Monday, October 8, 2012

Bank of America's Idiotic Litigation Strategy and Why the New York Attorney General is Licking His Chops

Bank of America's (including its affiliates, BAC) mortgage backed securities (MBS) litigation with MBIA (MBI) has just entered a new and dangerous phase, and BAC appears clueless, confused and exposed.

On October 5, 2012, MBI and BAC filed motions for summary judgement in MBI's fraud and breach of contract action against BAC.  These filings stand in the shadow of the New York Attorney General's filing of a fraud action against Bear Stearns and its parent J.P. Morgan (collectively, JPM) on October 1, 2012. The NYAG stated that its JPM action would serve as a template for additional actions against MBS issuers and originators. In other words, BAC was put on notice that it would be a likely target for a follow-on suit brought by the NYAG, for which its JPM suit would serve as a template. 

Given the NYAG's special statutory powers and reduced evidentiary burden, and the ability of the NYAG to piggyback on any private action by obtaining not only a litigation roadmap for its action but also, importantly, the ability to use collateral estoppel to have findings of fact and legal issues proven in any private action also proven for the NYAG's case, all as discussed below, BAC inexplicably led with its chin in its summary judgment motion, and all but invited the NYAG to launch its case based upon BAC's very own work product.

BAC's litigation strategy has often been criticized for lack of foresight in its failure to settle with MBI.  Now, BAC can fairly be accused of idiocy as its own papers offer the NYAG a crisp first draft for the NYAG's contemplated template action.

In order to appreciate the hazardous litigation context that BAC now finds itself, one needs only to contemplate how a NYAG action against BAC would be supported by BAC's own summary judgment motion in its MBI suit.

As with its suit against JPM, the NYAG possesses some extraordinary powers not available to private parties.  In alleging fraud in a civil suit under the NY Martin Act, the NYAG does not have to allege and prove fraudulent intent of the defendant.  This is a huge courtroom advantage that distinguishes a Martin Act civil suit from a private fraud action. 

In addition, unlike a private party who can seek only recovery of its own damages, the NYAG can seek disgorgement of the defendant's ill-gotten gains.  The mathematic difference in the mbs context is extraordinary. This power to seek disgorgement of profits, in effect, turns the NYAG's suit into a no-need-to-certify class action case.  Think of the power that the state attorneys general had in the tobacco litigation, seeking to obtain disgorgement of tobacco company profits, as compared to individual private litigants seeking their own individual damages. This same enhanced remedy-seeking power applies in the mbs context.

To illustrate the profit disgorgement point, in the NYAG suit against JPM, the NYAG alleged:  
"From 2003 through 2006, EMC securitized over one million mortgage loans valued at the time in excess of $212 billion...Moreover, as a result of a “vertically integrated model” that generated revenue, as the FCIC noted, “at every step, from loan origination through securitization and sale,”
Defendants took in money from a variety of sources, including: (i) loan fees on loans originated
by Bear Stearns affiliates, including EMC and BSRMC; (ii) proceeds from the sale of RMBS to
investors; (iii) fees from underwriting mortgage-backed securities; (iv) fees from servicing of the
securitized loans; (v) fees from CDOs into which these securities were repackaged; (vi) gains
and fees from trading in these securities and interest in the CDOs into which they were placed;
and (vii) management fees and carried interest from hedge funds and other investment vehicles
that invested in the vast array of securities and financial products structured by Defendants."

All of the profits earned at every stage of the securitization process over the course of over $212 billion of securitizations are on the table for disgorgement in the NYAG suit against JPM.  In any NYAG template action against BAC, the numbers are likely to be even bigger.

Finally, if the NYAG proves "persistent fraud," which was alleged in its suit against JPM, the NYAG has the power to seek revocation of the bank's right to do business in New York.  This is the business death penalty...and commentators have been deploring the lack of criminal charges in the NYAG action!

Moreover, it is not just that any NYAG template suit against BAC as compared to MBI's suit will look like a steroid-enhanced Barry Bonds standing next to a little leaguer. You have to appreciate the power of offensive collateral estoppel as a weapon the NYAG can use in its template suit against BAC. If MBI is able to prove any facts in its private action, those same facts will be deemed proven in the NYAG template action.  Since the NYAG will allege persistent fraud against BAC in its template action, all alleged facts that are proven by MBI in its private fraud action against BAC can serve to prove persistent fraud in the NYAG action without further effort by the NYAG.

In other words, MBI's factual allegations to prove its right to damages now serve double-duty; if BAC loses on any factual allegations to MBI, it will also have lost them to the NYAG in its much larger and dangerous template case against BAC.  (Of course, this also applies with respect to private actions against other mbs issuers such as JPM).

Now, before we turn to BAC's summary judgement motion (SJ), let's look at MBI's SJ.  In its amended complaint, MBI alleged two principal causes of action: fraud, and breach of representation and warranty (R/W) in the transaction documents.  The first action is an action based on the entirety of BAC's conduct, its statements in offering documents, its R/Ws in the transaction documents, statements in emails and to the press, various actions that it took in the securitization process etc.  The second action is based on various R/Ws, such as that the mortgage file relating to each mortgage was complete, information provided by BAC was true and complete, appraisals by licensed appraisers were done for each loan, information regarding borrower income, fico scores, loan to value ratio etc was complete and accurate, and others.

