An investment firm that agreed to buy distressed notes and hand over to the sellers most of the proceeds from litigation over the notes while keeping a share for itself may be engaged in champerty, a Manhattan commercial division judge has ruled, though she has ordered more discovery into the issue.

In an Aug. 15 ruling in Justinian Capital v. WestLB, 600975/10, Supreme Court Justice Shirley Kornreich (See Profile) ruled that if the plaintiff, Justinian Capital SPC, had bought distressed debt with the sole purpose of making mon-ey from litigation, the arrangement would be cham-perty under New York law. However, she said that there are “clearly questions of fact surrounding Justinian’s actual purpose and intent…that require further discovery to resolve.”

Justinian, according to the complaint, is the holder of two series of Class B notes issued by two special purpose vehicles sponsored by WestLB AG, a German bank. The special purpose vehicles have collapsed and the notes lost value. Justinian sued WestLB in 2010 alleging breach of contract, fraud, breach of fiduciary duty, negligence and unjust enrichment, among other things. Justinian was originally represented by Reed Smith, but Kornreich disqualified that firm because of conflicts in May 2011. It is now represented by Grant & Eisenhofer.

WestLB moved to dismiss on various grounds, among them that Justinian’s suit was champerty.

Champerty, a concept that originated in English common law, refers to an arrangement in which a party buys an interest in litigation, bearing the costs of the litigation but sharing in any gains arising from it.

In New York, champerty is prohibited by Judiciary Law §489(1), which says: “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.”

In last week’s decision, Kornreich noted that the concept of champerty has been treated narrowly by New York courts, citing Bluebird Partners v First Fidelity Bank, 94 NY2d 726, 733, a 2000 Court of Appeals case.

The court in Bluebird explained that champerty “has been limited to encompass not the purchase of a claim with intent to bring suit but, rather, the purchase of a claim for the sole purpose of bringing suit,” Kornreich said. “This is so because, as Bluebird Partners notes, the ancient prohibition of champerty must be reconciled with modern financial transactions,” in which distressed debt is frequently bought and sold and litigation is often likely.

Kornreich said that interpreting champerty too broadly would create a perverse incentive for issuers of distressed debt to publicly announce their intent to default, so that any party that purchased the debt would be “vulnerable to a charge of champerty.”

Nonetheless, Kornreich said that she believed that Justinian’s arrangement might be champerty.

Justinian agreed to pay the sellers of the notes $500,000 plus 80 to 85 percent of any recovery from litigation, meaning that it was effectively remitting most of the value of the notes it bought back to the sellers after completing the litigation and keeping only a small share for itself. The arrangement, Kornreich said, gave the appearance that the noteholders were “subcontracting out this litigation to Justinian.”

“The relevant inquiry is whether Justinian bought the instruments as a bona-fide investment (which would properly include the ability to enforce rightsthrough litigation) or if the purchase was merely pretext for conducting litigation by proxy in exchange for a fee,” the judge said. “The latter is classic champerty.”

“While allegations of champerty have been rejected in similar cases, this case appears to be unique,” the judge said. “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.”

Kornreich has stayed all discovery in the case except on the issue of champerty.

Grant & Eisenhofer director James Sabella, counsel to Justinian, could not be reached for comment.

Hughes Hubbard & Reed partner Marc Weinstein, counsel to WestLB, also could not be reached.