United States: The Future Of Auto Lease Securitization ~ Part 1
For years, participants in the securitization market have predicted a dramatic increase in the issuance of auto lease-backed securities. This article examines the "retitling problem," the most important reason this increase has failed to materialize; the use of titling trusts to solve the retitling problem; and issues that arise in the creation of a titling trust and the securitization of auto leases.
Auto leasing has quickly become popular among consumers, particularly for luxury autos. As new car prices have become less favorable for the average consumer, people have jumped at the opportunity to drive a better car with little or no down payment and to make monthly lease payments that are lower than the loan payments would be if they had bought the car. The people who always want to drive a new car rather than an older car normally would sell a car after two or three years and invest the proceeds in another new car. Because drivers who lease vehicles do not have to finance the residual value of the vehicle, leasing lets them avoid "overpaying" during the years they own the car just to receive the trade-in value when they buy their next car.
The benefits of leasing have become so attractive to consumers that many finance companies now have started to lease used cars too.
A. Auto Loans vs. Auto Leases
Most auto lessors have only recently become involved in auto leasing. Traditionally, their business has been making auto loans to finance auto purchases by consumers from auto dealers. Consequently, most leasing practices are derived from the originator's loan practices. In fact, one of the reasons auto leasing has been so successful is that finance companies have made leases and loans so similar for dealers that the dealers are indifferent between the two.
There are a few differences between the origination of an auto loan and an auto lease. Let's assume the agreed price is $30,000. In either case, after the customer selects a vehicle, the dealer walks the customer to the dealer's finance office in the back of the showroom. In either case, the customer completes a credit application. The customer is then asked to sign a form contract. For a loan, the form is labeled "retail installment sale contract;" for a lease "retail lease agreement." In both cases, the customer drives away with a new car. In both cases, the dealer completes and signs a box at the bottom of the form assigning the contract to the finance company.
In both cases, the dealer completes various documentation to be filed with the state Department of Motor Vehicles for a certificate of title to be issued. Here there is an important difference. In the case of a loan, the certificate of title is issued in the name of the customer as owner with the finance company listed as lienholder. In the case of a lease, the certificate of title is issued in the name of the finance company as owner.
Most important, in both cases, the dealer promptly receives $30,000 from the finance company. Consequently, just as for a loan, the finance company needs to finance a $30,000 investment. If the finance company plans to securitize its loans or leases, it wants to securitize its entire $30,000 investment.
B. Residual Values
The most important change in the leasing market is the rise of the short-term lease. Most auto leases today range between 24 and 36 months. Because a typical vehicle has a useful life of seven or more years, there is a substantial residual value in the vehicle, often more than 50% of the original cost of the vehicle. The large residual value enables the finance company to keep the monthly payment as low as possible. Residual values generally are determined through the use of the "Automotive Lease Guide", or ALG, which the automotive industry relies on as a predictor of the value of each specific make and model of vehicle at any time in the future. Using the ALG, the leasing company can obtain an estimate of the residual value of the vehicle after expiration of a two- or three-year lease, expressed as a percentage of the manufacturer's suggested retail price (MSRP).
If the originator desires to finance its lease portfolio, the combination of a low monthly payment and a significant residual value make it imperative for the originator to finance not only the leases but also the residual value. The residual value, however, by itself is not a receivable. Instead, it is received only when the car is sold at the end of the lease. Many of the complications of lease securitization result from the attempt to securitize the residual value of the vehicle.
C. Incentive Programs
There are a number of incentives that can be offered in a lease program. Typically these incentives are designed by the automobile manufacturer, but they may also be offered by the automobile finance company. For example, the manufacturer could attract customers by lowering monthly payments under the lease and raising the residual value from, for example, 50% to 60% of the MSRP. The manufacturer generally agrees to compensate the finance company for any losses the finance company sustains based on the difference between the present value of the actual residual and the present value of this increased residual.
The automobile manufacturer or finance company could also attract customers by lowering the implied finance charge on the lease contract, much as it does with low interest rate retail installment sales contracts. Incentive programs will generally expose securitization transactions to the credit risk of the automobile manufacturer or finance company providing the incentives, and may present true sale issues if the incentive is provided by the seller of the receivables.
