Last year saw
These transactions, which closely resemble secured loans, have been a flashpoint in times of prior market turmoil because repos enjoy special protection under bankruptcy law. After
The onset of the COVID-19 pandemic
Disruptions over the past two years and the portents of the FSOC report make it well worth considering how repo financers should respond when borrowers become distressed. This is particularly true given that repo lenders must make these decisions within days or hours of counterparty default.
There are important lessons for repo financiers and their advisors from the trial and appeals in In re HomeBanc Mortgage Corp., a litigation arising out of a repo borrower’s default at the outset of the Great Recession.
HomeBanc was in the business of originating and securitizing residential mortgage loans, and between 2005 and 2007 it financed its operations in part by placing on repo with Bear Stearns certain mortgage-backed securities that it had originated and held on its books. In 2007, soon after the residential mortgage market first became stressed, HomeBanc defaulted on its obligations to Bear Stearns, filing for bankruptcy protection days later.
Upon HomeBanc’s default, Bear Stearns was contractually required to ascertain the value of the repo’ed securities, and it conducted a bids-wanted-in-competition auction to do so. Eventually, HomeBanc’s bankruptcy trustee took issue with Bear Stearns’ actions and a decade of litigation commenced.
This article describes the HomeBanc courts’ application of Bankruptcy Code Section 559, which recognizes the “need for speed” by a repo lender facing counterparty default. It also describes the procedures that the repo lender used in structuring the post-default auction, which offer practical lessons for lenders who may need to act quickly should the market see another period of distress.
Why Repo Lenders Must Often Act Quickly to Address Borrower Default
Section 559 of the Bankruptcy Code provides a safe harbor that allows repo participants to liquidate repo collateral consistent with the parties’ contract, notwithstanding the automatic stay that would otherwise protect assets from creditors. This safe harbor recognizes the “need for speed” critical to the underlying purpose of repo financing arrangements and allows lenders to move quickly in the case of default.
HomeBanc reinforced this statutory purpose. The court noted that Section 559 is among the congressionally enacted “exceptions to the general rule disallowing ipso facto clauses for swaps” and certain other types of financial contracts to address volatility in the financial markets.
The absence of such protections would put the non-defaulting party at substantial risk, holding the bag if depreciating assets could not be valued or sold expeditiously.
Consistent with the need to allow repo lenders to act quickly, the HomeBanc court also rejected the notion that “credit enhancements” were not subject to the protection of the Section 559 safe harbor. Among the securities HomeBanc put on repo were several that the court held were “credit enhancements” (i.e., additional collateral supporting the existing loan) under the bankruptcy code because the confirmations reflected that these securities were purchased, individually, for zero dollars.
HomeBanc’s trustee argued that Section 562 of the code provides a more limited safe harbor, should apply to “credit enhancements.” The court disagreed, recognizing that obligating a repo lender to isolate credit enhancements from other repo’ed securities, and then auction them separately to value them in the event of default, would be “impractical” and “unduly cumbersome.”
The court also concluded that Section 559’s protection applied regardless of whether the liquidation satisfied, exceeded, or fell short of the repo debt—and accordingly, whether there were excess funds being returned to the bankruptcy estate—stating, “[t]he text reveals that § 559 can apply when there is an excess, shortfall, or break-even amount.”
Lessons from the HomeBanc front
To assess whether the repo lender “rationally appraised” the securities (the standard required under the governing law), theHomeBanc court considered several safeguards that Bear Stearns, in consultation with counsel, had put in place to conduct the auction. In light of those safeguards (discussed below), and notwithstanding the stress in the market for residential mortgage backed securities in the summer of 2007, the court found that the auction was rational, in good faith, and in compliance with the contract—and, therefore, within the Section 559 safe harbor. Perhaps most important, the court rejected the argument that distressed market conditions necessitated valuation through a discounted cash flow model instead of a market-based valuation.
Wide distribution of bid solicitations. Bid solicitations were distributed to approximately 200 potential buyers via a sophisticated, experienced sales force. Solicited entities included investment banks and advisors, pension and hedge funds, asset managers, and REITs. The court concluded that the breadth of the solicitation was reasonable, noted that email distribution was industry standard, and rejected the notion that email “blasts” were likely to be ignored.
Potential bidders had adequate information to evaluate the securities. Bid solicitations provided the description, CUSIP, face amount, and current factor for each of the securities. They identified a contact person who could provide additional information to interested bidders. The court found that the information provided was adequate and that it was not practical to attach bulky prospectus supplements or remittance reports, as interested bidders could obtain such information through ubiquitous third-party analytic software.
Potential bidders had adequate time to evaluate the securities. Bidders were solicited on a Friday (the day after default) for an auction the upcoming Tuesday. The court relied on testimony from market participants that this was more time than is typically provided to formulate a bid, which is consistent with balancing the “need for speed”—ensuring that undue delay did not result in depressed prices—and allowing time for market participants to assess value.
Affiliate bidding permitted. Affiliates of the lender were permitted to bid, and the court heard testimony that permitting affiliate bidding was typical industry practice. Safeguards ensured that the affiliate was in the same position as unaffiliated bidders. For example, bids were directed to an attorney in a different building from both the lender and affiliated bidder. The court noted that this atypical protection was “prudent and helpful” in ensuring the integrity of any affiliated bids. And affiliated bids were due earlier than unaffiliated bids, further ensuring that no affiliate could access other bids and adjust its offer.
Additional safeguards. Several additional safeguards were in place to ensure auction integrity, including a period of bid irrevocability and the seller’s ability to withdraw the securities from auction. The court rejected the notion that these safeguards depressed bidding, noting that the period of irrevocability provided the seller time to assess competing bids, and the seller’s ability to withdraw the securities allowed it to avoid unreasonably low bids.
Experience shows that repo default and the lender’s response often must occur within a matter of days, if not hours. Litigation challenging repo lenders’ actions always will have the benefit of hindsight. But if financiers are mindful of the road map set by cases likeHomeBanc, they will be in the best position to defend their actions and reap the benefits of the protections provided by applicable law.
The paper's authors include Jennifer Loach, executive director and executive counsel at JPMorgan Chase; as well as lawyers in Sidley Austin's securities and shareholder litigation practice: Andrew Stern (partner), James Heyworth (partner), Francesca Brody (associate), and Deborah Sands (associate).
