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 (See Profile) 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 a claim’s litigation costs in exchange for receiving a share of the proceeds.

Justinian Capital, a company formed in the Cayman Islands that billed itself as a “unique asset management business,” 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 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 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, which was filed in September 2010. The court first discussed the champerty argument in an Aug. 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.

“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,” she added.

On Sept. 18, 2013, Hughes Hubbard & Reed filed a renewed motion to dismiss on champerty grounds, based on newly produced documents such as the sale and purchasing agreement between Justinian and WestLB.

The firm pointed out that under the arrangement between DPAG and Justinian, DPAG retained control over the type of law firm that could be appointed to prosecute claims—it had to be on The National Law Journal’s 250 top law firm list or AmLaw 200—plus it had the right to object to proposed settlements and disbursements of any recovery in the litigation.

The firm also attached as an exhibit marketing materials Justinian issued to prospective clients, advertising its practice of capitalizing on “confrontational opportunities arising from the growing number of failing investment vehicles.”

“The plaintiff is a kind of litigation funder,” said Christopher Paparella, a partner at Hughes Hubbard & Reed, in an interview. “It was obvious when I read the agreement that they had a champerty agreement.”

In her recent decision, Kornreich distinguished this case from non-champertous ones by stating that while it’s permissible to acquire a claim in order to enforce a right, it’s not permissible when the sole motive is to make money by litigating it.

The judge, however, did not shy away from the opportunity to point out the potentially important role such “vulture funds” can play in these types of lawsuits which allege misdeeds by investment managers who peddled mortgage securities in the run-up to the housing crisis.

“If not for Justinian, many legitimate financial crisis lawsuits would simply not exist for reasons having nothing to do with their merits,” she stated. “That being said, it is for the Legislature, and not this court, to determine sound financial policy, an issue on which reasonable minds can surely disagree.”

Paparella said the decision was significant. “It provides some very good guidance to lawyers and business people in New York as to what constitutes champerty and what doesn’t,” he said. “I think that’s of particular importance given the growth of litigation funding in New York and America in general.”

James Sabella, a director at Grant & Eisenhofer, said an appeal of the decision is “likely.”

“I think what the justice did really undermines what the Legislature was trying to do when it amended the champerty statute a few years ago,” he said. “I think the legislature intended to exempt large commercial transactions in distressed debt from the reach of the statute and I think that she undercut that. We disagree with her view in terms of how to apply that statute.”