Legal considerations for CDO Transactions.
CDO transactions are rated primarily on the basis of the credit quality of the assets supporting the rated securities. The analysis of legal documents and, where appropriate, receipt of opinions of counsel that address insolvency and other issues, can resolve most legal concerns. Understanding the implications of assumptions made and criteria used enables an issuer to anticipate and resolve most legal concerns early in the rating process. (For a more detailed analysis of some of the issues discussed in this section, see Standard & Poor's April 2002 publication "Legal Issues in Rating Structured Finance Transactions.')
It is beyond the scope of this article to describe in depth the CDO criteria used in each of the jurisdictions that has one or more rated transactions. Rather, this article broadly describes the methodology used in reviewing the legal aspects of CDO securitization structures and the application of that methodology to the most commonly used U.S. structures. Nevertheless, it provides a useful guide to structuring CDO transactions in non-U.S. jurisdictions. Sponsors looking to structure non-U.S. transactions should discuss their transactions with Standard & Poor's early in the rating process, in order to resolve jurisdiction-specific legal and structural issues.
II. CDO TRANSACTIONS
In CDO transactions, the issuing SPE purchases a pool Of loans and bonds. In general, Standard & Poor's criteria for CDO transactions include the following considerations.
If the issuing SPE purchases the bonds in open market transfers, Standard & Poor's generally will not require a true sale opinion. If the bonds had been held in the transferor's portfolio for more than approximately three months, or they had been reported by the transferor other than as assets held for resale, Standard & Poor's generally will require a true sale opinion from the transferor to the issuing SPE.
As in structured transactions involving other asset types, Standard & Poor's generally will require inclusion of the applicable Uniform Commercial Code (UCC) Representations and Warranties in the relevant security agreement or, in specific circumstances, a security interest opinion in connection with the grant of a first priority perfected security interest from the issuing SPE to the indenture trustee/collateral agent for the benefit of the CDO holders and an entity-level tax opinion.
III. CLO TRANSACTIONS
In balance sheet CDO transactions, the transferor, generally a bank, wishes to securitize direct loans made to its customers (either term or revolving loans), or syndicated loans on which the bank has a funding obligation. To date, Balance Sheet CDO transactions have been structured by both FDIC-insured banks and by the U.S. branches of foreign banks.
If the loan being securitized is freely assignable, then the transaction is structured the same (and Standard & Poor's criteria are the same) as other asset-backed transactions. In most transactions, however, the loan agreement contains restrictions or limitations on the outright sale of the loan to a third party. Because of these restrictions and limitations, most of the balance sheet CDO transactions rated by Standard & Poor's to date have been structured as participations. However, the July 2001 revisions to Article 9 of the UCC providing for the override of certain contractual anti-assignment clauses in UCC 9-408 may be helpful in the structuring of future deals. Standard & Poor's continues to examine issues related to the override of restrictions on the sale of loans to CDO vehicles.
True Sale. As noted above, most of the Balance Sheet CDO transactions rated by Standard & Poor's to date have been structured as participations. In these transactions the transferor is either an FDIC-insured bank or a U.S. branch of a foreign bank. In the case of participations from FDIC-insured banks, the transfer generally would not need to qualify as a true sale. Instead, Standard & Poor's obtains comfort that a security interest granted by the bank in the loans would not be avoidable in the event of the bank's insolvency. An opinion regarding creation and perfection of the security interest, as well as an FDIC opinion to the effect that the security interest in the loans will be enforceable notwithstanding the insolvency of the transferor is required. (For a discussion of Standard & Poor's criteria with FDIC-insured banks, see section on Securitizations by SPE Transferors and Non-Code Transferors; in Standard & Poor's April 2002 publication "Legal Issues in Rating Structured Finance Transactions".)
In the case of participations from non-FDIC-insured banks, the participation must be structured as a true sale and appropriate opinions confirming such characterization must be provided at closing. In addition, appropriate regulatory comfort that, in an insolvency of the bank, the stare banking regulator will treat the participation as a sale of the loans and will not treat the loans as property of the bank is required.
