New York Judge Strikes Blow to Investor Putback Claims

Update: it appears that Walnut Place has already filed an appeal of the dismissal of its lawsuit against BofA and Countrywide – IMG.

Investors in Countrywide mortgage backed securities (MBS) were dealt a setback last Wednesday in their efforts to force the former subprime lender to repurchase defective mortgage loans.  Judge Barbara Kapnick’s decision, in New York Supreme Court, held that investors going under the name Walnut Place (revealed in court papers to be the hedge fund Baupost) did not have standing to pursue mortgage repurchase claims against Countrywide and Bank of America, as those claims were being pursued by the Trustee of those securitizations.  This decision sets the stage for all issues surrounding Bank of New York Mellon’s (BNYM) conduct in pursuing Countrywide mortgage putbacks to be adjudicated in a single forum, in the context of BNYM’s proposed $8.5 billion state court settlement with Countrywide and Bank of America.

While discovery battles are providing investors with potential leverage in the BNYM-BofA settlement proceedings – also in New York Supreme Court before the same Judge Kapnick and in which Walnut Place is a leading objector – the decision to dismiss the separate and earlier-filed Walnut Place lawsuit can only be viewed as a setback for investors, as it sets a significantly higher procedural bar to investor putback suits than investors had anticipated.

Though at least one commentator (hat tip reader Deontos) has suggested that the key holding in Judge Kapnick’s opinion was that “Plaintiff’s filing of this lawsuit… was premature under the circumstances,” the Judge actually makes two independent findings in favor of the defendants.  In fact, after cutting through the fog of this somewhat opaque decision, I’ve concluded that the first finding – that plaintiffs failed to establish the right to sue under the trust agreements – could actually be more favorable to the banks and damaging to MBS bondholders in the long run.

Defendants’ initial argument is that plaintiffs failed to allege an Event of Default under Section 10.08 of the Pooling and Servicing Agreements (PSAs), which is known as a “no action” or “collective action” clause and which is found in most PSAs.  Designed to eliminate “greenmail” or the hijacking of the trust by a self-interested bondholder, this clause provides that bondholders cannot sue unless a group holding no less than 25% of the voting rights in the Trust first provides the Trustee with written notice of an Event of Default, provides reasonable indemnity, and waits 60 days for the Trustee to take action before filing an action on their own.

The problem is that “Event of Default” is defined in the PSA as a narrow category of servicing breaches, which have nothing to do with the breaches of reps and warranties (primarily breaches of underwriting guidelines and standards at the time of origination) of which Walnut Place is complaining.  While the PSA provides a procedure for the Trustee to request that the originator or depositor repurchase loans that materially breach reps and warranties, there’s no clear procedure for how bondholders would enforce that right as third party beneficiaries.

Faced with this unfavorable contractual language, Walnut Place is left to argue that the Event of Default requirement should be read out of Section 10.08 completely, or at least when underwriting breaches are being alleged, and that they should be allowed to sue because they’ve complied with the other requirements of the no action clause.  These procedural requirements were first established in one of the only other cases to evaluate MBS bondholder standing to sue, Greenwich Financial v. Countrywide, in which the New York State Supreme Court tossed a proposed bondholder class action for failing to show 25% voting rights, make a demand on the Trustee and wait 60 days for action.  The irony is that this decision was also issued by – you guessed it – Judge Kapnick.

Yet, Judge Kapnick doesn’t buy the argument that the Event of Default requirement should be read out of the no action clause in this instance.  In fact, she says categorically that “plaintiffs’ reliance on Greenwich is misplaced.” (Opinion at 11)  Her explanation in this regard is not a model of judicial clarity, but it seems that Her Honor is saying that an Event of Default must be established even before the Court reaches the question of whether the other procedural hurdles have been met.  Here’s the full excerpt from the Opinion on that topic, in case you’d like to try to sort it out yourself:

In [Greenwich], this Court considered defendants’ contention that the plaintiffs had failed to allege an Event of Default, as required by the no-action clause.  Then, in rejecting plaintiffs’ argument that they were not subject to the no-action clause because they were suing for the benefit of all certificateholders, this Court emphasized that plaintiffs had also failed to comply with the other procedural requirements of Section 10.08. (Opinion at 11)

The Court ultimately holds that, unless there is an allegation that the Trustee is incapable of satisfying its obligations, then any claim that can be enforced by the Trustee on behalf of all bonds is subject to the no action clause, and thus the requirement of alleging an Event of Default.  Finding that “there is no allegation of misconduct or breach by the Trustee in the administration of the trusts” (Opinion at 14), Judge Kapnick concludes that plaintiffs must satisfy all requirements of the no action clause.

