Case Comment: Don't Forget Your Belts and Suspenders - Drafting Governing Agreements for Residential Mortgage Back Securities

Nicolas Pastor

Introduction

It should be no surprise that disputes involving Residential Mortgage-Backed Securities, (RMBS), have entered the sphere of New York City’s Court system. Before the market collapsed in 2008, these securities were essentially the “Wild West.” The seeming lawlessness in this new frontier perhaps showed human nature’s truest form. Further, it became abundantly clear that only Darwin’s fittest would survive. With billions of dollars at stake, a party’s mistaken omission of key contractual provisions equated to a death sentence. An oversight of this magnitude destined the runt of the litter to perish. IKB Int'l, S.A. v. Wells Fargo Bank, is the perfect example of this principle: the Court of Appeals has made it clear that the governing agreements of RMBS are in fact governing, and the court will not read-in implied duties that should have been explicitly delineated in these contracts.

Mortgage-Backed Securities

First, it is important to establish the players and set the scene. Residential Mortgage-Backed Securities are “the bundling of mortgage loans into a pool,” which are then sold to an affiliated purchaser, who in turn, “[p]laces the loans into a trust for securitization purposes.”^[1] This trust then sells certificates to purchasers who become certificate holders following their investment.^[2] Subsequently, when mortgagors pay the principal and interest on their respective mortgage, the certificate holders profit.^[3] However, as with any investment, the opportunity for profit inherently involves risk. The certificate holders have no direct relationship with the originating lenders of the RMBS: they thus have no say in the lending process.^[4] Certificate holders are at the mercy of the originating lender’s representations and warranties regarding the creditworthiness of the mortgagors.^[5] Meaning, if a mortgage within the trust is in breach of the originator’s representations and warranties, the certificate holders cannot directly hold the originator accountable, but rather the certificate holders must rely on the Trustee of the trust to “demand a repurchase of any defective mortgage that is in default.”^[6] The responsibilities of the Trustee are enumerated “by the securitization trusts’ governing agreements.^[7] One would imagine that the securitization trusts’ governing agreements are both heavily negotiated and scrutinized; however, these agreements are not immune to human error and omission in drafting.^[8]

Procedural History:

To best understand the case at hand, we must first start with the lawsuit at the trial level. Plaintiffs, IKB International, S.A. and IKB Deutsche Industriebank AG, purchased over $1 billion dollars’ worth of RMBS “certificates issued by 163 RMBS trusts for which defendants served as the trustees or co-trustees.”^[9] The central issue throughout the course of litigation, was Plaintiffs’ contention that defendants breached contractually defined duties and obligations. As best explained by the Court of Appeals, IKB, the certificate holders of the RMBS, brought action and sued the RMBS’ Trustees, alleging a breach of the governing agreements for “failing to enforce the pre-event of default (EOD) repurchase obligations of the obligated party.”^[10] Essentially stating that the Trustees failed to enforce, “the seller’s and/or originator's obligation to substitute or repurchase mortgage loans that do not conform to the seller's [representations and warranties].”^[11]

Further, the trial court narrowed this issue to a central question: When the governing agreements does not specifically state that the Trustee is the obligated party charged with the duty to enforce EOD repurchase obligations, does the certificate holder have an actionable offense against the Trustee for a failure to act in this regard?^[12] Both the trial court and the Appellate Division answered affirmatively, declining to grant Defendant’s motion to dismiss with respect to this issue. The trial court holding that “[t]he silence of the governing agreements as to the particular party . . . does not relieve the Trustees of their obligation to enforce remedies pursuant to the broader charge of the governing agreements”^[13] and the Appellate Division holding that the trial court “correctly declined to dismiss the . . . repurchase enforcement claims involving those governing agreements where the repurchase protocol is silent as to any enforcement mechanism, including specifying the party responsible for its enforcement.^[14]

As a result, the Court of Appeals was tasked with reexamining the lower courts’ decision to not dismiss Plaintiffs’ claim for breach of contractual duty. At issue were twenty-five trusts whose governing agreements did not specify that the Trustees were the obligated party in the enforcement of EOD repurchase obligations^[15].

