In yet another of the many cases against Residential Mortgage Backed Securities (RMBS) trustees for their alleged responsibility for losses suffered by investors, Judge Jesse Furman of the Southern District of New York precluded inquiry into the conduct of the trustee where a bankruptcy plan intervened. The plaintiffs were caught in a bind. Alleging misfeasance by the trustee prior to the commencement of the bankruptcy case would have been barred by the statute of limitations. Allegations of misfeasance subsequent to the commencement of the case were swept away by confirmation of the plan. The plaintiffs were accordingly left without a remedy, with the court not even addressing the merits of their claims.

Background

Fixed Income Shares: Series M, et al. v. Citibank N.A. (S.D.N.Y. March 2018) was an action brought by a number of funds against Citibank N.A. as trustee of a series of RMBS trusts. Following earlier dismissals, only two plaintiffs were left standing in the case. The dramatis personae and dramatis documenta were the usual for an RMBS case. American Home Mortgage Acceptance Inc. was the seller of the mortgages, and American Home Mortgage Servicing Inc. was the servicer. The trust was American Home Mortgage Investment Trust 2004-3, a Delaware statutory trust (AHM 2004-3 Trust). The main agreements consisted of a mortgage loan purchase agreement, an indenture and a servicing agreement.

The RMBS were issued in 2004. In August 2007, the promoter and the servicer filed for bankruptcy in Delaware. The bankruptcy court established Jan. 11, 2008, as the bar date for filing proofs of claim, and the trustee filed a proof of claim against each of the debtors’ estates prior to the bar date.

The bankruptcy court subsequently approved a liquidation plan with a formula that estimated claims for breach of representations and warranties. In March 2010, the bankruptcy court approved a stipulation resolving the trustee’s claims, which allowed no recovery for the representation and warranty claims and $65,000 for servicing-related claims. The trustee notified the noteholders under the AHM 2004-3 Trust of the court’s order and informed the noteholders that Citibank did not intend to take any further action in the bankruptcy proceeding “unless [it was] otherwise instructed and directed.” Citibank did not receive any instruction or direction from the noteholders.

Four years later, in November 2014, the plaintiffs filed suit against Citibank in its capacity as trustee. The claims that were the subject of the court’s decision were, first, that the trustee failed to act on representation and warranty breaches with respect to the defective mortgages following their discovery by Citibank. Second, the plaintiffs alleged, Citibank had knowledge of servicer breaches but failed to provide notice of the breaches to the investors, and also failed to act prudently to protect the investor interests following the occurrence of the events of default under the indenture.

The Court’s Analysis

Duties of the trustee

The court observed based on Elliott Assocs. v. J. Henry Schroder Bank & Trust, 838 F. 2d 66 (2d Cir. 1988) that the duties of an indenture trustee are more limited than the duties of a trustee at common law, in that the duties of an indenture trustee are “defined primarily by the indenture rather than by the common law of trusts.”

The indenture for the AHM 2004-3 Trust provided, as is customary, that upon discovery of a breach of representations and warranties made in a mortgage loan purchase agreement, the trustee was required to provide prompt written notice to the other parties to the agreement. In addition, upon the occurrence of an event of default that becomes known to the trustee, the trustee was required to notify all parties and the investors of the breach. Also, more generally, as is customary, upon the occurrence of an event of default the trustee was required to use the “same degree of care and skill … as a prudent person would exercise or use under the circumstances in the conduct of such person’s own affairs.”

Finally, the court noted, the indenture provided that the trustee was not deemed to have notice of an event of default unless a responsible officer of the trustee had actual knowledge of the event of default or the trustee received notice of such event at its corporate trust office.

Discovery and knowledge (and why it did not matter)

In its motion for summary judgment, the trustee apparently argued that the criteria for “discovery” and “actual knowledge,” which triggered the trustee’s various obligations under the indenture, had not been satisfied. In a succinct statement of the state of the law regarding these concepts, the court observed:

The meaning of those terms is an issue that has bedeviled courts in this District and in the state courts and is crying out for definitive judicial resolution, presumably by the Second Circuit or the New York Court of Appeals.

