It's been quite a momentous year for Canadian securitization. The size of the market broke through the C$100 billion ($81 billion) level. Litigation turned out well, confirming the validity of Canada's basic ABS structure. Complex accounting and regulatory changes were carried out. A major asset class was introduced. And cross-border transactions continued to securitize Canadian receivables in the US and UK capital markets.

Market size and direction

According to Dominion Bond Rating Service (DBRS), outstanding ABS exceeded C$100 billion for the first time, with term and ABCP closing 2004 at C$101.7 billion, a 5% increase over 2003. By March 31 2005, outstandings increased further, to about C$105.3 billion. Growth stemmed primarily from additional term issuance, as asset-backed commercial paper appears to have stabilized at about C$67 billion.

Individual deal size continues to increase as the economics of larger transactions has coincided with growing investor demand. While C$100 million issues were once the norm, C$500 million, C$600 million and even C$1 billion transactions are becoming increasingly common.

A new asset class arrived in Canada's public market in 2004, the first new entrant since Merrill Lynch initiated CMBS issuance in 1998. The 2004 innovator was GMAC FRC, which securitized ALT-A and sub-prime residential mortgages in two sequential pay amortizing transactions aggregating almost C$570 million. Although a number of commercial paper conduits contain residential mortgages, and Canada has a strong multibillion-dollar government-guaranteed MBS programme, the Canadian market had not seen a residential term transaction since Household's private placements in 1993.

As well, the continuing strength of a more exotic asset class indicates the growing maturity of the Canadian market. According to DBRS, commercial paper backed by synthetic CDOs grew in 2004 by 25% to C$6.5 billion, and increased investor appetite led to two multi-issuer multi-asset arbitrage conduits.

The growth of Canadian ABS has been steady, and has so far proven to be a safe haven for investors. This past year did not witness any downgrades, for collateral performance or otherwise, whereas several subordinated note classes received upgrades as a result of improved enhancement levels caused by underlying loan payments or defeasance, senior-note payments and strong collateral performance. CMBS performed particularly well, reporting neither liquidations nor defaults.

True-sale challenge

The Ontario Court of Appeal released its long-awaited decision in BC Tel in June 2005, and the Canadian securitization market breathed a collective sigh of relief. Ontario's highest court concluded that the one-step sale common to many domestic and cross-border Canadian securitization transactions effectively produces a true sale of the securitized assets. For the first time in Canadian legal history, its courts were called on to consider the effectiveness of the classic Canadian securitization structure. Unlike the US model, which uses a two-step approach, most Canadian securitizations provide for a recourse sale of receivables by their originator directly to a bankruptcy-remote vehicle that then issues ABS to the public. The securitization market in Canada has long relied on unrelated Canadian and English case law as establishing that a true sale will not be precluded simply because the seller retains the economic risk of ownership through a warranty that the receivables will collect in full.

The Court noted one of the benefits of a Canadian securitization that might not arise in other jurisdictions - the potential for capital tax savings. The federal government and a number of provinces levy an annual capital tax on borrowed money. When a corporation uses securitization proceeds to repay loans, its capital tax liabilities can be reduced by several million dollars, depending on the size and term of the securitization programme. It is readily apparent that this and the other benefits that flow from securitization will be realized only if the originator is viewed as entering into a sale of its receivables, rather than a secured borrowing under which the receivables remain its property. This was one of the critical issues before the Court.

BC Tel had issued a series of bonds that were not redeemable "by the application, directly or indirectly, of funds obtained through borrowings having an interest cost to the Company" that was lower than the bond coupon. BC Tel did subsequently redeem the bonds with the proceeds of a securitization under which it sold receivables to an ABCP conduit that issued commercial paper with a funding cost lower than the interest rate on the bonds. The bond investors complained that BC Tel had violated its non-redemption covenant because the securitization was either a direct borrowing by BC Tel rather than a sale, or at least an indirect borrowing.