Since plaintiffs already conceded that they had not alleged an Event of Default in this case, this finding meant that plaintiffs had not satisfied the requirements of the no action clause, and thus could not pursue contractual claims for relief as third party beneficiaries.  This holding does not rest on the later finding that Walnut Place’s lawsuit was “premature,” as we will see.  Instead, the holding rests entirely on the notion that bondholders must allege a servicing violation to even get a foot in the courthouse door.  And while creative arguments could be fashioned that bondholders should be allowed to sue for origination breaches after first notifying the Trustee of a servicing breach, this holding could also be read to suggest that bondholders simply have no right under the contract to enforce mortgage loan repurchases.  That is by far the more damaging takeaway from this case for bondholders, and will likely result in a decision to appeal by Walnut Place.

Let’s now take a look at the second piece of this opinion.  Having already found that plaintiffs had not satisfied their procedural requirement to obtain standing to sue under the contract, Judge Kapnick next considers whether plaintiffs can sue derivatively.  Generally, in order for party to sue derivatively, it must show either 1) that made a demand on the party with the express right to sue, and that party unreasonably failed to do so; or 2) that the party with the right to sue was so conflicted or otherwise incapable of doing so that a demand would have been futile.

It is only with respect to plaintiffs’ right to sue derivatively – requiring a determination of whether the Trustee unreasonably failed to take action or was incapable of doing so – that Judge Kapnick reaches the issue of the timing of Walnut Place’s filing.  In that regard, Her Honor finds that plaintiffs failed to make a viable allegation that the Trustee unreasonably refused to act, as it requested more time to evaluate Walnut Place’s demands and eventually did act, by filing its $8.5 billion Article 77 action in state court.  While some commentators have questioned whether Judge Kapnick was unreasonably expanding the 60-day period in the no action clause for the Trustee to take action (by finding that plaintiffs must grant the Trustee’s requests for more time), my reading is that this finding is being made entirely outside of the context of the PSA language.

Instead, Kapnick is determining whether the Trustee made an unjustifiable refusal to act, sufficient to constitute an abuse of discretion, which would open the door for plaintiffs to sue derivatively.  In this context, it makes sense that Judge Kapnick would find that a request for additional  time by the Trustee and the ultimate filing of a settlement action belie plaintiffs’ allegations that the Trustee unreasonably failed to act.

Finally, Kapnick addresses the question of whether the Trustee was conflicted or otherwise incapable of suing, such that a demand would have been futile.  Here, it seems that Kapnick simply does not have enough information to go on, as Walnut Place only raises the allegation of conflict “for the first time” in the context of this motion to dismiss.  Further, plaintiffs’ lone argument in support of a conflict of interest is that the Trustee’s fee is based on the principal balance of the loans in the pool, such that forcing repurchases of those loans would reduce the Trustee’s fee.

With the Trustee’s fee being pretty minimal to begin with, I can think of several better reasons that one could argue that the Trustee is conflicted in this case, including that BNYM gets over 60% of its Trustee business from Bank of America (so it wants to keep the bank happy) and that BNYM is largely motivated by a desire to avoid litigation losses stemming from its conduct in overseeing MBS trusts.  This is why BNYM’s side letter agreement with Bank of America, which guarantees Countrywide’s indemnification obligations and extends the indemnification of BNYM through its conduct in negotiating the settlement, is so important.

However, these are the exact arguments that Walnut Place and the other intervenors are making in the Article 77 proceeding to establish that BNYM was conflicted and should not be granted the right to settle putback claims on behalf of all 530 trusts.  Though Judge Kapnick could have granted Walnut Place leave to amend to beef up its allegations of Trustee conflict, it seems she would rather adjudicate that issue only once, in the context of the Article 77 proceeding.

Left only with an allegation that the Trustee unreasonably failed to act, it makes sense that Judge Kapnick would ultimately find that Walnut Place jumped the gun and filed its derivative suit prematurely.  But it was only because plaintiffs could not establish a direct right to sue under the PSAs that Kapnick even reached this conclusion.  This first holding is far more troubling – it suggests that the parties never even contemplated that bondholders would have a right to enforce putbacks.  While I don’t agree that this is the case, and think there are provisions of standard PSAs that demonstrate otherwise, this is clearly the issue that deserves the bulk of bondholder attorneys’ attention right now, and overcoming this contractual interpretation should be the primary focus of any eventual appeal.

About igradman

I am an attorney, consultant, book editor, and one of the nation's leading experts on mortgage backed securities litigation. I am the author of The Subprime Shakeout mortgage litigation blog, a partner at Northern California law firm Perry Johnson, Anderson, Miller & Moskowitz, LLP, and the editor of the critically-acclaimed book, "Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System," by Bill Frey. Follow me on Twitter @isaacgradman
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