A common claim alleged by monoline insurers is that RMBS sponsors fraudulently induced them to provide the insurance by misrepresenting the quality of loans and underwriting. As the story invariably goes, the insurer only discovered that it was defrauded after its vendor reviewed a sample of several hundred loan files, and was shocked to find that most loans, usually alleged to be somewhere between 75% to 95% of the sample, breached representations and warranties. On May 4, a New York court turned these types of post-loss file reviews against the insurer in CIFG Assur. N.A., Inc. v. Goldman Sachs & Co., Index No. 652286/2011 (N.Y. Sup. Ct.). Here, the court found that the very same file sampling and review easily could have been done – and legally should have been done – in the insurers’ due diligence. The insurer’s failure to conduct adequate due diligence when it issued its policy required dismissal of its fraud claim for lack of reasonable reliance.
The Transaction
In February 2007, Goldman Sachs (and its related entities) executed a securitization transaction involving 6,204 second-lien residential mortgage loans through the GSAA Home Equity Trust 2007-S1, by which it issued over $277 million in pass-through certificates. CIFG served as certificate insurer.
The Allegations of Fraudulent Inducement
CIFG alleges that it was fraudulently induced to insure the certificates by Goldman Sachs and one of the loan originators, M&T Bank, who allegedly hid their knowledge about the underwriting failures permeating the loan pool. CIFG claims that it conducted “robust” due diligence when it insured the deal, but admitted that it did not perform any loan-level analysis of the 6,204 pool loans, claiming it was not practical due to cost and time constraints.
Alas, CIFG contends that when loans began to default at “staggering rates” shortly after closing, it hired a consultant (Opus) to review selected loan files. Opus reviewed 491 nonperforming loans and identified a breach rate of approximately 80%. CIFG demanded repurchase of hundreds of loans, but no loans were repurchased. The lawsuit ensued.
The Order Dismissing the Fraudulent Inducement Claim
Justice Sherwood held that “[a]s a sophisticated party involved in an arms length transaction, CIFG had a duty to undertake an independent due diligence review of the risks associated with the guaranty it sold, including, at the very least, a review of a sample of the underlying mortgage loans which would have revealed the problems in such loans. Having failed to do so, CIFG cannot now be heard to claim that it justifiably relied to its detriment….* * * Had CIFG conducted proper due diligence prior to writing the insurance, it would have uncovered the alleged misrepresentations about which it now complains.”
In his order, Justice Sherwood focuses on a seminal question: if a monoline insurer can so readily identify “staggering” percentages of misrepresentations by having a vendor sample loan files, did they have a legal obligation to conduct due diligence using the same kind of sampling when they decided to insure the RMBS securities?
Where Will This Ruling Lead?
The trial court in CIFG reached a different conclusion than several other recent RMBS cases that denied motions to dismiss fraud claims by monoline insurers, applying DDJ Mgmt., LLC v. Rhone Group, LLC, 15 N.Y. 3d 147 (2010). DDJ held that the reasonable reliance element of fraud can be inferred “where a plaintiff has taken reasonable steps to protect itself against deception,” such as with “specific, written representations.” Id. at 154. Because “the question of what constitutes reasonable reliance is fact-intensive,” DDJ also held that it could not be resolved on the pleadings. Justice Sherwood seems to have concluded that where the plaintiff’s own complaint pleads that limited loan sampling in due diligence would have revealed “pervasive” breaches of representations and warranties, failure to conduct such due diligence is unreasonable. Even if the New York courts were to disagree and reverse the dismissal of the complaint in CIFG v. Goldman Sachs on appeal, we expect the same factual question to play a substantial role in monoline cases in discovery and trial. Because reasonable reliance is a factual question, DDJ Mgmt. may not be the final word on the issue of whether contractual representations will insulate challenges to reasonable reliance in RMBS-related tort claims, particularly where sophisticated parties choose to forego basic due diligence.