The recent challenge mounted in the LTV Steel bankruptcy case to the legal "true sale" analysis that supports nearly every mortgage-backed and asset-backed securitization transaction has prompted participants in the MBS and ABS markets to focus on a provision of federal legislation that had been largely ignored until now.
The U.S. House of Representatives recently passed its version of a widely publicized bankruptcy reform bill, and passage by the Senate of similar legislation appears likely. Although the legislation is principally designed to guard against consumer bankruptcy abuse, the Bankruptcy Reform Act of 2001 (the "Reform Act") includes several little-noticed amendments that would clarify, expand, and add provisions to the Bankruptcy Code dealing with financing transactions, including securitizations.
Of particular interest in light of the LTV Steel case is the provision that would provide for automatic "true sale" treatment of many transfers of financial assets into securitization vehicles, including some such transfers that might not be viewed as true sales under current law. But the pending legislation also raises new issues that must, if the legislation is enacted in its current form, be addressed by MBS and ABS issuers and their counsel.
The proposed legislation
In general, Section 541(a) of the Bankruptcy Code provides that the commencement of a bankruptcy case "creates an estate" composed of, among other things, "all legal or equitable interests of the debtor in property as of the commencement of the case," including "[p]roceeds . . . or profits of or from property of the estate." Section 541(b) lists certain property of the debtor that is excluded from property of the estate.
In the typical securitization transaction, assets are transferred from one entity (the "Originator") to a special purpose entity which may itself issue securities backed by the cash flow from the assets, or may transfer the assets to another entity that issues such securities. Securitizations are structured to reduce the risk that in a bankruptcy case involving the Originator as the debtor, the assets (and the attendant cash flow) would be deemed to be property of the debtor's bankruptcy estate under Section 541(a), thereby making them unavailable to the holders of the securities. As a condition to consummating a securitization transaction, issuer's counsel ordinarily is required to deliver a "true sale" opinion which, in effect, concludes that in a bankruptcy of the Originator, the transferred assets would not be property of the debtor's bankruptcy estate.
The Reform Act would amend Section 541 to provide that an "eligible asset (or proceeds thereof)" would not (except in the case of fraudulent transfers) be property of the estate "to the extent that such eligible asset was transferred by the debtor, before the date of commencement of the case, to an eligible entity in connection with an asset-backed securitization" in which at least one class of securities is rated investment grade.i
The Reform Act defines "eligible assets" as, in addition to cash and securities, "financial assets (including interests therein and proceeds thereof), either fixed or revolving, . . . including residential and commercial mortgage loans, consumer receivables, trade receivables, assets of governmental units, including payment obligations relating to taxes, receipts, fines, tickets and other sources of revenue, and lease receivables, that, by their terms, convert into cash within a finite time period, plus any residual interest in property subject to receivables included in such financial assets plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to security holders."
An "eligible entity" is an issuer or an entity "engaged exclusively in the business of acquiring and transferring eligible assets directly or indirectly to an issuer and taking actions ancillary thereto."
The term "transferred" for purposes of Section 541 means "the debtor, under a written agreement, represented and warranted that eligible assets were sold, contributed, or otherwise conveyed with the intention of removing them from the estate of the debtor" without regard to "(A) whether the debtor directly or indirectly obtained or held an interest in the issuer or in any securities issued by the issuer; (B) whether the debtor had an obligation to repurchase or to service or supervise the servicing of all or any portion of such eligible assets; or (C) the characterization of such sale, contribution, or other conveyance for tax, accounting, regulatory reporting, or other purposes."
These amendments would apply to any bankruptcy case commenced after enactment, meaning that the legislation would retroactively cover existing transactions that satisfy the criteria outlined above.
Effect on true sale analysis
As a practical matter, the Reform Act would not eliminate, even in transactions that satisfy the provisions of the Reform Act, the need for a legal opinion as to true sale, although it would likely change the way these opinions are written. Instead of concluding that a transfer of assets is a true sale, the opinion would likely say that the assets are "eligible assets" that were "transferred" to an "eligible entity" in connection with an "asset-backed securitization" as those terms are defined in the Bankruptcy Code.
In the event that a transaction were challenged in a bankruptcy case, the Reform Act would, if adopted, have the effect of requiring that the debtor prove that one of the definitional requirements was not met, thus taking the entire transaction outside the scope of those protections.
However, certain of the legal conclusions necessary under the terms of the pending legislation may not be easily reached in the context of some transactions. The Reform Act may, in fact, create true sale issues for securitization transactions that have not yet been thoroughly considered. In addition, several types of securitization transactions will not satisfy the provisions of the Reform Act regarding asset-backed securitizations. In these transactions, a true sale opinion relying on the analyses currently employed in such opinions will continue to be required.ii
The Reform Act would not affect the need for a legal opinion to the effect that, in the event of the insolvency of the transferor, a bankruptcy court would not have cause to order the substantive consolidation of the assets of the transferee with those of the transferor. This analysis is largely independent of the true sale analysis.
Issues under the Reform Act
These proposed legislative provisions should have the effect of simplifying some securitization structures and facilitating transactions that are difficult or impossible to execute under the constraints imposed by traditional true sale analysis, such as transactions in which there is substantial recourse against the Originator. However, the proposed statutory language would create potentially difficult issues of interpretation. These include whether subperforming or nonperforming assets would qualify as "eligible assets" under the Reform Act, and whether certain special purpose entities that are intermediary buyer/sellers between the Originator and the issuer in some securitization transactions would qualify as "eligible entities."
