CLI Editor’s Note: This column originally appeared in the New York Law Journal’s Litigation Special Report on July 14.
Several recent New York cases involving securitized-mortgage trusts have dealt setbacks to the trusts seeking to enforce contractual rights against the sellers of the mortgages for breach of warranties. See, e.g., Lehman XS Trust, Series 2006-4N, by U.S. Bank, as Trustee v. Greenpoint Mortgage Funding, 2014 WL 108523 (S.D.N.Y. 2014); Home Equity Asset Trust 2007-1 v. DLJ Mortgage Capital, 2013 WL 6997183 (N.Y. Sup. Court, Jan. 15, 2014); Home Equity Asset Trust 2006-5 (Heat 2006-5) v. DLJ Mortgage Capital, 2014 WL 27961 (N.Y. Sup. Court, Jan. 3, 2014); ACE Securities v. DB Structured Products, 977 N.Y.S.2d 229, 112 A.D.3d 522 (1st Dept. 2013) (reversing denial of motion to dismiss by the trial court); Nomura Asset Acceptance Corporation Alternative Loan Trust, Series 2005-S4, by HSBC Bank USA, as Trustee v. Nomura Credit & Capital, 2013 WL 2072817 (N.Y. Sup. Ct. May 10, 2013). Almost unanimously, the courts have been holding that such suits by the trusts are barred by the applicable six-year statute of limitations on breach of contract actions despite contractual language that purports to establish the accrual of the claims not at the time the warranties are made but at a later period. To the extent the decisions are upheld on appeal, they may signal the tail end of the exposure faced by the sellers of the mortgages to the trusts for breach of warranties regarding the credit quality of the mortgages sold prior to the financial crisis of 2008, the peak of sales activity and perceived abuses in connection with such sales.1
The Securitization Process
The securitization of mortgages involves the purchase of pools of mortgages from a seller that either purchases the loans from third parties or originates the loans itself. The pool of mortgages is deposited into a trust; it is securitized and subsequently resold to investors in the form of certificates. The seller of the pooled mortgages typically warrants the credit quality and several other characteristics of the underlying loans in the agreement to sell the loans, referred as the Mortgage Loan Purchase Agreement (MLPA). The MLPA sets forth the rights of the trust in the event of a breach of the warranties or representations made by the seller in connection with the loans. It typically provides that if the seller breaches a representation and “it is determined that such breach affects the value of the [loans] or the interest of the purchaser,” then the seller must either cure the breach or repurchase the affected loan. Lehman XS Trust, 2014 WL 108523 at *2. The MLPA may further provide:
Any cause of action against the Seller relating or arising out of the Breach of any representations and warranties … shall accrue as to any mortgage loan upon (i) discovery of such Breach by the Purchaser (ii) failures by the Seller to cure such Breach or repurchase such Mortgage Loan … and (iii) demand upon the Seller by the Purchaser for compliance with this Agreement.
See Lehman XS Trust, 2014 WL 108523 at *2.
Generally, the trust must give notice of the breach and allow for a certain cure period at the end of which, if no cure has been effected, the affected loan must be repurchased. After the financial crisis hit in 2008, these rights came into play often as many mortgage pools appear to have included mortgages that did not comply with the quality warranties given by sellers. In the complaints underlying many of the recent cases, the plaintiffs alleged that as high as 80 percent of the loans reviewed breached the representations made in the MLPAs. Id., Nomura, 2013 WL 2072817 at *4 (“… [the] investigation has identified material breaches of the Mortgage Representations in 510 out of the 565 Mortgage Loan Files … a whopping 91.8% failure rate.”).
The Recent Decisions
Faced with motions to dismiss grounded on statute of limitations, the plaintiffs in Lehman XS, Ace and Nomura raised arguments based on the language of clauses similar to the one cited above, that can be summarized as follows: (1) the claim did not accrue until it was discovered; (2) the parties agree in their contract that the claim would not accrue until the conditions specified in the clause above occurred; and (3) the failure to cure or repurchase is a separate breach, independent from the warranty breach, that triggers a new limitation period. Applying New York law, the courts rejected these arguments.
First, under New York law, a cause of action for breach of contract accrues, and the statute of limitation begins to run, at the time of the breach. See Nomura, 2013 WL 2072817 at *5; Structured Mortgage Trust 1997-2 v. Daiwa Finance, 2003 WL 548868 (S.D.N.Y. 2003). “Knowledge of the occurrence of the wrong on the part of the plaintiff is not necessary to start the Statute of Limitations running in [a] contract [action].” Nomura, 2013 WL 2072817 at *5 (citing Ely-Cruikshank v. Bank of Montreal, 81 N.Y.2d 399, 403 (1993)). The New York Court of Appeals applies an accrual-at-breach rule, even when the breach and injury are not simultaneous. Ely-Cruikshank, 81 N.Y.2d at 402. Applying these principles, the courts reasoned that the breaches occurred at the time the warranties are given, and not when the plaintiff discovers the wrong. See, e.g., ACE Securities, 977 N.Y.S.2d at 231. In other words, the breach that triggers the statute of limitations occurs upon the closing of the sale of the mortgages to the trust. Id.
