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Securitization 2004

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Dated: November 23, 2004

SECURITIZATION

A. SECURITIZATION STRUCTURE

This paper is intended to highlight certain issues relating to securitization in the context of the

Pakistani legal environment.

The term “securitization” encompasses a wide range of transactions. The renowned English jurist

of international finance, Philip Wood, contends that “securitisation is essentially a sophisticated

form of factoring or discounting of debts”. The classic model of securitization was adopted in the

Companies (Asset Backed Securitization) Rules, published by the SECP in 1999. On the basis of

this model, a typical securitization structure can be as follows:

-- The originator (i.e. the party wishing to raise finance) sells its present and/or future

receivables to a Special Purpose Vehicle (SPV) in return for a purchase price payable

immediately on sale. I will use the term sale and assignment interchangeably.

-- The SPV finances the purchase price of the receivables by issuing Term Finance

Certificates (TFC) or some other debt instrument. The SPV grants security to the

investors over the receivables to secure the borrowing. In case of a TFC offering, the

security is granted through the intermediation of a trustee.

-- The originator, as “servicer”, may continue to collect receivables on behalf of the SPV, in

return for which the SPV pays a servicing fee to the originator.

-- Any surplus income of the SPV after deducting the money required to repay the investors

is returned to the originator either as a service fee or through other methods of profit

extraction which I will discuss later.

-- The securitization transaction may involve a credit enhancer to ensure that the

receivables are sufficient to pay the investors on time. For example, a third party may

guarantee the obligations of the SPV.

B. ADVANTAGES OF SECURITIZATION

I am sure the other speakers will talk about the several financial and commercial advantages of a

securitization most notably relating to off balance sheet treatment. There are also various legal

impediments that can be overcome by securitization. I will mention three of them here. The first

is a regulatory obstacle: since the SPV does not fall within the regulatory ambit of the State Bank

the minimum debt to equity ratio requirement under the Prudential Regulations does not apply

where funding is provided by an SPV. Nevertheless, where investors in TFCs are banks in DFIs they

are required to comply with certain conditions set forth in a State Bank Circular issued in 2002.

These conditions include a minimum credit rating of “A” for the TFCs by an approved rating

agency as well as limits on banks’ total exposure towards the asset backed securities. The net

result is that banks and DFIs can structure a transaction whereby funding is provided to the

originator through the SPV without attracting Prudential Regulations IV and V. The State Bank is

placing reliance on the adequacy of rating of the debt instrument which I think is a step in the

right direction.

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The second legal hurdle that may be overcome through a securitization structure is a contractual

one: the originator may be party to one or more contracts which contain “negative covenants”

restricting the originator from creating any security interest over its receivables. A transaction

structured as a sale of receivables to the SPV can, in appropriate cases, overcome such negative

covenants. Indeed, the U.S. $ 250 Million International PTCL Securitization was not initially

structured as a true sale but when due diligence revealed that the Government had given

covenants to international institutions whereby it was restrained from creating security interest

over foreign receivables owed to public sector entities, the transaction was structured as a sale

of receivables. This is not an un-common use of a securitization structure in developed

economies.

Lastly, a securitisation structure can enable a private company (without converting itself into

a public company) to indirectly raise finances from the public, as TFCs are issued by the SPV

and not the originator.

C. LEGAL ISSUES

1. Assignment

Now I will try and analyse certain legal issues that arise in respect of this structure. Under

our laws, it is permissible for the originator to either sell the receivables or transfer the

receivables as security to the SPV. Both come within the meaning of assignment of

receivables: the former is an absolute assignment or true sale and the latter is an

assignment by way of security. Upon a valid assignment the SPV steps into the shoes of

the originator in respect of all rights of the originator against the debtor, that is, the

person who owes funds to the originator. I may also mention that an assignment of

receivables is a much superior form of security as compared to hypothecation of the

receivables because in the context of the assignment the lender step into the shoes of

the borrower at the time of creation of the security with respect to enforcing rights

against the debtors.

Subject to certain exceptions, to perfect an assignment, strictly speaking, consent of

debtors is not required but it is strongly recommended when the same is practical. The

practicality generally depends on the number of debtors. Consents would be highly

impractical in the context of securitization of utility bills where the utility’s customers are

numerous. Consents should, however, be obtained where, for example, lease rentals for

large plants and equipment are assigned. In the latter case the debtors are likely to be

few and the amount of receivable of each such debtor quite significant.

Even where consent is not obtained, notice of the assignment to the debtors should,

however, be given. There are case laws under our Transfer of Property Act to suggest

that if notice of assignment to the debtor is given, then the debtor's obligation can only

be discharged if payment is made by the debtor to the assignee, that is, the SPV. In other

words, if the debtors pay the originator after the notice has been given, its obligations of

the debtor to the SPV would not be discharged.

