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$70M Suit Against Cadwalader Reflects Risks of Practice in Mortgage-Backed Securities
Anthony Lin
New York Law Journal
September 26, 2007

As the global slowdown in the market for mortgage-backed securities threatens a core practice area of Cadwalader, Wickersham & Taft, the New York law firm is also wrestling with a $70 million legal malpractice suit brought by a major issuer of such securities.

Cadwalader is one of the nation's top law firms when it comes to securitizations, and its large practice in the area has helped catapult the firm to the top of the profitability charts over the past few years. Such transactions involve the creation and issuance of tradeable securities tied to fixed assets or revenue streams, most commonly residential or commercial mortgages.

Nomura Asset Capital Corp., a U.S. division of Japan's largest securities firm, filed suit against Cadwalader last October in Manhattan Supreme Court over documents the law firm drafted for a 1997 securitization transaction in which Nomura pooled 156 commercial mortgages worth around $1.8 billion.

At issue in the Nomura suit are two separate warranties Cadwalader included in the documents for the transaction. Both warranties stated that each mortgage included in the pool "qualified" for special tax status under Internal Revenue Service regulations. But one warranty more specifically stated that this meant the mortgages were backed by properties worth at least 80 percent of the mortgage amounts.

That second warranty became a problem for Nomura after a number of the mortgages went into default. LaSalle Bank, which was holding the securitized pool in trust, sued Nomura on the grounds that the defaulting mortgages were not qualified, with one large mortgage secured by property worth only around 60 percent of the loan.

Nomura hoped to escape liability on the basis of a "safe harbor" provision of the IRS regulations, which state that mortgages should be 80-percent secured by property but allow that an issuer's "reasonable belief" about a property's value may be sufficient to qualify a mortgage.

But the 2nd U.S. Circuit Court of Appeals reversed a trial court's dismissal of the suit and ruled in a 2005 decision in Lasalle Bank v. Nomura Asset Capital Corp., 424 F. 3d 195, that Nomura's inclusion of a second warranty specifying 80 percent created an obligation distinct from the IRS rules.

Following the 2nd Circuit decision, Nomura settled with LaSalle for $67.5 million. The issuer is now claiming Cadwalader committed legal malpractice by including an 80-percent warranty and is asking for $70 million in damages.

Represented by David Marriott of Cravath, Swaine & Moore, Cadwalader has moved to dismiss the suit, arguing that the firm cannot be held liable for failing to predict how the 2nd Circuit would rule. The firm claims the inclusion of both warranties was the "industry standard" for securitization documents, with almost identical language appearing in the Standard & Poor's structured finance manual.

Cadwalader further claims that Nomura's situation would be no different had the defaulting loans not been included in the securitized pool, as they would have remained on Nomura's books.

The motion to dismiss remains pending before Manhattan Supreme Court Justice Herman Cahn.

Neither Marriott nor Nomura's lawyer, Ammiana Stovall of Dreier in New York, would comment on the case.

Though the Nomura suit deals with a mortgage-backed securitization that took place several years ago, it is unfolding against the backdrop of a credit crisis centering on such securities and the default of the mortgages behind them.

Investors in mortgage-backed securities and other structured finance products have been hit hard by a wave of defaults among subprime mortgages. Some heavily exposed hedge funds have closed and most of the major investment banks have reported losses from structured finance units. Nomura announced in July it was pulling out of the U.S. residential mortgage-backed securities business due to losses in the subprime sector. Other banks have taken similar steps.

The situation is worrisome to those law firms that have large securitization practices. Aside from Cadwalader, these include Cleary Gottlieb Steen & Hamilton, Sidley Austin, McKee Nelson and Thacher Proffitt & Wood.

"Things are really at a standstill now," said Paul D. Tvetenstrand, the managing partner of Thacher Proffitt. "We're all waiting to see what happens next." Though the firm's lawyers remain busy with transactions begun months ago, he said, the pipeline of new deals has noticeably cleared.


Structured finance lawyers are also wrestling with the bankruptcies of clients, especially those mortgage companies whose loans were rolled into securities. Tvetenstrand noted that American Home Mortgage Investment Corp., which filed for bankruptcy in August, had been a major client of Thacher Proffitt.

American Home's primary outside counsel had been Cadwalader though, and the firm is representing the company in a raft of securities litigations filed against it over the summer. Cadwalader also has applied to be special counsel to American Home in its bankruptcy proceeding in the U.S. Bankruptcy Court for the District of Delaware, advising the company on asset sales and potential mergers.

It would be a plum assignment, as American Home has already received a $435 million bid for its mortgage service unit by financier Wilbur L. Ross. But the U.S. Trustee is opposing Cadwalader's retention on conflict-of-interests grounds, citing the law firm's work for the financial institutions that participated in transactions with American Home.

Few firms have gained as much from the previous years' boom in structured finance as Cadwalader. Once widely regarded as a second-tier firm, Cadwalader has steadily risen up the profit charts over the past several years. Last year, the firm had profits per partner of $2.9 million, ranking it third after Wachtell, Lipton, Rosen & Katz and Cravath, Swaine & Moore among the firms in the Am Law 100 survey of The American Lawyer magazine, a New York Law Journal affiliate.

Though he declined to discuss the Nomura suit, Cadwalader Chairman Robert O. Link said via e-mail that the firm, like the rest of Wall Street, was hoping for a swift rebound. But he said Cadwalader was also well-prepared for a slowdown.

"We have worked for many years to ensure that Cadwalader has a well-balanced mix of practices so that we are not as vulnerable as some other firms to inevitable economic fluctuations," he said.

Indeed, Cadwalader has invested heavily in lateral partners to expand its other practices. Earlier this year, the firm greatly expanded its bankruptcy practice with the addition of four partners from Weil, Gotshal & Manges. The firm has also recently recruited senior partners in antitrust and intellectual property.

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