“When one door closes, another door opens; but we so often look so long and regretfully upon the closed door, that we do not see the ones which open for us.”

― Alexander Graham Bell

The face of RMBS litigation took a dramatic turn last month when the focus of aggrieved mortgage bondholders moved beyond seeking recompense from the large banks who packaged and sold defective mortgage loans, and began targeting the other large banks that were hired to protect investors from such wrongdoing.  On June 18, 2014, a large group of investors that includes BlackRock and PIMCO filed six largely identical lawsuits in New York State Supreme Court against the six most prominent mortgage bond Trustees: Bank of New York Mellon (“BNYM”), U.S. Bank (“USB”), Wells Fargo, Citibank, Deutsche Bank, and HSBC.  The lawsuits collectively target over 2,200 residential mortgage-backed securities Trusts with an aggregate original principal balance of over $2 trillion, and alleged losses of over $250 billion.  An exemplar complaint is available here.

With these salvos, the fallout zone from the Mortgage Crisis has officially expanded, leaving very few players untouched.  However, this development was not surprising – at least to this humble long-time observer of and participant in residential mortgage backed securities (“RMBS”) litigation.  I have been predicting since as far back as 2010 that the Trustees who ignored or stood in the way of investor efforts to mitigate their losses would eventually face a day of reckoning.  In early 2011, I laid out the choice facing RMBS Trustees – protect investors or face their wrath – in the context of an iconic protest song by Bob Dylan.  But never did this potentiality come into sharper focus than with the filing of these six massive lawsuits last month.  As us litigation geeks are fond of saying, a complaint is worth a thousand words.

Towards the end of this article, I will delve into what exactly is being alleged in these suits, and what this shift means for existing and future putback lawsuits and settlements, as well as for Trustees, issuers and originators trying to deal with the fallout from the lingering mushroom cloud of the Mortgage Crisis.  But to understand why we have only now seen a major effort in this regard, let’s examine the top 5 developments that brought us to this point.

No. 5 – ACE II Closes Door on Non-Tolled Investor Actions, At Least For Now

No conversation about Trustee suits can take place without first understanding the status of the underlying mortgage repurchase litigation by investors against the issuing and originating banks, and particularly the evolving case law on the statute of limitations for such claims.  In particular, the key development in this space is the decision handed down by New York’s First Department Appellate Court just before the close of 2013 in ACE Securities Corp. v. DB Structured Products, Inc., 112 A.D.3d 522 (1st Dep’t 2013) (“ACE II’).  Therein, the Court held that putback claims filed after the 6-year anniversary of the Closing Date of a particular RMBS Trust are time-barred.

So, what exactly did ACE II entail?  In a three-page opinion that was as short on reasoning as it was long on significance, the First Department reversed the well-reasoned holding by Supreme Court Justice Shirley Korneich and found that contractual rep and warranty claims (i.e., “putback claims”) on ACE 2006-SL2 were time barred.  In doing so, the Court held that the 6-year statute of limitations for putback claims began to run from the RMBS Trust’s Closing Date, when any breach of the seller’s representations and warranties purportedly occurred.  It also held that it was a condition precedent to enforcement of putback claims to provide the seller with contractually-specified notice periods for cure and repurchase, without explaining how the claims could accrue for statute of limitations purposes while a condition precedent remained unfulfilled.  Finally, it held that the Trustee’s later substitution into the case did not “relate back” to an earlier filing by Certificateholders, since those bondholders lacked standing to sue on their own, and therefore the claims were untimely.

There is no topic that generates more questions from my consulting and legal clients these days than the impact of ACE II on the future of RMBS litigation.  Consistently, I have answered that regardless of what I think of the merits of the opinion, so long as the First Department’s restrictive view of the statute of limitations for these claims remains the law of the land, RMBS Trustees will face liability for sitting on their hands and blowing these claims.

