Defending Cases Involving Subprime Residential Mortgage Backed Securities

March 19, 2008March 19, 2008Scott E. EckasScott E. Eckas

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Subprime Litigation Includes …

Cases brought by investors in residential mortgage backed securities Cases brought by investors in residential mortgage backed securities (“RMBS”) against underwriters. (“RMBS”) against underwriters. See, e.g., Bankers Life Ins. Co. v. Credit See, e.g., Bankers Life Ins. Co. v. Credit Suisse First Boston Corp., et al.Suisse First Boston Corp., et al., No. 07-CV-0690 (M.D. Fla.)., No. 07-CV-0690 (M.D. Fla.).

Cases brought by RMBS investors against servicers and/or trustees of Cases brought by RMBS investors against servicers and/or trustees of the pool of mortgage loans. the pool of mortgage loans. See, e.g.See, e.g., , Ellington Credit Fund, Ltd., et al. v. Ellington Credit Fund, Ltd., et al. v. Select Portfolio Servicing, Inc., et al.Select Portfolio Servicing, Inc., et al., No. 08-CV-02437 (S.D.N.Y.)., No. 08-CV-02437 (S.D.N.Y.).

Cases arising from vehicles that held subprime based securities Cases arising from vehicles that held subprime based securities including, among others, CDOs, SIVs and conduits. including, among others, CDOs, SIVs and conduits. See, e.g.See, e.g., , Wells Fargo Wells Fargo Bank, N.A. v. CALYON, et al.Bank, N.A. v. CALYON, et al., No. 08-CV-01297 (S.D.N.Y.). , No. 08-CV-01297 (S.D.N.Y.).

Cases brought by municipalities under public nuisance and related Cases brought by municipalities under public nuisance and related theories. theories. See, e.g., City of Cleveland v. Deutsche Bank Trust Co., et al.See, e.g., City of Cleveland v. Deutsche Bank Trust Co., et al., , No. 08-CV-0139 (N.D. Ohio).No. 08-CV-0139 (N.D. Ohio).

Cases brought by subprime loan borrowers. Cases brought by subprime loan borrowers. See, e.g.See, e.g., , Poland v. Downey Poland v. Downey Sav. & LoanSav. & Loan, No. BC381724 (Cal. Super. Ct. )., No. BC381724 (Cal. Super. Ct. ).

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General Characteristics of RMBS Transactions

Mortgage loans are originated by various entities pursuant to Mortgage loans are originated by various entities pursuant to certain underwriting criteria and are sold into RMBS transactions certain underwriting criteria and are sold into RMBS transactions soon after the loans are made.soon after the loans are made.

Mortgage loans are pooled together and placed in a trust formed Mortgage loans are pooled together and placed in a trust formed specifically for the purpose of the transaction. specifically for the purpose of the transaction.

The trust then issues securities representing various types of The trust then issues securities representing various types of interests (usually including debt and equity) in the cash flows interests (usually including debt and equity) in the cash flows from that pool of mortgage loans. The interests in the trust are from that pool of mortgage loans. The interests in the trust are divided into multiple classes (“tranches”). The various tranches divided into multiple classes (“tranches”). The various tranches are generally rated by independent rating agencies such as are generally rated by independent rating agencies such as Moody’s Investors Service, Standard & Poor’s or Fitch Ratings. Moody’s Investors Service, Standard & Poor’s or Fitch Ratings.

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General Characteristics of RMBS Transactions

Holders receive distributions of amounts collected on the Holders receive distributions of amounts collected on the mortgage loans based on where the tranche falls in the trust’s mortgage loans based on where the tranche falls in the trust’s hierarchy of payments (the “waterfall”).hierarchy of payments (the “waterfall”).

The tranches that are entitled to receive distributions first bear The tranches that are entitled to receive distributions first bear less risk than the tranches lower down the waterfall. less risk than the tranches lower down the waterfall. Subordinated holders are compensated for the risk they Subordinated holders are compensated for the risk they undertake with higher interest rates.undertake with higher interest rates.

