AkerAlert Finance Law march 21, 2008 The American Home Mortgage Case and Repurchase Agreements By Jules Cohen, Esq. and Milton Vescovacci, Esq. In the field of mortgage warehouse lending, repurchase agreements are being used more frequently rather than traditional mortgage warehouse loan and security agreements because of the favorable treatment of repurchase agreements under the 2005 revisions to the United States Bankruptcy Code (the Bankruptcy Code ) if the seller files bankruptcy. 1 Rather than a mortgage loan originator pledging the loan as security for its obligations under a mortgage warehouse loan and security agreement, in the context of a repurchase agreement, the originator sells and assigns its entire interest in a mortgage loan to the warehouse lender (or, as more appropriately defined, the buyer ), who pays a purchase price for such mortgage loan to such seller and agrees to sell such mortgage loan back to the Seller or its designee on a specified future date not to exceed one year in exchange for repayment of the purchase price plus accrued price differential and applicable fees. In a bankruptcy of the seller of mortgage loans, if a repurchase agreement falls within the ambit of and satisfies the elements of the definition of a repurchase agreement and/ or a securities contract under the Bankruptcy Code, 2 the buyer may exercise certain contractual rights to liquidate, terminate and accelerate a repurchase agreement and sell the collateral without obtaining relief from the automatic stay of the bankruptcy. 3 The buyer may also exercise its contractual right to setoff any amounts due it by the seller against any cash or other assets held by the buyer. 4 The money received by the buyer may not be recovered as a preferential payment nor as a fraudulent transfer. So long as the safe harbor provisions are applicable and complied with, the Bankruptcy Courts will not inquire as to whether the transfer of the mortgage loans under the repurchase agreement are a purchase and sale transaction or a secured financing, and they will apply the plain meaning of the applicable statutes. The Bankruptcy Code gives this favorable treatment to repurchase agreements, securities contracts and certain other financial arrangements in order to preserve the liquidity of the market. 5 If a buyer needs to liquidate the mortgage loans by selling them, the buyer would also need to have the power to sell the servicing rights, since owning such servicing rights and having the right to sell same will produce additional value for the buyer. Recently, a warehouse lender had difficulty doing that in a bankruptcy case adjudicated in Delaware entitled In re American Home Mortg., Inc., 379 B.R. 503 (Bkrtcy.D.Del. 2008). In that case, the repurchase agreement provided that the seller was selling the mortgage loans on a servicing retained basis and that the seller who was acting as the servicer of the mortgage loans would charge a 50 basis point servicing fee for doing so. After the seller defaulted under the repurchase agreement, the buyer proceeded to sell the mortgage loans and wanted to transfer the servicing rights in connection with the sale to maximize its selling price. The buyer requested the seller to transfer the servicing rights to the new owner of the mortgage loans, along with the related loan records and escrow amounts. The seller refused to do so and took the position that it could sell the servicing rights to another servicer and keep the proceeds from the sale of servicing the rights. The buyer filed suit in Bankruptcy Court seeking injunctive relief and specific performance, and requested the court to order and cause the seller to transfer the servicing rights as designated by the buyer. The Bankruptcy Court decided that the contract for sale and repurchase and the transactions entered into thereunder was a repurchase agreement and a securities contract entitled to favorable safe harbor treatment under Sections 555 and 559 of the Bankruptcy Code. However, the Bankruptcy Court held that the part of the repurchase agreement concerning the servicing rights was (i) severable from the part concerning the sale of the mortgage loans because the mortgage loans were sold on a servicing retained basis and (ii) not a repurchase agreement or a securities contract under the Bankruptcy Code. Thus, the servicing rights could not be protected under the safe harbor provisions of the Bankruptcy Code. As such, ADVERTISEMENT
the Bankruptcy Court held that the buyer did not establish a basis for requiring the seller to transfer the servicing to the buyer, and since the part of the repurchase agreement concerning servicing rights could be severed, the seller was entitled to sell the servicing rights to another party and retain the sale proceeds in the bankruptcy estate for the benefit of the unsecured creditors. This case presents an interesting set of issues for warehouse lenders that use a repurchase agreement as the document of choice. The first issue that such warehouse lenders (or buyers) should be concerned with is whether they are purchasing the servicing rights along with the mortgage loans. Not doing so could lead to the conclusions held in the American Home Mortgage case, an outcome that was not favorable to the warehouse lender. Clearly, the value