Tuesday, March 19, 2013

The Core Question Presented to Justice Kapnick in the Bank of America Article 77 Proceeding

I have posted on the Bank of America (BAC) Article 77 proceeding regarding both substantive merits (Linsanity and the Bank of America Article 77 Settlement Valuation Experts ) and procedural stance (Handicapping Bank of America's Article 77 (Spoiler Alert: Who the Hell Knows? and Is Bank of America's Article 77 $8.5 Billion Settlement Hostage to its Case with MBIA?)

In a complicated situation, the core question presented to Justice Kapnick in the Article 77 is the following: 

"Is it reasonable for the settlement agreement to be approved by the Article 77 court, notwithstanding that the settlement agreement is made contingent and unenforceable by its terms until approved by the court, and such court approval is at a time when an important legal underpinning (mbs damage causation) to the settlement is no longer valid, if the committing to the settlement occurred prior to the demise of the legal underpinning?" 

This is essentially a $20-$40 billion question.

If Justice Bransten issues an adverse BAC successor liability decision before the Article 77 begins, that would only add a second legal underpinning to the settlement that would no longer be valid.

I can hear BAC's response to this question already: "One freezes in time for purposes of Article 77 court approval the relevant caselaw relating to mbs damage casuation that existed at the time the settlement was entered into.  The court is just determining the reasonableness of the trustee at the time the settlement agreement was entered into."  

Under this view, Justice Kapnick is obliged to disregard Judge Rakoff's opinion in Assured Gauranty v Flagstar that made clear that New York law relating to mbs damages requires only a showing that a representation and warranty breach had a material and adverse effect upon an mbs holder's risk of loss, instead of a showing that the breach caused the actual loan loss incurred by the mbs holder.

I would agree with this view if the settlement agreement resulted in the consummation of the settlement transactions at the time (or even if the settlement agreement was made enforceable by the parties, but enforcement was enjoined at the request of a third party pending judicial approval) .  If the transactions contemplated by the settlement agreement had closed, and repurchase and other claims against BAC were released and BAC paid $8.5 billion, then a subsequent court review of the settlement transactions would have measured the trustee's reasonableness at the time the transactions occurred.

But the settlement transactions have not occurred, and it was the parties themselves, the trustee and BAC, who expressly provided that the settlement transactions shall not occur, and that the settlement agreement shall remain contingent and unenforceable by the parties.  The settlement agreement requires and awaits court approval in order to for the settlement agreement provisions to become enforceable and for the settlement transactions to occur.  So what law is the Article 77 court to apply to these prospective settlement transactions which, at the time they are considered by the court, remain open and expressly unenforceable under the terms of the settlement agreement?  The law relating to causation at the time the settlement agreement was entered into, or the law relating to causation at the time the settlement transactions first become enforceable under the terms of the settlement agreement?

To my mind, the relevant analogy relates to a court decision made under old law, where new law arising after the court decision would reverse the decision.  If the court decision is still "open" and subject to appeal, of course an appeals court would apply new law in connection with the appeal.  If the court decision is "closed" once all right of appeal has lapsed, then the court decision under old law cannot be reopened and would be binding upon the parties.

In the case of the settlement agreement in the Article 77, the settlement agreement is still "open" and the transactions contemplated by the settlement agreement are unenforceable and expressly not permitted to occur by the very terms of the settlement agreement, until Justice Kapnick hears the case.

So, given these provisions of the settlement agreement, does Justice Kapnick apply old law or new law relating to mbs damage causation in connection with her determination whether or not the settlement transactions are to become enforceable? 

Seems to me, the essence of what makes an agreement an agreement, and not just a piece of paper (or these days, a digital file), is that the agreement is enforceable by the parties to the agreement.  So if Justice Kapnick is to apply good law at the time the trustee actually becomes a party to an enforceable agreement, Justice Kapnick should apply current law with respect to mbs damage causation.

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Disclosure: long MBI.  Follow me on twitter.

Sunday, March 17, 2013

Linsanity and the Bank of America Article 77 Settlement Valuation Experts

Now that on March 14, 2013 the intervenors and objecting investors (Intervenors) and Bank of America (BAC) have filed their expert opinions regarding settlement valuation in the Article 77 hearing, it is time to start analyzing the merits of the reasonableness of the $8.5 billion settlement.

I set out with this aim in my last blog post Handicapping Bank of America's Article 77 (Spoiler Alert: Who the Hell Knows?) , but I was surprised at the outset to see so many important, unresolved procedural questions (What is the Standard of Review by the Article 77 Court? Which Litigant has the Burden of Proof?).  I felt I had to pause to explain how indeterminate the Article 77 hearing process appears to me, with just a few months until the hearing is scheduled to begin, before beginning to address the merits.

