$315 ml Merrill deal shines light on damages in MBS litigation

December 6, 2011

A filing late Monday confirmed what I reported last month: Merrill Lynch has agreed to a $315 million settlement of a securities class action stemming from 18 Merrill mortgage-backed note offerings. This agreement is the fourth MBS securities settlement, following this summer’s landmark $125 million Wells Fargo class action deal and a pair of settlements with Citigroup and Deutsche Bank, totaling $165.5 million, that National Credit Union Agency reached in November. The Merrill agreement, negotiated by lead class counsel at Bernstein Litowitz Berger & Grossmann, is by far the biggest score so far for MBS investors in a securities suit (as opposed to contract, or put-back, litigation).

There are dozens more MBS securities suits out there, as the Merrill settlement agreement acknowledges: the deal carves out claims by AIG, the Federal Home Loan Bank of Boston, the Federal Housing Finance Agency, and other MBS investors that have already filed their own securities suits against Merrill Lynch. But one of the big mysteries of the MBS securities litigation has been how to value the cases, since there’s so little precedent in the way of settlements. The NCUA deals helped; the credit-union regulator repackaged and resold mortgage-backed securities belonging to five failed credit unions, so the agency actually knew how much the credit unions lost through their MBS investments. In its talks with Citi and Deutsche Bank (which the agency didn’t formally sue), NCUA was able to claim specific, fact-based damages.

The Merrill settlement documents provide significantly more insight for plaintiffs who don’t have the luxury of U.S. government backing to sell repackaged mortgage-backed securities. The documents don’t disclose the class’s specific damages claim; the case settled before investors filed their damages expert’s report. But the exhibits included along with the settlement brief indicate a methodology for calculating damages that other plaintiffs can use. MBS defendants, including Merrill Lynch, will undoubtedly continue to assert that MBS noteholders shouldn’t recover anything for their securities claims because they’re sophisticated investors who knew the riskiness of mortgage-backed notes. But as hundred-million-dollar settlements pile up, that’s a tougher argument to sell.

The Merrill class members, like most MBS securities plaintiffs, based their claims on Section 11 of the Securities Act of 1933, which holds that investors can recover damages if a registration statement contains false or misleading statements. (It’s a handy theory for investors, who don’t have to show fraudulent intent.) Section 11 includes three means of calculating damages. If investors sold their securities before bringing suit, their damages are the difference between what they paid for the stocks or bonds and the price the securities fetched. If they’re still holding their investment on the day the suit is filed, damages are defined as the difference between what they paid and the value of the securities on the filing date. If they sell while the litigation is underway, they’re permitted to claim the lesser of those two amounts.

That sounds simple, but when you’re trying to calculate the value of notes belonging to thousands of investors who bought and sold at different times in the illiquid MBS market, it’s not. Bernstein Litowitz and its experts did the next best thing. According to a table at the end of this exhibit to the memo in support of settlement, the class estimated the value of each tranche of every one of the 18 offerings in the class action had lost. (The table expresses the value of each MBS tranche on the day the suit was filed as a percentage of the offering price; so, for example, the most senior tranche in the table’s first-listed MBS offering was worth 58.26 percent of its par value on the day the suit was filed, while the lowest tranche was worth only 1.38 percent of its offering price.) The chart doesn’t tally up total losses based on the difference between the offering value and the value on the filing date, but Bernstein Litowitz said in the settlement memo that the calculation “amounts to billions of dollars in the aggregate.”

So why did the plaintiffs firm settle for $315 million? For starters, if the case had gone to summary judgment and then trial, Merrill and its parent, Bank of America, would have disputed the class’s estimate of the value of investors’ securities on the day the suit was filed (and thus, the class’s damages). Mortgage-backed notes aren’t like stocks trading in a robust market, so there’s a lot of wiggle room in pricing them. The notes are also unlike stocks in that many of them are still paying principal and interest, at least in the senior tranches, so the defense could assert price declines are illusory.

Moreover, Merrill’s lawyers at Skadden, Arps, Slate, Meagher & Flom would also have argued that any lost value in the securities was due to the economic downturn, not to misrepresentations in the registration materials. As Bernstein Litowitz wrote in the settlement memo: “Defendants asserted throughout the litigation — and were expected to continue to assert through summary judgment and trial — that the overall economic downturn, housing price declines, and reduced liquidity, not the alleged untrue statements and omissions, were to blame for the decline in the certificates’ value. … If successful in establishing their negative causation defense or other affirmative defenses, it is anticipated that defendants would argue that estimated damages were substantially less or zero.”

The $315 million proposed settlement still has to be approved by U.S. District Judge Jed Rakoff, who is overseeing the Merrill MBS class action. Bernstein Litowitz did not file a fee request as part of the settlement agreement.

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