Alison Frankel

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.

Schneiderman didn’t claim that New York pension funds actually have a stake in the Countrywide MBS trusts. Instead, he claimed standing under the parens patriae doctrine, asserting that he intervened “to protect the interests of the public and absent investors.” And that raises a question that Bank of New York Mellon — once it recovers from the shock of the AG’s filing — is sure to argue to Judge Barbara Kapnick as she weighs whether to approve the proposed settlement. Are investors — and the public at large — better off if the New York AG kills the proposed BofA settlement?

There are a lot of ways to look at the question. In the narrowest interpretation, will investors be able to recover more money for breach of warranty claims against Countrywide than they would under the settlement? Maybe. There have only been a few investor put-back cases filed against Countrywide, mostly by David Grais of Grais & Ellsworth, and they’re not far enough along to lay odds on their success. Mayer Brown, which represents BNY Mellon in the BofA proposed settlement, argues that a lot of obstacles stand between Countrywide noteholders and a windfall recovery from Bank of America. Those range from the loan-by-loan evaluation investors will have to make of individual underlying mortgages to Bank of America’s claim that it’s not liable for Countrywide’s failings.

Grais may be able to surmount those obstacles, which is why his goal in opposing the proposed BofA deal seems to be to force the bank to permit opt-outs for investors who want to take their chances in litigation. If the settlement blows up, however, every Countrywide MBS investor is going to have to slug it out in court, and they’re certainly not all represented by lawyers who are prepared for a long, expensive battle with BofA that may end with them getting nothing.

The AG’s filing, moreover, has implications beyond the BofA case. Bank of America and Bank of New York Mellon certainly bear a heavy load of responsibility for the MBS fiasco. The New York AG has been engaged in an investigation of their (and other banks’) various failures as a trustee, MBS issuer, and mortgage servicer. But this settlement was at least an attempt to mitigate the damage BofA and BNY Mellon have caused investors — and for some reason, Schneiderman waited until now to claim that BNY Mellon committed fraud and that BofA may have abetted it. That timing gives little incentive to any of the other banks facing billions of dollars in MBS breach-of-warranty liability to reach global deals with investors. Why spend months negotiating a settlement if the New York AG, under the broad aegis of protecting the public, attacks you after you reach a deal?

The AG’s filing gives MBS trustees even less incentive to push for investor settlements. Trustees have been incredibly slow to take action against MBS issuers, which is why regulators like Schneiderman are scrutinizing them. Bank of New York Mellon took a bold step when it hired Jason Kravitt and Matthew Ingber of Mayer Brown to talk to the Gibbs & Bruns group of 22 investors, instead of continuing to resist investors’ calls for action against MBS issuers. Its reward for reaching a deal with the Gibbs & Bruns investors? A Martin Act suit. Given that Schneiderman hasn’t brought Martin Act claims against MBS trustees that haven’t proposed global settlements, why would any trustee try to engineer a deal? For the banks that issued mortgage-backed securities and the banks that acted as trustees on MBS offerings, the Schneiderman filings are a very good reason to keep their profiles low by quietly defending cases by those investors with the fortitude to sue.

Then there’s the issue of the mortgage servicing provisions in the BofA settlement proposal. BofA and the Gibbs & Bruns group have touted the servicing provisions, which call for Bank of America to outsource loan service to companies tasked with renegotiating troubled loans, rather than pushing homeowners into default. Bank of America, in fact, regarded the loan modification provisions of the MBS settlement as template for solving the foreclosure crisis.

The AG’s filing, on the other hand, blasted the settlement’s servicing provisions as “too vague and ill-defined to provide any concrete value to investors.” Schneiderman complained that Bank of America’s poor track record in modifying troubled loans underscored the inadequacy of the servicing aspects of the settlement. The AG is in the midst of talks to reach nationwide mortgage modification deals with a host of banks, so I’m sure he’s speaking knowledgeably. But as a matter of tactics, he doesn’t seem to be sending a message of cooperation to BofA — or other banks.