An analysis of the reasonableness as to valuation of the $8.5 billion settlement requires a review of the opinion provided by RRMS Advisors, led by Mr. Brian Lin (Lin Report), to BNYM (Trustee) at the time the Trustee approved the settlement (a copy of the Lin Report is available here), in light of the settlement valuation reports of experts retained by the Intervenors (the Intervenors Report prepared by Mr. Charles Cowan, available here) and BAC (the BAC Report prepared by Mr. Philip Burnaman, available here).  Additional expert opinions relating to the powers of the Trustee and the reasonableness of the investigation conducted by the Trustee were also filed, but their review will await a future blog post.

It is easy to get lost in the statistical and securitization weeds contained in the Intervenors and BAC Reports, but this is not the level where one needs to look for a meaningful understanding of these reports.  God or the devil, depending on your persuasion, is in the assumptions made in these reports.  If the Article 77 hearing becomes simply a contest among valuation experts, then I would suggest that the reason why Justice Kapnick should prefer one expert over another lies with the validity of the assumptions made in these reports, particularly as to the proper representation and warranty (R&W) breach rate (R&W Breach Rate) and putback success rate (Success Rate).

In particular, the Success Rate (40%) adopted in the Lin Report (which was identical to the Success Rate proposed by the BAC Report, as opposed to the 50%-75% Success Rate proposed in the Intervenors Report), is improperly low, because it is premised upon an mbs damage causation theory that, after Judge Rakoff's recent opinion in Assured Guaranty v. Flagstar, is no longer good law in New York.

This has the effect of applying an improper 60% haircut to BAC's repurchase liability, which (together with using a depressed R&W Breach Rate) results in a $20 billion to $40 billion understatement.  This potential upward restatement of BAC's repurchase liability only highlights the importance BAC should place on settling with MBIA before Justice Bransten issues an adverse successor liability opinion.

Friday, March 8, 2013

Handicapping Bank of America's Article 77 (Spoiler Alert: Who the Hell Knows?)

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?

Tuesday, March 5, 2013

Here's an Interesting Thought Experiment: AIG Buys MBIA

I have posted here that it makes sense for Bank of America to (BAC) settle with MBIA before Justice Bransten issues her primary and successor liability opinions, in order to preserve BAC's leverage in seeking judicial approval before Justice Kapnick of the $8.5 billion settlement with institutional mbs investors.  A key issue to be considered in connection with this approval is whether BAC has successor liability for Countrywide's liabilities, and an adverse ruling by Justice Bransten has the potential to upset the settlement, as discussed here.  I also believe that it is more likely than not that BAC will lose on the motion regarding successor liability, as discussed here. One of the more prominent objectors to this settlement is AIG.

If you think about the interplay between the two proceedings, MBIA's action against BAC and AIG's objection to the settlement, the interests of MBIA and AIG are divergent, even antagonistic.  AIG would like to see MBIA not settle with BAC in order to have Justice Bransten issue an adverse successor liability holding.  MBIA would like to use the pendency of the institutional investor mbs settlement hearing as leverage to extract a settlement with BAC before that hearing commences at the end of this May.

Wouldn't the interests of MBIA and AIG both be served if AIG proposed to acquire MBIA for a premium to its current price, to account for the prospect of MBIA's potential settlement with BAC, and then the merged MBIA/AIG used its resources to continue both of their litigation actions against BAC until final judicial resolution?  How would that strike BAC?

Suppose AIG proposed an all stock acquisition of MBIA for $20/share.  This should satisfy MBIA management's short term price objectives, and then MBIA could manage its financial guaranty business for the long term having access to AIG's superior resources.

AIG's upside would be both short term, to the extent both MBIA and it are successful in their legal actions against BAC, and long term insofar as the combined entity would automatically become a reinvigorated participant in the financial guaranty business.

The cost to AIG of acquiring MBIA would be easily digestible, even if the purchase price amounts to more than just a bad day for AIG.

Monday, March 4, 2013

Double, Double,Toil and Trouble: Articles 77 and 78

Justice Kapnick issued her long-awaited opinion on the Article 78 hearing regarding MBIA's transformation transaction (Transformation) (ICYMI, MBIA wins), and it was air-tight and even subtly in-your-face. To read the opinion, see here.  I am on record before the decision as saying the likelihood of MBIA's success on the Article 78 case was 90%.  Bank of America (BAC) has stated that it will appeal Justice Kapnick's ruling.  Having read her decision, I will up MBIA's likelihood of success on appeal to 99.98%.  We are talking Ivory soap quality here.