MBI offers substantial information relating to both causes of action, but MBI's big gun in its SJ is the loan report it commissioned that was prepared by Steven Butler by conducting a random sampling of the securitized loans. (If the NYAG doesn't have a copy of the Butler report yet it certainly knows now that it should subpoena it...or just copy it from the MBI case docket if Judge Bransten decides to unseal it at the November 14, 2012 unsealing argument).  It is worth remembering that Judge Bransten has already ruled that the results of the sampling could be applied to the securitizations as a whole.  Based upon Butler's report, MBI alleges that over 56% of the loans breached BAC's R/Ws, and as to these 56% of the loans, BAC is unable to contest the allegation, and that it is prepared to show at trial that over 96% of the loans had material defects.

MBI is seeking recissionary damages for BAC's breach of its obligtion to repurchase loans that breached BAC's R/Ws.  Of the thousands of mortgages MBI put back for BAC repurchase, BAC refused to honor its repurchase obligations and, only after MBI commenced suit, BAC has repurchased only 4% of the mortgages put back to BAC.  It is also worth remembering that Judge Bransten has ruled that mortgages need not be in default in order for BAC to have breached its R/W, but that MBI need only show that it would not have entered into its insurance contract had it known of the breaches, and that recissionary damages (ie all of MBI's net losses arising from entering into the insurance contract) are available to MBI.

Now turning to BAC's SJ, BAC seeks summary judgment regarding the first claim of fraud not because it did not engage in fraud, but because it alleges that MBI knew of the fraud, and therefor MBI cannot claim that it justifiably relied upon BAC's R/Ws and other statements and procedures in the securitization process.  BAC seeks summary judgment regarding the second claim of breaches of its R/Ws in the transaction documents not because it did not breach the R/Ws, but because the transaction documents state that MBI's sole rememdy is to putback loans to BAC for repurchase.

Taking BAC's SJ at face value, BAC's claim that MBI knew of its fraud is a fact-intensive analysis that is not likely to be disposed at the summary judgment stage, and it appears weak given all of the allegations involved.  But the first crucial thing to bear in mind is that this allegation of MBI knowledge applies only to the first fraud claim, it does not apply to the breach of R/W claim. Unjustifieable reliance doesn't apply to an express warranty claim.

The second crucial thing to bear in mind is that, remembering MBI's action against BAC stands in the shadow of a NYAG template action, any party's knowledge of BAC's fraud has no applicability whatsoever to the NYAG in the template action. Not only does the NYAG not have to show fraudulent intent in its civil Martin Act action, but any knowledge of fraud by MBI cannot be a bar to the NYAG's claim brought, among other reasons, to clear fraud from the marketplace.

As to the second piece of BAC's SJ, it appears that BAC is insisting on a "catch-22" interpretation of the putback rights of MBI as well as the scope of judicial remedies available. Under BAC's view, it can blithely breach its repurchase obligation and, since this repurchase obligtion is MBI's sole rememdy, MBI can do nothing about it.  This is not a case where MBI failed to exercise its remedial rights (such as the instance of certain mbs trustees in other actions).  MBI put back thousands of loans to BAC, and BAC refused to repurchase them,  It certainly is within MBI's remedies to sue BAC for breach of its contractual repurchase obligation.

Again, nothing in BAC's assertion regarding MBI's remedies affects the NYAG in its template action.  The NYAG is under no limitation in seeking its enhanced statutory remedies (profit disgorgement), however painfully BAC misconstrues MBI's rights in MBI's case.

So, BAC is at a minimum punting on (and arguably admitting to) the question of whether it committed fraud, by relying on a defense (MBI's knowledge) that has no applicability in MBI's breach of R/W claim and doesn't apply to any NYAG claim of fraud in a template action.  As to MBI's breach of R/W claim, BAC is at a minimum punting on (and arguably admitting to) whether it breached the R/Ws, even though the NYAG can take BAC's breaches of its R/Ws as an important part of its fraud claim in its template action.

Why would BAC want to continue to litigate MBI's action by asserting weak arguments that not only have no bearing in a NYAG template action, but also go a long way to helping the NYAG write its complaint?

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.


  1. Hi,
    This article is interesting. My major question is this: MBI's balance sheet already has booked the 3.2 Billion potential recovery from BAC and other banks as the asset, and its book value is still only 2.5 Billion, so even if MBI wins the cases, what is the upside for the book value?


    1. the conversion of the receivable for cash would be a wash re book value, as you suggest. market value may be a different matter. you may want to look at adjusted book value, such as in BTIG's mark palmer's report when initiating coverage.

    2. Will the winning of this case affect adjusted book value, if the SEC book value is unchanged? I am a bit confused here.
      AGO has won the cases and has a cleaner book value that does not have such a huge assumption of winning a huge case, so is AGO a less risky investment?