Securitisation and Insolvency

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1 Nicky Andrews Tel Matthew McLennan Matthew.McLennan@aar.com.au Tel Alexandra Salib Alexandra.Salib@aar.com.au Tel AAR Insolvency Forum 16 July 2009 Deutsche Bank Place Corner Hunter and Phillip Streets Sydney NSW 2000 Australia Tel Fax Copyright Allens Arthur Robinson 2009

2 1. Introduction It has been said that you cannot pour new wine into old skins. That is not a rule which has hindered the creativity of the promoters and designers of securitisation trust structures, especially over the past decade. Their efforts have resulted in exotic combinations of otherwise familiar debt instruments and trusts. This paper is concerned with how those combinations work in the event of the economic failure of a securitisation structure or one of the participants in that structure. We will address: what securitisation (basically) is; how a securitisation trust is typically structured; conventional rules which apply to insolvent trusts and trustees and how those rules might operate in a securitisation context; some insolvency-related issues to consider when negotiating or reviewing securitisation trust documents; and how a typical securitisation trust will work when there is an insolvency event. The paper does not address the operation of the managed investment scheme provisions of the Corporations Act 2001 (Cth). 2. Securitisation in a nutshell Securitisation is a process that turns illiquid financial assets into liquid debt securities. This process occurs when an issuer, often a trustee, acquires a pool of income producing assets. The issuer then sells shares in the pool of assets, thus "securitising" those assets. The issuer uses the income from the assets to pay interest to the investors. Any asset with a revenue stream can be securitised. Residential home loans are among the most common assets to have been securitised in recent years. Aussie Home Loans and Registered Australian Mortgages Securities (RAMS) are examples of lenders that have funded residential mortgages through securitisation structures. Corporate loans and car leases are other examples of assets that can be securitised. mgms A v Page 2

3 3. A typical securitisation structure The attached chart (Annexure A) sets out a typical securitisation structure. The structure operates as follows: The trustee, usually a special purpose vehicle, purchases a pool of assets. The trust property is a pool of mortgages in this example. The originator is the provider of the assets. The trustee issues interests in the trust property to investors in the form of Class A and Class B notes. The trustee grants a charge over the trustee's interest in the pool of mortgages to the security trustee. The trustee and security trustee are often related entities. The prime mover behind the arrangement is the trust manager. The trust manager conducts the day-to-day operations of the trust. The trustee enters a Master Trust Deed with the trust manager. The Master Trust Deed sets out how the trust (or trusts) will operate and the powers and duties of the trustee and trust manager. The trustee also enters into a servicing agreement with the trust servicer. This agreement sets out the rights and duties of the servicer. The servicer will generally be responsible for receiving payments associated with the trust assets and remitting them to the trust account. A beneficiary takes any trust funds remaining after all fees are paid to the trustee, manager and security trustee, and distributions are made to the various classes of noteholders. The beneficiary, trust manager and servicer are often related entities. Other creditors of the trust may include swap providers, liquidity providers and originators. What we have described here is intended to represent a "typical securitisation trust structure". In practice, there is no such thing. There are, rather, a spectrum of different structures and provisions which share, in varying degrees, the typical features we have identified. What this means is that, although it is possible to generalize about securitisation and insolvency (as this paper does), it is important not to accept generalizations uncritically. Each structure must be approached with due care and it would be a mistake to rely on unverified assumptions about the rights and obligations constituted by any given structure. There are many possible complications that could be incorporated into the typical securitisation structure described. mgms A v Page 3

4 4. Trusts and insolvency This section of the paper is not an attempt to canvass the law of trusts and insolvency as a whole. Rather, it highlights key insolvency issues to be aware of in the context of a securitisation trust. 4.1 Two trusts at the core At the core of the securitisation structure are two trusts: the master trust and the security trust. Each trust is a set of relationships. In the case of the master trust, the relationships are among the trustee, the trust property (the pool of mortgages) and the beneficiary. These relationships are subject to the rights of the secured creditors (typically, the Class A and Class B noteholders) in the manner provided for in the trust documentation. In the case of the security trust, the relationships are among the security trustee, the trust property of the security trust (the charge over the trustee's interest in the pool of mortgages) and the beneficiaries of the security trust. The security trustee holds the charge for the benefit of the secured creditors of the trust. 4.2 A trust is not a legal entity Although it is common to speak about trusts in the same way that we speak about companies, a trust is not a separate legal person. This means that whenever a trust appears to act, it is in fact the trustee who is acting. It is the trustee who holds the assets which are subject to the trust, incurs debts on behalf of the trust and discharges those debts by making payments on behalf of the trust. The trustee does not act as agent. The trustee is personally liable for the debts of the trust. 4.3 Trustee liability and indemnity A typical master trust deed gives the trustee an express right of indemnity from trust assets in relation to debts properly incurred in carrying on the business of the trust. This express right reflects, and is in addition to, the trustee's right of indemnity under the general law. Both a typical trust deed and the general law restrict the trustee's right of indemnity to debts 'properly' or 'reasonably' incurred. This limitation on the trustee's right of indemnity tends to make trustees conservative entities. Generally, trustees do not want to risk incurring any expenses improperly because they do not want to be liable for debts in respect of which they have no right of indemnity. In practice, this means that trustees want to act only on specific instructions and are reluctant to exercise any discretion. A typical master trust deed will limit the trustee's liability to the extent of the trustee's indemnity. That is, the trustee will be liable only to the extent that there are trust assets to satisfy the debt in question. The position under the general law is the same, provided that the trustee makes clear when it is incurring debts that it is acting as trustee only and not in a personal capacity. The limitation of the trustee's liability to the trust assets means that noteholders and other trust creditors lend against the credit of the trust, not the trustee. Trust creditors face the risk that the trust assets will be insufficient to meet the liabilities incurred by the trustee. This limitation on the trustee's liability will not prevent a disgruntled trust creditor from, for example, serving a statutory demand on the trustee. In order to have the demand set mgms A v Page 4

