SecuritizationIssues: - liquidity support and credit enhancement - profit extraction - overcollateralization - recharacterization (true sale) - substantive consolidation - other originator insolvency issues (deals under value, preferred, etc) - risks associated with methods of transfer - risk of insolvency of the SPV (non-petition, limited recourse) - subordination of creditorsSecuritization, unlike term loans, concerns not the balance sheet strength of a particularborrower, but performance of a specific pool of assets. Debt raised is more likely to be bonds orother transferable securities, the intention - securities created are liquid securities, and tradedrather than held on balance sheet. Emphasis in structuring such transactions - on assets involved,the cashflows generated by those assets, and isolating those assets from the risk of insolvency ofthe originator. The originator sells the assets to another entity not connected to it (usually anSPV), the purchase price is raised by a syndicated loan or bond issue; investors agree that theonly source of payment for the syndicated loan or the bonds is the cash generated from the loan.DD is on the assets, not the SPV + if originator goes insolvent, it wouldn’t affect SPV’s rights tothe assets.Originator – (assets for money) – SPV – borrows money through bonds/syndicated loan –Investors (get payments on bonds, source – underlying assets).Assets capable of being securitised – mortgages, finance and operating leases, real estate leases,trade receivables, conditional sale/hire purchase receivables – generally, any stream of income,whether or not interest-bearing.Process: 1. Select the pool of assets; 2. Establish SPV; 3. Raising of funds by the SPV tofacilitate the purchase or funding of receivables from the originator; 4. Theservicing/administration agreement - originator will normally be appointed asservicer/administrator of the assets - gives the originator the benefit of an uninterruptedrelationship with his customers; administrator must provide info on performance of the assets,collect receivables on behalf of the SPV; 5. Liquidity support and credit enhancement techniques(overcollateralization – type of CE); 6. SPV pays to O excess income from assets which is notpaid to bondholders, either as servicing fees or high interest rate on subordinated note or othermeans.Advantages for O: 1. Accounting treatment - O can raise money without loan appearing on itsbalance sheet – it has less assets and less liabilities => more borrowing capacity;2. Capital raising – O gets money now + excess spread: interest SPV receives on assets is oftenhigher than that paid to noteholders, O receives the excess by different ways of profit extraction,e.g., O holds the most junior note with a high interest rate. Cheaper capital – (than bonds andloans) – junior tranches of notes bear the first loss, so the senior ones are rated AAA, therefore,carry low interest rate.3. Regulatory (capital adequacy requirements).Disadvantages: 1. O tend to transfer their best receivables, which may affect their own ability toissue unsecured bonds; 2. Expensive; 3.Technical – as there must be real transfer of risk of thereceivables; 4. Debtors may object to change of creditor.Issues arising under Insolvency LegislationAlthough the English courts will normally give effect to a sale transaction and not recharacteriseit as a secured lending, per the Exfinco case, transactions may still be overturned by insolvency
laws intended to protect the interests of creditors of an insolvent. If the O goes insolvent,administrator/liquidator may attack transactions and reclaim property under the Insolvency Act1986. Any transfer of assets must be considered against the possibility of the insolvency of theO. 3 sections of the Insolvency Act 1986 to be addressed when considering a securitisation ofassets with English originator: 1. 238 - transactions at an undervalue – unlikely to be an issue in S. – Applies only if the seller was insolvent at the time of the sale, or becomes insolvent as a consequence of the sale, if the sale was to a connected person, if the sale was within two years of the onset of the insolvency. Involves sale of assets for a consideration that is substantially less than the value of the consideration given by the seller. In S purchase price is not equal to the face value of the assets, but is calculated on the basis of the present value of the assets. If discount factor was unnaturally high, then an issue may arise. Court won’t make an order if the company entered into the deal in good faith and for carrying its business, and that at that time there were reasonable grounds for believing that the transaction would benefit the company 2. 239 –preferences. Preference is given to a person if it’s one of the originators’ creditors, surety or guarantor of any of its liabilities, when the Co does something that puts this creditor in better position in case of liquidation of the Co. Court won’t order unless the Co giving preference wanted to produce this effect.The act by the Co should be done within 6 months prior to onset of the insolvency, or 2 years (recipient - connected person); Co insolvent at the time the preference is given. Unlikely in case of S, cause SPV is unlikely to be a creditor of the originator at the time of any purchase, and the originator is unlikely to be influenced by a desire to improve the position of the SPV. Section 239 should be borne in mind – e.g., in a revolving purchase where the originator may retain the SPV’s cash over a period, or where SPV lends to the originator. 