Federal Judge Refuses to Narrow Mortgage Putback Claims, Paving Way for Lender Repurchase Liability

Posted on July 27, 2012 by igradman

It has been just over a month since I published my series on the Top 5 RMBS Cases to Watch this Summer.  In case you missed it, here’s a quick recap of my top five cases:

  • No. 5 – Syncora v. EMC
  • No. 4 – Retirement Board v. Bank of New York Mellon
  • No. 3 – ABN AMRO Bank v. Dinallo (Article 78)
  • No. 2 – In re the Application of Bank of New York Mellon
  • No. 1 – MBIA v. Countrywide

Already, some of the developments I predicted in the first installment of this series – including a favorable ruling for Syncora on summary judgment in its case against EMC, which I will discuss today – have come to fruition, engendering important consequences.  With Syncora having just struck a $375 million settlement this past week with Countrywide and Bank of America, I decided it was time to make good on my promise to write a follow-up to this series – an epilogue, if you will.

My goal was to write an article walking through the most likely end-game scenarios in this morass of residential mortgage backed securities (RMBS) litigation and offer some predictions on the ultimate subprime shakeout.  Yet, upon sitting down to write this article, I realized that there were various and distinct end game scenarios depending on who held the RMBS claims and the nature of the claims they were asserting.  To avoid burdening my loyal readers with a 5,000 word tome, I will be dividing up this discussion into a series of posts addressing recent developments and their impact on end games.  Today, I address the impact of Judge Crotty’s summary judgment decision in Syncora v. EMC  in finally bringing some clarity to mortgage putback litigation.

The Concept of Proof

Just over a month ago, at the start of the NBA Finals, I was having an interesting conversation with a friend about the concept of proof.  He was excited about the prospect of Kevin Durant and the Oklahoma City Thunder getting to square off in the Finals against LeBron James and the Miami Heat.

“Durant has won three consecutive NBA scoring titles by age of 23,” he said, “Nobody has ever done that.  He’s the best player in the league already, but most people won’t recognize it until he beats the Heat.”  My friend was suggesting that while he already knew that Durant was the league’s best player, Durant still had to “prove it” to the rest of the world by leading his team to a championship on the game’s biggest stage against the consensus number one team and player.  While there would be endless argument and speculation prior to the Finals, a championship – the generally accepted method of proof in sports – would end the debate, and few would dispute who the best really was.

Of course, the 2012 NBA Finals did establish who the best player in the game was, but it wasn’t Durant.  While Durant is clearly a gifted scorer – and at 23, has plenty of room to grow – James proved himself to be the better all-around player, playing solid defense while averaging 10.2 rebounds and 7.4 assists to go along with 28.6 points per game.  Durant, by contrast, averaged 30.6 ppg, but chipped in only 2.2 assists and 6.0 rebounds.  James walked away with his first championship and the NBA Finals MVP award, and largely put to rest the debates about his greatness, at least for now.

All of this got me thinking about the concept of proof in the context of RMBS liabilities.  Whereas proof in basketball is established on the court, proof in legal disputes is established in the courtroom – where facts and arguments are presented by way of an adversarial process, and the factfinder settles issues and assigns liability.  Once liability has been assigned, the distribution of losses can be assessed, the market and its participants can adjust, and life can move on.

Until recently, with RMBS legal proceedings progressing slowly, we had few precedents to which to look to form a consensus on which side – be it investors and insurers or Wall St. banks – had the better of these arguments.  I could write until my fingers ached about how weak I thought banks’ defenses were in these cases, but until we had proof in a court of law, the debate would rage on.  Banks could continue to under-reserve for RMBS losses based on various versions of the “global catastrophe defense,” while trustees like Bank of New York Mellon (BNYM) could justify minimal settlement values based on these defenses and the purported protections of the corporate veil.  But all of that is beginning to change.

Crotty Takes a Stand

In the first article in my Top 5 series, I discussed how bond insurer Syncora’s patience would finally be paying off this summer, when federal Judge Paul Crotty was expected rule on the insurer’s summary judgment motion in the 2009 case, Syncora v. EMC.    Therein, I predicted that, based on his prior rulings in the case, Crotty would decline to adopt EMC and J.P. Morgan’s narrow view of the materiality requirement for mortgage putback claims (that the breach must actually have caused the borrower to stop making mortgage payments), and instead find that a breach must merely have a material impact on the risk profile of the loan.  On June 19, 2012, Crotty finally issued the ruling that was more than six months in the making, adopting Syncora’s much broader definition of materiality and giving both bond insurers and MBS holders hope that the years of litigation would eventually pay off.

Understanding exactly what Judge Crotty decided and what it means for litigants is essential to understanding how these cases are likely to play out, so I thought it was worth walking through this opinion in some detail.  His Honor was asked by Syncora to rule on three distinct issues: (1) that EMC was required pursuant to the securitization trust agreement to repurchase loans that breached reps and warranties as of the closing of the securitization, regardless of whether those breaches caused any loan to default; (2) that Syncora could establish that EMC materially breached the insurance agreement between the parties by showing that a breach materially increased Syncora’s risk of loss on the Transaction (again, even if the breach did not directly cause a claim payment); and (3) notwithstanding that Syncora’s insurance policy was irrevocable, the Court could grant Syncora equitable relief equivalent to rescission (awarding them claim payments less premiums).

If you’ll recall, Judge Eileen Bransten was faced with a very similar set of questions from MBIA on summary judgment in its case against Countrywide.  In response, Bransten ruled that MBIA need not show a direct causal link between a misrepresentation or a breach of the insurance agreement to prove its claims of fraud or breach of contract, respectively.  She also ruled that rescissory damages were available to MBIA in lieu of actual rescission.  These were important victories for all monolines pursuing claims based on RMBS losses.  However, Her Honor punted on the key question of the causation or materiality standard for loan putbacks, the loan-level claims at the heart of BofA’s $8.5 billion settlement with BNYM, leaving RMBS investors out in the cold with little “proof” or even guidance on the strength of their claims.

That all changed with Crotty’s opinion.  Crotty, of course, was well aware of Bransten’s prior summary judgement decision when making his ruling and decided to reference it explicitly in his Order.  Therein, Crotty sides with Bransten on the question of loss causation in the context of the insurance agreement.  Drawing from well-established insurance law that holds that an insurance company may avoid a policy and/or recover losses if a breach materially increases the risk covered by the contract, Crotty holds that, “Syncora may establish a material breach of the [Insurance and Indemnity Agreement (I&I)] by proving that EMC’s alleged breaches increased Syncora’s risk of loss on the Policy, irrespective of whether the breaches caused any of the HELOC loans to default” (Crotty Order at 16).

This turns out to be the only issue on which the two judges could explicitly agree.  Where Bransten finds that rescissory damages were available, Crotty punts that issue down the road.  Yet, more significantly, where Bransten punts on the issue of the standard for loan-level putbacks, Crotty steps into the breach.

