Rochelle's Daily Wire

Debtors and trustees should read a Fifth Circuit opinion to understand how the sale of a debtor’s claims should be structured to prevent the sale from being champertous and void.

The debtor severely injured the creditors in an auto accident. The debtor was insured, but the policy limits would not cover all the creditors’ damages. The debtor filed a chapter 7 petition, but the bankruptcy court modified the automatic stay by allowing the creditors to sue.

The insurer refused to settle and allegedly failed to inform the debtor about the settlement discussions or the debtor’s potential personal liability if damages turned out to exceed policy limits.

At trial in state court, the creditors won a judgment for $4 million. More than the policy limits, the judgment gave the debtor a bad faith claim against the insurer.

The debtors scheduled the bad faith claim as an asset in the bankruptcy case. The trustee offered to sell the bad faith claim to the creditors for $10,000, but the creditors didn’t have the cash to buy.

Consequently, an outfit that finances litigation won bankruptcy court approval to purchase the claim for $10,000. In turn, the financer conveyed the claim to the creditors in return for a nonrecourse $10,000 loan, plus interest.

In federal district court, the creditors sued the insurer on the bad faith claim, but the district court granted the insurer’s motion to dismiss. The district court reasoned that the sale to the financer was champertous under Mississippi law and therefore void. Because the creditors had suffered no injury by not owning the bad faith claim, the district court dismissed for lack of Article III jurisdiction.

In the Fifth Circuit’s June 12 opinion, Circuit Judge Jerry E. Smith quoted the Mississippi Supreme Court for defining champerty “as a bargain between a stranger and a party to a lawsuit by which the stranger pursues the party’s claim in consideration of receiving part of any judgment proceeds.”

When the creditors appealed dismissal, the Fifth Circuit certified a question, asking the Mississippi Supreme Court to say whether Mississippi law allows “a creditor in bankruptcy to engage a disinterested third party to purchase a cause of action from a debtor.”

The Mississippi Supreme Court answered the question as follows:

This Court finds that the plain language of Mississippi Code Section 97-9-11 (Rev. 2020) prohibits a disinterested third party engaged by a bankruptcy creditor from purchasing a cause of action from a debtor’s estate.

Crabtree v. Allstate Prop. & Cas. Ins. Co. (Crabtree II), --- So. 3d ----, 2025 WL 1409047, at *1 (Miss. 2025).

Judge Smith interpreted the Mississippi court’s answer to the certified question to mean “that the assignment of [the debtor’s] claim by the bankruptcy trustee to [the financer] was champertous and void under Mississippi law.” Because the financer never acquired the claim, he said that the financer “could not have assigned it to [the creditors].”

Judge Smith therefore held that “the [creditors] have not asserted an injury caused by [the insurer] because they never acquired [the debtor’s] bad-faith claim against [the insurer].” He affirmed the district court’s dismissal of the suit for lack of Article III standing because “the [creditors] do not possess [the debtor’s] bad-faith claim against [the insurer].”

Observations

Could the trustee and the creditors have structured a valid sale by using a different structure? Would the creditors have had standing if the financer had provided financing for the creditors to buy the claim in return for a portion of the recovery?

Judge Smith quoted Mississippi’s definition of “champerty” as being a circumstance where a “stranger pursues the party’s claim in consideration of receiving part of any judgment proceeds.” If the financer were providing financing, would the financer still be a “stranger [who] pursues the party’s claim”? Would it matter whether the creditors or the financer controlled the litigation?