Choice of Law

Drunken sailors may be forgiven for spending excesses while on shore leave, but Bank of America is still trying to shake off a financial hangover from its 2008 acquisition of Countrywide Financial for $4 billion in stock.

Soon after the takeover, BofA's effort to strip the meat off Countrywide and toss the carcass of toxic securities onto investors sparked multiple lawsuits alleging fraud, breach of contract, and bad faith. The bank's commitment eleven months later to assume nearly $17 billion in Countrywide debt and guarantees seems like chump change today.

At the time of the purchase, Countrywide - the nation's largest residential lender - had originated $408 billion in mortgages and held a loan-servicing portfolio of $1.5 trillion. To date, Bank of America has reported spending about $40 billion on Countrywide since 2007, and costs continue to mount.

As the risks ratchet up, so have the bank's efforts to shield itself from potential successor liability. Now BofA's fate appears to rest in the hands of two judges - one a federal judge in California's Central District, the other a state court justice in New York. So far, they have expressed opposing views of Bank of America's responsibility for the mounting Countrywide tab.

In early 2009 U.S. District Judge Mariana R. Pfaelzer of Los Angeles rejected an investment fund's claim that BofA is obligated to pay for any and all of Countrywide's indiscretions. Relying on little legal analysis, Pfaelzer wrote, "Nothing properly before the court suggests that BofA has done more than expressly assume some liabilities in consideration of the acquisition. ... Nor does anything properly before the court suggest that BofA has de facto merged with Countrywide."

Judge Pfaelzer then dismissed the bank as defendant without determining whether the laws of California, Delaware, North Carolina, or New York should apply (Argent Classic Convertible Arbitrage Fund L.P. v. Countrywide Fin. Corp., 07-CV-7097 (C.D. Cal. order issued Mar. 19, 2009)).

Countrywide and Argent settled the California litigation in 2010. But by then BofA was facing a similar suit in New York brought by MBIA, the nation's largest bond insurer and an investor in 15 Countrywide mortgage-backed securities pools. The bank's lawyers brandished Pfaelzer's ruling, hoping for a similar outcome. But State Supreme Court Justice Eileen Bransten rejected Pfaelzer's approach and applied more plaintiff-friendly New York law instead. Bransten found support for MBIA's allegations that BofA's buyout of Countrywide amounted to a de facto merger, raising the prospect that the bank would be liable for repurchasing billions in bad mortgages (MBIA Ins. Corp. v. Countrywide Home Loans, 2009 WL 2135167 (N.Y. Sup. Ct. order issued Apr. 27, 2010)).

Back in California, Pfaelzer had a second chance to rule on the question of BofA's liability when another institutional investor sued Countrywide in 2010. This time the judge applied Delaware law (based on Countrywide's incorporation), again rejecting successor liability claims and dismissing Bank of America from the case (Maine State Ret. Sys. v. Countrywide Fin. Corp., No. 10-CV-302 (C.D. Cal. order issued Apr. 20, 2011).

BofA got even more good news last August when eight additional federal shareholder actions against Countrywide - lawsuits originally filed in Illinois, New York, Ohio, and Oklahoma - were consolidated in Pfaelzer's court. In November she certified those cases as a class action, leaving Countrywide and a half-dozen of its former underwriters as defendants (In re Countrywide Fin. Corp. Mortgage-Backed Sec. Litig., 11-MDL-2265).

With summary judgment motions now looming - both before Pfaelzer in Los Angeles and before Bransten in New York - the financial stakes are immense. William Frey, CEO of Greenwich Financial Services and a plaintiff in another suit against Countrywide in New York, estimates that BofA could be liable for "north of $100 billion."

At that magnitude, the liability would exceed Countrywide's assets - and could drag BofA into a liquidity crisis that threatens its solvency. According to Isaac Gradman, a mortgage litigation expert who blogs at The Subprime Shakeout, the key question for the presiding judges is which state's laws to apply. Delaware requires a showing of fraud to establish successor liability; both New York and California offer plaintiffs easier standards in cases that may involve a de facto merger.

Exaggerating only slightly, Gradman says that if the bank eventually is kept on the hook for Countrywide's debts, "You can't help but look at BofA's takeover as the most egregiously horrible decision of all time."

