Fingerhut, Martin

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Law and Business Review of the AmericasVolume 8 | Number 1 Article 112002Trends and Developments in the Canadian ABSMArketMartin FingerhutFollow this and additional works at: https://scholar.smu.edu/lbraThis Article is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in Law and BusinessReview of the Americas by an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu.Recommended CitationMartin Fingerhut, Trends and Developments in the Canadian ABS MArket, 8 Law & Bus. Rev. Am. 211 (2002)https://scholar.smu.edu/lbra/vol8/iss1/11Winter/Spring 2002 211Trends and Developmentsin the Canadian ABS MarketMartin Fingerhut*After experiencing a period of breakneck growth exceeding 50 percent annually, 2001saw the Canadian asset backed securities (ABS) market pause to catch its breath.' Totaloutstanding asset-backed securities increased by less than 2 percent.2 As well, for the firsttime since 1994, outstanding asset-backed commercial paper showed minimal growthover the previous year. After jumping from $41 billion in 1998 to $53 billion in 1999,and then to $60 billion in 2000, Asset-backed commercial paper (ABCP) closed 2001 atabout $62 billion.3 This pattern echoed the experience of new multi-seller commercialpaper (CP) conduits 4-from eleven in 1999, which issued $7 billion that year; and five in2000, which issued $6.8 billion; three new multi-seller conduits appeared in 2001, withissuance of about $1 billion. This apparent levelling off may be somewhat misleadingand temporary; however, because significantly reduced CP issuance by Canadian bankswas offset by increased activity in the corporate sector.One important development in the Canadian ABCP market was the expanded useof extendable commercial paper (ECP) as a liquidity substitute-33 percent of all newABCP comprised ECP; and outstanding ECP increased by 73 percent to over $1 billion5Dominion Bond Rating Service (DBRS) expects this trend to continue.6Picking up the slack, the term ABS market continued to mature in 2001. AlthoughCP conduits have historically been the engines that drove the Canadian market, lastyear's growth came primarily from term issuance. About $5 billion in new paper resultedin an 8 percent increase in outstanding term ABS to just over $21 billion. The mostsignificant development in this sector was the increased prominence of public issuance.Every term transaction was issued in the public market, except for a series of notes outof one of the conduits. At the end of 2001, public ABS stood at about $12 billion, upby 42 percent from 2000, and comprising about 52 percent all outstanding term ABS.7Although growth has slowed, there is solid evidence that securitization is increasinglybecoming a more important component of the Canadian corporate treasurer's fundingstrategy. Asset-backed CP now exceeds all non-government short-term debt-includingCP and BAs. With the growing propensity of banks to tighten credit, and the prospect of* Blake, Cassels & Graydon LLP, Toronto, Canada, martin.fingerhut@blakes.com1. Statistics are courtesy of Dominion Bond Rating Service at http://www.dbrs.com (last visitedon Aug. 10, 2002).2. Id.3. Id.4. Id.5. Id.6. id.7. Id.212 Law and Business Review of the Americasfurther downgrades, reliance on securitization should increase as borrowers are deniedaccess to Canada's highest rated corporate CP market and move, voluntarily or otherwise,to diversify their funding sources.Referring to Enron's use of derivatives, U.S. Treasury Secretary Paul O'Neill recentlynoted: "Our rules and our laws have not kept up with the speed of evolution of ideas."8These remarks equally apply to securitization, as shown by the almost constant reviewand revision of the rules and laws affecting ABS transactions in an attempt to catch upto leading edge securitization practices, and the ever-increasing size of the market. In2001, for example:* The Canadian accounting regulatory body adopted a Canadian version of FAS140, and repealed the restrictive 10 percent limit on seller recourse which hadstood since 1989.* Basle revised its proposals to overhaul the regulatory capital treatment for thesecuritization activities of financial institutions, proposals that the EuropeanSecuritization Forum warned may threaten the future of the whole market.* The Canadian ABS market took comfort from actions of Canadian andU.K. courts and regulatory authorities, which established a number of usefulrecharacterization principles, and pointed the way to securitize nonassignableagreements.* And Canadian and U.S. tax authorities began discussing the total eliminationof withholding tax on cross-border payments of interest between arm's lengthparties, which will undoubtedly lead to the securitization of billions of dollarsof Canadian consumer and corporate receivables in the U.S. capital markets.9In 1899, the Commissioner of the U.S. Patent Office announced that everything thatcould be invented had been invented. This proclamation turned out to be as accurate asthe notion that all possible asset classes have been securitized. 