Alison Frankel

Back when former Goldman Sachs director Rajat Gupta’s most pressing problem was the Securities and Exchange Commission’s civil case against him, his defense scored a small victory when the SEC agreed to drop an administrative proceeding against him and brought civil charges in federal court instead. Gupta’s lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel, had fought to have Gupta’s case heard by a federal judge, rather than an SEC administrative law judge, because the rules of evidence in administrative proceedings favor the agency. Among other things, the SEC can admit hearsay evidence, and defendants don’t have the same rights to depose opposing witnesses. Although the SEC can’t seek the same penalties in administrative proceedings as it can in federal court, they can be an effective way for the agency to make a statement about improper conduct.

Except when the defendants win.

On Friday, the SEC’s chief administrative law judge, Brenda Murray, entered a painstaking 58-page decision that cleared former State Street executives John Flannery and James Hopkins on all of the SEC’s sprawling allegations that they misled investors about the mortgage-backed securities holdings in State Street bond funds. Murray found that the agency failed to show at trial that Flannery and Hopkins violated any securities laws in communicating with investors about the funds’ subprime MBS holdings. She went out of her way to describe the former State Street execs as candid, believable witnesses who were frustrated to be on trial.

Murray’s ruling is yet another courtroom rebuke to the SEC, which in the last few years has seen several high-profile trials end in victory for defendants. Most notably, in 2009 a San Francisco federal judge dismissed stock options backdating charges against Broadcom executives; and in 2010 a Manhattan federal judge exonerated two traders in a landmark SEC case alleging insider trading in credit-default swaps. The State Street loss is perhaps an even bigger black eye for the SEC, given that the loss came in an administrative proceeding, the agency’s home turf.

“This is a case where the SEC should never have proceeded against my client,” said Mark Pearlstein of McDermott Will & Emery, who represented former State Street Americas chief investment officer Flannery. “We felt all along that if we received a fair hearing we would prevail. Chief judge Murray gave us a very fair hearing.”

Hopkins, who was a former head of project engineering for State Street, was represented by John Sylvia of Mintz Levin. “We and our client are thrilled,” Sylvia said. “We’ve maintained from the outset that this is a case that never should have been brought.”

The ruling may be a setback for the SEC in another way as well. Agency lawyers urged the chief ALJ to adopt a narrow interpretation of the U.S. Supreme Court’s June 2011 ruling in Janus Capital v. First Derivative Traders. In Janus, the court ruled that a mutual fund adviser isn’t liable for the fund’s allegedly false statements in a prospectus because the adviser did not make the statements at issue. The SEC argued that the Janus decision should apply only to private securities fraud cases, and not to its causes of action. The administrative law judge, citing a ruling by U.S. district judge Colleen McMahon in Securities and Exchange Commission v. Kelly, said Janus extends to the SEC’s allegations.

In the end that didn’t matter in the case against Flannery and Hopkins, because Murray found that the SEC’s allegations of misstatements fell short. But the agency may want to think twice about asking the full commission to review the chief ALJ’s reasoning on Janus. The SEC, which told Reuters that it is reviewing the ruling, has three weeks to decide whether to appeal Murray’s initial determination to the full commission.

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The Mortgage Electronic Registration Systems — or MERS, as it’s known — is the business everyone loves to hate. MERS was established in the 1990s to streamline the process of packaging mortgage loans into mortgage-backed securities. Its members, all players in mortgage securitization, reasoned that it would be easier to securitize mortgages if there were a centralized electronic database of the loans, rather than physical paperwork scattered at mortgage lending institutions across the country. The MERS mortgage registry was essential to the securitization boom of the 2000s. But after the housing bust, MERS has been something of a litigation piñata. Homeowners have filed a multitude of suits challenging MERS’s legal right to foreclose and its alleged robo-signing foreclosure practices. More recently, local officials have begun suing MERS for cutting them out of the mortgage registration process and supposedly cheating them out of mortgage recording fees.

Thursday’s complaint against MERS by Delaware Attorney General Joseph Biden III includes those familiar allegations, which MERS has had a pretty good (but definitely mixed) record of defending. But Biden’s complaint goes on to raise broader questions about MERS’s role in the MBS industry. According to the Delaware AG, MERS helped MBS issuers and securitization trustees peddle securities that were flawed at their core. The suit claims that MBS trusts may not actually have owned some of the mortgages bundled into the securities they sold. If those allegations prove true, this complaint could wreak havoc in the mortgage securitization industry.

It’s no secret that the New York and Delaware AGs have a lot riding on their MBS investigations. New York Attorney General Eric Schneiderman lost his spot on the committee of attorneys general negotiating a multi-state deal with five major banks because of his insistence that the settlement address failures in mortgage securitization as well as in the foreclosure and servicing process. He’s taken considerable political heat as a result, but just this week, Schneiderman told MSNBC’s Rachel Maddow that he and Biden are committed to “looking at the conduct of individual institutions and individuals to see if there were misrepresentations made, to see if there was fraud committed, to see if criminal acts were also a part of this.” He added, “We’re determined to follow it through until we get the relief the homeowners need and hold accountable the people who caused this.”

Until Thursday’s MERS suit — and a simultaneous MERS subpoena issued by Schneiderman, as my colleague Karen Freifeld first reported — the only publicly-known result of the joint Delaware-New York MBS investigation was Schneiderman’s fraud suit against Bank of New York Mellon, the Countrywide MBS trustee. By taking on MERS, the AGs are signaling an attack on the entire securitization process.

According to the complaint, “the MERS System was both unreliable and frequently inaccurate” in accounting for owners of the mortgage loans registered in its database. As a result, Delaware asserted, many loans were not properly transferred to securitization trusts — in breach of the pooling and servicing agreements that governed the trusts. The complaint claims that MERS engaged in deceptive trade practices by transferring insufficiently documented loans to MBS trusts, but it’s not much of a leap to infer potential AG cases against the trustees that were supposed to oversee MBS paperwork or, for that matter, against the issuers that assembled the mortgage portfolios underlying the securities they sold.

