Sher v. RBC Capital: Master Repurchase Agreement (MRA) Liquidation Provision Breached by RBC

Practical Law Legal Update w-000-6801 (Approx. 5 pages)

Sher v. RBC Capital: Master Repurchase Agreement (MRA) Liquidation Provision Breached by RBC

by Practical Law Finance

Background

Prior to its delisting in 2008, Thornburg Mortgage, Inc. (Thornburg) was a publicly traded real estate investment trust (REIT), investing in RMBS supported primarily by high-grade adjustable-rate mortgages (ARMs).

Thornburg's earnings were derived from the spread between the interest income it earned on the RMBS and the cost of funds used to acquire these securities. Thornburg financed its acquisitions of RMBS primarily through financing agreements with investment banking and securities firms such as RBC. These transactions were generally in the form of repos and were governed by an umbrella MRA.

On September 8, 2003, RBC and Thornburg entered into an MRA that would govern future repo transactions between the parties. Under the MRA, as is typical, Thornburg would sell the RMBS to RBC and repurchase them at a later date for a higher price. As is the case with all repos, the transaction effectively functioned as a secured loan extended by the buyer of the RMBS (RBC) to the seller of the RMBS (Thornburg), with the difference in sale price and repurchase price representing the cost of financing.

Then, on August 13, 2007, five repo transactions matured and RBC agreed to roll over (continue) those transactions for another month, resulting in a $4.2 million rollover "pair-off" payment owed by Thornburg to RBC, which included amounts for accrued and unpaid interest on the RMBS and changes in the market value of the RMBS during the prior period. Thornburg did not satisfy the $4.2 million pair-off.

Under the MRA, if Thornburg failed at any time to meet a margin call or to repurchase securities as required under the MRA, RBC had the option to declare an event of default.

On August 14, 2007, RBC issued another margin call in the amount of $11 million. In support of this margin call, RBC provided Thornburg with its internal margin call price estimates for all of the outstanding RMBS under the 21 repos, valuing them at $576.3 million.

Later that day, RBC's managing director faxed Thornburg a letter declaring an event of default under the MRA for failure to repurchase purchased securities upon the applicable purchase dates.

Under the MRA, if Thornburg failed to meet a margin call or to repurchase securities under the MRA, RBC had discretion to either:

Immediately sell part or all of the MBS "in a recognized market (or otherwise in a commercially reasonable manner) at such price or prices as [RBC] may reasonably deem satisfactory."
To keep the MBS and credit Thornburg "in an amount equal to the price therefor on such date, obtained from a generally recognized source or the most recent closing bid quotation from such a source."

August 15, 2007, Thornburg disputed RBC's $11 million margin call, contending that RBC had undervalued the collateral RMBS by $6.2 million.

On August 16, 2007, RBC's managing director emailed Thornburg, indicating that he needed "either . . . an agreement as far [as] continuing the repo for one month or . . . to start soliciting bids for the entire portfolio." He also advised Thornburg that "the auction process, [would include] soliciting bids for the portfolio as a whole in order to gauge its worth." The parties never came to an agreement either to roll over the repurchase transactions that had matured on August 13, or to satisfy the disputed August 14 margin call.

RBC exercised its default remedies by electing to retain the RMBS collateral and credit Thornburg based on an arm's-length bid that RBC had obtained from Goldman Sachs. The amount of the credit was equal to the highest of the three bids RBC received on August 17, 2007 from generally recognized sources: Bear Stearns, Lehman Brothers, and Goldman Sachs.

On April 30, 2011, Joel Sher, the Thornburg Chapter 11 trustee, filed suit against RBC, alleging that:

By taking improper advantage of fluctuations in the market for RMBS, RBC issued improper margin calls and wrongfully seized and liquidated RMBS that it held as collateral under the MRAs between RBC and Thornburg.
RBC acted in a commercially unreasonable manner in soliciting bids for and pricing the RMBS that were to be repurchased by Thornburg under the MRA, resulting in a final credit to Thornburg for far less than fair value for the RMBS.

