Every new asset class invariably poses its own particular legal challenges. Whether as a result of the characteristics of the receivable itself, or of the business culture in which it arises, each receivable type can be expected to give rise to a distinct set of legal, tax or regulatory issues. The CDO is no exception in requiring the securitization team to address legal issues that seldom arise in mainstream securitizations.
As an asset type, the CDO is in some ways quite similar to more traditional collateral pools of payment obligations owed by a diversified group of obligors. However, these obligations do exhibit a feature not normally associated with the standard consumer and corporate receivables that have to date been securitized in Canada, in that they arise from individually negotiated transactions. This inherent distinction of the classic CDO gives rise to a rather unique legal issue, one that causes little concern in the securitization of more traditional asset classes - namely, whether the underlying collateral pool has been effectively sold to the securitization vehicle.
The "true sale" opinion is a standard feature of the vast majority of Canadian securitizations. In its simplest terms, the opinion verifies that the assignment of the receivables to be securitized is effective to pass ownership of these receivables from their originator to the securitization vehicle, and that such assignment will be effective as against the seller's creditors and its trustee in bankruptcy. This result is relatively easy to achieve in respect of receivables that are created under agreements, invoices or other standard form documents prepared by the seller's legal advisors. Corporate loans and bonds, on the other hand, usually differ in one critical respect - the negotiation process often results in a restriction on the lender's right to freely assign or transfer the borrower's repayment obligation. This restriction can give rise to some troubling business and legal questions.
As a general rule, if an agreement says nothing about the parties' entitlement to assign their rights under it, those rights will be freely assignable. A credit card issuer is able to sell its portfolio of credit card receivables because the standard credit card agreement is silent as to the issuer's ability to sell or assign the cardholder's obligations. However, borrowers under multi-million dollar loan agreements usually have significant bargaining power, and many feel quite strongly about being able to control the identity of their lenders. As a result, assignability restrictions of one kind or another often find their way into these arrangements, sometimes by way of complex provisions that cover several pages.
While courts and commentators have for years debated the effect of a provision that prohibits the assignment of rights under an agreement, England's highest court recently concluded that an unambiguous assignment prohibition will invalidate any attempted transfer of such rights, at least insofar as the original parties to the agreement are concerned. Thus, if a loan agreement contains such a prohibition, and the lender nevertheless sells the loan receivable to a securitization trust, the borrower could successfully resist any attempt by the trust to collect the receivable - a result which would negate one of the basic elements of securitization, the ability to isolate and control the securitized receivables in the event of the seller's insolvency. Such an anti-assignment provision would also compromise a lawyer's ability to provide an unqualified true sale opinion since current case law leaves open the question as to the interest that can be obtained by the purchaser of a "non-assignable" receivable. In the narrow field of receivables owed by the federal government, such as taxes, the Supreme Court of Canada has ruled that clear language in the Financial Administration Act absolutely invalidates any assignment of such receivables without government consent, with the result that an assignee (for example, a securitization trust) would require such consent in order to obtain any rights whatsoever in a debt of the federal Crown.
A further complication presented by many loan agreements concerns the distinction between "assignments", which are often expressly prohibited, and "participations", which are commonly permitted subject compliance with certain administrative procedures and the payment of a relatively modest fee. There is a considerable body of sometimes inconsistent U.S. and Canada case law dealing with participations, but as yet no clear authority as to the nature of the participant's interest in a participated receivable. Nevertheless, it should be possible to draft participation language that clearly defines the nature of the participant's rights.
One approach would be to permit participations by way of absolute sales of proprietary or ownership interests in the borrower's obligation, while leaving the participant with restricted voting and other rights under the loan agreement. This "proprietary interest" type of participation, if exercised in favour of a securitization vehicle participant, should enable legal counsel to provide the necessary true sale opinion. Alternatively, the participation provisions could permit only a risk-sharing arrangement under which the lender would agree to pay the participant a portion of any loan repayments that are received by the lender. This form of participation gives the participant rights against the lender but no interest in the underlying loan receivable, a position which would be inconsistent with a securitization vehicle's need to be isolated from the seller's credit risk. Since the distinction between these two types of participation is not widely appreciated, legal counsel may be faced with participation language which does not clearly set out the participant's intended rights, necessitating a sometimes difficult analysis as to whether a true sale opinion can be provided.
It might be noted that the Personal Property Security Acts of a number of provinces contain provisions that expressly address anti-assignment restrictions which appear in consumer or commercial agreements. These provisions, which are modelled on comparable language in Article 9 of the UCC of the United States, expressly validate assignments that are otherwise prohibited by the underlying contracts. Unfortunately, these statutes do not provide a perfect solution. Firstly, while a statutory safe harbour will certainly enable a securitization vehicle to acquire an ownership interest in receivables even in the face of a clear provision forbidding the assignment, the assignment may nevertheless constitute a breach of the anti-assignment provision and permit the borrower to exercise certain rights or remedies under the agreement, and the parties to the securitization might be expected to decline to facilitate a breach of the underlying loan agreement. As well, this legislative relief does not extend to Ontario or Quebec, jurisdictions which would likely give rise to a significant portion of the receivables to be securitized under a diversified portfolio of Canadian loan and bond obligations.
It can be seen that the foregoing assignability issue will add a significant element to the securitization due diligence process. Each contract or other obligation being assigned must be reviewed in order to identify any assignment restrictions, and to analyze their effect on the securitization. The existence of either a clear or ambiguously worded restriction will provide a challenge to the lawyers and other parties involved to devise an innovative structure to adequately isolate the securitized receivables from the seller's creditors notwithstanding the seller's inability to effect a true sale.