Three Landmark Decisions for Insurers and RMBS Investors

Quinn Emanuel recently secured landmark rulings for its client MBIA Insurance Corporation (“MBIA”) in three major decisions in MBIA’s long-running lawsuit against Countrywide Home Loans, Inc. (“Countrywide”), various Countrywide affiliates, and Bank of America Corporation (“BAC”) (on a successor liability theory). Each of these rulings played a critical role in securing a favorable settlement of the lawsuit for MBIA. Collectively, they have significantly re-shaped the legal landscape for RMBS claims in a way that fundamentally alters how these claims will be litigated going forward and that will likely prove highly advantageous to RMBS insurers and investors, and to non-RMBS insurers as well.

MBIA brought suit in 2008 in New York State Supreme Court (Justice Eileen Bransten), alleging that (1) Countrywide fraudulently induced it to insure 15 residential mortgage-backed securitizations, (2) Countrywide materially and pervasively breached its contractual representations and warranties under the RMBS agreements, and (3) Countrywide breached its contractual obligations to repurchase materially defective loans. The representations and warranties made by Countrywide—which it affirmatively elected to provide in order to sell its RMBS, in turn reaping it huge profits—related to the characteristics of the loans underlying the RMBS, and thus to the likelihood that claims would be made under MBIA’s policies. As Quinn Emanuel argued, MBIA required these representations and warranties because, as the originator of the loans underlying the transactions (approximately 380,000 loans across all 15 securitizations), Countrywide had vastly more knowledge about the loans than MBIA. Moreover, MBIA had no access to the loan files prior to closing, and, in any event, it would have been highly inefficient for it to conduct a duplicative loan review of this huge volume of loans when such review was not only part of the sponsor’s and broker dealer’s standard due diligence responsibilities, but was specifically backed up by the sponsor’s representations and warranties.

Recognizing these realities, the three decisions addressed below—one issued by the First Department and two by Justice Bransten—largely endorsed Quinn Emanuel’s view of the case, and roundly rejected the principal legal obstacles Countrywide sought to raise to MBIA’s claims.

First Department Decision on Loss Causation
Countrywide’s primary defense to MBIA’s claims—the same defense that has been raised by RMBS sponsors across the country facing claims of fraud and breach of warranty arising out of their misconduct during the housing boom—was that, whatever the merits of the claims, in order to establish common law fraud and breach of contract, MBIA had to prove that its losses were proximately caused by Countrywide’s misrepresentations (“loss causation”), and MBIA could not make such a showing because the proximate cause of its losses was the so-called “housing crisis” rather than Countrywide’s misconduct.

Leaving aside the significant role played by Countrywide’s (and other RMBS sponsors’) pervasive fraud in triggering the housing crisis, Countrywide’s argument is wrong as a matter of law. Quinn Emanuel moved for partial summary judgment on this issue, and Justice Bransten agreed that, pursuant to New York Insurance Law §§ 3105 and 3106, an insurer—including a financial guaranty insurer—need not establish loss causation in order to prevail on a claim for fraud or breach of warranty; all the insurer need show is that it would not have issued its policy without the misrepresentation (§ 3105) or that the breach of warranty materially increased its risk under the policy (§ 3106).

On April 2, 2013, the First Department affirmed Justice Bransten’s decision and held that a New York court is “not required to ignore the insurer/insured nature of the relationship between the parties to the contract in favor of an across the board application of common law,” as urged by Countrywide. MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 963 N.Y.S.2d 21, 22 (1st Dep’t 2013). The First Department not only affirmed the application of the insurance law causation rule to RMBS claims by a financial guaranty insurer, but expressly rejected Countrywide’s argument that the insurance law rule applies only to claims for rescission, not damages. It held that the reference to “defeating recovery thereunder” in §§ 3105 and 3106 contemplates “the recovery of payments made pursuant to an insurance policy without resort to rescission.” Id.

As Quinn Emanuel argued, the rationale for the application of the insurance law causation rule to claims by RMBS insurers, and specifically to claims seeking recovery of payments made under policies, not just claims for rescission, is clear. The Court of Appeals has repeatedly held that it is a fundamental principle of insurance law that all insurers have the right to select the risks they insure. Moreover, if an insurer had to prove loss causation to obtain relief from a policy it was induced to issue by fraud or breach of warranty—whether by way of rescission or through recovery of claims paid—there would be every incentive for an insurance applicant to misrepresent facts relevant to the insured risk: if the misrepresentations came to light, the applicant could still argue that they did not cause the claimed losses, and if the insurer were able to prove they did, the applicant would merely be denied recovery on a policy that would never have been issued had it told the truth.

