Introduction

Companies are increasingly incorporating securitizations and
securitization-like financing arrangements as part of their capital
structure. Utilizing these types of structured financing
arrangements enables companies to diversify their lender base,
increase their borrowing capacity, and even lower their financing
costs. Securitization techniques may also be used to capture other
benefits such as tailoring the financing to desired credit ratings,
reducing lenders’ regulatory capital charges or achieving
particular treatments for tax or accounting purposes.

Asset-based lending in general, and securitization in
particular, provides corporate borrowers with borrowing capacity
against assets that, from a pure cash-flow-based lending
perspective, may have limited to no borrowing value.
Securitizations also have the potential for achieving a better
regulatory treatment and a higher rating differential compared to
the corporate credit rating, compared to more traditional secured
financing arrangements. As such, operating companies should
consider including securitization structures as part of their
capital structure.

Cash-flow loans, even if secured, primarily look to a
borrower’s EBITDA and enterprise value. So long as the company
retains sufficient enterprise value that the company is likely to
restructure (and not liquidate) in case of any insolvency, cashflow
lenders primarily look to the protection afforded to secured
lenders in a bankruptcy restructuring (i.e. Chapter 11 or
equivalent insolvency proceedings). Provided that the collateral
securing the cash-flow loan has sufficient value for the lenders to
remain fully secured in case of insolvency proceedings, they will
likely view any additional collateral as essentially a form for
boot collateral: nice to have, but not particularly additive to the
company’s borrowing capacity. As such, cash-flow lenders will
also generally have a greater tolerance, and even preference, for
maintaining a security interest in core assets of the borrower that
are not likely to be sold during a restructuring. In contrast,
asset-based lenders primarily look to the cash-flow associated with
particular assets and the liquidation value of such assets as
providing the basis for the amount of financing that such lender
will be willing to provide against such assets. A borrower may
therefore be able to obtain significant additional borrowing
capacity from various assets that cash-flow lenders do not give
much value or where the asset-based financing does not have any
particularly adverse impact on the borrower’s EBITDA or, by
extension, the borrowing capacity under cash-flow loans. A prudent
mix of asset-based and cash-flow borrowing therefor has the
potential for unlocking additional access to financing. By
utilizing common securitization credit-enhancing techniques to
decouple the rating of the asset-based financing from that of the
operating company and restricted subsidiaries that would constitute
the borrower group under a more traditional cash-flow loan, it is
possible to achieve a ratings lift and other potential benefits
that overall reduce the borrowing cost while expanding the universe
of potential lenders. This decoupling is typically achieved by
establishing a bankruptcy-remote special purpose entity (the
“securitization SPE”) that neither provides, nor relies
on, credit support to or from its non-SPE affiliates.

The cash-flow from the securitization would flow back to the
borrower-group through a combination of the up-front purchase price
and cash-flow through the securitization SPE equity and, depending
on the securitization structure, would typically retain its
operating income treatment. As such, the operating income impact of
selling receivables or income to a securitization entity is
typically minimal, thereby allowing for continued financing under
an EBITDA facility generally to the same level as if there was no
such receivables securitization. Consequently, it is common for
secured cash-flow financings, even when made to highly leveraged
companies (i.e. “leveraged loans”), to allow for an
unlimited or near-unlimited amount of such receivables
securitizations.

The relationship between asset-based lenders and cash-flow
lenders is more complex where the underlying asset is of a type
that is central to the company’s enterprise value or where the
securitized asset consists of less liquid operating assets that
makes it difficult to fully decouple the securitization financing
from the operating company’s credit. Securitization structures
nevertheless may be able to unlock additional value, even for
assets that a company is likely to view as important for its
business and therefore likely to require during a reorganization.
It is, for example, possible to construct a securitization of
assets for which the related cash-flows are in the form of lease,
rent, licensing fees or other payments from the related company and
where a sale of such asset would require a significant amount of
time or a significant discount. However, in those circumstances,
the payment obligations (in the form of lease or licensing fees or
otherwise) by the operating company that obtained financing through
such securitization structure and the potential adverse impact on
such company’s operations and enterprise value that would
result from the sale of core assets away from the company, are such
that other creditors would want stronger guardrails around such
financings. Cashflow lenders typically include a number of
covenants that are intended to protect them in case of
securitizations or similar add-on financings of such assets. While
it is usually possible to carefully structure a securitization of
operating assets to comply with a typical high-yield or leveraged
loan covenant package, such securitizations will have elements in
common with some liability management transactions that, to put it
mildly, are not always viewed favorably by cash-flow lenders. For
example, there have been instances where lenders to distressed
companies have objected to the use of “drop down”
financings that move core assets away from the cash-flow lenders.
However, while drop-down liability management transactions have
many aspects in common with a securitization, there are also
important differences between such transactions and an asset
securitization structured outside a distressed scenario. This will
be discussed in more detail below.

