When a securitization trust accepted an assignment of a claim that the seller of a defaulted loan had against a third party as part of the settlement in a fever pitched litigation battle with that seller – and then sued a lender with whom it had no direct dealings to recoup losses sustained from that loan - the Second Circuit asked New York’s highest court to clarify the application of the New York law against “champerty” so that it could render a decision on the merits of the case before it.
What is Champerty and Why is it a Bad Thing?
“Champerty” is the practice of buying an assignment of a claim with the intent of commencing a lawsuit. Since medieval times, such conduct has generally been prohibited as a matter of public policy to prevent the strife and harassment that could result from allowing attorneys and businesses to purchase claims for the primary purpose of bringing litigation.
New York codified the public policy at New York Judiciary Law § 489, which provides in relevant part that:
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 ... a 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 (emphasis supplied).
Only assignments made for the purpose of bringing a lawsuit fall within the statutory prohibition. This implies an exclusion of any other purpose. Champerty is an affirmative defense to any lawsuit and if the defense is successful, the assignment will be declared void. A violation of the New York statute is also a misdemeanor and monetary fines may be imposed on those responsible. Given these harsh penalties, “champerty” is clearly something to avoid.
In the case described below, the assignment involving the claim of champerty was estimated to be worth $10 million to the trust, so a decision declaring the assignment to be void would have serious financial implications for the trust and its investors.
New York Analysis
In response to the question certified by the Second Circuit, the New York Court of Appeals has opined that the Judiciary Law prohibiting champerty – the purchase of a claim for the purpose of allowing the purchaser to commence an action or proceeding – “does not apply when the purpose of the assignment is the collection of a legitimate claim.” A purchaser who has a pre-existing proprietary interest in the claim may acquire the right to pursue the claim and not be deemed to have violated the law against champerty as the statutory prohibition was not intended to bar the pursuit of litigation by a party that has a substantial interest in the matter prior to the assignment of the legal claim to it.
This interpretation arose from litigation concerning a commercial mortgage banking securitization in which the “Trust” – representing the holders of the certificates of the Merrill Lynch Mortgage Investors in a pool of mortgage loans secured by the underlying mortgages – sued UBS (the successor in interest to Paine Webber Real Estate Securities Inc., which provided the original financing for the mortgage loans), alleging that some of the loans were in default at the time of purchase and that Paine Webber (and thus UBS as its successor) had breached representations made in the Mortgage Loan Purchase Agreement (MLPA). In particular, the Trust contended that the “Arlington” loan was in default at the time of sale due to acts of fraud on the part of the borrower. The sale of a loan that was in default at the time of the closing would be a breach of Paine Webber’s (UBS’s) representations and warranties under the MLPA. [Note: The federal district court that held that the assignment was void due to champerty noted that it was “undisputed” that the principals in Arlington had used forged documents and false statements to obtain the loan. Although the loan’s originator and first seller to Paine Webber – Love Funding – was unaware of the fraud when the loan was made, the loan was in technical “default” at the time of the sale under the terms of the MLPA. Had the original seller – Love Funding – been asked by the purchasers of the loan – Paine Webber and UBS as successor – it would have been obligated under the terms of its MLPA to cure the default or repurchase the loan, indemnifying the purchaser for all related costs and expenses due to the default.]
After more than two years of intense and expensive litigation (characterized by the federal district court as “scorched earth litigation” involving one federal court, two Texas state courts and a New York state court; seventy or more attorneys located at ten separate law firms; and tens of millions of dollars in legal fees), the Trust and UBS reached a settlement. UBS paid the Trust over $19 Million to be released from further litigation over the sale of loans in the portfolio. However, with respect to the Arlington loan there was no monetary settlement. Instead, UBS assigned all of its rights under the MLPA with Love Funding, the originator of the Arlington loan, as sole consideration for its release from all claims made in the litigation between the Trust and it.
Armed with the assignment, the Trust demanded that Love Funding (the originator of the Arlington loan) either cure its breaches under the MLPA or pay $10 Million to settle the claim. The Trust also commenced an action in the Supreme Court of New York County alleging that Love Funding had breached the MLPA by representing that the Arlington loan was not in default at the time of closing.
The action was removed to federal court. Love Funding raised the defense of champerty against the claims of the Trust. The U.S. District Court for the Southern District of New York held that since the Trust had accepted the assignment of the Love Funding MLPA for the primary purpose of bringing a lawsuit against Love Funding, the assignment was void for champerty. Therefore, the Trust was not entitled to any award of damages.
