The Bankruptcy Code's automatic stay gives corporate debtors a breathing period in which to evaluate their financial condition and attempt to reorganize their business operations. See 11 U.S.C. §362(a). Another protection granted a debtor in bankruptcy is the ability to avoid and recover payments made within 90 days prior to filing bankruptcy. See 11 U.S.C. §547(b). However, these protections are not unlimited. In acknowledging that the automatic stay and avoidance powers should not be without limitation, Congress enacted specific exceptions to each. See, e.g., 11 U.S.C. §§362(b) and 547(c) and 28 U.S.C. §959(a).

Indeed, Congress recognized that certain industries could destabilize if various types of transactions were not quickly settled as a result of the automatic stay or were later the subject of an avoidance action. To address these concerns, Congress enacted 11 U.S.C. §362(b)(6) and (b)(7) and the rather complex provisions of 11 U.S.C. §546(e) and (f). See, e.g., Enron Corp. v. Credit Suisse First Boston Int'l. (In re Enron Corp.), 328 B.R. 58, 66 (Bankr. S.D.N.Y. 2005). These provisions provide some protection and assurance under certain circumstances and for particular kinds of transactions.

Understanding the practical application of these provisions requires an understanding of what has become a common transaction: the pooling and selling of mortgage loans (i.e., a securitization transaction) and the often-included repurchase obligations. As the economy slows and the housing market declines, the application of these provisions may also become more common.

Mortgage Loan Purchase Agreements and Associated Repurchase Obligations

In a booming housing market, mortgage lenders (the seller in a securitization transaction) commonly originate a substantial number of mortgage loans, collect their fees and then quickly sell a bundle or pool of loans to a third-party investor (the purchaser in a securitization transaction). However, because so many loans are often sold at one time, the purchaser rarely undertakes a full review of each and every individual loan prior to closing. To expedite the closing of a securitization transaction, the seller typically agrees to repurchase, after the purchaser conducts a thorough post-closing review, any and/or all individual loans that do not meet the purchaser's criteria as of the time of sale. These repurchase obligations may arise months or even years after the securitization transaction closes.

For visualization, the diagram outlines a typical securitization transaction of a mortgage loan sale that includes a repurchase obligation by the seller.

Because the past several years have seen historically low interest rates and a corresponding boom in demand for both new and refinanced home mortgages, securitization transactions have become common and very profitable for both the seller and the purchaser. However, the recent rise in mortgage interest rates, together with the corresponding decrease in demand for both new and refinanced loans, is beginning to put cash-flow pressures on mortgage lenders. This trend is especially true for those mortgage lenders whose income is primarily dependent on earning origination and other fees prior to a securitization transaction.

Without the continued income from new originations, some mortgage lenders are finding themselves short of cash to satisfy repurchase obligations as the housing market declines and previously-sold pools of loans begin to default. As such, purchasers are becoming increasingly exposed to the possibility that their sellers will not have the cash to meet their repurchase obligations and/or will file bankruptcy.

Due to the impending threat of repurchase obligation defaults and the potential for a boom in mortgage lender bankruptcies, the following two strategies will help to minimize the risk to the purchaser: (a) settling repurchase obligations on a regular basis as pre-petition protection and (b) setting off against a repurchase obligation deposit post-petition. These strategies work together to protect the purchaser both pre-petition (via regularly settling repurchase obligations with the seller) and post-petition (by setting off free of the automatic stay). Both such strategies, however, require prior planning and action.

Settling Repurchase Obligations as Pre-Petition Protection

Sections 546(e) and (f) of the Code provide protections for certain qualifying entities. Specifically, §546(e) states, in relevant part, that "the trustee may not avoid a transfer that is a...settlement payment, as defined in §101 or 741 of this title, made by or to a...financial institution...[or] financial participant...that is made before the commencement of the case...." 11 U.S.C. §546(e).

Similarly, §546(f) provides that a "trustee may not avoid a transfer that is a...settlement payment, as defined in §741 of this title, made by or to a repo participant or financial participant, in connection with a repurchase agreement and that is made before the commencement of the case...." 11 U.S.C. §546(f). As a result, these provisions afford significant protection to qualifying entities. The determination of whether an entity qualifies requires a close examination of various Code definitions.

Section 546(e) Protections

The initial consideration under §546(e) is whether a purchaser is a "financial institution" or a "financial participant." A "financial institution" is defined as "a Federal Reserve bank, or an entity (domestic or foreign) that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally insured credit union, or receiver, liquidating agent or conservator for such entity, and when any such Federal Reserve bank, receiver, liquidating agent, conservator or entity is acting as agent or custodian for a customer in connection with a securities contract (as defined in §741)...." 11 U.S.C. §101(22)(A). If a purchaser is one of these types of entities, then it qualifies as a "financial institution" for §546(e) purposes.

