A Call for Industry Awareness of Risks Relating to Residual Interests in Securitizations

The Task Force on Residual Interests of the American Bar Association Committee on Securitization and Structured Finance[1] was organized in response to a series of ongoing litigation proceedings described by one writer as a “multicourt, multistate legal war,”[2] that involves 15 special purpose Delaware statutory trusts known as the “National Collegiate Student Loan Trusts” (the “Trusts” or “NCSLTs”). These proceedings have raised serious concerns among securitization industry participants—in particular, as to whether securitization documents properly address the role of residual interest holders in special purpose vehicles.

The issues being litigated in the NCSLT proceedings focus on whether certain actions of the residual interest holder in the Trusts were properly authorized. At this point, the legal consequences of such actions largely remain unresolved. Accordingly, the goal of the Task Force in writing this article is to raise awareness of these concerns and the possible ramifications when such concerns aren’t fully considered.

We start by summarizing the background, history and current status of these cases. We then examine issues relating to trust agreements under Delaware law, as well as more generally under securitization indenture documents. Finally, we recommend several principles to consider in drafting securitization documents in light of these cases.


Between 2001 and 2007, the Trusts acquired and provided financing for over 800,000 private student loans in aggregate principal amount exceeding $15 billion through the issuance of over $12 billion in aggregate principal amount of investor notes. Until 2009 the Trusts were owned jointly by an affiliate of First Marblehead Corporation and The Education Resources Institute, Inc. (“TERI”). In 2008 TERI went bankrupt; thereafter Vantage Capital Group (“VCG”), a Florida-based private investor, acquired (through its affiliates) the majority of the beneficial ownership interests (a /k /a, residual equity interests) in the Trusts.

Once it acquired the beneficial interests, VCG took a number of actions in its capacity as beneficial owner. In November 2015 VCG directed the Owner Trustee for the Trusts to engage counsel chosen by VCG, and to enter into a Servicing Agreement (the “Odyssey Servicing Agreement”) with Odyssey Education Resources, LLC, a VCG affiliate (“Odyssey”), to service non-performing loans for certain of the Trusts. That direction was given notwithstanding that the Trusts had pre-existing agreements with other servicers to collect defaulted loans. The Odyssey Servicing Agreement, among other things, allowed Odyssey to purchase such loans from the Trusts at a discount from market price. Then, during the course of 2015 and early 2016, Odyssey incurred more than $1.24 million in legal fees and costs allegedly conducting diligence on the Trusts’ portfolios and submitted those invoices for payment from the Trusts’ assets.

In response to the demand for payment of Odyssey’s invoices, the Indenture Trustee commenced a Trust Instruction Proceeding in Minnesota (later removed and transferred to Delaware Federal District Court) seeking judicial direction. Additional counsel were subsequently engaged at VCG’s direction for other matters, resulting in invoices for millions of dollars of additional legal fee costs, costs that were also submitted for payment from the Trusts’ assets.

These and other actions by VCG seeking to control the Trusts resulted in multiple legal proceedings spanning several states, including four lawsuits in the Delaware Chancery Court. Three of those lawsuits involve various claims and causes of action by VCG, or by the Trusts at VCG’s direction, against the Trusts’ primary and special servicers, administrator, indenture trustee, owner trustee, noteholders and note insurer, and the fourth an action by noteholders against VCG, which proceedings, not surprisingly, have now been consolidated by the Chancery Court.

Finally, independent of those actions, another perhaps even more noteworthy proceeding relating to the Trusts was commenced in 2017 by the Consumer Financial Protection Bureau (the “CFPB”). In that year, the CFPB filed suit against the Trusts in Delaware Federal District Court based on alleged conduct of the Trusts’ servicers. The CFPB also filed a proposed consent judgment, negotiated with counsel retained at VCG’s direction, that would have resulted in a broad transfer of control to VCG over the Trusts’ assets.

Description and Current Status of Relevant Litigation Proceedings

The litigation stemming from VCG’s attempts to act on behalf of the Trusts has now been pending for several years, and the litigation landscape relating to these issues remains in flux. It is therefore unclear whether any of VCG’s attempts to bind the Trusts will succeed, or whether VCG will ultimately face legal consequences for its attempts to control the Trusts without authorization from other trust parties. However, 2020 and 2021 saw material developments in several of these cases.