Dealers or automobile manufacturers may also actively encourage lessees under lease contracts to purchase, trade in, or refinance leased vehicles in the last year prior to maturity of the lease. World Omni Financial Corp. (WOFCO) recently disclosed that fewer than 20% of the leases scheduled to terminate in a year are actually returned to World Omni 1.
Lessees or dealers may typically prepay or buy out a lease by purchasing the vehicle for the remaining principal payments under the lease plus the contractual residual value and a small processing fee. Under such an early lease termination, there will generally not be a residual loss because the full residual value is being paid by the lessee or the dealer. A proactive lease termination program should reduce the finance company's residual value risk, but will shorten the weighted average maturity of a securitization transaction.
II. The Goal: Avoiding The Originator's Bankruptcy Risk
One of the most important reasons for issuers to securitize their assets is to obtain a lower all-in cost of funds with which to finance their businesses. The lower cost of funds is possible only if the originator is able to isolate the financial assets sought to be securitized from the bankruptcy risk of the originator's business so that purchasers and investors may instead focus solely on the economic risks of the portfolio being securitized. Quite often, even an extremely low-rated originator may originate financial assets that (when properly credit-enhanced) are considerably more creditworthy.
For example, suppose an originator has gone through a leveraged buyout and subsequently securitizes a receivables portfolio. The rating obtainable for a properly credit-enhanced portfolio in this circumstance may be three or more levels above that of the originator and the nominal rate of financing several multiples of 100 basis points below the leasing company's cost of funds.
In the case of most persons subject to the Bankruptcy Code 2, one normally understands isolation to mean that the sold financial assets will no longer be part of the seller's or originator's bankruptcy estate (and thus usually not subject to the jurisdiction of the Bankruptcy Court) 3. To remove assets from the bankruptcy estate of an originator or seller, the purchaser must insure that the transfer constitutes a "true sale" and not, in substance, merely a secured financing. That is, the characteristics of the transfer must more closely approximate a sale as opposed to a mere secured financing. While there are a variety of cases on the subject, none is dispositive, so enormous amounts of time and energy are spent structuring securitizations to comply with this elusive concept.
The reasons for this, in turn, are the automatic bankruptcy stay and, under the Bankruptcy Code, the court's power to alter materially even a secured party's rights in financial assets serving as collateral for an extension of credit. These powers include the power to (1) reduce the amount of financial assets that secure indebtedness; (2) substitute different kinds of collateral (such as inventory or closed manufacturing plants) for financial assets or cash collateral; (3) grant a new "super priority lien" which is senior to the lien of the secured creditor; (4) stay the payment to the secured creditor of cash proceeds from collateral that secures its debt; (5) reject the leases or any "executory" contracts (such as a servicing agreement) that the debtor may have with the lender or purchaser or that are appurtenant to the financial asset collateral; (6) substantively consolidate the bankruptcy of the debtor with that of an affiliate so that the assets of each are subject to the liabilities of each; and (7) alter the secured party's rights as part of a bankruptcy plan of reorganization.
All of these actions the court can take would increase the riskiness of the investment or delay payment to the secured creditor. That's why for a securitization deal to have a rating higher than the originator's rating, you need to have a "true sale."
A. The Retitling Problem
A typical securitization of financial assets might have this structure:
Step One: The originator would sell the assets to a newly-formed, bankruptcy-remote subsidiary (the "Sub") in a transaction structured to be a "true sale" for bankruptcy purposes.
Step Two: The Sub would transfer the assets to a trust (the "Securitization Trust") in exchange for securities issued by the Securitization Trust.
Step Three: The Sub would sell the securities either directly to investors in a private placement or to underwriters in a public offering.
Exhibit 1 diagrams the typical securitization structure. When ordinary accounts receivable or chattel paper are securitized, the transfers required by the first two steps can often be completed with a simple one-page assignment document. A motor vehicle, however, can be transferred only if (1) the originator signs the back of the certificate of title and certifies the odometer reading, and (2) the transferee applies for a new certificate of title in its own name. The procedures are time-consuming and require some effort and expense, particularly on a large scale. The retitling fees payable to the state Departments of Motor Vehicles ("DMVs") alone often would be prohibitively expensive. This problem is commonly referred to as the "Retitling Problem."
