Securitizing Trade Finance Cash Flows

1 Introduction

A ground-breaking securitization, structured and pioneered by Bank of America’s securitization team in London for Turkiye Garanti Bankasi A.S., in June, 1999, raised approximately $200 million for Garanti and has positive implications for other institutions in emerging markets seeking liquidity for their operations. The importance of the Garanti deal is that the cash flow securitized was trade finance payment rights – to date an unidentified asset class for the purpose of securitization but one which should be of interest to many emerging market and other issuers in the future.

Trade financiers will recognize that pursuant to the Uniform Customs and Practice for Documentary Credits (1993 Revision ) ICC (“UCP 500”), it is possible for a bank in an emerging market to acquire reimbursement rights against an issuing bank in an importer’s country by (i) negotiating against conforming documents under an unconfirmed letter of credit or (ii) paying against conforming documents under a confirmed letter of credit where such bank is acting a the confirming bank. This is because UCP 500 specifies that by negotiating or paying under a confirmation against conforming documents a recourse right against the issuing bank of the letter of credit arises for the negotiator and confirmer. This reimbursement right is a valuable asset class rendered all the more valuable because, in practice, documents presented under letters of credit are refused by an issuing bank on presentation only in unusual circumstances and then, generally, for only minor discrepancies that are easily corrected.

Likewise collections can produce a valuable asset class. The ICC has published the Uniform Rules for Collections (1995 Revision) (“URC 522”) which purports to govern export related cash against documents transactions. This regime contemplates that an exporter will, following shipment, select a bank (known as a remitting bank) to handle the collection of payments in respect of bills of lading and other shipping documents in the exporter’s possession. The remitting bank will, in turn, send those documents to a collecting bank along with a collection instruction that specifies the terms and conditions to apply when shipping documents are delivered to the importer. The collection instruction also directs the collecting bank how to transfer funds to the remitting bank. The collection instruction, if properly drafted, can create a reimbursement right in favor of the remitting bank from the collecting bank when the collecting bank is paid by or through the importer; this reimbursement right is capable of securitization.

Garanti, in common with many banks in emerging markets for whom trade finance is a core business, had substantial claims arising from letters of credit and collections against credit worthy bank obligors in Western Europe and the United States. These reimbursement rights (hereafter called “Trade Payment Rights”) were securitized by the bank through a series of steps that are best understood by analyzing the collateral structure for the transaction and the cash flows for the transaction.

1.2 Issuing Structure.

Under the transaction, Garanti created a special purpose off-balance sheet company located in a tax neutral jurisdiction (“SPC”) and sold its existing and future Trade Payment Rights to that company. Garanti retained obligations to act as servicer of the Trade Payment Rights. Arrangements were made for all Trade Payment Rights to be paid directly to accounts maintained in the joint name of the servicer, as the agent of the SPC, and a collateral trustee with various banks in Western Europe and the United States.

The SPC funded the acquisition of Garanti’s Trade Payment Rights by issuing floating and fixed rate notes limited in recourse to the assets of the SPC which substantially comprised the transferred Trade Payment Rights (“Notes”). The SPC also issued a subordinated note to Garanti as partial payment for the Trade Payment Rights. In each payment period during which the SPC is to receive payment of Trade Payment Rights it is required first to satisfy its obligations under the Notes and other expenses of the transaction with remaining cash flow being paid to Garanti under the subordinated note.

The Notes were subscribed for by a New York domiciled Trust which in turn issued certificates, limited in recourse to the proceeds from SPC’s Notes, to U.S. onshore and international investors pursuant to Rule 144A and Regulation S under the United States Securities Act of 1933 (as amended). An independent indenture trustee incorporated in the jurisdiction of the SPC acted as trustee of the Notes issued by the SPC. A diagram of the collateral structure is attached as Diagram 1.

1.3 “Future Flow” Deals.

The Garanti deal was a “future flow securitization.” Such a transaction depends on the ability of the originator -- Garanti -- to produce and sell its export receivables denominated in hard currencies until repayment in full of the securities issued to investors pursuant to the securitization. If Garanti fails to generate hard currency export receivables, payments to the SPC will decline or at worst stop. Without revenue, the SPC cannot make payments on the Notes and the issuing trust cannot make payments under the certificates issued to investors. Future flow securitizations are thus a bet on the continued viability of originators, such as Garanti, as would be a similar bet on the viability of a borrower under any secured or unsecured term loan. Such transactions do not rely entirely on the quality of existing receivables, but also rely on future receivables. Accordingly, such transactions do not involve the issuance of securities that are truly “asset-backed”. Future flow securitizations have been undertaken that generate a steady source of foreign currency through various business lines including international credit card processing and foreign cheque cashing. As mentioned above, Garanti extended this type of transaction to a new asset class-Trade Payment Rights.

