Alison Frankel

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 judge opted for a broad interpretation of the federal Class Action Fairness Act, a 2005 law intended to keep big cases involving lots of claimants out of state court. Grais & Ellsworth, which represents a group of Countrywide MBS investors who don’t like the proposed BofA settlement, removed the case to federal court under CAFA’s provisions for mass cases. (I’ve written here and here about Grais & Ellsworth’s rationale for the removal and BNY Mellon’s arguments against removal.) The test for a mass action involves three questions: Does the case involve monetary relief; does it involve 100 or more plaintiffs; and do their claims involve common questions of law or fact? In siding with Grais & Ellsworth on each of those questions, Pauley considered the implications of the proposed settlement, not the technicalities of Article 77, the New York law under which the case was filed.

“BNYM’s argument exalts form over substance,” he wrote with regard to arguments by BNY Mellon’s Mayer Brown lawyer Matthew Ingber that the Article 77 proceeding didn’t involve a claim for monetary relief, since all the trustee sought was a ruling that BNY Mellon had acted reasonably in reaching the settlement. Pauley was similarly scornful of the trustee’s assertion that the Article 77 proceeding involved only one plaintiff, BNY Mellon. “BNY Mellon’s argument is untenable,” he wrote. “BNYM is trustee for 530 separate and unique trusts and seeks approval for its decision to settle the claims of each individual trust.”

In all, Pauley seemed to find the settlement supporters’ Article 77 gambit to have been too clever by half. He noted that his research uncovered only 28 Article 77 decisions in the last 40 years, many of which involved uncontested proceedings and garden-variety trust administration issues. He said, in fact, that he could find no authority to support the idea that a single Article 77 proceeding can be used to evaluate a decision affecting 530 trusts.

BNY Mellon had also argued that Grais & Ellsworth’s client, an investor group called Walnut Place, doesn’t have the right to remove the proposed settlement to federal court because it’s not a defendant in the case. Indeed, as Ingber of Mayer Brown argued at the Sept. 21 hearing before Pauley, Walnut Place will receive money if the proposed settlement is approved, so it can’t be considered a defendant under the traditional definition. Pauley concluded, however, that BNY Mellon was once again looking at form rather than substance, calling its argument “crabbed.” Walnut Place, he wrote, was adverse to BNY Mellon, the Article 77 plaintiff, so it is a defendant for the purposes of removal.

Finally, the judge shredded settlement supporters’ hole card: a ruling by the U.S. Court of Appeals for the Second Circuit that concluded a previous Countrywide MBS case — a Grais & Ellsworth suit — belonged in state court under the “securities exception” to the Class Action Fairness Act. As I’ve explained, the securities exception is counterintuitive. If the only claims at issue in a case involve federal securities laws, the case falls under the exception and goes back to state court. If state law claims are involved, it stays in federal court. (Weird, right?)

Pauley found that even though the previous Second Circuit ruling involved Countrywide mortgage-backed securities, it concerned the rights of MBS investors. The proposed settlement, on the other hand, involves the rights and duties of BNY Mellon as securitization trustee. The bank had argued that those duties derive from the contracts that govern the Countrywide MBS; but even BNY Mellon conceded in a round of briefing earlier this month that it also had common-law trustee duties. “Because a court evaluating BNYM’s conduct as trustee must rely on New York common law, and not simply the bare text of the [trust contracts],” the judge wrote, “the securities exception does not apply here.”

BNY Mellon and the Gibbs & Brun investor group that supports the proposed settlement will surely ask for Second Circuit review of Pauley’s ruling, although it’s not clear to me whether they’ll have to get Pauley’s leave to file an interlocutory appeal. (Remember, Bank of America is technically not a party to the case.) If the Second Circuit upholds the ruling, it’s very bad news for BofA. Given the harsh treatment Pauley has dished out to settlement supporters in two hearings and in Wednesday’s ruling, it’s clear the lawyers who crafted the $8.5 billion dollar deal have a long way to go before they get Pauley to sign off. (There’s also the rather enormous matter of what Pauley called the “procedural difficulty inherent in continuing this action in federal court,” where there’s nothing remotely like an Article 77 proceeding.)

