Asset securitisation and the effect of insolvency on special purpose vehicles

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Robin Parsons, Partner
Phillip Taylor, Associate
Alex Rovira, Associate
Sidley Austin Brown & Wood LLP

Securitisation in its classic or paradigm form involves the sale by an originator of its income-generating assets to a special purpose vehicle (SPV) which finances the acquisition of those assets by issuing debt securities to one or more investors. The income generated by the assets is then used by the SPV to service its obligations to the holders of the securities. The SPV will normally be a company or other legal entity which has no (or only minimum) outside creditors, and whose sole functions are to acquire and hold the assets and to issue the securities.

A key feature of securitisation is that the value of securities issued will be determined by the performance of the pool of segregated assets, and not by the continuing creditworthiness of the originator. The separation of the credit risk of the originator and the credit risk of the SPV in this way often enables the originator to obtain lower-cost financing through securitisation than it would otherwise be able to obtain. For example, many originators with corporate credit ratings of BBB (the lowest investment grade rating at Standard & Poor’s) have securitised assets resulting in an issue of AAA-rated securities. Securitisation may also achieve other objectives; for example, it may allow a regulated entity to remove assets from its balance sheet for regulatory capital purposes and thus do more business.

Insolvency of the originator – substantive consolidation and true sale issues

The objective of many securitisation structures is to isolate the SPV from the risks associated with an insolvency of the originator. In order to meet this objective:

•  the SPV and the originator must be treated in an insolvency as separate entities; and

•  the sale of assets to the SPV must be a ‘true sale’ – that is, it should not be capable of being set aside by an insolvency officer of the originator or recharacterised as a secured loan of the purchase price.

The law has evolved differently on each side of the Atlantic in relation to these issues.

Substantive consolidation

In the United States, substantive consolidation is a judicially created doctrine flowing from the general equity powers granted to federal bankruptcy courts under Section 105 of Title 11 of the United States Code (the Bankruptcy Code). The effect of substantive consolidation is to ‘pool’ the assets and liabilities of more than one debtor in the bankruptcy process and, in some cases, non-debtors. To the extent substantive consolidation is effected, inter-company claims and guarantees by other debtors are disregarded.

In determining whether substantive consolidation is warranted, the courts take into account two critical factors:

•  whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; and

•  whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.

Additionally, the courts will consider whether there exists a ‘cloak of fraud’ or other inequitable, unjust or unconscionable conduct or result that calls for equitable redress.

Several courts have also adopted a more liberal standard for substantive consolidation, pursuant to which the benefit to creditors plays a more significant role in determining whether substantive consolidation should be allowed. In Eastgroup Props v Southern Motel Assoc, Ltd the Eleventh Circuit opined that the “basic criterion by which to evaluate a proposed substantive consolidation is whether ‘the economic prejudice of continued debtor separateness’ outweighs ‘the economic prejudice of consolidation’” such that the proponent of substantive consolidation must show that:

•  there is substantial identity between the entities to be consolidated; and

•  consolidation is necessary to avoid some harm or to realise some benefit.

In England, it is much more difficult for a court to disregard the distinct identities of the originator and the issuer. To do so, the court would have to pierce the corporate veil. In the absence of fraud, and provided that the issuer has a real commercial purpose and is not simply a façade of the originator, an English court will be reluctant to pierce the corporate veil in an insolvency of either the originator or the issuer.

True sale

In the United States, bankruptcy courts have considered whether a purported sale of financial assets is properly recognised as a true sale, with the result that the financial assets are outside the estate of the debtor, or whether the purported sale is more properly characterised as a loan. Although different courts apply different factors, or give the same factor or set of factors different emphasis, it is evident from the case law that the substance of the transaction is most relevant in determining this question, and that the facts should be evaluated in their totality to determine the nature of the transaction.

The most significant consideration in resolving whether a transaction would constitute a true sale is whether, examining the transactions in their totality, the seller will, in substance, part with the risks and benefits of ownership of the assets. Although recourse arrangements by themselves are not necessarily conclusive of the true sale/loan analysis, the existence of recourse is indicative that a purported sale is in fact a loan. The intention of the parties is a relevant but not controlling factor in determining whether a transfer of an asset should be characterised as a true sale or a loan.

