Canadian securitization 2000: Current trends and developments.

If you were looking for two words to describe the current state of Canadian securitization, they would be Growth and Change.

I. INTRODUCTION

If you were looking for two words to describe the current state of Canadian securitization, they would be Growth and Change.

Outstanding asset-backed commercial paper grew from $41 billion at the end of 1998 to $53 billion at the end of 1999--and represented almost 50% of all non-government Canadian short-term debt. Outstanding term ABS grew from $8 billion to $13 billion, a record-breaking increase. All in all, Canadian ABS has increased at an annualized rate of 56% since October 1997.

As to NHA mortgage-backed securities, 1999 saw an all time record of $13 billion in new issuance, up by 42% over the previous year. Outstanding MBS volume at yearend totaled $28 billion, up from $20 billion at the end of 1998. While a number of new corporate sellers did begin to securitize last year, Canada's significant ABS growth continued to be driven by banks and trust companies whose securitized assets grew from $27 billion to $36 billion at the end of 1999, amounting to more than 50% of the entire ABS market. We also saw growth in the volume of non-standard assets being securitized, such as mutual fund deferred sales charges, insurance premiums, and credit tenant lease payments.

In addition to Growth, the other major theme this past year has been Change, or the promise of imminent Change.

1999 saw the first public securitization of bank assets in the Canadian capital markets. Change was also seen in the nature of the assets being securitized. Personal lines of credit were securitized for the first time. And CIBC originated and securitized over $500 million of sub-prime residential mortgages.

The accounting rules, however, did not change. The delay this time had more to do with waiting for the U.S. Financial Accounting Standards Board ("FASB") to complete its revisions to FAS 125 (now FAS 140), which we will likely adopt before the end of 2001, to create a harmonized Canadian version.

One more Personal Property Security Act holdout-Newfoundland--joined Canada's modern personal property security regime in 1999, leaving only 2 common law jurisdictions--the Northwest Territories and Nunavut -- in the old document registration system.

1999 also saw the ABS market welcome a new form of credit enhancement -- transactions are now being backed by financial guarantee insurance provided by off-shore special purpose insurance vehicles.

Perhaps it is not surprising that the new Internet-based economy has already had a significant effect on the securitization industry, just as it has on most other industries. In the first place, new virtual lenders as well as traditional old economy lenders are beginning to securitize loans originated on the Web. It remains to be seen how PC to PC originated loans will perform as compared to the more traditional face to face variety. As well, the Web is being utilized by Wells Fargo to provide bond and collateral level information to Canadian CMBS investors for the first time.

Growth and Change are two signs of a maturing market which promises to play an ever-increasing role in the process of raising funds on a cost-efficient basis and managing corporate Canada's balance sheets.

II. THE NEW $25,000 ARC FEE UNDER THE COMPETITION ACT

After almost three years of proposals and discussions, the Competition Act and its Notifiable Transactions Regulations were finally amended on December 27, 1999 to exempt the basic securitization transaction from the Notifiable Transactions provisions. Under these provisions, certain transactions which exceed two monetary thresholds -- in terms of the size of the parties, and the size of the transaction -- cannot close before the Commissioner of Competition is given certain specified information, and the statutory waiting period passes. The process is commonly referred to as "merger prenotification", and is intended to allow the Competition Bureau to assess the competitive impact of these transactions. While traditional securitizations clearly raise no competitive issue, they often technically meet the threshold for notification, and most practitioners have made it a standard practice to apply for and obtain an Advance Ruling Certificate, or ARC, confirming that the pre-notification requirements do not apply.

One of the proposed amendments to the competition legislation was to exempt securitization transactions from the pre-notification requirements, since they amounted to about 15% of all transactions examined by the Competition Bureau. The scope of the exemption was critical since a $25,000 ARC application fee was also to be introduced. Apart from this significant fee, each securitization is accompanied by a legal opinion to the effect that the transaction complies with all applicable legislation. To ensure the exemption was broad enough to avoid the fee and support their opinion, a working group of Toronto law firms that practise in the area was assembled to review the proposed exemption and make recommendations to the Competition Bureau for the purpose of expanding and clarifying its scope.