Summary of Securitization Features and Character of the
Receivables

1. Securitizations – a summary of key
   features

Securitization, at its core, involves isolating the securitized
asset from the originator and its affiliates and obtaining
financing secured and serviced by such assets. Typically, such
asset isolation will involve a “true sale” of such assets
to a “bankruptcy remote” special purpose entity (i.e. the
securitization SPE). True sale is a legal and accounting concept
intended to capture a transfer that will be respected in a
potential bankruptcy of the transferor, such that the transferred
assets are no longer part of a transferor’s property or
bankruptcy estate. That analysis hinges on whether the attributes
of the transaction have more in common with a sale than a secured
loan. Not surprisingly, the more attributes the relevant transfer
has in common with a typical sale transaction, the more likely it
is that a court will determine the transfer to be a true sale.
Conversely, the more the transaction includes features that are
more typical of a loan, the greater the likelihood that the
transaction would be characterized as a transfer of collateral
securing a loan. Some features, such as transferring the economic
risks and rewards of ownership, are given greater weight than
others in determining whether a purported sale will in fact be
respected as such or instead be recharacterized as a loan.

Effectuating a true sale to a securitization SPE that is
affiliated with the transferor would not be of much use in
effectuating isolation of the assets, if the separate existence of
the SPE could not be maintained in the face of a bankruptcy
proceeding against its non-SPE affiliates. As such, it is also
important to structure the SPE to minimize the risk of the SPE
becoming substantively consolidated with such affiliates, as well
as to minimize the risk of any voluntary or involuntary bankruptcy
filing of the SPE.

The risk of the SPE becoming subject to an involuntary
bankruptcy is typically reduced by limiting the SPE’s
activities to the securitization transaction and requiring
transaction parties to waive or limit their right to bring a
bankruptcy proceeding against the SPE. Contractual provisions that
prevent the SPE from voluntarily filing for bankruptcy protection
are not enforceable on public policy grounds. Therefore, the risk
of a voluntary filing by the SPE is addressed more indirectly: in
part, by limiting the activities of the SPE; in part, requiring the
SPE’s contract counterparties to agree that their claims
against the SPE will be limited to its assets; and, in part, by
requiring that any bankruptcy filing and certain other material
actions require the affirmative vote of an independent manager
whose fiduciary duty runs to the SPE itself and not its
shareholders. Finally, to protect against a bankruptcy court
applying the equitable “substantive consolidation”
doctrine, the charter and transaction documents typically include a
number of separateness covenants that are required to be observed
at all times.

The “decoupling” of the securitization SPE from its
affiliates, together with credit enhancements such as
overcollateralization, collateral pool diversification, liquidity
reserves and cash trap or amortization triggers, typically enables
the securitization SPE to issue debt with a significantly better
credit rating than the cashflow loans of the SPE’s affiliates.
This can be very attractive to companies with a low investment
grade or sub-investment grade rating. Even where the collateral is
limited to a single asset for which the cash-flow to the
securitization SPE comes from the affiliated borrower group and its
restricted subsidiaries, it is possible to achieve a credit rating
above that of the relevant payment obligors if the securitized
asset is sufficiently important to the continued business of the
payment obligors such that they are likely to continue to make
lease, license or other relevant payments relating to such asset,
even if they become subject to Chapter 11 bankruptcy.

Given the collateral isolation and the non-recourse nature of
securitization debt, there is typically a lot of flexibility around
where in the corporate organization structure the securitization
SPE can be located. The securitization issuer can be a subsidiary
of the borrower group or it can be a sister company that sits
outside the borrower group. The SPE can be wholly owned or owned
only in part by the borrower group or its affiliates and it can be
structured as an unaffiliated entity altogether.

