Purchaser of Residential Mortgage-Backed Securities Sued Claiming Fraud, Negligent Misrepresentation, Aiding and Abetting a Fraud and Rescission

This action arose from the plaintiffs’ investment in residential mortgage-backed securities (RMBS) that were issued or underwritten by the defendants. The defendants moved to strike the complaint pursuant to Federal Rules of Civil Procedure (FRCP) 12(b)(1) and (6).

The complaint alleged that the defendants had engaged in improprieties in connection with “the creation, offering, and sale of certain RMBS.” The claims included “common law fraud, fraudulent concealment, and, in the alternative, negligent misrepresentation,…,claims of aiding and abetting fraud or, alternatively, a claim of rescission based on mutual mistake.”

The plaintiffs had purchased more than $243 million worth of RMBS certificates from the defendants. The plaintiffs alleged that the defendants failed to reveal in any “Offering Materials that originators systematically abandoned their underwriting standards [standards], thereby reducing the quality of loans in the securitization pool [pool] by making it less likely that borrowers would be able to repay.” They further alleged that the defendants “manipulated and failed to disclose the true results of their due diligence vendors’ [DD vendor] review of the…pools.” The plaintiffs also alleged that the defendants understated the loan to value (LTV) and combined loan to value (CLTV) ratios of the pools “by overstating the appraised values of the underlying properties.” The plaintiffs further alleged misrepresentations about the owner-occupancy status of mortgaged properties and the failure to transfer certain mortgages and notes [mortgages] to the RMBS trusts.

In the offering materials, the defendants represented that the underlying loans (loans) conform “with originators’ underwriting guidelines [guidelines] or possessed sufficient ‘compensating factors’ to justify inclusion in the securitizations.” The defendants had represented that they do their own “redundant due diligence review of loans made by the originators.” The complaint alleged that the defendants “knew that ‘the originators systematically abandoned their…guidelines,’” “ignored red flags during the due diligence process” that indicated that the loans, “neither complied with the…guidelines nor had any compensating factors.” The plaintiff contended that the defendants and their DD vendor had access to and performed due diligence on loan files and, therefore, “either knew or was reckless in not knowing that the originators had abandoned their…guidelines.”

The plaintiffs cited a Federal Housing Finance Agency (FHFA) forensic review of loans. The FHFA found that “80 percent of the loan files it reviewed ‘had not been written within the stated guidelines, or otherwise breached Defendants’ representations.” Moreover, a DD vendor report showed significant failures to comply with the “originator’s guidelines” or lacked “sufficient compensating factors to justify purchase.” Additionally, a DD vendor employee testified in an unrelated action that the vendor’s employees were urged by their supervisors, at the behest of their clients, to “approve loans that did not satisfy…guidelines and lacked compensating factors.”

As to one of the securitizations, the defendants allegedly knew that the originator had abandoned standards since the defendants had a “warehouse lending arrangement” with the originator and “were permitted to conduct loan review on-site.”

The court found that the plaintiffs had sufficiently alleged that defendants “knew facts or had access to information suggesting that their public statements were not accurate.” The plaintiffs allegations raised “a strong inference that Defendants either knew or were reckless in not knowing that their offering materials falsely stated that the loans comprising the securitizations at issue met originators’…guidelines.”

The plaintiffs had also alleged that “the originators deliberately inflated their appraisals” and that “Defendants were aware of this inflation by virtue of their own due diligence” and that such “inflated appraisals led to artificially low [LTV] and [CLTV] ratios….” The plaintiffs’ statistical study indicated that the defendants significantly understated the weighted average LTV and CLTV ratios. The plaintiffs’ “loan-level investigation also found that owner-occupancy rates in [certain] trusts were overstated by 20.2, 22, and 16.1 percent.”

The court found, however, that the allegations were insufficient “to raise a strong inference of scienter with respect to misrepresentations about LTV ratios and owner-occupancy rates.” Although the magnitude of an inaccuracy may “sometimes provide circumstantial evidence that a fraud defendant made her false statements knowingly or recklessly,” generally, “such evidence must be supported by additional circumstantial evidence in order for the plaintiff to carry her pleading burden, particularly where the originator of the false information is a third-party.”

The plaintiffs had not pleaded “sufficient facts to demonstrate that Defendants knew about the overvalued appraisals allegedly performed by the originators, or about misstatements regarding owner occupancy.” The plaintiffs had not pleaded facts showing that the defendants had “double-checked the appraisal values and owner-occupancy information provided by the originators” and the facts alleged did not “raise a strong inference of scienter with respect to these categories of alleged misrepresentations.”

The court found that the plaintiffs had sufficiently pleaded that defendants “falsely represented that the investment ratings provided by credit rating agencies” were false and that the defendants “knew that the information provided to the credit rating agencies­—­e.g., that the loans complied with originators’…guidelines—was false. To the extent that the alleged misrepresentations regarding credit ratings [were] based on” the defendants’ knowledge of the “originators’ abandonment of…guidelines,” such claims adequately pleaded scienter. With respect to misrepresentations involving the LTV/CLTV ratios and owner occupancy rates, however, the complaint did not adequately plead scienter.

