The Top 5 RMBS Cases to Watch this Summer: No. 5 – Syncora v. EMC

Posted on June 11, 2012 by igradman

As summer approaches and the weather turns warmer, RMBS litigation is also heating up, generating long-awaited precedent that will dictate how mortgage losses are likely to be allocated by the courts.  In order to keep my readers apprised on what to watch for over the next three months in the key mortgage derivative lawsuits, I am launching a series called the Top 5 RMBS Cases to Watch this Summer.   Starting today, and continuing over the next week, I will be analyzing the latest developments in one bellwether case per day in the world of RMBS litigation.  I will conclude the series with an article on possible end game scenarios, so that we can begin to understand how the subprime crisis will finally shake out, and what it will mean for the future of mortgage finance.  So, without further ado, I present case number 5 in the Top 5 RMBS Cases to Watch this Summer.

Case No. 5 – Syncora v. EMC

Though patience is ordinarily a virtue, it’s a prerequisite in the world of residential mortgage backed securities (RMBS) litigation.  That’s because progress in complex litigation always takes longer than anyone expects.

Take the lawsuit by bond insurer Syncora against mortgage lender EMC Mortgage (formerly a subsidiary of Bear Stearns that’s now wholly owned by JP Morgan Chase) as a prime example.  On December 19, 2011, Syncora v. EMC, Case No. 09-cv-3106 (S.D.N.Y. 2009) became the focus of significant attention when Reuters blogger Alison Frankel wrote that a partial summary judgment decision on the issue of loss causation was “imminent” and anticipated that we’d have a ruling in the case “before the end of this week.”  Sitting here nearly six months later, we are still awaiting that decision.

Of course, this isn’t Ms. Frankel’s fault – she provides some of the best and most timely coverage of RMBS litigation in the business.  Ms. Frankel was relying on statements made by His Honor himself, when Judge Paul Crotty announced at a hearing on October 12, 2011 that, “I think it would be in everybody’s interest to get a decision [on summary judgment] before we break for the holidays.  That’s what I’ll try to do.” (October 12 Transcript at 24:22-24)  Apparently, progress takes longer in complex litigation than even judges expect.

The good news is that we can finally see the light at the end of the tunnel.  A hearing on the summary judgment motion has been set for this Wednesday, June 13, 2012.  With the motion fully briefed and oral argument complete, Judge Crotty certainly should be able to hand down a decision by the end of the summer.  In fact, given the delay we’ve already seen and the importance of this decision to the case and the broader litigation landscape, I would expect the decision to come down by mid-July – but don’t hold me to it.  Judges work on their own schedules, and the demands of their dockets may force things to the back burner for far longer than we (or they) would like.

Whenever the decision comes down, there’s good reason to believe that Syncora’s patience will be rewarded.  Judging by Crotty’s previous decision on summary judgment, which I analyzed here, Hizzoner is none too pleased with EMC’s interpretation of its contractual responsibilities or conduct thus far in living up to those responsibilities.  Having previously declined to limit Syncora’s relief to the put-back remedy (which he famously described as being designed for “onesies and twosies”) and having authorized Syncora to use statistical sampling to prove its claims, I anticipate that Crotty will be similarly disinclined to limit Syncora’s access to the put-back remedy by adopting a narrow definition of materiality.

I’ve discussed at length how important the definition of materiality/loss causation will be to the ease of proof in put-back litigation.  No single issue would cause a bigger swing in the pendulum of losses from investors to banks than a ruling that put-backs do not require a showing that the identified breach of reps and warranties actually caused the loan to go into default.

Since Judge Eileen Bransten punted on that issue in her partial summary judgment ruling in another major monoline suit – MBIA v. Countrywide – Crotty could be the first to rule definitively on whether this is a viable defense.  If he goes the way I expect he will (and the way he should, given the strength of the arguments on each side) and rules that a breach must merely have a material impact on the riskiness of the loan rather than actually cause the borrower to stop making payments, it will provide clarity on the scope of repurchase liabilities and facilitate significantly larger recoveries for the monolines and RMBS investors.  It would also undermine the assumptions made by Bank of New York Mellon in settling Countrywide put-back claims for pennies on the dollar (tune in later this week to see if BNYM’s Article 77 proceeding makes the Top 5 list).

On the other hand, Crotty could also decide to punt on the issue, forcing litigants and commentators to put Guns N’ Roses’ classic track on repeat and dig deep for what’s left of our “Patience.”  Either way, this ruling is certainly one to watch for in the months to come.

Click here to continue to the next post in this series – Case No. 4 – and find out what recent ruling has the securitization industry worried and mobilizing against it…

Posted in Alison Frankel, allocation of loss, Bank of New York, banks, Bear Stearns, broader credit crisis, contract rights, costs of the crisis, Countrywide, emc, investors, JPMorgan, Judge Eileen Bransten, Judge Paul Crotty, Judicial Opinions, lawsuits, lending guidelines, liabilities, litigation, loss causation, loss estimates, monoline actions, monolines, mortgage market, private label MBS, putbacks, rep and warranty, repurchase, responsibility, RMBS, subprime, The Subprime Shakeout, Trustees, underwriting guidelines, underwriting practices | 12 Comments

Last Minute Fireworks Provide Preview of MBIA Restructuring Trial, Beginning Today

Posted on May 14, 2012 by igradman

A last minute hearing before Judge Barbara Kapnick in New York Supreme Court on Tuesday provided drama worthy of prime time television, illustrating the stakes of the trial beginning today between MBIA, the New York Insurance Department (“NYID”), and Bank of America (“BofA”) over the propriety of the bond insurer’s 2009 restructuring.  The telephonic hearing held on May 8 (the “May 8 Hearing,” transcript available here) centered largely on the scope of the Article 78 proceeding, something that Judge Kapnick had addressed at length at a prior hearing on April 20, but about which the parties still appeared to have widely differing views.  This led to heated arguments and an exasperated judge, who ultimately was forced to hang up on the parties when they continued to argue after their allotted time was up.