But establishing successor liability won't be easy for the plaintiffs. Robert Daines, a Stanford Law School professor, says the two legal theories involved - corporate veil piercing and successor liability - are fact-intensive and "may turn on documents or testimony that would be produced at trial." To succeed on either theory, according to Daines, the plaintiffs would probably need to show that BofA materially underpaid for the Countrywide assets.

In a memo he wrote for lawyers representing Bank of New York Mellon in separate BofA-related litigation, Daines listed four exceptions to the general rule that a buyer is not liable for the seller's debts: if it agrees to assume liability, if it is a mere continuation of the selling company, if it engages in fraud, or if the asset sale is a de facto merger between the buyer and seller.

Delaware courts, Daines wrote, are loath to recognize de facto mergers "because it would create a great deal of uncertainty." In New York, however, he cited language from a venerable federal case describing de facto mergers as a "judge-made device for avoiding patent injustice that might befall a party simply because a merger has been called something else." (See In re Penn Central Securities Litigation, 367 F. Supp. 1158, 1170 (E.D. Pa. 1973).)

Daines concluded carefully: "Though I think the economic arguments and bulk of the case law favor [BofA], I cannot ignore the stream of case law in New York and elsewhere that is something of a wild card - the relatively wooden application of which could theoretically hold [BofA] liable."

Surely BofA's lawyers at New York's Wachtell, Lipton, Rosen & Katz anticipated such claims when they structured the all-stock Countrywide acquisition in January 2008. But according to Thomas J. Hall, a specialist in financial institution lawsuits at New York's Chadbourne & Parke, it can be difficult for buyers to prevent claims of successor liability and still acquire the assets they want. "[BofA] took many managers, personnel, and business operations [from Countrywide]," Hall says. "If they hadn't done that, they would have gotten assets, but not all they wanted. That's where merger starts to creep in."

The class action before Judge Pfaelzer may turn on choice of law. "Our position has been that California law should apply," says Julie Goldsmith Reiser, a partner at Cohen Milstein Sellers & Toll in Washington, D.C., and co-lead counsel for the Maine State plaintiffs. "Delaware law applies to each company's shareholders when you're talking about rights and responsibilities. [But] in our situation, we believe Countrywide committed a tort. It misrepresented its loans to investors - third parties who don't control the transaction, vote on the transaction, or get compensated for the transaction. Our suggestion is the court should apply tort law."

BofA's spokeswoman Shirley Norton declined to comment on the successor liability issues, and company lawyers were not permitted to discuss the Maine State case. But in court filings Matthew Close, a partner in the Los Angeles office of O'Melveny & Myers, argued for BofA that Countrywide's reincarnation as the bank's subsidiary in 2008 "was not an asset transfer that could qualify as a de facto merger."

Nor would Countrywide's sale of assets to the bank satisfy the continuity-of-ownership requirement for successor liability, Close argued: Consideration for the asset transfer was not BofA stock but rather the bank's assumption of Countrywide's debts and guarantees, among other things. Close dismissed New York Justice Bransten's decision in MBIA because the plaintiffs failed to allege that BofA's acquisition of Countrywide was "engineered to harm [its] shareholders and creditors."

Judge Pfaelzer's earlier rulings notwithstanding, Reiser has another theory to support the plaintiffs' de facto merger claim. BofA's intent in acquiring Countrywide should be determined, she says, by looking at how the IRS treated the transaction. Reiser argues that merger documents indicate it was considered a tax-free "reorganization" under the Internal Revenue Code (28 U.S.C. § 368). That is exactly what the plaintiffs allege: Countrywide shareholders became BofA shareholders, Countrywide's business continued, and BofA assumed its obligations. "If you're going to take [over] a company ... you can't just shed its liabilities," Reiser contends. "Otherwise, whenever a company gets into trouble it would sell to somebody else, who would continue to run it just to avoid tort liability.

"Countrywide could have gone into bankruptcy, but instead it sold itself to Bank of America," she says. "Bank of America should stand behind the liabilities."

Pamela A. MacLean, a freelance writer based in the Bay Area, has reported on state and federal courts for more than 25 years.

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