Beth Kaswan of Scott + Scott has the fervor of a pioneer when she talks about the implications of U.S. District Judge William Pauley's ruling Tuesday that her client, a Chicago police officers' pension fund, can proceed with some claims that Bank of New York Mellon violated its duty to Countrywide mortgage-backed securities investors under the federal Trust Indenture Act. "Judge Pauley is the first judge to say the Trust Indenture Act, in existence since 1939, does apply in this type of circumstance to mortgage-backed securities," Kaswan told me Wednesday. "That means investors can sue trustees, even if they can't cobble together 25 percent" of the voting rights in any particular trust -- a prerequisite to suing under the pooling and servicing agreements governing most MBS trusts.

Kaswan, who said her firm was the first to assert the federal law against an MBS trustee, believes Pauley's 19-page decision offers a significant new route to damages for MBS investors. The Manhattan federal judge ruled that the Chicago fund only has standing to bring claims for the trusts in which it invested, reducing the number of Countrywide MBS trusts in the case from 530 to 26. But he also said that investors in those 26 trusts can sue BNY Mellon for allegedly failing to notify certificateholders that Countrywide and Bank of America supposedly breached their obligations to the trusts and for failing to take action on those breaches.

Kaswan said the ruling means that even investors who sold their Countrywide mortgage-backed notes at a loss -- who are not slated for recovery under Bank of America's proposed $8.5 billion global settlement with Countrywide MBS holders -- have a viable cause of action. The federal law also imposes duties on the trustee beyond those specified in MBS pooling and servicing agreements, Kaswan said, which means investors have a better chance to show BNY Mellon failed certificateholders.

All of the benefits Kaswan sees in Pauley's ruling derive from the judge's conclusion that the Trust Indenture Act applies to mortgage-backed securities. Pauley's holding, in turn, relies on his finding that mortgage-backed notes are equivalent to bonds, not equity. Pauley pointed to other court rulings that have likened MBS pass-through certificates to bonds, to the Internal Revenue Service's distinction between creditors and shareholders, and to the payment structure of MBS trusts to conclude that trust certificates are more like bonds than ownership interests.

BNY Mellon's lawyers at Mayer Brown strenuously argued otherwise in their motion to dismiss the case. Except for one Delaware Countrywide MBS trust in which the Chicago fund invested, the other New York trusts in the case issued equity securities, not debt, according to the BNY Mellon brief. Conveniently, Mayer Brown quoted a securitization treatise written by its own partner, Jason Kravitt: "With regard to trusts, certificates evidencing ownership interest therein should be viewed as equity securities since certificateholders are only entitled to receive distributions ... when, as, and if the trust receives funds ... and the ownership interests represented by trust certificates rank junior to trust obligations and liabilities."

BNY Mellon argued that under the plain language of the pooling and services agreements, which refer to the "ownership" interest of certificateholders, the New York trust securities are equity. The bank also cited the Securities and Exchange Commission, the U.S. Treasury, and the U.S. Department of Labor as authorities that treat mortgage-backed certificates as equity, not debt.

The bank will almost certainly challenge Pauley's conclusion that MBS certificates are debt, which could have implications beyond this case for the securitization industry.(BNY Mellon spokesman told Jon Stempel of Reuters Tuesday that the bank disagrees with the judge's finding on its potential liability under the Trust Indenture Act.) So we won't really know if Pauley's ruling amounts to a watershed for MBS investors until it's tested on appeal.

Interestingly, Scott + Scott's assertion of the Trust Indenture Act is the only reason Pauley has jurisdiction over the case, which otherwise makes breach-of-contract and negligence claims un d er state law. BNY Mellon has, of course, been down the jurisdictional road with Pauley before, when the judge ruled that BofA's global settlement belonged in federal court. As you'll surely recall, he was subsequently reversed by the 2nd Circuit Court of Appeals, which sent the global settlement back to New York State Supreme Court Justice Barbara Kapnick.

Kapnick has been notably less receptive to arguments that BNY Mellon should face claims of failing investors than Pauley was in Tuesday's ruling. Last week, she dismissed Walnut Place's suit against Countrywide and BNY Mellon, reasoning that Walnut's case was barred by Countrywide MBS pooling and servicing agreements that grant the MBS trustee the power to bring suit; contrary to Walnut's claims, she said, BNY Mellon had taken action to protect investor interests by negotiating the proposed $8.5 billion global settlement. In Tuesday's ruling, Pauley noted Kapnick's finding in the Walnut case, but said "at this preliminary state, this court expresses no opinion regarding BNYM's diligence."

(Reporting by Alison Frankel)

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