A number of the working group's recommendations were adopted, and the exemption as enacted appears broad enough to cover most traditional securitizations of consumer and corporate receivables.

It is important to note that the exemption may not extend to certain non-standard structured finance transactions. For example, in two transactions, involving the sale of leases together with the underlying leased equipment, the Competition Bureau has taken the position that the exemption does not apply and required the payment of the $25,000 fee in order to provide an ARC. As well, the exemption will not apply in certain cases involving third party servicers. Accordingly, a careful review of the definition of "asset securitization transaction as set Out in the Notifiable Transactions Regulations should form part of every securitization checklist.

The door is not closed to further refinements to the scope of the exemption. At a meeting with the Competition Law Section of the Canadian Bar Association, representatives of the Competition Bureau expressed a willingness to receive further submissions with respect to issues that are causing practical difficulties.

III. TRUE SALE UPDATE

Canadian lawyers have long taken the view, contrary to their counterparts in the U.S., that the retention of significant risk by the seller under a securitization transaction should not compromise a lawyer's ability to provide a clean "tue sale" opinion. This view is based on English and Canadian case law -- none of which deals specifically with securitization -- which has consistently taken the approach that where the parties' intention to sell assets is clearly evidenced by the terms of their agreement and the applicable circumstances, the courts will not recharacterize the transaction as a loan simply because the seller has guaranteed collection of all or a portion of the receivables, or because the same economic results could have been achieved under a loan arrangement.

In my view, this is not a victory of form over substance, but rather the recognition of the true legal substance of a transaction whereby one party sells assets to another, and separately agrees to guarantee the value of the assets being sold. It is true that the seller has assumed or retained liability or risk with respect to the transferred assets, but the buyer, just as clearly, has become the legal owner of the assets.

This Anglo-Canadian position has recently found significant support at the highest level of the Canadian legal system. In the Shell Canada decision, the Supreme Court of Canada last October took pains to direct the lower courts not to recharacterize commercial transactions simply because they were entered into for the purpose of minimizing taxes, or because the same economic result could have been achieved by structuring the transaction differently. I won't get into the details of the case, which dealt with raising money through the use of currency swaps. The bottom line is that the Supreme Court emphatically overruled a Federal Court of Appeal which was overly concerned with the "economic realities" of the transaction.

The Supreme Court did acknowledge that the courts must be sensitive to the economic realities of a transaction, rather than being bound to what at first appears to be its legal form. Nonetheless, the Court made a number of significant findings:

* Absent a specific provision of the Income Tax Actor a finding that a transaction is a sham, the taxpayer's legal relationships must be respected in tax cases.

* As well, the economic realities of a situation cannot be used to recharacterize a person's bona fide legal relationship. Recharacterization is only permissible if the label attached by the taxpayer to a transaction does not properly reflect its actual legal effect.

* Further, a searching inquiry for either the economic realities of a particular transaction, or for the general object and spirit of a provision of the Income Tax Act; can never supplant a court's duty to apply an unambiguous provision of the statute to the taxpayer's transaction.

* The Court emphasized that its role is not to prevent taxpayers from relying on the sophisticated structure of their transactions, which taxpayers are entitled to arrange in such a way that they meet particular provisions of the Income Tax Act.

* Unless the Income Tax Act provides otherwise, a taxpayer is entitled to be taxed based on what it actually did, not based on what it could have done.

* The Court expressly refused to adopt a rule that, where there are two ways to structure a transaction with the same economic effect, the Court must have regard only to the one without tax advantages. It held that, in the absence of a specific statutory bar, taxpayers are entitled to structure their affairs in a manner that reduces their taxes.

* It is important to note that the Income Tax Act's General Anti-Avoidance Rule, or GAAR, was not in effect when the facts in the Shell Canada case arose. Another case, this time involving Canadian Pacific, is wending its way through the tax courts, and will test a number of the above findings in the GAAR context.

In a separate decision, the Singleton case, the Federal Court of Appeal held that a series of related transactions must be viewed independently when determining their legal effect. A taxpayer withdrew funds from his firm's capital account, used them to purchase a house, and then borrowed funds to replenish his capital account. The trial court collapsed the two transactions and held that the borrowed funds were in effect used to purchase the house (which meant that interest paid on those funds were nondeductible).

