Alison Frankel

The biggest news to come out of Tuesday’s ongoing hearing to evaluate Bank of America’s proposed $8.5 billion settlement with investors in 530 Countrywide mortgage-backed securities trusts is that the Office of the Comptroller of the Currency gave Bank of America clearance to put Countrywide into bankruptcy if Countrywide’s liabilities threatened BofA’s existence. Or at least that’s what Kathy Patrick of Gibbs & Bruns, who represents 22 institutional investors that negotiated the proposed deal with BofA and Countrywide MBS trustee Bank of New York Mellon, said her clients were told by BofA Chief Risk Officer Terry Laughlin in 2011 as they tried to come to terms on a settlement of investor claims that Countrywide breached representations and warranties about the underlying mortgage loans. To my knowledge, Patrick’s assertion – which was intended to support her argument that MBS investors risked getting much less than $8.5 billion for their put-back claims – is, if true, the first tangible indication that Bank of America ever did more than hypothesize bankruptcy for Countrywide.

Objectors to the proposed settlement, meanwhile, scored points with their argument that BNY Mellon had options aside from acquiescing to what AIG counsel Michael Rollin of Reilly Pozner called “a sweetheart deal for BofA.” Both Rollin and his partner Daniel Reilly, who occupied most of the three hours of opening arguments by objectors (including 22 AIG-related entities, several Federal Home Loan Banks, the investment manager Triaxx and a variety of pension funds and local banks), emphasized that after the Countrywide MBS trustee received a demand letter from Gibbs & Bruns on behalf of major institutional investors, the trustee could simply have begun requesting loan files from BofA as the servicer of Countrywide MBS trusts, evaluating those loan files for material breaches, and demanding that Bank of America repurchase defective loans.

Rollin played a deposition clip from a BofA servicing executive, who said it was the bank’s official policy to repurchase loans that breached representations and warranties. That statement alone, Rollin said, proved the fallacy of arguments that BNY Mellon and the Gibbs & Bruns investor group could not have pierced the corporate veil to tag Bank of America with successor liability for Countrywide’s breaches. The trustee could simply have asserted put-backs to BofA as the servicer, Rollin suggested, without ever getting into the quagmire of successor liability. After all, the Reilly Pozner lawyers argued, the $8.5 billion settlement amounts to the put-back of only 2.5 percent of the 1.6 million mortgages underlying 530 Countrywide MBS trusts covered by the deal. Had BNY Mellon taken the alternative route of demanding the put-back of defective loans, they said, the trustee could have forced BofA to buy back a higher percentage of loans.

“The trustee wants your honor to believe that this settlement was the only way,” Rollin told New York State Supreme Court Justice Barbara Kapnick. “But it wasn’t the only way. There were other ways to achieve more.”

But for a hearing that is supposed to determine whether Bank of New York Mellon made a reasonable and good-faith decision to settle put-back claims on behalf of all 530 Countrywide MBS trusts, there was an awful lot of hostility exchanged Tuesday by lawyers for the two camps of MBS investors in the case, the Gibbs & Bruns group that negotiated the deal and the AIG-led coalition that opposes it.

What a complaint U.S. Attorney Preet Bharara filed against Countrywide and Bank of America on Wednesday!

Earlier this month, when the New York Attorney General filed accusations of securitization fraud against JPMorgan Chase, I said we should put aside cynicism about the AG’s copycat allegations and be grateful that, at last, a government official was demanding accountability for systemic corruption in the mortgage-bundling business. The new complaint against BofA demands no such nose-holding: It asserts powerfully detailed — and original — accusations of billion-dollar fraud in the way Countrywide approved mortgages destined for purchase by Fannie Mae and Freddie Mac, and in Countrywide’s and BofA’s subsequent (alleged) refusal to repurchase defective loans.

To be sure, the U.S. Attorney had help from a whistle-blower, a former Countrywide Home Loans executive vice president named Edward O’Donnell. O’Donnell filed a relatively bare-bones False Claims Act complaint last February. As always in FCA cases, the complaint was sealed as the Justice Department checked out the allegations and deliberated whether to intervene in the case. Those deliberations can take years, but not in this case, when the government is under intense pressure to make good on promises of fighting mortgage fraudsters. Eight months after O’Donnell initiated his action in federal court in Manhattan, the U.S. Attorney’s office intervened, making the suit public.

AIG’s $6 billion in mortgage-backed securities claims against Countrywide survived a near-death experience late Wednesday, when U.S. District Judge Mariana Pfaelzer of Los Angeles issued her ruling on Countrywide’s statute of limitations defense. In a 25-page opinion, Pfaelzer tossed AIG’s federal securities claims, as well as some fraud and negligent misrepresentation claims by AIG subsidiaries. But AIG said in an email statement that the ruling leaves alive “more than 98 percent of the recovery it seeks.” For a plaintiff that feared the worst – as AIG most certainly did, thanks to a silver bullet Pfaelzer handed to Countrywide in February – the judge’s ruling is a stunning reprieve.

