The usual well-informed sources - bankers, issuers, investors, rating agencies and even lawyers - have come to an unusual consensus: Canada in the year 2000 will experience material growth in both domestic and cross-border securitization. While term issuance fell slightly in 1999 to about $5.5 billion ($8 billion in 1998), asset-backed commercial paper ended the year at a record $53 billion (up from $41 billion the previous year). Prospects for 2000 are heightened because of a number of long-awaited structural changes to the Canadian securitization market, and because this market has begun hitting the radar screens of more U.S. and European investment banks and conduits. The following will summarize the basic infrastructure of Canadian securitization, and in particular highlight how it differs from its U.S. counterpart.
All the common asset classes are represented, particularly credit cards, residential and commercial mortgages, trade receivables, auto and equipment loans and leases, lines of credit, and mutual fund fees. While subprime mortgages have been securitized, the product is still virtually nonexistent in Canada. Collateralized loan obligations have been funded through CP conduits, and discussions for significant term transactions are currently under way. The more exotic assets, such as structured settlements, taxi medallions, media royalties, catastrophe bonds and the like, have yet to appear, due either to the absence of product or to the still comparatively risk adverse Canadian investor.
Canada's Securities Market
Each province has its own securities commission. In part because of the difficulty and cost of clearing a prospectus through several commissions, and in part because of the regulators' lack of experience in this area, issuers have until recently almost unanimously avoided the public market, and have instead utilized Rule 144A-type private placements for term ABS distribution. Recently, however, Canada's Securities Administrators proposed a number of amendments to Canada's securities laws which will revolutionize this country's approach to the public distribution of securities, and in particular facilitate the distribution of asset backed securities in Canada's public capital markets, including through the use of a shelf prospectus. Although the new system is technically not yet in force, it has already led to over $3 billion in public ABS issues by way of special exemptive orders. Similar U.S. developments in 1992 preceded a dramatic increase in securitization volume, and comparable results are expected to result from the revitalized Canadian system, which will likely be officially activated by mid-2000.
The federal Canadian government and a number of provinces impose a capital tax on the debt and equity components of a corporation's balance sheet. If securitization proceeds are kept off balance sheet and used to repay debt, the issuer may be able to significantly reduce its capital tax liability (e.g. by 52.5 basis points or more on the amount securitized).
However, current Canadian accounting rules have erected a sometimes frustrating impediment to achieving off-balance sheet treatment for an ABS transaction. Since 1989, accountants have treated securitization as a sale (rather than a financing) only if the "significant risks and rewards" of ownership are passed to the purchaser, and have denied sales treatment if transferor recourse is not "reasonable" in relation to credit, prepayment, interest and exchange rate risks. For example, recourse exceeding two or three times historical losses might be considered "unreasonable" and lead to financing treatment. Compounding the effect of this allornothing approach, sales treatment is "unlikely" where the transferor's recourse exceeds 10% of the sale proceeds.
These artificial accounting restraints will soon be a part of Canadian ABS history. The Canadian Institute of Chartered Accountants (FASB's counterpart) has, after considerable debate, agreed to replace its current approach with a Canadianized version of FAS 125. This virtual overhaul of the Canadian accounting approach to securitization is expected to be adopted by the second quarter of 2001, and should stimulate securitization by making it possible and/or less difficult to effectively securitize assets currently constrained by the risks and rewards accounting model.
While ABS accounting standards are, as indicated above, more onerous in Canada than in the U.S., obtaining a "true sale" for legal and bankruptcy purposes is much more straightforward. Unlike the economic approach followed by U.S. attorneys, the quantum of seller recourse has not been a significant factor in Canadian true sale legal opinions, since Canadian and U.K. case law indicates that the amount of risk retained by the seller should not determine whether a transaction will be characterized as a sale or a loan. More relevant in Canada is the parties' intention to effect an absolute sale rather than a charge by way of security, particularly as indicated by the program documents (which should employ unambiguous conveyance and sale terminology rather than language which refers to security interests and assignments). As a result, a true sale is almost invariably achieved by way of a simple single tier structure, rather than the two-tier approach normally utilized in the U.S.
At long last, Canada has evolved to the status of having "only" two provincial legal systems for perfecting sales and security interests in accounts receivable, a distinct improvement over the three systems formerly in place. All provinces outside Quebec have a personal property security regime based on Article 9 of the U.S. Uniform Commercial Code, and generally permit a single filing in the jurisdiction where the seller or debtor has its chief place of business. Financing statements are easy to complete, and are usually signed only by the secured party. Quebec, which is governed by modified French civil law, normally requires a separate filing for receivables located in that province, and also requires an additional document (a hypothec) when creating a security interest. The purist should note that while two northern territories continue to use yet a third type of British-style document filing system, they are expected to adopt the more common provincial model in due course.
There are significant differences between the Canadian and U.S. tax rules applicable to securitization. Canada's securitization practice has not been impacted by significant tax legislation (no Remic's or Facit's up north). Canadian tax and legal principles are generally consistent: debt for tax will also result in debt for legal and bankruptcy purposes. As well, Canadian special purpose trusts are normally taxpayers which are taxed at the highest marginal rate (rather than tax-exempt flow through vehicles), and Canada does not permit tax consolidation for parent and subsidiary corporations. It is therefore particularly important to match revenues and expenditures for each entity in the securitization structure in order to avoid unnecessary taxes.
Canada imposes a 7% tax (GST) on the supply of most types of goods and services. Sellers therefore often transfer receivables on a "fully serviced basis" without a discrete servicing fee which would trigger GST.
The U.S. capital markets are increasingly being accessed to fund the securitization of Canadian-based receivables. One significant challenge is Canada's less liberal withholding tax regime which imposes a 25% tax on interest or rent payable to non-residents (reduced to 10% under the current Canada/U.S. tax treaty). Various techniques are utilized to securitize Canadian receivables offshore on a tax-free basis, some more esoteric then others. Non-interest bearing trade receivables are sold cross-border at a discount, with the parties taking the position that the discount is both deductible by the seller and free of withholding tax because it does not constitute interest. Long-term corporate debt obligations, such as franchisee or mortgage loans, can generally be sold into the U.S. markets without withholding tax so long as no more than 25% of the principal is repayable within 5 years. As well, certain types of short-term interest-bearing receivables can be securitized in Canada and then funded in the U.S. with arms-length debt that complies with the 25%/5 year test. Other transactions take advantage of a treaty exemption for purchase-money debt between a U.S. seller and a Canadian buyer. There are also exempt asset classes, such as airplane leases, government-guaranteed mortgages and software royalties; as well as various types of exempt investors, such as foreign governments, foreign insurers carrying on business directly in Canada, and an extensive list of approved foreign tax-exempt investors. These and other cross-border strategies are being explored as U.S. and other offshore interest in Canadian securitization continues to increase.
All in all, systemic changes as well as heightened domestic and international interest bode well for strong Canadian ABS issuance in the coming years.