Mitigating Servicing Fraud in aStructured Finance TransactionKENT R. WILLIAMS

KENT R . WILLIAMSis executive vice presidentof LeaseDimensions, Inc. inPortland, OR.kent williams@leasedimension$.com E

vents in the past several years havecaused 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 thisfraud and abuse, leaving the impression thatstructured 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 inwhich an event of perceived fraud or abuse hasoccurred. Moreover, the long-term success ofthe structured fmance industry proves its value.

Unfortunately, there have been a fewinstances in which a servicer has perpetratedfraudulent or abusive actions to harm a struc-tured finance transaction. These actions,whether intentional or not, have caused prob-lems within the affected transactions, resultingin losses to the investors. Industry spectatorshave used the negative publicity associated withthese relatively few situations as proof of abu-sive and fraudulent practices in the structuredfmance marketplace.

All structured fmance professionals sharea common interest in reducing fraud and abusein any form. The industry has responded byrefming legal language, by clarifying servicingactions, and by increasing reporting require-ments. These actions are intended to mini-mize, if not eliminate, potentially fraudulentpractices. Even though the structured fmanceindustry'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 acomprehensive tutorial for every fraudulentand abusive practice conceivable within struc-tured fmance. Rather, it will explore threeareas of this topic from the perspective of astructured fmance servicer who has servicedhundreds of transactions across the majorityof 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 warningsigns for servicing fraud?

3. What practices should industry partici-pants adopt to help reduce fraud?

These areas will be discussed as simplyas possible to allow the reader to conceptu-alize an application in his/her unique positionas a structured-fmance professional. The overallconclusion of this discussion should be to fur-ther motivate all structured fmance profes-sionals to contribute to the ongoing refmementof this industry, with our primary goal beingto further eradicate fraudulent or opportunisticpractices followed by servicers throughout thestructured finance industry.

FRAUD: INTENDED OR NOT?

There are two types of fraud a servicercan perpetrate: intentional and unintentional.

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Intentional fraud is a situation where the servicer makesa conscious decision to apply abusive or fraudulent prac-tices as it performs its servicing functions. Historicallyspeaking, this is not the initial intention of a servicer asit begins to service a transaction. Rather, a servicer morecommonly commits the second type of fraud, uninten-tional, and then gradually begins to commit more andmore 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 situationwhere it must commit "intentional" fraud to cover upthe "unintentional" fraud.

There are two points to this topic: 1) few servicersintend to commit fraud, and 2) less fraud would occur ifmore industry participants were watching. An uninten-tional fraudulent action, if caught in its early stages, canbe resolved more quickly, and with less negative impact,than fraud that has been perpetrated for enough time tobecome an act of intentional fraud. Industry participants,if properly educated about how fraud can occur, and ifproperly motivated to exercise their responsibilities to thetransaction, can help detect and resolve abusive and/orfraudulent actions in the early stages. This proactiveapproach 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 followsto help the reader better understand the core opportuni-ties for servicing fraud.

Cash

A servicer processes a significant amount of cash onbehalf of the transaction stakeholders. The servicer isresponsible for collecting, allocating, and distributing itappropriately. There are several opportunities for a servicerto apply fraudulent practices in the course of cashprocesses. Following are some of the areas in which a ser-vicer's actions can lead to unintentional or intentionalabuse.

Commingling Funds. Each transaction is structuredas a unique legal entity for a variety of reasons. The legalentity'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 offunds commingling.

Each transaction should have a clear and conciseprocess for receiving, holding, and distributing funds. Aservicer may elect to establish a unique payment lockboxfor each transaction, with a unique depository account intowhich funds are placed. This is a simple and straightfor-ward way to keep funds segregated. The downside of thisprocess can be the number of lockboxes and bank accountsavailable to the servicer and the associated costs incurredto 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 offunds from the clearing account to each transaction'sunique depository account. This is a workable process ifit is well controlled and carefully monitored.

