The United States Third Circuit Court of Appeals (the "Third Circuit") issued an opinion on February 16, 2011 in the American Home Mortgage chapter 11 proceeding that upheld a determination by the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") on the valuation of a creditor’s claim that in connection with the termination and acceleration of a mortgage loan repurchase agreement.1 The decision is significant because the Third Circuit affirmed the Bankruptcy Court’s decision that the post-acceleration market value of the mortgage loans was not a relevant method of determining a deficiency claim when there existed another commercially reasonable determinant of value at the time of acceleration. Instead, the court credited the use of the Discounted Cash Flow ("DCF") method to determine value, which method, among other things, ignores market conditions anticipated future loan performance and the market standard ways in which investors evaluate and mark the value of such assets.
Facts and Procedural History
Pursuant to a 2006 Repurchase Agreement, Calyon purchased approximately 5,700 mortgage loans with an original unpaid principal balance of just under $1.2 billion. On August 1, 2007 (the "Acceleration Date")—after the Debtor2 defaulted on some of its obligations under the Repurchase Agreement—Calyon served the Debtor with a notice of default and accelerated the Repurchase Agreement. As a result of such acceleration, the Debtor became obligated to repurchase the mortgage loans at the Repurchase Price, which was set on the Acceleration Date in accordance with the terms and conditions of the Repurchase Agreement. On August 6, 2007, the Debtor filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code in the Bankruptcy Court.
Calyon filed four identical proofs of claim against the four Debtor entities for an amount that exceeded the Repurchase Price. The Debtor objected to the claims seeking to expunge or reduce them under § 562 of the Bankruptcy Code, which addresses the time at which repurchase damages are to be measured. Pursuant to § 562, the relevant date on which damages arising from the failure of a repo seller to repurchase assets from a repo buyer are measured shall be dependent upon the existence of "commercially reasonable determinants of value." 3
The Debtor argued that using the DCF method, the value of the loan portfolio exceeded the Repurchase Price as of the Acceleration Date and, therefore, Calyon lacked a deficiency claim. Notably, the DCF analysis employed by Debtor adjusted for fluctuations in interest rates and actual delinquency of the portfolio, but did not take into account any subsequent deterioration of credit performance or increase in delinquency rates that might inure to the loan portfolio over time. Calyon argued that market or sale value was the appropriate valuation methodology but because the secondary mortgage market was dysfunctional on the Acceleration Date and because there were unresolved issues regarding ownership of the portfolio and the quality of the mortgage loans therein, a commercially reasonable determinant of value was not available at that time. Calyon further argued that the earliest possible date at which a market value could be determined was August 15, 2008 (more than one year after the Acceleration Date), and on that date the market value of the loan portfolio was approximately $480 million below the Repurchase Price, resulting in a deficiency claim for that amount.
The Bankruptcy Court held a two-day evidentiary hearing on the Debtor’s objections, hearing expert testimony from both sides. In addressing this issue of first impression, the Bankruptcy Court reasoned that § 562 is intended to prevent the "moral hazard" of measuring damages on a date other than the date a repurchase agreement is terminated, accelerated and liquidated, since to do so effectively makes the defaulting party an insurer of the non-defaulting party’s investment in those assets, and held that the DCF method was a "commercially reasonable determinant of value" for the purposes of § 562. Under this method, the value of the loan portfolio exceeded the Repurchase Price on the Acceleration Date. Accordingly, the Court held that Calyon had no deficiency claim and entered an order expunging Calyon’s claims.
Calyon appealed and the parties jointly certified the issue to the Third Circuit, circumventing an intermediate appeal to the District Court.
The Appeal and Appellate Ruling
On February 16, 2011, the Third Circuit issued an opinion rejecting a portion of the Bankruptcy Court’s reasoning but, nonetheless, upholding its determination that Calyon’s deficiency claim should be expunged because, on the Acceleration Date, the DCF method was a "commercially reasonable determinant of value" which yielded a value in respect of the underlying mortgage loan portfolio which exceeded the Repurchase Price.
In affirming the Bankruptcy Court’s order, the Third Circuit adopted the Bankruptcy Court’s reasoning that market or sale value on the Acceleration Date was inapposite where a dysfunctional market and uncertainty regarding the quality and ownership of the portfolio rendered an immediate sale of the portfolio commercially imprudent. The Third Circuit found persuasive the Bankruptcy Court’s analysis that market value should be employed to determine an asset’s value in a properly functioning market, but that when a market is dysfunctional, statutory construction of § 562 supports the conclusion that any other commercially reasonable determinant of value may be used. Consequently, the Third Circuit reasoned that in a dysfunctional market, where an alternative commercially reasonable determinant supports a valuation that exceeds the repurchase price obligation, the counterparty has incurred no damages which justify a deficiency claim. Accordingly, the Court of Appeals affirmed the order of the Bankruptcy Court expunging Calyon’s proof of claim.
This case represents one of the first appellate decisions addressing the application of § 562 to the valuation of claims based upon terminated or accelerated repurchase agreements. Importantly, there is nothing in the Third Circuit opinion or the underlying Bankruptcy Court ruling that expressly limits the principles of the decision to repurchase agreements. Presumably, the interpretation of § 562 and the determination of what constitutes a commercially reasonable determinant of value could feasibly apply to any financial transaction that is safe-harbored under the Bankruptcy Code, such as swap contracts or commodities contracts.
The conclusion reached by the Third Circuit ignores many of the factors that repo counterparties routinely use to value mortgage loan portfolios—present and projected market conditions, loan quality, tenor, interest rate, etc. A simple DCF analysis values a mortgage loan in isolation, assumes a regular stream of payments and is based on the twin premises that assets such as mortgage loans are held for their cash flow, not for the distress sale in the secondary market and a cash flow valuation should, absent unusual circumstances, result in the same valuation as the market price. These premises are difficult to square with the realities of holding a distressed portfolio in a dysfunctional market—the assets are likely to become more distressed over time, rendering a straight-line cash flow formula wholly inaccurate. Moreover, the basic investment strategy of market participants is to invest in mortgage loan assets (whether or not distressed) on a short-term basis for a price that assumes there will be a market exit. Few, if any, enter into these transactions with a view to holding the assets in portfolio and realizing on the investment through the long-term receipt of cash flows.
Notwithstanding, non-defaulting parties now need to keep in mind that in the event there is found to be a dysfunctional market which depresses the resale value of the assets, in the event they terminate, accelerate or liquidate their financial contract in the context of a bankruptcy filing, the appropriate method of valuing any damages for the purposes of § 562 may well be the DCF method, not the market price. Such party may be forced to mitigate its potential damages by keeping the portfolio, and may also be deprived of recourse to recover any deficiency insofar as the DCF method results in a value for the assets that exceeds the related repurchase price.