As the focus of this blog is the merits of the MBIA v. Bank of America (BAC) litigation and their implication for the valuation of MBIA, I have not spent a great deal of time focusing on the merits of BAC's Article 77 litigation, apart from noting that the pendency of the Article 77 should afford BAC ample reason to want to settle with MBIA before Justice Bransten renders an adverse decision on BAC's successor liability. But to the extent that the Article 77 plays an important strategic role in any analysis of settlement potential between BAC and MBIA, it is appropriate that I spend some time analyzing the Article 77.
My initial takeaway? Who the hell knows!
As far as I can tell, the two most important questions that I have when I first analyze a judicial action are still undecided: i) what is the standard of judicial review, and ii) who bears the burden of proof.
The New York statute authorizing Article 77 actions does not state what the standard of judicial review is (unlike the statute authorizing Article 78 actions, where it is clear that an arbitrary and capricious standard applies). BNYM, as trustee, of course has argued that the settlement should be approved if the trustee has acted honestly and within the ambit of its discretion, while the objectors argue that a thorough examination of both the process and substance of the settlement should be conducted.
As far as I can tell, Justice Kapnick has not ruled on the matter. My best guess is that Justice Kapnick will focus upon the reasonableness of the trustee's inquiry and analysis, and reliance on its experts, but a more rigorous standard might be applied if Justice Kapnick believes it was an improper conflict of interest for BAC to indemnify BNYM against all liabilities arising in connection with the settlement. Typically, when a trustee is negotiating on behalf of its beneficiaries in a matter adverse to a third party, it is appropriate for the trustee to seek indemnification from its beneficiaries rather than the adverse third party. Pretty fundamental stuff.
Which party has the burden of proof is also in dispute. Typically, the party seeking to obtain a judicial determination (here the trustee) has the burden of proof, but of course the trustee argues in the Article 77 that the objectors should bear this burden.
In a typical Article 77 action, who bears the burden of proof is not a contentious or meaningful matter. Article 77 actions usually involve a judicial determination that a trustee's accounting for funds held in a trust was appropriate, and so the accounting is presented to the court, and it is either right or wrong upon review, and the matter is disposed of without further ado.
In the BAC Article 77, you have over $200 billion of mbs that were projected to result in over $100 billion in losses, and thorny legal issues such as loan sampling, loss causation and materiality, and successor liability were at stake. What kind of investigation should the trustee have made in connection with this fact pattern? What claims should the trustee release and for what amount of payment?
One can readily see that the question as to who bears the burden of proof in the BAC Article 77 is a much more momentous decision than in the run-of-the-mill Article 77. A far as I can tell, Justice Kapnick has not ruled on this matter either.
What manner of discovery will be engaged in? This is currently being thrashed about in the Article 77's motion practice, and Justice Kapnick seems to be making her decisions on an ad hoc basis...which I don't criticize because there is no other basis for her to make these decisions. There really is very little statutory and case law guidance. Of course, the trustee has been resisting objectors' discovery at every turn, while the objectors have been pushing for the type of discovery that would be normal in a typical plenary action.
Here, the objectors seem to be holding their own. For example, Justice Kapnick recently held that the trustee should have its valuation expert, Brian Lin of RRMS Advisors, produce all documentation that Mr. Lin reviewed in connection with the preparation of his valuation report.
Will Mr. Lin eventually have to take the stand and suffer through what I expect will be withering cross-examination of his credentials and methodology used in arriving at his valuation conclusion? You would think Justice Kapnick would order this if she has ordered production of the materials he reviewed in connection with the issuance of his report. But as far as I can tell, Justice Kapnick has not ruled upon the question as to whether live testimony will be required.
The manner in which the trustee framed the analysis, namely whether the trustee acted honestly within its discretion, may actually be an improper framing of the question presented. This assumes that the trustee had discretion to i) grant BAC forbearance from a declaration of an event of default, ii) settle the action on behalf of the investors, and iii) receive indemnification from BAC. The trusee did not have this discretion, says Prof. Tamar Frankel, one of the preeminent legal scholars on trusts and securitization, whose expert opinion was filed recently by the objectors.
I do think there is one thing about the Article 77 that is clear. BAC's risk/reward profile is skewed in a highly asymmetric and adverse manner. Put another way, the best BAC can do is to have its reserve for the Article 77 action remain at the settlement amount, $8.5 billion. There can be no further upside. If the settlement is not approved, BAC will need to increase its mbs putback reserves by many billions of dollars.
Lots of questions I see, little advice I can offer. Well, here's perhaps the best near-term tell that I think people should be looking at. The loan files.
The objectors pointed out that the trustee did not inspect any loan files in connection with its investigation. The objectors argued that this was improper and asked Justice Kapnick to order a reunderwriting of a sample of the loans. Of course, the trustee objected stenuously, but Justice Kapnick took a middle of the road sensible approach, and ordered that a random sampling of 150 loans files be reunderwritten. Again, this is something of an ad hoc judicial approach, but that is what you get when a judge has no hard and fast rules imposed upon her by the authorizing statute.
While this sample is not sufficient in size to be statistically significant for purposes of extrapolating the results to the total pool of loans, it does get the camel's nose under the tent. As far as I can tell, the results of this small scale reunderwriting have not been produced, but these results bear significantly upon the reasonableness of Mr. Lin's analysis.
If the results of this reunderwriting show a high number of material defects, what is Justice Kapnick's next move? Order a much larger, statistically significant reunderwriting sample? Who the hell knows?