For the first time since the Canadian securitization market came into existence, issuers are able to sell asset-backed notes to U.S. investors without dealing with withholding tax issues for non-exempt transactions. Elimination of withholding tax on arms-length payments of interest to U.S. investors came at a critical time for many Canadian issuers faced with few, if any, liquidity alternatives. Such issuers are now able to tap the term securitization market and extend the offerings to qualifying U.S. investors. The notes may also have credit enhancement in the form of a performance guaranty where the Canadian originator is a subsidiary of a foreign parent. These securities should be very attractive to U.S. investors looking for highly rated notes.
State of the Canadian ABCP Market - The August Freeze
Freezes can occur in the summertime in Canada, and that's exactly what happened in the Canadian commercial paper market in August 2007. The ABCP market all but shut down as the number of market participants unable to sell paper in the market mounted due to the subprime debacle.
Liquidity problems in the Canadian ABCP market were compounded by the Canadian-style "market disruption event," which was a precondition to drawing on the back-up liquidity lines. The Canadian-style market disruption event required that most or all market participants be excluded from the ABCP market before the back-up liquidity providers were obligated to honor the draw requests. In contrast, the global-style liquidity disruption events more commonly used outside of Canada permit draws for a number of liquidity disruption events, such as the ABCP issuer's failure to pay or the bankruptcy or insolvency of the ABCP issuer. The fact that some, but not all, market participants were excluded from borrowing in the ABCP market led back-up liquidity providers for many non-bank sponsored issuers to refuse draw requests, and many ABCP issuers defaulted in payment of maturing ABCP.
Shortly after this nonpayment of Canadian ABCP began, the major market participants gathered to restructure the market. In what became known as the "Montreal Accord," the participants agreed to a standstill period and a restructuring for the defaulted ABCP issuers. The standstill remains in effect while the participants work through restructuring issues relevant to the types of issuing entities. In addition, a general restructuring of Canadian liquidity agreements has occurred, and the Canadian-style market disruption event has been eliminated in favor of the global-style liquidity events. Issuers are currently working with rating agencies on the basis of the newly designed features, but investors are still not anxious to jump back into the Canadian ABCP market. At this point, term securitizations may be an attractive financing alternative.
The Repeal of Withholding Tax on Interest Payments to U.S. Residents
It's probably more than a coincidence that both U.S. and Canadian governments ratified the Fifth Protocol to the Canada-U.S. Income Tax Convention in what seemed like record time in the midst of the ABCP market turmoil. The repeal of withholding tax on arms-length payments of interest to U.S. residents took effect on January 1, 2008 and offers tax relief to those with securitizable assets seeking liquidity outside of Canada.
Elimination of withholding tax on interest payments is a welcome change for both U.S. resident investors and Canadian issuers. Prior to the repeal, U.S. investors were required to pay a withholding tax of 10% on interest payments received from Canadian resident issuers. This amount was withheld by the Canadian issuer and remitted to the Canadian tax authority on behalf of the U.S. investor.
With elimination of the withholding tax, the playing field has been leveled for both U.S. and Canadian issuers to compete for U.S. liquidity. However, the parties still have to address foreign currency fluctuations that a U.S. investor may have to manage. A currency swap can be used (i) so that the notes can be denominated in U.S. dollars and (ii) to manage currency fluctuation risks. The Canadian issuer will have to
factor the cost of the currency swap into the cost of the transaction.
Canadian Securities Laws
Canadian securities offerings are regulated at the provincial level. In general, with respect to exemptions for private transactions, the provincial securities laws are similar to the U.S. Securities Act of 1933, as amended (the "U.S. Securities Act"). In Ontario, for example, the Securities Act (Ontario) and the rules, instruments and policies of the Ontario Securities Commission govern securities issuances.
From a U.S. investor's perspective, full blown disclosure in the form of an offering document may or may not be necessary in order to fully understand the risks associated with the purchase of notes from a particular issuer. Under the Securities Act (Ontario), where the U.S. investors are "accredited investors," as this phrase is defined in clause 1.1 - Definitions of NI 45-106, securities can be privately placed without the use of an offering document, or with a more limited form of disclosure, such as a transaction summary.1 However, if the investor does not fall squarely into one of the definitions of accredited investor, there is a general exemption for investors with holdings of more than $150,000 (Canadian). Note that qualifying for this exemption does not necessarily exempt an issuer from the prospectus requirements in all jurisdictions.
