Mi t i gat i ng Servicing Fraud i n a

Structured Finance Transaction

KENT R. WILLIAMS
KENT R. WILLIAMS
is executive vice president
of LeaseDimensions, Inc. in
Portland, OR.
kent williams@leasedimension$.com
E
vents in the past several years have
caused some industry pundits to pro-
pose that the structured finance mar-
ketplace is riddled with systemic abuse
and widespread fraud. Furthermore, transac-
tion servicers are often blamed for causing this
fraud and abuse, leaving the impression that
structured fmance servicing is seriously flawed.
These are not valid assumptions. Industry sta-
tistics show that there are thousands of "text-
book perfect" transactions for every deal in
which an event of perceived fraud or abuse has
occurred. Moreover, the long-term success of
the structured fmance industry proves its value.
Unfortunately, there have been a few
instances in which a servicer has perpetrated
fraudulent or abusive actions to harm a struc-
tured finance transaction. These actions,
whether intentional or not, have caused prob-
lems within the affected transactions, resulting
in losses to the investors. Industry spectators
have used the negative publicity associated with
these relatively few situations as proof of abu-
sive and fraudulent practices in the structured
fmance marketplace.
All structured fmance professionals share
a common interest in reducing fraud and abuse
in any form. The industry has responded by
refming legal language, by clarifying servicing
actions, and by increasing reporting require-
ments. These actions are intended to mini-
mize, if not eliminate, potentially fraudulent
practices. Even though the structured fmance
industry's policing actions generally have been
FALL 2004
successful, there are still opportunities to fur-
ther mitigate any untoward servicing practices.
This article is not intended to provide a
comprehensive tutorial for every fraudulent
and abusive practice conceivable within struc-
tured fmance. Rather, it will explore three
areas of this topic from the perspective of a
structured fmance servicer who has serviced
hundreds of transactions across the majority
of consumer-based lending categories:
1. What are a few types of potential ser-
vicing fraud in a structured transaction?
2. What are some of the possible warning
signs for servicing fraud?
3. What practices should industry partici-
pants adopt to help reduce fraud?
These areas will be discussed as simply
as possible to allow the reader to conceptu-
alize an application in his/her unique position
as a structured-fmance professional. The overall
conclusion of this discussion should be to fur-
ther motivate all structured fmance profes-
sionals to contribute to the ongoing refmement
of this industry, with our primary goal being
to further eradicate fraudulent or opportunistic
practices followed by servicers throughout the
structured finance industry.
FRAUD: INTENDED OR NOT?
There are two types of fraud a servicer
can perpetrate: intentional and unintentional.
THE JOURNAL OF STRUCTURED FINANCE 3 9
Intentional fraud is a situation where the servicer makes
a conscious decision to apply abusive or fraudulent prac-
tices as it performs its servicing functions. Historically
speaking, this is not the initial intention of a servicer as
it begins to service a transaction. Rather, a servicer more
commonly commits the second type of fraud, uninten-
tional, and then gradually begins to commit more and
more servicing fraud as the negative impacts of the unin-
tentional fraud accumulate. This is similar to the old adage
"lies beget lies," as the servicer fmds itself in a situation
where it must commit "intentional" fraud to cover up
the "unintentional" fraud.
There are two points to this topic: 1) few servicers
intend to commit fraud, and 2) less fraud would occur if
more industry participants were watching. An uninten-
tional fraudulent action, if caught in its early stages, can
be resolved more quickly, and with less negative impact,
than fraud that has been perpetrated for enough time to
become an act of intentional fraud. Industry participants,
if properly educated about how fraud can occur, and if
properly motivated to exercise their responsibilities to the
transaction, can help detect and resolve abusive and/or
fraudulent actions in the early stages. This proactive
approach to mitigating fraud will benefit the entire struc-
tured fmance industry.