Finally, there’s the message the AG sent to New York businesses. BNY Mellon’s response to the AG was as remarkable, in its way, as the AG’s filing. “The allegations by the New York attorney general are outrageous, baseless, unsupported by fact and law and we will fight them if necessary in court,” the bank said in a rare display of adjectives by a financial institution. “We are confident that we have fulfilled in all respects our responsibilities as trustee. The AG’s action is misguided and fails to comprehend the role of the trustee and the benefit the settlement would provide to investors.”

A BNY Mellon spokesman told me the bank didn’t want to comment on the broader implications of the AG’s filing, but directed me to Kathryn Wylde, CEO of the Partnership for New York City, a business development non-profit. She said that the AG’s “careless action” hurts New York’s standing as a financial center.

“It’s disappointing from the standpoint of the business community that the AG would make a fraud accusation against a major financial institution — in the press,” she told me. “And to not have any consultation with the institution? The bank was blindsided by what appears to be an outrageous charge.” (The AG’s press office declined comment.)

Thursday’s filing unquestionably changes the tenor of the BofA MBS settlement. It could end up changing a lot of other things as well.

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The hearing scheduled to take place tomorrow before Manhattan state supreme court judge Barbara Kapnick could turn out to be a straight-forward affair. The judge could simply hear brief arguments on whether to expedite discovery on Bank of America’s proposed $8.5 billion settlement of Countrywide MBS noteholders’ breach-of-warranty claims, issue a ruling, and call it a day. Given that this will be the first time that the architects of the deal — Mayer Brown for Bank of New York Mellon, the MBS trustee; Gibbs & Bruns for a group of 22 major institutional investors ; and Wachtell, Lipton, Rosen & Katz for BofA — will be gathered in the same room with the small but feisty group of lawyers opposing the settlement, I’m hoping for some heated rhetoric, at the very least. Remember, this hearing is the first chance for these lawyers to register their positions with Judge Kapnick. It’s going to be very interesting to see what each of them make of that opportunity.

The nominal issue before the judge comes from a July 27 order to show cause, filed by Scott + Scott on behalf of a four public pension funds. The show-cause order argues that the schedule suggested by BNY Mellon (and approved by Judge Kapnick) doesn’t offer investors a chance to reach an informed decision about whether to oppose or endorse the proposed deal. Noteholders are supposed to file intervention notices by August 30. Scott + Scott says investors need to conduct expedited discovery before then.

“Document discovery is needed to evaluate the reliability of the expert opinions and the reasonableness of the settlement,” the filing says. “The [self-styled] public pension fund committee also believes that discovery bearing upon the interests and potential conflicts of the negotiating parties, the adequacy of the development of the facts, as well as the basis of the expert reports, is warranted.”

Scott + Scott has already been in consultation with lawyers for other opponents of the proposed settlement, including David Grais of Grais & Ellsworth. Grais has been the most prolific intervenor in the BofA MBS proceeding. Early on he filed an objection on behalf of a group of unidentified investors operating under the name Walnut Place who were already deep in MBS litigation against BofA at the time the global settlement was announced. Since then Grais has moved to intervene on behalf of six Federal Home Loan Banks and three other Countrywide noteholders, including a motion Wednesday on behalf of a new investor group called Cranberry Park. (Walnut Place and Cranberry Park? What’s up with that?)

The intervenors’ side of Kapnick’s courtroom will probably also include two other firms representing Federal Home Loan Banks in MBS litigation: Keller Rohrback and Robins, Kaplan, Miller & Ciresi, both of which signed Grais’s brief on behalf of the FHLBs. There’s also a new intervenor group of six insurance companies, which is represented by Wollmuth Maher & Deutsch.

