Champerty Found In $209 Million Notes Purchase by Cayman Shell from German Bank

October 31, 2016

In today's Blog, we got two German banks, we got a Cayman Island shell company, we got lawyers hotly contesting a dispute in the New York State court system, and we got a feudal French legal concept that decides who wins -- not just your plain, everyday French legal concept but one going back to the days when dragons roamed the skies and way, way, way before you could get an all-day breakfast menu at McDonald's. We're talking about a time when wireless communication consisted of having your serf carry a message to someone else's serf and hoping that some guy running around the forest with a gang of so-called merry men didn't kill or capture your serf before he delivered your message. 

$209 Million Down the Drain

In 2003, Deutsche Pfandbriefbank AG ("DPAG") purchased about $209 million in notes (the "Notes") issued by two special purpose companies: Blue Heron VI Ltd. and Blue Heron VII Ltd., which were sponsored and managed by WestLB AG, New York Branch and WestLB Asset Management (US) LLC (collectively, "WestLB").  By January 2008, the Notes had lost nearly all value. Not happy with the stunning financial reversal, in the summer of 2009, DPAG's board of directors approved filing a direct lawsuit against WestLB.

The Cayman Island Shell Game

DPAG and WestLB are German banks and in 2009 each was receiving substantial financial support from the German government, which partially owned WestLB. Given the government's involvement with both banks, DPAG's Board feared that its institution of legal proceedings against WestLB could provoke the withdrawal of the government's support. That fear of reprisal motivated DPAG to consider some relationship whereby a third party would sue WestLB but remit a portion of any recovery back to DPAG.  

Towards implementing the third-party option, in February 2010, DPAG entered into discussions with Justinian Capital SPC & Co., a Cayman Islands shell company with virtually no assets.  Thereafter, Justinian proposed that it purchase the Notes from DPAG, which would essentially transfer the losses from the German bank's balance sheet to Justinian's and thereby avoid the declaration of a realized loss. Following this transaction, Justinian would sue WestLB to recover the losses and would pay DPAG a portion of the recovery in the form of a fee to be retained by Justinian.  DPAG's Board approved the proposal and the transaction concluded in April 2010.

What's A Million Bucks Between Friends?

Pursuant to the Sale and Purchase Agreement (the "Agreement"), Justinian agreed to pay $500,000 for the Blue Heron VI notes and $500,000 for the Blue Heron VII notes, both of which would be assigned to Justinian. The twist in this transaction was that the assignment was not contingent on Justinian's payment of the $1,000,000 purchase price for the Notes and the absence of said payment would not be deemed a default or breach under the Agreement. In fact, the only consequence of any failure to pay would be that interest accrued on the $1,000,000 purchase price and Justinian's 20% recovery share would be reduced to 15%.  As of October 2016, Justinian never paid any portion of the $1,000,000 and there has been no such demand by DPAG.

The Joust Begins

Days after the execution of the Agreement and just before the applicable Statue of Limitations expired, Justinian filed a Summons with Notice in New York State Supreme Court and commenced its lawsuit against Defendant WestLB.  Justinian Capital SPC v. WestLB AG, N.Y. Branch (Opinion, New York State Supreme Court, 2012 NY Slip Op 22227, 37 Misc. 3d 518 / August 15, 2012). Defendant Brightwater Capital Management LLC was dismissed from the case by the Supreme Court.

In its Complaint, Plaintiff Justinian asserted that Defendant WestLB had purchased ineligible assets for the Blue Heron portfolios, thus causing their deterioration in value and the causes of actions were breaches of contract, fiduciary duty, and the covenants of good faith and fair dealing; fraud, negligence, and negligent misrepresentation. WestLB moved to dismiss, alleging that Justinian lacked standing to bring this action. Justinian opposed the motion. In reply, WestLB raised the affirmative defense of champerty.


Let us now return to the days of yore and the arcane legal concept birthed in feudal France: Champerty. As explained in the NYS Supreme Court Opinion, champerty grew out of the practice :

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." Champerty was developed "to prevent or curtail the commercialization of or trading in litigation."

