The U.S. Court of Appeals for the Third Circuit recently held that six Delaware asset securitization trusts could appoint an additional servicer to collect loans in default, but violated the trust documents by transferring to the beneficial owners powers reserved for the trustee.
The Third Circuit also held that the agreement appointing the additional servicer was invalid because it modified the underlying trust documents and thus required the trustee’s and noteholders’ consent.
A copy of the opinion in In re National Collegiate Student Loan Trusts is available at: Link to Opinion.
The six trusts were created between 2003 and 2005 under the Delaware Statutory Trust Act. The trusts each issued notes entitling their holders to the income from the student loans purchased with the note proceeds. To secure the notes, the trusts pledged the student loans under a “Granting Clause” in documents called “Indentures” entered into with a national bank as “Indenture Trustee.”
“The Trust Agreements appointed an owner trustee (the “Owner Trustee”) to act for and manage the affairs of each Trust. The Owner Trustee in turn appointed an administrator (the “Administrator”) to aid it in discharging its duties and to take certain actions under an administration agreement (the “Administration Agreement”).”
“To fund the acquisition of the student loans, the Trusts issued Notes to the Noteholders. The Notes are backed by the loans and are paid through principal and interest payments received from student loan borrowers.”
The parties to the Administration Agreement for each trust were the owner trustee, a national bank as “Indenture Trustee” a limited liability company as “Depositor”, and a corporation as the administrator.
The Granting Clause of the indentures transferred to the indenture trustee not only the student loans securing the notes, but also “all Servicing Agreements and all Student Loan Purchase Agreements, including the right of the Issuer to cause the Sellers to repurchase[,] or the Servicer to purchase, Student Loans from the Issuer….”
The indentures also required the trusts to “maintain an arm’s length relationship with … of any the [Trusts’] Affiliates” and “avoid the appearance of conducting business on behalf of any Owner or any Affiliate of an Owner … [and] require[d] the consent of Noteholders and the Indenture Trustee in order to ‘waive, amend, modify, supplement or terminate’ and of the Basic Documents.”
At the outset, the trust documents only provided for the servicing of performing student loans, not those in default, because the loans were guaranteed by a Pennsylvania agency. However, in 2008 that entity went bankrupt, and in 2009 the trusts “entered into a ‘Special Servicing Agreement’ [with a third party (the “Special Servicer”)] for the purpose of servicing two categories of non-performing student loans, ‘Defaulted Loans’ and ‘Delinquent Loans.’” The Special Servicing Agreement provided that the indenture trustee would replace the special servicer if the latter resigned.
In 2012, the special servicer “was sold” and it resigned, thus making the indenture trustee the special servicer.
During the indenture trustee’s tenure as the special servicer, the trusts alleged that “over $1 billion of loans … bec[a]me uncollectable due to the expiration of the relevant statute of limitations and over $4 billion of loans … defaulted [and] [t]he trusts are paying servicing fees in excess of any revenues they can collect on the Defaulted Loans.”
“In addition, lawsuits filed by [the indenture trustee acting as the special servicer] against borrowers for collection on Defaulted Loans were dismissed due to faulty documentation and procedures, and subsequently the Trusts were sued in both class action suits and by individuals for illegal collection practices.”
The owners then hired a third loan servicer in 2014 in order to “mitigate losses” (the “Odyssey Agreement”). At that time, “the beneficial owners of the Trusts were an affiliate of [a national bank] and an affiliate of [the entity named as] “the authorized representative of the Owners in connection with the … transaction.” In 2017, one of the member-owners of the third loan servicer resigned, leaving the remaining member as “the majority equity owner of the Trusts and the only owner of [the third servicer, leaving] one entity doing the pooling and the servicing of the student loans.”
The trusts then asked the indenture trustee to approve the hiring of the third loan servicer, but it refused, arguing that “the Odyssey Agreement unilaterally, and thus impermissibly, amended the Basic Documents” and was thus incompatible with the Special Servicing Agreement.
“In December 2015, the Trusts submitted more than $1.24 million in invoices from the [third loan servicer] for payment from the Indenture Trust Estate … [for] services such as conducting audits and other work to evaluate which Defaulted Loans could be sold.” The administrator “refused to process the invoices and requested additional information[,] [sending] the invoices to [the] Indenture Trustee, complaining that no documentation was provided for the alleged expenses.”
In 2016, the indenture trustee filed suit in state court seeking a declaratory judgment whether the third servicer was improperly appointed, invalidating the Odyssey Agreement “because it would amend or modify the [trust documents], and whether the invoices submitted [under the Odyssey Agreement] should be paid.”
The trusts removed the case to the federal court, and the matter was later transferred to a trial court in the Third Circuit. After discovery, the parties filed cross-motions for summary judgment.
The federal magistrate judge issued a Report and Recommendation (“R&R”), recommending that the trial court “grant the Trusts’ motion for summary judgment, deny [the indenture trustee’s] motion, and order that the Odyssey invoices be paid.”