I believe there’s support for the assertion that Judge Pauley interpreted the Class Action Fairness Act too broadly in a pair of recent rulings by two federal circuits considering whether state attorney general parens patriae suits are mass actions. Both the Ninth Circuit and the Fourth Circuit have said that judges must hew closely to the language of CAFA in deciding whether a case is a mass action. Pauley wrote that he was “reluctant to indulge” BNY Mellon’s reliance on CAFA’s legislative history. We’ll have to wait and see if the Second Circuit supports his reluctance.

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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.

The asset management firms BlackRock and PIMCO were key members of Franklin’s Clearinghouse. But they were also Gibbs & Bruns clients. On Aug. 4, 2010, Gibbs & Bruns partner Kathy Patrick sent an email to her MBS clients, including BlackRock, PIMCO, the New York Federal Reserve Bank, and MetLife. In that email, Patrick made it clear that Gibbs & Bruns clients should not support the Clearinghouse’s effort.

“Since some of you were previously in the Clearinghouse, it may be that Mr. Franklin believes (mistakenly) that he is authorized to send a notice of default on your behalf,” the email said. “If you have not already done so, it is important that you promptly advise him that he is not authorized to send a notice of default on your behalf … You should also make clear that he should not include your bonds in the count of any bonds he uses to reach the percentages required to tender such a notice.”

After Patrick’s email went out, PIMCO and BlackRock left the Clearinghouse, which never sent its notice of default to BNY Mellon. Gibbs & Bruns’s clients were left as the only investors pushing the trustee to act on their breach-of-contract claims against Countrywide successor BofA.

Patrick told me there was nothing inappropriate about her confidential email to her own clients. Nor did any action by her clients prevent the Clearinghouse from proceeding without them. (More on both points below.) Moreover, she said, Madden’s comments to Judge Pauley were true: Gibbs & Bruns’s clients were the only Countrywide MBS investors who took meaningful action to enforce their claims.

Nevertheless, in a deal that has generated so much controversy — including complaints that the Gibbs & Bruns group shut other investors out of the settlement process — the Kathy Patrick email is going to give opponents of the proposed $8.5 billion agreement new ammunition. At the very least, the new disclosures will mean more complications and delay for supporters of the embattled settlement.

This story begins back in 2009, when Tal Franklin (who did not return my phone calls) had a brilliant idea: because investors have to have significant voting rights to demand action from securitization trustees, Franklin devised a sort of dating service for MBS holders. They could register their bonds with the Clearinghouse, then investors with holdings in particular trusts could team up to obtain the requisite voting rights for asserting put-back claims. The Clearinghouse attracted some of the biggest MBS investors in the country, including Fannie Mae, BlackRock, and PIMCO.

Franklin wasn’t the only lawyer interested in mortgage-backed securities litigation, though. By February 2010, PIMCO had already retained its longtime lawyers at Gibbs & Bruns to represent it in investigating potential MBS claims. That month, Gibbs & Bruns participated in a PIMCO-organized conference for MBS investors. According to Patrick, Franklin also spoke at the conference, making a pitch for investors to join the Clearinghouse. Patrick and Franklin spoke once on the phone later that month, Patrick said. Since then, they haven’t talked.

BlackRock was at the February 2010 conference. By April or May, it had also signed a client agreement with Gibbs & Bruns. (Kathy Patrick goes way back with BlackRock: she represented a predecessor mutual fund in a 1990s case involving for-profit prisons in Texas.)

On June 17, Gibbs & Bruns sent the first letter on behalf of its clients to BNY Mellon. The letter, according to Patrick, asserted that the securitization trustee was obligated to take action on non-performing Countrywide mortgages. Gibbs & Bruns also demanded a meeting with BNY Mellon’s then-lawyers at Pillsbury Winthrop.