3. 423 - transactions involving a fraud on the creditors – applies regardless of whether originator is insolvent at the time of the transfer; only if the purpose was to put assets beyond the reach of any person that can make a claim – also unlikely to be applied to S. Hill v Spread Trustee Company v another  – the court said it is a subjective test – it needs to be proved that the person (not just a reasonable person) actually had this purpose. 4. if a floating charge is taken over the assets - Section 245.Cross-Border Insolvency Regulations: if the O is outside UK/its constituent jurisdictions, theliquidator/administrator may under Model Law on Cross-Border Insolvency commenceproceedings for recognition of the foreign proceeding under the insolvency laws of theapplicable jurisdiction, if a foreign proceeding takes place where the centre of its main interestsis (reg.office), or where its establishment (place non-transitory economic activity) is.Substantive consolidationNo formal doctrine of substantive consolidation under English law. It is rarely applied ifdirectors of a company act bona fides in the best interests of the company, except for fraud, orillegal or improper purpose. To avoid consolidation of assets of the originator with SPV: 1. SPVmust not be its subsidiary; 2. the requirements of FRS 5 must be met.True sale1. Absolute transfer of the assets from the Originator to the SPV; 2. Risk of recharacterisation ofsuch transfer as a secured loan (SPV to originator secured by assets); 3. Risks of set aside of thesale of the assets;
Importance of true sale: 1.Removal of assets from ownership of Originator - removal of O risk;2. Accounting, capital adequacy/regulatory treatment of O; 3. Contractual restrictions on O eg:negative pledge in existing financing documents.Recharacterisation – implications: 1. O doesn’t obtain regulatory/accounting treatment; 2.security will be void against a liquidator – no registration as per CA 1985 (395); 3. The moneywill be treated as unsecured loan and SPV will have an unsecured claim against O upon itsinsolvency. 4. the money secured by the charge (price paid by the SPV) becomes repayable by Oto the SPV – because when a charge becomes void, the money secured by it immediatelybecomes payable.LawRe George Inglefield Limited (1933)- differences between a sale and a secured loan:1. in sale the seller is not entitled to get back the subject matter of the sale by returning thepurchase price; 2. SPV doesn’t have to account to O for the surplus if he sells assets for a sumexceeding the amount paid to O; 3. If SPV sells assets for a sum below the amount paid to O,SPV cannot recover the balance from O.Welsh Development Agency v Export Finance Co (1992)–whether relations btw Exfinco andParrot constituted a sale or secured loan:- CA heldit was a sale - a transaction should be giventhe commercial effect intended by the parties according to documentation, if they’re not a sham.Provisions in the deal docs similar to those in secured financing did not exclude that this is asale. The court looked at the document as a whole – but it is not recommended to include in asale document any number of provisions included into loan docs. Points to look at: 1. Profitextraction; 2. Recourse to O (when can be made); 3. O’s right to repurchase assets (Notobligation to repurchase after breach of warranty).Ownership of SPV – important because: 1. Rating agency concerns; 2.Substantive consolidation(UK SPV’s assets being consolidated with a US parent).Insolvency remoteness of SPV1. Investment decision based on the value of SPV assets; 2. Rating perspective; 3. London listingrequirements - if no three year trading record - need project or full guarantee or issue out of anSPVAchieved through: 1. Restrict activities/indebtedness through constitutional docs; 2. Noemployees; 3. Identifiable group of creditors; 4.Limited recourse against SPV (contractualprovisions + security); 5.Non-petition; 6.Claims of creditors through order of priorities; 7.No USparent of the SPV.Limited recourse – 2 wordings: 1. Debt doesn’t become due; 2. Debt becomes due, but isrecoverable to a certain extent – this option is better, otherwise security cannot becomeenforceable unless debt falls due. When the assets are exhausted, docs should provide that thedebt is extinguished to prevent insolvency of SPV.Liquidity supportDesigned to smooth payments because of mismatches, not to make up for defaults.For short-term cash flow difficulties (e.g., interest payments on the bonds) –liquidity facility, ifthe SPV doesn’t have sufficient immediately available cash (e.g, if the dates of bond interestpaymentsdo not coincide with the dates when payments of interest on the underlying assets arereceived, or increase in payments on the bonds which is not matched by interest payable by theunderlying debtors). LS is taken into account by credit rating agencies when they assess thedeal, so the relevant banks should also have good ratings (same for CE).Credit enhancement