2. Receivables arising under non-executory
   contracts

As noted above, there is a broad variety of cash-flows that can
be securitized. Loans, leases and payment obligations for goods
delivered and services rendered such that the only remaining
obligation is the payment, are particularly well suited for
securitizations. Such contracts are not executory, and therefore
cannot be rejected in case of a bankruptcy affecting either party
to the transaction giving rise to such receivable. Receivables
arising from a company’s ongoing business activities with its
customers may also be securitized but will be subject to some
increased risks of delay or failure to pay if the originating
company fails to perform any future obligations to the customer.
Such failures could result in the customer (i.e. “account
debtor”) using such future breach as a counterclaim to reduce
its payment obligations with respect to the assigned
receivables.

Generally, the uniform commercial code distinguishes between
set-off rights stemming from different contracts and set-off rights
arising under the same contract (also referred to as recoupment).
An assignee, including a securitization vehicle, can generally
prevent an account debtor from being able to set off unrelated
claims it has against the seller of such payment rights to the
securitization SPE, simply by giving such debtor notice of the
assignment. However, such notice will not suffice to prevent the
relevant debtor from asserting claims under the same contract.
Preventing such claims requires the debtor to waive such defenses
to payment. In circumstances where the relevant originator or
servicer of the receivables has sufficient credit quality and
sufficiently well-established operations that allow the risk of
set-off and recoupment to be carried by such originator without
much impact to the rating of either the securitization entity or
the relevant originator or servicer, it may not be necessary to go
through the extra steps of decoupling such risks. From a true sale
perspective, it is permissible (and typical) to have recourse
against the servicer or originator for any bona fide set-off or
recoupment claims that an account debtor raises as defenses to its
payment obligation on any receivable sold in a securitization, so
long as such recourse does not relate to the account debtor’s
financial inability to pay. The recourse provided for set-off and
recoupment claims, as well as for any indemnity or repurchase
obligations relating to any breach of representations, warranties
or covenants of any seller of assets to a securitization SPE or of
any service provider to the SPE, are often referred to as
“typical securitization undertakings” (or words of
similar import in leveraged loan facilities) and are generally
permitted in conjunction with any permitted securitization
transactions.

3. Receivables arising under executory
   contracts

Any contract where both parties have performance obligations
remaining at the time that one party becomes subject to bankruptcy
proceedings are likely to be an “executory contract” that
can be rejected in bankruptcy; see, Bankruptcy Code Section 365
(providing that subject to court approval and certain limitations,
a debtor in bankruptcy can assume or reject any executory contract
or unexpired lease), Matter of C & S Grain Co., 47 F.3d 233,
237 (7th Cir. 1995) (For the purposes of the Bankruptcy Code, an
executory contract is one in which the obligations of each party
remain substantially unperformed.); and In re Spectrum Information
Technologies, Inc., 190 B.R. 741, 747 (Bankr. E.D.N.Y. 1996)
(“contracts where one party has completed performance are
excluded from the ambit of section 365”). Examples of
executory contracts include intellectual property licenses and
ongoing service contracts. A rejection of a contract in bankruptcy
is the same as a breach by the bankrupt party of its obligations
thereunder and will give the counterparty a right of recoupment
that may permit such counterparty not to make further payments
under its contract, unless such right has been waived, even when
the related receivables have been sold to a securitization SPE. Any
risk that a bankruptcy by the company could result in a material
reduction in the payment obligations under the receivables sold by
the company is, naturally, inconsistent with the securitization
principle of decoupling the SPE’s credit from the company’s
credit.

If a securitization includes receivables under executory
contracts, the question then becomes how best to insulate the SPE
from the Company’s rejection risk. As noted above, one way to
address the issue would be to have the account debtor agreeing to
waive its right to assert any counterclaims or right to set-off and
recoupment for the assigned receivables. Such waiver could either
be entered into directly with the SPE, for example at the time of
assignment or any invoicing by the SPE. Such agreement could also
be entered into between the company and the customer, for the
benefit of any assignee of the payment rights, including the
securitization SPE. The uniform commercial code expressly provides
that such waiver of rights under commercial contracts are
enforceable so long as the assignee took assignment for value, in
good faith and without knowledge of any existing counterclaims. See
UCC 9-403 (b). The only exceptions to enforcing such waiver are
defenses based on: (i) infancy of the obligor to the extent that it
is a defense to a simple contract; (ii) duress, lack of legal
capacity or illegality of the transaction under other law; (iii)
fraud in the inducement; or (iv) discharge of the obligor in
insolvency proceedings. Notably, rejection by the account creditor
or account debtor of a contract in bankruptcy does not amount to
discharge of such contract nor does any breach by the account
creditor constitute one of the remaining defenses that can be
asserted after assignment.