However, to the extent it’s not apparent from my description of the holding, let me make something perfectly clear: I disagree completely with the conclusions reached by the First Department in ACE II.  I believe the decision was guided more by pragmatic concerns over the flood of litigation that might result if Justice Kornreich’s opinion became the law of the land than by the well-settled principles of New York Law and the language of the contracts at issue.  This is evidenced by the dearth of any meaningful logical reasoning in the ACE II opinion, as well as by its internal inconsistencies.  For example, the First Department consistently refers to the contractual prerequisite to a repurchase claim of notice, opportunity to cure and demand for repurchase (the “Repurchase Protocol”) as a “condition precedent,” but then does not treat the Protocol as a condition precedent for purposes of the accrual of the repurchase claim (as the relevant authority dictates).

Instead, the Court holds that while filing a repurchase claim before complying with the Repurchase Protocol renders a repurchase claim a “nullity,” it also holds that the clock begins ticking on a repurchase claim before this Protocol has been fulfilled.  In other words, the claims in ACE II had been filed, according to the Court, both too early and too late.

No. 4 – Leave to Appeal ACE II is Granted

I am not the only one who feels that this decision was incorrect, and indeed, HSBC Bank USA (“HSBC”), the Trustee of ACE 2006-SL2, has decided to appeal ACE II all the way up to the Court of Appeals, the highest court in New York.  Though HSBC was not entitled to appeal ACE II as a matter of right, just last week the Court of Appeals granted such leave, while also granting motions from CXA-13 Corp. and the Association of Mortgage Investors to file amicus briefs in support of HSBC’s position.  Briefing on this appeal should now take place over the next few months, with oral argument likely to be scheduled a few months after briefing is complete.  This means that we are unlikely to see a decision on this appeal before the first quarter of 2015.

HSBC has also hired former U.S. Solicitor General and top appellate dog, Paul Clement, to head their appellate team, showing that they take this appeal very seriously.  In his first action as counsel of record, Clement participated in a motion to reargue, or in the alternative, to seek leave to appeal to the Court of Appeals.  Therein, he argued on behalf of HSBC that the First Department’s “brief fails to grapple” with existing New York precedent “in a meaningful way,” and “did not even address, let alone attempt to reconcile” its decision with other New York cases relating to continuing obligations.  Though the Court of Appeals may be inclined, as the First Department likely was, to restrict the flow of future putback litigation that is currently clogging its lower court dockets, they will certainly have a serious legal effort and strong arguments to contend with before doing so.

But this is not to say that the ACE II was a bolt from the blue.  To the contrary, I have been writing for years that this outcome was a possibility, and have been counseling clients that putback claims should be filed before the 6-year anniversary expires in the event that the courts find that the repurchase obligation was not a continuing one (such that it renews each time a party fails to repurchase a defective loan upon notice of same).  And certainly, the Trustees were aware, or should have been aware, that courts examining this relatively new question of law could go in either direction, and thus they should have filed any claims within six years in an abundance of caution.

Unfortunately, many Trustees dragged their heels, despite bondholders’ efforts to compel them to file claims before the 6-year anniversary.  Indeed, as the timing of many investor cases can attest – including ACE II itself – though investors believed that the statute of limitations should be a continuous one, they filed many of these cases in their own name on the eve of the six-year anniversary in an attempt to preserve their claims.  In many of these cases, the Trustees eventually substituted in as plaintiff (albeit after the six-year anniversary and, according to ACE II, too late), thereby acknowledging that the claims were valid and that the Trustee was the proper party to bring them.  Should ACE II survive, these cases will carry with them some of the strongest threats of liability against Trustees.

Certainly, the Court of Appeals may reverse ACE II, which would render much of this moot, so long as the Trustees then take up the mantel of now-timely putback litigation in earnest.  Note that even without a hard and fast time bar, it’s safe to say that bondholders would still have viable claims for damages against Trustees based on, among others, delays by the Trustees in enforcing their rights, the failure to monitor and enforce servicing obligations, and a failure to investigate or enforce a whole host of other practices by the various deal parties that ultimately cost the Trusts money.  However, in the absence of such a reversal, RMBS Trustees and investors alike must assume that this will be the law of the land going forward.  This means we are likely to see a flood of litigation against Trustees alleging that the banks sat on their hands and blew the statute of limitations on valuable putback claims.