The Trust appealed and the United States Court of Appeals for the Second Circuit decided that resolution of the Trust’s appeal depended on significant and unsettled questions of New York law. The Second Circuit certified three questions to the New York Court of Appeals concerning the scope of the prohibition against champerty of which the Court of Appeals answered two in the negative and determined that the first question need not be answered. The statute in question – New York Judiciary Law §489(1) – basically provides that a corporation or association may not buy or take an assignment of a note, other thing in action or any claim “with the intent and for the purpose of bringing an action or proceeding thereon.”
The Court of Appeals opined that the champerty statute does not apply when the purpose of an assignment of a legal claim is the “collection of a legitimate claim.” Applying that reasoning to the facts of the present dispute, the Court of Appeals noted that the Trust. as holder of the Arlington loan and the entity that would suffer damages of any default on the loan, had a pre-existing proprietary interest in the loan and that if the Trust’s purpose in taking the assignment of Paine Webber’s/UBS’s rights under the Love Funding MLPA was to enforce its rights, then “as a matter of law, given that the Trust had a pre-existing proprietary interest in the loan, it did not violate the Judiciary Law §489(1).”
The Court of Appeals also responded to the Second Circuit’s request to clarify the champerty doctrine to certain facts presented in the case. The district court had found that the Trust’s intent to sue Love Funding was to recover an amount greater for its losses on the Arlington loan than the amount it had demanded in settlement. Moreover, the district court noted that the Trust believed that Love Funding could be made to indemnify the Trust for a portion of its legal fees incurred in connection with its litigation with UBS, its lawsuit related to a foreclosure action against the Arlington loan, and related actions against the Arlington borrowers. The district court concluded that the intent of the Trust in suing Love Funding was not simply to be made whole on losses it sustained from the Arlington loan default, but also to “profit” from past litigation – a purpose the district court found consistent with champerty.
The Court of Appeals dismissed these findings as irrelevant to the evaluation of a charge of champerty. The Court noted that there were no New York cases holding that it is champerty to acquire indemnification rights for costs and expenses incurred in prior legal proceedings as a part of any settlement. The Court also noted that there was were no New York cases standing for the proposition that it is champerty to settle a dispute by accepting a transfer of rights that has the potential for a larger financial recovery than the amount the same party demanded as part of a cash settlement. Thus the Court of Appeals dismissed the idea that any profit motive involved in accepting the assignment of a legal cause of action should be viewed as an act of champerty.
Evaluation
This response by the Court of Appeals to the certified questions posed by the Second Circuit should be seen as a positive development from the perspective of those involved in the securitization of loans and other debt obligations. It clarifies that the mere assignment of a cause of action will not sustain a charge of champerty, provided that the assignee – including a trust representing the certificated holders of a particular pool of loans – has a proprietary interest in the substance of the matter assigned, if the interest existed prior to the assignment of the right to pursue a legal claim or cause of action. It would seem that a trust that represents the holders of certificates issued to investors in a pool of securitized loans will always have a proprietary interest in any individual loan that is a part of the pool and that such an interest will pre-date the assignment of any cause of action that a trust may seek in an attempt to recoup losses sustained by the investors. Moreover, the fact that the assignee of a claim might obtain a larger financial recovery then the assignee demanded as part of a cash settlement by commencing the lawsuit is irrelevant to the analysis of whether an act of champerty has been committed.
See Trust for the Certificate Holders of the Merrill Lynch Mortgage Investors, Inc. et al, Appellant v. Love Funding Corporation Respondent, Court of Appeals Opinion dated October 15, 2009 # 123, 2009 NY Slip Opin. 7323, 2009 NY LEXIS 3862. Prior history: See 556 F.3d 100; 2009 U.S. App. LEXIS 7643 (2nd Circuit 2.13.09); 496 F.3d 171, U.S. App. LEXIS 18237 (2nd Cir. N.Y. 2007); 499 F. Supp. 2d 314 (S.D.N.Y. 2007); 2007 U.S. Dist. LEXIS 13566.
Grace Sterrett is a partner in the New York office of Hudson Cook, LLP. Basis Points readers can reach Grace at 518-383-9440 or by email at gsterrett@hudco.com.