Alison Frankel

When New York attorney general Eric Schneiderman sued Bank of New York Mellon in August, the AG asserted that the Countrywide mortgage-backed securitization trustee had breached its duty to MBS investors. “As trustee, BNYM owed and owes a fiduciary duty of undivided loyalty,” said the AG’s suit, which was filed as a counterclaim in BNY Mellon’s case seeking approval of the proposed $8.5 billion Bank of America settlement with MBS investors. “[BNYM] breached that duty to [investors'] detriment and disadvantage, by failing to notify them of issues regarding the quality of loans underlying their securities.”

But according to BNY Mellon, it had no such duty.

The bank’s lawyers at Mayer Brown and Dechert filed a 14-page brief this week outlining its interpretation of the responsibilities of an MBS securitization trustee. The filing came at the direction of Manhattan federal Judge William Pauley, who’s deciding whether the BofA MBS settlement should be heard in state court, where BNY Mellon filed it, or in federal court, where key objectors to the proposed settlement want it to proceed. Pauley was concerned with the “securities exception” to the Class Action Fairness Act, which could end up guiding his decision on the forum question. For BNY Mellon, however, any discussion of its trustee responsibilities is fraught with danger. It’s already facing the New York AG’s claims, and several other state attorneys general have threatened similar actions. MBS investors, meanwhile, are pushing BNY Mellon (and other securitization trustees) to bring put-back claims, with the implied threat that investors will take action against trustees unless they do.

BNY Mellon’s brief pushes back against that pressure, asserting that the trustee’s responsibilities don’t extend much beyond the ministerial duties spelled out in the pooling and servicing agreements governing MBS trusts. New York law, the filing said, imposes only two addition burdens: the trustee must avoid conflicts of interest and must perform its ministerial functions “with due care.” According to BNY Mellon, there’s an important distinction between ordinary trustees and indenture trustees. Indenture trustees, it said, do not have “a traditional duty of due care.” Its duties — beyond those two basic responsibilities implied in New York law — are strictly defined by the pooling and servicing trust contracts.

The New York AG argued that the duties of an indentured trustee change when there’s a default. (He also asserted that BNY Mellon failed even to carry out its “ministerial” duties to MBS holders.) Defaults trigger a heightened duty under New York law, which says that a trustee must behave as a “prudent man” would with regard to his own affairs. State-law precedent, the AG brief said, holds that the “prudent man” standard of care is a fiduciary duty — and BNY Mellon breached it when the bank failed to notify Countrywide MBS investors of defaults in underlying mortgage loans.

BNY Mellon’s brief countered with two arguments, one legal and one factual. Even if default triggers a heightened standard of care for indentured trustees, it argued, those new duties are still governed by the trust agreement. The bank quoted language referring to the extra duties as “a relatively minor change in the legal landscape.” Moreover, according to BNY Mellon, there has been no default, under the precise language of the pooling and servicing agreements. “The Events of Default are strictly defined and none has occurred,” the brief said.

We’ll have to wait for Pauley to say what he thinks of the bank’s description of its duties. In the meantime, there’s a good question for the rest of us to contemplate. BNY Mellon’s brief tells investors in asset-backed securities that they shouldn’t count on indentured trustees to do anything more than their specified administrative duties. That leads to the conclusion that securitization trustees consider all substantive responsibility to police asset-backed deals to lie with investors. Will securitization agreements have to change for that market to be revived? And if investors insist on more accountability for trustees, will anyone agree to take on that duty?

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Helen Chaitman of Becker & Poliakoff represents more than 300 investors who had accounts with Bernard Madoff. For more than two years she’s hammered away at one particular argument in federal bankruptcy court, in Congress, even on YouTube: Madoff bankruptcy trustee Irving Picard of Baker & Hostetler shouldn’t be allowed to demand the return of profits that Madoff investors pulled out of their accounts as long ago as 2002, six years before the Ponzi scheme imploded in December 2008. On Tuesday night, Chaitman finally found vindication, even though it wasn’t in any of her cases. Manhattan federal judge Jed Rakoff, ruling in Picard’s fraud case against the owners of the New York Mets, concluded that a section of the federal bankruptcy code precludes Picard from attempting to claw back money Madoff investors pulled out of the Ponzi scheme before 2006.

“This is something I’ve been saying from the beginning,” Chaitman told me. “Anyone who didn’t withdraw their money in the last two years [of Madoff's scheme] is out completely.” Jonathan Landers of Milberg, who represents 30 clawback clients, agreed: “This is a very, very significant ruling.”

That’s putting it mildly. Judge Rakoff’s 18-page ruling could completely upend the Madoff bankruptcy. Among the big-name Madoff investors who would be off Picard’s hook completely if Rakoff’s ruling stands is former Securities and Exchange Commission general counsel David Becker, who’s in hot water for allegedly failing to alert SEC commissioners of a potential conflict of interest stemming from his parents’ long-closed Madoff account. Picard had filed a clawback suit against Becker, who inherited money after his parents’ account was liquidated in 2002; Rakoff’s ruling would wipe out Picard’s suit.

Other big winners from Rakoff’s ruling could be Madoff’s surviving children, who would still face a $58.7 million clawback claim for their two-year withdrawals but not claims on another $83.3 million they withdrew between 2002 and 2006, according to Picard’s 2009 complaint. Bank Medici founder Sonja Kohn’s clawback exposure would be reduced from $38.8 million to $11.2 million. Madoff’s early alleged enablers Frank Avellino and Michael Bienes would be looking at $17.2 million in clawback claims, not $56 million. Hard luck Madoff investor Melvyn Weiss, the onetime securities class action kingpin who was convicted for paying kickbacks to name plaintiffs, won’t see much relief from Rakoff’s ruling. His two-year exposure is $17.5 million, only $2 million less than Picard’s six-year claim.