5 aside, the trustee will need to show that there is a genuine dispute about the existence of the debt. This is likely to require that the trustee prove that its liability is limited to the extent of the trust assets and those assets are insufficient to satisfy the debt in question. This can be difficult if all of the trust's detailed financial records are in the possession of the trust manager, as they typically are. 4.4 What happens when the trust is insolvent? Securitisation structures are designed so that all expenses payable by the trustee, such as the fees of entities managing the trust assets, and returns payable to investors, will be met by the stream of income from the underlying assets. There is, however, a possibility that the assets of the trust will not be sufficient to meet trust expenses. In this situation, as the definition of insolvency in the Corporations Act does not apply, what does it mean to say that a trust is insolvent? The master trust deed may not satisfactorily, or directly, address the possibility of the trust becoming insolvent. If this issue is addressed, it is likely to be from the perspective of the senior noteholder. That is, only a failure to make an interest payment to a Class A noteholder will be an event of default by the trustee. The Class A noteholder will therefore determine how the creditors overall can respond to such an event of default. If the trust is insolvent, the rights of the trustee usually take priority over other creditors. The trustee's right of indemnity from the trust assets is protected by an equitable lien over trust assets (see section 6 below) 4.5 What happens when the trustee is insolvent? Professional trustee companies are used in securitisation structures because they can be relied upon to perform the role of the trustee diligently and faithfully. Nevertheless, the trustee is unlikely to be a single purpose entity. The trustee is likely to carry on other businesses and incur debts in the course of doing so. The trustee could become insolvent. It is important that lenders are aware of the extent to which assets of the trust will be exposed to non-trust (or personal) creditors of an insolvent trustee. Under a typical master trust deed, the trustee's insolvency will result in its replacement. Some creditors who are likely to claim against the assets held on trust, and their respective abilities to make such a claim, are set out below. Personal or non-trust creditors of the trustee have no claim against the trust assets, as the assets held on trust can only be used to discharge trust liabilities. Personal creditors of the trustee may, however, have an indirect claim by way of subrogation to the trustee's right to be reimbursed in respect of expenses it paid as trustee. Such claims take priority over the charge held by the security trustee, and thus the interests of secured creditors. In practice, claims by way of subrogation are likely to be relatively small, as the trustee will not have large reimbursement claims against the trust. A liquidator of the trustee may recover his or her expenses from assets held on trust to the extent that the liquidation relates to the business of the trust. The mgms A v Page 5

6 prompt replacement of the insolvent trustee ought to prevent the liquidator's costs from being an issue for lenders. A voluntary administrator of the trustee is unlikely to be carrying on the business of the trust. If he or she does so, the voluntary administrator would probably be entitled to recover his or her costs in the same way that a liquidator may do so (although we are not aware of any decided cases on this issue). As the trustee is personally liable for trust debts, where trust assets are insufficient to satisfy the claims of trust creditors, those trust creditors may prove in the liquidation of the trustee along with non-trust creditors. In doing so, however, trust creditors will need to bring into the hotchpot the benefit of any recoveries from trust assets. The foregoing assumes that the trustee has not mixed personal assets and trust assets, or intermingled multiple trust assets. Intermingling of trust assets is a real risk in the securitisation context, as in the following example: a loan is originated into warehouse trust A; the originator is entitled to a fee which is payable by trustee A from the assets of trust A; trustee A later transfers the loan to trust B. The trustee of trust A and trust B is the same person, acting in two different capacities; trustee B ought to remit sufficient funds to trustee A to satisfy the originator's fees; due to an administrative oversight/poor planning by the trust manager, trustee B does not remit the funds to trustee A. The relevant funds are, instead, paid to the beneficiary of trust B; and the result could be an unsatisfied liability in trust A which ought to have been met from the assets of trust B. mgms A v Page 6

