Fate of Mortgage-Backed Securities Cases Remains Uncertain
Editor's Note: This column was originally published in The New York Law Journal's Special Report on Litigation on Sept. 9.
Several threshold issues currently pending in New York's state and federal appellate courts will dictate whether we are nearing the end of new mortgage-backed securities lawsuits and determine what the local landscape for the remaining cases will look like.
One such issue is the First Department's anticipated decision regarding the application of New York's six-year statute of limitations to breach of contract claims arising out of the representations and warranties integral to the mortgage-backed securities (MBS) transactions. The determinative question is what triggers the running of the statute of limitations: Is it, as Judge O. Peter Sherwood held in Nomura, the securitization date?1 Or is it, as Judge Shirley Werner Kornreich found almost immediately thereafter in ACE Securities, the date that the seller refused to abide by its contractual obligation to repurchase the non-conforming loans?2 These divergent Commercial Division decisions hinge on the characterization of the breach: Is it a straight breach of representation and warranty claim, accruing when the representations were made at closing? Or is it instead a breach of the continuing repurchase obligation, triggered once the seller refuses to repurchase the loan?3
The underlying contractual provisions are substantially the same in ACE Securities and Nomura, and representative of those that permeate MBS litigation. The mortgage loan purchase agreement (MLPA) contains dozens of representations and warranties regarding the characteristics and quality of the bundled loans that are secured by residential (or commercial) real estate. The pooling and servicing agreement (PSA), under which those loans are deposited into a trust and securitized through the issuance of certificates to investors, mandates an exclusive protocol for addressing breaches of the representations and warranties contained in the MLPA: Upon discovery or notice of the breach, the seller must cure the breach, substitute a conforming loan, or repurchase the loan at a purchase price dictated by the PSA. The MBS breach of contract actions typically arise out of the seller's refusal to repurchase those loans suffering from breaches of representations and warranties in contravention of the repurchase protocol set forth in the governing contracts.
Sherwood's Nomura decision views the investors' claims as straightforward breaches of representations, accruing on the date the alleged false representations, which "did not arise or change over time," are made.4 In contrast, the repurchase obligation was held to be simply a remedy for the breach of representation claim—not an independent duty giving rise to a separate breach.5 Recognizing the fundamental principle that a breach of contract action accrues when the party has a legal right to demand payment,6 Sherwood ruled that the accrual begins from "'the date of the first alleged breach,' not from the time plaintiff chooses to seek a remedy."7 To hold otherwise would allow a party to "circumvent the statute of limitations by indefinitely deferring its demand for payment."8
The Nomura decision is consistent with and relies on that in Structured Mortgage Trust 1997-2 v. Daiwa Finance,9 a 2003 MBS put-back action from the Southern District of New York in which the court held that "since the facts warranted in the [contract] were not true when made, the statute of limitations began to run at that time, and expired six years later."10 In rejecting the plaintiff's tolling argument, the court found that the right to make the repurchase demand was complete "when the wrong is committed, and not when the plaintiff discovers it"11 and that to hold otherwise would be to impose the "rejected accrual-at-injury rule."12
Given the holdings in Nomura and Daiwa, the relevant determination is when the MBS investor had the legal right to demand repurchase—not when the investor actually made a repurchase demand. Further, an actionable breach of a representation under the operative Nomura contracts (i.e., one triggering the repurchase protocol) must have a "material and adverse effect" on the interest of the certificate holders. This two-step trigger (false representation with material and adverse effect) is common in MBS contracts. It is becoming increasingly more settled under New York law that "material and adverse effect" is determined at the closing date of the transaction and focuses not on the actual default or performance of any particular loan, but rather on the risk of loss. In its recent MBIA decision, for example, the First Department held that "[t]here is simply nothing in the contractual language which limits [the] repurchase obligations" to post-securitization performance.13 Similarly, in Wells Fargo Bank v. Bank of America, pending in the Southern District of New York, the court held that material and adverse effect does not equate with default.14 Thus, if the relevant determination is when the investor had a legal right to seek repurchase of the loans (putting aside discovery or notice of the breach), then it would appear that the recent cases regarding material and adverse effect would bolster the determination by the courts in Nomura and Daiwa that the appropriate accrual date for a breach of representation is the securitization date.
Yet Kornreich's decision in ACE Securities painted a very different view of the breach of a repurchase obligation than that set forth in Nomura, holding that the "continuing performance" doctrine coupled with the "nature of the parties' relationship under the PSA" compelled a different result than in Daiwa.15 According to Kornreich, a false representation is not in and of itself a breach of the PSA; the only "contractual wrong" that the seller can commit is its failure to comply with the repurchase obligation.16 Citing to several cases applying New York's continuing performance doctrine, Kornreich reasoned that because the seller has a "recurring obligation" under the PSA to adhere to the repurchase protocol, every failure to do so is an independent breach that "'may begin the running of the statute [of limitations] anew.'"17
There is at least one case in which the continuing performance doctrine has been applied in connection with an MBS repurchase obligation: Lehman Bros. Holdings v. National Bank of Arkansas, an Eastern District of Arkansas case in which the court found that because under New York law the failure to repurchase non-conforming loans is an independent breach of contract, the plaintiff could not have sued for breach until it demanded repurchase. 18 The Bank of Arkansas court cited to LaSalle Bank National Association v. Lehman Bros. Holdings, 237 F. Supp. 2d 618 (D. Md. 2002), which, in turn, cites to Resolution Trust v. Key Financial Services, 280 F.3d 12, 18 (1st Cir. 2002), in support of its characterization of the repurchase obligation as an independent breach under New York law. However, the First Circuit in Resolution Trust found that it is "of no significance" that the district court's determination relied upon the characterization of the failure to repurchase loans as an independent breach.19 Because of this apparent leap in reasoning, Sherwood in Nomura ultimately found Bank of Arkansas and LaSalle "unpersuasive,"20 and Kornreich—perhaps seeking to avoid the fray altogether—did not cite either case.
Kornreich did recognize that the cause of action accrues when the party making the demand becomes entitled to make the demand—and not when the actual demand is made. But, contrary to the holdings in Nomura and Daiwa, Kornreich reasoned that the plaintiff was entitled to make a demand only after discovery or receipt of notice of the breach by the seller and the expiration of the applicable cure period dictated by the repurchase protocol.21 The court thus concluded that the statute of limitations began to run when the seller improperly rejected the trustee's demand to repurchase loans—not at the date of execution of the governing contracts.22 The court likened the nature of the repurchase obligation to the reinsurance context, where, in order to obtain payment, an insurance company is obligated to make a demand on the reinsurance company when it pays a claim to the underlying insured.23 Analogously, under New York law, the reinsurer does not breach its contractual obligations until it improperly rejects an insurance company's demand for payment.
Kornreich also noted that a finding that the statute of limitations began to run at the close of the transaction "utterly belies the parties' relationship and turns the PSA on its head."24 Under that contract, the trustee had no duty to review the loan files or conduct any due diligence, and any right to seek repurchase is not negated by any diligence or review that it may have performed. Starting the clock running upon the close of the transaction would effectively create a duty—in contravention of the terms of the PSA—for the trustee to conduct diligence on the loans in order to utilize the repurchase protocol, if necessary, before the expiration of the statute of limitations.25 The court concluded that the creation of such a duty undermines the essential purpose of the repurchase protocol: to shift the risk of non-compliant loans to the seller.