of the mortgage loans purchased without the servicing rights is diminished, especially if the mortgage loans have to be sold subject to the servicing rights of a bankrupt servicer. A possible solution to this issue is to provide in the repurchase agreement that the mortgage loans being purchased by the buyer include the servicing rights and are being sold on a servicing released basis, that the buyer of the mortgage loans is the owner of the servicing rights and designates the seller as an interim servicer of the mortgage loans and agent of the buyer until further notice from the buyer that it is terminating the servicer and transferring the servicing rights to a successor servicer, and that the purchase price is being determined in part to compensate the seller for the value of the mortgage loans and for servicing such mortgage loans on an interim basis. It may also be helpful to provide in the repurchase agreement that the intent of the parties is that the provisions concerning the servicing rights are an integral, non-severable part of such agreement which the buyer has relied on in part in setting the purchase price of the mortgage loans, and which will enable the buyer to obtain the maximum value from the sale of the mortgage loans by having the ability to sell the related servicing rights, free from any claims or encumbrances. Such provisions may result in the buyer of the mortgage loans being able to terminate the seller as servicer before or after bankruptcy, and sell the servicing rights without being hindered by the automatic stay imposed as a result of the seller s bankruptcy or the seller s attempts to sell the servicing rights. As a precautionary measure, the repurchase agreement should also provide that, in the event a court of competent jurisdiction determines the servicing rights were not sold by seller to the buyer or that such rights are not an interest in a mortgage loan and are severable from the mortgage loan, despite the parties intent to treat them as a purchase and sale transaction under the repurchase agreement, the seller grants to the buyer a first priority, perfected security interest in and lien on the servicing rights, with that provision of the repurchase agreement constituting a security agreement under the applicable Uniform Commercial Code in effect ( UCC ). 6 By doing so, a buyer should, at the very least, have a security interest in and lien on the servicing rights that it could enforce in the event of a default by the seller under the repurchase agreement. Arguably, and it s not a point that the American Home Mortgage court addressed or focused on, a security agreement or arrangement or other credit enhancement related to a mortgage loan or an interest in a mortgage loan is considered a repurchase agreement pursuant to 11 U.S.C. 101 (47)(v), which if presented before a court in a similar case, may be entitled to the same safe harbor treatment as are mortgage loans and interests in mortgage loans in a repurchase agreement. If a court of competent jurisdiction were to agree with such an argument, then the buyer should be allowed to terminate the servicer and sell the mortgage loans and the related servicing rights (not as an owner of such rights but as a secured party disposing of collateral) and/or enforce its other remedies 2 under the repurchase agreement and under applicable law, without being subject to the automatic stay (if the seller is in bankruptcy). Any proceeds realized from the disposition of such servicing rights will be applied by the buyer to repay the seller s obligations under the repurchase agreement, with the remaining proceeds, if any, required to be returned to the seller. If a deficiency occurs in respect of the amounts due under the repurchase agreement at least in respect of the portion of the repurchase agreement that constitutes a security agreement such amount could be the subject of a deficiency claim that may be brought, to the extent permitted by applicable law, by the buyer as a secured party against the seller and any guarantor (if applicable) or obligor (as such term is defined under the UCC) of the seller s liabilities and obligations under the repurchase agreement. In addition, as demonstrated by the American Home Mortgage case, an important element of transferring the servicing rights is the ability to ensure that the buyer or its designee gets immediate, ready access to the servicing records so that the servicing and collection of mortgagor payments is not interrupted. To address that, the repurchase agreement should provide that the seller will furnish a copy of the servicing records and any other reports and data as may be required by the buyer, in such format acceptable to Buyer, on a regular, current basis (i.e., weekly or monthly). Moreover, the repurchase agreement should provide that the seller will cooperate fully with the buyer and its designee, in the event the buyer terminates the Seller as a servicer, to ensure an orderly and prompt transfer of servicing and the servicing records and collections (received to date and subsequently) to the buyer or a successor servicer appointed by the buyer. This should reduce the time to effect such servicing transfer and the potential interruptions in the collection of any mortgage loan payments from mortgagors.