I say air-tight because the opinion addressed each of BAC's arguments and dismissed them with faultless appeals to statutory language, case law and logic.  BAC's strategy was to argue that an "arbitrary and capricious" standard of judicial review should not be applied to the decision by the New York Department of Financial Services (NYDFS) to approve the Transformation, but rather the court was obliged to apply a less onerous standard that looked to whether there were any factual errors or errors of law underpinning the NYDFS decision.

BAC understood that it could not win under the appropriate "arbitrary and capricious" standard of review, and so it tried inundate Justice Kapnick with as many alternative arguments and claims as could withstand the red-faced standard of legal argumentation.  In many instances,  BAC's arguments for a different standard of review were not grounded by any citations to statute and case law, or were cited to cases that were inapposite to the facts in the Article 78 hearing.  Justice Kapnick simply pointed this out each and every time, and dismissed each of BAC's claims.

An example is BAC's claim that the stock redemption element of the Transformation should have been analyzed under New York insurance statutory law applicable to stock dividends, insofar as stock redemptions have a similar financial effect upon the issuer as a stock dividend.  Except, as Justice Kapnick curtly pointed out, NY statutory insurance law applies a particular standard to stock dividends that it doesn't apply to stock redemptions.  So, perhaps BAC might want to amend the statute given its particular insight, but the Court would decline the invitation. End of argument.

I say subtly in-your-face because of two portions of Justice Kapnick's opinion, in particular.  Everyone knows that BAC's Article 78 case serves a dual purpose:  i) try to invalidate the Transformation, and ii) generate leverage to negotiate a favorable settlement of MBIA's fraud and mbs putback action against BAC.  Hence, here comes an interesting footnote to Justice Kapnick's opinion:

"The court notes at the outset, that after reviewing a voluminous number of Article 78 cases spanning many years, including, but not limited to those brought against the NYID, the Court is not aware of any Article 78 proceeding where the petitioners, who are seeking to overturn an agency's decision, were not the original applicants or otherwise parties to the proceeding at the agnecy level"

In other words, while clothed in a mild form of understatement, the Court is saying "we know why you, BAC, are here.  We are not naive."  Bob Ehrlichman, may he rest in peace, would have called this footnote a "modified, limited zinger".

The other modified, limited zinger that I would highlight is the following:

"During oral argument on May 18, 2012, Petitioners [BAC] handed up a case appendix entitled "Courts Have Long Held That Article 78 Petitions Should be Granted When an Agency Acts on Inaccurate or Incomplete Information."  After reviewing the Appendix, the Court finds that none of the 14 cases cited provide a basis for this Court to annul the Approval Letter [approving the Transformation]".

In other words, the Court is essentially saying "here comes BAC with its best hope to argue that an "arbitrary and capricious" standard should not apply to approval of an agency decision when that decision is based upon inaccurate information, and it turns out that none of the cases BAC cites are worth the Court's consideration.  Excuse me?"

And Sullivan & Cromwell (BAC counsel) charges how much an hour?

What may be lost in this long-awaited analysis of Justice Kapnick's Article 78 decision are the simultaneous goings-on in her other BAC proceeding of note, the Article 77 hearing to consider the approval of Bank of New York Mellon's decision as Trustee to approve BAC's settlement of over $100 billion in actual and potential mbs investor losses for $8.5 billion.

Filings in the Article 77 action are going to heat up, but I recommend that you read two important expert opinion filings already made by AIG as an objecting investor:  Professor Tamar Frankel's opinion here and Professor Coates's opinion here. [Full disclosure:  I took Professor's Frankel's Corporation Law class in law school in 1978.  May she be a lesson to all of us in longevity and engagement!]

I have argued that BAC's Article 77 case is held hostage to MBIA's summary judgment motion regarding BAC successor liability here, and that BAC will likely lose on this motion here.  Hence, BAC should be strongly motivated to settle its litigation with MBIA.  Interestingly, the objecting mbs investors are off to a strong start with these expert opinion submissions, and BAC may not be out of harms' way even if it settles with MBIA before Justice Bransten issues her successor liability opinion.

[UPDATE:  It is unusual to find a well-written article about a court opinion.  Here is an excellent piece written about the decision.]

Double, Double, Toil and Trouble,
Fire burn, and caldron bubble.
Macbeth, Act IV, Scene 1

NB:  this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice.  Investing is a tough game, and everyone must do and "own" their own work, because you will certainly own your investments.

Disclosure: long MBI.  Follow me on twitter.