Here’s why. Pfaelzer has not been a particularly good friend to investors in Countrywide mortgage-backed securities, particularly when it comes to the statute of limitations on their claims. In a ruling last August, Pfaelzer said that MBS investors were on notice of potential federal securities claims against Countrywide as of Feb. 14, 2008. Given the three-year time limit on those federal claims – and Pfaelzer’s role overseeing all Countrywide MBS litigation in federal court – her ruling meant that any Countrywide investor who hadn’t filed a complaint by Feb. 14, 2011, or who didn’t have a tolling agreement was too late.

Countrywide MBS plaintiffs had an alternative route to recovery, though, through fraud and negligent misrepresentation claims under state laws, some of which have less restrictive time limits. New York, for instance, has particularly generous laws, giving plaintiffs up to six years to file fraud cases. So the New York-based insurer AIG didn’t completely despair when its Countrywide MBS claims were severed from its $10 billion suit against Bank of America and transferred to Pfaelzer in Los Angeles. (AIG doesn’t think any part of its MBS case belongs in federal court, but that’s another story.) The insurer had to expect that in Pfaelzer’s court its federal securities case wouldn’t survive Countrywide’s statute of limitations defense. But it also had reason to be confident that its New York state fraud claims would be fine.

None of the firms battling Countrywide and Bank of America on behalf of mortgage-backed securities investors has dedicated more resources to the fight than Quinn Emanuel Urquhart & Sullivan. Quinn represents some of the biggest MBS claimants in suits against Countrywide, including AIG and the Federal Housing Finance Agency. The firm also represents MBIA in the bond insurer’s long-running New York State case against Countrywide. If anyone on the plaintiffs’ side has the goods on Countrywide and Bank of America, in other words, it’s Quinn Emanuel.

That’s why a ruling Thursday by U.S. District Judge Mariana Pfaelzer of Los Angeles federal court is such a blow to Countrywide MBS investors. Pfaelzer, who’s overseeing the consolidated federal-court MBS litigation against Countrywide, dismissed Allstate’s successor-liability and fraudulent-conveyance claims against Bank of America, with prejudice. Quinn represents Allstate, and offered detailed allegations that Bank of America’s 2008 acquisition of Countrywide was structured to deliver Countrywide’s revenue-producing businesses to BofA while simultaneously walling off the mortgage company’s looming liability for subprime mortgages and mortgage-backed securities.

Pfaelzer said, however, that Quinn Emanuel hadn’t come up with sufficient facts to back its assertions. She rejected two different theories: first, that Bank of America and Countrywide engaged in a fraudulent conveyance or transfer; and second, that BofA’s acquisition of Countrywide was a de facto merger. The judge has previously found for Bank of America in two other rulings on the de facto merger question (here’s Pfaelzer’s April 2011 opinion in an MBS class action against Countrywide), but this is the first time she’s delivered a definitive ruling on fraudulent-conveyance allegations.

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 drumbeat of calls for Bank of America to put what remains of Countrywide into Chapter 11 has grown so loud and relentless that according to a report last month by Bloomberg, BofA is actually considering what’s been called the “nuclear option.” Resorting to a Countrywide Chapter 11 would be fraught with unknown but surely devastating consequences for a commercial bank, as bankruptcy guru Harvey Miller of Weil, Gotshal & Manges explained in a fascinating Bloomberg video. But more significantly, there’s a good chance it wouldn’t accomplish the intended goal of roping off BofA’s liability for Countrywide’s mortgage-backed securities mess.

If Bank of America can succeed in limiting its MBS litigation losses to Countrywide’s remaining assets, it will have to show that it didn’t assume liability for Countrywide’s conduct when it acquired the mortgage company in 2008. That’s known as successor liability, and it was one of the key questions Bank of New York Mellon considered as it weighed the fairness of BofA’s proposed $8.5 billion settlement with Countrywide MBS investors. BNY Mellon’s expert, Professor Robert Daines of Stanford Law School, produced a 58-page treatise that concluded it would be very difficult for MBS investors to establish BofA’s successor liability.

Professor Daines looked at a variety of theories plaintiffs could pursue to stick BofA with the hot potato of Countrywide MBS liability. Most, he said, are non-starters, but if there’s any route to successor liability it would probably be through an argument, under New York law, that BofA’s acquisition of Countrywide was a de facto merger. There’s a four-prong test for such a determination, according to the professor, but its interpretation depends to a very large extent on the judge hearing the case. “The doctrine is thus unpredictable and there is even a disagreement about how the four-factor test should be applied: several decisions suggest that the courts apply a ‘flexible’ standard: i.e., they consider all of the factors and that any of these factors could trigger a de facto merger,” Professor Daines wrote in the analysis for BNY Mellon.

