Bankruptcy Remote or On Thin Ice?
Securitizations are based on having assets protected from the potential bankruptcy proceedings of the seller of those assets. No bankruptcy remoteness is like trying to skate with dull blades.
Having kids alone is financially challenging. Now imagine having three sons that play ice hockey. The cost of ice skates alone can be prohibitive, constant blade sharpening only makes it worse. Dull skates can impair a skater’s ability to turn, stop and dampen their overall control. As a fixed income investor, focused on preservation of capital and income, I purchased an electric skate sharpener. Over time, using this sharpener is much cheaper than going to the ice rink and regularly paying to have the blades sharpened. Furthermore, my sons now earn extra income by sharpening their teammate’s skates.
Yes, my sons have a nerd for a father; one that would encourage them to have their teammates commit to a future sharpening schedule at a set price. My sons would then have the foresight to take these receivables and put them in a Special Purpose Vehicle (SPV) and sell them to investors. And, of course, my sons would be instructed to follow all security laws before selling the cash flows from the receivables in the SPV. My sons will have cash today from the security sale, and the debate between spending their proceeds on ice cream and adding to their 529 college savings plans would begin.
Now that the SPV has been set up and investors have purchased the cashflows generated from the skate sharpening receivables, let’s assume that my son’s teammate Gretzky gets injured and no longer needs his skates sharpened. A new teammate McDavid joins the team and commits to paying my son to sharpen his skates. My honorable son takes receivables from McDavid and puts them in the SPV to replace the receivables from Gretzky.
Now let’s say that my son loses his job as a Zamboni driver. This causes him to declare bankruptcy. My son’s creditors (various streaming and gaming services) want to collect the money he owes them. These creditors sue for the money he makes from sharpening his teammates skates, but all of the proceeds from selling the assets are gone and the only thing remaining are the receivables in the SPV. Will the creditors be successful in taking the receivables from the SPV or will the court say that they are bankruptcy remote?
Investors in Asset-Backed Securities (ABS) must evaluate the factors that make a true sale of receivables to be protected from creditors of the seller of the assets to the SPV. Under the bankruptcy code of the United States, if the seller of the assets to a SPV goes bankrupt the creditors of the seller can challenge whether the assets were perfected or if the sale of the assets are a secured loan instead of a true sale.
Sales of financial assets typically have elements of both sales and secured loans. There is no definitive judicial authority to analyze the type of sophisticated transactions that commonly characterize ABS assets. Investors who rely on the true sale opinion that accompanies most ABS transactions have to be aware of this fact. The chart below examines the factors U.S. Courts have used in the past to determine if a transaction is a true sale or a secured loan.
Intent of the Parties
In addition to what is stated in the agreement between the buyer and seller, U.S. Courts have also examined the parties' practices, objectives, business activities and relationships. In these cases, they determined whether the transaction was a sale or a secured loan - only after analysis of the evidence as to the true nature of the transaction.
Recourse can take various forms, including an originator’s obligations to buy back the defaulting receivables. Originator's guarantee that the receivables will be collected, or the SPV's ability to withhold cash payment to the originator until the corresponding receivables are collected. If the SPV owned the loans they would bare the risk of a decline in the market value of the loans.
Control of the Assets
If the originator has truly sold its receivables, it should have little interest in whether the accounts are actually collected, since only the buyer should realize any losses.
If there is a reallocation of the risks and benefits of ownership, the agreement is not irrevocable. For instance can the seller of the assets unilaterally modify the interest rate applicable to the receivable contract? Similarly, a true buyer of receivables should be able to resell those receivables without any restrictions.
Tax and Financial Accounting Treatment
The more ways a transaction is treated as a sale or a secured loan, the more persuasive evidence there is that courts should be consistent with the determination.
Other Agreement Terms
If the SPV sets forth conditions the seller of the collateral has to follow, this argues for a secured loan determination. In this case the SPV would be in charge of the decision making with the seller of the collateral acting as a loan conduit. If the SPV pays different purchase rates for different types of loans or picks and chooses what receivables it would purchase after credit for the receivables have been extended - this would make the transaction look more like a true sale.
Relationship to a Loan Transaction (whether the transferor retained the right to redeem the transferred assets or the right to surplus)
When an SPV purchases assets and is allowed to keep any surplus as a benefit of ownership, it would seem that the transaction is a true sale. When an SPV has to return the surplus, it would seem that the transaction is a secured loan.
Do investors in my son’s securitization need to be concerned about whether the receivables in the SPV are protected from their creditors post-bankruptcy? When Gretzky’s underperforming receivables are removed from the trust and McDavid’s new assets were substituted, did that cause true sale concerns? Does the fact that the seller of the receivables to the trust also services the collateral because of his relationship with his teammates hurt the ABS investors’ claims on the assets? Do Dodd Frank and Solvency II risk retention rules requiring my son to retain some ownership of the ABS (risk retention) also hurt a true sale determination? My son’s ABS investors may want to balance how these “protections” may affect the bankruptcy remoteness of the assets in the ABS. True sale and bankruptcy remoteness are the most important pillars of securitization, and therefore require strict adherence to legal precedence and documentation in order to protect the SPV assets when things go poorly for the seller. Given the importance of securitizations to the economy, Courts have generally protected securitized investors in instances when a seller/sponsor bankruptcy has occurred.
All characters and entities appearing in this work are fictitious. Any resemblance to real persons, dead or alive are purely coincidental.