Judge Dismisses MBS Case on Champerty Grounds

A shell company that sought to profit from a failed investment portfolio built on mortgage-backed securities has no standing to sue the investment manager because its motive for suing violates New York’s champerty doctrine, a Manhattan state court judge ruled.

The Feb. 24 decision by Justice Shirley Kornreich in Justinian Capital v. WestLB AG, 600975/2010, marks a rare occasion in which a New York court found alleged conduct to be champertous, which occurs when a third party bears the expense of litigating a claim in exchange for receiving a share of the proceeds.

The plaintiff in this case was Justinian Capital, a company formed in the Cayman Islands that billed itself as a “unique asset management business.” It sought to take advantage of the distressed debt market by pursuing financial crisis litigation on behalf of another party.

Justinian was not the original holder of the mortgage notes at issue in the underlying transaction. Those notes were originally held by German bank Deutsche Pfandbriefbank AG (DPAG), which in 2003 had invested about 180 million euros in two special purpose companies that were set up by investment manager WestLB.

After suffering losses on these investments following the U.S. housing crisis, DPAG decided not to sue WestLB, to avoid a political and business conflict. The German government partially funds the bank and partially owns WestLB.

That’s when Justinian entered into the picture, bringing breach of contract and fraud claims against WestLB pursuant to a sale and purchase agreement brokered in 2010.

According to WestLB’s counsel at Hughes Hubbard & Reed, the arrangement was a sham: Justinian did not actually purchase the underlying notes but was subcontracted to pursue litigation as DPAG’s proxy in exchange for a 15 percent contingent fee. In other words, it only held a 15 percent stake in the litigation despite its alleged purchase of all notes.

Justinian was initially represented by Reed Smith until the firm was disqualified by the court due to a conflict of interest. The substituted counsel, Grant & Eisenhofer, argued that its client was protected from a champerty affirmative defense by the safe harbor provision, which the New York Legislature enacted in 2004 to protect transactions involving securities that have a purchase price of at least $500,000.

Justinian argued that since its sale and purchase agreement with WestLB listed a purchase price of $500,000 each, the safe harbor provision was invoked. However, Kornreich noted that even if the agreement cited this threshold amount, the exclusion did not apply, since Justinian never paid this amount, nor had the assets to pay it.

Kornreich’s decision dismissing with prejudice all claims in this case is predated by a number of procedural developments in this action, first filed in September 2010. The court first discussed the champerty argument in an August 15, 2012 decision in which the judge stayed all discovery except that related to the defense’s champerty claim.

“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,” Kornreich stated at the time. “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,” she continued.