My prediction is that the intervenors will protest that Bank of New York Mellon is attempting to railroad the settlement through court approval with unnecessary haste. The Scott + Scott filing points to discovery that’s been taken in other MBS litigation against Countrywide, and argues that the intervenors need to know if BNY Mellon and the Gibbs & Bruns group considered that evidence before reaching their agreement with BofA. “The key point here is that the persons being asked to release multi-million dollar or multi-billion dollar claims and to submit written objections to the settlement that would release their claims by August 30, 2011, should be permitted to do so on an informed basis,” the intervenors’ brief says.

Bank of New York Mellon’s Mayer Brown lawyers will lead the defense of the deal, arguing against tampering with the schedule Judge Kapnick has already approved. The bank and the institutional investor group have already said in responses to the intervenors that they’ve disclosed a tremendous amount about how the settlement came together, including all of the expert reports BNY Mellon solicited to evaluate the settlement’s fairness and a detailed narrative of negotiations in BNY’s petition for approval of the settlement. Kathy Patrick and Robert Madden of Gibbs & Bruns will also be in court to back BNY Mellon’s argument. Bank of America isn’t officially a party to the litigation, but you can be sure Wachtell Lipton lawyers will be in attendance, albeit not at counsels’ table, as extremely interested parties.

There are a couple key things to watch. Most importantly, does Judge Kapnick treat this case as she would a class action, in which objectors can have a real impact on the proceedings and can usually opt out of a settlement they don’t like? Or does she give broad deference to BNY Mellon as trustee, as deal supporters say she must?

Remember, BofA, BNY Mellon, and the Gibbs group structured the settlement as an Article 77 proceeding under New York state law. Article 77 proceedings usually take place in garden variety trust disputes, and under New York law, the bar for blocking a decision by the trustee is incredibly high. Under Article 77, anyone with an interest in the trust has a right to challenge the trustee’s decision, which is why the intervenors have standing to challenge the BofA settlement. But unless objectors can show that BNY Mellon, as trustee, abused its discretion, acted unreasonably, or otherwise breached its fiduciary duty to the trusts’ beneficiaries, the court is not supposed to interfere with the trustee’s power.

“The objectors keep saying this is like a class action, and we say, ‘You’re wrong,’” said Madden of Gibbs & Bruns.

It will also be worth paying attention to the reception David Grais receives from deal supporters. The BNY Mellon and BofA side has said that Grais declined an invitation to join settlement talks alongside the Gibbs & Bruns group. Grais maintains in court filings that he was never offered the chance to participate fully in settlement negotiations.

The other big question is whether New York Attorney General Eric Schneiderman will have a say at Friday’s hearing. As Andrew Longstreth has reported for Reuters, the N.Y. AG has been looking hard at the settlement proposal. Both sides have apparently made a pitch to the AG, but so far, he hasn’t committed to supporting or opposing the deal. (The Delaware Attorney General is also said to be considering an intervention motion.) I called Schneiderman’s press office to ask whether the AG’s office will be represented in Judge Kapnick’s courtroom Friday but didn’t hear back.

For more of Alison’s posts, please go to Thomson Reuters News & Insight

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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.

Here’s how the investors and the bank came to their numbers. As OTC explained earlier this week, the key metric is the value of the investors’ valid claims that Countrywide breached its representations and warranties on the mortgage loans underlying the securities. To determine that number, both the bank and the investor group began with a calculation of how many of the mortgages in the underlying pools would go into default. They next considered what percentage of the value of a defaulted underlying mortgage would be lost to investors—a figure Lin calls the “severity rate.” (If, for instance, a homeowner defaulted on a $100,000 mortgage and the mortgage-holder was later able to sell the mortgaged property for $75,000, the severity rate would be 25 percent.) Two more numbers then come into play: the breach rate, which represents the percentage of mortgages in the pool that breached Countrywide’s assurances to investors; and the success rate, which is the percentage of claims on which investors could successfully demand a bank buyback.

