It is safe to say that Canada is a particularly
securitization-friendly jurisdiction. No legislation is or was
necessary to make it work, and recent expansion of Canadian
activity has resulted in it becoming a significant securitization
market, with outstanding asset-backed term and commercial paper
aggregating just under C$100 billion. A number of changes to
Canada's accounting and securities rules has brought its
securitization framework closer to that of the US, and will help
maintain securitization as an important component of the funding
strategy of Canadian corporate treasurers.
Non-Canadian issuers, investment bankers, credit enhancers,
trustees, servicers and rating agencies are increasingly expanding
their operations, and securitization expertise, to Canada. Examples
include Americredit, Banc One, Bank of New York, Bank of
Tokyo-Mitsubishi, Barclays Capital, Burger King, Capital One,
Chubb, Citigroup, CNH, Computershare, DaimlerChrysler, Deere,
Fitch, GE Capital, Global Securitization, GMAC, Goldman Sachs,
Honda, MBNA, Merrill Lynch, Mizuho Financial Group, Moody's,
Nissan, Rabobank, Radian Asset Assurance, S&P, Sears, State
Street, Sumitomo, Wells Fargo and XL Capital Assurance. Further,
cross-border transactions are bringing Canadian receivables into
the much deeper and more flexible US and European capital markets.
In view of this, it appears timely to summarize the basic
infrastructure of Canadian securitization, particularly as compared
to its US counterpart.
ASSETS SECURITIZED
All the usual asset classes are represented, notably credit
cards, residential and commercial mortgages (including reverse
mortgages), trade receivables, auto and equipment loans and leases,
mutual fund fees, personal lines of credit and franchisee loans.
Collateralized loan obligations (CLOs), stranded costs and subprime
mortgages are also beginning to be securitized. More exotic
components of the US repertoire, such as structured settlements,
taxi medallions, pharmaceutical royalties and catastrophe bonds,
have yet to appear.
CANADA'S SECURITIES MARKETPLACE
Canada has 13 securities commissions, one in each province and
territory. In part because of the difficulty and cost of clearing a
prospectus through several commissions, and in part because of the
regulators' lack of structured finance experience, issuers had
traditionally avoided the public capital markets. As a result,
Canadian asset-backed securities had been distributed almost
exclusively through commercial paper conduits and private
placements, in addition to truly private deals and cross-border
transactions. However, recent revisions to Canada's securities
framework now permit asset-backed securities to utilize short form
prospectuses and a shelf prospectus system, and have introduced new
eligibility criteria that facilitate the public distribution of
investment grade ABS by special purpose vehicles. Virtually all
term ABS issued in Canada's capital markets are now distributed by
way of prospectus.
ACCOUNTING ISSUES
Canadian accounting rules had until recently created a
frustrating roadblock to removing certain securitized assets from
the transferor's balance sheet. In 1989, a "temporary" accounting
guideline denied sales treatment for securitizations unless the
purchaser obtained the significant risks and rewards of ownership,
and transferor recourse was reasonable in relation to credit,
prepayment, interest and exchange rate risks, determined with
regard to concentration levels and statistical loss experience. For
example, recourse exceeding 2 or 3 times historical losses may well
have been unreasonable under the 1989 guideline. A further
constraint mandated that accounting sale treatment was unlikely if
transferor recourse exceeded 10% of the sale proceeds.
The Canadian accounting rules have recently experienced a
fundamental change. The risks and rewards model has given way to
the financial components principle that underlies FAS 140 of the
United States. This change to Canada's accounting standards for
transfers of receivables should result in increased securitization
activity for particularly strong pools of receivables (which
require greater recourse than was permitted under the historical
loss test), for poorly performing portfolios (which commonly
require recourse exceeding 10%), and for cross-border transactions
(which have become easier to structure as a result of the
convergence of US and Canadian accounting standards).
TRUE SALE
Although structuring a Canadian securitization to satisfy
accounting standards was formerly more difficult than in the US,
obtaining a true sale for legal and bankruptcy purposes has
traditionally been more straightforward. The quantum of seller
recourse has not been a significant factor in Canadian true sale
opinions, since applicable case law indicates that the amount of
risk retained by the seller should not affect the characterization
of the transaction as a sale or loan. More relevant is the intent
of the parties to effect an absolute sale rather than a security
arrangement, as indicated by the language utilized in the
transaction documents. As well, options to repurchase must be
carefully scrutinized to ensure that they will not be construed as
evidencing a disguised mortgage. This legal true sale approach
almost invariably results in a single tier structure as compared to
the more complex two-tier approach commonly used in the US.
The Supreme Court of Ontario recently endorsed the foregoing
principles in the first securitization case to reach the Canadian
courts. The BC Tel decision, handed down in January 2003 and
currently under appeal, upheld as a true sale a one-step transfer
to a multi-seller commercial paper conduit which featured full
recourse for defaulted receivables during the revolving period as
well as a separate reserve during liquidation for up to five times
the historical loss experience of the transferred portfolio. The
Court did indicate that while significant (or even full) recourse
for collectibility of transferred receivables would not compromise
a true sale, the same may not apply to economic recourse that
guarantees a particular return to the transferee without regard to
the performance of the acquired receivables.
PERFECTION
Canada has two separate legal systems for perfecting sales and
security interests. All provinces and territories outside Quebec
have a personal property security regime based on Article 9 of the
US Uniform Commercial Code and generally permit a single filing in
the jurisdiction where the seller of accounts receivable has its
chief executive office. The Quebec Civil Code may require a
separate filing to achieve perfection for property located in that
province and an additional document (a hypothec) for creating
security over Quebec-based assets. Perfection by registration
(rather than notice to the account debtor) in Quebec is possible
only where the sale includes a defined class of receivables (a
universality), and care must be taken in drafting the transfer
documents in order that the appropriate perfection opinion can be
obtained.