The indenture trustee and the noteholders filed objections to the R&R. In response, the trusts argued “that most of their objections raised new arguments not presented before the Magistrate Judge, including that the Granting Clause precluded the Trusts from hiring [the third servicer].”
The trial court “essentially adopted the R&R in its entirety and held that arguments not presented to the Magistrate Judge were waived.”
On appeal, the Third Circuit began by discussing the standard of review, explaining the difference between interpretation and construction of a contract. “[C]ontract interpretation is a question of fact reviewed for clear error and construction is a question of law reviewed de novo. … Contract interpretation involves determining the meaning of the contract language and giving effect to the parties’ intent. … Construction of a contract goes beyond interpretation and requires determining the legal effect and consequences of contractual provisions.”
The Court then found that the case before it raised issues of contract construction because the meaning of particular terms was not disputed. Instead, it had “to determine the legal effect of and interplay between various provisions of the [trust documents] and the Odyssey Agreement.”
The Third Circuit agreed with the indenture trustee and the noteholders that the Odyssey Agreement violated the indentures’ Granting Clause, “not because the plain language of the Granting Clause prohibits the Trusts from appointing a new servicer, but rather because the Odyssey Agreement specifically assigned to the Owners of the Trusts several rights reserved for the Indenture Trustee, for the benefit of the Noteholders” in the trust documents.
The Court rejected the trusts’ argument that the indenture trustee and the noteholders “waived their argument that the Granting Clause precludes the Trusts from entering into the Odyssey Agreement.” First, the Court reasoned, “the Trusts misrepresent that the [trial court] held that the Granting Clause argument was waived” because it expressly held “that ‘the granting clause does not preclude the trusts from appointing new servicers.’ It recited the standard for waiver but “did not hold that there was waiver.”
Second, the Third Circuit reasoned, “the Noteholders argued to the Magistrate Judge ‘that the Odyssey Agreement violates the grant of the Indentures,’ … and joined [the indenture trustee’s] submissions on summary judgement, which include arguments that the Odyssey Agreement violated the Clause.” Thus, the Court found that “[o]n this record, the Trusts cannot claim the Granting Clause argument surprised them.”
Finally, the Court reasoned, “even if [the indenture trustee and the noteholders] had not clearly raised the argument, we have discretion to consider whether the Odyssey Agreement contravenes the Grant of the Indenture (something we would do if needed), which presents a ‘pure question of law….”
Next, the Third Circuit found that the plain language of the Granting Clause did not prohibit the trusts from appointing a new servicer because the language was not absolute and did not “divest the Trusts of their power and responsibility to appoint servicers.”
In addition, the Court noted, the trusts retained certain obligations under the trust documents, including the “obligation ‘to enter into such agreements that are necessary’ to ‘provide for … the servicing of the Student Loans” and the Granting Clause stated that ‘none of the obligations’ of the granting party are transferred….” The Third Circuit held that “reading the Granting Clause here to prevent the Trusts from hiring a new Servicer would render meaningless” the other provisions of the trust agreements …, “including, inter alia, their right and power to hire, designate, and appoint the Special Servicer …, to direct audits on behalf of the Trusts, … and to protect the Trusts and take action if they become aware of a servicer default….”
“Because the Granting Clause does not state that it divests the Trusts of their power and obligation to appoint servicers and because interpreting the Clause to do so would render several other provisions of the Basic Documents not effective,” the Court held that “the Granting Clause does not categorically prohibit the Trusts from appointing another servicer.”
The Third Circuit cautioned, however, that “[t]his conclusion does not end our analysis” because the fact that “the Trusts still have authority to appoint a new servicer does not mean that the Odyssey Agreement specifically does not violate the Granting Clause.”
The Court then agreed with the indenture trustee’s and the noteholders’ argument that “the Odyssey Agreement impermissibly reserved for the Trusts several rights that the Granting Clause conveyed to the Indenture Trustee, including, among other things, the right to replace [the third servicer] for cause …, and the right to direct [it] to act free from liability to the Indenture Trustee….”
In addition, the Third Circuit found that “the Odyssey Agreement impermissibly modified and supplemented the Basic Documents” without the indenture trustee’s and noteholders’ consent, holding that “the District Court’s conclusion [to the contrary] contravenes well-settled New York law … [u]nder [which] parties to contracts cannot do anything that ‘will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.’”
In particular, the Odyssey Agreement “had the effect of altering the Basic Documents even if there was no formal amendment” because it allowed the third servicer “to purchase Defaulted Loans at a ‘purchase price’ that is 10% less than fair market value of the Defaulted Loan, in other words, to retain a 10% commission for arranging for the sale of the Loan.”
The Third Circuit went on to list “several additional provisions of the Odyssey Agreement that modified the terms” of the trust documents without the required consent of the indenture trustee and the noteholders before holding that “the Odyssey Agreement violated the Granting Clause and the Consent Clause” of the indentures.
Finally, because the trial court did not “consider whether the invoices would be payable if the Odyssey Agreement were invalid and thus void[,]” the Third Circuit remanded the case for the trial court “to decide in the first instance whether Odyssey’s invoices are payable.”