Date of Commentary: April 2013
Commentary - UK
In our publication “Legal Criteria for European Structured Finance Transactions” (the “EU Legal
Criteria”), DBRS considers the application of the legal criteria and related methodologies for structured
finance transactions in Europe. The criteria and methodologies set out in the EU Legal Criteria should
be regarded as applying generally to a structured finance transaction in the United Kingdom of Great
Britain and Northern Ireland (the “UK”). This commentary (“Commentary”) sets out certain specific
considerations arising in the context of structured finance transactions documented under the laws of
England and Wales (“English law”). Unless otherwise defined, words and expressions used in this
Commentary shall have the meanings given to them in the EU Legal Criteria.
This Commentary is limited to the specifics of an English law transaction in the UK, as to date the laws
of Scotland and Northern Ireland have had limited scope in structured finance transactions (other than
with regard to the law applicable to the transfer and perfection of transferred assets originated under
the laws of Scotland or Northern Ireland). As such, references in this Commentary to structured finance
transactions in the UK are references to structured finance transactions in the UK documented under
English law. It should be noted that English law is often used in structured finance transactions
involving assets or entities not situated or incorporated in England and Wales. Where this is the case,
the information contained in this Commentary (other than section II - “Asset Transfer”) may have
limited application.
This Commentary does not purport to address every legal issue that might arise in connection with a
UK structured finance transaction nor may it be considered as legal advice.
Asset Transfer
In the UK, the “true sale” of assets in a structured finance transaction is not enshrined in a specific
statutory framework (as it is, for example, in Italy under Law No. 130), and so general legal principles
apply.
DBRS notes that structures other than ones based upon a true sale may be used in structured finance
transactions. Alternative structures which have been used in the UK structured finance market include
originator trusts and secured loans. Transactions structured other than through a true sale are
considered on a case-by-case basis.
METHOD OF ASSIGNMENT
Under English law, assets can be transferred by way of an equitable assignment (under which the
Originator retains the legal title to the asset with the SPV holding an equitable ownership interest) or an
assignment pursuant to section 136 of the Law of Property Act 1925 (“LPA”). Under both of these
methods, the transfer results in the SPV having a proprietary interest in the assets that are the subject of
the transfer. Although an assignment under section 136 of the LPA (“statutory assignment”) gives the
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SPV certain benefits (e.g. the SPV can bring a claim directly against an obligor), its main advantage
derives from the giving of notice of the assignment to an obligor. The benefits of giving notice are
discussed further below.
Despite the benefits which a statutory assignment may give to an SPV, it is very common for transfers of
assets in structured finance transactions in the UK to be structured to take effect as an equitable
assignment. This is largely due to issues relating to the giving of notice to obligors (both from a
practical perspective and, with regard to the Originator, from a customer perspective). Generally, the
SPV and any security trustee will be precluded from notifying the underlying obligors of the transfer
until such time as certain events occur (the “Perfection Events”), at which point notice will be given and
the transfers will take effect as statutory transfers. DBRS expects that all transactions providing for
equitable assignments contain clear provisions enunciating the Perfection Events (which DBRS expects
to be adequate to ensure, insofar as practicable, that notification of the assignment to the underlying
obligors occurs prior to the commencement of any insolvency process with respect to the Originator)
and a mechanism (such as a power of attorney) by which the SPV and/or security trustee can notify the
underlying obligors of the transfer.
With regard to the giving of notice of assignment, it should be noted that:
•
prior to notice being given, the obligor can obtain a good discharge by paying the Originator in
accordance with its contract with the Originator;
•
prior to notice being given, an obligor may set off against the SPV and/or the security trustee
claims which it has against the Originator (although the giving of notice does extinguish in all
circumstances these rights of the obligor);
•
the priority of proprietary interests granted for value over receivables is generally governed by
the date on which notice of each proprietary interest is given to the obligor in respect of the
receivable concerned. The first to give notice to the obligor will generally take priority,
although a person who has actual or constructive notice of a prior interest at the time he takes
his own interest cannot take priority by giving notice to the obligor first; and
•
prior to notice being given in accordance with the LPA, the SPV will have to join the Originator
as a party to any action which the SPV may want to take against an obligor (although, the
courts have generally joined Originator to actions initiated by related SPVs).
DBRS expects the representations, warranties and covenants of the Originator in the transaction
documents to address these risks. DBRS also expects that these issues be considered by legal counsel to
the transaction.
Neither English law nor equity provide for the current assignment of a debt which has not yet come into
existence (i.e. only when the debt comes into existence can the assignment attach and the interest pass).
Until such time, the contract purporting to assign a future debt will only operate as a contract to assign
(as opposed to an assignment) which would be enforceable like any other contract, only if given for
value. Although there is no case law on this point, such a contract, assuming its validity as a general
matter, should in principle be enforceable through an insolvency of the Originator, but may be
vulnerable to being set aside as a consequence of any of the issues arising out of insolvency. DBRS
expects counsel to confirm the enforceability, as a general matter, of any agreement for the assignment
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of future receivables and to address the risk of any such agreement being set aside on the insolvency of
the Originator.
