A View From the Exchange: Broken Securitisations: Understanding the Litigation Risks

Recent high-profile insolvencies across the US and Europe have brought securitisation failures sharply into focus. Names like First Brands, Stenn, and Prax have made headlines, with investors facing substantial losses. However, beyond the immediate financial fallout, these cases have exposed a web of litigation risks that practitioners and market participants should ensure they understand.

When Securitisations Go Wrong

Securitisation is, generally, a structured financing technique usually involving the conversion of illiquid assets (such as loans or trade receivables) into tradeable securities (or loans). It usually involves the pooling of multiple similar assets which are then sold to a separate (usually orphan) vehicle that borrows in the private capital markets or issues bonds in the public markets to finance the acquisition of such pools.

This enables financial institutions to free up capital, transfer risk, and gain liquidity.

A distinct benefit of securitisation over other methods of financing is that the risk for the lenders/investors attaches to the assets rather than the originating institution. Cashflows from the underlying assets (i.e., repayment of the underlying obligors) are the main source of repayment of interest and principal to the investors under the bonds/loans. The lenders/investors are, therefore, normally only affected in a limited way on the insolvency of the originator or servicer (usually the originating institution, which continues to service the receivables on behalf of the orphan vehicle).

Traditionally, securitisations default due to (among other things):

• deterioration of the underlying assets stemming usually from market conditions (e.g., mortgage borrowers default on their repayments due to unemployment spikes or interest rate increases);
• poor underwriting standards (such as loose lending standards or aggressive property valuations) which means that the structure was fragile from the point of creation (as was the case with certain securitisations in the financial crisis during 2007-2009); and
• certain counter-party risks, such as the mismanagement of the assets or the asset level cashflows by the servicer.

Arguably, these are foreseeable risks. However, more recent failures have exposed different kinds of problems which are much harder to guard against, including fraudulent conduct, for example, assets that:

• never existed (and which involve e.g., fabricated invoices); or
• were purportedly sold or pledged across multiple vehicles.

The Reconciliation / Investigations Minefield

These securitisations rarely fail cleanly and the issues above are not generally exposed until failure occurs. At that point, an insolvency practitioner is usually appointed and will conduct a reconciliation/ investigation exercise in relatively short order. This serves two purposes: first, to determine what assets genuinely exist, who has valid claims to them, and how collections should be allocated among competing beneficiaries, and, secondly, importantly, to identify the basis for potential claims against third parties (see below).

This investigation can be complex and time-consuming, frustrating those entities seeking to recover monies they believe are rightfully theirs (as the beneficiaries under the securitisation structure). It is nonetheless critical that this process is painstakingly completed and verified with all parties' agreement to suggested allocations, if possible.

However, disputes with co-investors over the allocation of recoveries are becoming increasingly common, and challenges to costs and conduct can arise. Where reconciliation exercises produce contested conclusions, the courts may ultimately have to determine entitlement (again, a time consuming and expensive process).

Potential Defendants and Claims

For investors in a broken securitisation, the litigation risk is multi-faceted. Pursuing claims against those responsible requires careful analysis to identify the right defendants and causes of action.

The originator or servicer may be the most obvious target but, where those entities are insolvent, we must look further afield. This includes:

• Directors and officers of the originator or servicer may face claims for breach of fiduciary duty, negligence, fraudulent trading or wrongful trading. Where directors have caused or permitted the misrepresentation of assets or the misapplication of funds, personal liability may follow. Responsive D&O policies may exist, potentially making recoveries easier (although fraud is often excluded from cover).
• Auditors who signed off on accounts failing to reflect the true position may face negligence claims. They should also have PI cover, making recovery and enforcement simpler.
• Legal advisors who structured transactions or provided opinions may face scrutiny if transaction documents enabled the fraud or they failed to identify obvious red flags. They should likewise have PI cover.
• Counterparties who received payments to which they were not entitled, or co-investors who received preferential treatment could face, for example, unjust enrichment claims.

For directors and officers in particular, asset tracing may be required to follow the flow of funds through complex corporate structures and multiple jurisdictions. This is notoriously difficult and, even where assets are located, enforcement can be drawn-out. The practical reality is that even a successful claim may yield only a partial recovery, or none, after years of litigation.

Looking Ahead

Market participants are already responding to these failures, with enhanced due diligence on originators and servicers, more frequent collateral audits, direct confirmation of large receivables, and tighter restrictions on commingling. However, securitisation remains an important funding tool, particularly for newer businesses seeking competitive financing. The challenge will be striking the right balance between investor protection and commercial practicality.

For lawyers advising in this space, understanding where the litigation risks lie is no longer optional.

Authors: Lynn Dunne, Partner; Theodoros Kotsiras, Counsel; Joanna Middlemass, Associate