The Economic Loss Doctrine and the Split of Authority Within the Southern District of New York

• Posted on: Oct 18 2019

Readers of this Blog know that, as a general matter, New York courts will not permit a tort claim to survive a motion to dismiss when the claim arises from a breach of contract. [We have written about the Duplication of Claims Doctrine (here).] Indeed, courts routinely dismiss a tort claim where “[t]he existence of a valid and enforceable written contract govern[s] a particular subject matter” and the recovery sought arises out of the same facts and circumstances. Clark-Fitzpatrick v. Long Is., 70 N.Y.2d 382 (1987). However, where “a legal duty independent of the contract itself has been violated[,]” or where the misrepresentation is “collateral or extraneous to the terms of the parties’ agreement,” a fraudulent inducement claim can stand side-by-side with “a simple breach of contract” claim.  Dormitory Auth. v. Samson Constr. Co., 30 N.Y.3d 704 (2018) (citation omitted). See also Cronos Grp. v. Xcomip, LLC, 156 A.D.3d 54, 62-63 (1st Dept. 2017); McKernin v. Fanny Farmer Candy Shops, Inc., 176 A.D.2d 233, 234 (2d Dept. 1991).  This is arguably so even when the damages sought in the tort action overlap with the contract action. (Financial Structures Ltd. v. UBS A.G., 77 A.D.3d 417, 419 (1st Dept. 2010) (requiring each of the following elements to be present to find duplication: a tort is “based on the same facts that underl[ay] the contract cause of action, [was] not collateral to the contract, and d[id] not seek damages that would not be recoverable under a contract measure of damages.”).

In the Southern District of New York, the courts are split on the impact of overlapping damages. Compare Blackrock Core Bond Portfolio v. U.S. Bank Nat’l Ass’n, 165 F. Supp. 3d 80, 106 (S.D.N.Y. 2016) and Triaxx Prime CDO 2006-1, Ltd. v. Bank of New York Mellon, No. 16-cv-1597, 2018 WL 1417850, at **6-7 (S.D.N.Y. Mar. 8, 2018), aff’d sub nom., Triaxx Prime CDO 2006-1, Ltd. v. U.S. Bank Nat’l Ass’n, 741 F. App’x 857 (2d Cir. 2018) (summary order) (dismissing tort claims as barred by the economic loss doctrine) with Ambac Assurance Corp. v. U.S. Bank Nat’l Ass’n, 328 F. Supp. 3d 141, 157-60 (S.D.N.Y. 2018); Phoenix Light SF Ltd. v. Deutsche Bank Nat’l Tr. Co., 172 F. Supp. 3d 700, 719 (S.D.N.Y. 2016) (“Phoenix Light/DB”); Commerzbank AG v. U.S. Bank Nat’l Ass’n, 277 F. Supp. 3d 483, 496-97 (S.D.N.Y. 2017) (“Commerzbank/U.S. Bank”) (allowing tort claims to proceed).  “This schism centers on whether a defendant’s alleged breach of extra-contractual legal duties is independently sufficient to foreclose application of the economic loss rule, or whether a plaintiff must also allege damages flowing from the tort claims that are independent of the damages flowing from the contract claims.” Ambac Assurance Corp., 328 F. Supp. 3d at 158.  The district courts dismissing tort claims that arise from collateral facts or independent duties do so under the economic loss doctrine – e.g., courts dismiss claims even where the plaintiff alleged an extra-contractual duty because the damages alleged “in connection with the breach of fiduciary duty claims arise entirely from defendants’ obligations under the [contract].” Phoenix Light SF Ltd. v. U.S. Bank Nat’l Ass’n, No. 14-cv-10116, 2016 WL 1169515, at *9 (S.D.N.Y. Mar. 22, 2016) (“Phoenix Light/U.S. Bank”).