Alternatively, a purchaser may qualify if it is a "financial participant." A "financial participant" is defined as including the following entities that, "at the time it enters into a securities contract...[or] repurchase agreement....or at the time of the date of the filing of the petition," meets detailed financial benchmarks within the previous 15-month period related to either the principal amount of the entity's total gross loans outstanding or the entity's gross mark-to-market positions. 11 U.S.C. §101(22A)(A). A "financial participant" must therefore be a party to a "securities contract" and must meet the financial benchmarks given in §101(22A)(A).

While the purchaser must evaluate its financials to determine whether it qualifies under §101(22A)(A)'s financial criteria, a "securities contract" is expressly defined to include "a contract for the purchase, sale or loan of...a mortgage loan or any interest in a mortgage loan, a group or index of...mortgage loans or interests therein (including an interest therein or based on the value thereof), or option on any of the foregoing...." 11 U.S.C. §741(7)(A)(i). Thus, a "securities contract," by definition, includes the purchase and sale of mortgage loans.

Assuming a purchaser qualifies as either a "financial institution" or a "financial participant," one must determine whether the payment at issue qualifies as a "settlement payment." Section 741(8) broadly defines "settlement payment" as "a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment or any other similar payment commonly used in the securities trade...." 11 U.S.C. §741(8).

As a result, a particular settlement payment must be "commonly used" in the relative trade. See Enron Corp. v. Bear, Stearns Int'l. Ltd., 323 B.R. 857, 870 (Bankr. S.D.N.Y. 2005) (concluding "that in order to qualify as a settlement payment that is protected by the safe harbors [of §546(e)], the settlement payment must be 'commonly used' within the industry..."). Similarly, a "settlement payment" includes "a transfer of securities that completes any securities transaction, including repo transactions." Jonas v. Farmer Bros. Co. (In re Comark), 145 B.R. 47, 52 (B.A.P. 9th Cir. 1992). Again, "securities" include notes such as mortgage promissory notes. See 11 U.S.C. §101(49)(A)(i).

Notwithstanding the Code's broad definition of "settlement payment" and the inclusion of "note" (such as a promissory note under a mortgage loan) in §101(49)(A)(i)'s definition of "security," there are cases construing §546(e) to only apply in public securities markets and not to private transactions. See, e.g., Kipperman v. Circle Trust F.B.O. (In re Grafton Partners LP), 321 B.R. 527 (B.A.P. 9th Cir. 2005); Jewel Recovery v. Gordon, 196 B.R. 348, 353 (N.D. Tex. 1996); In re Olympic Natural Gas Co., 258 B.R. 161, 165-66 (Bankr. S.D. Tex. 2001). However, these cases arose in the context of the purchase and sale of stocks and did not involve the transfer of mortgage loans. In fact, no published opinion appears to have specifically analyzed §546(e) in light of the purchase and sale of mortgage loans.

Further, nowhere does the Code proscribe the settlement of mortgage loan repurchase obligations. Not only does §546(f) provide that a settlement payment made "in connection" with a repurchase agreement (which expressly can include the sale and repurchase of mortgage loans) cannot be avoided, §741(7)(A)(i) expressly provides that mortgage loans can be the subject of "securities contracts." The fact that the protections under §546(e) (and (f)) should be applied to the sale of mortgage loans is further bolstered by the fact that §555 of the Code, which does not mention "settlement payment," permits a party to a "securities contract" to liquidate the contract post-petition free of the automatic stay. Thus, the seemingly contradictory case law cannot provide a basis for excluding mortgage loan securitizations from §546's protections.

Indeed, the Code's express provisions contemplate that settlement payments made in the context of the mortgage loan purchase and sale trade (and not the public stock trade) are entitled to §546's safe-harbor provisions. Among these safe-harbor provisions are §546(f)'s protection of repurchase obligations.

Section 546(f) Protections

Section 546(f) prohibits the avoidance of a pre-petition settlement payment made to a "repo participant" or "financial participant" "in connection with a repurchase agreement...." 11 U.S.C. §546(f). The definition of a "financial participant" in §546(f) is the same as that discussed above with regard to §546(e), but "repo participant" is separately defined.