No. 3 – Trustees Begin Facing Suits Even Before Statute of Limitations Issues Arise

A lot of folks have asked me if we can look to any precedents in assessing the recent complaints by BlackRock and PIMCO.  The short answer is yes, but only a few.  The law firm of Scott + Scott LLP filed three lawsuits in the Southern District of New York (Case Nos. 1:11-cv-05459, 1:11-cv-08066 and 1:12-cv-02865), in which they sued Trustees for failing to protect bondholder interests.  These cases were filed well before ACE II brought the statute of limitations into focus, and are framed as class actions rather than derivative actions.  Nevertheless, these suits have been largely successful thus far.

The suits are notable in part for their reliance on the Trust Indenture Act (“TIA”) to support some of their claims against the Trustee.  Under the TIA, indenture trustees are charged with certain minimum fiduciary duties, even in the absence of contractual language in the trust indenture itself.  In fact, while this Act was passed back in 1939, it was intended to address a similar situation as the one we’re faced with today – that investors in a bond structure are forced to rely on a trustee to protect their interests, but the trustee instead takes a passive role in reliance on the minimal language in the indenture.

In response, the trustees and certain amici from the banking industry began jumping up and down and hollering that the industry never intended the TIA to apply to RMBS Trusts, as those trusts were really more like equities than debt securities.  Thus far, two out of three judges in SDNY have rejected this argument in denying motions to dismiss on this theory, and the third ruling is currently being appealed before the Second Circuit.  This suggests that courts are willing to hold Trustees to at least minimum duties of loyalty and care in their oversight of RMBS trusts.

[Full disclosure: I have worked with Scott + Scott on certain aspects of these cases.]

In April 2014, we saw another effort by investors to hold RMBS Trustees accountable for breaching their contracts, common law duties and the Trust Indenture Act.  In Royal Park Investments v. U.S. Bank National Association, Case No. 14-CV-2590 (S.D.N.Y. 2014), bondholder Royal Park has purported to bring a class action on behalf of holders of bonds in over two dozen RMBS trusts against U.S. Bank.  Royal Park styles the Complaint as a “Class Action and Verified Derivative Complaint,” though the Court is likely to force Royal Park to choose one or the other structure for the litigation.  Though the suit is long-winded and a bit unfocused (here is the Complaint, for those who really want to get into the weeds, and it’s 221 pages long), it seeks over $6.7 billion in damages and contains extensive factual recitation regarding why U.S. Bank failed to live up to its obligations, and thus it must be taken seriously by the Trustee.

But these actions were only a prelude in size and scope of the massive actions we that were filed last month.

No. 2 – Major Investors File Sweeping Actions on Heels of ACE II; But End Game Remains Unclear

Though they never mention ACE II by name, the Complaints filed last month by BlackRock, PIMCO, et al. (collectively, the “Institutional Investors”) repeatedly suggest that by failing to act, the Trustee has lost the chance to do so, and the Trusts have been permanently damaged.  This is, I believe, what prompted these huge institutions to file their suits now.  In essence, the Complaints all allege that the Trustees were conflicted from the outset, in violation of their duty of independence (a.k.a. the duty of loyalty), and that this caused them to breach their contractual, statutory and common law duties to take action against the sponsors of the trusts and the servicers of the loans in the trusts.

I have had a unique view into the potential for claims against Trustees, as a major component of my practice is representing investors in dealings with Trustees, including many in which the Trustees and investors are potentially or actually adverse to one another.  Thus, I have seen firsthand the asymmetry in interests between Trustees and the bondholders they are generally charged with protecting.  But long before I was representing investors, I was writing about the struggles those investors were facing in compelling Trustees to protect their interests.

