Securitization Flashcards
What is Securitization?
Financing by way of using an underlying portfolio of debts to issue debt securities in a way which seeks to insulate the Investor from risks other than the portfolio’s nonperformance.
Textbook – P. 747; Lecture Notes.
What is Schwarcz’s Definition of Securitization?
A transaction wherein an SPV issues securities to investors and, directly or indirectly, uses the proceeds thereof to purchase rights to, or expectations of, payment, which shall constitute the primary source of repayment of said securities.
Steven L. Schwarcz, What is Securitization? And for What Purpose?, 85 Southern California Law Review [1288] (2012).
Against what Expectation is Debt raised in a Securitization?
The underlying portfolio’s performance, i.e. cashflow and bankruptcy remoteness.
Lecture Notes.
‘Receivables’ is the term used to describe the assets in an Underlying Portfolio, namely because they typically represent rights to payments at a future date.
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [135] (1994)
Why is the Underlying Portfolio’s Performance the measure against which Expectations are set?
The cashflow deriving therefrom is what the SPV shall use to pay its bonds.
Textbook – P. 749.
According to Schwarcz, how does Securitization generate value for both the Lender and the Borrower?
Securitization’s dissociation of the Borrower’s best-performing areas from the company’s wider risks allows it to raise finance against these areas at a comparatively lower cost whilst delivering Lenders a lower-risk investment.
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [134] (1994)
In other words, “The SPV’s lower cost of funds is passed on to the originator through a higher selling price for the originator’s receivables.” Tranching may also be used in conjunction to further optimize the cost of finance.
How does Tranching further optimize the Cost of Finance?
The blended interest rate, i.e. the average interest rate across all tranches, may be calibrated to be lower than the interest rate of a single class of securities.
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [143] (1994)
According to Schwarcz, when is Securitization most Valuable to a Borrower?
When the cost of funding, as reflected by the interest rate on the SPV’s securities, is otherwise less than the cost of the Originator’s other sources of funding (transaction costs included).
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [134] (1994).
“The greatest benefit of securitization is its potential for bringing low cost capital market financing to companies that would otherwise be unable to access the capital markets.”
To an Investor, what are the most Relevant Factors in its decision to invest in a CDO/CLO?
- Quality of the underlying portfolio.
- Full beneficial ownership in the underlying porftolio.
- Bankruptcy remoteness.
- Credit enhancement.
- Supporting collateral.
Lecture Notes.
What Criteria does an Investor observe when Analyzing the Quality of an Underlying Portfolio?
- Credit rating.
- Dilution risk.
- Maturity.
- Frequency and size of payment installments.
- Exposure to early termination rights.
- Exposure to default and enforcement rights.
- Exposure to breach of warranty.
What does Bankruptcy Remoteness denote?
Insulation from the Originator’s and SPV’s insolvency risk.
Textbook – P. 748.
“All emphasis in the structuring of the transaction [should be] on the assets being securitized, and all extraneous factors that could possibly seize the cashflow generated by these assets should be removed from the structure.”
Lecture Notes.
Why is Bankruptcy Remoteness such an Important Characteristic for the SPV to possess?
It hugely influences the SPV’s credit rating, a factor which contributes enormoulsy to the success of a securitization transaction.
Moody’s – Bankruptcy Remoteness Criteria for Special Purpose Entities in Global Structured Finance Transactions [1].
Why is Securitization thought to be a more Efficient form of Financing?
The risk calculus is based on just one underlying portfolio as opposed to an entire businesses, which simplifies the task of analysis.
Textbook – P. 748.
How can Securitization aid Lenders in Capital Adequacy Optimization?
The technique involves the transfer of loans, and therefore results in freed space on balance sheets.
Lecture Notes.
What is the Risk Retention Requirement?
Originators must retain a 5% net economic interest in the securitized assets.
What is a True Sale Securitization?
One where the Originator transfers its interest in the underyling portfolio to the SPV by way of sale, including any security or guarantees.
Textbook – P. 748.
‘Sale’ denotes a Loan Transfer. Ideally, Novation is used, but due to potential issues with security, notice, or general restrictions, Equitable Assignment is typically resorted to. The other methods may be used, but are relatively suboptimal.
What does the term ‘True Sale’ Denote?
“A sale that is sufficient under bankruptcy law to remove the Receivables from the Originator’s bankruptcy estate.”
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [134] (1994)
Will Notice of the Assignment pursuant to the True Sale Securitization be given to the various Debtors?
Not unless necessary, e.g. Originator’s insolvency or breach of contract, or a Debtor’s default.
Textbook – P. 748.
How is the use of Equitable Assignment without Notice problematic for the SPV, and through it, the Bondholders?
- Debtors get a good discharge by paying the Originator, which may be problematic if it becomes insolvent or breaches warranties.
- Debtors accumulate set-off rights against the Originator.
- Claims of priority and the Rule in Dearle v Hall.
- EA may offend negative pledges and contractual restrictions.
- SPV cannot directly preclude contractual modifications to the UP, although it can use contract undertakings to protect itself.
