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tags: Methodologies & Frameworks
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# Methodology for Review of MIP6 Structured Finance Transactions

Title: Methodology for Review of MIP6 Structured Finance Transactions
Author(s): @eumenes, @christiancdpetersen
Reviewers: @williamr, @luca_pro, @sebventures, @teej, @Philinje, @Porter_Smith
Type: Proposal
Purpose: For discussion
Date Proposed: 2022-01-17

The Real World Finance Core CU (“**RWF CU**”) proposes to use the criteria in this paper to evaluate proposed MIP6 structured finance transactions (each a “**Proposal**”). The methodology and criteria below build upon the [[Informal Poll] RWF Collateral Risk Level](https://forum.makerdao.com/t/informal-poll-rwf-collateral-risk-level/12254) and the [SES Project Real-World Sandbox](https://forum.makerdao.com/t/real-world-sandbox-final-deliverable-for-consultation-round/11915) report. The criteria are intended to capture “best practice” in the structured finance market and may be considered appropriate for the on-boarding of real world collateral into Maker vaults. The RWF CU will update the Maker community to the extent of any proposed revisions to these guidelines.

When reviewing **the risk and the expected return** to Maker for investing in a specific tranche of a Proposal, RWF CU assesses the following areas to determine the ability of the tranche to pay timely interest and principal under the terms of the transaction’s legal documents at a risk level that is equivalent to Investment Grade with an appropriate return. The RWF CU, in its risk assessment, will highlight material weaknesses in light of these criteria for the Maker community’s consideration.

The criteria are intended to provide guidance to potential applicants and the operational core units of Maker DAO. These criteria remain subject to change and further input from the Maker community.

1. **Asset Manager (or, in general, the Applicant)**: has the size, structure, personnel, and resources for managing the business and implementing the investment mandate including
a. The ownership provides oversight
* Consistent professional & ethical behavior
* Reasonable ownership structure
* Reasonable governance structure
* Strategic direction
* Accountability, including
* Selection, support and review of senior management
* Strategic planning
* Financial oversight
* Legal oversight

b. Senior Management provides management including
* Consistent professional & ethical behavior
* Clear reporting lines
* Separation of duties
* Significant experience of success (& track record) investing in eligible and related assets, including origination, underwriting, structuring, servicing and portfolio management
* Experience working together **or** **reasonable demonstration of capacity to perform as a newly formed organization**
* Knowledgeable on current trends in
* Eligible and related assets
* Market financing terms and structures
* Credit performance
* Competition
* Regulation and compliance
* Mitigating key man risk

c. Ownership and Management are aligned with Maker
* Demonstrable and meaningful economic exposure given nature of transaction (measured on a relative basis)
* All third party transactions are conducted at arm’s length
* **Disclosure of all potential conflicts of interest with Maker, MKR holders, or any related party**

d. The Asset Manager has the processes, staffing and channels to source investments
* Policies and procedures
* Staffing and resources
* Active/prospective pipeline demonstrating significant scale and eligible profile of collateral

e. The Asset Manager follows investment processes at both the fund level and (individual asset) investment level, including
* Fund investment and portfolio management process
* Fund guidelines, policies and procedures including
* Strategy
* Risk appetite
* Eligible assets
* Fund concentration limits
* Use of leverage and subordination levels
* Performance benchmarking
* Ongoing portfolio management, including
* Policies and procedures
* Monitoring investments, including monitoring of originators, servicers, backup servicers and other third party service providers
* Updating fund and investment forecasts, including stress cases, as needed
* Fund and Investment valuations
* Portfolio compliance and auditing
* Workouts
* Fund and portfolio management decision process

* Individual asset investment process
* Investment underwriting policies and procedures including
* Investment strategy and risk appetite
* Originator review
* Servicer review
* Collateral performance assessment with expected and stressed performance forecasts
* Concentration matrix
* Transaction finance structure
* Transaction legal structure with bankruptcy risk analysis (see section 4 below)
* Cash flow modeling sensitivity analysis
* Surveillance and reporting
* Title or lien searches and insurance
* Individual investment decision process

