The U.S. Court of Appeals for the Second Circuit recently affirmed the dismissal of an action by the trustee of a residential mortgage-backed securities trust for breach of contractual obligations to repurchase mortgage loans that allegedly did not conform to representations and warranties, holding that:

  1. the breach of contract claim was barred by the statute of limitations, which ran from the date the representations and warranties were made;
  2. the so-called "extender provision" of the federal Housing and Economic Recovery Act did not apply to the trustee's claim; and
  3. the trustee's claim for breach of the implied covenant of good faith and fair dealing failed as duplicative.

A copy of the opinion is available at:  Link to Opinion

The defendant originated mortgage loans and sold them to a non-party sponsor pursuant to a purchase agreement dated June 1, 2006.  The agreement contained representations and warranties ("Reps and Warranties") about the quality of the loans and their compliance with certain origination and underwriting guidelines.

After a series of transactions involving sales and assignments, the loans ended up in a securitization trust for which the a trustee ("Trustee") received all the rights, title and interest in the mortgage loans for the benefit of the certificate-holders in the securitization.  The Trustee also stepped into the sponsor's shoes, including its rights against the defendant originating lender arising from the Reps and Warranties.

The securitization trust issued certificates representing interests in the mortgage loans to investors in a public offering, the closing date of which was May 8, 2007.  One of the certificate purchasers was the Federal Home Loan Mortgage Corporation ("Freddie Mac").

The purchase agreement contained a protocol for any material breach of the Reps and Warranties that required notice of any breach and required the originating lender to cure the breach, with a possible 15-day extension. If the breach was not cured, the lender had to repurchase the loans at a predetermined price.

The purchase agreement also contained a section providing that any cause of action based on a material breach of the Reps and Warranties would accrue upon the earlier of (a) discovery of the breach by the lender or notice thereof by the trustee to the lender; (b) the failure of the lender to cure any material breach; and (c) demand by the trustee for compliance with the purchase agreement.

The Federal Housing Finance Agency ("FHFA") sued the originating lender in New York state court as conservator of Freddie Mac and on behalf of the Trustee on May 8, 2013.  The lender removed the case to federal district court pursuant to 28 U.S.C. § 1345, which confers jurisdiction on district courts over "all civil actions, suits or proceedings commenced by the United States, or by any agency or officer thereof expressly authorized to sue by Act of Congress."

The Trustee took over the case from the FHFA, and on October 18, 2013 filed the complaint based on diversity jurisdiction under 28 U.S.C § 1332 instead of § 1345.

The defendant mortgage lender moved to dismiss the complaint, arguing that that breach of contract claim was barred by New York's the statute of limitations. The district court agreed, ruling that the cause of action accrued when the Reps and Warranties were made, that "the extender provision of the Housing and Economic Recovery Act ("HERA"), 12 U.S.C. § 4617(b)(12), did not apply because FHFA abandoned prosecution of the action after realizing it was not the proper plaintiff", and that the claim for breach of the implied covenant of good faith and fair dealing failed because it was duplicative of the breach of contract claim.

The Trustee appealed.  The Second Circuit began its analysis by explaining that "[w]hen sitting in diversity jurisdiction and determining New York state law claims, we must apply 'the law of New York as interpreted by the New York Court of Appeals."

The Court explained that "New York's six-year limitations period on contractual claims generally runs from the time the contract was breached" and cited a recent New York Court of Appeals decision holding that "[a] cause of action for breach of contractual representations and warranties that guarantee certain facts as of a certain date—but do not guarantee future performance—accrues on the date those representations and warranties become effective."

The Second Circuit then turned to determine whether the Reps and Warranties contained any guarantee of future performance or whether the clause defining the accrual of a cause of action constitutes a substantive condition precedent, which would delay accrual of the cause of action."

The Court found the Reps and Warranties in the case at bar indistinguishable from those in the recent controlling New York Court of Appeals decision because they "guaranteed only 'certain facts about the loans' characteristics as of' the execution date, not how the mortgage would perform in the future." In addition, as in the controlling New York case, "as an 'alternative remedy' to damages, the repurchase obligation ... was itself dependent on, and indeed derivative of' the representations and thus also 'could not be reasonably viewed as a distinct promise of future performance.'"

The Second Circuit rejected the Trustee's argument that because there was an express provision providing that the Reps and Warranties survived the sale of the loans they promised future performance because the Reps and Warranties here "guarantee, at their core, no more than the present characteristics and quality of the loans as of a specific moment in time. Whether they 'survived' or remained valid and enforceable "does not alter the question of performance."  The Court held that, because immediately upon the effectiveness of the Reps and Warranties, the Trustee was "entitled to demand the contractual remedy—cure or repurchase—as to any material breach, … the cause of action therefore accrued at that time."

The Court next addressed, and rejected, the Trustee's argument the "the Accrual Clause makes demand 'a substantive condition precedent to suit that delayed accrual of the cause of action...'" explaining that "New York courts 'distinguish between substantive demands and procedural demands.'" In the case of substantive demands, the statute of limitations 'begins to run only after such demand and refusal,' while [in the case of procedural ones] … the limitations period 'begins to run when the right to make the demand is complete.'"

The Court reasoned that while the language of the clause defining when a cause of action accrued under the contract "makes an initially appealing case for inclusion as a substantive condition precedent" the New York Court of Appeals' recent decision "requires us to examine the object of the demand, rather than merely apply the phrase 'shall accrue' as a talisman. Instead, we must ask whether demand 'is a condition to a party's performance (substantive) or whether it 'seeks to remedy a preexisting wrong' (procedural)."

Finding that the relevant "performance" was the truth or falsity of the Reps and Warranties, the Court concluded that "notwithstanding the 'shall accrue' language, the Trustee's demand seeks only the remedy to which it is already entitled, not performance of the underlying contractual obligation. Accordingly, the demand is merely procedural and does not delay accrual of the cause of action."

The Court thus agreed with the District Court that the statute of limitations began to run on the date the Reps and Warranties became effective, and were either true or false at that time. Because the lawsuit was "facially untimely," the Court turned to the only remaining issue: "whether HERA extends the statute of limitations for the Trustee's claim."

As you may recall, HERA's so-called "extender provision" provides that in any action "brought by [FHFA] as conservator or receiver, the statute of limitations begins to run on whichever is later, "the date of the appointment of [FHFA] as conservator or receiver" or "the date on which the cause of action accrues."

The Court rejected the Trustee's argument that the lawsuit was brought by the FHFA when it filed the summons and notice in state court, and thus "HERA delays accrual of the cause of action until September 6, 2008, when FHFA was appointed conservator of Freddie Mac" because after the case was removed to federal court, the trustee filed the complaint and prosecuted the case without any participation by FHFA. Under such circumstances, the Court concluded that "the present action cannot reasonably be said to  have been 'brought by' the FHFA" within the meaning of the so-called extender provision under HERA.

Because HERA's extender provision did not apply, the Trustee's claim was barred as untimely.

The Second Circuit, in concluding also rejected that Trustee's last argument that "its claim for breach of the implied covenant of good faith and fair dealing was erroneously dismissed as duplicative" because both claims arose from the same facts and sought identical damages for the alleged breach of the explicit language of the agreement.

Accordingly, the district court's order of dismissal was affirmed.