The Trust Instruction Proceeding pending in Delaware Federal District Court[3] initially sought instructions as to whether Odyssey was properly appointed as special servicer. Intervening investors also asserted that (x) the new Odyssey Servicing Agreement violated the clauses granting liens to the Indenture Trustee (the “Granting Clauses”) and requiring consent of the Indenture Trustee or noteholders (the “Consent Clauses”) in the Trusts’ Indentures and (y) the Trusts (acting through VCG) were engaged in self-dealing. In September 2018, the District Court ruled that the actions taken on behalf of the Trusts did not violate the Granting Clauses and Consent Clauses in the Trusts’ Indentures and that the related invoices should be paid from the Trusts’ assets.

In August 2020, the Third Circuit reversed in part,[4] holding that:

  • The Trusts (here, acting through VCG) may appoint a new servicer so long as the appointment does not violate any terms of the Trusts’ governing agreements, including those agreements’ prohibitions on improper self-dealing.
  • The Odyssey Servicing Agreement did violate the Granting and Consent Clauses because it impermissibly reserved for the Trusts (again, acting through VCG) several rights conveyed by the Granting Clause to the Indenture Trustee, including the right to replace any servicer for cause, and violated the Indenture Trustee’s right to consent to modifications to any servicing agreement and the Trust governing agreements.

The Court did not reach the issue of whether the Odyssey Servicing Agreement also constituted improper self-dealing prohibited by the Indenture, but noted that VCG “stands on both sides” of the Agreement, and that “[i]t is hard to see how such a transaction could be considered as conducted at arm’s length.”

The case was remanded to consider whether invoices submitted for payment from the Trusts’ assets are payable even if the Odyssey Servicing Agreement was invalid and thus void. The case remains pending before the Delaware Federal District Court as of the date of publication of this article.

The CFPB action in Delaware Federal District Court[5] sought, among other things, to hold the Trusts liable under the Consumer Financial Protection Act of 2010 (the “CFPA”) for alleged servicing violations and to approve a CFPB Consent Judgment entered into by VCG’s counsel purportedly on behalf of the Trusts. The Consent Judgment would have (w) placed servicing control of the entire 800,000-loan portfolio in the hands of VCG, (x) required proceeds of collections to be turned over to an account under VCG’s control, (y) authorized VCG to audit all 800,000 loans held by the Trusts, at the Trusts’ expense, and (z) required payment of almost $20 million by the Trusts in restitution, disgorgement, and civil money penalties.

The court issued two important rulings in this case in the last twelve months:

  • In May 2020,[6] the court refused to enter the proposed CFPB Consent Judgment based upon the court’s holding that VCG’s counsel had not been authorized to enter into the CFPB Consent Judgment on behalf of the Trusts.
  • In March 2021,[7] the court dismissed the CFPB’s complaint based upon findings that the CFPB initially filed the case in September 2017 when the bureau’s structure violated the U.S. Constitution’s separation of powers,[8] that the CFPB’s attempted ratification was untimely, and that the CFPB was not entitled to equitable tolling of the statute of limitations given an absence of pleaded facts showing that the bureau diligently pursued its rights.

The court’s March 2021 ruling on the motion to dismiss was notable for what it did not address. First, it did not respond to the Trusts’ important substantive arguments that the Trusts are not “covered persons” under the CFPA (although the court noted that it “harbors some doubt that the Trusts are ‘covered persons’ under the plain language of the statute”). In addition, the ruling did not address the assertion that the CFPB did not state claims against the Trusts based on alleged servicing violations, because those claims could only lie against the servicers themselves. Those arguments, therefore, remain open legal questions on which a court has not yet ruled.

The court order allowed the CFPB to replead its case by filing an amended complaint, noting, however, that it was “hardly clear” that the bureau could “cure the deficiencies noted in the memorandum opinion.” The CFPB filed an amended complaint on April 30, 2021. On October 1, 2021, after the motion to dismiss the amended complaint was fully briefed, Judge Noreika, the presiding judge, was replaced (possibly due to a backlog of jury trials) by Judge Stephanos Bibas, a 2017 appointee to the Third Circuit. Judge Bibas has indicated that he will hear oral argument before deciding the motion.

It is of course unknown at this point whether or how the change in presiding judge will affect the progress, timing and result of the CFPB proceeding.

