Bank of America and the standard of review: A tale of two cases

April 26, 2012

The most important woman in Bank of America’s life right now may well be New York State Supreme Court Justice Barbara Kapnick. In the last five days, Kapnick has presided over two critical hearings, one to determine whether the BofA-led group challenging MBIA’s $5 billion restructuring can put on live witnesses and the other to determine whether BofA’s proposed $8.5 billion settlement with investors in Countrywide mortgage-backed securities will remain a special proceeding under New York trust law.

Bank of America got good news at the end of both hearings. Kapnick agreed on Apr. 20 to hear live testimony in the MBIA regulatory case and ruled on Apr. 24 that objectors to the proposed MBS settlement can’t convert it to a more standard adversary case. But BofA didn’t get everything it wanted.

Kapnick was very clear about limiting the evidence the banks can put on in the MBIA case, which is being brought under a proceeding known as Article 78. “This case is really, really directed towards the actions of the Insurance Department in approving this transaction,” she told bank counsel from Sullivan & Cromwell, according to this transcript of the hearing. “It’s not a case about all the intentional and terrible things that you alleged.” Under Article 78, she said, her job is simply to decide whether the state insurance department (now the Department of Financial Services) made a reasonable determination to approve the MBIA restructuring, or whether its approval was “arbitrary and capricious.” Based on the transcript, Kapnick considers that a high bar for the banks to clear.

Her deference to the regulators should, in an ironic way, have been good news for Bank of America in the other case, its proposed MBS settlement. As you no doubt remember, Bank of New York Mellon, as Countrywide MBS trustee, filed for approval of the settlement under New York’s Article 77, which permits trustees to seek a judge’s endorsement of trust decisions. BNY Mellon, BofA, and the institutional investors who negotiated the $8.5 billion deal have long argued that the standard of review in Article 77 is whether the trustee acted reasonably – precisely analogous to the standard Kapnick said she intends to apply in the MBIA case under Article 78.

But as it happens, there’s a crucial difference between Article 77 and Article 78. The New York code spells out the standard of review in Article 78 proceedings, but not in Article 77 trust proceedings. So there’s no statutory framework to guide Kapnick’s evaluation of the proposed MBS settlement.

At Tuesday’s hearing, BNY Mellon counsel Matthew Ingber of Mayer Brown and the institutional investors’ lawyer, Kathy Patrick of Gibbs & Bruns, urged Kapnick to set a low bar for approving the settlement. The court should defer to the trustee’s power to settle claims on behalf of the trusts, they argued, and override BNY Mellon’s decision only if there’s evidence the trustee abused its discretion or acted in bad faith. “The question before you is, did the trustee act within the bounds of its discretion? What is the standard that governs? What does the contract say?” Patrick told Kapnick. (My Reuters colleague Karen Freifeld was at the hearing and kindly shared her notes.)

Kapnick had defined the scope of review issue in an Apr. 4 show-cause order she referenced Tuesday, calling on objectors to show why the appropriate standard is not “whether (the settlement) decision is within the bounds of the trustee’s reasonable discretion.” The judge declined, however, to rule on that scope.

In fact, objectors’ steering committee member Daniel Reilly of Reilly Pozner (who represents AIG) told me in an email that even though Kapnick decided to keep the case an Article 77 proceeding, her comments at the hearing indicate that she intends to look more critically at the deal than BNY Mellon and the Gibbs & Bruns group want. The judge said that she has researched Article 77 and now believes the proceeding gives her “a lot of discretion.” She said she will probably grant more discovery than the trustee and the Gibbs group want (though less than the objectors want). “I do not see why I cannot do everything that (objectors) want under Article 77,” she said. “I think that’s very broad.”

“We are pleased that Justice Kapnick rejected the efforts of Bank of New York to restrict discovery and made clear that the intervenors can take discovery that will allow the court and the investors to properly evaluate the reasonableness of the settlement and the process by which it was reached,” said Reilly, who argued that BNY Mellon’s own proposed findings require significant discovery.

Investors’ counsel Patrick said the objectors are jumping to a conclusion Kapnick didn’t reach. “Having made (the) threshold determination to keep the case an Article 77 proceeding, Justice Kapnick then set a second hearing to determine what discovery is actually necessary to determine whether the trustee acted within the scope of its reasonable discretion in deciding to settle the trusts’ claims,” Patrick said in an email. “That is the issue to be decided in an Article 77 proceeding, and we believe discovery will be shaped by that standard.”

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