When a Mortgage Company Goes Into Bankruptcy

BANKRUPTCY OVERVIEW

Lender Claim

Bank Funded Mortgage Originator pursuant to Warehouse Line of Credit

Bank Takes Lien on Mortgages Generated by Mortgage Originator

Perfect Pursuant to Applicable Law

SECURED CLAIM

• Mortgage Originator Files Bankruptcy
• Automatic Stay – Section 362
• Except as provided in subsection (b) of this section, a petition filed under section 301 operates as a stay, applicable to all entities, of;
• the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the case under this title;
• any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate;
• any act to create, perfect, or enforce any lien against property of the estate;
• any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title;
• any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title; and
• the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor.

Ipso Facto Default Clause – Section 365

• Not withstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on:
• the insolvency or financial condition of the debtor at any time before the closing of the case
• the commencement of a case under this title; or the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

The Lender is Prevented from:

• Liquidating Collateral
• Accelerating Loan/Enforcing It against Mortgage Originator (IPSO Facto Default Clause – in Documents)
• Offsetting Against Obligation of Mortgage Originator

Impact of Bankruptcy:

• Collateral Property of Estate – Disposed in Plan
• Claim Addressed in Plan
• Bifurcation Secured/Unsecured Claim
• Competing with Other Creditors for Limited Dollars
• MCA Financial Corp.
• Case No. 99-42172
• U.S. Bankruptcy Court
• Eastern District of Michigan, Southern Division
• On January 22, 1999, the MCA entities dismissed their 900 employees and ceased operations. On January 28, 1999, the Commissioner of the Michigan Financial Institutions Bureau appointed B. N. Bahadur as Conservator of Debtors.
• On February 10, 1999, Debtors filed voluntary Chapter 11 petitions, which cases were subsequently consolidated.
• During the cases, Debtors ceased nearly all operations and liquidated most of their assets.
• Lenders holding mortgage loans as collateral formed the “Bank Group.”
• Unsecured Creditors Committee was also formed.
• Many other creditors/interests – secured lenders, taxing authorities, investors, employees, City of Detroit, unsecured creditors.
• Total Number Of Filed Claims: 3193
• Goal of Bank Group to protect position and maximize recovery on collateral.
• Financing order entered – allow Debtors to utilize Bank Group’s cash collateral.
• Bank Group did not pursue motion for relief from stay – (recognizing documentation issues; minimal value of collateral/expense associated with disposition of collateral). Forced to oppose numerous motions made by third parties.
• On June 21, 2000, the Court entered an Order Approving Settlement Agreement with the Bank Group. The Settlement Agreement provided, inter alia, that Debtors would receive 40% from the sale of all Title-Mismatch Collateral and 25% of all related entity collateral.

The Debtors’ Plan

• Debtors filed a Second Amended Consolidated Plan and Disclosure Statement on July 19, 2000. Confirmed August 21, 2000.
• The Plan was a liquidating plan. The Agent was authorized to liquidate the remaining assets of the Debtors and distribute them to creditors in accordance with priorities established under the Bankruptcy Code.
• Class 11 wage claimants to receive 25% of their allowed claims on the effective date. Class 12 Benefit Claims and Class 13 Deposit Claims to be paid 100% of their allowed claims on the effective date. The Bank Group agreed to allow use of its cash collateral to fund these payments in connection with settlement.
• In general, secured creditors were paid to the extent of the value of their collateral. Allowed unsecured claims were to receive distributions, but only after payments of administrative claims and repayment of postpetition and emergency loans. Unsecured claims estimated to exceed $180,000,000. Shareholders would not receive any distribution.
• Bank Group Claim/Implementation of Settlement
• Treatment of Bank Group Claim
• Secured portion equal to value of remaining collateral to be paid as liquidated subject to surcharge.
• Unsecured – balance of claim in separate class of unsecured claims.
• Plan provided for Bank Group to receive release from Debtors’ bankruptcy estates, Debtors, The Pools, Sigma Financial, Certificate holders in the Pools.
• Bank Group transferred 1450 properties to Pool Liquidating Agent.
• Bank Group agreed to provide up to $1,250,000 to Plan Agent for post-confirmation expenses and to fund priority classes 11-14 in the Plan.
• Agreed to split proceeds of certain notes with a face value of $4,204,681.86 with the Debtors.
• Unsecured Claim – share pro-rata, but waived right to share in first $500,000 distributed.
• Debtors’ Liquidation Analysis
• Best case scenario – 7.4% distribution to unsecured creditors.
• Most likely case 0%.