The structure used in Garanti minimized the sovereign risks inherent in securities offerings from issuers located in non-investment grade countries by separating the emerging market issuer from the source of the securities’ repayment. If the foreign currency revenue to be used to repay the securities never crosses the border into the originator’s country, in this case Turkey, and the offshore vehicle issuing securities to international investors has a first claim on the revenues, the securities largely avoid two of the main sovereign risks associated with the originator’s home jurisdiction: devaluation risk and repatriation risk.

Investors increasingly look to the credit ratings that securities they purchase receive from independent rating agencies such as Moody’s, Standard & Poor’s and Duff & Phelps to determine the securities’ level of repayment risk. In the Garanti transaction the certificates ultimately issued to investors were rated “BBB” by both Duff & Phelps and Fitch IBCA. Generally, a securities issue from an issuer in an emerging market such as Turkey will receive a rating no higher than the country’s foreign currency sovereign rating, because even the best company in the country will be affected by the local government’s monetary policy and ability to service its own foreign currency debt. As a result, if the local government does not have an investment grade rating for its foreign currency obligations (generally BBB- or better in the Standard & Poor’s and Duff & Phelps rating systems), the rating agencies’ ‘sovereign ceiling’ will prevent local companies from achieving an investment grade rating on their own foreign currency obligations. Future cash flow securitizations, if properly structured, however, allow a company in an emerging market country to ‘vault over’ the sovereign ceiling, achieving a foreign currency credit rating higher than the country’s sovereign rating. In this way, an emerging market issuer can open the door to longer-term and much cheaper financing than it could otherwise obtain. These benefits will in most cases outweigh the substantial transaction costs and administrative inconvenience incurred in structuring and operating under the securitizations. Future cash flow securitizations depend on complex structures intended to isolate an originator’s foreign currency cash flow from the sovereign risks of the originator’s home jurisdiction. The key legal issues associated with this type of transaction are discussed below.

2 Key Legal Issues.

Most future flow securitizations in emerging markets use a bankruptcy-remote trust or corporation specially organized for the transaction; the Garanti deal was no exception.

Use of by an offshore entity helps to isolate the sovereign risks in the transaction by placing the owner of the assets and the assets out of the legal reach of the originator’s home jurisdiction and by facilitating offshore collection of receivables proceeds. Most securitizations to date have been completed with the ultimate securities purchased by international investors being issued by master trusts created under New York law. Some investors generally prefer a US issuer because of the greater certainty as to US legal and tax issues and because some investors, such as US insurance companies, face regulatory constraints on their ability to purchase securities issued by foreign entities.

2.2 Formation Of An Intermediary SPC.

The Garanti future flow securitization used not only a New York master trust, but also an intermediary special purpose company in a non-US off-shore jurisdiction.

The principal reason for creating such a structure is to isolate the receivables not only from the sovereign risks of the originator’s jurisdiction, but also from potential US bankruptcy risks. From a US bankruptcy perspective, a two-tier transaction helps ensure that a ‘true sale’ of receivables from the originator to a non-US entity has occurred that is not subject to the jurisdiction of US bankruptcy courts. If a true sale occurs under applicable local law, the assets transferred to the intermediary vehicle, in this case SPC, are beyond the reach of a bankruptcy court in the originator’s home jurisdiction or the US if the originator becomes insolvent.

Without this two-tier structure, there remains a potential risk that the originator’s insolvency might lead to the originator’s transfer to, say, the New York trust in the present transaction being recharacterized as a security interest by a US bankruptcy court if the originator filed for bankruptcy in the US or its US assets otherwise came under the jurisdiction of a US bankruptcy court in connection with a foreign insolvency proceeding. Acceptance of jurisdiction by a US court is unlikely if the originator lacks US property. Also, application of US law on the transfer issue should not occur if the transaction documents provide for the originator’s local law to govern. In any event, however, US bankruptcy courts have wide discretion in their rulings, and as some bank accounts to collect receivables are located in the United States and are in the nature of US property, rating agencies prefer the safety of a two-tier structure.

