Titling Trusts Make Lease Securitizations Less Costly and Easier
Unlike the securitization of vehicle installment sale contracts, vehicle lease securitizations have developed rather slowly. Although the legal, tax, accounting and regulatory framework and analyses are somewhat different than for installment sales, the most significant impediments for leases were the various state certificate of title laws. This article traces how this problem has been largely solved by the use of "Titling Trusts."
State retitling laws when vehicles are sold or transferred were the largest issue. Retitling and reregistering of a leased vehicle, together with complying with other requirements such as obtaining odometer readings and emission control certifications, is required when the vehicle is sold or, in some states, upon the transfer of "any interest" in the vehicle. In many states, a violation of applicable titling laws constitutes a criminal offense.
Additionally, as is the case with all securitizations, the transaction must be structured so that in the event the lessor (the "Sponsor Lessor") became bankrupt, the leased vehicles and the related leases would not constitute part of its bankruptcy estate. As a result, prior to 1994, the majority of motor vehicle lease financings involved either the use of surety bonds or direct-pay letters of credit or the expensive and time-consuming process of retitling motor vehicles into a bankruptcy remote entity.
Use of a Titling Trust. The Titling Trust, a special purpose trust whose activities are limited to owning leased vehicles and the related leases, was introduced to the financial markets by World Omni Financial Corp. in 1994. From time to time, the Sponsor Lessor transfers, pledges or otherwise assigns its rights to receive the cash flows from specified leased vehicles and leases (i.e., monthly lease payments and proceeds from the sale or other disposition of the leased vehicles) in a securitization. Although a beneficial interest in the related leased vehicles and leases will be transferred, retitling and reregistration of the leased vehicles is not required because each vehicle remains owned by the Titling Trust until it is sold or otherwise disposed of following its
- sale to the lessee;
- repossession after a lease default; or
- return upon lease maturity.
By significantly reducing retitling and state tax risks while simultaneously satisfying bankruptcy concerns, the Titling Trust removed the obstacles that previously had prevented the efficient securitization of motor vehicle leases and afforded Sponsor Lessors with additional and less expensive sources of funding.
The use of Titling Trusts has become universally accepted throughout the financial community and they are expected to be involved in the vast majority of all future motor vehicle lease securitizations. Major companies that have established Titling Trusts include AutoNation, BMW, Ford, GECC, GMAC, Honda, Ryder and Toyota.
Structure and operation of a Titling Trust. A Titling Trust generally is owned directly by the Sponsor Lessor (in the case of highly rated Sponsor Lessors) or indirectly through one or more bankruptcy remote entities. The Sponsor Lessor will retain ownership of all Titling Trust assets for both accounting and tax purposes until a securitization occurs. At that time, the related leased vehicles and leases may be retained or sold for accounting and tax purposes, depending upon the structure of the securitization.
Due to state tax considerations, most Titling Trusts are owned by special purpose limited partnerships; however, in response to the continued development of state tax laws, a simpler ownership structure is expected to be introduced by early 1999. Regardless of the ownership structure, Titling Trusts are structured in a manner such that a legal opinion can be rendered following a bankruptcy of the related Sponsor Lessor, the leased vehicles and leases owned by the Titling Trust will not be included in the Sponsor Lessor's bankruptcy estate.
The assets of the Titling Trust consist principally of leased vehicles, titled in the name of the Titling Trust or in the name of the trustee for the Titling Trust, and the related leases, which reflect the Titling Trust as lessor (either directly or through the assignment clause of the leases). Liens are not generally placed on either the certificates of title to the leased vehicles or the related leases. The Titling Trust will obtain all state licenses and qualifications necessary to own leased vehicles and leases and applicable sales taxes will be paid upon its acquisition of leased vehicles.
The Titling Trust's activities will be limited to acquiring and being the record holder of title to leased vehicles and the related leases. The Titling Trust will at all times retain title to the leased vehicles and the leases until termination of a lease or any sale or other disposition of a leased vehicle, at which time the Titling Trust will comply with applicable retitling and reregistration requirements. The Sponsor Lessor services the leases on behalf of the Titling Trust and continues to provide lease-related services to lessees. As a result, the lessees are not affected by the Titling Trust or its activities.
The Trust will issue "beneficial interests." The Titling Trust will issue an "undivided trust interest" or "UTI" that represents the right to receive all proceeds of Titling Trust assets not otherwise allocated to one or more "special units of beneficial interest" or "SUBIs." SUBIs represent the right to receive all proceeds from certain specified leased vehicles and leases. Neither type of interest represents ownership of the related leased vehicles and leases but instead represents the right to receive the cash generated from them.
The Sponsor Lessor (or an affiliate) causes the Titling Trust to allocate specified leased vehicles and leases to a SUBI. When a SUBI is created, the related leased vehicles and leases are no longer represented by the UTI. Payments on the leases and leased vehicles are not available for any other lease securitization. Legal title to the leased vehicles and leases remains with the Titling Trust and, since title and ownership of the leased vehicles is not transferred, no retitling or reregistration is required.