POTENTIAL AREAS OF SERVICING FRAUD
The majority of fraudulent or abusive servicing prac-
tices can be categorized into three areas: cash, collateral,
or reporting. Further discussion of each category follows
to help the reader better understand the core opportuni-
ties for servicing fraud.
Cash
A servicer processes a significant amount of cash on
behalf of the transaction stakeholders. The servicer is
responsible for collecting, allocating, and distributing it
appropriately. There are several opportunities for a servicer
to apply fraudulent practices in the course of cash
processes. Following are some of the areas in which a ser-
vicer's actions can lead to unintentional or intentional
abuse.
Commingling Funds. Each transaction is structured
as a unique legal entity for a variety of reasons. The legal
entity's cash should be segregated from all other cash con-
trolled by the servicer. Failure to do so allows the oppor-
tunity for fraud and abuse. The payment lockbox and the
depository account are two of the most common areas of
funds commingling.
Each transaction should have a clear and concise
process for receiving, holding, and distributing funds. A
servicer may elect to establish a unique payment lockbox
for each transaction, with a unique depository account into
which funds are placed. This is a simple and straightfor-
ward way to keep funds segregated. The downside of this
process can be the number of lockboxes and bank accounts
available to the servicer and the associated costs incurred
to support the multiple entities.
A more efficient cash process might be for a ser-
vicer to have a single lockbox to receive all funds, regard-
less of the transaction to which they apply. In this scenario,
all received funds typically are deposited into a servicer-
controlled "clearing" account, with a periodic transfer of
funds from the clearing account to each transaction's
unique depository account. This is a workable process if
it is well controlled and carefully monitored.
The opportunity for monetary fraud or abuse can
arise when funds are received into an account without
clear assignment to a transaction. Depositing funds into
this type of "operating" account might allow a servicer
to misuse the funds received for a specific transaction.
The structured finance industry has experienced several
situations in which a transaction's funds were used to meet
the operating needs of an issuer/servicer, usually with the
intent of repaying the funds before the distribution date.
Regardless of intent, this misuse of transactional funds is
a type of fraud that should not occur.
Possible warning signs:
Manual process to reconcile and allocate funds
High percentage of physical checks received at
servicer's location
High incidence of back-dated payments
Distribution dates missed
Slow delivery of reports, regular and ad hoc
Failure to provide periodic account
reconciliations.
Cash Distribution. Structured fmance documents
establish a clear methodology for applying and distributing
the cash proceeds received during each collection period.
Cash is allocated to pay transactional expenses and to reduce
the outstanding debt appropriately. Any remaining cash is
then distributed to the various stakeholders.
Transaction documents set a date on which the dis-
tributions are to be made. Miscategorizing account status
and not matching the receipt and distribution of funds
40 MITIGATING SERVICING FRAUD IN A STRUCTURED FINANCE TRANSACTION FALL 2004
are two of the more common fraudulent actions that ulti-
mately can harm the performance of a transaction.
Miscategorizing Account Status. Structured finance
transactions generally have a diverse array of underlying
collateral, pooled into like-kind asset categories, upon
which the transaction balance is based. The underlying
accounts that support each transaction can be grouped
into active or inactive status. Transaction documents care-
fully defme the situations that create an active or inactive
status. This is important for a variety of reasons, but this
section will discuss how an account's status impacts a trans-
action's cash.
Cash receipts from active accounts are treated nor-
mally, according to the instructions in each transaction's
documents. However, an inactive account might be
defmed as a non-recoverable account. This means that
there is little or no likelihood of additional cash flow from
this account. The transaction documents will then specify
that this account should be liquidated, meaning that it
should be purchased from the transaction. This entails
withholding the total purchase price for this account from
the allocated cash distributions. This, in turn, will reduce
the cash distributed to the residual holder, which is often
the issuer/servicer.