- SPV cannot claim in its own name against the Debtors, although this is mostly a procedural problem.
Textbook – P. 749; Lecture Notes.
In Practice, in the context of Securitization, how are Loans transfered by Equitable Assignment?
-
By way of offer and acceptance.
- The Originator offers the relevant loans to the SPV, who accepts the offer by way of payment, whereupon equitable title therein is transferred.
- Under such circumstances, even if notice is given to the Debtors, legal title will not be transferred until a written assignment is executed.
Lecture Notes.
This is done to avoid stamp duty.
Must the Bonds pursuant to a Securitization be issued Pari Passu?
No. They may be tranched according to various rates of risk and returns.
Textbook – P. 749.
How might an SPV go about overcoming any short-term Cashflow Difficulties?
By drawing from a liquidity facility granted to it at the outset.
Textbook – P. 749.
Such difficulties may arise from mismatches in the time of receipts of income from the portfolio.
How might an SPV go about overcoming any long-term Cashflow Difficulties?
By drawing from a credit enhancement facilit(ies) granted to it at the outset.
Textbook – P. 749-750.
Such difficulties may arise from mismatches in interest and currency, or the inadequate generation of surpluses.
Are the SPV’s Bondholders secured?
Yes. The SPV will transfer any securiy and guarantees received from the Originator, as well as any anciliary assets (e.g. liquidity support), to a Trustee who shall hold them for the Bondholders’ benefit.
Textbook, P. 750.
The providers of the liquidity and credit enhancement facilities will also be Beneficiaries to this Security Trust.
Following Transfer, does the Originator maintain any association with the Underlying Portfolio?
Potentially, either as:
- Its Administrator; or as
- A Creditor of the SPV, which did not fully fund the Transfer.
Textbook – P. 750.
It is common for the Originator to maintain an association by assuming the role of Administrator, chiefly because it wishes to maintain a commercial relationship with its Debtors and because, for lack of them being given notice, it is still who they must pay to obtain a good discharge.
As Administrator, what is the nature of the Originator’s relationship with the SPV?
The Originator will hold its benefit in the Underlying Portfolio, and any payments received thereto, expressly on Trust for the SPV. There will also be Servicing Agreement between the two governing the former’s responsibilities and compensation.
Textbook – P. 750-751.
Monies received pursuant to the Trust should be held in a separate account to eschew issues of commingling and traceability.
What do the Contents of a Servicing Agreement typically pertain to?
- EODs;
- Succession (of the Originator as Administrator);
- Interest rates;
- Administration fees;
- Rights and obligations, e.g. information covenants or segregation of cashflows;
- Guarantees and indemnities;
- Uses of the SPV’s surplus cash;
- Liability for acts and omissions;
- Representations and warranties;
- Arrears and enforcement procedures;
T Burns, The Transfer of Future Rights in Securitisations: A Comparative Study of the Law in England and Scotland (2009) 24 Journal of International Banking Law and Regulation 35.
What Avenues of Credit Enhancement are available to an SPV?
- Term loan facility, i.e. credit enhancement facility.
- Subordination, i.e. tranching.
- Over-collateralization.
- Spread account.
- Guaranteed investment contract.
- Derivatives, e.g. interest rate and currency swaps.
The external means of credit enhancement do bear an additional cost for the risk reduction they bear.
How does Tranching Credit-Enhance a Securitization?
Subordination. Each subsequent Class credit-enhances the last by acting as a barrier against credit-related losses, with the junior-most Class credit-enhancing the entire deal given its vanguard positon.
Lecture Notes.
A provision effecting subordination as such is called a Waterfall Clause.
How can Tranching be used to extract Surplus Profits from the SPV (generated by the UP)?
Class X Notes, i.e. Notes which comprise a tiny proportion of principal but whose interest is variable and is contingent upon the surplus profits generated by the SPV per quarter.
Lecture Notes.
This does not offend §238 if entered into on Day 1, unless the Class X Notes are heavily subordinated, in which case, there may be a problem. It also allows the Originator to accelerate its income stream from the securitization.
What is a Letter of Credit?
A payment mechansim used to provide an economic guarantee to a Borrower from a Lender.
What is Over-Collateralization?
A credit enhancement technique whereby the SPV does not fully pay for the Transfer to leave itself a cushion, a sum redeemable at the securitzation’s end.
Textbook – P. 751.
What are the Originator’s Objectives in a True Sale Securitization?
- To fully disconnect itself from the SPV.
- To raise finance at a favorable price relative to other alternatives.
- To optimize its balance sheet from the standpoints of both capital adequacy and risk management.
- To fully insulate itself from the risk of the portfolio’s nonperformance, and any liabilities associated therewith.
Textbook – P. 758.
How can the Originator demonstrate Independence from the SPV?
By evidencing no interest in the SPV’s capital and total freedom from its influence. Accordingly, the SPV should be established as an independent entity which, at most, deals with the Originator.
Textbook – P. 758.
How ought the Riskiness of Securitization be kept minimal for the SPV, and through it, the Bondholders?
