The transfer of future rights in securitisations - Burns

A future flow securitisation is more complex than an ordinary asset-backed securitisation. This is

because it is trying to raise corporate finance on the basis of assets (receivables) that are not in

existence at the time of the contract, but these are expected to come into existence in the future.

The securitisation structure

As the subject matter of this article is securitisation, let me provide a short definition of what

securitisation means, before giving a definition of a future flow securitisation.

A statutory definition of securitisation is provided in the Capital Requirements Directive

(implementing Basel II). According to this Directive, a securitisation is a:

“… transaction or scheme, whereby the credit risk associated with an exposure or pool of
exposures is tranched having the following characteristics: (a) payments in the transaction or

scheme are dependent upon the performance of the exposure or pool of exposures; and (b) the

subordination of tranches determines the losses during the on-going life of the transaction or

scheme”.5

The principal aim of securitisations, which are carried out on behalf of companies, is to enable

those companies wishing to borrow significant sums of money, to obtain such funds more cheaply

from the capital markets.7

The way a typical or “traditional” securitisation8 is structured to achieve this goal of low-cost

funding can be outlined briefly.9 The company (i.e. the originator) wishing to raise the low-cost

funds from the capital markets sells its receivables to a bankruptcy remote special purpose

vehicle (SPV), which in turn pays for these rights by selling bonds or commercial paper (e.g.

fixed and floating notes) to investors on the capital markets. It is normal for the originator to be

employed as the administrator or “servicer” by the SPV to collect the receivables from the

debtors. Indeed, the originator will often insist on this to maintain its commercial relationship

with its customers. This servicing contract will normally cover many issues such as the setting of

interest rates; arrears and enforcement procedures; how the surplus cash of the SPV is to be

invested; the terms that can lead to a termination of the servicing agreement; administration

fees; liability for acts or omissions; insurance against error and employee fraud and provisions

for a successor administrator/servicer.10

Another key feature of the standard securitisation structure is that the originator will seek to

ensure that the SPV is insolvency-remote from the originator. This is achieved by incorporating

the SPV as a separate company and avoiding or minimising the organisational links between the
two entities. This strategy normally works efficiently because in the United Kingdom, the principle

of the separate personality of a company is one that has been strongly endorsed in the courts in

the United Kingdom ever since theSalomon v Salomon & Co Ltd judgment.11 Even within groups

of companies that seem to be closely interconnected, the individual companies that make up the

group still enjoy separate corporate personality in law and the courts do not lightly disregard that

principle and lift the veil of incorporation.

As a consequence, it is unlikely that creditors of the originator will be able to make successful

claims on the assets of the SPV should the originator become insolvent. This fact serves to

reassure the investors in securitised products. The corporate structure also serves to lower the

credit risk for investors and helps to improve the credit rating of the bonds that are subsequently

issued by the SPV.

The potential investors in securitised bonds may be persuaded to buy the bonds if they are

independently rated as “investment grade” securities by the rating agencies (such as Moody's or

Fitch or Standard and Poor) and therefore have a very low risk of default. Credit reference

agencies such as Moody's Investor Service or Fitch, or the Standard and Poor Corporation provide

investors with an assessment of the risk of default by assigning grades to securities. Each agency

has its own grading system, but generally, a triple “A” grade means that the company issuing the

bonds has an extremely strong capacity to pay its coupon on time and that the risk of default is

negligible. However, low grades from BB to D indicate that the securities indicate higher risks of

default. In Fitch's grading, a C grade means “default is imminent.” Thus, in order to get a suitable

rating as “investment grade” bonds, the credit risk of the SPV in a securitisation structure must

be very low. This can be achieved in a number of ways, including credit enhancement measures,

which need to be put in place at the time of the deal. Credit enhancement can take various

forms, such as a bank letter of credit to back the issue, or by issuing bonds in tranches in a

subordination structure. Under this arrangement the junior tranche bears the risk of all the initial

losses, leaving the senior tranches with a much-reduced anticipated default rate.16 In a typical

mortgagebacked securitisation, for example, the originating bank may purchase the

junior tranche to reduce the risk for the senior bondholders. Another form of credit enhancement

is over-collateralisation. Over-collateralisation occurs where the pool of assets is of greater value

than is needed to support the payments due to the investors. This is designed to help to ensure

that if there is a shortfall in the cash expected from the revenue-generating assets, there should

be surplus funds available within the SPV to cover that*J.I.B.L.R. 37 shortfall.17 In future flows

securitisations substantial credit enhancement can be used to induce investors to buy the
securitised bonds as a compensation for the possible increased legal risk associated with the

buying and selling of rights to assets that do not yet exist.