Under the economic loss doctrine, “[a] plaintiff cannot seek damages by bringing a tort claim when the injury alleged is primarily the result of economic injury for which a breach of contract claim is available.” Phoenix Light/DB, 172 F. Supp. 3d at 718-19 (citing BNP Paribas Mortg. Corp. v. Bank of Am., N.A., 949 F. Supp. 2d 486, 505 (S.D.N.Y. 2013)). Significantly, “Plaintiffs’ allegations that Defendant breached duties independent of its contracts do not, themselves, ‘allow evasion of the economic loss rule, which presents a second, distinct barrier’ to tort claims stemming from contractual relationships.” BlackRock Allocation Target Shares: Series S. Portfolio v. Wells Fargo Bank, Nat’l Ass’n, 247 F. Supp. 3d 377, 399 (S.D.N.Y. 2017) (“Wells Fargo I”) (quoting Royal Park Invs. SA/NV v. HSBC Bank USA, Nat’l Ass’n, 109 F. Supp. 3d 587, 599 (S.D.N.Y. 2015)). “The economic-loss rule provides that ‘a contracting party seeking only a benefit of the bargain recovery may not sue in tort notwithstanding the use of familiar tort language in its pleadings.’” Wells Fargo I, 247 F. Supp. 3d at 399 (quoting Phoenix Light/U.S. Bank, 2016 WL 1169515, at *9).

In National Credit Union Admin. Bd. v. Deutsche Bank Nat’l Trust Co., 14-cv-8919 (SHS) (S.D.N.Y. Oct. 15, 2019) (here), Judge Sidney H. Stein sided with the courts that applied the economic loss doctrine to dismiss negligence/gross negligence and breach of fiduciary duty claims seeking damages that overlapped with those sought by the plaintiff’s contract claims.

National Credit Union Administration Board v. Deutsche Bank National Trust Co.

Background

The National Credit Union Administration Board (“NCUA”) is an independent federal agency that regulates federal credit unions. Among NCUA’s powers is the authority to place failed credit unions into liquidation. Upon liquidation, NCUA succeeds to “all rights, titles, powers, and privileges of the credit union, and of any member, accountholder, officer, or director of such credit union with respect to the credit union and the assets of the credit union.” 12 U.S.C. § 1787(b)(2)(A)(i).

According to NCUA, in 2009 and 2010, in the aftermath of the financial crisis, it placed several failed corporate credit unions into liquidation and thus succeeded those entities. The failed corporate credit unions had assets that included residential mortgage-backed securities (“RMBS”) in trusts for which Deutsche Bank served as trustee. Each trust consisted of hundreds of individual residential mortgage loans that were pooled together and securitized for sale to investors. The trusts were governed by agreements called Pooling and Servicing Agreements (“PSAs”).

Plaintiff filed suit against Deutsche Bank in connection with its duties as Trustee to the RMBS trusts. According to the complaint, Deutsche Bank had both common law and contractual duties as Trustee to, inter alia, (1) review the underlying mortgage files for completeness and accuracy, (2) notify appropriate parties and take various actions should it discover breaches of representations and warranties (“R&Ws”) concerning the mortgage loans, and (3) take similar protective actions upon learning of events of default concerning the trust. NCUA alleged that Deutsche Bank was derelict in its duties and failed to perform its obligations. According to NCUA, reports of systemic problems with the mortgages and the trusts, as well as Deutsche Bank’s own involvement in the RMBS market, supported the likelihood that Deutsche Bank had notice of the issues with the underlying mortgages, and yet it allegedly took no remedial action.

Plaintiff asserted claims for: (1) breach of contract related to Deutsche Bank’s alleged breaches of the PSAs; (2) negligence and gross negligence related to Deutsche Bank’s alleged neglect of its duties as trustee; (3) breach of fiduciary duty; (4) declaratory judgment that Deutsche Bank was not permitted to use trust funds to pay its litigation costs; and (5) breach of contract for Deutsche Bank’s alleged unlawful withdrawals from the trust funds to pay its litigation costs.

