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 of Scott + 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. Scott + Scott was so happy about Pauley's ruling that the firm immediately brought another case for the same client based on the same theory. In the second case, the Chicago fund sued Bank of America and U.S. Bank as trustees for Washington Mutual mortgage-backed securities.

The MBS industry, which regards the securities as equity, not debt, was not happy that Pauley saddled trustees with liability beyond their minimal duties in MBS contracts. In June, BNY Mellon's lawyers at Mayer Brown moved the judge to reconsider or certify the ruling for appeal to the 2nd Circuit Court of Appeals, with amicus support from The Clearing House Association, the Securities Industry and Financial Markets Association, the American Bankers Association and the New York Bankers Association. The judge hasn't yet taken action on the trustee's motion.

But on Friday, a second federal judge in Manhattan backed Pauley's reasoning. U.S. District Judge Katherine Forrest ruled in Scott + Scott's class action against the WaMu MBS trustees that mortgage-backed securities are debt, so trustees can be liable under the TIA. (She said the fund had adequately pleaded its claim under the indenture act that the trustees failed to notify investors of breaches of representations and warranties about the underlying mortgage loans but not its claim that the trustees failed to take reasonable action.)

In addition to citing several decisions from judges in the 2nd Circuit that refer to MBS as bonds or describe them as akin to bonds, the judge listed the qualities that, in her view, define mortgage-backed securities as debt rather than equity: "The certificates have a fixed maturity date and principal balance; certificate-holders receive regular principal and interest payments on fixed distribution dates; interest accrues on a periodic basis; the interest is paid off; and the certificates are subject to yield maintenance agreements," she wrote. Forrest explicitly rejected arguments by trustees' counsel from Munger, Tolles & Olson and Sidley Austin (for BofA) and Morgan, Lewis & Bockius (for U.S. Bank) that MBS are not bonds because they do not entail fixed or guaranteed distributions but depend on the performance of the underlying mortgages.

This battle over the status of mortgage-backed securities may not be over, though. Forrest did not address an alternative argument in the trustees' joint motion to dismiss, which cited a section of the Trust Indenture Act that exempts "certificates of interest" from the federal law. According to the defense motion, the Securities and Exchange Commission has relied upon that exemption in several no-action letters declining enforcement actions against issuers of mortgage pass-through certificates without qualifying indentures. The SEC has also referred to the exemption in the Corporate Finance Division's public guidance on the Trust Indenture Act. "In short, for 35 years the SEC has treated MBS pass-through certificates as exempt from the TIA," the motion said. "This unbroken record has, in turn, produced a uniform understanding among legal commentators that certificates evidencing ownership interests are exempt from the TIA, with resulting reliance by the industry."

BNY Mellon has also raised the argument of the SEC's longstanding interpretation of the law in its reconsideration motion before Pauley, but Scott + Scott countered that in the agency's recent MBS case against Option One, the SEC referred to mortgage-backed securities as "debt obligations." The SEC has also appended a note to its Corp Fin guidance, stating that it is considering its view of mortgage-backed securities and the TIA in light of Pauley's ruling last April.

Class counsel Kaswan of Scott + Scott said that Forrest's decision reinforces Pauley's holding. "This is the very situation the Trust Indenture Act was intended to address," she told me. "Investors would expect the MBS trustees to look out for their interests." Interestingly, the Pauley ruling doesn't seem to have inspired many TIA-based investor suits against MBS trustees. According to Kaswan, so far, only her firm has brought follow-on cases.

U.S. Bank counsel Michael Kraut of Morgan Lewis referred me to a bank spokesman, who sent an email statement that addressed U.S. Bank's argument that it's not liable in this case because it wasn't serving as trustee during the time the Chicago pension fund owned securities. "We acquired the securitization trust administration business from Bank of America at the end of 2010," the statement said. "We were not the original trustee for the trusts involved in this case, and the plaintiff has conceded that we were not the trustee at the time that the plaintiff held any interest in the trusts. Accordingly, we have no liability as successor trustee." I left messages with BofA lawyers but didn't hear back.

(Reporting by Alison Frankel)

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