I wrote an article back in July 2010 about investors firing a warning shot across Trustee bows, and noting that Trustees may be sued for failing to live up to the fiduciary duties they acquire when they become aware of specific breaches by parties to the Trust Agreement.  In January 2011, I wrote about potential Trustee liabilities stemming from their duties to confirm that mortgages were properly transferred into the Trusts.  Later that month, I wrote an apropos article that laid out the choice with which Trustees were being presented – sue or be sued – and how certain Trustees were beginning to cooperate with investors.  Notably, I wrote that, “[t]he [active] trustees seem to be recognizing that while they were willing to drag their heels at first in the name of industry solidarity, this isn’t their battle, and they don’t want to find themselves on the hook for the errors and omissions of subprime lenders.”

Unfortunately, the deals in which Trustees ultimately took action were and remain the minority; and we are now seeing the consequences of this, as major institutions turn on the Trustees for burying their collective heads in the sand on the bulk of the subprime and Alt-A deals where defects ran rampant.

So, who is behind these massive suits, and what are their motives?  At the outset, it’s important to note that the Pooling and Servicing Agreements covering most RMBS Trusts provide the Trustee with rights to indemnity from the Seller or Sponsor against any costs or liabilities arising out of the Seller or Sponsor’s breach of its representations and warranties.  As such, the large RMBS issuers likely will continue to bear the brunt of the liabilities arising out of these latest lawsuits against the Trustees.  It is for this reason that the Institutional Investors’ filing of these six massive Complaints against all six major Trustees gives me pause.

Remember, the Institutional Investors behind these lawsuits are largely the same parties that were the architects of the $8.5 billion Countrywide settlement that I have repeatedly referred to as a “sweetheart deal” because of the size of the potential recoveries and the manner in which the investors and Trustee in that deal showed up to a gun fight with a water pistol.  [For background, see prior articles here, here, here and here.]  As the New York Supreme Court recently approved most parts of that settlement, these investors likely have been emboldened to cobble together similar pennies-on-the-dollar global settlements that threaten to put to bed all putback claims against JP Morgan and Citigroup, respectively.  I could devote an entire article to the similarities and differences between these various deals, but suffice it to say that while these last two settlements are procedurally on stronger footing than the Countrywide deal (giving Trustees the option to accept or reject the settlement on a deal-by-deal basis), they still amount to paltry payoffs compared to what could have been recovered.

Thus, when these latest Trustee cases were filed, my initial reaction was that these were similar efforts to place a cap on liabilities by engineering a global settlement, so that the Institutional Investors could keep their own investors, the large banks (their frequent business partners), and the Trustees (often affiliates of their business partners) happy.  The filing of the Complaints as derivative actions, meaning the plaintiffs are purporting to act on behalf of the entire Trusts to enforce (or settle) all potential claims the Trusts might have, only further suggests that the plaintiffs were setting up a global settlement that would cut off future suits.

And the countervailing fact that the Complaints were filed by respected plaintiff’s law firm Bernstein Litowitz, instead of Kathy Patrick’s Gibbs & Bruns, was not enough to convince me otherwise; it’s clear that Patrick was conflicted and would have had a hard time taking positions adverse to Trustees in any event.  That is, she just spent years in the Countrywide settlement proceedings arguing that BNYM, as Trustee, had acted reasonably, without conflict and above reproach, in an effort to see her settlement (and $85 million payday) approved.  It could potentially harm her efforts to see that settlement finally approved (it is still up on appeal, with oral argument coming sometime this fall) if she were to now file a complaint against BNYM claiming that the bank was actually operating under a massive conflict of interest.