A "repo participant" is "an entity that, at any time before the filing of the petition, has an outstanding repurchase agreement with the debtor." 11 U.S.C. §101(46). In turn, a "repurchase agreement" is defined as "an agreement...which provides for the transfer of one or more...mortgage loans...against the transfer of funds by the transferee of such...mortgage loans...with a simultaneous agreement by such transferee to transfer to the transferor thereof...mortgage loans of the kind as described in this clause, at a date certain not later than one year after such transfer or on demand, against the transfer of funds...." 11 U.S.C. §101(47)(A)(i). In summary, "repurchase agreements" require the transfer of certain assets by one entity to another, with both parties agreeing that the buyer will transfer some or all of the same or similar assets back to the seller by a certain date or on demand.

Because the seller in the transaction diagramed on p. 58 typically has ongoing repurchase obligations, upon demand and at an established price, the seller and purchaser are each a "repo participant," and the agreement to repurchase is a "repurchase agreement." As repo participants to a repo agreement, payments made in satisfaction of a repurchase obligation are not avoidable in a subsequent bankruptcy proceeding.

Thus, when a securitization transaction includes repurchase obligations, the purchaser should regularly evaluate the status of its seller's repurchase obligations. Regular evaluations will alert the purchaser to unsatisfied repurchase obligations and will allow the purchaser to determine the appropriate course of action. Specifically, the purchaser can settle outstanding repurchase obligations by having the seller make a "settlement payment" as defined in §741(8) and as discussed above, and/or set off unsatisfied repurchase obligations against subsequent securitization transactions with that seller. Either course of action, so long as its constitutes a §741(8) settlement payment, will provide a defense against an avoidance action in the seller's subsequent bankruptcy case.

Even if pre-petition settlement payments fail to fully satisfy outstanding repurchase obligations, a purchaser is not necessarily defeated, assuming it takes the proper precautions, such as a repurchase obligation deposit.

Setting Off Against Pre-Petition Deposits Post-Petition

In addition to the protections afforded to qualifying purchasers of mortgage loans in §546(e) and (f), a purchaser can take additional pre-petition action by obtaining a pre-petition deposit from the seller as security for the seller's repurchase obligations under the mortgage loan sale agreement. By requiring a deposit, the purchaser not only holds security in case the seller defaults on its repurchase obligations, but can also set off this deposit post-petition against the seller's repurchase obligations without first seeking relief from the automatic stay. See 11 U.S.C. §362(b)(6) and (b)(7).

Specifically, §362(b)(6) provides that the automatic stay does not apply to:

the setoff by a...financial institution...[or] financial participant of any mutual debt and claim under or in connection with ...securities contracts, as defined in §741 of this title, that constitutes the setoff of a claim against the debtor for a... settlement payment, as defined in §101 or 741 of this title, arising out of...securities contracts against cash, securities, or other property held by, pledged to, under the control of or due from such...financial institution...[or] financial participant...to margin, guarantee, secure or settle ...securities contracts....

11 U.S.C. §362(b)(6). Section 362(b)(7) provides similar protections to "repo participants" or "financial participants" in connection with "repo agreements." 11 U.S.C. §362(b)(7). Section 362(b)(6) and (b)(7), therefore, permit qualified purchasers (i.e., a "financial institution," "financial participant" or a "repo participant") to use any deposit related to the seller's pre-petition repurchase obligations to immediately settle, post-petition, the seller's repurchase obligations without regard to the automatic stay.

In obtaining such a deposit, a purchaser should consider escrowing a certain percentage of a securitization transaction's sale proceeds. Further, a purchaser should also retain any deposit held as part of any pre-petition settlement of repurchase obligations, with proceeds from the "new" securitization transaction to satisfy the then-outstanding repurchase obligations.

By taking such precautions, which require careful forethought and drafting of the securitization transaction documents, a purchaser can lessen or even avoid the impact of a seller's subsequent bankruptcy case.

Conclusion

Securitization transaction purchasers should regularly evaluate outstanding repurchase obligations and enter into settlement agreements to satisfy such repurchase obligations. When structuring these settlements, specific provisions stating that the seller acknowledges and agrees that the settlement payment falls within §546(e) and (f) and is not subject to later avoidance are important because their inclusion may avoid a subsequent preference dispute.

Additionally, purchasers should retain pre-petition repurchase obligation deposits if the pre-petition settlement is only a partial settlement of the seller's repurchase obligations (i.e., additional review to confirm criteria represented by the seller or if the purchaser has obtained additional loans under a master sale agreement). Retention of a deposit will provide the purchaser with additional protections should the seller file bankruptcy before all of its repurchase obligations are fully satisfied.

While none of these considerations are risk-free, the purchaser has cash in its bank account, has a defense to a subsequent avoidance action and can setoff post-petition without restraint of the automatic stay. The consideration of these issues is important because, while scant case law addresses such issues, they will certainly be in the foreground of the next wave of bankruptcy filings.