Meanwhile, a leading member of Franklin’s Clearinghouse, Bill Frey of Greenwich Financial, was pulling together data on Countrywide MBS defaults, based on first-lien mortgages BofA agreed to modify despite second-lien mortgages on the same property. (Frey subsequently discussed the strategy at an October 2010 MBS investors’ conference organized by David Grais of Grais & Ellsworth.) Frey found, according to his comments at that conference, “defaults in every single (Countrywide MBS) trust.” Fannie Mae, another Clearinghouse member, reviewed and ultimately endorsed Frey’s analysis.

Throughout the early summer of 2010, Clearinghouse leaders held long conference calls to decide how to proceed against Bank of New York Mellon and Countrywide, based on Frey’s evidence of default. By early August, Franklin had prepared a draft notice of default to be sent to BNY Mellon. I’ve been told the draft notice — which I’ve been unable to obtain — included the evidence Frey had assembled of specific breaches in specific trusts.

Then Patrick sent the Aug. 4 email to her clients and the Clearinghouse effort fell apart.

“Several of you have contacted me to indicate that the alternative clearinghouse organized by Tal Franklin may be on the verge of sending a letter to Bank of New York declaring BONY in default of its obligations under the Countrywide (pooling and servicing agreements),” the email said. “That is not in your interests.”

Gibbs & Bruns, the email said, believed it was making progress with BNY Mellon and did not want that progress to be halted by the Clearinghouse notice of default. “We were aggressively pushing BNY Mellon to take action throughout the summer,” Patrick told me. “Our clients were understandably anxious that a lawyer they had not engaged was purporting to act on their behalf.”

Patrick said the email, which was sent only to her clients, didn’t seek to squelch the Clearinghouse, but just to remind her clients to make sure Franklin knew what they wanted to do. “All our clients did was say, ‘You can’t use our holdings (to reach the 25 percent voting rights threshold),’” Patrick told me. “If the Clearinghouse had 25 percent in any deal and had information indicating default, they should have sent the notice. I don’t know why they didn’t.”

They didn’t because without PIMCO and BlackRock, the Clearinghouse couldn’t muster the requisite voting rights. The other Clearinghouse investors were effectively stranded. And that leads to a question that has dogged supporters of the proposed $8.5 billion BofA settlement: why didn’t Gibbs & Bruns invite more Countrywide MBS investors and their lawyers into talks with BNY Mellon and BofA? I’ve previously reported on AIG’s claim that Patrick didn’t return a call from its lawyers at Quinn Emanuel Urquhart & Sullivan (Patrick said the Quinn lawyer who called didn’t identify himself as counsel to AIG) and David Grais’s assertion that he was told he could not participate directly in settlement talks (Patrick has said that Grais’s discussions were with BofA and the trustee, not her). Patrick has always said that she responded to any Countrywide MBS investors who contacted Gibbs & Bruns, but she declined to disclose whether Clearinghouse members who supported the draft notice of default subsequently called Gibbs & Bruns, citing client confidentiality.

After BlackRock and PIMCO made it clear that they would not support the Clearinghouse’s letter to BNY Mellon, Gibbs & Bruns continued to pursue the trustee. Patrick sent the bank a letter on Aug. 20, following an unsuccessful meeting with BNY Mellon’s Pillsbury lawyers. On Sept. 3, the trustee told Gibbs & Bruns that it did not intend to take any action on her letter. Patrick told me she received BNY Mellon’s letter in the middle of the day. By day’s end, she said, she was circulating a draft notice of non-compliance among her clients.

Gibbs & Bruns made the final version of that letter public in October 2010. One source familiar with Franklin’s Clearinghouse draft notice told me the Gibbs notice read like a “watered down” version of Franklin’s draft, “with less evidence.”

