Whither BofA MBS deal: Can banks walk if case stays with Pauley?

October 21, 2011

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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