By Hardeep Singh Chawla and Aashna Chawla, Amity Law School
Editor’s note: Securitization has undoubtedly emerged globally as an important technique for bundling assets and segregating risks into marketable securities. However, when securitization acquires a tendency of becoming transnational, there are several issues which emerge. Let us consider a situation where an Indian company, in order to market its handicapped securities, attempts to raise funds from the Indian capital market itself. This would not posit any difficulty, whatsoever, considering the fact that the law governing the process of securitization would be Indian. However, if the same Indian company were to raise funds from the USA or another country, it necessitates an examination of the laws of the jurisdictions whose borders have been crossed and the manner in which the laws of such jurisdictions work together with the company’s home jurisdiction.
SECURITIZATION OF A CROSS BORDER TRANSACTION: TRACING THE LAW AND POLICY
Transnational or cross-border securitization benefits emerging markets to a large extent. In the recent past there has been a substantial movement towards internationalization of securitization and, therefore, a resultant boost in cross-border securitization transactions has occurred. This is predominantly because many countries do not have a developed capital market. Cross-border securitization is a complex process and involves multiple legal systems with unfamiliar terms and unfamiliar rules. Furthermore, the dynamic and fast changing domain of securitization causes difficulty when trying to attain a firm grasp in the securitization process. A firm dealing in international securitization should familiarize itself with relevant local laws in order to grasp the fundamental legal principles of cross-border finance.
Securitization – The need thereof
The term ‘securitization’ has been defined ‘as a process of homogenizing and packaging financial instruments into a new tangible one’. In securitization, a company partly deconstructs itself by separating certain types of highly liquid assets from the risks generally associated with the company. This is achieved through the establishment of a separate entity known as a Special Purpose Vehicle (hereinafter ‘SPV’)to which these assets of the company are transferred.
The SPV, in turn, issues securities to raise funds from the capital markets. Thus, the company uses these assets to raise funds in the capital markets at a lower cost than if the company had raised funds by directly issuing the debt itself. The company retains the savings generated by these lower costs while the buyers of the securities, issued by the SPV, benefit by holding such investments with lower risk.
The process of securitization involves a typical transaction wherein a company, seeking to raise funds, transfers assets to the SPV-organized especially for this purpose to reduce the likelihood of bankruptcy. The transferring company is called the originator because it is the original company that supplies the assets. The assets themselves are typically payment obligations, which are owed to the originator by third parties. Generically, these obligations are referred to as receivables or financial assets. The entities obligated to pay the receivables are known as obligors.
The transfer is intended to separate the assets from risks associated with the originator. The originator will often structure the transfer so that it constitutes a true sale, which is a sale that is sufficient under bankruptcy and commercial law to remove the assets from the originator’s bankruptcy estate. Therefore, special consideration must be given to ensure that the transferred assets are protected from the claims of the creditors of the originator. Instead of structuring the securitization transaction through a sale, the parties may structure the securitization through a secured loan, thus, reducing the transaction costs.
In such cases, however, the transaction documents must ensure that the loan forwarded by the SPV is adequately secured. The loan advanced by the SPV must be secured by a charge on the receivables so that the SPV becomes a secured creditor of the originator. Further, the SPV must ensure that local law permits the SPV, as an interested creditor, to enforce its charge against the receivables in the event of bankruptcy of the originator.
The SPV must be organized in such a way that the likelihood of bankruptcy is remote. This is because the interest of the prospective buyers for the securities issued by the SPV is a function of the degree to which the SPV is bankruptcy proof and sheltered from the demands of the originator’s creditors, in the event the originator becomes bankrupt.
The SPV should be a legal entity, distinct and independent from the originator. This prevents creditors of the originator from having claims against the SPV; that enables creditors to file an involuntary bankruptcy petition against the SPV. Therefore, the SPV must observe all appropriate third-party formalities with the originator. These additional steps help to reduce the risk that the originator, if bankrupt, will either cause the SPV to voluntarily file for bankruptcy.
After the assets or receivables are transferred to the SPV, the SPV will issue securities, usually debt or debt-like instruments, to raise funds. The funds generated by the SPV, through the issuance of securities, are transferred to the company as consideration for the sale of the receivables when the securitization is structured through a sale. The funds generated by the SPV will be transferred as consideration for a loan if the securitization is structured through a secured loan. In the event the securitization transaction is structured through a sale, these securities are redeemable from collections on the receivables purchased by the SPV. If the securitization transaction is structured through a secured loan, these securities are redeemable from the repayment of the loan by the originator.