Lawyers for MBS investors and bond insurers have already poured untold hours into scrutinizing mortgage loan file documents for breach of contract cases against issuers. They’ve generally focused on whether the underlying mortgage pools live up to the representations and warranties MBS issuers made about things such as owner income and loan-to-value ratios. But imagine if they can argue, as the Delaware AG does in Thursday’s MERS suit, that trusts never owned the loans in MBS pools at all. We’re looking at a whole new world of put-back liability.

MERS told Reuters that there’s no merit to the Delaware AG’s claims of unfair trade practices. I left a message for MERS outside counsel Andrew Sandler of BuckleySandler, but he wasn’t available.

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When Philip Yeatts was born in Brownfield, Texas, in September 1962, he had no right leg. His right arm ended in a stump above his elbow, and he had a cleft palate and deformed tongue. Annette Manning, born in Green Bay in 1960, had only buds of fingers and an arm that ended in a stump — just like Mary Hurson, born the same year in New York City, and Tammy Jackson, a 1962 baby in Ranger, Texas. In a heartbreaking new complaint against GlaxoSmithKline, Sanofi-Aventis, Aventor, and Grunenthal, these four plaintiffs, along with eight others (in three parts here, here, and here) claim that their birth defects resulted from their mothers’ use of the now-notorious anti-nausea drug Thalidomide — and that the drug companies engaged in a 50-year scheme to cover up how widely Thalidomide was prescribed in the U.S., and how varied were the birth defects that could result from the drug.

“The question is going to be, ‘Why now?’” said Steve Berman of Hagens Berman. “The answer is that medical science has advanced. We now understand the mechanism by which Thalidomide works. There’s been a complete change in the knowledge of how it caused birth defects.”

Thalidomide was widely prescribed as a treatment for morning sickness in Europe in the late 1950s and early 1960s, until evidence emerged that the drug resulted in grave birth defects. Some countries, including England and Germany, established compensation systems for Thalidomide victims. There was no such plan in the U.S., where drug companies said Thalidomide had only been prescribed in a very restricted controlled study. According to Berman, after the awful consequences of Thalidomide came to light in the 1960s, fewer than a dozen American families sued and reached settlement with the drug companies that made and marketed the drug.

Decades later, an Australian lawyer Berman knows was contacted by Australians who believed their birth defects were caused by Thalidomide — which has resurfaced as a potent treatment for a form of cancer. Berman’s friend, Peter Gordon, ultimately reached a settlement on behalf of Australian Thalidomide victims. News of that deal, Berman said, brought Gordon inquiries from Americans who suspected Thalidomide was responsible for their injuries. Gordon brought in Berman.

Berman’s better known as a securities and antitrust plaintiff’s lawyer, but he told me there was no chance he wouldn’t take this case once he heard victims’ stories. “It’s so compelling,” he said. “We all felt we had to do this.” Most of the clients Hagens Berman represents in the Thalidomide case, Berman said, “have been searching their whole adult lives to find out what caused this.”

Berman said his team dug into the archived records of, among other things, a 1962 Congressional investigation of the drug, which was never approved in the U.S. They found that contrary to what drug companies told the public, Thalidomide was prescribed to about 20,000 patients in the U.S., under the supervision of about 1,200 doctors. They also found evidence that the drug companies were aware of Thalidomide’s potentially tragic side effects long before the drug was pulled off the market in the Europe.

And many of those doctors didn’t keep careful records of patients who received the drug. As the Hagens Berman complaint makes clear, each alleged Thalidomide victim has a unique story. Some have medical records showing their mothers took Thalidomide during their pregnancies. Some have mothers who recall taking the drug; others have family members who will attest their mothers used Thalidomide. For some plaintiffs, Berman said, the nature of their birth defects is the only link they’ll be able to show to Thalidomide.

But recent research on the drug’s properties as a cancer treatment, he said, has made it clear that Thalidomide can cause the unilateral deformations some of his clients suffer, and not just the bilateral birth defects that have been traditionally associated with the drug. “It used to be that if you had the bilateral defect, known as flippers, you were called a Thalidomide baby,” Berman said. “Most of the others, doctors would just say, ‘This stuff happens.’”

Berman told me there are probably many more people born in the U.S. in the late 1950s and early 1960s whose birth defects were caused by Thalidomide, which, according to him, affected the children of almost every pregnant woman who took the drug.

I left a message for Glaxo lawyer Michael Scott, who removed the Thalidomide case from the Philadelphia Court of Common Pleas to U.S. District Court for the Eastern District of Pennsylvania. He didn’t return my call.

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The Justice Department and the Securities and Exchange Commission apparently do not have the evidence to assert a classic insider-trading case against former Goldman Sachs and Procter & Gamble director Rajat Gupta. Typically, the government brings insider-trading cases against people who profited directly from trades based on confidential information. Gupta doesn’t fall into that category. Neither the SEC nor the DOJ claims that he realized any direct profits from the trades Galleon Group chief Raj Rajaratnam allegedly made based on his tips. Indeed, Gupta’s lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel, has said many times that Gupta “lost his entire investment” in Rajaratnam’s hedge fund. “[Gupta] did not trade in any securities, did not tip Mr. Rajaratnam so he could trade, and did not share in any profits as part of any quid pro quo,” Naftalis told Reuters in a statement.

But while the absence of a direct profit motive complicates the Justice Department and SEC cases against Gupta, it doesn’t preclude them. The government doesn’t have to show that Gupta directly profited by tipping Rajaratnam, only that he benefited in some way from passing along inside information. “It’s not your standard model, but it’s not unprecedented,” said Thomas Gorman of Dorsey & Whitney, who represented an Ohio State business-school professor convicted in a no-profits insider-trading case in 2005.

