Repurchase Obligations under Mortgage Loan Sale Agreements Protection from the Automatic Stay and Future Avoidance Actions

The Bankruptcy Code's automatic stay gives
corporate debtors a breathing period in which to evaluate their
financial condition and attempt to reorganize their business
operations. <i>See</i> 11 U.S.C. §362(a). Another protection
granted a debtor in bankruptcy is the ability to avoid and recover
payments made within 90 days prior to filing bankruptcy. <i>See</i> 11

U.S.C. §547(b). However, these protections are not unlimited. In
acknowledging that the automatic stay and avoidance powers should not
be without limitation, Congress enacted specific exceptions to each.

<i>See</i>, <i>e.g.</i>, 11 U.S.C. §§362(b) and 547(c) and
28 U.S.C. §959(a).</p><p> Indeed, Congress recognized that certain
industries could destabilize if various types of transactions were not

quickly settled as a result of the automatic stay or were later the
subject of an avoidance action. To address these concerns, Congress
enacted 11 U.S.C. §362(b)(6) and (b)(7) and the rather complex
provisions of 11 U.S.C. §546(e) and (f). <i>See</i>,<i> e.g.</i>,
<i>Enron Corp. v. Credit Suisse First Boston Int'l.</i> (<i>In re
Enron Corp.</i>), 328 B.R. 58, 66 (Bankr. S.D.N.Y. 2005). These
provisions provide some protection and assurance under certain
circumstances and for particular kinds of transactions. </p><p>Understanding

the practical application of these provisions requires an understanding

of what has become a common transaction: the pooling and selling of
mortgage loans (<i>i.e.</i>, a securitization transaction) and the
often-included repurchase obligations. As the economy slows and the
housing market declines, the application of these provisions may also
become more common. </p><p><b>Mortgage Loan Purchase Agreements and
Associated Repurchase Obligations </b></p><p>In a booming housing market,
mortgage lenders (the seller in a securitization transaction) commonly

originate a substantial number of mortgage loans, collect their fees
and then quickly sell a bundle or pool of loans to a third-party
investor (the purchaser in a securitization transaction). However,
because so many loans are often sold at one time, the purchaser rarely

undertakes a full review of each and every individual loan prior to
closing. To expedite the closing of a securitization transaction, the
seller typically agrees to repurchase, after the purchaser conducts a
thorough post-closing review, any and/or all individual loans that do
not meet the purchaser's criteria as of the time of sale. These
repurchase obligations may arise months or even years after the
securitization transaction closes. </p><p>For visualization, the diagram
outlines a typical securitization transaction of a mortgage loan sale
that includes a repurchase obligation by the seller. </p><p>Because the past

several years have seen historically low interest rates and a
corresponding boom in demand for both new and refinanced home mortgages,

securitization transactions have become common and very profitable for

both the seller and the purchaser. However, the recent rise in
mortgage interest rates, together with the corresponding decrease in
demand for both new and refinanced loans, is beginning to put
cash-flow pressures on mortgage lenders. This trend is especially true

for those mortgage lenders whose income is primarily dependent on
earning origination and other fees prior to a securitization
transaction. </p><p>Without the continued income from new originations, some

mortgage lenders are finding themselves short of cash to satisfy
repurchase obligations as the housing market declines and
previously-sold pools of loans begin to default. As such, purchasers
are becoming increasingly exposed to the possibility that their sellers

will not have the cash to meet their repurchase obligations and/or will

file bankruptcy. </p><p>Due to the impending threat of repurchase
obligation defaults and the potential for a boom in mortgage lender
bankruptcies, the following two strategies will help to minimize the
risk to the purchaser: (a) settling repurchase obligations on a
regular basis as pre-petition protection and (b) setting off against a

repurchase obligation deposit post-petition. These strategies work
together to protect the purchaser both pre-petition (via regularly
settling repurchase obligations with the seller) and post-petition (by

setting off free of the automatic stay). Both such strategies,
however, require prior planning and action. </p><p><b>Settling Repurchase
Obligations as Pre-Petition Protection </b></p><p>Sections 546(e) and (f) of

the Code provide protections for certain qualifying entities.
Specifically, §546(e) states, in relevant part, that "the
trustee may not avoid a transfer that is a...settlement payment, as
defined in §101 or 741 of this title, made by or to a...financial

institution...[or] financial participant...that is made before the
commencement of the case...." 11 U.S.C. §546(e).

