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By Tara Eliza Castillo, Mark W. Harris and David Hatef
Tara Eliza Castillo is a partner in Alston & Bird's Finance Group, where her practice focuses on debt securities, structured finance, securitizations and other asset-backed finance transactions. Tara advises clients on securities and regulatory compliance issues relating to the securitization aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act and Regulation AB.
Mark W. Harris is a partner in Alston & Bird's Finance Group, representing issuers, underwriters, sellers, servicers and other transaction participants in connection with domestic and cross-border public and private securitization transactions involving single-family and commercial/multifamily mortgage loans, home equity loans, subprime automobile loans, commercial office leases, life settlements, timeshare receivables and other financial assets.
David Hatef is an associate in Alston & Bird's Finance Group. He represents large banks and financial institutions as issuer and underwriter counsel on securitizations across multiple asset classes.
Consumer finance companies (“FinCos”) play a critical role in the U.S. economy. FinCos provide an alternative source of funds to underbanked consumers who otherwise have limited access to credit from financial institutions and other traditional lenders. Based on the most recently published FDIC National Survey of Unbanked and Underbanked Households, in 2013 20% of the U.S. population was underbanked and 7.7% of U.S. households did not have a bank account. In a post-financial crisis environment, the population of underbanked consumers is expected to continue to grow due in large part to increased banking regulations and more stringent credit underwriting standards.
FinCos rely upon secured and unsecured bank term loans and syndicated revolving credit facilities as a means to fund and sustain origination growth. However, such forms of debt financing are often tied to high interest rates, fees and restrictive financial covenants. Employing securitization as a funding source can diversify a FinCo's funding base and grant the FinCo direct access to the secondary capital markets, increase liquidity and lower the cost of funds. Establishing a securitization program is a significant undertaking and requires time, money and resources. In order to best maximize the benefits of a securitization program, a FinCo's executive management team must identify and address certain key operational and ongoing compliance considerations at the beginning of the process.
An asset-backed security (ABS) is a security backed by a self-liquidating financial asset. Securitization structures have been used by FinCos to securitize a wide variety of mainstream asset classes such as auto loans, credit card loans, consumer loans, mortgage loans, small business loans, student loans, trade receivables and other esoteric asset classes such as intellectual property royalties, life settlements, structured settlements, insurance premium finance receivables, solar energy loan receivables and timeshare loan receivables.
A FinCo that originates or purchases receivables may securitize them using a variety of structures. For purposes of this article, we will assume that the FinCo will use a plain vanilla “two-step” securitization structured as follows: the FinCo will originate and acquire receivables and transfer such receivables to a bankruptcy-remote special purpose entity (SPE) that has been formed solely for the purpose of purchasing the receivables to be securitized. This entity is referred to as the depositor (the “Depositor”). The Depositor will in turn transfer the receivables to a Delaware statutory trust (the “Issuer”). The Issuer then issues the asset-backed securities, which may be in the form of notes and/or pass-through certificates. The bankruptcy remote nature of the Depositor and Issuer ensure that the receivable and related proceeds are isolated from the FinCo's creditors. After the receivables are transferred to the Issuer, recourse to the FinCo is limited to the FinCo's obligation to repurchase and/or substitute a receivable if it is determined at a later date that such receivable did not meet certain representations and warranties relating to the eligibility of the subject receivables as of the date of such determination. Unless an event of default occurs, the ABS investor will receive scheduled interest and principal payments. Such payments will made from the obligor receivable payments collected by the servicer during the immediately preceding collection period, and to the extent there is a payment shortfall other amounts relating to certain credit enhancements.
A securitization program is designed to allow a FinCo to access the secondary market on a routine basis, economic and market conditions permitting. In connection with each securitization transaction, the FinCo will form a new trust issuer to issue the ABS. Each ABS issuance will be backed by a discrete pool of receivables that have not otherwise been pledged or encumbered except in connection with a warehouse financing facility. Before a FinCo moves toward the path of establishing a securitization program, careful attention needs to be paid to the terms of the FinCo's existing debt financing arrangements to determine whether a securitization is permissible.