The Federal Court of Appeal disagreed. It referred to recent decisions of the Supreme Court of Canada which has held that it is improper to ignore the legal and commercial reality of a transaction, whether or not motivated for tax planning purposes, and that the Courts must not disregard a transaction's legal form.

In the Singleton case, the Court acknowledged that Singleton had acted solely for the purpose of reducing his tax liability, and that he deliberately structured his transactions in order to bring his borrowing and his obligation to pay interest within a particular section which permitted the interest to be deducted. Again referring to an earlier Supreme Court of Canada decision, the Court held that "taxpayers are entitled to arrange their affairs, including non-arm's length transactions, for the sole purpose of achieving a favourable position regarding taxation".

The Court also found that the "legal and commercial reality" of the transaction was simply that Singleton withdrew his own funds from his firm's account to purchase a house, and then borrowed funds to replenish his capital account. It expressly rejected the "connected series of transactions" approach which would require that a number of separate transactions be collapsed into a single transaction in order to determine their true legal effect.

This decision is strong support for the approach we have long followed -- that a properly drafted sale of receivables, whose purchase price is borrowed by the purchaser by issuing debt securities, should not be collapsed or recharacterized as a borrowing by the seller. Leave has been granted to appeal Singleton to the Supreme Court of Canada -- hopefully, that Court's comments will be as favourable to securitization as those in the Shell Canada case.

IV. APPLICATION OF WITHHOLDING TAX TO CROSS-BORDER SECURITIZATIONS

In addition to being securitized domestically, Canadian receivables are increasingly being securitized off-shore. The issue that must always be addressed in these circumstances is the application of Canada's relatively onerous withholding tax regime.

Interest-bearing corporate loans can benefit from the long-term debt exemption provided by section 212(1)(b)(vii) of the Income Tax Act. CMBS transactions and franchisee loan programs have both been securitized into the U.S. capital markets relying on this exemption.

Standard trade receivables do not bear interest, and are normally sold at a discount. Notwithstanding a somewhat ambiguous 1992 technical interpretation from Revenue Canada, Canadian tax practitioners have consistently taken the position that the discount does not constitute interest and that the cross-border sale of these receivables will not give rise to withholding tax. It is nevertheless comforting to be able to report that at least one cross border trade receivables securitization has undergone a successful tax audit without challenge on the withholding tax issue. But it should be noted that Revenue Canada did question the reasonableness of the size of the discount that the parties applied to the transaction.

V. LEGISLATIVE EVENT RISK

When a securitization transaction veers from traditional structures, one must "think outside the box" for the purpose of discovering and dealing with legal and business risks that do not normally apply.

The recent New Brunswick toll road transaction provides a real world example of such a situation. In 1998, $150 million of notes were issued, backed by tolls to be paid by motorists using the highway between Fredericton and Moncton. An election was called after the issue closed and the opposition party pledged to abolish all tolls on the Province's highways. The opposition won, and the tolls were in fact abolished. One commentator at the time suggested that, if the Province were to remove the tolls, the investors might be able to redeem their bonds at a hefty premium. It was noted that the issue was just a matter of money and that "no bond is impervious to legislative change".

In the end, the Government proceeded on the basis of a "shadow toll" approach, and made payments based on actual use of the highway. Since the highway was now toll-free, use increased by 80%, and there was more than enough to pay the bonds as they came due. While no losses were incurred as a result of this unanticipated event, the experience nevertheless supports the value of going through the appropriate "what if" scenarios when structuring a non-traditional transaction.

VI. REGULATORY UPDATE-FOREIGN BANK BRANCHES IN THE CAPITAL MARKETS

Both corporations which securitize by way of private placement, and single or multi-seller conduits, can all proceed on a relatively anonymous basis. However, regulated entities-such as banks and insurance companies-must access Canada's capital markets under the watchful eye of federal and provincial regulators and in compliance with a constantly changing maze of policies, guidelines and legislation.

