The Third Circuit handed down a decision on Christmas Eve that’s required reading for participants in repurchase transactions, but it’s a snooze for everyone else.
The case involved a default on a repurchase agreement, or repo, in the summer of 2007, when the market for residential-backed mortgage securities was dysfunctional, some say.
The debtor was in the business of originating and securitizing residential home mortgages. The debtor’s pre-bankruptcy financing included repos, with one of the country’s major brokerage houses playing the role of lender.
The repo agreement called for the debtor to repurchase 37 securities at a specified date for $64 million. The pledged securities included nine where the repurchase price was zero. In his December 24 opinion, the Third Circuit’s Chief Judge D. Brooks Smith characterized the nine as “credit enhancements” referred to in Section 101(47)(a)(v).
When the debtor did not repurchase the securities, the broker gave notice of default. Later the same day, the debtor filed a chapter 11 petition commencing a case that was eventually converted to chapter 7.
After default, the broker advertised an auction of the entire package of securities several days after bankruptcy. A third party bid for only two securities. The broker’s trading desk made the only bid of $60.5 million for the entire package, including the credit enhancements. The broker accepted its own bid. Because the bid was less than the repurchase price, there was no surplus for turnover to the debtor.
The chapter 7 trustee sued the broker on several theories, including violation of the automatic stay in liquidating the securities without permission from the bankruptcy court. Bankruptcy Judge Kevin Carey in the first instance, and the district court on appeal, ruled that the broker was covered by the safe harbor exception to the automatic stay applicable to repos in Section 559. The lower courts ruled that the exception to the stay included the credit enhancements. Judge Carey stepped down from the bench at the end of August.
The Appeal to the Circuit
In the circuit, the trustee contended that the broker’s sale was not in good faith because the auction was defective and the markets at the time were dysfunctional. The trustee also argued that the exception to the automatic say did not apply to the credit enhancements. The trustee lost on both arguments.
If the credit enhancements fell within the definition of repos, then the broker had the right to liquidate the credit enhancements under the safe harbor in Section 559. In turn, Section 101(47)(a)(v) defines repos as including credit enhancements, but not credit enhancements that “exceed the damages . . . measured in accordance with” Section 562.
The appeal turned on the meaning of the word “damages” in Section 101(47)(a)(v). The trustee contended that “damages” only refers to the loss, deficiency, or shortfall after liquidating repo securities.
Judge Smith said that even a “first-year law student” would know the trustee was wrong. “Damages,” he said, means everything that is recoverable after a default, not just the deficiency or loss. Any other meaning, he said, “would contradict common understanding within the legal profession.”
The result would be “problematic” and “impractical” for repo lenders, Judge Smith said, if “damages” only meant the loss and the exception to the automatic stay only pertained to the repo securities. In that case, the lender could only liquidate the repo securities to determine if there was a loss. Then, he said, the lender could sell the credit enhancements one by one, “to fill the hole.”
Judge Smith held that the broker was entitled to liquidate the entire package of securities, including the credit enhancements, because lenders “often seek to liquidate quickly, but a need to differentiate between repos and credit enhancements would substantially slow the process.”
Good Faith
The repo agreement required the broker to value the securities after default in good faith. Normally, a proper auction results in a good faith valuation.
The trustee, however, contended that the valuation was not made in good faith because the markets at the time were dysfunctional.
Judge Smith conducted a “plenary review” and upheld the bankruptcy court’s good faith finding.
The trustee argued there was never an auction or sale because the broker merely transferred the securities from the finance desk to the mortgage-trading desk.
Judge Smith disagreed. He said there was no requirement in the repo agreement that the broker sell the securities to a third party. He also agreed with the bankruptcy court’s finding that the mortgage-backed securities market at the time was “sufficiently functional.” He said the trustee “mistakenly equates a declining market with a dysfunctional one.”
Judge Smith declined to “disturb the Bankruptcy Court’s finding that the auction process followed proper industry standards.”
The appeals court affirmed the judgment.
The Third Circuit handed down a decision on Christmas Eve that’s required reading for participants in repurchase transactions, but it’s a snooze for everyone else.
The case involved a default on a repurchase agreement, or repo, in the summer of 2007, when the market for residential-backed mortgage securities was dysfunctional, some say.
The debtor was in the business of originating and securitizing residential home mortgages. The debtor’s pre-bankruptcy financing included repos, with one of the country’s major brokerage houses playing the role of lender.
The repo agreement called for the debtor to repurchase 37 securities at a specified date for $64 million. The pledged securities included nine where the repurchase price was zero. In his December 24 opinion, the Third Circuit’s Chief Judge D. Brooks Smith characterized the nine as “credit enhancements” referred to in Section 101(47)(a)(v).
When the debtor did not repurchase the securities, the broker gave notice of default. Later the same day, the debtor filed a chapter 11 petition commencing a case that was eventually converted to chapter 7.
After default, the broker advertised an auction of the entire package of securities several days after bankruptcy. A third party bid for only two securities. The broker’s trading desk made the only bid of $60.5 million for the entire package, including the credit enhancements. The broker accepted its own bid. Because the bid was less than the repurchase price, there was no surplus for turnover to the debtor.
The chapter 7 trustee sued the broker on several theories, including violation of the automatic stay in liquidating the securities without permission from the bankruptcy court. Bankruptcy Judge Kevin Carey in the first instance, and the district court on appeal, ruled that the broker was covered by the safe harbor exception to the automatic stay applicable to repos in Section 559. The lower courts ruled that the exception to the stay included the credit enhancements. Judge Carey stepped down from the bench at the end of August.
The Appeal to the Circuit
In the circuit, the trustee contended that the broker’s sale was not in good faith because the auction was defective and the markets at the time were dysfunctional. The trustee also argued that the exception to the automatic say did not apply to the credit enhancements. The trustee lost on both arguments.
If the credit enhancements fell within the definition of repos, then the broker had the right to liquidate the credit enhancements under the safe harbor in Section 559. In turn, Section 101(47)(a)(v) defines repos as including credit enhancements, but not credit enhancements that “exceed the damages . . . measured in accordance with” Section 562.