The securities are sold pursuant to an offering memorandum that The securities are sold pursuant to an offering memorandum that discloses the characteristics of the securities and the risks discloses the characteristics of the securities and the risks attendant to the investment. After initial sales are made trading attendant to the investment. After initial sales are made trading occurs in the secondary market. The securities are typically occurs in the secondary market. The securities are typically purchased by sophisticated institutional investors.purchased by sophisticated institutional investors.

Trustees prepare reports based on the performance of the Trustees prepare reports based on the performance of the underlying mortgage loans on a monthly basis. These reports underlying mortgage loans on a monthly basis. These reports are typically available on a trustee’s website.are typically available on a trustee’s website.

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General Characteristics of RMBS Transactions

The degree to which the investment is successful – The degree to which the investment is successful – particularly for subordinated holders – depends on how particularly for subordinated holders – depends on how well the underlying pool of mortgage loans perform, which, well the underlying pool of mortgage loans perform, which, in turn, is directly related to the general state of the United in turn, is directly related to the general state of the United States housing market. States housing market.

Any events that could cause the mortgage loan borrowers Any events that could cause the mortgage loan borrowers to have difficulty making their payments (such as rising to have difficulty making their payments (such as rising interest rates for an adjustable rate mortgage) or selling interest rates for an adjustable rate mortgage) or selling their property (such as a softening of the housing market) their property (such as a softening of the housing market) would affect the performance and outlook of the would affect the performance and outlook of the securities. securities.

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Typical Claims Based on RMBS Transactions

Federal Securities Law ClaimsFederal Securities Law Claims

State Securities Law ClaimsState Securities Law Claims

State Common Law ClaimsState Common Law Claims

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State Common Law Claims

Disclosure Based ClaimsDisclosure Based Claims

Nondisclosure Based ClaimsNondisclosure Based Claims

Often, state common law claims are Often, state common law claims are subject to longer statutes of limitations subject to longer statutes of limitations than federal securities law claims.than federal securities law claims.

Generally, state common law claims have Generally, state common law claims have less technical pleading requirements than less technical pleading requirements than federal claims.federal claims.

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Typical Disclosure Based Claims

FraudFraud

Negligent MisrepresentationNegligent Misrepresentation

Often, disclosure based claims arise out Often, disclosure based claims arise out of statements or omissions included in of statements or omissions included in the offering memorandum. Such claims, the offering memorandum. Such claims, however, may also arise from other oral however, may also arise from other oral or written statements concerning the or written statements concerning the securities.securities.

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Typical Issues and Defenses for Disclosure Based Claims

Primary fact issue: where/when/how Primary fact issue: where/when/how plaintiff acquired the securities.plaintiff acquired the securities.

Related legal issues:Related legal issues:

Misrepresentation or OmissionMisrepresentation or Omission

Reasonable RelianceReasonable Reliance

Loss CausationLoss Causation

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Misrepresentation or Omission

Where/how was the alleged misrepresentation or omission Where/how was the alleged misrepresentation or omission made?made?

Disclosure in offering materials:Disclosure in offering materials:

Risk of loss on the mortgage loans Risk of loss on the mortgage loans

Underwriting standards Underwriting standards

Characteristics of the collateral poolCharacteristics of the collateral pool

PrepaymentsPrepayments

SubordinationSubordination

IlliquidityIlliquidity

Can the claim be based on an omission?Can the claim be based on an omission?

Statement of past or existing fact?Statement of past or existing fact?

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Reliance

Actual reliance likely required.Actual reliance likely required.

Reliance must be REASONABLE.Reliance must be REASONABLE.

One factor in determining reasonableness One factor in determining reasonableness is whether the information allegedly relied is whether the information allegedly relied on was current at that time.on was current at that time.

Monthly Trustee Statements. Monthly Trustee Statements.

Track performance of underlying mortgage Track performance of underlying mortgage loans.loans.

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Loss Causation

Loss must reasonably directly stem from the Loss must reasonably directly stem from the alleged misrepresentation or omission and be alleged misrepresentation or omission and be independent of other causes.independent of other causes.

