In a remaining vestige of the financial crisis, the U.S. Bankruptcy Court for the District of Delaware (“Court”) recently issued an opinion upholding a repo counterparty’s sale of collateral following the insolvency of the counterparty to the repo. The Chapter 7 Trustee for the insolvent counterparty had challenged the sale on the basis that the sale, conducted through an auction, was not conducted in good faith or in a commercially reasonable manner and therefore violated the repurchase agreement. At auction, an affiliated trading desk of the non-defaulting party submitted the winning bid (there were 2 bids submitted) and took possession of the securities upon payment of the auction price. The issue was distilled and examined on the basis of the following three components:
- was the decision to determine the Net Asset Value of the securities held as collateral rationale or in good faith;
- was the auction process in accordance with industry standards;
- was the non-defaulting counterparty’s acceptance of the value obtained in the auction rationale or in good faith.
With respect to the first point, the Chapter 7 Trustee argued that the securities in question, residual interests in residential mortgage backed-securities, should be valued using a discounted cash flow model. The non-defaulting party countered that BWIC (bids wanted in competition) was a commonly used method to buy and sell securities, including residual interests, among institutional investors. The Court concluded that the use of the BWIC auction process to value the residual interest securities was not irrational or made in bad faith.
The Chapter 7 Trustee similarly argued that the timing of the auction was irrational and in bad faith because the market in August 2007 was dysfunctional. The Court proceeded to examine whether or not the auction was a “commercially reasonable determinant of value” within the meaning of Bankruptcy Code § 562. After conflicting testimony about whether or not the mortgage-backed security market was “dysfunctional” in August 2017, the Court found that the non-defaulting party proceeded to liquidate the securities upon the default of the counterparty as permitted by the GMRA and the Bankruptcy Code and chose to auction the securities in order to determine what a willing buyer would pay for them. The Court then concluded that, in viewing the case in light of events unfolding in August 2007, that the auction “was a commercially reasonable determinate of value” and was not irrational or done in bad faith.
With respect to the second point, the Chapter 7 Trustee argued that the auction process did provide potential bidders with sufficient information, the bidders did not have sufficient time to evaluate the bid notice (bid notice emailed on Friday and auction was held the following Tuesday), that the email “blast” (197 recipients) to potential bidders was likely to be ignored as spam email and that bidders were required to submit irrevocable bids while the non-defaulting party unfairly reserved the right to exclude a security from the auction or extend the auction deadline. The Court concluded that the evidence “shows that there was nothing unusual about the Bid Solicitation procedures and nothing to indicate that the procedures were designed to- or did- discourage bidding on the [Securities].”
With respect to the last point, the Chapter 7 Trustee proffered a discounted cash flow analysis in an effort to show that the amount paid for certain securities was not rationale or in good faith. The non-defaulting party countered that the cash flow model did not incorporate what anyone was willing to pay for such securities in August 2007 and therefore its value was far removed from the value someone was willing to pay for the securities. The Court agreed with the non-defaulting party and found the non-defaulting party rationally accepted the results of the bid process even though the bid was from its affiliated trading desk.
Take-away: The Court’s opinion is generally good news for repo buyers as it shows that a buyer can promptly dispose of collateral following a seller default and as long as the liquidation process is reasonable it will be upheld by a Bankruptcy Court.
The opinion can be found here.
Good Day. Good Liquidation. DR2.