Introduction
Companies are increasingly incorporating securitization financings into their capital structure. This enables them to diversify their lender base, increase their borrowing capacity and potentially lower their financing costs. Depending on the overall capital structure and the underlying assets, securitization techniques may also be used to unlock additional benefits in a wide range of areas, such as improving credit ratings, reducing lenders' regulatory capital charges, operating under less intrusive covenants, obtaining particular tax or accounting treatments, or establishing a more portable financing structure
Fundamentally, lenders in a securitization, like all asset-based loans, lend against the liquidation value of the relevant underlying asset. Unlike traditional asset-based loans, securitizations also seek to decouple the financing from the credit risk of the company that establishes the financing (the "securitization sponsor"). This typically means that the issuer in a securitization is established as a special purpose entity (the "securitization SPE") that cannot be a guarantor for, or pledge its assets to support, any other debt. It also means that the securitization SPE's debt obligations will not have recourse to the securitization sponsor or its affiliates.
Lenders under cash-flow loans, in contrast, lend against the earnings capacity and enterprise value of the borrowers, guarantors and those of their subsidiaries that are restricted by the loan agreement (collectively, the "borrower group and its restricted subsidiaries"). Investment grade loans tend to be unsecured, while lower rated loans, referred to as "leveraged loans", are typically secured by the borrower group's assets. However, a borrower with significant enterprise value that files for bankruptcy protection is more likely to go through a chapter 11 reorganization than a chapter 7 liquidation. As such, the lenders under a leveraged loan are therefore more focused on ensuring that their collateral package protects their status as secured claimants in any bankruptcy proceeding and less focused on lending against the liquidation value of their collateral. Said differently, collateral in excess of what is required to fully secure the leveraged lenders will not provide much additional lending value under a leveraged loan. A company can therefore use such excess assets to support a securitization financing without any significant reduction in borrowing capacity under its cash-flow loans
Receivables are assets that are well suited for securitization financing in conjunction with a cash-flow financing. A diversified pool of receivables may be able to support a significant advance rate under a securitization, while a sale of such receivables will not significantly impact the earnings capacity or enterprise value of the borrower group and its restricted subsidiaries. Consequently, it is fairly common for leveraged loan facilities to include a generous or even unlimited basket for receivables securitizations as part of the exceptions to the restricted covenants. It also possible to securitize less liquid operating assets, so long as the structure provides for continued debt service under the securitization even if the company using such operating assets becomes subject to bankruptcy proceedings. It is even possible to construct a securitization of assets for which the cash-flows are in the form of lease payments, licensing fees or other payments coming from the affiliated borrower group and its restricted subsidiaries. However, lenders under cash-flow loans made to such borrower group will want to make sure that their position is adequately protected when establishing such an add-on securitization. Leveraged loans typically contain a number of covenants that have to be satisfied, and which can be satisfied, as part of establishing an add-on securitization financing. However, there have been instances where lenders under leveraged loans have objected to distressed borrowers using "drop down" financings as part of liability management transactions to move assets away from the cash-flow loan collateral. Such drop-down financings have many aspects in common with a securitization financing, though there are also important differences between such liability management transactions and constructing an optimal capital structure outside such distressed scenario. This will be discussed in more detail below.
Summary of Securitization Features and Character of the Receivables
a. Securitizations - a summary of key features
Securitization, at its core, involves isolating the securitized asset from the originator and its affiliates and obtaining financing secured and serviced by such assets. Typically, such asset isolation will involve a "true sale" of such assets to a "bankruptcy remote" special purpose entity (i.e. the securitization SPE). True sale is a legal and accounting concept intended to capture a transfer that will be respected in a potential bankruptcy of the transferor, such that the transferred assets are no longer part of a transferor's property or bankruptcy estate. That analysis hinges on whether the attributes of the transaction have more in common with a sale than a secured loan. Not surprisingly, the more attributes the relevant transfer has in common with a typical sale transaction, the more likely it is that a court will determine the transfer to be a true sale. Conversely, the more the transaction includes features that are more typical of a loan, the greater the likelihood that the transaction would be characterized as a transfer of collateral securing a loan. Some features, such as transferring the economic risks and rewards of ownership, are given greater weight than others in determining whether a purported sale will in fact be respected as such or instead be recharacterized as a loan.
Effectuating a true sale to a securitization SPE that is affiliated with the transferor would not be of much use in effectuating isolation of the assets, if the SPE itself would be combined with its affiliates' bankruptcy estates, whether as a result of the SPE becoming subject to a bankruptcy filing or as a result of the SPE being substantively consolidated with a bankrupt affiliate. It is therefore typical to include various features in the SPE's charter and the relevant transactions documents to limit the likelihood of such events.
The risk of the SPE becoming subject to an involuntary bankruptcy is reduced by limiting the SPE's activities to the securitization transaction and requiring transaction parties to waive or limit their right to bring a bankruptcy proceeding against the SPE. Contractual provisions that prevent the SPE from voluntarily filing for bankruptcy protection are not enforceable on public policy grounds. Therefore, the risk of a voluntary filing by the SPE is addressed more indirectly: in part, by limiting the activities of the SPE; in part, requiring the SPE's contract counterparties to agree that their claims against the SPE will be limited to its assets; and in part, by requiring that any bankruptcy filing and certain other material actions require the affirmative vote of an independent manager whose fiduciary duty runs to the SPE itself and not its shareholders. Finally, to protect against a bankruptcy court applying the equitable "substantive consolidation" doctrine, the charter and transaction documents typically include a number of separateness covenants that are required to be observed at all times.
