repurchase agreements in bankruptcy and the …tblawllp.com/recleapril10(2).pdf · 7 bankruptcy 101...

bankruptcyRepurchase Agreements in Bankruptcy

And The Subprime Mess

April 10, 2008

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The Panel

• Jay Teitelbaum Mr. Teitelbaum is a partner in Teitelbaum & Baskin LLP with offices in New York and White Plains specializing in commercial transactions and litigation, creditor’s rights and bankruptcy and restructuring. Over the past 20 years, Mr. Teitelbaum was associated with Zalkin Rodin & Goodman and was a partner in the bankruptcy and restructuring group of Morgan Lewis & Bockius. More information is available at www.tblawllp.com.

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Outline

I. Introduction

II. Bankruptcy 101 for Real Estate ProfessionalsIII. Mortgage Repurchase Agreements In Bankruptcy

IV. Political Reaction to the Subprime Mess

V. Bankruptcy and Like Kind Exchanges

VI. Conclusion

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Introduction

• The steady increase over the last 12-18 months in mortgage defaults and the fear of more to come has negatively affected virtually all aspects of the real estate business, including mortgage lenders, investors in mortgage loans, mortgage servicers, real estate developers, furniture companies and homeowners.

• Recent real estate related bankruptcy cases include: American Home Mortgage, New Century, Alliance Mortgage, Levitt & Sons and many others.

• In addition, KB Homes, Beazer and other developers/builders havereported precipitously declining revenues; Countrywide Financial may have been brought back from the brink of bankruptcy by Bank of America and major financial institutions, including Citibank, Bear Stearns, Merrill Lynch, AIG and others, have reported multi-billion losses related to subprime mortgage exposure.

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Introduction

• Desperate homeowners are being victimized in home equity theft scams.

• Prospective homeowners with builder or developer contracts face both the loss of their deposits and incompleted homes.

• There are ongoing civil and criminal investigations into the conduct of major financial institutions.

• What does it all mean and what is the effect of the Bankruptcy Code on this situation?

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Bankruptcy 101 for Real Estate Professionals

• Bankruptcy cases may be commenced voluntarily by debtors or involuntarily by creditors.

• Bankruptcy Courts are federal courts located in every district nationwide where federal district courts are located.

• Although there are certain limitations on who may be a debtor under the Bankruptcy Code, generally, any corporate entity (other than a bank or insurance company) or individual may be a debtor.

• This includes builders, developers, non-bank loan originators, loan servicers, homeowners, owners of commercial properties, etc.

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• Bankruptcy cases may be commenced either as liquidations under Chapter 7 or reorganizations under Chapter 11.

• In Chapter 7, a trustee is automatically appointed and immediately displaces management.

• In Chapter 11, the debtor’s management remains in place unless there is evidence of fraud or gross mismanagement.

• In either case, immediately upon the commencement of the bankruptcy case, the automatic stay operates to enjoin creditorsfrom taking any action to pursue “property of the estate” in order to collect of the debtor’s outstanding obligations.

• Also upon filing, an “estate” and the term “property of the estate” is very broadly defined to include all property of any kind in which the debtor has any interest as of the filing date.

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• Contracts entered into prior to a bankruptcy case and with obligations remaining on both sides as of the filing date are “executory contracts” under the Bankruptcy Code.

• Leases, unconsummated agreements for the purchase or sale of property, loan servicing contracts, construction contracts and, prior to certain changes in the law, repurchase agreements, are typically executory contracts.

• Generally, executory contracts may be assumed or rejected by the debtor.• In order to assume a contract, the debtor must cure most defaults under

the contract. In addition, once assumed, so long as the debtor is able to provide proof of adequate assurance of future performance, an assumed executory contract may be assigned.

• Rejection of an executory contract constitutes a breach of the contract as of the filing date and all damages for breach are general unsecured claims.

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Bankruptcy 101 For Real Estate Professional

Landlord’s Gain Leverage

In large cases, it has become common for the time to assume or reject leases to be repeatedly extended, sometimes until confirmation.

Bankruptcy Code §365(d)(4) Limits The Time To Assume

(A) An unexpired lease of nonresidential real property under which the debtor is the lessee shall be deemed rejected, and the trustee shall immediately surrender that nonresidential real property to the lessor, if the trustee does not assume or reject the unexpired lease by the earlier of –

(i) the date that is 120 days after the date of the order for relief; or(ii) the date of the entry of an order confirming a plan.