All of which now sends us into the lists of this judicial jousting, where we come upon ye olde proclamation in:

New York Judiciary Law § 489: Purchase of claims by corporations or collection agencies

1. No person or co-partnership, engaged directly or indirectly in the business of collection and adjustment of claims, and 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, 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;  provided however, that bills receivable, notes receivable, bills of exchange, judgments or other things in action may be solicited, bought, or assignment thereof taken, from any executor, administrator, assignee for the benefit of creditors, trustee or receiver in bankruptcy, or any other person or persons in charge of the administration, settlement or compromise of any estate, through court actions, proceedings or otherwise.  Nothing herein contained shall affect any assignment heretofore or hereafter taken by any moneyed corporation authorized to do business in the state of New York or its nominee pursuant to a subrogation agreement or a salvage operation, or by any corporation organized for religious, benevolent or charitable purposes.  Any corporation or association violating the provisions of this section shall be liable to a fine of not more than five thousand dollars;  any person or co-partnership, violating the provisions of this section, and any officer, trustee, director, agent or employee of any person, co-partnership, corporation or association violating this section who, directly or indirectly, engages or assists in such violation, is guilty of a misdemeanor.

2. Except as set forth in subdivision three of this section, the 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, in which event the exemption provided by this subdivision shall apply as well to all other items, including other things in action, claims and demands, included in such assignment, purchase or transfer (but only if such other items are issued by or enforceable against the same obligor, or relate to or arise in connection with such bonds, promissory notes, bills of exchange and/or book debts or the issuance thereof).

3. The rights of an indenture trustee, its agents and employees shall not be affected by the provisions of subdivision two of this section.

The Dirty Business of Making Money from Litigation

In considering the issues presented and the impact of Champerty, the NYS Supreme Court offered this observation [Ed: Footnotes omitted]:

In sum, New York draws a distinction "between one who acquires a right in order to make money from litigating it and one who acquires a right in order to enforce it." (Id. at 200.) The latter motivation is permissible; the former is not. (Id.) Intent and purpose are usually questions of fact. (Bluebird Partners, 94 NY2d at 738.) As a result, New York's champerty laws have traditionally been "limited in scope and largely directed toward preventing attorneys from filing suit merely as a vehicle for obtaining costs." (Id. at 734, citing Elliott Assocs., L.P. v Banco de la Nacion, 194 F3d 363, 372-373 [2d Cir 1999].) Given these strictures, New York courts have rarely encountered a case in which the challenged conduct was found, as a matter of law, to constitute a violation of the statute. (Bluebird Partners, 94 NY2d at 734-735 ["(t)his Court's jurisprudence demonstrates that while this Court has been willing to find that an action is not champertous as a matter of law . . . it has been hesitant to find that an action is champertous as a matter of law"] [citations omitted].) This reluctance is warranted. The financial industry is critical to New York's economy, and its courts are rightly wary of fomenting uncertainty in its vibrant secondary debt markets by exposing the purchasers of debt instruments to charges of champerty. (Bluebird Partners, 94 NY2d at 739 ["To say the least, a finding of champerty as a matter of law might engender uncertainties in the free market system in connection with untold numbers of sophisticated business transactions-a not insignificant potentiality in the State that harbors the financial capital of the world"].)

This is a particular concern in the market for high-risk distressed debt since it is the very nature of such instruments that they are likely, or even destined, to be defaulted on-thereby making litigation a near precondition to their enforcement. (Elliot Assocs., L.P., 194 F3d at 380.) Any investor purchasing them is probably doing so with the primary or sole intent of bringing an action. For this reason, it has been noted that an expansive reading of the statute's reference to the buyer's purpose would create a "perverse result" in regard to such claims. (Id. at 380-381.) Obligors on distressed instruments would be incentivized to preemptively and publicly pronounce an intent to default. Any purchaser would be vulnerable to a charge of champerty given that their purpose would necessarily be to bring a suit upon the instruments.

