In a pair of decisions that may either frustrate or appease monoline insurers that covered residential mortgage-backed securitizations, Manhattan Supreme Court Justice Shirley Kornreich dismissed claims for fraud in one case while limiting damages in another case to loans that didn’t conform to a contract’s terms.
The rulings in Assured Guaranty v. DLJ Mortgage Capital, 652837/2011, and Assured Guaranty v. Deutsche Bank Structured Products, 650705/2010, were issued on Monday. Both involve RMBS transactions for which Assured, one of the largest monoline insurers in 2006 and 2007 before the subprime mortgage crisis, guaranteed revenue to investors.
Due to the large number of defective mortgage loans serving as the underlying collateral, Assured says it was exposed to a steep number of current and future policy claims. It sued for fraud and breach of loan representations and repurchase obligations against DLJ and Credit Suisse and breach of loan warranties and the repurchase protocol against Deutsche Bank.
Noting that the July 3 decisions were meant to be “read together,” Kornreich handed Assured—represented here by different firms—both a setback and some level of vindication. However, she did not allow either the insurer or banks off the hook for the risks they assumed in entering into transactions that precipitated the 2008 financial crisis.
In Assured v. Deutsche Bank, the judge continued the state and federal judges’ steady march towards permitting loan sampling to compute damages—a method that’s been challenged by defendant banks to little avail.
The repurchase, or put-back, action involves Deutsche’s alleged breach of contract in refusing to buy back loans from Assured that failed to meet the bank’s representations and warranties. Kornreich granted partial summary judgment to Deutsche by holding that Assured’s sole remedy is recovery of damages for non-conforming loans only.
“Assured’s ability to recoup claim payments via the put-back mechanism cannot be used as a means to also recover claims paid attributable to conforming loan defaults caused by a market crash—the very risk it insured and for which it collected premiums,” she wrote.
The judge, however, held that Assured can recover all-nonconforming loan losses and that a sampling of one slice of the portfolio where loans were breached gave Deutsche adequate notice of its obligation to repurchase such loans.
During April 8 oral arguments, Assured’s attorneys pointed to the consistent line of holdings on this issue, according to a transcript of the hearing.
“Every single case at the state court level and at the federal court level has held there is constructive notice that has been shown based upon disclosures of the basic breaches,” Erik Haas, a partner at Patterson Belknap Webb & Tyler, told the court. “Every single case.”
Kornreich denied Assured rescissory damages, but said it was entitled to be reimbursed for costs and legal fees per its insurance and indemnity agreement with Deutsche Bank. In a footnote to her decision, the judge criticized sponsoring banks’ “lack of respect” for the repurchase protocol” (in her other ruling, she called this practice “galling”) and urged banks to assure investors that when loans they sponsor fail to conform, they “will promptly make good on their repurchase obligations without the need to resort to litigation.”
RMBS cases, whether insurer or investor-led, have become among the most expensive to litigate in the Commercial Division, due to heavy motion practice, quantity of discovery, valuation required of experts and frequent intermediary appeals to the higher court.
In May 2012, Deutsche and Assured entered into a partial settlement narrowing claims and defenses. Deutsche is also suing Greenpoint Mortgage Funding, the originator of the loans, in a third-party complaint for breach of contract and indemnification.
Lead counsel for Deutsche is James Brandt, a partner at Latham & Watkins. Brandt and Patterson’s Haas declined to comment on the ruling. Greenpoint is represented by Murphy & McGonigle.
In the other ruling, the issue before Kornreich was a motion to dismiss fraud claims filed by Assured against DLJ Mortgage, as loan originator, and Credit Suisse, as loan underwriter, in an amended complaint.
The judge dismissed such claims as rescissory damages and breach of committment and engagement letters in an Oct. 2012 ruling. Assured, represented in this action by Quinn Emanuel Urquhart & Sullivan, filed an amended complaint in October 2013 to reflect new information gleaned in discovery.
“Defendants routinely turned a blind eye to known defects, in return for price breaks on mortgage loans, and did so on the ‘down low’—again, according to their own internal communications—so that the loans could be securitized without investors or insurers noticing their defects,” Philippe Selendy, a partner at Quinn Emanuel and lead counsel for Assured, argued in court papers.
Yet Assured did not prevail on its fraud claims. Kornreich minced no words when discussing the insurer’s failure to guard against risk in a 24-page decision that included 27 footnotes and extensive discussion of monoline case law, including Kornreich’s past rulings in the MBIA v. Countrywide cases and MBIA v. Credit Suisse.
“It is not Credit Suisse’s job to conduct Assured’s due diligence,” she wrote. “Moreover, Assured, a sophisticated financial insurance company, is supposed to decide for itself the relevant universe of risk it deems to be material to diligence before issuing insurance. And Assured did just that.”
She continued, “Assured made the business decision to forgo conducting a thorough investigation of the state of the origination market and, instead, relied on warranty protection as a cheap proxy that it hoped would correlate to all origination risk.”
“Reasonable minds may disagree about whether this was a prudent strategy,” she wrote. “In hindsight, Assured’s decision looks terrible. But hindsight is irrelevant.”
Kornreich’s ruling on the fraud claims, which Quinn Emanuel is expected to appeal, underscores the tenuous viability of RMBS fraud claims in suits between highly sophisticated parties—court rulings have been mixed on the issue. As the judge noted, the “prophylactic provision rule is controversial,” which bars a fraud claim in the absence of such a provision, as held by the Appellate Division, First Department in ACA Financial Guaranty v. Goldman Sachs, 106 AD3d 494 (1st Dept. 2013), a case that will be heard by the Court of Appeals.
“Nonetheless, if the prophylactic provision rule does not apply here,” Kornreich wrote in Assured v. DLJ Capital, “it is hard to see how it is ever applied.”
Additionally, Kornreich denied Assured’s motion to compel production of documents relating to Credit Suisse’s credit default swap transactions but said since the bank has a contractual obligation to make a repurchase analysis, such documents relating to that are discoverable.
She denied Credit Suisse’s motion to compel Assured turn over documents relating to its internal RMBS policies and procedures and understanding of the risk of transactions, holding they were irrelevant in light of the fraud claim’s dismissal.
The judge noted that despite her findings on fraud, the case is “very much a viable breach of contract action.”
John Ansbro and Richard Jacobsen, partners at Orrick, Herrington & Sutcliffe, are lead counsel for DLJ and Credit Suisse. The attorneys did not respond to requests for comment.