By Martin Fingerhut, a partner at the law firm of Blake, Cassels & Graydon LLP, Toronto, Canada
After experiencing a period of breakneck annualized growth exceeding 50%, 2001 saw the Canadian ABS market pause to catch its breath. Total outstanding asset-backed securities increased by less than 2%. (These and certain of the following statistics are courtesy of Dominion Bond Rating Service.)
For the first time since 1994, outstanding asset-backed commercial paper showed minimal growth over the previous year. After jumping from $41 billion in 1998 to $53 billion in 1999, and then to $60 billion in 2000, ABCP closed 2001 at about $62 billion. This apparent levelling off may be somewhat misleading and temporary, however, since significantly reduced CP issuance by Canadian banks was offset by increased activity in the corporate sector.
Picking up the slack, the term ABS market continued to mature in 2001. CP conduits have historically powered the Canadian market. But last year's growth came primarily from new term issuance of about $5 billion, resulting in an 8% increase in outstanding term ABS to just over $21 billion. Public ABS, which accounted for all new term issues, now stands at about $12 billion, up by 42% from 2000.
New asset classes continue to appear. This past year saw the first Canadian securitization of annuities and fully cancellable water heater rental agreements, as well as the first publicly issued dealer floorplan ABS. And corporate loans, power contracts, stranded costs, municipal tax liens and even viatical settlements are currently on the Canadian drawing board.
On the "true sale/recharacterization" front, Canada had more good news in 2001 from the Supreme Court of Canada and various regulatory agencies. In the Singleton decision, the Supreme Court expressly insisted on giving effect to the legal and commercial reality of a transaction, regardless of its "true economic purpose", and held that it would be improper to "recharacterize" a taxpayer's bona fide relationship as a result of "economic realities". The Court also refused to collapse separate, although related, transactions and treat them as "one simultaneous transaction," whether or not they were designed to minimize tax liability.
Adopting a similar approach, the Canada Customs and Revenue Agency announced that they will no longer look to the "economic realities" of a transaction to recharacterize a taxpayer's legal relationship, and cancelled a long-standing Interpretation Bulletin which had permitted leases to be recharacterized as sales for tax purposes if their terms created sale-like economic results, such as bargain purchase options.
Additional support came from the Ontario Ministry of Finance, which had formerly treated equipment leases containing bargain option prices as conditional sales. Under their new policy, a lease will exist "where leasing companies, in the normal course of their business, write leases on lease paper in specific lease language, regardless of whether the option payment is nominal".
This refreshing acceptance of the primacy of the legal, rather than economic, effect of transactions may soon be put to the test in the first securitization case to come before the Canadian courts. BC Tel's bondholders have complained that, when BC Tel prepaid their bonds with the proceeds of a securitization, it contravened a covenant against using funds borrowed at a lower interest rate. Time will tell whether we have a Canadian LTV on our hands.
The Canadian accounting landscape was completely redesigned with the adoption of a Canadian version of FAS 140, and the repeal of the restrictive 10% limit on seller recourse which had stood since 1989. The new flexibility of providing additional seller recourse should expand the number of Canadian deals that can be done on a cost-effective basis.
We are with increasing frequency encountering receivables which are expressed to be non-assignable. With the emergence of CLOs involving loans negotiated without any thought of their eventual securitization, anti-assignment provisions will become even more familiar. It is clear under Canadian and U.K. cases that, subject to relieving legislation, which does not exist in Ontario or Quebec, an assignee will obtain no rights in an assigned contract which contains a clear non-assignability clause. But it may be possible to securitize these non-assignable contracts nevertheless.
In a recent English decision, a party to a non-assignable contract declared himself a trustee of the contract for another person. The English Court of Appeal agreed that this arrangement effectively transferred the assignor's beneficial rights under the contract to the trust beneficiary - without violating the non-assignability clause. There seems no reason in principle why this approach should not work in a securitization context.
In 1917, Canada introduced a "temporary income war tax act". One of the taxes that proved not to be so temporary, and that particularly affects securitization, is Canada's 10%-25% withholding tax on interest paid by Canadians to non-residents. In an era when international cross-border securitization is rapidly growing, this tax creates an economic disincentive for Canadians to securitize their receivables in foreign capital markets - or for foreign capital to fund domestic securitizations.
Which is not to say that no Canadian receivables are currently being securitized off-shore:
*Canadian trade receivables are frequently securitized, without withholding tax, in both U.S. and U.K. securitization vehicles. The receivables are sold at a discount, and the discount is not considered interest.
*Long-term corporate loans, such as commercial mortgages and franchise loans, are also being securitized cross-border free of withholding tax. These transactions take advantage of the common Canadian withholding tax exemption for corporate obligations which do not require repayment of more than 25% of the principal in the first 5 years.
*Other persons and transactions also escape Canada's withholding tax regime. These include government-guaranteed obligations, foreign entities that are exempt from tax in their home jurisdictions, and non-resident insurance companies which carry on business in Canada.
Nevertheless, there still remains a significant body of Canadian interest-bearing receivables that cannot easily be securitized cross-border. While a domestic securitization of short-term Canadian obligations can be funded with long-term foreign capital in a way that complies with the 25%/5 year rule, the structure is somewhat complex, and may attract an unwelcome Canadian "capital tax". As well, credit cards, personal lines of credit, car loans, home equity loans, and all other manner of consumer obligations do not fit within the standard withholding tax exemption for long-term corporate debt.
It is not hard to understand the desirability of securitizing Canadian receivables in the U.S. and other foreign capital markets on a withholding tax free basis:
*The less risk adverse nature of U.S. investors is well known. Accessing this market would ease the significant and growing problem of placing lower rated or subordinate Canadian ABS.
*As well, Canadian investors are not yet familiar with certain asset classes that have already been securitized in the U.S. - such as CLOs, stranded costs and defaulted receivables. The ultimate success of securitizing less common Canadian asset classes may depend on being able to place at least a portion of such offerings offshore.
*And the massive size of the U.S investor base would relieve anxieties both about the scarcity of liquidity and about the ability of the Canadian market to absorb available ABS product.
The Canadian withholding tax impediment may soon be history. When the Canada-U.S. tax treaty was recently amended, it was agreed to leave withholding tax "on the table" for further discussion. It now appears that Canada and the U.S. will completely eliminate withholding tax for arm's-length debt, regardless of term. This was a key recommendation of the recent MacKay Task Force. Canadian officials now acknowledge that the case for elimination is well-understood and logical. I have little doubt that we'll see an end to this obstacle to cross-border securitization some time next year.
Similar action in Australia led to the securitization of billions of dollars of residential mortgages in the U.S. capital markets. I think we can expect similar results for Canadian residential mortgages, credit card obligations and other interest-bearing receivables, as well as significant purchases by U.S. investors of subordinate and lower-rated tranches of Canadian deals.
What can we
look forward to in 2002?
*Volume should at least match 2001 and may increase significantly, as sizeable bank securitizations come up for renewal.
*We can expect increased use of the Canadian public market, and perhaps the emergence of Collateralized Debt Obligations to challenge the prominent position currently occupied by CMBS.
*And cross-border issuance of Canadian ABS into the U.S. market may increase significantly following the elimination of withholding tax and the resultant availability of a larger and considerably less conservative investor class.