The solution to the Retitling Problem is the "Titling Trust." A Titling Trust is a trust formed to purchase vehicles and leases directly from dealers. Title to the vehicles is then held by the Titling Trust. The originator is never listed on any certificate of title, but owns a beneficial interest in all leases and related vehicles that have not been securitized. At the time of a securitization, instead of transferring the leases and related vehicles to a Securitization Trust, the originator transfers a beneficial interest in the trust to the Securitization Trust. In most states, there is no need to undertake the effort and expense of retitling the vehicles because the legal owner of the vehicles, the trust or trustee, does not change.
To form a trust, the person forming the trust, also known as a "grantor" or "settlor," signs a trust document conveying property to the trust or the trustee, and provides that the property, and any additional property to be held by the trust in the future, will be held by the trust for the benefit of the trust beneficiaries. The grantor can provide that beneficiaries will share some or all of the property, or that different beneficiaries will have interests in different property. The interest of a beneficiary is called a "beneficial interest" in the trust.
In a simplified example, we can imagine a family with three children named Arthur, Barbara, and Charlie. Assume their mother wants to form a trust for the children. She deposits into the trust her furniture for Arthur, her clothing for Barbara, and her jewelry for Charlie. The terms of the trust permit each beneficiary (each child) to have access to the particular assets held by the trustee for him or her, but not to the assets held for the others. Each child is entitled to require the trustee to transfer his or her assets to him or her or to any third party designated by that child. Each child can also transfer his or her beneficial interest in the trust to third parties. For example, if Barbara transfers her beneficial interest in the trust to a third party, the third party becomes entitled to all rights to the clothing, but Arthur's and Charlie's rights with respect to the furniture and jewelry are unaffected. This is exactly how a Titling Trust works.
In a Titling Trust structure, it is the Titling Trust, not its sponsor, that is the originator. The Titling Trust buys the leases and related vehicles from dealers. It hires the sponsor as a servicer to originate the assets on its behalf, to collect lease payments, to enforce the leases and to receive and sell the vehicles at the termination of the lease. All leases (and related vehicles) that have not been securitized are held by the trust for the benefit of the sponsor. At any time, the sponsor can select a list of leases and related vehicles to be securitized and divide its beneficial interest in the trust into two components, a beneficial interest in the securitized leases and vehicles, and a beneficial interest in those leases and vehicles that will continue to be held for the account of the sponsor.
Exhibit 2 is a diagram illustrating the contractual structure and obligations of a titling trust.
Mechanically, the securitization would be completed by following the three steps described above. The asset to be securitized is the specific beneficial interest representing rights in the securitized leases and vehicles. This specific beneficial interest would be sold in a "true sale" to a special-purpose, bankruptcy-remote subsidiary. The subsidiary then transfers the beneficial interest in the Titling Trust to a Securitization Trust in exchange for securities issued by the Securitization Trust, which is sold by the subsidiary in either a private placement or a public offering. Exhibit 3 is a diagram of the structure of a securitization involving a beneficial interest in a titling trust.
III. Setting Up A Titling Trust
A. Form of Trust; Name of Trust
The Titling Trust can be either a common law trust or a business trust. We generally recommend using a Delaware business trust for several reasons.
First, some jurisdictions (Pennsylvania, for example) do not permit common law trusts to hold title to vehicles but do permit business trusts to hold title to vehicles. Second, business trusts offer greater statutory protection to holders of the securities in a securitization against any vicarious tort liability of the Titling Trust. In other words, there is less of a "piercing the veil" risk that the beneficiaries of a Delaware business trust will be held liable for liabilities of the trust than beneficiaries of a common law trust.
Third, business trusts provide a greater ability to construct a "fire wall" separating liabilities that relate to one pool of leases and vehicles from the assets of other pools. Under the provisions of Section 3804 of the Delaware Business Trust Statute, the trust agreement can provide that liabilities with respect to vehicles of one beneficial interest in the Titling Trust are not enforceable against other assets of the Titling Trust 4. Of course, this provision of the Delaware business trust statute has never been litigated in an actual case. It is a distinct possibility that a court would not shield the assets of one beneficial interest from liabilities relating to assets of another beneficial interest if the result would leave an injured plaintiff without an adequate remedy.
If a Delaware Business Trust is selected, the Trustee must have a place of business in Delaware. Most large banks now have a trust department office or a separate trust company in Delaware for this purpose.
