Alison Frankel

It’s way too early to assume that Manhattan federal judge William Pauley III will end up deciding the fate of Bank of America’s proposed $8.5 billion settlement with investors in Countrywide mortgage-backed securities. But that doesn’t mean it’s too early to start wondering what will happen to the proposed deal if he does.

First, a caveat: Bank of New York Mellon, the Countrywide securitization trustee that filed the case in New York state Supreme Court , has the right to request appellate review of Pauley’s ruling that the case belongs instead in federal court under the Class Action Fairness Act. And when BNY Mellon asks the U.S. Court of Appeals for the Second Circuit to hear the appeal, the bank will surely remind the appellate court of its own language in a previous Countrywide MBS case, in which the Second Circuit decided the suit should go back to state court. In his ruling Wednesday, Pauley cited the “paramount federal interests” at stake in the BofA MBS settlement. But the previous Second Circuit MBS ruling expressly rejected that rationale. “If Congress meant the consideration of a class action’s importance to the nation as a whole to trump these limiting provisions [under CAFA], it would have indicated that intent,” the Second Circuit panel wrote in Greenwich Financial v. Countrywide. “Congress wisely chose not to leave it to the federal courts to assert jurisdiction over whatever class actions seemed to judges to be ‘of national importance’ — a standard much too amorphous to admit of consistent judicial application — but instead to define concrete criteria for federal jurisdiction under CAFA.”

That language doesn’t seem to bode well for the Countrywide MBS investors who want Pauley to evaluate the proposed settlement. But this is a weird, unpredictable case. I wouldn’t bet anything more valuable than an ice cream sundae on whether the Second Circuit will take the appeal and overturn Pauley.

If the case stays in federal court, there’s going to be a preliminary fight over what shape it takes. There’s no federal analog for New York state’s Article 77, the vehicle under which BNY Mellon filed this case. Article 77 permits a trustee to obtain a judge’s endorsement of its actions, under a standard that requires only that the trustee behaved reasonably. In his ruling Wednesday, Pauley called on all of the parties to submit a joint proposal for how the case should proceed in federal court. BNY Mellon and the Gibbs & Bruns investor group that supports the proposed settlement are likely to argue that Pauley should hear the case as a declaratory judgment action that would essentially replicate the Article 77 state court proceeding. They’ll argue that Pauley should only decide the question at issue in the case as it was filed: Did BNY Mellon act reasonably as a trustee in reaching the proposed settlement?

But Grais & Ellsworth – the law firm that moved the proposed settlement to federal court — is likely to have a different idea of how Pauley should structure the case. At a Sept. 21 hearing, Owen Cyrulnik of Grais & Ellsworth proposed that the case be treated as a class action, with each of the 530 trusts in the proposed settlement treated as a class member. (Keep in mind that Grais & Ellsworth’s goal is to win the right to litigate outside of the settlement on behalf of investors in three of the Countrywide MBS trusts.) That would presumably permit Pauley much more power over the merits of the settlement. Pauley has already shown considerable skepticism about BofA’s attempt to settle the claims of thousands of noteholders in 530 trusts through a vehicle that doesn’t give investors any right to opt out. Whatever structure he devises if he keeps the case, he’s probably not going to permit BofA, BNY Mellon, and the Gibbs & Bruns group to bind all Countrywide mortgage-backed noteholders to a settlement they had no hand in negotiating.

The key paragraph in Manhattan federal judge William Pauley III‘s 21-page ruling Wednesday in Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed-securities investors is the last one.

“The settlement agreement at issue here implicates core federal interests in the integrity of nationally chartered banks and the vitality of the national securities markets,” Pauley wrote. “A controversy touching on these paramount federal interests should proceed in federal court.”

That sentiment infuses the judge’s analysis of where BofA’s proposed deal should be evaluated: Before Justice Barbara Kapnick in Manhattan state Supreme Court, where Countrywide MBS trustee Bank of New York Mellon filed the case as a special proceeding under an obscure state law; or before Pauley in federal court, where there’s no analogous procedure for binding thousands of investors in 530 trustees to a settlement only 22 of them had a hand in negotiating. Pauley’s decision to keep the case in federal court throws the settlement off the carefully-designed track the bank, the trustee, and the investor group that supports the deal hoped to keep it on.