2001 saw the first Canadiansecuritization of annuities and fully cancellable water heater rental agreements, as well asthe first publicly issued dealer floorplan ABS. Corporate loans, power contracts, strandedcosts, municipal tax liens, and even viatical settlements are currently on the Canadiandrawing board.On the true sale/recharacterization front, Canada had more good news in 2001 fromthe Supreme Court of Canada and various regulatory agencies. In 1999, the Court firmlyheld in the Shell case, that the legal nature of an agreement should not be recharacterizedfor economic reasons, or because the agreement was structured to minimize taxes.'0 InSeptember 2001, the Supreme Court handed down the Singleton case." Like Shell, it isa tax case that does not deal with sales or securitizations. But, it will be a very valuableaid when considering whether a properly structured and documented securitization willbe found to be a sale or a borrowing.The basic question in Singleton, as in Shell, Was whether a transaction's economicresult should determine its legal characterization. The tax authorities urged the Court8. Id.9. Id.10. Shell Canada v. Canada, 3 S.C.R. 622 (1999).11. Singelton v. Canada, 2 S.C.R. 1046 (2001).Winter/Spring 2002 213to examine the economic realities of the taxpayer's transactions. The Court expresslydeclined to do so on the basis that:* Courts are not permitted to ignore the legal and commercial reality of a trans-action in an attempt to give effect to its true economic purpose. They shouldnot recharacterize a taxpayer's bona fide relationship as a result of the economicrealities of the situation.* Courts should give effect to sophisticated transactions even though they aredesigned to minimize tax liability.* Finally, it would be improper to collapse separate, although related, transactionsand treat them as one simultaneous transaction. These transactions must beviewed independently, whether or not they take place on the same day.12By analogy, in a securitization context it should be irrelevant that assets are sold toa special purpose vehicle to enable it to borrow funds on the security of the purchasedassets. It should similarly be irrelevant that the seller is, in effect, obtaining financingbased on the purchaser's cost of funds.The recent Supreme Court recharacterization decisions are having a salutary effecton our friends at Canada Customs and Revenue Agency (CCRA). A long-standing Inter-pretation Bulletin had provided that leases could be recharacterized as sales for taxpurposes, if their terms created sale-like economic results, such as a bargain purchaseoption. 3 In cancelling the Bulletin, the CCRA stated that, as a result of the Shell case,they will no longer look to the economic realities of a transaction to recharacterize ataxpayer's legal relationship.14 A lease is a lease, and a sale is a sale.Additional support for this approach recently came from another governmentsource-the Ontario Ministry of Finance. An equipment lease containing a bargainoption price had been treated as a conditional sale, rather than a lease, requiringpayment of retail sales tax on the total contract price at the time the agreement wassigned, rather than on each periodic payment, as with a "true" lease. The Ministry willnow rely on strict legal concepts to distinguish between leases and sales. According totheir new policy, a lease will exist where leasing companies, in the normal course of theirbusiness, write leases on lease paper in specific lease language, regardless of whether theoption payment is nominal.It's encouraging to see courts and government officials alike, accept the primacy ofthe legal effect of the relevant documentation. This can only be helpful if, and when,Canadian courts or tax authorities have to determine whether a particular agreement,which is documented as a sale, is really a disguised loan. These issues may be put tothe test in the first securitization case to come before the Canadian courts. The BC Telaction will be heard in late 2002. BC Tel's bondholders are complaining that when BCTel prepaid their bonds with the proceeds of a securitization, it contravened a covenantagainst using funds borrowed at a lower interest rate. Time will tell whether we have aCanadian LTV on our hands.12. Id.13. CCRA INTERPRETATION BULLETIN at http://www.ccra-adrc.gc.ca/menu/EmenuKLA.html (lastvisited on Aug. 10, 2002).14. Id.214 Law and Business Review of the AmericasWe must keep in mind, that having the courts give effect to the legal, rather thaneconomic, results of a transaction is only half the battle. The other half is getting theagreement right. The operative provisions should be straightforward and consistent, onlywith an absolute sale. To say, as did an agreement put before an English court, that aparticular transfer is being made as security for the seller's obligations, is problematic.A recent Federal Court of Appeal decision from Quebec provided another illustration ofan agreement that didn't get it right. 