(B) (i) The court may extend the period determined under subparagraph (A), prior to the expiration of the 120-day period, for 90 days on the motion of the trustee or lessor for cause.

(ii) If the court grants an extension under clause (i), the court may grant a subsequent extension only upon prior written consent of the lessor in each instance.

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Bankruptcy 101 For Real Estate Professionals

Bankruptcy Code §503(b)(7) Claim Limitation

• Administrative claims are limited if the debtor changes its mind.

(7) with respect to a nonresidential real property lease previously assumed under section 365, and subsequently rejected, a sum equal to all monetary obligations due, excluding those arising from or relating to a failure to operate or a penalty provision, for the period of 2 years following the later of the rejection date or the date of the actual turnover of the premises, without reduction or setoff for any reason whatsoever except for sums actually received or to be received from an entity other than the debtor, and the claim for remaining sums due for the balance of the term of the lease shall be an unsecured claim under section 502(b)(6);

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• Secured creditors are prevented by the automatic stay from foreclosing on their collateral, but are entitled to “adequate protection” which can take a variety of forms but is designed to protect the value of the creditor’s collateral as of the filing date; secured creditors are entitled to receive their collateral, its value or the indubitable equivalent at the end of the case.

• General unsecured creditors receive a pro rata portion of the unencumbered debtor’s assets after payment of administrative expenses (i.e., the costs of the case and post-filing operating expenses if applicable) and priority claims (i.e., employee wages and certain taxes).

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• In order to foster equality of distributions to creditors, the debtor is empowered to pursue avoidance actions including:

• Preferences: Any payment made by the debtor to a creditor within 90 days prior to the filing (or one year if to an insider) on account of an antecedent debt while the debtor was insolvent which permitted the creditor to recover more than it would have in a liquidation. Defenses include providing new value, contemporaneous exchanges and ordinary course payments.

• Fraudulent Conveyances: Payments made with actual intent to hinder, delay or defraud creditors or for which the debtor received less than reasonably equivalent value while the debtor was insolvent or rendered insolvent.

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Mortgage Repurchase Agreements – the Players

• Homeowners and developers borrow money from mortgage lenders to finance residential or commercial property purchases; the mortgages are packaged and sold, in a variety of forms, to all types of investors – from financial investors to individuals.

• Mortgage servicers and originators, such as American Home Mortgage, not only originate loans, they administer the mortgages, including the collection of principal and interest and the distribution of same to beneficial holders.

• To maintain liquidity, companies such as American Home enter into repurchase agreements pursuant to which the mortgagee sells a collection of mortgages to a financial institution with an obligation to repurchase the mortgages at a price which reflects the principal plus an interest component.

• This is a $6 trillion industry relied upon by private companies to provide short term liquidity and by the Federal Reserve to provide stability in the banking system. See Appendix A (Brief by Securities Industry Financial Markets Association (SIFMA) and January 4, 2008 Decision of the United States Bankruptcy Court Delaware).

• The industry is in a state of chaos.• The impact, however, is being borne by individuals due to a tightening

mortgage market and reduced liquidity.

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Mortgage Repurchase Agreements and the Bankruptcy Code -- History

• Prior to 1982, the insolvency of a party to a repurchase (repo) agreement presented risks to the liquidity of the investment.

• In the bench decision of the Southern District of New York Bankruptcy Court, in August 1982, in In re Lombard Wall (Case No. 82-8-11556), the Court held that the automatic stay applied to repurchase agreements.• The automatic stay (Code § 362) prevents the non-debtor party from exercising

rights under the agreement, such as terminating the agreement, accelerating the obligations and exercising remedies.

• The repurchase agreement was an “executory contract” which the debtor could assume or reject (Code § 365) within the timeframes set by the Bankruptcy Code.

• Payments made under the repurchase agreement could be the subject of avoidance actions (Code §§ 547 (preferences) and 550 (transferee liability)).

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Mortgage Repurchase Agreements and the Bankruptcy Code - History

• Following the Lombard Wall decision, the mortgage repurchase market stalled.

• In response Congress began working on amendments to the Bankruptcy Code which were passed in 1984 and which expressly excluded these agreements from the effect of the automatic stay.

