Managing the unexpected in structured finance transactions

Structured finance transactions and asset backed securities generally exclude the transaction parties from taking any action other than that prescribed by the transaction documentation. Whilst this approach provides certainty that the transaction will operate as intended, this inherent lack of flexibility can present difficulties when unexpected events occur such as:

• disputes in relation to the interpretation of transaction documents
• counterparty defaults and downgrades
• the unavailability of replacement counterparties (at least at economically attractive rates)
• changes in rating agency policy
• funding shortfalls to finance the payment of on-going and/or exceptional unexpected expenses
• litigation relating to the above

Participants in asset backed securities, whether it be the issuer itself, the originator in an RMBS transaction, the servicer in a CMBS, the manager of a CLO or a class of noteholder frequently find the process of implementing a waiver or an amendment to the transaction documentation to address an unexpected event such as those outlined above more challenging than expected.

The transaction documentation will usually require that any modification, waiver or amendment - even where such modification, waiver or amendment may be proper and reasonable in the circumstances - requires the prior consent of the trustee.

The trust deed sets out conditions that govern when the trustee may consent to a waiver, modification or amendment. These conditions typically require that any significant change must be directed by an extraordinary resolution of the most senior class, or possibly all classes of noteholder. There is usually an exemption to the requirement to obtain a direction from noteholders where the trustee is of the opinion that the relevant waiver, modification or amendment is (i) proper to make and not materially prejudicial to the interests of the relevant noteholders, (ii) to correct a manifest and proven error or (iii) formal, minor or technical.

In order to implement a change without the approval of all other classes of noteholder, transaction parties or a specific class of noteholders often seek to demonstrate that the “no material prejudice” or “manifest” exceptions apply. In practice, it is relatively rare and obvious where the “manifest error” or “formal, minor or technical” exceptions apply and so it is far more common for parties to request the trustee to make a determination of “no material prejudice”.

The trustee’s main – usually justifiable – concern in making a determination of “no material prejudice” is that it may be exposed to claims from affected noteholders that the relevant change was materially prejudicial to their interests for reasons that were not obvious at the time the trustee made such determination.

Due to these concerns, trustees will generally only be sufficiently confident to make a determination of “no material prejudice” where one or more of the following applies:

• it can be clearly demonstrated that the proposed amendment either (i) does not affect any class of noteholder or (ii) only affects the class of noteholders that have directed the relevant amendment
• an appropriate transaction party delivers a certification as to a particular fact or circumstance that supports a determination of no material prejudice
• a suitably qualified expert delivers an opinion that relevant modification will not cause material prejudice upon which the trustee may rely

Where the analysis is complex and/or can only be determined with specialist knowledge, a third party expert opinion is likely to be the only option acceptable to the trustee. Sometimes an indemnity is offered to the trustee, but this may not always be satisfactory from the trustee’s perspective due to doubts as to whether an indemnity can provide protection to the trustee where a breach of trust may have occurred.

Gemini was a single loan CMBS transaction secured over a portfolio of UK retail properties that closed in November 2006. Following the 2008 financial crisis, there as a marked decline in the rental income on the underlying retail properties supporting the CMBS, leading to a default by the borrowers and the loan entered special servicing. The special servicer ultimately enforced the security over the borrowers and proceeded to sell the underlying property assets over a period of time crystallising a significant capital losses for the issuer and noteholders. A number of disputes followed including three separate legal proceedings.

The most senior class of notes passed a series of extraordinary resolutions over a period of several years to enable the issuer to manage several developments, including:

• the introduction of limited recourse provisions to the senior notes to address certain liability concerns of the issuer and its management
• the restructuring of the liquidity facility and payment waterfalls to implement a settlement agreed between the senior noteholders and the liquidity facility provider
• the further restructuring of the payment schedule for the senior notes to provide the issuer with a cash reserve to enable it to comply with certain payment obligations that may have arisen in connection with the valuation litigation
• directing the issuer to continue and, if appropriate, settle a significant litigation claim

The senior noteholders were able to implement this series of complex and commercially significant amendments primarily on the basis that the relevant amendments only affected their interests and not those of the junior noteholders.

Norton Rose Fulbright has extensive experience of advising participants in structured products, securitisation, repackaging and other structured finance transactions on the interpretation of the documents and related litigation, including high profile transactions such as:

• Gemini CMBS in relation to the matters referred to above
• Theatre 1 and 2 securitisation, in connection with interpretation of contractual provisions and Beddoe orders and court directions
• Windermere VII and XIV, Fornax and Hercules CMBS in relation to servicer replacements
• Fairhold Homes securitisation in relation to issues of default and interpretation