UBL/PCIP Seminar on Securitization...2018/10/12 · assignment by way of security. Upon a valid assignment the SPV steps into the shoes of the originator in respect of all rights

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UBL/PCIP Seminar on

Securitization

2003

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PAPER FOR UBL/PCIP SEMINAR ON SECURITIZATION

A. SECURITIZATION STRUCTURE

This paper is intended to highlight certain issues relating to securitization in the context of the Pakistani legal environment. I will deal with the SECP rules and State Bank circular relating to securitization in a very cursory manner, as these aspects of the law will be dealt with my colleagues on the panel. The term “securitization” encompasses a wide range of transactions. The renowned English jurist of international finance, Philip Wood, contends that “securitisation is essentially a sophisticated form of factoring or discounting of debts”. The classic model of securitization was adopted in the Companies (Asset Backed Securitization) Rules, published by the SECP in 1999. These rules define “securitization” as “a process whereby any Special Purpose Vehicle raises funds by issue of Term Finance Certificates or any other instruments with the approval of the Commission for such purpose and uses such funds by making payment to the originator and through such process acquires title, property or right in the receivables or other assets in the form of actionable claims”. The essential features of this model are as follows: -- The originator (i.e. the party wishing to raise finance) sells its present and/or future

receivables to a Special Purpose Vehicle (SPV) in return for a purchase price payable immediately on sale. I will use the term sale and assignment interchangeably.

-- The SPV finances the purchase price of the receivables from banks or by issue of term

finance certificates (TFC) or raises a loan. The SPV grants security to the investors over the receivables to secure the borrowing. In case of a TFC offering, the security is granted through the intermediation of a trustee.

-- The originator, as “servicer”, may continue to collect receivables on behalf of the SPV, in

return for which the SPV pays a servicing fee to the originator. -- Any surplus income of the SPV after deducting the money required to repay the investors

is returned to the originator either as a service fee or through other methods of profit extraction which I will discuss later.

-- The securitization transaction may involve a credit enhancer to ensure that the

receivables are sufficient to pay the investors on time. For example, a third party may guarantee the obligations of the SPV.

B. ADVANTAGES OF SECURITIZATION

Several of the other speakers have discussed and will discuss the various benefits of securitization from an accounting, commercial and financial angle (particularly as they relate to off balance sheet treatment). From a legal angle at least three obstacles can be overcome through a securitization structure. The first is a regulatory obstacle: since the SPV does not fall within the regulatory ambit of the State Bank the minimum debt to equity ratio requirement under the Prudential Regulations does not apply where funding is provided by an SPV. Nevertheless, investors in TFCs banks/DFIs are required to comply with certain conditions set forth in BPD Circular No. 31 issued by the State Bank in 2002. These conditions include a minimum credit rating of “A” for the TFCs by an approved rating agency as well as limits on banks’ total exposure towards the asset backed securities. The net result is that banks and DFIs can structure a transaction whereby funding is provided to the originator through the SPV without attracting Prudential

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Regulations IV and V. The State Bank is placing reliance on the adequacy of rating of the debt instrument which I think is a step in the right direction. The second legal hurdle that may be overcome through a securitization structure is a contractual one: the originator may be party to one or more contracts which contain “negative covenants” restricting the originator from creating any security interest over its receivables. A transaction structured as a sale of receivables to the SPV can, in appropriate cases, overcome such negative covenants. This is not an un-common use of a securitization structure in developed economies. Lastly, a securitisation structure can enable a private company (without converting itself into a public company) to indirectly raise finances from the public, as TFCs are issued by the SPV and not the originator.