The contract claims stemmed from Deutsche Bank’s contractual duties as Trustee under the PSAs. Among the duties alleged to have been breached include: (1) pre-Event of Default (“EOD”) obligations, such as taking possession of and reviewing mortgage files conveyed to the trust and notifying relevant parties of any defects as well as providing notice of and enforcing repurchase rights with respect to mortgages that were found to be in breach of the R&Ws, and (2) post-EOD obligations where, after Deutsche Bank had notice of an EOD, it was required to provide notice to all certificateholders and act prudently in managing the EOD.

The negligence/gross negligence claims stemmed from Deutsche Bank’s alleged duty to “administer the trusts without negligence” which it purportedly violated though the “fail[ure] to avoid conflicts of interest” and thus “protect the interests of the certificateholders,” specifically by not “(1) acting in good faith; (2) providing notice to certificateholders when appropriate … and (3) acting with undivided loyalty to certificateholders.” The breach of fiduciary duty claim stemmed from Deutsche Bank’s alleged fiduciary duty “following Events of Default to act in good faith, with due care and undivided loyalty, and without conflicts of interest, when performing the obligations set forth in the PSAs,” which NCUA alleged that Deutsche Bank failed to do.

On October 5, 2018, NCUA filed a motion for leave to file a proposed second amended complaint. Deutsche Bank opposed the amendment and moved to dismiss the amended allegations on the merits.

With regard to the negligence/gross negligence and breach of fiduciary duty claims, Deutsche Bank argued that those claims should be dismissed because: (1) they were barred by the economic loss doctrine; (2) they were duplicative of plaintiff’s contract claims; (3) there was no fiduciary duty and the allegations of conflicts of interest were conclusory; and (4) there could be no negligence because Deutsche Bank’s duties were limited under the PSAs.

Among other things, the Court denied the motion to dismiss Plaintiff’s contract claims and granted the motion to dismiss the negligence/gross negligence and breach of fiduciary duty claims.

The Court’s Decision

a) The Economic Loss Doctrine

The Court agreed with the courts within the Southern District of New York that found the economic loss doctrine to apply to tort claims asserted against RMBS trustees. The Court rejected NCUA’s assertion that the economic loss doctrine did not apply because it pleaded “a legal duty separate from the contract claim,” holding that “even if true, the economic loss doctrine ‘presents a second, distinct barrier’ to the tort claims.” Slip Op. at 26, quoting Wells Fargo I, 247 F. Supp. 3d at 399. See also Nat’l Credit Union Admin. Bd. v. U.S. Bank Nat’l Ass’n, No. 14-cv-9928, 2016 WL 796850, at *11 (S.D.N.Y. Feb. 25, 2016) (even where a claim “may arise from common law duties and not from the PSA, ‘the injury’ and ‘the manner in which the injury occurred and the damages sought persuade us that plaintiff’s remedy lies in the enforcement of contract obligations,’ and are barred by the economic loss doctrine.”) (quoting Bellevue S. Assocs. v. HRH Const. Corp., 78 N.Y.2d 282, 293 (1991)).

The Court held that “the basis for plaintiff’s damages sound in Deutsche Bank’s failures to take actions under the PSAs, for which the asserted contractual remedies would be appropriate.” Slip Op. at *26.  The Court found support in its decision in the Second Circuit’s summary affirmance of Triaxx and the Appellate Division, First Department’s decision in Blackrock Balanced Capital Portfolio in which the court affirmed the dismissal of the plaintiff’s tort claims against the RMBS trustee, finding that “‘the court correctly determined that the tort claims [were] barred by the economic loss doctrine.’” Id., quoting Blackrock Balanced Capital Portfolio (FI) v. U.S. Bank Nat’l Ass’n, 165 A.D.3d 526, 528 (1st Dept. 2018).

