Friday, June 28, 2013

The ResCap Bankruptcy, Bank of America Article 77, and the Death of Competence of Wall Street

The ResCap bankruptcy case and the Bank of America (BAC) Article 77 proceeding involve companies with many similarities, so it is striking to see how different are the two different judicial processes in efficiently and fairly resolving the cases.

ResCap and Countrywide are both insolvent mbs originators subject to a multiplicity of legal claims arising from the financial crisis.  They have solvent parent holding companies each of which conducted transactions with the subsidiaries which give rise to claims that the parent company should have successor liability for the subsidiaries' liabilities.

There is one major difference, however.  ResCap's bankruptcy case is proceeding in an open and fair manner with a full investigation into all of the relevant facts necessary to adjudicate the claims, and reach a settlement in connection therewith.  BAC's Article 77 proceeding, by contrast, is the concluding act to a mockery of a process that, if the BAC/BNYM settlement is upheld, presages the death of competence on Wall Street.

What do I mean by this?  It has been reported that Justice Kapnick, the presiding judge of the Article 77 proceeding, herself has stated in open court that "everything is backwards" in the Article 77 proceeding.  When you compare the bankruptcy proceeding to the Article 77, in particular with respect to the extent the facts of the dispute have been investigated before a settlement was reached, as well as the inclusiveness of the process, you will see why this is so true.

In the ResCap bankruptcy, there was a thorough investigation of the facts underlying the claims and transactions at issue in the case.  This was performed not only by the parties, but also by an examiner appointed by the bankruptcy judge, who shared his materials with the debtor and creditors committees as he was conducting the investigation.  While his final report was not unsealed while the debtor and the creditors committees were negotiating the plan support agreement, it is safe to conclude that the parties profited from the fruits of this investigation and, because of this investigation, the debtor and creditors had all of the facts at their disposal necessary to negotiate their settlement in an intelligent manner.

As well, when it came time to negotiate a deal with the debtor and the contribution its parent would make to the bankruptcy estate, all of the unsecured creditors were included in a committee, and each had the benefit of representation of counsel for the entire committee.  The negotiation also had the benefit of a mediator, a sitting federal bankruptcy judge, who was able to encourage settlement.

So in the ResCap bankruptcy, the facts were obtained before the negotiation, and the negotiation was conducted by all of the creditors sitting at the table represented by impartial counsel who represented all of the creditor committee members.

This is a competent process designed to result in a competent result, because all of the work that needed to be done before a settlement decision was reached had, in fact, been done.

As for the Article 77, as Justice Kapnick puts it, everything is bakwards.

BAC and the settling investors negotiated a settlement without knowing the important facts.  Which facts?  The extent to which the loan files sitting in the custody of BNYM, as trustee, complied with representations and warranties made about them in the transaction documents!  The parties were speculating about breach rates, and the trustee's financial advisor accepted BAC's speculation of breach rate, all in complete ignorance of what the actual breach rate was.  This actual breach rate could have been determined by a re-underwriting of the loan files.  Why did the trustee maintain the loan files? For precisely this sort of eventuality!  Can you imagine a bankruptcy judge endorsing the fairness of a case in which the parties had ready access to the facts but declined to investigate them?

Moreover, the negotiation between BAC and the settling investors did not involve a group of creditors that represented all creditors with an interest in the matter, and no effort was made by the trustee to try to include them.  The settling investors and its counsel expressly disclaim any inference that they were acting on behalf of the creditor group as a whole.

In fact, BAC was able to argue that Countrywide's bankruptcy would result in no recovery for creditors because there would be no successor liability for BAC, the creditors would have to show that the representation and warranty breaches directly caused the creditors' losses, and that sampling of loans and extrapolation to the entire pool would not be permitted, all of which were highly debatable claims by BAC which were given far too much credence by the settling investors precisely because the settling investors had failed to do their homework and had not conducted a thorough investigation before settlement discussions (unlike the case in ResCap).

Moreover, the settling investors were represented by counsel not qualified to practice New York law, which would apply to any litigation of the dispute (Ms. Patrick is a Texas lawyer), and who was not independent (Ms. Patrick's firm will receive a success fee equal to 1% of the settlement paid by BAC, but only if the settlement is upheld in the Article 77; indeed, Ms. Patrick's firm is more a party with an economic interest in the outcome of the proceeding than counsel representing creditors, much less all of the creditors whose interests are being adjudicated).

My point is not that the settling investors are not sophisticated financial institutions, nor that Ms. Patrick is not an able litigator or negotiator.  It is simply the point that the settling investors did not avail themselves of a process by which they could complete a full and fair investigation of the relevant facts before they commenced negotiations, a process also that would fairly include all creditors with an interest in a settlement that purports to bind all creditors...and now, the settling investors seek judicial approval over this failed process.

Instead, the settling investors were bullied by bluffing threats made by BAC that betrayed the settling investors' lack of knowledge of the relevant facts, for failure to have conducted a prior investigation.  To the BAC reported threat that it would put Countrywide in bankruptcy (which apparently moved the settling investors off their initial settlement bid in a hurry), the settling investors should have said, "go ahead make our day"...then, you would have had a bankruptcy process adjudicate the BAC/Countrywide matter in a way that would have resembled the ResCap/Ally matter.  Based on the ResCap/Ally bankruptcy result and Justice Bransten's holding that New York law applies to BAC's successor liability, want to place a bet on whether this would have resulted in a higher settlement award payable by BAC?

Indeed, putting Countrywide into bankruptcy was the last thing BAC would have wanted, as it would have effectively consolidated all of the investor and monoline mbs cases against it and Countrywide into one proceeding where the adversaries' costs of that proceeding would have been borne by the bankrupt estate. This would have eliminated BAC's legal strategy of economic attrition against the monolines. A completely idle threat!

The distressing thing to me about the Article 77 proceeding is what it implies as to the future of competence on Wall Street.  While Justice Kapnick is a very able judge, she has not practiced a day of commercial law in her life, and simply knowing what the law says about a trustee's duties, in general terms, is no substitute for having practiced on Wall Street where, at one time, competence mattered.  Really, competence is on trial in the Article 77, as well as the interests of the intervening investors.

So, now it is reported that Justice Kapnick has requested that the parties submit the Article 77 matter to mediation, a request that BAC refused.  It seems that BAC has found itself a process by which competence is not a prerequisite to approval, and it is intent on sticking with it.

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.

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