Richard A. Chesley is a corporate partner and office chair of the Chicago office of Paul, Hastings, Janofsky & Walker LLP. He practices primarily in the areas of restructuring litigation, with an emphasis on bankruptcy transactions both in the United States and internationally. Keith Miller is a partner in the firm’s litigation practice in New York. Kimberly Newmarch is an associate in the firm’s Chicago office and is a member of the finance and restructuring group. The authors can be reached at [email protected], [email protected], and [email protected], respectively.
Delaware Bankruptcy Court Issues Opinion
of First Impression With Respect To Repo
Agreement
RICHARD CHESLEY, KEITH MILLER AND KIMBERLY NEWMARCH
A recent decision in the American Home Mortgage bankruptcy
case establishes guidelines for determining the applicability of
Sections 555 and 559 of the Bankruptcy Code, and the extent of
the protection provided by such sections.
I
n 2005, sections of the Bankruptcy Code concerning repurchase agreements were amended to, among other things, clarify and expand the definition of “repurchase agreement” to specifically include mort-gage related securities, mortmort-gage loans and interests in such mortmort-gage related securities and loans. As Congress noted, these amendments were intended to make clear that the exercise of a contractual right of a repur-chase participant to cause the liquidation of a repurrepur-chase agreement were not stayed under Chapter 11. With the recent wave of bankruptcy filings by numerous subprime originators, all of whom were parties tosignifi-cant repurchase agreements, questions have loomed and disputes ensued regarding the reach of Sections 555 and 559 of the Bankruptcy Code.
Today the answer to many of the questions regarding the applicabili-ty of such sections has judicially been determined. With the issuance on January 4, 2008 of an opinion by the Honorable Judge Christopher Sontchi in the American Home Mortgage bankruptcy case, guidelines for determining the applicability of Sections 555 and 559 of the Bankruptcy Code, and the extent of the protection provided by such sections, have been resolved.
GENERAL BACKGROUND
The debtors and plaintiff were parties to a repurchase agreement dated as of November 21, 2006 (the “Agreement”). The Agreement pro-vided for the transfer of one or more mortgage loans or interests in mort-gage loans from the debtors in exchange for the transfer of funds from the plaintiff to the debtors. The Agreement further provided that the plaintiff will return the mortgage loans or interests in the mortgage loans to the debtors not later than 180 days after the initial transfer in exchange for the transfer of funds from the debtors to the plaintiff. As is typical in most warehouse lending arrangements, the purpose of the Agreement was to provide the debtors with funds for the origination of mortgage loans. Immediately upon origination, the mortgage loans were transferred to the plaintiff on an interim basis while the debtors attempted to arrange for their final disposition, either by sale to a private investor (whole loan sale) or to a securitization trust. Upon final disposition of the mortgage loans, the loans were repurchased by the debtors in exchange for a pay-ment to the plaintiff — consisting of the original purchase price paid to the debtors plus the “price differential” (i.e., interest).
THE COURT’S OPINION
In the In re American Home Mortgage, Inc. case, the court was pre-sented with two important questions. First, whether the applicable Agreement was in fact a “repurchase agreement” within the meaning of Section 101(47) of the Bankruptcy Code, and thus protected by the “safe
harbor” provisions contained in Sections 555 and 559 of the Bankruptcy Code. Second, whether the contract provisions related to servicing of the underlying mortgage loans were also protected by the aforementioned safe harbor provisions.
The plaintiff argued that in order for the court to determine whether a “true” repurchase agreement under the Bankruptcy Code existed, it need only apply the definition set forth in Section 101(47) to the four cor-ners of the Agreement.1 The debtors, on the other hand, urged the court
to go beyond the definition of “repurchase agreement” under the Bankruptcy Code, and specifically examine certain terms of the Agreement as well as extrinsic evidence, such as prior contracts entered into between the parties, in order to determine whether it was a “true” repurchase agreement or a disguised secured financing.