As an attorney, I’m not usually one for fictional courtroom dramas, probably for the same reasons that my cardiologist father never wanted to watch ER and the firefighters I know couldn’t stand the movie Backdraft.  It’s hard to enjoy a fictional work about a profession you live and breathe daily, especially when the dramatic plot twists make it almost laughably unrealistic.  (I have to admit that I make an exception for The Good Wife, as the topical  story lines and character development allow me to overlook the unrealistic courtroom scenes – most of the time.)

But as I read through the transcript of Tuesday’s hearing, I wondered whether I was being too hard on courtroom dramas.  In fact, if I had seen the kind of last minute shenanigans depicted in the transcript unfold in one of these television programs, I probably would have scoffed at the absurdity of it all.  When would the parties ever show up in front of a judge on the eve of trial  and argue over whether there was a need for a trial at all?  I wouldn’t have believed it; but reading the saga unfold in a real life transcript, I couldn’t put it down.  For those of you who don’t view hearing transcripts as page-turners, I will try to summarize the major takeaways from Tuesday’s hearing, with plenty of quotes thrown in to give you the flavor of the proceedings.

Rundown of May 8 Telephonic Hearing

Though buried in a slew of references to cases and statutes, the gist of the argument playing out on the phone before Judge Kapnick on Tuesday was that BofA wanted a ruling that there was going to be a full blown trial starting today on whether MBIA’s 2009 restructuring was improper, while MBIA and the NYID wanted the Judge to hold a “summary proceeding” and restrict the material that could be presented.  Essentially, MBIA and the NYID wanted the Judge to drive the proceedings, and restrict BofA to presenting only the evidence Her Honor determined she needed to evaluate a genuine issue of fact.  Each party relied on statements Kapnick made during the April 20 hearing to support its respective position.

BofA’s attorney, Robert Giuffra from Sullivan & Cromwell, stated that, “on April 20, the Court could not have been clearer that the parties were having a trial starting on May 14.”  (May 8 at 4:8-9.)  He focused on Kapnick’s use of the word “trial” during the prior proceeding, noting that Her Honor had used the word over 40 times and that BofA thus understood from the April 20 hearing that there would be a full trial.  (May 8 Hearing at 5:21-23.)  However, anyone who read that prior transcript or my prior article will recall that Kapnick used many different words to describe the proceeding that would begin this week, and indicated she didn’t place much importance on the name, saying:

I have made that very clear from the outset, that it is, whether you call it a trial, I said I don’t want to fight about the semantics, whether you call it a trial or a hearing with evidence. I think everybody understands.  (April 20 Hearing 44:18-22.)

Clearly, Her Honor was mistaken, because when MBIA attorney Marc Kasowitz, from Kasowitz Benson Torres & Friedman LLP, was allowed to respond, he stated that “nothing could be further from the truth,” as MBIA’s understanding was that the Court was going to hold an “Article 78 summary proceeding.” (May 8 Hearing at 8:3-7.)  Also drawing from statements Her Honor made at the April 20 Hearing, Kasowitz argued that,

the summary proceeding should go as the Court indicated in the last conference, i[n] that there should be argument by other lawyers, other parties, to present to the Court the evidence that has been adduced during the course of this proceeding.  And if there are issues of fact, if there is an issue of fact or issues of fact, then the Court can try those issues and if the Court would like to hear from witnesses, then the Court can say I would like to hear from some witnesses on some of the issues of fact… (May 8 Hearing 10:5-14.)

In her response to these widely differing views, Kapnick sought to clarify her position, saying, “Well, I mean, I guess this goes back to are there any issues of fact that need to be tried.  Obviously, this is not a trial de novo and this is not — I mean, I have a relatively simple ‘determination’ as to whether or not the Superintendent’s determination, the Department of Insurance’ determination was arbitrary and capricious…” (May 8 Hearing at 13:7-13.)  The Judge went on to note that she did not view the issue of whether the NYID’s decision was arbitrary and capricious itself as an issue of fact, but instead as the ultimate issue she would be asked to determine.

This explanation did little to placate the parties.  Eventually, the NYID’s attorney, David Holgado, from the Office of the New York Attorney General, was allowed to chime in, and largely supported MBIA’s position, noting,

the hearing that your Honor really was contemplating is…[one in which] your Honor should hear argument from the parties regarding the papers that have already been submitted and that you may, as Mr. Kasowitz pointed out, ask for submission of additional proof, which is the sum testimony that your Honor mentioned in addition to the ‘glorified oral argument’ that you envisioned for this hearing. We have no issue whatsoever with what your Honor stated at the April 20th conference and we certainly have been trying to follow it faithfully in preparation for trying it.  (May 8 Hearing at 15:15-16:3.)

Holgado also noted that the reason BofA was trying to turn the proceeding into a full blown trial was so that it could apply the formal rules of hearsay to exclude the affidavits presented by NYID staff and elicit their statements de novo.  Holgado referred to those arguments at “specious” and argued that the Court should “of course consider” the submissions that have already been made by the Department, at which point he was interrupted by Giuffra.  (May 8 Hearing at 19-20.)