The opportunity for monetary fraud or abuse canarise when funds are received into an account withoutclear assignment to a transaction. Depositing funds intothis type of "operating" account might allow a servicerto misuse the funds received for a specific transaction.The structured finance industry has experienced severalsituations in which a transaction's funds were used to meetthe operating needs of an issuer/servicer, usually with theintent of repaying the funds before the distribution date.Regardless of intent, this misuse of transactional funds isa 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 documentsestablish a clear methodology for applying and distributingthe cash proceeds received during each collection period.Cash is allocated to pay transactional expenses and to reducethe outstanding debt appropriately. Any remaining cash isthen distributed to the various stakeholders.

Transaction documents set a date on which the dis-tributions are to be made. Miscategorizing account statusand 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 financetransactions generally have a diverse array of underlyingcollateral, pooled into like-kind asset categories, uponwhich the transaction balance is based. The underlyingaccounts that support each transaction can be groupedinto active or inactive status. Transaction documents care-fully defme the situations that create an active or inactivestatus. This is important for a variety of reasons, but thissection 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'sdocuments. However, an inactive account might bedefmed as a non-recoverable account. This means thatthere is little or no likelihood of additional cash flow fromthis account. The transaction documents will then specifythat this account should be liquidated, meaning that itshould be purchased from the transaction. This entailswithholding the total purchase price for this account fromthe allocated cash distributions. This, in turn, will reducethe cash distributed to the residual holder, which is oftenthe issuer/servicer.

The issuer/servicer conceivably can increase thecash flow it receives from a transaction by miscategorizinginactive accounts as active, thereby reducing the amountof account balance to be liquidated from the transactionalcash flows. Whether intentional or not, this type of ser-vicer activity should be construed as abuse or fraud as itultimately will harm the overall transaction performance.Additional areas where status miscategorization may befraud and/or abuse will be discussed in the Reportingsection 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 ofpotential cash abuse relates to the timing of periodic cashdistributions. Each transaction has a defmed distributiondate 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 endof the collection period by 10 to 20 days. This allows theservicer adequate time to close the books on the previouscollection period and to prepare the requisite reports tosupport the cash distributions.

Problenis can arise if the actual cash collected in theprior collection period is not sufficient to meet the sched-uled distribution amounts on the distribution date. Thismight happen for a variety of reasons. For example, thetransaction might have incurred immediate repossessionexpenses during the collection period, yet the proceedsfrom the related collateral sale are not yet recognized. Or,worse yet, the servicer might be advancing account duedates with non-payment extensions in an effort to improvedelinquency 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 reserveaccount from scrutiny. As a result, a possible solution tothis cash shortfall is to "borrow" funds that have beencollected 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 servicermay have every intention of paying them back as quicklyas possible, this type of cash fraud can be indicative ofmore 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 intendsto commit fraud can manipulate the cash within a struc-tured finance transaction. For example, the receipt andaccounting 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 wouldbe happy to explain these and other areas of possible abuse.AU stakeholders will benefit as the structured fmance industrycontinues to increase its awareness of, and response to, thesetypes of actions for current and future transactions.

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Collateral

The majority of structured finance transactions relyupon some type of underlying collateral to provide theultimate 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 aresult, the valuation and maintenance of the collateral isa critical factor in creating and retaining value within atransaction.

There is opportunity for fraud and abuse as it relatesto the collateral backing a transaction. This section willdiscuss 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 intentis not to discuss every conceivable facet of this problem,but to provide insight into the areas in which ongoingscrutiny should be focused.

Collateral Valuation. The valuation of each trans-action's underlying collateral is critical, regardless of thetransaction structure or collateral type. A simple way toincrease the size of a transaction is to inflate collateralvalues, thereby increasing the portfolio investors own. Ina similar vein, losses for non-performing accounts can bereduced by adjusting the collateral value appropriately.Therefore, the valuation of collateral is a servicing func-tion that should remain under review throughout theterm of a transaction.

For example, a mortgage appraisal can be impactedfavorably by using inaccurate addresses for the compara-tive nearby appraisals. Adding subtle extra options to avehicle appraisal can represent its value inaccurately. Inac-curately measuring a commercial property's previous occu-pancy rates will also increase its value improperly. Whilethis situation is nothing new to those structured financeprofessionals involved in each specific industry, collateralvaluation should always remain on everyone's watch listfor 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 thetypes of charges that might be added to the debtor's totalobligation. Up front, an issuer may elect to capitalizeexternally incurred costs, thereby increasing the originalcollateral value. This is not uncommon and not necessarilydetrimental to the transaction. Capitalized costs caninclude equipment upgrades or add-ons, or various typesof insurance and warranty programs. While these mayadd true value when used with discretion, too much ofa good thing can increase the incidence of default as wellas the severity of ultimate losses.