• Congress noted that “the effective functioning of the repurchasemarket can only be assured if repurchase investors will be protected against open-ended market loss arising from the insolvency of a dealer or other counter-party in the repurchase market… A collapse of one institution involved in repurchase transactions could start a chain reaction, putting at risk hundreds of billions of dollars and threatening the solvency of many additional institutions.”

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Mortgage Repurchase Agreements and the Bankruptcy Code – Applicable Provisions

• Since 1984 Congress has enacted:• Bankruptcy Code §§ 555 and 559, which protect the exercise of

certain contractual rights to liquidate, terminate and accelerate repurchase agreements upon a bankruptcy;

• Bankruptcy Code §§ 362(b)(7) and 362(o), which exempt from the automatic stay, and all other Bankruptcy Code stays, setoffs andrealization against collateral for repurchase agreements;

• Bankruptcy Code §§ 546(f) and 548(d), which provide exemptions from preference and fraudulent transfer avoidance for settlementand margin payments; and

• Bankruptcy Code §§ 101 and 741, which define the key terms repurchase agreement, margin payment, settlement payment, repurchase participant and financial participant.

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• Following the 2005 Amendments, Bankruptcy Code § 101 (47) defines a repurchase agreement as:

(i) an agreement, including related terms, which provides for the transfer of one or more certificates of deposit, mortgage related securities (as defined in section 3 of the Securities Exchange Act of 1934), mortgage loans, interests in mortgage related securities or mortgage loans, eligible bankers' acceptances, qualified foreign government securities (defined as a security that is a direct obligation of, or that is fully guaranteed by, the central government of a member of the Organization for Economic Cooperation and Development), or securities that are direct obligations of, or that are fully guaranteed by, the United States or any agency of the United States against the transfer of funds by the transferee of such certificates of deposit, eligible bankers' acceptances, securities, mortgage loans, or interests, with a simultaneous agreement by such transferee to transfer to the transferor thereof certificates of deposit, eligible bankers' acceptance, securities, mortgage loans, or interests of the kind described in this clause, at a date certain not later than 1 year after such transfer or on demand, against the transfer of funds

(ii) any combinations of agreements or transactions referred to in clauses (i) and (iii);

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• Bankruptcy Code definition of “repurchase agreement” cont’d:

(iii) an option to enter into an agreement or transaction referred to in clause (i) or (ii);

(iv) a master agreement that provides for an agreement or transaction referred to in clause (i), (ii) or (iii), together with all supplements to any such master agreement, without regard to whether such master agreement provides for an agreement or transaction that is not a repurchase agreement under this paragraph, except that such master agreement shall be considered to be a repurchase agreement under this paragraph only with respect to each agreement or transaction under the master agreement that is referred to in clause (i), (ii) or (iii); or

(v) any security agreement or arrangement or other credit enhancement related to any agreement or transaction referred to in clause (i), (ii), (iii) or (iv), including any guarantee or reimbursement obligation by or to a repo participant or financial participant in connection with any agreement or transaction referred to in such clause, but not to exceed the damages in accordance with section 562 of this title.the term “repurchase agreement” does not include “a repurchase agreement under a participation in a commercial mortgage loan.”

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• A mortgage repurchase agreement is thus defined in the Bankruptcy Code as a single agreement with two components:• First, there must be a transfer of specified securities or property by a

transferor to a transferee, against the transfer of funds by the transferee to the transferor.

• Second, there is a contemporaneous agreement by the transferee to transfer back to the transferor the same or equivalent securities or property, against a transfer of funds by the transferor to the transferee (which funds equate to the original transfer of funds, plus an additional amount usually representing interest) at a date certain not later than one year after the initial transfer (or upon demand).

• Congress recognized that mortgage loan repurchase agreements are distinct from the more traditional government backed obligations (i.e., Treasury notes) underlying certain repurchase agreements.

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Mortgage Repurchase Agreements and the Bankruptcy Code – Recent Cases

• On August 7, 2007, American Home Mortgage Holdings, Inc. and itsaffiliated debtors filed voluntary petitions under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court for the District of Delaware (Case, Case No. 07-11047).

• Prior to filing, American Home was in the business of mortgage loan origination, servicing and sales. According to “first day” papers, American Home serviced over 197,000 loans with an aggregate principal face amount of over $46.7 billion and originated $58.9billion in aggregate principal face amount.

