Acquiring or originating loan portfolios: the role of back-up servicer

If you are planning to acquire or originate a portfolios of loans (whether secured or unsecured) and these need to be serviced by a third party servicer, you may want to put in place arrangements for a back-up servicer, just in case.

Back-up servicing appointments have increased significantly in recent times, reflecting a growing demand by rating agencies, originators and investors to mitigate the risk of a disruption to the servicing of the underlying assets.

This article explains the essentials of why a back-up servicer is important, on what basis a back-up servicer can be appointed, and how the appointment is usually documented.

What is a back-up servicer, and why would you need one?

A back-up servicer is a service provider who agrees to take over the servicing of a portfolio of assets on the occurrence of certain trigger events, most commonly failure of the existing servicer to perform or the servicer’s insolvency. It is typically put in place for portfolios of residential mortgages, and increasingly for commercial mortgages and unsecured loans too.

From the perspective of the legal and/or beneficial owner of the relevant assets, when it comes to the day-to-day administration of those assets, it is important that there is a Plan B if the current servicer of those assets should fail to perform or becomes insolvent. A back-up servicer who could step into the shoes of a failing servicer could mitigate the following risks:

• the possibility that collections of the receivables expected from the underlying assets are not carried out or not carried out to the standard required;
• leading on from point 1, the potential impact of disrupting the servicing of any debt raised on the acquisition of these assets as well as any payments expected by investors; and
• where the transaction is rated and the servicer suffers a downgrade, the potential default of any rating agency requirements in the underlying documents.

So what do back-up servicers actually do?

There is a little jargon involved in the appointment of a back-up servicer. A back-up servicer can be appointed on a ‘cold’, ‘warm’ or ‘hot’ basis, which signals the back-up servicer’s readiness to take the place of the existing servicer. To explain that in a little more detail:

• Cold appointment: a cold appointment of a back-up servicer is the most common type of appointment. It is generally used where the risk of the existing servicer defaulting under the terms of its servicing agreement is considered to be minimal and the parties do not expect that the servicing will need to be transferred. Underlying asset level data is stored by the back-up servicer and uploaded to the back-up servicer’s IT systems periodically but the assets and their performance are not usually monitored continuously.

• Warm appointment: a warm appointment is an increased operational standard of readiness to take over the existing servicer function. The appointment terms vary between back-up servicing contracts but under this type of appointment a back-up servicer is in a better position to transition into the role of servicer on reasonably short notice. This may involve the back-up servicer monitoring the underlying assets on a periodic basis and reporting back to the appointing party.

• Hot appointment: where there is an imminent or perceived higher risk of a disruption to the servicing capabilities of the existing servicer, the back-up servicer may be appointed to be able to service the underlying assets on very short notice (usually a week or so) and to the standard required of the existing servicer.

In practice, a back-up servicing agreement will put in place triggers that could elevate the level of appointment of a back-up servicer and the fees paid accordingly. Therefore, although the terms ‘cold’, ‘warm’ and ‘hot’ are used, the nature of the appointment is very often bespoke to the transaction to which it relates. In addition, it isn’t necessarily the type of appointment chosen but the identity of the back-up servicer appointed that will mitigate the risk of a disruption to servicer continuity. There are many servicers providing this back-up service and it is useful to look to one or more rating agency’s report(s) on the particular servicer for an indication as to whether that servicer has the capacity and skill to transition from a cold appointed back-up servicer to a fully functioning servicer in as short a timeframe as possible.

How are back-up servicing arrangements documented?

Although a back-up servicer need not necessarily be identified at the point when the loan portfolio is acquired or originated, effective back-up servicer provisions including, importantly, triggers for appointment, should be reflected in the initial legal documentation. This is to ensure that a default by an existing servicer does not lead to a failure to service the loans and any security involved.

Depending on the parties’ attitude to risk and the value of the transaction, a back-up servicing agreement can be entered into with the back-up servicer from the outset, setting out the services expected prior to back-up servicer being called upon and the transition mechanics when called upon. This has the benefit of saving time on the negotiation of the terms of that agreement at a time when the servicing of the underling assets may require a quick transition to a new servicer to minimise disruption.