New York's highest court, the Court of Appeals, is rarely called upon to consider the ancient doctrine of champerty, the prohibition against financing someone else's litigation. Before Thursday, the last significant interpretation of champerty from the Court of Appeals was back in 2009, when the court issued a very narrow holding in Trust for Certificate Holders v. Love Funding.
Since then (and for reasons having nothing to do with the Love decision), litigation funding has boomed. Billions of dollars of investment capital is now deployed in commercial and personal injury cases in U.S. courts, through funds dedicated to litigation finance as well as via distressed debt investors who buy securities that carry the potential of big litigation payoffs. Much of litigation in New York state courts over mortgage-backed securities, for instance, was brought by investors who bought deeply discounted MBS notes in order to bring breach of contract claims against issuers and underwriters.
So it is significant that on Thursday, the N.Y. Court of Appeals clarified the state's definition of champerty in Justinian Capital v. WestLB AG - the first New York high court decision in more than 100 years to conclude a transaction was champertous, according to WestLB's lawyer, Christopher Paparella of Hughes Hubbard & Reed. The Court of Appeals upheld summary judgment for Paparella's client, which had been sued for fraud in connection with two special purpose vehicles. Justinian, a small, Cayman Islands-based litigation funder, brought the case against German bank WestLB after it agreed in 2010 to pay a different German bank $1 million to acquire an interest in the WestLB special purpose vehicles.
The bad news for litigation funders and distressed debt investors is that the Court of Appeals majority in Justinian concluded champerty has broad reach in New York law. The opinion rejected arguments by Justinian’s lawyers at Grant & Eisenhofer and amicus Burford Capital that champerty only prohibits lawsuits in certain circumstances, such as when the underlying claim is frivolous, the claim purchaser is suing in order to drive up its own legal fees or the suit would not have been filed but for the sale of the claim. According to the Court of Appeals, New York law expansively defines champerty as “the purchase of notes, securities, or other instruments or claims with the intent and for the primary purpose of bringing a lawsuit.”
That sounds ominous for litigation funders and distressed debt investors - but the Court of Appeals also confirmed in the Justinian decision that there is a giant loophole in New York champerty law. As the opinion explains, in the early 2000s New York’s legislature created a safe harbor for sophisticated investors. As long as the purchaser contracts to pay at least $500,000 for the underlying securities, the champerty prohibition does not apply.
The Court of Appeals’ opinion, written by Chief Judge Janet DiFiore for the five-judge majority, said the buyer does not even have to have paid the $500,000 in order to cross the threshold of the safe harbor. New York created the safe harbor in acknowledgment of the sophisticated secondary market, which doesn’t always pay cash on the barrel head to acquire securities that could be the basis of litigation. Requiring an actual payment of at least $500,000 to allow investors the protection of the safe harbor “would be overly restrictive and hinder the legislative goal of market fluidity,” the judge wrote. “Payment obligations may be structured in various forms, whether by exchange of funds, forgiveness of a debt, a promissory note, or transfer of other collateral.”
The Court of Appeals said the crucial consideration is whether the purchaser has a “binding and bona fide” agreement to pay the $500,000. In this case, the court said, Justinian didn’t meet that standard because it intended to pay off its $1 million obligation from the proceeds of the litigation against WestLB.
That is not what legislators contemplated when they created the safe harbor, the Court of Appeals ruled. “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,” Judge DiFiore wrote.
WestLB lawyer Paparella said the court’s ruling reflected the judges’ skepticism about this particular deal and won’t affect well-capitalized litigation-oriented investors who qualify for the safe harbor. If the ruling affects litigation finance, he said, it will be small players who feel it because they may not be able to commit to a binding agreement to pay at least $500,000 for underlying securities.
“A lot of people are running around trying to get into the litigation funding game, and a lot are doing it on a shoestring,” he said.
Litigation finance pioneer and sole amicus curiae in the case Christopher Bogart of Burford Capital agreed that the Court of Appeals decision will not hurt large funds like his. In fact, Bogart said in a blog post about the decision, the ruling will actually help funders like Burford because of the court's strong endorsement of the safe harbor.
“The court held that the doctrine of champerty (from ‘feudal France or merry old England’) has no application whatsoever in New York when a payment or investment exceeds $500,000, as is the case with all of Burford’s investments,” Bogart wrote.
Two Court of Appeals judges dissented from the majority opinion, mostly because they did not believe the case should have been decided on summary judgment.