In Practice: Market Trends in Mitigating Conduct Risk in Private Asset Backed Structured Finance Transactions
Finance providers have sharpened their focus on transparency, reporting, and enhanced protections, while originators are becoming more receptive to this heightened vigilance. Whereas additional demands and protections may increase financial and administrative burdens for all parties, they also have the potential to promote transaction durability.
Practical Implications for Market Participants
This article explores market trends in considerations and practical steps taken by finance providers and originators to mitigate misconduct and enhance transaction resilience.
Due diligence
Finance providers are allocating more time and resources to enhanced and expanded scopes of pre‑close due diligence to thoroughly understand, end‑to‑end:
- originators’ policies and compliance of such policies with applicable laws and regulations;
- originators’ underwriting processes;
- originators’ collateral and cash‑management processes; and, critically;
- how originators’ policies operate in practice, including whether there are divergences between written procedures and observed practices.
On identifying any pitfall areas, parties could then consider whether pre-close compliance measures may need to be implemented and could have a better view of the scope of covenants, monitoring and reporting obligations that may need to be implemented to reflect the level of comfort finance providers are seeking based on the findings.
A deeper understanding of originators’ businesses reduces information asymmetry between parties, gives financing providers comfort in their reliance on the origination and servicing systems and ultimately strengthens relationships between finance providers and originators.
Audit reports: frequency, scope and triggers
Traditional market practice contemplates annual or bi-annual delivery of audit reports, with the frequency of disclosure escalating on defined triggers. Finance providers are increasingly seeking:
- wider scopes of audit reports;
- more frequent delivery of audit reports; and
- re-examination of triggers in transaction documents.
The scopes of audit reports are expanding to cover in-depth review of the data tapes and the underlying loan files giving finance providers greater transparency. Given the short term nature of certain asset classes, finance providers are also finding that more frequent delivery of audit reports may help identify areas of concern earlier. We also see finance providers revise triggers in the transaction documents to capture a wider range of adverse findings, including anomalies in payment patterns, discrepancies between servicing reports and bank statements and inconsistencies in disclosures, with interim reviews and targeted exercises authorised when such findings emerge.
As a result, cost allocation is also evolving; while routine audits remain a transaction expense, the enhanced and recurring reviews may have a greater cost that requires upfront negotiation as to who will bear such expense. Ultimately motivations should be aligned where these measures incentivise and encourage robust internal controls.
Inspection rights: access and systems-level review
Inspection rights are also broadening in some instances to permit short‑notice access to premises, records and systems. The objective is for finance providers to validate loan‑level data, observe cash‑application processes and test the integrity of the platforms being used. Inspection regimes increasingly contemplate read‑only systems access, controlled data‑extraction protocols and on‑site reviews. Well-structured inspection regimes balance oversight with operational continuity by defining reasonable time windows, clear points of contact and focused scopes that target risk‑relevant areas without paralysing day‑to‑day operations.
Bank account transparency: following the cash
Finance providers typically obtained read access rights to accounts in the name of the special purpose vehicle, but not to originators’ accounts where, in certain instances, collections are first received. Some finance providers are exploring seeking read access rights to originator accounts as well. Such visibility would enable them to track sources of funds, timings of sweeps and overall cash movements. This increases transparency and allows finance providers to identify any irregularity or unreported collections, misapplied payments and undisclosed set‑offs at an early stage.
Indemnities and asset warranties: looking beyond the special purpose vehicle
We also see a trend of shifting of certain indemnities and warranties from the special purpose vehicle to the originator. Indemnities and look‑through warranties given by originators have the potential to offer direct recourse and recovery, including by way of example, upon the occurrence of account freezes, insolvency stays or operational disruption.
The key aspects for parties to consider is balancing enhanced originator liability while preserving structural features that afford adequate bankruptcy remoteness, off-balance sheet treatment and other regulatory objectives.
Conclusion
The trends explored in this article reflect the market’s response to recent cases. While these enhanced measures, do not, by themselves, resolve the information asymmetry around title or competing claims over receivables, they prompt both sides to address any weaknesses in systems and incorporate targeted mitigants and protections.
These developments may cause participants to question whether the UK should revisit a key feature of the 2016 Secured Transactions Law Reform Project; that is the adoption of a system of registration of sold receivables (akin to a UCC-style public-filing regime in the US). A well‑designed registry may provide greater system‑wide visibility over security interests and assignments and reduce the risk of double‑pledging. In the meantime, market participants should be prepared to expect requests for enhanced protections pre-close and in transaction documents, with verification, transparency and recourse at front of mind for many participants.