The government, in fact, has broad leeway to define the benefits a tipster derived from disclosing confidential information, Gorman said. Benefits can be as amorphous as enhancing a friendship or angling for future favors. In the Gupta case, the SEC and the Manhattan U.S. Attorney are so far offering only vague motives for his alleged insider trading. The SEC’s new complaint asserted that Gupta received indirect profits from Rajaratnam’s illicit trades, since he was an investor in Galleon funds. The complaint also refers to Gupta’s “variety of business dealings with Rajaratnam,” and alleges that the former McKinsey chief “stood to benefit from his relationship with Rajaratnam.” Similarly, the U.S. Attorney’s indictment said Gupta revealed inside information to Rajaratnam to deepen his relationship with the Galleon chief. “Gupta benefited and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial,” the indictment said.

But in a twist, Gupta’s best defense may turn out to be the close relationship with Rajaratnam that’s at the heart of the government’s allegations against him. That defense relies on an SEC rule and a September 2011 ruling by the U.S. Court of Appeals for the Second Circuit in a previous insider trading case, U.S. v. Gansman.

James Gansman, a former Ernst & Young lawyer, was, like Gupta, accused of passing inside information to someone who subsequently used it to make money. In Gansman’s case, he allegedly gave his lover details of M&A deals E&Y was working on. Gansman didn’t make money from her trades, but the government implied that he gave her the information in order to prolong their affair.

At Gansman’s 2009 trial, his lead defense lawyer, Barry Bohrer of Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer, focused on an SEC rule enacted in 2000 to address when family members or close personal friends owe a duty of confidentiality or loyalty to someone who has disclosed inside information. The rule was intended to specify when the people who receive confidential information can be prosecuted for misusing it, but Bohrer turned the rule into a defense. He argued that Gansman had a right to tell jurors that he expected his girlfriend to keep the inside information confidential, because they had a history of sharing work-related disclosures. Over the government’s objection, Manhattan federal judge Miriam Cedarbaum agreed to instruct Gansman’s jury that he contended “any material non-public information that [his girlfriend] may have received from him was shared with her as part of a relationship in which they shared work and personal confidences.”

The jury convicted Gansman, who appealed to the Second Circuit. In appellate filings here and here, Bohrer argued that the jury instruction Cedarbaum delivered didn’t go far enough. He contended Gansman was entitled to tell jurors that he disclosed inside information to his girlfriend only “as part of a relationship of trust and confidence, in which they had a history and practice of sharing work and personal confidences,” so he “reasonably expected that [she] would keep any confidences he shared with her confidential and would not use those confidences to buy or sell securities.”

The Second Circuit denied Gansman’s appeal, concluding that the jury instruction Cedarbaum delivered wasn’t far enough from the one Gansman wanted to warrant overturning his conviction. (The appellate panel also pointed to evidence that Gansman knew his girlfriend was trading on the information he provided.) But, crucially, the appeals court ruled it’s appropriate for accused tipsters to argue that they trusted the people who received their inside information not to trade on it.

“The SEC has recognized a number of situations … in which a tippee, but not the tipper, may be liable for insider trading on the theory that the tippee owed a duty of trust or confidence to the tipper and the tipper conveyed confidential information without intending to have it used for securities trading purposes,” the Second Circuit opinion said. “Here, it was perfectly appropriate for Gansman to seek to present to a jury a defense that his relationship and interactions with [his girlfriend] exemplified just such circumstances. That is, Gansman was entitled to support his general defense that he lacked the intent to commit securities fraud by showing, in particular, that he shared ‘a history, pattern, [and] practice of sharing confidences’ with [her] sufficient to create a duty of trust running to Gansman.”

The Gansman appellate ruling, said Gorman, could certainly be extended to the Gupta case, in which, according the government’s indictment, the tipper and tippee maintained “a personal relationship and friendship.” “Gupta could argue, ‘I didn’t think he’d trade on it,’” Gorman said. “If Gupta believed Rajaratnam would keep the information confidential, based on the facts of circumstances of their longstanding relationship, that could be an effective defense.”

There are risks for Gupta in that defense, of course. To show that he trusted Rajaratnam to keep his disclosures to himself, he would have to show a history of exchanging confidences with the now-convicted Galleon chief. That might not go over well with jurors, who, in the government’s criminal case, would ultimately decide whether Gupta was justified in believing Rajaratnam wouldn’t trade on his disclosures.

Michael Kendall of McDermott Will & Emery, a former federal prosecutor who’s not involved with Gupta’s defense, said Gupta would have a hard time convincing jurors that he believed Rajaratnam wouldn’t trade on confidential information. “It wasn’t like [Gupta] was telling his priest or rabbi,” said Kendall.

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In 1998, 400 investors in a trust that distributed revenue from a communications satellite got word that their securitization trustee had settled a $41 million suit against the satellite’s fuel supplier. The trustee, IBJ Schroeder, filed a New York State Article 77 proceeding to obtain a judge’s endorsement of the $8.5 million settlement. Some of the investors protested the deal, arguing that the trustee didn’t have the power to settle the case without consulting them. In 2000, a New York appeals court ruled that, in fact, IBJ Schroeder did have that power, under both New York law and the contract governing the satellite revenue trust. The lower court ultimately ruled in the Article 77 case that even if investors considered the settlement amount too low, Schroeder hadn’t acted unreasonably or imprudently in striking the deal.

If you’re wondering why I’m telling you about an 11-year old ruling involving a defunct communications satellite, it’s because the IBJ Schroeder opinion is sure to be invoked by Bank of New York Mellon, the trustee of those Countrywide mortgage-backed securities, as well as the 22 Countrywide MBS investors represented by Gibbs & Bruns as they appeal last week’s decision by U.S. District Judge William Pauley III of Manhattan federal court. In holding that the federal courts have jurisdiction over Bank of America’s proposed $8.5 billion settlement, Pauley took issue with BNY Mellon’s use of an Article 77 proceeding to get the deal approved. The judge wrote that Article 77 is usually employed to resolve garden-variety trust administration issues; BNY Mellon and Gibbs & Bruns will use the IBJ Schroeder ruling to argue at the U.S. Court of Appeals for the Second Circuit that, contrary to Pauley’s assertion, there’s precedent for using Article 77 exactly as they did in the BofA MBS case.

