Tuesday, December 30, 2014

Mortgage-Backed Securities Trust Certificates Were Exempt from Trust Indenture Act

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

In an action by a group of pension funds against the Bank of New York Mellon over the poor performance of residential mortgage-backed securities (RMBS) following the 2008 financial crisis, the Second Circuit held that the pension funds lacked standing to assert claims related to RMBS trusts in which they did not invest, because different concerns were implicated for the two sets of trusts. In an issue of first impression, the court also held that the RMBS trust certificates, which were governed by pooling and servicing agreements, were exempt from the Trust Indenture Act (Retirement Board of the Policemen's Annuity and Benefit Fund of the City of Chicago v. The Bank of New York Mellon, December 23, 2014, Livingston, D.).

Background. First, the court explained how an RMBS trust works. Trusts are created to receive streams of interest and principal payments from mortgage borrowers, and a mortgage lender sells pools of mortgages into these trusts. The right to receive trust income is divided into certificates and sold to investors, called certificateholders. The trustee hires a mortgage servicer to administer the mortgages. Governing agreements, often styled as pooling and servicing agreements (PSAs), set forth the terms of the securitization trusts and the rights, duties, and obligations of the trustee, seller, and servicer.

In this case, Bank of New York Mellon (BNYM) created and acted as trustee for 530 RMBS trusts between 2004 and 2008. Most of the trusts were governed by PSAs and organized under New York law, but some were governed by sale and servicing agreements (SSAs) paired with indentures and organized under Delaware law. The plaintiff pension funds were certificateholders for twenty‐five of the PSA‐governed New York trusts and one of the SSA‐ and indenture‐governed Delaware trusts.

Countrywide Home Loans, Inc. and affiliates, now owned by Bank of America Corporation, originated the residential mortgage loans underlying the 530 trusts at issue and sold them to the trusts. Countrywide made numerous representations and warranties about the characteristics, credit quality, and underwriting of the mortgage loans. If Countrywide learned that particular loans breached the representations and warranties in a way that materially and adversely affected the certificateholders, it was obligated to cure the defect or repurchase the defective loans from the trust.

The pension funds filed suit in the Southern District of New York, contending that there were “systemic and pervasive” defects among the loans underlying the trusts, causing the loans to default at higher‐than‐expected rates. They argued that BNYM was responsible for Countrywide’s alleged breaches of its representations and warranties because BNYM owed to certificateholders fiduciary duties of care and loyalty, contractual duties under the trusts’ governing agreements, and statutory duties imposed by the Trust Indenture Act (TIA). According to the pension funds, BNYM knew of the widespread defects among the trusts’ loans, and therefore had a duty to enforce Countrywide’s repurchase obligation and, under the TIA, inform certificateholders of Countrywide’s breaches.

The district court ruled that the pension funds did not have standing to bring claims pertaining to RMBS trusts in which no named plaintiff had invested, and dismissed those claims. The district court also held that the TIA applied to certificates issued by the PSA‐governed New York trusts. Subsequently, the court declined to reconsider this order, but certified it for interlocutory appeal.

Standing. The Second Circuit affirmed the district court’s dismissal of claims relating to RMBS trusts in which no named plaintiff had invested, finding that the pension funds lacked standing as to those claims. The court analyzed the plaintiffs’ standing under NECA‐IBEW Health & Welfare Fund v. Goldman Sachs & Co. (2012), which allowed plaintiffs in putative class actions to assert claims related to RMBS certificates they did not own. According to the court, NECA addressed the “murky” line between traditional Article III case-or-controversy standing, which requires personal injury that is fairly traceable to the defendant’s conduct and likely to be redressed by the requested relief, and “class standing.”

NECA established a two-part test for class standing: (1) whether the plaintiff personally has suffered some actual injury as a result of the putatively illegal conduct of the defendant, and (2) whether the conduct implicates the same set of concerns as the conduct alleged to have caused injury to other members of the putative class by the same defendants. In this case, the plaintiffs satisfied the first prong, but not the second. The conduct did not “implicate the same set of concerns” as BNYM’s alleged failure to take action with respect to defaults in other trusts in which Plaintiffs did not invest.

In NECA, the absent class members’ claims were similar to those of the named plaintiff in all essential respects, and the proof contemplated for all of the claims would be sufficiently similar. Here, however, BNYM’s alleged misconduct would have to be proved loan‐by‐loan and trust‐by-trust, and answering factual questions for the trusts in which plaintiffs invested would not answer the same questions for the numerous trusts in which they did not invest.

Exemption from Trust Indenture Act. Next, the court addressed whether the district court had correctly held that the TIA applied to the certificates purchased by Plaintiffs that were issued by PSA‐governed New York trusts. The court concluded that the TIA did not apply to the New York certificates.

The TIA provides that instruments to which it applies must be issued under an indenture that has been “qualified” by the SEC. However, the TIA applies only to certain kinds of instruments. BNYM contended that the New York certificates at issue fell within two exemptions: (1) Section 304(a)(1), because they were equity securities, not debt securities; and (2) Section 304(a)(2), which provides that the TIA does not apply to “any certificate of interest or participation in two or more securities having substantially different rights and privileges.”

The court determined it did not need to decide whether the New York certificates qualified as “debt,” and assumed arguendo that the certificates were not exempt from the TIA under Section 304(a)(1). However, in an issue of first impression, the court held that they were nonetheless “certificate[s] of interest or participation in two or more securities having substantially different rights and privileges” and therefore exempt under Section 304(a)(2).

First, the court concluded that the certificates were “certificates of interest or participation.” They were evidenced by a certificate (as opposed to a note), and the PSAs referred to them as “mortgage pass‐through certificates” and to the holders of the instruments as “certificateholders.” Payments on the certificates were contingent on the cash flows generated by the underlying mortgage loans, because there was no meaningful source of cash other than the loans themselves. Second, the certificates were “in two or more securities,” because (1) the mortgage loans were securities; (2) each trust held hundreds or thousands of loans; and (3) the security‐like attributes of each tranche were merely attributes of the certificates themselves. Finally, the court found that the numerous mortgage loans held by the trusts had “substantially different rights and privileges,” because the loans had different obligors, payment terms, maturity dates, interest rates, and collateral.

In holding that the certificates issued by the PSA‐governed New York trusts were exempt from the TIA under § 304(a)(2), the court noted that the SEC has held the position since at least 1997 that the where the assets of the certificated trust include a pool of mortgage loans with multiple obligors administered pursuant to a “pooling and servicing agreement,” the certificates are treated as exempt from the TIA under Section 304(a)(2).

The case is Nos. 13‐1776‐cv, 13‐1777‐cv.