United States: Lessons from the Securitization Process

Under the guise of a largely procedural case, the Southern District Court of New York has shed some light on the legal aspects of an often obscure corner of the securitization process: the relationship between the transferor of a mortgage loan and the acquirer and trustee/administrator of a REMIC trust holding the pool of mortgages of which the loan is a part. At one level, the case merely rejects the respective claims of the two parties that, in addition to breach of contract claims under the pooling and servicing agreement ("PSA"), there are companion torts. The acquirer, LaSalle Bank N.A., sought to charge Citicorp Real Estate Group, Inc., the transferor, with negligent failure to disclose a breach by the borrower of warranties under the loan documents. The transferor sought to attack LaSalle for breach of a duty of good faith and fair dealing for failure to notify Citicorp for over two years of the borrower's breach. In each case, the court, in ruling on a motion to dismiss (on which it accepts, for purposes of ruling, that the factual allegations are true), held that the tort claim could not be maintained. The acquirer's tort claim failed because the court concluded that there was no "special relationship" between the buyer and seller of the mortgage -- only a contractual one; thus, no fiduciary duty could arise. The seller's tort claim was viewed by the court as merely duplicative, and not "independent," of its breach of contract claim.

As the skirmishes in this case continue, the most interesting learning may come from what the parties can actually prove.

The borrower, a hotel owner and franchisee of a Residence Inn by Marriott, was notified by Marriott one day prior to the execution of the PSA of the borrower's default under the franchise agreement. Citicorp didn't originate the loan, but acquired it from an originator.

LaSalle asserted that Citicorp failed to disclose such a default, in breach of its warranties that the origination and servicing of the loan met with generally accepted servicing standards (the franchise agreement was due to expire shortly and the hotel required extensive renovations) and that no material default existed under the Loan (although a default under the franchise agreement would be a loan default). Citicorp alleged that the failure of LaSalle, for over two years, to notify Citicorp of the borrower's breach (as required by the PSA), and LaSalle's foreclosure (through the special servicer) of the loan, deprived Citicorp of its right to choose between curing the default or repurchasing the loan -- a right provided under the PSA. One of Citicorp's defenses is based on the allegation that it never received Marriott's notice of default from the borrower or Marriott.

Citicorp's claims are not only designed to deflect its own potential liability, but also to create an affirmative claim for damages.

What ever the facts are proven when the case goes to trial, this case is significant for serving as a window into the potential mechanical challenges, facing both securitizers and administrators of loans, in the securitization process. The former, especially when including loans it did not originate, must be careful to learn the status and quality of loans added to a pool; the latter must recognize its responsibility to be more than passive. The investors and the viability of the securitization phenomenon rely on both. Without their commitment to, and success in, these roles, the financial markets will lose faith and the system will break down.

This article has been prepared for general informational purposes only and is not intended as legal advice.