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

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.

About igradman

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