United Western Bancorp Inc (fka UWBKQ)

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MBS Investors are Entitled to Increased Bankruptcy Distributions
By Shan A. Haider on November 12, 2014

Posted in Case Law, Default & Bankruptcy
Investors in mortgage-backed-securities (“MBS”) suffered significant losses in connection with the Financial Crisis. Those losses generated a substantial amount of litigation brought by MBS investors; much of it centered on securities-fraud based causes of actions against originators, sponsors, and/or depositors involved in securitizations. In addition to securities litigation, the Financial Crisis yielded many bankruptcy filings by parties connected to the issuance of MBS – leading to an intersection between the litigation claims and the bankruptcy cases. MBS investors have found some solace over their losses (through increased recoveries) in decisions reached by the bankruptcy judges presiding over the Washington Mutual and Lehman Brothers bankruptcy cases. More precisely, these decisions held that the MBS investors’ claims are not subject to subordination in bankruptcy, unlike the situation faced by typical purchasers of securities issued by debtors.

Typically, securities-based tort claims against a debtor in bankruptcy are subordinated to claims made by other general unsecured creditors, pursuant to bankruptcy code section 510(b). Section 510(b)’s purpose is to prevent shareholders from maneuvering their way to parity with general unsecured creditors. The policy driving section 510(b) is based on the risk profile of a creditor versus an equity holder; the creditor expects a fixed return, whereas, equity’s expectation is to share in profits (if any). Thus, a security holder should bear the weight of the risk involved with purchasing a security – not the general unsecured body. Section 510(b) assures that claims asserted against a debtor that arise from the purchase of its securities receive no distribution, unless general secured creditors are paid in full (a rarity). However, as explained in Lehman and Washington Mutual, section 510(b) does not apply to MBS investors who lodge claims against bankrupt originators, sponsors, or depositors.

MBS investors are saved from subordination because securitizations utilize a bankruptcy remote issuer to issue the securities. Ironically, the use of a bankruptcy remote entity in securitizations results in increased bankruptcy rights for MBS investors. Section 510(b) subordinates securities-based claims only if based on a “security of the debtor” or of a debtor’s affiliate. 11 U.S.C. § 510(b)(emphasis added). The MBS investor, on the other hand, holds securities issued by a non-debtor bankruptcy remote entity. A debtor may have performed as an originator, sponsor, or depositor, in connection with the securitization. However, it was not the issuer of the MBS; that function was performed by the bankruptcy remote SPE (please note that certain securities regulations deem a depositor as an issuer, as discussed in the Lehman decision referenced herein). Thus, the MBS investor’s claims are not subordinated.

The MBS investor’s benefits are twofold :

the MBS investors maintain the benefits of investing in an off-balance sheet bankruptcy remote entity (such that this investment is not affected by an originator’s/sponsor’s creditors) and
the MBS investor is able to share in distributions to the originator’s/sponsor’s unsecured creditors.
Two decisions from the leading bankruptcy jurisdictions (S.D.N.Y. and Delaware) have ruled that section 510(b) subordination does not apply to MBS investors. See In re Lehman Bros. Holdings Inc., 513 B.R. 624 (Bankr. S.D.N.Y. 2014); In re Wash. Mut., Inc., 462 B.R. 137 (Bankr. D. Del. 2011). In Lehman, the debtors performed a variety of roles in connection with the purchase and sale of MBS; however, they did not have any liability on the obligation evidenced by the MBS. The Lehman debtor entities originated and/or purchased loans, marketed the MBS, and was the depositor in connection with the securitization. Nevertheless, despite these connections to the MBS, the MBS provide no recourse against any Lehman debtor entity. In other words, Lehman’s multi-faceted involvement results in securities litigation exposure, but stops short of resulting in exposure to claims grounded in the contractual rights given to the MBS investor. In Washington Mutual, the court explained that a claim based upon the debtor’s sale of its own securities (ie Wamu selling Wamu equity) is fairly and properly subordinated because the purchaser assumed that bankruptcy risk; whereas, if Wamu sold stock of another completely independent company (ie Wamu selling Apple), the purchaser should only be exposed to the insolvency subordination risk of an Apple bankruptcy, not that of a Wamu bankruptcy. In each case, the debtors’ estates argued that 510(b) was applicable because the MBS was a security of the debtors or of the debtors’ affiliates; however, the courts disagreed.

Securitizations are attractive to originators and their stakeholders (including general unsecured creditors and equity) because, in part, the originator’s balance sheet is improved. Risk-carrying receivables are transferred to a bankruptcy remote special purpose entity in exchange for value. The SPE then securitizes those receivables, issuing MBS. The balance sheet clean-up benefits the originators’ stakeholders because it reduces credit risk, reduces cost of funding, increases return on equity (ROE) and optimizes certain metrics – such as debt to equity ratios. This is beneficial to the originator’s unsecured creditors, who in turn should be more willing to extend credit (and on more favorable terms). However, as explained above, an MBS investor is able to share in distributions available to general unsecured creditors.



[ See:

https://www.corporatetrustinsider.com/2014/11/mbs-investors-are-entitled-to-increased-bankruptcy-distributionsby-shan-haider-on-november-12-2014/ ]