Even so, the Institutional Investors have softened the conflict of interest language in the BNYM Complaint as compared to those of the other Trustees.  While the Plaintiffs allege in their claim for Breach of Fiduciary Duty of Independence (the Third Cause of Action) in the five non-BNYM lawsuits that the Trustees are “economically beholden to the sellers” because so much of their business comes from the sellers, Plaintiffs allege that BNYM is conflicted only because it “did not want to incur the associated transactional costs of exercising the Trusts’ rights against these entities or shine the light on its own wrongful conduct.”  It seems clear that with the New York Supreme Court’s approval of the $8.5 billion Countrywide settlement still subject to appeal, the investors are reluctant to take a position that could be used against them.  At a minimum, this raises questions about how aggressively the Institutional Investors will be pursuing these claims.

However, upon reading the Complaints themselves, I must allow for the possibility that these institutions may truly be seeking justice, or at least to maximize their recoveries, rather than placate the large banks.  The Complaints throw the book at the Trustees, bringing up all of the strongest arguments as to why Trustees had a duty to act, knew about problems in the Trusts, and failed to lift a finger.  They pull in literally thousands of Trusts, which increases the potential size of the claims, and have thrown around the $250 billion number as the potential damage figure, which would make it more difficult to settle for, say, another few billion dollars.

Yet, the aspect of these Complaints that, more than any other, forced me to consider that they were actually bona fide attempts at mitigating losses was not the Trusts and claims included in these Complaints, but the Trusts and claims that were not.  Namely, the six Complaints exclude potentially the strongest claims and the most powerful fact patterns by excluding any deals in which putback litigation has been initiated or significant putback activity has taken place.  That is, they have not sued the Trustees on deals like the one at issue in ACE II, where the investors seemed to take all the right steps to compel the Trustee to act, were forced to file on the day before the statute of limitations expired when the Trustee failed to act, and then had their case dismissed when the Trustee decided to step in only after the six-year anniversary had passed.  These situations present some of the strongest fact patterns for potential lawsuits against Trustees.

Similarly, in deals where active investors submitted repurchase claims through the Trustee to the responsible parties and obtained certain repurchases (but only a fraction of the claimed defective loans), and/or where the responsible parties filed Rule 15Ga-1 disclosures with the SEC regarding repurchase requests, investors also have potentially very strong cases against the Trustees.  There, they can argue that the Trustees were put on actual notice of widespread defects by way of the repurchase demands (and resulting repurchases, which validated those findings), but did nothing to enforce the bulk of the loans where lenders ignored their contractual repurchase obligations.  So, the Institutional Investors’ decision to exclude these deals suggests that they realize that those stronger claims don’t belong in their generic mass action that differentiates very little between deals.

At the same time, the lawsuits by the Institutional Investors also exclude the deals that are currently subject to the global settlements proposed for Countrywide/BofA, JP Morgan and Citigroup.  So, perhaps part of the impetus for these suits was to encourage the Trustees to accept the deals, by insinuating that so long as the Trustee accepts a settlement (even one that’s pennies on the dollar), it won’t face liability.  I think it’s safe to say that the jury’s still out on what is really motivating these suits, and what end game the plaintiffs’ are envisioning, but I think that RMBS Trustees, industry players and observers alike must allow for the possibility that while these Complaints suggest the plaintiffs mean business, the ultimate global settlement may reveal otherwise.

No. 1 – Additional Trustee Lawsuits Continue to Pour In, Suggesting Material Risk to Trustees

Since the Institutional Investors’ filing of their six massive lawsuits, we’ve seen at least four other Trustee suits filed over the last week.  On June 27, 2014, Commerce Bank and several other funds, credit unions, insurance companies and banks, filed a complaint against BNYM (Index No. 651967/2014, available here) requesting an accounting on 93 separate Countrywide RMBS Trusts, alleging that BNYM “engaged in a widespread failure to obtain and hold critical documents evidencing the mortgage loans belonging to the Trusts.”  It also seeks to preserve claims against BNYM for entering into the $8.5 billion settlement with BofA, to the extent the settlement is not finally approved.