Under Rakoff’s ruling, Madoff mentor Jeffrey Picower’s clawback liability would have been slashed from $2.4 billion to a fraction of that amount. But according to Picower counsel William Zabel of Schulte Roth & Zabel, the reduction in Picower’s case is “irrelevant,” since his widow decided to return $7.2 billion to the Madoff estate to remove any taint from her foundation.

Picard has asserted a total of about $8 billion in clawback claims, seeking the return of fictitious profits withdrawn from Madoff Securities accounts. That total includes claims against the financial institutions, such as UBS, UniCredit, and HSBC that allegedly abetted Madoff’s fraud. If Judge Rakoff’s ruling stands, about $5 billion of those clawbacks would be disallowed because the money was withdrawn before 2006.

The decision is obviously a boon to the Mets owners and their lawyers at Davis Polk & Wardwell. The judge left standing only one of Picard’s fraud counts against the Mets, limiting the Madoff trustee’s potential recovery to no more than $386 million, rather than the nearly $1 billion in principal and profits Picard wanted. Moreover, for Picard to get his hands on any of the Mets owners’ principal, he will have to prove they were “willfully blind,” a prospect Judge Rakoff doesn’t seem to consider very likely. He said Picard’s evidence that the Mets owners deliberately ignored warnings of Madoff’s fraud was sufficient to get past the Mets’ motion to dismiss but still “less than overwhelming.”

That’s only the beginning of this ruling’s story, though. Judge Rakoff has offered an interpretation of the intersection of bankruptcy and securities laws that could extend well beyond the Madoff bankruptcy. Bankruptcy lawyers are just beginning to parse the decision, but there’s no doubt that if it stands, it could have profound implications for bankruptcy trustees trying to recover money for defrauded investors.

Rakoff’s ruling is based on a provision of the federal bankruptcy code that offers a so-called “safe harbor” in cases involving stock brokerages and securities contracts. The provision restricts a bankruptcy trustee’s ability to undo securities transactions except in cases of actual fraud. The intent of the provision was to quell market chaos, putting a two-year time limit on a trustee’s attempts to go after counterparties in stock deals. The safe harbor cuts out fraudulent conveyance claims based on state laws, which often have longer time frames. (New York, for instance, has a six-year statute of limitations on fraud, which is the source of Picard’s assertion that he can recover fictitious profits dating back six years.)

In the Madoff Chapter 11, Manhattan bankruptcy court judge Burton Lifland ruled that the safe harbor provision doesn’t apply in the Madoff case. Federal appeals courts have found that the provision does not apply to Ponzi schemes, and Manhattan federal court senior judge Kimba Wood recently ruled, albeit indirectly, that the safe harbor doesn’t come into play in the Madoff case.

Judge Rakoff, however, found it does. He concluded that under a June 2011 ruling by the U.S. Court of Appeals for the Second Circuit, in a case involving a trustee’s attempt to recover money from a redemption of Enron debt, he must look at the plain language of the safe harbor provision. And under a strict reading of the law, he said, Madoff investors are shielded from fraudulent conveyance claims except in instances of actual fraud. “Because Madoff Securities was a registered stock brokerage firm,” the judge wrote. “The liabilities of customers like [the Mets owners] are subject to the ‘safe harbor’ provision.” Madoff’s contracts with his customers, Judge Rakoff wrote, fell under the provision’s definition of a securities contract; and his customers’ withdrawals from their accounts constituted “settlement payments” or transfers “in connection with a securities contract” under the language of the law.

Rakoff expressly rejected arguments by Picard’s Baker & Hostetler lawyers that Congress did not intend the safe harbor to protect investors who cashed out fictitious profits, because seeking the return of their ill-gotten withdrawals would have no effect on the broader market. They also argued that Congress meant the law to protect only brokers, not investors. Judge Rakoff said that didn’t matter. “Resort to legislative history is inappropriate where, as here, the language of the statute is plain and controlling on its face,” he wrote.

Landers of Milberg said Rakoff’s interpretation was compelled by the Second Circuit’s Enron decision, which holds that “there’s no squirreling around with [the provision]-if it applies, it applies.”

Picard has no automatic right to appeal Judge Rakoff’s ruling, but must petition the judge to grant leave for an appeal. Spokeswoman Amanda Remus declined comment on the trustee’s plans.

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When I first read the Federal Housing Finance Agency Inspector General’s report criticizing Freddie Mac’s $1.35 billion MBS put-back settlement with Bank of America, I wondered if the FHFA IG had just exposed billions of dollars in untapped bank liability. The IG report notes, after all, that Freddie’s deal with BofA (unlike Fannie Mae’s simultaneous $1.52 billion BofA settlement) resolves not only pending breach of contract claims, but also any future claims that Countrywide breached representations and warranties on the mortgages it sold Freddie. Those are exactly the kinds of global settlements banks are going to have to reach if they have any hope of resolving their MBS put-back liability.

So if the FHFA Inspector General is castigating Freddie for overlooking BofA’s liability for mortgages that defaulted four or five years after they were issued — and FHFA is generally reckoned to be the most experienced evaluator of reps and warranties claims there is — have other put-back claimants underestimated potential bank liability? Are bond insurers and MBS investors making the same supposed mistake as Freddie Mac?

The short answer is no.

The IG report faults Freddie for failing to account for the exotic mortgage loans that proliferated in the housing bubble. Homeowners with interest-only or adjustable-rate mortgages often made it through the early teaser-rate years, only to default when they had to begin making higher payments. The FHFA IG report indicates that Freddie Mac has seen tens of thousands of these mortgages go into default three to five years after they were issued.

That changed the traditional default bell curve, in which deficient mortgages went sour within a year or two and default rates slowed thereafter. But according to the FHFA IG, Freddie never adjusted its process of reviewing defaulted loan files to reflect the changed default model. The government agency continued looking for breaches of reps and warranties in loans that went bad within the first two years after they were issued, even though the exotic mortgages of the housing boom frequently took longer to sour. As a result, the report said, Freddie may have severely underestimated its put-back claims against Countrywide.

