Legal Risks of Servicer Bankruptcy or Insolvency in Securitization Transactions

Abstract

The purpose of this article is to discuss some of the important legal risks under United States law relating to a bankruptcy or insolvency of the servicer of the assets in a securitization transaction. These risks include the inability to enforce the transaction documents against the servicer or to require the servicer to turn over property in its possession, the inability to terminate the servicing agreement or the servicer, the ability of the servicer to stop servicing the assets or to assign the servicing agreement in violation of the terms of the servicing agreement, the possibility that commingled collections in the possession of the servicer at the time of the bankruptcy or insolvency proceeding belong to the servicer, the possibility that commingled collections previously paid to investors will have to be returned as preferential transfers, the possibility that regulators will require changes to the servicing agreement, and the risk that the servicer will use the threat of one of these outcomes to negotiate changes in the servicing agreement. The occurrence of any these outcomes could result in losses to the investors. The risks that these outcomes will occur can be reduced by designing a transaction structure that will allow for the effective replacement of the servicer with a successor servicer before the servicer goes into bankruptcy or insolvency.