7 5. Negotiating and reviewing documents: insolvency issues 5.1 Focal points The purpose of this section is to highlight some key issues for lenders to consider when negotiating securitisation documents. These issues are also relevant for insolvency practitioners, creditors and advisors assessing what action to take in the event that the trust and/or the trustee in a securitisation structure becomes insolvent. 5.2 Events of default The performance of the securitisation structure depends on the performance of both the underlying assets and the parties that manage those assets. Failure of one of the participants in the securitisation structure to perform its obligations under the trust documentation can be extremely problematic, and costly, for lenders. It is therefore important that the events of default in relation to each of the key participants in the securitisation structure are drafted to enable lenders to remove and replace underperforming entities promptly. The events of default in a securitisation structure are often limited to: illegality of, or defect in, trust documentation; and failure to pay the senior, or Class A, noteholder. This limited set of events of default restricts the options of creditors in the event that the trustee, the trust manager or servicer is not adequately performing its duties. Events of termination for each of the trustee, trust manager and servicer should also include: insolvency of the entity or any related body corporate; breach of key obligations by the entity; and cross-termination rights where the trustee, trust manager and/or servicer are related entities. For example, the trust documentation may provide that if an event 5.3 Right to information of termination occurs in relation to the trust manager, then an event of default also occurs in relation to the servicer and the trustee. If the trust assets are insufficient to meet trust expenses, it is essential that noteholders have access to information to determine why the payments are not being met. It may be that the underlying assets are not performing or that a participant in the securitisation structure is not performing its duties. For example, a Class B noteholder would require further information about the accounts of the trust in the following scenario: on the coupon payment date, Class A noteholders are paid in full, and Class B noteholders receive nothing; a Class B noteholder contacts the trustee, who indicates that it did not make a payment to Class B noteholders as it was not instructed to do so by the trust manager; mgms A v Page 7

8 the trust manager maintains that it can only make payments to noteholders out of funds placed in the collection account by the servicer, which were insufficient to pay Class B noteholders on the payment date; and the servicer maintains that it can only place those funds that it receives into the collection account, which it had done by the payment date. It would be important for a lender in the scenario described to have access to the accounts of the trust. Unless the trust documentation creates a right for lenders to access information relating to trust accounts from the trust manager and servicer, lenders typically rely on the trustee to obtain such information. Lenders negotiating trust documentation should ensure that they will have an independent right to access the accounts held by the trust manager and servicer. Another possibility is to have failure to deliver accounts included as an event of default or termination in the trust documentation. mgms A v Page 8

9 6. Enforcement 6.1 The waterfall The waterfall is an expression used to describe the order in which cashflows received by the issuer (the trustee in our example) are distributed among the creditors of the issuer. Generally, there will be a separate waterfall for principal and for income received from the pool of trust assets prior to the occurrence of an event of default. 6.2 Pre-default waterfall Absent any event of default, the typical income waterfall requires distributions in the following order: (a) (b) (c) (d) (e) (f) (g) expenses of the trustee; fees of the trustee and security trustee; other expenses of the trust; expenses of the trust manager and servicer; interest payments to Class A noteholders; other specified expenses, including payments to other classes of noteholders; and payments to the beneficiaries. A noteholder's position in the waterfall depends on the class of note held by the noteholder. In our example, Class A noteholders would be paid in full before any Class B noteholders are paid. Some, but not all, securitisation documents require that, if Class A noteholders are paid in full and Class B noteholders receive nothing on any given payment date, then, on the next payment date, the omitted payment to Class B noteholders must be made before the next payment is made to Class A noteholders. 6.3 Post-default waterfall After an event of default occurs, the typical waterfall requires distributions in the following order: (a) (b) (c) (d) (e) (f) fees and expenses of the security trustee; fees and expenses of the receiver; fees and expenses of the trustee; amounts due to priority secured creditors (the Class A noteholders); amounts due to other noteholders, by class; and amounts due to other creditors. It is arguable that a trustee, trust manager or servicer in default under the trust documentation should not continue to enjoy payments in priority to creditors lower in the waterfall. Lenders need to consider whether the trust documentation should subordinate a party's position in the waterfall while that party is in default. Ensuring that payments to the mgms A v Page 9

10 defaulting party are subordinated may provide an additional incentive to the trustee, trust manager and servicer to fulfill their duties under the trust deed. 6.4 The security trustee The security trust deed provides security to the numerous creditors of the issuer, or trustee. It would be impossible to provide security to each and every noteholder severally. Instead, the issuer grants a security to the security trustee. The security trustee then declares that it holds the benefit of that security on trust for the creditors of the issuer. The security trustee's role is to preserve the trust fund. Although the security trustee may act on its own initiative, it will often require a resolution of the creditors to act, particularly if the action involves the appointment of a receiver. Obtaining a resolution can be a time consuming process, as it requires a meeting of creditors which can only be held after giving notice (which is usually 14 days). It is a trite observation that the ability of the receiver to get in and realise the underlying assets will depend on the quality of those assets. Though trite, this observation is pertinent because the nature of a securitisation structure is such that there will often be a real risk that the rights that constitute those assets cannot be enforced economically. The greater the number of assets in the pool and the lower the value of each asset, the harder it will be for the receiver to enforce the trustee's rights. mgms A v Page 10

11 Annexure A A typical securitisation trust structure Other creditors eg swap providers, liquidity providers and originators Noteholders Class A Class B $ Debt Instruments Charge over Trust Manager Trustee assets of trust Security Trustee $ Sale/ origination Trust Servicer Pool of mortgages Beneficiary mgms A v Page 11