There is a common misperception that common law trusts are preferable over business trusts because business trusts are expressly subject to the Bankruptcy Code, while common law trusts are not. In fact, trust law in most states generally provides that if a beneficiary of a common law trust becomes insolvent and the beneficiary can spend or otherwise has access to the assets of the trust, those assets may become subject to the beneficiary's insolvency proceeding. Consequently, although a business trust may become a debtor in a bankruptcy proceeding, a business trust may provide greater protection against the bankruptcy risk of the sponsor 5.
A name also should be selected for the Titling Trust. Some states restrict the length of the owner's name appearing on certificates of title. Prospective sponsors of Titling Trusts may want to consider this limitation in naming their Titling Trust.
Because the Titling Trust will be conducting a leasing business very similar to that currently conducted by the sponsor, there is a question whether the Titling Trust requires any of the same licenses, permits, sales tax exemptions and other governmental items (collectively, "Governmental Items") held by the sponsor.
Leasing companies have taken three different approaches to determine the Governmental Items necessary for the Titling Trust in each state:
Approach One: Hire local counsel in each state to determine what Governmental Items are necessary. This approach has the advantage of being extremely careful. The disadvantages are that it is very expensive, burdensome and time-consuming.
Approach Two: Do Nothing. Some aggressive finance companies have taken this approach. They would argue that the Titling Trust is merely a shell that performs no activities and conducts no business on its own. Instead, all business is conducted on behalf of the Titling Trust by the finance company, which acts as Servicer. Consequently, because the Servicer has all of the required Governmental Items, these finance companies have taken the position that no Governmental Items need be obtained by the Titling Trust.
The advantage to this approach is that it is inexpensive and simple. We believe this approach is extremely risky, however, and do not recommend it.
Approach Three: Duplicate Your Existing Governmental Items. Approach three is our recommended approach. The Titling Trust will be conducting the same leasing business that is currently being conducted by the sponsor and is unlikely to need any Governmental Item the sponsor does not already have. If the sponsor has a good list of the Governmental Items in each state that are required for its leasing business, this approach can be efficiently and inexpensively accomplished. In fact, most of this work can be performed by sponsor employees rather than outside counsel.
Although most Governmental Items will require commitment of clerical time to fill out forms and the payment of small filing fees, the cost to duplicate each Governmental Item probably will be less than the local counsel fees to determine if the Governmental Item is required. Potential issuers should be aware, however, that most of the required forms were not drafted with Titling Trusts in mind, and it is not unusual for the local governmental agencies to have questions.
C. Vicarious Tort Liability
Let's assume that the lessee of a leased vehicle is driving while intoxicated, gets into an accident and kills the other driver. The other driver's family sues the Titling Trust as the owner of the vehicle. Can the Titling Trust be held responsible for the actions of the lessee?
The laws of each state vary on this question. Most states hold the owner of a vehicle liable for negligent operation of the vehicle by a person using the vehicle with the owner's permission 6. Some states, but not all, have exemptions from these laws for leasing companies.
The most common ways to deal with vicarious tort liability are for the sponsor to indemnify the Titling Trust for amounts paid as litigation defense costs, judgments and settlements for vicarious liability claims or for the Titling Trust to become an additional insured on the sponsor's insurance policies.
D. Consumer Credit Laws
There are a host of federal and state laws and regulations which purport to protect consumers who enter into vehicle leases. These include the federal Consumer Leasing Act of 1976 and Regulation M of the Federal Reserve Board, which require various disclosures in the form of lease contract, and state "Lemon Laws," which may permit a lessee to terminate the lease or to obtain refunds of some or all monthly payments for vehicles that do not comply with manufacturer's warranties after a specific time period or a specified number of attempts to correct the problem.
If the lessee asserts any rights with respect to a lease transaction that does not comply with applicable laws and regulations, the Titling Trust could be disadvantaged, either because the cash flows to the Titling Trust from that lease will be reduced or eliminated or because the Titling Trust, as assignee of the lease, may in some cases be held liable for the violation.
Consumer credit problems generally are dealt with through representations and warranties of the sponsor, as the Titling Trust's servicer. The servicer is required to represent and warrant that the lease transaction complies with all applicable laws and regulations. If there is a problem with a lease because of a violation of law, the servicer is required to purchase the lease and related vehicle for the remaining unpaid principal amount of the lease plus accrued and unpaid interest. Usually, the servicer or the Titling Trust also has the benefit of similar remedies against the dealer who leased the vehicle.