Under English law, the question of whether a transaction described by the parties as a sale of goods could be recharacterised as a secured loan was considered by the Court of Appeal in Welsh Development Agency v Export Finance Co Ltd. The court had regard to the manner in which the parties had described their transaction in the documents as evidence of what, in substance, the parties had agreed, and held that despite similarities to a mortgage or charge, the agreement was what it purported to be. However, the decision in Export Finance is not relevant where the transaction is a sham. Under English law, for a transaction to be deemed a sham, the parties must have intentionally executed documents that give the appearance of creating legal rights and obligations different from those which the parties intended to create.

Cases such as Export Finance, Lloyds and Scottish Finance v Cyril Lord Carpet Sales Ltd (which characterised the practice of block discounting as a sale of debts rather than a charge) and Re George Inglefield Ltd (which sets out guidelines as to the essential differences between a transaction by way of sale and purchase and a transaction by way of security) have provided increased legal certainty that asset sales in English law securitisations will not be recharacterised as secured loans, provided that the rights and obligations arising are consistent with a sale and purchase and that the transaction cannot be described as a sham in the narrow sense referred to above. A liquidator or administrator of the originator would have difficulty arguing that such a sale was in fact a charge which was void against him and the originator’s creditors for lack of registration pursuant to Section 395 of the Companies Act 1985.

Avoidance of antecedent transactions

A liquidator or administrator of the originator could also seek to challenge the sale of assets to the issuer as a transaction at an undervalue or a preference under Sections 238 to 241 of the Insolvency Act 1986. The risk of such a challenge is normally mitigated by ensuring that:

•  the originator is solvent at the time of the sale and does not become insolvent as a result;

•  the sale is made on commercial terms; and

•  the issuer is not a creditor of the originator prior to the transaction.

If the originator is incorporated in England, it should not be assumed that the only risk of challenge is under English insolvency proceedings. If the originator’s centre of main interests is within another EU jurisdiction (other than Denmark), main proceedings may be opened there and it is possible that a challenge could be made under the laws of that jurisdiction for the transaction to be set aside. Moreover, there is nothing to prevent a liquidator or administrator in appropriate cases taking advantage of foreign insolvency law to have the transaction set aside.

Alternatives to a true sale

There are a number of techniques that may be employed to isolate the credit risk of the originator from the performance of the asset portfolio without the originator selling the asset portfolio to an SPV. The most common is synthetic securitisation, where the issuer SPV enters into a derivative contract (typically, a credit default swap) and uses the proceeds of issue to fund payments under the contract, which arise according to the performance of a ‘reference portfolio’ of assets. The originator will thus obtain protection from the risk of default of the portfolio.

Insolvency of originator/servicer – effect on asset servicing

Often when assets are securitised, the originator continues to service the assets on behalf of the SPV. Many securitisations that have suffered difficulties have done so because of deficiencies of the servicer, or ultimately because of the insolvency of the servicer. It is therefore important that securitisation transactions include provisions whereby the servicer can be replaced by a back-up servicer upon the occurrence of certain events and provide for other options where no alternative servicer is available.

Insolvency of the SPV issuer – insolvency remoteness

In addition to seeking to ensure that assets are effectively transferred to the SPV, and that the SPV and the originator are treated as separate entities, most securitisations in England and in the United States also attempt to restrict the possibility of an insolvency of the SPV itself. It is common to agree that the obligations of the SPV to make payment should be limited to the amounts available to the SPV for such payments, and that any obligations remaining after enforcement of the security and the application of proceeds of enforcement against the secured debt should be extinguished.

Creditors of the SPV will, to the extent possible, enter into covenants not to commence or join in an insolvency proceeding of the SPV. However, an SPV could have unforeseen or foreseen but unavoidable creditors that are not parties to the transaction – for example, tax authorities following a change in tax law. An SPV could also put itself into an insolvency process should circumstances dictate that it is the interests of the SPV to do so.

In US transactions, where the SPV is often a subsidiary of the originator, provisions are usually included in the SPV’s corporate documents requiring that all directors, including independent directors, consent unanimously to any bankruptcy filing. For additional bankruptcy remoteness the SPV may also be required to issue preferred stock to one or more unaffiliated third parties, with its certificate of incorporation preventing the filing of the bankruptcy petition without the participation of the holders of the preferred stock.

Administrative receivers

An English administration of the SPV can in many cases be avoided or postponed by the appointment of an administrative receiver by the security trustee on behalf of the investors. While, as a result of amendments made to the Insolvency Act 1986, many creditors taking security will not have the power to appoint an administrative receiver, these restrictions do not affect many securitisations because they will fall within an exception for certain capital market transactions.