“By choosing to review intensively only those loans that defaulted within two years of origination,” the IG report asserts, “Freddie Mac did not examine close to 100,000 2006 vintage loans.Those loans that were not reviewed have a combined unpaid principal balance exceeding $50 billion.” The report cited a senior FHFA examiner who estimated that BofA’s liability for those unreviewed loans could run to billions of dollars, although in a footnote deep in the report the IG quoted a more moderate estimate of $500 million to $1 billion in total additional revenue (not just from BofA) for Freddie if it changed its loan review process to account for later-defaulting mortgages.

It’s too late to undo Freddie Mac’s settlement with BofA, and the IG’s report doesn’t argue otherwise. Instead, it calls for Freddie Mac to revise its mortage loan review process and to assure that senior managers respond quickly and sufficiently to staff concerns.

In fairness to Freddie Mac, there’s a good reason the agency focused its attention on mortgages that went into default quickly. Lenders are usually quicker to accept claims that material breaches in their reps and warranties led to the mortgage’s default if the loans fail right away. In other words, put-back claims on mortgages that went into default within a year or two are the low-hanging fruit of MBS put-back litigation. When homeowners default several years into their mortgage, mortgage issuers are likelier to assert that economic conditions — such as a homeowner losing a job or the decline in housing values — are responsible for the mortgage’s failure. Banks typically argue that they’re only liable to repurchase loans that failed as a direct result of their underwriting breaches. So forcing put-backs of later-defaulting loans is a tougher prospect.

But that doesn’t mean that bond insurers and MBS investors are ignoring those late defaults. To the contrary — they’re fully aware that it takes adjustable-rate mortgages longer to fail. My reporting indicates that if Freddie Mac truly didn’t assert put-back claims against BofA for mortgages that went bad after three years (there’s some doubt about that proposition), Freddie is an outlier. “I can guarantee that MBS investors and monolines aren’t limiting their review,” said one bond insurers’ lawyer. A lawyer for MBS investors added: “If a loan breached warranties on the day of closing and didn’t go into default until three years later, it’s no less in default.” This lawyer, like the monolines’ counsel, said no reasonable put-back claimant is limiting review to mortgages that defaulted within one or two years.

The proof is in the deals BofA has already struck with the bond insurer Assured Guaranty and with the investor group represented by Gibbs & Bruns. Under the Assured deal, BofA is continuing to pay the bond insurer for materially deficient mortgage loans issued in 2006 and 2007 — including loans that defaulted long after 2008 or 2009.

The embattled $8.5 billion BofA settlement with Countrywide MBS investors, meanwhile, explicitly accounted for late-defaulting mortgages, according to Kathy Patrick of Gibbs & Bruns. “The analysis the Inspector General claims FHFA should have done for recent defaults, we did,” Patrick told me. “We captured all loans that were 60 or more days delinquent and specifically analyzed [them].” The expert who opined on the fairness of the settlement amount for Bank of New York Mellon, the Countrywide securitization trustee, described his process of deriving a default rate in a filing BNY Mellon made public in the proceeding to win judicial approval of the proposed deal. The expert, Brian Lin of RRMS Advisors, said he accounted for defaults that occurred all along the timeline, including loans that hadn’t yet gone into default but were 60 days’ overdue. The default rate he used in reaching an estimate that BofA’s put-back exposure is about $9 to $11 billion specifically addressed loans that fell into trouble long after they were first issued.

Even Fannie Mae apparently didn’t limit its review of loan files to early defaults; the FHFA Inspector General was tasked with looking at both the Fannie and Freddie BofA settlements, but flagged only Freddie’s loan review methodology.

Freddie Mac has promised not to reach any additional settlements without considering the IG’s recommendations that it revamp its loan review process. And it shouldn’t. No reason the government shouldn’t do what everyone else already is.

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You had to be a sophisticated investor if you wanted to give J. Ezra Merkin your money. The hedge fund director made that clear in the offering documents for three of his funds: investors had to entrust considerable assets to him (at least $5 million for individuals and $25 million for businesses); had to conduct their own due diligence before deciding to invest; and had to accept the risk that Merkin’s funds might lose their money. Unsaid, but well-understood by many of the investors in Merkin’s Ascot fund (at least according to Merkin lawyer Andrew Levander of Dechert), was that Merkin would be feeding investors’ money to Bernard Madoff.

Merkin earned between 1 and 5 percent fees on the hundreds of millions of dollars he funneled to Madoff beginning in the early 1990s. At the same time, his own Madoff investment blossomed to more than $100 million. When Madoff’s Ponzi scheme was exposed in December 2008, Merkin was as stunned as his hedge fund clients, according to his lawyers. Merkin also claimed that he and his family were among Madoff’s biggest victims, with nine-figure paper losses.

Many doubted that depictions of events, including the New York attorney general, who filed a state-law fraud action against Merkin; real estate developer and Merkin investor Morton Zuckerman, who brought in Susman Godfrey for a New York state supreme court suit; and investors in Merkin’s Ascot, Gabriel, and Arial funds, whose cases were consolidated in June 2009 in a Manhattan federal court securities class action. The hedge fund investors, represented by lead counsel from Abbey Spanier Rodd Abrams & Paradis and Wolf Haldenstein Adler Freeman & Herz, alleged that Merkin had misrepresented the operation of his funds in offering documents that implied Merkin himself — and not Bernie Madoff — would be making investment decisions. They also asserted that Merkin ignored warning signs.

In an August 2010 motion to dismiss, Dechert focused on the “explicit disclosures” in the fund offering materials, which, according to Dechert, specifically granted Merkin the right to delegate investment decisions to outside money managers. “The offering memoranda disclosed not only the fact that investment discretion would be delegated to other money managers, but also the heightened risks associated with delegating assets,” the brief said. The funds weren’t required to disclose that the outside money manager was Madoff, the brief said, but the Ascot documentation did just that, twice identifying Madoff as the prime broker and custodian of the fund. Moreover, Merkin’s own enormous losses in Madoff’s Ponzi scheme were proof that he wasn’t acting with the requisite intent to deceive his investors.

