by Martin Fingerhut Blake, Cassels & Graydon LLP
Canadian Securitization ended the year on a high note with the release of the first securitization case ever to reach the Canadian courts. The BC Tel decision upheld the transaction as a true sale, and thus validated the customary one-step Canadian structure, which may be contrasted to the two-tier approach common to the U.S.
BC Tel had entered into a Receivables Purchase Agreement under which it had sold its receivables on a revolving basis to a multi-seller commercial paper conduit. The seller's bondholders had argued that the securitization should be characterized as a borrowing which contravened a negative covenant in their bond indenture. However, the court found in no uncertain terms that the transaction "was in law a true sale and not a secured borrowing".
Confirming the position long held by many Canadian securitization counsel, the court pointed to the two factors necessary to achieve a Canadian true sale. The primary issue will always relate to the intention of the parties - and this intention will be determined by examining both the language of their agreement as well as their conduct. A sale intention will be found if the contractual language contains clear and consistent sale terminology rather than references to loans, security, principal or interest. Any contrary conduct would have to be "clear and unequivocal" for it to negate clear contractual language of sale. While some may disparage this approach as a victory of form over substance, I think it is more proper to recognize it as allowing the form chosen by the parties to cast light on the intended substance of their arrangement.
The second element of a true sale, as found by the BC Tel court, is the absence of an "equity of redemption", which would confer on the transferor, at its option, a right to repurchase transferred assets on repayment of the amount advanced to it. The presence of such a right would be a strong factor in favour of characterizing a transaction as a secured loan rather than a true sale. The BC Tel Receivables Purchase Agreement passed this "ultimate test" since the seller did not have the absolute right to require that the transferred receivables be reassigned to it. Importantly, the court recognized that not all repurchase rights would constitute an unacceptable equity of redemption, such as BC Tel's right to terminate the agreement and repurchase the receivables if the transferee exercised an increased costs clause.
A particularly significant aspect of the decision was how the court dealt with the issue of recourse. The contract in question provided for full recourse during the revolving period, and recourse to the extent of the agreed 5% reserve (up to five times historical losses) following the termination date. Such recourse was found not to be inconsistent with a true sale. As well, it was quite clear that the Court would not have negated the true sale even had there been 100% recourse for collectibility throughout the life of the agreement. The court did leave open the question as to whether "economic recourse," which guarantees a return of the amount advanced plus a calculated yield thereon, without reference to collectibility of the transferred receivables, might tilt the balance in favour of a loan rather than a sale.
All in all, the case was excellent news for the Canadian securitization industry, upholding as it did the traditional one-step structure, which is employed for both domestic and cross-border securitizations of Canadian receivables.
Canadian securitization in 2002 was positive in other ways as well. Issuance volume continued to increase, albeit at a reduced rate. Outstanding term ABS ended the year at about C$24 billion (up from C$22 billion), while ABCP remained fairly constant at approximately C$61.5 billion. Innovation continued to create nontraditional ABS structures, such as Canada's first sub-prime car loan deal, a C$500 million telephone receivables transaction, CIBC's second synthetic CDO, and a C$500 million water heater rental contract securitization offered in conjunction with a related income trust financing (the Canadian counterpart of a whole business securitization).
On another positive note, and in pointed contrast to concerns voiced by the U.S. Senate Subcommittee examining Enron Corp.'s financial transactions, a multi-year review by the Office of the Superintendent of Financial Institutions (OSFI) concluded that Canadian banks were using special purpose vehicles "appropriately" in securitization transactions, and that "adequate controls were in place" regarding their creation and for ongoing monitoring.
Not all news was rosy, however. Although a recent change to Canada's federal sales tax (GST) legislation confirmed that purchasers of receivables were not responsible for unremitted GST, taxing authorities have taken the position that the legislative fix applies only to whole receivable transfers and not to sales of co-ownership interests. Pending clarification or further legislative action, GST concerns have resulted in more complex structuring, increased reserves and/or additional monitoring.
Canadian tax authorities are also questioning the ability of equipment lessors to achieve capital tax relief through a securitization. A number of provinces and the federal government levy a tax on the right-hand side of the balance sheet (including liabilities and equity) of certain corporations. The combined tax depends on the jurisdictions in which the corporation carries on business, but can exceed an annual rate of 50 basis points on the corporation's year-end capital position. For tax reasons, the proceeds of an equipment lease securitization are paid to the lessor by way of "prepaid rent." Lessors use the prepaid rent to repay outstanding liabilities, thus reducing their capital tax base. Tax authorities have recently taken the position that prepaid rent should be included in the capital tax base, thus significantly increasing the lessors' tax liability, and raising serious questions as to the economic viability of securitization for such lessors. Discussions are ongoing with taxation officials, and a court case, should one prove necessary, is probably years away.
One concern facing Canadian securitization is the reducing amount of credit enhancement available in the domestic marketplace, caused in part by downgrades of numerous potential enhancers and in part by capital restraints causing others to stop offering ABS credit support. This void is beginning to be filled by financial guaranty insurers, not Canadian entities since OSFI is currently uncomfortable with the risk posed by financial guarantee insurance, but by U.S. and other non-resident monolines that have begun to provide cross-border support to a number of Canadian ABS transactions and programs. The documentation is complex - it must be structured to ensure compliance by the non-resident (and non-licensed) insurer with Canadian federal and provincial insurance legislation, and should contain an appropriate allocation of responsibility for applicable withholding, excise, income and insurance premium taxes.
While elaborate cross-border structures are currently allowing Canadian securitizations to benefit from off-shore financial guaranty insurance, a simpler solution may be at hand. Discussions with OSFI are under way to devise an acceptable means of permitting domestic insurers to provide this insurance without putting policyholders at risk. Similar discussions with provincial insurance regulators have also been positive. As a result of these initiatives, there may soon be a significant increase in the use of financial guaranty insurance policies to support Canadian ABS transactions.
A continuing irritant in the Canadian capital markets has been the existence of 13 securities regulators (one for each province and territory), each of which must vet public offering documents, including those relating to ABS transactions. The resultant time and cost inefficiencies have been a source of complaint for many years, and have more recently raised the spectre of federal pre-emption. Due at least in part to a desire to retain jurisdiction, provincial and territorial regulators are seriously considering the development of common securities legislation, with one result being the ability to offer securities throughout Canada following approval by a single provincial regulator. Anything that reduces time delays and costs can only be beneficial for the continuing development of Canadian securitization.
As at year-end, Canada and the U.S. continue to move towards the elimination of withholding tax on cross-border payments of interest. Once the necessary tax treaty amendment is finalized and ratified, the current 10% withholding tax levied on interest paid by Canadians to U.S. residents will be reduced to zero. This could have a considerable effect on the Canadian securitization market. Although trade receivables (which do not bear interest), and certain long-term debt obligations (for which there is a withholding tax exemption), are currently being securitized in the U.S. capital markets, Canada's 10% withholding tax creates an uneconomic barrier to the securitization of billions of dollars of residential mortgages, credit card and other consumer obligations, equipment lease rentals, and short-term corporate obligations. As well, the conservative nature of Canadian investors, which by and large have a strong preference for triple-A product, may stand in the way of the domestic securitization of asset classes that require significant subordinate tranches. Removing withholding tax will make available to Canadian originators the much deeper and broader U.S. investor class. If the Australian experience is any gauge, the elimination of Canadian withholding tax should lead to a significant amount of strongly underwritten Canadian receivables being securitized in the U.S. capital markets.