But even as the Second Circuit decides whether to take up the issue of the rights and responsibilities of securitization trustees, state attorneys general are likely to pounce upon some of the language in Pauley’s 21-page ruling. I warned that there might be unintended consequences for indentured trustees when the judge asked for briefing on the BNY Mellon’s duties. After Pauley’s ruling, that warning is now a red alert. New York attorney general Eric Schneiderman and his faithful follower, Joseph Biden III of Delaware, have both announced that they’re investigating MBS securitization trustees. Schneiderman showed he’s serious by filing state-law fraud claims against BNY Mellon along with his petition to intervene in the BofA Article 77 proceeding. In his complaint against BNY, Schneiderman argued that once an investment goes south, as many of the MBS trusts have, the indentured trustee has a fiduciary duty to trust beneficiaries under New York common law.

BNY Mellon’s lawyers, on the other hand, argued in a brief to Pauley that an indentured trustee does not have a fiduciary duty to beneficiaries. The investment contract, BNY Mellon said, governs the trustee’s responsibilities. Standard securitization contracts, known as pooling and servicing agreements, say the indentured trustee serves a ministerial function, mostly making revenue distributions to investors. BNY Mellon told the judge that its only responsibilities, aside from those specified in pooling and servicing agreements, are common law duties to avoid conflicts of interest and to exercise due care.

The judge, however, took a broader view of the source of the trustee’s responsibilities — and that’s good news for regulators who are trying to find routes to liability for securitization trustees. Pauley considered the question in the context of determining whether the proposed BofA settlement falls into an exception to federal court jurisdiction in the Class Action Fairness Act. But his reasoning, of course, can be cited in other contexts.

Pauley cited Judge Learned Hand — who sat on the same court a century ago — to conclude that indentured trustees can’t evade a duty of loyalty to beneficiaries just because their responsibilities are defined by a contract. BNY Mellon had asserted its only duty to act in good faith came from the Countrywide pooling and servicing agreements. Pauley said it comes instead from state common law. As New York and Delaware regulators consider causes of action against securitization trustees, they’re going to have stronger claims if they can argue that trustees breached their state-law duties to investors. Similarly, trustee defenses are weakened if they can’t argue that their responsibilities were strictly defined by pooling and servicing agreements.

The New York and Delaware AGs are in an awkward limbo right now in the BofA MBS litigation. When Grais & Ellsworth removed the case to federal court, their intervention petitions were pending before Judge Barbara Kapnick in New York State Supreme Court. (BNY Mellon and Gibbs & Bruns, you may recall, filed fiery briefs opposing the N.Y. AG’s intervention.) The AGs stayed out of the federal court case while Pauley decided whether to remand it. But now they’re likely to renew their intervention petitions before the federal court judge, who has already raised a lot of the same questions as the AGs about the fairness of a binding settlement that was reached without consulting most of the investors it will affect. (The New York AG’s Martin Act counterclaim against BNY Mellon, in case you’re wondering, can technically proceed in federal court as well.) As I’ve said before, it’s too soon to say for sure that the proposed settlement will stay with Pauley. But if it does, invigorated attorneys general are the last thing BofA, BNY Mellon, and the Gibbs & Bruns group need.

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It’s way too early to assume that Manhattan federal judge William Pauley III will end up deciding the fate of Bank of America’s proposed $8.5 billion settlement with investors in Countrywide mortgage-backed securities. But that doesn’t mean it’s too early to start wondering what will happen to the proposed deal if he does.

First, a caveat: Bank of New York Mellon, the Countrywide securitization trustee that filed the case in New York state Supreme Court , has the right to request appellate review of Pauley’s ruling that the case belongs instead in federal court under the Class Action Fairness Act. And when BNY Mellon asks the U.S. Court of Appeals for the Second Circuit to hear the appeal, the bank will surely remind the appellate court of its own language in a previous Countrywide MBS case, in which the Second Circuit decided the suit should go back to state court. In his ruling Wednesday, Pauley cited the “paramount federal interests” at stake in the BofA MBS settlement. But the previous Second Circuit MBS ruling expressly rejected that rationale. “If Congress meant the consideration of a class action’s importance to the nation as a whole to trump these limiting provisions [under CAFA], it would have indicated that intent,” the Second Circuit panel wrote in Greenwich Financial v. Countrywide. “Congress wisely chose not to leave it to the federal courts to assert jurisdiction over whatever class actions seemed to judges to be ‘of national importance’ — a standard much too amorphous to admit of consistent judicial application — but instead to define concrete criteria for federal jurisdiction under CAFA.”

That language doesn’t seem to bode well for the Countrywide MBS investors who want Pauley to evaluate the proposed settlement. But this is a weird, unpredictable case. I wouldn’t bet anything more valuable than an ice cream sundae on whether the Second Circuit will take the appeal and overturn Pauley.

If the case stays in federal court, there’s going to be a preliminary fight over what shape it takes. There’s no federal analog for New York state’s Article 77, the vehicle under which BNY Mellon filed this case. Article 77 permits a trustee to obtain a judge’s endorsement of its actions, under a standard that requires only that the trustee behaved reasonably. In his ruling Wednesday, Pauley called on all of the parties to submit a joint proposal for how the case should proceed in federal court. BNY Mellon and the Gibbs & Bruns investor group that supports the proposed settlement are likely to argue that Pauley should hear the case as a declaratory judgment action that would essentially replicate the Article 77 state court proceeding. They’ll argue that Pauley should only decide the question at issue in the case as it was filed: Did BNY Mellon act reasonably as a trustee in reaching the proposed settlement?

