Alison Frankel

On Monday, after word leaked that Bank of America and MBIA had resolved their epic five-year, multidimensional litigation against one another, investors in both companies judged the deal. Shares in MBIA, whose structured finance arm had been widely considered to be on the brink of a regulatory takeover, closed 45 percent higher at $14.29, adding about a billion dollars to the market capitalization of the insurer’s holding company. Bank of America’s shares went up as well. They didn’t rise as dramatically as MBIA’s, closing up 5 percent at $12.88. But that added $6.9 billion to BofA’s market cap – three times as much as the $1.6 billion in cash that the bank agreed to pay to MBIA as part of the settlement.

The comparison between the raw percentage rise in share price and the total dollars added to each company’s market cap is instructive in considering which side, if either, got the better of this settlement. As investor reaction indicated, this deal was much more important to MBIA than to Bank of America. With $1.6 billion in cash from the bank, plus the remittance of $137 million in MBIA notes held by BofA, MBIA’s withered structured finance arm can pay back the $1.7 billion it owes the company’s bond insurance arm, which financed settlements with some of the banks that had challenged MBIA’s 2009 restructuring. BofA also agreed in Monday’s settlement to drop its regulatory and fraud claims stemming from that restructuring, which leaves only Societe Generale remaining in restructuring cases against MBIA. Assuming the insurer can reach a settlement with Societe Generale, the cloud of uncertainty over its 2009 split will be entirely removed and MBIA’s bond insurance arm will be able to return to the business of writing policies on state and municipal financings.

MBIA also eliminated any uncertainty about what it might owe Bank of America under credit default swap agreements with BofA predecessor Merrill Lynch. BofA held a total of $7.4 billion in MBIA policies, $6.1 billion of which was on CDS deals. The actual value of those policies was a matter of speculation and interpretation. I’ve heard that Bank of America had drastically written down its potential recovery from MBIA to the neighborhood of a $1 billion. But if MBIA went into rehabilitation (the insurance version of Chapter 11), the priority of claims by CDS counterparties would have been determined by New York State Department of Finance chief Benjamin Lawsky, who has been deeply involved in settlement talks between MBIA and BofA and might have been using the priority of claims as a bargaining chip. In any event, MBIA’s takeaway from the settlement isn’t just the $1.7 billion in cash and other considerations it received from BofA. It’s really that amount plus BofA’s potential recovery from the CDS policies.

Most importantly, the settlement saves MBIA’s future as an ongoing operating company. Two weeks ago, MBIA was fending off talk that New York regulators were on the verge of putting the structured finance unit into rehabilitation. On Monday, by contrast, state finance chief Lawsky said that the $500 million credit line BofA agreed to provide to MBIA as part of the settlement assured the insurer’s solvency. In cash terms, MBIA did not get all of the $5 billion it claimed Countrywide and Bank of America owed it for misrepresenting the quality of loans underlying mortgage-backed securities insured by MBIA. It didn’t even get all of the approximately $3 billion it has counted as an asset from the long-running Countrywide fraud and breach-of-contract litigation. But it got just enough to get back into the bond insurance business, which means MBIA can eventually revive its once thriving municipal bond insurance business. (BofA, meanwhile, has the option of participating in the upside for MBIA, via five-year warrants on about 10 million shares, or roughly 5 percent of MBIA’s equity.)

For MBIA, in other words, the litigation with Bank of America was truly do or die, which is why its investors reacted so jubilantly to the settlement. For the bank, MBIA has been more like a nasty cold than an existential threat, hence the more muted market response to Monday’s settlement.

Late last month, without any fanfare, a New York appeals court issued a terse, one-page ruling that upheld the dismissal of Walnut Place’s breach-of-contract suit against Countrywide, Bank of America and Countrywide’s mortgage-backed securitization trustee, Bank of New York Mellon. It was an abrupt end for what was once a promising attempt at vindication for an MBS investor. It was also a huge setback for Walnut, its lawyers at Grais & Ellsworth and all the other Countrywide MBS investors who were counting on litigation against BofA as an alternative to the bank’s proposed $8.5 billion global settlement of breach-of-contract, or put-back, claims.

