CURRENT AND EMERGING LEGAL STRUCTURE OF SECURITISATION
VINOD KOTHARI
Most traditional securitisation transactions hinge on legal isolation of assets originated by the originator. The reason is obvious: the originator has to create a structure that is independent of the credit, quality or continued existence of the originator. This is considered as one of the pre-requisites of asset-based ratings: assets are rated on their own strength only if assets have been distanced from their originator. Hence, legal isolation of the assets is the means to achieve the crucial objective of a securitisation transaction – asset-based ratings. Notably, legal transfer is not the end by itself – it is the means to an end.
One of the simplest and surest methods of legal isolation is transfer. The originator originates assets and transfers the same to a separate entity. In most securitisation transactions, the transferee entity is a special purpose vehicle. A special purpose vehicle is essentially a legal and substantive myth – it is an entity that is created solely for the purpose of holding the assets so transferred, and does not have, did not have, and cannot have any other purpose or business. Being limited to a sort of an asset-holding device, the special purpose entity is no more and no less than the assets transferred by the transferor. As an entity, the special purpose vehicle has no assets, liabilities, incomes or losses. Therefore, the entity itself does not at all reflect into the quality of the securities it issues. Those securities are as good or as bad as the assets transferred by the transferor – hence, the name "asset backed securities".
The special purpose entity is net-worth remote, income remote, and hence bankruptcy remote. It is substantively a nothing, and "nothing" cannot go bankrupt. That is why special purpose vehicles are known as bankruptcy remote entities. Since the bankruptcy or losses of the special purpose vehicle is not an issue at all, a rating agency may completely ignore the credit quality of the issuer, that is, the special purpose vehicle, and proceed solely on the strength of the credit quality of the assets. Thus, asset backed securities are rated based on the quality of the assets, ignoring the quality of the issuer. This is possible only due to the nature of the special purpose vehicle – if the vehicle by itself has potential income, losses, net worth or the lack of it, it would be clearly wrong to think of asset-based ratings.
From the above, it must be clear that securitisation is premised on asset isolation, and constitution of the special purpose vehicle and the transfer of assets to it are simply means to achieve asset isolation. Clearly, this is not the best way to achieve asset isolation, and going forward, legal developments must bring forth better and more transparent ways of isolating assets, in which case neither would special purpose vehicles be required, nor any true sales.
Securitisation structures have faced legal challenges in the past. Leave aside legalese, the primary plank for the challenge has been: is the isolation of assets achieved by a commercial sale of the assets, or is it merely a ploy to dedicate certain assets of the entity to a specific section of investors and make them unavailable to the rest of the creditors of the entity? When an entity goes into bankruptcy, a bankruptcy judge sits with equity in his heart and his task is to ensure that the losses are fairly distributed. True, that in bankruptcy, every stakeholder suffers losses and distributing losses is far tougher than distributing profits. The securitisation investors claim immunity from losses except to the extent of the losses in the dedicated pool of assets. Therefore, the bankruptcy judge faces the question as to whether this isolation of assets was achieved by a sale that can be commercial respected, or is it merely a stage-show. That is where the "true sale" question comes up.
The most common ground on which true sales are assailed is that the so-called sale from the transferor to the SPV lacked commercial reality, as it was not backed by transfer of risks and rewards. If one puts the several pieces of the transaction together, the holistic view is that certain external investors took a pre-fixed rate of return backed by sufficient degree of credit enhancements. The credit enhancements are the risk retained by the transferor, and the excess of the actual returns from the pool over the pre-fixed investors' return is the residual return of the transferor. The big picture is not very different from traditional funding. Lawyers often bring the notions of form and substance here. Essentially, the form versus substance question on either extreme becomes ridiculous, and any midpoint solution is merely a subjective compromise. A sheer reliance on form would mean every transaction that is made to look like a securitisation must be respected as one – in which case, the court has no role at all. A rigorous exploration of substance could lead to the reckoning that the ultimate substance of all financial transactions is funding. Courts invariably avoid either of these extremes and end up on a mid-point solution, which is always subjective. There is really no way to remove this subjectivity.
Another weak link in the true sale analysis is the nature of the special purpose vehicle itself. As discussed above, the special purpose vehicle is a substantive nothingness. If it is nothing, than a transfer of assets to a "nothing" must also, by itself, be "nothing", once again, disputing the very notion of true sale. If, on the other hand, the special purpose vehicle is a substantive entity, it cannot be bankruptcy remote, any more than man can be immortal. Therefore, there is a clear contradiction here too.
Going forward, the purpose of securitisation will have to be served by better legal structures. Perhaps, cellular companies, or protected cell companies as they are often called, will be a better solution. If a corporation, without transferring assets externally, can achieve internal isolation, it serves the purpose of securitisation. The other, and arguably easier, solution is to use secured lending. If a country has robust security enforcement laws, secured lending may itself be reasonably bankruptcy remote, more so because entities do not go bankrupt overnight. The secured lender, say the special purpose vehicle, gets sufficient time to take action prior to bankruptcy of the originator and enforce security interests on assets. The legal fraternity and the rating agencies need to have a more serious discussion on these alternatives to the true sale methods.