Not every securitisation will be protected. One pitfall for the unwary, for example, is the definition of the types of capital market instrument that can be issued under the transaction. The legislation generally excludes instruments creating or acknowledging indebtedness for, or money borrowed to defray, the consideration payable under a contract for the supply of goods or services. If the sale of assets to the SPV is deemed to be a supply of goods (as in a sale and leaseback of aircraft), careful analysis is required before it can be said for certain that the capital market exception applies.

Why does it matter if an administrative receiver cannot be appointed?

Whereas an administrative receiver owes duties principally to his appointer, an administrator owes his duties to all the company’s creditors, including the unsecured creditors. If the SPV has no creditors other than those arising under the securitisation, there is arguably little difference in practice because the administrator will be chosen by the security trustee and can in general be expected to comply with the wishes of the transaction creditors. If the capital market exception does not apply so that an administrative receiver cannot be appointed, the rating agencies will analyse the transaction more closely to determine the extent to which, on the particular facts, the administration might interrupt cash flows or result in it taking longer to realise the secured assets.

Whole business securitisations

Almost any asset that produces a revenue stream can be securitised, including – especially in the United Kingdom – the ‘whole business’ of a company. Where the asset being securitised is the originator’s whole business, the distinction between a straightforward corporate credit and a securitisation is at its finest, and the risk of an insolvency of the originator interfering with the securitisation is at its most acute. Notwithstanding this, a whole business securitisation can often provide financing at a lower cost than a loan from a commercial bank.

Whole business securitisations do not generally involve a true sale of the originator’s business to the SPV issuer, which instead on-lends the proceeds of the issue to the originator and collects revenues from the originator’s business as the loan is serviced. The repayments are used to service the SPV’s obligations under the securities.

The single most important factor that has made whole business securitisations possible and cost effective in the United Kingdom is the availability of administrative receivership as an enforcement strategy. If the transaction is properly structured, it is still possible (notwithstanding the general prohibition on the appointment of administrative receivers in non-capital markets contexts) to appoint an administrative receiver over an originator in a whole business securitisation.

Whole business securitisation is not used in the United States. Generally, a bankruptcy court would consider the business assets under such a structure to be a part of the originator’s bankruptcy estate. Also, the amount of control that the originator would maintain over its business and assets may make the SPV susceptible to substantive consolidation with the originator. Furthermore, the US Bankruptcy Code does not afford the secured creditor the same priority and control as are available to the secured creditor under English law.

Future flow securitisations

In future flow securitisations originators sell assets that have not yet come into existence, but are expected to be created in the future. Examples include export-related receivables deriving from the export of commodity and manufactured products, long-distance telephone receivables, airline ticket receivables, airport landing fees, international credit card vouchers and other future remittances.

In the English context, it is possible for the SPV to acquire title in equity to future assets as and when they come into existence, provided that they are sufficiently identified and value is given. There is, of course, a risk that the assets may never come into existence should the originator’s business fail, and there may also be undervalue issues if the bulk of the consideration is payable out of deferred cash flows.

In the United States, there are several increased risks with future flow securitisations. In the first instance, a bankruptcy court may determine that a future flow securitisation is not a true sale because investors will usually demand some sort of recourse to assure that the future flows will be realised. The bankruptcy risk associated with the true sale may be reduced by implementing a multi-tier structure, under which the originator transfers the assets to a first-tier SPV by means of a true sale and the first-tier SPV then transfers the assets to a second-tier SPV.

Other risks also hinder future flow securitisations, including:

•  the continued servicing of the future assets by the originator;

•  treatment of existing versus future generated receivables after bankruptcy; and

•  accounting for the sale or merger of the originator.

While most of these risks can be mitigated, it remains uncertain how bankruptcy courts will rule on future flow securitisation deals.

Summary

A securitisation transaction must, if it is properly structured, take into account these insolvency considerations and the legal opinion issued should contain a careful analysis of any such risks associated with the structure. The analysis should deal with the enforceability of the transaction documents, including the agreement for the sale and purchase of these securitised assets and the validity and effectiveness of the security granted by the issuer. In the English market, the rating agencies will ordinarily expect the opinion to confirm that the capital market exception applies and that the security trustee can, on a default, appoint an administrative receiver. In the US market, the rating agencies would expect the opinion to state expressly that a court would hold that the transfer of the assets effected by the agreement constitutes a true sale rather than a secured loan, and that the court would not order the substantive consolidation of the assets and liabilities of the originator with those of the SPV. In the English market, where this is less of an issue, the opinion typically states that the agreement is effective to transfer title to the SPV, and it may also state that there is no formal doctrine of substantive consolidation under English law.