The backyard brawl between the AIG-led objecting investors on one hand and Bank of New York Mellon (BNYM) and the investors supporting BofA’s $8.5 billion settlement on the other is about to get even messier. As I last wrote on May 29, before the merits hearing on the Article 77 settlement began in New York Supreme Court, that AIG had subpoenaed the records and testimony of Bill Frey, a bondholder advocate that had been hired to develop evidence against Countrywide. We had heard very little about that testimony until this past Friday, September 20, when BNYM and the supporting investors filed this motion to prohibit Frey from testifying.
The essence of the 2-page motion is that Frey’s testimony was both irrelevant and protected from disclosure by an NDA. But both of these arguments may be subject to attack.
BNYM and the institutional investors that support the deal, including BlackRock and PIMCO (the “Institutional Investors”), argue that the only topic at issue in the Article 77 proceeding is whether the Trustee’s conduct in reaching and submitting this settlement was reasonable. Since the Trustee never hired Frey or considered any of his work, nothing Frey would say could have any bearing on whether the Trustee’s actions were reasonable.
However, Frey’s testimony may reveal that the settlement was actually the product of a non-arms-length transaction, something that the Trustee should have investigated before swallowing the deal and its assumptions whole. And I believe that this is why the Institutional Investors are afraid of what Frey will say on the stand.
As has long been rumored, and as Debtwire has previously reported, Frey had developed, on behalf of Tal Franklin’s much larger group of investors (a group that originally included BlackRock and PIMCO), a study of whether servicing practices by Countrywide had complied with its servicing obligations. This study found that, in nearly every deal examined, Countywide had violated its servicing obligations in its treatment of first liens for which it or BofA held the associated second lien (i.e. self-dealing). Multiple sources have told me that this study was actually verified by Fannie Mae, which confirmed that the methodology and results were accurate.
However, when it came time to submit this information to BNYM and demand that it take action, which would have created an Event of Default and heightened duties for BNYM, the Institutional Investors pulled out, submarining Franklin’s effort. Instead, the Institutional Investors, led by attorney Kathy Patrick, opted to ignore this hard evidence, stay on friendly terms with BofA and BNYM, and negotiate the sweetheart deal (8 cents on the dollar of potential claims) that’s now at issue in the Article 77 proceeding.
When reached by telephone, Frey told me that he had “no comment” regarding the legal proceedings. Frey’s attorney, Bob Knuts, and the attorneys for the objectors and the Institutional Investors did not return calls for comment.
While we don’t know exactly what Frey’s testimony would entail, or what his records would reveal, we can only imagine what juicy details would emerge regarding the way this deal came together. From the lone internal email communication that has been released to the public thus far, we’ve already learned plenty.
Here is a copy of that email from Kathy Patrick to her group of Institutional Investors, informing them that participation in attorney Tal Franklin’s more aggressive effort to declare an Event of Default in a letter to the Trustee “is not in your interests.” [Note that this email was originally published by Reuters in connection with this story - the link remains but the content is now subscription-only, so I have posted it on Scribd.] Patrick goes on to tell her group that “it would be a terrible shame to waste the traction we have gained with BONY by sending them a default letter at this critical stage.”
Patrick then notes that she believes that sending conflicting instructions to the Trustee would cause it to freeze in place and do nothing. Tellingly, she concludes with the line, “[w]e don’t want to be forced to go to war with [BONY] if there is an opportunity to achieve victory by different means.”
The email initially came to light during the time that U.S. District Court Judge William Pauley had the case before him, and was considering whether to remand the proceeding back to state court. Though Patrick was arguing before Judge Pauley that her clients were the only game in town and any amount they got was pure gravy, read this email and tell me you’re not left with the distinct impression that there was another, more serious game in town, and that her clients, instead of playing in the big leagues, opted to play patty-cake with the Trustee.
In short, Frey’s testimony and records could show that Kathy Patrick’s clients, like BlackRock and PIMCO, had purposefully ignored strong evidence at their disposal, and had negotiated a settlement that was better for BlackRock and PIMCO than it was for the pensioners and savers whose money they managed. In other words, they never really intended to litigate these claims or push BofA for the best deal possible – instead, they may have had business reasons (including liquidity needs supplied by BofA and overlapping ownership with BofA) for wanting to keep BofA happy while looking like they were pursuing remedies. Why else would the Institutional Investors provide a limited conflict waiver to BNYM attorney Mayer Brown, so that the Trustee’s counsel could only negotiate a settlement, and would not be permitted to litigate?
This raises perhaps the most important question to emerge from this trial – did these Institutional Investors breach their fiduciary duties to their own investors by agreeing to this deal? This is a question that every union pension fund and college endowment that runs money through these institutions should be asking, whether or not this deal gets approved. If these money managers gave away valuable claims for pennies on the dollar based on conflicts of interest, they should have to face the music.