C LEGAL ISSUES 1. Assignment

Now I will try and analyse certain legal issues that arise in respect of this structure. Under our laws, it is permissible for the originator to either sell the receivables or transfer the receivables as security to the SPV. Both come within the meaning of assignment of receivables: the former is an absolute assignment or true sale and the latter is an assignment by way of security. Upon a valid assignment the SPV steps into the shoes of the originator in respect of all rights of the originator against the debtor, that is, the person who owes funds to the originator. Subject to certain exceptions, to perfect an assignment, strictly speaking, consent of debtors is not required but it is strongly recommended when the same is practical. The practicality generally depends on the number of debtors. Consents would be highly impractical in the context of securitization of utility bills where the utility’s customers are numerous. Consents should, however, be obtained where, for example, lease rentals for large plants and equipment are assigned. In the latter case the debtors are likely to be few and the amount of receivable of each such debtor quite significant. Even where consent is not obtained, notice of the assignment to the debtors should, however, be given. There are case laws under our Transfer of Property Act to suggest that if notice of assignment to the debtor is given, then the debtor's obligation can only be discharged if payment is made by the debtor to the assignee, that is, the SPV. In other words, if the debtors pay the originator after the notice has been given, its obligations of the debtor to the SPV would not be discharged.

2. Present vs. future flow securitization

In the context of securitization, present receivables relate to receivables that have been generated out of any service rendered or any contract entered into. The fact that a payment under a certain contract is due several years from today does not mean that the securitization relates to future flows. Future flows refer to receivables that have not been generated at the time of securitization, for example, utility bills that may be owed by customers to a utility company. Here, generally stated, at a future date the utility will be used by a customer, where after the utility company will bill the customer thus generating a receivable. The recently concluded mobile phone securitization is based on future flows. The distinction between existing and future flow receivables is critical to determine

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whether or not off-balance sheet treatment will be permitted. I understand that from an accounting angle off balance sheet treatment of a future flow transaction would be extremely difficult if not impossible.

3. True Sale

The next issue that I would like to deal with is the concept of a true sale. Before I discuss true sale, however, I want to deal with a popular misconception that securitization necessarily involves a true sale. This is incorrect. Instead of purchasing receivables, it is perfectly feasible for an SPV to lend funds to the originator and have the receivables assigned to it by way of security. The only circumstance where this is not possible is where the originator is a bank/DFI. In this case, BPD Circular No. 31 requires securitization to be by way of true sale and lays down very stringent standards for such sale. Where debt equity ratio is not an issue, there is even no need to have an SPV, in which case receivables may be assigned as security without a securitization as such. For entities other than banks/DFIs a loan structure through an SPV is an option. This structure is advantageous for investors from a risk point of view. As with a true sale, the SPV would be entitled to sue and recover directly from the debtors. In addition, it would have full recourse against the originator for outstanding amounts in the event receivables dry up. The structure is disadvantageous from the originator’s point of view because the receivables will remain on its balance sheet. I will let the accountants deal with the advantages of off-balance sheet treatment. Getting back to true sale, if an assignment is characterised as a true sale (as opposed to an assignment by way of security) then the receivables sold (provided that they are present/existing receivables) can effectively be taken out of the balance sheet of the originator. Determining whether or not an assignment of receivables is a true sale is a complex question made more so by the absence of Pakistani law on point. Broadly and loosely stated, generally recognized standards of true sale require that all risks and rewards associated with the receivables be transferred in their entirety to the SPV. In the absence of Pakistani (or indeed Indian) law on point it is common for our courts to fall back on English common law principles. These principles are liberal: provided the sale is properly documented and is treated by the parties as such the courts will recognize the transaction as a sale even if the buyer has limited recourse to the seller for unpaid receivables and even if the seller has a right of repurchase. However, in view of the much stricter accounting standards and the possibility that our courts may not follow English law to the letter it may be advisable to maintain some of the generally recognized standards of a true sale. Moreover, in case an accounting opinion is required on true sale, the lawyer’s job on giving a true sale opinion becomes easy as the accounting standards are more defined and much stricter. One final point on true sale. The true sale standard set forth in State Bank Circular where banks/DFIs act as originators is relevant from the point of view of satisfying State Bank’s regulations. It is not relevant for determining whether a transaction is otherwise a true sale. Thus, if the originator is not a bank or DFI, the true sale standard set forth in the circular need not be followed.

