Hailsham Chambers lenders’ claims seminar

Hailsham Chambers lenders’ claims seminar Tuesday 28 April 2009

Securitisation and Lenders’ Claims Paul Mitchell and Eva Ferguson

What is securitisation? • Take a portfolio of income producing assets (e.g., mortgage loans owned by a bank) – known as “receivables” • Convert the receivables into a capital sum by selling the cash generated by them to a third party

Types of securitisation • Three broad methods of securitising: • Sale • “Synthetic” method • Loan

Sale method (1) • The lender (“the Originator”) sells receivables to a Special Purpose Vehicle (“SPV”). • The receivables are a mixed bag of mortgage loans – some to people who are solid risks, others to people who are far more risky

Sale method (2) • The SPV funds the purchase of the receivables by issuing commercial paper (“CP”) – bonds, Notes etc that pay interest to the holder • Say it is receiving interest payments from the receivables at varying rates... • It offers a range of products to investors, from AAA-rated investments (that are stable and pay a low rate) to BBB or worse (riskier but with higher rates).

Sale method (3) • The theory is that the amount of interest received by the SPV from the receivables is higher than the amount paid out to those who have bought the SPV’s commercial paper (“the spread”) • The SPV uses the spread to pay the Originator fees to collect in the money owed by the borrowers

Sale method (5) • The investors buying the CP need the SPV to be “insolvency remote” from the Originator – if the Originator becomes insolvent, the SPV must remain unaffected. (Cf analysis in MBNA v Commissioners of HMRC [2006] EWHC 2326) • Furthermore, the SPV is owned by a charitable trust/ a corporate service provider.

Sale method (6) • Because the SPV is owned by a charitable trust, it should have no liability to tax; and • It is not an asset owned by the Originator and does not show on the Originator’s balance sheet. • Result: Originator has transformed long-term loans into cash; and the risk of default has been transferred to the investors in the SPV’s commercial paper.

Synthetic method (1) • More complex • By a series of linked transactions, the risk of the mortgagors defaulting is transferred from the Originator to those who buy the SPV’s commercial paper, but... • The mortgage loans themselves stay on the Originator’s balance sheet

Synthetic method (2) • (1) Originator enters credit default swap with the SPV • Originator agrees to pay SPV a regular fixed premium, in exchange for... • An agreement by the SPV to make payments to the Originator in the event that mortgagors default

Synthetic method (3) • (2) the SPV issues CP... • And with the proceeds acquires a portfolio of income producing assets (“the collateral”) • (3) the SPV applies (a) income received from the Originator and (b) interest income received from the collateral to pay interest on the CP it has issued

Synthetic method (4) • (4) the SPV applies payments of principal received from the collateral as follows: • First, to make payments to the Originator as and when mortgagors default • Second, to repay the capital owed to the investors in its CP as such repayments fall due • Result: the risk of mortgagors defaulting is transferred from Originator to investors

Loan method • Different structure, with no SPV • Owner of receivables issues CP directly against the security of those receivables • Receivables are charged to the party lending money to the Originator • Result: Originator has obtained liquid assets against the security of illiquid assets

Benefits of securitisation (1) • Allows lender to transform illiquid assets (mortgage loans) into liquid and tradeable financial market instruments; and... • Allows lender to transfer credit risk associated with mortgages to third parties; and...

Benefits of securitisation (2) • (For sale and synthetic methods) allows lender to leverage its balance sheet because: • Once loans have been transferred to SPV, the risk to the lender of borrower default has gone with them; and so • The lender needs to maintain less regulatory capital to support its lending and can thus lend more.