However, Giuffra did not get far before being interrupted in turn by Kapnick, who challenged BofA’s attempts to strike portions of the administrative record:

But let me just interrupt you. I mean, I understand that on a trial, there are evidentiary rules.   But you can’t tell me that all of those affidavits are excluded now because maybe some of the things in them are — do not comport exactly with the evidentiary rules.   I mean, that I cannot accept.   I mean, I cannot accept that you’re not trying to throw out all of the documents that you just spent the past three years submitting.   That is part of the record.  (May 8 Hearing at 19:19-20:2.)

Kapnick also began to express frustration with BofA’s extreme position and their attempts to lock Her Honor into a ruling she didn’t believe she made, saying:

I mean, I don’t agree with you, Mr. Giuffra.  I mean, it is very nice that somebody went through and counted how many times the word trial was used in the transcript.  I don’t have the time to do that or the interest or maybe the court reporter put that in the end or something like that, but I envisioned not your standard trial, and I think that is what I said at the end, even though I said some type of trial, but sort of in quotation marks. (May 8 Hearing at 20:23-21:5)

So we know that we will be seeing a “trial” starting today, but it won’t necessarily look like your typical trial.  Of course, that begs the question: of what will this “trial” actually consist?  Ultimately, Kapnick attempted to articulate how she envisioned the May 14 proceeding, and it sounded awfully similar to the way MBIA and the NYID described it:

really, this is a presentation by you [BofA] as to why you believe that you have enough information to suggest that or to prove that, to support your petition that this determination by the State Insurance Fund was arbitrary and capricious and abuse of discretion.   I mean, that is really the standard that I am bound by, by Article 78.

If, as we are going through this, somehow there is an issue of fact, I mean, an issue of fact would be I thought that the Insurance Department had these 4,500 pages in front of them and now I learn they didn’t and there is an issue as to did they have them or didn’t they have them…

[I]f during the argument or during the presentation of your — of the case, through the motion and whatever else you want to say, that there are significant issues of fact that are raised, that then you think there should be some type of hearing or trial on that issue, then we will have to deal with that, but I don’t — I think that — I thought that I did not say this was a full blown trial that I might have in a lot of other cases because it is an Article 78 proceeding which usually does not have a trial…  (May 8 Hearing at 21:6-22:22.)

However, this did not stop the parties from continuing to argue their positions, and despite Her Honor’s repeated warnings about the need to wrap up the hearing, they went back and forth for several more rounds on the structure and nature of today’s “trial” before Kapnick had finally had enough.

Judge Kapnick Reaches Her Limit

Ultimately, even the most patient judge reaches a breaking point, and Judge Kapnick is no different.  For me, despite all of the fireworks between the parties, the most colorful aspects of Tuesday’s proceeding came from the Judge herself, who was clearly taken aback by the vitriol between the parties and their inability to agree to even the most basic issues:

I mean, nobody seems to listen to anything I said last time.   You all stuck to exactly your guns like we weren’t here for 65 pages  on the transcript.   You’re all interpreting it in certain ways.   I guess I hope that you would sort of understand what I was saying, but I guess you don’t.  (May 8 Hearing at 23:18-23.)

Later, Her Honor added,

I mean, you’re trying to pigeonhole me into calling something something that I have not said.  I will go back and read all 65 pages over the weekend, but that is not what I said…

So I mean, I never had so much time on a phone with whether it is a hearing or a preliminary injunction, a hearing, or a trial, or whatever.   I never have that and I mean, this is really a very unique situation. So I am sorry if I have not been as clear as you think I should have been.  Mea culpa.  (May 8 Hearing at 29:12-15; 31:8:13.) 

This building frustration finally boiled over when the parties could not even agree as to the order in which they would deal with issue’s at the start of today’s proceedings. After repeatedly warning the parties that time was short, and that she needed to break to give her staff time for lunch before her afternoon calendar, Her Honor finally reached her limit when the parties continued to argue over whether the judge would begin today’s “trial” by deciding evidentiary motions or deal first with determining the relevant issues of fact.  This is where the Judge finally stepped in:

I will tell you what.  I am really sorry that there is nothing you can agree on.  I am really very sorry.  I am not used to this and for lawyers of this caliber to disagree on every single thing, not cooperate with each other on anything. I don’t have time.   I am sorry, my court reporter is looking at me and I have to hang up.  (May 8 Hearing at 33:7-13.)

Ultimately, that is exactly what the judge did, over the parties’ continued efforts to get in a final word, saying “No.  Bye bye now.  I have to go.”  (May 8 Hearing at 35:10-11.)

If this level of contentiousness is any indication of the fireworks we will see at the Article 78 “trial” over the next few weeks, then we are in for some real life courtroom drama that would make the writers of The Good Wife proud.  So, as Terrell Owens says, “grab your popcorn.”  Bet-the-company litigation of the sort currently playing out between MBIA and BofA does not come along often, but when it does, the drama should be well worth watching.