The Court of Appeal upheld the trial court's conclusion that the asset transfer in the BC Tel securitization constituted a sale. In doing so, the Court validated the basic elements of Canadian securitization that have been used since the late 1980s (as well as the related true-sale legal opinions). The decision will be a critical reference point for analyzing whether a particular securitization will receive sale treatment or be recharacterized as a loan.

In determining whether the transfer under a securitization constitutes a sale, the court must determine the parties' true intention by analyzing:

• the language of their contract, the factual matrix existing when the contract was made, and their conduct in implementing the contract; and
• the substance of the transaction, rather than merely its form.

Although general in nature, these principles can be put to good use in practice. The first serves to emphasize that the terminology used to effect a transfer of assets and the parties' actions must be consistent only with a sale, and must not carelessly include language or conduct that is suggestive of borrowing or giving security. As elaborated by the Court of Appeal, the second principle is a helpful reminder that the overall legal effect of the transaction is paramount, whether or not it shares some characteristics with a secured loan.

More particularly, the Court of Appeal provided its views on a number of factors that the trial judge analyzed to determine the parties' intention:

• Particularly "compelling" as pointing to a sale was that BC Tel did not have a "right of redemption," that is, the ability to reacquire its receivables except in limited circumstances.
• A true sale will not be rejected simply because the purchaser has no right to retain any surplus from collections of the receivables, which are permitted to flow back to the seller (as, for example, the balance of the purchase price of the transferred receivables).
• On the question of whether a sale can exist if the seller retains the ownership risk for the transferred property, both judicial levels agreed that recourse as to "collectibility" (for example, a guaranty that the receivables will be paid in accordance with their terms) is consistent with a sale. Alternatively, "economic recourse" - a warranty that the buyer will receive a return of its investment plus an agreed-upon yield that is unrelated to the receivables' payment terms - would favour loan characterization.
• It is important to a sale conclusion that the purchase price of the assets be ascertainable from the language of the agreement and that those assets be identifiable.
• As well, by upholding the trial decision, the Court of Appeal implicitly agreed that it will not be fatal to a sale determination if the seller retains responsibility for collecting the sold receivables.

Although agreeing that BC Tel's securitization included a true sale, and not a direct borrowing that violated its non-redemption covenant, the Court of Appeal nevertheless found that BC Tel had breached that covenant because it had improperly obtained the redemption funds indirectly by using the funds borrowed by the ABCP conduit. In coming to this result, the Court provides a useful reminder that a corporation's various contracts and other relationships must be carefully analyzed to determine the implications of a securitization. Simply concluding that the transaction includes a sale for legal, tax and bankruptcy purposes will not necessarily provide assurance that the transaction complies with all relevant restrictions, particularly those that might relate to an indirect raising of borrowed funds.

Cross-border securitization

With little fanfare, non-interest bearing Canadian trade receivables have been securitized in the US, the UK and Europe for almost 20 years. Along the way, numerous issues have been identified and resolved:

• If the asset purchase agreement is properly documented, withholding tax should not apply to the cross-border payment of collections (including that portion representing the purchase price discount). It is common to exclude from the sale any part of the receivables that represents financing charges or default interest (which could attract withholding tax).
• Where the Canadian seller is appointed the offshore purchaser's collection agent, special care is required to ensure that this does not give rise to the purchaser having a permanent establishment in Canada that would subject the purchaser to Canadian tax.
• Although it is clear that the federal sales tax component (known as GST) of a receivable can be assigned, the Canadian tax authorities take the position that this is not the case when only an interest in the receivable is sold rather that the entire receivable. On the other hand, certain provincial sales taxes are not assignable, and are often excluded from cross-border sales.
• Perfecting a sale of Quebec receivables can present special challenges. Perfecting through registration (rather than notice) is possible only if the Quebec receivables constitute a universality, a complex concept relating to classes of receivables. As well, the sale agreement should provide for a single sale of present and future receivables (because each sale would require a separate registration), and one that can be easily described on the registration form.
• The subordinated note given to the seller for the balance of the receivables' purchase price can give rise to a deemed dividend unless the purchaser is unrelated to the seller (for example, an ABCP conduit) or controlled by it (rather than by a foreign affiliate). Or it might be practicable to pay the full purchase price in cash, and reduce the cash portion paid in connection with a foreign affiliate's concurrent securitization.

