Opinion

Alison Frankel

How to woo a judge (when $8.5 bln is at stake)

By Alison Frankel
May 6, 2013

With the gigantic news Monday that¬†Bank of America has reached a global settlement with the bond insurer MBIA¬†- agreeing to pay MBIA $1.7 billion and acquiring five-year warrants on about 10 million shares of the insurer’s holding company – the bank’s most pressing piece of litigation has become its proposed $8.5 billion settlement with investors in Countrywide mortgage-backed securities. Friday was the deadline for noteholders who have previously intervened in the special proceeding to evaluate the deal to announce where they stand.

There were some encouraging developments for BofA and fellow settlement proponents Bank of New York Mellon (the Countrywide MBS trustee) and the major institutional investor group represented by¬†Gibbs & Bruns. The investment management firm Fir Tree, whose funds hold Countrywide notes with a face value of $550 million,¬†announced support¬†for the proposed settlement, asserting that the “widespread lack of objection” by Countrywide MBS investors “reflects deep and broad support among holder of securities for the proposed settlement.” The Federal Housing Finance Agency, which had filed a¬†wishy-washy “conditional objection”¬†to the deal back in September 2011, dropped its half-hearted resistance. And the New York and Delaware attorneys general, who entered the case with a bang,¬†departed with a whimper, deferring to “capable and sophisticated counsel” for private noteholders with objections to handle things from here.

But a total of 68 noteholders objected to the settlement in filings on Friday. And though 20 of them are affiliated with AIG, they’re otherwise a diverse group that includes four Federal Home Loan Banks, a couple of public pension funds and Cranberry Park, the nom de litigation of an investment fund family with a significant Countrywide MBS stake. As I read competing briefs by objecting noteholders, who want New York State Supreme Court Justice¬†Barbara Kapnick¬†to reject the $8.5 billion settlement, and by BNY Mellon, which brought the special proceeding under state trust law to win court approval of the deal, I was struck by the difference in the way the two sides want Kapnick to look at the settlement. Opponents are asking the judge to examine the settlement through a microscope, scrutinizing details. Proponents want her to take a broad view of the trustee’s discretion and the magnitude of $8.5 billion.

The simpler course for Kapnick would be to approve the settlement. As BNY Mellon noted throughout the¬†brief it submitted Friday, the $8.5 billion deal would be one of the largest payouts in U.S. litigation history. Does any judge want to make that much money disappear, especially when only 68 noteholders, of presumably thousands that own Countrywide MBS, have objected to the agreement? Besides, according to BNY Mellon, the very fact that objectors dispute the value of investors’ breach-of-contract claims justifies its decision to settle. In the trustee’s account, BNY Mellon had a choice of agreeing to an $8.5 billion deal supported by investors holding upward of $30 billion in notes in hundreds of Countrywide trusts or of rejecting the settlement and taking the risk that MBS noteholders would receive nothing unless they succeeded in very difficult and time-consuming litigation. BNY Mellon’s lawyers at¬†Dechert¬†and¬†Mayer Brown¬†argued that Kapnick should accord considerable deference to the trustee and approve any settlement it reached in good faith. But even if the bank is held to a higher standard, the brief said, BNY Mellon’s decision to take the $8.5 billion ultimately offered by Bank of America wasn’t even a close call.

“Certificateholders with billions of dollars in holdings requested that the trustee enter into (the settlement). The settlement amount – $8.5 billion – was $3.7 billion more than Countrywide was able to pay assuming (counterfactually) no other liabilities, and the prospect of recovering from Bank of America under theories of successor liability were dim,” BNY Mellon’s brief said. “And the alternative of years of litigation with no certain outcome was one that the trustee in good faith believed was not in the best interests of certificateholders.”

According to the brief, Kapnick need not resolve disputes between BNY Mellon and objectors over the adequacy of the trustee’s advisors if she determines that the bank operated in good faith and in accord with the interests of shareholders. Even if she disagrees with some of the trustee’s analysis or believes that it could have made different decisions, BNY Mellon said, “that would not make (the trustee’s) decision an abuse of discretion.”