But Grais & Ellsworth – the law firm that moved the proposed settlement to federal court — is likely to have a different idea of how Pauley should structure the case. At a Sept. 21 hearing, Owen Cyrulnik of Grais & Ellsworth proposed that the case be treated as a class action, with each of the 530 trusts in the proposed settlement treated as a class member. (Keep in mind that Grais & Ellsworth’s goal is to win the right to litigate outside of the settlement on behalf of investors in three of the Countrywide MBS trusts.) That would presumably permit Pauley much more power over the merits of the settlement. Pauley has already shown considerable skepticism about BofA’s attempt to settle the claims of thousands of noteholders in 530 trusts through a vehicle that doesn’t give investors any right to opt out. Whatever structure he devises if he keeps the case, he’s probably not going to permit BofA, BNY Mellon, and the Gibbs & Bruns group to bind all Countrywide mortgage-backed noteholders to a settlement they had no hand in negotiating.

That brings us to the big question: If the case stays before Pauley, and if he permits opt-outs, can BofA walk away from the $8.5 billion settlement? The short answer is yes, although it may depend on how many opt-outs there are.

There are two relevant portions of the June 29 settlement agreement. One seems to me to be an absolute out for BofA. In a provision called “Withdrawal from Settlement,” the agreement says that if trusts holding a pre-set percentage of the total unpaid principal balance of the Countrywide MBS included in the deal don’t participate in the settlement, then BofA can withdraw. The big question mark there is the percentage. The settlement agreement says it’s “confidential,” but says that it’s already been determined by BofA and BNY Mellon.

If opt-outs don’t hit the specified percentage under the withdrawal clause, I think the banks could also fashion a case for withdrawing under the settlement agreement’s specification that New York state Supreme Court is the “settlement court” under which BNY Mellon agrees to seek approval of the deal under Article 77. The agreement says that the settlement is subject to final court approval from the settlement court — i.e., New York state Supreme. If the parties cannot obtain final approval from the court, the agreement says, the deal is void. So if the banks were desperate to walk away from the settlement in federal court, they could argue that they never agreed to have the case heard there.

Which leads, of course, to the question of why BofA might want to get out of the proposed $8.5 billion settlement. The bank reached the Countrywide MBS deal to end uncertainty about the size of its MBS liability. The settlement was supposed to reassure shareholders and permit the bank to put the MBS issue behind it. Obviously, things haven’t worked out that way. There’s more investor attention than ever on BofA’s liability for mortgage-backed securities, and the bank’s share price hasn’t exactly rebounded. Meanwhile, BofA has already taken the financial hit of setting aside MBS reserves. At some point, the bank could decide that opt-outs from the settlement so compromise the value of certainty that it would rather take its chances in the courts, where crucial questions like BofA’s successor liability for Countrywide’s mistakes are still undecided.

We’re a long, long way from there. But Countrywide MBS investors should be starting to ask themselves whether they’re better off with the settlement BofA agreed to or, in the best-case scenario in which they band together to get standing, with years of litigation.

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A year ago, the New York Court of Appeals gave a big, shiny gift to accounting firms facing fraud claims. Both the Delaware Chancery Court and the U.S. Court of Appeals for the Second Circuit had asked New York’s high court to clarify its application of the common-law doctrine of in pari delicto, which basically holds that wrongdoers can’t demand compensation from their partners-in-crime. Trustees for two companies shattered by internal fraud had sued their auditors, claiming that the auditors failed to detect, and maybe even helped cover up, the wrongdoing by corporate insiders. But the Court of Appeals, in its October 2010 ruling in Kirschner v. KPMG, said that if the corporation benefited in any way from the insider’s fraud, in pari delicto shields the auditors.

“So long as the corporate wrongdoer’s fraudulent conduct enables the business to survive — to attract investors and customers and raise funds for corporate purposes,” the New York court wrote, the doctrine applies.

Lawyers from Boies, Schiller & Flexner relied heavily on New York’s Kirschner ruling in their Aug. 31 motion to dismiss claims against the boutique auditor Rothstein, Kass & Company. It’s easy to see why: The case against RKC seems to fit exactly the scenario the Court of Appeals described.

Two veteran hedge fund execs, Peter McConnon and Timothy Lyons, retained RKC to vet a trader named James Crombie, their partner in a newly-formed fund called Paron. According to Paron’s amended complaint in San Francisco superior court, investors wanted a green light from the auditor before they’d sink money into Paron. RKC gave Paron its okay in November 2010. You can guess what happened next: It turned out that Crombie had falsified his trading records.

The National Futures Association launched an audit of Paron in March 2011, which prompted McConnon and Lyons to conduct their own check on Crombie. According to Paron’s complaint against RKC, they found discrepancies in the documents he’d given them. They reported their findings to the NFA and Paron’s clients. Soon thereafter, the fund shut down. McConnon and Lyons claimed in their suit to have suffered tens of millions of dollars in losses, as well as damage to their reputations.

Boies Schiller argued, however, that Paron, McConnon, and Lyons had all benefited from Crombie’s deception, at least in the short term. So under the Kirschner in pari delicto analysis, they couldn’t blame RKC.

“Because Crombie’s fraud is properly imputed to Paron, Paron cannot sue RKC for failing to stop it from defrauding investors,” the auditor asserted. “It is in pari delicto with RKC and cannot recover.” (The auditor’s lawyers also disputed Paron’s account of its engagement, asserting that it wasn’t hired to verify Crombie’s trading records.)

Paron’s lawyers at Braun Hagey & Borden countered that the New York standard has never been adopted by a California court. “Under California law, in pari delicto is never applied to innocent parties,” Braun Hagey partner J. Noah Hagey wrote in Paron’s response to RKC. “A [motion to dismiss] only may be sustained if the complaint alleges that every decision maker in the company was involved in the misconduct.” McConnon and Lyons, Paron argued, were the victims of Crombie’s fraud, not beneficiaries of it. Crombie’s actions cannot be imputed to Paron and its principals.

Judge Harold Kahn of San Francisco Superior Court agreed with Paron. After a hearing Wednesday he entered an order denying RKC’s motion to dismiss (which is called a demurrer in California). Kahn hasn’t written an opinion explaining his ruling, but he clearly accepted Paron’s interpretation of in pari delicto, since his ruling reinstates claims that had been dismissed by the previous judge on Paron’s case.