That one-page appellate ruling reverberated powerfully on Monday, when Walnut – otherwise known as the Boston hedge fund Baupost – filed a request to withdraw from the special New York proceeding to evaluate BofA’s MBS settlement. Framed as a letter to New York State Supreme Court Justice Barbara Kapnick from Grais partner Owen Cyrulnik, the request offered no explanation for Walnut’s withdrawal; Cyrulnik and Baupost spokeswoman Elaine Mann declined to comment.

But Baupost was facing an imminent decision about whether to request leave to appeal the dismissal of its case against BofA to New York’s highest court. Given the unlikely prospect that the Court of Appeals would agree to take the case, the hedge fund appears to have decided not to continue to spend money on litigation with little chance of a return. And given that the dismissal of Walnut’s suit makes it very difficult for the hedge fund – or any other MBS investor – to recover on put-back claims outside of the global settlement, Walnut apparently determined that it wasn’t economically rational to continue its challenge to the $8.5 billion deal. (From what I’ve heard, Bank of America did not pay Walnut anything in exchange for the hedge fund’s withdrawal; a Bank of America spokesman declined to comment to my Reuters colleague Karen Freifeld.)

Oh, the ironies of megabillion-dollar securities class action litigation!

Last Friday, shareholders filed their response to summary judgment motions by Bank of America and its executives in a class action claiming BofA failed to tell shareholders about Merrill Lynch’s escalating losses and sky-high executive bonuses before BofA bought Merrill in 2008. As you would expect, the shareholders and their lawyers at Bernstein Litowitz Berger & Grossmann, Kaplan Fox & Kilsheimer and Kessler Topaz Meltzer & Check spend considerable time rebutting defense arguments that, as a matter of law, shareholders weren’t injured by BofA’s alleged disclosure lapses. Those arguments, the plaintiffs’ lawyers said, have already been rejected in U.S. District Judge Kevin Castel‘s class certification decision in February.

But deep in the 115-page filing is a more intriguing discussion of the role BofA’s lawyers at Wachtell, Lipton, Rosen & Katz played in the bank’s disclosure decisions. You may recall that former CEO Kenneth Lewis said he is entitled to summary judgment in the case because he relied on his CFO’s assurances that he’d consulted BofA lawyers on disclosure, and they’d said shareholders didn’t need to be told of interim Merrill loss projections that dwarfed initial reports. Lewis’s lawyers at Debevoise & Plimpton implied that the former CEO was under the impression that his CFO, Joe Price, had spoken both to the bank’s then-GC, Timothy Mayopoulos, and to BofA’s deal counsel at Wachtell.

The shareholders’ opposition brief demolishes that implication. “The record … establishes that BoA excluded Wachtell from the disclosure analysis at the critical time in the weeks before the [shareholder] vote,” the brief said. “Wachtell’s senior partners have uniformly testified that they were not informed of Merrill’s key December 3 loss estimate prior to the vote, and that Wachtell was not consulted at all on the issue of disclosure after November 20. Indeed, Wachtell did not learn of the magnitude of Merrill’s losses until December 12, when BoA contacted Wachtell one week after the vote to terminate the transaction because of Merrill’s losses.”

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.

Former Bank of America CEO Kenneth Lewis has a simple argument for why he’s not liable to shareholders who claim they were defrauded into supporting BofA’s 2008 acquisition of Merrill Lynch: It’s the lawyers’ fault. In a summary judgment brief filed Sunday night in the shareholder class action, Lewis’s counsel at Debevoise & Plimpton asserted that as Merrill Lynch’s fourth-quarter projected losses ballooned from the $5 billion BofA had estimated in November to more than $10 billion by Dec. 3, Lewis asked BofA’s then-CFO, Joe Price, whether those losses had to be disclosed to shareholders. He was informed that the CFO had “consulted with legal counsel” and had concluded that interim projections didn’t need to be made public.