TRUE SALE
Where the SPV gains an interest in the assets by way of a transfer of either the equitable or legal title to
such assets (as opposed to a structure under which the SPV gains an interest in the assets through an
originator trust), DBRS expects a true sale analysis to be completed and a true sale opinion to be
included in the transaction legal opinions.
Under English law, if the transfer is not considered a true sale, the transfer could be recharacterised as a
security financing. Further, if recharacterised as security financing such claim would be void for lack of
registration leaving the creditor claims to be treated as unsecured. Fortunately, the courts in England
have considered the issue of true sale and its ambit on a number of occasions and the case law is
relatively settled.
As a general principle, the English courts will not recharacterise the transfer as a security assignment
unless:
•
the documents providing for an outright transfer do not represent the agreement of the parties;
or
•
even though the documents describe the assignment as outright, their legal effect, when
properly construed, is that they create rights by way of security.
However, where a transfer is recharacterised as an assignment by way of security, and such security
requires registration under English law, if such registration has not been carried out the security would
be void. In this scenario, upon the insolvency of the Originator, the SPV would only be an unsecured
creditor of the Originator.
In order to ensure that the transfer is effected as a true sale and that an appropriate opinion is given, a
number of matters will need to be considered and analysed by counsel to the transaction (including
those set out in the EU Legal Criteria). Where the opinion regarding true sale is subject to certain
assumptions, DBRS expects to see these assumptions verified through representations made by the
appropriate parties in the documentation.
PREFERENCE AND AVOIDANCE OF TRANSFER
In the UK, there are certain times when a transaction can be set aside by the courts. Due to the
complexity of this matter, DBRS usually requests that counsel appointed to the transaction conduct a
thorough analysis of this risk and provide a legal opinion that the transfer could not be set aside. For
further information on this matter, see “Insolvency Issues” below.
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Special Purpose Vehicles
FORMS OF SPVS
A number of legal entities are available for utilisation as an SPV in the UK depending on the needs and
the objectives of the transaction. However, the predominant vehicle used in these transactions is a
public limited company (or “PLC”). Limited liability partnerships (established under the Limited
Liability Partnership Act 2000) are English law entities which may also be utilised in UK structured
finance transactions, but their use is less prevalent. In addition, non-English entities are frequently
established and used in English law governed structured finance transactions. Regardless of the
structure chosen, bankruptcy remoteness is a prerequisite of any SPV used in a securitisation and a
characteristic that must be present in order to maximise the structural benefits in an ABS transaction.
Similar to SPVs in other jurisdictions, in the UK, SPVs are often managed by a professional corporate
service provider who will provide the SPV with a majority (if not all) of the directors of the SPV.
Where the SPV is in a form other than a PLC or private limited company, DBRS may request additional
matters to be analysed and included in a legal opinion.
HOLDING STRUCTURE OF SPV
Where the SPV is a company (as opposed to a partnership), DBRS usually expects to see the shares of
the SPV either held by a share trustee on trust for charitable purposes, or held by a holding company
structured as a special purpose vehicle. The shares of the holding company would then be held by a
share trustee on trust for charitable purposes.
DBRS notes however that certain types of transactions may be structured in a different manner. For
example, in CMBS and whole business securitisations, the property company will usually be part of the
Originator group whilst the SPV issuing the notes would generally be an orphan SPV. In these types of
structures, DBRS may request certain additional matters relevant to the property company to be
covered in the transaction legal opinions.
LIMITED POWERS
SPVs used in structured finance transactions in the UK generally do not have a limitation on activities
codified in their constitutional documents. This is due to the existence of the doctrine of ultra vires in
English law, under which acts carried out by the SPV beyond the scope of the powers granted in the
SPV’s constitutional documents will be void. As a result, DBRS does not expect an English SPV’s
powers under its constitutional documents to be limited. However, DBRS expects the exercise of powers
of the SPV to be subject to covenants, warranties and representations in the transaction documents.
BANKRUPTCY REMOTENESS
Utilising an SPV in a structured finance transaction in the UK will not by itself result in the structure
achieving bankruptcy remoteness. Rather, the SPV is expected to make certain representations,
warranties and covenants in the transaction documents in order to ensure that the SPV will be treated as
bankruptcy remote. These are addressed further in the EU Legal Criteria.
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DBRS also expects the transaction documents to contain limited recourse and non-petition provisions to
shield the SPV against the risk of insolvency. These provisions would also need to be considered and
their effectiveness confirmed in the transaction legal opinions.
Consolidation risk
As a general principle, English law does not have a concept of substantive consolidation. English courts
are generally very reluctant to lift the corporate veil in order to treat the assets of a separate legal entity
as the assets of its parent.