In the section on putbacks, the most robust section of his Order, Crotty begins by noting that the trust agreements did not require a breach to have caused a default to trigger a repurchase, but only that a breach “adversely affects the interests of the Note Insurer” or the value of those interests (Crotty Order at 7).  The question, therefore, was the nature and scope of the insurer’s “interests” (Id.)

Crotty then goes on to conduct an extensive analysis of insurance law and the well-known principles that insurers have a right to know the risks they are undertaking, that insurers rely on representations and warranties in assessing and pricing risk, and that breaches of those warranties are deemed material if they would have affected in the insurer’s willingness to insure the risk at the agreed price.  He then goes on to make findings specific to Syncora and EMC, including that the truthfulness of the reps and warranties was a condition precedent to Syncora issuing its Policy, and that a breach of those reps would have adversely affected Syncora’s interests (Crotty Order at 8).

Crotty rejects EMC’s argument that “adverse affect” really means “pecuniary loss,” finding that the parties’ agreements did not reflect this understanding (Id. at 9).  He goes on to point to several sections of the trust agreements that suggest that even current loans could be put back under certain circumstances (Id. at 9-10).

Finally, he addresses head-on Judge Bransten’s prior finding that the trust agreement language was “ambiguous” and that there might be meaningful variation between the language in the various trust agreements at issue.  His Honor first notes that “there is no suggestion that the Operative Documents did not apply uniformly to all of the HELOC loans in the Transaction” (Crotty Order at 13).  He then goes on to find that the Court in MBIA v. Countrywide “did not explain its reasoning” that the repurchase provisions were subject to varying interpretations and that Bransten’s opinion “is not persuasive” to the extent that it found ambiguity in those provisions.  This clears the way for Crotty’s ultimate holding in that regard, which could not be clearer, and is worth quoting in full:

[T]he requirement in Section 7 of the [Mortgage Loan Purchase Agreement (MLPA)] that a breach of a representation and warranty must “adversely affect[] the interests of the Note Insurer” is not ambiguous.  EMC’s proposed construction has no basis in the plain language of the parties’ agreements.  Syncora need not prove that the allegedly breached representations and warranties caused any of the HELOC loans to default in order to show that its interests as an insurer were adversely affected for purposes of triggering EMC’s repurchase obligation under the MLPA. (Id. at 15)

Now, this is plainly a win for the monolines – and the fact that EMC has already filed a Motion for Reconsideration shows that the lender is concerned.  Assuming that Crotty declines to reconsider his order (a quick read-through of the motion shows little new information or basis for reconsideration) and that other courts addressing this issue find Crotty’s Order persuasive (likely given that he’s a respected federal judge who wrote a reasoned, logical opinion), monolines will no longer have to go through the onerous task of proving exactly why a borrower stopped making payments in order to put a loan back to an issuer or originator.  Proving simply that a breach of reps and warranties made the loan riskier is far easier to do.  But what would this mean for investors?

Essentially, this holding, if it stands, will give investors a solid platform from which to argue for the same putback rights as monolines.  Though Judge Crotty limited his holding to monolines (and indeed, it would have been overreaching had he purported to rule on the interests of investors, when that issue was not before him), His Honor’s reasoning could just as easily be applied to investors seeking to enforce repurchases.  Just as an insurer has an interest in understanding the risk that it is insuring, an investor has an interest in understanding the risks underlying its investment.  In fact, this principle forms the foundation for state and federal securities laws, which allow investors to recover their losses when they can prove that a risk was materially misstated in the offering documents.

What Crotty’s Order would do is provide persuasive authority for knocking out a fundamental piece of the banks’ argument – that a breach of rep and warranty is measured at the time of default and must be shown to have caused a default to trigger the repurchase remedy.  When the analysis changes from such a loss causation perspective to one in which courts consider whether an underwriting breach as of the trust closing had other adverse effects, investors will almost certainly win.  It does not require much of a logical leap to argue that, just like an insurer, an investor’s interests are adversely affected by a breach that makes a loan more likely to default in the future, even if it was not the ultimate or proximate cause of any default.

This ruling should embolden investors who were sitting on the sidelines, unsure about the strength of their claims, to come forward and assert repurchases.  However, as I will be discussing in later posts in this series, those who have not yet started down this path may have now lost out on their chance to do so.  While we’re starting to hear rumblings that German bondholders are getting active and considering collective action against U.S. banks to recover their losses (the U.S. effort to do the same lost steam when Kathy Patrick’s group pulled out), the statute of limitations window is quickly closing, and it now appears that the fix is in when it comes to some of the largest lenders.

Keep an eye out next week as I tackle potential end game scenarios for the various types of claims, starting with the monoline litigation.

Posted in allocation of loss, Ambac, Bank of New York, banks, bondholder actions, contract rights, costs of the crisis, Countrywide, damages, emc, global catastrophe defense, incentives, Investor Syndicate, investors, Judge Eileen Bransten, Judge Paul Crotty, Judicial Opinions, lawsuits, lenders, liabilities, litigation, loss causation, loss estimates, MBIA, MBS, monoline actions, monolines, pooling agreements, private label MBS, public perceptions, putbacks, rep and warranty, repurchase, rescission, responsibility, RMBS, securitization, settlements, statutes of limitations, subprime, summary judgment, underwriting guidelines, underwriting practices | Tagged | 4 Comments

The Top 5 RMBS Cases to Watch this Summer: No. 1 – MBIA v. Countrywide, BofA

Posted on June 15, 2012 by igradman

After a week-long build-up (I’m sure the suspense is killing you), we’ve reached the No. 1 case in our countdown of RMBS Cases to Watch this Summer.  You may wish to catch up with parts I, II, III, and IV, if you haven’t already.  Though Case No. 2, Bank of New York’s Article 77 settlement, may have garnered more media attention thus far, another case gets my vote for No. 1 because it represents a true adversarial process, the best and only way, as far as I know, to establish any semblance of “proof” as to who is to blame for the massive losses associated with mortgage derivatives.  Read on to find out why the nation’s former No. 1 bank may want to stop the freight train that is our No. 1 case, before it’s too late.

No. 1 – MBIA v. Countrywide, Bank of America

Even relative newcomers to this blog should be well aware of the importance that I place on our No. 1 case, MBIA v. Countrywide, et al., No. 602825/2008 in New York State Supreme Court, presided over by Judge Eileen Bransten.  As one of the earliest-filed subprime RMBS cases, and one that has been skillfully and tenaciously litigated since the beginning by MBIA’s counsel, Quinn Emanuel, this case is one of the closest to resolution and to answering some of the tough legal questions hanging over this industry.  And based on what we’ve seen thus far, if and when this case begins producing final judgments, BofA is not going to like the answers.