More challenging yet can be the cross-border securitization of interest-bearing receivables. Most consumer assets, such as credit card receivables, will attract withholding tax if sold cross-border, but this need not apply to certain corporate loans. For example, a franchisor was able to provide low-cost funding to its Canadian franchisees, through loans that were securitized with a US-based ABCP conduit, by meeting the three basic elements of Canada's withholding tax exemption for long-term debt:

1. The borrowers had to be corporations, rather than individuals, trusts, or partnerships having an individual partner.
2. Mandatory repayments could not exceed 25% of the loan during the first five years of the loan term, and the loan agreement could not include any event of default that, under Canada Revenue Agency policies, would improperly permit the lender to shorten the five-year loan term. The lender also avoided amendments and assignments of the loan arrangement that would be viewed as creating a new obligation.
3. The loan structure and the parties' relationship had to reflect that they were acting at arm's length.

This long-term debt model has been successfully adapted to also securitize short-term corporate loan receivables offshore without withholding tax. In one case, a finance company securitized floorplan loans with a Canadian special purpose corporation, which obtained a secured loan from Euromarket investors on a five-year/25% basis that qualified for the long-term withholding tax exemption. In another, a Canadian corporation borrowed 5/25 compliant funds from an offshore ABCP conduit and on-lent the funds to a Canadian single-seller securitization trust. As usual, innovation begets unique issues. Here, it was necessary to deal with early amortization events under the Canadian securitization that could not be matched by similar events of default under the cross-border loan, and with the Canadian tax authority's discomfort with back-to-back loan structures that are used to avoid withholding tax.

Gaap convergence

There was a time when the Canadian accounting rule for securitization differed from its US counterpart. Apart from the Canadian standard being more restrictive (such as by limiting seller recourse to 10%), the conflicting approaches created confusion for cross-border transactions, and complicated even Canadian securitizations if the seller had a US parent that applied US Gaap to the transaction on its consolidated financial statements.

For better or worse, the new Canadian accounting rule (AcG-12) adopts, almost in its entirety, the US Gaap position for securitization (FAS 140). Notwithstanding the obvious benefits that flow from a single north American true-sale accounting standard, alarm bells are beginning to sound in regards to possible US amendments that are likely to be implemented in Canada. The proposed revision includes a requirement that sales of beneficial interests in receivables, as opposed to the receivables as a whole, be carried out through a two-step transaction involving an entity that satisfies certain restrictive criteria applicable to what is known as a qualified special purpose entity (QSPE). If this requirement is added to Canadian Gaap principles, it could compromise the use of the straightforward single sale structure recently blessed by the Ontario Court of Appeal.

Accounting convergence has in fact proceeded much farther than Canadian securitization participants had anticipated. Canadian Gaap had historically looked at share ownership to determine whether two entities should be consolidated. A new accounting rule, AcG-15, has now introduced to the Canadian market the joys of FIN 46, the US standard for consolidating entities based on complex notions of what constitutes control. It has become necessary for companies to identify any variable interest entity (VIE) in which it has a variable interest, to determine whether it is the primary beneficiary of the VIE, and, if so, to consolidate it. VIEs would normally include the special purpose entity used in most securitizations, but is a much broader concept, as shown by the following summary of a VIE provided by the Canadian accounting body:

• the equity is not enough to permit that entity to finance its activities without external support; or
• equity investors lack either voting control, an obligation to absorb expected losses, or the right to receive expected residual returns.

As to a VIE's primary beneficiary - this is the entity that is determined to absorb most of the VIE's expected losses (a much broader concept than mere financial shortfalls) or receive most of its expected residual returns, or both.