E. Criminal Statutes; Retitling
Certificate of title statutes originally were enacted to reduce vehicle thefts. Before these statutes were enacted, a criminal could steal a car and sell it just by delivering the keys to the buyer. An unsuspecting buyer would have no reason to believe the car was stolen. With a certificate of title statute, the crook needs to obtain not only the keys, but also the certificate of title, which is less likely to be kept in the car.
When a beneficial interest in a Titling Trust is transferred, rights are being transferred in a pool of specific vehicles and related leases. The question necessarily arises whether such a transfer without retitling the vehicle results in a violation of the state's certificate of title laws. The wording of the statutory retitling requirements varies from state to state. Some states clearly require retitling only when the legal titleholder is changed. Other states purport to require retitling whenever "any interest" in the vehicle is transferred by "an owner" (which may be defined as a person having "any interest" in the vehicle). Consequently, there is a significant ambiguity in many of these state statutes with respect to the transfer of a beneficial interest in a Titling Trust.
Because of their crime-reduction purpose, most certificate of title statutes have criminal provisions that also vary from state to state. Some states make it a felony to knowingly violate the statute or to knowingly put a vehicle title in a false name.
There are competing interests in making a judgment on whether these statutes are violated. Because the objective of the statutes is to reduce vehicle theft, one can argue that there should be no violation if the use of a Titling Trust does not increase the risk of auto theft. It is hard to imagine how this financing device would increase auto theft.
Another more recent justification for these statutes, however, is to help the state raise revenue. A state might argue that, by transferring a beneficial interest in a Titling Trust, the sponsor is depriving the state of the fees normally payable upon the transfer of the vehicle. The contrary argument, of course, is that the transaction would not occur if such fees were required.
There also are good policy reasons that justify not imposing criminal liability on the use of a Titling Trust. By permitting the use of a Titling Trust, states are enabling leasing companies to finance their activities at lower rates. The competitive effect of this will necessarily be to pass along some of the savings to consumers, most likely by lowering the interest rate the sponsor uses in calculating the monthly payment. If some states are more restrictive than others in facilitating the use of Titling Trusts, consumers in the restrictive states would be disadvantaged because they will have to pay more than consumers in other states.
It is difficult to construct any argument that would justify criminal liability if vehicles were held in a Titling Trust for the sponsor's own account without any transfer of a beneficial interest. This would be no different from holding vehicles in a nominee corporation, a practice currently used by many finance companies and banks. The only real issue, if any, arises upon the transfer of a beneficial interest in a Titling Trust representing rights in leases and vehicles titled in a particular state.
Few lawyers believe that there is a serious risk that the use of a Titling Trust or the transfer of a beneficial interest in it would result in a criminal violation. The scope of the language of the criminal statutes, the lack of any formal administrative interpretations of these statutes, and the novelty and complication of Titling Trust structures, however, prevent lawyers from assuring clients that there is absolutely no risk of criminal liability.
Most auto lease securitization transactions have included an indemnity by the sponsor against any fines or penalties that could result from violations of law in the transaction. Some sponsors have become more comfortable with the risk by seeking formal or informal guidance from the relevant state DMVs 7.
F. State Sales Taxes
There is also a question whether, upon the transfer of a beneficial interest in a Titling Trust representing rights in a pool of leases and vehicles, a sales or transfer tax will be due with respect to the vehicles. Lawyers and accountants generally will support a reporting position that such taxes should not be payable upon the transfer of a beneficial interest in the Titling Trust, although the question is not free from contrary arguments. Among other helpful factors is the characterization of the securitization transaction for tax purposes as debt rather than a sale. There are exemptions from sales tax in many states for a sale of tangible personal property that will be held for lease.
We know of no company that has securitized its leases that has taken a contrary position. Generally, the sponsor of the Titling Trust will indemnify other participants in the transaction against this risk. If the securitization transaction will involve many states, the sponsor generally becomes comfortable with this risk by seeking the advice of its public accounting firm and not including in the transaction vehicles titled in states that are likely to present a significant sales tax issue.
G. Creating a Non-taxable Entity
Because the leases produce rental income, it is critical that the Titling Trust not be subject to taxation like a corporation. Two different approaches have been followed in the two public lease securitization structures: nominee or partnership.
