Legal View: Second Circuit Rejects Champerty Defense
Champerty is not a word often heard these days, even though it is a living doctrine in modern law and on occasion has real bite. In a recent case, the Second Circuit Court of Appeals reversed a trial court ruling that had dismissed a mortgage trust’s suit for indemnification for loan losses from the originator. Trust for Certificate Holders of Merrill Lynch Mortgage Investors v. Love Funding Corp., 391 F.3d 116 (C.A.2, N.Y.). However, the reasoning of the decision leaves some room for the distressed debt markets to be concerned.
Love Funding was the originator of a $6.4 million loan on a Louisiana apartment complex, funded by Paine Webber Real Estate Securities, Inc. Paine Webber included the loan as one of 36 sold to Merrill Lynch Mortgage Investors, Inc., in late 1999, which Merrill Lynch, in turn, assigned to the Trust for securitization. Love Funding and Paine Webber had each, when selling the loan, represented the loan was not then in default and provided an indemnification against any losses suffered on account of a breach of representations. In 2002, the loan went into default, and a Louisiana court determined the borrower. had secured the loan by fraud. The fraud, in turn, meant the borrower had been in default since the loan was originated – thereby breaching Paine Webber’s and Love Funding’s representations.
The Trust then sued UBS (Paine Webber’s successor) on account of the loan, among others. The litigation was settled in 2004 with the Trust returning 33 loans to UBS. UBS paid $19.375 million for 32 of the loans. However, the sole consideration for the loan at issue in this case was an assignment of UBS’s rights under the original mortgage loan purchase agreement with Love Funding. The Trust then commenced this suit for breach of representations against Love Funding.
Dismissed as “Champertous”
The federal district court granted UBS summary judgment on the breach of representation claim. However, it then allowed Love Funding to amend its answer to assert champerty as a defense, and dismissed the suit on that basis. According to a New York statute, “no corporation or association . . . shall solicit, buy or take an assignment of . . . a bond, promissory note, bill or exchange, book debt, or other thing in action, or any claim or demand, with the intent of bringing an action or proceeding thereon.” The court found that the Trust had carved out this one loan in order to acquire the lawsuit against Love Funding, from which it expected to be able to recover more than it could recover from UBS, and that the suit was therefore champertous.
Certification to the New York Court of Appeals
On appeal to the Second Circuit Court of Appeals, the court certified questions on the interpretation of the champerty statute to the New York Court of Appeals. The Court of Appeals accepted the certification, and in its ruling emphasized that champerty “has always been limited in scope and largely directed toward preventing attorneys from filing suit merely as a vehicle from obtaining costs”. Acquiring a thing in action in order to obtain costs is champertous, while acquiring it to protect an independent right of the assignee is not. For example, it is not champertous to acquire a debt instrument with the intent to collect on it by litigation. Noting that the Trust had a preexisting interest in the loan that underlies the breach of representation claim, the court states that if the Trust took the assignment of the cause of action to enforce its rights, that was not champerty under New York law.
With this clarification in hand, the Second Circuit held the evidence adduced could not support a claim of champerty. Love Funding urged that the case be remanded to the trial court for a factual determination on the Trust’s intent in acquiring the cause of action. According to Love Funding, the assignment amounted to champerty even under the Court of Appeals ruling because the Trust’s intent was not to enforce its rights under the indemnification, but to “engage in a speculative litigation venture against Love Funding to generate and recovery costs and damages far greater than its actual losses on the loan.” In support, it pointed out the Trust had originally estimated its loss on the loan at $3 million, but that it was demanding in its suit that Love Funding repurchase the loan for $10 million. The court, however, found no basis in the evidence to support a claim that the “Trust’s intent was to employ litigation to profit from the costs and fees generated therein” rather than to recover the full value of its contractual claims. Accordingly, the Second Circuit remanded for entry of judgment in favor of the Trust and a calculation of damages.
Observation
This case may raise concerns for purchasers of distressed debt. While the court noted in dicta that it is not champerty to acquire a debt instrument with the intent to collect on it through litigation, the actual decision seems to rely heavily on the fact that the Trust had a pre-existing interest in the loan and a claim against UBS, and acquired the rights against Love Funding to vindicate those interests. A third-party purchaser, however, would have no preexisting interest and would be unable to make such an argument.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. Alvin Arnold is the editor of the BDO Real Estate Monitor. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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