• American Home also sold loans and invested in mortgage loans andmortgage backed securities.

• According to American Home, the bankruptcy was caused, at least in part, by a write down in its loan and security portfolios which caused warehouse lenders to begin exercising remedies.

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• On the first day of its bankruptcy cases, to sell both its servicing business and assets consisting of:• mortgage loans owned by the Debtors not subject to warehouse

lender liens;

• mortgage loans owned by the Debtors and subject to warehouse lender liens and repurchase rights;

• “scratch and dent” mortgage loans owned by the Debtors; and

• the Debtors’ mortgage-backed residual interests in securitization trusts.

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• In American Home:• The Debtors had over $10 billion in mortgages which

were subject to various repurchase agreements. An example of one such agreement is annexed as Appendix B.

• Post-petition, several counterparties objected to the proposed sale of the Debtors’ servicing business and a few sought to enforce the termination provisions of the repurchase agreements which were claimed to include the right to designate the servicing agent.

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• The issues for the Bankruptcy Court included:• Whether the operative agreements were repurchase agreements or

secured financing agreements.

• Whether the servicing provisions were an integrated part of the repurchase agreement.

• The Bankruptcy Court held: As a matter of law, the agreements were repurchase agreements and the counterparty could exercise its rights to terminate and liquidate the securities, but the agreements provided for the Debtors to designate the servicing agent -- a so-called servicing retained arrangement, as opposed to a servicing released arrangement, where the buyer designates the servicing agent.

• There may be appeals or motions for a rehearing with respect to this second ruling.

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• Good News: The American Home decision conforms to the express intent of Congress with respect to defining repurchase agreements.

• Bad news: The Court ignored the economic realities of the transaction and created an artificial bifurcation of the servicing aspects of the agreement.

• Takeaway: Parties will need to consider the distinction between servicing retained and servicing released in drafting and pricing deals.

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Additional Issues – Proof of Ownership

• The astronomical increase in trading of mortgage loans has created issues for lenders holding mortgages, but lacking appropriate loan documentation; foreclosure proceedings have been dismissed. • Countrywide financial is the subject of investigations by the United

States Trustee for filing allegedly false claims in bankruptcy cases where it had no documents or had recreated documents purporting to set forth its calculations of interest, fees and other charges.

• Countrywide and others are also subject to investigation by various state attorneys general.

• Federal and state courts are taking hard looks at foreclosure proceedings and stopping them where the lenders cannot produce evidence of ownership of the mortgages or there exist other technical deficiencies. See e.g., Deutsche Bank National Trust Co. v. Castellanos, Sup. Ct., Kings County, January 14, 2008.

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Political Reaction to the Subprime Mess

• In late 2007, in response to the media reports of people losing their homes as their subprime mortgages reset and defaults increased, Congress was considering the Emergency Home Ownership and Mortgage Equity Protection Act of 2007.

• The thrust of two competing bills by Representatives Sanchez and Conyers was to modify the Bankruptcy Code to allow mortgagees to modify the terms of their home mortgages. See Appendix C for a discussion.

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• In bankruptcy, secured claims are secured to the extent of the value of the collateral and unsecured to the extent of any deficiency. U.S. v. Ron Pair, 489 U.S. 235 (1989).

• In furtherance of a public policy to encourage home equity lending, as part of the 1978 Bankruptcy Act, Congress passed Bankruptcy Code § 1332 (b)(2). Nobelman v. American Savings Bank, 113 S. Ct. 2106 (1993).

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• Bankruptcy Code § 1332 (b)(2) provides:b) Subject to subsections (a) and (c) of this section, the plan may-

(2) modify the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor's principal residence, or of holders of unsecured claims, or leave unaffected the rights of holders of any class of claims. (emphasis supplied).

• There is a similar provision for individual Chapter 11 cases (Bankruptcy Code § 1123(b)(5)).

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• Special Bankruptcy Code protections and exemptions are not unique to the residential mortgage industry.

• As part of the 1978 Bankruptcy Act, Congress also passed Bankruptcy Code §1110 to provide special protections to the airline financing industry. Like §1322, §1110 provides that the contractual rights and remedies of a secured party with a security interest in airline equipment (as defined in the Bankruptcy Code) cannot be altered or modified by a debtor in bankruptcy. 11 U.S.C. §1110; In re Continental Airlines, Inc., 932 F.2d 282, 291-93 (3d Cir. 1991).