A type of fraud more closely related to the servicingof a structured finance portfolio is the ongoing capital-ization of amounts during the repayment term. Forinstance, the servicer may need to force-place insuranceto protect the collateral, and elect to capitalize the insur-ance. This inflates the collateral value without increasingits 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 notonly 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 theright, to substitute collateral throughout the term of thetransaction. This can be good for the transaction if usedto retain the consistency of the underlying collateral.However, it also can allow the issuer/servicer to impactthe transaction adversely by straining the issuer/servicer'sfinancial survival during the transaction's term. As such,any substitution of collateral should remain under scrutinythroughout the entire term of the transaction.

For example, as delinquency or loss rates climbhigher than originally projected, the issuer/servicer mayexercise its substitution rights and replace an inactiveaccount with an active account. While this substitutionmay appear to be good for the transaction, the issuer thenmust absorb the full loss of the repurchased account. Asa result, the transaction's performance may look greatwhile the issuer/servicer is absorbing losses for which itis not adequately capitalized.

42 MITIGATING SERVICING FRAUD IN A STRUCTURED FINANCE TRANSACTION FALL 2004

This situation can be compared to a form of dryrot, 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 onlyis the issuer/servicer's ultimate survival jeopardized, butthe servicer also may need to reduce servicing activitiesto reduce costs to help survive the added cash drain ofthe ongoing repurchase program. Lack of servicing atten-tion might impact a transaction's health negatively byreducing overall portfolio performance. Moreover, thenegative performance trends can distress the transactionfurther 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 ofthese are unique to a specific collateral type and are beyondthe scope of this discussion. Many will be related to atransaction's specific structure, or to the relationshipsamong 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 atransaction, but throughout its term.

Reporting

The reporting function of a structured finance trans-action is the primary way for the various stakeholders toobtain information regarding that transaction's perfor-mance. Legal language establishes the type of reports tobe delivered, the information contained in the reports,and the timing of report delivery. Stakeholders typicallypay a high degree of attention to the contractual provi-sions that will govern this reporting function, particularlyas a way of mitigating the types of servicing fraud expe-rienced in the past.

Regardless of the industry's efforts to define reportingrequirements in a clear and concise manner, there remainseveral areas of potential abuse and/or fraud in the way aservicer can report transactional data. Reporting fraudand/or abuse can have a negative effect on a transaction'scash flow, liquidity, profitability, longevity, and payout.

This article will discuss a few areas in which a servicermight exercise improper reporting practices, with theintent of illustrating the different ways industry partici-pants can help recognize potential abuse or fraud in aproactive manner going forward.

Account Status. As discussed above in the Cash fraudsection, the reported status of the underlying collateralhas a serious impact on several aspects of a structuredfinance transaction. For example, a servicer might dosomething as seemingly innocuous as providing automaticextensions to past-due accounts. That servicer might dothis to reduce delinquency, thereby avoiding delinquencytrigger events that cause a reduction in cash distributions.Or, the servicer lnight do it to reduce the required interestadvances 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" accountdid not make its anticipated payment. Interest is overpaidas the missing payment does not appropriately reduceprincipal balance. Servicing fees are overpaid because theservicer is carrying inactive accounts as active. Investorsare misled regarding the stability and likely repayment ofthe transaction.

