Securitization Tested

Legal Issues in Originator/Servicer Failures

Cynthia A. Baker, CounselMayer, Brown, Rowe & Maw

Structured Finance Risks

• Legal Risks– True Sale / Recharacterization as Secured Loan– Consolidation of Bankruptcy Remote SPV

• Structural Risks– Limits of Trustee Activities– Servicing Risk

• Effective Limits on Remedies for Breach

• Servicing Transfers

True Sale / Recharacterization

• Much of the up-front focus in securitizations has been on legal isolation of assets

• LTV challenged inventory and receivables securitizations in bankruptcy – Settled

• Avianca Bankruptcy – Recent Challenge

True Sale – Legal Test

• recourse for credit and interest rate risk– Note the link here to “Collateral Risk”

• the right or obligation to repurchase assets– Repurchase for breach of representation vs.

– Repurchase based based on creditworthiness

– Substantial numbers of bad assets can be • Legal

• Origination/Servicing

• amount of retained control over assets

Consolidation of SPV

• Legal Basis (should be addressed in structure)– degree of difficulty in segregating assets and

liabilities– transfer of assets without observance of

corporate formalities. – increased profitability due to consolidation at a

single physical location– presence of consolidated financial statements

Consolidation of SPV

• Legal Basis (Operational Risks)– commingling of assets and business functions

• Legal structures attempt to avoid

• Breach of agreements is a risk

– unity of interests and ownership– existence of intercorporate guaranties on loans

• Consequences of default for transaction

Structural Risks

• Economic theory identifies problems that may exist in any transaction structure– Agency problem – act through agent whose

interests may not be aligned with investors– Collective action / free-rider problem

• All investors have interest in monitoring / taking action to enforce agreements

• Benefits shared generally but cost borne individually

Structural / Legal Leverage

• Going to court to enforce contracts should always be a last resort

• Going to court does not generally lead to satisfactory results for persons with real dollars at risk in the meantime

• Provide financial incentives and deterrents for actors to behave in investors’ interest

Limits of Trustee Activities

• Tasks largely ministerial• Only take actions specifically required• Enforcement action only on direction and

indemnification– Appointed as “agent” to act on behalf of bondholders

– What is trustee’s business?• Interests aligned with investors?

• Structural responses?

– Blame the Investor – What can investors do?

Servicing Risks

• As defaults increase, servicing costs increase• Dislocation of operations in troubled company• Severe financial distress may cause companies to

take action would not otherwise consider– Imbalance of risks / rewards

– Lenders/investors bear risks – management reaps rewards

Servicer Nonperformance

• Ipso Facto clauses (default because of bankruptcy) generally unenforceable

• Can the lack of performance be proved in 20 minutes? Objective, bright-line tests

• The “Just Say No” Defense for Servicers

Servicer Nonperformance

• Executory Contracts:– Assume with all burdens– Rejection as prepetition breach– Timing:

• Must assume or reject at time of plan

• Earlier motion to assume or reject

Servicer Nonperformance

• The S&P Approach (4/22/02)– Seek assumption or rejection and relief from

the stay to terminate servicer– Assumption requires adequate assurance of

future performance and cure of past defaults– Rejection of Contract – Legally treated as

prepetition breach – Failure to perform after assumption –

administrative claim for damages

Servicing Transfers

• Heilig-Meyers – 67% of obligors paid in stores

• NextCard and First Consumers – Cutoff of future credit affects servicing

• Transfer of records– Is the filing done?– Where are the records– Can they be transferred and assimilated?

Servicing Transfers

• Who will service and at what price?– Conseco – requested bankruptcy court order

payment and at higher rate– FCNB – OCC ordered FCNB to resign as

servicer – could continue until successor appointed if:

• Withhold sufficient funds to cover all costs and expenses (more than servicing fee)

• Increased priority consistent with that required by third-party

Responding to Risks

• Understand Limits of Trustee Activities– Monitoring Transactions– Mechanisms for Collective Action

• Understand Servicer Risks– Can the servicer effectively be replaced?

• Cost

• Operations

– Structural incentives for servicer performance?