[Author’s Note: I will not be able to attend the “trial” this week in New York, but if any loyal readers are in attendance, please email me or post comments with any thoughts, reactions, or particularly colorful moments – IMG]

Posted in Attorneys General, banks, bench trials, BofA, Countrywide, Insurance Department, Judge Barbara Kapnick, Judicial Opinions, lawsuits, liabilities, liquidity, litigation, MBIA, monoline actions, monolines, Regulators, restructuring | Tagged , , , , , , , | 1 Comment

MBIA on Winning Streak Heading into Trial on Restructuring Challenge

Posted on April 24, 2012 by igradman

Monoline insurer MBIA, the most influential plaintiff in mortgage crisis litigation, has been on a roll lately in its lawsuits against Bank of America and other institutions over issues stemming from the subprime meltdown.  But MBIA will face its stiffest challenge yet next month, as a New York Superior Court judge has decided to hold a trial on the Article 78 challenge by three banks, including BofA, to the insurer’s 2009 restructuring.

With each passing month, MBIA has made progress in its RMBS lawsuits, putting it closer and closer to obtaining recoveries on its distressed portfolio of mortgage derivative insurance and ultimately emerging from the mortgage crisis as a viable entity.  But much of that may depend on the resolution of challenges to MBIA’s restructuring, including the upcoming proceeding under Article 78, a vehicle for challenging whether the decision of a body or officer was in excess of authority or an abuse of discretion.

The trial on that matter, which should focus primarily on the actions of New York’s insurance regulator rather than MBIA itself, is now set to go forward on May 14, 2012.  But if the trial results in the nullification of the 2009 restructuring, in which MBIA split its troubled structured finance business from its healthier municipal bond insurance business, MBIA could bear the brunt of the fallout.

Judge Barbara Kapnick, who should be a familiar name to readers of this blog as the jurist presiding over Bank of New York Mellon’s Article 77 proceeding to approve BofA’s $8.5 billion putback settlement, among others, will also preside over BofA’s Article 78 challenge.  At an April 20 hearing, Kapnick ruled that this challenge would proceed to a bench trial (meaning there is no jury and the judge acts as the factfinder), meaning that Her Honor will have sole authority to determine whether the New York Insurance Commissioner acted within its discretion in approving the restructuring.  Judging from the transcript of the hearing, Kapnick is seeking to hold a streamlined proceeding over a two-week period in which few experts will be introduced and the main focus is the decision-making process of the two primary players at the New York Insurance Department (NYID).  Read Alison Frankel’s excellent article comparing the similar standards of review in the Article 77 and 78 proceedings to see how Judge Kapnick may be hard-pressed to rule in favor of the banks under Article 78 by finding an abuse of discretion, without also finding an abuse of discretion in BNYM’s decision to settle Countrywide putback claims at a steep discount.

Regardless, MBIA heads into this trial riding high on a litigation winning streak that has put it in a strong negotiating position.  As plaintiff, MBIA has been scoring victory after victory in its suit against BofA and Countrywide over allegations that it was misled by the lender about the quality of loans MBIA was agreeing to insure.  As defendant, MBIA has managed to wrangle settlements with the vast majority of banks and funds that have challenged  its 2009 restructuring and the New York Insurance Commissioner’s decision to approve the same.  Just last week, MBIA settled one of the outstanding suits it faces concerning this overhaul, announcing that it had reached a deal with Aurelius Capital Management that resulted in the dismissal of the entire action.

As I’ve discussed, MBIA has been somewhat of a trailblazer for both monoline and investor plaintiffs wishing to sue the banks for deficient underwriting and for breaching their representations surrounding non-prime lending.  Having filed its suit against Countrywide (and later BofA) back in September 2008, MBIA was responsible for some of the earliest precedential ruling on key issues such as BofA’s successor liability, the use of statistical sampling to prove underwriting breaches and the propriety of the banks’ loss causation defenses.

More recently, MBIA has garnered a slew of victories on discovery issues, including winning permission from Judge Eileen Bransten to depose BofA CEO Brian Moynihan, to obtain BofA’s repurchase review documents, and to press ahead with discovery and trial on claims that BofA is on the hook for Countrywide’s liabilities as its successor-in-interest (the last two rulings were recently upheld by the First Department on appeal, see here and here).  Judge Bransten’s Order on the Moynihan deposition in particular demonstrates that Her Honor is tiring of BofA’s heel dragging on discovery, and is giving short shrift to its defenses regarding relevance and burden in favor of giving MBIA broad access to discovery.  I liked this line from Her Honor’s Order in particular: “Moynihan therefore has unique knowledge regarding his intentions and state of mind when he made statements about BAC’s responsibility for Countrywide’s liabilities, which are undoubtedly relevant to MBIA’s claim for successor liability.” (Order at 14.)

Bransten has scheduled another hearing for May 4 on whether to compel BofA to produce documents in two additional categories: 1) documents regarding BofA’s alleged assumption  of Countrywide liabilities and 2) documents BofA has withheld under an assertion of Bank Examiner privilege.  I expect the trend of discovery wins for MBIA to continue on both fronts.  With each additional win, MBIA is hoarding additional ammunition to use in summary judgment motions coming up in August and in ongoing settlement negotiations.

But MBIA’s strong position in its RMBS cases could be significantly undermined by the earlier resolution of the Article 78 proceeding in any manner that upsets the restructuring.  Though it can take solace in a favorable standard of review – essentially whether the NYID acted irrationally in approving the restructuring, given what it knew at the time – MBIA has a less favorable judge and some unpleasant evidence to contend with (including that it hid from the Insurance Commissioner a report by Lehman Bros. in the months prior to the restructuring, which suggested that MBIA had woefully insufficient reserves for losses on its CDO portfolio).  Though it’s uncertain how much of this evidence Judge Kapnick will consider when analyzing the NYID’s decision, what is certain is that an adverse judgment in the Article 78 proceeding, the first major civil trial stemming from the mortgage crisis, could raise questions about MBIA’s solvency and throw the company into turmoil.