New York State Supreme Court

In parsing its way through the competing claims and assertions, the NYS Supreme Court decided to order limited discovery on the issue of champerty and to reserve its judgement on the pending Motion to Dismiss. As the Supreme Court explained
[Ed: Footnotes omitted]:

[D]efendants have submitted a business presentation by Justinian in which it lays out its business model as follows: (1) purchase an investment that has suffered a major loss from a company so that the company does not need to report such loss on its balance sheet; (2) commence litigation to recover the loss on the investment; (3) remit the recovery from such litigation to the company, minus a cut taken by Justinian; and (4) partner with specific law firms (such as Reed Smith) to conduct the litigation.

While allegations of champerty have been rejected in similar cases, this case appears to be unique. In fact, it appears that the court may be presented with a question of first impression: whether a company (Justinian) may partner with a law firm (Reed Smith) to purchase debt instruments where the primary motivation for doing so is to make money from the litigation. This court believes that the answer, under New York's current statutory scheme, is no.

Documentary evidence submitted by Justinian suggests that it might be subject to the safe harbor created by section 489 (2). As discussed supra, Justinian purchased the Class B Notes through the SPA, pursuant to which it was to pay DPAG $500,000 plus 80% or 85% of the net proceeds of any settlement or judgment it secured. The safe harbor provision of section 489 (2) is unavailing to Justinian because if defendants' allegations are true, the SPA is not really an agreement for the sale of the Class B Notes. If Justinian were really buying the Class B Notes, it would not be remitting the majority of their value back to the sellers. Alternatively, if Justinian were merely buying approximately 15-20% of the Class B Notes, it could not sue for 100% of the lost value caused by defendants-it would be limited to the value of its share. The sellers would be necessary parties to this action in order for a judgment to be entered in the amount of the entire loss. Instead, the SPA may be an agreement whereby the owners of the Class B Notes are subcontracting out this litigation to Justinian. If this is so, the scheme would be prohibited by champerty. If the prohibition of champerty is no longer a viable policy given the realities of the modern financial and legal climate, it would be up to the legislature, not the court, to say so.

2014 Supreme Court Dismissal

After the champerty discovery ended, the Supreme Court treated Defendant's Motion to Dismiss as a Motion for Summary Judgment and dismissed the Complaint following a finding that the Agreement was champertous. Justinian Capital SPC v. WestLB AG, N.Y. Branch (Opinion, New York State Supreme Court, 2014 NY Slip Op 24046, 43 Misc. 3d 598 / February 24, 2014). As set forth in the Supreme Court's 2014 Opinion:

No reasonable finder of fact could conclude that Justinian was making a bona fide purchase of securities. The only reasonable way to understand the SPA is that DPAG was subcontracting out its litigation to Justinian for political reasons. To be sure, the court need not definitely resolve the question of whether there was some, remote possibility that DPAG might have had a change of heart and, had the SPA not been consummated, decided to sue before the statute of limitations was set to expire later that month. This speculative inquiry is a red herring since, as this court understands the discussed Court of Appeals precedent, it is not champerty to sue on behalf of debt that you buy for yourself, but it is champerty to sue, on behalf of another and for a fee, for debt that is not really your own. The latter is litigation by proxy and prohibited by section 489. If this is not champerty, then champerty no longer exists in New York State. Such a proclamation must come from the legislature, not the courts. Accordingly, it is ordered that the motion by defendants WestLB AG, New York Branch and WestLB Asset Management (US) LLC to dismiss the complaint on the ground of champerty is granted, and the clerk is directed to enter judgment dismissing the complaint with prejudice.

2015 New York State Appellate Division Affirms

On May 21, 2015, the New York State Appellate Division, First Department, affirmed the Supreme Court's dismissal. Justinian Capital SPC v. WestLB AG, N.Y. Branch (Decision and Order, New York State Supreme Court, Appellate Division, First Department 2015 NY Slip Op 04381, 128 A.D.3d 553, 10 N.Y.S.3d 41 / May 21, 2015). Thereafter, Plaintiff Justinian appealed to the New York State Court of Appeals.

