On December 23, 2014, the United States Court of Appeals for the Second Circuit issued an opinion on an issue of first impression, namely the scope of § 304(a)(2) of the Trust Indenture Act of 1939, 15 U.S.C. §§ 77aaa-77aaaa (the “TIA”), and its application to certificates issued by trusts under pooling and servicing agreements (“PSAs”).  See Ret. Bd. of Policemen’s Annuity & Benefit Fund v. Bank of N.Y. Mellon, Nos. 13-1776-cv, 13-1777-cv (2d Cir. Dec. 23, 2014).

The United States District Court for the Southern District of New York (Judge William H. Pauley, III) previously granted in part and denied in part Bank of New York Mellon’s motion to dismiss claims relating to the purchase of certificates from certain residential mortgage-backed securities (“RMBS”) trusts.  See Ret. Bd. of Policemen’s Annuity & Benefit Fund v. Bank of N.Y. Mellon, 914 F. Supp. 2d 422 (S.D.N.Y. 2012).  The district court held that the TIA applied to RMBS trusts governed by PSAs. The district court also held that the plaintiffs lacked “class standing,” or standing to assert claims related to RMBS trusts in which they did not invest, since such claims do not raise “the same set of concerns” as the plaintiffs’ own claims. Plaintiffs appealed the district court’s ruling on class standing and defendant Bank of New York Mellon (BNYM) appealed the district court’s holding on the application of the TIA.

Noting that RMBS trusts have “become a familiar subject of litigation” in the Second Circuit, the Second Circuit affirmed the district court’s denial of class standing.  The Court of Appeals held that the plaintiffs lack standing to assert claims against BNYM, the RMBS trustee, related to trusts in which the plaintiffs did not invest because such claims do not “implicate[] the same set of concerns” as the named plaintiffs’ own claims.  The Court of Appeals focused on the fact that the specific terms and parties in each RMBS trust were not identical and would need to be reviewed in each and every case thus making class standing inappropriate.

With regard to the application of the TIA to trusts governed by PSAs, the Second Circuit noted that this issue has generated conflicting decisions from district courts in the Southern District of New York.  The Court then explained that the TIA applies only to certain kinds of instruments, namely “only instruments that do not fall within at least one” of the TIA’s exemptions. In addressing the exemptions, the Second Circuit held that the certificates were exempt because they were “‘certificate[s] of interest or participation in two or more securities having substantially different rights and privileges,’ namely, the numerous mortgage loans held by each trust.”

The Second Circuit found that the certificates issued by the RMBS trusts were “certificate[s] of interest or participation” because (a) they were certificates (as opposed to notes) and (b) payments to certificateholders were contingent on the cash flows from the underlying mortgages.  The Second Circuit held that the certificateholders did not have to receive all of the cash flows in order to make the payments contingent and therefore qualify as a “certificate of interest or participation.”  The issue of whether the certificates remained “certificates of interest or participation” was “arguably [a] more difficult question” for the Second Circuit because the payments on the underlying mortgages were not simply passed through to certificateholders.  Ultimately, the Court held that the contingent nature of the payments together with the administrability concerns “would seem to necessitate rules for parceling out the returns from th[e] underlying securities.”

Next, the Second Circuit held that the certificates were for “two or more securities.”  The Court rejected the plaintiffs’ arguments that the certificates were for a single security, namely, the corresponding tranche.  The Second Circuit noted that a tranche is not a security, but rather a name to describe a group of certificates.  Rejecting the plaintiffs’ arguments, the Second Circuit also held that the underlying mortgages qualify as securities under Section 304(a)(2) of the TIA.

The Court next held that mortgage loans have “substantially different rights and privileges” because the mortgages have different obligors, payment terms, maturity dates, interest rates, and collateral.”  The Second Circuit noted that its decision was consistent with the SEC’s position that instruments such as the ones at issue were exempt under Section 304(a)(2).

The Second Circuit declined to decide whether the certificates at issue qualify as non-exempt “debt” or as an exempt “equity” security under § 304(a)(1) of the TIA, so that issue remains for another day.

Sheppard Mullin represents a party in Millennium Partners, L.P. et al. v. U.S. Bank National Association, et al., 12-cv-07581, which is pending in the Southern District of New York.  That case involved substantially similar claims to those at issue in Retirement Board.  Sheppard Mullin successfully obtained the dismissal of all of the claims, other than a claim based on the TIA.  The parties agreed to stay that litigation pending the Second Circuit’s decision in Retirement Board.