Judge Deborah Batts, who’s overseeing the federal class action, agreed. In a 40-page ruling disclosed Monday, the judge concluded that the plaintiffs had plucked particular statements out of offering documents while ignoring the overall context of the hedge funds’ investment disclosures. “Plaintiffs cannot be permitted to ‘cherry pick’ language from the offering memoranda, and then ignore explicit cautionary language, which warned plaintiffs that third-party managers would have custody over the funds’ assets,” she wrote.

Nor was there evidence that Merkin knew or should have known Madoff was a Ponzi schemer, the judge found; unlike the Fairfield Greenwich defendants in a ruling by her Manhattan federal court colleague Victor Marrero, Judge Batts said, Merkin didn’t evidence serious doubts about Madoff until it was too late.

In what may turn out to be the most controversial parts of Batts’s ruling, the judge dismissed the investors’ state and common law claims, finding that they’re precluded by the federal law pre-empting suits involving financial instruments covered by the Securities Act of 1933 and the Exchange Act of 1934 and New York State’s Martin Act, which reserves state-law fraud cases for the AG.

That holding, according to Morton Zuckerman’s lead counsel, rules directly contrary to prior rulings by state supreme court judge Richard Lowe III in the Zuckerman and state AG cases against Merkin. In fact, said Harry Susman of Susman Godfrey, Judge Batts’s dismissal is “crazy. She’s a federal judge and I don’t want to second-guess her, but all you can do is shake your head.” In Zuckerman’s case, Susman said, Judge Lowe recently re-instated state law securities fraud claims after a state appellate court found they’re not precluded by the Martin Act. (Susman did concede that unlike investors in the federal class action, Zuckerman was able to point to specific assurances he received from Merkin about how his investment would be handled.)

Presumably, the investors in the dismissed federal class action could still see some recovery from the AG’s suit against Merkin, which is headed for a summary judgment ruling on liability. Lawyers at Abbey Spanier and Wolf Haldenstein declined my requests for comment.

But Merkin counsel Andy Levander of Dechert said Judge Batts’s opinion is vindication for Merkin. “It’s what we’ve said all along,” Levander told me. “The facts show the Mr. Merkin was not a crook, not a fraudster. He did a good job but he missed this.” Levander declined to comment on whether Judge Batts’s opinion will have sway in the AG case, but said, “It’s a good first step.”

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Lucy Marcus, a consultant, Harvard Business Review writer, and corporate director, posted an HP- and Yahoo-inspired cri de coeur Friday at HBR. “How bad does it have to get before we come to terms with the fact that we need to fix the boardroom?” she wrote, in a piece entitled “It Is Time to Fix Our Boardrooms.” Marcus’s idea is that boards should fix themselves. Independent directors have to think hard about who’s sitting around the table with them, she said, and “assess whether the board and the individual directors have the skill and the will to rise to the challenge of future-proofing the organizations that they serve.”

Marcus doesn’t discuss the role shareholders should play in board reform, but the truth is that unless they’re Carl Icahn or CalPERS, they have precious little power over corporate directors. (Thanks to the Securities and Exchange Commission’s recent decision not to challenge an appellate decision striking down the proxy access rule, shareholders don’t even stand much of a chance of ousting directors in favor of their own board candidates.) Ordinary investors should have maximum leverage over corporate boards when they’re gathered together in a class action demanding accountability. That vehicle does exist. Derivative suits, in which shareholders stand in the shoes of the corporation to bring class action claims against directors and officers, give investors an opportunity to blame boards for breaching their duties.

Unfortunately, that’s about all derivative suits give shareholders, though: an opportunity to air allegations without a lot of hope they’ll make a difference. As Tom Hals reported Thursday in an insightful Reuters piece on the dim prospects for derivative suits against Hewlett-Packard, Delaware law makes it incredibly hard for shareholders to win these cases. The Chancery Court’s entrenched “business judgment rule,” which dates back to 1984, presumes that “in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the company.” In the 2006 dispute over Disney CEO Michael Ovitz’s $100 million golden parachute, the Chancery Court affirmed that under the business judgment rule, “the board’s decision will be upheld unless it cannot be attributed to any rational purpose.”

Translation: Unless a corporate board behaved with manifest irrationality or demonstrably abandoned its duties, it’s insulated from breach of duty claims by shareholders. Gross incompetence is not a viable cause of action. The standard is outright venality. Remember Chancellor Strine’s controversial ruling in the Massey case last spring? Strine found that even the coal company’s alleged flouting of safety laws and apparent willingness to endanger its employees might not amount to a breach of the board’s fiduciary duty for the purposes of a derivative suit.

Boards get yet more protection from the peculiar strictures of derivative litigation. Derivative suits aren’t the same as securities class actions, in which shareholders have rights as stock holders. In derivative litigation they’re acting on behalf of the corporation, not on their own behalf. (It’s a tautology, of course, because they’re the nominal owners of the corporation.) So before shareholders can proceed with a derivative claim, they have to either demand that the board take action or show a judge that such a demand would be futile. Either path is difficult. If shareholders serve a demand, boards typically form a special litigation committee of independent directors, and the committee brings in a law firm to advise it. For whatever reason you care to ascribe, it’s the very, very rare special litigation committee that ends up recommending the board sue its own members. More often, shareholders will claim demand futility, arguing that directors are too conflicted — usually because of the compensation they receive or their ties to corporate officers — to separate their own interests from those of the corporation. Those are tough claims to prove, especially under Delaware’s board-friendly standards.

Occasionally defendants do agree to settle derivative suits (or else they’d be absolutely no reason for shareholders’ lawyers to file them). The stock options backdating scandals of the early 2000s, for instance, produced a bunch of derivative deals, including a record-setting $900 million settlement with United Health board members, after the board’s special litigation committee actually recommended a suit. Kevin LaCroix at the D&O Diary has a list of the next-biggest derivative settlements: Oracle’s board members paid $122 million to resolve insider trading allegations; Broadcom paid $118 million in another backdating case; and AIG directors agreed to two settlements of $115 million and $90 million for claims based on former CEO Maurice Greenberg’s alleged self-dealing and AIG’s participation in an allegedly sham reinsurance deal.