Concerned with long-term financial viability of the SPV. Methods: 1. Over-collateralisation–sale of more receivables than are needed to cover the funding loan, or sale at a discount;providesSPV with a cushion of additional assets in excess of its liabilities on the bonds. Can beaccompanied by an option to the O to buy back the remaining assets at the termination of S. Ifoption is exercised – the amount payable by O for the remaining assets will be off-set againstremaining liability of SPV to pay for the over-collateralisedpart of assets. 2.Subordinated loansor deferred prices– O may make sub.loan to the SPV, limited in recourse to available assets,ranking behind the bonds in the right of repayment. O may also defer payment of the price forassets. Alternative or additional – bonds to be ranked (rights under some bonds subordinated toother bnds).3. Use of spread accounts (Reserve account)–by which the sum received by SPVfrom the assets is greater than its expenditure, so that gradually a cash pool is built up.4.Guaranteed investment contract -fin.institution pays a rate of return on spare cash held bySPV equal to at least the interest payable by SPV on bnds. 5.Derivatives (interest rates, swaps)contracts btw SPV and fin.institutions – to provide hedging to protect SPV against adverseinterest or currency rates. This method is required if SPV is at risk (e.g., underlying portfoliocarries interest at a fixed rate and bnds carry interest at a floating rate). E.g. interest swap – bankfor a fee pays floating/fixed to cover fixed/floating mismatch btw the interest rate of thereceivables and funding loan. 6. Guarantees (obligations to purchase defaulted receivables,letters of credit, irrevocable and unconditional obligations to lend provided by a third party).Security given by SPV–protection against the consequences of insolvency of SPV –SPV givesin favour of security trustee (ST) to secure the creditors. ST holds security and acts on behalf ofbondholders, providers of liquidity facility and CE. Security secures all of the SPV’s obligations(current/contingent) and covers its present and future assets. The principal element of SPV’sassets – assets bought from O. So far as it is possible, security will be fixed, but part of it may besubject to floating charge. Security holder (chargee) may appoint an administrative receiver ofthe SPV (charger); the adm.receiver owes its primary responsibility to the chargee. Suchappointment blocks appointment of administrator, and directors of eligible co to obtainmoratorium in the context of making a proposal for co’s voluntary arrangement - these 2 actionsmay prevent the chargee from enforcing security.Tranching–issue of senior/junior notes (junior carry higher rate), object –increase availablefinance + since the first loss is borne by junior notes, senior notes can be rated AAA. Loss firstaffects the junior bonds before senior tranche is prejudiced. Proceeds of assets are paid in asequential order from senior to junior, as per waterfall clause. Noteholders don’t have recourse toSPV’s assets, only the collateral; only the trustee can enforce. Result – noteholders look to thecollateral in an order, if it’s inadequate – no claim against SPV.Profit extraction –methods: 1. SPV defers part of the price to O until senior notes are fullypaid - usual method. Deferred purchase price is subordinated to senior and junior notes. Similar– subordinated loan from O to SPV OR SPV buys most junior notes of SPV (equity piece).Profit – very high rate of interest on the deferred price.Holding of junior notes – deducted fromO’s capital for capital adequacy purposes. 2. Servicing fees for administration of assets.Risks associated with methods of transfer: 1. Legal assignment – problem: giving notice to alot of underlying borrowers; 2. Equitable assignment: (a) SPV has no legal title – has to join theO as co-defendant; (b) lack of notice – priority of creditors (Dale v Hall); (c) lack of notice – set-off risk (until notice is given, borrowers continue to get a good discharge paying to O and haveset-offs with O); (d) money tracing problem – SPV may claim money on O’s account in case ofO’s insolvency – but the money could be dispersed. Solution – take a security or trust over theaccount (but you also have to motivate the liquidator to obtain money payable by the borrowersfor you). 3. Declaration of trust–O declares trust over assets – SPV cannot sue directly. If O’s
insolvent, liquidator needs to be motivated to pursue the money. Solution – liquidator makessome money from obtaining the money for the SPV. 4. Novation –needs consent of all parties,which can be obtained in the loan contract (Carlil and the Carbolic Smokeball); the only way totransfer obligations; most common method, since it’s a clean transfer and works for capitaladequacy. 5. Sub-participation – double credit risk (risk of non-payment by the underlyingdebtors and that of the O) – means that securitization wouldn’t survive O’s bankruptcy. Solution(?).Subordination of Claims: 1. paripassu principle; 2. does it apply where debt is secured? 3. legalopinions. 4. Non-petition language - does it work.Question on risks of securitization (including for investors): 1. Risks in the portfolio (poor performance) – credit enhancement, liquidity support 2. Risk of upsetting the transfer (re-charectarisation – case law; originator liquidation – cases when liquidator may claw back assets; substantive consolidation – only if US parent, importance of SPV ownership) 3. SPV’s insolvency risk (prepayment risk for the investors, but not the risk of non-payment – investors have security), ways to mitigate it.