The Governing Agreements in Question

Sections 2.02 and 2.03 of these twenty-five governing agreements states that:

When a document defect or breach of representations and warranties in a loan is discovered, the obligated party must first attempt to cure the defect or breach and, if the defect or breach cannot be cured, the obligated party must then remove the loan and either substitute a complying loan in its place or repurchase the loan.^[16]

Notably, neither of these sections explicitly state who the obligated party is; nor does it state which party is responsible for the repurchase obligation itself or the enforcement of the repurchase protocol.^[17] Plaintiffs contend that Section 2.06, which obligates the Trustee to “exercise the rights referred to above for the benefit of all … Holders of Certificate,” creates an affirmative duty of the Trustee to enforce the repurchase protocols set forth in Sections 2.02 and 2.03 because of their physical placement above 2.06 within the governing agreements.^[18]

The Appellate Division’s Take

The Appellate Division held that contract interpretation should be holistic and that “every part should be given ‘effect’.”^[19] This court thus concluded that the phrase “agrees to,” found in Section 2.06, created an express affirmative duty in the Trustee to enforce the repurchase protocols enumerated in the prior sections of the governing agreement. ^[20]Its reasoning largely centered around avoiding a reading that is “absurd [and] commercially unreasonable … [to the] expectations of the parties.”^[21]

The Court of Appeals’ Response

This finding of law was directly overruled by the Court of Appeals, as they did not find a breach of an implied contractual duty by Wells Fargo.^[22] Plaintiff’s contention that Section 2.06 created an implied affirmative duty to enforce repurchase protocols, was not accepted by the Court, as they specifically elected to read within the four corners of the governing agreements, in accordance with their prior jurisprudence.^[23] Additionally, language within other provisions of the governing agreements almost extinguishes the possibility of implied duties; the court noting that, “[t]he governing agreements here make clear [a] circumscribed scope of duties.”^[24] The Court found that the responsibility to enforce the repurchase protocols could not be thrusted upon the Trustees, because of the failure to include explicit language outlining which party was tasked with the enforcement of the EOD repurchase agreements in Sections 2.02 and 2.03.^[25]

Importantly, the Court stated that the phrase “[e]xercise the rights referred to above,” found in Section 2.06, merely explains that the Trustee is to act for the benefit of the certificate holders and thus does not create any implied duties.^[26] The Court largely relied on Phoenix Light SF Ltd. v Deutsche Bank Nat'l Tr. Co., 585 F Supp. 3d 540, 591 (SD NY 2022), which dealt with the similar issue of a plaintiff contending that “the rights referred to above” language created an affirmative duty in Deutsche Bank, the defendants, to enforce repurchase obligations.^[27] Similar to the governing agreement between IKB and Wells Fargo, the agreement between Phoenix Light and Deutsche Bank contained a nearly identical provision stating that Deutsche Bank’s duties were limited to the express provisions of the governing agreements.^[28] The court thus concluded that “it would be improper to interpret the vague, general language of the ‘rights referred to above’ clauses to create an implied repurchase duty in direct contravention of the GAs' [governing agreement’s] other provisions.”^[29] This reasoning was directly applied to the present case at hand. The Court of Appeals determined that reading Section 2.06 in a way that places an implied affirmative duty on Wells Fargo would directly contradict the governing agreement’s assertion that the Trustee “shall undertake to perform such duties and only such duties. . . specifically set forth in this [a]greement.”^[30] From the Court’s perspective, it became abundantly clear that a drafting omission occurred as both parties were well aware of the requisite language that was necessary to create a duty in the Trustee to act.^[31]