Independent director
As with SPVs in other jurisdictions, in UK structured finance transactions an Originator should not be
in a position to control the activities of the SPV. This is especially important with respect to any
decision by the SPV voluntarily to enter into winding-up, liquidation or other formal insolvency or
solvent liquidation proceedings. There may be an incentive for an Originator experiencing financial
difficulty to have an SPV it controls voluntarily enter into proceedings in order to gain access to the
SPV’s assets.
In order to protect against this possibility, DBRS expects that the board of directors of an English SPV
contains at least one independent director, and that equivalent safeguards are included for any other
form of SPV entity.
CORPORATE BENEFIT
Directors of an English SPV will need to be satisfied that the assumption by the SPV of the liabilities
under the terms of the ABS and entering into the related transaction documentation has a corporate
benefit for the SPV. In order to support analysis on this point, generally a fee will be paid to the SPV
out of the issue proceeds (which may be retained until the SPV is wound up).
Security and Bond Documentation
TRUST STRUCTURE
In a structured finance transaction in the UK, typically two trusts are established under the transaction
documents. The trustee of these trusts is generally the same corporate trustee house (the “ABS
Trustee”). Under the first trust, the ABS Trustee holds on behalf of the holders of the Rated Securities
(the “Noteholders”) the SPV’s covenant to pay. This is generally considered the “note trust”. A second
trust will also be established (the “security trust”) whereby the ABS Trustee (in this capacity, the
“Security Trustee”) holds the security granted by the SPV on trust for the benefit of the Noteholders
and other specified secured creditors (the “Secured Creditors”). Any enforcement of the security is
pursuant to the security trust (albeit that it generally will require an instruction from the ABS Trustee
on this matter).
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TYPE OF SECURITY
Under English law, security can be granted through a charge1 or an assignment by way of security.
There are two categories of charge, a fixed charge and a floating charge2. On the insolvency of a
company the holder of a floating charge is in a worse position than the holder of a fixed charge. This is
due to the fact that there are three groups of creditor whose priority ranks after a fixed charge holder
but before the floating charge holder with regard to proceeds from liquidation3.
Whether a charge is fixed or floating ultimately turns on the degree of control the chargee has over the
assets. Although the Spectrum Plus case sought to clarify the parameters of a fixed charge, there is still
an element of uncertainty as to when a fixed charge may be recharacterised as a floating charge. The
distinction between a fixed and floating charge may also have implications with regards to the priority
of payments on the enforcement of the security. This issue is considered further in “Insolvency Issues”
below.
Generally in the UK, the security package over the assets of the SPV in a structured finance transaction
will be structured as follows:
(i) a first-ranking security interest over specific assets (such as the assets subject to the transfer,
accounts, eligible investments and contractual rights) either by way of a charge or through an
assignment by way of security; and
(ii) a floating charge over any of the SPV’s assets which are not effectively charged by (i) above.
DBRS notes that the nature of the security being taken will depend on the specifics of a transaction, and
as such DBRS acknowledges that there is no “hard and fast” rule regarding the nature of the charge to
be given by the SPV. However, DBRS expects legal counsel to the transaction to analyse this issue and
may consider that the taking of certain security by way of assignment by way of security or fixed charge
(as opposed to floating charge) is consistent with the ratings contemplated, and that the nature of the
charge be analysed in the transaction legal opinion.
The efficacy of the security package on the insolvency of the SPV is also fundamental in any structured
finance transaction in the UK. DBRS expects a legal opinion to confirm that the granting of security
under the security documents is effective and binding and unable to be set aside on the insolvency of the
SPV.
1. A charge represents an agreement by which a particular asset is appropriated to the satisfaction of a debt such that the
creditor is entitled to look to the asset and its proceeds to discharge the indebtedness, in priority to the claims of unsecured
creditors. The charge does not transfer ownership to the creditor, it is merely an encumbrance.
2. Under a fixed charge the asset is appropriated to satisfaction of the debt immediately (or at least as soon as the debtor
acquires an interest in it). By contrast, under a floating charge appropriation is deferred. The creditor’s rights initially
attach not to specific assets but instead to a shifting ‘fund’ of assets, the chargor remaining free to manage the fund in the
ordinary course of its business. It is only when the chargor’s power to deal with the assets are brought to an end that the
floating charge ‘crystallises’, fastening on the specific assets then comprised in the fund.
3. These groups are (1) preferential creditors (which following the Enterprise Act were reduced to essentially claims by
employees and contributions to pension schemes); (2) up to £600,000 in total which is made available to unsecured
creditors; and (3) the costs of the liquidator or administrator. While amounts which would be due on insolvency to the
first two groups can generally be ascertained, amounts due to the last group (especially the costs of an administrator) can
be difficult to estimate.
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ENFORCEABILITY BY NOTEHOLDERS
In UK structured finance transactions, the transaction documents require enforcement rights to be
exercised by the Security Trustee on behalf of the Noteholders4. The only time that this will not be the
case is where the Security Trustee has become bound to take enforcement steps and fails to act within a
reasonable time. As noted above, it is also typical for the ABS Trustee to be required to instruct the
Security Trustee before the latter will enforce the security interests it holds on behalf of the Secured
Creditors, and Secured Creditors will usually have no unilaterally exercisable rights of enforcement
except in exceptional circumstances.