There have been a number of changes to the regulatory infrastructure of Canadian securitization which have proceeded somewhat in the shadow of both the more widely discussed systemic changes to be effected by OSFI's imminent overhaul of the rules that govern the securitization of financial institution assets, and the recent opening of Canada's public capital markets to securitization.

Firstly, pending a total re-writing of OSFI's B-5 and D-4 securitization guidelines, these guidelines have been touched up to deal with the foreign bank branches which recently became eligible to carry on business in Canada. New guideline B-5A, dated January 2000, was issued to level the playing field as between foreign bank branches and the Canadian banks. The new guideline mirrors Guideline B-5, except that references to capital requirements have been removed to recognize that the home jurisdiction of the foreign bank will govern capital requirements for the branch's Canadian activities. Instead, where a Canadian bank is required to hold capital in certain circumstances, a foreign bank branch is required to adjust its on- balance sheet assets by an equivalent amount.

In addition, OSFI's securitization accounting guideline - Guideline B-4 - has been reissued, although it continues to bear the same July 1994 date. The changes are not significant, and simply reflect the fact that foreign bank branches do not hold capital in accordance with OSFI's guidelines, and do not produce annual financial statements.

VII. LIBERALIZED RULES FOR INVESTMENTS BY MUTUAL FUNDS IN SENIOR AND SUBORDINATED ABS

There is some concern that recent significant growth in Canadian securitization may soon strain Canadian investors' capacity to absorb the increased product. Accordingly, it is comforting to see additional avenues opening up for ABS placement.

One of these avenues is the new and improved public securitization market which will permit additional institutional investors, and even the retail public, to invest in senior and subordinated ABS.

Added to this, increased investment flexibility has also been created by an amendment to the rules governing investment by mutual funds. Previous investment restrictions prohibited mutual funds from purchasing more than 10% of any particular class of securities; and short-term debt obligations were treated as a single class for this purpose.

The new rule, contained in National Instrument 81102, only prohibits mutual funds from purchasing a security where the fund would end up holding more than 10% of the issuer's votes or equity securities. This new flexibility will, for example, permit a mutual fund to acquire all or a significant portion of an issue of ABS subordinated notes. Formerly, the fund would not have been entitled to acquire more than 10% of the issue.

VIII. OUTSOURCING BY FEDERALLY REGULATED FINANCIAL INSTITUTIONS

In January of this year, OSFI released Guideline B-10 to regulate the outsourcing of business functions by banks and other federally regulated financial institutions, including foreign bank branches.

The Guideline is restricted to those outsourcing arrangements which are found to be material pursuant to a risk/materiality assessment carried out in accordance with specified procedures. Insofar as securitization is concerned, financial institutions have begun to outsource certain back office and treasury functions in connection with the operation of their multi-seller conduits. As well, in view of proposed banking legislation, which is expected to lead to a new wave of strategic alliances and joint ventures involving Canadian financial institutions, we may see a greater move to outsource the origination, servicing, collection and securitizing of credit cards, mortgages, consumer loans and other traditional bank products.

OSFI recognizes that outsourcing arrangements may create significant benefits. So the Guideline is not intended to discourage or prevent such arrangements. The Outsourcing Guideline does not expressly prohibit any particular arrangement or subject it to approval. The Guideline simply recognizes that an arrangement under which a third party provides material services to a bank or other financial institution introduces new risks and responsibilities that must be addressed.

If a particular outsourcing arrangement is considered "material" in accordance with the Guidelines' risk/ materiality criteria, the financial institution is required to identify and manage the risks and responsibilities created by the arrangement. The risk-management program should provide for the evaluation of the service provider, a satisfactory service contract, confidentiality and security needs, the requirements of the regulator and implementation of proper internal controls, all in accordance with the detailed requirements of the new Guideline.

IX. NEW STATUTORY RIGHTS OF ACTION FOR OFFERING MEMORANDA

In addition to facilitating public market securitization, Canada's securities administrators are in the process of significantly overhauling all the rules and regulations that apply to accessing our capital markets.