- The Underlying Portfolio’s quality and real value should be clear, and preferably, strong.
- Full and uncontestable beneficial interest in the UP should be acquired by the SPV.
- The SPV’s liquidity and credit quality should remain sufficient.
- Comprehensive security and guarantees should be held on behalf of the Bondholders.
Textbook – P. 759.
These criteria form the grounds of Credit Rating Agencies’ (CRAs) assessments of an asset-backed Bond Issuance.
What does a Credit Rating represent?
The Agency’s, “opinion of the likelihood that a particular Obligor or financial obligation will timely repay owed principal and interest,” as based upon an, “an in-depth credit analysis covering qualitative, quantitative, and legal issues.”
Ross and Malpass, The Role of Rating Agencies and Their Potential Exposure in the Ongoing Credit Crisis, (2008) 7 Journal of International Banking and Financial Law [349-350].
This is neither an audit nor a due diligence exercise for legal purposes, but nevertheless acts as, “an objective standard to give investors comfort.”
Why is a Favorable Credit Rating key to the Success of a Securitization?
Given most investors’ lack of time and resources to fully investigate the firms in which they invest, they use credit ratings to, “determine the minimum return that they will accept on a given investment.”
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [136] (1994)
Therefore, to raise funds at as low a cost as possible, it is critical to be assigned as strong a credit rating as possible. From this paradigm does securitization’s efficiency gains derive: by raising finance against a relatively higher-rated portfolio, the Borrower is able to raise the same amount of capital at a lower cost, ceteris paribus.
How will the Quality and Real Value of an Underlying Portfolio be assessed?
By analyzing its commercial and legal issues.
What Commercial Issues present themselves in the Assessment of an Underlying Portfolio’s Quality and Real Value?
- Likelihood of default.
- Rate of recovery in case of default.
- Adequacy of security.
- Size and frequency of payments.
Textbook – P. 759.
The Originator should be made to demonstrate that it honored these criteria when it incepted the loans to the relevant Debtors.
What Legal Issues present themselves in the Assessment of an Underlying Portfolio’s Quality and Real Value?
- Risk of dilution, e.g. due to set-off rights.
- Risk of re-characterization.
- Legitimacy of the Originator’s title.
- Strength of the Originator’s claim, e.g. Dearle v Hall.
- Existence of early termination rights.
- Effect of breaches of warranty.
- Enforcement rights and other default procedures.
- Extent of regulatory compliance.
- Transferability of debts, security, and other related rights.
How may the SPV’s Legal Title in the Underlying Portfolio be Impeached?
In various assets, it may transpire that:
* Assignment was contractually prohibited.
* Third Parties possess legitimate claims in the interests therein.
* The Debtors possessed set-off rights against the Originator, which now obtain against the SPV.
Texbook – P. 760-761
How may the SPV’s Hedge against the Impeachment of its Legal Title in the Underlying Portfolio?
It may oblige the Originator to warrant that:
- No contractual restrictions exist against Assignment.
- It is solely entitled to the interest in the loans and has not created any rights therein in favor of third parties.
- Either no set-off rights exist or that all set-off rights have been disclosed.
How may the Loan Transfers between the Originator and the SPV be Upset?
- Re-characterization to a form of secured financing which would be voided for lack of registration.
- Recission of contracts under §186 IA 1986.
- Disclaimer of onerous property under §178 IA 1986.
- Clawback for defrauding creditors under §423 IA 1986.
- Clawback for transacting at undervalue under §238 IA 1986.
- Clawback for preferentially treating a creditor under §239 IA 1986.
- If sub-participation is used, Clawback for avoiding a floating charge under §245 IA 1986.
Textbook – P. 761; Lecture Notes.
Re-characterization is unlikely for reasons explained in the Loan Transfers Deck. It is Clawback that is the greater threat.
From whence does the Risk of Clawback under §238 arise?
Over-collateralization. The Originator, to the extent that it did not receive full consideration at the time of sale, transacted at undervalue.
Textbook – P. 761.
This is problematic because Credit Enhancement is not purposed with profiting the SPV and must be capable being returned to the Originator, but simultaneously, must be readily available to the SPV should it need to draw on additional funding.
When can a Liquidator claim under §238?
If the transaction:
- Was within two years of the insolvency proceedings’ onset and to a connected person;
- Was executed when the Originator was insolvent; or
- Sent the Originator into insolvency.
IA 1986 – §240.
The definition of ‘connected person’ can be found under §249 and §435. This same window applies to claims under §239.
Preemptively speaking, how is the Originator’s Insolvency Risk best hedged against?
Due diligence, e.g. audits, solvency certificates, etc., ensuring that the Originator is sufficiently financially stable to satisfy bankruptcy remoteness criteria.
Lecture Notes.
Ultimately, given that insolvency is a matter of fact, rather than law, there is only so much that can be done by lawyers.
What constitutes Transacting at Undervalue?
Receiving consideration significantly lesser in value relative to that which was provided.
IA 1986 – §238(4)(b).