Should the originator default on repayment of the loan, the SPV would enforce its charge on the receivables and the securities would be redeemed from collections on the receivables. As a result, potential buyers of the securities should look to the cash flow from the purchased receivables and not necessarily to the credit of the originator for repayment. The risk that these payments may not be made on time is an important factor in valuing the receivables and a potential buyer must seek to evaluate the aggregate rate of default. Therefore, statistically, a large pool of receivables, due to many obligors for which payment is reasonably predictable, is preferable to a pool of a smaller number of receivables due from a few obligors.
Advantages of Securitization
The advantages stemming from the process have been explained as under:
(a) Economic generation of funds –
Transferring receivables to the SPV enables the originator to separate these assets from their corresponding liabilities. The originator is able to raise funds at a lower cost through securities issued by the SPV, as compared to raising funds by issuing securities directly. For example, the securities issued by the SPV may have a higher investment rating than securities issued directly by the originator.
(b) Facilitates compliance of capital-adequacy guidelines –
If the originator is a bank or similar financial institution, the originator may be required to maintain risk-based capital under the capital-adequacy guidelines. Thus, the sale of receivables to the SPV, such as loans reflected as assets on a bank’s financial statements, would lower the amount of capital that must be maintained under these guidelines and reduce the bank’s effective cost of funds.
(c) Compliance with restrictions relating to the quantum of debt –
An originator may be restricted by its indenture covenants from incurring or securing debt beyond a specified level. As such, securitization through the sale of receivables would enable the originator to raise funds in compliance with such covenants because the originator sells the receivables and does so without incurring debt; the debt is incurred by the SPV.
(d) Balance sheet efficiency –
The receivables and assets to be securitized are removed from the balance sheet of the originators and the same is repaid to them by the sale proceeds of the securities to the QIB by the SPV. Hence, the same process leads to balance sheet efficiency as assets are removed by an equivalent cash requirement, which is the purpose of the process. The originator can issue the asset-backed-securities without the recourse provision which would reduce its risk on the default of the borrower. Once such deal concludes, the originator can book its profit after applying the accounting principles, i.e., revenue recognition and revenue accounting that is done on an accrual basis.
(e) Credit exposure –
The originators raise funds upon the sale or transfer of the securities to the SPV and limit the credit exposure to the risks. Typically, following securitization, the originator’s credit exposure will be limited to any credit enhancement it may provide. The process of securitization helps in diversifying the portfolio and reduces the risk associated with the credit.
(f) Asset-liability matching –
Securitization transactions are generally based on matching the payments on the securities issued to the actual cash flows on the underlying assets (e.g., securitized loans). That approach inherently achieves asset-liability matching with respect to the securitized assets. Asset-liability matching allows a lender to fund itself more efficiently and to pass some of the cost savings on to its customers.
(g) Higher returns to the investors –
The investors would invest in securities that give them the maximum yield. Thus, the investor would invest in security receipts if it is found that there are better returns in the securitization agreement than in other securities. There are credit agencies that help the investors make a consolidated choice and, hence, they invest after they are satisfied that it would produce better yields.
Cross-Border Securitization – Structure and Issues
There is a need to establish the SPV in the foreign market where the SPV intends to issue securities because the capital markets of some foreign countries may be more established and might provide a better source of finance. International securitization, also known as cross-border securitization, enables the company to generate funds at a lower cost from capital markets in foreign countries.
Cross-border securitized transactions traditionally develop because of opportunities present in existing international business practices. The general structure of these transactions is:
(a) The company originating the asset is in one country;
(b) A trust or other special purpose entity in another country purchases the originator’s receivables;
(c) The payers on the receivables are outside the originator’s country;
(d) The receivables are largely denominated in the same currency as the securities;
(e) The trust receives payments directly from the payers and makes distributions directly to investors.
As there are various benefits that accrue to the parties in the securitization transaction, one has to look into the aspect of the efficiency that accrues to the players involved in the process and the prime nature of the market forces. The various economic models can measure the same. Efficiency is generally defined using either the Pareto or Kaldor-Hicks efficiency model. The Pareto efficiency model states, “in the context of a securitization transaction, [the transaction is efficient if it] would make the parties to the securitization-the originator and the [Special Purpose Vehicle]—better off, and no parties worse off.”
Generally, the parties who are potentially made worse-off would be the unsecured creditors, the Kaldor-Hicks efficiency model states, “in the context of a securitization transaction, [the transaction is efficient if] the aggregate benefit to the parties to the securitization exceeds any net harm to other parties.”