5The case held that a purported sale agreement should be treated as an agreementto manage, rather than purchase, a portfolio of receivables.16 Agreements put forward assales will stand and fall on the language relied on to express that intention, and it wasnot surprising that this particular agreement in fact fell:• The purchase price depended on the amounts collected-if nothing was col-lected, nothing would be paid by the purchaser. The court found that, withouta purchase price, there could be no sale.• The agreement required the seller to repurchase for $1.00 all receivables remain-ing uncollected after six months. Retransfer provisions, particularly when theyapply to the entire portfolio, can be problematic, as they smack of an equityof redemption, and raise a question as to whether the assets in question wereintended to be sold.• Matters were not at all helped when the seller declared bankruptcy a scant twodays after signing the receivables agreement, nor by the fact that it was theseller's secured creditor, rather than the purchaser, who attempted to upholdthe sale for the purpose of preserving its rights as a secured party. 7This transaction did not pass the smell test.We are, with increasing frequency, encountering receivables that are expressed tobe nonassignable. With the emergence of CLOs, involving loans negotiated without anythought of their eventual securitization, anti-assignment provisions will become evenmore familiar.It is clear under Canadian and U.K. case law that, subject to relieving legislation,which does not exist in Ontario or Quebec, an assignee will obtain no rights in anassigned contract which contains a clear nonassignability clause. The transfer of such acontract could not support the necessary true sale opinion. But, it may be possible tosecuritize these nonassignable contracts nevertheless.A recent English decision, involving the well-known boxing promoter Don King,may give guidance for a new strategy for securitizing these contracts. In that case, aparty to a nonassignable contract declared himself a trustee of the contract for anotherperson.'" The English Court of Appeal agreed that this effectively transferred the assig-nor's beneficial rights under the contract to the trust beneficiary without violating thenonassignability clause. 9 There seems no reason in principle why this approach shouldnot work in a securitization context.15. Banque Royale du Canada v. Canada, 240 N.R. 370 (1991).16. Id.17. Id.18. Don King Prod. v. Warren, 2 All E.R. 218 (1999).19. Id.Winter/Spring 2002 215In 1917, Canada introduced a temporary income war tax act. The taxes imposed bythis act turned out to be not so temporary.What does this have to do with securitization? Well, one of the taxes that particularlyaffects securitization is Canada's 10 to 25 percent withholding tax on interest paid byCanadians to nonresidents. In an era when international cross-border securitization israpidly growing, this tax creates an economic disincentive for Canadians to securitizetheir receivables in foreign capital markets-or to attract foreign capital to fund domesticsecuritizations.This is not to say that no Canadian receivables are currently being securitized off-shore:* Canadian trade receivables are frequently securitized, without withholding tax,to both U.S. and U.K. securitization vehicles. The receivables are sold at a dis-count, and the discount is not considered interest.* Long-term corporate loans, such as commercial mortgages and franchise loans,are also being securitized cross-border free of withholding tax. These transac-tions take advantage of the common Canadian withholding tax exemption forcorporate obligations, which do not require repayment of more than 25 percentof the principal in the first five years.* Other persons and transactions also escape Canada's withholding tax regime.These include government-guaranteed obligations, foreign entities that areexempt from tax in their home jurisdictions, and nonresident insurancecompanies that carry on business in Canada.Nevertheless, there still remains a significant body of Canadian interest-bearingreceivables that cannot easily be securitized cross-border. While a domestic securitizationof short-term Canadian obligations can be funded with long-term foreign capital, in away that complies with the 25 percent/five-year rule, the structure is somewhat complex,and may attract an unwelcome capital tax. As well, credit cards, personal lines of credit,car loans, home equity loans, and all other manner of consumer obligations do not fitwithin the standard withholding tax exemption for long-term corporate debt.It is not hard to understand the desirability of securitizing Canadian receivables inthe U.S. and other foreign capital markets on a withholding tax free basis:* The less risk adverse nature of U.S. investors is well known. Accessing thismarket would ease the significant, and growing problem, of placing lower ratedor subordinate Canadian ABS.