It can be readily appreciated that determining whether a company will be considered a VIE's primary beneficiary can be of utmost importance. For example, the new rules could require a company securitizing through a multi-seller ABCP conduit to consolidate the conduit's entire asset and liability position, or could deny off-balance-sheet treatment for a securitization that uses a single seller trust. These potential consequences have led many conduits to issue an equity tranche that would attribute most of the conduit's variable interests to a third-party investor willing to consolidate the conduit, and led as well to more complex securitization structures for the purpose of accessing consolidation exemptions and safe harbours, such as through the use of QSPEs. This remains a work in progress because the rules for determining variable interests and primary beneficiaries are so complex that even accounting professionals freely acknowledge confusion, new explanatory guidelines are expected, and yet additional directives will probably amend, and possibly make more restrictive, the QSPE criteria.

Regulatory convergence

National standards are coalescing on the regulatory front as well. The Office of the Superintendent of Financial Institutions (OSFI) recently amended Guideline B-5, the regulatory framework for securitization transactions involving Canadian banks and other federally regulated financial institutions (FRFIs). The changes derived partly from a desire to level the playing field with the US regulatory position, and partly to modify certain elements of the previous Guideline that OSFI was persuaded were unduly restrictive or unclear. Among the more important changes are:

• a requirement that securitization documents clearly state that regulatory actions affecting an FRFI that securitizes its receivables cannot precipitate early amortization;
• removal of the distinction, when assessing capital requirements, between FRFIs that securitize their receivables, and those that provide enhancement facilities or invest in subordinate ABS without doing so;
• use of external ratings to determine certain risk-based capital requirements;
• allocation of a capital charge to liquidity facilities (unless available only in the event of a general market disruption);
• a revised definition of general market disruption that suggests such a disruption need apply only to a particular ABCP conduit rather than to the entire commercial paper market. This might permit S&P, Moody's or Fitch to conclude that a liquidity facility that is available only in the event of such a disruption complies with its criteria, and that it could as a result, and for the first time, rate Canadian ABCP conduits that have such a facility;
• FRFI servicer advances will be permitted if the advances must be repaid within 31 business days; and
• FRFI clean-up calls will be permitted when the pool falls to 10% of the original balance.

OSFI purposely kept the B-5 revisions to a minimum because it intends to make further changes before November 2007 to align B-5 more closely with Basel II.

All in all, the past year has shown further maturity and sophistication in the Canadian ABS market. Additional growth is expected, along with continued integration with US and international ABS practices and structures.

Author biography

Martin Fingerhut Blake Cassels & Graydon LLP Martin Fingerhut is a partner in the Toronto office of Blake Cassels & Graydon LLP and chair of Blakes' structured finance group. He is chair of the Securitization and Derivatives Subcommittee of the American Bar Association's Commercial Financial Services Committee, former vice-chair of the Securitization Subcommittee of the Business Law Section of the International Bar Association, and chair of the Developments in Business Financing Committee of the ABA's Business Law Section. He was a member of the expert advisory group to Uncitral with respect to the Convention on the Assignment of Receivables in International Trade. From the earliest days of the Canadian securitization market, Fingerhut has been involved in the establishment of multi-seller commercial paper conduits, and in the securitization of trade receivables, credit card receivables, corporate loans, floor plan loans, conditional sale contracts, leases, residential and commercial mortgages, natural resources and other assets under one-time, ongoing and cross-border transactions and programmes. Fingerhut has been recognized as a respected securitization practitioner by the American Lawyer/Lexpert Guide to the Leading 500 Lawyers in Canada, the Canadian Legal Lexpert Directory of leading lawyers in asset securitization, Law Business Research's International Who's Who of Securitization Lawyers, Legal Media Group's Guide to the World's Leading Structured Finance and Securitization Lawyers, its Guide to the World's Leading Capital Markets Lawyers, and the Chambers guide to the leading Canadian banking and finance lawyers. Fingerhut is a fellow of the American College of Commercial Finance Lawyers and has sat on its board of regents. Martin can be contacted at 1-416-863-2638 or martin.fingerhut@blakes.com