The plaintiffs had also alleged that the defendants “frequently did not assign the underlying mortgages and notes to the issuing trusts, contrary to their representations.” Such allegations were insufficient to raise a strong inference of scienter and fraud claims regarding faulty transfer of mortgages and notes were dismissed.

With respect to alleged false representations as to conformance with guidelines, the defendants argued that the statements were not materially misleading since “the offering materials disclosed that originators might make exceptions to their…guidelines” and that “the inclusion in the offering materials of a ‘repurchase or substitute’ provision, under which Defendants pledged to repurchase or substitute for non-compliant loans in the mortgage pool, put Plaintiffs on notice that non-compliant loans would be included in the…pool of mortgages.” The defendants further argued that the plaintiffs failed to allege “sufficiently particularized” allegations since “they do not necessarily relate to the loans” backing the subject certificates.

Other courts had held that “such disclosures or warnings do not give notice to investors of the defendant’s ‘wholesale abandonment of…standards.’” Further, “the repurchase or substitute” provision “did not give notice that originators had engaged in a wholesale abandonment of their…guidelines.” Based on the plaintiffs’ own statistical analysis of the loans and the FHFA report, the court found that such allegations were sufficient to “raise an inference that the originators systematically abandoned their…guidelines with respect to the loans” and, “[i]n not disclosing this alleged practice, the offering materials contained material misstatements or omissions.”

Since the defendants “knew that the risk presented by the underlying loans could not be properly assessed by the rating agencies, the representation in the offering materials that credit ratings reflected credit quality was false and misleading.” Thus, the court held that the complaint sufficiently pleaded misstatements regarding credit ratings.

With respect to reasonable reliance, the court explained that the plaintiffs were not required to conduct an investigation of “loan tapes” that were available. Prior judicial precedent held that “even in the face of knowledge that many of the originators supplying loans to these [pools] engaged in dubious underwriting practices, ‘the [government-sponsored enterprises] were entitled to rely on defendants’ assertion that the loans that underlay these particular securities complied with the guidelines set out in the offering materials.’”

Moreover, the plaintiffs had alleged that they had performed “extensive due diligence before purchasing the Certificates, including analyzing ‘the quality of the collateral’ (including average FICO scores, LTV ratios, and occupancy type), the anticipated credit ratings, and the quality of the originators and servicers.” The court explained that “[g]iven that sophisticated plaintiffs are not required to ‘conduct their own audit’ in order to rely on a defendant’s allegedly fraudulent representations, the plaintiffs had alleged sufficient facts to plead justifiable reliance.”

The court rejected the defendants’ argument that the plaintiffs failed to plead “loss causation,” since they had not alleged facts, “if proven, would show that [their losses were] caused by the alleged misstatements as opposed to intervening events.” The defendants had also argued that the plaintiffs had not pleaded “cognizable damages,” since they had “not sold the Certificates on which their claim is based and,…,continue[d] to receive underlying interest payments.”

The court stated that “fraud damages equal the difference between the price paid for an asset and its true value as of the date of the sale.” The court found that the plaintiffs had adequately alleged that “the Certificates are worth far less than they paid for them and that their true value would have been much lower at the time of sale had [defendants] disclosed, inter alia, that originators had systematically abandoned their…standards.” Thus, the motion to dismiss for failure to plead cognizable damages was denied.

The court then held that the plaintiffs failed to plead facts demonstrating the special relationship which is necessary to sustain claims for negligent misrepresentation and fraudulent concealment. The plaintiffs argued that the defendants had “superior knowledge of essential facts.” However, they had failed to cite any case “involving RMBS in which a negligent misrepresentation or fraudulent concealment claim ha[d] been permitted to proceed on this theory.” Since New York courts have routinely dismissed such claims, the court dismissed such claims. The court also denied the motion to dismiss with respect to the aiding and abetting of fraud allegations.

Finally, the court dismissed the rescission claim since “the statements regarding title transfer in the offering materials were forward looking in that they contemplated Defendants’ future obligations under the contracts.” The court noted that “[t]he doctrine of mutual mistake affords equitable relief only where the parties were mistaken as to facts existing at the time the contract was entered into.” Since the plaintiffs did not plead mutual mistake as to a then existing fact, the court dismissed the rescission claim. Thus, the court granted in part and denied in part, the defendants’ motion to dismiss.

Landesbank Baden-Württemberg v. RBS Holdings USA, 12 Civ. 5476, NYLJ 1202652232036, at *1 (SDNY, Decided April 9, 2014), Gardephe, J.

Rent Stabilized Tenant Must Certify Her Household Income to Her Landlord Because the Landlord Receives Federal Low-Income Housing Tax Credits

A landlord had commenced a holdover proceeding against a rent-stabilized tenant. The salient issue was whether the income certification requirements imposed by the Federal Low-Income Housing Tax Credits (LIHTC or Act) program “conflict with Rent Stabilization Code (RSC) §2522.5[g] which requires landlords to offer renewal leases to their tenants on the same terms and conditions as their expiring leases.”

