The key paragraph in Manhattan federal judge William Pauley III's 21-page ruling Wednesday in Bank of America's proposed $8.5 billion settlement with Countrywide mortgage-backed-securities investors is the last one.

"The settlement agreement at issue here implicates core federal interests in the integrity of nationally chartered banks and the vitality of the national securities markets," Pauley wrote. "A controversy touching on these paramount federal interests should proceed in federal court."

That sentiment infuses the judge's analysis of where BofA's proposed deal should be evaluated: Before Justice Barbara Kapnick in Manhattan state Supreme Court, where Countrywide MBS trustee Bank of New York Mellon filed the case as a special proceeding under an obscure state law; or before Pauley in federal court, where there's no analogous procedure for binding thousands of investors in 530 trustees to a settlement only 22 of them had a hand in negotiating. Pauley's decision to keep the case in federal court throws the settlement off the carefully-designed track the bank, the trustee, and the investor group that supports the deal hoped to keep it on.

The judge opted for a broad interpretation of the federal Class Action Fairness Act, a 2005 law intended to keep big cases involving lots of claimants out of state court. Grais & Ellsworth, which represents a group of Countrywide MBS investors who don't like the proposed BofA settlement, removed the case to federal court under CAFA's provisions for mass cases. (I've written here and here about Grais & Ellsworth's rationale for the removal and BNY Mellon's arguments against removal.) The test for a mass action involves three questions: Does the case involve monetary relief; does it involve 100 or more plaintiffs; and do their claims involve common questions of law or fact? In siding with Grais & Ellsworth on each of those questions, Pauley considered the implications of the proposed settlement, not the technicalities of Article 77, the New York law under which the case was filed.

"BNYM's argument exalts form over substance," he wrote with regard to arguments by BNY Mellon's Mayer Brown lawyer Matthew Ingber that the Article 77 proceeding didn't involve a claim for monetary relief, since all the trustee sought was a ruling that BNY Mellon had acted reasonably in reaching the settlement. Pauley was similarly scornful of the trustee's assertion that the Article 77 proceeding involved only one plaintiff, BNY Mellon. "BNY Mellon's argument is untenable," he wrote. "BNYM is trustee for 530 separate and unique trusts and seeks approval for its decision to settle the claims of each individual trust."

In all, Pauley seemed to find the settlement supporters' Article 77 gambit to have been too clever by half. He noted that his research uncovered only 28 Article 77 decisions in the last 40 years, many of which involved uncontested proceedings and garden-variety trust administration issues. He said, in fact, that he could find no authority to support the idea that a single Article 77 proceeding can be used to evaluate a decision affecting 530 trusts.

BNY Mellon had also argued that Grais & Ellsworth's client, an investor group called Walnut Place, doesn't have the right to remove the proposed settlement to federal court because it's not a defendant in the case. Indeed, as Ingber of Mayer Brown argued at the Sept. 21 hearing before Pauley, Walnut Place will receive money if the proposed settlement is approved, so it can't be considered a defendant under the traditional definition. Pauley concluded, however, that BNY Mellon was once again looking at form rather than substance, calling its argument "crabbed." Walnut Place, he wrote, was adverse to BNY Mellon, the Article 77 plaintiff, so it is a defendant for the purposes of removal.

Finally, the judge shredded settlement supporters' hole card: a ruling by the U.S. Court of Appeals for the Second Circuit that concluded a previous Countrywide MBS case -- a Grais & Ellsworth suit -- belonged in state court under the "securities exception" to the Class Action Fairness Act. As I've explained, the securities exception is counterintuitive. If the only claims at issue in a case involve federal securities laws, the case falls under the exception and goes back to state court. If state law claims are involved, it stays in federal court. (Weird, right?)

Pauley found that even though the previous Second Circuit ruling involved Countrywide mortgage-backed securities, it concerned the rights of MBS investors. The proposed settlement, on the other hand, involves the rights and duties of BNY Mellon as securitization trustee. The bank had argued that those duties derive from the contracts that govern the Countrywide MBS; but even BNY Mellon conceded in a round of briefing earlier this month that it also had common-law trustee duties. "Because a court evaluating BNYM's conduct as trustee must rely on New York common law, and not simply the bare text of the [trust contracts]," the judge wrote, "the securities exception does not apply here."

BNY Mellon and the Gibbs & Brun investor group that supports the proposed settlement will surely ask for Second Circuit review of Pauley's ruling, although it's not clear to me whether they'll have to get Pauley's leave to file an interlocutory appeal. (Remember, Bank of America is technically not a party to the case.) If the Second Circuit upholds the ruling, it's very bad news for BofA. Given the harsh treatment Pauley has dished out to settlement supporters in two hearings and in Wednesday's ruling, it's clear the lawyers who crafted the $8.5 billion dollar deal have a long way to go before they get Pauley to sign off. (There's also the rather enormous matter of what Pauley called the "procedural difficulty inherent in continuing this action in federal court," where there's nothing remotely like an Article 77 proceeding.)

I believe there's support for the assertion that Judge Pauley interpreted the Class Action Fairness Act too broadly in a pair of recent rulings by two federal circuits considering whether state attorney general parens patriae suits are mass actions. Both the Ninth Circuit and the Fourth Circuit have said that judges must hew closely to the language of CAFA in deciding whether a case is a mass action. Pauley wrote that he was "reluctant to indulge" BNY Mellon's reliance on CAFA's legislative history. We'll have to wait and see if the Second Circuit supports his reluctance.

(Reporting by Alison Frankel)

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