The Minnesota Court of Appeals affirmed in a recent case that the securitization agreements at issue authorized the creation of reserves to ensure that the securitization trust could meet its contractual obligation to indemnify servicers against future trust-related litigation expenses. The decision upholds the longstanding industry practice of setting aside such anticipatory reserves.
In a typical securitization transaction, the governing agreements provide that service providers such as servicers and trustees are entitled to be indemnified out of securitization cash flows for losses, liabilities, and expenses incurred in connection with the securitization. This indemnification right is typically senior to the rights of investors to receive distributions. In other words, each month the securitization trust must first pay its indemnification obligations before the remaining funds can be distributed to investors.
To ensure that sufficient funds are available to satisfy anticipated indemnifiable expenses, service providers will sometimes set aside reserves in a trust account until indemnifiable expenses are incurred. When needed, the service providers reimburse any incurred expenses from the reserved funds and distribute any excess in accordance with the priority of payments, or “waterfall,” in the governing agreements.
As securitization-related litigation proliferated in the wake of the 2008 global financial crisis, some investors challenged this practice. In 2017, a New York court rejected such a challenge, holding that a securitization trustee may set aside reserves for anticipated litigation expenses at the time a trust is terminated. So-Ordered Transcript, PIMCO Absolute Return Strategy 3D Offshore Fund Ltd. v. Wells Fargo Bank, Nat’l Ass’n, No 654743/2017 (N.Y. Sup. Ct. Dec. 5, 2017), at 18:3-20:16. However, that court did not address the question in the context of a securitization trust that was not terminating.
The case decided by the Minnesota Court of Appeals—In re Wachovia Bank Commercial Mortgage Trust Commercial Mortgage Pass-Through Certificates, Series 2007-C30—concerned a commercial mortgage-backed securitization trust referred to as the C30 Trust.
When the C30 Trust was created in 2007, it possessed more than 260 commercial mortgage loans with an outstanding principal balance exceeding $7 billion. By December 2018 (when the funds at issue were set aside in a litigation reserve), the C30 Trust held only five remaining assets—all experiencing some level of distress—with an outstanding principal balance of $115 million. Cash was still expected to flow through the C30 Trust, but the timing and amounts were unpredictable.
In December 2018, the C30 Trust made its usual monthly distribution of trust funds pursuant to the waterfall. The next day, the C30 Trust’s special servicer, CWCapital Asset Management LLC, directed the master servicer and the paying agent to hold back $38 million as a reserve for anticipated losses, liabilities, and expenses in connection with two litigations related to the C30 Trust.
The paying agent clawed this money back from certain recipients of the December 2018 distribution. Of the $38 million, approximately $10 million was used to fund a litigation settlement five months later. The remaining $28 million was never used.
Investors with different economic interests raised competing assertions. Certain investors who were relatively junior in the waterfall, and from whom the funds were clawed back, argued that the reserves were not permitted under the trust’s governing agreement, while other investors who were more senior in the waterfall disagreed.
In light of these clashing assertions, US Bank National Association, as trustee of the C30 Trust, commenced a trust instruction proceeding in Minnesota seeking the court’s instruction to resolve the dispute about whether the reserves were permitted. [1]
After fact and expert discovery, the junior and senior investors filed cross-motions for summary judgment. The paying agent, the master servicer, US Bank, as trustee, and CWCapital, as the former special servicer, joined the senior investors’ motion in whole or in part. The trial court denied the junior investors’ motion and granted summary judgment in favor of the senior investors, holding that the reserves were permitted under the C30 Trust’s governing agreement. The junior investors appealed.
On appeal, the Minnesota Court of Appeals affirmed the trial court’s ruling.
First, the court held that the governing agreement for the C30 Trust unambiguously permitted reserves for anticipated indemnification obligations because despite the agreement not explicitly referencing litigation reserves, the indemnity provisions “reasonably imply that the trust’s servicers have broad authority to ensure that the trust meets its obligations to indemnify various parties before distributions are made.”
Second, the court recognized, if reserves were not permitted, that “would nullify the indemnification clause as the trust’s assets dwindled,” which would be “a commercially unreasonable result, leaving the trust incapable of satisfying its indemnification obligations as its assets dwindled.”
Third, the court noted that all of the parties to the governing agreement—the master servicer, special servicer, and trustee—agreed that reserves were permitted. The court characterized the investors as “strangers to the contract” and rejected their competing interpretation because the contracting parties’ interpretation was “illumined by conduct on the part of the signatories.”
The decision from the Minnesota Court of Appeals affirms the general principle and industry practice that, under certain circumstances, securitization service providers may set aside anticipatory litigation reserves. It remains to be seen whether this decision will dissuade investors from challenging these types of reserves in the future.
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[1] Morgan Lewis represented US Bank in this matter.