2. Present vs. future flow securitization

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In the context of securitization, present receivables relate to receivables that have been

generated out of any service rendered or any contract entered into. The fact that a

payment under a certain contract is due several years from today does not mean that

the securitization relates to future flows. Future flows refer to receivables that have not

been generated at the time of securitization, for example, utility bills that may be owed

by customers. Here, generally stated, at a future date the utility will be used by a

customer, where after the utility company will bill the customer thus generating a

receivable. The Paktel securitization is an example of future flow transactions where the

receivables are generated when the customer makes the phone call in the future.

The distinction between existing and future flow receivables is critical to determine

whether and to what extent off balance sheet treatment will be permitted. I understand

from friends in the accounting profession that in terms of IAS32 and IAS39 off balance

sheet treatment in respect of receivables other than future flow is a well-established

subject to fulfilling requirements of the IAS. Future flow is more complicated because

there are no receivables on the books against which the purchase price received on the

sale of receivables can be adjusted on the asset side and therefore an entry has to be

made on the liability side of the balance sheet. I understand that there is a US Accounting

Guideline called EITF 88-18 in respect of treatment of future flow securitizations. If the

conditions of such guidelines are satisfied, then notwithstanding the recording of a

liability on the balance sheet such liability amount may be excluded for the purpose of

determining debt equity ratio of a company which effectively means that several of the

advantages of off balance sheet treatment is also available in the context of future flow

securitizations. I may mention that these guidelines are not only beyond my expertise

but, quite complicated, onerous and in my view somewhat unclear.

3. True Sale

The next issue that I would like to deal with is the concept of a true sale. Before I discuss

true sale, however, I want to deal with a popular misconception that securitization

necessarily involves a true sale. Instead of purchasing receivables, it is perfectly feasible

for an SPV to lend funds to the originator and have the receivables assigned to it by way

of security. The only circumstance where this is not possible is where the originator is a

bank/DFI. In this case, the State Bank Circular requires securitization to be by way of true

sale and lays down very stringent standards for such sale. This is so because sale of banks

assets impacts on the capital adequacy ratios, which I will discuss in the context of a very

brief discussion on mortgage securitizations later.

For entities other than banks/DFIs a loan structure through an SPV is an option. This

structure is advantageous for investors from a risk point of view. As with a true sale, the

SPV would be entitled to sue and recover directly from the debtors. In addition, it would

have full recourse against the originator for outstanding amounts in the event

receivables dry up. The structure is disadvantageous from the originator’s point of view

because the receivables will remain on its balance sheet.

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Getting back to true sale, determining whether or not an assignment of receivables is a

true sale is a complex question made more so by the absence of Pakistani law on point.

Broadly and loosely stated, generally recognized standards of true sale require that all

risks and rewards associated with the receivables be transferred in their entirety to the

SPV.

In the absence of Pakistani (or indeed Indian) law on point it is common for our courts to

fall back on English common law principles. These principles are liberal: provided the sale

is properly documented and is treated by the parties as such the courts will recognize the

transaction as a sale even if the buyer has limited recourse to the seller for unpaid

receivables and even if the seller has a right of repurchase. However, in view of the much

stricter accounting standards and the possibility that our courts may not follow English

law to the letter it may be advisable to adopt the accounting standards as a benchmark

for constructing a true sale, even if accounting objectives is not a key consideration in a

particular transaction.

Moreover, in case an accounting opinion is required on true sale, the lawyer’s job on

giving a true sale opinion becomes easy as the accounting standards are more defined

and much stricter.

One final point on true sale. The true sale standard set forth in State Bank Circular where

banks/DFIs act as originators is relevant from the point of view of satisfying State Bank’s

regulations. It is not relevant for determining whether a transaction is otherwise a true

sale. Thus, if the originator is not a bank or DFI, the true sale standard set forth in the

circular need not be followed.

4. Stamp Duty

Stamp duty payable on an assignment deed is considerable and would be a major

stumbling block for securitization were it not for the option of equitable assignments

which are permissible in the province of Punjab. This is a complex legal issue but let me

briefly touch upon the same.

5. Mortgage Securitization

The mode of equitable assignment to avoid stamp duty is, however, not

available in my view in the context of securitization of mortgages of immovable

properties. Under the Registration Act, any instrument which purports or operates to

create, declare, assign, limit or extinguish any right, title or interest in immovable

property requires compulsory registration, which is not the case in respect of movable

properties and debts.

The mortgage securitization can be structured where the title to the mortgaged

property remains with the originator and the interest in the receivables is transferred. In

our view, even such transfer of interest will require compulsory registration. Thus, the

problem can be effectively cured by an issuance of SRO waiving or reducing the

applicable stamp duty and registration fees. Such SRO should include all kinds of

properties as we would be more comfortable with the proper legal assignment as

opposed to equitable assignments.

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Assuming the stamp duty and registration issues can be managed, I would very

briefly state that in case of a mortgage securitization, given our laws, the title to the

mortgaged property would remain with the originator and the originator would hold the

same as agent for the SPV. The purchased receivables in our case would not only include

payments of principal and mark-up under the loan agreement but also proceeds received

by the originator upon the sale of the mortgaged property in case of a foreclosure which

recover will need to be made as the agent of the SPV.

