The Appellate Division of the New York Supreme Court, First Department, recently upheld a lower court decision barring holders of certificates issued by a securitization trust (the "Holders") from pursuing a derivative suit against loan originators who allegedly made false representations and warranties about the characteristics and credit quality of residential mortgage loans sold to the trusts.  Dealing a loss to the investors, the court held that the right to bring such claims belonged to the securitization trustee (the "Trustee"), not the holders of mortgage-backed securities.1


Countrywide Home Loans, Inc. and others ("Countrywide") sold packages of residential mortgage loans to certain securitization trusts (the "Trusts"), whose administration was governed by Pooling and Servicing Agreements (the "PSAs").  The PSAs contained a so-called "no-action" clause, which limited the Holders' rights to bring an action with respect to the PSAs.2 Following the collapse of the subprime mortgage market, the Holders alleged that Countrywide made false representations and warranties in the PSAs about the characteristics and credit quality of certain loans sold to the Trusts that were delinquent or had gone into default. 

The Trustee sent Countrywide written notice of the alleged misrepresentations and demanded that it repurchase close to 2,000 noncompliant loans.  When Countrywide failed to repurchase the loans at issue within the contractual 90-day period set forth in the PSAs, certain Holders wrote letters to the Trustee stating that they owned 25% or more of the voting rights in the Trusts and purporting to direct the Trustee to file suit against Countrywide within sixty days.  The Holders also offered to indemnify the Trustee against the costs, expenses and liabilities resulting from instituting such litigation.  The Trustee responded in writing that it needed more time to conduct a good faith evaluation of the legal and practical issues raised by the Holders.

After the sixty-day period elapsed without the Trustee bringing their requested action, the Holders commenced a derivative action against Countrywide and others in the Supreme Court of the State of New York, County of New York3 alleging breach of contract in relation to the PSAs governing the Trusts.  Subsequently, the Trustee filed a petition with the same court seeking approval of a proposed settlement covering 528 trusts (including the instant Trusts) that required Countrywide to pay $8.5 billion to settle various claims including claims for breach of representations and warranties contained in the PSAs governing the trusts.

The Court Dismisses the Holders' Derivative Action

The defendants moved to dismiss the Holders' derivative action on two grounds.  First, they contended that the "no-action" clause limits the Holders' right to sue under the PSAs solely to claims alleging an Event of Default.  The PSAs define an Event of Default as a specified failure of the Master Servicer to perform its servicing duties (i.e., collection of principal and interest payments from the underlying mortgages, and paying those monies to the Trusts).  Defendants argued that, because the Holders by their own admission did not allege an Event of Default under the PSA, the "no-action" clause barred the Holders' derivative action.

Next, the defendants argued that even if the "no-action" clause did not apply, the Holders did not satisfy the pleading requirements for bringing a derivative action, namely, showing that the Trustee's refusal to bring suit was an abuse of the Trustee's discretion, or that it would otherwise be futile to make such a demand due to the Trustee's conflict of interest.

The court agreed with the defendants' interpretation of the "no-action" clause, dismissing the Holders' arguments that (i) notice of an Event of Default was not a necessary precondition to bringing suit under the PSAs, and (ii) that the limitations of the "no-action" clause only applied to actions based on an Event of Default.  Reviewing pertinent case law concerning the scope of "no-action" clauses, the court found that such clauses generally apply to any claim that can be enforced by a trustee on behalf of interest holders, unless there is some allegation of misconduct on the part of the trustee.  Therefore, the court held that the "no-action" clause barred the Holders' derivative action for failure to allege an Event of Default under the PSAs.

The court also agreed that the Holders failed to satisfy the pleading requirements for a derivative action.  The court dismissed the Holders' allegation that the Trustee unreasonably refused to sue in light of the Holders' own assertion that the Trustee requested more time to investigate their demand.  Moreover, the court found that the Trustee's settlement with Countrywide, which included a settlement of the Holders' misrepresentation claims, directly contradicted the Holders' claim that the Trustee refused to take action against Countrywide.

Accordingly, the court dismissed the Holders' complaint.  The Holders appealed the decision to the Appellate Division, which upheld the lower court decision, finding that the "no-action" clause of the PSAs "plainly limits certificate holders' right to sue to an 'Event of Default,' which under [the PSAs], involves only [the conduct of] the Master Servicer."4


"No-action" clauses serve several purposes.  They prevent one or more investors from pursuing claims so as to obtain relief for themselves to the detriment of others who are similarly situated.  They are also designed to provide trustees ample opportunity to review potential claims and determine whether to pursue them on behalf of all certificate holders.  Such clauses also centralize disputes so that claims settled by a trustee may not be brought by others.  In this instance, these underlying purposes were well-served.