Restricted Covenants and P ermitted Securitization Provisions
Corporate financing agreements typically include extensive negative covenants that operationally restrict how a FinCo may conduct its business. Such covenants may also implicitly restrict a FinCo from entering into a securitization by restricting the FinCo and its subsidiaries from creating, assuming or incurring additional debt, or creating any liens on the pledged assets. If a securitization is permissible, the financing agreement will explicitly carve out a securitization from the scope of the negative covenants relating to indebtedness and liens.
If a FinCo contemplates entering into a future securitization, it should consider negotiating certain permitted securitization provisions into its existing financing agreements. For example, a “securitization take-out” provision permits a FinCo, subject to certain conditions being met, to prepay all or a portion of the outstanding loan obligation and require the lender or administrative agent acting on behalf of the lender to release its security interest and lien on the related receivables. Such provision may include a cap on the amount of the outstanding loan obligation the FinCo may prepay. A financing agreement may also explicitly permit a FinCo to enter into a securitization, provided that each securitization or the securitization program in the aggregate does not exceed a certain dollar amount, and the lender has approval and consent rights with respect to the securitization structure and operative agreements. If such approval and consent rights are granted, the FinCo should include a condition that the applicable lender will not unreasonably delay, condition or withhold such approval or consent.
Lender Approval and/or Noteholder Consent
If the financing agreement does not explicitly permit a securitization or includes negative covenants that indirectly or directly prohibit the FinCo from entering into a securitization, the FinCo will need to work with the secured lender and/or noteholders to amend and restate the underlying financing agreements. Obtaining approval and/or consent, and amending and restating the underlying financing agreements, can take time. If a FinCo is seriously considering establishing a securitization program, it may want to consider initiating conversations with the key stakeholders prior to engaging a securitization structuring agent.
In connection with evaluating the feasibility of a securitization, FinCo management must evaluate the current state of its origination, servicing (if such function is not outsourced to a third party) and compliance platforms in light of the following readiness considerations.
Licenses Relating to the Secondary Purchase of Receivables
In connection with its business, a FinCo and its originator subsidiaries, if any, are required to comply with the consumer regulatory scheme in each of the states in which it originates or takes a direct assignment of receivables. Certain state regulatory schemes, however, also regulate the secondary purchase of receivables by the FinCO or an SPE (including the Depositor and/or Issuer), and require such entities to also obtain a finance license. Depending on the state, the licensing application process can take two to three months, and in most cases the state licensing authority will require the entity and related direct and indirect equity owners to provide personal and financial information. Further, opting into a state's licensing scheme may subject the FinCo to additional recordkeeping, financial reporting, disclosure and other requirements. Since the securitization agreements will require each party to the securitization sale structure to provide corporate capacity representations (including compliance with applicable law), any and all licensing requirements need to be satisfied prior to the closing of the securitization transaction.
In connection with a securitization transaction, an investor will base its investment decision, in part, on the creditworthiness of the underlying receivables, not the creditworthiness of the FinCo. The investor will expect the FinCo to use one or more SPE entities to sell and transfer the receivables. The investor will also expect the ultimate transferee and owner of the receivables, in this case the Issuer, to be an SPE. Establishing and maintaining certain bankruptcy remote protections is critical to the securitization process. If the FinCo were to become a debtor or debtor in possession under the Bankruptcy Reform Act of 1978 (the “Bankruptcy Code”), the bankruptcy court would need to determine whether (1) the transfer of the receivables from the FinCo to the Depositor constituted a true sale and not secured loan, and (2) whether it should disregard the separate legal existence of the Depositor and order the substantive consolidation of the assets and liabilities of the Depositor with the assets and liabilities of the FinCo.
Critical to a bankruptcy court's true sale analysis is the court's determination that the receivables transferred were sold and not pledged by the FinCo to the Depositor, and that the purchase price for the receivables reflected the estimated fair market value for the receivables at the time of transfer and purchase. If a bankruptcy court determined that the receivables were not in fact “sold,” or if they were sold then at a discount, then the receivables could be considered to be property of the FinCo's bankruptcy estate under Section 541 of the Bankruptcy Code, and the Depositor's rights would be limited to the rights of a secured creditor. Further, the automatic stay provisions of Section 362 of the Bankruptcy Code would prevent the collection of the related receivables by the Depositor.