</p><p>Similarly, §546(f) provides that a "trustee may not avoid a

transfer that is a...settlement payment, as defined in §741 of
this title, made by or to a repo participant or financial participant,

in connection with a repurchase agreement and that is made before the
commencement of the case...." 11 U.S.C. §546(f). As a
result, these provisions afford significant protection to qualifying
entities. The determination of whether an entity qualifies requires a
close examination of various Code definitions. </p><p><b>Section 546(e)
Protections </b></p><p>The initial consideration under §546(e) is
whether a purchaser is a "financial institution" or a
"financial participant." A "financial institution"

is defined as "a Federal Reserve bank, or an entity (domestic or
foreign) that is a commercial or savings bank, industrial savings bank,
savings and loan association, trust company, federally insured credit
union, or receiver, liquidating agent or conservator for such entity,
and when any such Federal Reserve bank, receiver, liquidating agent,
conservator or entity is acting as agent or custodian for a customer
in connection with a securities contract (as defined in
§741)...." 11 U.S.C. §101(22)(A). If a purchaser is one

of these types of entities, then it qualifies as a "financial
institution" for §546(e) purposes. </p><p>Alternatively, a
purchaser may qualify if it is a "financial participant." A
"financial participant" is defined as including the following
entities that, "at the time it enters into a securities
contract...[or] repurchase agreement....or at the time of the date of
the filing of the petition," meets detailed financial benchmarks
within the previous 15-month period related to either the principal
amount of the entity's total gross loans outstanding or the entity's
gross mark-to-market positions. 11 U.S.C. §101(22A)(A). A
"financial participant" must therefore be a party to a
"securities contract" and must meet the financial benchmarks

given in §101(22A)(A). </p><p>While the purchaser must evaluate its
financials to determine whether it qualifies under §101(22A)(A)'s

financial criteria, a "securities contract" is expressly
defined to include "a contract for the purchase, sale or loan
of...a mortgage loan or any interest in a mortgage loan, a group or
index of...mortgage loans or interests therein (including an interest
therein or based on the value thereof), or option on any of the
foregoing...." 11 U.S.C. §741(7)(A)(i). Thus, a
"securities contract," by definition, includes the purchase
and sale of mortgage loans. </p><p>Assuming a purchaser qualifies as either
a "financial institution" or a "financial
participant," one must determine whether the payment at issue
qualifies as a "settlement payment." Section 741(8) broadly
defines "settlement payment" as "a preliminary settlement

payment, a partial settlement payment, an interim settlement payment,
a settlement payment on account, a final settlement payment or any
other similar payment commonly used in the securities trade...."
11 U.S.C. §741(8). </p><p>As a result, a particular settlement payment
must be "commonly used" in the relative trade. <i>See Enron
Corp. v. Bear, Stearns Int'l. Ltd.</i>, 323 B.R. 857, 870 (Bankr.
S.D.N.Y. 2005) (concluding "that in order to qualify as a
settlement payment that is protected by the safe harbors [of
§546(e)], the settlement payment must be 'commonly used' within
the industry..."). Similarly, a "settlement payment"
includes "a transfer of securities that completes any securities
transaction, including repo transactions." <i>Jonas v. Farmer
Bros. Co.</i> (<i>In re Comark</i>), 145 B.R. 47, 52 (B.A.P. 9th Cir.
1992). Again, "securities" include notes such as mortgage
promissory notes. <i>See</i> 11 U.S.C. §101(49)(A)(i).

