In this blog post, Pramit Bhattacharya, a student of Damodaram Sanjivayya National Law University writes about securitization in the international market. The post discusses the advantages and issues involved in international securitization.
Securitization has emerged as a growing trend worldwide. Many companies securitize their transaction to segregate the risks or illiquid into marketable securities. When securitization becomes international, there are a lot of issues involved. For instance, suppose, an Indian company raises fund in the Indian capital market itself to float its securities, then there will be no major issues. But if the same Indian company wants to float its securities in the US or European Capital market, it’ll not only have to comply with the law which is there in India, but it’ll also have to comply with the laws of the specific foreign capital market. With many companies going global, and the securities market in their own country not developed fully, they look to exploit the international market.
What is Securitization?
Securitization can be defined as a process through which risk and illiquid assets are liquidated into tangible and marketable securities. In this process, an entity deconstructs its assets and turns them into marketable securities. The process of securitization includes setting up of a separate entity known as a Special Purpose Vehicle (SPV). The assets of the company are then transferred to this SPV, and the SPV issues securities to and raises funds from the market.[1] These funds are procured from the market at a lower cost and investors also get the benefit of holding these securities at a lower risk. The assets are transferred to the SVP to reduce the chances of bankruptcy. The company which transfers the assets is known as originators. The assets are known as receivables and the entity which receives the assets are known asobligors. The transfer is done in such a way that it is considered to be a sale in the eyes of the law because in that case the assets are not shown any more in the originator’s bankruptcy estate. This ensures that the transferred assets cannot be claimed by the creditors in case of bankruptcy. Sometimes the assets are also transferred through secured loans, instead of a sale, which further reduces the cost of transacting.[2] The SPV should be an independent and separate legal entity from the originator. Special care should be taken to structure the SPV in such a way that the chances of the SPV going bankrupt are minimal. In the unfortunate case that the originator becomes bankrupt, the SPV should be sheltered.[3] After the SPV issue securities and raise funds, they transfer these funds to the originator company as consideration for the sale of the assets or the loan which has been taken.
Advantages of Securitization
Efficient Generation of Funds
By transferring the assets to an SPV, the originator separates its assets and liabilities, which enables it to raise the fund at a lower cost, as compared to the cost of issuing securities if the originator had done it directly.
Compliance with Capital-adequacy Standards
Compliance-adequacy standards are important in the case of financial institutions and banks. They are required to maintain risk-based capital. Thus, when any asset is transferred to the SVP, such as a secured loan, and it is shown as an asset in the financial statement of the bank, it would lower the capital level which must be maintained, and the bank or the financial institution would be able to raise funds effectively.
Compliance with maximum limit of debt
Many times, companies are restricted from securing debts beyond a specified limit. By transferring the assets to the SPV and then raising the debts through them, the company would be able to raise further debts without crossing the restricted limit.
Credit Exposure
When funds are raised through the SPV, they are also able to limit the credit exposure to risks. The securitization of the assets and risks will help the entity in diversifying its portfolio and thereby reduce the risks associated with credit.
Cross-Border Securitization
Cross-border securitization is also known as international securitization. Cross-border securitization is generally done because of the opportunities provided by the international market. It is also done when the capital market of the originator company is not fully developed. The general structure which is followed in a cross-border transaction is that the originator has the headquarters in one country. The assets of the originator are purchased by a special purpose entity, belonging to the country where the originator wants to float its securities. Thus, the payers or the obligors are situated outside the country. The receivable are denominated in the same currency as the securities and then the special entity receives the payment directly from the payers. The distribution to the investors is also made by the special entity.[4]
Jurisdictional framework involved in Cross-border Securitization
When any cross-border securitization is undertaken, two things are to be considered. The first is to determine the jurisdiction of the transactions and the second is to determine the jurisdiction of the seeking the finances. There are various factors which affect these considerations, like tax implication in that nation, the stability of the government in the country, the services the country provided to the companies and investors, socio-economic status of the people living in the country, strictness of rules and regulation in the country, etc. For instance, the capital market in the US is an excellent source of raising finance because of the efficient pricing and diversified customer base. But the compliance level and disclosure levels are very high, which may not be possible for a company. Comparing this with the Capital Market in some of the European countries, it can be observed that their compliance and disclosure levels are not too high, and are flexible. But they have a limited investor base.