Disadvantages (1) • In the context of lenders’ claims against professionals, the disadvantages are: • Lender has transferred title to the loan/ title to the benefit of the loan to a third party • Lender has already been repaid in part or in full (either at initial sale to SPV or as the result of payments under the credit default swap contract with the SPV)

Possible lines of defence for professionals • Who has title to sue the professional in respect of loss suffered? • Proceeds of Securitisation: Can D bring them into account or are they “res inter alios acta”? • Contributory negligence

Who should sue the professional? The Lender? The SPV? But query: a) Duty of Care? b) Practicality of Funding? 1) Title to Sue

Effect of Securitisation • What is likely to be transferred to the SPV is the legal charge, i.e. the lender’s rights against the borrower (but n.b. Paragon Finance Plc v Pender [2005] EWCA Civ 760) • Distinguish between transfer of the charge and transfer of the lender’s rights against third parties arising in connection with its obtaining the charge

If the lender did not purport to transfer to the SPV its rights against third parties, is it going to be entitled to recover anything more than nominal damages from the professional? For the SPV to sue one of the professionals involved, the lender would have had to have assigned all of its rights against that professional to the SPV Alternatively, the SPV would have to establish that the professional owed it an independent duty of care

Cost of Litigation • Even assuming SPV can sue one of the professionals... • There might not be adequate money within the SPV to fund the litigation: possible security for costs implications

2) Securitisation and loss • Does the fact of securitisation mean that the lender has in effect suffered no loss? OR • Is the securitisation process to be seen as a collateral benefit which is res inter alios acta?

Banques Bruxelles Lambert SA v Eagle Star Insurance Co Ltd [1995] 2 All ER 769 Syndication of loans BBL made loans based on D’s valuations Loan agreements in respect of 3 properties entered for £200m BBL then syndicated part of its loan to “Substitute Banks”

Effect of Syndication BBL’s retained exposure lower than its original advance Nonetheless BBL claimed the full amount of loss. Argued no regard should be paid to subsequent syndication on basis it was res inter alios acta BBL had not suffered the loss in respect of which it sued

As regards the Substitute Banks “The principle of res inter alios acta requires the court to disregard an indemnity received by the plaintiff from a third party in respect of the loss caused by the defendant. It does not require or permit the court to assess damages on the basis of a fiction; to treat losses sustained by third parties as if they have been sustained by the plaintiff. The intervention of the syndicate banks did not indemnify BBL in respect of consequences of entering into the loan transactions. It resulted in the syndicate banks suffering those consequences in place of BBL. The loss claimed by BBL is not loss suffered by BBL prior to syndication, but loss suffered by all the syndicate banks after syndication”

The syndication of the loans meant that losses were ultimately suffered by parties other than the original lender; thus the original lender could not sue in respect of those losses.

Whether sums received by lender will be taken into account will depend on facts of the securitisation (cf Interallianz Finanz AG v Independent Insurance Company [1997] EGCS 91) Where securitisation is inextricably linked to lender’s business model, strongly arguable that sums received as a result are not res inter alios acta: see BBL Headline points

3) Contributory Negligence • As yet unknown, but seems possible that availability of securitisation might have encouraged inappropriate risk taking by lenders • E.g. sub-prime lending: if the business model depends on lending to securitise, is there less incentive to lend prudently?

In a market awash with cheap money (in large part as the result of securitisation) and strong competition to lend, possible that lending targets set by management put pressure on underwriters to nod through bad loans.

Conclusions • Securitisation and its ramifications not yet widely understood • There are grounds for believing that questions relating to securitisation may play a role in the ensuing round of lenders’ litigation • Watch this space...

Equitable Claims Francis Bacon

Background Last time round Were any lessons learned? CML Handbook They thought it was all over The resurrection of the Ninjas Introduction

Target v Redferns Bristol & West Building Society v Mothew Swindle v Harrison Paragon Finance v Thakerar Nationwide v Balmer Radmore Background: last time

Sub-prime Buy to let Lending to securitise Packaging The ever rising(!) property market Recklessness? Background: recent lending

Equitable claims more common than expected Two types of claim: Negligence wrapped up as breach of trust / fiduciary duty “True” equitable claims Additional claims Breach of warranty of authority Breach of undertaking Barclays Bank v Weeks Legg & Dean The claims being made

Breach of trust: does the allegation go to the solicitor’s power / authority to deal with the advance? Breach of fiduciary duty: does the lender allege more than mere incompetence? Liability issues (1)

Theoretically, yes In practice, no Weeks, Legg & Dean (above) at 328D-E: “Theoretically his liability as a trustee is strict, but in practice it is not, for if he acts honestly and reasonably and ought to be excused from liability, the court will grant him relief under section 61 of the Trustee Act 1925.” Liability (2): Is breach of trust strict?

