Monday, February 11, 2013

Sole Remedy v. Rescissionary Damages

In a little noticed decision by the 1st Appellate Division involving MBIA v Credit Suisse, the appeals court unanimously held that a waiver of jury trial contained in a mbs transaction document was not applicable where MBIA was alleging that there was fraud in the inducement to enter into the transaction document.  See 1st-Appellate-Division-Order.  This decision has important implications for the ability of MBIA to prove damages in its other actions against Bank of America (BAC) as well as other mbs originators.

As I discuss below, if MBIA can obtain rescissionary damages from BAC because the insurance contract is voidable due to BAC's breaches that induced MBIA to enter into the insurance contract, then all of the provisions in the insurance contract that might limit MBIA's recovery may similarly be avoided.  The most important such limitation, providing that the monoline's "sole recovery" for breach is to put back defective loans for repurchase, has the potential to limit a monoline's recovery in a way that rescissionary damages does not.  Even if the mbs originator's liability for breach is proven, a monoline will want to maximize its damage recovery by claiming rescissionary damages rather than damages for breach of a putback obligation.

For example, take the recently issued opinion by Judge Rakoff in the case of Assured Guaranty v. Flagstar.  When Judge Rakoff found that Flagstar had breached its transaction document representations and warranties (R&W) made to Assured Guaranty, Judge Rakoff analyzed damages payable by Flagstar in terms of the documents' provision that Assured Guaranty's "sole remedy" was to put back defective mortgage loans to Flagstar for repurchase.  When Judge Rakoff found further that Flagstar breached its repurchase obligation, Judge Rakoff then went into a "what if" analysis to determine whether Assured Guaranty would have incurred losses even if Flagstar had honored its repurchased obligation.

This "what if" analysis gave Flagstar a second bite of the apple, to show that even if it had repurchased all of the defective loans in the trust pools that Assured had guaranteed, Assured had no damages arising from Flagstar's breach because Assured would have incurred insurance losses in any event.  This might happen, for example, because there was insufficient credit support created by the securitization structure.  This is a causation argument made by mbs originators applied to the monolines' damages claim as opposed to their liability claim.

In the event, Judge Rakoff found that based upon Assured Guaranty's expert evidence as to the hypothetical outcome of the trusts' payment waterfalls where there was no putback breach, Assured Guaranty would have suffered no losses.  This proved that Flagstar's failure to honor its repurchase obligation, in fact, resulted in Assured Guaranty's losses, thereby entitling Assured Guaranty to the award of its damage claims almost in their entirety.

MBIA is pursuing put back claims against BAC and its other mbs defendants, similar to Assured Guaranty, and will have to prove its damage claim under this theory of the case in a similar manner.  If, for example, MBIA can't prove that it would have avoided losses if BAC repurchased all defective loans, then MBIA might be able to win on liability but lose on damages.

But importantly, MBIA is also seeking rescissionary damages for breach of insurance agreement.  Because the truth of BAC's R&Ws was a condition precedent to MBIA's entering into the insurance agreement, and NY insurance law provides that an insurer is entitled to void an insurance contract where the insured has misrepresented facts at the time the contract is entered into (see MBIA's primary liability claim), MBIA is seeking to be placed in the same position it would have been had it known the true state of affairs with respect to BAC's mortgage loan pools and, therefore, it declined to insure the pools.

Justice Bransten has already ruled in a preliminary motion that MBIA is entitled to rescissionary damages if it can show that it would not have insured the pools had it been aware of BAC's R&W breaches. BAC has appealed this decision.  An issue raised on appeal is whether MBIA is barred from receiving rescissionary damages from BAC where it will not rescind its insurance contracts.  MBIA will not rescind because of the resulting inequity to faultless insured noteholders.  BAC argues also that MBIA cannot rescind where MBIA has continued to receive insurance premiums.  There is NY insurance caselaw to the effect that an insurer cannot deny recovery for misrepresentation by the insured where the insurer becomes aware of the misrepresentation but continues to maintain the policy and collect premiums.

MBIA is arguing on appeal with respect to this argument that one must distinguish its right to rescind its insurance agreement (one form of recovery), which MBIA is not pursuing because its insurance contract is unconditional, from its right to receive rescissionary damages from BAC (a different from of recovery).  By obtaining rescissionary damages, MBIA is seeking to be put in the position it would have been in if MBIA had been aware of BAC's misrepresentations and declined to insure, without resulting in the harm to faultless noteholders that would result from rescission.  See MBIA's appellate brief.  The NY insurance law regarding continued receipt of premiums is inapposite where, as MBIA argues, rescission is impracticable (inequitable to faultless noteholders to void insurance).

But another BAC argument on appeal is that where the insurance agreement stipulates that MBIA has a "sole remedy" for breach of R&W, MBIA cannot go outside that contractual limitation to obtain an alternative remedy.  This argument is really identical to the argument that was before the 1st Appellate Division, that a contractual bar to jury trial cannot be circumvented by the claim that the contract is voidable in the first instance.

We know now what the 1st Appellate Division thinks of that argument.

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.


  1. No "disclosure: long MBI"? Did you exit your position or just not include the disclosure?

  2. I was surprised today that the 1st Appellate Division reversed Justice Bransten on the availability of rescissory damages. Not clearly explained why just because MBIA made policies unconditional for benefit of noteholders, MBIA couldn't seek damages from originator. I wouldn't expect the NY Court of Appeals to grant leave to appeal to either BAC or MBIA.