A New Wave of Mortgage Bond Litigation
Five years after the financial crisis, the first wave of lawsuits filed by investors seeking to recover losses on MBS is still slogging its way through the courts, and, for many, the clock is ticking. The bulk of cases to date were brought under federal securities law; most were filed in 2007 and 2008 and face a two-part statute of limitations: one year from discovery and three years from the date of issuance of the securities.
Despite a few settlements, such as one for Wells Fargo for $125 million in July of 2011, another for $40 million by Lehman Brothers in October 2011 and another for $315 million by Bank of America on behalf of Merrill Lynch in December 2011, banks and other defendants have been whittling down their potential exposure to claims significantly by exploiting legal technicalities.
But federal securities laws aren't the only avenue for recovering MBS-related losses; various state laws also govern securitizations. And in some cases, the statute of limitations for such cases is much longer than it is for cases brought under federal securities laws - as long as six years. That means the door is still open to file new lawsuits.
Some lawyers seeing the most chance of success for "putback" litigation, where there is a contractual remedy - governed by state law - requiring the seller of the mortgages to pay back the bonds at par as a result of breaches of misrepresentations. "From a pure legal standpoint, putback claims are the best option to achieve recoveries from the banks that underwrote the securitizations," said Zachary Rosenbaum, a partner at Lowenstein Sandler.
The firm Lowenstein Sandler represents investors and financial institutions in disputes arising from securitizations and syndicated loans in a variety of asset classes and industries. The securitization litigation team has worked on fraud claims in RMBS to disputes involving put-backs and warranties on consumer credit card debt pools, as well as claims by participants in syndicated commercial loans and distressed real estate transactions. Rosenbaum won dismissal of the $1.8 billion claim filed on March 2008 in the New York state court by financial guarantor FGIC against client IKB Deutsche Industriebank. FGIC was attempting to rescind a financial commitment issued in the U.K. as loss protection to a structured vehicle.
Putback litigation, which is based on the pooling and servicing agreement for MBS deals, was also the basis for a proposed $8.5 billion settlement BofA agreed on behalf of Countrywide in June 2011. The settlement is being contested by investors who allege that it was riddled with self dealing by the trustee negotiating on their behalf, Bank of New York Mellon.
Nevertheless, the case demonstrates the potential scope of liabilities banks face under putback claims. "Eight billion dollars is not pocket change" said Isaac Gradman, managing member of IMG Enterprises, an MBS consulting firm. If BofA was willing to settle for that amount, it's because "the potential losses could be many times that amount."
An advantage to seeking recoveries through putback claims, according to Gradman, is that "you don't have to show a traditional misrepresentation, just that a rep and warranty was breached. You can take advantage of pretty concrete evidence in the form of loan files." Gradman, who also publishes the blog Subprime Shakeout, said reviewing loan files will show if individual loans were underwritten to guidelines, meaning the evidence is "more black and white."
He noted that investors pursing putback claims are limited to a "loan-by-loan remedy" - for each bad loan, they can get one putback. "The courts have been allowing statistical sampling to come into play, so you can extrapolate to the whole pool, but it's still on a loan-by-loan basis," he said. "Only those loans with a breach get put back."
By comparison, Gradman said, securities laws claims require a showing of a misrepresentation that affects an entire investment in a material way. "Sometimes it's more difficult to show, based on an offering document, that something was directly misrepresented in a way that would have been material to an objective investment decision. But if you can show that material misrepresentation, you get to recover all of your losses. It's a much broader remedy."
There are two federal securities laws that govern securitizations, the Securities Act of 1933 and the Securities Act of 1934. Of the two, the '33 Act is broadly considered more plaintiff-friendly, because the plaintiff does not have to prove that there was an intent to defraud. The plaintiff must only prove that the offering materials were misleading in a material way.
In some cases, the same deals that are the subject of litigation under federal securities laws are also subject to putback litigation under state contract law, according to Neil McCarthy at Lawyer Links, a legal consulting firm. "The theoretical exposure here is enormous, because of the large amount of RMBS that got sold," he said.
Kevin LaCroix is an attorney and executive vice president at OakBridge Insurance Services, which provides directors and officers insurance, the source of funds for the settlements of a number of securities lawsuits related to the financial crisis. LaCroix maintains a blog tracking the progress of such cases; the scorecard indicates there have been at least three settlements of cases specifically related to RMBS. (The scorecard doesn't include BofA's settlement of claims against Countrywide, which is being challenged.) In at least another 11 cases, courts have granted defendants' motion to dismiss class action status and in at least 16 cases courts have denied motions for such class action dismissals.
Despite the number of dismissals, LaCroix said it's too early to draw any conclusions about the eventual rate of success of this kind of litigation. "Very few cases have emerged beyond the most preliminary stages," he said.
One problem for plaintiffs in cases brought under federal securities laws, according to people who follow these cases, is that courts have been inconsistent in how they apply the statute of limitations. Plaintiffs have argued that the statute should be "tolled," with the clock stopped, so long as the class action process is being litigated, but courts have not always agreed.
For example, in September 2011, a federal judge in New Jersey dismissed the class action status of an MBS-related lawsuit brought against UBS Securities by the Pension Trust Fund for Operating Engineers. The judge ruled that the pension fund failed to adequately plead compliance with the one-year statute of limitations. The pension fund's amended complaint said that in September 2007, the plaintiff purchased a "super senior" tranche of an MBS deal relying on offering materials that it alleges failed to adequately describe the riskiness of the underlying mortgages.
UBS argued that the plaintiff waited too long to file its complaint; the bank's brief in support of its motion to dismiss cited allegations, reports and lawsuits from 2007 that it argued should have put the pension fund on constructive notice of claims made against UBS well over a year before the pension fund filed its action.
