The securitization industry is preparing to strike back at a U.S. Court of Appeals ruling that allows the Federal Deposit Insurance Corp. (FDIC) to ignore a credit card ABS trust contract's ipso facto clause, which would have triggered an early amortization of outstanding notes from defunct credit card issuer NextBank.
The Bank of New York, as indenture trustee of the NextCard Credit Card Master Note Trust, sued the FDIC, which was appointed as NextBank's receiver in 2001. Essentially, Bank of New York argues that the FDIC acted outside its receivership powers when it refused to honor an early amortization clause upon NextBank's failure. The District of Columbia Circuit of the U.S. Court of Appeals ruled in FDIC's favor, essentially forcing investors in NextBank's credit card ABS notes to wait longer than necessary, under the deal's original contract, to be made whole on their principal.
If the FDIC is held liable, it could be ordered to make the noteholders whole again. If affirmed by the appellate court, however, argue securitization professionals, the ruling will undermine investors' confidence in the trust agreements that bind asset securitization deals.
"The noteholders are concerned that the ruling ... would chill the use of securitization and deprive a number of worthy financings [of taking] this approach," said someone familiar with the situation.
The Bank of New York will likely appeal the decision, H. Stephen Harris, Jr., a partner at the law firm Alston & Bird, said. Furthermore, the American Securitization Forum, an industry trade association, is preparing to file an amicus brief in the pending case, hoping to educate the court about the mechanics of credit card securitization and the importance of upholding provisions designed to protect investors' interests in ABS.
NextBank was an Internet-based consumer credit card issuer established in 1999. By February 2002, before NextBank failed, it had drummed up business from 1.2 million customers - primarily subprime - whose accounts totaled about $1.9 billion. It funded itself primarily through securitization. By October 2001, the FDIC learned that NextBank's low capitalization levels and lending practices had put it at risk for failure. Later that year, the Office of the Comptroller of the Currency found that NextBank improperly accounted for poor credit quality on delinquent accounts, and appointed the FDIC as NextBank's receiver.
NextBank had issued several credit card-backed ABS deals since its inception. At stake are payments on notes issued from "Series 2000-1" and "Series 2001-1," each with four A to D tranches. Bank of New York acted as indenture trustee for NextBank. It also represented the interests of noteholders, which included large institutions such as Credit Suisse, Goldman Sachs, JPMorgan Securities, Deutsche Bank and Barclays Capital, according to court documents.
Initially, the Bank of New York did not challenge the FDIC's position. Indeed, it reminded noteholders in a letter dated a week after the FDIC appointment as NextBank's receiver that "the FDIC may have the power to prevent the triggering of automatic default or acceleration provisions, such as the Early Amortization Period, regardless of the terms of the transfer and servicing agreement, the indenture, or the instructions of those authorized to direct the indenture trustee's actions."
Further clarifying its position, the FDIC later notified the Bank of New York that, as receiver, it had the authority to enforce a depository institution's contracts, thus its appointment as receiver alone was not enough to require automatic acceleration of note repayments, and that action would be in "direct contravention of the Financial Institutions Reform Recovery and Enforcement Act (FIRREA)."
In July 2002, the FDIC notified the Bank of New York that NextBank's credit card portfolio failed to meet critical performance standards, an event that triggered early amortization under the master indenture independently of the ipso facto clause. When this began, the FDIC closed the credit card accounts by prohibiting credit card holders from making new charges and it continued to pay all noteholders monthly interest.
The FDIC claimed that the trust's ipso facto clause, which called for accelerated repayment of notes and principal, was unenforceable, according to the FIRREA, and informed the Bank of New York of its position. Enacted in 1989, the statute updated federal oversight of thrifts, among other things. Under FIRREA, the FDIC has broad powers to resolve the affairs of a failed depository institution, including repudiating contracts to which the depository institution is a party.
The definition of the term "party," and the question of whether the master indenture was beyond the FDIC's reach because NextBank never entered into it, is a major point of contention between the Bank of New York and the regulatory agency. The court, in its decision, appeared to side with the FDIC in its interpretation of its powers under FIRREA. It said the FDIC did not exercise its repudiation powers in the NextBank case, and that although the regulator declined to make accelerated payments under the ipso facto clause, it continued to pay noteholders according to the regular schedule.
"The FDIC therefore did not disaffirm or repudiate a contract,' but ignored a single contract provision," the court's decision read.
As for the outstanding ABS debt, class A and class B noteholders on the 2000-1 and 2001-1 deals recouped their principal and interest fully. Meanwhile, Class C and Class D noteholders continue to receive interest payments, and only half of Class C's outstanding principal has been repaid, according to the decision.
It is unclear whether the trust has enough funds to make the C and D noteholders whole, Alston & Bird's Harris said. The FDIC, however, could be ordered to do so if the agency is held liable on appeal.
"We think [the FDIC's action] is beyond the power that Congress gave to the FDIC," Harris said, "and that will be the central issue on appeal."
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