Applicability of Safe Harbor Provisions to the Contract
Relying heavily on the plain meaning of the Bankruptcy Code and the facts before it, the court found that it need only consider whether a con-tract involving the sale and repurchase of mortgage loans fits the defini-tion of “repurchase agreement” under Secdefini-tion 101(47) of the Bankruptcy Code to determine whether the safe harbor provisions of Section 555 and 559 apply. The court held that it should not, as the debtors’ contended, examine extrinsic evidence such as past dealings to determine whether a “repurchase agreement” existed. Citing Supreme Court precedence, the court stated that “when a statute’s language is plain, the sole function of the courts, at least where the disposition by the text is not absurd, is to enforce it according to its terms.” In other words, “applying the plain meaning of the statute is the default entrance — not the mandatory exit.” The court went on to find “that Congress said what it meant and meant what it said in drafting the definition of repurchase agreement; [and] no further inquiry or consideration of other contractual provisions is required.” Applying the plain meaning of Section 101(47) to the Agreement, the court concluded that the Agreement did in fact constitute a “repurchase agreement” under the statute and the “safe harbor” provi-sions of Sections 555 and 559 of the Bankruptcy Code were applicable.
Applicability of Sections 555 and 559 to Servicing Agreements
Following its determinations regarding the applicability of Sections 555 and 559 to the Agreement itself, the court addressed the issue of whether Sections 555 and 559 also applied to those parts of the agreement related to servicing of the underling mortgage loans. Here the court made a critical distinction between the portion of the Agreement that provides for the sale and repurchase of mortgage loans and the portion of the Agreement that provides for the servicing of the mortgage loans. The court held that the safe harbor provisions of Section 555 and 559 of the Bankruptcy Code do not apply to the servicing portions of the Agreement. The court explained that the portion of the Agreement which provides for the servicing of the mortgage loans is “severable” from the portion of the Agreement providing for the sale and repurchase of mortgage loans. In reaching this conclusion the court emphasized two things: 1) “[t]he terms, nature and purpose of a repurchase agreement are different from an agreement relating to servicing mortgage loans;” and 2) the mortgage loans in the instant case, “were sold to the Purchasers on a servicing retained basis, i.e., the Debtors retained the right to designate the servicer under the loans,” as opposed to a “servicing released” basis. Selling the mortgage loans on a “servicing retained basis,” the court noted was “strong evidence of the parties’ intent to sever the servicing.”
Moreover, the court held that the servicing portion of the contract did not fall within the definition of “repurchase agreement” set forth in Section 101(47) of the Bankruptcy Code. Because the servicing portion was both “severable” and failed to meet the criteria outlined in Section 101(47) for “repurchase agreement,” the court found no reason to compel the debtors to transfer the rights and obligations relating to servicing the mortgage loans.
IMPACT OF THE COURT’S OPINION
For counterparties to repurchase agreements, the court’s opinion is gen-erally welcome news. Such counterparties can now be more confident that when a seller of the underlying mortgage loans enters bankruptcy and con-sequently triggers a default under the repurchase agreement, such counter-party purchaser is free to terminate the repurchase agreement, recover or
sell the underlying collateral, liquidate or foreclose the underlying collater-al, or pursue any other course of action authorized by the repurchase agree-ment without having to seek relief from the automatic stay.
The court’s opinion with respect to the servicing provisions contained in such repurchase agreement is not such welcome news for counterpar-ties. Provided that servicing has not been transferred prior to the com-mencement of the Chapter 11 case, the court’s opinion will likely prevent a counterparty from requiring the debtor to transfer the servicing of the underlying mortgage loans. The counterparty will simply be left as a party to an executory contract; one that recent history has taught may be the most valuable asset of these struggling debtors.
FUTURE CONSIDERATIONS FOR REPO AGREEMENT PARTIES
As having a debtor (that may well be in the process of laying off key personnel) act as a servicer for the underlying mortgage loans will likely not be a position in which a counterparty wishes to find itself, counter-parties must be vigilant in monitoring the financial position of its ser-vicers and make sure that servicing is transferred prior to the filing of any bankruptcy petition. Given that servicing may well be the most valuable asset owned by the now bankrupt mortgage originator, counterparties may also want to consider purchasing the right to designate the servicer at the time that the underlying mortgage loans are purchased. While such a purchase may result in an additional up-front cost to the counterparties, such a cost may save counterparties a lot of headaches down the road.
NOTE
1 Under the statute, the sale and repurchase of mortgage loans constitutes a “repurchase agreement” if it: (i) provides for the transfer of one or more mortgage loans or interests in mortgage related securities or mortgage loans; (ii) against the transfer of funds by the transferee of such mortgage loans or interest in mortgage related securities or mortgage loans; (iii) with a simul-taneous agreement by such transferee to transfer to the transferor thereof mortgage loans or interests in mortgage related securities or mortgage loans; (iv) at a date certain not later than 1 year after such transfer or on demand; and (v) against the transfer of funds. 11 U.S.C. § 101(47).
