Though Bank of America (BofA) has taken its share of lumps over the past six months, this may be the one that leaves the biggest mark. In an opinion issued today in the Southern District of New York (available here and hereinafter referred to as the “Order”), Judge William Pauley denied Bank of New York’s (BoNY) motion to send its Article 77 proceeding–seeking court approval for its decision to settle putback claims in 530 Countrywide trusts for $8.5 billion–back to state court. This decision means that BoNY’s conduct will be evaluated under far less favorable standards for BoNY and BofA, and that disapproving bondholders may be permitted to “opt out” of the settlement.
If you will recall (and if you don’t, feel free to read my prior articles here and here for background), BoNY originally filed this action in New York state court in June of this year, seeking judicial approval under Article 77 for its decision to settle potential repurchase claims or “putbacks” with respect to 530 Countrywide RMBS trusts. Legal commentators hailed the use of Article 77 as “novel” and “creative” (it is usually reserved for garden variety family law trusts and other express trusts), citing the difficulty that investors would have in challenging the settlement under this special vehicle of New York law.
However, it soon became clear that numerous powerful parties were lining up in opposition to the settlement and were raising issues that would be difficult to ignore. These included a challenge by the New York Attorney General, which accused BoNY of persistent illegality and fraud and raised the question of whether mortgages were properly transferred into Countrywide trusts at the outset. At last count, 44 separate groups had filed petitions to intervene and challenge the settlement (or obtain more information) and one group had filed a petition to intervene in support of the accord.
In a surprise move, one such objector, Walnut Place, LLC, essentially hijacked the case–removing it to federal court and framing it as a “mass action” under the Class Action Fairness Act (CAFA). This threatened to change the entire nature of the proceeding and prompted BoNY to file a motion to remand, in which it argued that Walnut Place’s efforts were unjustified and “frivolous” and urged Judge Pauley to send the case back to the friendlier confines of New York Supreme Court.
In hearings leading up to today’s Order, it appeared that Judge Pauley was skeptical about BoNY’s role and conduct in negotiating this settlement, and seemed inclined to keep the case. In particular, His Honor seemed fixated on whether BoNY was subject to fiduciary duties derived from sources outside of the Pooling and Servicing Agreements (PSAs), which would weigh against finding that this case fell under the “securities exception” to CAFA. This skepticism may have been exacerbated by revelations earlier this month that Gibbs & Bruns, the law firm representing the investors supporting the settlement, had urged its clients to withdraw from a parallel effort by Talcott Franklin’s Investor Clearinghouse to take more aggressive action against BoNY (you can read Alison Frankel’s astute coverage of these recent developments here). But while the outcome of this motion may have been foreseeable, it was the tone of today’s opinion that I found most surprising.
In holding that CAFA provided the federal court with exclusive jurisdiction over this case, Judge Pauley found that Walnut Place had satisfied the elements for a mass action under CAFA, in that the case involved 1) monetary relief, 2) 100 or more persons, and 3) common questions of law and fact. The Court did not seem to struggle with finding any of these elements or in dismissing BoNY’s claims that Walnut Place was not a proper party to remove the case.
The most robust discussion was reserved for the evaluation of whether the securities exception to CAFA applied, but even that thorny question was dealt with in relatively short order. Repeatedly citing to Greenwich Financial v. Countrywide, 603 F.3d 23 (2d Cir. 2010), one of the earliest cases arising from the mortgage crisis (and discussed frequently on The Subprime Shakeout), Judge Pauley found that the “pivotal question” in reaching this determination was “whether a plaintiff’s claims arise under the terms of an instrument that creates or defines securities or plaintiff’s claims arise under an independent source of federal or state law.” (Order at 16) His Honor noted that BoNY had conceded that New York trustees owe certain common law duties to trust beneficiaries that could not be waived, including the duty to avoid conflicts of interest. In that regard, Pauley held that, “this duty–grounded in New York common law and not the terms of the PSAs–lies at the heart of the Article 77 Proceeding.” (Order at 17)
In disposing of BoNY’s counterarguments that the sources of its obligations were actually the governing PSAs, which had modified and superseded the Trustee’s common law duties, Judge Pauley noted wryly that, “PSAs are not talismans endowed with the power to ward off federal jurisdiction. Because the Article 77 Proceeding necessarily involves New York common law, the securities exception does not bar removal.” (Order at 19) In other words, if the case involves common law questions not arising out of an agreement creating or defining a security, that’s enough for Pauley to find that the federal courts have jurisdiction.