Settlement

• On June 13, 2001, this Court entered (a) Stipulated Order Transferring Title to HCDC consistent with Debtors’ Second Amended and Restated Combined Consolidated Plan Under Chapter 11 of the Bankruptcy Code and Disclosure Statement and (b) Stipulated Order Transferring Title to DNDC Consistent with Debtors’ Second Amended and Restated Combined Consolidated Plan Under Chapter 11 of the Bankruptcy Code and Disclosure Statement. Under the above sale orders 1,306 properties that had been surrendered to Bank Group for disposition at the Bank Group’s discretion were sold to the Housing and Community Development and the Detroit Neighborhood Development Corporation for a total of $7,500,000.
• Based on the Settlement Agreement, the Agent and the Bank Group agreed that 319 of the rental Properties sold and 118 of the retail Properties sold were Title-Mismatch Collateral, and that 520 of the rental Properties and 75 of the retail Properties were Related Entity Collateral.
• The parties also agreed to a pro-rata apportionment of the $7,500,000 sale proceeds of $3,332 per rental Property and $14,078 per retail Property.
• Based on the above, Debtors received $1,786.720 of the sale proceeds and the Bank Group received $4,395,471 of the sale proceeds.
• USA Commercial Mortgage Company
• Case No. 06-10725
• U.S. Bankruptcy Court
• District of Nevada
• USA Commercial Mortgage Company (“USACM”), which sometimes did business under the trade name “USA Capital,” is a Nevada corporation with its main office in Las Vegas. USACM filed a voluntary Chapter 11 case on April 13, 2006.
• Prior to the petition date, USACM was in the business of underwriting, originating, brokering, funding and servicing commercial loans primarily secured by undeveloped land and residential and commercial developments, both on behalf of investors and for its own account.
• As of the petition date, the loan portfolio USACM was servicing consisted of approximately 115 loans having a combined outstanding balance of approximately $960 million.
• USACM’s business also included soliciting individual investors to purchase fractional interest in loans, as well as originating and servicing the loans. As of the petition date, there were approximately 3,600 investors whose names appear as a “Lender” in the documents for one or more of the serviced loans.
• Same story six years later.
• Prior to April 2006, USACM regularly made monthly interest payments to direct lenders regardless of whether the particular loans in which the direct lenders had an interest were performing or nonperforming. For example, during the first three months of 2006, USACM collected on average approximately $5.3 million per month in interest payments on the serviced loans but paid out on average approximately $9.7 million per month to the direct lenders.
• It is reported that prior management diverted at least 46 million in principal repayments for use as interest payments to investors.
• USACM’s inability to continue making monthly payments to all direct lenders was a significant contributing factor in the Debtors’ decision to file for bankruptcy protection.
• Another significant contributing factor was an investigation by the U.S. Securities & Exchange Commission. Prior to the petition date, USACM and an affiliate received notice from the SEC that they were the subject of a Regulatory Investigation. Results indicate
• USACM’s inability to continue making monthly payments to all direct lenders was a significant contributing factor in the Debtors’ decision to file for bankruptcy protection.
• Another significant contributing factor was an investigation by the U.S. Securities & Exchange Commission. Prior to the petition date, USACM and an affiliate received notice from the SEC that they were the subject of a Regulatory Investigation. Results indicate
• Many of the non-performing loans appear to have been extended to borrowers who were affiliated or otherwise related to USACM’s pre-petition management, such that the owners and officers of USACM were partial owners of the borrower entities through one or more of their various entities.
• USACM’s loan servicing database contained substantial errors, including but not limited to the following: (a) some borrower payments were not entered into the system; (b) most interest payments from borrowers were not posted in a timely manner; (c) payments were not applied according to the governing loan documents, which indicate that payments are applied first to outstanding interest, then principal; (d) the amount of interest owed by borrowers was not calculated with the correct number of days outstanding or correct amount of principal owing; (e) check numbers used were not in sequence or were used multiple times; and (f) servicing fees were not charged; or were calculated incorrectly.
• The primary shareholders relinquished management authority to Thomas J. Allison of Mesirow Financial Interim Management, LLC, who became the President, Chief Restructuring Officer, and Chief Executive Officer of USACM continues to serve in that capacity.
• Orders approving debtors’ use of cash to continue operating;
• Approval of motion to hold funds pending a determination of the proper recipients;
• Records reconstructed/investors statements mailed to all direct lenders and fund members;
• $65 million distribution to investors approved by Court – one of the primary goals of Debtors’ new, post-petition management was to distribute to investors, as promptly as possible after the initial accounting work and reconstruction of the loan records was completed, a significant portion of the funds USACM had collected and was holding.