The second issue that the American Home Mortgage case presents to warehouse lenders, as repurchase agreement buyers, is whether a premium for the purchase of the servicing rights is required to be paid by the buyer. The court suggests that a premium is required because it is customary to pay an additional purchase price for such rights in the industry, and that the value of servicing rights is calculated differently from the value of mortgage loans. Moreover, the court suggests that any failure to pay such premium to the seller would constitute evidence that the servicing rights were not purchased. A possible solution for this is to provide in the repurchase agreement the specific amount of such premium paid by the buyer. Alternatively, the repurchase agreement may provide that such premium is a portion of and included in the overall purchase price paid by the buyer for the mortgage loans. The third issue that the American Home Mortgage case presents to warehouse lenders, as repurchase agreement buyers, is whether a servicing fee is required to be paid to the servicer. The court does not address whether a servicing fee is required or what would happen if none were provided for in the repurchase agreement or paid to the servicer. In long-term financings, such as securitizations and other transactions structured as true sales, it is common industry practice to provide the specific amount of the servicing fee and pay such a fee monthly to a servicer, especially to a party servicing mortgage loans as an agent (and not as a principal) of the owner of such loans. However, in short-term or interim financings, such as mortgage warehouse financings, payment of such a fee is not as customary. Since the court in the American Home Mortgage case did not conclude as to this issue, it is impossible to know whether not paying a servicing fee would adversely affect the outcome as to the ownership of the serving rights. Warehouse lenders may either provide in their repurchase agreements for the payment of a specific amount (or a formula for calculating such amount) representing the servicing fee payable to the seller and the frequency of such payment or stay silent as to this issue, as is more the custom in the industry to date. In conclusion, the adoption of mortgage repurchase agreements by warehouse lenders in lieu of mortgage warehouse loan and security agreements appears to have been a positive move in as far as avoidance of the automatic stay and exercise of contractual rights of such lenders to cause the liquidation, termination or acceleration of their repurchase agreement. However, it is now more critical than ever to ensure that a warehouse lender s repurchase agreements contain the latest features to ensure that such lenders are adequately protected from outcomes such as that found in the American Home Mortgage case. If you have any questions concerning the subject matter of this client alert, please contact either Jules Cohen directly at 407-419-8512 or by email at jules.cohen@akerman.com or Milton Vescovacci directly at 305-982-5671 or by email at milton.vescovacci@akerman.com. 1 See the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, modifying 11 U.S.C. 101-1532. 2 Section 101(47) of the Bankruptcy Code provides that a repurchase agreement (which definition also applies to a reverse repurchase agreement) (A) means (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 combination of agreements or transactions referred to in clauses (i) and (iii); (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 any such clause, but not to exceed the damages in connection with any such agreement or transaction, measured in accordance with 11 U.S.C. Section 562; and (B) does not include a repurchase obligation under a participation in a commercial mortgage loan. 3
Section 101(46) of the Bankruptcy Code provides that a repo participant is an entity that, at any time before the filing of the petition, has an outstanding repurchase agreement with the debtor. See 11 U.S.C. 101(46). Section 741(7) of the Bankruptcy Code provides that a securities contract (A) means (i) a contract for the purchase, sale, or loan of a security, a certificate of deposit, a mortgage loan or any interest in a mortgage loan, a group or index of securities, certificates of deposit, or mortgage loans or interests therein (including an interest therein or based on the value thereof), or option on any of the foregoing, including an option to purchase or sell any such security, certificate of deposit, mortgage loan, interest, group or index, or option, and including any repurchase or reverse repurchase transaction on any such security, certificate of deposit, mortgage loan, interest, group or index, or option; (ii) any option entered into on a national securities exchange