The second issue which the companies have to consider is to see the law applicable in a particular country. Ascertaining which law will be applicable in a case of cross-border securitization across which jurisdiction is crucial since different countries may have different laws relating to the capital market and the companies.
Issues involved in Cross-border Securitization
Commercial financial issue
It is important that the interest of the SPV is secured from the creditors of the originator.
- Perfection – the phrase “perfection’ means protecting the interest of the transferee entity from the creditors of the transferor.[5] There are various ways in which the interest of the transferee company can be perfected. It can be through public notice system or notification.
- Priority- Priority can be defined as a ranking of multiple claims against a specifically transferred asset. In the case of an SPV, priority means ranking the claim of the SPV higher than the claim of any other third party.
- Commingling- one more risk in case of securitizationis that the proceeds received from the floating or securities and the originator’s own fund may be merged. In situations where the originator company is freely allowed to use the proceeds collected by the SPV for its own purpose, the law may find that the actions of the originator are in conflict with the claim of the SPV that they have a perfect interest in the funds.
Enforcement issues
Having a theoretical law is not enough for a company to go through with a transaction. It is important that these rights can be enforced also. When a legal system grants any rights, it is not necessary that they can be enforced also. In many cases, foreigners are not favored a bit less than the local citizens when it comes to the enforcement of rights. The originator and the SPV may have to submit to the jurisdiction of the country where they want to float their securities.[6]
Foreign Currency issue
In any international transaction, currency issues are always there. In the case of international securitization, the currency in which the investors buys the securities may be different from the currency in which the SPV repays them. So foreign exchange regulation have to be considered by the originator and the SPV before securitization. There is also a risk of fluctuation in the currency rates which the company may have to face.
Taxation issues
There are some major taxation issues which are involved in the case of international securitization.
- Withholding Tax – Payments which are considered as interest may be considered for income tax purposes as withholding tax under certain jurisdictions. In case of international securitization, interest payment can take place in the following ways-
- If the obligors who are in a different country pay interest for the receivable to the originator company, which is located in a different country, the payment made will be may be subjected to withholding tax, in the country in which the obligors are.
- If the transfer of assets between the originator and the SPV is considered as a secured loan, the tax authorities may subject it to withholding taxes, and tax on interest paid on the loan will be collected from the company.
- Taxation of the SPV- When the SPV collect the money of the securities, they can also be subjected to certain taxes.
- Taxation of the investor- Investors can also be subjected to withholding tax in the case of international securitization. These taxes depends on the jurisdiction under whose authority the investor is residing.
Concluding Remarks
Securitization allows companies to raise funds at a lower cost and without going beyond the permissible level of debts. But when securitization is done internationally, the jurisdiction and law applicable in the particular country should be given special consideration. The socio-economic and political factors of the country should also be kept in mind before securitization. This will help the companies to carry out the process of securitization uniformly.
Footnotes:
[1]Claire A. Hill, Securitization: A Law Cost sweetener for Lemons, 74 Wash. U.L.Q, 1061 (1996).
[2]Peter Pantaloe, Rethinking the role of Recourse in the sale of Financial Assets, 52 Bus. L. R 159 (1996)
[3]Shenker&Colletta, Asset Securitization – Evolution, Current Issues and New frontiers, 69 Tax. L. Rev. 1369(1991).
[4]Yuliya A. Dvorak, Transplanting Asset Securitization: Is the Grass Green enough on the other side? 38 Hous. L. Rev. 541 (2001).
[5]Steven L. Schwarcz, Symposium: The Impact on Securitization of Revised UCC Article 9,74 Chi.-Kent L. Rev. 947, 953 (1999).
[6]Thomas C. Mitchell, The Negative Pledge Clause and the Classification of Financing Devices: A Question of Perspective, First Instalment, 60 Am. Bankr. L.J. 153 (1986).
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