New billion-dollar MBS question: Are there limits on monoline damages?

April 11, 2013

Countrywide’s new lawyers in New York State Supreme Court litigation with MBIA have come out firing. In a pair of letters interpreting last week’s ruling by the Appellate Division, FirstDepartment, the bank’s counsel from Simpson Thacher & Bartlett are asserting an aggressive argument that the appellate opinion limits MBIA’s potential recovery to the repurchase of materially deficient underlying mortgage loans – a restriction that would prevent MBIA from collecting from the bank the full amount of insurance claims it has paid on underperforming Countrywide mortgage-backed securities. If Countrywide is correct – and that’s far from certain – bond insurers could have a much tougher route to recovery against MBS issuers than we’ve assumed in the wake of Assured Guaranty’s decisive win against Flagstar in February.

Here’s Countrywide’s argument, which the bank first staked out in an April 3 letter to New York State Supreme Court Justice Eileen Bransten of Manhattan, who is overseeing the MBIA case. The state appeals court, as you probably recall, ruled last week that MBIA may not recover rescissory damages, which the opinion called “a very rarely used equitable tool.” MBIA’s rescissory theory would have required Countrywide to, in essence, make MBIA whole, as if it had never agreed to insure Countrywide MBS in the first place. By knocking out that route to recovery, Countrywide argued, the appeals court left MBIA without any claim for compensatory damages. Instead, the bank said, under the terms of its agreements with the bond insurer, MBIA’s sole remedy is the repurchase of materially deficient underlying mortgage loans. “Any other interpretation is flatly contradicted by the First Department’s decision,” the bank said. “The First Department made clear that MBIA is not entitled to unwind the contract and receive all of its claims payments merely upon proving that it would not have entered the contract but for Countrywide’s alleged misrepresentations – this is the very rescissory relief that the First Department held unavailable to MBIA.”

MBIA’s lawyers at Quinn Emanuel Urquhart & Sullivan, you will not be surprised to hear, disputed Countrywide’s interpretation of the appellate ruling in their April 8 letterto Bransten, which offers what we English majors might call a close text analysis of the First Department’s cryptic missive. The bond insurer pointed to a sentence in which the appeals court said that MBIA can seek “recovery of payments made pursuant to an insurance policy without resort to rescission.” Why, MBIA asked, would the appeals court refer to recovery of those payments if MBIA’s sole remedy were repurchase? That’s especially true, MBIA argued, because the opinion cited insurance law provisions that provide for broad recovery. If the First Department had wanted to restrict MBIA’s damages to the “sole remedy” of repurchase – which is specified in only one paragraph of MBIA’s agreements with Countrywide – it would have said so.

MBIA asserted that the appeals court’s silence on the sole remedy question, in the face of vehement arguments by Countrywide in appellate briefing, amounted to a rejection of Countrywide’s position. The bond insurer cited the opinion’s final note – “We have considered the parties’ remaining arguments and find them unavailing” – as “clear” evidence that the appeals court was on its side.

But MBIA’s letter wasn’t the end of the debate-by-letter. On Wednesday, New York State Supreme Court Justice Charles Ramos, who is presiding over claims by the bond insurer Assured Guaranty against JPMorgan Chase and various Bear Stearns entities, gave Countrywide additional ammunition, as Simpson Thacher wrote in a second letter to Justice Bransten. Ramos (whose ruling is attached to the Countrywide letter) explicitly held that Assured’s sole remedy is the repurchase of deficient loans. That ruling, Countrywide said, put Ramos in good company with his former colleague Bernard Fried (now retired) and U.S. Senior District Judge Jed Rakoff, who also held in Assured’s case against Flagstar that the bond insurer’s sole remedy is repurchase. “The First Department panel implicitly endorsed Countrywide’s ‘sole remedy’ argument by favorably citing Judge Rakoff’s opinion,” the bank wrote. “Several other courts interpreting nearly identical contractual language have held that monoline insurers are limited to the express remedies agreed upon by the parties to the contract.”

So who’s right: Countrywide and JPMorgan in propounding a restricted view of what bond insurers may recover, or the bond insurers with their more expansive interpretation of damages? If you look to Rakoff’s rulings in the Assured case, which everyone, including the First Department, suggests, the answer is both. Rakoff did hold that Assured’s sole remedy is repurchase, as the banks assert. But he also did something a bit tricky in his post-trial decision. Rakoff said that Flagstar could not actually repurchase the deficient loans because they were in default and the 90-day cure period had long since passed. So instead, he said, Assured was entitled “to reimbursement of the claims it has paid to the bondholders to the extent that the (repurchase) amounts Flagstar should have paid into the trust would be sufficient to cover Assured’s claim payments.” The compromise basically made Assured whole, as if it had been entitled to compensatory damages. That’s the approach advocated by the monolines.

To make sense of the dueling Countrywide and MBIA letters on the Rakoff, Ramos and First Department rulings, I called Donald Hawthorne of Axinn, Veltrop & Harkrider. Hawthorne represents bond insurers in MBS litigation, so he’s admittedly not objective. But he’s also a former Debevoise & Plimpton counsel with an appreciation for defense arguments. Hawthorne acknowledged that the First Department holding on bond insurer remedies isn’t a model of clarity, but said the “fairest reading” of the opinion would permit MBIA to recover a form of compensatory damages. “The court said, we’re not going to recognize the unusual remedy of rescission, but we’re going to be more conservative and look under insurance law provisions.” It’s significant, Hawthorne said, that the court quoted language from insurance law provisions permitting insurers to avoid policies or block payment of claims.

Ramos’s decision may actually permit similar recovery, Hawthorne said, despite its “sole remedy” holding and its finding that Assured’s agreement with JPMorgan subsidiaries does not grant the insurer indemnification for policy claim payments. Ramos did find that Assured is entitled to reimbursement of its fees and cost under a provision of its insurance agreement. The judge quoted that provision as granting the insurer “full recourse against the seller for any payment made under that policy arising as a result of the seller’s failure” to repurchase defective loans. That provision could be Assured’s route to the sort of damages Rakoff effected in the Flagstar case, Hawthorne said. “That converts put-back claims due to the trust to cash payments to the insurer,” he told me.

So the bottom line, in Hawthorne’s reading, is that monolines should be able to obtain substantially all of their recovery even if repurchase is deemed to be their sole remedy. “From the plaintiffs’ side, these decisions are going to have little practical impact on recovery,” he said. “As the Assured case demonstrated, put-back recovery is going to give you back a substantial part of your claims.”

(This post has been corrected. A previous version incorrectly reported that Hawthorne was a partner at Debevoise and that Justice Fried was an appellate judge.)

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