Determination of Jurisdictional Framework
There are two key steps to be considered in structuring any cross-border securitization. The first step is the determination of the jurisdiction of the transaction, and second is the jurisdiction of the company seeking finance and that source of finance. There are numerous factors that govern this search, such as strict restrictive regulations for the protection of investors; the tax implications in that country; the amenities that the country offers; political stability; the number of institutional investors domiciled in the country; and the country’s socio-economic status.
As to the latter consideration, for example, a country’s laws and socio-economic conditions may for the purpose of one objective of the transaction, while not catering to other objectives. The same principle is true for the remaining considerations. For instance, capital markets in the United States are a significant source of securitization financing, because the markets have a broad investor base and efficient pricing. Nevertheless, the issuance of securities in the United States capital markets may require compliance with the United States securities law, which demands extensive disclosure if the securities are issued without restriction on trading-otherwise known as public offerings.
In comparison, some of the European capital markets may have less compliance cost and more flexibility, but a more limited investor base. Hence, there are multifarious things like efficient pricing and market maturity that the players involved in the cross-border securitization process should take into consideration.
Determination of law applicable to cross-border securitization
The second step is ascertaining the law applicable to the cross-border securitization. Since the fundamental feature of international securitization is that different processes of securitization are performed in different countries or different jurisdictions, ascertaining which law applies to the cross-border securitization, is necessary. The contract and documents that govern the agreement are determined by the principles of private international law.
The legal sanctity of the cross-border securitization transactions
Professionals, such as investment bankers and lawyers, have a crucial impact on the development of international securitization law.
Frequently, lawyers draft the documents and contracts involved in a cross-border securitization transaction, which:
(a) provide guidelines to reference and
(b) constitute a private law between them. Therefore, the lawyers who develop these private contracts create international securitization law.
Standardized contracts and other legal documents have developed in various spheres and are contained in numerous publications, websites, and other databases. By allowing easy access to accurate information on domestic laws all over the globe, these databases enhance the uniformity of cross-border securitization.
Various issues involved in the cross-border securitization transaction:
There are various considerations and issues that are involved in a typical cross-border securitization transaction. Since the various processes of securitization are subject to the laws of the country in which they occur, ensuring that there is compliance with applicable local law is necessary. These issues are discussed below:
(a) Commercial Financial Issues –
The securitization agreement must secure the interest of the SPV and safeguard its assets from the claims of the originator and the originator’s creditors. In this context, various legal considerations must be taken into account to determine how the SPV and its investors stand against the originator’s creditors: whether the securitization transaction is potentially preferential or fraudulent, and whether other legal impediments exist to prevent securing the interests of the SPV.
(i) Perfection – The term “‘perfection’ refers to the protection of a transferee’s interest in transferred assets from creditors of the transferor and from the transferor’s trustee in bankruptcy.” There are different modes in which the transferee’s interest is perfected in different jurisdictions.
Some jurisdictions have a filing or other public notice system for perfection, while other legal systems may require notification to obligors, which may be expensive. Often, the local perfection procedures may be unclear or impractical, in which case investors are forced to rely on the originator’s representations, warranties, and covenants that the receivables transferred to the SPV are unencumbered. This illustrates the need for a uniform perfection regulatory system at a global level.
(ii) Priority – The term ‘priority’ is defined as the ‘ranking of multiple claims against a transferred asset.’ In securitization context, however, priority means that the claims of the SPV on the transferred receivables should be made superior to any third-party claims. In most jurisdictions, priority is established by the chronological sequence in which the filing required for perfection has been completed.
If the originator is located in a jurisdiction that does not have a filing requirement or other registration system to indicate priority, the investors may have to rely on the originator’s representations, warranties, and covenants-creating a much greater risk of fraud than in jurisdictions that use public filing systems.
(iii) Commingling – Another risk is that cash received on account of the receivables and, the money which is realized when the receivables mature, may be mixed or commingled with the originator’s own funds. In situations where the originator is freely permitted to use collections realized from the maturity of the receivables, a Court may find the originator’s control inconsistent with the SPV’s claim that it has a perfected interest in the collections. Local tracing laws may ameliorate this risk to an extent. Commingling may also be prevented by using lockboxes or by segregating cash flows.
