Gross Negligence Allegation Doesn't Defeat Sole Remedy Clause: Pool-Trustee’s Damage Claims Against Sponsor Dismissed

February 1, 2021

By: Alan Kolod and David Rabinowitz

The New York Court of Appeals recently decided an issue of interest to the financial services industry and, potentially, to all commercial contracting parties. In a 4-1 decision (two judges taking no part), the Court on a motion to dismiss enforced a “sole remedy” clause for breaches of representations against the plaintiff trustee for a RMBS pool, despite its claim that the alleged breaching party had acted in a “grossly negligent” manner that should have rendered unenforceable any limitation on damages clause.  

Allegations in the Complaint

The case involved the agreements structuring an issue of residential mortgage-backed securities (RMBS). The agreements were between the trustee holding the mortgages that had been transferred to the RMBS pool, which issued securities to investors, and the sponsor and depositor of the mortgages into the pool. The agreements contained extensive representations and warranties, effective at closing, as to the quality and characteristics of each mortgage deposited into the pool. But they also limited the trustee’s remedy for a breach of such a representation to obtaining either cure of the specific breach or repurchase of the non-compliant loan at a contractually defined Repurchase Price.

The case arose from the 2008 meltdown of the RMBS market, and the pool trustee alleged that the sponsor and depositor had been grossly negligent in failing to notify it of nonconforming loans and in failing to cure or repurchase the defective loans. The defendants moved to dismiss the complaint to the extent it sought relief beyond or other than the sole remedy.  The plaintiff trustee responded that the public policy against contract clauses exculpating parties from liability for gross negligence barred enforcement of the sole remedy clause.

Background and Significance of Sole Remedy Enforcement

The decision was the third by the Court of Appeals enforcing such a sole remedy provision in the RMBS context.  In each case, the plaintiff had alleged that based on its audit of the pool, the majority of mortgages were non-conforming.  Practically, the significance of the issue related to what the plaintiff would need to prove for relief, and the scope of the relief available, for the alleged contractual breaches. In effect, the plaintiff in each of the three cases sought relief on a pool-level basis but the clause limited its relief to the individual loan-level.  In each case, the Court of Appeals considered but rejected the plaintiff’s assertion that some pool-level representation, to which the sole remedy clause did not apply, had been breached, finding that all of the alleged breaches were breaches of representations as to individual loans.  It then found that the sole remedy provision applied to such loan-level representations regardless of the extent or pervasiveness of such breaches throughout the pool of mortgage loans.

The Specific Issue of Gross Negligence

But the most recent case was the first in which the Court specifically addressed the question of whether allegations of gross negligence rendered the sole remedy clause an unenforceable exculpation contrary to public policy.  In answering that question, the Court made clear that the complaint had not alleged any tortious conduct by the defendants, only breach of contract.  It also did not question plaintiff’s premise that an exculpation would not be enforceable against a claim for grossly negligent (but non-tortious) breach of a contract.  Taking this as given, the Court analyzed the scope of two competing public policies, one barring contractual provisions granting immunity for wrong-doing and the other favoring freedom of contract. 

In essence, the Court held that in the context of a cause of action sounding only in breach of contract the policy favoring freedom of contract allowed sophisticated commercial parties to contract for a reasonable sole remedy or limitation of liability clause negotiated at arm’s length.  In this context, a reasonable limitation was one that did not wholly exculpate the breaching party and provided for more than nominal or illusory damages.  The Court further held that the sole remedy clause in this case satisfied the test of reasonableness because the defendants had conceded that "if a breaching loan has already been liquidated, the defendant will still be liable to pay the Repurchase Price, and thereby make the Trust whole, even if actual repurchase of the loan (i.e., specific performance) is impossible because the loan no longer exists.”

Implications of the Decision

The decision appears to have implications for both contractual drafting and litigation over contractual breach.  On this motion there appeared to be no issue as to the commercial sophistication of the parties or the arm’s length negotiation of the sole remedy clause.  The Court was also able to assess the reasonableness of the sole remedy, since it found it would “make the Trust whole.”  But such determinations may not be possible on a motion to dismiss in other situations.  The decision arguably leaves open such questions as (i) whether and when a remedy that does not make the plaintiff whole may nevertheless be “reasonable;” (ii) the ramifications of allegations of intentional or grossly negligent breach of contract in cases where the defendant does not have the benefit of a limitation of remedy clause; and (iii) whether and when a breach of contract may rise to a level of misconduct that triggers a more stringent review of the remedy limitation. 

From the drafting perspective, the lesson of the decision is the need for greater attention to the drafting and potential implications of remedy limitations, particularly when they may relate to or impinge on contract rescissionary remedies, such as those for fraudulent inducement of contract.

Matter of Part 60 Put-Back Litig., 2020 NY Slip Op 07687 (December 22, 2020).