Actions taken by or at the behest of VCG are also at the core of a series of four lawsuits involving the Trusts that have been consolidated in the Delaware Chancery Court for the purpose of resolving proposed declarations regarding certain common contract interpretation issues:[9] (1) a March 2016 action filed in the name of the Trusts (at VCG’s direction) seeking emergency authorization to compel the Pennsylvania Higher Education Assistance Agency, the primary servicer for performing loans, to provide its books and records for an audit by Boston Portfolio Advisors, a former member (along with VCG) of Odyssey; (2) a March 2018 action filed in the name of the Trusts (at VCG’s direction) against the Indenture Trustee, the Administrator, and certain special servicers alleging their failure to supervise servicing; (3) a November 2018 action filed by noteholder investors against VCG for breach of contract, civil conspiracy, and breach of fiduciary duty; and (4) a November 2019 action filed by VCG against the Trusts’ Owner Trustee, Indenture Trustee, Administrator, Note Insurer, and Noteholders seeking declaratory relief regarding various Trust constituents’ rights and certain contract interpretation issues under the Trusts’ governing agreements.

In August 2020, the Court issued a lengthy memorandum opinion containing rulings on the following subjects:

  • Ownership of Collateral and Rights to Act on Behalf of Trusts. The court ruled that the Granting Clauses of the Trusts’ Indentures convey all the beneficial interest in and the right to control the collateral to the Indenture Trustee for the benefit of the Note Insurer and the Noteholders, even pre-Event of Default. The Trusts retain legal title to the collateral and the right to exercise authority over such collateral to the extent of fulfilling the Trusts’ obligations. Until the Indenture is discharged, the Trusts cannot take any action that “derogates from the Granting Clause or otherwise violates a Basic Document.”
  • Fiduciary Duties. The court ruled that the residual interest holders owe the Note Insurer and the noteholders fiduciary duties when acting on behalf of the Trusts, or when directing Trust parties to act on behalf of the Trusts or their assets. This duty arises because of the Note Insurer’s and the noteholders’ relationship to the collateral, not because of their relationships to the Trusts. The Trusts must “regulate their conduct” and act in the best interests of the collateral’s beneficial owners, and the residual interest holders’ duty “surely entails” an obligation not to use control of the collateral to advantage themselves at the expense of the Note Insurer and noteholders.
  • Delegation of Owner Trustee’s Duties. The court held that the Owner Trustee cannot delegate its authority to agents answerable only to residual interest holders without those directions flowing through the Owner Trustee. Specifically, the Owner Trustee could not fully delegate to VCG’s counsel the Owner Trustee’s rights to approve the proposed CFPB Consent Order.
  • Other Rulings. The court’s ruling also (1) defined the Administrator’s and the Owner Trustee’s rights and obligations; (2) held that the Trusts’ governing agreements must be read as a whole, including incorporating provisions from other documents; (3) declined to issue requested declarations regarding certain parties’ rights to direct the Trusts’ activities at issue in the case; (4) issued a declaration that amendments to the governing documents require Indenture Trustee, Note Insurer, and noteholder consent; and (5) held that, to be paid by the Trusts, Owner Trustee expenses must relate to the Owner Trustee’s limited contractual duties, but that certain Administrator expenses may include Trust expenses reimbursable by the Trusts’ assets.

As of the date of publication of this article, discovery is proceeding on the remaining common contract interpretation issues. Trial on these issues is expected to commence next year.

We note that, in addition to the proceedings described above, there are or have been cases or proceedings involving the Trusts in other jurisdictions, including New York, Illinois and Florida, mostly seeking reimbursement for fees and expenses incurred by various professionals at VCG’s direction. We have, in the interest of brevity, focused on the proceedings with the greatest relevance to the concerns that the Task Force seeks to highlight.

Effect of the Delaware Statutory Trust Act

The rulings of the Delaware Chancery Court described above have highlighted some significant statutory principles under Delaware law that relate to the scope of rights of beneficial owners of trust interests. Accordingly, those rulings as well as the Delaware Statutory Trust Act need to be carefully considered by transaction participants in determining the appropriate rights of residual owners.

A stated policy of the Delaware Statutory Trust Act, 12 Del. C. § 3801, et seq. (the “Act”), is to give maximum effect to the principle of freedom of contract and to the enforceability of governing instruments (collectively referred to as the “Trust Agreement”). Although the default rule under the Act is that the business and affairs of a statutory trust are managed by or under the direction of its trustees, in practice that default rule is frequently altered by the provisions of the Trust Agreement. For example, to the extent provided in the Trust Agreement, any person (including a beneficial owner) may be given rights to direct the trustees or other persons in the management of the statutory trust. In addition, pursuant to Section 3806(b)(7) of the Act, a Trust Agreement “may provide for the appointment, election or engagement, either as agents or independent contractors of the statutory trust or as delegates of the trustees, of officers, employees, managers or other persons who may manage the business and affairs of the statutory trust and may have such titles and such relative rights, powers and duties as the governing instrument shall provide.”