relating to foreign currencies; (iii) the guarantee by or to any securities clearing agency of a settlement of cash, securities, certificates of deposit, mortgage loans or interests therein, group or index of securities, or mortgage loans or interests therein (including any interest therein or based on the value thereof), or option on any of the foregoing, including an option to purchase or sell any such security, certificate of deposit, mortgage loan, interest, group or index, or option; (iv) any margin loan; (v) any other agreement or transaction that is similar to an agreement or transaction referred to in this subparagraph; (vi) any combination of the agreements or transactions referred to in this subparagraph; (vii) any option to enter into any agreement or transaction referred to in this subparagraph; (viii) a master agreement that provides for an agreement or transaction referred to in clause (i), (ii), (iii), (iv), (v), (vi), or (vii), together with all supplements to any such master agreement, without regard to whether the master agreement provides for an agreement or transaction that is not a securities contract under this subparagraph, except that such master agreement shall be considered to be a securities contract under this subparagraph only with respect to each agreement or transaction under such master agreement that is referred to in clause (i), (ii), (iii), (iv), (v), (vi), or (vii); or (ix) any security agreement or arrangement or other credit enhancement related to any agreement or transaction referred to in this subparagraph, including any guarantee or reimbursement obligation by or to a stockbroker, securities clearing agency, financial institution, or financial participant in connection with any agreement or transaction referred to in this subparagraph, but not to exceed the damages in connection with any such agreement or transaction, measured in accordance with 11 U.S.C. 562; and (B) does not include any purchase, sale, or repurchase obligation under a participation in a commercial mortgage loan. See 11 U.S.C. 741(7). Section 101(22A) of the Bankruptcy Code provides that a financial participant means (A) an entity that, at the time it enters into a securities contract, commodity contract, swap agreement, repurchase agreement, or forward contract, or at the time of the date of the filing of the petition, has one or more agreements or transactions described in paragraph (1), (2), (3), (4), (5), or (6) of 11 U.S.C. 561(a) with the debtor or any other entity (other than an affiliate) of a total gross dollar value of not less than $1,000,000,000 in notional or actual principal amount outstanding on any day during the previous 15-month period, or has gross mark-to-market positions of not less than $100,000,000 (aggregated across counterparties) in one or more such agreements or transactions with the debtor or any other entity (other than an affiliate) on any day during the previous 15-month period; or (B) a clearing organization (as defined in section 402 of the Federal Deposit Insurance Corporation Improvement Act of 1991). See 11 U.S.C. 101(22A). 3 See 11 U.S.C. 555 and 559. Section 555 provides that The exercise of a contractual right of a stockbroker, financial institution, financial participant, or securities clearing agency to cause the liquidation, termination, or acceleration of a securities contract, as defined in 11 U.S.C. 741, because of a condition of the kind specified in 11 U.S.C. 365(e)(1) shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title unless such order is authorized under the provisions of the Securities Investor Protection Act of 1970 or any statute administered by the Securities and Exchange Commission. As used in this section, the term contractual right includes a right set forth in a rule or bylaw of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act), or in a resolution of the governing board thereof, and a right, whether or not in writing, arising under common law, under law merchant, or by reason of normal business practice. Section 559 of the Bankruptcy Code provides that The exercise of a contractual right of a repo participant or financial participant to cause the liquidation, termination, or acceleration of a repurchase agreement because of a condition of the kind specified in 11 U.S.C. 365 (e)(1) shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of a court or administrative agency in any proceeding under this title, unless, where the debtor is a stockbroker or securities clearing agency, such order is authorized under the provisions of the Securities Investor Protection Act of 1970 or any statute administered by the Securities and Exchange Commission. In the event that a repo participant or financial participant liquidates one or more repurchase agreements with