The transaction documents typically contain a provision setting out an order pursuant to which each
payment in the payment order is effectively subordinated to each payment ranking above it in the order
of priorities. This provision is often referred to as the payment priorities provision or the “waterfall”.
The waterfall should ensure that essential payments required to maintain the structure are paid first.
The waterfall should also specify the priority in which creditors are paid upon the enforcement and
realisation of the security. In some cases waterfalls are expanded to provide for separate (sub or
supplemental) principal and interest waterfalls. DBRS notes that such structural mechanisms can impact
cash flow allocation and may complicate the rating analysis. DBRS reviews such mechanisms to
determine whether they are consistent with the ratings contemplated.
The priority in which ABS holders are paid is an essential consideration in the credit rating process. It is
important to ensure that in a default scenario, the Security Trustee and/or the ABS Trustee has access to
the funds required to pay costs of enforcement. This is usually addressed by having such costs rank
senior in the waterfall. DBRS typically anticipates that amounts payable to other service providers to
the SPV that rank senior in priority of payment to the Rated Securities be for clearly identifiable or predetermined amounts, or be capped. In cases where payable amounts are variable and not subject to a
cap, DBRS reviews the transaction’s sensitivity to estimated increases to determine consistency with the
contemplated rating.
One issue which has arisen recently in the structured finance market concerns the enforceability of the
“flip clause”. Historically, in structured finance transactions, the payment right of the swap
counterparty ranks above the payment of principal to Noteholders in the waterfall. However, in the
event that the swap is terminated due to the default of the swap counterparty, any termination
payments due to the counterparty under the swap typically “flips” to below interest and principal
payments to the Noteholders in the waterfall. The purpose of these types of provisions is to prevent
payment of onerous termination payments to a defaulting swap counterparty at the expense of the
Noteholders.
While the validity of such a clause (commonly referred to as a ‘flip clause’) has been upheld by the
English courts, the U.S. Bankruptcy court has recently declared flip clauses to be unenforceable ipso
facto5 provisions under the U.S. Bankruptcy Code.
4. In the case of a transaction covered by financial insurance the financial insurer (who would have the obligation to pay
timely interest and ultimate principal) may control enforcement rights at least during such time as they are honouring their
obligations.
5. Under the U.S. Bankruptcy Code, provisions that purport to modify or terminate an executory contract (a contract
where performance is due on both sides) based on the bankruptcy or insolvency of either party are unenforceable upon the
commencement of the bankruptcy proceeding. Such provisions are commonly referred to as ipso facto clauses because the
fact of bankruptcy or insolvency itself purports to trigger the termination or modification.
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In assigning ratings to a transaction, DBRS considers the potential exposure of the Rated Securities to
any derivative counterparty on its default, together with any structural features intended to mitigate
that risk, which may include flip clauses6. Whatever mitigants may be proposed, DBRS expects the
enforceability of those provisions, including in the event of a bankruptcy of the derivative counterparty,
to be analysed by counsel.
Insolvency Issues
The legal opinions for a UK structured finance transaction will need to consider a number of matters
relating to English insolvency law. These include the risk that a transfer of assets may be set aside on the
insolvency of the Originator as well as the possibility that an administrative receiver might be appointed
on the insolvency of the SPV.
CLAWBACK
The Insolvency Act of 1986 (as amended) (the “Insolvency Act”) establishes several circumstances in
which transactions are capable of being set aside, even if they were not made with the intention of
defrauding creditors. These include, but would not be limited to:
•
transactions at an undervalue;
•
voidable preferences; and
•
floating charges.
The court will look to the effect of the transaction, and specifically whether it can be said to prejudice
the general body of creditors. However, a transaction will only be set aside if it meets certain criteria,
including having occurred within a certain period prior to the insolvency proceedings being commenced.
Transactions at an undervalue
The transfer of assets to an entity (either outright or as security by way of an assignment) may be set
aside by the courts where the assignor has subsequently gone into liquidation or administration if:
•
it is a transaction at an undervalue (i.e. a gift or a transfer for too little consideration);
•
the transfer took place within 2 years of the commencement of the liquidation or
administration of the assignor; and
•
the assignor was insolvent at the time of the transfer or as a result of the transfer (insolvency is
presumed where the transaction is with a connected person).
6. For further information on how DBRS analyses the risk of derivative counterparty default in European structured
finance transactions see “European Derivative Counterparty Criteria” at www.dbrs.com.
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However, a defence will apply where it can be shown that:
•
the assignor entered into the transfer in good faith and for the purpose of carrying on its
business; and
•
at the time of the transaction, there were reasonable grounds for believing that the transaction
would benefit the assignor.