As recently as April 24, I wrote about the progress MBIA was making in its case against Countrywide and BofA, in which it seeks compensation for the insurance payments it has made based on losses in 15 separate mortgage backed securities trusts.  Therein, I noted that MBIA was on a roll, having won several recent discovery and case management motions, providing the bond insurer with an ever-growing stockpile of ammunition to use in its forthcoming summary judgment motion.  But even since that time, there have been several developments that have only confirmed and continued this trend, as MBIA marches steadily toward a potentially crushing victory at trial.  I will run through those developments below, followed by a head’s up on what to watch for in this case going forward.

Motion to Compel Fraud-Related Documents

One of MBIA’s primary claims is that it was fraudulently induced to provide insurance for Countrywide’s securitizations based on misrepresentations by the lender regarding loan quality and the quality control procedures that it had in place.  Though common law fraud is typically difficult to prove, as it requires showings of knowledge, intent and reliance, a successful fraud claim could return to the aggrieved party the full amount of its loss plus punitive damages.  Usually, this requires some kind of smoking gun – emails or internal documents in which high-ranking corporate officers acknowledge a problem but cover it up and/or fail to disclose it to their business partners.

MBIA has been looking for just this type of smoking gun since the beginning of their case, and it appears they believe they’ve found it, in the form of internal Countrywide documents relating to its fraud hotline and internal fraud investigations.  If Countrywide knew there was widespread fraud in its loan origination processes, and covered up that information, it could certainly form the foundation for a finding that it intentionally misled MBIA into providing insurance coverage.  And Countrywide has certainly acted like MBIA is knocking on the door of a treasure trove of damaging evidence, as it has fought like crazy to avoid producing these documents.

But Judge Bransten is having none of it.  On May 25, Bransten issued her ruling (actually dated May 11 or May 15, depending on which version you pull up on the docket), in which she granted the bulk of MBIA’s discovery requests, and generally only limited the insurer’s requests when they extended to documents unrelated to the securitizations at issue in the case.  In particular, Bransten granted MBIA’s requests for:

  • Documents related to Countrywide’s “fraud hotline” (email, fax, mail and telephone hotline for complaints about illegal behavior by Countrywide employees) as to the loans at issue;
  • Documents related to loans at issue that were referred to Countrywide’s internal Fraud Risk Management Group and Fraud Prevention and Investigation Department;
  • All meeting minutes from 2004 to 2007 from three senior management committees (alleged to reveal Countrywide compliance and underwriting policies and its understanding of how its market share related to the same) and any other minutes that refer generally or specifically to materials relevant to securitizations at issue;
  • Countrywide internal modeling files on the securitizations at issue, if not already produced; and
  • Documents regarding two terminated employees and the fraud investigations  for which they were responsible at Countrywide, as well as documents regarding any fraud cover-up.

Whew!  That document dump should keep Quinn’s associates busy for awhile, and should reveal some very juicy details about what Countrywide knew about fraud and when, and what it did or didn’t do about it.  What might be even more significant about this ruling, however, is that Judge Bransten seems to have found her voice, emerging as a strident champion of the legal process while confronting head-on Countrywide/BofA’s complaints about the mounting burden of this litigation.  In the final paragraph of her Order, she writes:

the court acknowledges, and is sympathetic with, Countrywide’s statements regarding the volume of documents it has produced.  However, past production bears no relation to current and ongoing discovery obligations, and, while colorful, recitations of numbers of pages and volumes of documents produced is unpersuasive and is not considered.  Discovery, though expensive and exhaustive, must be completed in full. (May 25 Order at 16)

This trend only continues in the Judge’s next ruling, discussed below.

Motion to Compel Clawed Back Documents and Sanctions for Delay

On May 4, the parties appeared before Judge Bransten to argue about whether Countrywide had the right to “claw back” documents it had previously produced in the middle of depositions, and right when plaintiff’s counsel was about to use those documents to question opposing witnesses.  At the time, MBIA counsel Peter Calamari asked the Court to sanction Countrywide, stating

I do believe that they should be sanctioned. I also believe that additional depositions should, might need to take place once we get the documents. (May 4 Transcript at 57:11-14)

Yet, Calamari also made clear that he did not want the case schedule slowed down as a result of these issues.  In general, plaintiffs are already incentivized to try to propel their cases forward, both to put pressure on the opposition and to keep costs from spiraling out of control.  But in this case, there’s an additional factor: MBIA wants this case to reach trial before BofA’s separate plenary action against MBIA (alleging violations of debtor-creditor law in connection with MBIA’s restructuring) gets there first.

Though an unlikely scenario given the current state of the two cases, should BofA’s plenary action (pending before Judge Barbara Kapnick in New York Supreme Court) reach trial first, it would put MBIA in a precarious position.  On one hand, the monoline could go to trial and risk losing, meaning the restructuring could be invalidated and/or MBIA could be hit with massive damages and no longer have the financial wherewithal to prosecute its case; on the other hand, MBIA could settle with BofA out of a position of weakness and on unfavorable terms.  By far, MBIA would prefer to put BofA in that position by accelerating its MBS lawsuit to the point that it’s ready to go to trial first, thereby forcing BofA to make the tough decision from a weakened position.

Another reason that MBIA would like to accelerate its case is that it has an opportunity to score major victories against Countrywide/BofA on summary judgment.  Pursuant to the court’s Amended Pretrial Scheduling Order, opening summary judgment briefs are due by August 31 of this year, and the motions should be fully briefed by the end of October.  At any point thereafter, depending on what’s raised in MBIA’s motion, Bransten could rule on issues such as successor liability, loss causation and even on the merits of MBIA’s contractual arguments, should she find no genuine issue of fact exists.  Adverse rulings in this regard could be devastating for BofA’s proposed $8.5 billion settlement of Countrywide putback claims currently pending before Judge Kapnick, undermining the very assumptions on which the settlement figure is based (for detailed analysis of the loss causation issue and its impact, see my prior article here).

Thus, we have seen MBIA’s counsel emphasize at each turn that they want to keep the case on track, and decrying Countrywide and BofA’s apparent efforts to drag their heels.  At the May 4 hearing, in response to MBIA’s arguments, Judge Bransten also expressed frustration both with the parties’ conduct during discovery and with the overall pace of the litigation.  Though Bransten didn’t limit her comments solely to Countrywide, it’s hard to read the following comments, given the context of MBIA’s discovery motion, without concluding that she has the nation’s former No. 1 lender in her sights:

Really, just in general. We really have got to step up to the plate and take a big deep breath and grow up a bit. All right… Even I, I used to practice, too. But, it has been years. But, nevertheless, you’re practitioners… you don’t go around clawing back things in the middle of depositions. Particularly, when there has been prior notice given. It is just wrong.

Now, you may not get an answer you’re a hundred percent happy with. But, that is litigation. No one gets through this process liking everything that happens, no one.  Even The Judge (Smiles). It just doesn’t happen. So, of course, you’re going to get an answer that you wish you didn’t have. But, that is reality.