Eric Creizman, who wrote the brief for UBS while he was at Gibson, Dunn & Crutcher, said that while the court's decision was good for banks, it gave the plaintiff a chance to replead. "So it's not a definitive victory at this point," he said.
Still, the later these class action type lawsuits are brought to court, the harder it will be for plaintiffs to argue that they are filing within the statute of limitations. "You have to make the case why [an alleged misrepresentation] wasn't discovered sooner," said Creizman, who has since left Gibson Dunn to found Creizman. "As time passes, it's going to be harder to argue that you went unnoticed of fraud."
Another technical issue that banks have exploited is the way lawyers represent a class of investors. A securitization can be filed under a common registration statement with the Securities and Exchange Commission (SEC) that can be good for up to a year and incorporate billions of dollars in more than one deal.
"Plaintiff lawyers had hoped that their named plaintiff could represent all investors who had purchased RMBS registered with the SEC under a common registration statement, which would have resulted in much larger exposure," McCarthy said. "But the courts have generally ruled that the named plaintiff in the lawsuit can only serve as the class action representative for other investors who bought in the same RMBS offering."
Some courts have gone further, ruling that the named plaintiff can only serve as a class action representative for other investors who bough the same tranche in the same offering, reducing banks' exposure to claims even further.
The effect of these ruling has been to create "orphaned claims." An investor in a particular RMBS security may or may not be represented in a pending class action based on federal securities law, depending on the luck of the draw ... which offering the named plaintiff brought. An orphaned claim will lapse with no vale unless the RMBS investor brings its own action.
There are disadvantages to seeking recoveries through putback claims as well. "Pooling and servicing agreements often contain a no-action or collective-action clause, which says that individual bondholders can't bring an action for putbacks unless they first go through certain steps designed to prevent a rogue investor from hijacking a trust," Gradman said.
"This has insulated originators and issuers from having to buy many of the loans back. Bondholders must band together to accumulate 25% of the voting rights in a deal... that's tough to do, since most investors don't publicly report what they hold." Also, "you have to petition the trustee with specific evidence of the issues identified." Gradman said this is difficult because the trustee also controls access to the loan files that have this evidence... and to get the trustee to listen, you need specific evidence. It's a Catch 22."
As the dispute over BofA's settlement over practices at the former Countrywide illustrates, trustees have a conflict of interest: they are typically affiliates of banks that originate and securitize mortgages, although not necessarily of the banks that sponsored the securitizions that are the subject of a particular lawsuit. For instance, two of the largest trustees are subsidiaries of Wells Fargo and Deutsche Bank.
BNY Mellon, the trustee in the BofA/Countrywide case, declined to comment for this article.
"The trustees do not view it as an obligation to take any affirmative action now withstanding all the information that is in the market place that should give it a clue that there are viable putback claims," Rosenbaum said. "The investors haven't been able, for the most part, to aggregate sufficient percentages to bring the cases en masse as one would have expected about a year or so ago."
McCarthy said the consolidation that has taken place among banks since the financial crisis has only increased these conflicts of interest, since most major investment banks now have a subsidiary that acts as a trustee for RMBS deals.
Gradman said trustees also throw up other hurdles. "They require broad indemnification... and some investors feel this indemnification is excessive.," he said. "Trustees also demand broad confidentiality agreements ...so it's been a long process to even get through petitioning trustees, but at that point, if you petition and satisfy all requirements, and the trustee says it won't do something on your behalf, you have the right to pursue a putback... then, before you file a suit demanding putbacks, you have to give the offending party the opportunity to cure or rebut the breach. Those are some of reasons why haven't seen more" of these cases.
On the other hand, Gradman said, "it's a difficult initial hurdle to overcome, but once you do put in the time, you have a pretty concrete avenue to recovery. It's pretty clear in the documents if loans have been breached in a materially adverse way and the issuer ought to buy [them] back."
State contract law isn't the only alternative to federal securities law for pursuing claims for RMBS-related losses; state securities laws also confer some advantages. LaCroix said that, while it's difficult to pursue collective action under state securities law, as a result of the Private Securities Litigation Reform Act, it's feasible for investors to pursue cases individually if the claim is large. And like state contract law, the statute of limitations on state securities law can be longer than it is for federal securities laws, according to McCarthy. Under New York State, where most investment banks that securitized mortgages are based, the statute of limitations is six years. That means the door is still open for investors who bought RMBS in 2006 and 2007 to file a claim. McCarthy believes that this is why a number of foreign banks have explored this option.
In January 2012, Dexia, the Brussels-based French-Belgian lender, filed a claim in New York State Court against JPMorgan over losses on $1 billion of MBS sold by Bear Stearns , which was acquired by JPMorgan during the financial crisis. In December 2011, German bank HSH Nordbank also filed a claim against Ally Financial, JPMorgan and Barclays Capital over losses on $159 million of MBS it purchases from the bank in New York State Court. And Dutch pension firm Stichting Pensioenfond ABP filed a lawsuit against JPMorgan relating to losses on MBS it bought from the firm also in December last year.
McCarthy expects to see more cases filed in New York State Court in 2012. "At this point in time, it's clear that the big banks when putting these deals together didn't do a good job," he said. "That's not the issue," he said. Any investor who has lost other kinds of cases" ought to be thinking about bringing their own action in state court. The clock is ticking and you have to do something else or you will lose your claims.
Another category of claims, according to Gradman, is tort claims, such as common law fraud, fraudulent inducement and negligent misrepresentation. He said there is a recently filed case by a German organization that acquired a bunch of MBS, and the complaint consisted entirely of tort claims filed under New York common law. "The fund is called Sealink; it took over some of the riskiest assets of failed German lender Landesbank Sachsen AG."