2016 New York State Court of Appeals Affirms

Although the Court of Appeals affirmed the lower courts, it did so in a divided 5:2 Opinion. Justinian Capital SPC & Co. Appellant, v. WestLB AG, & Co., et al.,  Respondents (Uncorrected Pre-Publication Opinion, New York State Court of Appeals, No. 155 October 27, 2016) [Opinion by Chief Judge DiFiore with Rivera, Abdus-Salaam, Fahey and Garcia concurring; Dissent by Stein with Pigott concurring]. 

The Court of Appeals notes that under Judiciary Law §489(1), Champerty would not apply per Judiciary Law §489(2) when "an aggregate purchase price of at least five hundred thousand dollars" is applicable.  In setting its findings apart from the lower courts', the Court of Appeals declined to find that the Safe Harbor of 489(2) required an "actual payment" of at least $500,000; but, in contrast, found that the legislative intent did not impose such a condition precedent. In providing its rationale, the Court of Appeals explained that:

[T]he safe harbor was enacted to exempt large-scale commercial transactions in New York's debt trading markets from the champerty statute in order to facilitate the fluidity of transactions in these markets (see Assembly Mem in Support, Bill Jacket, L 2004, ch 394). The participants in commercial transactions and the debt markets are sophisticated investors who structure complex transactions. Requiring that an actual payment of at least $500,000 have been made for these transactions to fall within the safe harbor would be overly restrictive and hinder the legislative goal of market fluidity. The phrase "purchase price" in section 489 (2) is better understood as requiring a binding and bona fide obligation to pay $500,000 or more for notes or other securities, which is satisfied by actual payment of at least $500,000 or the transfer of financial value worth at least $500,000 in exchange for the notes or other securities. Such understanding conforms with the realities of these markets in which 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. We emphasize that we find no problem with parties structuring their agreements to meet the safe harbor's requirements, so long as the $500,000 threshold is met, as set forth above.

Page 12 of the Court of Appeals Opinion 

In deeming the purchase of the Notes as champertous, the Court of Appeals summed up its findings in this manner:

[T]he record establishes, and we conclude as a matter of law, that the $1,000,000 base purchase price listed in the Agreement was not a binding and bona fide obligation to pay the purchase price other than from the proceeds of the lawsuit. The Agreement was structured so that Justinian did not have to pay the purchase price unless the lawsuit was successful, in litigation or in settlement. The due date listed for the purchase price was artificial because failure to pay the purchase price by this date did not constitute a default or a breach of the Agreement. The Agreement permitted Justinian to exercise the option to let the due date pass without consequence and simply deduct the $1,000,000 (plus interest) from its share of any proceeds from the lawsuit.

In sum, we hold that because the Notes were acquired for the sole purpose of bringing litigation, the acquisition was champertous. Further, because Justinian did not pay the purchase price or have a binding and bona fide obligation to pay the purchase price of the Notes independent of the successful outcome of the lawsuit, Justinian is not entitled to the protection of the safe harbor. In essence, the Agreement at issue here was a sham transaction between the owner of a claim which did not want to bring it (DPAG) and an undercapitalized assignee which did not want to assume the $500,000 risk required to qualify for the safe harbor protection of section 489 (2) (Justinian).

Pages 13 - 14 of the Court of Appeals Opinion

The Dissent objects to the majority's Opinion largely on the grounds that Summary Judgment was inapproriate because the resolution of the questions as to the transfer of the Notes and the applicability of the Safe Harbor primarily rested on determinations of intent, which required the presentation of factual issues at trial. As explained in the Dissent's concluding paragraphs:

Finally, the majority correctly notes this state's leadership role in promoting and supporting large scale, complex commercial markets and transactions, and recognizes that participants in such transactions are "sophisticated investors" (majority op at 10). However, in my view, the majority's decision discourages transactions aimed at fostering accountability in commercial dealings, generally, and, in this particular case, successfully forecloses litigation against parties that are alleged to have committed fraud against all of the investors in more than one portfolio.

In sum, resolution of the questions of whether the transaction was champertous and, if so, whether the parties' contract included a bona fide obligation for plaintiff to pay $1 million for the notes, such that the safe harbor provision would apply, requires a fact finder to ascertain the parties' intent, a determination that is inappropriate on a motion for summary judgment.

Page 10 of the Dissent

Historic video of legal proceedings from feudal times: