Guest Post: Rights of MBS Bondholders against the Company: Part 1

[The following post is contributed by
Nidhi Bothra of Vinod Kothari & Company. The author may be contacted at
nidhi@vinodkothari.com]
The financial crisis of 2007-08 led
to several failed securitization transactions and brought in a storm of litigation
in structured products.[1] Post
the crisis, several bondholders sued the originators alleging
misrepresentations on the quality of loans underlying the mortgage-backed
securities that led to series of litigation and final settlements[2] in
some cases as well. There have been several rulings, post the crisis where the
rights of the bondholders to proceed against the originator-banks have been put
to question, questioning the privity of contract between the bondholders and
the originator companies.
In this post, we discuss one
such ruling of DB Structured Products Inc and try and elucidate the privity of
contract between the bondholders, trustees and the originator companies in case
of structured instruments and the likes.
Rights
of the beneficiary/ bondholders – in light of DB Structured Products ruling
The right of the bondholders to
bring suit against the originator company has been put to question and
curtailed in the provisions of the agreement binding them, in a recent ruling
of
ACE Corp vs. DB Structured Products Inc
(briefly discussed previously
here
on the specific question of limitation).
In the recent ruling, the
plaintiff (ACE Securities Corp.) alleged that the defendant had breached the
representations and the warranties in connection with the securitization of a
pool of mortgage loans governed by a Mortgage Loan Purchase Agreement (MLPA)
and a Pooling and Servicing Agreement (PSA). The clauses of the PSA indicated
that the certificate holders did not have the authority to provide notices of
default in connection with the sponsor’s breach of representations and that the
trustee could bring the suit against the defendant in such cases. The
certificate holders commenced action on behalf of the trust. The New York
Appellate Division held that the certificate holders lacked standing to
commence action on behalf of the trust and dismissed the complaint.
Bar
on bondholders rights to ‘putback’: spate of rulings over the years
The court placed reliance on the
ruling of
Walnut Place LLC vs. Countrywide Home Loans Inc.
In this case, Walnut (plaintiff) held mortgage-backed securities backed by the
mortgage loans of Countrywide. The plaintiffs investigated into the portfolio
of the loans sold by Countrywide and found that Countrywide had made false
representations and warranties about in the pooling and servicing agreement
(PSA) about the credit quality of the loans adversely affecting the interest of
the plaintiffs. Bank of New York Mellon, the trustee vide a letter demanded that
Countrywide repurchase those loans referring to the relevant clauses of the PSA
and on the same date plaintiff sent the letter to trustees for the breach of
representation and warranties relating to the delinquent loans. The defendant
failed to repurchase the loans within the stipulated time and the plaintiff
directed the trustees to file a suit against the defendant. Since the trustee
did not prefer the suit, the plaintiff commenced action on its own.
The defendants submitted that
the requirements for bringing a derivative action by the plaintiffs were not
met. Defendants rely on the case of Velez
v. Feinstein,[3]
where the Court held that:
[i]n an
action brought by a beneficiary on behalf of a trust, the beneficiary must show
why he has the right to exercise the power, which the law and the trust
agreement in the first instance confide in the trustees, to bring a suit on
behalf of the trust. This will normally require either a showing of a demand on
the trustees to bring the suit, and of a refusal so unjustifiable as to
constitute an abuse of the trustee’s discretion, or a showing that suit should
be brought and that because of the trustees’ conflict of interest, or some
other reason, it is futile to make such a demand.
The complaint was dismissed by
the court on the grounds that the PSA limited the rights of the certificate
holders to sue for the breach of servicers obligations (event of default)
further the section barred the certificate holders from initiating any suit
except where an event of default had occurred. The rights to initiate suit for
repurchase of the loans was with the trustees under the PSA and not the
certificate holders.
In Feldbaum vs. McCrory
Corporation
, the Court upheld a no-action clause providing that security
holders must give notice of an event of default, on the grounds that “if the trustee is capable of satisfying its
obligations, then any claim that can be enforced by the trustee on behalf of
all bonds … is subject to the terms of a no-action clause
.”
In a similar case of Greenwich Financial Services Distressed
Mortgage Fund 3, LLC
vs. Countrywide
Financial Corp
.[4], Greenwich
the plaintiff brought a class action against Countrywide, the defendant,
requiring the defendant to repurchase the mortgage loans on which defendant has
agreed to reduce the payments. The defendants submitted that the suit was not
maintainable on the grounds that the procedural requirements under the pooling
and servicing agreement (PSA) were not met and that there was a limitation on
the rights of the certificate holders under the PSA which were not complied
with. The relevant clause of the PSA read as below:
No
Certificateholder shall have any right by virtue or by availing itself of any
provisions of this Agreement to institute any suit, action or proceeding in
equity or at law upon or under or with respect to this Agreement, unless such
Holder previously shall have given to the Trustee a written notice of an Event
of Default and of the continuance thereof, as provided in this Agreement, and
unless the Holders of Certificates evidencing not less than 25% of the Voting