If a US bankruptcy court with proper jurisdiction were to rule that the originator’s transfer of receivables was not a true sale, investors’ prospects for timely repayment would be grim under the US Bankruptcy Code. First, investors would be stopped by the Code’s automatic stay provisions from pursuing any recovery actions against the debtor, such as attachment proceedings against the receivables or other property of the debtor. Second, investors would be likely to lose their security interest in receivables generated after the bankruptcy filing, because under the Code property acquired by the debtor after the filing remains property of the debtor’s estate and not subject to a lien created under a security agreement entered into before filing (unless the property was ‘proceeds’ of assets previously acquired and subject to such a prior security agreement). As a result, investors would be ‘undersecured’ creditors under the Code (i.e. creditors owed a principal amount of debt greater than the value of their security). Third, to the extent investors are undersecured, the debtor may be able to recover, as a preferential transfer, any debt service payment made within the 90 days before the filing.

2.3 Transfer Of Assets.

From a ratings perspective, the nature of Garanti’s transfer of export receivables represented the key legal issue. This is because rating agencies generally require assurance on three related transfer issues. First, that the securitized assets have been validly transferred under applicable local law. Second, that such transfer has been ‘perfected’ under applicable local law in the sense that a local bankruptcy court would not find that the transfer could be challenged successfully by either the bankrupt originator (and hence other creditors of the originator in bankruptcy) or third party transferees with a claim on the assets. Third, the SPC was required to have a claim on the transferred assets prior in right to all other claims (other than those of holders of Notes represented by the indenture trustee).

If these three conditions are met, the SPC would have a prior claim to the transferred assets free from any legal challenge at all times short of Garanti’s insolvency. The rating on the ultimate securities issued to investors reflected the SPC’s legal rights, and mirrored Garanti’s local currency rating, which in turn reflected the assessed probability of Garanti’s insolvency.

With respect to the first of these transfer issues it is worth noting that differences between the law of an originator’s home jurisdiction and the laws of the place of incorporation of various entities used in a securitization(s) and between the rules governing transfers for bankruptcy, tax and accounting purposes in the various jurisdictions, provide opportunities for legal ‘arbitrage’. Many transfers in single-tier securitizations are sales for bankruptcy purposes in the originator’s home jurisdiction, but secured loans for US and home jurisdiction tax purposes and for home jurisdiction accounting purposes (particularly if the originator retains recourse obligations). Two-tier transactions such as the Garanti transaction incorporating a true sale from the originator to an offshore intermediary vehicle are more likely to be considered a sale for multiple purposes, which may be necessary if the originator has issued debt instruments containing a negative pledge clause that would prohibit granting a security interest in its assets.

Perfection of the transfer is the second transfer issue that the rating agencies analyze. Whatever the legal form of the transfer for the purposes of local bankruptcy law, the transfer must be properly perfected under the law of each applicable jurisdiction. Often it is not easy to identify which law governs perfection of the transfer. Consequently, one must often take care to perfect under each jurisdiction’s law that may apply, usually those of the originator’s home jurisdiction, the US, the SPC’s jurisdiction, the obligors’ jurisdiction and the law of the contract (if any) being assigned and the law governing the assignment instrument.

Priority is the third transfer issue that the rating agencies analyze in transactions such as these. The priority of the transfer should be absolute, because the transferred assets become the unencumbered property of the initial transferee in the first instance.

In Garanti the rating agencies required (as they typically do) as a condition to delivering their ratings letter, that the originator’s counsel in its home jurisdiction, in the jurisdiction of the intermediary SPC, in the jurisdiction of the most important obligors and in the US have delivered legal opinions as to the desired effect of the transfer under local law. In addition, the Garanti transaction documentation contained extensive representations and warranties by Garanti as to the transfer. The material inaccuracy of these representations and warranties would constitute a default event under the transaction documentation, giving rise to a suspension or termination of Garanti’s right to receive residual cash flows from the SPC under the Notes until certificate investors have been fully repaid.

2.4 Tax Issues.

Future flow securitizations also raise a host of tax issues for originators and intermediate and other vehicles, which often affect the viability of transactions. In addition to the issue of entity-level taxation for, say, the SPC, tax issues relate to withholding tax on interest, value added tax on services, stamp tax on asset transfers and capital gains tax on asset transfers. All these topics need to be investigated and are beyond the scope of this short paper.

3 Conclusion

The ground-breaking future cash flow securitization in the Garanti deal required a major commitment of time from the issuer and bankers, lawyers, accountants, rating agencies, and other advisors. However, the time commitment and the transaction costs proved worthwhile and should prove worthwhile in the future, as such securitizations should offer substantial rewards in the form of lower financing costs for emerging market issuers. Companies in non-investment grade countries that have strong export earnings or other sources of foreign exchange can also avail themselves of the techniques used in Garanti because an investment grade rating for the transaction provided by a properly-structured transaction can open the door to financing sources that would otherwise be closed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.