The US District Court for the Southern District of New York recently ruled in favor of issuers of residential mortgage-backed securities (RMBS) in a case that was a long-running challenge to the Employee Retirement Income Security Act of 1974.

In Powell, et al. v. Ocwen Financial Corporation, et al. (No. 18-CV-1951 (VSB), 2023 WL 3756847, (SDNY June 1, 2023)), the US District Court for the Southern District of New York granted the defendants’ motion for summary judgment in a case closely watched by the asset-backed securities industry. The plaintiff is a multiemployer pension plan whose claims in the case challenged the foundational principles of how the Employee Retirement Income Security Act of 1974, as amended (ERISA) applies to asset-backed securities.

The key issue in the Ocwen case is whether the underlying assets of the trusts that issued the securities were “plan assets” within the meaning of ERISA. The determination of “plan asset” status is addressed in a US Department of Labor regulation often referred to as the “plan asset regulation,” and depends on whether the securities in question in this case were debt interests or equity interests.

The District Court found that no reasonable trier of fact could conclude that any of the mortgage-backed securities at issue in the case could cause any of such underlying assets to be “plan assets” within the meaning of ERISA. Thus, the court granted summary judgment in favor of the defendants, which were Ocwen Financial Corporation and a long list of other parties with various roles in the securitizations at issue in the case.

BACKGROUND ON THE CASE

In 2018, the trustees of the United Food & Commercial Workers Union & Employers Midwest Pension Fund (the Fund), a multiemployer pension plan subject to ERISA, sought to certify a class of ERISA-governed benefit plans that purchased notes and certificates issued by six RMBS trusts.

Three of the trusts were indenture trusts that issued notes (the opinion refers to these notes as the “At-Issue Notes”). The other three trusts were real estate mortgage investment conduit (REMIC) trusts that issued certificates (the opinion refers to these certificates as the “At-Issue Certificates,” and to the At-Issue Notes and At-Issue Certificates collectively as the “At-Issue Securities”). Entities that seek to operate as REMICs must meet certain conditions, as compared to other issuers of asset-backed securities, and receive different tax treatment than non-REMICs.

The plaintiff alleged that Ocwen Financial Corporation, and the various other defendants in the case, breached their fiduciary duties under ERISA and engaged in prohibited transactions under Section 406(b) of ERISA in the management of the mortgages held by the six trusts that issued the At-Issue Securities.

In 2019, in response to the defendants’ motions to dismiss, the court issued an opinion and order that identified two “threshold issues” for determining if the plaintiff may proceed against any of the defendants. The first threshold issue was whether the mortgages underlying the trusts constituted “plan assets” of the Fund. The second was whether Ocwen may be considered a fiduciary of the Fund, which depended on whether the mortgages underlying the trusts constituted “plan assets” of the Fund. In 2020, the parties each filed motions for summary judgment, along with a variety of replies.

THE COURT’S ANALYSIS

The Southern District of New York began its analysis with a discussion of the US Department of Labor regulation, often referred to as the “plan asset regulation,” that addresses when an ERISA plan’s assets include the underlying assets of an entity in which the ERISA plan invests. Specifically relevant to the court’s analysis, the plan asset regulation provides the following:

Generally, when a plan invests in another entity, the plan's assets include its investment, but do not, solely by reason of such investment, include any of the underlying assets of the entity. However, in the case of a plan's investment in an equity interest of an entity that is neither a publicly-offered security nor a security issued by an investment company registered under the Investment Company Act of 1940 its assets include both the equity interest and an undivided interest in each of the underlying assets of the entity. . . . 29 C.F.R. § 2510.3-101(a)(2) (emphasis added).

Thus, with exceptions that are not relevant to At-Issue Securities, whether an entity can be “looked through” and have its assets deemed to be plan assets due to an investment by an ERISA plan depends on whether the ERISA plan’s investment is an “equity interest.” The plan asset regulation defines “equity interest” as “any interest in an entity other than an instrument that is treated as indebtedness under applicable local law and which has no substantial equity features.” 29 CFR § 2510.3-101(b)(1).

On the question of “applicable local law,” the court noted that certain trusts were Delaware statutory trusts and others were “creatures of New York law.” The Court further noted that each trust’s governing agreement contains a clause providing that it is governed by New York law. The court then concluded that both Delaware and New York law would look to the “terms of the contract governing the security to determine whether it was debt or equity.”

After analyzing the terms of the indenture agreements for the At-Issue Notes, the court concluded that both New York and Delaware law would find the At-Issue Notes to be debt based on the terms of the indenture and the fact that the indenture agreements refer to the notes as “indebtedness” for all purposes.

In a surprising twist of the decision, the court also concluded that the At-Issue Certificates were debt, stating that New York courts have characterized as debt arrangements in which a certificateholder receives “payments pursuant to a prioritized pass-through scheme for distributing the money paid into the various REMICs by people who had taken out mortgage loans and were paying them back.” The court acknowledged that residual interest certificates, which were not at issue in the case, may be equity interests as they hold “upside potential,” but that the REMIC certificates represented another type of interest in the REMIC trust that can be characterized as debt.

This holding came as a surprise because the market practice among the ERISA bar of the asset-based securities industry is generally to view REMIC certificates as equity interests and, rather than look to avoid ERISA plan asset status, instead rely upon a set of prohibited transaction exemptions referred to as the “underwriter’s exemptions” to deal with the consequences of ERISA plan asset status.

The court then tackled the other prong of the plan asset regulation’s definition of “equity interest”—that of “substantial equity features.” Correctly noting that there are no Department of Labor interpretations or other hints on what may constitute “substantial equity features,” the court turned to Internal Revenue Service (IRS) guidance for factors applicable to distinguish between debt and equity.

Among those factors supporting the treatment of the At-Issue Securities as debt were (1) fixed interest rates and legal final maturity dates, (2) various payment enhancements to bolster the probability that the holder will be paid, and (3) investment grade debt ratings by agencies that rate only debt securities.

In addition, the court found that the plaintiffs failed to identify any features that amount to “substantial equity features”—concluding that neither downgrades nor variability in interest and principal payments over the years supported characterization as equity.

KEY TAKEAWAYS

The Ocwen case is notable because court decisions at the intersection of ERISA and asset-based securities are scarce. The case also garnered a lot of attention prior to this opinion because a decision going the other way—a holding that the At-Issue Notes were equity interests and the holding of the At-Issues Notes by ERISA plans could cause the underlying assets of the trusts to be plan assets—could have been extremely disruptive to the ERISA plan market for all types of securities issued as notes, not just for asset-backed securities.

Issuances of securities as notes are structured on the assumption that notes do not constitute equity interests. If that assumption were no longer warranted, note issuances would have to be structured very differently in order to market them to investors subject to ERISA or prohibited from being acquired by ERISA plans entirely.

The holding regarding the At-Issue Notes not being an equity interest is consistent with the general approach and practice among the asset-backed securities ERISA bar and thus can serve as confirmation of that approach and practice.

However, while the holding regarding the At-Issue Certificates not being an equity interest may have been more surprising to the ERISA bar, it does not seem likely, by itself, to change the common practice of treating certificates as potentially equity interests and relying instead on the underwriter’s exemptions to avoid the negative consequences of the assets of the issuer being plan assets.

Also, this decision is a single District Court decision, for which a notice of appeal has already been filed. Further, as noted above, there is no Department of Labor guidance on these questions either.

Therefore, the market may await further confirmation before deciding to treat REMIC certificates as debt interests based on this decision. Given the impending appeal, this may not be the last word in the Ocwen saga.

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