Meanwhile, if Trustee had signs that the deal wasn’t truly arms-length, it shows that the Trustee may not have acted reasonably in accepting the deal. Instead, it should have asked more questions about the process and how the numbers were reached, and certainly should have invited other stakeholders to participate in the conversations, before seeking the Court’s approval for the settlement, and pre-committing itself to use its “best efforts” to see that the deal was approved, no matter what evidence emerged.
At its heart, our legal system is adversarial in nature, and requires both sides to be pulling as hard as they can for the best result possible, so that the factfinder can find the middle ground. If nobody was actually acting in an adversarial manner during the settlement negotiations, and if the settlement is then given a presumption of reasonableness in the Article 77 proceeding, it distorts this adversarial process.
As I wrote about recently, this proceeding is odd in that party that stands to lose the most (BofA) isn’t even a party to the proceeding, and the party pulling for the deal to be approved (BNYM) has no stake in the outcome, other than preserving the indemnity provided to it by BofA. Thus, it makes for an awkward and distorted platform from which to render justice of any sort. At the very least, Judge Kapnick would have to look more closely at the deal and the Trustee’s actions if it becomes clear that the deal was the product of conflicted self-dealing.
[As an aside, this also raises questions about Fannie Mae's involvement and the reasonableness of its conduct. If it's true that Fannie had verified data that showed that Countrywide had engaged in widespread servicing defaults, why didn't it (or the FHFA as conservator) pursue claims based on that data to recover funds for taxpayers? Why would Fannie only be willing to go forward if BlackRock and PIMCO had joined? Sure, there's a strength in numbers argument, but Fannie's holdings (as revealed through the FHFA lawsuit against Countywide) were sizeable enough for it to pursue significant claims on its own. Did it lack the political cover to move forward with putback and breach of contract claims, and if so, was that a proper consideration when leaving taxpayer money on the table?]
In short, there are many reasons to think that Frey’s testimony would be relevant to Justice Kapnick’s evaluation of the merits of this Article 77 proceeding. There is also grounds to believe that the NDA signed by Frey only covered certain aspects of his work, and only a limited time period. One source, who asked not to be identified, told me that much of Frey’s work and communications with investors took place before any NDA was in place.
All of this raises interesting questions about where this proceeding is heading and what Justice Kapnick will do. She has stated on the record that she wants objectors to wrap up their case by this Wednesday. However, she’s also indicated that she may set aside time in Novermber for closing arguments.
This motion throws a wrench in the Justice’s original time frame for wrapping up the hearing. She must first review briefing and hear oral argument on whether Frey’s testimony should come in. Then, if she rules that it can, the parties will have to review any documents he intends to produce, and will likely have a fight over which of his communications and other documents are protected or subject to privilege. Evaluating all of this will take time, and Kapnick is unlikely to exclude potentially relevant evidence based simply on an arbitrary deadline. Doing so would provide AIG and the other objectors with ample grounds for appeal.
Call me an idealist, but I believe in the American system of justice and the rule of law. But the system only works if the aggrieved parties actually present their claims.
Here, few can dispute that the aggrieved parties are the pensioners, retirees and savers of the world who were duped into buying mortgage backed securities that didn’t live up to their promises – not even close. The problem is that there are too many layers of imperfect principal-agent relationships between the aggrieved parties and the responsible parties, to achieve widespread justice.
The savers invest in various BlackRock or PIMCO fixed income funds, for example. Most of these savers have no idea what those funds actually bought or currently hold. BlackRock and PIMCO then have a fiduciary duty to manage those funds to get the best returns possible for their investors. But if things go horribly wrong, they often lack the incentives to stick their necks out and file lawsuits. Instead, they opt to stay with the pack, preserve their business relationships, and not rock the boat.
Even when certain bold investors decide to press their claims, they must go through passive Trustees, who want to do everything in their power to avoid getting sued, and conflicted servicers, who act to protect their own portfolios rather than acting in the best interests of bondholders. Only if those bondholders can compel the Trustee and the servicer to act in their interests can they then take advantage of the justice system and the rule of law to see their contracts enforced against the Countrywides, EMCs and GreenPoints of the world.
As you can see, there are many steps along the way in which the incentives to press these claims can be distorted, and the agents do not always act in the best interests of their principals. This Article 77 proceeding is the product of several of these distortions. And while it’s not obvious at first to the untrained eye, which only sees that investors managed to squeeze $8.5 billion out of BofA, the more accustomed one gets to the way this deal came together, the more evident it becomes that the process was far from legitimate.
Should Bill Frey’s testimony be allowed in, as I think it should, it will help Justice Kapnick come around to that view, making it incrementally more likely that she’ll reject the deal. But whether or not the deal goes through, it’s beginning to look more and more obvious that many of the proponents of the deal (and not just BofA) should wind up having to defend themselves in court when all is said and done against claims of breach of fiduciary duty, negligence, and breach of contract. Should enough aggrieved parties be willing to press such claims, I’d be willing to bet that some form of justice will ultimately prevail.