Patrick heatedly rejected the suggestion that she borrowed strategy or language from Franklin or the Clearinghouse. She never even saw his draft letter to BNY Mellon, she said, nor did she receive any Clearinghouse materials from her clients. The notice of deficiency Gibbs & Bruns sent to the trustee, she said, “was based on binders of evidence I and my team put together over the course of months of investigation, none of which came from the Clearinghouse.”

Patrick also rejected speculation that BlackRock backed away from the Clearinghouse effort and threw in with Gibbs & Bruns because it didn’t want to take a hard line with Bank of America, which still owned 34 percent of the asset manager in the summer of 2010. (David Grais raised the issue of BlackRock’s alleged conflict of interest in Walnut Place’s petition to intervene.) BlackRock had already signed on with Gibbs & Bruns by the time the Clearinghouse draft default notice was circulating, she said. The asset manager didn’t change course in August 2010, according to Patrick. It had already picked its course.

And as Gibbs partner Bob Madden told Judge Pauley at the Sept. 21 hearing, that course forced Bank of America to the negotiating table for a year of hard-fought talks. “This was no effort to help Bank of America. This was an effort to bring Bank of America to justice,” Madden said. “This was no collusive, self-selected group of people who decided to get in a room with Bank of America and cut a sweetheart deal.”

Will Judge Pauley agree — or will news of the Clearinghouse’s aborted pursuit of BoA and BNY Mellon lead him to authorize discovery on that question? I bet I’m not the only one who can’t wait to find out.

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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.

The New York AG argued that the duties of an indentured trustee change when there’s a default. (He also asserted that BNY Mellon failed even to carry out its “ministerial” duties to MBS holders.) Defaults trigger a heightened duty under New York law, which says that a trustee must behave as a “prudent man” would with regard to his own affairs. State-law precedent, the AG brief said, holds that the “prudent man” standard of care is a fiduciary duty — and BNY Mellon breached it when the bank failed to notify Countrywide MBS investors of defaults in underlying mortgage loans.

BNY Mellon’s brief countered with two arguments, one legal and one factual. Even if default triggers a heightened standard of care for indentured trustees, it argued, those new duties are still governed by the trust agreement. The bank quoted language referring to the extra duties as “a relatively minor change in the legal landscape.” Moreover, according to BNY Mellon, there has been no default, under the precise language of the pooling and servicing agreements. “The Events of Default are strictly defined and none has occurred,” the brief said.

We’ll have to wait for Pauley to say what he thinks of the bank’s description of its duties. In the meantime, there’s a good question for the rest of us to contemplate. BNY Mellon’s brief tells investors in asset-backed securities that they shouldn’t count on indentured trustees to do anything more than their specified administrative duties. That leads to the conclusion that securitization trustees consider all substantive responsibility to police asset-backed deals to lie with investors. Will securitization agreements have to change for that market to be revived? And if investors insist on more accountability for trustees, will anyone agree to take on that duty?

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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.”

But then David Grais of Grais & Ellsworth, in a move as bold and novel as the banks’ use of Article 77, removed the case to federal court, arguing that the settlement is a mass action under the federal Class Action Fairness Act. And there, BNY Mellon met with quite a different reception. At a Sept. 1 hearing, Manhattan federal judge William Pauley gave BNY Mellon’s counsel, Matthew Ingber of Mayer Brown, pretty rough treatment. “Isn’t it unusual to use an Article 77 proceeding to seek approval for a settlement of this type,” the judge demanded, according to a transcript of the hearing. “Isn’t it odd that the trustee appears to have chosen such a proceeding whose main benefit appears to be to limit the rights of the trust beneficiaries to opt out of the settlement? You don’t think that is in any way at odds with the trustee’s fiduciary duty to the beneficiaries of the trust?” Judge Pauley went on to grill Ingber on the experts BNY Mellon engaged to determine the fairness of the settlement and the controversial side letter to the settlement agreement in which BofA affirms indemnity for BNY Mellon as trustee.