MBIA has the same problem. “God, that wasn’t the right answer.” You cannot stop it. Discovery is broad. It is complete. And frankly, I do think it has been, there has been a tendency of delay. Now, Mr. Calamari would want me to merely give sanctions. It is part of his motion, so I’ll be considering that. But, I am getting closer and closer. You don’t want me to get that annoyed that I really consider that what is happening is a tremendous delay, an unnecessary delay. If I do it is going to cost a substantial amount of money. And I don’t want to have that happen. It is humiliating. It is not right. It’s not right. And not professional. (May 4 Transcript at 60:26-62:26.)

Just over a month after that hearing, on June 7, Judge Bransten issued her ruling, which yielded few surprises based on those comments.  Her Honor granted almost every request in MBIA’s Motion to Compel, with the exception of its request for sanctions.  In that regard, she noted in her Order:

All parties in this action are represented by zealous advocates, as is proper and the court appreciates.  However, the court has taken note of conduct up to the present date, including continual allegations of as well as actual delay and apparent failure of both sides to substantively meet and confer.  Interruptions of depositions, inconvenient to the deponent and expensive to all sides, will not be tolerated.  Further interruption by any side will lead to an imposition of costs.

However, the court declines to impose sanctions at this time.  The conduct as related to the court is subject to interpretation, and the court does not find the conduct rises to a sanctionable level. This may change if BAC continues to conduct itself in a manner which may be interpreted as either deceptive or geared towards a goal of delay. (June 7 Order at 16 (internal citations omitted))

The long and short of this is that MBIA will get documents regarding BofA’s alleged de facto merger with, and assumption of liabilities of, Countrywide.  These include loss reserve accounting estimates and Countrywide acquisition-related documents, which should provide further ammunition for MBIA’s claims that BofA bears responsibility for Countrywide’s liabilities as its successor-in-interest.  MBIA also gets to hold the threat of sanctions over defendants’ heads should they play games with discovery going forward.  All-in-all, a big win for the monoline that allows it to continue to obtain damaging evidence while keeping its case on track.

The Track Ahead: What to Watch For

Having had little success before Judge Bransten, BofA has apparently decided that it stands a better chance before the New York Supreme Court’s Appellate Division for the First Department.  Though Bransten has a relatively successful track record on appeal, including in this case, BofA has continued to appeal nearly every meaningful ruling Bransten has made to the higher court.  Most recently, BofA appealed Bransten’s loss causation ruling as it applies to MBIA’s fraud and breach of insurance contract claims (background here), after which MBIA cross-appealed as to her ruling on the issue of loss causation for put-back claims.  The appeal and cross-appeal of the Partial Summary Judgment Order in MBIA v. Countrywide (and the virtually identical Order in the related case of Syncora v. Countrywide) is calendared for hearing before the Appellate Division during the October 2012 term, if the appeal is perfected.

Also up on appeal is Bransten’s Order denying Countrywide’s Motion to Compel discovery regarding MBIA’s practice of insuring similar risks.  Though Countrywide had argued that it was entitled to test whether MBIA followed its stated guidelines in practice, and therefore whether the insurer actually relied on Countrywide’s representations in deciding to insure the deals, Judge Bransten denied the motion.  She found that Countrywide could test that fact based on the documents already produced in this case relating to the securitizations at issue, MBIA’s guidelines or lack thereof, and relevant witness testimony.

While these appeals are being heard in the higher court, there will be no shortage of activity in Bransten’s trial court this summer.  MBIA will continue to plow through discovery, including trying to obtain and digest all of the new documents Countrywide has been compelled to produce, as well as squeeze in all of its fact depositions, prior to the August 31 deadline for submission of summary judgment motions.  This may include forcing BofA CEO Brian Moynihan to sit for deposition a second time, after Judge Bransten suggested that this would be the logical result of Moynihan’s statement that he couldn’t remember facts about certain meetings without having the meeting minutes in front of him (the same minutes Countrywide was trying to withhold and is now being forced to produce).  Does anyone doubt that Moynihan is sick of talking about, let alone participating in, legacy mortgage litigation?

Expert discovery will also continue throughout the summer, with August 1, 2012 being set as the deadline for expert depositions relating to primary liability against Countrywide.  In short, while this should be a long, hot summer for all parties to this litigation, I have a feeling that BofA is starting to feel the heat a bit more acutely, as the victories continue to pile up for MBIA.

Let’s be clear: BofA is relying heavily on the success of BNYM’s $8.5 billion settlement as part of its plan to put its legacy mortgage issues behind it. For the bank to allow this much smaller (by dollar amount at stake) but far less auspicious RMBS case to chug forward and potentially derail its settlement would be to make a tactical mistake of epic proportions.  With statutes of limitations windows closing, and the threat of additional litigation from MBS investors beginning to subside, BofA should become far more cognizant of the threat of litigation from its own shareholders if, after eating tens of billions of dollars in losses in mortgage liabilities, it stubbornly refuses to settle with MBIA for a few (billion) dollars more.

I hope you enjoyed this week-long rundown of the Top 5 RMBS Cases to Watch this Summer.  Keep an eye out for the epilogue to this series in the coming weeks, as I begin to evaluate end game scenarios and endeavor to tackle the big question on everyone’s mind – how will all this subprime madness ultimately shake out?

Posted in accounting, allocation of loss, appeals, Bank of New York, banks, BofA, bondholder actions, contract rights, costs of the crisis, Countrywide, damages, discovery, fraud, global settlement, impact of the crisis, incentives, investors, irresponsible lending, Judge Barbara Kapnick, Judge Eileen Bransten, Judicial Opinions, jury trials, lawsuits, lenders, lending guidelines, liabilities, litigation, litigation costs, loss causation, MBIA, MBS, media coverage, misrespresentation, monoline actions, monolines, mortgage fraud, private label MBS, putbacks, quinn emanuel, rep and warranty, repurchase, responsibility, RMBS, securitization, settlements, statutes of limitations, subprime, successor liability, The Subprime Shakeout, timeline, Trustees, underwriting guidelines, underwriting practices, vicarious liability | 4 Comments

The Top 5 RMBS Cases to Watch this Summer: No. 2 – In re the Application of Bank of New York Mellon

Posted on June 14, 2012 by igradman

This is the fourth installment in my countdown of the Top 5 RMBS Cases to Watch this Summer.  Click on the following links to read parts I, II, and III.  Today, we address a case that is anything but typical, but which if successful, could become the template for global RMBS settlements for many of the banks burdened by legacy mortgage liabilities.

No. 2 – In re the Application of Bank of New York Mellon (Article 77 Proceeding)

It’s no secret that BNYM’s proposed $8.5 billion settlement with BofA and Countrywide over breaches of reps and warranties (a.k.a. mortgage put-backs) is one of the most important and influential pieces of ongoing RMBS litigation.  The approval of this settlement could put the bulk of BofA’s legacy mortgage issues behind it while creating a framework for other RMBS originators, issuers and trustees to settle their outstanding mortgage liabilities.