</p><p>Notwithstanding the Code's broad definition of "settlement
payment" and the inclusion of "note" (such as a
promissory note under a mortgage loan) in §101(49)(A)(i)'s
definition of "security," there are cases construing
§546(e) to only apply in public securities markets and not to
private transactions. <i>See</i>, <i>e.g.</i>, <i>Kipperman v. Circle
Trust F.B.O.</i> (<i>In re Grafton Partners LP</i>), 321 B.R. 527
(B.A.P. 9th Cir. 2005); <i>Jewel Recovery v. Gordon</i>, 196 B.R. 348,

353 (N.D. Tex. 1996); <i>In re Olympic Natural Gas Co.</i>, 258 B.R.
161, 165-66 (Bankr. S.D. Tex. 2001). However, these cases arose in the

context of the purchase and sale of stocks and did not involve the
transfer of mortgage loans. In fact, no published opinion appears to
have specifically analyzed §546(e) in light of the purchase and
sale of mortgage loans. </p><p>Further, nowhere does the Code proscribe the
settlement of mortgage loan repurchase obligations. Not only does
§546(f) provide that a settlement payment made "in
connection" with a repurchase agreement (which expressly can
include the sale and repurchase of mortgage loans) cannot be avoided,
§741(7)(A)(i) expressly provides that mortgage loans can be the
subject of "securities contracts." The fact that the
protections under §546(e) (and (f)) should be applied to the sale

of mortgage loans is further bolstered by the fact that §555 of
the Code, which does not mention "settlement payment,"
permits a party to a "securities contract" to liquidate the
contract post-petition free of the automatic stay. Thus, the seemingly

contradictory case law cannot provide a basis for excluding mortgage
loan securitizations from §546's protections. </p><p>Indeed, the
Code's express provisions contemplate that settlement payments made in

the context of the mortgage loan purchase and sale trade (and not the
public stock trade) are entitled to §546's safe-harbor provisions.
Among these safe-harbor provisions are §546(f)'s protection of
repurchase obligations. </p><p><b>Section 546(f) Protections </b></p><p>Section
546(f) prohibits the avoidance of a pre-petition settlement payment
made to a "repo participant" or "financial
participant" "in connection with a repurchase
agreement...." 11 U.S.C. §546(f). The definition of a
"financial participant" in §546(f) is the same as that
discussed above with regard to §546(e), but "repo
participant" is separately defined. </p><p>A "repo
participant" is "an entity that, at any time before the
filing of the petition, has an outstanding repurchase agreement with the

debtor." 11 U.S.C. §101(46). In turn, a "repurchase
agreement" is defined as "an agreement...which provides for
the transfer of one or more...mortgage loans...against the transfer of

funds by the transferee of such...mortgage loans...with a simultaneous

agreement by such transferee to transfer to the transferor
thereof...mortgage loans of the kind as described in this clause, at a

date certain not later than one year after such transfer or on demand,

against the transfer of funds...." 11 U.S.C. §101(47)(A)(i).
In summary, "repurchase agreements" require the transfer of
certain assets by one entity to another, with both parties agreeing
that the buyer will transfer some or all of the same or similar assets

back to the seller by a certain date or on demand. </p><p>Because the
seller in the transaction diagramed on p. 58 typically has ongoing
repurchase obligations, upon demand and at an established price, the
seller and purchaser are each a "repo participant," and the
agreement to repurchase is a "repurchase agreement." As repo

participants to a repo agreement, payments made in satisfaction of a
repurchase obligation are not avoidable in a subsequent bankruptcy
proceeding. </p><p>Thus, when a securitization transaction includes
repurchase obligations, the purchaser should regularly evaluate the
status of its seller's repurchase obligations. Regular evaluations
will alert the purchaser to unsatisfied repurchase obligations and
will allow the purchaser to determine the appropriate course of action.