Future flow securitisations

The normal asset-backed securitisation structure, described earlier, is appropriate for companies

that have sufficient receivables at the time of the deal to ensure that the repayment of the

securities is a self-liquidating exercise from day one. But what about companies that do not have

sufficient existing receivables to cover the deal? These companies with insufficient current

receivables may require the cash for the general proposes of business, or they may have an

urgent need for large sums of money to invest in new infrastructure, but would, prima facie

appear to be excluded from securitisation. However, thanks to the innovative development of

future flows securitisation such companies may be able to obtain low cost funding from the

capital markets to fulfil their strategic business goals by using the future flows method. If a

company is capable of generating a steady, reliable cash flow in the future from its operations, it

could seek to establish a future flows securitisation based on its future receivables. It is

important to note that these are receivables that are not currently contracted for (as opposed

to payments due in the future under a current contract). They are “pure” future rights.

A future flow securitisation has been described as:

“… a transaction that is partially asset-backed (i.e. where the aggregate value of the currently
existing receivables is a multiple of the required interest and scheduled principal amortisation

payments for a single period, but is less than the total outstanding funding)”.

Such a transaction is therefore “dependent on continued future receivables generation in order to

fully repay funding”.

The main disadvantage of future flows securitisations is that the success of the deal depends

upon the originator staying in business to produce the goods and services that generate the

future revenues to repay the bondholders. This exposes the investors to an unsecured credit

risk, if the originator were to become insolvent. As a consequence, the investors will be

concerned about the credit rating of the originator. Moreover, when the credit rating agency

sets the credit ratings for the structure, it will probably cap it at the level of the originator's

rating. This rating will indicate the increased level of risk that the investors may have to bear if

they choose to invest in future flows securitisations as opposed to normal asset backed

securitisations.20 FN (Because the rating agencies will assign a rating to the structure that

matches the rating of the originator in a future flows deal for the reasons given in the text above,

there is no point in using the senior-subordinate structure that assists normal asset backed

securitisations achieve a higher credit rating.) In this situation, investors will be keen to obtain as
many protective devices as they can to minimise this investment risk (such as demanding

over-collateralisation; the establishment of a cash reserve; the insertion of covenants restricting

the originator's ability to borrow from others, and a range of early amortisation triggers).21 They

will also want their lawyers to minimise any legal risks associated with the transfer

(assignment) of future rights. Of particular concern is the risk of the transfer failing to give

the buyer the unencumbered ownership of the receivables, which could leave the investors

as unsecured creditors in the event of the originator's insolvency.22

The transfer of future rights in future flow securitisations under English Law
One of the key issues in future flows securitisations is that the originators are trying to sell the

rights to future receivables (for example, income from airline tickets yet to be sold, or future

book debts) where there is no guarantee that these receivables will materialise. At

common law it would seem that the maximnemo dat quod non habet (you cannot sell what you

do not have), could be an impediment to the assignment of future rights. Indeed, it has been

noted that the English:

“… common law has never recognised the transfer of ownership of pure intangibles [such as
debts] except by means of a novation requiring the consent of the debtor”.23

However, both statute law and equity have attempted to facilitate the transfer of debts and other

intangibles with different degrees of success. However, it is equity that has provided the most

satisfactory solution to the particular problem of future rights.

In equity, if there is an identifiable debt, which is not in existence today, but will be

ascertainable in the future, there can be a valid contract (giving rise to rights in personam

between the buyer and seller). This arises where there is a binding promise by the seller to

transfer the debt when it comes into existence. At that point the transfer of the real right (the

right in rem) takes place and will be regarded as if it had been made at the time of the

contractual agreement.

Legal assignments under statute

Law of Property Act 1925 s.136. Legal assignments of things in action: - (1) Any absolute

assignment by writing under the hand of the assignor (not purporting to be by way of charge

only) of any debt or other legal thing in action, of which express notice in writing has been given

to the debtor, trustee or other person from whom the assignor would have been entitled to claim

such debt or thing in action, is effectual in law (subject to equities having priority over the right

of the assignee) to pass and transfer from the date of such notice-(a) the legal right to such debt

or thing in action; (b) all legal and other remedies for the same; and (c) the power to give a
good discharge for the same without the concurrence of the assignor: Provided that, if the

debtor, trustee or other person liable in respect of such debt or thing in action has notice-(a) that

the assignment is disputed by the assignor or any person claiming under him; or (b) of any other

opposing or conflicting claims to such debt or thing in action; he may, if he thinks fit, either call

upon the persons making claim thereto to interplead concerning the same, or pay the debt or

other thing in action into court under the provisions of the Trustee Act 1925.

Assignments generally may be carried out under s.136 of the Law of Property Act 1925.24

The Act requires that the assignment

1. be in writing under the hand of the assignor.