Under the UNCITRAL Convention, the risk of commingling is minimized. As per the UNCITRAL Convention, if upon maturity of the receivables, the proceeds are received by the originator, then the SPV will have a priority over the right of any other party, if either of the following conditions are satisfied: (1) the originator has received them under instructions from the SPV to hold the proceeds so received for its benefit, or (2) the proceeds are held by the originator for the benefit of the SPV separately and are reasonably identifiable from the assets of the originator.
(b) Enforcement issues –
In an international and commercial context, having theoretical rights under the law is not enough. The critical question is whether one can enforce those rights, recognizing that the legal system granting the rights may not be the same as the one in which enforcement occurs. Furthermore, foreigners may not be viewed favorably when enforcing rights against local citizens. Therefore, the investors may require the originator to submit to the jurisdiction of the country in which the investors reside or, at least, submit to the jurisdiction of the country where the SPV is located.
This choice of law requirement is advantageous to investors for both procedural reasons and for convenience. Additionally, the investors would not face any bias against foreigners in the originator’s judicial system. The investors can simply sue in the jurisdiction to which the originator has submitted, obtain a judgment, and take the judgment to the originator’s home jurisdiction to be enforced against the assets of the originator.
(c) Foreign currency issues and mitigation of risk on account of fluctuation in the foreign currency exchange rate –
Currency exchange issues are always pertinent in any cross-border transaction. In cross-border securitization, the problem is that the currency in which investors purchase the SPV’s securities may be different than the currency the SPV receives to repay them. In this context, currency exchange controls and relevant regulations must be considered. There is a risk that the originator’s home jurisdiction may limit the export or private use of the US dollars or other relevant foreign currency.
The exchange rate risk, which the investors bear, is generally hedged through swaps and other derivative products. A derivative product, in its most basic form, is a contract that creates future rights and obligations regarding an asset that underlies a larger transaction. Derivative products can be broken down into forwarding contracts and options.
In an option, one party pays for the right, but not the obligation, to buy an asset at a future date for a negotiated price. A forward contract is a contractual obligation to buy or to sell an asset, such as foreign currency, at a specified price at future settlement date. A swap is an array of forwarding contracts, which cover each date when settlement is to be made.
(d) Taxation issues in cross-border securitization transactions –
The taxation issues in a cross-border securitization transaction are of seminal importance. The major tax concerns in a cross-border transaction are:
(i) Whether the transfer of receivables from an originator to the SPV is to be treated as loan or sale – This question is governed, of course, by the tax law of the company’s jurisdiction, and can depend on whether benefits and burdens of ownership of the assets have been transferred. If the transfer of assets from the company to the SPV is a sale for tax purposes, the company may have to recognize tax loss or gain in its own jurisdiction. A cross-border withholding tax is a jurisdiction’s attempt to tax a non-resident’s interest income to the extent such interest is paid by a resident.
For example, the jurisdiction of the company may attempt to tax interest income of the SPV if the transfer of assets from the company to the SPV is characterized for tax purposes as a loan from the SPV to the company.
(ii) Withholding tax – Payments that are treated as interest for income-tax purposes may be subject to withholding taxes in the jurisdiction of the payer, and the cost thereof must be factored into the particular transaction.
The interest payments may take place in a cross-border securitization in the following cases:
(a) if the obligors in one country pay interest on the underlying receivables to the SPV in another country due to sale of receivables, the payments made by the obligors may be subject to withholding tax regulations in the country where the obligors are resident, and,
(b) if a transaction between the originator in one country and the SPV in another country is treated as a loan by the tax authorities of the originator’s jurisdiction, there may be withholding taxes on interest paid on the loan. For example, the jurisdiction of the company may attempt to tax interest income of the SPV if the transfer of assets from the company to the SPV is characterized for tax purposes as a loan from the SPV to the company.
Since the non-resident SPV may not be directly subject to taxes in the company’s jurisdiction, that jurisdiction may require the company to withhold a portion of the amount of interest, otherwise, payable and pay the withheld amount to the relevant taxing authority. The final case is where the SPV in one country raises money by issuing debt instruments to investors in another country. Here the interest that would be paid by the SPV on the debt instruments may be subject to withholding-tax regulations in the country of the SPV.
(iii) Taxation of the special purpose vehicle – The establishment of the SPV in a cross-border securitization transaction is desirable as it would both minimize withholding-tax on any interest payments made by the SPV and avoid mainstream tax on the net income of the SPV assuming that it is an entity subject to such tax. One more situation that arises in such kinds of transactions is that if the SPV owns receivables of obligors in another jurisdiction and the originator services the receivables in that other jurisdiction on behalf of the SPV, whether in such cases SPV can be taxed, is to be ascertained. One can take reference from the concept of permanent establishment and the ambit of the same in the bilateral DTAA between the countries.
