Bear Stearns’ failure to inform the company insuring a $1.2 billion portfolio of mortgage-backed securitizations about “significant problems” in the loan collateral pool could signal a contractual breach that supports a fraud claim, a Westchester County Supreme Court judge has ruled.

In a May 6 decision, Westchester Commercial Division Justice Alan Scheinkman (See Profile) dismissed without prejudice MBIA Insurance’s $168 million fraud action against J.P. Morgan as successor-in-interest to Bear Stearns, whose 2008 collapse was tied to subprime mortgage lending.

MBIA alleges that Bear Stearns doctored due diligence reports prepared by a third party to conceal inherent problems in the collateral pool surrounding a 2006 securitization. MBIA says it relied on these misrepresentations when issuing its insurance policy.

In his 41-page decision in MBIA Insurance v. J.P. Morgan Securities, 64676/2012, Scheinkman said there was evidence to support the claim that Bear Stearns manipulated the reports by Mortgage Data Management Corp., but there was “absolutely no evidence that anyone at MBIA as much as glanced at the content of the spreadsheet” which allegedly omitted loan characteristics such as poor credit and compliance grades.

While he granted J.P. Morgan’s summary judgment motion for dismissal, the judge left the door open for this case to head to trial by allowing MBIA to move for leave to amend its complaint within 20 days to plead new claims of fraudulent concealment and violation of Insurance Law Section 3105.

“There is evidence in this record that may support the imposition of a duty on the part of Bear Stearns to speak as well as that would support a claim on the part of MBIA that it relied on Bear Stearns’ silence,” the judge wrote.

The decision is one of the latest in New York to address the fallout from residential mortgage-backed securitizations resulting from alleged efforts by financial institutions to unload toxic mortgages onto investors and shift risk onto insurers such as MBIA before the housing market collapsed.

The origin of this action, however, is somewhat unique. It was filed in 2012 following discovery in a separate New York County Commercial Division action, MBIA v. GMAC Mortgage, 600837/2010, over the same 2006 securitization. In the course of discovery, MBIA counsel at Quinn Emanuel Urquhart & Sullivan learned that the original due diligence report had been altered to conceal the fact that one-third of the loans in a sample did not comply with sponsor GMAC’s loan underwriting guidelines.

In its latter complaint, MBIA alleges that it would have forsaken any insurance agreement “had all of the information that Bear Stearns received from [due diligence provider] MDMC been in the spreadsheet provided to MBIA.” The insurer alleges that it had to make net claim payments of $168 million as of March 2012 due to $286 million in losses stemming from that transaction.

GMAC’s bankruptcy in 2012 led to a settlement of the initial MBIA v. GMAC case, according to lawyers familiar with the action.

In its motion for summary judgment, J.P. Morgan’s counsel at Greenberg Traurig argued there was no evidence showing MBIA, a “sophisticated and experienced insurer of RMBS securitizations,” relied on these due diligence reports to competitively bid on and ultimately issue a financial guaranty policy.

“To the contrary, the record shows that the due diligence results did not matter to MBIA,” its brief stated.

Lead counsel for MBIA is partner Peter Calamari of Quinn Emanuel. Lead counsel for J.P. Morgan is Richard Edlin of Greenberg Traurig. The attorneys declined to comment on the ruling.

Scheinkman, who heard oral arguments on this motion in November 2013, devoted considerable space in his ruling to the factual time frame in this case as established by various affidavits, such as when Bear Stearns initially received the due diligence report from MDMC; the nine-day delay that ensued before Robert Durden of Bear Stearns passed on this report to MBIA; and the hurried consummation of the insurance agreement following this chain of events.

The judge made clear he did not think it was just Bear Stearns that may have cut corners. He highlighted the fact that basic steps a person conducting a due diligence review might take did not occur, such as making a computer entry that the document had been reviewed or sending an email alert to someone else that the review was complete. While the judge noted that Lauren Desharnais, the MBIA employee responsible for coordinating this due diligence review, was on a flight the day the reports were received, he wrote, “Given the proliferation of emails on this deal and in the business generally, the court finds it peculiar that no email has been identified which would indicate that Desharnais or anyone at MBIA had reviewed the Durden email.”

Still, the failure on MBIA’s part to demonstrate it had relied on Bear Stearns’ allegedly doctored reports to its detriment was not fatal to the case, as Scheinkman provided a new road map for MBIA to follow for its amended complaint.

Indeed, such alternate theories of liability were first introduced by MBIA counsel in its opposition to J.P. Morgan’s motion for summary judgment. Scheinkman said that the fact these claims were not pleaded in the complaint did not defeat their admissibility.

In addition to considering the merits of a possible insurance law claim, the judge cited a string of appellate authority to acknowledge the plausibility of a fraudulent concealment claim. He stated that the relationship between MBIA and Bear Stearns could be held as “contractual” and that under the “special facts” doctrine, Bear Stearns could have had a duty to disclose “special knowledge not available to MBIA” which would have rendered the transaction unfair.

In other words, MBIA can pursue a fraud claim based not on what Bear Stearns submitted in these reports, but based on what Bear Stearns did not state throughout the entire due diligence process.

“We are pleased that the court’s opinion allows us to amend our complaint and to continue to present our case seeking recovery of our damages from JP Morgan’s misconduct in connection with this transaction,” MBIA spokesman Kevin Brown said.