Paron and its Braun Hagey team still have a long way to go; RKC claims it was never supposed to check the trading records that turned out to be falsified. And California corporations hoping to sue their auditors can’t count on a ruling by one trial judge to protect their claims. But this ruling is at least a small chink in auditors’ in pari delicto armor.

Paron counsel Hagey and a Boies Schiller spokesperson declined comment.

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The key paragraph in Manhattan federal judge William Pauley III‘s 21-page ruling Wednesday in Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed-securities investors is the last one.

“The settlement agreement at issue here implicates core federal interests in the integrity of nationally chartered banks and the vitality of the national securities markets,” Pauley wrote. “A controversy touching on these paramount federal interests should proceed in federal court.”

That sentiment infuses the judge’s analysis of where BofA’s proposed deal should be evaluated: Before Justice Barbara Kapnick in Manhattan state Supreme Court, where Countrywide MBS trustee Bank of New York Mellon filed the case as a special proceeding under an obscure state law; or before Pauley in federal court, where there’s no analogous procedure for binding thousands of investors in 530 trustees to a settlement only 22 of them had a hand in negotiating. Pauley’s decision to keep the case in federal court throws the settlement off the carefully-designed track the bank, the trustee, and the investor group that supports the deal hoped to keep it on.

The judge opted for a broad interpretation of the federal Class Action Fairness Act, a 2005 law intended to keep big cases involving lots of claimants out of state court. Grais & Ellsworth, which represents a group of Countrywide MBS investors who don’t like the proposed BofA settlement, removed the case to federal court under CAFA’s provisions for mass cases. (I’ve written here and here about Grais & Ellsworth’s rationale for the removal and BNY Mellon’s arguments against removal.) The test for a mass action involves three questions: Does the case involve monetary relief; does it involve 100 or more plaintiffs; and do their claims involve common questions of law or fact? In siding with Grais & Ellsworth on each of those questions, Pauley considered the implications of the proposed settlement, not the technicalities of Article 77, the New York law under which the case was filed.

“BNYM’s argument exalts form over substance,” he wrote with regard to arguments by BNY Mellon’s Mayer Brown lawyer Matthew Ingber that the Article 77 proceeding didn’t involve a claim for monetary relief, since all the trustee sought was a ruling that BNY Mellon had acted reasonably in reaching the settlement. Pauley was similarly scornful of the trustee’s assertion that the Article 77 proceeding involved only one plaintiff, BNY Mellon. “BNY Mellon’s argument is untenable,” he wrote. “BNYM is trustee for 530 separate and unique trusts and seeks approval for its decision to settle the claims of each individual trust.”

In all, Pauley seemed to find the settlement supporters’ Article 77 gambit to have been too clever by half. He noted that his research uncovered only 28 Article 77 decisions in the last 40 years, many of which involved uncontested proceedings and garden-variety trust administration issues. He said, in fact, that he could find no authority to support the idea that a single Article 77 proceeding can be used to evaluate a decision affecting 530 trusts.

BNY Mellon had also argued that Grais & Ellsworth’s client, an investor group called Walnut Place, doesn’t have the right to remove the proposed settlement to federal court because it’s not a defendant in the case. Indeed, as Ingber of Mayer Brown argued at the Sept. 21 hearing before Pauley, Walnut Place will receive money if the proposed settlement is approved, so it can’t be considered a defendant under the traditional definition. Pauley concluded, however, that BNY Mellon was once again looking at form rather than substance, calling its argument “crabbed.” Walnut Place, he wrote, was adverse to BNY Mellon, the Article 77 plaintiff, so it is a defendant for the purposes of removal.

Finally, the judge shredded settlement supporters’ hole card: a ruling by the U.S. Court of Appeals for the Second Circuit that concluded a previous Countrywide MBS case — a Grais & Ellsworth suit — belonged in state court under the “securities exception” to the Class Action Fairness Act. As I’ve explained, the securities exception is counterintuitive. If the only claims at issue in a case involve federal securities laws, the case falls under the exception and goes back to state court. If state law claims are involved, it stays in federal court. (Weird, right?)

Pauley found that even though the previous Second Circuit ruling involved Countrywide mortgage-backed securities, it concerned the rights of MBS investors. The proposed settlement, on the other hand, involves the rights and duties of BNY Mellon as securitization trustee. The bank had argued that those duties derive from the contracts that govern the Countrywide MBS; but even BNY Mellon conceded in a round of briefing earlier this month that it also had common-law trustee duties. “Because a court evaluating BNYM’s conduct as trustee must rely on New York common law, and not simply the bare text of the [trust contracts],” the judge wrote, “the securities exception does not apply here.”

BNY Mellon and the Gibbs & Brun investor group that supports the proposed settlement will surely ask for Second Circuit review of Pauley’s ruling, although it’s not clear to me whether they’ll have to get Pauley’s leave to file an interlocutory appeal. (Remember, Bank of America is technically not a party to the case.) If the Second Circuit upholds the ruling, it’s very bad news for BofA. Given the harsh treatment Pauley has dished out to settlement supporters in two hearings and in Wednesday’s ruling, it’s clear the lawyers who crafted the $8.5 billion dollar deal have a long way to go before they get Pauley to sign off. (There’s also the rather enormous matter of what Pauley called the “procedural difficulty inherent in continuing this action in federal court,” where there’s nothing remotely like an Article 77 proceeding.)

I believe there’s support for the assertion that Judge Pauley interpreted the Class Action Fairness Act too broadly in a pair of recent rulings by two federal circuits considering whether state attorney general parens patriae suits are mass actions. Both the Ninth Circuit and the Fourth Circuit have said that judges must hew closely to the language of CAFA in deciding whether a case is a mass action. Pauley wrote that he was “reluctant to indulge” BNY Mellon’s reliance on CAFA’s legislative history. We’ll have to wait and see if the Second Circuit supports his reluctance.

