Loss Waterfall Disclosure

Status: v0.1 draft. This document defines the order in which losses are absorbed on default, and the invariant that bounds the maximum uncovered loss. Counsel posture confirmed by Drew 2026-06-05; counsel review per jurisdiction continues as a parallel workstream, not a build gate.

Where this sits in the Custody Framework

This document operates under Category B of the Custody Framework Charter — the escrow-only category that governs lending pool capital, loan accounts, collateral escrow, and the Circle Protection Reserve. Member vote does not apply to Category B custody; the rule is constitutional. Accounts are opened in the name of the Members' own co-operative legal form, with a multi-signature mandate held by the Lending Committee.

Category A — regular cycle contributions in single-jurisdiction Circles, which may be Member-to-member or escrow-held by Member vote — is outside this surface. Category C — Circles that cross a jurisdictional boundary — adds the escrow-only rule to all funds in those Circles; this surface inherits Category C when the Circle is cross-border.

The waterfall — in order

When a loan defaults, the regulated lending entity executes the following recovery sequence. Each step's amount is recorded on the loan's default ledger. The sum of the steps equals the outstanding balance at default.

Step 1 — Liquidate posted collateral

The collateral the borrower posted at origination is called.

Cash deposit in escrow → liquidated immediately; held until the loan-to-value haircut applied at origination is satisfied.
Pledged future hand-payout → at the next scheduled hand-payout, the pledged portion is paid to the lender, not to the borrower. Continues until pledge is satisfied or the term ends.
External asset → liquidated under the asset's own enforcement mechanism (judicial or otherwise per jurisdiction).

If collateral was sufficient to cover the outstanding balance, the waterfall stops here. Surplus is returned to the borrower.

Step 2 — Call the guarantor

If the loan had a guarantor, the guarantor is called for the consumed unsecured capacity they pledged at origination. The guarantor is jointly and severally liable with the borrower.

The guarantor may settle in full immediately and seek reimbursement from the borrower (subrogation).
Where the guarantor cannot settle in full, an installment plan is offered, on terms no harsher than what was offered to the borrower.
The guarantor's own Standing is not penalised by the call itself; their unsecured capacity is reduced by the consumed amount until they recover it.

If steps 1+2 cover the outstanding balance, the waterfall stops.

Step 3 — Set off the borrower's own stake

If the borrower held a stake of their own in the lending fund (a PoolFunder row), that stake is set off against the outstanding balance. The borrower's own staked capital reduces their own debt before fellow pool contributors are touched.

Step 4 — Lien future hand-payouts

If the borrower remains an active Member of any circle from which hand-payouts are due, those payouts are intercepted at source by the entity (in coordination with the circle's Treasurer) until the outstanding balance is satisfied or the borrower exits the circle.

The intercepted amount may be capped at a percentage of each payout (e.g. 50%) to avoid pushing the borrower into further default on circle contributions.

Step 5 — Draw the pool's reserve

If steps 1–4 are insufficient, the pool's reserve fund (typically 5–10% of pool capital, held back at origination of every pool stake) is drawn. The reserve absorbs the next layer of loss before any individual Pool Contributor takes a hit.

The reserve is replenished from future interest income.

Step 6 — Residual shared by the loan's pool contributors

Any residual after steps 1–5 is shared pro-rata among the Pool Contributors of this specific loan (per their LoanFunder.shareAmount). Pool-wide loss-sharing does not apply unless the loan's pool contributors are insufficient to absorb the residual, in which case the next layer is the entire pool's Pool Contributors pro-rata to their pool stake.

The invariant

After security and set-off, the loss remaining is less than or equal to the unsecured trust the pool deliberately extended (U). Maximum uncovered loss on any single loan is a number you set in the underwriting formula, never a surprise on default day.

In other words: when a loan is approved, the platform's loan disclosure form shows both U (the unsecured trust extended) and the projected pool contributor exposure if everything else in the waterfall recovers zero. The pool contributor's worst case is bounded by U, capped further by the pool contributor's pro-rata share.

