Morgan Stanley Mortg. Loan Trust 2006-13ARX v. Morgan Stanley Mortg. Capital Holdings LLC

• Decision Date: 11 August 2016
• Parties: MORGAN STANLEY MORTGAGE LOAN TRUST 2006–13ARX, etc., Plaintiff–Appellant, v. MORGAN STANLEY MORTGAGE CAPITAL HOLDINGS LLC, etc., Defendant–Respondent.
• Court: New York Supreme Court — Appellate Division

143 A.D.3d 1

36 N.Y.S.3d 458

2016 N.Y. Slip Op. 05781

MORGAN STANLEY MORTGAGE LOAN TRUST 2006–13ARX, etc., Plaintiff–Appellant,

v.MORGAN STANLEY MORTGAGE CAPITAL HOLDINGS LLC, etc., Defendant–Respondent.

Supreme Court, Appellate Division, First Department, New York.

Aug. 11, 2016.

Molo Lamken LLP, New York (Steven F. Molo, Justin M. Ellis, Tuongvy T. Le, Joel M. Melendez and Gajan Sivakumaran of counsel), for appellant.

Davis Polk & Wardwell LLP, New York (Brian S. Weinstein, James P. Rouhandeh, Carissa M. Pilotti and Craig T. Cagney of counsel), for respondent.

ANGELA M. MAZZARELLI, J.P., KARLA M. MOSKOWITZ, ROSALYN H. RICHTER, JUDITH J. GISCHE, JJ.

GISCHE, J.

This case arises from the securitization and sale of residential mortgages. The mortgage loans originated with an affiliated entity of defendant, Morgan Stanley Capital Holdings LLC (Morgan Stanley). Plaintiff, U.S. Bank National Association (Trustee), as trustee of the Morgan Stanley Mortgage Loan Trust 2006–13ARX holding the underlying loans (“Trust”), seeks redress for the massive loan defaults that occurred, rendering the residential mortgage backed securities (RMBS) it sold to outside investors virtually worthless. Insofar as relevant to this appeal, the Trustee, in addition to its other breach of contract claims, alleges that Morgan Stanley breached a contractual duty to notify the Trustee of the defective loans, giving rise to damages not governed by the sole remedies restrictions in the parties' agreements, and also that Morgan Stanley's gross negligence otherwise renders the sole remedies clauses unenforceable. We are called upon to decide whether the motion court correctly granted defendant's preanswer motion dismissing these particular claims. We hold that, consistent with our recent decision in Nomura Home Equity Loan, Inc. v. Nomura Credit &

Capital, Inc.

, 133 A.D.3d 96, 108, 19 N.Y.S.3d 1 (1st Dept.2015) [lv. granted 1st Dept. January 5, 2016], defendant's alleged breach of its contractual duty to notify the Trustee of defective loans gives rise to an independent, separate claim for breach of the parties' agreements, which should not have been dismissed. We also hold that, under the highly deferential standard afforded to pleadings, the particular facts alleged in the amended complaint are sufficient to support plaintiff's claim of gross negligence, which should not have been dismissed (Sommer v. Federal Signal Corp., 79 N.Y.2d 540, 554, 583 N.Y.S.2d 957, 593 N.E.2d 1365 [1992] ).

Morgan Stanley is the successor in interest to Morgan Stanley Mortgage Capital, Inc., which sold debt, in the form of 1,873 residential mortgage loans, to a Morgan Stanley affiliate, Morgan Stanley Capital I, Inc. The sale, which represented an unpaid principal balance of more than $600,000,000, was largely effectuated through two integrated agreements, a Mortgage Loan Purchase Agreement (MLPA) and a Pooling and Servicing Agreement (PSA), both dated as of September 1, 2006. These residential mortgage loans were pooled together and sold to the Trust, which issued certificates representing ownership shares in the combined assets. These RMBS were then offered for sale, by prospectus, to investors. Mortgage payments were the anticipated source of revenues that the Trustee would use to pay investors. However, when hundreds of the borrowers defaulted in making their mortgage payments, the RMBS became virtually worthless (see Nomura at 99, 19 N.Y.S.3d 1 [discussion on how RMBS are created] ).

MLPA Article III, section 301, sets forth 39 warranties and representations made by Morgan Stanley in connection with the sale of the loans to the Trust. These are incorporated by reference in the PSA. Most of the representations and warranties pertain to the characteristics, quality and overall risk profile of the loans. Among them are the following:

“(a) The information set forth in the Mortgage Loan Schedule is complete, true and correct in all material respects as of the Cut–Off Date [September 1, 2006].

