Are mortgage-backed securities bonds or equity? 2nd Circuit to decide

May 8, 2013

I’m ready to make a bold declaration: We’ve reached the beginning of the end of private litigation over deficient mortgage-backed securities. Think about it. The bond insurers that pioneered MBS cases are reaching settlements right and left with the banks that sponsored notes. MBIA’s $1.7 billion deal with Bank of America is the most dramatic, but Assured Guaranty reached a $358 million settlement with UBS on the same day. MBS class actions are in their end stages, now that the U.S. Supreme Court has signaled disinterest in MBS class standing. New securities fraud complaints by individual MBS investors have tailed off, and though I continue to see new breach-of-contract filings by trustees suing at the direction of noteholders with the requisite voting rights, time is running out on those suits even under New York’s generous statute of limitations. I don’t think it’s a coincidence that Kathy Patrick of Gibbs & Bruns, who has spent the last few years deep in talks with big banks over the put-back claims of her enormous institutional investor clients, told my Reuters colleague Karen Freifeld that she’s looking ahead to Libor securities litigation. Or that Quinn Emanuel Urquhart & Sullivan, which began preparing to represent plaintiffs in MBS cases all the way back in early 2008, is now investing heavily in products liability litigation.

Don’t get me wrong. Billions of dollars are still going to move from banks to monolines and investors, especially once the Federal Housing Finance Agency cases begin to settle. But we’ve climbed almost to the top of the learning curve. We know the myriad deficiencies in the underwriting and securitization process and the multifaceted defenses banks and credit rating agencies have raised to evade liability for those deficiencies. That’s valuable information, and not just for MBS plaintiffs. If the market for residential mortgage-backed securities is ever to be revived robustly – which, at least in the ideal of policy, would be of enormous benefit to homeowners – investors and sponsors alike will be wiser and warier.

The 2nd Circuit agreed Tuesday to hear an appeal that should go a long way toward answering one of the most controversial remaining questions in MBS litigation: What is the potential exposure of securitization trustees to MBS investors? As you know, the responsibilities of MBS trustees have been hotly debated in Bank of America’s proposed $8.5 billion settlement with investors in Countrywide mortgage-backed securities, with an expert for objectors to the settlement arguing that trustees are inherently conflicted by institutional relationships with MBS sponsors. That’s an interesting theoretical point, but meanwhile, in a lower-profile arena of MBS litigation, a Chicago police pension fund represented by Scott + Scott has asserted claims directly against securitization trustees that supposedly breached their duty to noteholders.

The Chicago fund has survived dismissal motions in two MBS trustee cases in federal court in Manhattan, one against Bank of New York Mellon before U.S. District Judge William Pauley and the other against BofA (as successor to LaSalle) and U.S. Bank before U.S. District Judge Katherine Forrest. As I’ve previously written, both judges agreed with Scott + Scott that mortgage-backed securities are debt, not equity, which subjects MBS trustees to the federal Trust Indenture Act of 1939. In February, Pauley denied BNY Mellon’s motion to reconsider but granted the trustee permission to seek an interlocutory appeal. (Forrest, meanwhile, just reconfirmed her analysis of MBS trustees and the TIA in a May 6 opinion denying the trustees’ motion to dismiss an amended complaint filed by Scott + Scott.)

In their brief asking the 2nd Circuit to accept the discretionary appeal, BNYM’s lawyers at Mayer Brownemphasized the “enormous practical importance” of the issue. Pauley’s ruling, the bank asserted, was at odds with the guidance of the Securities and Exchange Commission and the established expectations of the securitization industry, which (according to the bank) considers mortgage-backed securities to be equity, not debt, and thus out of the purview of the TIA. Industry groups, including the Securities Industry and Financial Markets Association and the American Bankers Association, consider this to be a significant enough issue that they filed amicus briefs supported BNYM’s request to be heard on appeal, just as they had previously backed its motion for reconsideration.

Though she obviously believes the appeals court should affirm that MBS trustees are subject to the TIA, pension fund counsel Beth Kaswan of Scott + Scott actually agrees with the securitization industry that this is a critical question. Holding trustees accountable, she said, “would impose fundamental controls over the abuses that have been responsible in large part for the financial crisis…. The application of the Trust Indenture Act to these trusts could not be more important.” (I should note that the 2nd Circuit also agreed to hear the pension fund’s appeal of Pauley’s ruling on its standing to assert class action claims against BNYM.)

The 2nd Circuit’s word probably won’t be the last on the duties of MBS trustees, since whichever side loses at the appeals court will likely ask the Supreme Court for review. Other investors, meanwhile, have bypassed federal court and sued MBS trustees under common-law theories of negligence; as I reported last week, the Knights of Columbus won a ruling permitting the group to proceed with such claims against BNY Mellon.

But it’s helpful that the appeals court has agreed to take the case and help resolve the law. Litigation, after all, shouldn’t just be about assessing blame for mistakes of the past but also about avoiding them in the future.

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I can see one major lesson in all this: only a fool buys any new security. The probability of litigation dwarfs any potential return.

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