The question in this case is whether the trustee of a residential mortgage-backed security (RMBS) trust can bypass a contractual “sole remedies” clause and seek compensatory damages by showing that the RMBS sponsor was grossly negligent.
RMBS are securities that entitle their holders to a fixed income stream from monthly residential mortgage payments. Mortgage loans are extended by a mortgage originator, which then sells the loans to a different financial institution, sometimes known as a “sponsor.” The sponsor pools the loans and sells them to a trust, which in turn collects the monthly mortgage payments and distributes a portion of them to RMBS holders.
To give RMBS holders confidence that the mortgage loans will be timely repaid, the sponsor, upon transferring the loans to the trust, represents to the trust in writing that the loans were underwritten according to specified guidelines. The sponsor agrees that if the trustee discovers that any loans were not underwritten according to the guidelines, the trustee may request that the sponsor cure the underwriting defect or repurchase those loans. And if the loans were indeed noncompliant, the sponsor must cure any underwriting defects or repurchase the loans. The financial institution and the trustee agree that this cure-or-repurchase obligation is the trust’s “sole remedy” for noncompliant loans.
In this case, the trustee, Deutsche Bank, sued the sponsor, Morgan Stanley, after Morgan Stanley refused to cure or repurchase loans that Deutsche Bank believed to be noncompliant. But in addition to specific performance of the sole remedy—i.e., requiring Morgan Stanley to cure or repurchase each noncompliant loan—Deutsche Bank sought compensatory damages to make the trust whole for any losses suffered when noncompliant loans failed to perform. Deutsche Bank claim that the sole-remedy provision did not apply if Morgan Stanley was grossly negligent.
Supreme Court, New York County, disagreed. It held that Deutsche Bank was limited to the sole remedy it had bargained for. But the First Department reversed. That court held that Deutsche Bank’s allegations of gross negligence—including allegations that the SEC had found that Morgan Stanley acted fraudulently in sponsoring the RMBS trust at issue—allowed Deutsche Bank to seek compensatory damages, despite the sole-remedy provision. The court relied on Court of Appeals cases holding that a contractual limitation on damages cannot insulate a party from liability for its gross negligence. Doing so would violate New York public policy because it would, in essence, exculpate a party for its own intentional misconduct.
This is not the first case in which a trustee has sought to get out from under a sole-remedy provision. In HSBC Bank USA, N.A. v. Nomura Credit & Capital Inc., 30 N.Y.3d 572 (2017), the Court affirmed dismissal of a trustee’s claims for general contract damages as a result of alleged misrepresentations made in connection with an RMBS deal. The Court held that the plaintiffs were limited to the cure-or-repurchase remedy set out in the deal documents. As the Court explained, the trustee had alleged that the sponsor made misrepresentations about loans in the trust, albeit “pervasive” and “systemic” misrepresentations. And the agreed-upon sole sole remedy for such misrepresentations was cure or repurchase.
The Court reiterated this holding in Ambac Assurance Corp. v. Countrywide Home Loans, Inc., 31 N.Y.3d 569 (2018), holding that the plaintiff in that case—an insurer that agreed to insure an RMBS securitization against loss—could not avoid a sole remedy provision in an insurance contract “executed by sophisticated parties as part of a complex securitization process” merely by asserting “‘broader’ or numerous violations of representations and warranties” in the relevant deal documents.
The First Department granted Morgan Stanley leave to appeal to the Court of Appeals.