Although the case law in this area is limited, Standard & Poor's believes that participations can be structured and documented such that the transfer can be viewed as a sale of an equitable interest in the underlying loans. Thus, in an insolvency of the transferor, the transferor as the holder of bare legal title, would have no property interest in the loans. The participation agreement should include the following provisions:
Segregation of funds. If the transferor is rated 'A-1' or higher, loan receivables should be deposited into a segregated custodial account within two business days of receipt, where the funds may be held for 30 days. Within the 30-day period, the receivables should be transferred to the issuing SPE. If the transferor's rating falls below 'A-1', loan receivables should be deposited upon receipt directly into either a separate trust account in the name of the issuing SPE in the transferor's trust department (where funds may be held for 30 days), or a lockbox arrangement with another depository institution that is rated 'A-1' or higher.
During the revolving period, collections may be transferred from these segregated custody accounts or obtained from the issuing SPE for the purpose of making new loans, with the issuing SPE receiving an equivalent dollar amount of loan participations. The issuing SPE should have no obligation to purchase further receivables in the event of a receivership or conservatorship of the transferor.
Document segregation. The loan agreements that are part of the securitized pool should be physically segregated from other transferor loan or participation agreements. These loan or participation agreements should be held in custody by the transferor and clearly segregated in files conspicuously labeled to show that the loans or participations are held by the transferor as custodian for the issuing SPE and for the transferor as lender. The portion of each loan or participation transfered to the issuing SPE at any point in time (which may vary during the revolving period) should be specified in the loan or participation files.
Recordkeeping and reporting requirements. The transferor should keep complete, accurate, and separate records for each loan, including records sufficient to monitor the amount of each loan that is transfered to the issuing SPE, the transfers of loan receivables from the transferor's general and custody/trust accounts to the issuing SPE and the use of the receivables for reinvestment during the revolving period.
Documentation of the transaction should delineate clearly the transferor's various roles and its duties. In particular, documentation should reflect the extent to which the transferor remains in the role of a lender for some portion of the participated loans. In addition, the transferor's duties as the lender of record and servicer of the loan participations should be governed by a formal written agreement.
The agreement should either specify that the transferor shall not, without written consent of the participant:
* Make or consent to any alteration of the terms of the underlying loans;
* Undertake to release any of the collateral or security (if any) for the underlying loans;
* Accelerate or retard the maturity of the underlying loans;
* Alter or amend the underlying loan; or
* Waive any claim upon the borrower or any guarantor in connection with the underlying loans; or
* state clearly that the transferor's duties, as servicer (and lender of record) of the loans, to the issuing SPE are equivalent to the fiduciary obligations that a trustee owes to its beneficiaries.
If applicable, the documentation also should reflect the transferor's acting as a custodian for the loan receivables for the 30-day period before the transfer of the funds to the issuing SPE. The transferor's fee for acting as custodian should be separate from any servicing fees. All fees should be established on an arm's-length basis.
Standard & Poor's generally requires that, as a backup position, the participation be analyzed also as a borrowing by the transferor from the issuing SPE, secured by the underlying loans. This requires the transferor to grant to the issuing SPE a first priority perfected security interest in the underlying loans and loan receivables and to file UCC financing statements or execute one or more control agreements to perfect the security interest.
To obtain legal comfort regarding both the true sale and backup security interest discussed above, Standard & Poor's typically requests the following legal comfort:
* A true sale opinion to the effect that the sale of loan participations in accordance with the transaction documents and the procedures required to be followed thereunder will effect a sale to the issuing SPE of the full equitable interest in the portion of the loans represented by the participations;
* A nonconsolidation opinion, if applicable, between the transferor and the issuing SPE; and
* Inclusion of the applicable UCC Representations and Warranties in the relevant security agreement or, in specific circumstances, a statement to the effect that, if a court reviewing the transaction does not characterize the transaction as effecting a sale of a beneficial interest in the loans or participations, the transfer of loan participations in accordance with the transaction documents and the procedures required to be followed thereunder nonetheless would create a first priority perfected security interest in favor of the issuing SPE in the underlying loan receivables.
Set-off. Standard & Poor's examines the risk of borrower set-off in all balance sheet CDO transactions, regardless of whether the transfer of loans is structured as a participation or an outright assignment. If the borrower is not notified of the sale of, or granting of a participation in, the loan by the transferor, it would continue to have set-off rights against the transferor. Accordingly, in an insolvency of the transferor, the borrower may reduce its loan payments by the amount of any deposits held with the transferor or any amounts otherwise owed by the transferor to the borrower. If the loan agreement contains an explicit waiver of set-off by the borrower, reserves for borrower set-off are generally not required. In certain jurisdictions, opinions of counsel that the waiver of set-off provisions would be enforceable against the borrower in an insolvency of the bank may be required. If, on the other hand, the documents do not contain a waiver of set-off provision, the transaction should provide sufficient credit support (either as a reserve fund or a transferor's interest) to cover potential set-offs by the borrower. The transferor should have the capability to monitor borrower deposits on a periodic basis (generally weekly for lower-rated institutions and monthly for higher-rated ones). The transferor also should agree to be liable for any losses caused by borrower set-off.