How can a Transaction challenged under §238 be saved?
If the Court is convinced that:
- The Originator entered into the transaction in good faith and to carry on its business; and that at the time,
- The Originator had reasonable grounds for believing that the Transaction would benefit the company.
IA 1986 – §238(5).
In Z’s view, how likely is an Attack under §238 to Succeed?
Unlikely. The parties will likely have arranged to settle the over-collateralized sum in future, i.e. deferred consideration or a trust, thereby disarming the claim.
Textbook – P. 762.
Penn agrees, stating that although the Originator will not receive a price equal to the UP’s face value, it will receive a price that is, “calculated on the basis of the present value of the assets,” which incorporates the over-collateralization discount, and therefore, escapes §238. He adds that the SPV is quite unlikely to be deemed a ‘connected person’, and that §238(5) is not difficult to satisfy. §423 is subject to similar analysis.
What is Deferred Consideration?
An agreement to receive the remainder (if) of the over-collateralized sum after the SPV has settled its debt with the Bondholders as consideration for the True Sale.
Lecture Notes.
How can a Trust be used to Disarm §238?
A Trustee would hold legal title in the UP in favor of both the SPV and the Originator. The former’s entitlement will encompass whatever is necessary to service its debt, and the latter’s whatever is remaining therefrom once said debt has been discharged.
Lecture Notes.
The SPV would be obligated to transfer the UP to the Trustee pursuant to the Sale Agreement should this avenue be selected. It is critical that the parties’ beneficial interests are sufficiently certain to satisfy the Three Certainties.
Pursuant to §238(5), what are the Relevant Considerations from the Court’s standpoint?
- The Originator’s financial position prior to entering the transaction;
- The benefit, or reasonable expectation thereof, to be realized upon entering the transaction;
- The financial, operating, and market risks undertaken by entering into the transaction;
- The consequences of not entering into the transaction, particularly in light of alternative methods of financing.
- The position of the Originator’s existing, prospective, and contingent creditors before and after the transaction.
Lecture Notes.
What constitutes Preferential Treatment of a Creditor under §239?
The putting of a Creditor into a better position than it would have otherwise enjoyed, in case of the Debtor’s insolvency, as a result of the Debtor having deliberately done, failed to do, or suffered anything.
IA 1986 – §239; Lecture Notes.
In Penn’s view, how likely is an Attack under §239 to Succeed?
Unlikely. It is improbable that either the SPV will be a Creditor of the Originator at the material time or that the latter will be motivated by a desire to improve the former’s position in insolvency.
Lecture Notes.
Under any securitization structure where the SPV can become a Creditor of the Originator, e.g. a revolving purchase structure or lending arrangements, §239 should be considered much more closely.
Pursuant to Bankruptcy Remoteness, how will the SPV be structured as a Corporate Entity?
As an entirely separate company with minimal organizational links to the Originator.
Textbook – P. 758.
Its share capital should therefore be held either directly, or indirectly through a trust, by someone as far removed from the Originator as possible, e.g. a charity or some other entity that cannot be run as a busienss. All of this works because of the principle of separate corporate personality under Salomon v Salomon.
What are the Insolvency Act’s Two Tests for Insolvency?
- Cashflow Insolvency, i.e. the inability to repay liabilities as they fall due.*
- Balance Sheet Insolvency, i.e. when liabilities exceed assets.**
IA 1986 – *§123(1)(e), **§123(2).
Regarding §123(1)(e) and the Cashflow Test, what is the Lesson to be Learned from Re Cheyne Finance?
The Cashflow Test contains an element of futurity, i.e. is concerned with both immediately and prospectively payable debts.
Allison – The Supreme Court Decision in Eurosail, [492]; Re Cheyne Finance [2008] EWHC 2402.
Regarding §123(2) and Balance Sheet Insolvency, what are the Lessons to be Learned from Eurosail?
- Without good reason to the contrary, assets and liabilities do not have to be taken at their face values on the balance sheet.
- §123(2) does not mechanically turn on the question of, “whether liabilities… exceed its assets.”
- Contingent and prospective liabilities are accounted for by means of valuation,* rather than simple aggregation.
- §123(2)’s is supplementary to §123(1)(e). It covers cases where, although debts are paid as they fall due, “it is clear that it will not be able to meet its future or contingent liabilities.”
- Audited accounts are a good starting point, but no be-all-end-all as commercial considerations are still relevant.
- The more remote a contingent liability and the more distal a prospective liability, the less weighty they become.
Sidley Austin – Eurosail Court of Appeal Jugment; Allison – The Supreme Court Decision in Eurosail, [496]; BNY v Eurosail [2011] EWCA Civ 22;[2013] 1 WLR 1408; Insolvency Rules 1986 – 4.86, 4.94, and 11.13.
The definitveness of a ‘Point of No Return’ was floated by the Court of Appeal and rejected by the Supreme Court, describing that §123(2) can only be relied upon by future and contingent Creditors who believe that their Debtors can no longer repay their future or contingent liabilities. Rejection was grounded on confusion with §214 (wrongful trading) and complication of §238 and §239.
