By Thomas J. Quigley and Christopher C. Costello, Winston & Strawn LLP
The recent economic downturn has resulted in a greater number of real estate loans going into default. Many of these loans were packaged and sold as commercial and residential mortgage-backed securities (“MBS”) issued in the heyday of the real estate bubble. Borrower defaults have spawned a myriad of lawsuits by investors in mortgage-backed securities against lenders that sold the loans to securitization trusts.
Mortgage loan purchase agreements, which along with pooling and servicing agreements govern the sale of the loans into the trust, typically contain representations and warranties issued by the loan seller. The standard representations and warranties provide investors with assurances that the loans have been properly documented, appropriate underwriting standards and servicing practices have been complied with, and the seller knows of no borrower defaults, among others. The governing agreements also afford the trustee with specific remedies if a representation or warranty is breached.
The most common remedy sought on behalf of investors, through an action brought by the trustee or special servicer, is to compel the seller to repurchase the loan at the contractually-determined “repurchase price.” The obligation to repurchase, however, is not unconditional. It generally arises only when a breach has a “material and adverse effect” on the value of the loan, the underlying property or the interests of the investors. Technical breaches, or those with minimal impact, do not trigger the repurchase provision.
What constitutes a material and adverse effect is often a fact-specific inquiry. Some investors have argued that the material and adverse standard can be established by showing that had the breach been made known to them at the time of securitization, it would have impacted their investment decision. Investors advancing this theory rely on the purchaser's contractual right to “kick-out” an agreed-upon percentage of loans before closing. They contend “that the breach was material because the loan would not have been in the pool if the seller had informed the purchaser about the breach prior to its inclusion.”1 These investors seek to employ the securities law standard of whether a reasonable investor would have considered the information material to the decision to invest in the security.2
But, “investor materiality” and “material and adverse effect” are not synonymous. “Investor materiality” is not the appropriate standard to be applied to a breach of representation or warranty claim in a MBS transaction for several reasons. First, a material breach which would cause a prudent investor to remove the loan from the pool prior to closing might never ripen to the point where it affects the investors' interests in a way that is both material and adverse. For example, breaches that could impact the ability to foreclose on the property or collect from the borrower in the event of default might cause an investor to reject that loan, but if the loan performs, and there is no need to ever declare the loan in default, the breach might never have the requisite effect. While a loan does not necessarily have to go into default,3 as a threshold matter the seller has to show a measurable loss stemming from the breach. There is no hard and fast rule concerning what measure of loss is material, but at a minimum, the investor would be expected to demonstrate that the breach caused a meaningful diminution in the value of the investment.4
The timing of when to measure the effect of a breach further demonstrates the inapplicability of the investor materiality test to determine whether a breach had the requisite material and adverse effect. Many mortgage loan purchase agreements afford the loan seller a specified period in which to cure (i.e., a 90-day window that can be extended for an additional 90 days if the loan seller works diligently to cure the breach). If, for instance, there is a defect in the loan documentation that can be cured by the borrower's re-execution of documents within the time provided to cure, the breach cannot be deemed to have a material and adverse effect unless and until the cure period expires. Regardless of whether a breach of representation or warranty would have caused a buyer to remove a loan from the pool, if it was cured in a timely fashion, it did not materially and adversely have an effect on the investor's interests, and the repurchase obligation is unavailable.
In seeking to hold a loan seller liable, investors also often rely on one of the purposes of the mortgage loan purchase agreement — to allocate risk of loss between loan sellers and buyers.5 But not all risks are meant to be borne by the sellers. The material and adverse effect requirement should prevent purchasers from shifting the risks associated with their investment decision to the loan sellers which played no role in that decision-making process.
Assuming, however, that investors are correct in relying on investor materiality as the applicable standard by which a breach should be judged, loan sellers are not without rebuttal. If the investors' decision making is at issue, then all of the factors that led a purchaser to invest should be considered in determining what was and was not material to that decision.
For example, the “B-piece buyers” who purchase the unrated, riskiest tranches of an MBS routinely conduct extensive due diligence prior to closing. They examine the loans, mortgages and other relevant data, and often re-underwrite loans using proprietary models in order to forecast how a loan will perform in the future. These analyses are used to determine which loans are rejected or “kicked out” of the pool, and they reflect the information that was available to and relied upon by the B-Piece buyers prior to closing. In some instances, loans that are known to have an increased risk of default are allowed to remain in the loan pool simply because the B-piece buyers determined that those loans are not as risky as some of the others or, even if certain loans present a greater risk, those loans are not large enough to affect their planned rate of return as compared to larger loans that would have a greater impact upon default.
Investors who purchase the rated, or less risky tranches, implicitly rely upon the B-piece buyers to vet the riskiest loans, since losses are applied first to the owners of the unrated MBS certificates before they are applied to the holders of the higher, rated certificates. In other words, the B-piece buyers face the initial risk of loss and they would be the most likely investors to be impacted by loans that end up in default. Thus, in any evaluation of the investment decision-making process, the nature and extent of the due diligence conducted by the B-piece buyers, and by extension, the holders of the rated certificates, would be relevant in assessing the extent to which a breach of representation or warranty was truly material to the purchasers' decision of which loans to accept and which to “kick-out.”
Mortgage loan purchase agreements often provide that a seller is not relieved of liability for a breach simply because the purchasers conducted due diligence.6 But just because a loan seller is not relieved from liability as a matter of law does not mean that evidence of the investors' due diligence is not relevant to whether a breach of representation or warranty was in fact material to the investors. If the trust puts investor materiality at issue, the B-piece buyers' due diligence is clearly relevant evidence of what was important (and unimportant) in the decision-making process. Purchasers cannot use investor materiality as both a sword and shield.
Moreover, known risks should be taken into account in assessing what was material to the investors' decision. A disclosed risk can take precedence over an express representation or warranty absent an express preservation that the representation or warranty applies despite the disclosure.7 The prospectus, prospectus supplement and private placement memoranda that are made available to prospective MBS purchasers prior to closing contain detailed disclosures of the multitude of risks entailed in investing in an MBS, including the possibility that the underlying loan may lose value due to a variety of factors outside the control of the loan seller. Any representation or warranty that conflicts with these disclosed risks might well be unenforceable unless the governing agreements provide that the representation or warranty will continue to apply despite the disclosed warnings.
Even if a disclosed risk does not negate a representation or warranty, the risks disclosed to the purchasers are relevant to an evaluation of the purchasers' investment decision. The nature and extent of the risks that the investors were willing to bear sheds light on the purchasers' overall decision to invest in the MBS or to accept or reject particular loans in the pool.
In sum, investor materiality is the wrong standard to use in a MBS breach of representation or warranty case. A plain reading of that language rejects the notion that it is equivalent to a material and adverse effect on the loan, the property or the interests of the certificate holders. As one court noted, “[t]he fact that an investor might have made a different decision had he or she had different information may make that information material to the investor's decision, but it does not make the omission of that information cause a material and adverse effect on the loan. ‘Material information’ and ‘material effect’ are not the same thing.”8
But, if investors are allowed to equate material information with material effect, then what is good for the goose is good for the gander. All of the factors that went into the investors' decision, including their due diligence in deciding which loans to retain in the pool and which risks they knew or should have known they would have to assume, not just the representation and warranty provisions, should be considered in the analysis.
Thomas J. Quigley is a partner and Christopher C. Costello is an associate in the New York office of Winston & Strawn LLP. They specialize in commercial and financial litigation including MBS litigation.
© 2013 Winston & Strawn LLP
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