Therefore, as a general matter, Standard & Poor's requires either that loans being securitized have a full waiver of set-off by the borrowers (this waiver of set-off would also prohibit a borrower under a revolving credit agreement from setting off payments due on drawn amounts against the portion of the revolving commitment that had not been drawn), or if the loan agreements do not include a waiver of set-off, that a reserve fund be established to cover (or that the transferor's interest cover) the amounts deposited by the borrower with the financial institution in full.
For FDIC-insured institutions, Standard & Poor's also is concerned that the FDIC, as a receiver or liquidator of an insolvent bank, would have the incentive to mandate a borrower set-off even if the borrower had waived its right to set-off against the bank. In asking the borrower to set off against the loan any amounts that the borrower has on deposit with the bank, the FDIC would maximize the amount available for distribution to the depositors and would also comply with the depositor-preference statutes. Accordingly, in the case of CLO transactions out of FDIC-insured banks, additional credit enhancement to cover set-off risk will generally be required (even if the loan agreements contain a waiver of set-off), unless the transfer of loans from the bank is structured as a true sale and an appropriate true sale opinion is given at closing.
Lender liability. For revolving loans, whether or not an institution transfers the unfunded commitment obligation to the issuing SPE, the question arises whether the issuing SPE could be held liable for the failure of the institution to lend to the borrower when the borrower requests a future draw. Standard & Poor's believes that lender liability claims, although possible in theory, are unlikely to affect the issuing SPE's ability to pay the rated securities in a full and timely manner. First, the financial institutions undertake to service the transferred loan or participation in the same prudent manner as the remainder of its portfolio. Second, if the borrower is insolvent, or there is a material breach of covenant under the loan, the financial institution is not obligated to lend.
As a corollary, if the borrower is financially sound, but the financial institution will not lend, the borrower would be able to find financing elsewhere. Thus, the borrower would be unable to show it was damaged by the financial institution's failure to lend. If the borrower is able to show damage, and the financial institution is solvent, then the financial institution has breached its covenant to the issuing SPE and is obligated to the issuing SPE for the damages. Third, if the financial institution is insolvent, Standard & Poor's is comfortable that the receiver or liquidator will repudiate the obligation to make further advances.
If the unfunded commitment is transferred to the issuing SPE, Standard & Poor's typically will evaluate whether the issuing SPE has the funds necessary to make funds available to the borrower, in a full and timely manner, when requested. Standard & Poor's also will typically require that any negative carry or basis risk be covered to a level commensurate with the rating of the highest rated tranche issued by the issuing SPE. This can be accomplished through a variety of credit supports, including, for example, loans from appropriately rated banks, swaps, and reserve funds.
As with other asset types, the issuing SPE in a CDO transaction is required to grant to the indenture trustee/ custodian, on behalf of the holders of the rated securities, a first priority perfected security interest in its assets, the participations and any collateral securing the participations (that is, the underlying loans) and to file UCC financing statements to perfect the security interest of the indenture trustee/custodian. To obtain legal comfort regarding the indenture trustee/custodian's first priority perfected security interest in the participations, Standard & Poor's generally will request inclusion of the applicable UCC Representations and Warranties in the relevant security agreement or, in specific circumstances, a security interest opinion.
Standard & Poor's
ROSALEEN MANZI is Managing Director and Associate General Counsel of Standard & Poor's Ratings Services. She advises the CDO, ABS and Insurance groups regarding the legal aspects of their transactions.
Ms. Manzi holds degrees from Smith College and The University of Pennsylvania Law School.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||collateralized debt obligations|
|Publication:||The Securitization Conduit|
|Date:||Mar 22, 2002|
|Previous Article:||Hedging considerations in CDO transactions.|
|Next Article:||Securitize this! Collateralized debt obligations.|
|CREMAC liquidates $180m of its bonds.|
|The CDO product.|
|CDO positioned to be dominant capital source for funding.|