* Investment personnel for fund and individual investments including
* Roles, responsibilities and reporting lines
* Separation for investment vs ongoing portfolio decisioning
* Experienced credit investors/structurers/fund managers in eligible assets
* Ability to assess, structure and price investment grade transactions
* Experience overseeing originators and servicers
* Experienced with portfolio management and workouts
* Mitigating key man risk
* Process for changing Investment Guidelines and Policies
* Process for transitioning to another asset manager if Asset Manager exits

f. The Asset Manager follows Risk Management processes including
* Policies and procedures
* Staffing and resources
* Roles, responsibilities and reporting lines
* Oversight at both fund and investment level
* Pricing/valuation at both fund and investment level

g. The Asset Manager provides reporting to the investor including
* Technology, systems and information security
* Fund level and investment level
* Frequency, accuracy and timing
* Detailed fund remittance with cash reconciliation
* Non-performing portfolio tracking and recovery guidance

h. The Asset Manager follows audit and quality control processes that address key risks to business and investment portfolio
* Policies and procedures
* Staffing and resources

i. The Asset Manager has financial controls, liquidity and funding including
* Audited financial statements for Asset Manager, funds, and borrowers
* Capital sources for funds outstanding
* Debt facilities outstanding
* Consistently profitable Asset Manager or at least 12 months operating cash on hand
* Three year financial model including required funding
* Asset under management
* Asset performance
* Personnel
* Technology and systems

j. The Asset Manager follows legal and compliance processes including
* Policies and procedures
* Staffing and resources
* Legal and Compliance framework mitigating key risks such as KYC/AML
* Disclosure of any pending corporate events, regulatory action or material litigation
* Disclosure of conflicts of interest between the asset manager and the proposed end-borrower entities
* Disclosure of litigation or bankruptcies of end-borrowers

2. **Asset Manager Historical Performance**: the Asset Manager provides a performance track record that demonstrates their ability to generate risk adjusted returns through the business cycle, including
* Fund and investment level details
* Monthly investment
* Losses analysis and rationale
* Senior and junior facility level
* Asset level
* In the eligible and related assets
* Includes gross returns, various expenses and net returns to investors
* Use of leverage
* As compared with a reasonable performance benchmark
* Auditable

3. **Transaction Financial Structure:** The proposal’s financial structure, asset base, and cash flow analysis support the timely repayment of interest and principal for the given tranche. A key initial consideration will be whether the asset pool is a static pool (fixed assets with a stated payment profile) or a revolving pool (where new assets and/or new borrowings can be added to, or subtracted from, the collateral pool, within a certain time frame). Static pools are less complex and operationally intensive than revolving asset pools. Revolving asset pools will require contractual mechanisms to ensure that the new on-boarded assets meet the eligibility criteria set forth in the financing documents and the risk retention standards are maintained.

a. Financial structure
* Cash flow diagram (DAI to USD/Other to DAI)
* Priority of payments
* Timing of funds received from assets
* Payment of recurrent transaction expenses
* Trustee or equivalent
* Servicer
* General administration
* Other senior payments such as hedging cost
* Payment of Interest
* Payment of Principal
* Prepayment provisions
* Other funds or payments
* Any payment caps/limits
* Post event of default priority of payments
* Account control
* Collateral security over SPV account(s)
* Mechanics for payments from SPV accounts
* Credit Enhancement
* Overcollateralization
* Excess Spread
* Cash Reserve Accounts
* Subordination
* Third Party Liquidity
* Performance Thresholds / Triggers
* Delinquencies (current / cumulative)
* Defaults (current / cumulative)
* Cash shortfalls
* Others
* Financial Covenants
* Asset Manager financial health
* Originator financial health
* Servicer financial health
* Borrower creditworthiness
* Audit, accounting and reporting

b. Asset Base: asset eligibility criteria and concentration limits
* Detailed investment policies and processes for the fund level
* Detailed investment policies and processes for the investment level

c. Cash flow analysis
* Expected, stressed and break even scenarios
* Detailed collateral performance assumptions such as
* Default curves
* Prepayment curves
* Replines
* Recoveries
* Interest rates

4. **Transaction Legal Structure**: each Proposal should be reflective of acceptable securitization practice in the relevant jurisdiction. Proposals in the United States, European Union, Asia-Pacific, Oceania and elsewhere will be largely driven by the legal regimes applicable to those jurisdictions.