Lewis’s brief implies (but does not directly state) that Price had spoken not only to Bank of America’s general counsel at the time, Timothy Mayopoulos, but also to BofA’s outside lawyers at Wachtell, Lipton, Rosen & Katz. For Lewis, it doesn’t much matter who Price talked to — or even whether Price really received the legal advice he allegedly passed along to Lewis. What’s significant, according to the former CEO’s brief, is simply that Lewis had a good-faith reason to believe disclosure wasn’t warranted. Lewis didn’t even assert a formal advice-of-counsel defense but said his “understanding of what BAC’s CFO was told by counsel” is enough to rebut shareholder claims that he intended to mislead them.

But for Wachtell, professional integrity is at stake in the guidance it gave its longtime client in the run-up to the shareholder vote on the Merrill merger. Wachtell, after all, is one of the premier M&A law firms in the country. Its reputation would be sullied if it had offered the bank advice so misguided that BofA ended up the subject not only of regulatory inquiries by at least four state and federal agencies but also of a gargantuan shareholder suit.

There’s a good reason the exchange of information in civil litigation is called discovery. If you want an example of the kind of powerful facts shareholders can obtain once they’re finally allowed to take depositions from securities class-action defendants – and remember, they only get there after surviving defense motions to dismiss – look no further than the motion for summary judgment that plaintiffs’ lawyers filed Sunday against Bank of America in the securities class action over the Merrill Lynch merger. There’s nothing like a former CEO’s admission that insiders withheld dire predictions from shareholders to boost the class’s case.

Shareholder lawyers always knew they’d have more information than usual in the securities litigation against BofA, which allegedly failed to warn investors about Merrill Lynch’s precarious finances before shareholders approved the Merrill merger in the fall of 2008. When plaintiffs’ lawyers first filed lead counsel motions in the spring of 2009, the Securities and Exchange Commission, the New York Attorney General, the North Carolina AG and even Congress were all already poking at the Merrill merger. They were focused on whether BofA adequately disclosed the billions of dollars it had agreed to set aside for bonuses to Merrill executives, in addition to the bank’s communications with shareholders about Merrill’s mounting losses in the last quarter of 2008.

Just weeks after Denny Chin (then a federal district judge in Manhattan, now on the 2nd Circuit Court of Appeals) appointed lead counsel – Bernstein Litowitz Berger & Grossmann; Kaplan Fox & Kilsheimer; and Kessler Topaz Meltzer & Check – the SEC announced a settlement with BofA for disclosure violations. And when U.S. Senior District Judge Jed Rakoff rejected the SEC’s initial settlement and demanded more information about BofA’s disclosure decisions, plaintiffs’ lawyers in the class action pounced. In October 2009, they asked Chin to order the defendants to give them whatever BofA, Merrill and bank officials were turning over to regulators and congressional investigators. In November 2009, Chin granted the motion. Whatever documents the defendants were producing to anyone else, he said, they also had to turn over to shareholders.

Of the 18 banks that challenged MBIA’s restructuring in 2009, only two – Bank of America and Société Générale – remain. On Monday, unless there’s a last-minute settlement this weekend, they will finally go to trial in New York State Supreme Court to argue that New York state insurance regulators should not have approved MBIA’s split, which stripped $5 billion in capital from MBIA’s crippled structured-finance insurance business.

But exactly what shape the trial will take – and what relief BofA and SocGen can ultimately obtain – remains unclear. Bank lawyers from Sullivan & Cromwell, MBIA counsel from Kasowitz Benson Torres & Friedman, and state lawyers from the office of New York Attorney General Eric Schneiderman are all preparing for a proceeding whose parameters have not been set. The banks call it a trial and continue to insist they are entitled to call expert witnesses such as former state insurance officials, who would opine on the adequacy of former Insurance Superintendent Eric Dinallo’s vetting of MBIA’s restructuring. MBIA and the state say the proceeding, brought under an expedited process known as Article 78, should be limited to a few witnesses with direct knowledge of the regulatory investigation. Justice Barbara Kapnick, who is overseeing the case, has called the trial “a glorified oral argument, with some testimony, the crucial testimony, to support it.”

