Defending Cases Involving Subprime Residential Mortgage Backed Securities March 19, 2008Scott E. Eckas
Subprime Litigation Includes … • Cases brought by investors in residential mortgage backed securities (“RMBS”) against underwriters. See, e.g., Bankers Life Ins. Co. v. Credit Suisse First Boston Corp., et al., No. 07-CV-0690 (M.D. Fla.). • Cases brought by RMBS investors against servicers and/or trustees of the pool of mortgage loans. See, e.g., Ellington Credit Fund, Ltd., et al. v. Select Portfolio Servicing, Inc., et al., No. 08-CV-02437 (S.D.N.Y.). • Cases arising from vehicles that held subprime based securities including, among others, CDOs, SIVs and conduits. See, e.g., Wells Fargo Bank, N.A. v. CALYON, et al., No. 08-CV-01297 (S.D.N.Y.). • Cases brought by municipalities under public nuisance and related theories. See, e.g., City of Cleveland v. Deutsche Bank Trust Co., et al., No. 08-CV-0139 (N.D. Ohio). • Cases brought by subprime loan borrowers. See, e.g., Poland v. Downey Sav. & Loan, No. BC381724 (Cal. Super. Ct. ).
General Characteristics of RMBS Transactions • Mortgage loans are originated by various entities pursuant to certain underwriting criteria and are sold into RMBS transactions soon after the loans are made. • Mortgage loans are pooled together and placed in a trust formed specifically for the purpose of the transaction. • The trust then issues securities representing various types of interests (usually including debt and equity) in the cash flows from that pool of mortgage loans. The interests in the trust are divided into multiple classes (“tranches”). The various tranches are generally rated by independent rating agencies such as Moody’s Investors Service, Standard & Poor’s or Fitch Ratings.
General Characteristics of RMBS Transactions • Holders receive distributions of amounts collected on the mortgage loans based on where the tranche falls in the trust’s hierarchy of payments (the “waterfall”). • The tranches that are entitled to receive distributions first bear less risk than the tranches lower down the waterfall. Subordinated holders are compensated for the risk they undertake with higher interest rates. • The securities are sold pursuant to an offering memorandum that discloses the characteristics of the securities and the risks attendant to the investment. After initial sales are made trading occurs in the secondary market. The securities are typically purchased by sophisticated institutional investors. • Trustees prepare reports based on the performance of the underlying mortgage loans on a monthly basis. These reports are typically available on a trustee’s website.
General Characteristics of RMBS Transactions • The degree to which the investment is successful – particularly for subordinated holders – depends on how well the underlying pool of mortgage loans perform, which, in turn, is directly related to the general state of the United States housing market. • Any events that could cause the mortgage loan borrowers to have difficulty making their payments (such as rising interest rates for an adjustable rate mortgage) or selling their property (such as a softening of the housing market) would affect the performance and outlook of the securities.
Typical Claims Based on RMBS Transactions • Federal Securities Law Claims • State Securities Law Claims • State Common Law Claims
State Common Law Claims • Disclosure Based Claims • Nondisclosure Based Claims • Often, state common law claims are subject to longer statutes of limitations than federal securities law claims. • Generally, state common law claims have less technical pleading requirements than federal claims.
Typical Disclosure Based Claims • Fraud • Negligent Misrepresentation • Often, disclosure based claims arise out of statements or omissions included in the offering memorandum. Such claims, however, may also arise from other oral or written statements concerning the securities.
Typical Issues and Defenses for Disclosure Based Claims • Primary fact issue: where/when/how plaintiff acquired the securities. • Related legal issues: • Misrepresentation or Omission • Reasonable Reliance • Loss Causation
Misrepresentation or Omission • Where/how was the alleged misrepresentation or omission made? • Disclosure in offering materials: • Risk of loss on the mortgage loans • Underwriting standards • Characteristics of the collateral pool • Prepayments • Subordination • Illiquidity • Can the claim be based on an omission? • Statement of past or existing fact?
Reliance • Actual reliance likely required. • Reliance must be REASONABLE. • One factor in determining reasonableness is whether the information allegedly relied on was current at that time. • Monthly Trustee Statements. • Track performance of underlying mortgage loans.
Loss Causation • Loss must reasonably directly stem from the alleged misrepresentation or omission and be independent of other causes. • “[W]hen a Plaintiff’s loss coincides with a market-wide phenomenon causing comparable losses to other investors, the probability that the loss was caused by an alleged fraud decreases.” Hampshire Equity Partners, II, L.P. v. Teradyne, Inc., No. 04-CV-3318, 2005 WL 736217, at *5 (S.D.N.Y. Mar. 30, 2005), aff’d, 159 F. App’x. 317 (2d Cir. 2005).
Typical Nondisclosure Based Claims • Breach of Fiduciary Duty • Breach of Contract
Breach of Fiduciary Duty • May be based on alleged conduct prior to, at the time of or after the sale of the securities. • Requires a relationship of trust and confidence. • Such a relationship cannot be created unilaterally. • This claim may be precluded because generally, contract claims cannot be repackaged as a tort.
Breach of Contract • Generally, RMBS transactions are administered pursuant to a pooling and servicing agreement (“PSA”). • Breach of contract claims under a PSA are typically brought against the trustee or servicer based on post-closing conduct.
Breach of Contract • Generally, breach of contract claims are relatively easy to plead. • Standing • If a servicer or trustee allegedly breached the terms of the PSA, such a breach would affect the trust generally and not the individual plaintiff. • Claims that injure the trust generally must be brought as derivative claims and comply with applicable rules. See, e.g., Debussy LLC v. Deutsche Bank AG, No. 05-CV-5550, 2006 WL 800956, at *3-4 (S.D.N.Y. Mar. 29, 2006), aff’d, 2007 WL 1748468 (2d Cir. June 19, 2007). • No action provisions in the PSA.
Defenses May Vary from State to State • Often, which state’s law governs will have a significant effect on whether a claim can be brought. • In New York, claims for negligent misrepresentation and breach of fiduciary duty based on the purchase of securities are barred by the Martin Act, N.Y. Gen. Bus. Law § 352 (McKinney 1996). See, e.g., Joffee v. Lehman Bros., Inc., No. 04-CV-3507, 2005 WL 1492101, at *13-14 (S.D.N.Y. June 23, 2005). • Certain states, for example, do not recognize the tort of negligent misrepresentation beyond an employment or traditional professional relationship. See, e.g., Trytko v. Hubbell, Inc., 28 F.3d 715, 720-21 (7th Cir. 1994).