Depending on capital needs, the Sponsor Lessor can directly or indirectly fund the daily operations of the Titling Trust through capital contributions or loans that are secured by a pledge of the UTI or a SUBI. Alternatively, the Sponsor Lessor may obtain warehouse or other interim financing that will be secured by a pledge of the UTI or a SUBI. In any event, Sponsor Lessors frequently utilize some sort of term "take-out" financing.
The basic Titling Trust platform affords Sponsor Lessors with a variety of financial options, including
- joint ventures;
- warehouse and interim financings; and
- short-term commercial paper and term financings.
For accounting purposes, the transactions can be structured so that the related assets either remain on or are removed from the Sponsor Lessor's consolidated balance sheet. Although Sponsor Lessors have generally retained the tax benefits associated with the related leased vehicles, several transactions have involved the transfer of tax ownership of the related leased vehicles and the related tax benefits.
Moreover, Titling Trusts can accommodate "like-kind exchange"1 programs, where for federal income tax purposes, sales proceeds of vehicles coming off lease are used to acquire new leased vehicles as if the new vehicles were exchanged for the old vehicles. Like-kind exchange programs permit Sponsor Lessors to defer the payment of tax on the sale proceeds of vehicles coming off lease. They result in significant savings either to Sponsor Lessors that regularly purchase new leased vehicles or to investors that acquire motor vehicle lease securitization tax benefits.
Creation of a Titling Trust. The time and expense involved in creating a Titling Trust have greatly decreased in the past few years as many of the legal, tax and regulatory issues have been identified and addressed. For example, Sponsor Lessors of most early Titling Trusts sought written confirmation from the state departments of motor vehicles in which vehicles would be leased approving
- the use of Titling Trusts
- titling vehicles in the name of the Titling Trust or the trustee and
- transferring beneficial interests in the Titling Trust
Although several states require the use of a co-trustee, substantially all states now permit the foregoing concepts. Similarly, state licensing issues have been identified and experience has been gained in obtaining the licenses and qualifications required of a Titling Trust. Although issues will inevitably arise in connection with the establishment of a Titling Trust, particularly when dealing with state legal or tax issues or where the Sponsor Lessor is a depository institution, potential Sponsor Lessors should derive comfort from the fact that they will not be breaking new ground.
The Sponsor Lessor will need to develop four basic documents to establish a Titling Trust:
- a Trust and Servicing Agreement describing the provisions that apply to the UTI and all SUBIs;
- a SUBI Supplement amending the Trust and Servicing Agreement when a SUBI is issued;
- a Servicing Agreement describing the servicing provisions that apply to all assets of the Titling Trust; and
- a SUBI Servicing Supplement amending the Servicing Agreement and describing the servicing provisions that are particular to the specific leased vehicles and leases allocated to a SUBI.
In addition to the SUBI Supplement and SUBI Servicing Supplement, the Sponsor Lessor will also be a party to various securitization documents that may include some combination of a trust agreement, transfer agreement, pooling and administration agreement, sale-leaseback agreement and trust indenture.
Establishment of nationwide Titling Trusts are now fast and easy. A Titling Trust can be established, licensed and activated in as little as 90 days. Although a Sponsor Lessor may wish to focus its efforts on the states where it does the majority of its business notwithstanding licensing issues associated with "leakage",2 the additional time and costs associated with a national Titling Trust are not significant. Depending upon the preferred timetable, all leases originated after a specified date can be assigned to the Titling Trust and the related leased vehicles can be titled in the name of the Titling Trust or the trustee. Alternatively, the Titling Trust can accept leases and leased vehicles in states without licensing requirements and, in all other states, as soon as all applicable licenses have been received.
Titling Trusts improve flexibility and potentially lower funding costs. Prior to the advent of Titling Trusts, restrictions imposed by state titling laws restricted the ability of lessors to securitize their leases. This lack of flexibility increased the cost of funds of some lessors and kept other entities from being fully competitive. Ultimately, consumers pay higher prices and have fewer lease options if lessors cannot access the capital markets funding available to entities that finance motor vehicle installment sale contracts.
The creation of a Titling Trust by a Sponsor Lessor will greatly increase the number of available financing alternatives without adversely affecting lessees. The basic Titling Trust platform will accommodate every type of lease financing currently used, including like-kind exchanges.
The Titling Trust has become universally accepted by vehicle lessors and by the capital markets. Many more Titling Trusts are expected to be formed in the future. Titling Trust assets are expected to expand beyond motor vehicles and other certificate of title-related assets to include equipment leases and other assets.
1. Internal Revenue Code Section 1031. These exchanges, which can be used by any vehicle lessor, will be discussed in a future AFU. 2. "Leakage" refers to several types of cross-state transactions. One example is the frequent circumstance where a lessee moves from a state in which the related leased vehicle is titled in the name of the Titling Trust to a different state. Alternatively, a dealer may want to employ one set of titling procedures and papers for leases with lessees who live in adjacent states.