The "decoupling" of the securitization SPE from its affiliates, together with credit enhancements such as overcollateralization, collateral pool diversification, liquidity reserves and cash trap or amortization triggers, typically enables the securitization SPE to issue debt with a significantly better credit rating than the cashflow loans of the SPE's affiliates. This can be very attractive to companies with a low investment grade or sub-investment grade rating. Even where the collateral is limited to a single asset for which the cash-flow to the securitization SPE comes from the affiliated borrower group and its restricted subsidiaries, it is possible to achieve a credit rating above that of the relevant payment obligors if the securitized asset is sufficiently important to the continued business of the payment obligors such that they are likely to continue to make lease, license or other relevant payments relating to such asset, even if they become subject to chapter 11 bankruptcy.
Given the collateral isolation and the non-recourse nature of securitization debt, there is typically a lot of flexibility around where in the corporate organization structure the securitization SPE can be located. The securitization issuer can be a subsidiary of the borrower group or it can be a sister company that sits outside the borrower group. The SPE can be wholly-owned or owned only in part by the borrower group or its affiliates and it can be structured as an unaffiliated entity altogether.
b. Receivables arising under non-executory contracts
As noted above, there is a broad variety of cash-flows that can be securitized. Loans, leases and payment obligations for goods and services that have been delivered such that the only remaining obligation is the payment, are particularly well suited for securitizations. Such contracts are not executory and therefore cannot be rejected in case of a bankruptcy affecting either party to the transaction giving rise to such receivable. Receivables arising from a company's ongoing business activities with its customers may also be securitized but will be subject to some increased risks of delay or failure to pay if the originating company fails to perform any future obligations to the customer. Such failures could result in the customer (i.e. "account debtor") using such future breach as a counterclaim to reduce its payment obligations with respect to the assigned receivables.
Generally, the uniform commercial code distinguishes between set-off rights stemming from different contracts, and set-off rights arising under the same contract (also referred to as recoupment). An assignee, including a securitization vehicle, can generally prevent set-off from unrelated claims simply by giving the obligor notice of the assignment, but will generally not be able to prevent recoupment under the same contract absent express waiver from the payment obligor. In order to protect the SPE against such defenses to payments or the costs of disputes around whether the customer in fact is obligated to pay the relevant receivable, it is typical to include recourse for such losses and costs to the company that sold such receivable to the SPE. However, to maintain the true sale of the receivables to the SPE, it is important to appropriately limit such recourse and there should not be recourse to the company for the account debtor's financial inability to pay. The recourse provided for set-off and recoupment claims, as well as for any indemnity or repurchase obligations relating to any breach of representations, warranties or covenants of any seller of assets to a securitization SPE or of any servicer providers to the SPE, are often referred to as "typical securitization undertakings" (or words of similar import) in leveraged loan facilities, and are generally permitted in conjunction with any permitted securitization transactions.
c. Receivables arising under executory contracts
Contracts where both parties have performance obligations remaining at the time when one party becomes subject to bankruptcy proceedings are likely "executory contracts", which can be rejected in bankruptcy. See, Bankruptcy Code Section 365 (providing that, subject to court approval and certain limitations, a debtor in bankruptcy can assume or reject any executory contract or unexpired lease). See: Matter of C & S Grain Co., 47 F.3d 233, 237 (7th Cir. 1995) (for the purposes of the Bankruptcy Code, an executory contract is one in which the obligations of each party remain substantially unperformed); and In re Spectrum Information Technologies, Inc., 190 B.R. 741, 747 (Bankr. E.D.N.Y. 1996) ("contracts where one party has completed performance are excluded from the ambit of section 365"). Examples of executory contracts include intellectual property licenses and ongoing service contracts. Any risk that a bankruptcy by the company could result in a material reduction in the payment obligations under the receivables sold by the company is, naturally, inconsistent with the securitization principle of decoupling the SPE's credit from the company's credit.
If a securitization includes receivables under executory contracts, the question then becomes how best to insulate the SPE from the Company's rejection risk. As noted above, one way to address the issue would be to have the account debtor agreeing to waive its right to assert any counterclaims or right to set-off and recoupment for the assigned receivables. Such waiver could either be entered into directly with the SPE, for example at the time of assignment or any invoicing by the SPE. Such agreement could also be entered into between the company and the customer, for the benefit of any assignee of the payment rights, including the securitization SPE. The uniform commercial code expressly provides that such waiver of rights under commercial contracts are enforceable so long as the assignee took assignment for value, in good faith and without knowledge of any existing counterclaims. See UCC 9-403 (b). The only exceptions to enforcing such waiver are defenses based on: (i) infancy of the obligor to the extent that it is a defense to a simple contract; (ii) duress, lack of legal capacity or illegality of the transaction under other law; (iii) fraud in the inducement; or (iv) discharge of the obligor in insolvency proceedings. Notably, rejection by the account creditor or account debtor of a contract in bankruptcy does not amount to discharge of such contract, nor does any breach by the account creditor constitute one of the remaining defenses that can be asserted after assignment.
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Originally published by International Comparative Legal Guide to Securitisation (ICLG)
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