But as LaCroix and my friend Susan Beck of the Am Law Litigation Daily have written, those derivative settlements are almost always covered by directors and officers insurance policies. Even the cost of defending derivative suits is covered by standard D&O policies. So aside from embarrassment, there’s really little consequence for board members from even the rare derivative suit that ends with a sizable payment to shareholders.

No consequence means no accountability for even egregious conduct. It’s hard to see how Lucy Marcus’s vision of reformed corporate boards can be realized when board members have so little incentive to change.

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In a way, it’s a shame that James Goold of Covington & Burling isn’t a historical novelist.

He’s come up with some great fodder, like the story of Captain Diego de Alvear. In 1804, as Spain girded for war with England in the ever-shifting enmities of the Napoleonic era, Spain assembled a four-ship squadron to transport gold and silver from Peru, then a Spanish territory, to Spanish coffers. At the last minute, the second-in-command of one of the ships, the Medea, fell ill, so de Alvear was transferred to the Medea from another ship, the Mercedes. The rest of his large family — his wife, three sons, four daughters, and a nephew — stayed aboard the Mercedes as the ships sailed from South America to Spain. One day before the squadron was due to reach port in Cadiz, the British Navy intercepted the ships. The Spanish Navy refused to surrender, touching off what became known as the Battle of Cape Saint Mary, a pivotal moment in the history of the Spanish Empire. As de Alvear watched from the Medea, British artillery struck the Mercedes. The ship exploded. De Alvear’s entire family disappeared, along with scores of Spanish sailors, chests of treasure, and two ancient bronze cannons, destined to be melted down and recast as modern weapons.

Of course, Goold would never have come across the tragic story of Diego de Alvear if it weren’t for his real job. The Covington counsel has carved out one of the most interesting microniches I’ve ever run across: he represents foreign sovereigns in disputes with commercial treasure hunters over the rights to shipwreck recoveries. On Wednesday the U.S. Court of Appeals for the Eleventh Circuit, in a 53-page opinion that cites the de Alvear story, ruled that the Foreign Sovereign Immunity Act bars U.S. courts from hearing a case involving rights to treasure that a company called Odyssey Marine Exploration recovered from the site of the 1804 Mercedes explosion. The three-judge appellate panel didn’t decide who owns the treasure — which Odyssey has estimated to be worth $500 million — but the ruling in effect grants it to Spain, since the court ordered the booty to be transferred to Spanish custody.

This is the third time Goold has won such a ruling for a foreign sovereign. (He told me that in several other cases, treasure hunters backed off claims before courts reached a decision.) Even with that history, though, the Mercedes investigation was particularly thrilling. According to Goold, Odyssey was very secretive about its excavation of the site, in an operation it code-named “Black Swan.” Through international military and diplomatic sources, Spain (and Covington) learned that the Black Swan operation was taking place in the waters off Gibraltar, where the Mercedes went down, and that Odyssey had transported a Gulfstream filled with gold and a Boeing 757 filled with silver to Florida.

Odyssey insisted it didn’t know what ship was the source of the treasure, since no vessel was recovered. Spain, which suspected Odyssey had found the Mercedes wreckages, was able to obtain Gibraltar’s records of what the treasure hunter recovered from the sea bed. Covington also found the ship’s manifest Mercedes had filed in Montevideo, Uruguay, the ship’s last port before it blew up. The manifest cited the two ancient bronze cannons Mercedes was carrying back to Spain — one of which Odyssey had recovered from the site. That and other evidence, such as the dates on the coins Odyssey recovered, led Spain to conclude that Odyssey was pulling up wreckage from the Mercedes explosion.

Goold told me that Spain regarded Odyssey’s excavation as an affront to its history, as if a foreign commercial venture were recovering treasure from ships destroyed in Pearl Harbor. Odyssey had filed an admiralty action in federal district court in Florida to win rights to the treasure. Spain entered to challenge the court’s jurisdiction under foreign sovereign immunity. (The litigation also attracted claims by Peru, which asserted that because the treasure came from Peruvian land it should be awarded to Peru; and descendants of private Spanish citizens, who asserted that the Mercedes was carrying their ancestors’ private property.)

Goold said Spain opted for the jurisdictional challenge, rather than a battle over actual ownership, because FSIA claims receive an expedited hearing. He and a Covington team hunkered down in Madrid — in a reconstructed 19th-century frigate captain’s quarters in the naval archives — to prove that Odyssey’s treasure came from the Mercedes, and that the Mercedes was acting as a warship. According to the Eleventh Circuit opinion, written by Judge Susan Black for a panel that also included Judge Frank Hull and Judge Walter Stapleton of the Third Circuit, Spain and Odyssey submitted 125 exhibits between them on the question of the ship’s identity, including reams of historians’ affidavits and original Spanish documents. That evidence persuaded the district court that the wreckage belonged to the Mercedes. The court subsequently ruled that Foreign Sovereign Immunity applied to the case, because the treasure came from a Spanish warship.

Odyssey’s general counsel, Melinda MacConnel, raised some intriguing arguments in the Eleventh Circuit appeal. She asserted that much of the treasure recovered from the site belonged not to Spain, but to private citizens who paid the Spanish Navy to transport their property. That private property, she said, isn’t covered by foreign sovereign immunity. Moreover, she argued, FSIA comes into play when there’s a shipwreck. No wreckage of the actual Mercedes vessel, which exploded at the surface, has been found. Finally, MacConnel argued that the FSIA only bars litigation when the goods at issue are in the possession of the foreign sovereign; Spain didn’t physically possess the Odyssey-recovered treasure, so it couldn’t claim immunity from litigation.

The Eleventh Circuit disagreed, finding that the district court correctly concluded that the FSIA means U.S. courts don’t have jurisdiction. Goold said that Odyssey could try to sue to recover the treasure in Spanish courts, but he doesn’t think it stands much of a chance.