a debtor and under the terms of one or more such agreements has agreed to deliver assets subject to repurchase agreements to the debtor, any excess of the market prices received on liquidation of such assets (or if any such assets are not disposed of on the date of liquidation of such repurchase agreements, at the prices available at the time of liquidation of such repurchase agreements from a generally recognized source or the most recent closing bid quotation from such a source) over the sum of the stated repurchase prices and all expenses in connection with the liquidation of such repurchase agreements shall be deemed property of the estate, subject to the available rights of setoff. As used in this section, the term contractual right includes a right set forth in a rule or bylaw of a derivatives clearing organization (as defined in the Commodity Exchange Act), a multilateral clearing organization (as defined in the Federal Deposit Insurance Corporation Improvement Act of 1991), a national securities exchange, a national securities association, a securities clearing agency, a contract market designated under the Commodity Exchange Act, a derivatives transaction execution facility registered under the Commodity Exchange Act, or a board of trade (as defined in the Commodity Exchange Act) or in a resolution of the governing board thereof and a right, whether or not evidenced in writing, arising under common law, under law merchant or by reason of normal business practice. See 11 U.S.C. 559. 4
4 Section 362(b)(6) of the Bankruptcy Code permits a financial participant to effect a set off, without violating or seeking relief from the automatic stay, of any mutual debt and claim under or in connection with commodity contracts (as defined in 11 U.S.C. 761), forward contracts, or securities contracts (as defined in 11 U.S.C. 741), and clarifies that the setoff may be exercised against cash, securities or other property pledged to or under control of the persons referred to thereunder that constitutes the setoff of a claim against the debtor for a margin payment (as defined in 11 U.S.C. 101, 741, or 761), or settlement payment (as defined in 11 U.S.C. 101 or 741), arising out of commodity, forward, or securities contracts against cash, securities, or other property pledged to or under the control of such person to margin, guarantee, secure, or settle such contracts. Similarly, Section 362(b)(7) of the Bankruptcy Code permits a financial participant to effect a setoff of any mutual debt and claim under or in connection with repurchase agreements that constitutes the setoff of a claim against the debtor for a margin payment, as defined in Sections 741 or 761 of the Bankruptcy Code, or settlement payment as defined in Section 741 of the Bankruptcy Code, arising out of repurchase agreements against cash, securities, or other property held by, pledged to, under the control of, or due from such repo participant or financial participant to margin, guarantee, secure or settle repurchase agreements. 5 Although not discussed by the court in the American Home Mortgage case, it is important to also treat a repurchase agreement as a master netting agreement, as defined under 11 U.S.C. 101(38A), because in addition to having the contractual right to liquidate, terminate or accelerate under Sections 555 and 559 of the Bankruptcy Code, the buyer under such agreement may be entitled to exercise its contractual right to offset and/or net against any payment amounts or other transfer obligations arising under one or more repurchase agreements, securities contracts, master netting agreements and other types of financial contracts. See 11 U.S.C. 561. Other provisions may apply if any one of the parties to the repurchase agreement is a financial institution subject to the Federal Deposit Insurance Act (12 U.S.C. 1821 et seq.) or the Federal Deposit Insurance Corporation Improvement Act of 1991 (12 U.S.C. 4402 et seq.). 6 As a precautionary measure, the provision could also be broadened to grant a security interest in and lien on any assets related to the mortgage loans, such as (purely for illustrative purposes only) any rights to insurance proceeds, take-out commitments and the applicable take-out proceeds associated with such take-out commitments, hedging arrangements and the applicable proceeds associated with such hedging arrangements, that are intended to be sold by the Seller and purchased by the buyer in connection with the purchase and sale of such mortgage loans in case a court of competent jurisdiction determines that none of such assets fall within the ambit of the repurchase agreement definition provided under 11 U.S.C. 101(47) or a securities contract definition provided under 11 U.S.C. 741(7). 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