1. Structurally Embedded Laws of General Application
1.1 Insolvency Laws
Upon the commencement of bankruptcy proceedings, creditors will, with some exceptions, be subject to the automatic stay on their ability to collect on, or otherwise enforce against, the property of the bankruptcy estate, even if they have been granted a security interest in such property. Lifting the automatic stay can be time-consuming and costly, and the impact on the creditors in the meantime could be material. In addition, the bankruptcy court has broad statutory and equitable powers that could affect the creditors' rights depending on the specific facts and circumstances of the bankruptcy, including the power to:
- release excess collateral, thereby reducing the amount of collateral available to the secured creditor;
- add additional super-priority debt, pari passu debt or junior debt secured by the collateral;
- substitute different collateral for the original collateral; and
- reject executory contracts.
A bankruptcy also renders unenforceable provisions that trigger off a debtor's bankruptcy or financial condition (so called ipso facto clauses) except for certain enumerated rights and contract types.
Consequently, a key focus of securitisation transactions is to insulate the securitisation issuer (the issuer) from such bankruptcy risks. If a seller's sale of assets to the issuer is deemed to be a loan from the issuer to the seller despite being in the form of a sale then the issuer will be subject to the automatic stay on its ability to collect on, or otherwise enforce against, the transferred assets upon the seller becoming subject to bankruptcy proceedings. Consequently, one important aspect of insulating the issuer and its assets against the risks of the transferor's bankruptcy is to ensure that the assets are transferred in a 'true sale', which is discussed in more detail immediately below. Alternatively, it is also possible to structure a securitisation transaction using certain types of contracts that are afforded protections against the automatic stay and some of the other more troublesome bankruptcy powers, which is discussed in more detail under the heading "Protected Contracts" below.
As part of insulating a securitisation transaction from potential bankruptcy risks, it is also important to protect against voluntary and involuntary bankruptcy filings of the issuer as well as the issuer's dissolution. These considerations are discussed in 1.2 Special-Purpose Entities. Furthermore, even where the securitisation entity is otherwise solvent and is not subject to any involuntary or voluntary bankruptcy petition, there is a risk that a bankruptcy court applying the equitable doctrine of substantive consolidation could pull a securitisation issuer into the bankruptcy of its sponsor, seller or their affiliates in the absence of sufficient separateness between such entities and the issuer, which is discussed below under the heading "Substantive Consolidation."
True Sale v Secured Loan
If an asset has been transferred to an issuer in a true sale, the asset will cease to belong to the seller and will not be part of the seller's estate in the event of any subsequent bankruptcy proceedings involving the seller. Documenting the transfer as a sale is important, but not dispositive. The Uniform Commercial Code (UCC) expressly provides in Section 9-202 that title to collateral is immaterial. It is possible to have a true sale where the seller retains title, just as it is possible to have a loan even though the seller transfers title. When distinguishing between transfers constituting true sales and transfers only conferring a security interest, courts have focused upon whether the transaction predominantly has the characteristics of a sale or those of a secured loan. Not surprisingly, the more numerous the secured loan characteristics of a transaction, the greater the likelihood that a court will view it as a loan and, conversely, the more numerous the sale characteristics, the greater the likelihood of sales treatment by the court. However, not all factors are given equal weight in this analysis.
Generally, the most important factors that a court will consider in resolving the characterisation of a transaction are (i) recourse and collection risk, and (ii) the transferor's retained rights in the transferred assets. The level and nature of recourse against the transferor appears to be the most significant factor in determining whether a transaction constitutes a granting of a security interest or a true sale. The greater the degree of recourse to the transferor and the more collection risk retained by the transferor, the smaller the likelihood that a court would view the transaction as a true sale. That is not to say that all recourse precludes a transaction being characterised as a true sale. Recourse for breach of representations and warranties limited to the characteristics and condition of the purchased assets at the time of sale are generally viewed as consistent with a sale treatment. Similarly, the courts have consistently held in the context of receivables that where a seller of receivables bears all the risk of non-collection from account debtors, the transaction is a secured loan. As such, securitisation transactions generally will seek to limit the recourse to time of sale representations that go to the characteristics and conditions of the sold assets and will ensure that the delinquency risk is borne by the securitisation entity.
Another important factor in distinguishing a true sale from a secured loan is the absence of a right of the transferor to redeem the transferred property. Similarly, a right of the transferor to receive (or for the transferee to account for) any surplus is also an important factor for concluding that the transaction is a secured loan rather than a true sale. Securitisation transactions often do permit some degree of repurchases for purposes of maintaining compliance with the appropriate diversification requirements of the securitisation. However, in order to ensure compliance with the true sale criteria, such repurchases tend to be limited both to a maximum percentage of the transferred assets as well as a prohibition against reacquiring delinquent or defaulted assets.
Administration of, and control over, the underlying assets is another factor frequently cited by courts in resolving the loan versus sale characterisation. For example, the fact that a transferee has the authority to control the collection on the relevant assets and that the obligors have been notified of the transfer would support a true sale treatment. However, in many instances it is current market practice for a seller of loans or receivables to remain as servicer thereof and as such it is not dispositive if a loan obligor is not notified of such sale.