What many people with whom I speak don’t seem to understand, however, is how this settlement came about, and the fact that it was not the product of a typical adversarial process.  Namely, certain large institutional investors with complex and interwoven relationships with BofA, a bank’s bank that could face liabilities for wasting valuable put-back claims if it doesn’t act, and a too-big-to-fail bank that is being crushed under the weight of its legacy mortgage liabilities are endeavoring to settle claims on behalf of the entire universe of Countrywide bondholders.   And in order to do so, they have to convince a New York state court judge that the decision to settle settlement amount and process are reasonable.

In the epilogue to this series of articles, I’m going to talk about end game scenarios for mortgage litigation, and how the concept of “proof” will be an integral factor.  Currently, there is so little precedent in RMBS litigation and thus so few established facts or “proof” of wrongdoing or liability, that it’s possible for the various players to have wildly differing views of the potential outcomes and associated liabilities.  This greatly affects their loss reserves and settlement posture associated with legacy mortgage obligations.

Thus, it remains possible for the major banks to justify under-reserving for private label mortgage repurchases by stating that they have insufficient experience with these types of put-backs to set an accurate reserve amount (see this recent repurchase report from Natoma Partners for an accounting perspective on the banks’ ever-growing loss reserves).  It also allows BNYM, BofA and the Kathy Patrick-led institutional investors to justify settling Countrywide bonds with over $200 billion of losses to date for a mere $8.5 billion by appealing to untested legal defenses and repurchase statistics from BofA’s dissimilar deals with the GSEs.  I’m reminded of a Shel Silverstein poem from one of my favorite childhood books, Where the Sidewalk Ends, entitled, “No Difference.” Though at its core, this was probably a poem about racial bias, this stanza seems particularly applicable here:

Rich as a sultan,
Poor as a mite,
We’re all worth the same
When we turn off the light.

So long as we’re in the dark about how courts will interpret RMBS trust agreements, all arguments and defenses are worth the same.  But if those defenses are rejected by courts or the GSE repurchase numbers are shown to be wildly disparate from private label liabilities, it would begin to illuminate the true value of these arguments, and this settlement could come under heavy fire and ultimately be rejected by Judge Barbara Kapnick (yes, the same judge who heard BofA’s Article 78 challenge to MBIA’s restructuring).

In the context of the final RMBS case to watch (coming tomorrow), we will talk about how some of BofA’s untested legal defenses (which BNYM used to justify the $8.5 billion settlement amount) could be tested in court, and why BofA and BNYM are thus eager to complete the Article 77 settlement approval process before other major RMBS cases reach trial.  In this segment, I’ll review how developments in the Article 77 proceeding itself threaten to undermine the metrics used to justify the settlement.

The biggest recent development is that Judge Kapnick has approved the petition of the New York and Delaware Attorneys General to intervene in the case.  In her ruling, Kapnick first noted that “[t]here appears to be no precedent to the scenario here,” which she called “admittedly a very unique proceeding, and which is also arguably ‘the largest private litigation settlement in history.’”

Ultimately, however, Kapnick found that the AGs had articulated legitimate “quasi-sovereign” interests in the litigation – securing an honest marketplace and eliminating fraudulent and deceptive business practices – and ruled that the AGs had parens patriae standing to intervene.  She further found that there was no reason to believe that the AGs’ intervention would be the source of unnecessary delay, as “the Court will control the discovery process and is already working with the parties to move discovery forward.”

Interestingly, Judge Kapnick cited Judge Pauley’s prior Order granting the AGs’ petition to intervene while the case was in federal court.  She found that while Pauley had been overturned by the Second Circuit as to his Order Denying Remand, the Second Circuit had not specifically or explicitly vacated his Order granting the AGs’ motion to intervene, meaning she could consider it as an “advisory opinion.”  As I noted in an article a few weeks back, though Judge Pauley is no longer overseeing this case, he continues to have a major impact on these proceedings.

What AG intervention means is that a vocal, independent and influential party will have the right to participate in the case as if it were any other party to the proceeding.  New York AG Eric Schneiderman has already shown that he believes BNYM was one of the bad actors that perpetuated and worsened the mortgage crisis, and will likely continue to take aggressive steps to uncover evidence of trustee misconduct in discovery.  These may include tackling the issue of whether home loans were incorrectly transferred into the trust in the first place, an issue that investors have been reluctant to touch (until recently), but which the AGs have indicated that they seek to investigate.  So, while Kapnick does not anticipate AG intervention causing “unnecessary delay,” this does not mean that the AGs won’t influence the scope of discovery, and potentially lengthen the discovery timeline.

Should the AGs threaten to expose particularly damaging evidence in discovery, it could force BNYM and BofA to negotiate with the AGs to find out what it would take to make them go away.  Should the AGs, to whom Judge Kapnick will likely show some deference as the highest-ranking prosecutors of their respective states, actually expose damning evidence of misconduct by those parties, it will make it more difficult for Kapnick to rubber stamp the settlement.

The other major development in the Article 77 proceeding has been the battle over loan files, the outcome of which is something to watch closely this summer.  Debtwire reports that Judge Kapnick will hold a hearing on this topic at 2 PM ET today.  While Kapnick had initially told the parties to meet and confer to select an initial number of loan files to review between 150 and 500, the investor Steering Committe now argues that this will take over seven months and yield little of use.

I’ve spoken at length about the importance of loan files, the documents that contain black and white evidence of whether loans met underwriting guidelines, and this case is no different.  Investors challenging the settlement want access to files to show how many loans are actually deficient; BofA and BNYM want to avoid getting too granular about the trustee’s estimates of deficiencies and focus instead on the reasonableness of the process used by the trustee to reach the settlement figure.

BofA has actually intervened with a petition on its own behalf for the first time in the state court case (note that BofA is not technically a party to the Article 77 proceeding, but is now the subject of a third-party request for documents, as it holds the loan files), to argue as to why the court should not order the production of significant loan files.  Interestingly, BofA states that, “[l]oan-file review will answer no questions. It will lead only to interminable delay and unnecessary litigation, loan-by-loan-by-loan. It will bog down this proceeding for no good reason.”  I can’t resist pointing out the irony of this statement after CEO Brian Moynihan famously said during BofA’s Q3 2010 earnings call, in minimizing the company’s potential put-back losses:

This really gets down to a loan-by-loan determination and we have, we believe, the resources to deploy against that kind of a review… we will go in and fight this.  It’s worked to our benefit to—we have thousands of people willing to stand and look at every one of these loans.

Curious how the bank will advocate a loan-by-loan review when it works to its benefit (by driving up the timeline and costs of put-backs), but will argue just as ferociously that loan level review is unnecessary when asking a court to approve as reasonable its sweetheart settlement with a favored group of investors.

