The amendment excludes from the property of the estate of the debtor "eligible assets" "transferred" to an "eligible entity" prior to bankruptcy in connection with a securitization, the most senior tranche of which is rated investment grade by one or more rating agencies. A qualifying transfer occurs simply by the transferor stating in writing that eligible assets were sold, contributed or otherwise conveyed with the intention of removing them from the transferor's estate. The transfer is deemed effective even though there is recourse back to the transferor or the transferor has an obligation or option to repurchase the eligible assets. Moreover, the characterization of the transfer for accounting, tax or regulatory reporting purposes will not change this result.
After the amendment is enacted, the traditional "true sale" analysis of ascertaining whether the transferor retains the risks and benefits of ownership of a transferred asset could become moot for federal bankruptcy purposes in the case of investment grade issuances. (For unrated offerings, the current true sale analysis would continue, thereby potentially creating a double standard.) As discussed below, however, the amendment does not purport to alter state property laws governing what constitutes a sale; rather, by excluding from property of the estate of the debtor financial assets which have been transferred in accordance with certain formalities, the amendment generally seeks to avoid application of the automatic stay provision contained in Section 362(a)(4) of the Bankruptcy Code. Moreover, for accounting purposes, there is considerable uncertainty as to what evidence will be required to support the conclusion that a sale has occurred under FAS 125 since the amendment satisfies only the isolation requirement of FAS 125 and makes no pretense of addressing whether the transferor retained control over the transferred property.
Background
The principal purpose of the amendment is to eliminate any uncertainty that may exist as to whether assets that have been transferred to a special purpose vehicle in a securitization will be excluded from the estate of a debtor under the Bankruptcy Code. Such uncertainty results from the fact that currently, property owned by a debtor that is purported to have been transferred to a special purpose vehicle is considered excluded from the debtor's estate only when a "true sale" of the assets has occurred under state property law (i.e., the risks and rewards of ownership of such property have been transferred to such special purpose vehicle). As a result, law firms are now required to opine as to whether the facts and circumstances of a given securitization qualify as a "true sale." Such opinions are based on numerous factual assumptions and an extensive analysis of the case law that has developed in analogous situations over the years; typically, counsel is careful to point out in such opinions that there are no cases directly on point. Consequently, "true sale" opinions are heavily qualified, read more like a legal research memorandum than an opinion normally rendered in a financial transaction and lack the definitiveness which investors typically expect in a securities offering.
In addition, there is the danger that a court could wrongly decide whether a sale has occurred. For example, it is the prevailing view that this is exactly what happened in Octagon Gas Systems v. Rimmer,4 when the Tenth Circuit held that, because a sale of accounts is subject to Article 9 of the Uniform Commercial Code, a seller of accounts always retains a "legal or equitable interest" in the accounts sold for purposes of Section 541 of the Bankruptcy Code. This caused a tremendous problem for any transferor having operations in those states comprising the Tenth Circuit (which include Colorado, Kansas, New Mexico, Oklahoma, Utah and Wyoming) even though the rating agencies and most, if not all, law firms in the securitization area believed such case to be wrongly decided. It was finally necessary for the Permanent Editorial Board of the UCC to issue a clarifying amendment to Official Comment 2 to Article 9-102 of the UCC.3 One of the intended effects of the amendment to Section 541(b) of the Bankruptcy Code is to eliminate the possibility of the occurrence of another Octagon situation and to promote greater certainty and consistency in the treatment of transfers in securitizations in all jurisdictions for federal bankruptcy purposes. This would be accomplished essentially by asking whether the required words of "transfer" were used and no longer on whether substantial risks or benefits of ownership of such property had been retained by the debtor or sold to the transferee as a matter of state property law.
Rating Agency Considerations
Although the rating agencies have not yet taken a position on the issues raised by the amendment, it seems that, henceforth, in lieu of a "true sale" opinion, the rating agencies should only require an opinion that simply states that an "eligible asset" has been "transferred" to an "eligible entity" based on assumptions as to the essentially factual determinations required under new Section 541(b)(5) and that such eligible assets would not be included in the property of the transferor's estate. However, it will still be necessary to form the transferee as a bankruptcy-remote special purpose entity since otherwise there exists a danger that the assets and liabilities of the special purpose entity could be consolidated into the estate of the transferor upon the transferor's bankruptcy. In such circumstance, new Section 541(b)(5) would not be effective to shield asset-backed and mortgage-backed securities holders from application of the automatic stay provisions contained in Section 362(a)(4) of the Bankruptcy Code. Thus, law firms are likely to continue to be required to deliver "non-consolidation" opinions.
