In the fifth opinion involving the repo liquidation saga of HomeBanc, the Third Circuit addressed several crucial issues involving the liquidation and valuation of repo collateral in bankruptcy. In re HomeBanc Mortg. Corp., 2019 WL 7161215 (3d Cir. Dec. 24, 2019).
HomeBanc and Bear Stearns were parties to two repo agreements which, at the relevant time, covered thirty-seven securities including nine involving confirmations showing zero purchase price. When the repos became due, HomeBanc was required to purchase the securities for $64 million. Unable to do so, HomeBanc made a proposal that Bear Stearns refused; instead, Bear Stearns offered to purchase thirty-six of the securities for $60.5 million. HomeBanc refused. When no payment was made, Bear Stearns declared a default. Later that day, HomeBanc filed for Chapter 11, which was eventually converted to Chapter 7.
Upon default, the repo agreements required Bear Stearns to determine, in its reasonable opinion, the fair market value of the securities, using such pricing sources and methods as it considered appropriate. It chose to do so by a public auction.
Bear Stearns’s finance desk sent a bid solicitation to approximately 200 different entities, and also sought bids from its own mortgage trading desk, implementing extra safeguards to prevent any insider advantage; i.e. the Bear affiliates had to submit their bids thirty minutes before the deadline to Bear’s legal department, which was located in a separate building from the trading desk. Two bids were submitted: An unrelated bidder bid $2.2 million for only two securities and Bear’s mortgage trading desk placed an all or nothing bid for $60.5 million. Bear’s finance desk accepted the inside bid. Bear Stearns then proceeded to allocate the winning bid among the securities, including $900,000 for each of the zero purchase price securities.
First Issue: The Interplay between Sections 559 and 562
At the time of the auction, after one outstanding security was dealt with separately, twenty-eight of the securities were straight repo securities (“True Repo Securities”), while eight securities were provided as collateral for the repos (“Collateral Securities”). While property pledged as collateral for repos qualifies for the repo safe harbor, there is a distinction in treatment between True Repo Securities and Collateral Securities. In Section 101(47), which defines repos for Bankruptcy Code purposes, subsection (v) captures within the definition collateral arrangement. But subsection (v) adds a limitation – collateral arrangement are repos, “not to exceed the damages in connection” with the repo, with the damages to be measured in accordance with Section 562 of the Code.
Relying on this limitation, HomeBanc’s trustee argued that Bear Stearns violated the stay by liquidating the Collateral Securities prior to determining damages, if any, resulting from the liquidation of the True Repo Securities. The trustee buttressed the argument by noting that Section 559 – the Section providing the main safe harbor treatment for repos – provides that any excess proceeds resulting from the liquidation of repos are deemed property of the estate. Thus, at the heart of the trustee’s argument was the definition of the term “damages,” a term not defined in the Bankruptcy Code.
The trustee argued that the term “damages” means “shortfall,” “loss,” “deficiency,” or “debt” and therefore the Collateral Securities should not have been liquidated prior to a determination that Bear Stearns suffered a loss for the liquidation of the True Repo Securities. Bear argued that damages must include a legal claim – here, its enforcement rights provided under the repo agreements upon default.
The Court rejected the trustee’s theory and reasoned that while the term “damages” is not defined in the Bankruptcy Code, “every first-year law student learns to automatically connect ‘damages’ with what is potentially recoverable in court, and not necessarily an underlying loss or injury,” and that such an interpretation is consistent the Code as a whole.
More importantly, however, the Court held that accepting the trustee’s theory is simply unworkable and impractical. Accepting that approach would require the non-defaulting party to first divide the securities to True Repo Securities and Collateral Securities, and then proceed to liquidate only the True Repo Securities. If there is a shortfall at the end of that process, the non-defaulting party should proceed to liquidate Collateral Securities, one by one until no shortfall exists. This process could take a decade in lieu of the quick liquidation contemplated by the Code and will eliminate all or nothing bids, requiring multiple auctions to value each security individually.
Second Issue: Section 559 Applies Regardless of Excess Proceeds
Section 559 provides that any excess proceeds resulting from liquidation of repo securities are property of the bankrupt’s estate. Relying on the Third Circuit decision in American Home Mortgage, the trustee argued that the safe harbor did not apply since there were no excess proceeds.
In American Home Mortgage, the Third Circuit stated that “sections 559 and 562 address different situations. Section 559 applies only in the event that a … liquidation results in excess proceeds … §562 … applies when the contract is liquidated, terminated, or accelerated and results in damages rather than excess proceeds.” The Court rejected the argument as taking the quoted language out of context. Section 559 is clear that it applies regardless of the existence of excess proceeds.
Third Issue: Good Faith
Finally, the trustee argued that Bear Stearns did not act in good faith in valuing the securities since a public auction is not an appropriate method to measure values in a dysfunctional market, that the auction time frame was too short, that Bear Stearns did not really sell the securities but rather transferred them from one of its affiliates to another, and that the allocation of value to the zero purchase price securities was artificial. The Court rejected these challenges.
The Court found that the market was declining but not dysfunctional as the evidence established that transactions were taking place and there was no evidence that potential buyers lacked adequate information to price securities or the absence of creditworthy market participants. It is noteworthy that the Court reached this conclusion notwithstanding testimonies from several witnesses that the market was in turmoil and dysfunctional, an auction that Bear Stearns attempted to hold a week earlier produced no outside bids, and Bear Stearns reduced its internal valuations of the securities form $119 million on August 3, 2007 to $68 million on August 6, 2007.
As to auction process objections, the Court found that soliciting bids between Friday morning of August 10 and Tuesday August 14 for an auction to be held on August 14 was adequate, that the materials provided adequate information, and that the safeguards put in place as to the Bear affiliates were adequate.
Finally, the Court rejected the challenge based on the arbitrary allocation of value to the zero value purchase securities, holding that internal allocation of values by the winning bidder in an all or nothing bid is irrelevant.
While HomeBanc provides much needed clarity to the process of liquidating securities and collateral subject of the repo, as well as the other safe harbor provisions of the Bankruptcy Code, it does little to provide clarity on what constitutes a dysfunctional market, especially in light of its seemingly contradictory opinion in American Home Mortgage.
Further, as part of its interpretation of the term “damages” as requiring a legal claim, the Court held that “damages” require the filing of a deficiency claim, fully recognizing that it incentivizes bad behavior by allowing the non-defaulting party to avoid judicial scrutiny by not asserting a deficiency claim. The lesson here – market participants should include contractual valuation requirements incorporating good faith standards.