This irony is not lost on the counsel for the Steering Committee of investors who are challenging this deal.  Though in their first letter, they argued that this issue was not yet ripe for review and that BofA’s opposition brief is untimely, they have now responded with a short brief of their own, which is well worth reading.  Therein, they note that:

  1. Loan files are essential to test the Trustee’s assumption that the settlement was reasonable;
  2. BofA has produced hundreds of thousands of loan files in other litigation, so the burden cannot be that great; and
  3. BofA is exaggerating the time it will take to review and present evidence of breaches, since this info can be presented in the aggregate.

Most interestingly, the Steering Committee attacks head-on BofA’s claim that its repurchase experience with the GSEs is an appropriate measuring stick, and the result of an extended, adversarial and arm’s length process.  In that regard, counsel points out that:

  • GSE Guidelines were less stringent with respect to credit, repayment ability and collateral;
  • The FHFA has since reported that Freddie Mac had a flawed loan review methodology and failed to review 300,000 loans potentially subject to repurchase by BofA; and
  • The FHFA’s office of the inspector general reported that Freddie Mac management asserted the need to maintain relationships with loan sellers such as BofA as a factor weighing against more expansive loan review and put-back process, which undermines the argument that BofA’s GSE experience reflects actual arms-length, adversarial negotiations.

The Steering Committee ultimately advocates for a review of between 4,630 and 6,470 loans in order to generate a statistically significant sample.  It maintains that the sample of about 150 non-random loans that BofA has purportedly offered to produce would not be statistically significant or inform the opinion of its expert.

At the end of the day, Article 77 provides BNYM and BofA a highly advantageous playing field on which to litigate the reasonableness of this settlement, as it restricts the Judge to a binary decision (to accept or reject the settlement) under a favorable standard (arbitrary and capricious).  The banks would prefer that Judge Kapnick not look too closely or shine too much light on the deal, and instead presume that it was the product of honest, adversarial negotiations.

However, the more evidence the Steering Committee and the AGs can compile to show that the Trustee ignored evidence, relied on unreasonable assumptions, and/or chose a dollar figure far below what it could have expected from litigation, the better chance they have of making Judge Kapnick just uncomfortable enough to send BNYM back to the drawing board.  And the decisions of other courts adjudicating RMBS litigation could also help to illuminate the problems with this settlement, discouraging other issuers from using the Article 77 template to resolve their own mortgage problems.  The implications of this case make it one to watch throughout this summer, and until its resolution (likely sometime in late 2013).

Click here to continue to the final post in this series on the No. 1 RMBS Case to Watch this Summer. 

Posted in accounting, allocation of loss, Attorneys General, Bank of New York, banks, BofA, bondholder actions, conflicts of interest, contract rights, damages, discovery, Freddie Mac, global settlement, improper documentation, investors, Judge Barbara Kapnick, Judge William Pauley, Judicial Opinions, lawsuits, lending guidelines, liabilities, litigation, loan files, loss causation, MBIA, MBS, pooling agreements, private label MBS, putbacks, rep and warranty, repurchase, RMBS, securities, securitization, sellers and sponsors, settlements, timeline, too big to fail, Trustees, underwriting guidelines | Tagged , | 10 Comments

The Top 5 RMBS Cases to Watch this Summer: No. 3 – ABN AMRO Bank v. Dinallo (Article 78)

Posted on June 13, 2012 by igradman

My Top 5 RMBS Cases to Watch series began earlier this week with a look at a long-running lawsuit by bond insurer Syncora against EMC and a novel investor lawsuit against Bank of New York Mellon, as Trustee, both of which are being heard in federal court in New York.  Today, I will tackle a state court case that doesn’t deal directly with RMBS, but which was engendered by, and could have a major influence over, the allocation of mortgage derivative losses.  As our Top 5 Countdown continues with Case No. 3, let’s examine how the impact of a Judge’s forthcoming decision after weeks of “quasi-trial” will reverberate throughout other ongoing lawsuits, including several cases over which the same Judge will be presiding.

No. 3 – ABN AMRO Bank v. Dinallo (Article 78 proceeding)

A few weeks ago, I wrote about some last-minute shenanigans that took place in ABN AMRO Bank v. Dinallo and were worthy of a prime time television courtroom drama.  Namely, with only a few days to go before the parties were to present what has variously been called a “quasi-trial” or a “glorified oral argument” on BofA and Societe Generale’s challenge to MBIA’s restructuring, the parties held an impromptu call with the Judge to argue over the scope of the proceeding and whether there should be a “trial” at all.  On the call, Judge Barbara Kapnick reiterated that there would be some kind of trial, that she would hear from live witnesses on any questions of fact she deemed relevant, and then ultimately hung up on the parties when they overstayed their welcome.

Since that time, Judge Kapnick has indeed conducted what amounted to a “glorified oral argument” on the Article 78 challenge (a special vehicle under New York law for challenging agency decisions), but declined to hear from any live witnesses, and instead opted for no less than seven rounds of oral argument from the various parties.  This has resulted in a proceeding with very little of the drama or entertainment value that preceded it.

In fact, the banks challenging the restructuring wrapped up their final arguments last Thursday, clearing the way for Judge Kapnick to make a ruling in this widely-followed precursor to BofA’s plenary action against MBIA (over which Judge Kapnick will also preside) and MBIA’s put-back case against BofA (before Judge Eileen Bransten). As Judge Kapnick begins her deliberations on the merits of the Article 78 challenge, she can’t help but be cognizant of the following external factors:

  1. That her decision will likely be appealed;
  2. That she’ll have a chance in BofA’s plenary action to address head-on whether MBIA violated debtor-creditor law or withheld material information when seeking approval of its restructuring from regulators, and
  3. That she has another major case pending in her court that has also been brought via a special vehicle under New York law (Bank of New York Mellon’s Article 77 action to obtain approval for the trustee’s settlement), in which the standard of review (arbitrary and capricious) is virtually identical to that of the instant case.

These external conditions will certainly factor into the Judge’s decision, even if not cited directly.

For example, Judge Kapnick has stated on the record that she expects her decision to be appealed, which gives us some clues as to how she might be leaning based on how the “quasi-trial” played out.  As Alison Frankel has pointed out on her blog, the fact that Judge Kapnick declined to hear testimony from live witnesses such as Jack Buchmiller and Eric Dinallo, the two New York Insurance Department (NYID) officials whose names came up repeatedly during these proceedings, supports the impression that she’s not inclined to rule in the banks’ favor.  Should Kapnick have had serious doubts about the steps they took in approving MBIA’s transaction, I would have expected her to want to hear from those gentlemen herself, to see them subjected to thorough cross-examination (either by the banks’ counsel or by Her Honor herself), and have them explain to the Court what they did and why.  This would lay the groundwork for Kapnick to make a finding against the Department based on a credibility determination, something about which appellate courts are generally highly deferential.

Suffice it to say, if Judge Kapnick was going to stick her neck out and make the extraordinary ruling that the NYID acted arbitrarily and capriciously in approving MBIA’s restructuring, I would expect to have seen her take pains to create a record in support, which would bolster her ruling on appeal.  Instead, the outcome of the “trial” suggests that Kapnick did not feel there were disputed issues of fact, or that anything raised in the banks’ presentation constituted reversible error by the NYID on its face, which leads me to believe she’ll rule in favor of the NYID.