In practice, the trustee of a statutory trust used in a securitization transaction retains limited discretion with respect to the statutory trust and its assets. Subject to its rights under the Trust Agreement, the trustee will act upon proper direction by the person with the authority to direct the trustee as provided by, and in accordance with, the Trust Agreement. Such direction can also require additional persons, such as investors or an indenture trustee, to provide consent to the giving of such direction. Trust agreements are often drafted so as to require such consents for non-ministerial actions, such as material changes to transaction documents adversely affecting holders; replacing an indenture trustee, administrator or servicer; selling or assigning the trust estate; and such other significant actions as the parties deem necessary. When drafting and negotiating the Trust Agreement, the parties should carefully consider what actions might require additional consents and what actions may be taken unilaterally by the person authorized to direct the trustee in the management of the statutory trust.

Section 3809 of the Act incorporates the laws of the State of Delaware pertaining to trusts and makes such laws applicable to statutory trusts, except to the extent otherwise provided in the Trust Agreement or the Act. Consequently, although trustees of a statutory trust may have duties similar to those of a common-law trustee (such as care, loyalty, good faith, candor and safekeeping of trust assets), contractual provisions in the Trust Agreement often alter those duties. These duties may not apply to those persons who have the right to direct the trustee or otherwise control the management of the statutory trust or the trust estate. However, under current Delaware case law, it is likely that such persons would have, at a minimum, a duty not to use their control of the statutory trust or control over the trust estate to their advantage at the expense of others who might have a beneficial interest in the statutory trust or the trust estate.[10]

The full scope of the duties of a directing party has not been completely fleshed out under Delaware law, but fortunately the Act provides for a method to manage such duties. The Act permits the expansion, restriction or elimination of duties in the Trust Agreement “to the extent that, at law or in equity, a trustee or beneficial owner or other person has duties (including fiduciary duties) to a statutory trust or to another trustee or beneficial owner or to another person that is a party to or is otherwise bound by the” Trust Agreement. However, the Trust Agreement cannot eliminate the implied contractual covenant of good faith and fair dealing. A provision to restrict or eliminate fiduciary duties must be clear and unambiguous in the Trust Agreement in order to be enforceable.

It should be noted that a beneficial owner’s beneficial interest in a statutory trust is freely transferable. As such, if one of the rights of a beneficial owner in the trust is the right to direct the trustee, the parties to the transaction should consider whether restrictions on transfer of that beneficial interest are needed in order to have some limits on who might exercise the direction right. Any such restrictions should be set forth in the Trust Agreement.

Transaction Documents and Other Considerations

The non-recourse, senior/subordinate structure typical in securitizations contemplates that senior security holders will have prioritized control of collateral proceeds, but that they will also benefit from other control provisions, such as the Consent Clauses referenced above. It is not surprising that the Third Circuit relied heavily on the Granting Clauses and Consent Clauses of the NCSLT indentures—provisions typical of indenture documents with this structure—in holding that the beneficial holders exceeded their authority. The potential disconnect between Granting and Consent Clauses, on the one hand, and the trust agreement provisions in the NCSLT’s transaction documents, on the other hand, was clearly a gap the residual interest holders tried to exploit.

The lessons learned in these cases are clear. Securitization documents that are not clearly drafted may inadvertently permit residual holders to claim that they should receive collateral proceeds that would otherwise be used to pay amounts owed on senior classes of notes. Any attempt by a residual holder to rely upon unclear provisions in transaction documents to settle or compromise, either directly or indirectly, claims related to trust assets could have unanticipated, adverse consequences on senior holders and trustees.

Although the marketplace has many examples of providing “first loss” holders with some level of control over asset dispositions, drafters should consider addressing the risk of a residual holder gaining control over, and title to, trust assets. For example, drafters may wish to include express restrictions on who may appoint additional servicers and the terms of such appointments, as well as conditions to payment of fees and reimbursement of expenses of such additional servicers. In an effort to avoid potential conflicts, parties should also consider whether and under what circumstances affiliation between a servicer and holders of residual interests should be permitted.

Attention should also be given to the level of disclosure provided to investors in respect of asset dispositions and the expected level of indenture trustee involvement in such dispositions. As a result of the NCSLT cases, parties should take a fresh look at existing forms with a view towards clearly and unambiguously defining the role of the indenture trustee, while reducing the possibility of conflicting instructions from different investor groups.