The issuer/servicer conceivably can increase the
cash flow it receives from a transaction by miscategorizing
inactive accounts as active, thereby reducing the amount
of account balance to be liquidated from the transactional
cash flows. Whether intentional or not, this type of ser-
vicer activity should be construed as abuse or fraud as it
ultimately will harm the overall transaction performance.
Additional areas where status miscategorization may be
fraud and/or abuse will be discussed in the Reporting
section below.
Possible warning signs:
Higher than expected delinquency or losses
Delinquency rates hovering close to triggers
High rate of extensions granted, due date changes,
or rewrites
Inconsistent liquidation timeframes
Sporadic or large reductions in reserve accounts,
followed by none
Slow dehvery of reports, regular and ad hoc
Not Matching Distribution Funds. Another area of
potential cash abuse relates to the timing of periodic cash
distributions. Each transaction has a defmed distribution
date on which the cash collections from the prior col-
lection period are distributed according to the terms of
the deal. Distribution dates typically lag behind the end
of the collection period by 10 to 20 days. This allows the
servicer adequate time to close the books on the previous
collection period and to prepare the requisite reports to
support the cash distributions.
Problenis can arise if the actual cash collected in the
prior collection period is not sufficient to meet the sched-
uled distribution amounts on the distribution date. This
might happen for a variety of reasons. For example, the
transaction might have incurred immediate repossession
expenses during the collection period, yet the proceeds
from the related collateral sale are not yet recognized. Or,
worse yet, the servicer might be advancing account due
dates with non-payment extensions in an effort to improve
delinquency rates, thereby negatively affecting cash flow.
Cash reserve accounts should cover this specific sce-
nario in the majority of instances. But, in a worst-case sit-
uation, the servicer may also want to protect the reserve
account from scrutiny. As a result, a possible solution to
this cash shortfall is to "borrow" funds that have been
collected in the current collection period. These "bor-
rowed" funds then can be used to meet the prior peri-
od's cash distribution requirements. While the servicer
may have every intention of paying them back as quickly
as possible, this type of cash fraud can be indicative of
more serious problems that have not yet been discovered.
Possible warning signs:
Lack of adequate distribution funds at period end
Slow distributions (after the distribution date)
Slow delivery of reports, scheduled and ad hoc
High rate of extensions, deferments, or due-date
changes
Delinquency rates hovering close to trigger levels
Vendors complaining of slow payment (aged
accounts payable)
Slow liquidation process compared to industry
norms
There are other areas in which a servicer who intends
to commit fraud can manipulate the cash within a struc-
tured finance transaction. For example, the receipt and
accounting of prepayments and lump-sum payments, pay-
ment application order, third-party expenses, reserve funds,
and suspended payments all can be misused to the detri-
ment of stakeholders. Any structured finance servicer would
be happy to explain these and other areas of possible abuse.
AU stakeholders will benefit as the structured fmance industry
continues to increase its awareness of, and response to, these
types of actions for current and future transactions.
FALL 2004 THEJOUKNAL OF STRUCTURED FINANCE 41
Col l at eral
The majority of structured finance transactions rely
upon some type of underlying collateral to provide the
ultimate value to the stakeholders. This is true for mort-
gage-backed securities (MBS), commercial mortgage-
backed securities (CMBS), asset-backed securities (ABS),
and can even be true for collateralized loan obligations
(CLO) and collateralized debt obligations (CLO). As a
result, the valuation and maintenance of the collateral is
a critical factor in creating and retaining value within a
transaction.
There is opportunity for fraud and abuse as it relates
to the collateral backing a transaction. This section will
discuss a few of the more common areas in which a ser-
vicer might exercise practices that are fraudulent or abu-
sive to the transaction stakeholders. The author's intent
is not to discuss every conceivable facet of this problem,
but to provide insight into the areas in which ongoing
scrutiny should be focused.
Collateral Valuation. The valuation of each trans-
action's underlying collateral is critical, regardless of the
transaction structure or collateral type. A simple way to
increase the size of a transaction is to inflate collateral
values, thereby increasing the portfolio investors own. In
a similar vein, losses for non-performing accounts can be
reduced by adjusting the collateral value appropriately.