To arrive at its demand of $27 billion to $52.6 billion, the Gibbs & Bruns group asserted that $107.8 billion of the underlying mortgage pool would go into default. The investors applied a severity rate of 66 percent, a breach rate of 60 percent, and a success rate of 50 to 75 percent. (Lin said the latter two rates were too high, based on his “industry knowledge.”) The bank used different figures to reach its $4 billion estimate of investors’ claims, but Lin didn’t spell out BofA’s exact numbers.

In any event, Lin and his team arrived at their own conclusions for default, severity, breach, and success rates, based on the two sides’ presentations and their own expertise. RRMS said 36 percent of the defaulted underlying loans breached Countrywide’s representations and warranties, and investors would prevail on 40 percent of their buy-back claims on those loans. Lin made calculations using two different severity rate models—one estimating that investors would recover only 40 percent of the value of defaulted underlying mortgages; the other estimating a 55 percent recovery. He also offered two different default models.

In the end, Lin arrived at a range of $8.8 billion to $11 billion for investors’ claims. Importantly, he reached those results without knowing that negotiations between BofA, BoNY, and the Gibbs & Bruns group had produced a tentative $8.5 billion settlement agreement. In a second opinion, Lin says the servicing aspects of the proposed settlement “can be viewed as an industry precedent-setting, pro-active approach in regard to establishing a framework to enhance recovery efforts.” (Supporters of the proposed settlement assert that the servicing provisions, which require BofA to hand off responsibility for renegotiating troubled mortgage loans, could be worth as much or more to investors as the cash part of the deal.)

When Mayer Brown submitted BoNY’s petition for court approval of the $8.5 billion settlement proposal, partners Jason Kravitt and Matthew Ingber said that their expert’s valuation didn’t include discounts for BofA’s legal defenses against the investors’ claims. The other three expert reports released Tuesday explain what those legal defenses would have been—and may still be if the proposed settlement isn’t approved.

First off, Mayer Brown obtained an opinion from Capstone that said the trustee could recover no more than $4.8 billion from Countrywide, based on Countrywide’s assets. That’s important because in another expert opinion, Stanford Law School professor Robert Daines said it would be “difficult” for MBS investors to prevail in claims that Bank of America is responsible for Countrywide’s breaches of representations and warranties on the underlying mortgages. (There’s a lot more nuance in Professor Daines’s scholarly 58-page analysis, but the takeaway is that investors can’t be sure they could pierce the corporate veil and hit Bank of America for Countrywide’s failings.)

Finally, New York University School of Law professor Barry Adler opined on the standard for investor breach of contract claims against MBS issuers. Bank of America asserted in negotiations that unless the breaches were material—meaning that Countrywide misrepresented the facts that led to the mortgage’s default—the bank isn’t liable. Investors argued that every breach is material because they wouldn’t have purchased the securities without Countrywide’s representations and warranties about the underlying mortgages. Professor Adler’s 13-page opinion concludes that the law is unsettled but that the bank “appears to [have] a reasonable position.”

Kathy Patrick of Gibbs & Bruns, who represents the investor group that negotiated the deal, told OTC she’s glad the expert reports have come out. “We believe investors will find it very helpful ,” she said. “The trustee’s expert opinions… confirm and support the trustee’s decision to enter into the settlement.”

As Bank of America’s proposed $8.5 billion deal to resolve put-back claims by Countrywide mortgage-backed certificate holders comes under increased scrutiny, including a new inquiry by New York attorney general Eric Schneiderman and two newly-filed objections to the deal by major investor groups, some very intriguing news has emerged about Grais & Ellsworth, the prominent MBS investors’ firm that’s leading the charge against the BofA settlement.