(iv) Taxation of investors – The tax law of each investor’s jurisdiction normally governs this, although the tax characterization of securities issued to investors in the SPV’s jurisdiction (if different) may be relevant. Investors may also be subject to withholding taxes on cross-border interest payments.
The importance of rating agencies
It is increasingly common in cross-border financial transactions, and especially in securitization, for investors to rely to a large extent on rating agencies for comfort as to the structure of the transaction and for informational diligence on the underlying collateral or other assets. Rating agencies are private companies whose business is assessing the risks associated with the full and timely payment of debt securities. The significance of the rating depends entirely on the reputation among investors of the particular rating agency.
The SPV with AAA-rated securities can charge a lower interest rate on those securities, and still, attract investors, than can the SPV with the lower rated securities. The lower interest rate lowers the SPV’s financing cost, which in turn lowers the financing cost of the company for which the SPV was created
Uncitral’s impact on cross-border securitization –
Based on a text prepared by the United Nations Commission on International Trade Law (UNCITRAL), the United Nations Convention on the Assignment of Receivables in International Trade Convention will be enforceable upon being adopted by five States. Its main goal is to facilitate the financing of contractual monetary claims (receivables), including securitization and related service transactions in which no financing is provided.
The preamble of the convention explicitly identifies facilitating credit at more affordable rates and protecting debtors as goals of the convention. These goals may well be read as an indirect reference to practices such as securitization.
The convention eliminates or reduces the number of obstacles to cross-border transactions, relating mainly to certain statutory limitations and to contractual limitations
Moreover, the convention breaks new ground in centralizing all priority issues to the law of the assignor’slocation. The need of this convention if felt when the reference of priority in proceeds work which is, covered by a so-called ‘lock-box arrangement’, to the law of the assignor’s location. This rule may well facilitate significantly receivables financing in countries in which property rights in proceeds are not recognized. Furthermore, the convention’s independent conflict-of-laws rules provide useful guidance in filling gaps in the convention and add value to the convention to the extent they may unify generally applicable conflict-of-laws rules.
International securitization enables a company to raise funds at lower costs from capital markets in foreign countries. The structuring of an international securitization basically revolves around two issues: first, determining the jurisdictions in which the cross-border securitization operates, and second, ascertaining the applicable law and structuring the securitization in consonance with it.
There are numerous factors – such as restrictive regulations for the protection of investors, the relevant tax implications, and the amenities available in that country – that influence the choice of country for raising funds through securitization.
Consequently, the whole socio-economic condition of a country should be analyzed before choosing to structure a cross-border securitization. With respect to the regulation of the international securitization transactions, it is to be concluded that the international securitization law governs the international securitization.
Furthermore, the various processes of securitization are subject to the law of the country where they occur. There has been dynamic growth and development of the international securitization laws by means of lex juris, much like the development of the law relating to internet transactions. In contrast to the process of creating the domestic laws and the international treaties, the process of creating lex juris is flexible.
The process avoids the procedural and political straitjackets of the domestic and international institutions. Lex juris represents fundamental values that command a consensus. If lex juris rules deviate from these fundamental values, domestic law will keep a check on this deviation. Thus, based on the research work carried out, it can be concluded that lex juris is and will continue to be a strong influence in the evolution of the international securitization laws; it will emerge as a forerunner in the formulation of the international rules that cut across nations to regulate specific global activities.
As the process of securitization becomes uniform, the issues related to securitization also become uniform. Since the laws addressing these issues vary between countries, the establishment of a universally accepted international code specifically designed to govern these concerns at an international level would greatly facilitate transnational securitization. The UNCITRAL convention is a significant step towards harmonizing the laws governing international receivables financing, thereby facilitating the growth of cross-border securitization in general.
Formatted on February 20th, 2019.
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 An SPV is merely another corporate entity distinct from the original company (‘originator’), to which the receivables are transferred. Accordingly, the purpose of the SPV is to hold receivables and issue debt instruments.
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 Priority is sometimes colloquially defined as first in time, first in right. Generally, this definition gives priority to the first person to file against the asset. See, U.C.C. § 9-312(5)(a)(2000).
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 Supra note 34.
 See, Supra note 5, In a contract of assignment (which may be defined as the transfer of property in receivables), an assignor is the old creditor in the transaction giving rise to the assigned receivable and is normally the borrower in the finance contract.
Edited by: Hardeep Singh Chawla