The most dramatic moment at the Sept. 21 hearing on Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed securities investors came near the end, when Gibbs & Bruns partner Robert Madden stood up to address Manhattan federal judge William Pauley’s concerns about how the settlement came to be. Tall and clear-spoken, Madden captured the judge’s attention as he explained that his clients, a group of 22 large institutional investors, hadn’t entered a sweetheart deal with BofA, but had banded together to force the bank to pony up billions to investors for claims BofA thought it would never have to deal with.

“The problem was that these repurchase claims were lying fallow,” Madden said, according to the transcript of the hearing. “No one was doing anything. None of (the investors now objecting to the deal) were doing anything. And, I’m sorry to say, the trustee wasn’t doing anything. Limitations were running on those claims, and nothing was happening.”

Or was it?

I’ve learned that in the summer of 2010, as Gibbs & Bruns began to push Countrywide MBS trustee Bank of New York Mellon to act on its assertions that mortgages underlying the Countrywide securities were deficient, another group of Countrywide MBS investors was finalizing its own notice of default to serve on BNY Mellon. Members of the RMBS Clearinghouse, run by former Patton Boggs partner Talcott Franklin, had undertaken an extensive analysis of the underlying Countrywide mortgages, and, according to two sources familiar with the Clearinghouse’s activities, were on the verge of sending BNY Mellon a notice that would trigger put-back litigation.

When New York attorney general Eric Schneiderman sued Bank of New York Mellon in August, the AG asserted that the Countrywide mortgage-backed securitization trustee had breached its duty to MBS investors. “As trustee, BNYM owed and owes a fiduciary duty of undivided loyalty,” said the AG’s suit, which was filed as a counterclaim in BNY Mellon’s case seeking approval of the proposed $8.5 billion Bank of America settlement with MBS investors. “[BNYM] breached that duty to [investors'] detriment and disadvantage, by failing to notify them of issues regarding the quality of loans underlying their securities.”

But according to BNY Mellon, it had no such duty.

The bank’s lawyers at Mayer Brown and Dechert filed a 14-page brief this week outlining its interpretation of the responsibilities of an MBS securitization trustee. The filing came at the direction of Manhattan federal Judge William Pauley, who’s deciding whether the BofA MBS settlement should be heard in state court, where BNY Mellon filed it, or in federal court, where key objectors to the proposed settlement want it to proceed. Pauley was concerned with the “securities exception” to the Class Action Fairness Act, which could end up guiding his decision on the forum question. For BNY Mellon, however, any discussion of its trustee responsibilities is fraught with danger. It’s already facing the New York AG’s claims, and several other state attorneys general have threatened similar actions. MBS investors, meanwhile, are pushing BNY Mellon (and other securitization trustees) to bring put-back claims, with the implied threat that investors will take action against trustees unless they do.

BNY Mellon’s brief pushes back against that pressure, asserting that the trustee’s responsibilities don’t extend much beyond the ministerial duties spelled out in the pooling and servicing agreements governing MBS trusts. New York law, the filing said, imposes only two addition burdens: the trustee must avoid conflicts of interest and must perform its ministerial functions “with due care.” According to BNY Mellon, there’s an important distinction between ordinary trustees and indenture trustees. Indenture trustees, it said, do not have “a traditional duty of due care.” Its duties — beyond those two basic responsibilities implied in New York law — are strictly defined by the pooling and servicing trust contracts.

On Wednesday night, Grais & Ellsworth filed a 29-page brief laying out its arguments for why Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed securities investors belongs in federal court, not in New York state court, where Bank of New York Mellon, as Countrywide MBS trustee, filed it. I’ll talk about Grais’s assertions in a moment, but first I want to explain why the jurisdictional question is so crucial to the ultimate fate of BofA’s proposed deal. Two transcripts tell that tale.

