Wednesday, December 19, 2012

On MBIA's Motion For Summary Judgment on Breach of Insurance Agreement, Justice Bransten Has Nothing To Fear But Fear Itself

At the hearing before Justice Bransten last week on whether to grant MBIA summary judgment (SJ) on its claim that Bank of America (together with its affiliates, BAC) breached its insurance agreement with MBIA, BAC counsel had this to say:  "Now, the request by plaintiff here, your Honor, to award billions of dollars in damages in what amounts really to the word of one man sight unseen other than in the courtroom today whose testimony is flatly disputed by at least six Countrywide experts is remarkable, is extraordinary and I suggest to your Honor it is unprecedented."

Judges are institutionally reticent to find that there is no remaining issue of fact so as to authorize the grant of SJ, and BAC counsel led off its argument by seeking to stoke this reticence.  As well, "unprecedented" is not normally a part of a judge's comfort zone.  Whether or not this caused Justice Bransten any apprehension beyond normal judicial caution we will not know.  But if Justice Bransten thinks carefully about the nature of the evidence necessary to prove the breach of insurance agreement claim and reviews the actual evidence presented at the SJ hearing, then to paraphrase FDR, any fear Justice Bransten might have to award SJ to MBIA on the claim of breach of insurance agreement would be based only on fear itself.

It is important to keep in mind that with respect to MBIA's claim that BAC breached its insurance agreement, the facts necessary to prove this case are contained in boxes holding loan files...indeed, many boxes holding over 389,000 loan files.  This is entirely a documentary case, based on loan files that need to be inspected, and the results of this inspection that need to be analyzed and argued in terms of the representations and warranties (R/Ws) made about them in the insurance agreement. This is hardly a case that involves the "word of one man."
What needs to be done to prove or disprove a breach of R/Ws contained in the insurance agreement is to afford each side the opportunity to (i) inspect the loan files in the same statistically significant sample of loans selected from the insured securitizations, in effect conducting a re-underwriting of the loan files, (ii) issue a report based on its re-underwriting, and (iii) impeach the accuracy and validity of the other party's re-underwriting, if there is a material discrepancy between the results of each re-underwriting.  This has been done.  MBIA conducted its re-underwriting of the entire sample and issued its report (Butler report), whereas BAC declined to conduct a similar re-underwriting, but rather presented evidence in rebuttal of the Butler report.

Given that the R/Ws contained in the insurance agreement refer to matters relating to the mortgage loans that can be determined by means of a review of the documents contained in the loan files (as may be supplemented to the extent necessary by subpoenaed documentary information to verify matters such as borrower income), breach of insurance agreement R/Ws is not a claim where live witnesses are needed to present their recollection of events, the trier of fact should assess the live witnesses' demeanor or credibility, or the trier of fact is needed to determine whether some action was reasonable under the circumstances. 

The insurance agreement speaks for itself as a document to be interpreted as a matter of law.  Similarly, the results of the re-underwriting of the loan files by MBIA contained in the Butler report and BAC's rebuttal of the Butler report will determine whether the insurance agreement R/Ws have been breached, based on (i) the presence or absence of documents such as qualified appraisals, the mortgage note etc. in the loan files, and (ii) what those documents disclose on their face after inspection with respect to matters such as FICO score, combined loan to value ratio etc, as compared to the R/Ws made with respect to such matters.

As discussed below, for purposes of its SJ motion, MBIA is moving only on loans bearing defects that BAC's own executives have testified would adversely affect credit quality, and which BAC's own underwriting guidelines indicate are material (eg MBIA moved on SJ with respect to only incorrect FICO scores that caused the loan to be mispriced loan under BAC's pricing protocols, indicating materiality).

Of course, mistakes can be made in the re-underwriting process, but BAC has been afforded the opportunity to correct any mistakes made in the Butler report.  All of the loans have file numbers, they have been inspected, re-inspected, and any mistakes corrected.  There is no need for live witness testimony about the results of the re-underwriting, as once each party has had the opportunity to inspect the sample loan files and rebut the the results of the other party's re-underwriting, the results speak for themselves as competent testimony of each party.

