There was much gnashing of teeth in the mortgage-backed securities industry last April, when U.S. District Judge William Pauley of Manhattan ruled that mortgage-backed certificates are debt, not equity. That finding, in turn, led Pauley to conclude that MBS trustees are subject to the federal Trust Indenture Act of 1939, which imposes duties on bond trustees. Under the TIA, Pauley said, MBS trustees can be liable if they fail to notify investors of deficiencies in the trust's underlying mortgage loans and fail to act on those deficiencies. Beth Kaswan ofScott + Scott, who represents the Chicago pension fund that brought the suit before Pauley (which named Bank of New York Mellon as Countrywide's MBS trustee), told me at the time that the "watershed" decision was a way for investors to get around MBS pooling and servicing agreements, which typically require 25 percent of a trust's investors to band together before they can bring any action against an issuer.
There's been relatively little notice of this, but it has potentially-enormous consequences. If this ruling -- that MBS certificcates are in fact debt, then liability could be extended under the TIA which would upend the attempt to play the game that a trustee has only a "ministerial" duty.
At issue is the fact that MBS trustees are typically paid a relatively-nominal fee and do basically nothing, other than have their name on the deal. If they suddenly are responsible for monitoring and reporting breaches of reps and warranties on the underlying loans, then suddenly they have a duty to surveil those notes and actually be a gatekeeper on the integrity of the deal itself.
This, of course, would include whether the physical notes bearing endorsements were ever delivered to the trustee in the first place!
It would be a grand day indeed were we to finally get a ruling that when you claim to be something (e.g. "Trustee") that you really have to act like one!
This fight isn't over, needless to say, and probably won't be in the immediate future -- but it does bear watching.