BNY Mellon, you’ll recall, used a highly unusual device when it asked for court approval of the proposed $8.5 billion settlement in late June. The bank filed the case as an Article 77 proceeding in New York state supreme court, taking advantage of a state law that permits trustees to seek a judge’s endorsement of their decisions. Using Article 77 was a deliberate tactic by BNY Mellon, BofA, and the 22 institutional investors who support the settlement. The lawyers who put together the deal considered and rejected other possible vehicles for court approval, but decided that Article 77 was the fastest, cleanest way to resolve claims involving 530 separate trusts. The provision, which is usually invoked in garden-variety trust cases, gives broad discretion to trustees, who are generally assumed to be acting in the best interests of trust beneficiaries.

The Article 77 strategy looked brilliant at the first hearing on the settlement before New York state supreme court judge Barbara Kapnick. According to a transcript of the August 5 hearing, Judge Kapnick shot down objectors to the deal who, in her view, wanted to proceed with discovery as if the case were a class action. “It’s important to remember that this petition was brought as an Article 77 petition,” the judge said. “It’s not a class action. There aren’t provisions in there to opt out that you are talking about. That’s not what this is. If you started it, maybe that’s what you would have done, but they started it and that’s what they did. I have to work, at least now, within the confines of the proceeding that is before me.”

There is never a dull moment in Bank of America’s attempt to resolve its Countrywide mortgage-backed securities liability. In a stunning move Friday, the law firm leading the fight against BofA’s proposed $8.5 billion settlement with Countrywide MBS noteholders removed the case from New York state supreme court to federal court. “The purpose of removal is to make sure that this proceeding is adjudicated in the proper forum,” Grais & Ellsworth wrote in a letter to lawyers for Bank of New York Mellon (the Countrywide MBS trustee) and for the big institutional investors who crafted the proposed settlement. “We believe in good faith that this proceeding is subject to federal jurisdiction as a mass action under the Class Action Fairness Act.” (Here’s the Grais & Ellsworth letter with the removal petition attached.)

The removal to federal court plunges the proposed settlement, at least temporarily, into more uncertainty than ever. Judge Barbara Kapnick, who is presiding over the unusual state court proceeding to evaluate the proposed deal, had imposed an August 30 deadline for Countrywide MBS investors to intervene in the case. She had also established a preliminary schedule for the discovery Grais & Ellsworth and other objectors’ counsel have demanded from BNY Mellon, BofA, and the institutional investors and their Gibbs & Bruns counsel. The removal to federal court means that Judge Kapnick isn’t in charge of the case, so it’s not clear whether lawyers are required to abide by her schedule.

The Grais & Ellsworth filing was a surprise tactic. The firm has been in the state court litigation since early July, filing its initial petition to intervene only days after Bank of New York Mellon, as Countrywide trustee, filed a suit asking for court approval of the settlement of investors’ claims. David Grais even appeared before Judge Kapnick at an August 5 hearing on objectors’ requests for expedited discovery. Grais & Ellsworth apparently waited to remove the case to federal court until Judge Kapnick granted the firm’s motion to intervene in the state court case on Monday. (Grais, who was not in the office Friday, didn’t respond to my e-mail; his partner Owen Cyrulnik, who signed the letter to opposing counsel, didn’t respond to an e-mail and phone message.)

As expected, the Delaware attorney general’s office moved Tuesday night to intervene in Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed noteholders. The Delaware petition to intervene and supporting brief are notable for their moderate tone, in contrast to last week’s fiery objection and counterclaims by the New York attorney general. Tuesday’s filings, signed by Delaware deputy AG Jeremy Eicher, said that Delaware is concerned about BofA’s indemnification of the MBS trustee, Bank of New York Mellon — the same conflict-of-interest allegation raised by just about every intervenor who so far has surfaced in the case. Delaware, which noted that two of the Countrywide MBS trusts are Delaware vehicles, argued that it needs more information about the proposed settlement in order to protect investors.