Though Pauley appears unwavering and far from ambivalent in reaching this holding, the conclusion of his Order includes a remarkable appeal to the “core federal interests” implicated by this case, in what can only be described as a “belt and suspenders” approach to the determination of jurisdiction. Rather than resting simply on the fact that the elements of CAFA were met and that the plaintiff did not carry its burden of proving any exception applied, Pauley recognizes the national implications of this case in an effort to bolster the decision to keep it in state court. When reading the final paragraph of the Order, which I quote in full, consider whether this language will help Pauley’s opinion survive a potential appeal or suggest that he was swayed more by the case’s national prominence than an unemotional application of the relevant law:
The Settlement Agreement at issue here implicates core federal interests in the integrity of nationally chartered banks and the vitality of the national securities markets. A controversy touching on these paramount federal interests should proceed in federal court. And Congress enacted CAFA to provide a federal forum for such cases. For the foregoing reasons, the Court denies BYNM’s motion to remand. (Order at 21, citations omitted)
As much as I might agree with Pauley’s statements regarding the national implications of this case, I don’t believe issues such as the “integrity of nationally chartered banks and the vitality of the national securities markets” were actually before the Judge in this instance. Instead, he was asked to rule on the narrow issue of whether remand of the Article 77 Proceeding was proper. Because it’s tough to see how the vitality of the securities markets is directly implicated in adjudicating such a motion, I think this colorful flourish at the end of an otherwise well-reasoned opinion only weakens the credibility of the Order by suggesting that the Judge may have been influenced by the national attention this case has garnered. Judge Pauley may have been well advised to end the discussion in his Order after the finding that the securities exception did not apply. As Brad Pitt says in Moneyball in his role as Billy Beane, “when you get the answer you’re looking for, hang up.”
Implications
So what does this all mean to BoNY and, more importantly, BofA? On one hand, the precise procedural implications are yet to be decided. Pauley included a section in the Order entitled “Remaining Issues,” in which he states that “This Court recognizes the procedural difficulty inherent in continuing this action in federal court” and orders the parties to submit a joint case management report by October 31 and appear before him on November 3 for a status conference. (Order at 20) On the other hand, I can’t help but speculate that Pauley will not be forced (as Judge Kapnick would have been in state court) to defer to the standards and constraints of Article 77 in adjudicating this case. Having found that the federal court has exclusive jurisdiction under CAFA, Pauley will likely handle the case along the lines of other “mass actions.” Though mass actions are not governed by the identical procedural standards as ordinary class actions, I would expect that Judge Pauley will borrow certain aspects. This will likely include the application of an “entire fairness” standard to evaluate the settlement rather than the more deferential “abuse of discretion” standard. It will likely also mean that the Court will either require that a majority of potential claimants (i.e. bondholders) approve of the settlement, or allow disapproving bondholders to “opt out.” This will completely undermine BofA’s strategy of settling uncertainty in the markets and resolving its legacy Countrywide liability in a rapid and favorable manner. Now, the Court will likely be able to examine the inner workings of how this deal came about, learn that most bondholders were not consulted or notified, realize that BoNY’s experts based their loss estimates on inapplicable information provided to them by BofA, and evaluate whether BoNY was acting under a conflict of interest when agreeing to this settlement. Disapproving bondholders may be able to extract themselves from this settlement, preserve their claims, and file separate lawsuits against Countrywide and BofA. None of this is good for BofA.
Thus, the biggest question remaining in my mind is, can BoNY voluntarily withdraw this settlement without invoking the ire of Judge Pauley and startling the markets, or now that they’ve proceeded down this path, are they stuck with the monster they’ve created? Only one thing’s for sure: BofA’s black eye will not be healing anytime soon.