One might ask why an account debtor would be willing to waive
such recoupment rights against an assignee of the payment claim.
However, the customer will typically continue to be able to make a
claim against the provider of goods and services, even if it waives
its right to dispute any payment obligations. In that respect, the
waiver puts the assignee of the receivable in the same position as
if the assignee had made a loan directly to the account debtor for
the purpose of the account debtor to pay for the goods and services
at the time of the contract. The account debtor would in either
case be expected to repay its loan regardless of whether the
account debtor was satisfied with the goods delivered or services
rendered.

In many circumstances, it will not be practicable, however, to
obtain a waiver of recoupment rights from the customer. Under those
circumstances, it may be necessary to ensure that additional assets
or rights have been transferred to the securitization SPE in order
to give the SPE the ability to continue to perform under the
executory contract if the company fails to do so.

4. Transfer of assets beyond receivables and related
   contracts

Some executory contracts provide counterparties with additional
protections against a rejection in bankruptcy, in particular
intellectual property licenses and real-property leases. Section
365(n) of the bankruptcy code provides the licensee with a right to
either elect to treat such contract as terminated (to the extent
the licensee otherwise had a contractual right to do so) or to
retain its rights under its license of such intellectual property,
as such rights existed immediately before the commencement of the
bankruptcy case. Leases of real property where the debtor is the
lessor also are afforded similar bankruptcy protection to where the
bankrupt entity is the lessor, allowing the lessee to retain its
rights under the lease for the remainder of the lease term pursuant
to Section 365(h), even if the lessor rejects such lease in
bankruptcy.

It is therefore possible to protect any related license or lease
payment streams by ensuring that the securitization SPE becomes the
lessee vis-à-vis the company that owns such property, with
rights to sub-lease or sub-license such real or intellectual
property, as applicable, to the relevant third-party obligors.
Should the licensor or lessor file for bankruptcy, the SPE will,
naturally, elect to continue such lease and license
transactions.

For other assets that do not have such express bankruptcy
protections available, it may be necessary for the securitization
sponsor to transfer actual ownership of the relevant assets
required to service the financed cash-flows to the SPE upfront. The
more revenue-generating assets and related rights are transferred
to the SPE, the greater the SPE’s ability to continue to
generate revenue and service its debt, effectively operating as a
separate business line, even if the transferor or servicer becomes
subject to bankruptcy proceedings.

In some cases, such as whole business securitizations, the
principal revenue-generating assets of the business will reside in
the securitization structure, thereby making it difficult for the
remaining business to obtain other financing outside the
securitization. Nevertheless, a company may decide that a
securitization financing would still be preferable compared to
other corporate financing alternatives. Placing the operating
assets into an SPE structure in principle allows for another
operating company to step in and service the assets, essentially
allowing for an efficient transfer or sale of the business
operations inside the SPE (with the accompanying debt) to such
successor servicer. The more easily a third party could step in and
take over the servicing of the assets (or otherwise be incentivized
to pay down the financing at the SPE level in order to take out the
assets), the greater the extent to which the credit of the SPE can
be decoupled from the credit of the parent company that established
the operating business securitization. However, even where the
ability to fully decouple is limited, a whole business
securitization structure will often permit a sub investment grade
corporate group to achieve a ratings step-up to a low investment
grade rating, which significantly increases the investor base and
reduces the cost of funds. As such, whole business securitization
is used in a significant number of restaurant franchises such as
Sonic, Domino’s, Wendy’s and Taco Bell, as well as fitness
clubs such as Planet Fitness and automotive services such as Driven
Brands, all with a rating typically in the BBB (sf) range.