For the Titling Trust to have nominee status, the relationship between the Titling Trust and the beneficiaries must meet the three requirements set out by the U.S. Supreme Court in Commissioner v. Bollinger, 485 U.S. 340 (1988). First, the fact that the Titling Trust is acting as agent for the beneficiary with respect to the leases must be set forth in a written agreement at the time the leases and vehicles are acquired. Second, the Titling Trust must act as agent and not principal with respect to the leases and vehicles for all purposes. Third, the Titling Trust must hold itself out as an agent and not a principal in all dealings with third parties relating to the leases and vehicles. Id. at 349-50. The World Omni Origination Trust was created to be a nominee, but also included certain provisions to support a partnership "fallback" argument.
Prior to 1996, to achieve a partnership, the trust agreement would have required many cumbersome features designed to assure treatment as a partnership for tax purposes. These included the need to provide for at least two beneficiaries of the trust, the assumption of general partner liability by one of the beneficiaries, and dissolution of the Titling Trust upon the bankruptcy of the "general partner." The Ford Credit Titling Trust is structured as such a partnership. The new "Check the Box" regulations now assure that a trust or any other non-corporate entity will automatically be treated as a partnership by default unless it "checks the box" to be treated as a corporation for tax purposes.
While both the nominee and partnership structures accomplish the desired result, the nominee structure is more simple, involves no disadvantages and permits its sponsor to do certain types of transactions that are much more complicated with a partnership. The check the box rules permit a sponsor to structure the titling trust as a nominee and to painlessly achieve a partnership fallback.
H. Perfection Issues
Perfection issues become more complicated in an automobile lease securitization because the securitization trust does not directly own the leases or leased vehicles that constitute the assets of the trust, and thus may not have a perfected security interest in the leased vehicles. Ownership and generally perfection of a security interest in a vehicle is governed by state certificate of title statutes. It would be very costly to retitle and name the securitization trust as a lienholder on individual certificates of title in order to obtain a perfected security interest.
Both the World Omni and Ford transactions describe in their prospectuses the risks of the securitization trust's indirect ownership of the leased vehicles. Absent prior perfection of the trust's security interest in the assets being securitized, the holder of a perfected lien in the assets would have priority over the interest of the trust in the assets. The securitization trust can at least perfect its interest in the certificate of beneficial interest and all proceeds under the leases.
Liens on the leased vehicles that could take priority over the trust's interest in the leased vehicles include tax liens, mechanics and similar liens and liens imposed under state and federal statutes such as the Pension Benefit Guaranty Corporation (PBGC).
I. ERISA Issues
The rating agencies have raised a question as to whether the lack of a first-priority perfected security interest in the leased vehicles will increase the risk that the PBGC could impose a lien on the assets of the "corporate family" of a securitization trust under the Employee Retirement Income Security Act of 1974 ("ERISA") 8. If the seller/originator of the leased vehicles has unfunded pension liabilities, the rating agencies' view is that the PBGC could impose a prior lien on the leased vehicles securitized by a member of the seller's affiliated group under ERISA. The size of the residual values in an auto lease transaction aggravates this rating agency perception.
There is no precedent for the PBGC asserting a lien on collateral to the detriment of public investors having a security interest in that collateral. In addition, as a governmental agency, the PBGC seems to be unlikely to assert a lien in a manner that could precipitate a bankruptcy.
The Ford prospectus specifically discloses the risk that the PBGC could assert that the trust assets are subject to PBGC liens, but asserts that its plans are substantially fully funded. The prospectus states that the securities being issued by the securitization trust could be downgraded if unfunded ERISA liabilities of the Ford group were to arise in the future.
World Omni committed to provide the securitization trustee and the rating agencies with a monthly officer's certificate stating that its plans are currently fully funded. Failure to comply with the certification will trigger a buildup of all excess collections into the trust's reserve fund.
Standard & Poor's has, however, stated that in evaluating the ERISA risks of an auto lease transaction it will also take into account the terms of a transaction and any structural features built into the transaction that might otherwise mitigate the ERISA risks.
J. Investment Company Act
No entity in the automobile lease securitization structure can be an investment company under the terms of the Investment Company Act of 1940. The Investment Company Act regulates publicly traded mutual funds. In general, it would be difficult for any entity in a securitization transaction to comply with the restrictions under the Act, including operational restrictions and restrictions on transactions with affiliates. Each entity in the structure will need to rely on some exemption from investment company status. Available exemptions for different entities include Sections 3(b)(1), 3(c)(1), and 3(c)(5) under the Investment Company Act and Rule 3a-7.
