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