Now after all this, if there is a material dispute between the results of the re-underwriting performed by BAC and MBIA, respectively, after eliminating any false discrepancies that Justice Bransten may determine to be irrelevant or improperly asserted as a matter of law, then there is a role for a trier of fact to sort through the re-underwriting dispute.

But, this is not the case with respect to MBIA's motion for SJ on breach of insurance agreement.  Indeed, after reviewing the results of the parties re-underwriting and reviewing the
disputes between these results, after eliminating those discrepancies that Justice Bransten is authorized to decide as a matter of law, and applying a materiality standard under New York insurance law that, while a mixed question of law and fact, is also susceptible of resolution on SJ, it is clear that MBIA is entitled to SJ on its claim of breach of insurance agreement. 

Section 3105 of the New York Insurance Law provides that

(a) a representation is a statement as to past or present fact, made to the insurer by...the applicant at or before the making of the insurance contract as an inducement to the making thereof.

(b) no misrepresentation shall avoid any contract of insurance or defeat recovery thereunder unless such misrepresentation was material. No misrepresentation shall be deemed material unless knowledge by the insurer of the facts misrepresented would have led to a refusal by the insurer to make the contract.

(c) In determining the question of materiality, evidence of the practice of the insurer which made such contract with respect to the acceptance or rejection of similar contracts shall be admissable.

Section 3106 of the New York Insurance Law provides that 

(a) warranty means any provision of an insurance contract which has the effect of a condition precedent of the insurer's liability thereunder, the existence of a fact which tends to diminsh, or the non-existence of a fact which tends to increase, the risk of the occurrence of any loss...

(b) a breach of warranty shall not avoid an insurance contract or defeat recovery thereunder unless such breach materially increases the risk of loss...within the coverage of the contract.

Four points to note:  (i) there is no statutory requirement for MBIA to show that it justifiably relied upon BAC's misrepresentations, unlike with respect to MBIA's fraud claim, where a showing of justifiable reliance by MBIA is necessary; (ii) the standard of materiality of the R/W breaches is not some industrywide or reasonableness standard, but rather a standard measured against MBIA's own underwriting practice; (iii) any insurance contract procured by a material misrepresentation is void ab initio (which establishes the basis for MBIA to ask for rescissionary damages); and (iv) MBIA need only show that BAC's breaches materially increased MBIA's risk of loss at the time the insurance contract was entered into, not that the breaches caused the loans to default.

MBIA's Butler report conducted a re-underwriting of a sample of 6,000 loans, spread equally over the 15 BAC securitizations at issue.  While BAC sought in its motion papers to both invalidate the statistical sample as evidence that can be extrapolated across all securitized loans as well as the Butler report, Justice Bransten has already ruled that MBIA's statistical sampling method is valid and the sample may be extrapolated as evidence with respect to all loans, and BAC's argument to invalidate the Butler report based upon Mr. Butler's alleged inadequacy as an expert is particularly weak.

The Butler reports showed that 56% of the loans contained material breaches of BAC's R/Ws in the insurance agreement, and MBIA argued in its SJ motion papers and at the SJ hearing that BAC's attempt to contradict the Butler report by offering rebuttal evidence contained only feigned attempts to create a triable fact, or were simply incorrect as a mater of law.

MBIA's reply brief states for example:

"(i) on the 1,423 loans that breached the representation and warranty that an appraisal had been performed by a "qualified appraiser," Countrywide ignores the "qualified appraiser" requirement and suggests that the borrower's own representation suffices; (ii) on the 626 loans that breached the representation and warranty that there had been "no default," Countrywide ignores that "default" is defined to include a misrepresentation by the borrower; and (iii) on the 460 loans that breached the representation and warranty that the Mortgage File is complete, Countrywide ignores the plain language of the Transaction Documents, and thus, incorrectly claims that with respect to certain of the loans, the missing document is not part of the Mortgage File."

These purported rebuttals by BAC do not create legitimate questions of fact because they are premised on incorrect legal assertions of what the securtization documents require, and Justice Bransten is perfectly capable on SJ motion to make this ruling as a matter of law.