4. Stamp Duty

Stamp duty payable on an assignment deed is considerable and would be a major stumbling block for securitization were it not for the option of equitable assignments

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which are permissible in the province of Punjab. A discussion on this issue is beyond the scope of this paper.

5. The SPV

I will next, very briefly, talk about the structure of the SPV. In terms of the Securitization Rules, an SPV (which is required to register with the SECP) may either be a trust or a public limited company with a paid-up capital of not less than one hundred thousand rupees. Ownership of the originator and the SPV may not be connected in any way. In terms of the State Bank Circular referred to earlier, bank/DFIs participating in a securitization transaction cannot own any share capital in the SPV either. Ownership of the SPV and its funding can therefore pose a problem, as will be discussed in more detail by my learned colleagues. The SPV, after paying its obligations to the investors and its administrative costs, should be in a position to return the balance remaining to the originator in terms of a profit extraction formula. An example of such a formula is the service fee referred to earlier. The originator continues to collect the purchased receivables on behalf of the SPV, and in return is paid a service fee by the SPV. However, in developing the formula for e.g. determining the service fee care needs to be taken to ensure that the transaction does not lose its true sale character. This is so because in a true sale, the purchaser, i.e. the SPV, would retain the residual interest after paying the investors. If all residual amounts are returned to the originator, then it could be considered a mortgage redemption. One last point with respect to the SPV is that it is possible to use an SPV for a series of securitizations. In other words, after the investors are paid off, there would be no need to constitute a new SPV for further securitization.

6. Bankruptcy remote

Another issue which arises in the context of a true sale securitization is whether the securitization is “bankruptcy remote” i.e. whether in the event of the originator’s bankruptcy its creditors would have any claim on the receivables sold to the SPV. In our view, a purchaser for due consideration (of the receivables) would be entitled to have his interests in the purchased property of the insolvent to be dealt with at least as favourably as the interests of a secured creditor holding security interest over such property. Under Pakistani law, it is well established that a secured creditor can effectively stand outside bankruptcy if it so desires or may submit to bankruptcy to prove its debt. The Supreme Court of Pakistan has held that a secured creditor is at liberty to realise his security in any manner he likes. This would suggest that securitization transaction in Pakistan can be structured as being bankruptcy remote. However, applying certain principles of English common law, a problem could arise in respect of receivables that have not been generated at the time a liquidator is appointed. The security may not catch receivables if the liquidator of the bankrupt must earn the receivables to bring them into existence by rendering services. The rationale for the same is that upon bankruptcy it would not be fair to unsecured creditors to deplete the assets of the bankrupt for the advantage of a secured creditor.

7. Recovery laws

Finally, the application of the Recovery laws (namely the Financial Institutions (Recovery of Finances) Ordinance, 2002) and jurisdiction of the banking courts in securitization

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transactions is not free from doubt. My colleagues on the panel will deal with this issue in more detail.

D. TFC OFFERING

The final part of the securitization process is an offering by the SPV of redeemable capital such as TFCs. I think most of you are familiar with the way TFC offerings in Pakistan are being structured and, therefore, it is one part of the securitization transaction which is not novel from the Pakistani perspective. Under our company laws, redeemable capital such as TFCs may be offered directly to the public. In the event of a private placement, however, TFCs can only be issued to schedules banks, financial institutions and pension trust funds that thereafter are free to transfer the TFCs. The SPV may grant a security interest in the receivables to the trustee who will hold the security for the benefit of the TFC holders.

This paper is not and should not be construed or relied upon as a legal opinion on any matter stated above nor is it in any way exhaustive of the subject.

Author(s)

If you would like further information on any issue raised in this note please contact:

Khozem A. Haidermota HaiderMotaBNR

Senior Partner,

[email protected]

+92 (021) 111-520-000

www.hmcobnr.com

INSIGHT January 1, 2018

OIL & GAS INDUSTRY

OVERVIEW

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UBL/PCIP Seminar on Securitization...2018/10/12 · assignment by way of security. Upon a valid assignment the SPV steps into the shoes of the originator in respect of all rights