MacConnel told me Odyssey intends to ask for en banc review of the appellate ruling, focusing on the possession and private property arguments. “This ruling gives foreign sovereigns greater power than the U.S.,” she said. She said she expects the Peruvians and descendants to join the request for review.

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One of the verdant new fields the Dodd-Frank act has opened for litigators involves the Securities and Exchange Commission’s say-on-pay rule, which requires public companies to put executive compensation up for an advisory shareholder vote every two years. The rule went into effect in January. By May, Dena Aubin of Reuters was already reporting on a surge in shareholder derivative suits claiming boards breached their fiduciary duty by pushing through pay packages that shareholders voted down.

Darren Robbins of Robbins Geller Rudman & Dowd, whose firm has led the shareholder say-on-pay litigation, said there have been about a dozen derivative suits filed in state and federal courts. At least two have settled, according to a July 2011 report from Drinker Biddle & Reath (one settlement included $1.75 million in legal fees). But the say-on-pay rule — and ensuing litigation — is so new that plaintiffs lawyers didn’t really know whether it would provide a reliable income stream.

That prospect looks a little more likely after a ruling Tuesday by Judge Timothy Black of Cincinnati federal court. In a tart 12-page ruling, Judge Black noted shareholders’ “overwhelming rejection” of a multimillion-dollar pay package for three officers of Cincinnati Bell, even as the company’s earnings and share price slid. “Normally, a board of directors is protected by the ‘business judgment rule’ when making decisions about executive compensation,” the judge wrote. But shareholder lawyers from Robbins Geller, he said, had adequately alleged that the Cincinnati Bell board isn’t entitled to that protection.

“The complaint provides factual allegations and not simply conclusory allegations,” Judge Black wrote, in language you’re going to see quoted by plaintiffs firms across the land. “These factual allegations raise a plausible claim that the multimillion dollar bonuses approved by the directors in a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of Cincinnati Bell’s shareholders and therefore constituted an abuse of discretion and/or bad faith.”

The judge also rejected the directors’ argument that shareholders didn’t serve a demand on the board. “Given that the director defendants devised the challenged compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative shareholder vote on the compensation,” he wrote, “plaintiff has demonstrated sufficient facts to show that there is reason to doubt these same directors could exercise their independent business judgment over whether to bring suit against themselves for breach of fiduciary duty.”

Judge Black said the board could argue its business judgment and demand futility defenses in a summary judgment motion or at trial. (Here’s the board’s motion to dismiss; Grant Cowan of Frost Brown Todd declined comment.)

Shareholder counsel Robbins of Robbins Geller told me the ruling is good news for plaintiffs lawyers. “Ohio is a fairly conservative jurisdiction, and the Cincinnati Bell board raised substantive and procedural arguments that were rejected by the judge,” he said. “That tells you judges — as well as shareholders — find it distasteful for boards to ignore the will of shareholders.”

I should note that Judge Black’s ruling is contrary to the decision of a state court judge in Georgia, who dismissed a shareholder derivative suit against the board members of Beazer Home in a say-on-pay suit. The Georgia judge ruled from the bench; here’s the transcript of arguments in that case, which also featured Robbins Geller as plaintiffs counsel.

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The Association of Financial Guaranty Insurers doesn’t exactly mince words. In a newly-released letter to Credit Suisse CEO Brady Dougan, the executive director of the bond insurance group, Teresa Casey, accused the bank of “materially” understating its obligation to repurchase deficient underlying mortgage loans securitized in Credit Suisse MBS offerings. “We estimate that Credit Suisse’s obligations in respect of the securities insured by AFGI members aggregate billions of dollars,” the AFGI letter said. “We seek to understand the reasons why the full magnitude of the liability has not yet been recognized by Credit Suisse.”

The letter is further evidence of the looming issue of bank liability for breaches of the representations and warranties on underlying mortgage loans. You’ll recall that the Securities and Exchange Commission sent MBS players a letter last October, warning them about disclosing reps and warranties liability and reserves; the Public Company Accounting Oversight Board also put out an MBS alert for auditors in December 2010.

The bond insurers that comprise the membership of AFGI have been in the vanguard on MBS reps and warranties claims; both MBIA and Ambac have been litigating against Credit Suisse in New York state supreme court for years. The AFGI letter cites that litigation, as well as more than a dozen other MBS cases against Credit Suisse, in asserting that “well more than half” of the mortgage loans backing Credit Suisse MBS “were ineligible for securitization.”

The letter includes a not-so-veiled threat, in a not-so-veiled attempt to force settlement discussions: “Some of our industry members have pursued a laborious loan-by-loan representation and warranty put-back process, with Credit Suisse refusing to repurchase any loans whatsoever,” the bond insurers said. “The failure by Credit Suisse to make any effort to honor its obligations can only be interpreted as bad faith.We write in the hope of resolving Credit Suisse’s contractual and legal obligations in a manner that will cause the least disruption to Credit Suisse while preserving our rights in advance of Credit Suisse’s year-end audit that we expect will put increasing pressure on accounting and disclosure obligations surrounding this liability.”

Did you catch that, Credit Suisse? The bond insurers are going to be scrutinizing your regulatory filings if you don’t come to the table. (For the record, in Credit Suisse’s most recent filing, the bank reported $1.6 billion in outstanding mortgage repurchase claims in the second quarter of 2011, up from $504 million in the first quarter.) “Our industry seeks acknowledgment and resolution of the massive debts owed by the major RMBS sponsors due to their breaches of representations and warranties of the quality of the mortgage loans underlying their RMBS,” said AFGI executive director Casey, in an e-mail statement to me.

Credit Suisse isn’t the first bank to get a reps and warranties letter from the bond insurance group. In September 2010, Bank of America CEO Brian Moynihan received a similar AFGI letter, claiming BofA’s put-back liability just to bond insurers was $10 to $20 billion. Within months, Bank of America reached a $2 billion reps and warranties settlement with Assured Guaranty, a leading member of the bond insurance group. (BofA and Countrywide are still in litigation with other monolines.)

