Tomorrow, the Court will hear argument in Deutsche Bank National Trust Company v. Morgan Stanley Mortgage Capital Holdings LLC, a breach-of-contract case arising from a residential mortgage-backed securitization.
A mortgage-backed securitization allows investors to share the risks and rewards of mortgage lending. A financial institution, known as a sponsor, will buy a large number of mortgage loans from the issuing banks and will then pool them into a trust. The trust then issues securities, known as certificates, to investors. A trustee—usually also a financial institution—is tasked with making sure the trust operates as intended.
To ensure certificateholders that the mortgage loans in the trust will perform, the sponsor makes a number of contractual representations about their creditworthiness. The contracts governing the trust say that if the sponsor’s representations are inaccurate, the trustee can force the sponsor to cure the breach (for instance, by providing additional information about a borrower that may have been missing from the mortgage documentation) or repurchase the affected loan. The contracts also say that this cure-or-repurchase remedy is the trustee’s “sole remedy” for a breached representation.
The main issue in this case is whether a trustee (here, Deutsche Bank) may bypass that sole-remedy provision if it can show that the sponsor’s (here, Morgan Stanley’s) breaches were the result of gross negligence. The Appellate Division said yes. It based its decision on New York’s longstanding public policy that a contracting party “cannot insulate itself from damages caused by grossly negligent conduct”—a principle the Court of Appeals has made clear in cases such as Sommer v. Federal Signal Corp., Kalisch-Jarcho v. City of New York, and Abacus Federal Savings Bank v. ADT Security Services, Inc. The Appellate Division also held that the trustee pleaded gross negligence by alleging that 100% of the loans in the trust failed to comply with Morgan Stanley’s representations.
In the Court of Appeals, Morgan Stanley pursues two main lines of attack against the trustee’s gross-negligence argument:
First, Morgan Stanley says that New York’s public policy, as expressed in cases like Sommer, does not apply. That policy prevents parties from shielding their gross negligence through contractual terms that exculpate them or limit the available damages to a nominal sum. But the sole-remedy provision, Morgan Stanley points out, does neither of those things. In fact, it’s designed to make the trust whole by curing all breaches or repurchasing nonperforming loans.
In response, the trustee points to the Court’s 2012 decision in Abacus. There, the Court held that “exculpatory clauses and liquidated damages clauses in contracts are not enforceable against allegations of gross negligence.” Liquidated-damages clauses, the trustee observes, don’t shield a party from liability entirely. Just the opposite, they require the party to pay a fixed sum. The trustee also cites cases from other courts applying the gross-negligence exception to bypass clauses that merely limit the plaintiff from pursuing certain damages theories, such as lost profits. Finally, the trustee takes issue with Morgan Stanley’s claim that the cure-or-repurchase remedy will make the trust whole, since some loans in the trust have been liquidated or foreclosed on and thus can’t be repurchased.
Second, Morgan Stanley contends that even if the gross-negligence exception applies, the trustee hasn’t pleaded gross negligence. As the Court of Appeals has held, gross negligence is conduct that is tortious. Morgan Stanley’s alleged wrongdoing, however, was its failure to uncover pervasive breaches. That conduct isn’t tortious, Morgan Stanley claims, since the duty to detect breaches arose under the parties’ contract, not through tort law. Morgan Stanley also posits that failure to detect widespread breaches amounts to gross negligence, allowing trustees to bypass the sole-remedy provision, then the Court’s holdings in two recent RMBS cases would be meaningless. In those cases—Nomura Home Equity Loan, Inc., Series 2006-FM2 v. Nomura Credit & Capital Inc. and Ambac Assurance Corp. v. Countrywide Home Loans—the Court held that sole remedy clauses limited plaintiffs to the cure-or-repurchase remedy, even if the plaintiff alleged “pervasive” breaches. In other words, Morgan Stanley argues that the gross-negligence theory simply repackages the previously rejected pervasive-breach theory.
The trustee, however, contends that Morgan Stanley’s alleged conduct satisfies the gross-negligence standard because Morgan Stanley ignored red flags and admitted to intentional wrongdoing. On that score, the trustee cites Morgan Stanley’s settlement with the Securities Exchange Commission for $300 million for representing that the alleged breach rate for loans in the trust was small when it knew that the breach rate was four times as high. As did the Appellate Division, the trustee also relies on the fact that 100% of the loans in the trust were eventually shown to be in breach of Morgan Stanley’s representations—a sign of an extreme departure from ordinary standards of care, says the trustee.
In addition to the gross-negligence issue, the parties focus on two other issues:
- Punitive damages. Morgan Stanley argues that the trustee’s demand for punitive damages should be dismissed because the trustee does not allege that Morgan Stanley directed tortious conduct at the trustee (rather than at third parties) or that Morgan Stanley’s conduct was egregious. The trustee says that Morgan Stanley waived this argument by failing to raise it in Supreme Court and that, in any event, Morgan Stanley directed egregious conduct (knowingly selling defective loans) at the trustee (who was responsible for acquiring conforming loans on the trust’s behalf).
- Attorneys’ fees. Morgan Stanley argues that the trustee’s request for attorneys’ fees should be dismissed because the clause on which the trustee relies in seeking fees refers only to reimbursement for “costs and expenses” but doesn’t mention attorneys’ fees—in contrast to other provisions of the contract. The trustee responds by relying on the Court’s decision in Hooper Associates, Ltd. v. AGS Computers, Inc., which says that a provision that clearly implies a right to attorneys’ fees will support a fee award. In the trustee’s view, by allowing the trustee to recoup the “costs and expenses” of “enforc[ing]” Morgan Stanley’s repurchase obligation, the contract clearly implies a right to attorneys’ fees.