The list of areas where account status can be reportedinaccurately is as long as the number of status itemsincluded in each report. A servicer could misreport, inten-tionally or not, the status of active accounts, delinquentaccounts, bankrupt accounts, litigation accounts, repos-sessed or foreclosed accounts, substituted accounts, deferredaccounts, extended accounts, workout accounts, etc. Thepoint is that a document's legal language needs to outlinethe requirements for each reporting status clearly, and thetransaction participants need to be aware of the potentialfor misreporting. Swift and decisive action should be takento 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

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Cash Application. In addition to the potential areasof abuse and fraud discussed earlier in the Cash section,there are other ways for a servicer to misapply the cash itreceives to infiuence the way a transaction is reported inac-curately. Again, these actions can be simple, yet also canhave dire consequences when viewed in the context of anentire transaction. As a result, the informed stakeholdershould be apprised of this type of activity, and also shouldtake immediate action if cash misreporting is suspected.

An easy way for a servicer to reduce delinquency isto lower the payment threshold required to advance anaccount's due date. It is the practice in many industriesto advance an account's due date when a payment withinan acceptable percentage of the normal payment amountis received. But, a servicer potentially can reduce delin-quency rates to a significant degree simply by loweringthe payment threshold to 90% or 80% or 70% or even50%. Negative impacts to the transaction are similar tothose previously discussed.

Another area of potential abuse is for a servicer toinappropriately allocate cash receipts to accounts. This istypically a more egregious practice where the servicerintentionally misstates an account status in an effort tokeep the account current. In this case, the servicer maystate an inactive account incorrectly as a current accountwhile it repossesses and sells the collateral. Proceeds fromthe collateral sale can then be applied to the account asthough they were monthly payments received from thedebtor, thereby creating the illusion of an active account.The negative impacts of this action are evident, yet allstakeholders should be knowledgeable enough to recog-nize the warning signs in order to detect and eradicatethis 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 ofpotential reporting fraud in this brief an overview. But,this information is provided in hopes of better educatingeach stakeholder as to the areas in which a servicer caneffect transactional fraud and/or abuse. Immediate andcoordinated action by a transaction's stakeholders can helpto identify if fraudulent practices may occur, whether

intentional or not, and take timely action to correct themto minimize the potential negative consequences to thetransaction.

RESPONSIBILITY OF INDUSTRY PARTICIPANTS

A structured finance transaction involves multipleentities throughout its life. The responsibility to mitigateservicing fraud lies with all participating organizations,not just the servicer. Granted, the servicer needs to bethe first and last defense against improper practices, andthere 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 takeaction to keep a transaction on track. The collapse of afew structured finance transactions, some of which havegarnered a high degree of publicity, should motivate thefull cast of supporting organizations to work together ina cooperative effort to continue to shore up this industry.

Recent trends in the structured finance industrydemonstrate an increase in cooperation, mutual support,and ongoing interaction among the various constituentsto each transaction. This will help reduce the incidenceof servicing fraud and abuse in the structured financeindustry. All industry participants should support andencourage this positive momentum. Furthermore, industryparticipants can further improve the long-term perfor-mance of the structured finance industry by seeking andsupporting education efforts to identify and mitigatepotential 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 ofbeneficial organization traits, but is focused on mitigatingservicing fraud in a structured finance transaction.

Issuer

The entire process begins with an issuer that wantsor needs access to an efficient market to finance parts ofits 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. Someare seeking to diversify their funding sources; some areseeking a funding source. Most issuers have their ownservicing 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 toeliminate 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 successof all its participants

be prepared to cooperate with, and be responsiveto, each of the organizations involved in its struc-tured transaction.

An issuer that takes each of these responsibilitiesseriously is likely to do its part to eliminate fraud andabuse within a structured finance transaction.

Underwriter

An issuer seeking to access the capital markets hasa diverse array of underwriters with which it can work.Some are international organizations; some are local. Somespecialize in specific transactions; some do them all. Somepossess expertise in every facet of the process; some useoutside experts to help. Some have unlimited access tofunds; some do not. All underwriters seek to providevalue in their services.

Regardless of the issuer's selection, every under-writer shares a few critical responsibilities that will helpmitigate 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 effortsto eradicate servicing fraud and abuse in every transaction.

Legal Counsel

Options for an issuer's legal counsel are as diverse asevery other position on the structured finance team. Somelegal firms specialize in a specific type of transaction; somesupport them all. Some firms write documents for usethroughout the world; some limit themselves to geo-graphic areas. Some firms custom-craft every requireddocument; others use off-the-shelf documents.