The Court took issue with NCUA’s argument that it had “actually asserted [a] separate duty owed by Deutsche Bank,” noting that “although the [proposed complaint] contain[ed] the proper words to make out an independent tort claim, the pleading [was] quite hollow on substance.” Id. at *27. Citing to the language of the proposed complaint, the Court stated: “The fact that Deutsche Bank’s alleged duty stems from the PSAs is revealed by the glaring oxymoron nestled within the PSAC’s negligence allegations: ‘Defendant owed the certificateholders, including Plaintiffs, extracontractual duties under the PSAs.’” Id. The Court rejected NCUA’s explanation that the use of the quoted language was intended to “to demonstrate that there were ‘extracontractual duties’, viewing such language as a mere label “to somehow transmogrify them into extracontractual claims.” Id., quoting Triaxx, 2018 WL 1417850, at *6.

The Court also found that the fiduciary duty claim suffered from the same infirmity. Id. “Less conspicuous but also consistent [was] the reference to the PSAs in the fiduciary duty count.” Id.

The Court concluded that “[b]ecause, among other indicators, the consistent references to the PSAs reveal[ed] how reliant NCUA’s tort claims are on the contracts at issue, the Court grant[ed] defendant’s motion to dismiss plainitff’s tort claims on economic loss grounds.” Id.

b) NCUA’s Tort Claims Were Deemed to Be Largely Duplicative of Its Contract Claims

“Independently”, the Court granted Deutsche Bank’s motion to dismiss NCUA’s tort claims because they were “duplicative of the contract claims – with one exception.” Id., citing Bayerische Landesbank, N. Y. Branch v. Aladdin Capital Mgmt. LLC, 692 F.3d 42, 58 (2d Cir. 2012) (where “the basis of a party’s claim is a breach of solely contractual obligations, such that the plaintiff is merely seeking to obtain the benefit of the contractual bargain through an action in tort, the claim is precluded as duplicative.”); Bakal v. U.S. Bank Nat’l Ass’n, No. 15-cv-6976, 2018 WL 1726053 (S.D.N.Y. Apr. 2, 2018), aff’d, 747 F. App’x 32 (2d Cir. 2019).

With respect to the negligence claim as it related to pre-EOD duties, the Court held that Deutsche Bank owed NCUA a duty to avoid conflicts of interest. Slip Op. at *28.  “Allegations of breach of an independent duty to avoid conflicts of interest,” said the Court, “are properly pled as negligence claims, not as breaches of any fiduciary duty.” Id., citing Phoenix Light SF Ltd. v. Bank of New York Mellon, No. 14-cv-10104, 2015 WL 5710645, at *7 (S.D.N.Y. Sept. 29, 2015). “Therefore,” concluded the Court, “solely to the extent that plaintiff’s negligence claim in Count Two alleges a breach of duty to avoid conflicts of interest, that claim is not duplicative.” Id., citing Commerzebank/BNYM, 2017 WL 1157278, at *6 (dismissing all tort claims as duplicative save for claims relating to trustee’s conflict of interest); Fixed Income Shares: £Series M v. Citibank N.A., 130 F. Supp. 3d 842, 857-58 (S.D.N.Y. 2015) (same). However, the Court dismissed the claim “because of the economic loss doctrine.” Id.

Takeaway

The economic loss doctrine preserves the distinction between claims sounding in contract and those sounding in tort and protects defendants from disproportionate damages awards that a judgment in tort may impose. Though originated in the context of product liability and construction cases, the economic loss doctrine has been applied in a wide variety of cases having nothing to do with their forerunners. Consequently, what was a straightforward way to achieve the goals of the doctrine has become a principle of law with no standard application.  

Given the split in authority within the Southern District of New York, the question remains whether the economic loss doctrine can truly be applied outside the products liability and construction law context.  National Credit Union answers this question by adding to the uncertainty surrounding application of the doctrine.

Tagged with: Breach of Contract, Breach of Fiduciary Duty, Economic Loss Doctrine, fraud and commercial litigation., Gross Negligence, Negligence