Grais & Ellsworth filed new objections to the deal on behalf of two investor groups with large Countrywide MBS holdings Wednesday. But its first objection to the BofA settlement came on behalf of a coalition of MBS investors under the name Walnut Place, which had sued Bank of America in February. (Walnut Pace asserted put-back claims in two of the 530 trusts that offered Countrywide mortgage-backed certificates.) In a July 5 petition to intervene in the New York state supreme court proceeding to evaluate the proposed $8.5 billion BofA deal, Walnut Place raised some pretty serious questions about Bank of New York Mellon’s strong motivation, as trustee for the Countrywide MBS offerings, to go along with BofA’s proposal. Grais & Ellsworth also criticized the trustee for having “negotiated [the global deal] in secret, without the knowledge or consent of Walnut Place.”

That accusation of secret negotiations designed to cut out Walnut Place seems like powerful evidence of a potentially collusive deal—but according to Bank of New York Mellon, it’s just not true. In a  July 11 response to the Grais & Ellsworth filing, the trustee’s lawyers at Mayer Brown say Grais & Ellsworth was invited to join settlement discussions between Bank of America and the Gibbs & Bruns investor group that ultimately negotiated the proposed deal. But instead of opting to participate in the process, Grais & Ellsworth proceeded to file Walnut Place’s suit against BofA. Mayer Brown asserts.

“Bank of America and Countrywide told counsel for Walnut Place that they were negotiating a settlement,” the Mayer Brown July 11 filing says. “They offered to report to Walnut Place on a current and ongoing basis about settlement discussions, and to provide confidential information that the parties were evaluating in connection with the settlement. And they invited Walnut Place to provide input on settlement discussions.”

In an accompanying affidavit, Mayer Brown partner Matthew Ingber detailed discussion between BofA and Grais & Ellsworth. According to the affidavit, Bank of America lawyers met with Grais & Ellsworth, after the firm had demanded that Bank of New York, as trustee, commence a breach-of-warranties suit against BofA.  At that meeting, on February 2, Grais & Ellsworth was informed that BoNY and BofA were “actively negotiating a settlement that could resolve the issues raised by [Grais & Ellsworth’s client] Walnut Place,” Ingber says. The law firm was “invited to provide input on settlement discussions,” the affidavit asserts, and was asked “to delay the filing of any lawsuit temporarily so that settlement negotiations could run their course.” Three weeks after the meeting, however, Grais filed the Walnut Place suit against BofA.

Grais & Ellsworth has a different interpretation of the February 2 meeting. “[BoNY] omits several critical facts,” the firm contends in a brief filed Wednesday. “Neither [BoNY] nor Bank of America ever informed Walnut Place or its counsel that [the trustee] was participating directly in any settlement negotiations. Walnut Place did not learn that [the trustee] was directly involved in a proposed settlement until it was announced in the press.”

Moreover, according to Grais & Ellsworth, Bank of America refused to tell Walnut Place anything about the settlement talks unless Grais & Ellsworth agreed to “a set of highly unusual conditions.” Among those conditions: “Walnut Place would be told what was said in settlement discussions, but it would never be permitted actually to participate in those discussions,” the Walnut brief says. When Grais & Ellsworth “respectfully declined this proposal,” Walnut Place never heard again from BofA or BoNY about settlement talks.

Judge Barbara Kapnick should have quite a time sorting this kerfuffle out.

In other BofA MBS news, OTC heard Wednesday from the office of Congressman Brad Miller, whose letter to the Federal Housing Finance Agency was cited in Tuesday’s post, Why BofA is (partly) to blame for criticism of its MBS deals. Miller’s legislative aide, Corey Frayer, took exception to any implication that the congressman has not delved into the complexities of put-back claims. I did not intend to impugn Congressman Miller’s grasp of the BofA settlement proposal; in fact, his letter to the FHFA raises the same questions about the value of the claims the BofA deal would settle that the OTC post raises.

Frayer also said that Miller’s office has talked to Gibbs & Bruns about scheduling a meeting to review the settlement proposal. The Congressman’s goal, he said, is not to reach its own conclusion about the fairness of the BofA settlement, but “to make sure FHFA is doing its due diligence.”