RBC argued that the MRA afforded it sole discretion, as the non-defaulting party, to credit Thornburg with "any good faith price obtained from a generally recognized source." According to RBC, it fully complied with the plain and unambiguous text of the MRA by crediting Thornburg with a price from a generally recognized source (Goldman Sachs).

The Thornburg Chapter 11 trustee argued that:

It was entitled to summary judgment on the grounds that RBC breached the MRA by failing to credit it with "default date pricing," as required under the MRA.
As a result of that breach, RBC's August 14, 2007 margin call prices – internal valuations created on the date of the event of default – constituted a "price obtained from a generally recognized source" and were therefore the relevant and appropriate measure of Thornburg's damages for RBC's breach.

Outcome

The court granted the Thornburg trustee summary judgment on its claim that RBC breached the MRA by failing to credit Thornburg with default-date pricing, as required under the MRA. The court rejected RBC's argument that basic principles of New York contract law prevented an interpretation of the MRA that would require a non-defaulting party to credit the defaulting party with collateral prices created by the non-defaulting party itself.

Specifically, the court rejected RBC's arguments that:

because no "default date pricing" existed, there was no breach; and
it was within RBC's discretion to determine the credit using the August 17, 2007 Goldman bid because:
- the plain and unambiguous language of Section 11(d)(2) of the MRA permits the non-defaulting party, in its sole discretion, to establish the source for prices, not the price itself, in the absence of a "generally recognized source"; and
- the undisputed record evidence demonstrates that RBC did not value Thornburg's RMBS portfolio on a daily basis; rather, RBC's MBS trader valued the RMBS only on discrete occasions.

The court rejected these arguments, denying RBC's motion for summary judgment on the grounds that RBC did not act in good faith or within its contractual discretion to calculate Thornburg's RMBS liquidation credit under the MRA using a bid from an independent market participant (Goldman Sachs).

The court noted that the parties agreed that the plain and unambiguous language of the MRA required the non-defaulting party, electing under the agreement to retain the RMBS collateral (of which it thereby effected purchase under the MRA), to calculate the liquidation credit using a price obtained from a generally recognized source "as of" the default date.

It was not disputed that RBC valued and credited Thornburg with prices for the RMBS that were derived from the Goldman bid, made on August 17, 2007, three days after the default date.

Price Obtained from a Generally Recognized Source

The court held that, as a matter of law, RBC's August 14, 2007 internal valuation of Thornburg's RMBS portfolio constituted a "price . . . obtained from a generally recognized source," as required under the MRA. The court therefore agreed with the Thornburg trustee's assertion that RBC's August 14, 2007 internal valuation of the RMBS that Thornburg failed to repurchase under the MRA was the appropriate measure of damages.

The court noted that RBC did not dispute that its internal valuations constituted a "price . . . obtained from a generally recognized source." Rather, RBC's corporate designee actually conceded that RBC's internal marks constituted prices from a generally recognized source. However, RBC argued that:

It was under no obligation to credit Thornburg with a "'true value' or 'fair market value' or the 'highest available price.'"
It was within its sole discretion under the MRA to calculate the credit to Thornburg using an actionable bid from an independent market participant and not an internal mark or pricing estimate.

The court rejected this argument, reasoning that:

Nothing in the plain language of Section 11(d)(i)(B) of the MRA required that the "price . . . obtained from a generally recognized source" be derived from an executable bid.
Section 11(d)(i)(B) of the MRA explicitly mandated that the credit amount be determined in the same manner as done for margin maintenance.

Practical Implications

Though the court in this case ruled on what constitutes a price "obtained from a generally recognized source" in the context of an MRA, the ruling is important because it may be applicable to close-out and termination valuation of other types of financial contracts such as securities lending agreements, ISDA Master Agreements, and others.

Though not from a New York court, the case provides an important interpretation of New York law in an unsettled area that often involves a complex chronology of facts.

For further details on repos, see Practice Note, Repos: Overview (US).

Sher v. RBC Capital: Master Repurchase Agreement (MRA) Liquidation Provision Breached by RBC | Practical Law