Ms. Frankel has noted that this factor could also point the other way, in that Kapnick may face reversal for not allowing live testimony and giving the banks a full and fair hearing, but I think that the limited nature of the Article 78 proceeding will work in Kapnick’s favor in this case.  Rather than holding a de novo review of the merits of the NYID’s decision, Kapnick’s role was to provide a highly deferential review of an agency decision, informed largely by the administrative record.  Unless she intends to rule against the NYID without even reaching the “arbitrary and capricious standard” (unlikely, as my reading of the case law would not support such a finding in this case), the absence of live testimony signals a rubber stamp of the transformation.

Regardless of the outcome, though this is not technically a case about RMBS, this decision is certainly one to watch for, as a win for BofA could force MBIA to unwind its company-saving restructuring (or at least into a favorable settlement of its put-back claims), while a win for the Department of Insurance would clear the way for MBIA to inflict major mortgage put-back pain on its bank counterparties as it continues to push forward with its put-back lawsuits.  Recall that the reason MBIA was forced to restructure is that mounting losses from its mortgage-related insurance products threatened to overwhelm the monoline’s healthier municipal bond business.

Yet, even with the restructuring, MBIA has apparently been able to satisfy all of its mortgage-related insurance policy claims.  As I have discussed in the past, I view the banks’ challenge to MBIA’s restructuring to have been brought as a litigation counterweight in the first place, to provide the banks (and particularly BofA) with a bargaining chip with which to drive down the settlement cost of MBIA’s auspicious mortgage repurchase claims.  The fact that all but a handful of the 16 or so of the banks originally challenging the restructuring have now settled with MBIA, save the one bank with the most potential exposure to MBIA’s claims, only bolsters this view.

For those interested in reading through the nitty-gritty details of this Article 78 “trial,” MBIA has conveniently posted transcripts from each day of proceedings on its website.  Though most of the parties’ presentations dealt with arcane issues of financial modeling and accounting rules, one argument in particular caught my attention and illustrated the overlap between this case and other RMBS litigation.

In arguing that the NYID’s decision to approve MBIA’s restructuring was “arbitrary and capricious,” the banks raised an allegation that either MBIA or the Department of Insurance should have hired BlackRock to conduct a solvency analysis on the bond insurer, as BlackRock “is the best modeling firm in the world.”  (June 1 Transcript at 1509:24)  MBIA attorney Mark Kasowitz responded, in turn, that the NYID had no responsibility to hire a third party to conduct a solvency analysis when the third party’s process lacked transparency, stating:

Your Honor, the idea that this court should null the transformation because Superintendent Dinallo did not outsource his regulatory obligations to a third-party firm that wouldn’t let him see what their proprietary models are, frankly, absurd. (June 4 Transcript at 1779:2-6)

But what really caught my eye was that the banks raised the fact that BlackRock had asserted put-back claims against Countrywide and BofA as evidence that BlackRock was impartial and non-conflicted.  In response, Kasowitz proceeded to identify several conflicts of interest that existed between BlackRock and Bank of America as further support of MBIA’s decision not to hire the firm.  These arguments are very likely to be raised in the separate Article 77 proceeding in which Judge Kapnick is being asked to approve Bank of New York’s $8.5 billion settlement with, among others, BlackRock.  This may make Judge Kapnick more open to conflict-of-interest-based challenges to the supposedly adversarial process through which the trustee and institutional investors reached their settlement over Countrywide put-back claims.

In the Article 77 case (which just might make our Countdown later this week), BlackRock is part of an investor group that claims to represent the interests of the majority of bondholders.  However, as I’ve detailed in the past, there are many reasons to believe that BlackRock, PIMCO and the other funds supporting this sweetheart settlement have little interest in obtaining fair value for their claims.  Kasowitz touched on some of those reasons during his sur-reply presentation in the Article 78 proceeding:

BlackRock during the relevant time period here was owned almost 50 percent by B of A, who is a policyholder and a petitioner in this case and a plaintiff in the DCL matter and the like. We pointed out that, you know, that’s a pretty egregious conflict to hire as a consultant the people  who are, in effect, your counterparty and potentially your adversary.  It sounds like a conflict to me, your Honor.  We point out something else.  That wasn’t just our view about things.  We cited during our last presentation the report that was issued by the General Accountability Office of the federal government, which said in situations involving Bank of America or Merrill Lynch, BlackRock is off the list.  They have an inherent conflict.  They’re off the list.  (June 4 Transcript at 1782:20-1783:4)

While the argument over the failure to hire BlackRock evoked interesting parallels to ongoing RMBS litigation, it is ultimately a sideshow in the Article 78 proceeding.  It does, however, highlight how much subjectivity and how many judgment calls were involved in the NYID’s decision to approve MBIA’s restructuring.  It’s just these types of subjective calls that Kapnick is unlikely to second guess.  Though the banks make much of the fact that MBIA had insufficient earned surplus to issue the dividend it did as part of the transaction (and indeed, this is likely the banks’ best argument), I just don’t see Judge Kapnick feeling confident enough that this transformation ran afoul of the complex accounting and insurance law standards at play to find that the Insurance Commissioner’s decision was wholly irrational.

At the end of the “trial,” Kapnick suggested that it would take her several weeks, if not months, to go through all the evidence presented by the parties during their 3 years of litigation, meaning we should expect a decision on the propriety of MBIA’s restructuring sometime before the end of the summer.  Though this certainly will not be the last we hear of the challenges to MBIA’s restructuring, this initial ruling should have a major influence on the risk analyses of, and the course of negotiations between, two of the biggest players in RMBS litigation.

Click here to continue to Case No. 2 in our Top 5 Countdown, and find out why time is of the essence in one big bank’s efforts to put the mortgage crisis behind it.

[Correction: an earlier version of this article featured an typo in the name of the Article 78 case (hat tip reader Alex Ryer) – IMG]
Posted in accounting, Alison Frankel, allocation of loss, appeals, Bank of New York, banks, bench trials, BlackRock, BofA, CDSs, conflicts of interest, contract rights, counterparty risk, Countrywide, Judge Barbara Kapnick, Judge Eileen Bransten, Judicial Opinions, lawsuits, MBIA, MBS, media coverage, monoline actions, monolines, putbacks, Regulators, rep and warranty, repurchase, RMBS, securitization, settlements, Trustees, valuation | 9 Comments

The Top 5 RMBS Cases to Watch this Summer: No. 4 – Retirement Board v. Bank of New York Mellon

Posted on June 12, 2012 by igradman

Yesterday, I kicked off a countdown of the top 5 RMBS cases to watch this summer with a post about Syncora v. EMC and the impending summary judgment decision on loss causation.  Today, I’d like to talk about another case to watch this summer: Retirement Board of the Policemen’s Annuity and Benefit Fund v. Bank of New York Mellon, Case No. 11-CV-5459 in the Southern District of New York.  This case seeks to blaze an entirely new pathway to recovery – suing mortgage backed securities Trustees for failing to live up to their contractual and statutory duties to investors.  A win here for investors in this case could mean significant trustee liability and/or negotiating leverage to force trustees to act as fiduciaries for bondholders going forward.

