Securitization Tested Legal Issues in Originator/Servicer Failures Cynthia A. Baker, Counsel Mayer, 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?