Seemingly as a result, MBIA has adopted a tone of righteous indignation in its pleadings in the Article 78 proceedings.  The monoline can hardly contain its sense of outrage at having to defend its restructuring to the very banks that helped create the financial turmoil that necessitated the transaction.  This doozy of a final paragraph in the opening of its Sur-Reply brief has the distinct feel of being uttered by Jack Nicholson’s Colonel Nathan Jessup from A Few Good Men (at left), who scoffed at those who would rise and sleep under the blanket of the very freedom that he provides, and then question the manner in which he provides it.  See if you agree:

The Transformation was an effort in the public interest to ensure the availability of insurance in order to unfreeze the public finance markets.  It was accomplished without a dime of taxpayer funds.  It was reviewed for more than a year by dedicated professionals and approved by Superintendent Dinallo in the utmost good faith.  Contrary to the Banks’ egregiously false claims, no one “looted” anything or was enriched by it.  By contrast, the banking industry several years ago was bailed out with billions of dollars in taxpayer funds, after meetings over one weekend, to rescue it from the very financial crisis it played a major role in creating.  The Banks should not be heard to complain about what the NYID did here, and their Petition should be dismissed in its entirety.

Well, MBIA did not succeed in getting the plaintiffs’ petition dismissed, but neither did  plaintiffs succeed in getting Judge Kapnick to rule in their favor without a trial, despite a detailed and well-written brief by plaintiffs’ law firm, Sullivan & Cromwell.  So now it falls to Her Honor to listen to the evidence and decide whether to uphold or reverse the restructuring.  As I’ve said, Kapnick has indicated that she will take a narrow view of the evidence – focusing only on the reasonableness of the Insurance Commissioner’s conduct, and not that of MBIA.  As reported by Reuters, during the hearing to determine whether the case would go to trial, Her Honor said, “This case really addresses the actions of the insurance department in approving this transaction. It’s not a case about all these terrible intentional things, about concealing, [that MBIA is accused of having done].”

This certainly bodes well for MBIA – while also indicating that Kapnick may take the same deferential approach to BNYM in adjudicating the Trustee’s settlement under the restrictive guidelines of Article 77 (early returns on the hearing held today indicate that while Kapnick ruled the action will remain under Article 77, she will allow objections and may expand the scope of discovery).  I will keep you updated on developments in both actions as they arise, but suffice it to say that after almost four years of litigation, we are finally getting down to some significant merit-based determinations in this space, which will ultimately help to establish the allocation of losses from this monster of a crisis.

[Correction: a previous version of this story incorrectly identified the Article 78 plaintiffs’ law firm and the presiding judge in the second-to-last paragraph (hat tip reader C. Herzeca) – IMG]

Posted in Alison Frankel, allocation of loss, appeals, bailout, Bank of New York, banks, bench trials, BofA, bondholder actions, CDOs, contract rights, costs of the crisis, Countrywide, damages, discovery, global settlement, Government bailout, investors, Judge Barbara Kapnick, Judge Eileen Bransten, Judicial Opinions, lawsuits, liabilities, litigation, loss causation, MBIA, MBS, media coverage, monoline actions, monolines, private label MBS, putbacks, Regulators, rep and warranty, reserve reporting, responsibility, RMBS, settlements, statistical sampling, subprime, successor liability, The Subprime Shakeout, Trustees | 6 Comments

Pauley Stirs the Pot: Federal Judge Still Making an Impact as BofA Settlement Approaches Critical Crossroads in State Court

Posted on April 18, 2012 by igradman

On April 24, Judge Barbara Kapnick will hold a hearing in New York Supreme Court on whether Bank of American’s $8.5 billion settlement proposal should be evaluated under the restrictive Article 77 vehicle, or whether investors challenging the deal can open up the proceedings to broader inquiry.  And though all eyes will be focused on Judge Kapnick and which direction she appears to be leaning on this critical decision, it’s difficult to ignore the influence of a certain federal district court judge, whose name keeps popping up throughout the parties’ pleadings.

When mortgage backed securities (MBS) bondholders removed Bank of America’s (BofA) settlement with Bank of New York Mellon (BNYM) to federal court this past fall, they were betting that District Judge William Pauley’s court would prove to be a friendlier forum to litigate their objections to the controversial deal.  In that regard, they were right – Pauley’s October 19 decision to keep the case evinced not only an understanding of the national implications of the issues raised in the suit and the potentially serious conflicts of interest at play, but also a strong desire to be the one to parse through those issues.

Unfortunately for him and for the bondholders objecting to the deal, the Second Circuit disagreed, overturning Pauley’s denial of remand and sending the case back to Judge Kapnick in New York state court.  Nevertheless, Pauley continues to have a noticeable impact on the Article 77 proceeding, stemming both from the short time that he presided over this case and from his ongoing decisions in related proceedings.

With respect to the latter, Pauley recently issued a decision in a separate lawsuit by a group of pension funds against BNYM that provides investors with an additional direct avenue to threaten MBS trustees with liability.  As to the latter, in addition to both BNYM and the intervening investors repeatedly citing language from Pauley’s orders in making their arguments to Judge Kapnick, the New York Attorney General recently used Judge Pauley’s approval of his right to intervene as persuasive authority for why Kapnick should do the same.  I will examine each of these developments in turn.