That is not, of course, the view of objectors to the settlement, whose brief¬†opposing the deal¬†contended that BNY Mellon was more interested in protecting itself than in acting on behalf of certificateholders. I’ve previously written about the theoretical basis of objectors’ argument that¬†MBS trustees are inherently conflicted¬†because their business model relies on continued assignments from issuers. In the brief filed Friday, objectors’ counsel – led by¬†Reilly Pozner,¬†Keller Rohrback¬†and¬†Miller & Wrubel¬†- asserted that in this settlement, BNY Mellon’s conflict became actual, not merely theoretical, when it received a letter from Gibbs & Bruns in October 2010, directly accusing the trustee of failing to act in the interests of Countrywide MBS holders.

That letter started the clock ticking on BNY Mellon’s obligation to declare an event of default, according to objectors. The trustee was obliged to undertake an investigation on behalf of the noteholders who sent the letter, and, once an event of default was triggered, to notify all certificateholders. Instead, objectors contended, BNY Mellon looked out for itself, entered a so-called forbearance agreement to stop the clock on default. It then negotiated an indemnity agreement with Bank of America.

BNY Mellon has long countered that the Gibbs & Bruns investor group had the power to forbear its own notice of default and that the side-letter on indemnification was merely a restatement of the assurance the trustee already had in place through MBS pooling and servicing agreements. The objectors’ brief said that wasn’t true. BNY Mellon, according to deal opponents, was running scared from the liability it faced in the event of default. “When it chose to enter the settlement negotiations, BNYM faced its own substantial liability risk, including losing indemnity rights from BofA and being subject to heightened duties to represent and protect the interests of all certificateholders,” the brief said. “Despite BNYM’s protestations to the contrary, BNYM was preoccupied throughout the negotiations with obtaining a broad release for itself for claims that could be brought by certificateholders.” (How much was indemnity worth? According to objectors, BNY Mellon has spent $10 million on legal fees as trustee in this deal.) The trustee was haggling for even broader indemnity, according to objectors, but Gibbs & Bruns nixed it because the firm was concerned about the appearance of a conflict for the trustee.

Justice Kapnick has provided a hazy standard for the duty of an MBS trustee, which she has said is not “a full-fledged fiduciary” but owes a fiduciary obligation to “refrain from engaging in conflicts of interest, to act with a singleness of purpose and to have a duty of loyalty to the certificateholders.” BNY Mellon, according to objectors, failed in that duty.

The objectors also argued that Kapnick must weigh the overall reasonableness of the settlement, not just the trustee’s discretion. The trustee didn’t even look at loan files when it agreed to the deal, bringing in an expert who relied on “deeply flawed” assumptions of the breach rate for underlying Countrywide loans and the success rate for put-back claims. In the end, according to objectors, it failed certificate holders by permitting the Gibbs & Bruns group to negotiate the cash portion of the settlement even though the Gibbs group didn’t own notes in every Countrywide MBS offering.

So what do the objectors want? BNY Mellon, BofA and the Gibbs & Bruns group have argued that if Kapnick rejects the settlement proposal, $8.5 billion goes up in smoke and every Countrywide MBS investor must begin the litigation process, which is replete with procedural pitfalls. (Objectors say the event of default might eliminate some of those hoops.) Deal proponents are of the view that Kapnick has only one choice: Approve the settlement or reject it. Objectors, in both the joint brief and a separate brief by three public pension funds, claim that Kapnick has a third course. She can order the settling parties to restart negotiations, this time with notice to all certificateholders and the benefit of two years of judicial precedent to inform their talks. (Or else, the pension funds suggest, investors can sue BNY Mellon directly under the Trust Indenture Act, as their lawyers from Scott + Scott have done.)

Which approach will appeal to Kapnick? We’ll find out when she begins a hearing on the settlement on May 30 – unless the hearing is delayed by appeals by one side or the other on a pending ruling from the judge on privilege over communications between¬†Mayer Brown and the trustee. But that’s another story.

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