Did BNY Mellon violate ‘code of conduct’ in dealings with a community bank?

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A bank in Orange County, Calif., agreed in early 2016 to refinance a $5.5 million loan that a customer had obtained from Bank of New York Mellon. After paying off the original loan, First Foundation Bank waited to receive the collateral that had secured it.

More than three years later, First Foundation is still waiting.

In court filings, the $5.8 billion-asset bank has accused BNY Mellon of failing to live up to a promise to transfer the collateral. The New York-based bank has denied wrongdoing, asserting that the collateral was subject to competing claims.

Today the collateral — a portfolio of 28 municipal bonds — sits in a court-controlled account. Its ultimate destination may hinge on the outcome of separate litigation involving a California real estate developer who made a massive profit on the sale of desert property back in 2005.

First Foundation’s multimillion-dollar loan has gone into default, which raises the stakes on its efforts to recover the never-delivered collateral.

“This is a nightmare situation for a lender,” said Matt Prosseda, a former banker who is now an industry consultant at the Kafafian Group in Parsippany, N.J.

The labyrinthine events that led to this unusual morass are one of a kind. But the dispute is of wider interest because it highlights the friction than can result when the banking system’s reliance on trust bumps into the legal system’s dependence on formal rules.

The saga began with real estate speculation in the Southern California desert during the housing boom of the early 2000s.

A 600-acre property in the city of Desert Hot Springs resembled a moonscape, but in a red-hot housing market, developers saw potential, according to court papers. If the requisite permits and approvals were obtained, the property could be divided into as many as 2,000 lots where homes could be built.

In July 2004, a corporation in which a developer named J. Robert Gilroy was a shareholder purchased the property for $20 million from another developer, Michael LaMelza. Meanwhile, a former employee of LaMelza went to work for Gilroy. In 2005, after permits were obtained, the property resold for a whopping $110 million.

LaMelza later filed suit, alleging that Gilroy and the former employee had essentially hatched a plan to gain LaMelza’s trust, convince him to sell for $20 million, and then resell the land at a huge profit.

Gilroy provided a very different version of what happened during an interview Tuesday. He said that the LaMelza employee, who was a longtime friend, called him out of the blue over a Thanksgiving weekend and informed him that the developer wanted to sell.

Gilroy attributed the large profits to fortunate timing. “Inordinately lucky,” he said.

While the dispute between the two real estate developers was still pending, Gilroy and his wife established a limited liability company called San Miguel Equities, which was structured for the benefit of their children.

In September 2013, BNY Mellon approved a $7 million loan facility, secured by the portfolio of municipal bonds, to San Miguel Equities. San Miguel soon made two draws on the facility for a total of $5.5 million.

Then in December 2014, LaMelza obtained a $63.8 million judgment in his lawsuit against Gilroy and other defendants. Soon LaMelza was taking steps to wrest control of the San Miguel Equities assets that were being held by BNY Mellon.

An attorney for LaMelza argued in an August 2015 email to BNY Mellon that the bank should honor his client’s request even though LaMelza did not have a judgment against San Miguel.

In an allegation that Gilroy denies, LaMelza’s lawyer stated that a transfer of assets from Gilroy to San Miguel had been an effort to shield them from the eventual court judgment.

“This transaction was an obvious fraudulent conveyance intended to cheat LaMelza,” wrote LaMelza’s lawyer, Thomas Dressler.

BNY Mellon rejected LaMelza’s request. Then a few months later, San Miguel’s investment advisor at the New York bank, Steven Mills, took a new job as a portfolio strategist at Irvine, Calif.-based First Foundation.

The sequence of events that came next has left First Foundation without protection on its $5.5 million loan.

At Mills’ suggestion, San Miguel negotiated a loan facility with First Foundation in order to pay off the loan at BNY Mellon, according to court documents. Then First Foundation reached out to BNY Mellon to arrange for the payoff and the transfer of the collateral.

First Foundation alleges that its senior loan administrator contacted a BNY Mellon representative on or around Feb. 19, 2016, and was informed that the New York bank would release and transfer the collateral if First Foundation wired $5.5 million to BNY Mellon.