What is a Contingent Creditor?
A Creditor of a debt that, “will only become due in an event which may or may not occur,” and which is referable to, “an existing obligation.”
Walton – Inability to Pay Debts: Beyond the Point of No Return?, [3]; Stonegate Securities v Gregory [1980] 1 Ch 576.
What is a Prospective Creditor?
A Creditor of a debt that, “will certainly become due in the future,”* and arises out of a, “a current transaction or obligation, not a future obligation.”**
Walton – Inability to Pay Debts: Beyond the Point of No Return?, [3]; *Stonegate Securities v Gregory [1980] 1 Ch 576; **Burford Midland Properties v Marley [1994] BCC 604 Ch D.
Can a Creditor bring a Bankruptcy Petition on a Contingent Liability?
No.
IA 1986 – § 268.
What are the Necessary Elements of a Successful Bankruptcy Petition?
The Creditor of an unsecured debt of at least £750 must:
- Be owed a liquidated debt which is payable either immediately or at some future certain date; that
- The Debtor is either unable to repay the debt or has no reasonable prospect of repaying at the material time.
Walton – Inability to Pay Debts: Beyond the Point of No Return?, [4]. IA 1986 – §267-268.
Pursuant to Bankruptcy Remoteness, to what extent will the SPV’s Activities be Restricted?
With the goal of ensuring that the Bondholders are its sole Creditors, it will be limited to participating in the securitization namely through its Articles of Association and the Bond Issuance documentation.
Textbook – P. 763.
Tax neutrality will be engineered to eschew tax liabilities.
Pursuant to Bankruptcy Remoteness, what Measures are taken to Insulate the SPV against the Originator’s Insolvency?
- Contractually and constitutionally restrict business activities, especially indebtedness creation.
- Independent Board of Directors (neutralize piercing risk).
- No employees, with all activities being performed through Agents (minimize legal exposure).
- No parent companies, to minimize risk of substantive consolidation.
- Limit recourse against the SPV.
- Omnilateral use of Non-Petition Covenants.
- Clearly identify and curate the SPV’s Creditors.
- Regulate Creditors’ priority of claims using Inter-Creditor Agreements, subordination, etc.
Lecture Notes.
Pursuant to Bankruptcy Remoteness, how should Limited Recours Agreements between the SPV and its Creditors be drafted?
Either the debt cannot be accelerated or acceleration is limited to a particular asset or pool thereof. Resultantly, the SPV’s Creditors cannot claim against its entire balance sheet, and thereby, send it into insolvency.
Lecture Notes.
What is a Non-Petition Covenant?
A clause that prohibits whomever it binds from pursuing action for recovery against the SPV. It is essential for drafting to elucidate that such action is prohibited both before and after and EOD.
Lecture Notes.
How are Non-Petition Covenants enforced?
By application for injunctive relief, an equitable remedy which the Court discretionarily may award. Pursuant to the Court’s purposive approach, drafting and commercial purpose are key considerations.
Lecture Notes; Re Colt Telecom Group [2002] EWHC 2815 (Ch.) at [62]; Law Debenture Trust v Concord Trust [2007] EWHC 2255; Elliott International v Law Debenture Trustees [2006] EWHC 3063.
Under Colt, they are not contrary to public policy.
What are Moody’s Bankruptcy Remoteness Criteria with respect to Protective Features realting to Involuntary Bankruptcy?
- Business activities are suitably restricted, i.e. no indebtedness creation, mergers, ownership or occupation of real property, subsidiaries, or employees.
- Independently owned and managed, i.e. shareholders are sufficiently independent from the transacting parties and have no material economic interests in the SPV’s activities.
- No chance of incurring secondary liabilities (most relevant for multi-seller SPVs) or tax liabilities.
- No outstanding liabilities or Creditors from previous activities (most relevant for multi-seller and recycled SPVs).
- All necessary licences and authorizations have been obtained.
- Creditors have entered into Non-Petition Covenants, and there is otherwise no material probability that they will file against the SPV.
Moody’s – Bankruptcy Remoteness Criteria for Special Purpose Entities in Global Structured Finance Transactions [2-4].
What are Moody’s Bankruptcy Remoteness Criteria with respect to Protective Features realting to Voluntary Bankruptcy?
- Independently owned and managed, i.e. shareholders are sufficiently independent from the transacting parties and have no material economic interests in the SPV’s activities.
- Not independently owned, but a voluntary bankruptcy filing requires the vote of at least one independent director, who is a nationally-recognized corporate services provider, and owes no duty to the SPV’s shareholders.
- Shareholders and managemnt have no material incentive to file for bankruptcy.
- No material possibility of sufficient financial distress forcing voluntary filing.
Moody’s – Bankruptcy Remoteness Criteria for Special Purpose Entities in Global Structured Finance Transactions [4-6].
Is the Creditworthiness of the Liquidity and Credit Enhancement Facilities Providers a relevant consideration?
Yes. It impacts the transaction’s credit rating.
Textbook – P. 764.
