Structured Finance Loan Defined
The assets and cash flows backing the notes, bonds, or loans issued in the securitization, are typically pooled together, transferred to a separate Special Purpose Entity (SPE) and subject to a precise structure so as to be isolated from the credit and bankruptcy risk of the originator of the assets.
Potential Reasons for Using Securitization Structures:
- Lower cost of financing
- if the ABS have a rating that is higher than the credit rating of the Originator - Alternative source of financing
- Some Originators use securitization to ensure an additional source of funding if their other sources become unavailable or too expensive - Rating of the ABS
- The rating of the Originator does not usually limit the rating of the eABS - Better terms/availability
- Where the value of the assets can be separated from the bankruptcy risk of a less creditworthy Originator, thus avoiding an automatic stay.
Automatic Stay
If a Borrower files for bankruptcy, the bankruptcy court will have the power to stop payments on the obligations and to prevent the investors from taking action on the collateral to satisfy the Borrower’s obligations.
True Sale Methodology
A transfer of assets so that they are not the property of the transferor. The substance of the transaction must be that of a sale such that the transfer must move the burdens and benefits of owning the Receivables from the transferring entity to the receiving entity.
Factors considered in the True Sale analysis
- Fair purchase price
- Arms length Terms
- No recourse
- Whether assets remain sold once sold
- Whether risk of loss transfers
Substantive Consolidation
Under Substantive Consolidation, the SPE could be considered to be part of the Originator if the SPE is operated in a manner that leads 3rd Parties to reasonably believe that the SPE is merely a part of the Originator.
Some issues considered when determining whether to grant a substantive consolidation are:
- Did the creditors of the first entity reasonably rely on the availability of assets of the second equity to pay their obligations?
- Should creditors of the second entity have reasonably believed that the second entity’s assets would be available to pay obligations of the first?
- Are the assets and liabilities of both entities so hopelessly entangled that separation is impracticable in any event?
Originator
The entity that originates the Receivables.
Receivable
Represents an obligation to pay money. For example, a Receivable could be a loan or an amount owed by a commercial customer to a seller of a product. The Receivable converts to cash.
Account Debtor
The person or entity that is obligated to pay the Receivable
Servicer
The entity that collects payment on the Receivable
Servicer
The entity that collects payment on the Receivables. The Originator and the Servicer are usually the same person, pursuant to an arms length service agreement.
SPE
Special Purpose Entity
An entity whose sole purpose relates to accomplishing purchase of the Receivables from the Originator and therefore owns the Receivables. The SPE will issue Asset-Backed Securities. Because of its limited activities, the SPE entity is very unlikely to become insolvent and is referred to as “bankruptcy remote”
How to Structure a good Structured Finance Loan
- True Sale or True Contribution
- Non-consolidation: protecting against substantive consolidation of the assets of the SPE with those of the Seller/Transferor of assets by establishing a “bankruptcy remote” and “non-consolidatable” entity
- Perfection: in some cases, taking a back-up pledge and perfecting the interest of the purchaser/SPE in the assets.
Factors a court looks at to determine whether a True Sale has occurred
- Recourse: A proper securitization makes clear that there is no such recourse to the Seller/Transferor
- Irrevocability: The risks and benefits of ownership of the assets must be transferred to the Purchaser without a mechanism for reallocating those risks back to the Seller/Transferor down the road. For example, if the Seller has the right to reclaim the assets (a call option) at a time when the assets have appreciated in value and thereby deprive the Purchaser of the benefit of ownership of the assets, or if the Seller has the contractual right to call reclaim the assets at a fixed time for a fixed price, the attribute of irrevocability is absent and courts have viewed these transfers as creating security interests rather than sales.