It’s important to note, though, that Credit Suisse isn’t BofA (much as BofA would undoubtedly like company in its MBS misery-fest). Credit Suisse is known for holding out even when other banks settle, as in the Enron securities class action. The bank has taken a hard line on MBS put-back claims, arguing that it has no obligation to buy back valid underlying mortgage loans-and that the bond insurers’ repurchase claims are often inflated. (In an August conference call with analysts, Assured said it had submitted more than $1.1 billion in repurchase claims to Credit Suisse, and the bank hadn’t agreed to buy back a single loan.)

“AFGI’s letter adds nothing new,” the bank said in an e-mail statement to me. “It simply repeats the meritless accusations made in court filings by AFGI members who wish to evade responsibility for their own investment decisions. Credit Suisse will continue to fight these lawsuits.” It’s a safe bet that Credit Suisse won’t be the last bank to receive an AFGI letter bomb. In that August earnings call, Assured execs said that after the insurer reached a settlement with BofA, “we reallocated resources towards the other counterparties who provide us with rep and warranty protection, specifically Credit Suisse, UBS, JP Morgan Chase, Deutsche Bank, and Flagstar.” If you’re looking for a bank target list, that’s probably a pretty good one.

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Over the last couple of months Bank of America has taken a stock market and regulatory beating so brutal that it’s reportedly considering the previously unthinkable option of putting Countrywide into Chapter 11. BofA’s mortgage-backed securities exposure seems to have no upper limit; throughout BofA’s long hot summer, it felt like every week investors surfaced with new claims that BofA, Countrywide, or Merrill Lynch violated state and federal securities laws in MBS offerings.

Investors and bond insurers have, of course, made the same claims about Deutsche Bank, Credit Suisse, JPMorgan Chase, Morgan Stanley, Goldman Sachs, and a host of other MBS securitizers. Most notably, the Federal Housing Finance Agency ruined a lot of people’s Labor Day weekend when it filed 17 suits against just about every financial institution in the MBS game (except for Wells Fargo), asserting state and federal securities law claims.

But the difference, so far, between Bank of America and everyone else has been that BofA is facing litigation not just for securities claims but also for breaching contracts with MBS investors. Mortgage-backed securities, remember, were typically sold through trusts governed by pooling and servicing agreements. Those pooling and servicing contracts usually included provisions calling for the originator of the underlying mortgages to repurchase any loans found to violate the lender’s representations and warranties about their quality. Suits based on alleged breaches of reps and warranties are known as put-back claims — and there’s good reason to believe that banks’ put-back exposure may ultimately dwarf their securities law liability.

Consider the record to date. For all the turmoil in the stock market when an MBS investor like AIG or FHFA files a securities suit, there’s only been one public settlement of a claim that an MBS issuer violated securities laws: Wells Fargo’s $125 million class action deal in July. By contrast, BofA’s own estimation of its put-back exposure, according to its most recent presentation to analysts, is $18 billion, which includes the $3 billion it has already agreed to pay Fannie Mae and Freddie Mac for deficient mortgages the federal housing loan agencies bought directly from Countrywide; an estimated $2 billion BofA has agreed to pay the bond insurer Assured Guaranty; and the embattled $8.5 billion proposed settlement with Countrywide MBS investors for breaches in Countrywide’s reps and warranties. In addition, U.S. Bank, as the trustee in an offering backed by Countrywide mortgages, sued BofA in August, asserting that the bank is liable for breaches in Countrywide’s reps and warranties.

You may be thinking that put-back liability is only BofA’s problem. Put-back suits, after all, are not easy to bring. Investors can’t sue mortgage originators directly to demand compensation for deficient underlying loans. Those claims can be made only through the securitization trustee — and only after investors have jumped through a series of procedural hoops under the pooling and servicing agreements. Moreover, investors can’t take any meaningful action with regard to any individual trust unless they control 25 percent of the voting rights in the trust. Plaintiffs lawyers have spent the last three years trying to put together investor coalitions to get past that 25 percent threshold, but so far we’ve only seen those coalitions take action against Bank of America.

That’s going to change. I believe a combination of four factors is going to lead to an imminent rise in put-back claims against banks other than BofA.

The first consideration is mounting evidence of across-the-board breaches in mortgage originators’ representations and warranties about the mortgages underlying banks’ MBS offerings. The bond insurance industry and FHFA have been diligently combing through thousands of individual loan files, scrutinizing whether mortgage originators failed to live up to their promises about such things as loan-to-value ratios and homeowner occupancy rates. They’ve found that other mortgage originators — including the mortgage lending arms of Deutsche Bank and Credit Suisse — breached representations and warranties at least as often as Countrywide. Lawyers for bond insurers have also obtained key rulings from the New York state supreme court that permit them to use statistical sampling in put-back cases. Assuming those rulings extend to investors, put-back plaintiffs won’t have to look at every underlying loan file to assert breaches but can determine a breach rate by looking at a representative sample of loans.

Second, the clock is ticking on New York’s six-year statute of limitations for contract claims. Investors acted first against Countrywide because Countrywide was the biggest mortgage lender in the U.S. and because its October 2008 mortgage-refinancing settlement with 11 state attorneys general put investors on notice of deficiencies in Countrywide’s mortgage underwriting process. Since then, we’ve learned that Countrywide wasn’t the only one. Thanks to bond insurer litigation, securities suits, and Congressional investigations, the statute is running on investors’ breach-of-contract claims against other mortgage lenders and the banks that packaged their loans into MBS.

Third, securitization trustees are under pressure to act. Last week Wells Fargo, as trustee, filed a put-back suit against EMC (the erstwhile mortgage arm of Bear Stearns, now part of JPMorgan Chase). That was the third trustee put-back suit we’ve seen in just the last few weeks. Three isn’t a lot, but it’s a lot more than nothing.