Thus, the First Department’s decision supports recovery of payments made under a policy by any insurer—not just an RMBS insurer—without resort to rescission and without proof of loss causation, if the insurer can show simply that it would not have issued the policy without the misrepresentation or that the breach of warranty materially increased its risk under the policy.

First Department Decision on Repurchase Claim
In a parallel argument, Countrywide sought to limit MBIA’s recovery on its claims for breach of repurchase obligations by arguing that it was not contractually obliged to repurchase performing loans, on the basis that a breach of warranty did not materially and adversely affect MBIA’s interests (the contractual standard for repurchase) unless it proximately caused the breaching loan to default. Quinn Emanuel argued, consistent with recent federal court decisions to the same effect and with the insurance law loss causation rule, that MBIA’s interests were materially and adversely affected if the breaches merely increased its risk of loss under its policies, whether or not that loss actually materialized, and thus that performing loans were subject to the repurchase remedy. Id. at 22-23.

Again, the First Department accepted Quinn Emanuel’s argument, holding that MBIA need not show that Countrywide’s breaches of representations and warranties caused loans to default in order to obtain repurchase of those loans. While this holding is consistent with the insurance law causation rule, it was based simply on the language of the repurchase provision (a standard repurchase provision similar to that in many other RMBS contracts). The First Department held that there was nothing in this language that limited Countrywide’s repurchase obligations to cases of default, and that if the parties had wanted such a limitation they would have said so. Id. Thus, this decision supports claims not only by RMBS insurers but also by trustees (on behalf of investors) seeking repurchase of defective loans pursuant to similar repurchase provisions.

Summary Judgment Decision on Fraud Claim
Countrywide further argued, in moving for summary judgment on MBIA’s fraud claim, that MBIA could not show justifiable reliance on Countrywide’s misrepresentations as a matter of law. Quinn Emanuel argued that Countrywide once again ignored the insurer-insured nature of the parties’ relationship, and that an insurer’s fraud claim, as informed by N.Y. Ins. Law § 3105, does not require proof of justifiable reliance; but that, in any event, even if it did, MBIA could show justifiable reliance.

On April 29, 2013, Justice Bransten agreed with Quinn Emanuel. MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 2013 N.Y. Misc. LEXIS 1774, 2013 NY Slip Op 30903(U) (N.Y. Sup. Ct. Apr. 29, 2013). She held that, under Geer v. Union Mutual Life Ins. Co., 273 N.Y. 261 (1937), “the inquiry is not whether the insurer’s reliance on the misrepresented information was justifiable but instead whether the insurer might have refused the application had it been aware of the truth of the misrepresentation.” 2013 NY Slip Op 30903(U) at 9. This ruling, which again applies to insurers generally, not just RMBS insurers, means that an insurer is not required to meet a “reasonable insurer” standard to show that it would not have issued a policy. The test is simply whether this insurer would not have issued this policy had it known the true facts.

Justice Bransten further held, in a ruling subsequently echoed by the First Department in CIFG Assurance North America, Inc. v. Goldman Sachs & Co., No. 652286/2011, 2012 WL 1562718 (1st Dep’t May 1, 2012), that, even if MBIA did have to prove justifiable reliance, under common law fraud it was not precluded from doing so merely because of its admitted failure to review loan files, as Countrywide had argued. Citing DDJ Mgmt., LLC v. Rhone Grp. L.L.C., 15 N.Y.3d 147, 154 (2010) (“[t]he question of what constitutes reasonable reliance is always nettlesome because it is so fact intensive”), she held that she could not conclude before trial that MBIA’s failure to review loan files made its reliance unjustifiable, especially because, as Quinn Emanuel had argued, (1) MBIA did not have a right to review loan files before closing, and (2) MBIA obtained contractual representations and warranties as to the loans’ characteristics. 2013 NY Slip Op 30903(U) at 12-15.

Summary Judgment Decision on Contract Claims
Countrywide also moved for summary judgment on MBIA’s breach of contract. Again, Justice Bransten agreed with Quinn Emanuel in denying this motion. Most importantly, she rejected Countrywide’s “sole remedy” and “breach notice” arguments—also raised by RMBS sponsors in numerous other lawsuits across the country—and upheld Quinn Emanuel’s construction of a critical warranty in the transaction documents which is common to many other RMBS securitizations. Given the ubiquity of these issues in RMBS litigation generally, these rulings, too, will be broadly applicable to and will greatly facilitate RMBS claims by insurers and investors.