The real story, though, is that both the New York and Delaware AGs believe BofA and BNY Mellon can’t resolve their liability to MBS investors without including regulators in the deal. After all, the proposed $8.5 billion settlement encroaches on turf already claimed by New York AG Eric Schneiderman and Delaware AG Joseph Biden III; in June, the New York Times broke the news that the New York and Delaware AG offices were investigating the banks involved in the mortgage-backed securitization process — including sponsors and underwriters such as Countrywide and BofA and trustees such as BNY Mellon.

The Delaware and New York securitization probes, which are running parallel to the 50-state AG investigation of banks’ mortgage foreclosure practices, gave Schneiderman and Biden a platform to argue that MBS investors, as well as homeowners, are affected by slipshod mortgage underwriting practices and widespread foreclosures. In the wider foreclosure-resolution negotiations between mortgage lenders and state AGs, New York and Delaware have taken a lead in calling for banks to also address MBS liability.

Before Thursday night, opposition to Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed securities investors consisted of a handful of investor groups represented by a handful of law firms. Even if you counted the six Federal Home Loan Banks that have moved to intervene but haven’t yet gone on record opposing the deal, intervenors represented less than 7 percent of all Countrywide MBS noteholders. The 22 gargantuan institutional investors that negotiated the settlement were a much more potent force.

That all changed when New York attorney general Eric Schneiderman -- in a move that stunned deal proponents — filed an explosive motion to intervene in the $8.5 billion settlement. Schneiderman didn’t just register his opposition to the proposed settlement, which he said had been reached “without ever giving beneficiaries or their representatives an opportunity to test [whether] the proposed settlement is reasonable.” He went far, far beyond mere opposition: Schneiderman accused the Countrywide MBS trustee, Bank of New York Mellon, of breaching its fiduciary duty and said that Bank of America may have aided and abetted the breach. And to show that he was serious about those assertions, Schneiderman actually filed counterclaims against BNY Mellon along with his intervention motion.

The countersuit — a truly revolutionary filing — alleges three causes of action against BNY Mellon, in what is thought to be the first time the AG has accused an MBS trustee of fraud. Schneiderman claimed the bank breached its duty to investors because the settlement includes indemnification for the trustee — a “direct financial benefit” for BNY Mellon, according to the AG’s filing. Schneiderman also asserted that BNYM let down Countrywide MBS investors long before proposing the $8.5 billion settlement, by failing to notify certificate holders that underlying Countrywide mortgages were in default. Finally, the New York AG accused Bank of New York Mellon of securities fraud under New York’s Martin Act.

Faced with a barrage of investor criticism (see here, here, and here) of its proposed $8.5 billion mortgage-backed securities settlement with Bank of America, Bank of New York Mellon, the MBS trustee, has released the expert reports underlying the agreement. The reports—in particular the valuation report by Brian Lin, the managing director of RRMS Advisors—provide an extraordinary window into how this deal got done. They may not change anyone’s mind about the fairness of the settlement proposal, but they answer a lot of the questions that challengers of the deal have raised.

Let’s start with the numbers that were on the table when Gibbs & Bruns and its group of 22 major Countrywide MBS investors sat down across from Bank of America and its lawyers from Wachtell, Lipton, Rosen & Katz. The outside range of the investor group’s demands was $52.6 billion, according to Lin’s report. At the low end, the investors asked for $27 billion. Bank of America, according to the Lin report, calculated that investors could claim no more than $4 billion.

Lin began his evaluation of the investors’ Countrywide MBS claims by reviewing the presentations that the Gibbs group and BofA made to one another. (His company, RRMS, is a mortgage-backed securities consultant that advises MBS investors, packagers, and issuers. BoNY and its Mayer Brown lawyers selected Lin’s firm to provide an expert opinion after beauty contest interviews with several candidates, which had to have MBS expertise but couldn’t have a significant relationship with Bank of America.) Interestingly, Lin’s report indicates that the valuation methodology employed by both the investors and BofA was almost the same, although the two sides obviously plugged different assumptions into the basic formula.