* Canadian investors are not yet familiar with certain asset classes that havealready been securitized in the U.S.-such as CLOs, stranded costs and defaultedreceivables. The ultimate success of securitizing less common Canadian receiv-ables may depend on being able to place, at least a portion, of such offeringsoffshore.* The massive size of the U.S investor base would relieve anxieties, both aboutthe scarcity of liquidity, and about the ability of the Canadian market to absorbavailable ABS product.This withholding tax impediment may soon be history. When the Canada-U.S. taxtreaty was recently amended, it was agreed to leave withholding tax on the table forfurther discussion. It now appears that Canada and the U.S. will completely eliminate216 Law and Business Review of the Americaswithholding tax for arm's-length debt, regardless of term. This was a key recommenda-tion of the recent MacKay Task Force.2 1 Canadian officials now acknowledge that thecase for elimination is well-understood and logical. I have little doubt that we'll see anend to this obstacle to cross-border securitization some time next year.Similar action in Australia and Portugal led to the securitization of billions of dollarsof residential mortgages in the U.S. capital markets. I think we can expect similar resultsfor Canadian residential mortgages, credit card obligations and other interest-bearingreceivables, as well as significant purchases by U.S. investors of subordinate and lower-rated tranches of Canadian deals.On the legislative front, the last two common law holdouts-the Northwest Territo-ries and Nunavut-have finally adopted the PPSA regime.21 The laws of eleven Canadianjurisdictions now facilitate a single registration, and a single legal opinion for manycross-country securitization transactions. This was minor victory for efficiency and costcontrol.The appearance of a new asset class is always good news. CMBS22 have taken ourmarket by storm, and introduced a new class of investors to securitization.23 CLOs 24will hopefully have the same effect. In addition, a federal government initiative justgetting under way, may give rise to another securitizable asset-leases that carry a limitedgovernment guarantee.The Capital Leasing Pilot Project was launched on April 1, 2002.25 Two key elementsof the program will be of particular interest to the securitization community:* The federal government will guarantee up to 85 percent of the lessor's losses.* Eligible lessors expressly include Canadian leasing companies that participate insecuritization programs approved by a Canadian rating agency.26Over $1 billion of government-guaranteed small business loans were made last year,a portion of which have been securitized. It is likely that, next year at this time, we'll betalking about our experience in the securitizing of small business capital leases.What can we look forward to in 2002? Volume should at least match 2001, and mayincrease significantly, as sizeable bank securitizations come up for renewal. Discussionswill continue regarding the nature of the rules that should govern bank securitization.We can also expect increased use of the Canadian public market, and perhaps the emer-gence of Collateralized Debt Obligations to challenge the prominent position currentlyoccupied by CMBS. And cross-border issuance of Canadian ABS into the U.S. marketmay increase significantly following the elimination of withholding tax, and the resultantavailability of a larger and considerably less conservative investor class.20. MACKAY TASK FORCE at http://finservtaskforce.fin.gc.ca (last visited on Aug. 10, 2002).21. The term PPSA is commonly used to refer to the Person Property Security Act of one ormore of various Canadian provinces or territories. This legislation is modeled on Article 9gthe Uniform Commercial Code of the United States.22. Commercial mortgage backed securities.23. COMMERCIAL MORTGAGE BACKED SECURITIES at http://www.rebuz.com/research (last visitedon Aug. 10, 2002).24. Collateralized loan obligation.25. CAPITAL LEASING PILOT PROJECT at http://strategis.ic.gc.ca/SSG/laO1144e.html?what=e (lastvisited on Aug. 10, 2002).26. Id.

Trends and Developments in the Canadian ABS MArket

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Trends and Developments in the Canadian ABS MArket

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