SDNY Construes ‘Material and Adverse Effect’

In numerous pending lawsuits in New York federal and state courts, monoline insurers are suing Wall Street banks for alleged breaches of representations and warranties about the quality and characteristics of residential loans in RMBS pools. At stake in these suits is the ultimate responsibility for billions of dollars in losses suffered by RMBS certificate holders insured by the monolines. In most of these deals, the applicable MLPA, PSA and insurance contracts provide that the securitization’s sponsor must repurchase a loan if a breach of a representation or warranty “materially and adversely affects” the interests of the insurer in the loan. The fighting issue is whether this provision requires an insurer to prove that the alleged breaches of representations and warranties proximately caused the loan to become delinquent or default. Now, for the first time, a New York federal court has squarely addressed this critical question.

In Syncora Guarantee Inc. v. EMC Mortgage Corp., No. 09 Civ. 3106 (S.D.N.Y. June 19, 2012), Hon. Paul A. Crotty ruled in favor of the monolines and granted plaintiff Syncora’s motion for summary judgment on this issue. Judge Crotty held that (1) the sponsor became obligated to repurchase loans at the time its representations and warranties were breached (i.e. at the time of the closing of the Transaction), regardless of whether EMC’s breaches caused any loan to default, and (2) that the insurer may establish a material breach by showing that breaches of representations and warranties as of the closing date of the Transaction materially increased Syncora’s risk of loss on the Transaction, even if the breaches did not directly cause Syncora’s claim payments. Under the Federal Rules of Appellate Procedure, it would be difficult for the defendant to obtain appellate review of this decision before entry of final judgment, possibly requiring a full-blown trial.

This is the second trial court decision addressing the role of causation in a monoline insurer’s lawsuit this year. In January 2012, in MBIA Insurance Corp. v. Countrywide Home Loans, Inc., No. 605825/2008 (Sup. Ct., N.Y. Cnty. Jan. 3, 2012), Justice Bransten ruled that while MBIA was required to prove causation to prevail on its claims, it could make that showing by proving that the challenged representations induced it to issue the policies, and did not need to show that the breaches caused the loan defaults that resulted in MBIA’s claim payments. Like Judge Crotty’s decision in Syncora, Justice Bransten also ruled that MBIA could also prove causation by showing that the breach materially increased the insurer’s overall risk of loss. That decision has been appealed by defendants and a decision from the Supreme Court, Appellate Division, is expected near the end of 2012.

One question is whether institutional investors and trustees who are standing in the wings, ready to file their own claims for breaches of representations and warranties against similar sponsors, will receive the full benefit of this ruling. That is highly uncertain for at least two reasons. First, no New York appellate court has yet considered this same contract provision, and the opinion from the federal court in Syncora is not precedential. Second, and perhaps more important, like Justice Bransten’s opinion in MBIA v. Countrywide, Judge Crotty relied heavily on principles of insurance law and two insurance statutes that do not apply to claims brought by investors and trustees. That distinction will figure prominently as other courts consider the same language in non-insurance contexts. See, e.g., Lasalle Bank Nat’l Ass’n v. Nomura Asset Capital Corp., No. 0603339/2003, 2006 N.Y. Misc. LEXIS 9296, at *112-*113 (Sup. Ct., N.Y. Cnty. Sept. 6, 2006) (finding that negative performance of two commercial loans proved “material and adverse effect”).