As litigation stemming from the U.S. subprime mortgage crisis continues, the legal framework governing the liability of participants in residential mortgage-backed securities (RMBS) securitizations continues to develop. In a reversal of a lower court’s summary judgment decision — and a departure from First Department precedent — the Appellate Division, First Department, of the New York Supreme Court unanimously ruled that financial guaranty, or monoline, insurance companies pursuing fraud claims against sponsors of and other participants in failed RMBS trusts cannot take advantage of the lower bar for fraud available under New York’s Insurance Law. Instead, a monoline insurer must satisfy the standard common-law elements of a fraud claim, including that the insurer justifiably relied on the defendant’s fraudulent misrepresentations and that the insurer’s specific losses were caused by these misrepresentations.

Factual Background and Procedural History

Between 2004 and 2006, Ambac Assurance Corp. guaranteed payments on certain RMBS issued by trusts sponsored by Countrywide Home Loans. Many of the underlying mortgages began to default during and after the subprime mortgage crisis that began in 2007, and as a result, Ambac was required to make substantial payments on insurance claims. In 2010, Ambac sued Countrywide, asserting both fraudulent inducement and breach of contractual representations and warranties in connection with $25 billion of RMBS that Countrywide issued and Ambac insured.

In October 2015, Justice Bransten of the New York Supreme Court issued a summary judgment decision that, among other things, addressed the standard applicable to Ambac’s fraudulent inducement claim. The court held that, pursuant to Section 3105 of New York Insurance Law, Ambac was not required to prove all of the traditional elements of a fraud claim. Specifically, while Ambac was required to prove the existence of one or more material misrepresentations, it was not required to prove either its justifiable reliance on those misrepresentations or that the misrepresentations proximately caused Ambac’s losses (i.e., “loss causation”). Both parties appealed, and a panel of the First Department unanimously reversed the trial court’s decision.

The First Department’s Decision

The First Department agreed with Countrywide that Ambac must satisfy the “long-settled” common-law standard for proving a fraud claim, including the elements of justifiable reliance and loss causation.

  1. With respect to justifiable reliance, the court pointed to binding precedent from the New York Court of Appeals’ ACA Fin. Guar. Corp. v. Goldman, Sachs & Co., 25 N.Y.3d 1043 (2015), holding that a financial guaranty insurer must demonstrate justifiable reliance to prevail on a fraud claim. It is worth noting, however, that in ACA, the appeals court had issued its opinion without discussing, or being presented with arguments on, the relevance of New York Insurance Law. Consequently, the ACA decision’s reach as a precedent is uncertain, and the Ambac court’s ruling on this issue may not be the New York courts’ last word. In addition, the issue of justifiable reliance tends to be fact-intensive and therefore difficult to dispose of prior to trial; thus, even to the extent other courts follow Ambac on this issue, the ruling may pose a relatively low hurdle to the ability of monoline fraud claims to get to trial.
  2. On the issue of loss causation, the First Department in Ambac pointed to numerous cases recognizing that loss causation has long been an essential element of a fraud claim. The court rejected Ambac’s argument that this common-law standard was altered in its case by New York Insurance Law Section 3105, which permits a fraud claim so long as the insurer establishes that the defendant made a material misrepresentation. Section 3105 “has no applicability here,” the court held, because that statute, by its express terms, applies only when an insurer seeks to rescind an insurance contract or to defeat recovery under such a contract. Ambac was not seeking to rescind its insurance contract or to defeat an insured’s claim for payment, since its policy contained provisions — typical in monoline policies — expressly stating that the policy was irrevocable (and therefore not subject to rescission) and that Ambac’s payment obligations were unconditional.

The First Department acknowledged, however, that its loss causation holding directly conflicts with the recent decision of another First Department panel in MBIA Ins. Corp. v. Countrywide Home Loans, Inc., 105 App. Div. 3d 412 (1st Dep’t 2013), which held that loss causation is not a required element of a monoline insurer’s fraud claim. As a result, the law in the First Department is now divided on this issue. Although Ambac does not have an automatic right to appeal the First Department’s ruling to the appeals court (since the ruling was unanimous), the New York Court of Appeals might agree to hear an appeal to resolve this intra-department division of authority. And absent a resolution of the issue by the appeals court, this intra-department split makes it uncertain how New York state courts within the First Department (which covers New York County, as well as the Bronx) will rule in future fraud cases brought by monoline insurers.

Implications of the Ambac Decision

While most RMBS suits brought by monolines assert breach of contract, as well as fraud claims, the damages recoverable on fraud claims are more expansive: An insurer that prevails on a fraud claim is entitled to recover its entire loss on a particular policy (i.e., claims paid minus premiums received), rather than merely the specific losses attributable to nonconforming loans. In addition, fraud claims entitle a plaintiff insurer to a jury trial and the ability to pursue punitive damages. These rights are often waived by the policy, but that waiver applies only to claims arising under the policy (i.e., contract claims) and not also to claims that the insurer was fraudulently induced to issue the policy.

The First Department’s Ambac v. Countrywide ruling is therefore not helpful for monoline insurers that are pursuing RMBS fraud claims governed by New York law. However, given the Ambac ruling’s shaky grounding in prior New York precedent, it remains to be seen how faithfully other New York courts will follow its holdings, as to either justifiable reliance or loss causation.