The proverbial nail in the coffin for Plaintiffs’ claim arose when comparing the twenty-five trusts at issue in the present case with the other trusts within the RMBS. The other trusts had specific language within their governing agreements that expressly provided the Trustee’s duty to enforce repurchase protocols.^[32] Other courts have asserted that evidence of this language in the other trusts was not dispositive of drafter omission, stating that including this express language was merely “belt and suspender” language that possibly could have been omitted by the use of form agreements.^[33] However, the Court of Appeals made it abundantly clear that accepting the “belt and suspender” argument “would require us to disregard the plain language of the contracts and resort to unsupported speculation about the drafting process.”^[34] As a result, the Court concluded that Plaintiffs’ claim arising from the failure to enforce repurchase obligations should be dismissed.^[35]

Additionally, the Plaintiffs asserted torts claims arising out of the alleged breach of contract. The Court utilized the test set forth in Sommer v Federal Signal Corp., 79 NY2d 540, 552 (1992), which “evaluate[s] the nature of the injury, how the injury occurred and the harm it caused" to determine whether Plaintiffs’ tort claim was duplicative of their breach of contract claim.^[36] The Court quickly concluded that Plaintiffs’ tort claims were by nature as they stemmed from the same occurrence and resultingly dismissed this claim.^[37]

Conclusion

In Sum, the decision from the Court of Appeals has significant importance for practitioners. The Court alluded to the fact that the apparent drafter omission within the governing agreements could have occurred as a result of some last-minute deal making and negotiations.^[38] In this matter, this contractual oversight left the Plaintiffs essentially grasping at straws when their certificates became worthless. This case should serve as a sort of cautionary tale. Drafting parties must pay particular attention; purported catch-all language within the governing agreements will not create an implied duty in Trustees to enforce repurchase obligations. While the Trustees in this case breathed a very real sigh of relief, they too should not overlook the importance of this decision. Simply put, if a duty is enumerated in the governing agreements, the Trustee must tend to it. It is likely that because of this decision, governing agreements will be more heavily scrutinized and negotiated, which, one could argue, is a societal net positive. It becomes ever apparent that investors in residential mortgage-backed securities should be wary of ‘standard boilerplate’ contracts, and that they must spend the time and resources reviewing RMBS’ governing agreements prior to the purchase of these securities. The Court has made it clear that it will only entertain those who remember to wear their belts and suspenders.

---

^[1] Deutsche Bank Natl. Trust Co. v. Barclays Bank PLC 34 N.Y.3d 327, 117 N.Y.S.3d 137, 139 (2019).

^[2] Id.

^[3] Id.

^[4] IKB Int'l, S.A. v. Wells Fargo Bank, N.A., 40 N.Y.3d 277, 197 N.Y.S.3d 719, 731-32 (2023) (Wilson, J., dissenting).

^[5] Id.

^[6] Id.

^[7] IKB Int'l, S.A. v. Wells Fargo Bank, N.A., 40 N.Y.3d 277, 197 N.Y.S.3d 719, 723 (2023).

^[8] Id. at 732 (explaining that “[t]he repurchase/replacement right is a key mechanism by which the investor is assured of the soundness of the investment, given the lack of examination into the individual loan files before the loans are pooled).

^[9] IKB Int'l, S.A. v. Lasalle Bank N.A., 2021 NY Slip Op 30265(U) (Sup.Ct., N.Y. Co. 2021).

^[10] IKB Int’l S.A. 40 N.Y.S. 3d at 724.

^[11] IKB Int'l, S.A., 2021 NY Slip Op 30265(U) at 28.

^[12] Id. at 30.

^[13] Id.

^[14] IKB Int'l, S.A. v. Wells Fargo Bank, N.A., 208 A.D.3d 423, 175 N.Y.S.3d 5, 9 (1st Dept. 2022).

^[15] Id.

^[16] IKB Int’l S.A. 40 N.Y.S. 3d at 725.

^[17] Id.

^[18] See id. at 726; see Brief for Respondent at 11, IKB Int'l, S.A. v. Wells Fargo Bank, N.A., 40 N.Y.3d 277, 197 N.Y.S.3d 719 (2023) (2022-00165) (“[t]he Trustee agrees to hold the Trust Fund and exercise the rights referred to above for the benefit of all present and future Holders of the Certificates and to perform the duties set forth in this Agreement in accordance with its terms).