Preference
The transfer of assets to an entity may be set aside by the courts where the assignor has subsequently
gone into liquidation or administration if:
•
the assignor has done something which puts a creditor (including a guarantor) into a better
position than it would have been if the action had not been taken;
•
it was done within 6 months of the commencement of the insolvency of the assignor (or, in the
case of a connected person, within 2 years);
•
the assignor was insolvent at the time of the transfer or as a result of the transfer; and
•
the assignor was influenced in giving the preference by a desire to improve the position of the
creditor (this is presumed where the transaction is with a connected person).
Floating Charges
A floating charge may be set aside if it was granted to an unconnected person within one year (and the
company was insolvent at such time) or two years for a connected person.
If an insolvency officer can establish that the transaction took place within the relevant time, the
floating charge will be void, except to the extent of the value of the consideration exchanged for the
creation of the charge at the time of, or after the creation of, the charge.
Application of Clawback to UK Structured Finance Transactions
In a structured finance transaction in the UK, there are generally two elements or “legs” of a transaction
which could be affected by clawback: (1) the transfer of assets between the Originator and the SPV and
(2) the granting of security by the SPV to the Security Trustee.
With regard to the transfer of assets, upon the insolvency of the Originator there is the possibility
depending upon the facts that the transfer of assets could be challenged as a transaction at undervalue.
However, it is unlikely that the transfer could be challenged as a preference, as the SPV generally will
not be a creditor of the Originator.
On the insolvency of the SPV, the granting of security could also in theory be attacked as a preference
or as a floating charge. However, given the nature of SPVs as bankruptcy remote entities and of
structured finance transactions generally, such an attack would typically be considered unlikely.
DBRS expects these issues to be considered by legal counsel to the transaction, and where appropriate,
to be covered in the legal opinions.
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ENFORCEMENT OF THE SECURITY
Consideration will also need to be given to the position of the SPV in default and how best to ensure
that the Security Trustee is able to direct enforcement actions over the assets of the SPV. Under English
law, security can be enforced through a number of methods, including the sale of the assets or the
appointment of a receiver, an administrator or, where possible, an administrative receiver. With regard
to the appointment of a receiver or an administrator, various parties, including the creditor, the courts
and the directors of the SPV may have the power to make such an appointment. In a structured finance
transaction in the UK, DBRS expects the structure to ensure that the Security Trustee is able to control
this process, and that this be confirmed in the legal opinions.
Receiver
Under English law a receiver may be appointed by the chargee to realise the assets subject to the charge
at the best price reasonably obtainable at the time of realisation. The Security Trustee should have the
ability to appoint a receiver under the security documents.
Administration
Under Schedule B1 of the Insolvency Act, in certain circumstances an administrator may be appointed
over a company. The effect of administration is that during the period in which the administration
order is in force, the business of the company is managed by the administrator. Once a company is in
administration, no steps may be taken to enforce any security without the consent of the administrator.
The appointment may be made by:
•
an application to court by various parties including the company, its directors or any of its
creditors;
•
the holder of a qualifying floating charge over the whole, or substantially the whole, of the
company’s property through a filing with the court; or
•
the company or its directors through a filing with the court.
A floating charge will qualify if the charge gives the chargee the power to appoint an administrator and
the chargee holds security over the whole (or substantially the whole) of the company’s property. From
the perspective of a structured finance transaction, a key consideration concerns ensuring that the
Security Trustee is the holder of a qualifying floating charge and consequently has the right to appoint
an administrator. Importantly, if another person were then to seek to appoint an administrator, they
would need to give the Security Trustee (as the holder of a qualifying floating charge) a certain period of
notice (generally 5 business days), in which time the Security Trustee could either consent to the
appointment or appoint its own choice of administrator.
DBRS expects the legal opinion to confirm that the Security Trustee has been granted a qualifying
floating charge by the SPV under the security documents.
Administrative Receiver
Prior to 2003 and the introduction of the Enterprise Act 2002 (the “Enterprise Act”), English law
permitted a further form of enforcement of security by a qualifying floating charge holder - the
appointment of an administrative receiver. An administrative receiver is essentially a receiver over all, or
substantially all, of a company’s assets.
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However, in 2003, the Enterprise Act abolished the right of a holder of a qualifying floating charge to
appoint an administrative receiver. This abolition was subject to certain exceptions, including the
“capital market exemption”. Under this exemption, the appointment of an administrative receiver by a
floating charge holder is not prevented if it is pursuant to an agreement which forms part of a capital
markets arrangement and (a) a party incurs, or, when the agreement was entered into was expected to
incur, a debt of at least £50 million under the arrangement, and (b) the arrangement involves the issue
of a capital market investment.
Whilst DBRS recognises that this exemption may not apply to all structured finance transactions in the
UK, DBRS expects the legal opinions to contain an analysis of this issue, and where the transaction falls
within the exemption, to cover this matter.
SET-OFF
Set-off occurs where the underlying obligor is able to apply a liability owed to it by the Originator to
reduce an obligation owed by it pursuant to the securitised receivable (the cross-claims), with the net
result that it makes a reduced payment or no payment at all, to the SPV in respect of that receivable.
