Agricole Corporate and Investment Bank New York Branch, f.k.a. Calyon New York Branch v. American Home Mortgage Holdings, Inc. (In re American Home Mortgage Holdings, Inc.), No. 09- 4295, 2011 WL 522945 (3d Cir. February 16, 2011)

CASE SNAPSHOT

American Home entered into a mortgage loan repurchase agreement transaction with the repo buyer, Calyon. Following American Home’s default on some of its repo obligations, Calyon accelerated the repurchase agreement. The acceleration obligated American Home to repurchase the mortgage loans at their value on the acceleration date, approximately $1.1 billion. Within one week of the acceleration notice, American Home filed for bankruptcy under chapter 11. Calyon filed claims for damages, i.e., the difference between the repurchase price and the value of the mortgage loans, and American Home objected.

In a case of first impression, the Third Circuit decided the meaning of “commercially reasonable determinants of value” as used in section 562 of the Bankruptcy Code, which addresses the timing for the measurement of damages suffered in connection with repo agreements. Under section 562, such damages are measured as of the earlier of the date of rejection, liquidation, termination, or acceleration, unless there are not any commercially reasonable determinants of value (here, for the mortgage loans) as of such dates, in which case the damages are measured on the earliest date on which there are commercially reasonable determinants of value.

The Third Circuit held that it would be commercially unreasonable to determine the value of the mortgage loans on the acceleration date by use of a market valuation methodology, because of the global financial crisis at that time and resultant dysfunctional market, where market prices were unavailable or did not fairly reflect worth. The court concluded that a commercially reasonable determinant of value did exist on the acceleration date in the form of a discounted cash flow analysis. Further, because the discounted cash flow analysis determined that the value of the mortgage loans was greater than the repurchase price, Calyon had suffered no damages, and the court denied Calyon’s claims.  

FACTUAL BACKGROUND

In 2006, American Home entered into a repurchase agreement with Calyon, whereby American Home sold to Calyon and agreed to repurchase from Calyon approximately 5,700 mortgage loans with an original unpaid principal balance of just under $1.2 billion. In August 2007, American Home defaulted on some of its obligations under the repo agreement and Calyon accelerated the repurchase agreement; the acceleration obligated American Home to repurchase the mortgage loans for approximately $1.1 billion. Less than a week later, American Home filed for bankruptcy under chapter 11. Calyon filed claims for damages, i.e., the difference between the repurchase price and the value of the mortgage loans, and American Home objected.

At the time of the default, acceleration notice, and bankruptcy filing, the financial markets were in distress. Buyers of mortgage loans were difficult to find, and if buyers could be found, the offered purchase prices were extremely low, e.g., 10 percent of the unpaid principal balance of the mortgage loan. While Calyon’s original intent in entering into the repurchase agreement was to resell the mortgage loans within a short period of time, because of the market dysfunction, Calyon decided to keep the mortgage loans; in particular, because the borrowers were still making the principal and interest payments and, thus, the mortgage loans were generating cash flow.

COURT ANALYSIS

Section 562 of the Bankruptcy Code addresses the timing for the measurement of damages suffered in connection with repo agreements. Under section 562, such damages are measured as of the earlier of the date of rejection, liquidation, termination, or acceleration, unless there are not any commercially reasonable determinants of value as of such dates, in which case the damages are measured on the earliest date on which there are commercially reasonable determinants of value. Calyon argued that the only appropriate determinants of value under section 562 were a sale or market valuation and, because the mortgage loan market was dysfunctional on the acceleration date, i.e., unavailable or not fairly reflecting worth, a sale or market valuation of the mortgage loans was commercially unreasonable at that time. Thus, no commercially reasonable determinant of value was available on the acceleration date. Calyon, therefore, contended that its damages should be measured on the earliest date on which a market value for the mortgage loans could be determined, which it argued was 12 months after the acceleration date. Using that date, Calyon concluded that the market value of the mortgage loans was less than the repurchase price by nearly $500 million. Thus, Calyon claimed it had suffered nearly $500 million in damages.  

American Home argued that sale or market valuations were not the only appropriate determinants of value under section 562. Instead, a discounted cash flow analysis was also appropriate and commercially reasonable; in particular, when the market for the subject asset is dysfunctional and the asset generates cash flow, as in the present case. Using that method, American Home: (1) adjusted the interest rate of each mortgage loan to reflect market conditions, as described in the Federal Home Loan Mortgage Corporation’s Primary Mortgage Market Survey conducted by Freddie Mac; (2) accounted for actual delinquency rates on the mortgage loans as of the acceleration date; and (3) then applied the adjusted rates to discount cash flows for each mortgage loan. By this method, American Home determined the value of each mortgage loan and concluded that the aggregate value of the mortgage loans on the acceleration date exceeded the repurchase price. Thus, American Home contended that Calyon had suffered no damages.  

The Third Circuit found that a sale or market price should be used to determine an asset’s value under section 562 when the market is functioning properly. However, when the market is dysfunctional and a sale is impossible or prices do not reflect the asset’s worth, it would be commercially unreasonable to do so, and, thus, other determinants of value should be used under those circumstances. Under the current circumstances, where the market for the mortgage loans was dysfunctional and the mortgage loans were generating a cash flow, the court found the use of the discounted cash flow analysis to be both appropriate and commercially reasonable.  

In particular, the Third Circuit found an intrinsic problem and logical flaw with Calyon’s position that no commercially reasonable determinant of value existed in the context of the dysfunctional mortgage loan market. Specifically, in that context, the commercially reasonable action to take was to retain the mortgage loans and receive and retain the cash flows generated thereby. Cash flows, of course, can be used to determine value, as demonstrated by discounted cash flow analysis.  

Furthermore, the Third Circuit pointed out that accepting Calyon’s position would create a moral hazard contrary to the policy of the Bankruptcy Code to preserve liquidity of mortgage loans. Under Calyon’s interpretation of section 562, Calyon would be incentivized to continue to hold the mortgage loans and obtain the benefit of the cash flows being produced thereby because the risk of doing so would be reduced by the availability of damages claims against American Home.  

The Third Circuit concluded that a commercially reasonable determinant of value existed on the acceleration date in the form of the discounted cash flow analysis, and, because the discounted cash flow analysis determined that the value of the mortgage loans was greater than the repurchase price, Calyon had suffered no damages. The court noted that: “[W]here the court concludes that a valuation methodology other than a market value (in a dysfunctional market context) evidences that the asset’s value exceeds the underlying repurchase price obligation, the result is not that the counter-party is deprived of recourse to recover its damages, but rather that the counter-party has incurred no damages capable of being recovered.”  

PRACTICAL CONSIDERATIONS

Section 562 addresses swap agreements, securities contracts, forward contracts, commodity contracts, and master netting agreements, in addition to repurchase agreements. Therefore, the Third Circuit’s interpretation of “commercially reasonable determinants of value” could impact a large universe of financial instruments; in particular, because the Third Circuit is the first circuit in the Court of Appeals to weigh in on the issue. While the Third Circuit admonished that its reading would not chill the repurchase agreement market, the actual consequences of the opinion are yet to be seen.