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Bank of America filed a motion late Monday to disqualify Quinn Emanuel Urquhart & Sullivan as counsel to AIG in the insurer’s $10 billion suit claiming BofA, Merrill Lynch, First Franklin Financial, and Countrywide misrepresented the mortgage-backed securities they sold AIG. According to BofA’s lawyers at Munger, Tolles & Olson, a Quinn Emanuel partner who reviewed a draft of AIG’s complaint previously worked at Munger — and was privy to confidential information about how Merrill Lynch and its mortgage origination unit First Franklin intended to defend against MBS claims. Munger asserted that its former partner, Marc Becker, has a direct conflict of interest that should result in Quinn Emanuel’s removal from the AIG case.

“Quinn undertook this representation without even requesting a conflict waiver and screened Becker from involvement in this case only after defendants raised the issue,” the Munger disqualification motion said. “By then it was too late — Quinn had represented AIG in preparing this lawsuit for months, and Becker had already been involved in drafting the complaint and a significant motion in the case. Quinn’s flouting of the ethical rules mandates disqualification.”

Munger’s filings, first spotted by my Reuters colleague Noeleen Walder, disclose a trove of information about what happened between AIG and BofA in the months before AIG filed its $10 billion suit in July. They also raise the possibility that Bank of America will move to disqualify Quinn Emanuel in other cases involving MBS allegations against Merrill or First Franklin, including suits by the Federal Housing Finance Agency, Allstate, and Massachusetts Mutual.

Quinn Emanuel’s counsel, Gregory Joseph, said Munger’s disqualification motion is purely tactical. “Marc Becker practiced at Munger Tolles for 19 years as a highly respected and trusted associate and partner. They know perfectly well that he would not share any confidential information and he never did,” Joseph said in an email. “Bank of America doesn’t want to face Quinn Emanuel on the other side. Its motion never even addresses the governing standard — whether there is any risk of trial taint — because of course there isn’t.” (Quinn, as I’ve reported, pioneered MBS litigation and has filed dozens of suits for MBS investors, including most of the FHFA’s cases.)

Here’s the back story: Marc Becker was a partner at Munger Tolles until 2008, when he moved to Quinn Emanuel’s London office. According to declarations by Munger partner Marc Dworsky and former First Franklin general counsel and CEO Mark Malovos, Becker worked with First Franklin officers to craft an MBS defense strategy while he was a Munger partner. “Through his communications with Merrill Lynch and First Franklin representatives, Becker had access to highly confidential information and analysis regarding First Franklin’s home loan origination business,” the Dworsky declaration said. “Even more significantly, Becker was provided First Franklin’s internal projections of its exposure in connection with mortgage originations — the sensitivity and confidentiality of which is self evident.”

Munger’s filings said the firm first became aware of Becker’s alleged conflict in September, as partners reviewed Munger Tolles’ past work for Merrill Lynch and First Franklin. On Sept. 19, the firm sent a letter to AIG counsel Michael Carlinsky of Quinn, asserting that Becker had worked on Merrill Lynch and First Franklin matters, that Quinn Emanuel had not requested or received a waiver of conflict from either of them, and that both Becker and Quinn Emanuel should be disqualified as a result. Munger said it was first raising the issue with Quinn in a letter, rather than in a court filing, “given the importance of the issue.” The Munger letter asked Quinn to disclose whether Becker had worked on the AIG complaint.

At the same time, Munger partner Brad Brian emailed Quinn partner John Quinn. “Can we talk about Marc Becker and AIG v. Merrill?” Brian’s email said. Quinn replied, “Needless to say, Marc in London, has had and will have nothing to do with case.” (Here’s the full email exchange.)

Nevertheless, Quinn Emanuel was concerned enough about Munger’s letter that it brought in Joseph, whose Sept. 26 letter to Munger Tolles is a fascinating document. In it, Joseph asserted that BofA has been trying to knock Quinn Emanuel out of representing AIG since last January, when AIG and BofA signed a tolling agreement. In March or April, according to the Joseph letter, BofA informed AIG that it could participate in the talks that eventually produced the proposed $8.5 billion deal with Countrywide MBS investors — but only if it ditched Quinn Emanuel.

Moreover, the Joseph letter asserted, BofA has its own conflict problem. The bank’s associate general counsel, Christopher Garvey, worked on AIG matters as a partner at Goodwin Procter, and though AIG waived the conflict for prelitigation talks, Joseph wrote, AIG didn’t realize Garvey was still technically a Goodwin partner “seconded” to BofA. “Goodwin represented AIG in mortgage lending matters,” Joseph wrote. “If BofA pursues its reckless charge against Quinn Emanuel, AIG will be forced to address Mr. Garvey’s conflicts, and this will not be limited to Mr. Garvey but extend to all whom Mr. Garvey has tainted.”

Munger called Joseph’s assertion about Garvey “flatly incorrect” and “a smokescreen raised in an attempt to deflect attention from Quinn’s breach of its ethical duties” in an Oct. 4 reply to the Joseph letter. More importantly, the Munger letter said, Joseph hadn’t answered its question: Did Becker work on the AIG case against BofA?

It turns out that he did, as Joseph conceded in a second letter to Munger Tolles. Becker wasn’t part of Quinn’s AIG team, Joseph said, but had spent a total of 5.8 hours reading and suggesting structural changes in a draft of the original complaint and then reviewing AIG’s remand motion after BofA removed the case from New York state supreme court to federal court. Joseph said, however, that Becker never disclosed any confidential information about Franklin Financial or Merrill Lynch. (The Quinn partner didn’t even remember, according to Joseph’s first letter, that he’d done MBS work for those Munger clients.)

Munger’s response was to file Monday’s disqualification motion. Quinn Emanuel, as Munger noted in a footnote, is no stranger to such motions: It successfully moved to disqualify the Glaser Weil firm from representing MGA Entertainment in the Bratz doll dispute because a former Quinn lawyer had moved over to the Glaser firm. (Quinn Emanuel has also been in a long-running effort to remove Apple counsel Bridges & Mavrakis in the Samsung patent case in San Jose.)