The RWF CU will seek support from professional legal intermediaries senior/experienced in customary practice in these jurisdictions to benchmark a transaction against a market standard practice. The RWF CU clearly recognizes the potential for regulatory risks in the crypto space. Thus, the RWF CU views the transaction structure to be an evolving process guided by historical precedent.

Rather than be prescriptive as to form, the RWF CU has identified the following as important principles for any potential legal structure. **The RWF CU’s focus will be on substance over form**. Of course, certain exceptions may be appropriate from time to time in respect of “proof of concept” transactions with recognized, rated and regulated financial institutions (e.g. SocGen).

a. Avoid bankruptcy risk of the Asset Originator
* Transfer of assets from originator to a special purpose vehicle (“**SPV**”)
* True sale in form and substance to remove assets from the originator’s bankruptcy estate - transfer of equitable and legal rights
* Delivery of a true sale legal opinion from external counsel

As a legal matter, in the United States, no structure can be “bankruptcy proof” as the Bankruptcy regime in the United States grants debtors and the bankruptcy court with debtor-friendly rights and powers. The purpose of the “true sale” is to create bankruptcy remoteness.

Bankruptcy risk may be different in other jurisdictions where creditors have stronger rights during the insolvency process.

b. Avoid substantive consolidation of SPV with the Asset Originator
* Demonstrate separateness of SPV and originator in operations, governance, administration, and organizational formalities. Factors that support substantive consolidation include:
* Common ownership or control
* Common directors
* Consolidated filing of tax returns
* Consolidated accounting treatment
* Inter-corporate loans/guarantees
* Commingling of assets and business functions
* Asset transfers without observance of corporate formalities
* Common books and records, payment of liabilities, holding themselves as related entities
* Delivery of a non-consolidation legal opinion

c. SPV Characteristics
* SPV has limits on its purpose and activities
* SPV restricted from the issuance of indebtedness
* SPV restricted from the issuance of guarantees
* SPV restricted from mergers or reorganizations
* SPV restricted from changes to its organizational documents
* SPV mitigation of entity-level taxation
* SPV has an independent director
* SPV organizational documents require the vote of the independent director to make a bankruptcy filing or to amend the SPVs organizational documents
* Independent director is required to vote in the interests of the SPV and its debt securityholders
* Methodology for the removal/resignation of the independent director
* SPV restricted from termination of its existence
* Separateness covenants
* Non-petition clauses in contracts between SPV and 3rd parties

d. Transaction Considerations
* Form of SPV issuer (grantor trust, statutory trust, limited liability company, other, etc.)
* Case-by-case subject to applicable jurisdiction
* Focus on substance over form
* Most third party agents (trustees, etc.) will limit/restrict duties and liabilities (if permitted by applicable law)
* Existence of an agent to act for senior and junior security holders
* Enforcement of security holder rights
* Funds collection and distribution (e.g., Tinlake)
* Covenant Package (affirmative and negative)
* Representations and Warranties
* Payment priority
* Events of default
* Enforcement rights of security holders
* Indemnities
* Delegations of authority to third party
* Security interest / filings

e. Servicing and Collections
* SPV will require a servicing agreement for servicing and collecting on the underlying collateral
* Asset originator is typically the servicer
* Ensure servicer is a priority payment in cash waterfall
* Mechanism for the appointment of a replacement servicer
* Collection accounts
* Segregated collection account opened in name of SPV with an identified account bank
* Payments should be made into collection account
* No commingling of funds with servicer
* Define permitted investments with funds on deposit in collection account

5. **Maker Specific Issues**

a. Delaware Statutory Trust (“DST”)

The Maker community has expressed a preference for adopting the Delaware statutory trust model (“DST”) and the use of a trustee.

The DST structure may be implemented in various ways (e.g., 6S model vs standard use of a DST in many traditional securitizations with a US issuer). As the Delaware Code, in most sections, expressly provides that the trust agreement (not the statute) governs the roles, responsibilities and liabilities of the trustee, the contractual terms of the trust agreement are paramount to understand and evaluate for commerciality and risk.

The DST may be appropriate for United States transactions, but not appropriate for non-United States transactions. For instance, a DST may not be appropriate for a UK-only transaction. Further, the split of legal and beneficial ownership in common law trusts may not be familiar in civil law jurisdictions.

