Alison Frankel

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.

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Kathy Patrick wants to set the world straight.

The Gibbs & Bruns partner, who represented 22 major Countrywide mortgage-backed securities investors in the negotiations that led to the June 29 proposed $8.5 billion Bank of America deal, has come East from her home office in Houston to sell Countrywide MBS noteholders and anyone else who will listen on the settlement she and her partner Scott Humphries negotiated with BofA and Countrywide MBS trustee Bank of New York Mellon.

In the face of questions about the deal from six Federal Home Loan Banks, the New York State Attorney General, and a North Carolina Congressman, Patrick and Humphries spent Thursday in Washington and Friday in New York, meeting with MBS investors and “other interested parties” they declined to identify. The Gibbs lawyers’ message: The proposed BofA settlement represents a far better outcome for noteholders than continued litigation of loan-by-loan breach of contract claims against Countrywide. In that scenario, they insist, there would be no guaranteed outcome, no assurance investors can obtain a judgment against BofA as Countrywide’s successor, and none of the mortgage loan-servicing provisions that are a big part of the proposed deal. (The Gibbs & Bruns lawyers and some of their institutional investor clients argue that the servicing component of the deal, in which Bank of America has agreed to outsource loan servicing to specialists tasked with renegotiating troubled mortgages, could end up being as valuable as the cash part of the settlement.)

Patrick is particularly exercised that one objector to the proposed settlement has asserted that the deal “fails to address” securities claims pending against Countrywide. The settlement agreement specifically states that securities fraud claims are not part of the deal, and even if BNY Mellon, as trustee, wanted to give away investors’ right to sue for securities fraud, it has no power to do so. Patrick said she was so determined to preserve her own clients’ securities law claims that Gibbs & Bruns very nearly walked away from late-stage negotiations when Bank of America’s lawyers from Wachtell, Lipton, Rosen & Katz demanded a release. “We said not only no, but hell no,” Patrick said, adding that she was ready to leave $8.5 billion on the table.

Patrick said that so far, the only announced objectors to the settlement-as opposed to the New York AG, the Federal Home Loan Banks, and others who’ve said they want more information– are clients of Grais & Ellsworth, including a coalition of MBS investors that sued Bank of America after David Grais learned of the Gibbs & Bruns group’s settlement discussions. “There’s a misperception out there that lots of investors are unhappy with the deal,” Patrick said. “Look very carefully: They’re all represented by one lawyer at one law firm,” she said. Moreover, she added, no objector has suggested a viable alternative to the proposed settlement.

“Here’s a fundamental question any of these objectors will have to answer,” Patrick said. “What’s your plan? What is your plan to fix the servicing?…Unless you have a credible plan, unless you’re going to indemnify all of us against losing this bird in the hand, then you have nothing.”

OTC reached out to David Grais and Owen Cyrulnik for a response. Grais declined comment.

(Reporting by Alison Frankel)

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.”