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

Posted on July 27, 2012 by Isaac Gradman

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

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

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

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

The Concept of Proof

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

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

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

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

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

Crotty Takes a Stand

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted on June 15, 2012 by Isaac Gradman

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

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

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

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

Motion to Compel Fraud-Related Documents

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

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

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

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

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

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

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

Motion to Compel Clawed Back Documents and Sanctions for Delay

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

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

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

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

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

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

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

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

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

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

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

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

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

The Track Ahead: What to Watch For

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

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

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

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

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

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

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

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

Posted on June 14, 2012 by Isaac Gradman

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted on June 13, 2012 by Isaac Gradman

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted on June 12, 2012 by Isaac Gradman

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Posted on June 11, 2012 by Isaac Gradman

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 Isaac Gradman

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 Isaac Gradman

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 Isaac Gradman

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 Isaac Gradman

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