According to Rule 3a-7, the residual value of vehicles must represent cash flow from "eligible assets." Eligible assets are defined in Rule 3a-7 as: financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to security holders.
It is unclear whether the residuals in an auto lease transaction are "financial assets" or "other assets designed to assure... timely distribution of proceeds to the security holders." The staff of the SEC has reasoned that because vehicles are physical assets that require some action to be taken by a third party (e.g., the servicer) to realize the residual values, they do not convert "by their terms" into cash. It may be possible to convert residual values, or the residual value protection backing up residual values, to financial assets depending on the structure and credit enhancement used 9.
Section 3(b)(1) of the Investment Company Act allows an exemption for an entity that is engaged primarily in a business other than that of investing, owning or of trading in securities. The Section 3(c)(1) exemption for securities sold to fewer than 100 holders would be useful in a private offering, but not a public offering. Operating leases have not traditionally been found to qualify under the special finance company exemptions under Section 3(c)(5), although companies holding finance leases will be exempt because such transactions are viewed as essentially the equivalent of installment sales 10.
K. Special Problems: Renewing an Existing Lease
Leasing companies thinking about creating a new Titling Trust should understand that the state DMVs and taxing authorities will view the trust as an entity entirely separate from the leasing company. This is a relevant consideration when the lessee of a two-year lease wants to renew the lease for another two years. If the lease has been entered into between the lessee and the leasing company, and the certificate of title and vehicle registration are not changed on renewal, in some states fees required to be paid upon origination of the initial lease may be avoided. If the leasing company is the lessor of the original lease and the Titling Trust will be the lessor of the new lease, however, state DMVs generally require payment of all retitling fees, because title is in fact being transferred to the Titling Trust.
In addition, because title is being transferred, state taxing authorities also generally require the Titling Trust to pay a sales tax. Most leasing companies require the lessee to pay any such sales taxes.
1 Prospectus, "World Omni 1996-A Automobile Lease Securitization Trust."
2 Commercial banks, many trusts, savings and loan associations and insurance companies, for example, are not subject to the Bankruptcy Code. See 11 U.S.C.A. ß 109 (West. Supp. 1992).
3 11 U.S.C.A. ß 541(a) (West. Supp. 1992).
4 Section 3804(a) provides:
[I]n the event that the governing instrument of a business trust...creates one or more series..., and if separate and distinct records are maintained for any such series and the assets associated with any such series are held and accounted for separately from the other assets of the business trust, or any other series thereof, and if the governing instrument so provides, and notices of the limitation on liabilities of a series as referenced in this sentence is set forth in the certificate of trust of the business trust, then the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the business trust generally.
5 Like a bankruptcy remote corporation, the Titling Trust also should be structured to reduce the risk that the trust will be consolidated with the sponsor in the event of the sponsor's bankruptcy. For example, the governing instrument of the trust should provide that the unanimous consent of all trustees and beneficiaries of the trust will be required for the trust to file or join in a bankruptcy petition.
6 See, e.g., Section 17150 of the California Vehicle Code or Section 388 of the New York Vehicle and Traffic Law.
7 These same considerations are applicable to federal and state odometer statutes. If there were a transfer of a vehicle that required retitling, an odometer certification would also be required. Similarly, if retitling is not required, an odometer certification also would not be required.
8 "ERISA Risks Arise in Asset-Backed Deals," Standard & Poor's Structured Finance, Nov. 1994, p.18.
9 A similar issue arises under the definition of "asset-backed security" for purposes of qualifying for shelf registration on Form S-3 under the Securities Act of 1933. If Form S-3 is not available, it is not at all uncommon for securitization issuers to register on Form S-1.
10 Under a "finance" or "capital" lease, the lessor's residual interest in the vehicle is so insignificant that, as a practical matter, the lessor has sold the vehicle to the lessee and retained only a security interest in it. For accounting purposes, if the present value of the payments under a lease exceeds 90% of the fair market value of the vehicle, the term of the lease exceeds 75% of the useful life of the vehicle, or the lease gives the lessee a bargain purchase option, the lease will be deemed a "finance" lease. See Financial Accounting Standards Board, Accounting for Leases, Statement of Financial Accounting Standards No. 13.
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