Finally, there’s the most important consideration: the investors. Remember, investors don’t have standing to push trustees to bring reps and warranties claims unless they have the threshold 25 percent voting rights in an MBS trust. Throughout the MBS litigation investors have been reluctant to show themselves. But the controversy over BofA’s proposed $8.5 billion Countrywide MBS settlement has flushed investors into the open, beginning with the Gibbs & Bruns group of 22 major institutional investors that negotiated the deal and have steadfastly supported it. Subsequent intervention petitions in the case have disclosed the identity of dozens more Countrywide MBS holders, so presumably, they won’t be so reluctant to step up against other banks.

The Securities and Exchange Commission, meanwhile, has been warning financial institutions to brace for reps and warranties liability. Last October, in a letter from the SEC’s senior assistant chief accountant, the agency reminded MBS issuers and underwriters that they must disclose their exposure “relating to the various representations and warranties that you made in connection with your securitization activities and whole loan sales.” The letter called on banks to include in their public filings a discussion of their reps and warranties litigation risk and their MBS breach-of-contract reserves.

So far — and I know I keep using that phrase — big banks haven’t put a number on their reps and warranties exposure, which they’ve downplayed in public filings. Morgan Stanley’s most recent 10Q, for instance, said that the bank may “under some circumstances” face liability for “representations and warranties concerning approximately $46 billion of loans and the representations and warranties made by third-party sellers, many of which are now insolvent, on approximately $21 billion of loans.” It did not, however, report reserves for reps and warranties liability. Goldman Sach’s second-quarter 10Q reported that to date, mortgage repurchase claims against it “have not been significant,” and said it was “not in a position to make a meaningful estimate” of its ultimate exposure.” Credit Suisse reported only $1.6 billion in outstanding repurchase claims as of the end of the second quarter. JPMorgan Chase’s most recent report to the SEC addressed only the bond insurers’ put-back claims against EMC, and noted that its indemnifications by now-defunct mortgage issuers may not be worth much. It didn’t put any sort of number on its put-back exposure or reserves.

Will third-quarter filings have more to say about put-back exposure? Stay tuned.

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This summer, thanks to NPR’s This American Life, a patent holding company called Oasis Research became one of the most famous patent trolls in the land. The brilliant radio segment, When Patents Attack! (also available as a Planet Money print story), homed in on a sweeping patent for “an online back-up system,” which Oasis acquired from Intellectual Ventures in July 2010 and proceeded to assert in an Eastern District of Texas case against a dozen tech defendants. When NPR’s reporters tried to find out who or what Oasis is, they struck out. No one answered the door at Oasis’s deserted “office” in Marshall, Texas, and the company’s lead lawyer, John Desmarais of Desmarais LLP, politely declined to answer NPR’s questions when the reporters tracked him down at a tech IP conference. (He also declined, via e-mail, to answer mine for this story.)

But even as NPR exposed the troll, Oasis was winning key rulings in the East Texas case, which featured EMC, AT&T, and GoDaddy.com, among lots of other defendants. In May, federal magistrate Amos Mazzant recommended that Judge Michael Schneider deny the defendants’ motions to sever Oasis’s claims. In July, the judge adopted the magistrate’s recommendations. In August, Oasis’s Desmarais lawyers filed an amended complaint, asserting infringement of four patents in more than 100 claims against 12 defendants.

The defendants fought back on two fronts. EMC filed a petition at the U.S. Court of Appeals for the Federal Circuit, asking the appellate court to reverse Judge Schneider’s ruling on the question of joinder. “The district court committed clear error,” EMC’s petition said, “by allowing [Oasis] to join many unrelated companies in a single infringement action based merely on an allegation that the companies each independently offer the same type of service. In doing so, the district court endorses an increasingly common practice of nonpracticing entities who file patent infringement suits in the Eastern District of Texas. Their newest tactic is to sue a large number of unrelated and geographically dispersed defendants, accuse them of infringing the same patent without regard to service or product differences, resist severance, and then oppose transfer of the action to a different forum.”

At the same time, the defendants also asked Judge Schneider to rein in Oasis’s “shotgun” claims. “Plaintiff’s assertion of [between] 88 [and] 121 patent claims under the circumstances of this case is unreasonable, and requires a remedy by the court,” the defendants said in a motion to limit claims to a mere 20.

This week, the Oasis defendants got some good news on both fronts. In the East Texas case, the magistrate cut back the number of claims Oasis can assert. As Docket Report was the first to report, Magistrate Mazzant restricted Oasis to 31 claims across the four patents in the case. He didn’t cut the case down as much as the defendants had asked and said Oasis could later ask to add claims, but the ruling makes the defense more manageable.

More significantly, a coalition of tech industry giants filed an amicus brief at the Federal Circuit, supporting EMC’s arguments against multidefendant troll litigation. (The amicus brief was first reported by The Wall Street Journal.) “This case is only one in a cresting wave of patent-infringement lawsuits over the last few years in which plaintiffs have sought to join in one action numerous unrelated defendants, all of whom sell different products accused of infringing the same patent,” said the brief, filed by Gibson, Dunn & Crutcher. “This case presents an excellent vehicle for this court to put a permanent end to this abuse of joinder.”

As the amicus brief goes on the recount, the new patent reform bill attempts to address the exact kind of sprawling, multidefendant filing Oasis engaged in. But the new law comes too late to help the Oasis defendants-and all of the other defendants named in a rush of troll suits filed in East Texas in the last week, as the patent reform bill awaited President Barack Obama’s signature. EMC alone has been named in three new multidefendant cases since the new law passed.

“Although the new bill, which is expected to be signed into law, should correct joinder abuse going forward, it does not apply to any action filed before it becomes law,” the amicus brief said. “Thus, there is a compelling need for [the Federal Circuit] to address the issue raised in the mandamus petition because it affects numerous pending cases-many filed on the eve of the new statute’s enactment-that involve egregious misjoinders of scores of unrelated defendants.”

Will the Federal Circuit bite? I’ll let you know.

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