In connection with a bankruptcy court's substantive consolidation analysis, the bankruptcy court will take into account all of the facts and circumstances related to the FinCo's and Depositor's business operations and the underlying transactions. Key to this analysis will be a determination by the bankruptcy court that the FinCo and Depositor observed and complied with all of the obligations set forth under the Depositor's organizational documents and the securitization agreements, including covenants that relate to the Depositor's maintenance and operation of a business separate and distinct from the FinCo and its related affiliates. In connection with structuring a securitization, all transactions between the FinCo and its affiliated entities must be properly documented and made on an arms-length basis. For example, if the FinCo or an affiliate is servicing the underlying receivables, then such arrangement must be evidenced by a servicing fee that is customary for the industry. The bankruptcy court will also need to determine that the creditworthiness and assets of the FinCo were not held out by the FinCo or the Depositor as being available for the payment of the Depositor's liabilities or obligations. A guarantee by the FinCo or another upstream entity of all of the Depositor's obligations may be treated as a form of credit support and may suggest to a bankruptcy court that the Depositor is not legally separate and distinct from the FinCo or party providing the guaranty.
Ultimately, the bankruptcy court's determination to disregard or respect the separate legal existence of the Depositor is based on a facts and circumstances analysis. In structuring a securitization transaction, the FinCo, with guidance from legal counsel, will need to structure a transaction that takes into account all of the case law precedents applicable to a true sale and substantive consolidation analysis that have been recognized and observed by bankruptcy courts.
Loan Due Diligence and Data Quality
The investment bank engaged by the FinCo to structure and underwrite the securitization transaction will require detailed, granular loan level data information about the receivables being conveyed to the Issuer and the platform of receivables originated by the FinCo. During the initial stages of the engagement process, the structuring bank will request historical performance information about the receivables to determine such receivables' anticipated performance and prepayment schedule over the life of the deal in light of historical delinquencies and charge-offs. If the deal is rated, the structuring bank and rating agency will generally request historical information relating to the receivables going back three to five years. The quality of this information is critical to the securitization process, since such information will be disclosed in the private placement memorandum or prospectus supplement provided to the investors. Often the structuring bank will work with the FinCo to “scrub” data files to ensure the accuracy of the information. In connection with the securitization transaction, the FinCo will also be required to disclose information about the characteristics of the receivables being conveyed as of a certain date (generally within 30 days prior to closing referred to as the cut-off date), which may include average principal balance, weighted average annual percentage rate, range of FICO scores and geographic concentration. Addressing issues relating to data accuracy and historical information upfront can greatly streamline and facilitate the securitization process and avoid any unnecessary delays in the proposed timeline.
Decentralized vs. Centralized Banking System
Depending on the breadth of the FinCo's geographical footprint and organizational structure, the FinCo, together with one or more subsidiaries, will originate receivables. Prior to contemplating a securitization, each originator within the FinCo's organization structure may service the receivables on a decentralized platform basis. Further, collections received may be deposited into one or more accounts that include funds from other sources. Prior to executing a securitization, a FinCo will need to identify the steps necessary to migrate receivable collections and servicing to a centralized servicing platform basis by either making the decision to act as the servicer or to engage a third party or affiliate on an arm's-length basis. The FinCo will also need to redirect the stream of payments relating to the receivables sold to the Issuer into a collection account designated for the underlying securitization transaction. The FinCo can affirmatively shift from a decentralized to centralized platform basis by instructing or causing the obligor of each receivable to make future payments after a designated cut-off date directly into the collection account established for purposes of the securitization. Practically speaking, however, this change may present some operational challenges and may not be feasible for the FinCo to implement. As an alternative, the FinCo or servicer can sweep, or cause to be swept, any collections and proceeds relating to the receivables into the securitization collection account. Typically, the servicing agreement relating to a securitization will require the servicer to sweep all related amounts into the collection account within one or two business days. Further, the servicing agreement may specify that a failure to comply with such requirement will trigger a servicer termination event and/or default.
