The United States Court of Appeals for the Third Circuit issued an opinion on December 24, 2019, In re Homebanc Mortgage Crop., No. 18-2887, 2019 WL 7161215(3rd Cir. De. 24, 2019) that has significant consequences for participants in repurchases transactions. The court affirmed the lower court judgment, that the securities had been liquidated in good faith.
Facts
This appeal dealt with a default on repurchase agreements during the 2008 financial crisis. This default took place when the economy, and especially the market for mortgage-backed securities, was under great strain. The appeal centered on two things: liquidation and the defaulted mortgage-backed securities that were subject to two repurchase agreements. Multiple rounds of litigation took place in both District Courts and the Bankruptcy court. The suit was finally submitted to the Third Circuit by the Trustee for the estate. The appeal centered around four main questions.
- Whether a Bankruptcy Court’s determination of good faith regarding an obligatory post-default valuation of mortgage-backed securities subject to a repurchase agreement receives plenary review as a question of law or clear-error review as a question of fact;
- Whether “damages,” as described in 11 U.S.C. § 101(47)(A)(v), requires a non-breaching to bring a legal claim for damages or merely experience a post-liquidation loss for the conditions of 11 U.S.C. § 562 to apply;
- Whether the safe harbor protections of 11 U.S.C. § 559 can apply to a non-breaching party that has no excess proceeds after exercising the contractional right to liquidate a repurchase agreement; and
- Whether the company liquidated the securities at issues in compliance with the terms of the parties’ repurchase agreements.
The Debtor in this case was a business that both originated and securitized residential home mortgages. Through its course of business, it obtained financing from one of the nations leading brokerage houses that was acting as a lender. The financing that was obtained was a repurchase agreement or what is commonly known as a “repo.” In this case two repurchase agreements existed, a Master Repurchase Agreement and a Global Repurchase Agreement. Eventually the Debtors repo transactions became due, requiring them to buy back thirty-seven outstanding securities. The price that that was due was $64 million. The lender became exceedingly worried about the liquidity of the debtor. The lender made two offers the first was to extend the repurchase deadline for a payment of $27 million. The next offer they made was to buy the securities for a price of $60.5 million. The debtor failed to pay for the securities on time and rejected the offer of the creditor to buy them. It was at this point that the creditor issued a notice of default to the debtor requesting that the debt be paid on a certain date. When the debtor did not comply, they sent a formal default notice. The debtor then filed for Chapter 11 protection; which was later converted to a Chapter 7. Because of the default, the broker claimed out right ownership of the securities. The broker valued the securities and auctioned them. The Chapter 7 trustee for the estate brought the following claims (1) conversion for selling the securities. (2) violation of the automatic stay and (3) breach of contract. The District court made the ruling that the broker was covered under the safe harmer exception in Section 559.
Appeal and Ruling
Two main arguments were made by the Trustee: the first being that because the state of the market was dysfunctional at the time of the liquidation, the act of liquidating the securities was not made in good faith. The trustee’s second argument was that the exception to the automatic stay in this case did not apply to credit enhancements. To win this argument credit enchantments had to fall within the definition of repos. From there, the right to liquate them would put the broker under the protection of Section 559.
Section 101(47)(a)(v) was used by the District Court to conclude that thirty-seven of the securities were repos under Section 101(47)(a)(i). The court, in this case, viewed the matter as pedantic because creditors want to liquidate quickly, and forcing the process to differentiate between repos and credit enhancement would slow the process. Section 101(47)(a)(v) states that repos are in fact credit enhancements, unless they “exceed the damages.” From here, the court had to look at the meaning of the word “damages” in 101(47)(a)(v). The court held that “Damages” referred to a legal claim for damages, everything that is recoverable, not simply the loss as the Trustee argued. Given this, the court held that the broker was entitled to liquidate all thirty-seven of the securities.
On the good faith front, the court concluded the securities had been liquidated in good faith despite the state of the market at the time of liquidation, since the markets were “sufficiently functional,” and simply declining, rather than dysfunctional as the Trustee argued. The Court further stated that the Bankruptcy court was correct in finding the auction process for the repos “conformed to the industry standard,” resulting in their good faith determination.
