of success of the underlying claims. The court's conclusion that no bona fide seller of debt would have agreed to those terms is debatable. In any event, the court's decision may have the unintended result of increasing uncertainty and justifying higher fees by claims traders.

Perhaps the court's analysis would have been different had there been evidence that Justinian had actually paid the $1 million set forth in the SPA. While the decision does not refer to the existence or non-existence of that payment, proof of actual payment may have reduced the strength of the champerty defense. It is also not clear whether the court would have reached a different result but for Justinian's problematic marketing slides. Of course, it seems that there may have been far more probative indicia whether DPAG still considered itself the owner of the notes than Justinian's marketing materials.

Finally, the court's disdain for the role played by Justinian's then-counsel, Reed Smith, seems misplaced. The court went so far as to state that the firm had “aided and abetted” a potentially illegal transaction. Id. at 733. The court seems to have reacted strongly to Justinian's brochure, which listed Reed Smith as one of its three “litigation partners.” But there is no evidence that the firm helped structure or negotiate the SPA, which Justinian could have done on its own. Nor is there any evidence that Reed Smith solicited the seller. Rather, it seems that the firm's role was no different than as a garden-variety contingent-fee attorney.

The court concluded its decision by suggesting that the legislature had the power to strike down the champerty laws in their entirety. Id. at 734. While that is true, the harsh result in Justinian may be overturned on appeal, or future courts may distinguish it as applicable to the particular facts at issue and apply the statutory safe harbor instead. In the meantime, claims traders should take extra care marketing and structuring potential transactions when they buy claims that are likely to lead to litigation.

Jeffrey Gross is of counsel and Nathaniel J. Palmer is a senior associate at Reid Collins & Tsai LLP. They are resident in New York and Austin, respectively, and may be reached at [email protected] and [email protected].