This invariant is the single design property that makes cooperative lending defensible at scale. The math is consistent across L0 / L1 / L2 — only the parameters shift.

A worked example (L0, established borrower)

The borrower has Standing 550, three clean circles, one previously-repaid loan. The platform's formula returns:

standingBudget = 100 + 3·150 + 1·250 + 0.55·800 = £1,240, clamped to L0 ceiling £1,000
affordabilityCap = monthlyCapacity × maxTerm × DTI         (a real number from intake)
unsecuredCapacity (U) = min(£1,000, affordabilityCap) × 1.0 = £1,000 (assuming affordability ≥ £1,000)

The borrower requests £1,500. The unsecured portion is min(1500, U) = £1,000. The secured portion is £500. Collateral is posted at the required LTV.

At origination, the platform's loan disclosure shows the pool contributor side:

The 8 pool contributors of this loan are listed with their pro-rata shares.
Each pool contributor's maximum exposure on this loan (if waterfall recovers zero from steps 1–5) is their share × £1,000 = at most £125 per pool contributor.

On default, suppose:

Step 1: cash escrow recovers £525 (the secured portion gross of haircuts).
Step 2: no guarantor — skipped.
Step 3: borrower's own pool stake recovers £150 (the borrower happened to have that staked).
Step 4: future hand-payout interception recovers £200 over six months.
Step 5: pool reserve recovers £100.
Step 6 residual: £1,500 − (525 + 150 + 200 + 100) = £525, shared among 8 pool contributors.

Each pool contributor absorbs £525 / 8 = £65.62. Their maximum had been £125. The invariant held with room to spare.

What this means for borrowers

Standing is destroyed on default. The penalty in the Treasurer Tier and core Standing layer is severe — multiple cycles of recovery, not a single hit. Future unsecured borrowing capacity collapses.
A Financial Reliability Record is written. The record is portable across the platform and may be disclosed, with notice, to credit reference agencies in your jurisdiction. The record's content is documented; you have the right to see it and dispute it.
Borrowing is frozen. A minimum twelve (12) month freeze on all borrowing, including the L0 Payout Advance. The freeze may be longer where the default is large or the conduct was egregious.
Membership review. Where the default appears connected to misrepresentation or to gaming the platform's signals, membership action may be taken under the Terms of Service.
You can still dispute the default declaration itself. The dispute pathway is available. Stage 1 Conciliation is free.

What this means for pool contributors

Your maximum loss on any individual loan is bounded by the unsecured trust the pool extended, scaled by your pro-rata share.
The waterfall typically recovers a large fraction of the loss at L0/L1 — particularly via steps 3 and 4 (set-off and future-hand lien) when the defaulting borrower remains an active Member.
Pool-wide reserves and concentration caps mean a single bad loan cannot cascade into a pool-wide default unless concentration limits were breached (which the platform prevents).
Diversification is built into pool stakes — your stake funds many loans pro-rata; a single default touches only the loans it funded.

What this means for guarantors

Joint-and-several liability. The lender may proceed against you directly without exhausting the borrower first.
Your consumed unsecured capacity is at stake. That is the amount you pledged at origination.
Your Standing is not penalised for being called — only your unsecured capacity is reduced.
Subrogation right. Once you pay, you stand in the lender's place and may pursue the borrower for the amount paid.

Where this disclosure sits

This is the binding waterfall disclosure. It is referenced by every loan agreement, every Pool Contributor agreement, every guarantor consent, and every Pre-Borrowing / Pre-Pool-Contribution Risk Acknowledgement. It is the single canonical place the default order lives.

Changes to this document — including changes to the order of steps, the reserve calculation, or the invariant — are material amendments under the Cultural Architecture Policy and follow the Member-led Petitions Office process. Counsel sign-off and a Member-readable change history accompany every change.

Reminder: v0.1 draft. The order in §1 may need adjustment to comply with local creditor-protection rules — for example, some jurisdictions require future-hand interception (step 4) to follow rather than precede a court order. Counsel will confirm step ordering per jurisdiction.

Lending — Loss Waterfall Disclosure