Third Circuit Ruling Expands CFPB's Authority Over Securitization Trusts

A recent decision by the Third Circuit Court of Appeals [1] broadens the Consumer Financial Protection Bureau's (CFPB) authority to hold securitization trusts liable for the actions of their contracted servicers. The Court's ruling departs from past practice, potentially impacting how securitization is used in consumer finance.

Background: Securitization and Limited Liability

Traditionally, securitization trusts have been structured as passive, special purpose financing entities (e.g. no employees or operational duties) to isolate trust assets from the actions of third parties, like servicers. This compartmentalization of risk is a core principle of securitization. For instance, if a loan servicer engaged in deceptive practices, the trust holding the underlying loans wouldn't be liable - only the servicer would face financial penalties.

Third Circuit's Decision and Potential Impact

The Third Circuit's decision upends this established understanding. The Court agreed with the CFPB that securitization trusts can be considered "covered persons" under the Consumer Financial Protection Act (CFPA), potentially subjecting them to CFPB enforcement actions for unfair, deceptive, or abusive acts or practices (UDAAP) committed by their servicers [2].

This ruling has significant implications for the consumer securitization market, which has financed trillions in securities backed by various consumer loans. Transaction costs could potentially rise as parties seek to manage this new liability risk, and these incremental costs may ultimately be passed on to consumers. One must presume that the CFPB fully considered these potential consequences in its pursuit of broader enforcement powers.

Looking Ahead: Unresolved Issues and Risk Mitigation

The CFPB v. NCMSLT case doesn't settle all outstanding questions. The court still needs to determine if, and to what extent, the servicers in this case violated UDAAP and whether the trust bears any liability. This means the degree of liability and resulting financial consequences for trusts will vary based on the specific facts of each case.

Financial professionals can explore options to mitigate this new risk, although the effectiveness and cost of these measures remain uncertain. For example, including indemnification clauses in contracts, if not already present, with servicers could offer some protection. Investors may also need to consider the possibility of lower returns due to increased costs.

Overall, the Third Circuit's decision introduces a new layer of complexity to consumer securitization. The full impact on the industry and consumers will depend on how future cases are decided and how market participants adapt their practices.

Footnote:

[1] Consumer Financial Protection Bureau v. National Collegiate Master Student Loan Trust, No. 22-1864 (3d Cir. 2024).

[2] See the Structured Finance amicus brief, which argued trusts are not covered persons under the CFPA.