Pauley Confirms that Trust Indenture Act Applies to MBS

On April 3, 2012, Pauley issued an Order (hat tip reader Deontos) in a case called Retirement Board of the Policemen’s Annuity and Benefit Fund of the City of Chicago et al. v. Bank of New York Mellon, Case No. 11-CV-5459 in the Southern District of New York, that is still reverberating through legal and financial circles two weeks later.   Therein, Pauley held that a group of investors could pursue a class action for damages directly against BNYM as Trustee pursuant to the Trust Indenture Act (TIA) of 1939.

The group of investors was arguing that the Trustee had violated the TIA and breached its contracts and fiduciary duties by failing to confirm the proper transfer and documentation of the mortgage loans at the outset, to assist investors with repurchase claims, or to enforce servicer obligations.  Though Pauley dismissed the investors’ claims relating to Trusts in which they did not hold securities, he confirmed that the TIA did apply to the mortgage backed securities held by the investors because the certificates qualified as debt rather than equity securities.  (Order at 12)

For investors who have been slogging through the onerous procedural hurdles required to obtain standing to sue banks for mortgage repurchases or “putbacks” (including the recent decision by Judge Kapnick herself that seemed to raise the bar for investor standing), this decision is music to their ears.  It means that they can pressure MBS Trustees to assist them with putback claims and sue on their behalf (obviating the need for investors to obtain standing as third party beneficiaries) by using the threat of direct legal liability (in federal court, no less) against the Trustee as leverage.  Yves Smith of Naked Capitalism calls this a game-changer in mortgage investor litigation in general, and I would have to agree.

For investors holding Countrywide bonds, however, Pauley’s opinion created an even sweeter song.  No sooner had Pauley’s decision been published than the Steering Committee representing aggrieved Countrywide investors filed a motion to convert the Article 77 proceeding into a plenary action, in which they cited the decision prominently and even attached a copy of the ruling for Judge Kapnick’s benefit.  Their take on Pauley’s decision was that because it found that MBS were debt securities, Article 77 did not apply, as by its own terms it exempted “trusts for the benefit of creditors.”

Given the prominence of this line of reasoning in the Steering Committee’s brief, you get the impression that the Steering Committee believes this to be a strong argument.  At the very least, it’s a colorable argument that Article 77 is inappropriate on its face, which would force Judge Kapnick to convert the action into a plenary action, or something more akin to a fair fight on whether the $8.5 billion settlement is reasonable.

Of course, BNYM disagrees, and has now responded with an opposition brief in which it argues that “trust for the benefit of creditors” is a term of art that applies only to a specialized type of trust, in which a pre-existing creditor assigns assets to an assignee in trust for the purposes of paying off that creditor’s pre-existing debts.  If indeed the term is to be given such a particularized definition, mortgage backed securities trusts certainly would appear to fall outside the bounds of this narrow exception to Article 77.

The Trustee also makes sure to throw a jab at Pauley in footnote 3 of its opposition.  BNYM begins by noting that the Trustee “respectfully disagrees” with Pauley’s decision in Retirement Board, “holding that any security issued by a trust that holds mortgage loans is debt for purposes of the federal Trust Indenture Act.”  Somewhat more pointedly, BNYM goes on to say that:

[Pauley’s] decision is unprecedented and admittedly contradicts rulings from the SEC (to which the Retirement Board court expressly refused to give any deference), and from other government agencies, as well as secondary authority on this question, including a treatise written by counsel for one of the objectors in the proceeding, Talcott Franklin (whose clients declined to join in this Motion). (BNYM Opposition Brief at 4 n.3)

Though I haven’t yet seen an appeal filed to Pauley’s Retirement Board Order, this footnote appears to preview such an appeal, and I would not be surprised at all to see that case go up to the Second Circuit on more than one occasion before all is said and done.

In the meantime, Judge Kapnick will have her work cut out for her, parsing through the statutory language of Article 77 and trying to wrap her arms around whether it’s a proper vehicle to adjudicate the settlement of MBS putback claims in 530 separate trusts at once.  BNYM seems to have the better of these arguments, since there is little authority precluding an Article 77 proceeding in a case like this (indeed, there’s little authority on Article 77 at all, and no precedent on a case like this).  But as I’ve written before, this deal stinks to high heaven, so there’s always a chance that Judge Kapnick will use her considerable discretion to follow her conscience rather than the path of least resistance.

Pauley Cited as Persuasive Authority

Though Judge Pauley’s decision to deny remand of the Article 77 proceeding and keep the case in federal court was ultimately overturned, that has not stopped the case’s intervenors and would-be intervenors from citing his decisions as persuasive authority.  For example, in its Memorandum in support of converting the Article 77 proceeding into a plenary action (“Memo ISO Plenary Action”), the Steering Committee notes that Judge Pauley adopted the reasoning from an “unbroken line of cases” in finding that BNYM should be treated as a separate legal entity for each of the 530 Countrywide trusts that BNYM administers.  Though there are other cases that the Steering Committee could and did point to in support of this principle, it seems particularly relevant that a federal judge ruling on the exact same facts at issue here agreed with the reasoning of the intervening investors that the Trustee had to consider each trust individually.

Similarly, in describing the procedural history of the case, the Steering Committee makes sure to point out that Judge Pauley stated that he “ha[d] found no authority suggesting that a single Article 77 proceeding may evaluate the actions of 530 trustees with respect to 530 trusts.” (Memorandum ISO Converting Proceeding to Plenary Action at 3)  The Committee then goes on to cite Pauley’s holding that Article 77 proceedings, in sharp contrast to the one at issue, are typically “uncontested” and present “garden variety matters of trust administration.” (Id.)  Interestingly, in citing these holdings, the Steering Committee notes that Pauley’s decision was “reversed on other grounds,” implying that the cited holdings are still good law.

