Insurer Could Not Use Tort Theory to Transfer Back to Insured Risks the Insurer Had Assumed

On July 3, 2014, Justice Kornreich of the New York County Commercial Division issued a decision in Assured Guaranty Municipal Corp. v. DLJ Mortgage Capital, Inc., 2014 NY Slip Op. 51044(U), dismissing fraud claims that sought to hold an insured liable, on a tort theory, for risks the insurer had assumed.

In Assured Guaranty, the plaintiff monoline insurer sued various defendants in connection with RMBS transactions. The court granted defendant Credit Suisse's motion to dismiss the plaintiff's fraud claims, explaining:

[The plaintiff] alleges it was fraudulently induced to issue the subject financial guarantee policies based on Credit Suisse's countless misrepresentations about the loans in the transaction. Some of the alleged malfeasance expressly falls under the ambit of the PSA's representations and warranties, such as lies about borrowers' income. Other malfeasance, such as wholesale abandonment of underwriting standards, does not.

As discussed in DBSP, before a monoline agrees to guarantee revenue to RMBS investors, the monoline and the bank negotiate their risk of loss. Monolines take no risk on non-conforming loans and expressly negotiate the universe of loan defects that constitute non-conformance, negotiations which result in the representations and warranties. Banks want to limit their exposure by negotiating for as narrow a universe of representations as possible (even if banks can put-back non-conforming loans to originators under MLPAs, because originators pose more counterparty credit risk than global banks). The universe of representations ultimately agreed-to is the only universe of non-conformance coverage that monolines are entitled to. The monoline's risk is every possible problem with the loans not covered by the representations and warranties. So, for instance, when [the plaintiff] does not negotiate for the inclusion of a "no fraud rep" (or any other representation not included in the PSA), perhaps, thereby, charging a higher premium, it makes a conscious decision to take the risk that if such non-included representations cause losses resulting in claims payments, [the plaintiff] will not be reimbursed by Credit Suisse via a put-back.

Here, [the plaintiff] agreed to issue insurance to investors for all loan losses, while bargaining for partial reinsurance from Credit Suisse for non-conforming loan losses. By asserting a fraud claim, [the plaintiff] is trying to broaden the scope of its bargained-for partial loan loss protection to cover all loan loss risk. Stated another way, [the plaintiff] is trying to rewrite the contract by broadening the scope of its non-conformance protection. This is an attempt to retroactively alter the parties' risk allocation the crux of this transaction. To allow this is not only commercially unreasonable, it would violate the axiom that courts should interpret contracts in accord with the parties' intent and may not alter the contract to reflect its personal notions of fairness and equity.

[The plaintiff], in seeking a way around this problem, relies on the general principle that one need not expressly list every possible way in which one might be defrauded in a contract. This is true. Only specific, itemized waivers disclaiming reliance on particular representations are valid. Nonetheless, a fraud claim is barred where a sophisticated and well-counseled entity fails to include an appropriate prophylactic provision in the agreement governing the transaction from which the legal dispute arises to ensure against the possibility of misrepresentation. To be sure, appellate authority precludes this court, on a motion to dismiss, to deem [the plaitiff's] failure to conduct due diligence on the loan files as an absolute bar to a fraud claim. But the issue here is not whether [the plaintiff's] reliance on the representations and warranties that it bargained for was reasonable since, when one procures an express contractual warranty, one may absolutely rely on it. Instead, the relevant inquiry here, where the contract itself was insurance one big prophylactic mechanism and where all the risk was on the negotiating table and expressly allocated between sophisticated parties, is: can [the plaintiff] sue for fraud arising from the very risk it bargained to assume? The answer, of course, is no.

(Internal quotations and citations omitted) (emphasis added).

As to the plaintiff's fraud claims that sought to recover for malfeasance not addressed in the parties' agreement, the court rejected the plaintiff's argument

that since [the plaintiff] cannot contractually recover for losses arising from such risk, these losses arise from a breach of duty distinct from, or in addition to, the breach of contract. However, just because losses are not recoverable under the contract does not mean that a duty extraneous to the contract exists or that such duty was breached. Though contracts do not and cannot cover every eventuality and always include an implied duty of good faith and fair dealing, when the contract itself sets forth an express risk allocation, one cannot claim that one's counterparty had an unremunerated duty to warn of or prevent a loss when the duty to diligence the risk of such loss cannot be fairly imputed to that counterparty.

Here, Credit Suisse had neither the duty nor the incentive to thoroughly vet the loan pool. Just as [the plaintff] claims it reasonably declined to review loan files since it had warranty protection, so too can Credit Suisse claim that it declined to make similar diligence efforts since it had put-back rights to the originators. Credit Suisse, like so many banks sponsoring RMBS transactions, had no interest in making the sort of underwriting or due diligence efforts that insurance companies typically perform. Banks wanted a fee for structuring RMBS transactions, not RMBS market risk. By having [the plaintiff] issue insurance, the burden of diligencing risk not covered by the representations and warranties could be shifted from Credit Suisse to [the plainitff]. Though Credit Suisse still had some incentive to diligence non-conforming loan loss risk, it had no incentive to diligence conforming loan loss risk, since the former is the only liability Credit Suisse was left with under the negotiated transaction documents (and which was supposed to be mitigated by put-backs to originators).

It is not Credit Suisse's job to conduct [the plaintiff's] due diligence. Moreover, [the plaintiff], a sophisticated financial insurance company, is supposed to decide for itself the relevant universe of risk it deems to be material to diligence before issuing insurance. And [the plaintiff] did just that. [The plaintiff] made the business decision to forgo conducting a thorough investigation of the state of the origination market and, instead, relied on warranty protection as a cheap proxy that it hoped would correlate to all origination risk. Reasonable minds may disagree about whether this was a prudent strategy. In hindsight, [the plaintiff's] decision looks terrible. But hindsight is irrelevant. What matters is whether [the plaintiff], when it decided to issue the insurance, made a conscious decision to not conduct robust due diligence on the U.S. mortgage origination industry, and, instead, took the risk that it would be sufficiently protected by representations and warranties. This is no nettlesome inquiry; it is clearly what occurred.

So, to summarize, there are an infinite number of "bad" facts that make lending money to prospective homeowners a risky venture. Insufficient income, substantial debt, and poor credit are only some of the risks. But, when a sophisticated insurance company and global bank sit down at the negotiating table to bargain for the exclusive list of conditions entitling the insurance company to put-back loans, courts must give deference to the outcome of that negotiation. Insuring a billion dollar transaction is not a casual pastime that one does without a profound understanding of the relevant market risks. An insurer might not review the loan files if the cost of doing so is incompatible with its business model.[FN14] However, if an insurer forgoes conducting due diligence on the loan files and negotiates to bear the risk of malfeasance that such diligence would reveal, it then cannot claim it was fraudulently induced to enter into the transaction. Conduct due diligence or procure a sufficient prophylactic coverage to protect against your undiligenced risk. Do neither, and you are limited to your contractual bargain. At the end of the day, Assured cannot use a fraud claim to broaden the scope of its warranties.

(Internal quotations and citations omitted) (emphasis added).