At the SJ hearing, getting into the details of BAC's rebuttal, MBIA's counsel characterized BAC's attempt to contradict the Butler report, in order to create a genuine dispute of fact to defeat SJ, as insufficient as a matter of law.  For example, with respect to the qualified appraisal R/W, MBIA counsel stated:

"There 1,423 instances where we show that there was no qualified appraisal by a qualified appraiser. There are seven instances where Countrywide came back and said look we found an appraisal in the file, just seven. They put one of those on the screen. If you go through those, three of the seven, the basis for Mr. Butler's finding was not a missing appraisal, but that the appraisal was not performed by a licensed appraiser. For one of those loans the appraisal was in the first lien file, not in the second lien file. For two of those loans, the appraisal was in the second set of second lien files that they gave us, and for the last one the appraisal was in the second lien file but over 6 months old and therefore invalid. So you take the only seven instances on the appraisal rep where they came back with an actual dispute and of those three of them are on the wrong basis, and one of them is an invalid appraisal... We'll give them maybe it's two, maybe it's five, maybe it's seven. The bottom line is the overwhelming numbers here all point in the same direction. While they can quibble at the edges and produce instances in the ones and fives and sixes of disagreement with us as to each category, we have demonstrations as to the thousands and we submitted that in the Butler report."

With respect those loans that BAC was not able to contest contained breaches of R/Ws, BAC argued that the breaches were not material since many of these loans were still performing.  However, Justice Bransten has already ruled that MBIA must only show that a R/W breach increased MBIA's risk of loss at the time the insurance contract was made, and subsequent loan performance evidence is irrelevant.

BAC tried to argue that, with respect to determinations made in the Butler report that each R/W breach contained in the report was material, these determinations were a subject for a trier of fact to determine, rather than for a judge to determine at a SJ hearing.  But MBIA counsel was careful to point out that MBIA was only moving with respect to breaches that were deemed material under BAC's own guidelines.  MBIA's counsel stated at the SJ hearing:

"for this motion we moved only on objective standards of materiality as defined in Countrywide's own guidelines, pricing matrixes and witness testimony. The motion is not based on any subjective determination or expert opinion as to materiality by MBIA's expert. It's based on Countrywide's admissions as to what was material, what changed the pricing under their own protocols and so for example you've heard reference to this loan FICO was 698 instead of 701. There is a line that has to be drawn for characteristics of the borrower and it's Countrywide itself that draws that line. If you're above 700, you're a gold borrower. If you're below that, you're a preferred borrower and the preferred borrower pays higher interest because they are in a different bucket and Countrywide itself concluded that those are riskier loans... The risks are material under Countrywide's own unequivocal documents."

BAC also produced a report prepared by Professor Hubbard to the effect that loans that breach R/Ws did not fail to perform at a significantly higher rate than loans without such breaches.  MBIA responded that it had already produced testimony from BAC's own executives that the R/Ws with respect to the loans claimed to be in breach have the effect of increasing credit risk and risk of loss, that MBIA was not moving for SJ with respect to any R/W breaches that did not increase risk of loss.  Moreover,  the performance characteristics of loans is irrelevant, as the standard for breach is not whether the loans would not perform but rather whether they suffered an increased risk of loss.

BAC also argued that MBIA was on notice that there were R/W breaches when it received the results of a due diligence report prior to closing that indicated that some 30% of the loans in a small sample were "flagged" by the due diligence report.  But MBIA points out that the mere fact that they were flagged for further review and response by BAC doesn't mean MBIA had knowledge that these loans constituted breaches.  BAC responded to this due diligence report by stating that it would supply satisfactory responses why the flagged loans should remain in the securitizations, or remove the loans where it couldn't supply such response, and ultimately only 6% of the due diligence sample loans were removed from the securitizations.

But MBIA's larger point is that if BAC were trying to put MBIA on notice that there was on the order of 30% of the loans that contained a material breach of R/Ws, then BAC would have had a similar obligation under the federal securities laws to disclose that fact to the purchasers of the rmbs in a prospectus supplement filed with respect to the securitizations with the SEC and delivered to the purchasers.  And this BAC did not do. Moreover, actual knowledge by an insurer of the R/W breach is the New York standard, not just notice.

