Securitization remains an important tool for companies to realize value from future payment streams and raise financing, typically at a better cost of funds than the interest expense associated with a corporate loan or bond. While there are many different ways to structure a securitization transaction, it is of paramount importance to isolate the relevant cash-generating assets from the potential default and bankruptcy risk of the corporation. A typical transaction structure involves the sale of defined cash-generating assets (e.g., loans, accounts receivable) of a company to a bankruptcy-remote special purpose vehicle that issues securities to investors in order to raise funds for the company (the issuer).
The sale by the company must completely transfer the assets to the issuer (and remove those assets from the estate of the company) to be an effective “true sale”. A true sale provides the issuer’s creditors with assurances that in the event the company defaults or becomes bankrupt or insolvent its creditors will not have access to the assets sold to the issuer. Conversely, the company achieves present value monetization of future cash streams and optimal cost of funds for its financing needs. If improperly structured, a securitization transaction may be re-characterized by a court as a financing transaction.
Factors in true sale transactions
The leading case relating to the characterization of securitization transactions is the trial decision from Metropolitan Toronto Police Widows & Orphans Fund v Telus Communications (Widows & Orphans). In Widows & Orphans, the Ontario Superior Court held that, in addition to looking to the substance, and not merely the form, of the transaction and the intention of the parties, the factors considered by the courts in determining whether a transaction constitutes a true sale are:
- the transfer of ownership risk and the level of recourse;
- the ability to identify the assets sold;
- the ability to calculate the purchase price; and
- whether the return to the purchaser will be more than its initial investment and a calculated yield on such investment.
Additional factors to be considered in the case of a sale of receivables are:
- the right to retain surplus collections;
- a right of redemption;
- the responsibility for collection of the accounts receivables; and
- the ability of the vendor to extinguish the purchaser’s rights from sources other than the collection of the receivables.
More recently, in Coutinho & Ferrostaal GmbH v. Tracomex (Canada) Ltd., the British Columbia Supreme Court applied the factors set out in Widows & Orphans to a transaction involving steel rail. In this case the express language of the agreement indicated the transaction was a purchase and sale; there was no reference to loans, interest payments or security. Applying the Widows & Orphans principles, the Court looked to the “substance” or “true nature” of the transaction and found that it was a financing arrangement, upon consideration of the following factors:
- written communications between the parties during the negotiation of the agreement proposed a “financing” transaction;
- the “sale price” of the steel rail was considerably lower than the market value;
- there was a right of repurchase at the vendor’s option, which was expected to be exercised and where the repurchase price seemed to be based on an interest calculation; and
- the vendor continued to pay general liability insurance for the steel rail and agreed to reimburse the purchaser for storage cost if the right of repurchase was exercised.
Given that a number of the facts in the Coutinho case were consistent with a financing transaction, the decision seems to indicate a continuing reluctance of Canadian courts to re-characterize a sale of cashflow-generating assets as a secured financing when the transaction has been documented as a sale. The court, after weighing the factors, respected the form of the contract as an objective indication of the intention of the parties. Notwithstanding this approach of Canadian courts, any securitization involves a careful legal structuring based on application of the case law to the facts at hand, typically supported by a legal opinion.
The author would like to thank Corey McClary, Articling Student, for his assistance in preparing this legal update.
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