As I have already mentioned that sale by banks and DFIs of its mortgaged

receivables must satisfy a tough true sale test as contained in the State Bank Circular.

Effectively there should be no recourse whatsoever on the originator. While I appreciate

that this standard has been included as sale of these assets affects capital adequacy

ratios, consideration may be given to permitting recourse under a couple of

circumstances; first if the seller bank has fundamentally breached a warranty in reliance

of which the mortgaged receivables were acquired by an SPV, for example, if the Seller

has warranted that the debtor has made all principal and mark-up payments till date on

time, and at later transpires that the same warranty was not accurate the SPV may

require recourse against the originator. Second, the originator will need to play an

agency role to service the receivables and to enforce the mortgage on behalf of the SPV.

The argument of some recourse against the originator is even stronger in this case where

the originator fails to discharge such agency obligations. This, however, is a policy

decision that needs to be made.

The structure of a lease securitization is quite similar to a mortgage securitization

except that in this case the issue of registration fees and stamp duty can be addressed

through an equitable assignment. Because of time constraints I will not dwell on lease

securitizations any further.

6. The SPV

I would also like to make a few observations on the SPV itself. In terms of the

Securitization Rules, an SPV (which is required to register with the SECP) may either be a

trust or a public limited company with a paid-up capital of not less than one hundred

thousand rupees. Ownership of the originator and the SPV may not be connected in any

way. In terms of the State Bank Circular referred to earlier, bank/DFIs participating in a

securitization transaction cannot own any share capital in the SPV either.

The SPV, after paying its obligations to the investors and its administrative costs, should

be in a position to return the balance remaining to the originator in terms of a profit

extraction formula. An example of such a formula is the service fee referred to earlier.

The originator continues to collect the purchased receivables on behalf of the SPV, and

in return is paid a service fee by the SPV. However, in developing the formula for e.g.

determining the service fee care needs to be taken to ensure that the transaction does

not lose its true sale character. This is so because in a true sale, the purchaser, i.e. the

SPV, would retain the residual interest after paying the investors. If all residual amounts

are returned to the originator, then it could be considered a mortgage redemption.

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7. Bankruptcy remote

Another issue which arises in the context of a true sale securitization is whether the

securitization is “bankruptcy remote” i.e. whether in the event of the originator’s

bankruptcy its creditors would have any claim on the receivables sold to the SPV. In our

view, a purchaser for due consideration (of the receivables) would be entitled to have his

interests in the purchased property of the insolvent to be dealt with at least as favourably

as the interests of a secured creditor holding security interest over such property. Under

Pakistani law, it is well established that a secured creditor can effectively stand outside

bankruptcy if it so desires or may submit to bankruptcy to prove its debt. The Supreme

Court of Pakistan has held that a secured creditor is at liberty to realise his security in any

manner he likes. This would suggest that securitization transaction in Pakistan can be

structured as being bankruptcy remote.

However, applying certain principles of English common law, a problem could arise in

respect of receivables that have not been generated at the time a liquidator is appointed.

The security may not catch receivables if the liquidator of the bankrupt must earn the

receivables to bring them into existence by rendering services. The rationale for the

same is that upon bankruptcy it would not be fair to unsecured creditors to deplete the

assets of the bankrupt for the advantage of a secured creditor.

D. TFC OFFERING

The final part of the securitization process is an offering by the SPV of redeemable capital such as

TFCs. I think most of you are familiar with the way TFC offerings in Pakistan are being structured

and, therefore, it is one part of the securitization transaction which is not novel from the Pakistani

perspective. Under our company laws, redeemable capital such as TFCs may be offered directly

to the public.

E. CROSS BORDER SECURITIZATION

Before I conclude, I may just mention a point on cross border securitizations where the

government is the obligor.

An export receivables securitization and/or a worker remittance securitization can be structured

where Pakistan risk is minimized thereby substantially improving the rating resulting in cheaper

source of funds. PTCL’s international securitization was given an investment grade rating even

though the relevant rating at the time for Pakistan credit was three or four notches below

investment grade.

In conclusion, I would like to say that legal and regulatory obstacles in my view are not the reasons

handicapping the growth of securitization as a financing tool. We should look to financial and commercial

considerations to determine why securitizations in Pakistan have not flourished. Even in the context of

mortgage securitization where registration and stamp duty are a problem, I think that if there is burning

desire to develop this market from a commercial angle, solutions can be found.

7


Author(s)

If you would like further information on any issue raised in this note please contact:

Khozem A. Haidermota HaiderMotaBNR

Senior Partner,

[email protected]

+92 (021) 111-520-000

www.hmcobnr.com

INSIGHT January 1, 2018

OIL & GAS INDUSTRY

OVERVIEW

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