Kapnick agreed at a hearing on Apr. 20 to permit witness testimony at the trial, but she didn’t specify who could be called as a witness. Nor did she set firm rules when she held a conference call this week with all of the parties. So the first order of business Monday will almost certainly be argument on motions to define the trial, though it’s just as likely that the lawyers will end up fighting over the witnesses one by one, as they are proposed. Kapnick has set aside 16 trial days over four weeks for the proceeding.

In an ideal world, the value of a shareholder securities claim rests entirely on its merits. And now that you’ve stopped snickering, let’s talk about the real world, where two disputed settlements test the de facto assumption that securities claims are worth what a company’s directors and officers insurance carriers are willing to pay to resolve them.

In Bank of America’s proposed $20 million settlement in Manhattan federal court of a derivative suit based on its 2008 acquisition of Merrill Lynch, a group of plaintiffs’ firms with a parallel case in Delaware Chancery Court argue that the settlement is insufficient because $20 million is only a tiny fraction of BofA’s $500 million in D&O coverage. Last week Delaware Chancellor Leo Strine refused to enjoin the New York deal, leaving it up to U.S. District Judge P. Kevin Castel to decide whether the derivative shareholders are getting enough money. That’s a sensible result: Castel, after all, is overseeing consolidated Merrill-related securities litigation against BofA, so he’ll evaluate the proposed derivative settlement with the understanding that there are lots of other claimants waiting in line for a chunk of that $500 million in D&O insurance, even as it’s whittled down by defense fees.

Meanwhile, Castel’s Manhattan federal court colleague, U.S. District Judge Lewis Kaplan, last week expressed reservations about a $90 million settlement of securities class action claims against Lehman’s former officers and directors, including former CEO Richard Fuld. Kaplan said in a May 3 order that he understood $90 million was all that remained of Lehman’s $250 million D&O policy, but wanted to satisfy himself that shareholders wouldn’t be better off if their counsel at Bernstein Litowitz Berger & Grossmann pressed on and obtained judgments against individual defendants. To that end, he ordered five former Lehman officers to turn over to him the financial records they’d already produced to a settlement magistrate, retired U.S. District Judge John Martin.

According to Bank of America’s board, if three Delaware plaintiffs’ firms wanted to settle their shareholder derivative suit accusing the board of breaching its duty when it acquired Merrill Lynch, they should have asked. Instead, the Delaware firms bickered amongst themselves and refused to participate meaningfully in settlement talks, board members’ counsel at Davis Polk & Wardwell and Richards, Layton & Finger wrote in a brief filed in Delaware Chancery Court on Wednesday.

The BofA brief, which offers a rare behind-the-scenes account of the shuttle diplomacy the bank’s lawyers engaged in as they tried to get rid of parallel derivative suits in Delaware and New York, said that the board would have been perfectly willing to reach a deal with either set of plaintiffs’ firms, and actually reached out first to Delaware counsel from Chimicles & Tikellis; Horwitz, Horwitz & Paradis; and Wolf Haldenstein Adler Freeman & Herz. BofA said it was “rebuffed” by those firms, so when shareholders’ counsel in the New York federal court case, Kahn Swick & Foti and Saxena White, approached the board with a settlement offer, the bank began the talks that resulted in a $20 million proposed settlement earlier this month.

Even in the midst of those negotiations, the bank brief said, Davis Polk partner Lawrence Portnoy took a call from a Wolf Haldenstein partner who said the Delaware firms were finally ready to talk about a deal within the limits of BofA’s directors and officers insurance coverage. But before Portnoy could bring his clients into the loop, the other two Delaware shareholder firms informed him that Wolf Haldenstein had spoken out of turn and Delaware wouldn’t settle within the D&O policy limits. (That figure hasn’t been publicly disclosed in either derivative case, but my Reuters colleague Jon Stempel calculated it to be $500 million, based on Delaware plaintiffs’ filings.)

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.