Rolling Back the Repo Safe Harbors
by | posted in: Financial Firms and Safe Harbors | 0

Authors: Edward R. Morrison, Mark J. Roe, and Hon. Christopher S. Sontchi

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Recent decades have seen substantial expansion in exemptions from the Bankruptcy Code’s normal operation for repurchase agreements. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against prebankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to some creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007–2009, leading to a bailout of the repo market and the institutions supporting mortgage-backed securities. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of the exemption to mortgage-backed securities should be reversed.

This article is forthcoming in The Business Lawyer, and a draft is available here.

Practitioners, Academics, and a Judge Testify about Safe Harbors before Congress
by | posted in: Financial Firms and Safe Harbors | 0

Author: Stephen D. Adams

The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law has held two sets of hearings in recent months on the bankruptcy safe harbors for repos and derivatives from the automatic stay, from preference and fraudulent conveyance law, and from the limitations on ipso facto clauses.

This past Wednesday, March 26, Judge Christopher Sontchi, Seth Grosshandler, Jane Vris, Thomas Jackson, and Michelle Harner testified. Last December, Jeffrey Lacker, Donald Bernstein, and Mark Roe testified.

Judge Sontchi argued that the 546(e)’s exception for all settlement transactions is too broad and also urged Congress to narrow the safe harbors for repos. Seth Grosshandler, of Cleary Gottlieb, reported on the work of the ABI safe harbors advisory committee (which includes both Judge Sontchi and Prof. Roe) and warned that the safe harbors are complex and potentially costly to alter.  Jane Vris, representing the National Bankruptcy Conference (NBC), and Thomas Jackson, professor at the University of Rochester, testified on bankruptcy of SIFIs as an alternative to Dodd Frank resolution of bail-out.  Michelle Harner, professor at University of Maryland School of Law, testified in her role as the Reporter to the ABI Commission on Bankruptcy Reform about the Commission.

Mark Roe, professor at Harvard Law School, testified that the safe harbors facilitate excessive short-term funding of financial institutions and impede effective resolution of large financial failures, like that of Lehman in 2008.  Donald Bernstein, of Davis Polk, a member of the ABI bankruptcy commission, testified about the bankruptcy adjustments needed to adapt bankruptcy law to the FDIC’s Single Point of Entry resolution mechanisms.  Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, testified about the importance of bankruptcy reform to reduce the problem of too-big-to-fail and reduce reliance on short-term debt.

The written testimonies are linked above, and the video of the oral testimonies for the March 26th hearing will be found here once it has been posted, and is here for the December 3rd hearing.

For more on the bankruptcy safe harbors for derivatives and repurchase agreements, please see the post by Steven L. Schwarcz and Ori Sharon summarizing their recent paper, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, and the post by Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, and John Thompson, entitled Lehman Bankruptcy Court Issues Safe Harbor Decision, summarizing a recent Lehman case decision on the safe harbors, both published Tuesday.

Valuation Methodologies: A Judge’s View
by | posted in: Valuation | 0

Author: the Hon. Christopher S. Sontchi

There are a variety of methodologies to determine the value of assets that are routinely presented to bankruptcy courts: (i) asset-based valuation, (ii) discounted cash flow or “DCF” valuation, and (iii) relative valuation approaches, which include the “comparable company analysis” and the “comparable transaction analysis.”

This article explains in layman’s terms each of the methodologies and how they are used to reach a conclusion as to value.  An asset based valuation generally calculates the liquidation value of individual assets and aggregates them to arrive at a firm value.  DCF valuation calculates the value of any asset from the present value of expected future cash flows from it, which, in turn, rests on the proposition that a dollar today is worth more than a dollar tomorrow.  Relative valuation involves the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues.  The conclusion rests on the selection of the valuation metric, e.g., EBITDA, and the similarity of the companies or transactions used.  The conclusions from each of the methodologies are generally blended to arrive at a conclusion of value.

The article closes by noting that bankruptcy judges have become familiar and comfortable with the DCF, comparable companies and comparable transactions methodologies, which are often referred to as the “standard” methodologies.  Departures from the standard methodologies or how they are calculated must be explained to the judge.

This article was published in the American Bankruptcy Institute Law Review (20 Am. Bankr. Inst. L. Rev. 1 (2012)) and is available online here.