“(b) Seller is the sole owner and holder of the Mortgage Loans free and clear of any liens ... and has full right and authority to sell and assign same ...

“(d) The Mortgage Loan is not in default and all monthly payments due prior to the transaction have been paid ... “(m) There is no default, breach, violation, anticipated breach or event of acceleration existing under the Mortgage or the related Mortgage Note and no existing or known event which, with the passage of time ... would constitute a default, breach, violation or event of acceleration under such Mortgage or the related Mortgage Note ...

“(w) Each Mortgaged Property is improved by a one- to four-family residential dwelling ... ”

The MLPA states further that any representations and warranties are made to the “best of the Seller's knowledge” and provides for the following actions to take place in the event of a breach:

“(mm) ... if it is discovered by the Depositor, the Seller, the Service or the Trustee ... that the substance of such representation and warranty is inaccurate and such inaccuracy materially and adversely affects the value of the related Mortgage Loan or the interest therein of the Purchaser or the Purchaser's assignee, transferee or designee then, notwithstanding the Seller's lack of knowledge with respect to the substance of such representation and warranty being inaccurate at the time the representation or warranty was made, such inaccuracy shall be deemed a breach of the applicable representation or warranty.”

If any party later discovered that any loans breached a representation or materially and adversely affected the value of any loan, the purchaser's interest, etc., then within 90 days of such discovery, the party discovering the defect had to notify the other parties and the seller was obligated to cure the defect by providing any missing documentation, replacing the defective mortgage with an “eligible” one, or repurchasing the affected loan at the “purchase price,” defined as follows:

“the sum of (i) 100% of the unpaid principal balance of the Mortgage Loan on the date of such purchase and (ii) accrued interest thereon ... from the date through which interest was last paid by the Mortgagor to the Due Date in the month in which the Purchase Price is to be distributed to Certificate holders ... and (iii) costs and damages incurred by the Trust Fund in connection with repurchase ... that arises out of a violation of any predatory or abusive lending law ...”

The MLPA provides further that

“it is understood and agreed that the obligations of the Seller in this Section 3.01 to cure, repurchase or substitute for a defective Mortgage Loan constitutes the sole remedy of the Purchaser respecting a missing or defective document or a breach of the representations or warranties contained in this Section 3.01” (emphasis supplied).

The complaint alleges that the Trust has suffered more than $140 million in damages attributable to the falsity of the representations and warranties made by Morgan Stanley with reckless indifference, because it did not adhere to the barest minimum of underwriting standards. The Trustee claims that when it notified Morgan Stanley of the defective loans, demanding that Morgan Stanley repurchase them, Morgan Stanley refused to do so. The Trustee claims that upon conducting a forensic examination of the RMBS, it discovered that there were hundreds of loans that were of lesser quality than what Morgan Stanley had represented. The complaint alleges many of the underlying borrowers obtained their loans by providing basic and critical information on their applications that was inaccurate, if not outright false, and that Morgan Stanley failed to verify. For instance, the borrowers misrepresented their incomes, inaccurately reported their employment statuses and/or employment histories, and/or misrepresented their actual debt obligations. Some borrowers failed to disclose ownership of other mortgage encumbered properties, or that they did not occupy the underlying properties securing the mortgages. Many loans had incorrect and/or unsatisfactory debt-to-income ratios. The complaint alleges that Morgan Stanley should have notified the Trustee of these breaches because it knew of them, or could have discovered them with due diligence, given its superior access to documents and information about these loans. The Trustee contends that Morgan Stanley made representations to make the loans appear less risky than they were. Despite the sole remedy provision, the complaint alleges that contractual damages will not adequately compensate the Trust for its losses.

Morgan Stanley moved to dismiss the complaint. The motion court dismissed the fifth cause of action alleging a breach of contract based on Morgan Stanley's failure to notify plaintiff about the defective loans. The motion court rejected the Trustee's argument that Morgan Stanley's inaction constituted an independent breach of contract claim, finding that the requirement was not a contractual obligation, but merely a notification remedy. The motion court also dismissed the claims that Morgan Stanley's conduct constituted gross negligence on the basis that “the relief available to plaintiff is limited by the sole remedy provisions in the [PSA] and the [MLPA] ...” Alternatively, the motion court held that even if, legally, the sole remedy limitations in the MLPA and PSA could be rendered unenforceable by Morgan Stanley's willful misconduct or gross negligence, the complaint...