Bank of America (BAC.N), the nation's second largest bank, is seeking to resolve liabilities from its purchase of Countrywide Financial Corp in 2008. The settlement has been viewed as a template for other banks to address claims by investors who bought risky pools of mortgages before the housing market collapsed.

The ruling by the 2nd U.S. Circuit Court of Appeals on Monday reverses an October decision by U.S. District Judge William Pauley who had taken the case from state court.

The decision "likely narrows the scope of review that the settlement will face, and increases the probability that it gets approved in the proposed $8.5b range," John McDonald, a bank analyst at Bernstein Research, said in a note to clients.

Returning the case to state court means it will be reviewed under a law that gives Bank of New York Mellon (BK.N), the trustee that negotiated the settlement, broad discretion in matters such as agreements with investors.

Chief Judge Dennis Jacobs of the 2nd Circuit wrote in the decision the case was being dismissed for lack of jurisdiction. He said it was up to the state court to confirm whether BNY Mellon had the authority to enter into the settlement, and acted reasonably and in good faith, as the trustee requested.

"Whether a New York court is able and willing to grant the relief sought in this case is an issue for the New York courts," Jacobs wrote.

Lawrence Grayson, a spokesman for Charlotte, North Carolina-based Bank of America, said in a statement the bank was pleased by the ruling.

"We believe the trustee acted reasonably in entering into the settlement agreement and we look forward to completing judicial proceedings to approve the decision," Grayson said.

Investors and analysts largely embraced the settlement when it was announced in June 2011, with Bank of America shares rising about 3 percent the day it was disclosed.

Bank of New York Mellon, which made the deal with 22 institutional investors, including BlackRock Inc (BLK.N) and MetLife (MET.N), sought approval in New York state Supreme Court.

Other investors, led by a group called Walnut Place LLC, which was not part of settlement talks but would be bound by the terms, complained the $8.5 billion payout was too low and sought

Manhattan federal court as the venue for the proceedings.

Walnut Place is a name used by Baupost Group, a Boston-based hedge fund run by Seth Klarman.

A spokesperson for Baupost declined to comment.

Gibbs & Bruns, the Houston, Texas, law firm that negotiated the Bank of America deal for institutional investors, also has sent demands for investigations of mortgage-backed securities sponsored by JPMorgan Chase & Co, Morgan Stanley and Wells Fargo & Co.

If the settlement is ultimately approved, McDonald told clients, it could set the stage for other institutions to resolve claims.

Kevin Heine, a spokesman for Bank of New York Mellon, declined to comment.

Bank of America shares rose 2 percent Monday to $8.04 at the market close.

The case is Bank of New York Mellon v Walnut Place LLC et al, 2nd U.S. Circuit Court of Appeals, No. 11-4571.

(Reporting by Karen Freifeld; additional reporting by Rick Rothacker and Grant McCool.; Editing by Gerald E. McCormick, Steve Orlofsky and Richard Chang)

• A Permanent Economic Emergency