A recent Second Circuit decision could have significant ramifications for banks and other financial institutions attempting to manage litigation flowing from the credit crisis and manage exposure via the distressed debt market. The case, Trust for the Certificate Holders of the Merrill Lynch Mortgage Investors, Inc. Mortgage Pass-Through Certificates v. Love Funding Corp. ("Love Funding")1 bears close attention as proceedings now move to New York State's highest court, the New York State Court of Appeals.

The central issue in Love Funding is whether an assignee of certain contractual rights may be barred from pursuing remedies on those rights under a New York law which codified the old English law relating to "champerty." Champerty was aimed at preventing persons from buying and selling litigation claims simply as a way of obtaining costs and attorneys' fees (which under English law may be shifted on to the losing party). As codified in New York Judiciary Law § 489(1), a company may not "solicit, buy or take an assignment of … any claim or demand, with the intent and for the purpose of bringing an action or proceeding thereon." Ten years ago, the Second Circuit, applying New York law, held that champerty did not apply to the purchase of sovereign debt at steep discounts with the intent of demanding full payment coupled with the threat of litigation.2 Now the reach of that ruling – which had been thought to lay to rest champterty as a defense to debt purchase claims – has been called into question.

Assignment of a Claim As Part of a Settlement

Love Funding involved a dispute over mortgage-backed securities. Love Funding, an originator, entered into a conduit lending arrangement with Paine Webber Real Estate Securities Inc. (which later became part of UBS). In the mortgage-loan-purchase agreement (the "UBS MLPA"), Love Funding represented that none of the underlying mortgage loans were in default. In the event that representation was untrue as to any loan, Love Funding was to buy back the loan and otherwise indemnify the bank against any claims arising from the breach of that representation (and against fees and costs associated with such claims).

Among the loans covered by the UBS MLPA was a mortgage secured by a Louisiana apartment complex (the "Louisiana mortgage"). The Louisiana mortgage, together with over 30 other Love Funding mortgages, was then assigned and sold by PaineWebber to Merrill Lynch under another mortgage-loan-purchase agreement (the "Merrill Lynch MLPA"). In the Merrill Lynch MLPA, PaineWebber provided representations parallel to those provided by Love Funding in the UBS MLPA. Merrill Lynch placed the mortgages into a trust which then sold certificates to investors.

When the Louisiana mortgage went into foreclosure proceedings, a Louisiana state court noted in passing that the mortgage had been procured by fraud, which meant that the loan had been in default from the outset. The Trust sued UBS under the Merrill Lynch MLPA with respect to 33 loans (including the Louisiana mortgage) claiming breach of the representation regarding no loans having been in default.

After what the court termed "scorched earth litigation," UBS and the Trust agreed to settle the case. With respect to 32 loans UBS paid $19.375 million, and with respect to the Louisiana mortgage, the Trust received an assignment of UBS's rights as against Love Funding under the UBS MLPA, including the right to attorneys' fees and costs (the "Assignment").

The Trust then sued Love Funding on its representation regarding the Louisiana mortgage. Love Funding asserted a defense of champerty. The lower court ruled for Love Funding, pointing to the lack of other consideration for the Assignment and communications between the parties about the value of the potential claim against Love Funding on the Louisiana mortgage. Thus, the lower court found that the primary purpose of the Assignment was for the Trust to purchase a lawsuit against Love Funding, which it held was sufficient intent to violate New York's anti-champerty law.3

New York Law is Found to be Less Than Clear

On the Trust's appeal, the Second Circuit reserved decision. The court found that its prior decisions, including Elliot Associates, had not addressed facts like this.4 Moreover, the court had observed in Elliot that § 489 appeared to "forbid essentially all 'secondary' transactions in debt instruments where the purchaser had an intent to enforce the debt obligation through litigation."5 But the court there held that New York cases, while not consistent, did not support such a broad reading. Since Elliot intended to pursue payment before suing it lacked the intent crucial to a finding of champerty. Thus, under Elliot a mere intent to sue was not itself champertous.6

Here, the Trust had an interest in the loans which Love Funding had transferred under the UBS MLPA, but lacked the contractual privity to sue Love Funding directly. That is, although the Trust had an interest in collecting on a debt (i.e., Love Funding's obligations under the UBS MLPA), it had to "buy" that potential lawsuit by settling with UBS to acquire the contractual right to sue Love Funding. The court found New York law unclear on whether "an intent to acquire a lawsuit in such circumstances" constitutes champerty.7 The court then invoked a procedure under which it certified to the New York State Court of Appeals three questions of New York law8 which, to the extent answered, could then be applied to the Trust's appeal:

(1) Is it sufficient as a matter of law to find that a party accepted a challenged assignment with the "primary" intent proscribed by [the New York champerty law], or must there be a finding of "sole" intent?

(2) As a matter of law, does a party commit champerty when it "buys a lawsuit" that it could not otherwise have pursued if its purpose is thereby to collect damages for losses on a debt instrument in which it holds a pre-existing proprietary interest?

(3a) As a matter of law, does a party commit champerty when, as the holder of a defaulted debt obligation, it acquires the right to pursue a lawsuit against a third party in order to collect more damages through that litigation than it had demanded in settlement from the assignor?

(3b) Is the answer to question 3(a) affected by the fact that the challenged assignment enabled the assignee to exercise the assignor's indemnification rights for reasonable costs and attorneys' fees?

Implications

Love Funding could greatly complicate the ability of banks and other financial institutions to manage litigation flowing from the credit crisis and exposure via the purchase and sale of debt. The Assignment at issue in Love Funding was part of an integrated settlement, and there is no finding on what the Assignment would have been worth if divorced from the money paid to settle the claims on the other loans. Moreover, as noted by the Second Circuit, the Trust always had an interest in the contractual representation regarding whether loans were in default, it just lacked the contractual right to sue Love Funding on that representation. There was, however, no doubt that Love Funding faced potential claims from someone (i.e., UBS). If the assignment of claims as part of settlements creates issues under New York law, it could become much harder to manage and resolve such claims.

Similarly, given that litigation, including in bankruptcy proceedings, is often the only method for resolving the value of defaulted debt, Love Funding adds additional risks for distressed debt purchasers to consider in buying such obligations, and also creates potential fact issues relating to the intent of the parties that could affect the pricing of distressed debt. This case bears close attention by banks and other financial institutions as the certification to the New York Court of Appeals proceeds.