In terms of Priority, where does a Credit Enhancement Facility Rank relative to its other Liabilities?
Behind its Bonds.
Textbook – P. 764
At least the Senior Tranche of its Bonds.
What is a Spread Account?
A form of Credit Enchancement whereby any profits generated from the UP are put into an account to build up a capital reserve.
Textbook – P. 764.
What is a Guaranteed Investment Contract?
A form of Credit Enhancement whereby an Insurer guarantees the SPV a rate of return in exchange for holding a deposit for a period.
Textbook – P. 764.
The deposit would comprise any spare cash in the SPV’s hands.
Why is the Appointment of an Administrative Receiver convenient for the Security Trustee, and through it, the Bondholders?
An Administrative Receiver:
- Owes its primary obligation to the Security Trustee;
- Acts on its instruction;
- Oversees the business and all security-backed assets;
- Blocks the subsequent appointment of an Administrator.
Textbook – P. 766-770.
According to Lipson, what are the Essential Elements of a Securitization?
- Input: Underyling portfolio and the rights therein.
- (Intermediate) Structure: Bankruptcy insulation mechanisms and fixtures.
- Output: Securities created and the finance raised thereby.
Jonathan C. Lipson, Re: Defining Securitization, 85 Southern California Law Review [1233] (2012).
According to Schwarz, are Primary Payment Rights always preferrable to Nonprimary Payment Rights?
No. In his opinion, it all comes down to creditworthiness. A guarantee from a strong third-party may be significantly more value than the mortgage payments due on a subprime mortgage.
Steven L. Schwarcz, What is Securitization? And for What Purpose?, 85 Southern California Law Review [1285] (2012).
Schwarz further elaborates that the more pressing concern is high sensitivity to cash-flow variations in an Underlying Portfolio.
According to Schwarcz, what are the Sources of a Securitized Asset’s Value?
The likelihood of timely repayment and the coupon, i.e. interest rate.
Steven L. Schwarcz, What is Securitization? And for What Purpose?, 85 Southern California Law Review [1287] (2012).
According to Schwarcz, in terms of Servicing Loans, how can Tranching prove Problematic for the Originator?
Restructuring becomes a balancing act between the interests of different Bondholders, e.g. certain changes may prejudice the interests of interest-only Bondholders against principal-only Bondholders.
Steven L. Schwarcz, What is Securitization? And for What Purpose?, 85 Southern California Law Review [1290] (2012).
According to Schwarcz, what is the Fundamental Difference between Liquidity Support and Credit Enhancement?
The former provides for timely repayments on issued securities, whereas the latter bolsters solvency.
Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stanford Journal of Law, Business & Finance [141] (1994)
Describe the Process of Financing by way of Securitization from the Standpoint of the Originator
The Originator:
- Selects which assets shall comprise the UP.
- Establishes a bankruptcy-remote SPV.
- Transfers the UP to the SPV.
- Enters into a Servicing Agreement with the SPV.
- Installs liquidity support and credit enhancement mechanisms to bolster the SPV.
The SPV:
- Issues debt securities to finance the purchase of the UP.
What Criteria does the Originator use to select which Assets shall comprise the Underlying Portfolio?
- Maturity.
- Dilution Risk.
- Substitution rights.
- Early termination rights.
- Existence of set-off rights.
- Existence of security or guarantees.
- Procedures on default and enforcement.
- Size and frequency of payment, i.e. cashflow volatility.
Lecture Notes.
What are the Relevant Considerations for creating a Bankruptcy-Remote SPV?
- Ringfencing of the UP while it is with the Originator.
- Ownership structure of the SPV.
- Organizational links between the SPV and Originator.
- Balance sheet implications for the Originator.
Lecture Notes.
What are the ways in which an SPV can Raise Finance to fund the purchase of the Underlying Portfolio?
- Master Trust.
- Public issue of debt.
- Discrete issuance of debt.
- Private placement of debt.
- Term Loan, whether bilateral or syndicated.
From the Originator’s Standpoint, what are the Advantages of Securitization relative to other Avenues of Finance?
- Lower cost of funding.
- Capital adequacy relief.
- Diversification of funding.
- Confidentiality (if so desired).
- Improved liquidity (especially for revolving structures).
- Maintenance of exclusivity with Debtors.
- Faciliation of access to international capital markets for Borrowers who could not have otherwise accessed them.
Lecture Notes.
From the Investor’s (Lender’s) Standpoint, what are the Advantages of Securitization relative to other Avenues of Finance?
- Lower risk-weighted investment.
- Increased Borrower (SPV) creditworthiness.
- Incorporates independent credit analysis performed by CRAs.
- Continuous review of performance throughout.
- Higher liquidity, due to the securities being rated and Bonds.
- If self-purchasing and a bank, capital adequacy relief through the transformation of banking book assets into trading book assets.
From the Originator’s Standpoint, what are the Disadvantages of Securitization relative to other Avenues of Finance?
- High up-front costs, both to set up the SPV and over-collateralize it. The former may be countervailed by economies of scale.
