RMBS Case to Watch This Summer: No. 4

As I discussed a few months back, Judge William Pauley issued a groundbreaking decision in Retirement Board v. Bank of New York Mellon that sent ripples through the RMBS litigation world.  Specifically, Pauley found that the Trust Indenture Act (TIA) applied to the RMBS Trusts at issue because they were in actuality more like debt than equity.  This meant that investors could sue and impose liability on RMBS Trustees directly for failing to comply with their obligations to protect investors in the trusts they oversee.

At the time, I predicted that the decision would go up to the Second Circuit on appeal, and it now seems like that is the route Bank of New York Mellon (BNYM) is hoping to go.  On April 17, BNYM filed a Motion to Reconsider, in which it asks Judge Pauley to reconsider and reverse his prior decision or, in the alternative, to certify his Order for interlocutory review.  In layman’s terms, this means that BNYM wants to appeal a non-final Order prior to the end of the case, for which it needs the Court’s permission.

Not surprisingly, a number of bank advocacy groups, including SIFMA, the American Bankers Association and the Clearing House Association, have lined up behind BNYM in support of the Trustee’s Motion to Reconsider.  Their basic argument is that Pauley’s decision threatens to upset the market’s settled understanding regarding the obligations of RMBS Trustees (minimal) and delay the return of the moribund private label mortgage market (which isn’t coming back anytime soon, regardless).  In their Opposition, the investors’ counsel does a good job of pointing out that the TIA was intended to protect investors from just these sorts of passive Trustees and that investors will be none too eager to flock back to private label RMBS if they’re not adequately protected.

But all policy arguments aside, the outcome of this decision turns in large part on case precedent (or lack thereof) surrounding the TIA’s application to RMBS, and the SEC’s historical interpretation of the same.  The investors argue, consistent with Pauley’s Opinion, that the SEC’s interpretation of the applicability of the TIA is only persuasive if the reasoning behind that interpretation is persuasive.  In its Reply, BNYM blows right past this point, saying, “but plaintiffs do not deny that the SEC consistently, over many years, has adhered to the view that the TIA is not applicable to PSA-governed certificates.”

Well, plaintiffs may not have denied that the SEC has interpreted this issue consistently, but that doesn’t make it so.  In fact, I’ve uncovered evidence that the SEC itself has waffled on its characterization of RMBS.  Specifically, readers may recall that, earlier this year, Option One agreed to pay $28.2 million to the SEC to settle charges that the H&R Block subsidiary misled investors about its deteriorating financial condition.  In connection with this settlement, the SEC filed a Complaint on April 24, 2012 in which it discussed the RMBS issued by Option One as follows:

Option One’s RMBS were debt obligations that represented claims to the cash flows from pools of residential mortgage loans… [Those trusts] issued RMBS that represented claims on the principal and/or interest payments made by borrowers on the loans in the pool.”  (Complaint, SEC v. Option One, 12-SACV-633, at 5:20-25 (emphasis mine))

BNYM has argued vigorously that RMBS are equity securities and that investors have an ownership stake in the mortgage loans themselves, rather than the cash flows from those mortgages, to support the position that the TIA does not apply (by its terms, it only applies to debt securities).  Without much legal precedent, BNYM has had to rely extensively on the fact that the SEC has consistently interpreted RMBS as equity securities.  And yet, this passage from the Option One Complaint shows that even the SEC has interpreted RMBS governed by similar pooling and servicing agreements as debt securities representing claims on mortgage cash flows.  This undermines whatever persuasive impact the SEC’s interpretation may have had whatever court ultimately rules on this issue.

With BNYM’s Motion to Reconsider now fully briefed, counsel for the Retirement Board of the Policemen’s Annuity may wish to seek leave to file a supplemental brief to bring this juicy revelation to Hizzoner’s attention.  In any event, we should know by the end of the summer whether Pauley intends to reverse his original decision (unlikely) or certify the issue for interlocutory review (somewhat more likely).

Should the issue go up to the Second Circuit on appeal, BNYM runs the risk of creating unfavorable binding precedent for all lower courts in the Second Circuit, which is where most of these cases have been and would be brought.  But given the vehemence with which it and the bank advocacy groups have fought the application of the TIA, this is apparently a risk they feel is worth taking.  Since the onset of the mortgage crisis, RMBS trustees have done all they could to limit their own liability first and foremost, and minimize the costs they would incur to satisfy their obligations under the governing trust documents to boot.  This makes sense, as trustees are paid very little for their troubles.  Indeed, why should they incur liabilities or costs that they can avoid?

But investors and bond insurers have complained early and often about the fact that trustees have not lived up to their contractual obligations and should have been doing more to protect the certificateholders that have limited rights to take action on their own behalf.  Since standard trust agreements (known and pooling and servicing agreements) impose very few concrete obligations on trustees while providing them with broad indemnification rights at every step, getting trustee assistance has been quite difficult… up to now.

If RMBS trustees are actually subject to extra-contractual duties under the TIA, that changes everything.  This is especially true now that certain Attorneys General (see here and more recently here) and certain bondholders (see here and more recently here) are delving into whether mortgage were properly transferred into trusts in the first place – one area for which trustees are thought to be contractually responsible, and certainly a failure that could lead to liability under the TIA.  Aside from constituting a breach of reps and warranties, a finding that loans were not properly transferred into the trusts has been held to preclude the trusts from foreclosing on delinquent borrowers, meaning massive losses (and claims) for bondholders.  In short, the success of this novel pathway to recovery under the TIA could have a major impact on whether bondholders can look to trustees to should some of their losses or, in the alternative, use the threat of direct liability to wrangle trustee cooperation in enforcing their substantial mortgage put-back claims against originators and issuers.

Click here to continue to Case No. 3 in our Top 5 Countdown, and learn why a non-RMBS lawsuit has been garnering so much attention in mortgage litigation circles.

[Update: since this post was first published, Judge Pauley has granted plaintiffs’ counsels’ request to file in the public record the SEC documents referring to RMBS as “debt obligations” – IMG]