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Third Circuit Overrides Repo Damages ProvisionFebruary 24, 2011
On February 16, 2011, the United States Court of Appeals for the Third Circuit issued a decision that could radically alter the expectations of counterparties to repurchase agreements (“repos”). In Credit Agricole v. American Home Mortgage Holdings, Inc., Case No. 09-4295, the Court of Appeals affirmed a decision of the Bankruptcy Court that held that when the “seller” of assets subject to a repo files bankruptcy, the deficiency claim of the lender can be determined based on expert testimony regarding the “intrinsic value” of the underlying assets at the time of acceleration, even if the counterparty does not sell the assets and markets are frozen.
This issue can have a monumental impact on the damage claims available to counterparties. In American Home the counterparty who litigated the issue argued that it was entitled to a $478 million deficiency claim while the debtor argued that the claim was essentially zero. The Third Circuit sided with the debtor. And when debtors have multiple repo facilities, as was the case in American Home and many other recent chapter 11s, the impact is multiplied many times over.
American Home is particularly significant since it is the first Circuit Court decision on this issue and the Third Circuit includes Delaware, which is the home of many major chapter 11 cases.
For many years, certain financings were structured as repos. Although they had most of the elements of secured debt, these transactions were documented as a sale by the originator of certain assets to a “counterparty” with an obligation of the originator to repurchase them at a date in the near future at a price equal to the sale price plus a rate of return. Originally, repos were used largely among financial institutions and involved sales and resales of liquid and fungible assets such as treasuries. Such transactions involved trillions of dollars and were critical to the workings of financial markets. They also were sufficiently short term that it was often impractical for the financer/counterparty to perfect a lien on the underlying assets. In addition, unlike normal secured loans, the counterparty typically did not have to resell the exact same assets that it bought; rather, it just resold comparable treasuries or other financial assets.
In the 1980’s and 1990’s there was a spate of litigation as to whether repos were true sales or disguised financings. If repos were disguised financings, the counterparties would presumably need to perfect the liens and comply with the UCC rules concerning foreclosure of the underlying assets, including conducting commercially reasonable foreclosure sales. By and large, counterparties succeeded in this litigation, and courts held that in reselling underlying assets repo counterparties did not need to comply with UCC foreclosure rules, but could rely on the much more flexible standards set forth in their documentation. See, e.g., Granite Partners v. Bear Stearns, 17 F. Supp. 275 (S.D.N.Y. 1998).
When the originator filed bankruptcy, counterparties had less success claiming these transactions were true sales, and therefore exempt from the bankruptcy automatic stay. See, e.g., In re Lombard-Wall, 23 B.R. 165 (Bankr. S.D.N.Y. 1982).
The financial industry reacted by persuading Congress to pass a series of amendments to the Bankruptcy Code in 1984 that largely exempted repos from the effect of the Bankruptcy Code. At the time the Bankruptcy Code’s “safe harbors” were expanded to include repos, the definition of a repo in the Bankruptcy Code was limited largely to traditional repos of treasuries and other highly liquid financial assets.
In 2005, Congress amended the Bankruptcy Code to expand the “safe harbors.” For the first time, repos of mortgages and mortgage related securities were included in the definition of repos. The Bankruptcy Code was further amended to provide that whether the transaction was a true sale or a disguised secured loan was irrelevant — qualifying repos were entitled to the benefit of the bankruptcy “safe harbors.” And those “safe harbors” provided that repo counterparties were free to accelerate their facilities and dispose of the underlying assets without interference from a bankruptcy court notwithstanding the automatic stay. The 2005 amendments also included a provision addressing the timing for the measurement of damages in connection with the liquidation, termination, or acceleration of a repo. This import of this provision — section 562 — was appreciated by few at the time.
These changes in the law were implemented at the same time that the subprime and mortgage backed security industries were exploding. “Lenders” to these industries reacted by restructuring their facilities as repos. But they still maintained many of the provisions of secured financings and many were documented as hybrids. For example, in a “pure” repo, if the originator defaults the counterparty is entitled to keep the underlying assets and retain the excess value over the repurchase price without any obligation to conduct a foreclosure-type sale. But many of these new repos also incorporated UCC foreclosure remedies.
The housing crisis that precipitated the recent recession caused a collapse in the values of mortgage loans that were subject to repos. Values plummeted and markets froze. Unlike treasuries and more traditional repo assets, the counterparties did not have a liquid market in which to dispose of this “collateral.” And since many were concerned that they would be held to a commercially reasonable standard with respect to the disposition of these mortgages, they proceeded slowly.
The American Home Decision.
American Home took the position that the Bankruptcy Code “safe harbor” provisions contained in section 562 provided that a repo counterparty’s deficiency claim was to be fixed as of the date of acceleration even if the counterparty did not dispose of the underlying mortgage assets at that time. Since the repo counterparties usually set conservative advance rates and tended to declare defaults early, while by the time that they actually disposed of the mortgages values had plummeted, the amounts at issue were enormous.
American Home pointed out that section 562 provides that the measure of damages when a counterparty “liquidates, terminates or accelerates” a repo is determined as of the earliest of the date of “such liquidation, termination or acceleration.” In American Home’s case, this date was five days before American Home filed its bankruptcy petition. Section 562 also provides that if there are no “commercially reasonable determinates” of value as of that date, the counterparty’s damages are to be measured as the first date on which there is such a “commercially reasonable determinate of value.”
When the counterparty terminated and accelerated the repo, the mortgage markets were dysfunctional and all parties agreed that it would have been commercially unreasonable for the counterparty to have disposed of the mortgages.
The counterparty argued that a “commercially reasonable” determinate of value meant a market price when it actually disposed or reasonably could have disposed of the mortgage loans. The counterparty presented evidence that the market prices at the earliest reasonable date that the counterparty could have disposed of the mortgage loans was $478 million less than the contractual repurchase price on that date and this deficiency amount should be its measure of damages.
American Home countered that the language in the Bankruptcy Code did not peg damages to what the counterparty actually received on resell or could reasonably have received on resell. Rather, the measure of damages keyed off of “commercially reasonable determinates” of value, which could include the intrinsic value of the assets determined using other valuation methodologies, including a discounted cash flow (“DCF”) analysis of the mortgages in question. American Home argued that this test was a reasonable quid pro quo for the “safe harbor” provisions allowing the counterparty to liquidate the repo and dispose of the underlying assets without interference from the Bankruptcy Court. American Home argued that it would be inappropriate to give the counterparty this relief but also to allow it to impose on the estate and other creditors the risk of further market decreases after acceleration. American Home’s evidence of a “commercially reasonable determinate of value” was a DCF analysis presented by an expert witness of the mortgages taking into consideration the composition of the mortgages in the pool. Under this analysis, the counterparty had no deficiency claim.
The Bankruptcy Court agreed with the Debtor and found the DCF analysis persuasive. On February 16, the Third Circuit affirmed.
Many repos contain broad and powerful grants to the counterparty. Some are even arguably internally inconsistent, such as the incorporation of UCC secured lender rights at the same time that the repo agreement provides that the counterparty can deal with the underlying assets as an absolute owner. Many counterparties are also naturally guided by notions of commercial reasonableness either because they expect that this is what a court will require or it makes business sense.
While the “safe harbor” provisions of the Bankruptcy Code give repo counterparties powerful rights, they also arguably impose burdens on the counterparties that are inconsistent with the repo documentation. For example, the repo agreement in American Home favored the argument advanced by the counterparty. But according to the Third Circuit, this agreement was overridden by the Bankruptcy Code (just as are many provisions of secured loans and contracts).
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