As BNYM is quick to point out, however, the Second Circuit’s reversal was based on jurisdictional grounds, meaning that Pauley did not have subject matter jurisdiction over the case in the first place and thereby nullifying his prior rulings.  Though this argument speaks to the fact that the rulings have no precedential value, the greatest value of these rulings likely lies in their persuasive impact, which may be considerable.  In fact, Kapnick already seems to have been influenced by the events that have taken place in this case since the time it was removed from her court.

At the outset, Kapnick seemed determined to push the case through her court as quickly as possible under the assumption that it would proceed under Article 77.  According to the transcript of Kapnick’s first hearing in the case on August 5, the Judge chastised those objecting to the limited form of the proceeding, saying:

It’s important to remember that this petition was brought as an Article 77 petition, which I personally have hardly ever seen before, so I had to go into the C.P.L.R., which doesn’t have too much about Article 77, and read it.  That’s what they did. That’s the proceeding they brought.

It’s not a class action. There aren’t provisions in there to opt out that you are talking about. That’s not what this is. If you started it, maybe that’s what you would have done, but they started it and that’s what they did. I have to work, at least now, within the confines of the proceeding that is before me. (Transcript of Aug. 5, 2011 Hearing at 18:21-19:6)

However, according to the transcript of the telephonic hearing she held on March 19, 2013 post-remand, Kapnick seemed hyper-conscious of the subsequent input of federal judges in the case, and willing to entertain the notion that the action could take other forms, saying:

this is an Article 77 proceeding, if you don’t think — and there aren’t too many Article 77 proceedings to look at and see what the scope of discovery is, but certainly, it’s much more limited than a plenary action, which at the moment it is not.  If you think that this should be a plenary action, then you have got to do something like bring an order to show cause or a motion. I mean, you mentioned it in your papers, but I can assure you sua sponte I am not going to turn this into a plenary action.

You can argue, both of you, which I think you did a little bit in your papers, about what the Second Circuit said in their decision, which I reread last night. I don’t think they said, you know, that this is it and that’s the last word, it can never be something else. But it certainly is what it is at the moment, an Article 77 proceeding… If you think that it should be transferred, then you have got to do something to immediately make an application. (Transcript of March 19, 2012 hearing at 14:11-15:13)

Thus, Her Honor ultimately invited the parties to brief that issue.  This is how we wound up at the critical crossroads at which we find ourselves today.

Complicating matters even further, on April 10, 2012 (after the parties had filed their initial briefs on the Article 77 issue), NYAG Schneiderman sent a letter to Judge Kapnick (another hat tip reader Deontos) requesting that the Court grant his motion to intervene and allow him to “participate fully in the resolution of [these] questions.”  Schneiderman also cites to (you guessed it) another Pauley decision – the one in which Pauley granted Schneiderman’s prior motion to intervene – and attaches a copy of the ruling for Judge Kapnick’s benefit.

The reason that this complicates matters is that Her Honor has not yet ruled on whether the NYAG can intervene.  Though it sounds like the parties were in discussions over resolving the NYAG’s right to participate, those negotiations fell through, meaning that Schneiderman’s petition will almost certainly be contested (in the past, BNYM and the Institutional Investors supporting the deal argued that the New York and Delaware AGs lacked standing to intervene).  If Schneiderman seeks to participate fully in the proceedings, it would seem that Kapnick would want to first rule on his right to do so and, if she grants his petition, allow him to respond to the Plenary Action Motion prior to ruling on that important pleading.

The other reason that the NYAG’s participation complicates this proceeding, at least from BNYM’s perspective, is that the prosecutor seems hell-bent on exposing the Trustee’s conflicts of interest and allegedly negligent and illegal conduct in carrying out its duties as trustee.  Though Schneiderman has dropped the aggressive counterclaims that he sought to file initially in state court (perhaps realizing that a separate action would be the more appropriate forum for those claims and that dropping them would improve his chances of being allowed to intervene), his Petition to Intervene remains virtually unchanged from its original, aggressive form.  If the prosecutor raises enough thorny issues for BNYM, forcing Kapnick to address them through motion practice and discovery, it could wrench the proceedings out of the more limited (and more comfortable for BNYM and BofA) confines of Article 77.

The hearing on the Plenary Action Motion (and the Steering Committee’s related motion on the scope of discovery) is scheduled for April 24, and Judge Kapnick should issue her ruling within a few weeks thereafter.  How she comes out on the proper form for this proceeding will dictate the scope of discovery and the standard of review – two vital elements to BofA’s strategy of dealing with its mortgage repurchase exposure in a quick and favorable manner.  Though I still view it as highly likely that Kapnick will decide to continue to adjudicate the case under Article 77, paving the way for a rubber stamping of the deal, the Steering Committee, NYAG and Judge Pauley have raised enough thorny issues with the state law vehicle that Kapnick will at least be forced to think hard about its propriety.  This is indeed a critical crossroads in mortgage putback litigation, and investors, lawyers, bond insurers and the nation’s largest banks will be watching closely.