- Opportunity cost of over-collateralization, i.e. inert capital.
- Increased complexity and document-intensity.
- The Crown Jewels Problem and potential unpopularity with existing creditors, especially secured ones from who consents, releases of security, or renegotiation of covenants may be necessary.
Lecture Notes.
From the Investor’s (Lender) Standpoint, what are the Disadvantages of Securitization relative to other Avenues of Finance?
- Prepayment risk.
- Securities may be less liquid than Vanilla Bonds.
- Familiarity with the asset type is necessary.
Lecture Notes.
Who are the Parties involved in a Securitization?
- SPV.
- Originator.
- Liquidity Provider.
- Credit Enhancement Provider.
- Guaranteed Investment Contract Provider.
- Bond Trustee.
- Share Trustee.
- Underwriter.
Lecture Notes.
What are the Specific Documents which typically comprise a Securitization?
- Sale Agreement.
- Trust Deeds.
- Servicing (Administration) Agreement.
- Liquidity Support (Facility) Agreement.
- Credit Enhancement (Agreements and Provisions).
- Management (of the SPV) Agreement.
- Security Documentation.
- Bond Documentation.
- Guaranteed Investment Contract.
- Underwriting Agreement.
- Prospectus (Offering Circular).
Lecture Notes.
Optionally, derivatives may be employed, e.g. interest rate or currency swaps.
What must a Sale Agreement address?
- Selection of assets comprising the UP.
- Substitution of assets comprising the UP.
- Method(s) of transfer.
- T&Cs, i.e. CPs, R&Ws, EODs, Covenants, etc.
- Ring-fencing and other bankruptcy remoteness considerations.
Lecture Notes.
Power of Attorney may well be included.
Regarding Recharacterization, what are the Essential Differences between a Sale and a Secured Loan?
- A Sale does not entitle the Seller to an Equity of Redemption, unlike a Secured Loan.
- A Sale does not compel the Purchaser to account to the Vendor for any profits made on the resale of the subject matter, unlike a Secured Loan (by way of mortgage).
- A Sale does not entitle the Purchaser to recover from the Vendor any losses made on the resale of the subject matter, unlike a Secured Loan (by way of mortgage)
Lectures Notes; Re George Inglefield [1933] Ch 1.
An Equity of Redemption is the right to regain unencumbered title in an asset once the relevant secured obligation has been discharged.
What are the Lessons from the Precedent in Welsh Development?
- A Sale Agreement’s character will be determined according to its substance.
- There are no objective criteria underpinning this determination.
- Proper construction must be applied with reference to the whole of the agreement and the nature of the legal relationship the parties intended to create.
- Such terms as ‘sale’, ‘purchase’, and ‘price’ must be construed as they appear and are used.
- The mere presence of provisions which are similar to those used in secured financing is not determinative of character.
Welsh Development Agency v Export Finance [1992] BCLC 148.
Regarding Recharacterization, what are the most relevant Points of Consideration in the context of Securitization?
Lecture Notes.
What must a Servicing (Administration) Agreement address?
The Originator’s responsibilities, discretions, and liabilities regarding:
- Portfolio administration;
- Information and financial covenants;
- Cashflow management;
- Distribution of funds to the SPV or relevant Third Party;
- Servicing of miscellaneous fees, e.g. various costs and expenses;
- Treatment of prepayment;
- Minimization of interest (repayment) shortfalls; and
- Succession of itself.
Lecture Notes.
What must a Liquidity Support (Facility) Agreement address?
- T&Cs.
- Timing, receipt, and repayment of Drawdowns (particularly if Swaps are involved).
- Rating downgrade of the Provider.
Lecture Notes.
Trigger Point: A special emphasis ought be put upon Purpose, Utilization, and Conditions of Utilization, given that Liquidity Support is supposed to abet timely repayment rather than bolster credit. For instance, a distinction may be made between delinquent and defaulted receivables.
What may the Credit Enhancement Documentation (Agreements and Provisions) address?
- Tranching provisions.
- Subordinated debt (term facility).
- Insurance polic(ies), monoline or otherwise.
- Letter(s) of credit.
- Ranking and priority vis-à-vis Bondholders.
- Subrogation rights.
- Utilization rights.
Lecture Notes.
Trigger Point: which party may use these tools, and when?
When are Interest Rate and Currency Swaps used?
When the debt issued has a different interest basis or currency from that of the underlying receivables.
Lecture Notes.
What must the Trust Deeds address?
Bond Trust:
- T&Cs of the Bond Issuance, i.e. classes, interest rates, entitlements, enforcement, etc..
- Trustee’s rights, obligations, and liabilities.
UP Trust:
- Use and transfer of proceeds from receivables.
- Trustee’s rights, obligations, and liabilities.
Share Trust:
- For whom the SPV’s shares are held on behalf of.
- Trustee’s rights, obligations, and liabilities.
Lecture Notes
What must the Security Documentation address?
- Nature of the security, e.g. fixed or floating charge.
- From whom and by whom it is held, and the relevant interests.