It is worth noting some of the criticism levied against
corporate securitizations by some rating agencies, which primarily
centers around overstating the benefits of some highly leveraged
corporate securitizations. For example, Fitch Ratings commentary
published in December 2019 titled “U.S. Whole Business
Securitization Benefits Overstated”, criticized some whole
business securitizations that had achieved an investment grade
rating (in the “BBB” range) despite leverage multiples of
7× to 8× of EBITDA (which otherwise would qualify for a
rating significantly below investment grade). Fitch Ratings noted
several factors that raised its concerns; the first being whether
the securitization related to “the vast majority of [the
sponsors’] assets and liabilities” in contrast to
“traditional securitizations that are designed to isolate only
a part of the assets from the fortunes of the company itself
“, and others being industry considerations that were not of a
type that could be mitigated by use of a special purpose entity,
triggers or covenants alone, such as low barriers to entry,
exposure to technological advances and changes and consumer
preferences and lastly what Fitch viewed as an overstatement of the
difference between the control lenders had over replacing
management over the securitized operating assets compared to the
influence lenders and shareholders had in a more traditional
financing structure.

While there may be debate around the amount of credit
enhancements that a securitization structure of all of a
Company’s assets should be able to achieve as compared to a
traditional cash-flow-based financing, there seems to be far less
controversy and much greater acceptance of the credit enhancement
that a securitization can and should achieve where only a portion
of an operating company’s assets are separated out in a
securitization structure. Of course, the credit rating of the SPE
itself depends on typical credit factors such as overall leverage,
liquidation value of the assets, value of the assets when operated
by the SPE, ability for an alternative operator to step in and
operate the SPE without a material adverse impact on the cash-flows
or value of the assets, barriers to entry, etc. In SPEs where the
brand name and intangible rights tied to a particular operator are
crucial to the SPE’s value, especially when operating in a
business with low barriers to entry, the ability to decouple the
SPE’s credit from the operator’s credit may be limited.
Conversely, a whole business SPE structure in which valuable
operating assets are transferred to the SPE and where such assets
are of a type and in a line of business where a multitude of
different operators could step in and provide the required
servicing of the assets to ensure that the cash-flow to the SPE
continues, then there is a greater ability to decouple the credit
of the SPE from the credit of the sponsor-company. Examples of the
latter include oil and gas royalty securitizations from proved
developed and producing oil and gas reserves, and securitization of
telecommunication tower lease payments.

It is also possible to construct solid securitization structures
where the primary source of income to the securitization entity
consists of lease or royalty payments from the sponsor company (or
its affiliates). It is common and straightforward to build interest
reserve features that permit the securitization SPE to service its
debt during an interim period that allows it to enter into a
replacement lease or effectuate an orderly liquidation sale. For
example, in aircraft securitizations using enhanced equipment trust
certificates, the lenders benefit from liquidity facilities that
can be drawn when the lessee files for bankruptcy and rejects the
lease. The mere ability to effectuate such sale may create
sufficient incentives for the current operator, even if in
bankruptcy, to assume its lease payments in order to secure its
rights to continue to operate such assets. As noted above, this
would expectedly often be the case where the relevant asset is
important to the continued operations of the bankrupt lessee and
such likely assumption is itself credit enhancing. This is, amongst
others, illustrated in the securitization of spectrum by Sprint
Communications, Inc., where Moody’s awarded the notes a Baa2
(sf ) rating at a time when the Sprint corporate family rating was
B2. As part of its ratings rationale, Moody’s noted the
significant franchise value of Sprint, its substantial customer
base and its nationwide network structure as important contributing
factors, and that, in the case of an insolvency, Sprint would be
likely to realize more value as a going concern and therefore to
file for bankruptcy under Chapter 11, rather than liquidation under
Chapter 7. Because the securitized spectrum portfolio was important
to Sprint’s business operations, Sprint would be strongly
incentivized to assume the lease to avoid any disruptions in its
operations resulting from any Chapter 11 filing. In turn, this
would avoid disruption in the payments on the securitized notes.
The securitized notes also benefited from a liquidity reserve and
significant excess value of the collateral, but because of the
illiquid nature of the spectrum and the low number of comparable
spectrum license sales and the value of the spectrum, Moody’s
assigned secondary value to this credit enhancement in the spectrum
notes.

Originally Published by ICLG.

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