Restructuring

Contributed by Sunny Singh
On February 16, 2011, the Third Circuit issued its decision in In re American Home Mortgage Holdings, Inc., interpreting section 562 of the Bankruptcy Code, specifically the phrase “commercially reasonable determinants of value.”  American Home Mortgage Holdings Inc. and certain of its affiliates were parties to a repurchase agreement with Calyon New York Branch that governed the sale of, and obligation to repurchase, mortgage loans and certain other mortgage related instruments between American Home and Calyon.  Pursuant to the terms of the agreement, Calyon purchased approximately 5,700 mortgage loans with an original unpaid principal balance of just under $1.2 billion.  Prior to the filing of its bankruptcy case, sometime before August 1, 2007, American Home defaulted on some of its obligations under the repurchase agreement.  Calyon served American Home with a notice of default and accelerated the repurchase agreement on August 1, 2007 (the “Acceleration Date”).  As of the Acceleration Date, the repurchase price of the mortgage loans was approximately $1.14 billion.
American Home filed for chapter 11 approximately five days after the Acceleration Date on August 6, 2007.  Calyon filed proofs of claim against four of the debtors seeking damages of approximately $500 million.  According to Calyon, this amount represented the difference between the total repurchase price of the loans under the the repurchase agreement and the value of the loans, i.e., Calyon’s collateral, as of August 15, 2008, the date that Calyon argued was the appropriate date for measurement of its damages pursuant to section 562 of the Bankruptcy Code.  The debtors objected to the claims on two principal grounds:  (1) Calyon’s damages should be determined as of the Acceleration Date, and (2) in calculating such damages, the court was not required to determine the price at which the loans could be sold on the market, but could use a discounted cash flow methodology (“DCF”) to value the loans as of the Acceleration Date.
Section 562, which was enacted as part of the Bankruptcy Abuse and Consumer Protection Act of 2005, governs the timing of the measurement of damages in connection with repurchase agreements and certain other safe harbored derivatives contracts, such as swap agreements and forward contracts.  It provides that damages under a safe harbored contract shall be measured as of the earlier of the date that the debtor rejects the contract or the counterparty liquidates, terminates or accelerates such contract.  If no “commercially reasonable determinants of value” exist as of such date, however, then damages are to be measured as of the earliest subsequent date or dates on which there are commercially reasonable determinants of value.
The parties in American Home Mortgage disagreed as to whether “commercially reasonable determinants of value” existed as of the Acceleration Date.  The debtors argued that they did because a DCF could be applied as of the Acceleration Date to measure the amount of Calyon’s damages.  DCF values an asset’s cash flow, i.e., the principal and interest that the loans generated or were expected to generate over time.  Under the debtors’ calculations, as of the Acceleration Date, the value of the mortgage loans using DCF was equal to the repurchase price due to Calyon.  Thus, Calyon had no unsecured deficiency claim as of the Acceleration Date.
Calyon, on the other hand, argued that the only appropriate methodology under section 562 is the market or sale value of the loan portfolio.  Because the market was dysfunctional on the Acceleration Date, according to Calyon, there were no “commercially reasonable determinants of value” as of that date.  The earliest possible date that the market or sale value of the loan portfolio could be determined was over a year later on August 15, 2008.  According to Calyon, the market or sale value of the loans as of August 15, 2008 left it with an approximately $500 million deficiency claim against the debtors.
The bankruptcy court sustained the debtors’ objection and held that the phrase “commercially reasonable determinants of value” is not limited to the market or sale value of an asset, and, under the circumstances, the debtors’ proffered method of valuation, DCF, was a “commercially reasonable determinant of value.”  The bankruptcy court held that nothing in section 562 that would imply a limitation on any methodology used to determine value, provided it is commercially reasonable.  The use of the plural word “determinants” suggests that “any” commercially reasonable valuation may be used.  Moreover, the court noted that the primary purpose of the Bankruptcy Code provisions relating to repurchase agreements is to preserve liquidity in the relevant assets.  Section 562 “aligns the risks and rewards associated with an investment in those assets” and prevents the “moral hazard” that would result if damages were measured at a date other than the date of termination, acceleration or liquidation, such that a repo participant [here Calyon] could hold the asset at little or no risk.”  “This would make the debtor an insurer of the repo participant’s investment even though the debtor has no control over the management of the asset – thus, the moral hazard.”
The Third Circuit affirmed the bankruptcy court and held that the debtors had satisfied their burden to dispute Calyon’s claim.  The debtors had the initial burden to rebut the presumption of validity of Calyon’s claim and did so by demonstrating that Calyon’s reliance on the market value on a date after the Acceleration Date was not “commercially reasonable” because other commercially reasonable determinants of value existed as of the Acceleration Date.  The debtors supported their objection with expert testimony that DCF was an appropriate method and evidence that Calyon did not actually sell the loans, but held them and collected monthly payments to minimize its exposure and maximize the value of the loans.  Indeed, during the trial before the bankruptcy court, the debtors introduced a letter from Calyon stating that it was not in Calyon’s interest to sell the loans under current market conditions and that so long as principal and interest payments were being collected, Calyon’s exposure was reduced.  The court also rejected Calyon’s argument that its reading of section 562 would chill the repurchase market.  If Congress had intended section 562 to be limited to market or sale price, it would have said so as it did in section 559.
Judge Rendell wrote a concurring opinion to note that she was originally skeptical of the bankruptcy court’s conclusion that DCF was an appropriate “commercially reasonable determinant of value,” but ultimately fully endorsed the holding for three reasons.  First, the statute uses the plural of “determinants” of value.  Second, while “commercially reasonable” is often linked with disposition, the determination of what is commercially reasonable involves a fact specific inquiry.  Third, Calyon acknowledged that it retained the mortgages and was receiving the monthly mortgage payments.  Thus, Calyon had determined that it would maximize the value of the loans by retaining the mortgages and retaining cash over time rather than selling them.  DCF is consistent with Calyon’s determination and actions.
The opinion is one of the first major reported decisions on the recently enacted section 562 of the Bankruptcy Code, which can have an enormous impact on the valuation of a safe harbored contract and claims arising thereunder.  The Third Circuit made clear that under section 562 of the Bankruptcy Code, more than one commercially reasonable methodology may be applied to calculate a party’s damages.  Notably, the Court also stated that under normal market conditions, market or sale price is probably the appropriate methodology.  In this case, neither party disputed that there was a dysfunctional market as of the Acceleration Date, so the issue of whether the market or sale price value would control in normal market conditions was not before the Court.  But, given the Court’s consideration of Calyon’s actions and actual loss (or lack thereof), it appears that the use of market or sale price even under normal market conditions may subject to rebuttal if the facts and circumstances – including the creditor’s actions and whether it actually sold the underlying asset or suffered the claimed loss – demonstrate that a different methodology is appropriate.