One change to Ontario's securities legislation applies to Offering Memoranda, including those relating to a private placement of securitized notes. The Ontario statute will soon give a purchaser of securities, who buys under a prospectus exemption, a statutory right of action for rescission or damages if there is a misrepresentation in an Offering Memorandum which is provided to that purchaser. This will mirror the current position of most other provinces.

Under the current system, the issuer under an Offering Memorandum provides a contractual right of action if the issuer is relying on certain prospectus exemptions. The new statutory right will be substantially similar to that given to a purchaser under a prospectus.

X. CAPITAL TAXES

One of the by-products of a lease securitization, whether of the sale-sale-leaseback or the concurrent lease variety, is the capital tax saving which results when the proceeds of the transaction, in the form of prepaid rent, are used to repay debt or otherwise reduce capital.

Last year, the Ontario and federal tax authorities reassessed a particular lessor in respect of prepaid rent received under a concurrent lease securitization. The Ontario tax official treated the prepaid rent as equivalent to a loan from the securitization trust, since the amount of the prepaid rent was equal to the lessor's indebtedness which was being repaid by the proceeds of the securitization. The material in the public domain does not include copies of the underlying lease documentation or of the lessor's financial statements, and it is therefore difficult to draw a firm conclusion as to the application of this situation to lease securitizations in general. Nevertheless, those involved in these transactions, including legal counsel who have to render related opinions, cannot afford to ignore the unsettled nature of this issue.

XI. INSURANCE COMPANIES' OBLIGATION TO HOLD CAPITAL FOR INVESTMENTS IN SUBORDINATED NOTES

On September 15, 1999, OSFI issued a letter dealing with the obligation of federally regulated life insurance companies to hold capital for their investments in subordinated ABS notes. The letter noted that a number of insurance companies were not applying the correct capital requirements for these investments, perhaps as a result of an inadequate understanding of the relevant investment structure, including any credit support which the insurance company is providing to the securitization vehicle by virtue of purchasing the subordinated notes.

OSFI may be concerned that, when an insurance company invests in asset-backed notes on the one hand, and traditional corporate bonds on the other, it may not be properly distinguishing between its obligations under Guideline B-5, and those under the Minimum Continuing Capital Surplus Requirement guideline. Thus, when an insurance company invests in subordinated ABS notes, which by definition provide credit enhancement to the senior ABS notes, Guideline B-5 requires the insurance company to hold a minimum of 4% capital against the notes, regardless of their rating, unless the transaction provides for a significant first loss protection facility from an independent third party (such as pursuant to a spread account, an insurance policy or a letter of credit).

Take the situation where the insurance company purchases a double-A rated ABS note, as well as a double A rated traditional corporate bond. The capital required for the corporate bond would be 50 basis points in accordance with the capital guideline, and would be the same for the ABS note if the securitization structure included a significant first loss facility that protected the ABS note. However, where there was no first loss facility for the ABS note, or where it was not sufficiently "significant", the insurance company would be required to hold at least 4% capital against its investment.

OSFI is currently undertaking enhanced examination procedures, and one can assume that the examiners will be giving greater attention to the nature of the ABS notes held by insurance companies and other financial institutions to ensure that they are holding sufficient capital against their investments.

Martin Fingerhut is a partner in the Financial Services Group and Chair of the Structured Finance Group in the Toronto office of Blake, Cassels & Graydon LLP where his practice is principally in the areas of structured finance and financial services. He has chaired and participated in numerous programs in these areas sponsored by the Law Society of Upper Canada, the International Bar Association, the Canadian Bar Association, the American Bar Association and other organizations. Mr. Fingerhut has been involved in numerous transactions involving 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 in conjunction with one-time, ongoing and cross-border securitization programs. Mr. Fingerhut is listed in the American Lawyer/Lexpert Guide to the Leading 500 Lawyers in Canada, in Business Law Research's International Who's Who of Capital Markets Layers, in Euromoney's G uide to the World's Leading Securitization Lawyers and in the Chambers guide to the leading Canadian banking and finance lawyers, and is stated by the Lexpert Legal Directory as being one of the most frequently recommended Canadian securitization lawyers. Mr. Fingerhut is a fellow of the American College of Commercial Finance Lawyers and sits on its Board of Regents.