Therefore, the valuation of collateral is a servicing func-
tion that should remain under review throughout the
term of a transaction.
For example, a mortgage appraisal can be impacted
favorably by using inaccurate addresses for the compara-
tive nearby appraisals. Adding subtle extra options to a
vehicle appraisal can represent its value inaccurately. Inac-
curately measuring a commercial property's previous occu-
pancy rates will also increase its value improperly. While
this situation is nothing new to those structured finance
professionals involved in each specific industry, collateral
valuation should always remain on everyone's watch list
for potential fraud and abuse.
Possible warning signs:
Poorly documented valuation techniques
Higher values for apparently similar assets
Loss rates higher than industry comparables
Extraordinarily slow liquidation of selected collateral
Unique liquidation methodologies
(a better mousetrap)
Add-on Valuations. Another area in which a trans-
action's collateral values can be overstated relates to the
types of charges that might be added to the debtor's total
obligation. Up front, an issuer may elect to capitalize
externally incurred costs, thereby increasing the original
collateral value. This is not uncommon and not necessarily
detrimental to the transaction. Capitalized costs can
include equipment upgrades or add-ons, or various types
of insurance and warranty programs. While these may
add true value when used with discretion, too much of
a good thing can increase the incidence of default as well
as the severity of ultimate losses.
A type of fraud more closely related to the servicing
of a structured finance portfolio is the ongoing capital-
ization of amounts during the repayment term. For
instance, the servicer may need to force-place insurance
to protect the collateral, and elect to capitalize the insur-
ance. This inflates the collateral value without increasing
its real value. Or, the servicer may bring current a delin-
quent account by adding the past-due payments to out-
standing principal. This type of fraudulent practice not
only overstates portfolio performance, but also under-
states the likely loss in the event of an account's default.
Possible warning signs:
Significant debtor disputes over account balances
Cash flow shortages within the transaction
Portfolio amortization slower than expected
Loss rates higher than industry comparables
Liquidation of selected collateral extraordinarily slow
Collateral Substitution. A transaction might be struc-
tured such that the issuer has the opportunity, if not the
right, to substitute collateral throughout the term of the
transaction. This can be good for the transaction if used
to retain the consistency of the underlying collateral.
However, it also can allow the issuer/servicer to impact
the transaction adversely by straining the issuer/servicer's
financial survival during the transaction's term. As such,
any substitution of collateral should remain under scrutiny
throughout the entire term of the transaction.
For example, as delinquency or loss rates climb
higher than originally projected, the issuer/servicer may
exercise its substitution rights and replace an inactive
account with an active account. While this substitution
may appear to be good for the transaction, the issuer then
must absorb the full loss of the repurchased account. As
a result, the transaction's performance may look great
while the issuer/servicer is absorbing losses for which it
is not adequately capitalized.
42 MITIGATING SERVICING FRAUD IN A STRUCTURED FINANCE TRANSACTION
FALL 2004
This situation can be compared to a form of dry
rot, where the exterior of the structure appears sound,
but the interior is deteriorating rapidly. This type of sit-
uation can be bad for a transaction on two fronts. Not only
is the issuer/servicer's ultimate survival jeopardized, but
the servicer also may need to reduce servicing activities
to reduce costs to help survive the added cash drain of
the ongoing repurchase program. Lack of servicing atten-
tion might impact a transaction's health negatively by
reducing overall portfolio performance. Moreover, the
negative performance trends can distress the transaction
further in the event of the issuer/servicer's collapse.
Possible warning signs:
Increasing or ongoing rate of substitutions
Lower-than-expected loss rates for the transaction
Aging accounts payable at the servicer
Inordinate senior management turnover
Slow delivery of reports, scheduled and ad hoc
Major changes in operational structure
(consolidations, reorganizations, etc.)