The Plan/Disclosure Statement Filed

• Asset Sale/Liquidating Plan
• USACM and First Trust propose to sell certain assets including, servicing rights and specific loans, free and clear of liens and interests, to SPCP Group, LLC for the total cash purchase price of $47.5 million, pursuant to the terms of an asset purchase agreement. SPCP is acting as a stalking horse. Specific bid procedures have been put in place.
• Plan provides for assumption and assignment of agreements to purchaser and distribution of sales proceeds and liquidation of remaining proceeds.
• USACM is requesting that the exclusivity period to confirm plan be extended to the end of the year.
• General Comments on Mortgage Companies in Distress
• 1. Changes in Market Conditions, in the Business Environment, Can Take a Company Down.
• 2. When a Mortgage Company Resorts to Fraud to either (a) Save the Company, or (b) Make Money, a Lot of Innocent Bystanders Get Hurt.
• 3. Other Notes from Bankruptcy Cases involving
• Mortgage Companies.
• In Re First Alliance Mortgage Company, 298 B.R. 652 (C.D. Cal. 2003)
• “Debtor’s repayments of fully secured obligations, where each payment by debtor results in dollar-for-dollar reduction in debtor’s secured debt, do not hinder, delay or defraud creditors, and are not avoidable as fraudulent transfers, because they do not put assets otherwise available in bankruptcy distribution out of creditors’ reach and do not result in diminution of debtor’s estate.”
• “Creditors’ committee could not set aside, as fraudulent transfers subject to strong-arm avoidance, payments that debtor had made to financial institution that provided it with secured warehouse line of credit, where each payment that debtor made to financial institution to satisfy particular extension of credit resulted in release of mortgages with value in excess of amount repaid, which payments did not result in diminution of estate assets available to debtor’s creditors.”
• In re SGE Mortgage Funding Corp. 278 B.R. 653(Bkrptcy. M.D. Ga. 2001)
• “Residential mortgage broker’s assignment of its interest in mortgage notes and in mortgages securing them to investors who funded its mortgage loan business…[the] fact that these assignments were or were not recorded had no bearing on whether investors’ interest were perfected. [Perfection] could [only] be accomplished if investors took possession of [the] notes.”
• In re Leedy Mortgage Company, Inc., 111 B.R. 488 (Bkrtcy. E.D. Pa. 1990)
• “Mortgagees, whose accounts the debtor had agreed to service, were not entitled to secured claims for shortages in accounts, as funds which debtor had misappropriated could not be traced and mortgagees were unable to identify any specific property held by debtor at time of Chapter 7 filing that belonged to any of the mortgagees.”
• BANKRUPTCY CODE CHANGES IMPACTING MORTGAGE WAREHOUSE LENDING
• Recent amendments to the Bankruptcy Code may however provide a way for a lender restructure its transactions with the mortgage originators to lessen, and possibly eliminate, the costs of a mortgage originators bankruptcy to lender.
• Since 1984, non-debtor participants in repurchase agreements involving certain financial instruments have enjoyed special protections under the Bankruptcy Code.
• (1) enforceability of ipso facto default clauses in the repurchase agreement,
• (2) limited exemptions from the automatic stay,
• (3) additional defenses to preference claims asserted by a trustee or debtor-in-possession.
• In 2005, Congress amended Section 101(47)(A)(i) of the Bankruptcy Code to include mortgage loans as a type of financial instrument that could be the subject of a repurchase agreement and thus entitled to the protections afforded such agreements under the Bankruptcy Code.
• Bankruptcy Code Definitions
• 11 U.S.C. §101(46): The term “repo participant” means an entity that at any time before the filing of a petition has an outstanding repurchase agreement with the debtor.
• 11 U.S.C. §101(47)(A)(i): The term “repurchase agreement” means an agreement, including related terms, which provides for the transfer of one or more …mortgage loans… with a simultaneous agreement by such transferee to transfer to the transferor thereof … mortgage loans …, at a date certain not later than 1 year such transfer or on demand.