2. It should be an absolute assignment of the whole debt (and not by way of a charge only).

3. Express written notice of it should be given to the debtor.25 The notice does not have to
comply with any legal formalities. All that is required is the notice must state the fact that

there has been an assignment and an indication of what has been assigned

4. to whom the receivables have been assigned.

There is no time limit set within which a notice must be given. Giving a notice to the debtor is

vital in a statutory assignment. A notice has the effect of transferring the real right to the

receivables from buyer to seller and gives the assignee:

(a) the legal right to such debt or thing in action;

(b) all legal and other remedies for the same; and

(c) the power to give a good discharge for the same without the concurrence of the assignor.26

This method of assignment may work well in the case of existing receivables, and even in the

case of a debt arising out of an existing contract, but payable in the future,27 (buck v robson)

but it will not work in the case of pure future rights.

As the debtors cannot be identified at the time of the deal, no notice can be given to the debtors

and no transfer of the property in the debts can be made until the debt comes into existence.

However, the purported statutory assignment of pure future rights would not be a nullity. Where

the purported statutory assignment fails to comply with this notice requirement, the assignment

may nonetheless take effect as an equitable assignment (the consequences of which are

discussed below).28
However, the requirement of notice to the debtors is an inconvenient requirement in most

securitisations. In a typical asset-backed securitisation (such as a credit card or auto loan deal),

the number of debts assigned by the originator could be many thousands and it would be

expensive and commercially inconvenient to notify each debtor that their debt has been assigned

to a SPV under s.136 of the Law of Property Act. There may also be commercial reasons why the

originator may not wish to notify the debtors of the sale of the debts. An originator may wish to

have a long-term commercial relationship with the debtors and would not want the fact the debts

have been transferred to someone else to be made known to the debtors. Furthermore, sending

a notice of assignment may send the wrong signal to the debtors who might (mistakenly) assume

that the originator has sold the debts because the company is in some financial difficulty.29 For

these reasons, statutory assignment is rarely used in securitisations.

Equitable assignments
Under equitable assignment, if the purported assignment of future receivables is supported by

consideration it will be treated as a binding contract to assign the receivables.31

When the receivable comes into existence, equity will treat it as being assigned. The resulting

equitable assignment will be good against the assignor or its unsecured creditors, as if it

had been made at the time of the assignment.32

The leading case that established that it is possible to sell future receivables in this manner is the

House of Lords case of Tailby v Official Receiver. 33 which held that“… an assignment for

value has always been regarded in equity as a contract binding on the conscience of the

assignor and so binding the subject matter of the contract when it comes into existence”.

This is the case, provided, “it is of such a nature and so described as to be capable of being

ascertained and identified”. It is necessary therefore that, when the debt comes into

existence, that debt should answer to the description in the assignment, or be capable of being

identified as the thing, or as one of the things assigned, in order for the contract take effect as an

agreement to assign. Where this condition is fulfilled it will give rise to an equitable

assignment of the receivables the moment that they come into existence, without the

need for there being any further act.34

Equitable assignment therefore is informal, flexible and relatively inexpensive – Goode said

all that is necessary [for a valid equitable assignment] is that the creditor shall manifest a clear

intention to make an irrevocable transfer of the receivable”.37

The assignment does not even have to be in writing except where there is to be an equitable

assignment of an equitable interest in a receivable (as opposed to an assignment of the

receivable itself). In these cases the assignment must be in writing to be enforceable.38 (Section

53(1)(c) of the Law of Property Act 1925.)However, in practice all equitable assignments in

securitisations are in writing.

Giving notice to debtors is not an essential requirement of this method of transfer and this

makes it attractive for securitisations. As the originator is usually the servicer in a securitisation,

the debtors will continue to pay the originator and do not need to know that their payments will

ultimately be passed on to the bond investors via the SPV. Indeed, it usually does not matter to

the debtor to whom the payment of the debt is to be made.39

Nevertheless, it may be desirable for prudential reasons to give notice to debtors:

1. in order to maintain the assignee's priority against competing interests.

2. In the absence of a notice to debtors, the debtors may continue to acquire set-off rights.

3. Secondly, in the absence of notice, the assignor may give good discharge to the
debtor for amounts received by the assignor. This could potentially reduce the

expected income of the assignee.

4. Thirdly, the debtor and assignor may amend the assigned contract without the
assignee's knowledge, which will be enforceable against the assignee.

5. Finally, a third party taking a subsequent assignment without notice of the prior

assignment may, by giving notice ahead of the first assignee, take priority (according to the rule

in Dearle v Hall ).40

Ultimately, it is for the investors to decide whether the added protections available by giving

notice to the many debtors are worth the cost. In most securitisations, the equitable assignments

are not notified. The investors and the rating agencies are prepared to take the risk that “the

originators will not act fraudulently or with gross negligence”.41