Second, the argument that the parties agreed in their contract that the claim would not arise until a demand is made on the seller does not pass muster under New York law either. “[C]laims which are subject to a pre-suit cure or demand requirement accrue when the underlying breach occurs, not when the demand is subsequently made or refused.” Lehman XS Trust, 2014 WL 108523 at *3. Parties may not contractually adopt an accrual provision that extends the statute of limitations before any claims have accrued. Id. at *4 (citing John J. Kassner & Co. v. City of New York, 46 N.Y.2d 544, 551 (1979) and Caronia v. Philip Morris USA, 715 F.3d 417, 431 (2d Cir. 2013) for the proposition that if an agreement is made to waive or extend the statute of limitations at the inception of liability, it is unenforceable because a party cannot agree in advance to abrogate a statute founded on public policy). As the court in Nomura reasoned, the statute of limitations cannot run from the time a plaintiff chooses to seek a remedy. “To find otherwise would allow [plaintiff] to essentially circumvent the statute of limitations indefinitely deferring its demand for payment.” Nomura, 2013 WL 2072817 at *9, accord, Lehman XS Trust, 2014 WL 108523 at *4.
Finally, courts have rejected the argument that each failure to cure or repurchase defective loans after a demand is made constitutes a separate, new breach of the agreement. Nomura, 2013 WL 2072817 at *8; Lehman XS Trust, 2014 WL 108523 at *4. Courts, regard the cure provision as a remedy, which is not independent of the representations or warranties given. Lehman XS Trust, 2014 WL 108523 at *4. As such, under New York law, these remedial provisions are not recognized as separate promises that can support an independent cause of action.2 See also Deutsche Alt-A Securities Mortg. Loan Trust, Series 2006-OA1 v. DB Structured Products, 2013 WL 3863861 *10 (S.D.N.Y. 2013).
The commonality in these recent cases appears to be that the main allegations simply involved breaches of the representations and warranties in the MLPAs. A trust may not be barred, however, if the breaches of the representations and warranties can be tied to subsequent events that have a negative impact in the value of the loan or in the interest of the trust. See, e.g., U.S. Bank, as Trustee v. Dexia Real Estate Capital Markets, 959 F. Supp. 2d 443 (2013).3
Unlike the cases discussed above, the complaint in Dexia did not allege a massive failure of underwriting that tainted all or many of the representations made in an MLPA. Instead, the complaint was premised on a single loan and an underlying personal, full-recourse guaranty that was supposed to be triggered if certain conditions of the mortgaged property were not met. When the loan defaulted, and after ascertaining that the full-recourse guaranty had been triggered, the trust sued the guarantor in Minnesota state court. The Minnesota court ruled that the guaranty was not enforceable as it appears that Dexia affixed the guarantors’ signatures to a form that included the full-recourse provisions that had not been agreed by the guarantors. The trust then sued Dexia in the Southern District of New York, alleging breach of the warranty that all the documents associated with the mortgage, including the defective guaranty, were enforceable. Dexia filed a motion to dismiss, arguing that the suit was barred by the statute of limitations as it was based on warranties given more than six years earlier. The trust argued that the MLPA did not provide an immediate recourse upon the discovery of a breach of warranty. Pursuant to the MLPA, the breach needs to have a material effect on the value of the collateral to trigger recourse. That effect did not occur until the Minnesota court ruled the guaranty unenforceable. The district court agreed with the trust, denying the motion to dismiss.
The lesson to be gleaned from these cases is that sellers of the loans have a more limited exposure to damages for breach of warranties than they could have expected from the contractual language used in the sale documents. Since it may not be possible to extend the liability of the seller beyond six years from the time the representations are made, buyers will need to conduct whatever due diligence they deem necessary at early stages. This would likely increase transaction costs that in turn may affect the pricing of the securities. Equally significant, the limited exposure of the sellers may also affect the premium that insurance companies charge to insure the mortgages in the pools. Dexia, however, shows that the limitation to exposure after six years is not absolute, but may require a more targeted approach that was apparently absent in Lehman XS Trust, Nomura and ACE Securities.
Eduardo J. Glas is a partner at McCarter & English in New York, where his practice focuses on commercial law.
1. Lehman XS Trust is currently being appealed to the Second Circuit. In ACE Securities, the trust filed a petition for leave to appeal the appellate division’s decision to the New York Court of Appeals.
2. The only New York decision that has accepted this argument, other than the reversed decision of the trial court in ACE Securities, appears to be Federal Housing Finance Agency, as Conservator for the Federal Home Loan Mortgage on behalf of the Trustee of the Securitized Asset Backed Receivables Trust-2006-WM4 v. WMC Mortgage, No. 13 Civ. 0584, Dkt. No. 53 (S.D.N.Y. Dec. 17, 2013) (denying the defendant’s motion to dismiss complaint as time-barred on the ground that plaintiff pled the defendant’s failure to cure as an independent breach from the warranties). The decision appears to rely on the trial court opinion in ACE Securities, which was reversed by the appellate division. Still, the court upon further motion practice and being made aware of the reversal by the appellate division, denied a motion for reconsideration. The plaintiff has filed a motion requesting certification for appeal, which has yet to be decided.
3. Interestingly, Judge Shira Scheindlin decided Dexia and Lehman XS Trust.