Sole Remedy Clause May Not Insulate a Contracting Party From the Damages Caused by Its Gross Negligence

• Posted on: Aug 18 2016

In the commercial world, parties to a transaction often allocate the risk of economic loss in the event the transaction is not fully executed by including a sole remedy clause in their agreement. New York courts have long upheld such contractual provisions. However, as the First Department of the New York Supreme Court, Appellate Division, recently held, there are exceptions.  One such exception pertains to a party’s grossly negligent conduct. As explained in Morgan Stanley Mortgage Loan Trust 2006­13ARX v. Morgan Stanley Mortgage Capital Holdings LLC, 2016 NY Slip Op. 05781 (1st Dep’t. Aug. 11, 2016), a party cannot “insulate itself from damages caused by its grossly negligent conduct.” Id. at *4 (internal quotations omitted).

THE CASE

The case arose from the securitization and sale of residential mortgages.  The underlying mortgage loans originated with an affiliate of the defendant, Morgan Stanley Capital Holdings LLC (“Morgan Stanley”). The mortgage loans were pooled together and sold to the Morgan Stanley Mortgage Loan Trust 2006­13ARX (the “Trust”), which, through the plaintiff, U.S. Bank National Association (the “Trustee”), issued certificates representing ownership shares in the combined assets. These assets were then offered for sale, by prospectus, to investors as residential mortgage backed securities (“RMBS”). The Trustee sued Morgan Stanley to recover the losses sustained by investors who purchased the RMBS after a massive number of the loans defaulted.

Facts:

In 2006, Morgan Stanley 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”). 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.

The Proceedings Below:

The Trust alleged that it incurred more than $140 million in damages due to Morgan Stanley’s false representations and warranties. According to the Trustee, Morgan Stanley acted with reckless indifference by failing to adhere to minimum underwriting standards.  The Trustee claimed that when it notified Morgan Stanley of the defective loans, demanding that Morgan Stanley repurchase them, Morgan Stanley refused to do so. The Trustee claimed that a forensic examination of the RMBS showed that there were hundreds of loans that were of lesser quality than what Morgan Stanley had represented. The complaint alleged that many of the underlying borrowers obtained their loans by providing inaccurate, if not outright false, information on their applications that Morgan Stanley failed to verify.

The Trustee maintained that Morgan Stanley should have notified the Trustee of these conditions because it knew of them, or could have discovered them with due diligence, given its access to documents and information about the loans. The Trustee alleged that Morgan Stanley made representations to make the loans appear less risky than they were. Despite the sole remedy provision, the Trustee alleged that contractual damages would not adequately compensate the Trust for its losses.

Morgan Stanley moved to dismiss the complaint. The trial court dismissed the cause of action alleging a breach of contract based on Morgan Stanley’s alleged failure to notify the Trustee about the defective loans. The 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 court also dismissed the Trustee’s claims that it was entitled to damages caused by Morgan Stanley’s gross negligence on the basis that “the relief available to plaintiff is limited by the sole remedy provisions in the [PSA] and the [MLPA]….” Slip Op. at *4 (internal quotations omitted). Alternatively, the 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 Trustee’s complaint “did not contain facts to sufficiently support that claim.” Id.

The Court’s Decision:

In dismissing the Trustee’s failure to notify cause of action, the trial court observed that the issues raised by the Trustee were substantially the same as those raised in Nomura Asset Acceptance Corp. Alternative Loan Trust v Nomura Credit & Capital, Inc., an RMBS case that was pending before it, and that its ruling was consistent with that earlier case.  However, after the parties briefed the appeal, the First Department modified the Nomura decision, “holding that under similar RMBS agreements, a seller’s failure to provide the trustee with notice of material breaches it discovers in the underlying loans states an independently breached contractual obligation, allowing a plaintiff to pursue separate damages.” Slip Op. at *4 (citing Nomura Home Equity Loan, Inc. v Nomura Credit & Capital, Inc., 133 A.D.3d 96, 108 (1st Dep’t 2015) (lv granted 1st Dep’t Jan. 5, 2016)). Consistent with the First Department’s Normura decision, the Court reinstated the failure to notify claim.

In connection with the Trustee’s claims of gross negligence, the Court held that although the courts in New York will honor “the remedies that the parties have contractually agreed to,” they will not allow a party to “insulate itself from damages caused by its grossly negligent conduct.”

As a general principle of law, damages arising from a breach of contract will ordinarily be limited to those necessary to redress the wrong (see e.g. Rocanova v Equitable Life Assur. Socy. of U.S., 83 NY2d 603, 613 [1994]). Where parties contractually agree to a limitation on liability, that provision is enforceable, even against claims of a party’s own ordinary negligence (Sommer v Federal Signal Corp., 79 NY2d at 553, 554) …. There are exceptions to this rule of law, however, and as a matter of long standing public policy, a party may not insulate itself from damages caused by its “grossly negligent conduct (Sommer at 554).

Looking at the complaint, the Court found that the Trustee sufficiently alleged that Morgan Stanley acted with reckless indifference. In that regard, the Court noted that:

[The Trustee] alleged there were widespread breaches across the loans being held by the Trust and that Morgan Stanley failed to adhere to even minimal underwriting standards or to verify basic and critical information about potential buyers; it further alleges that Morgan Stanley had access to the underlying loan files and that more than half of the loans later reviewed by plaintiff’s forensic analysts revealed rampant breaches of the warranties Morgan Stanley made. It further alleges that Morgan Stanley simply ignored its contractual obligations, disregarded the known or obvious risks that the loans sold to the Trustee were defective and then failed to notify the Trustee of any breaches or effectuate a cure/repurchase. We hold that these allegations are sufficient to withstand dismissal at the pleading stage.

Takeaway:

Agreements limiting the remedies available to parties for the failure to perform the terms of their agreement are enforceable under the law.  In fact, such provisions are an accepted means to allocate risk between the parties. Morgan Stanley teaches that despite the parties’ attempt to contractually limit the remedies available for a breach, they cannot limit the remedies available for their fraudulent or reckless misconduct.

Tagged with: Securities Arbitration