There are other collateral-related areas in which ser-
vicer actions can place the transaction at risk. Many of
these are unique to a specific collateral type and are beyond
the scope of this discussion. Many will be related to a
transaction's specific structure, or to the relationships
among the various entities involved in the transaction.
The important point is to exercise a high degree of col-
lateral-related scrutiny, not only in the early stages of a
transaction, but throughout its term.
Reporting
The reporting function of a structured finance trans-
action is the primary way for the various stakeholders to
obtain information regarding that transaction's perfor-
mance. Legal language establishes the type of reports to
be delivered, the information contained in the reports,
and the timing of report delivery. Stakeholders typically
pay a high degree of attention to the contractual provi-
sions that will govern this reporting function, particularly
as a way of mitigating the types of servicing fraud expe-
rienced in the past.
Regardless of the industry's efforts to define reporting
requirements in a clear and concise manner, there remain
several areas of potential abuse and/or fraud in the way a
servicer can report transactional data. Reporting fraud
and/or abuse can have a negative effect on a transaction's
cash flow, liquidity, profitability, longevity, and payout.
This article will discuss a few areas in which a servicer
might exercise improper reporting practices, with the
intent of illustrating the different ways industry partici-
pants can help recognize potential abuse or fraud in a
proactive manner going forward.
Account Status. As discussed above in the Cash fraud
section, the reported status of the underlying collateral
has a serious impact on several aspects of a structured
finance transaction. For example, a servicer might do
something as seemingly innocuous as providing automatic
extensions to past-due accounts. That servicer might do
this to reduce delinquency, thereby avoiding delinquency
trigger events that cause a reduction in cash distributions.
Or, the servicer lnight do it to reduce the required interest
advances needed to make up for delinquent accounts.
Regardless of the servicer's motivation for this action,
the transaction is impacted negatively in several areas.
Total cash is shorted because a supposed "current" account
did not make its anticipated payment. Interest is overpaid
as the missing payment does not appropriately reduce
principal balance. Servicing fees are overpaid because the
servicer is carrying inactive accounts as active. Investors
are misled regarding the stability and likely repayment of
the transaction.
The list of areas where account status can be reported
inaccurately is as long as the number of status items
included in each report. A servicer could misreport, inten-
tionally or not, the status of active accounts, delinquent
accounts, bankrupt accounts, litigation accounts, repos-
sessed or foreclosed accounts, substituted accounts, deferred
accounts, extended accounts, workout accounts, etc. The
point is that a document's legal language needs to outline
the requirements for each reporting status clearly, and the
transaction participants need to be aware of the potential
for misreporting. Swift and decisive action should be taken
to quell any instances of suspected status reporting abuse.
Possible warning signs:
High rate of extensions, deferments, or due-date
changes
Any cumulative number that stays just below a
trigger (delinquency, loss, etc.)
Performance that is much better than similar
transactions
Slow delivery of reports, scheduled and ad hoc
Cash flow shortages
Slower than anticipated pool liquidation
Declining reserve funds
FALL 2004 THE JOURNAL OF STRUCTURED FINANCE 43
Cash Application. In addition to the potential areas
of abuse and fraud discussed earlier in the Cash section,
there are other ways for a servicer to misapply the cash it
receives to infiuence the way a transaction is reported inac-
curately. Again, these actions can be simple, yet also can
have dire consequences when viewed in the context of an
entire transaction. As a result, the informed stakeholder
should be apprised of this type of activity, and also should
take immediate action if cash misreporting is suspected.
An easy way for a servicer to reduce delinquency is
to lower the payment threshold required to advance an
account's due date. It is the practice in many industries
to advance an account's due date when a payment within
an acceptable percentage of the normal payment amount
is received. But, a servicer potentially can reduce delin-
quency rates to a significant degree simply by lowering
the payment threshold to 90% or 80% or 70% or even
50%. Negative impacts to the transaction are similar to
those previously discussed.
