Subprime lenders are most certainly feeling the heat. Over the last several weeks, the press and the financial markets have painted a woeful picture for subprime lenders and their investors, and it looks as if we are on the brink of a major makeover for a market that exceeds $600 billion.
A subprime lender is someone who lends to borrowers with weaker credit who might not otherwise qualify for a mortgage loan. Subprime lenders use short-term borrowings to finance mortgage loan originations. In many instances, the institutions that provide short-term borrowings to subprime lenders to facilitate loan originations also acquire on a short-term basis (usually under repurchase agreements) groups of newly originated mortgages. Ultimately, the subprime lender is obligated to “repurchase” the mortgages “sold” to said institutions. The repurchase is often accomplished with the creation of securitization vehicles used to acquire pools of mortgages with diverse risk portfolios.
The subprime lending market’s massive growth in 2006 has been undermined by an upswing in borrower defaults and a push for federal regulation that seeks to impose much tougher lending standards in the subprime arena. With companies such as New Century Financial Corp. and NovaStar Financial Inc. rumored to be on the verge of bankruptcy, and People’s Choice already in a proceeding, it seems this trend will continue.
So what does all this mean? For investors in the subprime market subject to multi-billion dollar derivative transactions - including many of the largest commercial and investment banks in this country - it could mean involvement in many complex bankruptcy proceedings. It is important, therefore, to understand the expanded protections afforded under the Bankruptcy Code to counterparties to certain derivative transactions (a contract whose value is based on the performance of an underlying financial asset or investment) in light of the recent amendments (as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005).
Upon filing a petition for relief under the Bankruptcy Code, Section 362(a) of the Bankruptcy Code instantly creates a stay that enjoins all entities from engaging in acts to enforce their rights against a debtor or its property. This “automatic stay,” however, is not without exception. In fact, a counterparty to a derivative transaction is permitted to terminate the transaction and realize on its collateral if it is a “Qualifying Party” to a “Qualifying Transaction.”
Qualifying Transactions include repurchase agreements, securities contracts, swap agreements, and master netting agreements. Qualifying Parties include repurchase agreement participants, financial institutions, financial participants, swap participants, and master netting agreement participants. Following the commencement of a bankruptcy case, Qualifying Parties to Qualifying (derivative) Transactions are permitted to set off any mutual debt and claim against the debtor (under, or in connection with, the contract or agreement at hand) that constitutes the setoff of a claim against the debtor for margin payment or a settlement payment arising out of the qualifying contract or agreement.
Qualifying derivative transactions are also immune from avoidance actions under many circumstances (avoidance powers permit the trustee/debtor to avoid certain transfers that prefer or defraud creditors). Indeed, Section 546(e) of the Bankruptcy Code exempts from the trustee’s or debtor in possession’s avoidance powers, “a transfer that is a margin payment... or settlement payment... made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency, that is made before the commencement of the case, except under Section 548(a)(1) of this title.”
The recent amendments to the Bankruptcy Code have further expanded the protections afforded to Qualifying Parties to Qualifying Transactions and are important to understand in the context of the current subprime lending crisis.
Many repurchase agreement participants will be happy to know that Congress’ expanded definition of “repurchase agreement” now includes transfers of mortgage related securities, loans or interests in mortgage-related securities or loans; options to enter into repurchase agreements; and master agreements containing an agreement or transaction that would otherwise be defined as a “repurchase agreement.” The previous definition of “repurchase agreement” merely covered mortgage-backed securities. The expanded definition is intended to include all obligations issued or guaranteed by Fannie Mae and Freddie Mac.
Congress expanded the definition of “securities contract” to include mortgage loans or any interest in a mortgage loan, a group or index of mortgage loans, and master agreements or credit enhancements related to a securities contract. Further, “securities contract” now includes any “repurchase or reverse repurchase transaction on any such security, certificate of deposit, mortgage loan, interest, group or index, or option...” This change is important for some subprime investors because it clarifies that a repurchase or reverse repurchase agreement that does not otherwise fall within the definition of “repurchase agreement,” may still be a Qualified Transaction under the definition of “securities contract.” The definition of “securities contract,” however, specifically excludes “any purchase, sale, or repurchase obligation under a participation in a commercial mortgage loan.”
Introduction of “Financial Participant”
A significant amendment to the derivative provisions of the Bankruptcy Code is the introduction of the definition of “financial participant.” The purpose of the inclusion of “financial participant” in the Bankruptcy Code is to limit the impact of insolvencies upon major market participants. For example, certain parties who would not qualify as a commodity broker or stockbroker in connection with a securities contract, will nonetheless qualify as a “financial participant.”
The term “financial participant” now appears in the various exceptions to the automatic stay, and transfers made to a “financial participant” are now immune from avoidance. Further, the term “financial participant” appears in Sections 555, 556, 559, and 560 (permitting Qualifying Parties with the ability to liquidate, terminate, and accelerate a Qualifying Transaction).
Exceptions to the Automatic Stay
The recent amendments to the Bankruptcy Code make an important clarification in the exceptions to the automatic stay. Qualified Parties are expressly permitted to set off and foreclose on collateral that has been pledged but cannot technically be held, such as receivables and book-entry securities, as well as collateral that has been repledged by the creditor and securities resold pursuant to repurchase agreements. Further, new Section 362(o) provides that the exercise by a Qualified Party of its rights to setoff and foreclose may not be stayed, thereby removing a court’s ability to impose a stay based on its equitable powers.
Master Netting Agreement
The new amendments introduce the definitions of “master netting agreement” and “master netting agreement participant. “ A master netting agreement participant in a master netting agreement is now permitted to exercise its right to net, setoff, liquidate, terminate, accelerate, or close-out multiple Qualifying Transactions. Moreover, the Bankruptcy Code now provides that the automatic stay does not stay the setoff of a mutual debt or claim against the debtor with respect to different Qualifying Transactions subject to a master netting agreement or one or more master netting agreements. This is a significant clarification for parties that have employed cross-product netting agreements.
Pursuant to new Section 562 of the Bankruptcy Code, following rejection by the trustee or debtor in possession, or liquidation, termination or acceleration of the Qualifying Transaction by the Qualifying Party, damages are measured at the earlier of the date of rejection or the date of liquidation, termination or acceleration. In circumstances where it is not commercially reasonable to determine the value of termination damages under either circumstance, an exception to Section 562 of the Bankruptcy Code provides that damages should be measured at the earliest subsequent date on which it was commercially reasonable to determine value.
(Opinions expressed are those of the author or authors, not of Dow Jones Newsletters.)
Paul Basta is a partner in the Restructuring Group at Kirkland & Ellis LLP. Leonard Klingbaum is a partner in the Corporate Group at Kirkland & Ellis LLP. Joshua Sussberg is an associate in the Restructuring Group at Kirkland & Ellis LLP.