Under English law set-off can arise either under contract or under law. Set-off can be separated into a
number of categories which can broadly be broken into set-off outside insolvency of a party and set-off
during insolvency of a party. Set-off under these two categories are very different:
•
outside insolvency the rights of set-off are quite limited, although they are capable of being
increased (or decreased) by contract. These rights fall into two categories, those which arise
from the operation of law and those which are created by contract. They can be divided into
the following categories:
- statutory set-off - this right derives from rules carried over from repealed statute law,
and is available in 2 types of money claim - a claim for a liquidated sum and other
money claims if their amount can be “readily and without difficulty ascertained” or
“ascertained with certainty” or “precision”;
- equitable set-off - unlike statutory set-off, equitable set-off does not require that the
cross-claims are liquidated or capable of ascertainment. However, the cross-claims
must arise from the same transaction (but not necessarily the same contract) and must
be so closely connected that it would clearly be unfair to allow one to be recovered
without taking account of the other;
- contractual set-off - rights of set-off can be created, extended or limited through
contract,
•
by comparison to the above, the rights of set-off within insolvency proceedings are extensive
and cannot be varied by contract. Insolvency set-off may be triggered by the party entering into
liquidation (rule 4.90 of the Insolvency Rules 1986), entering into administration (rule 2.85 of
the Insolvency Rules 1986) and entering into bankruptcy (section 323 of the Insolvency Act
1986).
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DBRS expects transaction counsel to consider the above rights of set-off and whether they apply to the
underlying contracts. Set-off by the obligor is generally prohibited under receivable contracts (such as
auto-loans), as well as residential and commercial mortgages. As a matter of English law, such
prohibition will generally be effective provided that neither party is subject to insolvency proceedings.
DBRS generally expects the Originator to provide informed representations with regard to the assets
which confirm the position regarding set-off and an indemnity to the SPV to cover any set-off risk that
may exist. However, DBRS recognises that on an insolvency of the Originator any claims the SPV
might have under such an indemnity are likely to be unsecured, and that other structural mitigants (such
as a reserve account covering the risk of offset mortgages) may be appropriate if the transaction is to
receive the contemplated ratings. DBRS considers the effectiveness of any features proposed to mitigate
set-off risk on a case-by-case basis.
DBRS also considers whether any set-off risk may be mitigated by the Financial Services Compensation
Scheme (FSCS). The FSCS is a fund that pays compensation to depositors if an authorised financial
services institution such as a bank, building society or credit union is unable, or likely to be unable, to
pay claims against it. The FSCS will be triggered on the default of the relevant institution and aims to
pay compensation in standard cases within seven days. The compensation limit for deposit claims was
increased from 1 January 2011 to £85,000. The limit applies per depositor per institution and on a
gross basis and covers deposits made in all currencies. Each depositor is entitled to compensation up to
this amount, whether the deposits are in sole or joint accounts. Where an obligor is entitled to
compensation under the FSCS7 DBRS believes that the likelihood of that obligor asserting set-off in
respect of balances on a deposit account held by it with the Originator should therefore be significantly
reduced, provided that the amount of the deposit does not exceed the limit.
Set-off risk may also arise within the context of the transaction itself, for instance if a servicer were to
seek to apply balances standing to the credit of the collections account by way of set-off to discharge
any liabilities owed to it by the SPV (or other transaction party in whose name the account may have
been opened). DBRS expects the transaction documentation to specifically exclude rights of set-off
between transaction parties (other than potentially amounts due by the SPV to the Originator) in order
to preserve the integrity of the payment priorities contemplated by the waterfall.
ENGLISH CONSUMER CREDIT TRANSACTIONS
The provision of credit (including certain types of housing loans) to consumers is regulated in the
United Kingdom by a number of pieces of legislation including the Consumer Credit Act 1974 as
amended (the “Consumer Credit Act”) and the Unfair Terms in Consumer Contracts Regulations 1999.
In any transaction backed by English consumer loans, DBRS requests that counsel address in detail the
implications of the foregoing.
The Consumer Credit Act
The Consumer Credit Act imposes a range of restrictions on consumer lenders. Most credit and hire
agreements with an individual will be caught by the prescriptive regime of the Consumer Credit Act,
although notably first charge residential mortgages and post-2007 agreements made with high net
worth individuals benefit from exemptions. For those agreements which are subject to the Consumer
7. From 1 January 2011, set off is no longer being applied by the FSCS to compensation amounts. This means if a
depositor owes a bank money, the debt is no longer set off against the positive balance when calculating the amount of the
protected deposit. Instead the Scheme pays compensation as a gross payout up to the limit. Where an individual has an
offset mortgage, depending on the structure of this product, if the deposit account is combined with the mortgage account,
the FSCS would treat this as an overdraft and no compensation for the deposit account would be payable by the FSCS.
Structured Finance Group
Commentary 12
Date of Commentary: April 2013
Credit Act but were entered into before April 2007, lenders had to comply with extremely strict form
and content requirements. If these requirements were not complied with, even in a minor technical
sense, the Consumer Credit Act rendered the agreement irrevocably unenforceable.