These are the same issues Grais & Ellsworth and other objectors to the settlement have raised and Judge Pauley is clearly listening to their arguments. It’s dangerous to read too much into how judges behave at preliminary hearings, but if I were BofA, BNY Mellon, or any other supporter of the settlement, I’d prefer my chances before Judge Kapnick a lot more than another hearing in front of Judge Pauley.

That’s why BNY Mellon argued strenuously in a Sept. 1 brief in federal court that the case should be sent back to state court. Calling Grais’s attempt to move the proceeding to federal court “frivolous,” the bank made four key arguments. First, BNY’s counsel at Mayer Brown and Dechert argued, the case isn’t a mass action under the Class Action Fairness Act. There’s only one plaintiff in the Article 77 proceeding — BNY Mellon as trustee — not the 100 plaintiffs that define a mass action under the federal law. The Article 77 proceeding doesn’t seek money damages, as CAFA requires, but simply judicial approval of the trustee’s action; and Grais’s client, a coalition of Countrywide MBS investors acting under the name Walnut Place, can’t remove the Article 77 case to federal court because it’s not a defendant in the proceeding.

Finally, the bank’s lawyers pointed to a ruling by the U.S. Court of Appeals for the Second Circuit that holds claims under MBS pooling and servicing agreements fall into an exception to CAFA’s removal provisions. As the bank’s brief noted, Grais & Ellsworth knows the Second Circuit ruling, in a case called Greenwich Financial Services v. Countrywide, quite well: it was counsel to the MBS investors who sought, successfully, to send their case against Countrywide back to state court. To put an exclamation point on its assertion that Grais shouldn’t have removed the case to federal court, the BNY Mellon brief asked Judge Pauley to award attorneys fees for the cost of litigating the removal petition.

In Wednesday’s filing, Grais & Ellsworth addressed all of the bank’s arguments in a brief that essentially asked Judge Pauley to look beyond the technicalities of the Article 77 proceeding and treat the proposed settlement as a de facto class action. Picking up on the judge’s own skepticism at the Sept. 1 hearing, the Grais brief asserted: “BNYM chose to file an Article 77 proceeding because it thought it could use the special proceeding to cherry-pick the aspects of class action settlements that it finds useful (court approval, global releases of the rights of all class members, ‘objections’ rather than interventions as of right, etc.), but to cast aside the aspects that it finds inconvenient (mainly the right to opt out).”

Grais asserted that even though BNY Mellon says it’s the only plaintiff in the Article 77 proceeding and claims that the case doesn’t seek money damages, there are in fact 530 trusts and $8.5 billion at issue. And even though the bank says Walnut Place isn’t a defendant, the Grais brief said, Walnut has intervened in opposition to the proposed settlement, which makes it an adverse party in the state case — a defendant in fact, if not in name. As for BNY Mellon’s demand for attorneys fees, the brief said, “despite BNYM’s repeated and reckless description of this removal as ‘frivolous,” there is no doubt that Walnut Place had an objectively reasonable basis for removing this action to federal court.”

The Grais brief also distinguishes between the Greenwich Financial case that led to the Second Circuit’s holding and the Article 77 proceeding. Greenwich was a case between an MBS investor and Countrywide as the MBS issuer, the brief said. The Second Circuit’s finding related to the rights of an MBS investor. But BNY Mellon isn’t an MBS investor, so the appellate court’s holding does not apply. (The brief includes a complicated, only-a-lawyer-could-love-it discussion of the source of rights under securitization pooling and servicing agreements; I called Grais and his partner Owen Cyrulnik for a layman’s explanation but didn’t hear back.)

Bank of New York Mellon has until tomorrow to respond to the Grais & Ellsworth brief. Judge Pauley has scheduled a hearing on the remand motion for next Wednesday. If he’s as outspoken as he was at the first hearing, we should get a pretty good idea of whose going to be overseeing this case — and whether the Article 77 gambit backfires on the banks.

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