As the court noted, there are cases holding that knowledge must be proved on a loan-by-loan basis (Ret. Bd. of the Policemen’s Annuity and Benefit Fund of the City of Chicago v. The Bank of N.Y. Mellon, 755 F.3d 154 (2d Cir. 2014)) and that constructive knowledge is insufficient to satisfy the requirements for “discovery” (Royal Park Invs. SA/NA v. HSBC Bank USA Nat’l Ass’n (S.D.N.Y. 2017)). On the other hand, other courts have held “that a trustee has a responsibility to ‘pick up the scent and nose to the source’ when it learn[s] of facts merely suggestive of a breach” (Blackrock Allocation Target Shares: Series B Portfolio v. Wells Fargo Bank Nat’l Ass’n, 247 F. Supp. 3d. 377 (S.D.N.Y. 2017)), and that “discovery occurs when a party ‘knows or should know that the breach has occurred’” (The Bank of N.Y. Mellon Trust Co., N.A. v. Morgan Stanley Mortg. Capital, Inc. (S.D.N.Y. June 19, 2013)).

The court found that it did not need to decide among the competing views of discovery and knowledge. The reason for this, the court said, was that by the time Citibank allegedly learned of the breaches, under whatever standard, it was foreclosed from taking action because the mortgage seller and the servicer had already filed for bankruptcy.

The court remarked:

  • Because of the automatic stay in bankruptcy, Citibank could not take any actions outside the bankruptcy proceedings against the debtors.
  • In the bankruptcy case, Citibank could not bring any new claims after the bar date had passed.
  • Because the relevant agreements were executory contracts, the trustee was precluded from pursuing contractual remedies that would have been available had the debtors not filed.

The plaintiffs, moreover, could not plead claims allegedly arising prior to the bar date because those claims would have been foreclosed by the six-year statute of limitations, which ran in January 2014, some 11 months before the complaint was filed.

The plaintiffs were left with the argument that the trustee breached its duties by agreeing to settle its claims “on the cheap.” The court rejected that claim as well in the absence of any basis offered by the plaintiffs that Citibank could have obtained a more favorable result.1 Here, the court relied on the bankruptcy court’s approval of a stipulation of settlement of the debtors’ liquidation plan, which stated that the plan was “in the best interest of the Debtors’ estates, their creditors and other parties and interests.” The district court also noted that in approving the plan, the bankruptcy court was required to conclude that the plan was “fair and equitable.”

The court shot down a number of other claims advanced by the plaintiffs, including that Citibank was conflicted because of its differing roles in the securitization transaction, allegedly serving as both underwriter and trustee. In particular, they argued that Citibank had an incentive not to prosecute representation and warranty claims because to do so would have exposed itself to liability in connection with the offering. As to this line of attack, the court had this to say. First, the plaintiffs were conflating two distinct Citibank entities, the indenture trustee and a separate Citibank entity which served as securities underwriter. But more fundamentally, the plaintiffs offered no concrete evidence that the trustee’s actions were influenced in any way by the alleged conflict of interest.

In conclusion, the court observed that the plaintiffs here were “stuck between a rock and a hard place.” To avoid the statute of limitations, they had to plead breaches arising in the bankruptcy case after 2009. By alleging claims resting on Citibank’s conduct in the bankruptcy case, “they run headlong into the bankruptcy problem,” that is, the bankruptcy court’s confirmation of the plan.

Observations

An obvious takeaway is the diligence that should attend the prosecution of claims against solvent parties in any financial meltdown. But just as obvious, facts and circumstances are often confused at the outset, parties may be initially unaware of their avenues of recourse, and financial instruments change hands, with the new owners necessarily coming late to the party. What else is therefore to be learned?

First, as Judge Furman aptly put it, the state of the law on a trustee’s “knowledge” and duties of inquiry remains in flux.

Second, at whatever stage of play, noteholders expecting a trustee to take action are advised to be express in their direction to the trustee and not to rely on the trustee’s innate post-default duties, which may point in different and even conflicting directions.

Third, a court is not likely to conflate the different arms of a financial institution in order to attribute misconduct to the institution’s trust function.

Last, once a bankruptcy court has approved a plan of reorganization, a plaintiff will face a high, and perhaps insurmountable, hurdle to establish liability against fiduciaries whose determinations were effectively absorbed into plan confirmation.