^[19] IKB Int'l, S.A, 175 N.Y.S.3d at 9 (citing Nomura Home Equity Loan, Inc., Series 2006-FM2 v Nomura Credit & Capital, Inc., 30 NY3d 572, 581, 69 N.Y.S.3d 520, 92 N.E.3d 743 (2017).

^[20] Id. at 9.

^[21] Id. at 12 (citing Matter of Lipper Holdings v Trident Holdings, 1 AD3d 170, 171, 766 N.Y.S.2d 561 (1st Dept 2003)); see id. at 12 (explaining that “[i]f no party to the agreement has the obligation to enforce the repurchase protocol in the event of the obligor’s breach, the repurchase protocol is effectively nullified).

^[22] IKB Int’l S.A. 40 N.Y.S. 3d at 722.

^[23] Id. at 725 (explaining “[w]e have long held that ‘when parties set down their agreement in a clear, complete document, their writing should as a rule be enforced according to its terms’) (citing Nomura, 30 NY3d at 58)

^[24] See id. (here the Court recounts the explicit language found within the governing agreements “the Trustee ‘shall undertake to perform such duties and only such duties as are specifically set forth in this Agreement,’ that ‘the duties and obligations of the Trustee shall be determined solely by the express provisions of this Agreement,’ that ‘the Trustee shall not be liable except for the performance of such duties and obligations as are specifically set forth in this agreement,’ that ‘no implied covenants or obligations shall be read into this Agreement against the Trustee’”)

^[25] Id.

^[26] Id. at 726.

^[27] Phoenix Light SF Ltd. v Deutsche Bank Nat'l Tr. Co., 585 F Supp 3d 540, 591 (SD NY 2022)

^[28] See id. (explaining that express language within the governing agreements is ruling: “the ‘duties and obligations of’ DB ‘shall be determined solely by the express provisions of this Agreement, and [DB] shall not be liable except for the performance and obligations specifically set forth in this agreement’”).

^[29] Id.

^[30] See IKB Int’l S.A. 40 N.Y.S. 3d at 725; see IKB Int’l S.A. 40 N.Y.S. 3d at 727.

^[31] See IKB Int'l, S.A, 175 N.Y.S.3d at 9 (Singh, J., dissenting) (explaining “It is clear from the agreements that the drafters understood what language [was necessary] to use to impose an affirmative duty on the trustee”); see also IKB Int’l S.A. 40 N.Y.S. 3d at 727.

^[32] See IKB Int’l S.A. 40 N.Y.S. 3d at 727 (“the Trustee ‘shall enforce the seller's obligation to repurchase’ or that another party acting on the Trustee's behalf ‘shall enforce’ the repurchase obligation).

^[33] See id. at 728 (“the inclusion of this language in some agreements but not in others is "'belt and suspender' language" that is "the product of being added to a form agreement that was 'duped out' as part of the deal documents in some cases but not others").

^[34] id.

^[35] Id.

^[36] See Sommer v Federal Signal Corp., 79 NY2d 540, 552, 583 N.Y.S.2d 957 (1992) (holding the Court “evaluate[s] the nature of the injury, how the injury occurred and the harm it caused"); see IKB Int’l S.A. 40 N.Y.S. 3d at 729.

^[37] See IKB Int’l S.A. 40 N.Y.S. 3d at 729 (holding “we conclude that any remaining tort claims, alleging conflict of interest and fiduciary duty violations, must be dismissed).

^[38] Id. at 728 (“The argument to the contrary, that the inclusion of this language in some agreements but not in others is ‘belt and suspender' language that is ‘the product of being added to a form agreement that was 'duped out' as part of the deal documents in some case but not others’”) (quoting (Finkelstein v U.S. Bank, N.A., 75 Misc. 3d 1202[A], 166 N.Y.S.3d 510 (Sup Ct, NY County 2022)).