One notable aspect of the NCSLT litigation decisions is court reliance on the conveyance language of the “Granting” Clause. As indicated by the name of that clause, practitioners may think of the conveyance language in this clause as merely a precautionary supplement to the security interest grant. But the NCSLT courts found the reverse: that, when considered in the context of the complete trust agreements and the commercial context, the “Granting” Clause is a conveyance supplemented by a precautionary security interest. Although there are certainly structures, particularly in the consumer area, that contemplate a trustee holding record title to assets, it will be interesting to see whether the marketplace starts to re-evaluate granting clauses containing conveyance language with respect to other asset types, useful as it may have been for the NCSLT noteholders.

Finally, substantive consolidation is another important area to consider when granting residual holders any degree of control over a special purpose vehicle. Although not raised as an issue in the NCSLT cases, control over an entity of the type asserted by the NCSLT residual interest holders could be a negative fact in a substantive consolidation analysis (a discussion of which is beyond the scope of this article).

Task Force Recommendations

The series of unfortunate circumstances giving rise to the NCSLT disputes has made it apparent to many in the securitization industry, including investors and trustees as well as originators and sponsors, that:

  1. Unclear provisions in securitization documents could present unforeseen problems, inasmuch as residual owners may seek to exploit such provisions to gain control of a securitization trust in ways not anticipated by other participants.
  2. As evidenced by the NCSLT litigation, residual owner rights could involve control over trust assets and therefore raise substantive consolidation concerns.
  3. Residual owners might engage in self-dealing or have conflicts of interest.
  4. The securitization industry needs to be aware of and consider these risks in its documentation.

In all circumstances, unless specifically negotiated and agreed upon by the relevant transaction parties, transaction parties must seriously consider whether the rights of residual owners should be subject and subordinate to provisions to the contrary in any other relevant transaction documents. True to their name, residual owners are entitled to residual cash flows, but securitization documents need to be clear on the other rights of residual owners and provide adequate protection to other parties should those rights extend beyond mere receipt of cash flows. Accordingly, the Task Force recommends the following in drafting securitization documents:

  1. If residual owners are entitled to rights beyond mere receipt of residual cash flow, those rights should be expressly and explicitly addressed in the relevant transaction documents. 
  2. If residual owners are given greater rights (and notwithstanding that such rights may give rise to obligations as a matter of law), consideration should be given as to whether to pair those rights with explicit contractual obligations, so that such rights are exercised in a manner consistent with, and not contrary to, the interests of other transaction parties.
  3. Consideration should also be given as to whether the rights of transferee holders of residual interests should be more limited than those made available to the originator/sponsor.

[1] Although this is a Task Force effort, special thanks go to Richard Facciolo, Elizabeth Frohlich, Jim Gadsden, Barbara Goodstein (Chair), Ori Lev, Doug Rutherford, Andrew Silverstein, and Craig Wolson for their contributions.

[2] Montgomery, Jeff, “Chancery Suit Seeks $150M in Student Loan Trust Damages,” Law360, November 14, 2018.

[3] In re Nat’l Collegiate Student Loan Trusts 2003-1, et al., Case No. 1:16-cv-341 (D. Del) (notice of removal filed Mar. 25, 2016).

[4] In re Nat’l Collegiate Student Loan Trusts 2003-1, et al., 971 F.3d 433 (3d Cir. 2020).

[5] Consumer Fin. Prot. Bureau v. National Collegiate Master Student Loan Trust, et al., Case No. 1:17-cv-01323 (D. Del) (filed Sept. 18, 2017), and related actions.

[6] Consumer Fin. Prot. Bureau v. Nat’l Collegiate Master Student Tr., C.A. No. 17-1323 (MN), 2020 WL 2915759 (D. Del. May 31, 2020).

[7] Consumer Fin. Prot. Bureau v. Nat’l Collegiate Master Student Tr., C.A. No. 17-1323 (MN), 2021 WL 1169029 (D. Del. Mar. 26, 2021).

[8] Relying upon Seila Law LLC v. Consumer Fin. Prot. Bureau, 591 U.S. ____ , 140 S. Ct. 2183, 207 L. Ed. 2d 494 (2020).

[9] In re National Collegiate Student Loan Trusts Litigation, Docket No. 12111-VCS (Del. Ch.) (filed Mar. 16, 2016), and consolidated actions.

[10] See, e.g., Cargill, Inc. v. JWH Special Circumstance LLC, 959 A.2d 1096 (Del. Ch. 2008) (citing In re USACafes L.P. Litig., 600 A.2d 43 (Del. Ch. 1991)).

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