On the same day, the Federal Home Loan Bank of Topeka, Doubleline Capital, and other funds filed three separate suits against HSBC, Wells Fargo, and Citibank, respectively (Case Nos. 651972/2014, 651973/2014, 651974/2014).  Though these cases are pre-RJI, and thus no Complaint is yet available, the Summonses with Notice indicate that these suits are for breach of contract, violations of the TIA, negligence and breach of fiduciary duty, on behalf of the plaintiffs and the trusts, based on the Trustees’ failure to take action to force Countrywide to repurchase loans sold to Trusts other than Countrywide-sponsored Trusts.  That is, the Summones allege that while BNYM took action as to the Countrywide-sponsored Trusts (which “constitute an attempt, however inadequate, to address defective mortgages in Countrywide trusts”), “[n]othing has been done by Defendant, or anyone else, to address the problem of defective mortgage loans in non-Countrywide trusts.”  The Summonses go on to detail some of the evidence that emerged from the BNYM Article 77 hearing, and seek redress on the remaining Countrywide loans for similar issues.

It’s safe to say that this is only the beginning of Trustee-focused litigation.  But, how do we get our arms around the real risk to Trustees?  As I mentioned, Trustees are indemnified to the extent that they can prove to a court that these losses arose out of breaches of reps and warranties by the issuing banks.  However, Trustees will likely have significant transactional costs in fighting these suits and establishing their indemnity claims against the large Wall St. banks.  In addition, Trustees do not have the right to be indemnified for their own gross negligence, bad faith, or willful misconduct.  In some deals, this exception also applies to plain old negligence.  Since such negligence is being alleged all over these latest complaints, there is some risk that the Trustees themselves will have to pay at least a portion of any judgment or settlement out of pocket.

And what is the size of that potential liability?  Well, the way I see these cases playing out is that they will be similar to an attorney malpractice case, where they will take the form of a “case within a case.”  That is, the plaintiffs will have to prove that the Trustee had a duty to act and didn’t, but also must prove the that underlying action would have had merit and have resulted in sizeable damages.  In theory, the Trustees (or their indemnitors) could be liable for the entire amount of damages that the unfiled putback claims could have recovered.  Also just in theory, but based on my experience in putback cases, that size could average 75-80% of the losses in these deals (so, for example, the damages in the Institutional Investor suits could approach $200 billion on the $250 billion in claimed losses, if all claims were successful) based on typical breach rates in deals of this vintage.

But, with BlackRock and PIMCO already having settled the Countrywide claims for approximately 8% or less of losses, they may be hard pressed to argue they would have recovered much more than that (or approximately $20 billion) through litigation/settlement.  This is yet another reason to be skeptical about the aggressiveness/representativeness of the Institutional Investor actions.  At the end of the day, much of that ultimate damage number is attributed to Trustee negligence or gross negligence depends on how much dirt the plaintiffs can uncover about what the Trustees knew or should have known, and what they did in response, and whether the factfinder is convinced that such conduct rises to the level of negligence or gross negligence.

Epilogue: Other Ramifications and Final Thoughts

In addition to the potential liabilities engendered by these six lawsuits themselves, the suits also put pressure on the Trustees to accept global deals that they’re currently evaluating on the JP Morgan and Citigroup deals, at least as to the deals that are not in active litigation or subject to an active direction letter from bondholders.  In those latter deals, the Trustees open themselves up to even greater liability if they were to settle claims where bondholders have been actively reviewing and/or putting back loans for the same price as claims where very little has been done.

The Trustees would also be biting off their noses to spite their faces, because in those deals, they’re already subject to a binding direction, and being provided indemnity by the bondholders, to pursue putbacks.  But for the remainder of the deals, the BlackRock/PIMCO lawsuits underscore the risks of doing nothing and passing on a deal that would settle the underlying putback claims.

Finally, these lawsuits demonstrate that there are potentially even greater liabilities (on a per-deal basis) awaiting Trustees who failed to act, or acted too late, on deals where active investors with the requisite holdings were putting back loans and/or attempting to direct the Trustees to take action.  As discussed above, these are the cases with the most compelling facts, and those about which the Trustees must be most wary as the tide begins to shift against them.