• Benefits Afforded to Repo Participants under the Bankruptcy Code which are not Available to Secured Lenders
• Contractual Right to Liquidate, Terminate, or Accelerate a Repurchase Agreement
• 11 U.S.C. §559 which provides that “the exercise of a contractual right of a repo-participant to cause the liquidation of a repurchase agreement because of a condition described in section 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 in any proceeding under title 11 of the United States Code.
• Allows for the enforcement of so-called “ipso facto” default clauses in the repurchase agreement which generally allow for acceleration of the term of repurchase agreement, termination of the repurchase agreement, and/or liquidation of the securities held as part of the repurchase agreement.
• Exemption from Application of the Automatic Stay for Setoff Rights:
• §362(b)(7) provides that a bankruptcy filing does not operate as a stay of the setoff by a repo participant…, of any mutual debt and claim under or in connection with the repurchase agreements that constitutes a setoff of a claim against the debtor for a margin payment, as defined in section 741 or 761 of this title, or settlement payment, as defined in section 741 of this title, 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….to margin, guarantee, secure or settle repurchase agreements.
• 11 U.S.C. §362(o) provides that the rights not subject to the stay pursuant to §362(b)(7) shall not be stayed by any order of a court or administrative agency in any proceeding under title 11 of the United States Code.
• Affirmative Defense to Avoidance Actions:
• The Bankruptcy Code and applicable state law provide a debtor-in-possession and/or a trustee with the power to avoid certain pre-petition transfers of property of the debtor. See 11 U.S.C. §§544-551.
• 11 U.S.C. §546(f) which provides: Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment as defined in section 741 or 761 of this title or settlement payment, as defined in section 741 of this title, made by or to a repo participant…, in connection with a repurchase agreement and that is made before the commencement of the case, except under 548(a)(1)(A) of this title.
• 11 U.S.C. §741(8) 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.
• Impact of Amendments
• The amendments to The Bankruptcy Code were intended to address the uncertainty of the characterization of the transactions as either financial contracts or ordinary loans
• Commentators believe that all repurchase agreements are explicitly covered by the definition of “Securities Contract” and intended to eliminate any inquiry as to whether a repurchase or reverse repurchase transaction is a purchase and sale transaction or a secured financing.
• Prior to the amendment there were a number of cases interpreting whether a contract was a true repurchase agreement or a secured transaction. In almost every instance where a legal characterization of a repurchase has been litigated, the court ruled that the agreements in question were ambiguous and consideration of extrinsic evidence was required before a final determination on the legal character of the agreement could be made.
• In Bevill, 67 BR. 557 (D.N.J. 1986) the court concluded that “[t]he selected inclusion…of terms customarily found in secured loan transactions does not automatically convert the [repurchase agreements] into secured loan instruments and does not nullify the express language of purchase and sale which the parties voluntarily choose to describe their transactions. However, the presence of such terms in the agreements does raise sufficient doubts as to the intent of the parties to justify examination of extrinsic evidence of intent.”

Conclusion

• The protections and benefits given to repo participants in a bankruptcy case are completely at odds with the primary purpose of the Bankruptcy Code – the maximization of the debtor’s assets for the benefit of all creditors. Consequently, debtors and/or trustees are going to be preconditioned to litigate the character of purported repurchase agreements if there are contradictory terms in an agreement.
• It remains to be seen if the debtors and/or trustees will acknowledge that the repurchase agreements are protected transactions that fit within the formal definitions developed in the marketplace and included in the Code.