Another area of potential abuse is for a servicer to
inappropriately allocate cash receipts to accounts. This is
typically a more egregious practice where the servicer
intentionally misstates an account status in an effort to
keep the account current. In this case, the servicer may
state an inactive account incorrectly as a current account
while it repossesses and sells the collateral. Proceeds from
the collateral sale can then be applied to the account as
though they were monthly payments received from the
debtor, thereby creating the illusion of an active account.
The negative impacts of this action are evident, yet all
stakeholders should be knowledgeable enough to recog-
nize the warning signs in order to detect and eradicate
this type of servicing fraud at its earliest signs.
Possible warning signs:
Cash shortfalls within the transaction
High percentage of partial payments
Lower-than-expected pool amortization
Slow delivery of reports, regular and ad hoc
Unidentifiable payments to borrower accounts
Delinquency or loss rates hovering close to trigger
levels.
It is impossible to illustrate the full spectrum of
potential reporting fraud in this brief an overview. But,
this information is provided in hopes of better educating
each stakeholder as to the areas in which a servicer can
effect transactional fraud and/or abuse. Immediate and
coordinated action by a transaction's stakeholders can help
to identify if fraudulent practices may occur, whether
intentional or not, and take timely action to correct them
to minimize the potential negative consequences to the
transaction.
RESPONSIBILITY OF INDUSTRY PARTICIPANTS
A structured finance transaction involves multiple
entities throughout its life. The responsibility to mitigate
servicing fraud lies with all participating organizations,
not just the servicer. Granted, the servicer needs to be
the first and last defense against improper practices, and
there are servicer-specific resources to support the ser-
vicing industry's efforts to mitigate fraud.
The complexity of a structured finance transaction,
however, is best supported when all involved parties take
action to keep a transaction on track. The collapse of a
few structured finance transactions, some of which have
garnered a high degree of publicity, should motivate the
full cast of supporting organizations to work together in
a cooperative effort to continue to shore up this industry.
Recent trends in the structured finance industry
demonstrate an increase in cooperation, mutual support,
and ongoing interaction among the various constituents
to each transaction. This will help reduce the incidence
of servicing fraud and abuse in the structured finance
industry. All industry participants should support and
encourage this positive momentum. Furthermore, industry
participants can further improve the long-term perfor-
mance of the structured finance industry by seeking and
supporting education efforts to identify and mitigate
potential servicer fraud and abuse.
Following is a servicer's perspective on the respon-
sibilities that each transaction's participant should exer-
cise. This is not intended to be a comprehensive list of
beneficial organization traits, but is focused on mitigating
servicing fraud in a structured finance transaction.
Issuer
The entire process begins with an issuer that wants
or needs access to an efficient market to finance parts of
its business. Issuers are diverse, and each has its own rea-
sons for using the capital markets. Some issuers are new;
some have participated in the markets for many years.
Some are infrequent issuers; some are regular issuers. Some
are seeking to diversify their funding sources; some are
seeking a funding source. Most issuers have their own
servicing operations; some outsource them.
Regardless of the issuer, there are a few critical
44 MITIGATING SERVICING FRAUD IN A STRUCTURED FINANCE TRANSACTION FALL 2004
responsibilities that will support the industry's efforts to
eliminate any fraudulent or abusive practices within struc-
tured finance transactions.
The issuer should:
approach the capital markets with a long-term per-
spective, not as a "get rich quick" program
demonstrate a business model that provides real, sub-
stantive, and long-term value to its constituency
recognize that the ongoing success of the structured
finance industry depends upon the mutual success
of all its participants
be prepared to cooperate with, and be responsive
to, each of the organizations involved in its struc-
tured transaction.
An issuer that takes each of these responsibilities
seriously is likely to do its part to eliminate fraud and
abuse within a structured finance transaction.
Underwriter
An issuer seeking to access the capital markets has
a diverse array of underwriters with which it can work.