Servicer Compliance and Ongoing Reporting Obligations
In most cases, the FinCo or an affiliate will act as the servicer for purposes of the securitization transaction. In this capacity, the FinCo or an affiliate will be required to observe certain affirmative and negative covenants for the life of the securitization. The servicer will also be responsible for providing the investors a monthly servicer report or certificate covering the collection period preceding the related payment date. In preparing and delivering such information, the servicer will be required to certify that the information presented is true, complete and correct in all material respects. The servicer report or certificate will include information relating to the securitized receivable pool's monthly performance, including information about interest collections, principal collections, total amounts available to make monthly distributions, amounts in the credit enhancement accounts and other pool data. The information reflected in the servicer report or certificate will have been negotiated prior to the execution of the securitization. The servicer will also be required to annually provide a certificate of compliance certifying that based on its review, the servicer has fulfilled all of its obligations under the securitization agreements or disclose whether there has been a default in the fulfillment of any such obligation. If the securitization is public, the servicer will be required to comply with the Regulation AB requirements, which require the servicer to deliver and file with the U.S. Securities and Exchange Commission (SEC) on or before 90 days after the end of such servicer's fiscal year a Form 10-K.
Securities Exchange Act Rule 15Ga-1 requires both public and private securitizers to disclose on Form ABS-15G, and file with the SEC via the EDGAR system, any fulfilled or unfulfilled repurchase request for any ABS held by a nonaffiliate. In connection with its initial securitization transaction, a FinCo will be required to file a Form ABS 15Ga-1 within 45 days following the quarter such transaction closed. If a FinCo does not otherwise have any SEC reporting obligations, it will be required to apply for an SEC filer access code to comply with its Rule 15Ga-1 reporting obligations. After the initial filing, the FinCo will have an obligation to file a Form ABS-15G within 45 days after the end of each calendar quarter, provided that the FinCo may suspend its duty to file if it has no activity to report during such quarter. No quarterly report is required thereafter, unless a demand is made, but the FinCo will still have an obligation to file a Form ABS 15-G annually. In addition, Rule 15Ga-2 requires the issuer or underwriter of a public or private securitization transaction to be rated by a nationally recognized statistical rating organization (NRSRO) to furnish on Form ABS-15G to the SEC, at least five business days before the first sale in the offering, the findings and conclusions of any third-party due diligence report. This disclosure requirement and speed bump needs to be factored into the securitization transaction timeline upfront so that compliance does not delay the pricing of the transaction.
In connection with a securitization program, a FinCo will need to evaluate its current servicing platform and determine whether it needs to implement new systems and controls to ensure compliance with the requirements set forth in the securitization agreements and applicable securities laws.
The U.S. ABS market has steadily improved in the years following the financial crisis, although it has experienced some periods of sluggishness due to regulatory uncertainty and other external global market conditions. In 2015, over $655 billion ABS, RMBS and CMBS were issued and purchased globally, $408 billion of which was ABS, RMBS and CMBS issued in the public and private U.S. market.
A FinCo may decide to issue ABS either in the public market, private market or both. Public ABS issuers inherently face higher regulatory upfront and annual costs for the life of the deal because they are subject to SEC disclosure and ongoing reporting requirements. In addition, Regulation AB II, which amends Regulation AB by substantively revising the offering process, disclosure and reporting requirements for public offerings of ABS, has further increased the cost of compliance and liability for even the most seasoned and institutional issuers.
The private market may appear more attractive for a first-time issuer since that market is currently subject to fewer SEC disclosure and ongoing reporting requirements. In addition, the private market will provide a first-time issuer greater flexibility to execute a transaction on an expedited basis. However, this accommodation may be short-lived since the SEC is still contemplating whether to apply certain aspects of the Regulation AB II requirements to private securitization transactions. Further, beginning December 24, 2016, the credit risk retention requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act will require sponsors, (or a majority-owned affiliate of the sponsor) of ABS to retain not less than 5 percent of the credit risk of the assets that collateralize an ABS. A sponsor (or a majority-owned affiliate of the sponsor) may comply with the credit risk retention requirements by retaining an eligible vertical interest, an eligible horizontal interest or a combination of the two, as long as such combined percentage equals no less than 5 percent.
In connection with determining whether to put a securitization program in place, as a final consideration, a FinCo will need to take into account the SEC requirements that govern public and private securitization transactions and costs related to compliance for the life of the underlying transaction.
Copyright © 2016 The Bureau of National Affairs, Inc. All Rights Reserved.
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