United States: Conditions And Covenants In Debt Documents: Strict vs. Substantial Performance

In the recently decided case of The Bank of New York Mellon Trust Company, N.A. v. Morgan Stanley Mortgage Capital, Inc. (2d Cir. April 27, 2016), a divided panel of the Second Circuit addressed the question of whether a trustee had timely exercised its right to require the seller of a mortgage loan deposited to a securitization vehicle to cure the breach of an underwriting representation. Along the way the panel had occasion to explore differences between a condition precedent and an obligation to perform, the concept of substantial performance of a performance obligation, and "awareness" of an organization where action must be approved through a chain of command.  What is perhaps remarkable about the opinion is the level of granularity at which the court, both majority and dissent, parsed the relevant contractual provisions, which validates the close attention that parties to complex debt arrangements should apply to their documentation. 

The Facts

In May 2007, Morgan Stanley Mortgage Capital Inc. sold an $81 million mortgage loan for the purchase of a retail center in Garfield Heights, Ohio, which was then placed into Morgan Stanley Capital One Trust 2007-IQ14, a nearly $5 billion mortgage securitization trust. The sale was pursuant to a mortgage loan purchase agreement ("MLPA") and a pooling and servicing agreement ("PSA"). Bank of New York Mellon ("BNY") was designated as trustee of the trust and as the entity entitled to enforce various related agreements, including the MLPA. The PSA also designated a master servicer and a special servicer with responsibility for servicing defaulted loans. BNY granted the master servicer and special servicer authority to act on its behalf when servicing and administering the loans.

Things did not go well for the retail center. The property was apparently constructed on a landfill and as a result suffered from gas intrusions into its facilities. The Ohio Agency for Toxic Substances and Disease Registry determined that the conditions at the property amounted to "an urgent public hazard." After sending numerous notices of lease default, Walmart, which was the anchor tenant, closed its store and canceled its lease in September 2008. Other tenants exercised co-tenancy clauses which allowed them to terminate their leases, reduce rents or discontinue rent payments. Not surprisingly, this resulted in a discontinuation in loan payments to the trust and the burgeoning of the trust's expenses as it sought to enforce its rights under the loan documentation.

The chain of events giving rise to the dispute in the case was as follows: 

September 9, 2008

The master servicer informed the special servicer that the loan would likely go into default within 60 days.

November 8, 2008

The borrower defaulted on a mortgage loan payment, and the loan was transferred for special servicing.

February 16, 2009

The director of special servicing wrote to internal counsel that Morgan Stanley breached the representation that it had "no knowledge of any material and adverse environmental condition or circumstance" affecting the property.

February 19, 2009

Internal counsel, after a review of the materials, confirmed that there was evidence of a breach.

March 3, 2009

The director of special servicing drafted and sent to counsel for review a notice of breach and request for cure.

March 14, 2009

A revised draft notice was sent to the director of special servicing's superior, who approved it on March 16, 2009.

March 18, 2009

A formal notice of breach and request for cure was sent to Morgan Stanley.

Additional correspondence followed in which Morgan Stanley defended its underwriting and refused to replace the loan.

The dispute centered on a provision of the MLPA governing mechanics of notice and cure, which read in relevant part as follows:

"[I]f there is a breach of any of the representations and warranties required to be made by the Seller regarding the characteristics of the Mortgage Loans and/or the related Mortgaged Properties ... [1] the party discovering such Material Breach shall promptly notify, in writing, the other party ... [2] Promptly (but in any event within three Business Days) upon becoming aware of any such ... Material Breach, the Master Servicer shall, and the Special Servicer may, request that the Seller, not later than 90 days from the Seller's receipt of the notice of such ... Material Breach, cure such ... Material Breach ..."

The District Court concluded based on this language that, as a condition to Morgan Stanley's obligation to repurchase or replace the loan, the servicer was required to provide a request for cure within three business days of becoming aware of the breach, which, based on the chronology above, it did not do. There were two critical issues on appeal: first, whether the contract language created such a condition precedent; and second, at what point the servicer became aware of the breach. The four federal judges who addressed this issue, one at the district level and three on the Court of Appeals, were evenly split. Unfortunately for Morgan Stanley, a majority of the Court of Appeals found against it on these issues.

The Court's Analysis

The majority opinion of the appeals court drew a distinction between a condition precedent and an obligation of performance. Quoting the New York Court of Appeals in Oppenheimer & Co. v. Oppenheim, Appel, Dickson & Co., 86 N.Y. 2d 685 (1995), the court observed that "while specific, talismanic words are not required, the law nevertheless demands that conditions precedent be 'expressed in unmistakable language.'" The court reviewed numerous other provisions of the MLPA in which the drafters had employed language implying a condition precedent. Here, the majority said, there was no such unmistakable language, so that delivery of a request for cure within three days was a performance obligation of the servicer, not a condition precedent to the obligation of Morgan Stanley to cure or replace the defaulted loan.

This in turn led to two inquiries, both of which the majority held were matters for a trier of fact. First, at what point could the servicer be said to have become "aware" of the breach? And second, even if there were a delay of more than three days between the servicer's awareness and its notice, did the servicer "substantially perform," so as not to excuse Morgan Stanley's obligation to cure or replace? As regards the second issue, the court observed, "New York common law will not require strict compliance with a contractual notice and cure provision if providing an opportunity to cure would be useless." Giuffre Hyundai Ltd. v. Hyundai Motor Am., 756 F. 3rd 204, 209 (Second Cir. 2014) (internal quotation marks omitted). This was obviously a nod in the direction of BNY, since cure of the environmental condition clearly would have been impossible in this case.

The minority opinion addressed an interesting question not expounded upon by the majority of the panel. Where there exists a chain of command in a corporate entity, so that approval to take action ultimately requires the assent of the person at the top of the chain, when is the entity deemed to have "awareness" of the circumstances triggering its obligation to act? Citing Krischner v. KPMG LLP (15 N.Y. 3d 446, 465 2010), the dissenting judge held that a presumption of corporate knowledge exists when lower-level responsible employees acquire the knowledge, even if that knowledge is never communicated to their superiors. The majority, apparently, disagreed.

Takeaways

This case provides some important lessons for performance of contractual obligations and enforcement of remedies, generally. Courts will draw a distinction between provisions constituting conditions precedent to another party's obligation of performance, which are applied strictly, and other obligations where the standard is substantial performance and where there is leeway to require a counterparty's performance even when the first party has not fully performed. The takeaway is that where conditions are intended, they should be formulated as such explicitly.

In agreements where performance obligations or other contractual provisions are keyed off of awareness of a hierarchical entity, it is often unclear when that awareness comes into existence as additional parties in the chain of command enter the picture. To avoid the uncertain determination of a trier of fact, terms such as "awareness" or "knowledge" should be precisely defined. While these issues are of general application, they take on special significance for financing documents where the papers are often complex, interrelated and laden with boilerplates from prior transactions shrouded in historical mist. The lesson is for parties on both sides of the table to pay particular attention to remedial provisions and to roll the tape into the future and ask how these provisions can be expected to work at the time they are called into play. Failure to do so may add considerably to the time and expense of enforcement or defense and aggravate the uncertainty of the outcome.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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