True Sale in Securitization - Essay Example

True Sale in Securitization I. Introduction The most common definition of securitization is the pooling of assets, which is generally backed by the securities issued to finance the pooled assets. Generally, securitization operates on the premise of forecasting the behaviour of particular assets with the help of efficient financial structures. These financial structures are called Special Purpose Vehicles (SPVs) whose functions may or may not be solely based on the administration of securities. Securitization of assets is aimed at generating more funds for the company. In the case of banks where the funds are usually tied up in loans granted to clients, the option of securitization is very vital for its continued operations and liquidity. Securitization of accounts receivables involves the sales of ‘future cash flow” transaction backed by the amount to be paid in the future by the borrowers of the bank. “Future cash flows” are accounts receivables, which are not yet due and demandable. The power to sell the receivables by the creditor stems from the concept of securitization, which is a “contractual right of a creditor to sell the goods of the debtor and apply the proceeds thereof in or towards the satisfaction of the debt.”1 There are three types of securitization currently used in the market. First, it could be treated as a “true sale” which is characterized by a transfer of all rights over the receivables to the SPV by the originator. Second is the synthetic securitization where the originator does not sell the accounts receivables but enters into a derivative transaction. Third, are the whole business securitizations, which a form of secured financing, and not a sale of the accounts receivables from the originator to the SPV. Of the three types of treatment, true sale may prove to be the safer ground for the seller. II. What is a true sale? a. Perspectives There are two points of view in true sale transactions namely the originator’s perspective and that of the SPV. Since Bank A falls under the category of an originator, we will then the originator’s perspectives. As earlier discussed, securitization is aimed at raising funds. For the originator, it is also a method of extracting profit. However, extraction of profit must be done with caution as it has the tendency to run foul with regulations and accounting principles. Under the rules and guidelines of the Securitisation and Asset Transfers (SE) as embodied in the FSA’s Interim Prudential Sourcebook for Banks, extraction of profits may be effected in the following manners, namely (a) as administration fees for the originator under the administration agreement2, (b) interest and credit enhancement3 (c) deferred purchase price which includes the accrual of interest in connection with over-collateralisation4. b. Conflict of law Securitization may become a subject of conflict of laws where the asset in question is be located in a different country from where the contract of loan was entered into. In some cases, there are methods of transfer which are not recongnized in other areas but it being practiced in some. The non-recognition of some methods of transfer may affect the nature of the transaction. Under English law, conflict of jurisdiction may be resolved by following the original intent of the parties and the tenor of the contract which is embodied in Article 35 of the EC Convention on the Law Applicable to Contractual Obligations. In the case of Marconi Communications International Limited v PT Pan Indonesia Bank Limited TBK (2005)6, the Court of Appeals ruled that in the absence of any agreements of parties, jurisdiction shall be conferred on the country which is proximate to the perfection of the contract. Characteristics of a True Sale and Re-characterization In the case of George Inglefield, Ltd. (1933)7, the Court set at least three indicators of a true sale transaction where (a) the vendor may not be entitled to get back the goods sold by returning the purchase price (b) where the mortgage property is sold and the proceeds thereof is not enough to pay the loan, the purchaser cannot the recover the balance from the mortgagor, thereby, the purchase shall bear the loss and (c) any profit realized from the sale of the property shall not accrue to the mortgagor but to the purchaser. Note that there are distinct characteristics of a true sale, which can be observed in the Court’s decision of the Inglefield case. First, an originator must ensure that the receivables do exist, it is valid and enforceable and owned by the originator at the time of the sale. We have to remember the maxim that you cannot give what you do not have. Second, the sale should not be treated as a form of financing arrangement where the originator is not selling the receivables but merely borrowing from the SPV using the receivables as collateral. This transaction is usually characterized by under valuation of the receivables and the continued presence and involvement of the originator in the administration of the loans portfolio. The danger presented in this kind of arrangement is that this may be subject to re-characterization by the Court and may declared as invalid for lack of registration as required under Section 395 of the Companies Act 1985. Re-characterization is one of the areas where usual conflict arise since the Court will intervene and interpret the contract according to its substance and not on the language by which it is written. In some instances the substance of the contract may be in conflict with the language thereof and may affect the legality of the whole transaction. In case of Welsh Development Agency v Export Finance Co.(1992)8, the Court ruled that the legality of the sale should be based on the substance of the agreement rather than the labels put by the parties thereto. However, in the later Court decisions in the case of Smith (Admin. Of Cosslett (Contractors) Ltd. V Bridgend CBC (2003)9, the Court ruled that reliance on the intent of the parties of contract is not the paramount rule in re-charaterization. Once contractual rights have been conferred to parties, this will not become just mere questions of intentions but of law. “The question whether it constitute security right is a question of law that is not dependent on the intentions”10 of the parties. Public interest seeks to protect the right of vulnerable people. Where the question is imbued with the elements of public interest, this shall “override the unrestrained freedom of contract”11 and may open the securitization transaction to re-charaterization. The third element of a true sale is that it should transfer beneficial ownership of the receivables to the SPV and that there are no obstacles, which might prevent the transfer thereto. Obstacles, which might prevent the transfer of the beneficial ownership of the receivable, may be the presence of negative pledges stipulated in the contract of loan as well as prohibition of transfers. Where these provisions are present in the contract signed by the parties in the loans agreements, the originator cannot transfer beneficial ownership of the receivables without running foul with the provisions of the contract. The fourth characteristic of true sale is that it should defeat the intervening interests of third parties, which have adverse claims on the receivables. It should also defeat the possibilities of set-off and counterclaims that other debtors may have over the receivables. This is especially true in the case of claims arising from equipment financing and consumer good financing where there are existing encumbrances attached to the equipments or the goods. The fifth element, which makes a transaction, a true sale in securitization is the fact that the receivables will not be affected by the originator’s insolvency. This means that the receivables should not be undervalued so as to remove it from claims under Section 238 of the Insolvency Act 1986. Therefore, with all these elements present, the transaction can be rightfully construed as a true sale and shall purport to extended protection to the buyer thereof in case of insolvency and third party claims. Bibliography Books, Laws and Articles 1. Companies Act 1985 2. Cranston, R. (2002), Principles of Banking Law, Oxford, Oxford University Press, 2nd edition 3. EC Convention on the Law Applicable to Contractual Obligations 4. Insolvency Act 1986 5. McKnight, A. (2003), Contractual Restrictions on a Creditor’s Right to Alienate Debts: PartⅠ, JIBLR ISSUE 1 6. McKnight, A. (2003), Contractual Restrictions on a Creditor’s Right to Alienate Debts: PartⅡ, JIBLR ISSUE 2 7. Rules and guidelines of the Securitisation and Asset Transfers (SE) as embodied in the FSA’s Interim Prudential Sourcebook for Banks 8. Trietel, G. (2003), Law of Contract, London, Sweet and Maxwell, 11th edition Cases 1. Agnew v. Commissioner of Inland Revenue (2001) 2 AC 710 2. George Inglefield, Ltd. (1933) Ch 1 3. Marconi Communications International Limited v PT Pan Indonesia Bank Limited TBK (2005) AER (D) 389 4. National Westminster Bank V. Spectrum Plus (2005) UKHL 41; [2005] 4 All ER 209 at [141] 5. National Westminster Bank v. Spectrum Plus (2005) UKHL 41; [2—5] 4 All ER 209 6. Smith (Admin. Of Cosslett(contractors) Ltd. V. Bridgend CBC (2003) AC 336, (2002) 1 All ER 292 at [41] & [53] 7. Welsh Development Agency v Export Finance Co.(1992) BCC 270 Read More