It should be noted that while the securitization amendment will govern the way in which assets that qualify for the Section 541(b)(5) exclusion will be treated in the context of a federal bankruptcy proceeding, as noted earlier, it does not purport to supersede state property laws governing what actually constitutes a sale. Specifically, a transaction that otherwise does not constitute a sale for state property law purposes but meets the requirements of the securitization amendment will be excluded from the estate of the transferor for federal bankruptcy purposes and, hence, not subject to the automatic stay provision of Section 362(a)(4). Beyond that, the effect of whether the transferor or transferee actually owns the asset (i.e. whether a "true sale" has occurred) and the ensuing consequences are unclear. If a "true sale" has not occurred, then creditors of the transferor's estate and holders of equity in the transferor would have a residual right to the transferred assets after holders of asset-backed securities have received their payments. Moreover, such creditors would also succeed to any voting rights which the transferor retained. It should be kept in mind that the primary focus of the drafters of this amendment was to protect cash flows to holders of asset-backed and mortgage-backed securities. Thus, the practical effect of the amendment is principally to serve as an additional exception to the automatic stay and to protect holders of asset-backed and mortgage-backed securities from the other powers of a bankruptcy court.
Structuring Considerations
The effect that the amendment may have in structuring transactions is potentially significant. Presently, in order to pass "true sale" requirements, transactions are structured so that there is very limited recourse to the transferor. Generally, such recourse is limited to breaches of customary representations and warranties as to the characteristics of the financial assets being securitized. Ongoing warranties as to the performance of securitized assets are generally not permitted in order to characterize a transaction as a "true sale." Similarly, the ability to repurchase the securitized assets so as to take advantage of an appreciation in value is also contrary to the requirements for establishing a true sale. It would appear that after enactment of the amendment, these considerations may be disregarded for federal bankruptcy purposes, and when securitization transactions are structured, provision of recourse to the transferor and repurchase options taking advantage of appreciation will now be possible. As discussed below, however, these factors may well be relevant to accountants under FAS 125 (for example, a repurchase option on the transferred assets, other than a clean-up call, currently is not permissible under FAS 125). In addition, a two-tier structure may not be necessary in instances where the degree of recourse back to the transferor is permissible for "non-consolidation" purposes and would not prevent sales treatment under FAS 125.
Accounting Considerations
The impact that the amendment will have on accounting treatment of rated securitizations is unclear. For sale treatment of financial assets under FAS 125, there must be evidence that "transferred financial assets have been ... put presumptively beyond the reach of the transferor [and its affiliates] and its creditors."5 An opinion that transferred assets would not be part of the transferor's bankruptcy estate would seem to satisfy at least the isolation requirements of FAS 125. However, paragraph 23 of the implementation guidance to FAS 125 instructs auditors to take into consideration all the "facts and circumstances" in determining whether sales treatment should be accorded to a transaction. Thus, it remains to be seen whether FASB and/or the AICPA's Auditing Standards Board will continue to require the type of true sale opinion currently rendered in securitizations as contrasted to a simple opinion that the transaction meets the requirements of amended Section 541(b)(5).
Conclusion
While it is obvious that the amendment to Section 541(b) of the Bankruptcy Code has potentially significant beneficial effects for all parties involved in investment grade securitizations, it is not yet clear the extent to which the amendment will simplify transaction structures and legal opinion requirements. Much work will need to be done with the rating agencies, third party credit enhancers and accountants to clarify structuring and legal opinion requirements.
Footnotes
1. In addition to HR 833 and S 625, other governmental entities have either passed or proposed rules that are intended to clarify the status of transfers in a securitization in the context of an insolvency or bankruptcy. On September 1, 1997, the Texas Uniform Commercial Code was amended to provide that in any transaction involving "accounts" or "chattel paper" under the Texas UCC, the parties' characterization of a transaction as a sale - not the extent of recourse against the seller or any other factors - will be conclusive as to whether such transaction will, under Texas law, be treated as a sale or grant of security interest. (See Texas UCC ' 9.102(d)).
Also, in September 1999, the FDIC (which has jurisdiction over the insolvency of federally insured depository institutions as opposed to the federal judiciary which has jurisdiction over "debtors" (which do not include such institutions) under the Bankruptcy Code) issued a proposed rule that would apply to insured depository institutions that states that "the FDIC shall not. . . reclaim, recover or recharacterize as property of the [institution]. . . any financial asset transferred by [the institution] in connection with a securitization. . . provided that such transfer meets all conditions for sale accounting under generally accepted accounting principles, other than the legal isolation condition, which is covered by this section." (See Proposed Amendment to 12 CFR 360.)
2. Both the House and Senate versions of the bill state the effective date to be the date of enactment (i.e., approval by President Clinton or an override of his veto) and that all the amendments in the bill will apply to cases commenced or appointments made under federal or state law after the date of enactment of the amendments. Accordingly, it would appear that, in addition to structuring transactions going forward in order to qualify under the securitization amendment, it makes sense to review existing securitizations to determine whether they could be easily amended so as to qualify under new Section 541(b).
3. See PEB Commentary No. 14, dated June 10, 1994.
4. 995 F.2d 948 (10th Cir.), cert. denied, 114 S. Ct. 554 (1993).
5. Financial Accounting Standards Board Statement of Financial Standards No. 125, paragraph 9.