The California bank further alleges that BNY Mellon did not state that it believed there was a dispute about who was entitled to the collateral. On or around March 2, First Foundation wired the payoff money to BNY Mellon.

In the subsequent weeks, First Foundation says that it made seven attempts through a designee company to contact BNY Mellon to confirm the transfer of the collateral, but the New York bank did not respond.

Simultaneously, a lawyer for BNY Mellon was communicating with counsel for LaMelza. Under an agreement that was allegedly struck between the two parties, BNY Mellon turned over the bond portfolio to the court’s control in return for being freed from separate legal claims related to the alleged fraudulent conveyance of Gilroy’s assets.

Lawyers for Gilroy have said that they did not learn about the agreement between BNY Mellon and LaMelza for another 18 months. “BNY Mellon concealed its secret plan to withhold the collateral,” they wrote in a complaint filed in December.

But BNY Mellon maintains that it did not receive a formal request from its customer to transfer the collateral until after learning on March 3 that it was facing millions of dollars of potential liability in connection with the fraudulent conveyance claims.

In public comments about the case, BNY Mellon has indicated that the dispute with First Foundation Bank is entirely a legal matter.

A complex sequence of events has left First Foundation without protection on its $5.5 million loan that has gone into default.

“There were a couple of requests from First Foundation Bank to us to transfer the portfolio. Those have no legal meaning,” Isabelle Ord, an attorney who represents BNY Mellon, said during a court hearing last year. “They don’t own the portfolio. They have no right to the portfolio.”

“And until our client who owns the portfolio tells us, ‘Transfer it somewhere else,’ we don’t do anything. Otherwise we’re wrong,” she added.

Ord also stated that there was no written contract between BNY Mellon and First Foundation Bank. Referring to First Foundation, she said, “Their only right is against their own borrower.”

BNY Mellon said in a statement Tuesday that the accusations are "without merit" and that it is "vigorously" defending itself in court against the accusations.

“BNY Mellon held a securities portfolio that was the subject of two competing claims. In response, BNY Mellon appropriately and responsibly asked a court to determine the securities portfolio’s rightful owner,” the statement said.

After San Miguel Equities defaulted on the loan from First Foundation, the Orange County bank obtained an arbitration award of $5.7 million, though it has not collected on that award. Since then, the customer’s liability has climbed to nearly $5.9 million.

But the interests of First Foundation Bank and its customer are aligned when it comes to the actions taken by BNY Mellon.

Last month, lawyers representing Gilroy and San Miguel filed a six-page complaint against BNY Mellon with the Office of the Comptroller of the Currency. It alleges that the New York bank has potentially violated various federal regulations, including those related to self-dealing and conflicts of interest.

On Tuesday, First Foundation CEO Scott Kavanaugh issued a written statement in support of those allegations. He said that BNY Mellon’s conduct violates the most fundamental duties that a reputable bank and financial adviser owe to its clients.

“It also violates the code of conduct that must exist between financial institutions in a world where refinancing and other multi-million dollar transactions are done on a daily basis via wire transfers and other electronic means,” Kavanaugh said. “Without that code of conduct, the lending industry would be in disarray.”

Lanny Davis, an attorney who is co-counsel to Gilroy in the litigation, said in an interview that BNY Mellon should have returned the $5.5 million loan payoff once it decided not to turn over the collateral. If the New York bank would do so, the collateral could be applied to the debt that Davis’ client owes to First Foundation.

“Just return the damn money,” said Davis, who is planning to hold a telephone press conference on Wednesday to publicize his client’s allegations. “Go back to status quo ante.”

No matter how the various lawsuits are resolved, BNY Mellon is not expected to gain ownership of the collateral. Ultimately, the portfolio of bonds seems likely to go either to First Foundation Bank or to LaMelza.

But it is still not clear if the litigation will come to an end anytime soon.

After BNY Mellon decided to turn over control of the bond portfolio to a judge, the original $63.8 million judgment against Gilroy from 2014 was overturned. LaMelza is currently appealing that decision, and the court’s ruling is not expected for at least five months.

In the meantime, the elusive bond portfolio remains under the control of an Orange County Superior Court judge.

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