• In the legislative history of Code §1110 the House Reports noted that “[w]hether or not there was an initial need for these provisions, their existence has become largely addicting to the financing industry, and now the industry claims it would simply cease financing of the relevant equipment if the protections were removed.” Id.; In re Pan Am. Corp., 125 B.R. 372, 376 (Bankr. S.D.N.Y. 1991).

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• It appears that there has been a realization that proposals to modify the Bankruptcy Code would have an adverse impact on mortgage loan financing.

• The remedial rate freeze may have a similar impact on future financing and upon the liquidity of Collateralized Mortgage Obligations.

• Sub prime lending should be regulated at the state level with predatory lending statutes such as Banking Law Section 6-l which became effective in 2007. See Appendix D for the statutory language.

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• The subprime situation and the general state of the economy have led to a rise in home equity theft scams.

• Homeowners are misled into believing that they are either granting a mortgage or temporarily conveying their title to a third party.

• In either case, the result is often that the property is overleveraged and the homeowners can never afford to regain title.

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• New York has enacted legislation to address this scam: New York Real Property Law 265A, entitled “Home Equity Theft Prevention Act”, effective February 1, 2007 and New York Real Property Actions and Proceedings Law 1303. Countrywide v. Taylor, 843 NYSupp 2d 495 (Sup. Ct., Suffolk County, September 20, 2007). See Appendix E.

• The statute applies to: • Acquisitions of title while properties are in foreclosure or default,• By a non-exempt party (exempt parties include, foreclosing lenders, court

appointed persons, bona fide purchasers for value and purchasers who will use the property as their primary residence),

• For less than reasonable value, • Often based upon misrepresentations or oral representations as to material

terms including repurchase rights.

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• Key provisions include:• All covered contracts shall contain the entire agreement and

include a notice of right of cancellation.

• Equity purchaser can take no action for 5 days.

• Equity purchaser cannot make any representations that it is acting for the seller.

• Presumption that a transaction which includes a purchase or repurchase option is a loan.

• Equity purchaser must verify that seller has or is likely to have a reasonable ability to exercise repurchase option.

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• Remedies for violations of subsections (3),(4),(6),(7) or (11),include:• Right of rescission within 2 years

• Damages including, actual damages, attorneys fees and treble damages

• Knowing violations may be a Class A misdemeanor, including a fine of up to $25,000.

• Implications as to transfer and insurability of title remain.

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Like Kind Exchanges and Bankruptcy

• In re: The 1031 Tax Group, Case No. Case No. 07-11448, Bankruptcy Court Southern District of New York.

• A 1031 exchange allows a taxpayer to defer capital gains on the sale of real property if the taxpayer:• sells the property using a Qualified Intermediary,

• identifies one or more replacement properties within 45 days of the initial sale,

• closes on the replacement property within 180 days of the initial sale.

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• This is not a discussion of the nuances of IRC §1031, but of the risks if the Qualified Intermediary is dishonest and/or becomes a debtor in bankruptcy.

• There have been a few 1031 bankruptcy cases over the past few years. Perhaps the most notorious is In re: The 1031 Tax Group.

• The cases point out that this is essentially an unregulated industry that poses significant risks to parties who deal with non-institutional qualified intermediaries.

• Absent express agreements creating a trust and a segregation of funds deposited with a qualified intermediary, the funds will bedeemed property of the estate of a debtor (Bankruptcy Code § 541) and subject to the claims of general unsecured creditors.

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• Most parties entering into a 1031 transaction assume that the funds delivered to the qualified intermediary are being held in trust for the depositor for the 180 day period.

• As the qualified intermediary makes its money from the float on the deposits, however, most 1031 agreements expressly disavow the creation of a trust or escrow relationship and authorize the qualified intermediary to commingle deposited funds and to invest funds in its discretion.

• What to do when confronted with a 1031 transaction.

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Conclusion

• Additional filings can be expected by mortgage servicers, builders, developers, homeowners and others.

• Additional write downs can be expected by financial institutions holding subprime debt in all of its forms.

• Government has limited ability to help.• The Bankruptcy Code, particularly as a result of the 2005

amendments, offers limited assistance to homeowners and businesses forced to commence bankruptcy proceedings.

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