The tenant had signed a rent stabilized lease in 1985. The lease had last been renewed in 2006. In 2010, the landlord assumed ownership of the building and executed a regulatory agreement (RA) with the NYC Department of Housing Preservation and Development (HPD). Under the RA, the landlord receives “federal low-income tax credits in exchange for, inter alia, restricting occupancy of the project to low-income families for reduced rents for the next 50 years.” In December 2010, the landlord requested that the tenant certify her household income and composition to the landlord in order to permit the landlord to comply with the RA and applicable federal regulations.

After the tenant refused to do so, the landlord served a notice to cure and thereafter a notice of termination. The landlord then sought possession of the apartment on the grounds that the tenant “violated a substantial obligation of her tenancy by failing to complete the certification forms.”

After rejecting the tenant’s argument that the court lacked subject matter jurisdiction, the court reviewed the LIHTC program. Pursuant to such program, “at least 20 percent of the units must be rent restricted and occupied by households with incomes at or below 50 percent of the area median income (AMI) or at least 40 percent of the units must be rent restricted and occupied by households with incomes at or below 60 percent of AMI….” Developers are required to certify their compliance with the program’s requirements “in order to remain eligible to receive tax credits” and developers are required “to keep records of the annual income certification for each low-income tenant per unit and documentation to support each low-income tenant’s income certification….” The tenant argued that the LIHTC program requirements “do not preempt RSC §2522.5[g] which requires [the landlord] to offer a renewal lease ‘on the same terms and conditions’ as her expiring lease,” i.e., without the certification requirement.

The court found that the LIHTC program does not preempt state law since there was neither a “clear and manifest purpose of Congress” to preempt, nor was preemption implicit in the federal scheme. However, the court found that “[t]he LIHTC program and RSC are easily harmonized to require both [landlord] to issue a renewal lease to [tenant] and [tenant] to certify her income to [landlord].”

RSC §2522.5[g] provides that “a renewal lease offered to a tenant:

…shall be on the same terms and conditions as the expired lease, except where the owner can demonstrate that the change is necessary in order to comply with a specific requirement of law or regulation applicable to the building or to leases for housing accommodations subject to the RSL, or with the approval of DHCR. Nothing herein may limit the inclusion of authorized clauses otherwise permitted by this Code or by order of the DHCR not contained in the expiring lease.

The court stated that “as the recipient of federal low-income housing tax credits, federal and state law require [landlord] to keep records of the total number of residential rental units in the building; the percentage of those units that are low-income units; the rent charged on each unit; the number of occupants in each low-income unit; the low-income unit vacancies in the building; the annual income certification of each low-income tenant per unit; and documentation to support each low-income tenant’s income certification….”

The court rejected the tenant’s argument that there is a difference between how new low-income tenants and existing rent-stabilized tenants should be treated. The court explained that neither LIHTC “nor its implementing regulations draw any such distinction” and the tenant’s reasoning was “hostile to the Act’s core requirement that participant landlords like petitioner must set aside a fixed percentage of all units in a given project to low-income households.” The court reasoned that to permit existing rent-stabilized tenants “to refuse to certify their income to LIHTC landlords,…,would cripple [landlord's] ability to allocate units-and tax credits-in the manner required by federal law and the RA.”

The court noted that without income certification from all tenants, a landlord “would have no reliable means of determining whether 20 percent of its units were leased to households with incomes at or below 50 percent of the HUD determined AMI or 40 percent of its units were leased to households with incomes at or below 60 percent of the HUD determined AMI.” Rather, a landlord “would have to rely entirely upon vacancies and ensuing new leaseholds to attempt to meet its federally mandated tax credit allocations.” Thus, the tenant’s position would “directly undermine the Act’s stated mission of serving the lowest income families in an assisted project….”

The court opined that income certifications pursuant to the LIHTC program did not “divest [tenant] of any rights under the RSC.” Rather, they permit the tenant to have “the ability to gain greater protections than offered by the RSC.” The court explained that the “[t]ax credits benefit rent stabilized tenants who are income-eligible by allowing them to pay potentially less than rent stabilized rents but never having to pay in excess of those rents.”

Thus, “tax credits are fully compatible with the remedial aims of the RSL and RSC to preserve the affordable housing stock in New York City….” The court noted that under the tenant’s interpretation of LIHTC and RSC, new rent stabilized tenants of assisted projects would have greater rights than existing tenants, i.e., they would have “the ability to pay rents lower than may be charged under the RSC.”

The court held that since the tenant had refused to submit LIHTC certification documents to the landlord, since such refusal was “a violation of a substantial obligation of her tenancy” and the tenant had failed “to timely cure her default after having been served with a notice to cure,” the landlord was entitled to terminate her tenancy and obtain a judgment of possession. Accordingly, the court granted the landlord a judgment of possession, with eviction stayed for 10 days to permit the tenant “to complete all certifications required by the LIHTC program.”

OLR, MM, L.P. v. Bracero, L & T 9998/12, NYLJ 1202653912035, at *1 (Civ. BX, Decided April 10, 2014), Madhavan, J.

Scott E. Mollen is a partner at Herrick, Feinstein and an adjunct professor at St. John’s University School of Law.