Specifically, the purchaser can settle outstanding repurchase
obligations by having the seller make a "settlement payment"

as defined in §741(8) and as discussed above, and/or set off
unsatisfied repurchase obligations against subsequent securitization
transactions with that seller. Either course of action, so long as its

constitutes a §741(8) settlement payment, will provide a defense
against an avoidance action in the seller's subsequent bankruptcy case.

</p><p>Even if pre-petition settlement payments fail to fully satisfy
outstanding repurchase obligations, a purchaser is not necessarily
defeated, assuming it takes the proper precautions, such as a
repurchase obligation deposit. </p><p><b>Setting Off Against Pre-Petition
Deposits Post-Petition </b></p><p>In addition to the protections afforded to

qualifying purchasers of mortgage loans in §546(e) and (f), a
purchaser can take additional pre-petition action by obtaining a
pre-petition deposit from the seller as security for the seller's
repurchase obligations under the mortgage loan sale agreement. By
requiring a deposit, the purchaser not only holds security in case the

seller defaults on its repurchase obligations, but can also set off
this deposit post-petition against the seller's repurchase obligations

without first seeking relief from the automatic stay. <i>See</i> 11
U.S.C. §362(b)(6) and (b)(7). </p><p>Specifically, §362(b)(6)
provides that the automatic stay does not apply to: </p><blockquote>
<p>the setoff by a...financial institution...[or] financial participant
of any mutual debt and claim under or in connection with
...securities contracts, as defined in §741 of this title, that

constitutes the setoff of a claim against the debtor for a...
settlement payment, as defined in §101 or 741 of this title,
arising out of...securities contracts against cash, securities, or
other property held by, pledged to, under the control of or due from
such...financial institution...[or] financial participant...to
margin, guarantee, secure or settle ...securities contracts....
</p></blockquote><p>11 U.S.C. §362(b)(6). Section 362(b)(7)
provides similar protections to "repo participants" or
"financial participants" in connection with "repo
agreements." 11 U.S.C. §362(b)(7). Section 362(b)(6) and
(b)(7), therefore, permit qualified purchasers (<i>i.e.</i>, a
"financial institution," "financial participant"
or a "repo participant") to use any deposit related to the
seller's pre-petition repurchase obligations to immediately settle,
post-petition, the seller's repurchase obligations without regard to
the automatic stay. </p><p>In obtaining such a deposit, a purchaser should
consider escrowing a certain percentage of a securitization
transaction's sale proceeds. Further, a purchaser should also retain
any deposit held as part of any pre-petition settlement of repurchase
obligations, with proceeds from the "new" securitization
transaction to satisfy the then-outstanding repurchase obligations.
</p><p>By taking such precautions, which require careful forethought and
drafting of the securitization transaction documents, a purchaser can
lessen or even avoid the impact of a seller's subsequent bankruptcy
case. </p><p><b>Conclusion</b> </p><p>Securitization transaction purchasers
should regularly evaluate outstanding repurchase obligations and enter

into settlement agreements to satisfy such repurchase obligations.
When structuring these settlements, specific provisions stating that
the seller acknowledges and agrees that the settlement payment falls
within §546(e) and (f) and is not subject to later avoidance are
important because their inclusion may avoid a subsequent preference
dispute. </p><p>Additionally, purchasers should retain pre-petition
repurchase obligation deposits if the pre-petition settlement is only
a partial settlement of the seller's repurchase obligations
(<i>i.e.</i>, additional review to confirm criteria represented by the

seller or if the purchaser has obtained additional loans under a master

sale agreement). Retention of a deposit will provide the purchaser with

additional protections should the seller file bankruptcy before all of

its repurchase obligations are fully satisfied. </p><p>While none of these

considerations are risk-free, the purchaser has cash in its bank
account, has a defense to a subsequent avoidance action and can setoff

post-petition without restraint of the automatic stay. The consideration

of these issues is important because, while scant case law addresses
such issues, they will certainly be in the foreground of the next wave

of bankruptcy filings.