Given that each province has its own securities laws, U.S. investors should obtain an opinion from the issuer's Canadian counsel that the securities are not required to be registered under the securities laws of the province in which the issuer is located.
U.S. Securities Laws
The Canadian issuer must comply with the U.S. Securities Act when offering securities in the U.S. to a U.S. investor. One exemption from registration for such notes would be to limit the offering to U.S. investors who are "accredited investors."2 Although there are some areas of overlap, "accredited investor" definitions under the U.S. Securities Act and the Canadian provincial statutes are not the same. Investors should carefully review the definitions with legal counsel. In addition, a U.S. investor may request an opinion from the issuer's U.S. counsel that the securities do not require registration under the U.S. Securities Act.
In addition, U.S. investors must comply with the U.S. Securities Act when considering a purchase of notes either domestically or abroad. In particular, investment companies that are regulated under the Investment Company Act of 1940 (the "Investment Company Act") must consider the attributes of the securities they wish to acquire in relation to the requirements of Rule 2a-7 of the Investment Company Act.3
Structural Features of Canadian Transactions
U.S. investors will be very familiar with the structure of Canadian asset-backed offerings, especially in relation to such legal hallmarks as bankruptcy remoteness from the originator through the use of a special purpose vehicle ("SPV") as issuer, servicing requirements, eligibility criteria in relation to the assets, perfection of security interests, non-consolidation and the scope of opinions.4
There are, of course, differences in some structural elements as well as legal issues and analyses, with which U.S. investors may not be familiar, such as the separation of legal and beneficial ownership in relation to leased property, differences under the Canadian bankruptcy regime and applicability of bulk sales laws. U.S. investors are advised to consult with their U.S. legal counsel to identify the risks associated with a particular Canadian asset-backed structure, in particular to identify how the structure is different from a U.S. structure with comparable assets.5
Credit Enhancement
Credit enhancement will look very familiar to the U.S. investor and will take the form of one or more of the following: overcollateralization, excess spread, reserve funds, letters of credit, insurance policies and swap agreements. In addition, and U.S. investors are sure to see this as a huge positive, in certain instances the notes will have as credit enhancement a performance guaranty by a foreign parent of its Canadian subsidiary. The foreign parent will guarantee performance of its Canadian subsidiaries' contractual obligations to the SPV as servicer as well as the originator's indemnity obligations. Presently, DBRS, the Canadian rating agency, will determine on a case-by-case basis whether it will require such a guarantee based upon such considerations as the extent of the Canadian subsidiary's obligation to the SPV, the credit rating of the subsidiary and the rating of the foreign parent.
Conclusion
U.S. investors looking for highly rated notes should look at asset-backed offerings north of the border. The structure of the transactions will look very similar to U.S. securitization structures for comparable receivables, and the differences, if any, should be minimal and easily comprehensible. There may even be a performance guarantee to enhance the structure. Given the repeal of the Canadian withholding tax, the favorable economic conditions in Canada at the present time, including the strength of the Canadian dollar, and the need for liquidity by Canadian issuers as a result of the ABCP August freeze, U.S. investors looking to purchase notes may find some very attractive Canadian asset-backed note offerings.
1 The Ontario Securities Commission has stated that a distribution of securities effected outside of Ontario by Ontario or non-Ontario issuers does not require a prospectus nor an exemption from the prospectus requirements where reasonable steps are taken by the issuer, underwriter and other participants effecting such distribution to ensure that such securities come to rest outside of Ontario. Although the policy has since been rescinded, Ontario practitioners still consider it to be the view of the Ontario Securities Commission.
2 "Accredited Investor" is defined in Rule 501 of Regulation D to the General Rules and Regulations to the U.S. Securities Act.
3 In order to qualify for purchase under 2a-7, the notes must (i) mature within 397 days of issuance, (ii) be U.S. dollar denominated, (iii) be rated in the highest short-term rating by one or more recognized rating agencies, and (iv) be secured by "qualifying assets."
4 DBRS, the Canadian rating agency, has produced "Legal Criteria for Canadian Structured Finance," May 2007, which can be found on their website, www.dbrs.com.
5 U.S. investors should also consult with local Canadian counsel as to any potential legal risks associated with the structure of the Canadian asset-backed notes. Note purchasers should obtain, and local Canadian counsel to the note purchasers should review, opinions from issuer's counsel similar to the opinions investors would receive in a U.S. offering.
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