- Perfection issues.
- Governing jurisdiction.
Lecture Notes.
What must the Underwriting Agreement address?
- T&Cs.
- Pricing.
- Nature of underwriting obligation, i.e. best efforts or full underwriting.
- Force majeure.
Lecture Notes.
A special emphasis on the CPs, which will extensively include the necessary collateral, credit enhancement, consents, credit ratings, and authorizations and licences necessary to issue the debt and administer the transaction.
In a Mortgage-Backed Securitization, how are the Underlying Mortgages transferred from the Originator to the SPV?
Incompletely. Equitable title is transferred to the SPV, with legal title remaining with the Originator on trust for the SPV. Arrangements are made for a complete transfer under certain circumstances, e.g. default.
Lecture Notes.
This is done to avoid the very expensive and time-consuming Land Registry fees.
What are the Risks associated with an Incomplete Transfer of Mortgages for the SPV in a Mortgage-Backed Securitization?
-
Vulnerability to a disposition of the assets by the Originator to a Good Faith Purchase who is unaware of the SPV’s rights.
- Remediable by keeping custody of the Charge Certificates with the SPV or its Agent.
-
No Power of Sale prior to the execution of the Deed of Transfer.
- Remediable by using Power of Attorney to exercise the Originator’s Power of Sale.
Lecture Notes.
Is it Prohibited for the SPV to Appoint an Administrative Receiver?
Only if the Receivership pertains to a qualifying floating charge, unless the transaction is a capital markets investment of at least £50m.
IA 1986 – §72A-§72B.
A ‘qualifying floating charge’ is one which enables the Holder to appoint an administrative receiver under the Act without needing a court order.* A ‘capital market investment’ is an investment which falls under Art. 77 of FSMA 2000 RAO 2001 and is either rated, listed, or traded.**
*IA 1986 – Sch. B1, Para. 14; **Sch. 2A, Para. 2.
What is the British Eagle Principle?
The principle that, whether in winding up or administration, a company’s property must be applied to satisfy its liabilities pari passu.
Lecture Notes; British Eagle v Air France [1975] 2 All ER 390; IA 1986 – §107 and §328(3); Insolvency Rules 1986 – R 4.181 and 2.85.
Pursuant to Tranching, can a Securitization Transaction contract out of the British Eagle Principle, thereby effecting a Subordination of Claims?
Yes. A Creditor which agrees to subordinate its claim thereby waives its entitlement to pari passu treatment.
- Re Maxwell Communications (No.2)* [1994] 1 ALL ER 737; SSSL Realisations (2002) [2006] EWCA Civ 7.
- Maxwell* also distinguished British Eagle on the grounds that the debts therein were not ‘mutual’, presumably meaning that they did not originate from the same place. Pari passu disapplies in case of secured creditors, which Bondholders in these transactions are.
Regarding Credit Rating Agencies and Potential Liability, what are the Lessons to Learned from Bathurst Regional? (Anomalous Case)
- CRAs owe a common law duty of care to the Investors of rated structured products if they come to rely on its opinionof the creditworthiness of the relevant Bonds.
- Objections of indeterminate liability will not obtain if the CRA knew, or could have know, the potential number of Bondholders in an Iusse and its exposure was limited in time.
- Vulnerability is the consequence of reasonable reliance, not an additional requirement thereof. Reasonable reliance, however, can be difficult to prove.*
- A lack of contractual privity does not preclude liability if the CRA was engaged by an ascertainable class of investors, or representative thereof, to communicate a rating.
ABN AMRO Bank v Bathurst Regional Council [2014] FCAFC 65.
Australian case. *In the judgment, it was often repeated that the Investors were not able to “second guess” the rating or undertake their own analysis of the risk of default. Whether this supports an assertion of reasonable reliance, though, is questionable given that they were sophisticated parties who would either hire an adviser or take their money elsewhere.
How is the SPV’s Income Stream Protected?
Through the imposition of a trust on the Originator’s relevant Collection Account in favor of the SPV.
Lecture Notes.
Having income directly funneled from the Underlying Debtors to an account in the SPV’s name is problematic because it would likely alert them to a Transfer. Likewise, transferring funds from the Originator’s Collection Account thereto would take days, and therefore, leave the relevant sums subject to insolvency risk in the meanwhile.
Regarding Servicing, what should be done if the Originator’s business or assets are so complex or unique that a ready Substitute Servicer cannot be found?
On Day 1, an entirely independent successor should be set up and enabled to inherit all of the Originator’s rights and assets insofar as they are needed to carry on its business should it become insolvent.
Lecture Notes.
Only very rarely will this be a consideration.
How should a Limited Recourse Provision be Drafted?
To limit Creidtors’ claims against the SPV to the assets that have been secured in their favor. Alternative drafting runs the risk of disabling Creditors from ever triggering their security.
Lecture Notes.
This risk arises from the fact that security attaches to obligations, and in this case, to trigger the security, Creditors would have to claim for the full debt. Thus, prohibiting them therefrom would effectively also prohibit them from enjoying their security.