Rights evidenced by the Certificates shall also have made written request to
the Trustee to institute such action, suit or proceeding in its own name as
Trustee hereunder and shall have offered to the Trustee such reasonable
indemnity as it may require against the costs, expenses, and liabilities to be
incurred therein or thereby, and the Trustee, for 60 days after its receipt of
such notice, request and offer of indemnity shall have neglected or refused to
institute any such action, suit or proceeding; it being understood and
intended, and being expressly covenanted by each Certificateholder with every
other Certificateholder and the Trustee, that no one or more Holders of
Certificates shall have any right in any manner whatever by virtue or by
availing itself or themselves of any provisions of this Agreement to affect,
disturb or prejudice the rights of the Holders of any other of the
Certificates, or to obtain or seek to obtain priority over or preference to any
other such Holder or to enforce any right under this Agreement, except in the
manner provided in this Agreement and for the common benefit of all
Certificateholders.
The court held that the clause
prevented the certificate holders from bringing any suit, proceeding or action
in equity or in law under the PSA unless the procedural requirements are
complied with. The court held that the plaintiff’s allegation that the trustee
failed to bring the suit against the defendant and that there was conflict of
interest in terms of reduction in fee if the defendant was required to
repurchase did not stand. Further the plaintiff’s plea that the trustee’s
response of evaluating the position before bringing the suit could not be
construed to be denial by the trustee and was premature under the
circumstances. Since the plaintiff had not complied with the procedural
requirements the suit was not maintainable.
Analogy
drawn in context of Debentures
Closer home, in the case of Narotamdas Trikamdas Toprani vs. Bombay Dyeing And Manufacturing Co. Ltd. And
Others
[5], the
maintainability of a suit initiated by the debenture holders against the issuer
company was challenged on the grounds that the agreement permitted the trustees
to bring suit against the company and the not the debenture holders. However
the Bombay High Court did not dismiss interim relief to the plaintiff on the
grounds of non-maintainability of the suit.
The plaintiff debenture holder
proceeded filed a suit with Bombay High Court demanding a declaration that the
company was not entitled to issue the proposed debentures ranking pari passu with the existing debentures
and is not entitled to secure the said issue by a first mortgage on the fixed
assets of the first defendant company.
The company challenged that the
suit itself was not maintainable and that the plaintiff had no locus standi to maintain the suit and
such a suit was maintainable by the trustees under the covenants of the
debenture trust deed entered into by the trustees with the company.
Under
clause 55 of the debenture trust deed,
“the debenture-holders shall in general
meeting have”, inter alia, “the powers to sanction any modification
of the rights of the debenture-holders against
the company or against its property whether such rights shall arise under these
presents or otherwise”. Under clause 56, the trustees may, from time to
time, and at any time whenever they think fit or expedient in the interest of
the debenture-holders, waive, on such terms
and conditions as shall deem expedient to them, any breach by the company of
any of the covenants contained in the said trust deed.
The defendant company contended
that the covenants of the debenture trust deeds conferred obligations on the
company towards trustees and not on the debenture holders and thus the
debenture holders’ class action cannot seek action for enforcement of the
covenants of the debenture trust deed. In the present case, the trustees are
also made party-defendants to the suit along with the first defendant company. The
Bombay High Court did not dismiss the suit on grounds of maintainability.
In case of Gramercy Emerging Market Fund vs. Essar Steel Limited[6],
the Gujarat High Court held that the debenture holders were the creditors of
the company and held that the petition for winding up by the debenture holders
was maintainable as the debenture trustees were party to such petition. However
the court held that the trustees were necessary party to the winding up
petition in the absence of trustee being party to the petition, the petition
could be dismissed.
(To
be continued)

– Nidhi Bothra



[1] There have been a total of 927 credit crisis filings from January
2007 through the end of June 2013. http://www.nera.com/nera-files/PUB_Subprime_Series_Part_X_Credit_Crisis_Update_1113.pdf
[2] A
lot of cases initiated during the crisis were settled in 2012-13. Of the cases
brought by MBS and ABS investors 8 such cases were settled in 2012, and 17 in
2013 through October for a total value of $6.6 billion. Fannie Mae and Freddie
Mac have recovered more than $18 billion from several financial institutions to
resolve mortgage repurchase claims. There have been over $34 billion of
settlements between the US government and various financial institutions,
related to foreclosure procedures and consumer finance issues such as fairness
in mortgage lending. On January 7, 2013, the Office of the Comptroller of the
Currency and the Federal Reserve Board announced an $8.5 billion agreement with
various banks such as Bank of America and Citibank regarding foreclosure
practices and mortgage loan servicing deficiencies.
http://www.nera.com/nera-files/PUB_Subprime_Series_Part_X_Credit_Crisis_Update_1113.pdf
[3] 87 A.D.2d 309,
315 (1st Dep’t 1982)
[6] http://www.indiankanoon.org/doc/1898011/
judgement dated 20th March, 2002

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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