““[W]hen a Plaintiff’s loss coincides with a [W]hen a Plaintiff’s loss coincides with a market-wide phenomenon causing comparable market-wide phenomenon causing comparable losses to other investors, the probability that the losses to other investors, the probability that the loss was caused by an alleged fraud decreases.” loss was caused by an alleged fraud decreases.” Hampshire Equity Partners, II, L.P. v. TeradyneHampshire Equity Partners, II, L.P. v. Teradyne, , Inc., No. 04-CV-3318, 2005 WL 736217, at *5 Inc., No. 04-CV-3318, 2005 WL 736217, at *5 (S.D.N.Y. Mar. 30, 2005), (S.D.N.Y. Mar. 30, 2005), aff’daff’d, 159 F. App’x. 317 , 159 F. App’x. 317 (2d Cir. 2005).(2d Cir. 2005).

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Typical Nondisclosure Based Claims

Breach of Fiduciary DutyBreach of Fiduciary Duty

Breach of ContractBreach of Contract

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Breach of Fiduciary Duty

May be based on alleged conduct prior to, at the May be based on alleged conduct prior to, at the time of or after the sale of the securities. time of or after the sale of the securities.

Requires a relationship of trust and confidence.Requires a relationship of trust and confidence.

Such a relationship cannot be created Such a relationship cannot be created unilaterally.unilaterally.

This claim may be precluded because generally, This claim may be precluded because generally, contract claims cannot be repackaged as a tort.contract claims cannot be repackaged as a tort.

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Breach of Contract

Generally, RMBS transactions are Generally, RMBS transactions are administered pursuant to a pooling and administered pursuant to a pooling and servicing agreement (“PSA”).servicing agreement (“PSA”).

Breach of contract claims under a PSA Breach of contract claims under a PSA are typically brought against the trustee are typically brought against the trustee or servicer based on post-closing or servicer based on post-closing conduct.conduct.

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Breach of Contract

Generally, breach of contract claims are relatively easy to Generally, breach of contract claims are relatively easy to plead.plead.

StandingStanding

If a servicer or trustee allegedly breached the terms of If a servicer or trustee allegedly breached the terms of the PSA, such a breach would affect the trust generally the PSA, such a breach would affect the trust generally and not the individual plaintiff.and not the individual plaintiff.

Claims that injure the trust generally must be brought Claims that injure the trust generally must be brought as derivative claims and comply with applicable rules. as derivative claims and comply with applicable rules. See, e.g.See, e.g., , Debussy LLC v. Deutsche Bank AGDebussy LLC v. Deutsche Bank AG, No. 05-, No. 05-CV-5550, 2006 WL 800956, at *3-4 (S.D.N.Y. Mar. 29, CV-5550, 2006 WL 800956, at *3-4 (S.D.N.Y. Mar. 29, 2006), 2006), aff’daff’d, 2007 WL 1748468 (2d Cir. June 19, 2007). , 2007 WL 1748468 (2d Cir. June 19, 2007).

No action provisions in the PSA.No action provisions in the PSA.

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Defenses May Vary from State to State

Often, which state’s law governs will have a significant Often, which state’s law governs will have a significant effect on whether a claim can be brought.effect on whether a claim can be brought.

In New York, claims for negligent misrepresentation and In New York, claims for negligent misrepresentation and breach of fiduciary duty based on the purchase of breach of fiduciary duty based on the purchase of securities are barred by the Martin Act, N.Y. Gen. Bus. Law securities are barred by the Martin Act, N.Y. Gen. Bus. Law § 352 (McKinney 1996). § 352 (McKinney 1996). See, e.g.See, e.g., , Joffee v. Lehman Bros., Joffee v. Lehman Bros., Inc.Inc., No. 04-CV-3507, 2005 WL 1492101, at *13-14 (S.D.N.Y. , No. 04-CV-3507, 2005 WL 1492101, at *13-14 (S.D.N.Y. June 23, 2005).June 23, 2005).

Certain states, for example, do not recognize the tort of Certain states, for example, do not recognize the tort of negligent misrepresentation beyond an employment or negligent misrepresentation beyond an employment or traditional professional relationship. traditional professional relationship. See, e.g.See, e.g., , Trytko v. Trytko v. Hubbell, Inc.Hubbell, Inc., 28 F.3d 715, 720-21 (7th Cir. 1994)., 28 F.3d 715, 720-21 (7th Cir. 1994).