Last week a rumor made the rounds of hedge funds that trade in Bank of America and MBIA shares: The bank had reputedly agreed to settle the bond insurer’s mortgage-backed securities fraud and put-back claims for $5 billion. The rumor turned out to be false, or at least premature, since no settlement is in the offing at the moment. But the size of the rumored deal gives you a sense of the magnitude of the litigation between the banks that packaged and sold mortgage-backed securities and the bond insurers that wrote policies protecting MBS investors. We are talking about billions of dollars — perhaps tens of billions — at stake in suits by MBIA, Syncora, Ambac, and Financial Guaranty against Countrywide, Credit Suisse, GMAC, Morgan Stanley, and other MBS defendants.

Last week, Manhattan state supreme court judge Eileen Bransten, who has been the leading jurist in the bond insurer cases against MBS issuers, heard oral arguments on the issue that will determine the magnitude of the banks’ liability: Can bond insurers demand damages based on banks’ misrepresentations on the day deals were signed? Or can MBS issuers point to the housing bust, and not their deficient underwriting, as the reason so many loans have gone bad in the years after the MBS were sold? The case argued Wednesday before Judge Bransten concerned summary judgment motions in the MBIA and Syncora suits against Countrywide, but as the judge noted in her introductory remarks to the overflow crowd in her courtroom, “I understand that this [argument] has a major impact on lots of people.”

For everyone who couldn’t squeeze into Judge Bransten’s courtroom, I’ve gotten hold of transcripts of the day-long hearing. I’m going to focus on the morning session on the loss causation issue, but here’s a link to the afternoon session on consolidating the issue of Bank of America’s successor liability for Countrywide MBS, which is specific to BofA.

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.

Monitoring the docket Tuesday afternoon, as motions to intervene in Bank of America’s proposed $8.5 billion settlement with Countrywide mortgage-backed securities noteholders piled up, was sort of like watching guests arrive a cocktail party. Oh, here come the hedge funds. Look, there’s a bunch of insurance companies. The public pension funds always head straight for the shrimp. Homeowners? Did anyone invite them? And, of course, Goldman Sachs had to show up fashionably late.

Other party guests may have looked glitzier, but none of Tuesday’s intervention motions is more important to the ultimate determination of the proposed settlement’s fairness than the one filed by the Federal Housing Finance Agency, the government agency that oversees Fannie Mae and Freddie Mac. No one knows the value of mortgage repurchase claims-the claims the proposed BofA deal resolves-better than FHFA.

Here’s why. In the MBS boom years, Fannie Mae and Freddie Mac bought hundreds of billions of dollars of mortgages from Countrywide and many other lenders. The government-sponsored entities packaged the loans into mortgage-backed bonds, just like other MBS issuers. But after the housing bubble burst, and Fannie and Freddie were placed under the federal government’s conservatorship, FHFA had both more of an incentive to get information about those underlying loans than other MBS issuers–and more power to get the information. In July 2010 the agency announced that it had issued 64 subpoenas for mortgage loan documents. Last October it brought in Quinn Emanuel Urquhart & Sullivan to advise on litigation against mortgage lenders that breached representations and warranties about the loans they sold to Fannie and Freddie.

Last October, when BofA’s proposed $8.5 billion settlement of Countrywide mortgage-backed securities breach of contract claims was just a twinkle in Kathy Patrick’s eye, David Grais of Grais & Ellsworth told me that one of the biggest problems for lawyers representing disgruntled MBS noteholders was the investors’ reluctance to come forward. Noteholders were afraid to provoke the banks that issued mortgage-backed securities, Grais said, so they didn’t want to sue under their own names. That’s why one of Grais & Ellsworth’s early put-back cases was filed on behalf of an ad hoc coalition of anonymous Countrywide MBS investors operating under the name Walnut Place.

It’s also why the Gibbs & Brun investor group that negotiated the BofA deal made such a splash. Kathy Patrick’s big institutional investor clients, including Pimco, BlackRock, and the New York Federal Reserve’s Maiden Lane funds, showed their faces when they offered public support for the proposed $8.5 billion settlement. In fact, after Grais’s Walnut Place investors filed an objection to the proposed deal, supporters of the settlement drew a contrast between the Gibbs group’s public face and Walnut’s anonymity.

But as time runs out for investors to claim a place in the litigation over the proposed settlement, more and more Countrywide MBS noteholders are shrugging off secrecy. On Monday, six new interventions motions appeared in either the original state court docket or in federal court, where Grais & Ellsworth removed the case last week. (A seventh intervention petition, by American Fidelity Assurance, popped up Tuesday morning.) The big news was the placeholder petition Grais filed on behalf of the Federal Deposit Insurance Corporation, which says it is “the receiver of numerous banks and owner of many certificates issued by many of the trusts that would be covered by the proposed settlement.” (Hard to know from that how big a stake the FDIC has in the Countrywide MBS offerings.) Like the six Federal Home Loan Banks that have already intervened in the proposed settlement, the FDIC isn’t yet objecting to the deal, but said it wants more information to evaluate the fairness of the deal.