MBIA also has to show, based on its own underwriting guidelines, that it would not have written insurance on these securitizations if it had know that 56% of the loans breached the insurance contract's R/Ws.  MBIA went on to show that it maintained a "no-loss" underwriting standard, under which MBIA would only insure securitizations which it believed would result in no payments under the policy.  While Justice Bransten might determine that this is an actual question of fact, namely whether an insurer maintaining a zero-loss underwriting policy would have insured these securitizations containing loans 56% of which breached R/Ws, it is hard to see how this is a genuine factual question that can't be decided at SJ.

Ultimately, whether or not Justice Bransten grants MBIA SJ on its breach of insurance contract claim depends on the extent to which Justice Bransten is comfortable in going though the evidence presented at the SJ in order to determine whether there is genuine issue of material fact.  Set forth below is an extended excerpt from a colloquy between Justice Bransten and MBIA counsel that illustrates that she was at least initially reticent about deciding this claim without trial; whether she warms up to this notion based upon MBIA's argument remains to be seen:

"THE COURT:...I think there is a difference between being in the summary judgment mode and being before trial. If you're asking a jury to accept your sampling, if you're asking a jury to accept what you are proposing are the facts based on the sale (sic)[sample], the jury can reject that saying well I don't think the sampling is enough. Say because there will be cross examination also. After all the facts are before the jury. But the jury would be in a position of saying that indeed the mechanism of the sample not the fact that anybody has come out with a better sampling method, just the mechanism that you chose to use is not sufficient for me to accept that as the proof in this matter, me the jury. And what's different is when you come to the judge, the judge is really a tryer more of law and you're asking me to make a judgment call saying yes you're a hundred percent right, the sampling is perfect and let's go forward and give you summary judgment. But that's the job of the jury, not this jury but another jury.

MR. SELENDY: Your Honor, with respect they would need to present a genuine dispute of facts such as a reasonable jury could find otherwise. There is no contest. There is no contest. Expert discovery has closed. There will only be our expert as to sampling and extrapolation and with respect to their experts, they agreed and we cited this in our papers that the extrapolation method from Doctor Cowan was correct. So the testimony is undisputed as to the validity of that sample and extrapolation and there is a reason why they haven't come forward with another expert. That's because sampling loans is no different than sampling any other population. It doesn't matter whether it's loans or voters or otherwise. You could take a sample and you could extrapolate. If they had a valid basis to contest it, they would have done so and they haven't, your Honor. That period is now closed and they can't come back with a new expert and say look this sample is unreliable. They just conceded that issue on the papers. It's not that your Honor previously ruled we can go forward for all purposes. You gave them the opportunity to oppose us and they did not. That's an affirmative election. That means right now there is no basis for any reasonable jury to find otherwise than that our sample are properly --

THE COURT: That doesn't go to the next step. Yes, you could say you're a hundred percent right. The sampling method is perfect, it's wonderful and hasn't been contested. But does it prove -- does your sample prove the elements of your causes of action?

 MR. SELENDY: That's a separate issue, your Honor.

THE COURT: Yes, and a very important one.

MR. SELENDY: And that issue doesn't turn on the staple sample or the extrapolation. It turns on what have we shown as to misrepresentation, what have we shown as to materiality, what have we shown as to the causation of an increased level of risk from misrepresentation, and what have we shown as to MBIA's harm. Those are the elements and we do show those. Specifically, your Honor, coming back to the question of what do we have to show here. As to the element of causation I referred you to Judge Rakoff's holding in which he was citing to you approvingly that the question is whether the misrepresentations of the sponsor caused a material increase in risk to the insurer. That's exactly what we've gone through today both the facts of the misrepresentations and as to the materiality in terms of risk of loss. That's the finding. Those are the elements of our cause of action which were proven and were unrebutted. I'd like to say a little bit more with respect to the material and adverse affect ruling that your Honor previously entered. That ruling was subject to our ability to come forward with evidence. The evidence we submitted was from Countrywide's own witnesses and depositions taken after that motion was submitted to this court. It's subsequent new evidence. There are unequivocal admissions. They confirm that the tests of materiality is day one and we have shown through the documentation, through Countrywide's own files that the types of breaches in the record are material by their own admissions. That's as a matter of law. There is no reasonable dispute as to those issues."

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Disclosure: long MBI.  Follow me on twitter.

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