As a result of the amendments introduced by the Consumer Credit Act 2006, an agreement which does
not comply with the Consumer Credit Act is no longer irrevocably unenforceable, but can only be
enforced by the lender on a court order.
Following the EC Consumer Credit Directive, changes introduced in February 2011 impose new
requirements on lenders, including an obligation to conduct creditworthiness checks, provide adequate
information and pre-contract information to consumers and new, although less prescriptive, form and
content requirements for agreements.
DBRS expects the implications of the Consumer Credit Act to be addressed through legal opinions (or,
as applicable, a due diligence report), including an opinion from counsel confirming that the securitised
assets are valid under the Consumer Credit Act. DBRS further expects that the Originator provide
informed representations and warranties confirming the compliance of the securitised assets with the
Consumer Credit Act.
Unfair Terms in Contracts Regulations
In addition, consumer loans are subject to the terms of the Unfair Terms in Consumer Contracts
Regulations 1999 (the “UTCCR”). DBRS expects transaction counsel to address the implications for
the transaction of the UTCCR. In particular, DBRS expects counsel to have conducted a review of the
Originator’s loan documentation and for counsel to confirm that such loan documentation complies
with the UTCCR or to identify any deficiencies in this regard and to analyse the consequences thereof.
DBRS further expects the Originator to provide informed representations and warranties confirming
the compliance of the securitised assets with the UTCCR.
The Financial Services Authority (FSA) and Office of Fair Trading (OFT) are both enforcers of the
UTCCR and a decision by either of these bodies can render an unfair term unenforceable against a
consumer. The courts will have the ultimate decision in whether a term is unfair should the FSA’s or
OFT’s decision be challenged in court.
Guidance issued by the FSA and OFT states that an unfair term is one which creates a significant
imbalance in the parties’ rights and obligations, to the detriment of the consumer. In determining
whether or not a term is unfair, the courts, FSA or OFT will have recourse to the UTCCR which
provide for a general requirement that terms in standard consumer contracts must be expressed in plain
and intelligible language.
Where a term is deemed to be unfair, although that particular term will be unenforceable against the
consumer, it will not render the entire contract automatically unenforceable.
Structured Finance Group
Commentary 13
Date of Commentary: April 2013
Servicing and Collections
The concept of a trust is fundamental to UK structured finance transactions. As noted above, there
generally are two trusts in most transactions, a security trust and a note trust. However, trusts may also
be used in other aspects of a transaction.
In many UK structured finance transactions8, the obligors generally continue to make their periodic
payments into an account in the name of the Originator, until such time as a Perfection Event occurs.
However, as these accounts are often used to collect receivables originated/collected by the Originator
related to both securitised and non-securitised assets, a risk of commingling arises. In order to mitigate
this risk, DBRS typically expects the Originator (or, where the account is not in the name of the
Originator, the entity in whose name the collection account is held) to declare a trust over the amounts
received into the collection account in favour of the SPV. The effect of this declaration is that such
amounts are excluded from the assets of the Originator should the Originator enter into insolvency
proceedings.
Under English law, a person can only declare a trust over an asset, not over a liability. If, as is
commonly the case with bank Originators, the bank declares itself as trustee in favour of the SPV over
the account into which collections are paid and the collections are deposited with itself as account bank,
the effect of the arrangement is that the bank Originator ceases to own an asset on trust for the
beneficiaries of the trust, but instead becomes a debtor for the equivalent amount. That does not affect
the personal fiduciary duties of the trustee, but it does mean that the beneficiaries (i.e. the SPV) have no
proprietary interest in the assets of the bank, and as such, the assets will not be segregated from the
insolvent estate of the bank Originator.
Legally, this risk can be avoided by the bank Originator ensuring collections are paid into an account
with another bank, over which a trust is declared. However, DBRS notes that this will generally not be
practicable for a bank Originator.
Furthermore, even where effective, a declaration of trust over a collection account is not without
limitations. In particular, on the insolvency of the Originator, it will not result in the funds subject to
the trust automatically being transferred to the SPV. Rather, any insolvency proceedings are still likely
to take considerable time to identify and distribute the trust property (i.e. the amounts received on
behalf of the SPV into the collection account) where such receipts are commingled with other receipts in
the collection account, resulting in an inherent liquidity risk even where a trust has been declared over
the collection account.
One mitigant for this risk is the establishment of clear procedures at the outset of the transaction for
identifying amounts received by the Originator and serviced by the Servicer (who often is the
Originator) on behalf of the SPV. Further, a reserve fund may also be appropriate to provide the SPV
with sufficient funds to meet its ongoing debt service obligations (depending on their frequency) under
the terms and conditions of the ABS to cover the anticipated period until the trust property is
distributed.
8
. CMBS, CLOs and CDOs may provide some exceptions.