Some are international organizations; some are local. Some
specialize in specific transactions; some do them all. Some
possess expertise in every facet of the process; some use
outside experts to help. Some have unlimited access to
funds; some do not. All underwriters seek to provide
value in their services.
Regardless of the issuer's selection, every under-
writer shares a few critical responsibilities that will help
mitigate any fraudulent or abusive practices within struc-
tured finance transactions.
The underwriter should:
validate the long-term value of the issuer's
business model
foster an issuer's long-term view of the capital
markets
bring to market only those issues that make
business sense for the issuer and for the industry
continue to validate the issuer's business model
after the transaction is completed
cooperate with each organization involved in the
transaction after funding.
An underwriter that demonstrates these responsi-
bilities will support the structured finance industry's efforts
to eradicate servicing fraud and abuse in every transaction.
Legal Couns el
Options for an issuer's legal counsel are as diverse as
every other position on the structured finance team. Some
legal firms specialize in a specific type of transaction; some
support them all. Some firms write documents for use
throughout the world; some limit themselves to geo-
graphic areas. Some firms custom-craft every required
document; others use off-the-shelf documents.
The differences go on, but counsel who is focused
on mitigating fraud and abuse in the capital markets will
share the following common characteristics.
Legal counsel must:
create a legal structure that protects all industry par-
ticipants by adhering closely to all applicable law
create a legal structure that minimizes the opportu-
nity for fraud, while still allowing the servicer the
freedom to exercise its expertise
create a legal structure that supports the issuer's and
the underwriter's long-term business perspectives
stay involved in the transaction until all parties under-
stand the legal structure supporting the transaction.
Counsel who demonstrates each of these charac-
teristics will seek to protect each industry participant
without limiting the flexibility required to ensure a trans-
action's success in today's turbulent environment.
Trustee
There are many trustees that can support a structured
finance transaction. The trustee tends to act as the con-
duit through which all participants communicate once
the transaction is executed. A trustee can be part of an
international organization or it may be a regional office.
It might specialize in certain types of transactions or it
may be a generalist. The trustee might have a specific
industry in which it acts or it might cover all industries.
The trustee should:
make sure the issuer understands the legal
requirements in the transaction documents
and acts accordingly
maintain an open and ongoing communication
channel with the issuer throughout the term of
the transaction
validate the information it receives according
to its legal responsibilities as described in the
transaction documents
FALL 2004 THE JOURNAL OF STRUCTURED FINANCE 45
maintain an open communication line with the
transaction investors and be responsive to their
inquiries
seek investor approval, according to document spec-
ifications, to take timely action to eliminate poten-
tial servicing fraud and/or abuse
stay involved in the transaction throughout its term,
regardless of the transaction's outcome.
A trustee that manifests these characteristics will play
an active role in maximizing a transaction s performance
and in mitigating and/or eliminating servicing fraud.
Servicer
In the majority of structured finance transactions, the
servicer is related to the issuer in some way. The servicer
may be a stand-alone business division for a large issuer
or it may be a department within a smaller issuer. A ser-
vicer also can be an independent third party that has been
hired for the sole purpose of servicing this transaction. A
servicer might be a large corporate entity or a small oper-
ating unit.
The servicer bears the brunt of supporting the trans-
action once it has been funded. Regardless of its rela-
tionship to the issuer, its size, or its scale, a proactive
servicer that is intent on eliminating servicing fraud and
abuse will exhibit the following characteristics.
The servicer must:
fully understand and adhere to the legal require-
ments of the transaction
maintain open communication with all entities
related to the transaction and be responsive to their
inquiries
demonstrate a servicing infrastructure to support
and to automate as many servicing functions as pos-
sible
be flexible and willing to evolve its servicing prac-
tices to meet the ever-changing needs of the struc-
tured fmance industry
welcome external inquiries and external audit of its
servicing practices
take immediate action to justify or eliminate any
servicing practices that are suspected of impropriety
bear the responsibility of proving that its servicing
practices are consistent with industry practice and
are above reproach.