First, Justice Bransten agreed with Quinn Emanuel that certain “sole remedy” provisions in the transaction documents were inapplicable to MBIA’s claims and did not bar any form of contract-based relief other than actual repurchase of breaching loans. She agreed that both the contractual language and the First Department’s decision on loss causation clearly contemplated that MBIA might recover other relief, including compensatory damages. Id. at 23.

Second, she rejected Countrywide’s argument that MBIA’s repurchase claims must fail as a matter of law because MBIA had not provided individualized notice of breaches with respect to 95% of the loans in the securitizations. She agreed with Quinn Emanuel that (1) pool-wide repurchase was available in lieu of loan-by-loan repurchase; (2) under the contract language, there was no requirement that MBIA give notice of all breaches—rather, as in most RMBS transaction documents, it was sufficient if Countrywide merely “became aware” of the breaches; and (3) MBIA sufficiently alleged that Countrywide became aware of the breaches by asserting that Countrywide monitored the performance and likelihood of delinquency of the loans on an ongoing basis, and that it also became aware of a significant number of defective loans from MBIA’s complaint, which disclosed that MBIA’s reunderwriting review had discovered breaches in approximately 91% of the loans reviewed. Id. at 24-25.

Third, Justice Bransten accepted Quinn Emanuel’s argument that the “no default” warranty in the transaction documents (warranting that “no default exists under any Mortgage Note,” which in turn defined “default” to include any borrower misrepresentations) was breached where borrowers made factual misrepresentations, and that the language of the contract was sufficiently clear that there was no need to consider parole evidence. Id. at 57-58. In other words, she agreed that this “no default” warranty in effect incorporated a “no fraud” warranty. Given that many other RMBS transactions include a similar “no default” warranty, this holding, too, will facilitate RMBS claims by many other insurers and trustees.

Summary Judgment Decision on Successor Liability Issues
In addition to Countrywide’s attempts to avoid primary liability for its fraud and breaches of warranty, BAC also moved for summary judgment on MBIA’s successor liability claim. Justice Bransten denied BAC’s motion and in holding that, if MBIA were able to prove its claims, BAC could be held liable for Countrywide’s fraud and breach of warranty on two independent theories of successor liability: (1) that Countrywide had de facto merged with BAC; and (2) that BAC impliedly assumed Countrywide’s liabilities. MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 2013 N.Y. Misc. LEXIS 1774, 2013 NY Slip Op 30904(U) (N.Y. Sup. Ct. Apr. 29, 2013).

With respect to MBIA’s de facto merger claim, in a crucial threshold ruling, Justice Bransten agreed that New York, not Delaware, law governed MBIA’s claim against BAC because New York choice of law principles favor a corporation’s principal place of business (for BAC, New York) over its place of incorporation (for BAC, Delaware). Id. at 13-18.

She further agreed that, under New York law, a de facto merger is to be determined by the substance, not the form of the transaction, and she employed this flexible approach in considering whether the following “hallmarks” of a de facto merger existed: (i) continuity of ownership, (ii) cessation of ordinary business, (iii) continuity of management and general business operations, and (iv) assumption of predecessor’s liabilities in the ordinary course of its business. Id. at 19-20. Thus, she held that BAC’s multiple transactions with Countrywide should be viewed together to determine whether the first hallmark (continuity of ownership) existed, and she rejected BAC’s argument that a strict asset for stock sale is necessary to establish such continuity. Id. at 23-26. Further, with respect to the fourth hallmark (assumption of liabilities), she rejected BAC’s formalistic argument that liabilities were assumed by Bank of America, N.A., not BAC. Id. at 44-45. She also rejected BAC’s similarly formalistic argument that a de facto merger finding would be barred merely because BAC paid “fair value” for Countrywide’s assets. Id. at 46-47.

On the implied assumption of liabilities claim, which provides an alternative basis for successor liability, and which is generally established when conduct or representations by the successor party indicate an intention to pay the predecessor’s debts, Justice Bransten again largely ruled for MBIA. First, she rejected BAC’s argument that a finding of implied assumption of liabilities was precluded by express disclaimers of liability included in the transaction documents, holding that these disclaimers were not effective where there existed evidence of BAC’s intent to pay Countrywide’s debts. Id. at 50. Second, she rejected BAC’s argument that the implied assumption of liabilities doctrine requires a showing that the third party creditor relied on the successor’s implied assumption of the predecessor’s debts. Thus, she held that it was irrelevant that MBIA had failed to demonstrate such reliance. Id. at 52-53.

These rulings have widespread application because they are relevant not only to the many other successor liability claims currently being brought against BAC arising out of Countrywide’s misconduct, but also to any other successor liability claims brought in New York, both in the RMBS context and otherwise.