The differences go on, but counsel who is focusedon mitigating fraud and abuse in the capital markets willshare 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 thefreedom to exercise its expertise

create a legal structure that supports the issuer's andthe 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 participantwithout 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 structuredfinance transaction. The trustee tends to act as the con-duit through which all participants communicate oncethe transaction is executed. A trustee can be part of aninternational organization or it may be a regional office.It might specialize in certain types of transactions or itmay be a generalist. The trustee might have a specificindustry in which it acts or it might cover all industries.

The trustee should: make sure the issuer understands the legal

requirements in the transaction documentsand acts accordingly

maintain an open and ongoing communicationchannel with the issuer throughout the term ofthe transaction

validate the information it receives accordingto its legal responsibilities as described in thetransaction documents

FALL 2004 THE JOURNAL OF STRUCTURED FINANCE 45

maintain an open communication line with thetransaction investors and be responsive to theirinquiries

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 playan active role in maximizing a transaction s performanceand in mitigating and/or eliminating servicing fraud.

Servicer

In the majority of structured finance transactions, theservicer is related to the issuer in some way. The servicermay be a stand-alone business division for a large issueror it may be a department within a smaller issuer. A ser-vicer also can be an independent third party that has beenhired for the sole purpose of servicing this transaction. Aservicer 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 proactiveservicer that is intent on eliminating servicing fraud andabuse 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 theirinquiries

demonstrate a servicing infrastructure to supportand 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 itsservicing practices

take immediate action to justify or eliminate anyservicing practices that are suspected of impropriety

bear the responsibility of proving that its servicingpractices are consistent with industry practice andare above reproach.

The servicer that demonstrates these characteristicswill prove consistently that it is beyond reproach and willset the standard for the structured fmance industry.

Backup Servicer

The backup servicer has grown in importance asthe industry continues to self-pohce its actions. In gen-eral, a backup servicer will be required to support anyservicer that is not an "investment-grade" company. Sometrustees will act as backup servicers, depending upon thetype of transaction. Some servicers, either independent oraffiliated, 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 theevent of a servicer default

demonstrate the characteristics of the servicer, as pre-sented above, in the event it becomes the successorservicer.

While a backup servicer cannot be the only line ofdefense against potential servicer fraud and abuse, it cancertainly be a critical component in mitigating servicerfraud in this industry.

Investor

Certain industry detractors have commented thatthe investor might be the only party other than the issuerwho remains interested in how a structured fmance trans-action plays out. One intent of this article is to debunkthat belief and to motivate all industry participants toretain an ongoing interest in the transactions in whichthey participate.

An active investor will demonstrate some of the fol-lowing characteristics in its efforts to mitigate servicingfraud 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% to25% percent better or worse than similar deals

question the trustee and issuer/servicer when itsongoing research and analysis identifies any trans-action anomalies

interact with the trustee and be responsive to thetrustee's request for investor caucus or input on trans-action matters

An investor's active and willing participation in thetransactions in which it has invested will further supportthe industry's efforts to lnitigate servicing fraud and abuse.

To summarize, the structured finance industry hasbeen unfairly accused of widespread servicing fraud andabuse. Although selected instances of fraud and abuse haveoccurred within the structured finance industry, some ofwhich have been perpetrated by the servicer, our industryis predominantly well administrated and sound. This doesnot, however, absolve industry participants of the sharedresponsibility to understand the possible types of servicingfraud, to know the potential warning signs for abusive orfraudulent 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 warningsigns, although all types of fraud share similar warningsigns. Slow reporting, cash flow shortfalls, and perfor-mance below or above industry norms are each warningsigns for potential fraudulent or abusive servicing practices.The primary point is for industry participants to be awareof these warning signs, to seek clarification from the ser-vicer, and to take the appropriate action jointly to resolveany 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 quicklydiffused and eliminated. The choice belongs to the par-ticipants in the structured fmance industry. Let's chooseto eliminate servicing fraud and abuse to contribute tothe long-term success of the structured fmance industry.

Editor's NoteKent R. Williams has run servicing operations for 20 years.

To order reprints of this article, please contact Ajani Malik atamaUk@iijournals.com or 212-224-3205.

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