Structured Finance Group
Commentary 14
Date of Commentary: April 2013
However, the best structural mitigant to the risk of Originator insolvency is to have the shortest
possible commingling period, so that upon the Originator’s insolvency there is the lowest possible
balance belonging to the SPV in the collection accounts. As such, balances in the collection accounts
should be frequently swept or otherwise separated and paid to a transaction account in the name of the
SPV over which a trust or first-ranking security interest is taken. For a description of how DBRS
generally views this risk see the EU Legal Criteria – Transaction Parties – Servicing and Collection –
Collection Accounts and Commingling.
Tax
9
ASSET LEVEL - WITHHOLDING TAX
Where the underlying assets are located in the UK, withholding taxes can arise in the UK if payment is
made to a person outside the UK. Generally speaking, UK withholding tax only applies in respect of
yearly payments of interest, rentals payable in respect of property situated in the UK, certain types of
royalties and certain types of “pure income” annuity payments.
In a securitisation context, therefore, the issue primarily arises where the underlying assets are loans
(and receivables) with a tenor of more than one year. In most, if not all, circumstances, the risk of
withholding tax can be eliminated if the payee is a company tax resident in the UK (such as a UK
securitisation company).
ASSET LEVEL - TRANSFER OF ASSETS
Generally speaking, transfer taxes (otherwise known as stamp duties) are only charged in the UK on the
transfer of interests in land, equity securities and certain types of debt instruments. Therefore, where
the assets being transferred are financial assets located in the UK, one would not normally expect stamp
duties to be relevant. Nonetheless, DBRS expects to see an opinion confirming that no stamp duties or
other transfer taxes are payable in the UK on the transfer of the assets.
VAT and other sales taxes typically do not arise in the UK in respect of a financial transaction of this
nature. Again, because of the possibility of specific transaction terms contradicting this general view,
DBRS expects to see an opinion confirming that this is the case in each transaction.
SPV LEVEL - TAX NEUTRALITY
Where the issuer is a UK limited company, DBRS generally expects the issuer to qualify for the UK tax
regime available to securitisation companies (see the Taxation of Securitisation Companies Regulations
2006). Broadly speaking, this regime enables a UK issuer or other company within the securitisation
structure to be taxed on the basis of its “retained profit” from the transaction. This amount will
generally be the fee referred to in “Special Purpose Vehicles - Corporate Benefit” above.
9
. DBRS would note that some sectors, e.g. whole of business type securitisations, may require additional tax analysis and
present the need for additional representations and covenants.
Structured Finance Group
Commentary 15
Date of Commentary: April 2013
This regime means that some of the vagaries of the UK corporation tax system can be ignored when
looking at the taxation of the issuer, particularly in relation to the fair value movement of derivative
transactions and the possibility of payments on limited recourse notes being treated as non-deductible
distributions. DBRS typically expects to see an opinion confirming that the issuer and any other
company through which payment flows are routed falls within the securitisation regime (whether as a
“note-issuing company”, an “asset-holding company” or an “intermediate borrowing company” - in
each case as defined in the regulations).
If it is anticipated that a UK issuer will not fall within the securitisation company regime, this should be
raised with DBRS at the earliest possible stage in order to ensure the structure achieves tax neutrality of
the issuer.
SPV LEVEL - SALES TAXES
Generally speaking, it is unlikely that a UK-based securitisation SPV will be able to recover input VAT
paid by it in relation to services received (for example in relation to transaction costs). It is therefore
important to demonstrate that the impact of such VAT has been taken into account in the cash flows of
the SPV.
RESIDENCE OF SPV AND SECONDARY TAX LIABILITIES
Where the issuer is incorporated in the UK, DBRS generally accepts that it will be treated as tax resident
there unless there are particular circumstances casting doubt on this presumption. Where, in a UKbased transaction, one or more of the SPV parties is located in an offshore jurisdiction, DBRS looks
closely at the arrangements put in place to ensure that the parties remain resident offshore.
Although SPVs are generally established in such a way as to minimise the risk of consolidation with any
other person for tax purposes, most jurisdictions have rules allowing tax authorities to impose taxes
unpaid by one entity on other connected entities. If it appears that there is a risk of any such taxes
arising (for example, where the shares in the SPV are owned by the Originator), DBRS expects specific
analysis and comfort to be provided to cover this eventuality.
Structured Finance Group
Commentary 16
Date of Commentary: April 2013
Contacts:
Claire Mezzanotte
Group Managing Director
Structured Finance
+44 (0)20 7855 6672
cmezzanotte@dbrs.com
Jerry van Koolbergen
Managing Director
Structured Finance - U.S. and European Structured Credit
Tel. +44 (0)20 7855 6660
jvankoolbergen@dbrs.com
Mary Jane Potthoff
Managing Director
Global CMBS
Tel. +44 (0)20 7855 6692
mjpotthoff@dbrs.com
Erin Stafford
Managing Director
Global CMBS
Tel. +44 (0)20 7855 6691
estafford@dbrs.com
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Structured Finance Group
Commentary 17