Posted in appeals, Attorneys General, Bank of New York, banks, BofA, bondholder actions, class actions, conflicts of interest, Countrywide, discovery, Event of Default, global settlement, investors, Judge Barbara Kapnick, Judge William Pauley, Judicial Opinions, jurisdiction, lawsuits, liabilities, litigation, MBS, motions to dismiss, private label MBS, procedural hurdles, putbacks, remand, removability, repurchase, RMBS, SEC, securitization, servicer defaults, settlements, standing, Trustees, Walnut Place | 3 Comments

Guest Post: The Migratory Patterns of Yield-Hungry Investors

Posted on April 12, 2012 by igradman

Editor’s Note: in this guest post, former bond insurance insider Steve Ruterman discusses important considerations for investing in private label MBS beyond credit risk analysis, including how investors can benefit from understanding the differences in servicer behavior and business models.  Such analysis can be combined with a strategy of selecting bonds that have the potential for significant upside from the enforcement of creditor rights, such as servicer termination and/or loan put-backs, to generate even greater returns for fixed income investors.  Those who wish to learn more about how to take advantage of either of these types of analyses with respect to MBS investments are welcome to reach out to me or Mr. Ruterman – IMG.

By Steve Ruterman, guest blogger

Speaking as a major consumer of televised nature programs, it has been a lot of fun to watch the ongoing cyclical migration of yield-hungry fixed income investors.  Just now, they are approaching subprime mortgage backed securities, which they know to have been dangerous in the past (see here, for example).  They are doing so because they believe the past danger came from the terrible credit quality of the loans in the pool, and that such risk may be exaggerated in the current pricing of the bonds.

Keep in mind that 2005 vintage pools have almost seven years of seasoning, so the downside risk of future defaults must have been at least somewhat mitigated.  Seasoning used to be considered a good thing: prices are low, and yields are attractive.  Other members of the ecosystem are now crowding around the pools.  We live in a competitive world, after all, so why not jump in?

My answer to the question is, “Jump in if you must, but first take the trouble to understand what kinds of critters also live in these pools.”

I refer, of course, to the loan servicers and the risks they may represent to investors.  These risks are independent of loan credit quality, and are often discounted by fixed income investors, despite their potentially significant impact.

I’m sure that readers of The Subprime Shakeout can readily accept the proposition that some loan servicers are better or worse than others.  So, how might an investor go about understanding those differences, and how might they reflect them in their valuations and projections of risk adjusted returns on RMBS?

In theory, it should be possible to run some objective analytics and conclude which servicers are doing a better job for bondholders than others.  A simple comparison of prepayment speeds, delinquency rates, and net credit loss experience across several servicers should do the trick, particularly if the analyst compares like asset classes and vintage origination years.

However, as previously discussed here, servicers may be incentivized to misreport speeds, delinquency rates, and/or losses.  Examples include:

  • A widespread industry practice in effect at present actually results in increased unpaid loan balances due to the modification of loan terms.  This is because the purpose of the modification is to claw back servicer advances on an accelerated basis.  Since servicers do not always report the volume of claw-back modifications monthly, there are no simple means for adjusting reported speeds.
  • The reported delinquency status of loans in loss mitigation or modification queues is flexible and can really be whatever the servicer wants it to be.

These are just a few examples of known servicer reporting issues which can materially affect the investor’s analytic efforts.

As in the last subprime mortgage cycle, many subprime loan pools have new servicers that have replaced the originals (see Moody’s comment).  Even if the same servicers are still in place, recent increases in servicing costs and regulatory pressures (such as the AGFS) have forced changes in old business models. Some original and replacement loan servicers have their own agendas, and in the pursuit of their own perceived best interests, they often act against the best interests of investors.  In fact, some servicers often take actions which cause dollar-for-dollar losses to the investors that rely on them.

The key to assessing the relative risk to an investor’s returns from any loan servicer is assessing the loan servicer’s business model. The investor always wants the servicer’s business model to achieve the following goals:

  1. Aggressively prevent current loans from rolling into early stage delinquency.
  2. If loans do roll into delinquency, take all necessary steps to cure the delinquency.
  3. Should any loans roll into the late stages of delinquency, take all steps necessary to mitigate potential losses and cure as many as possible.
  4. If all else fails and foreclosure is necessary and desirable in order to protect positive loan values, act quickly to minimize foreclosure and REO timelines.

Sounds simple, right? Unfortunately, this recipe does not describe the business model of some loan servicers, who spend as little money as possible on 1) and 2), above, for example, because they prefer to maximize the number of delinquent borrowers paying them late fees.

If the current disastrous state of the mortgage markets has anything to teach us, it is this: investors are going to have to do more to protect themselves than they have been accustomed to doing [Editor’s note: and they won’t be able to rely on the AGFS for meaningful change in servicer behavior -IMG].  Risks from servicers’ business models are quite material, and can only be avoided by understanding what each servicer’s model is, and is not.

Steve Ruterman is an independent consultant to institutions and institutional investors with significant RMBS exposures and a fan of The Subprime Shakeout.  He recently retired after a 14 year career with MBIA Insurance Corporation, during which he transferred over 20 mortgage loan pools to new servicers.  Mr. Ruterman welcomes your comments, and can be reached by email at Steve.Ruterman@yahoo.com.

Posted in Attorneys General, bondholder actions, conflicts of interest, firing servicers, foreclosure rate, guest posts, hedge funds, incentives, investors, junior liens, loan modifications, loan seasoning, MBIA, MBS, moral hazard, mortgage market, pre-investment due diligence, private label MBS, projecting risk adjusted returns, putbacks, regulation, Regulators, servicer defaults, servicer reports, servicers, subprime | Leave a comment