What is an Eligible Asset? Only limited legislative history is available regarding the asset-backed securitization provisions of the Reform Act. A Senate Committee Report published in connection with the introduction of similar legislation in 1999 (the "1999 Senate Report")iii states that the definition of "eligible asset" is based upon the definition of that term in Rule 3a-7 under the Investment Company Act of 1940. That definition, in turn, is substantially identical to the language in Form S-3 permitting shelf registration of asset-backed securities with the Securities and Exchange Commission (the "SEC").
The SEC staff has taken the position that, for purposes of eligibility for use of Form S-3, "asset-backed securities" do not include securities backed by pools of assets having total payment delinquencies in excess of 20% at the time of the offering,iv or by pools of assets that include any asset that is nonperforming at the time of the offering, which is generally interpreted as 90 days or more delinquent in payment.v Although the SEC staff has not formally enunciated a similar position as to the eligible asset definition under Rule 3a-7, practitioners generally treat the two standards similarly for purposes of rendering legal opinions in securitization transactions. As a result, creditors of a bankrupt transferor could argue that the asset-backed securitization safe harbor of the Reform Act was not intended to apply to transactions that included nonperforming assets or substantial concentrations of delinquent assets.
Transaction lawyers may therefore be reluctant to deliver an opinion that a pool of assets that includes nonperforming assets or substantial concentrations of delinquent assets constitutes a pool of "eligible assets" under the Reform Act. However, because the reasons for the SEC's position on what constitutes "asset-backed securities" for Form S-3 eligibility are not relevant to whether an asset has been transferred for purposes of the Bankruptcy Code, and because the SEC has not formally taken the same position in connection with Rule 3a-7, practitioners may be able to conclude that such assets are eligible assets.
What is an Eligible Entity? An entity that functions as an intermediary buyer/seller between the transferor of a pool of assets and the issuer (referred to here as a "Sponsor") is an eligible entity only if it is engaged "exclusively" in transferring assets in connection with asset-backed securitizations and in ancillary activities. Sponsors may file registration statements for offerings of asset-backed securities, enter into underwriting agreements or similar arrangements, retain ownership of subordinate securities or clean-up call rights, and take other actions that it may be relatively easy to conclude are "ancillary" to a particular securitization transaction. Whether a non-recourse financing of retained subordinate securities by the Sponsor is also ancillary to the securitization might be less clear. More difficult still is the question whether ownership by a Sponsor of subordinate securities or other rights or property related to a prior securitization transaction to which it was not a party - at present a relatively common practice although no longer necessary for qualifying transactions if the Reform Act is enacted - falls within the Reform Act's concept of permitted activities for an "eligible entity."
The analysis becomes more difficult if a Sponsor has been in existence for several years and been party to scores of transactions. It may not be possible to determine precisely the extent to which such a Sponsor has engaged in activities that, while permitted by its organizational documents and not jeopardizing its bankruptcy-remote status, may not have been "ancillary" to any particular securitization transaction.
Recourse to the Transferor. Based on the plain language of the proposed legislation and the limited legislative history, it appears that securitization structures in which the Originator retains a substantial subordinated interest may no longer be problematic from a true sale perspective, provided that they satisfy the other Reform Act criteria. Similarly, transactions in which the Originator is required to repurchase defaulted assets, and so-called "mandatory call" transactions in which the Originator is obligated to repurchase the assets on a specific date, may also to be permitted under the Reform Act.
The 1999 Senate Report states that "the definition of transferred' makes clear that the debtor's written intention as to the exclusion of the eligible assets will be honored, regardless of the state law characterization of the transfer as a sale, contribution or other conveyance, and regardless of any other aspect of the transaction (such as the debtor's holding an interest in the issuer or any securities issued by the issuer, the ongoing servicing obligation of the debtor, the tax and accounting characterization, or any recourse to the debtor, whether relating to a breach of a representation, warranty or covenant, or otherwise) which may affect a state law analysis as to the true sale."
If enacted as proposed, the Reform Act will deliver clear benefits to many securitization transactions. Transfers of substantially non-delinquent financial assets by special-purpose entities will generally have the benefit of the Reform Act safe harbor, provided that such transfers are for reasonably equivalent value, do not render the transferors insolvent and are not entered into with the intent to defraud creditors. The provisions permitting a transferor to retain an interest in the issuer and the issuer's securities, or to be obligated to repurchase the assets, will permit easier execution of transactions in which substantial credit support from the transferor is desired.
However, there will still be an important role for state law true sale analysis, both in the case of transactions in which all securities are sub-investment grade or unrated, and in the case of transactions not clearly covered by the Reform Act safe harbor.
i This and the following excerpts from the Reform Act are from Section 912, Asset-Backed Securitizations, of each of H.R. 333 (2001) and S. 220 (2001), which are substantially identical.
ii A Senate Committee Report published in connection with the introduction of similar legislation in 1999 characterized the provisions of that predecessor of the Reform Act regarding asset-backed securitizations as a "safe harbor." This implies that a true sale opinion may still be delivered in the case of transactions that do not satisfy the Reform Act criteria.
iii Senate Committee on the Judiciary, Bankruptcy Reform Act of 1999, S. Rep. No. 106-49.
iv The Bond Market Association, SEC Letter, October 16, 1997.
v The SEC staff has taken this position in comments on various registration statements for mortgage-backed and asset-backed securities.