Opinion

Alison Frankel

NY appeals court gives big boost to BofA in MBS put-back suits

By Alison Frankel
June 29, 2012

On Friday, the Wall Street Journal called Bank of America’s 2008 acquisition of the tottering mortgage giant Countrywide a $40 billion mistake. Sure, the bank only paid a total of $4.5 billion to pick up Countrywide, paying $2 billion for a minority stake in 2007 and an additional $2.5 billion for the rest of the company in 2008. BofA had its eye on Countrywide’s then-profitable mortgage servicing business, but since the acquisition Countrywide and its deficient mortgages have been pretty much nothing but trouble for Bank of America, which has seen its share price drop 68 percent and is still digesting what the Journal estimated to be at least $40 billion in “total real estate losses, settlements with government agencies and amounts pledged to investors who purchased poor-performing Countrywide mortgage-backed securities.” The Journal‘s Dan Fitzpatrick quoted a North Carolina banking professor who called BofA’s Countrywide acquisition “the worst deal in the history of American finance.”

Ouch. But thanks to a New York appeals court, BofA may have just put a fence around one big swath of Countrywide liability. On Thursday the Appellate Division, First Department, upheld Manhattan State Supreme Court Justice Barbara’s Kapnick‘s ruling that the mortgage-backed securities investor Walnut Place may not proceed with a breach of contract case against Countrywide. That ruling will severely limit the options for Walnut and the other investors who have objected to Bank of America’s proposed $8.5 billion global settlement with Countrywide MBS noteholders. It also puts the focus in the litigation over the global settlement on Bank of New York Mellon and its conduct as Countrywide’s MBS trustee, which Kapnick is also overseeing. My prediction: Unless Kapnick finds that BNY Mellon didn’t fulfill its duties as trustee in reaching that settlement, Countrywide MBS investors can’t sue outside of the deal.

And here’s why. MBS pooling and servicing contracts, you’ll recall, make it exceedingly difficult for noteholders to bring claims that underlying loans breached representations and warranties by mortgage issuers like Countrywide. Under standard PSA terms, investors can’t take any action unless they’ve amassed support from noteholders with 25 percent of the voting rights in a particular MBS trust. If they manage to get over that procedural hurdle, they must then demand an investigation of reps and warranties breaches from the MBS trustee and then wait months for the trustee to respond. Only if the MBS trustee fails to take action on their behalf can investors bring their own breach of contract or put-back suit.

Few private-label MBS investors have managed to run that obstacle course and file their own put-back claims. Walnut Place, a nom de litigation for the hedge fund Baupost, is in that small group. In April 2011, Walnut’s lawyers at Grais & Ellsworth sued Countrywide and MBS trustee Bank of New York Mellon in Manhattan State Supreme Court, claiming that they’d breached the PSAs governing two Countrywide MBS trusts.

Last July, after Bank of America announced that it had reached a global $8.5 billion put-back settlement with a group of 22 institutional investors in Countrywide mortgage-backed notes, BofA and Countrywide moved to dismiss the Walnut suit. They argued that Walnut didn’t have a cause of action under the pooling and servicing agreements because BNY Mellon had already taken action on its behalf: The trustee had entered into the negotiations that produced the $8.5 billion proposed settlement.

It was a supremely self-serving argument by BofA’s lawyers at Wachtell, Lipton, Rosen & Katz and Countrywide counsel at Goodwin Procter. Walnut had already surfaced as one of the leading objectors to the proposed global settlement, arguing that it cut the legs out from under its suit against the banks. BofA and Countrywide essentially said Walnut was right – the global settlement did, in fact, pre-empt its put-back suit – but that was tough luck for Walnut and every other Countrywide MBS investor. According to BofA, the global deal offered it broad protection because noteholders simply couldn’t satisfy the contract requirement of showing the MBS trustee hadn’t taken action.

In March, Kapnick agreed with the banks. “The trustee did, in fact, act upon [Walnut's] complaints, as demonstrated by the settlement agreement reached with the defendants and submitted to this court,” she wrote. “That settlement includes the claims at issue here.” I noted at the time that Kapnick’s reasoning could just as well apply to every other Countrywide MBS investor, since the $8.5 billion deal purports to resolve all of their put-back claims. If Walnut – which had, after all, filed its suit before the global settlement was announced – couldn’t get over the procedural wall of showing the trustee failed to act, I said, it was hard to see how any other investor could do better.

The one-page appeals court ruling makes it all the more unlikely that any Countrywide MBS investor has a viable claim outside of the global settlement, with a caveat I’ll get to in a minute. The no-action clause in the pooling and servicing contract is not ambiguous, the First Department said, and clearly bars Walnut’s suit. The court considered Walnut’s arguments that the “event of default” provision doesn’t apply and concluded that Walnut’s interpretation of the pooling and servicing agreements “would improperly excise the … provision and distort the plain meaning of the clause.”

That curt rejection of Walnut’s reasoning doesn’t leave much hope for Countrywide MBS investors with put-back claims – unless Kapnick finds that BNY Mellon wasn’t acting in their best interests when it entered into the proposed global settlement. That’s the caveat I mentioned. There’s a dispute in the special Article 77 proceeding over which side bears the burden of proof. BNY Mellon, which filed the case, believes objectors to the settlement have to show that it acted outside the bounds of reason when it agreed to the settlement. Objectors have argued that the trustee has to prove that the deal was reasonable. Either way, if the judge finds BNY Mellon was conflicted because of indemnity agreements with Countrywide or Bank of America, it’s conceivable that investors could bring their own breach of contract suits.

In the meantime, you can bet that the First Department ruling will entrench the banks as litigation with objectors continues. After all, compared with the $40 billion the Countrywide deal is costing BofA, legal fees are peanuts.

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