A federal judge rejected Bank of New York Mellon Corp's bid to dismiss a lawsuit by investors over its role as trustee for mortgage-backed securities that led to an $8.5 billion settlement by Bank of America Corp.

U.S. District Judge William Pauley in Manhattan said on Tuesday that bondholders who invested in 26 trusts alleged to have contained risky mortgage loans from the former Countrywide Financial Corp may pursue claims against Bank of New York Mellon. He dismissed a variety of other claims.

The decision relates to a lawsuit challenging Bank of New York Mellon's performance of its day-to-day obligations as a trustee, which includes ensuring that underlying home loans are properly documented and that bondholders' rights are protected.

Beth Kaswan, a lawyer for four pension funds in Chicago, Michigan and Pennsylvania that brought the case, said the decision leaves intact claims over securities backed by more than $30 billion of loans, and which have suffered more than $9 billion of losses or delinquencies.

She said she believes the decision is the first to let investors in mortgage-backed securities pursue claims against a trustee under the 1939 federal Trust Indenture Act.

The decision is a watershed, Kaswan said.

Kevin Heine, a spokesman for Bank of New York Mellon, said the company was pleased that the court narrowed the issues to be considered and removed the vast majority of trusts from the suit. We respectfully disagree with ruling's application of the Trust Indenture Act to non-indenture securitizations and will continue to defend against those claims, he said.

Countrywide had been the largest U.S. mortgage lender before being acquired by Charlotte, North Carolina-based Bank of America in July 2008.

The lawsuit was filed six weeks after Bank of America reached the $8.5 billion settlement in June, which was to resolve claims by investors in 530 mortgage securitization trusts that lost billions of dollars when the housing market collapsed.

Some investors in that case faulted Bank of New York Mellon, which negotiated the accord, for accepting a low payout. The settlement was intended to resolve many of Bank of America's liabilities from the Countrywide purchase.

NEGLIGENCE ALLEGED

In the current case, the pension funds accused Bank of New York Mellon of negligence and breach of fiduciary duty for doing nothing to remedy Countrywide's inadequate servicing of home loans contained in the trusts.

The bondholders said Bank of New York Mellon failed to take possession of loan files, including the original mortgage notes, or require Countrywide to fix or buy back defective loans.

Such failures created considerable uncertainty and should make the bank responsible for bondholder losses, regardless of the fairness of the $8.5 billion settlement, the complaint said.

Pauley said the bondholders could pursue claims that Bank of New York Mellon did not properly notify them that Countrywide had defaulted on some obligations, whether as a servicer or as a mortgage lender.

The judge nonetheless said the bondholders could sue only on the basis of the 26 trusts in which they invested, not all 530 trusts covered by the $8.5 billion settlement.

On February 27, Bank of America won a victory when the 2nd U.S. Circuit Court of Appeals ruled that the $8.5 billion settlement should be reviewed in a New York State court.

That ruling reversed Pauley's October decision to move the case to federal court. It meant the settlement's fairness will be reviewed under a state law that gives Bank of New York Mellon wide discretion to negotiate with bondholders.

The case is Retirement Board of the Policemen's Annuity and Benefit Fund of the City of Chicago et al v. Bank of New York Mellon, U.S. District Court, Southern District of New York, No. 11-05459.

(Reporting By Jonathan Stempel in New York; Editing by Leslie Gevirtz)

Lawsuit