(1) Is negligence a bar to the s.61 defence? s.727 of the Companies Act 1985 Re D’Jan of London Ltd [1994] 1 BCLC 561 at 564 Barings v Coopers & Lybrand [2003] EWHC 1319 (Ch) at paras.1125-48 (2) An all or nothing issue? (3) How far are terms of the retainer terms of the trust? Liability (3): further trust issues

B, a fraudster, creates a false office of a real firm of solicitors B applies for a loan, nominating S as his solicitors The false office purports to be acting for the vendor S sends the purchase monies, including L’s advance, to the false office and B absconds L asserts S’s identification obligations are trust obligations and alleges breach of trust, but not negligence In answer to a s.61 plea, L says that defence is not available because S was negligent Throughout, L asserts that contributory negligence is not available Liability (4): an example

Negligence/breach of contract Fraud Standard Chartered Bank v Pakistan National Shipping Breach of warranty of authority Bristol & West v. Fancy and Jackson Breach of undertaking Equitable claims Contributory negligence: overview

Equitable nature of breach of trust remedies Analogy with the Law Reform (Contributory Negligence) Act 1945, if necessary by reference to Target S.61 of the Trustee Act 1925 “wholly or partly” Contrib.: breach of trust

Nationwide v Balmer Radmore Richard Grosse Grounds of attack The decision itself The Commonwealth position The analogy with deceit Intentionality vs. dishonesty Mothew: “Conduct ... need not be dishonest but it must be intentional.” The Kriti Palm (AIC Limited v. ITS Testing) Fairness Contrib.: breach of fid. duty

What is recklessness? Fraser v Furman [1967] 1 WLR 898 (employers’ liability): “... actual recognition ... that a danger exists, and not caring whether or not it is averted. The purpose of the condition is to ensure that the insured will not, because he is covered against the loss by the policy, refrain from taking precautions which he knows ought to be taken.” Have lenders been reckless? If so, what impact should that have? Contrib.: recklessness?

CONTRIBUTION: FAIR SHARES William Flenley & Simon Wilton

Section 1(1): “Subject to the following provisions of this Act, any person liable in respect of any damage suffered by another person may recover contribution from any other person liable in respect of the same damage (whether jointly with him or otherwise)” Section 2(1): “...the amount of the contribution recoverable from any person shall be such as may be found by the court to be just and equitable having regard to the extent of that person’s responsibility for the damage in question” Section 6(1): “A person is liable in respect of any damage for the purposes of this Act if the person who suffered it ...is entitled to recover compensation from him in respect of that damage (whatever the legal basis of his liability, whether tort, breach of contract, breach of trust, or otherwise)” The Civil Liability (Contribution) Act 1978 (“The Act”)

A = the claimant B = defendant/party seeking contribution C= party from whom B seeks contribution

“(1) What damage has A suffered? (2) Is B liable to A in respect of that damage? Is C also liable to A in respect of that damage or some of it?” (Lord Bingham in Royal Brompton) First question: is there a right to contribution at all?

“same damage” does not mean “same damages” Lender’s claim: borrower is not liable for “the same damage” as solicitor/valuer (Howkins) See generally Royal Brompton Are B and C liable in respect of “the same damage” (s.1(1))?

s.1(4): B makes a bona fide settlement with A In determining whether B is liable to A, you assume that the factual basis which A pleaded against B was correct B has to show that, on that assumed factual basis, B was legally liable to A If B settles with A

Hailsham Chambers lenders’ claims seminar