TAXES
There are significant differences between the applicable
Canadian and US tax rules. Tax and legal principles in Canada are
generally consistent: debt for tax is also debt for
legal/bankruptcy purposes. As well, Canadian special purpose trusts
are normally taxpayers whose income is taxed at the highest
marginal rate (rather than tax-exempt flow through vehicles), and
Canada does not permit consolidation of parent and subsidiary
corporations for tax purposes. This leads to a need to match
revenues and expenditures for each entity in the securitization
structure in order to avoid paying taxes unnecessarily. In
structuring cross-border transactions, care must be taken to avoid
a non-Canadian purchaser becoming liable for Canadian taxes when it
appoints a Canadian servicer as its agent.
The federal government and certain provinces impose a capital
tax on the right hand side (ie, debt and equity) of a corporation's
balance sheet. If securitization proceeds are used to repay debt,
and thereby reduce the base on which capital tax is levied, the
seller can significantly reduce its annual capital tax liability.
Achieving off-balance sheet treatment for an ABS transaction can
therefore provide additional benefits in Canada as compared to
other jurisdictions. These benefits may be short-lived, however,
since the federal government and a number of its provincial
counterparts intend to reduce and eventually eliminate capital
tax.
Canada imposes a 7% goods and services tax (commonly called GST)
on the supply of most types of goods and services. Sellers
therefore usually transfer receivables on a fully serviced basis in
order to avoid charging a discrete servicing fee that would attract
GST, although the effectiveness of this approach is currently under
review by taxing authorities.
A major challenge to cross-border securitization is Canada's
withholding tax regime, which imposes a 25% withholding tax on
payments of interest or rent to non-residents. In most cases the
rate of withholding is reduced by treaty (for example the rate is
10% for payments made to residents of the United States or the
UK).
A number of techniques are currently being employed to fund
Canadian receivables offshore on a withholding tax-free basis.
Non-interest bearing trade receivables are sold cross-border at a
discount with the parties taking the position that the discount is
not subject to withholding tax since it does not constitute
interest. Certain corporate debt obligations can be sold into
foreign capital markets without withholding tax, so long as no more
than 25% of the principal is repayable within the first five years
of the original transaction. As well, certain short-term interest
bearing receivables can be securitized in Canada, and then funded
off-shore with foreign debt that complies with the 25%/five-year
test. Other transactions take advantage of a treaty exemption for
purchase-money debt between a foreign seller and a Canadian buyer.
There are exempt asset classes, such as airplane leases,
government-guaranteed mortgages and software royalties, which can
be securitized on a withholding tax-free basis. There are also
various categories of investors, such as foreign governments and an
extensive list of foreign tax-exempt investors, who are entitled to
purchase Canadian investments without paying withholding tax. These
and other cross-border strategies continue to be refined with the
growing interest in securitizing Canadian receivables in offshore
markets.
The US and Canada are currently discussing the elimination of
withholding tax on arms-length payments of interest between their
two countries. Abolition of withholding tax would likely have a
significant effect on where Canadians fund securitizations and
other structured finance products. While certain types of Canadian
receivables are currently being securitized offshore, Canada's
withholding tax regime imposes an economic barrier to the
securitization of billions of dollars of short-term corporate
obligations, residential mortgages, credit card receivables,
personal loans and other consumer obligations. As well, the
conservative nature of Canadian investors, which by and large shy
away from issues rated below AAA, is seen as impeding the domestic
securitization of asset classes that require significant
subordinate tranche support. Removing withholding tax would make
available to Canadian originators a broader and less risk-adverse
non-resident investor class. If the Australian experience is any
gauge, elimination of Canadian withholding tax will lead to a
significant increase in the amount of Canadian receivables that are
securitized in the US and other foreign capital markets.
ASSET TRANSFERABILITY
Receivables are generally assignable unless the underlying
contract or applicable legislation precludes assignment or requires
the obligor's consent. Only some provinces follow the approach
taken by Article 9 of the US Uniform Commercial Code, which
expressly validates assignments that contravene consent
requirements of assigned contracts. As well, certain Canadian
federal and provincial statutes invalidate assignments of
government receivables made without consent.
CONCLUSION
Canadian securitization volumes have been coursing upward over
the past several years. This trend is likely to increase, aided in
part by recent regulatory and accounting changes which facilitate
the structuring and execution of ABS transactions in both domestic
and offshore markets.
About the
author
Martin
Fingerhut
Mr Fingerhut is a partner in the Financial Services Group and
Chair of the Structured Finance Group of Blake, Cassels &
Graydon LLP. Mr Fingerhut is Chair of the Securitization and
Derivatives Subcommittee of the Business Law Section of the
American Bar Association and the former Vice-Chair of the
Securitization Subcommittee of the Business Law Section of the
International Bar Association. He was a member of the Expert
Advisory Group to UNCITRAL with respect to the Convention on the
Assignment of Receivables in International Trade. He has been
involved in the sale 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
securitization transactions and programmes. Mr Fingerhut is listed
in the American Lawyer/Lexpert Guide to the Leading 500 Lawyers in
Canada, in the Canadian Legal Lexpert Directory of leading lawyers
in asset/equipment finance, asset securitization and banking, in
Law Business Research's International Who's Who of Securitization
Lawyers, in Euromoney's Guides to the World's Leading
Securitization and Capital Markets Lawyers, and in the Chambers
guide to the leading Canadian banking and finance lawyers. Mr
Fingerhut is a Fellow of the American College of Commercial Finance
Lawyers and sits on its Board of Regents.
Mr Fingerhut can be contacted at +1 416 863 2638 or
martin.fingerhut@blakes.com
Blake Cassels & Graydon LLP
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