Intent of the parties is also a factor that, although not dispositive of the issue, is often cited by courts. While it is typical for securitisation documents to include a provision stating the intent of the parties to be that of effectuating a true sale, most courts de-emphasise the language used in a document and consider intent and actual conduct more relevant.
The courts have identified a variety of other factors that do not fall within the categories above but may be indicative of a secured loan. Among the more significant of these factors are the following:
- the transferor of the financial assets is a debtor of the transferee on or before the purchase date;
- the transferee's rights in the transferred assets can be extinguished by payments or repurchased by the transferor or by payment from sources other than collections on the financial asset; and
- the transferor is obliged to pay the transferee's costs incurred in collecting delinquent or uncollectible receivables.
Protection for Transferred Assets
An asset that is transferred in a true sale will, by definition, not be part of the transferor's estate and the issuer's rights in such assets will consequently not be affected by the transferor's bankruptcy. In contrast, a transfer that is characterised as security for a loan means that the seller continues to have ownership rights in such assets. The issuer's rights in the assets will therefore be subject to the automatic stay and all the other powers of the bankruptcy courts in the event of any bankruptcy proceedings relating to the seller.
Bankruptcy Court's Powers
The bankruptcy court has broad statutory and equitable powers, some of which are outlined above. Of all the bankruptcy court's powers, the automatic stay will likely have the most significant impact. The duration of the stay will be factspecific and difficult to assess in advance. Bankruptcy proceedings in the USA encompass a workout regime (Chapter 11 proceedings) as well as a liquidation regime (Chapter 7 proceedings). In particular, Chapter 11 proceedings have a high degree of variability in terms of the workout plan and surrounding facts that makes it difficult to predict how the exercise of the various rights and powers of the bankruptcy court may affect the issuer, if the transfer of assets to the issuer were to be characterised as simply providing the issuer with a security interest instead of outright ownership.
Opinion of Counsel
It is common to obtain a true sale opinion in conjunction with a securitisation and such opinion is typically required by rating agencies and accountants. Generally the opinion will describe the salient facts considered relevant by the courts faced with the question of distinguishing a sale from a loan and analyse these facts in light of the factors that speak for or against sale treatment. Typically some factors will support the true sale conclusion while other factors, in isolation, may have more in common with a secured loan. The opinion will usually identify these key factors and draw a conclusion based on the overall analysis and reasoning in the opinion letter. The conclusion delivered in a true sale opinion would typically be that a court properly presented with the facts would determine that the transfer of the relevant financial assets prior to the seller's bankruptcy will not constitute 'property of the estate' of the seller.
Other Aspects of Bankruptcy Remote Transfers
As noted above, a transfer of financial assets can constitute a true sale even if the seller retains title to the transferred assets. It is therefore possible to effectuate a true sale for accounting and bankruptcy purposes through a participation agreement. This is often an attractive means of transferring the financial asset when it is important for the seller to remain the holder of record; for example, where the financial asset consists of revolving loans or delayed draw commitments
Also, it is worth noting that the consideration for a true sale is not limited to cash. As such, the true sale analysis also applies where the relevant asset is contributed to the issuer in exchange for equity in the issuer. However, it is important that the consideration for the transferred assets has a reasonably equivalent value to such asset. A transfer for less than equivalent value is a factor that argues for treating the transaction as a loan instead of a true sale. Furthermore, transfers at less than equivalent value can also give rise to claw-back rights as a fraudulent conveyance under Section 548 of the Bankruptcy Code or similar provisions under applicable state law.
Where the transferor is an institution insured by the Federal Deposit Insurance Corporation (FDIC), the true-sale analysis will be similar, although the FDIC's receivership powers may be broader or different in many important respects to that of the bankruptcy court. However, the FDIC has promulgated non-exclusive safe harbour regulations that, if complied with, will provide additional comfort that a compliant transfer will be recognised as a true sale by the FDIC (see 12 CFR Section 360.6). The safer harbour rule includes a number of provisions that would apply in a typical non-safe harbour sale as well as additional provisions that establish various disclosure and documentary requirements that must be satisfied for the safe harbour to apply
1.2 Special-Purpose Entities
Creating a properly structured special-purpose entity (SPE) is a core tool in insulating the risks of a securitisation from that of other related parties. An SPE that is narrowly circumscribed in its permitted activities protects against the SPE incurring liabilities or becoming subject to credit risk from unrelated activities. Typical SPE separateness provisions also protect the SPE against the risk of substantive consolidation with the sponsor, seller and their affiliates. As such, the SPE construct provides important insulation for the securitisation structure and is, in many respects, a hallmark distinction between securitisations and other secured financing structures.
The primary goal of an SPE in a securitisation structure is to insulate the SPE against risks external to the securitised assets. The various rating agencies have promulgated requirements with different levels of detail that provide a useful checklist of required and desired features. These features can be categorised based on the type of risk they are intended to address, such as the risk of:
- incurring unrelated liabilities and otherwise becoming subject to involuntary bankruptcy filings;
- automatic dissolution of the SPE;
- voluntary bankruptcy filing by the SPE; and
- substantive consolidation of the SPE.
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