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A 21st Century Trust Indenture Act?

posted by Adam Levitin

MBS investors suffered a serious legal blow a couple of months back when the Second Circuit held that the Trust Indenture Act of 1939 doesn't apply to MBS

The Second Circuit's decision hinges on treating a "mortgage" as a "security." That's rather counterintuitive.  The Trust Indenture Act doesn't define "security," but refers to the Securities Act's definitions. The Securities Act defines "security" to include "any note" but the definition bears the caveat "unless the context otherwise requires." I'd think that the context would have pretty easily counseled for reading "note" not to include residential mortgages. What the Securities Act is trying to pick up are issuances of corporate notes.

Frankly, I think the Second Circuit's reading (and the resulting decision) are absurd.  First, it is hard to see any context in which "note" should be read to include "residential mortgage" (especially in light of all of the other things that constitute a "security" under the Securities Act, when Congress could easily have included a "mortgage" in the definition).  Second, the Second Circuit's reading arrives at an absurd policy result.  It excludes from the Trust Indenture Act the very sort of securities (proto-MBS) that were the driving force behind the creation of the Trust Indenture Act of 1939 (and the NY state Trust Indenture Act of 1935 before that).  The groundwork for the federal Trust Indenture Act was a 1936 SEC report authored by William O. Douglas, Jerome Frank, and Abe Fortas (among others) that documented in incredible detail the abusive role of trustees in mortgage bond reorganizations.  (While bankruptcy scholars have tended to focus on the railroad reorganizations chapter of the report, the real estate chapter is just as important, and goes a long way to understanding why Douglas was such a champion of the absolute priority rule.)

The point here isn't to belabor a questionable decision by the Second Circuit (which did not mention the policy issues in its decision, but I don't know if they were argued), but to underscore the ruling's consequence. At least in the 2d Circuit, it's now clear that MBS investors are not protected by the Trust Indenture Act, and that's a bad thing. This decision means that there's very little (if anything) protecting investors from wrongdoing by MBS trustees, whether acts of omission (e.g., failing to police servicers) or commission (e.g., entering into sweetheart settlements of rep and warranty liability). This is exactly what the Trust Indenture Act was supposed to prevent. If Congress cares about investor protection, it's time to devise a 21st century Trust Indenture Act. 

[Update:  A state securities regulator emailed me to draw my attention to the Supreme Court's 1990 decision in Reves v. Ernst & Young.  That decision expressly adopted an older 2d Circuit case's test regarding what is a security. That case excluded residential mortgage loans from the definition of "security" in the context of a securities fraud action. The 2d Circuit cited to its older decision (but not the Supreme Court's subsequent adoption of its test), but said that the context was different. Unfortunately, the 2d Circuit didn't think it was necessary to explain what about that context was sufficiently different to merit a different result. I can't see any plausible contextual distinction. There's really no context in which loans made for personal, family, or household purposes should ever be considered securities. They are subject to entirely different regulatory regimes, they are part of different markets, and no one would ever think to refer to such loans as securities. Except, apparently the 2d Circuit. It's one thing to arrive at the wrong conclusion after a serious analysis, but I am troubled that the 2d Circuit didn't bother to explain itself in this context.]  

 

Comments

Looks like linguistic gymnastics inended to protect the (insert adjective here) guys from liability.

Was the opinion by panel or En Banc?

I'm really surprised by your reaction to this, Adam, and frankly I'm starting to question some things.

A mortgage note is an instrument representing ownership of an income stream. Instruments that confer ownership of an income stream are securities unless an exception applies, period. The "you may not unless we specifically say you can" nature of the securities laws is intentional. It prevents people from trying to evade the securities laws through structure.

This is really bedrock stuff. In fact, when I meet a lawyer who claims to be a really good securities lawyer (and there are sooooo many), I use it as a test of whether they actually do understand securities or are really a clown.

What's different about the context, was that if the earlier case had come out differently than every dispute between a homeowner and lender would be a securities fraud case.

L, I respectfully disagree, even if it means you think I'm a clown. (If you're going to call me a clown, you should at least use proper grammar. Your last sentence, should read "differently, then" not "differently than".)

But addressing the merits, rather than the ad hominem: the '33 Act's definition of "securities" is broad. I don't think it's meant as an anti-evasion rule, however; I think it's just that it's hard to define security sensibly. For example, what's the difference between a junk bond and a syndicated leveraged loan? Very little that would justify excluding one, but not the other from the securities laws.

Even if the broad definition is an anti-evasion mechanism, that doesn't mean it's limitless. The "unless context requires otherwise" language is meant to put some common sense limits on the definition. No reasonable person would think that an extension of credit for personal, family, or household purposes was a "security" for the purposes of the securities laws. Your absolutist definition ignores this important textual limit on the scope of the definition.

I would like know when a note is sold wouldn't that make a mortgage a unregistered security, because the note was not registered as a security instrument. So wouldn't that valuate the Securities Act of 33 and 34.

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