No. 4 – Retirement Board of the Policemen’s Annuity and Benefit Fund v. Bank of New York Mellon

As I discussed a few months back, Judge William Pauley issued a groundbreaking decision in Retirement Board v. Bank of New York Mellon that sent ripples through the RMBS litigation world.  Specifically, Pauley found that the Trust Indenture Act (TIA) applied to the RMBS Trusts at issue because they were in actuality more like debt than equity.  This meant that investors could sue and impose liability on RMBS Trustees directly for failing to comply with their obligations to protect investors in the trusts they oversee.

At the time, I predicted that the decision would go up to the Second Circuit on appeal, and it now seems like that is the route Bank of New York Mellon (BNYM) is hoping to go.  On April 17, BNYM filed a Motion to Reconsider, in which it asks Judge Pauley to reconsider and reverse his prior decision or, in the alternative, to certify his Order for interlocutory review.  In layman’s terms, this means that BNYM wants to appeal a non-final Order prior to the end of the case, for which it needs the Court’s permission.

Not surprisingly, a number of bank advocacy groups, including SIFMA, the American Bankers Association and the Clearing House Association, have lined up behind BNYM in support of the Trustee’s Motion to Reconsider.  Their basic argument is that Pauley’s decision threatens to upset the market’s settled understanding regarding the obligations of RMBS Trustees (minimal) and delay the return of the moribund private label mortgage market (which isn’t coming back anytime soon, regardless).  In their Opposition, the investors’ counsel does a good job of pointing out that the TIA was intended to protect investors from just these sorts of passive Trustees and that investors will be none too eager to flock back to private label RMBS if they’re not adequately protected.

But all policy arguments aside, the outcome of this decision turns in large part on case precedent (or lack thereof) surrounding the TIA’s application to RMBS, and the SEC’s historical interpretation of the same.  The investors argue, consistent with Pauley’s Opinion, that the SEC’s interpretation of the applicability of the TIA is only persuasive if the reasoning behind that interpretation is persuasive.  In its Reply, BNYM blows right past this point, saying, “but plaintiffs do not deny that the SEC consistently, over many years, has adhered to the view that the TIA is not applicable to PSA-governed certificates.”

Well, plaintiffs may not have denied that the SEC has interpreted this issue consistently, but that doesn’t make it so.  In fact, I’ve uncovered evidence that the SEC itself has waffled on its characterization of RMBS.  Specifically, readers may recall that, earlier this year, Option One agreed to pay $28.2 million to the SEC to settle charges that the H&R Block subsidiary misled investors about its deteriorating financial condition.  In connection with this settlement, the SEC filed a Complaint on April 24, 2012 in which it discussed the RMBS issued by Option One as follows:

Option One’s RMBS were debt obligations that represented claims to the cash flows from pools of residential mortgage loans… [Those trusts] issued RMBS that represented claims on the principal and/or interest payments made by borrowers on the loans in the pool.”  (Complaint, SEC v. Option One, 12-SACV-633, at 5:20-25 (emphasis mine))

BNYM has argued vigorously that RMBS are equity securities and that investors have an ownership stake in the mortgage loans themselves, rather than the cash flows from those mortgages, to support the position that the TIA does not apply (by its terms, it only applies to debt securities).  Without much legal precedent, BNYM has had to rely extensively on the fact that the SEC has consistently interpreted RMBS as equity securities.  And yet, this passage from the Option One Complaint shows that even the SEC has interpreted RMBS governed by similar pooling and servicing agreements as debt securities representing claims on mortgage cash flows.  This undermines whatever persuasive impact the SEC’s interpretation may have had whatever court ultimately rules on this issue.

With BNYM’s Motion to Reconsider now fully briefed, counsel for the Retirement Board of the Policemen’s Annuity may wish to seek leave to file a supplemental brief to bring this juicy revelation to Hizzoner’s attention.  In any event, we should know by the end of the summer whether Pauley intends to reverse his original decision (unlikely) or certify the issue for interlocutory review (somewhat more likely).

Should the issue go up to the Second Circuit on appeal, BNYM runs the risk of creating unfavorable binding precedent for all lower courts in the Second Circuit, which is where most of these cases have been and would be brought.  But given the vehemence with which it and the bank advocacy groups have fought the application of the TIA, this is apparently a risk they feel is worth taking.  Since the onset of the mortgage crisis, RMBS trustees have done all they could to limit their own liability first and foremost, and minimize the costs they would incur to satisfy their obligations under the governing trust documents to boot.  This makes sense, as trustees are paid very little for their troubles.  Indeed, why should they incur liabilities or costs that they can avoid?

But investors and bond insurers have complained early and often about the fact that trustees have not lived up to their contractual obligations and should have been doing more to protect the certificateholders that have limited rights to take action on their own behalf.  Since standard trust agreements (known and pooling and servicing agreements) impose very few concrete obligations on trustees while providing them with broad indemnification rights at every step, getting trustee assistance has been quite difficult… up to now.

If RMBS trustees are actually subject to extra-contractual duties under the TIA, that changes everything.  This is especially true now that certain Attorneys General (see here and more recently here) and certain bondholders (see here and more recently here) are delving into whether mortgages were properly transferred into trusts in the first place – one area for which trustees are thought to be contractually responsible, and certainly a failure that could lead to liability under the TIA.  Aside from constituting a breach of reps and warranties, a finding that loans were not properly transferred into the trusts has been held to preclude the trusts from foreclosing on delinquent borrowers, meaning massive losses (and claims) for bondholders.  In short, the success of this novel pathway to recovery under the TIA could have a major impact on whether bondholders can look to trustees to shoulder some of their losses or, in the alternative, use the threat of direct liability to wrangle trustee cooperation in enforcing their substantial mortgage put-back claims against originators and issuers.

Click here to continue to Case No. 3 in our Top 5 Countdown, and learn why a non-RMBS lawsuit has been garnering so much attention in mortgage litigation circles.

[Update: since this post was first published, Judge Pauley has granted plaintiffs’ counsels’ request to file in the public record the SEC documents referring to RMBS as “debt obligations” – IMG]
Posted in allocation of loss, appeals, Attorneys General, Bank of New York, bondholder actions, chain of title, Complaints, contract rights, costs of the crisis, fiduciary duties, improper documentation, investors, Judge William Pauley, Judicial Opinions, lawsuits, liabilities, litigation, litigation costs, MBS, motions to dismiss, pooling agreements, private label MBS, procedural hurdles, putbacks, responsibility, RMBS, SEC, securitization, TIA, Trustees | 8 Comments