Few RMBS cases have gone to trial. As a result, there is little clear guidance concerning the level of proof required to reach or avoid reaching a jury in an RMBS case, especially when the defendant is a trustee.
A recent decision by Judge Valerie Caponi in the U.S. District Court for the Southern District of New York offers insights into the proof required, particularly as it relates to the issues of trustee “discovery,” the “material and adverse” trigger for the “notice” requirement, and a trustee’s failure to act because it has “reasonable grounds” for believing an indemnity is not “reasonably assured.”
In the case – Phoenix Light SF Ltd. et al. v. The Bank of New York Mellon, No. 14-CV-10104 (VEC) (S.D.N.Y. Sept. 7, 2017) – Judge Caproni addressed cross motions for summary judgment in an RMBS case involving twenty-one trusts and four categories of claims: (1) violations of the Trust Indenture Act; (2) breach of contract; (3) negligence, gross negligence, and negligent misrepresentation; and (4) breach of the covenant of good faith and fair dealing. Judge Caproni’s opinion addresses all claims, but the greatest insights concerning the proof required to reach a jury are contained in her discussion of the contract claims.
The first important issue the Court addressed was the meaning of the term “discovery” in the context of the trustee BNYM’s duty to notify the other parties of breaches of representations and warranties. Under the governing agreements, BNYM’s duties are triggered only “[u]pon discovery … of a breach of representation or warranty.” The Court noted a split of authority concerning whether “discovery” means inquiry notice, with a concomitant duty to investigate, or actual knowledge of a breach, but concluded that it did not have to reach that issue because the plaintiffs’ evidence was sufficient to reach a jury for four trusts, but insufficient for eight other trusts, under either standard.
The key difference between the two groups of trusts: For the former group, BNYM had received notices that identified specific loans and specific breaches, while for the latter group, the plaintiffs were relying on evidence of “pervasive breaches” or systemic misconduct to argue that BNYM had knowledge. As to the former group of four trusts, the Court characterized the plaintiffs’ proof as “scant,” but found it sufficient to reach a jury. The Court wrote:
Under the inquiry notice standard, a reasonable juror could find that the … [l]etters provided BNYM with notice of potential breaches that BNYM should have investigated; had it investigated, the investigation would have confirmed that there were breaches triggering BNYM’s obligation to provide prompt notice to the other parties to the [governing agreements]. Under the actual knowledge standard, when viewing the letters in the light most favorable to Plaintiffs, a reasonable juror could find that the letters identified loan-specific breaches of representations and warranties and that, because BNYM received those letters, it had actual knowledge of those breaches.
The second significant issue the Court addressed was what constitutes a breach that “materially and adversely” affects certificateholders, which is another contractual condition precedent to the requirement that a trustee provide notice. The Court adopted the definitions offered by Judge Castel in MASTR Adjustable Rate Mortgages Tr. 2006-OA2 v. UBS Real Estate Sec. Inc.,No. 12-cv-7322 (PKC), 2015 WL 797972, at *3 (S.D.N.Y. Feb. 25, 2015) and Judge Rakoff in Assured Guar. Mun. Corp. v. Flagstar Bank, FSB, 892 F. Supp. 2d 596, 603 (S.D.N.Y. 2012): that there must be evidence of a “significant increase in the risk of loss.” The Court ultimately concluded that a reasonable juror could find that breaches of representations or warranties related to loan-to-value ratios, appraisal values, occupancy status, and lien priority all produced a significant increase in the risk of loss.
The third significant issue the Court addressed was certificateholder direction and reasonable indemnity as a trigger to the trustee’s obligation to perform both pre-event-of-default and post-event-of-default duties. The Court noted that BNYM had two potential sources of indemnity: from the trust fund and from the sponsor, seller or servicer. In rejecting “BNYM’s bare allegations that indemnity was not reasonably assured” the Court observed that those arguments “appear[ed] to be little more than post-hoc justifications crafted in the context of litigation.” In the process, the Court implicitly rejected the argument that a trustee may use the absence of certificateholder direction and an indemnity as an excuse to sit back and do nothing.