That huge sigh of relief you heard late last week was the secondary debt markets exhaling as the New York Court of Appeals ruled that the centuries old doctrine of champerty did not preclude the secondary holders of distressed debt from litigating to enforce their rights in connection with the debt at issue. Rather, in Trust for the Certificate Holders of the Merrill Lynch Mortg. Investors, Inc. Mortgage Pass-Through Certificates Series 1999-C1 v. Love Funding Corp. ("Love Funding),² the Court clarified and reined in the application of Section 489 of the New York Judiciary Law ("Section 489") – the so-called champerty statute – under the watchful eye of the entire financial community and the Loan Syndications and Trading Association ("LSTA") trade group. In fact, the LSTA had submitted an amicus (or "friend of the court") brief to the Court of Appeals seeking to restrict the application of champerty under New York law in order to preserve the value and liquidity provided by the secondary debt trading market. Given the applicability of New York law to many sales or assignments of debt in the secondary market, the effect of the Court's decision will have a profound impact on both the markets and the courts.

Recent History of the Champerty Doctrine Under New York Law

The doctrine of champerty has its roots in medieval law and was developed to prevent assignments of lawsuits for the purpose of initiating litigation and profiting thereby.³ In the Middle Ages, the term "champerty" referred to any "situation where someone bought an interest in a claim under litigation, agreeing to bear the expenses but also to share the benefits if the suit succeeded."⁴

Over time, the doctrine of champerty evolved to conform with, and expressly permit, certain modern transactions concerning bond and other debt transfers. To this end, New York courts have adopted a narrow view of champerty, generally limiting its application to "preventing attorneys from filing suit merely as a vehicle for obtaining costs."⁵ This narrow interpretation is embodied within Section 489, the statute codifying the doctrine of champerty, which provides, in relevant part, that:

1. No person or co-partnership ... and no corporation or association ... shall solicit, buy or take an assignment of, or be in any manner interested in buying or taking 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; ..
2. [T]he provisions of subdivision one of this section shall not apply to any assignment, purchase or transfer hereafter made of one or more bonds, promissory notes, bills of exchange, book debts, or other things in action, or any claims or demands, if such assignment, purchase or transfer included bonds, promissory notes, bills of exchange and/or book debts, issued by or enforceable against the same obligor (whether or not also issued by or enforceable against any other obligors), having an aggregate purchase price of at least five hundred thousand dollars ...
3. The rights of an indenture trustee, its agents and employees shall not be affected by the provisions of subdivision two of this section.⁶

Despite a wealth of interpretive case law following the enactment of Section 489 and its subsequent amendment in 2004, open questions remained. Earlier this year, the United States Court of Appeals for the Second Circuit certified three questions to the New York Court of Appeals concerning the limits of the preclusive effect of champerty, including one which asked whether it constitutes champerty to accept an assignment with the "primary" intent proscribed by Section 489, or whether there must be a finding of "sole" intent.

The Court of Appeal's Decision in Merrill Lynch v. Love Funding, Corp.

On October 15, 2009, the Court of Appeals issued its decision in Love Funding, holding generally that a corporation or association that takes an assignment of a claim does not violate Section 489 if its purpose in acquiring the "thing" is to collect damages by means of a lawsuit for losses on a debt instrument in which it holds a pre-existing proprietary interest.

In Love Funding, the secondary assignee, Merrill Lynch Mortgage Investors, Inc. ("Merrill"), bought a pool of mortgage loans which had been originated by Love Funding from the original assignee, UBS (formerly Paine Webber). In this second transaction, UBS provided to Merrill certain representations and warranties concerning the validity of the underlying mortgage loans, which representations and warranties were virtually identical to those which had been obtained by UBS from Love Funding. These loans were then securitized in a trust (the "Trust").

Subsequent to the UBS/Merrill transaction, it was discovered that some of the underlying loans had fraudulently been obtained by the borrowers. The Trust then commenced litigation against UBS for breaches of the representations and warranties. After extensive litigation, the parties entered into a settlement agreement. With respect to one particular loan, the so-called "Arlington Loan," the only consideration provided by UBS for the settlement was the assignment of certain of its rights against Love Funding, including indemnification rights for the costs of litigating breaches of representations and warranties under those loan agreements against Love Funding.

While UBS never made demand upon Love Funding for its litigation costs in defending against Merrill's claims, in a separate suit brought against Love Funding, Merrill sought to recover certain of those costs incurred by UBS from Love Funding. Love Funding objected on the basis of champerty, and the United States District Court agreed that the Trust's acquisition of rights to indemnification costs from UBS was champertous, since the Trust had taken those rights with the primary purpose of recovering them from Love Funding it its subsequent lawsuit.

Adjudicating the certified questions of law, the Court of Appeals declined to squarely address the distinction between "primary" and "sole" intent. Instead, the Court of Appeals focused its attention on the purpose for which the claim was brought. Reaffirming and clarifying the standard by which to assess champertous assignments, the Court of Appeals held that the intended inquiry under the champerty doctrine requires analyzing whether the "purpose" for acquiring a "thing" or "right" is to make money from litigating it, or merely to enforce it. While the former may constitute champerty, the latter does not. Looked at another way, the Court stated that "the champerty statute does not apply when the purpose of an assignment is the collection of a legitimate claim." Rather, the Court continued, the statute seeks to avoid situations where a claim is brought which "'would not be prosecuted if not stirred up ... in an effort to secure costs.'"

Notably, the Court of Appeals' clarification of the champerty doctrine is consistent with a narrow reading of an 1847 decision by the Court of Chancery in Baldwin v. Latson,⁷ which explained that the purpose of champerty is "to prevent attorneys and solicitors from purchasing debts, or other things in action, for the purpose of obtaining costs from a prosecution thereof, and was never intended to prevent the purchase for the honest purpose of protecting some other important right of the assignee."⁸

Thus, Love Funding makes it clear that, generally speaking, secondary market transfers or purchases of debt operate to transfer the "collection of a legitimate claim" from one party to another, and are thus not champertous. In so doing, and by tracing the roots of the champerty doctrine back to abusive litigation by attorneys with no interest in the underlying transaction, the Court's decision provides much needed clarity and protection to those in the business of buying and selling distressed debt.

1. Mr. Siev is a partner, and Mr. Kochman is an associate, in the New York office of Reed Smith LLP. Their commercial litigation practices focus on matters involving financial institutions and structured credit products.
2. 2009 WL 3294928 (New York Court of Appeals, Oct. 15, 2009).
3. See Bluebird Partners, L.P. v. First Fid. Bank, N.A., 94 N.Y.2d 726, 729 (2000); Elliott Associates, L.P. v. Banco de la Nacion, 194 F.3d 363, 369 (2d Cir. 1999).
4. Bluebird Partners, 94 N.Y.2d at 734.
5. Id.
6. N.Y. Jud. Law. § 489 (McKinney 2007) (emphasis added).
7. 2 Barb. Ch. 306 (1847).
8. Id. at 308.