Given the jurisdiction-centric qualities of the Delaware statutory trust, it is perhaps more important to identify the principal qualities that the Maker community may want to see evidenced in a transaction. These might include:

* An independent, reputable, third party (not the borrower) to take action based on direction from Maker governance (or majority token holders) in certain defined circumstances (e.g., conditions precedent to disbursement of funds to borrower).
* An independent, reputable, third party to serve as paying agent (i.e. to initiate the fiat/DAI conversion for ultimate repayment to Maker and other creditors (e.g., TIN)).
* An independent, reputable, third party to hold and take direction in respect of, any assets pledged as collateral security for the benefit of Maker (and, if applicable, other creditors).
* An independent, reputable, third party to take actions directed by Maker (or majority token holders) in the case of a borrower default (sell assets, collect and distribute cash, exercise other collateral security rights, file claims, etc.).

A case-by-case analysis may be made as to whether the independent, reputable, third party needs to be:

(1) a “regulated” trustee (the definition of “regulated” may vary from jurisdiction to jurisdiction) or simply a “trustee” subject to the duties set out in applicable law; and

(2) a regulated bank with certain assets under management or other third party corporate service provider with certain assets under management (availability may vary from jurisdiction to jurisdiction).

The RWF CU, together with external legal support, will evaluate each proposed transaction in light of the standards described above and customary practice in the relevant jurisdiction.

b. DeFi Integration

The Maker protocol presents unique challenges as Maker is not a legal person and cannot sign legal documents. Further, real world assets are on-boarded into a Maker vault. Asset originators may propose various solutions to address the “DeFi integration” piece.

Any solution should be mindful of potential regulatory risks and mitigations.

The RWF CU expects the “DeFi integration” to be an iterative process of dialogue and continual learning.

c. Mixed On-Chain and Off-Chain Transactions

Some transactions may incorporate both on-chain and off-chain structuring considerations (e.g. Centrifuge). The RWF CU will have to evaluate the risks for each transaction on a case-by-case basis and develop mitigants as appropriate.

d. Administration

Each transaction should set forth a process for the administration of the underlying indebtedness. Administration of the underlying indebtedness may require more than one-level of decision-making. For discussion purposes only, this paper distinguishes between “Mandatory” decisions that require the affirmative vote of the Maker community and “Administrative” decisions that the Maker community may delegate to a person or committee of persons. The committee of persons may represent a member of the RWF CU, a person from compliance, a person from legal and/or perhaps a delegate, with such a committee acting on the basis of unanimity or majority decision-making. Majority decision-making may avoid the situation of deadlock with unanimous decision-making.

At the same time, the RWF CU recognizes the need to balance customary “administration” with the ethos of decentralization and management of potential attack vectors. This too will be an iterative process as the Maker community determines its comfort level between completely “hands-off” and very “hands-on”.

**Mandatory** decisions might include:

* Declaration of an event of default
* Exercise remedies after an event of default (other than the insolvency of the issuer which results in an automatic acceleration)
* Waiver of any default and its consequences
* Sale of collateral assets
* Change in the date for the payment of interest or principal
* Change in the maturity date
* Change in the interest rate
* Change in the method to compute principal or interest on
* Change in the commitment amount
* Creation of any liens on the collateral with a more senior priority
* Amend any agreement in a manner that may materially affect the note holders
* Trigger an asset review by a third party reviewer
* Certain specified amendment to the issuer or trust
* Changing the purpose and power of the issuer or trust
* Adding, changing or eliminating any provision of the issuer or trust’s governing documents

**Administrative** decisions might include:
* Replacement of the servicer
* Approve any replacement or successor to the trustee (or similar)
* Cure any ambiguity, defect or inconsistency in any document
* Compliance with any tax, regulatory or accounting requirements

The RWF CU will provide a proposal on “administration” for Maker community discussion.

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## Appendix

*Originator and Servicer Detailed Review*

1. Originator review
* Company and management
* Financial condition
* Controls and compliance
* Origination and sourcing
* Underwriting
* Technology

2. Servicer review
* Company and management
* Financial condition
* Controls and compliance
* Loan administration
* Customer service
* Collection accounts and cash management
* Account maintenance
* Default management - collections, loss mitigation and fraud
* Investor reporting
* Technology
* Back-up servicing analysis. Service transition analysis. Solution summary.