The servicer that demonstrates these characteristics
will prove consistently that it is beyond reproach and will
set the standard for the structured fmance industry.
Backup Servicer
The backup servicer has grown in importance as
the industry continues to self-pohce its actions. In gen-
eral, a backup servicer will be required to support any
servicer that is not an "investment-grade" company. Some
trustees will act as backup servicers, depending upon the
type of transaction. Some servicers, either independent or
affiliated, will also act as backup servicers.
The backup servicer should:
fully understand its responsibilities as outlined in the
transaction documents
complete its required duties as outlined in the docu-
ments in a timely and accurate manner
act as a resource for the transaction servicer, as requested
act as a resource for the other parties to the transac-
tion, as allowed by the transaction documents
take seriously its responsibility to be ready, willing,
and able to assume servicing for the transaction in the
event of a servicer default
demonstrate the characteristics of the servicer, as pre-
sented above, in the event it becomes the successor
servicer.
While a backup servicer cannot be the only line of
defense against potential servicer fraud and abuse, it can
certainly be a critical component in mitigating servicer
fraud in this industry.
Investor
Certain industry detractors have commented that
the investor might be the only party other than the issuer
who remains interested in how a structured fmance trans-
action plays out. One intent of this article is to debunk
that belief and to motivate all industry participants to
retain an ongoing interest in the transactions in which
they participate.
An active investor will demonstrate some of the fol-
lowing characteristics in its efforts to mitigate servicing
fraud in a structured transaction.
The investor should:
carefuUy review the information it receives from the
issuer prior to its investment in the deal
clarify any uncertainties in the transaction infor-
46 MITIGATING SERVICING FI ^UD IN A STRUCTURED FINANCE TRANSACTION FALL 2004
mation before it invests
make clear its expectations from the trustee and
issuer/servicer at the time it invests in the transaction
compare the monthly reported results with other
similar transactions to identify performance 15% to
25% percent better or worse than similar deals
question the trustee and issuer/servicer when its
ongoing research and analysis identifies any trans-
action anomalies
interact with the trustee and be responsive to the
trustee's request for investor caucus or input on trans-
action matters
An investor's active and willing participation in the
transactions in which it has invested will further support
the industry's efforts to lnitigate servicing fraud and abuse.
To summarize, the structured finance industry has
been unfairly accused of widespread servicing fraud and
abuse. Although selected instances of fraud and abuse have
occurred within the structured finance industry, some of
which have been perpetrated by the servicer, our industry
is predominantly well administrated and sound. This does
not, however, absolve industry participants of the shared
responsibility to understand the possible types of servicing
fraud, to know the potential warning signs for abusive or
fraudulent practices, and to guard against servicing fraud
and abuse cooperatively.
Servicing fraud generally occurs in the areas of cash,
collateral, or reporting. Each has its own unique warning
signs, although all types of fraud share similar warning
signs. Slow reporting, cash flow shortfalls, and perfor-
mance below or above industry norms are each warning
signs for potential fraudulent or abusive servicing practices.
The primary point is for industry participants to be aware
of these warning signs, to seek clarification from the ser-
vicer, and to take the appropriate action jointly to resolve
any suspected abusive servicing practice as quickly as pos-
sible. Most fraud occurs unintentionally at the beginning,
and can either mushroom out of control or be quickly
diffused and eliminated. The choice belongs to the par-
ticipants in the structured fmance industry. Let's choose
to eliminate servicing fraud and abuse to contribute to
the long-term success of the structured fmance industry.
Editor's Note
Kent R. Williams has run servicing operations for 20 years.
To order reprints of this article, please contact Ajani Malik at
amaUk@iijournals.com or 212-224-3205.
FALL 2004
THE JOURNAL OF STRUCTURED FINANCE 47