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Grupo Mexico’s lead lawyer, Alan Stone of Milbank, Tweed, Hadley & McCloy, told me Monday that the company was “shocked” by Chancellor Leo Strine’s 106-page Oct. 14 ruling that the company owes $1.26 billion to the shareholders of Southern Peru Copper Company — the second-biggest shareholder derivative award in history.

It is a pretty shocking ruling. Strine found that Grupo Mexico, which at the time owned more than 50 percent of the shares of Southern Peru, basically forced the publicly-traded company to overpay, in stock, for Minera, Grupo’s privately-held Mexican mining company. In reaching that conclusion, the Chancellor managed to do three remarkable things: He rejected the judgment of Goldman Sachs, which advised Southern Peru on the deal; he questioned decisions by former Wachtell, Lipton, Rosen & Katz partner Harold Handelsman, who represented a minority owner of Southern Peru that was eager to cash out its stake; and he concluded that a special board committee of investment bankers conducted a tainted analysis. From the lead judge in a court that’s best known for making it almost impossible to prosecute a shareholder derivative suit successfully, this is a ruling every securities and corporate lawyer should read. (Plus, it’s written in Strine’s usual fluent, engaging style.)

Don’t cry too hard for Grupo Mexico (if you happen to be the sort of person who cries for corporate defendants found liable of breaching their duty to shareholders). Not only is it planning to appeal, according to Milbank’s Stone, but it now owns about 80 percent of the shares of Southern Peru, so even if it loses on appeal and has to pay up, it’s basically moving money from one pocket of Grupo Mexico’s fat wallet to another.

Nevertheless, for the sake of fairness, here’s Grupo’s comment: “The decision is not supported by the evidence presented at trial and is inconsistent with Delaware law,” Stone told me. “The court held the admittedly independent special committee … to an unrealistic and unachievable standard. Moreover, the court substituted its judgment not only for highly sophisticated board members but also for that of Goldman Sachs.”

So with all that gravitas weighing in support of the Southern Peru decision essentially to pay Grupo $3.1 billion in stock for Minera, how did plaintiffs’ lawyers at Prickett, Jones & Elliott and Kessler Topaz Meltzer & Check convince Chancellor Strine the deal was improper? (It wasn’t by working quickly. Strine quotes Vice-Chancellor Lamb, who handled the suit for several years after it was filed in 2004, criticizing the plaintiffs’ lawyers for failing to prosecute the case, then adds his own chastisement.)

But the plaintiffs’ lawyers ultimately came up with evidence that when Goldman Sachs evaluated Grupo’s offer to sell Southern Peru Minera, it concluded that under a strict valuation analysis, the Mexican company wasn’t worth anything approaching the value of the shares Grupo Mexico wanted for it.

As the judge wrote: “Goldman summed up the import of these various analyses in an ‘Illustrative Give/Get Analysis,’ which made patent the stark disparity between Grupo Mexico’s asking price and Goldman’s valuation of Minera: Southern Peru would ‘give’ stock with a market price of $3.1 billion to Grupo Mexico and would ‘get’ in return an asset worth no more than $1.7 billion.” (In testimony, Grupo Mexico said the price it wanted for Minera came from its bankers at UBS.)

Instead of telling Grupo Mexico “to go mine [itself],” as Strine put it, the special committee charged with weighing the deal had Goldman revise the analysis. Because Minera wasn’t publicly traded and couldn’t be valued by its share price, Goldman turned to what Strine called a “relative valuation.” Grupo Mexico contended that the revised comparison meant that Southern Peru and Minera were being judged on a similar basis.

Strine saw it differently.

“The special committee justified paying a higher price [for Minera] through a series of economic contortions,” he wrote. “According to special committee member [Harold] Handelsman, these ‘bells and whistles’ made it so that ‘the value of what was being … acquired in the merger went up, and the value of the specie that was being used in the merger went down,’ giving the Special Committee reason to accept a higher merger price.” (In the course of the special committee’s eight-month consideration of the deal, Grupo did agree to take fewer Southern Peru shares for Minera, but Southern Peru’s share price also rose dramatically because copper prices spiked.) It didn’t help Southern Peru and Grupo Mexico that the Goldman Sachs banker who led the deal evaluation, a non U.S.-resident, refused to come to Delaware to testify.

Strine also included a lot of discussion of the role of Handelsman, a former Wachtell M&A partner who is now general counsel for the Pritzker family’s interests. The Pritzker entity that owned an 11 percent stake in Southern Peru at the time Grupo Mexico was pushing for the Minera deal — a vehicle called Cerro — was simultaneously negotiating with Grupo Mexico to unload its Southern Peru shares. That, according to Strine, put Handelsman, who was a member of the Southern Peru board’s special committee, in a weird position.

“Although I am not prepared on this record to find that Handelsman consciously agreed to a suboptimal deal for Southern Peru simply to achieve liquidity for Cerro from Grupo Mexico, there is little doubt in my mind that Cerro’s own predicament as a stockholder dependent on Grupo Mexico’s whim … influenced how Handelsman approached the situation,” Strine wrote.

“Put simply, although I continue to be unpersuaded that one can label Handelsman as having acted with the state of mind required to expose him to liability given the exculpatory charter protection to which he is entitled, I am persuaded that Cerro’s desire to sell influenced how Handelsman approached his duties and compromised his effectiveness.” (I left a message with Handelsman but didn’t hear back.)

Handelsman withdrew from the special committee’s vote on the deal, which was ultimately approved by shareholders. Strine also dismissed claims against him and the other special committee members, leaving just Southern Peru officers and Grupo Mexico as defendants. And those defendants, he concluded, breached their fiduciary duty by causing Southern Peru to pay an unfair price for Minera. He calculated the difference between what Southern Peru paid and what it should have paid to be $1.23 billion.

A final note: Strine didn’t suggest attorneys’ fees for the plaintiffs’ lawyers, but it doesn’t sound like he’s going to approve a windfall payout for this extraordinary award. He said fees will be paid out of the award and suggested the two sides get together on a suggestion.

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