- Control Over Assets Through Administration: Control over the assets by the Purchaser, generally in the form of administration of the assets has several components -
(I) Notice to the obligors under the assets that there has been a sale
(ii) Possession or marking of documents governing or evidencing the assets sold
(iii) Servicing and collecting the assets have been sold
(IV) Receipt and possession of collections - Express Intent of the Parties: A clear statement of the intent of the parties to a transaction to create a sale is helpful (although not alone sufficient) in concluding that it is one.
Bankruptcy Remote
An entity is unlikely to voluntarily file in bankruptcy or to be substantively consolidated with the Seller in the event of the Seller’s bankruptcy, and unlikely due to its limited purpose to have other creditors to be put into bankruptcy by any of its creditors.
Bankruptcy Remote Companies typically have the following features:
- Provide at least one independent, unaffiliated director on the board.
- Provide an independent, unaffiliated director on the board
- Obtain a commitment or statement of intent from management that they have no intent to cause the filing of a bankruptcy petition
- Include in the corporate charter that the corporation may not file bankruptcy or accede to an involuntary filing without the vote of its independent directors
- Keep separate corporate identities in terms of segregation of assets, separate books and records, separate financial statements, and separate office space.
- No commingling of assets and liabilities, having intercompany guarantees or transaction business with affiliates other than on arms-length terms.
Orphan Subsidiaries
The stock of the SPV is owned by an unaffiliated third person, often a charitable trust, in which case it is called an orphan subsidiary. The stockholder should have no incentive to cause the vehicle to file a bankruptcy petition or consent to the filing by the Seller of assets, and the stockholder itself, as a charitable trust, will not be subject to bankruptcy risk.
Limited Liability Companies and Limited Partnerships
These vehicles are often used by Sellers to accomplish certain tax objectives. Bankruptcy remoteness is achieved by including:
- Creating a general member that is a bankruptcy remote SPE with an independent member (non-economic and like an independent director) and seperateness covenants such as no comingling of assets with other parties, particularly affiliates
- Creating a single member LLC or partnership where that single member is a bankruptcy remote SPE
Substantive Consolidation 2
The present state of the substantive consolidation doctrine is that it is an extraordinary bankruptcy court remedy to be invoked typically only where:
1. Creditors of the SPE DID NOT rely on corporate separateness of the SPE from the Seller, creditors of the Seller DID reasonably rely on such assets being available to the Sellers/Creditors
- Where there has been commingling of assets and liabilities such that untangling the assets will not benefit the creditors of the SPE or is otherwise justified because the untangling is either impossible or too costly
The True Sale Opinion
An opinion from counsel that discusses whether in the event of the Originator’s bankruptcy, such assets would not be deemed property of the Originator (or any of the affiliates that owned the assets at any point during the transfer to the SPE.
Factors considered in a True Sale Opinion
- Whether there is recourse to the ORigintor for collection or non-payment
- Which party bears the risks and enjoys the benefits of ownership of the assets
- Whether a price approximating fair value has been paid for the assets conveyed or in the case of a true contribution to equity, the contribution is recognized as a contribution under applicable state law
- Whether the Originator retains any rights in or control over the assets (right of substitution, redemption, or repurchase)
- Whether collections from the transferred assets are segregated from any other assets that may be held by or retained by the Originator
- How the parties treat the transaction for tax, accounting, and regulatory purposes.
- The intent of the parties that the transfer be a sale (or contribution to equity) as opposed to a financing, particularly as indicated by either the economic substance of the transaction and the express language of the documents.
Separateness Covenants
A series of commitments by both the Originator and the SPE designed to protect the separate legal characters of those parties in order to avoid a substantive consolidation.
There are some obligations the SPE will maintain in its separateness covenants.
Non-Consolidation Opinion
An opinion that in the occurrence of bankruptcy by the Originator that the court would not use its powers of substantive consolidation of the SPE assets and debts with those of the Originator or its affiliates.
One of the key prongs to that analysis is to determine that the creditors of the Originator/Transferor should not have a reasonable expectation that such assets of the SPE will be available to them to pay the debts of the Originator/Transferor.
