[Kushagra is a student at Dr Ram Manohar Lohiya National Law University.]
Securitization is the conversion of illiquid assets, like loans, into marketable securities as an off balance sheet measure of financing. This involves bundling of a large number of issued loans and issuing certificates for claims upon any future receivables in return for a principal amount. These certificates are issued by a special purpose vehicle (SPV) that is set up solely for that purpose. The investors can then buy certificates for claims upon receivables based on varying, divided levels of risk The main intent behind such transactions being to transfer the future claims upon the loans to investors so that the originator bank can raise funds and generate liquidity for itself. The originator bank does generally retain servicing rights, i.e. collecting mortgage payments on behalf of the SPV and provides credit enhancements like over collaterization i.e. posting of assets as collaterals like the houses in case of a mortgage backed security whose value is more than the value of the underlying loan in order to reduce credit risk in case of default. Due to the off-balance sheet nature of the transaction and servicing rights, securitization transactions depend upon the sale of the receivables being a "true sale’’.
True Sales and the Factor Based Approach Towards Determining Them
True sales can be defined as when the entire rights and liabilities of the receivable is transferred by the seller such that there is no recourse left for the seller, even in the case of insolvency. The sale of the underlying loans being a true sale is essential in order to preserve the bankruptcy remote status of the SPV, i.e. ensuring that the originator bank going insolvent will not affect the status of the securities issued. The Indian securitization regime relies on a factor based approach to determine whether a transaction is a true sale or not i.e. a number of criteria are established and given weight in determining the nature of the transaction. The RBI has released the aforementioned factors in its guidelines for the derecognition of assets in its Securitization Guidelines (RBI Guidelines). Let us have a look at them individually.
SPE must be out of control of the originator
Control is defined in terms of the originator not having the option to repurchase or retain any part of the loans unless it is for credit enhancement and complies with the guidelines for the same. The reason being that if the originator retains a part of the exposure, then the transaction may be interpreted as a collateralized debt rather than a transfer.
Legal recourse
The RBI Guidelines state that the ‘transferred exposures are legally isolated from the originator in such a way that the exposures are put beyond the reach of the originator or its creditors, even in bankruptcy (specially IBC) or administration.’ However, the redundancy of such a requirement has been explored further in the later parts of this writing as the only way to determine whether a transferred exposure is legally isolated is examining it based on these factors.
Separation
The court may recharacterize the securitization transaction and consolidate the transferred exposures into the insolvency proceedings of the originator if it can be substantially proven that the originator and the SPV were excessively entangled. 8 SPVs were stripped of their bankruptcy remote status in the IL&FS bankruptcy petition due to excessive intermingling of administration and conflict of interest in management.
Intent behind contract
Intent is one of the main factors that is taken into account during proceedings involving the question of a true sale. As the transfer usually happens via an assignment agreement, the wording of the document is carefully pored over to determine whether the originator really intended to relieve themselves of all rights towards the transferred exposure. In IL&FS v. HDFC, the court held that due to the wording of the assignment agreement between IL&FS and HDFC, IL&FS could not claim the transferred exposure of rent receivables to be their assets as they clearly intended to transfer the claim to HDFC.
Redundancies of the Framework
Cases like Dewan Housing elucidate that even though the factor based approach towards determining a true sale has been legislated via the RBI Guidelines and the Financial Service Provider Insolvency Rules (FSP Rules) that state that no third-party assets shall be affected by moratorium under Section 14 of the Insolvency and Bankruptcy Code 2016. They, however, do little to address the root issue, which is the purposive failure of the approach. Every dispute regarding the nature of such transferred exposures eventually retreats to a post hoc analysis of the agreement being judged upon the aforementioned factors. In a judgment passed by the Bombay High Court, DHFL was prevented from making any further payments towards its transferred exposures, in essence, characterizing the transaction as a collateralized debt instead of a true sale. The judgment highlights the biggest drawback of the factor-based approach which is the purposive failure of protecting securitizations. The only way to determine the true sale nature of a transfer is via litigation, i.e. there is no safe harbor for such transfers. This leads to the legislation itself being a source of judicial uncertainty. The FSP Rules providing immunity for third party assets does little to relieve investors if the basis for determining whether the exposures owned by the SPVs count as third party assets can only be determined in court. Cases like Union Bank of India v. National Housing Banking continue to show how the legislature’s flawed approach towards determining true sales inspire judicial uncertainty, especially on the part of lower courts. The subjective burden of how much weight should be assigned to each factor leads to ambiguity in the interpretation and a purposive failure of the RBI Guidelines and the FSP Rules. Since the current conundrum faced by the nascent Indian securitization market mirrors the situation in the US, a closer look at the same is warranted.
Other Jurisdictions and Potential Solutions
After the tumultuous stance of individual states on the characterization of a securitization transaction, the US codified a safe harbor rule that states the following ‘the FDIC will not, in the exercise of its authority to repudiate contracts, recover or reclaim financial assets transferred in connection with securitization transactions.’ Prior to such safe harbor provisions, cases like re LTV Steel Co., the bankruptcy court declared that the transferred receivables of LTV Steel, the originator, could be used to continue the business operations of the same. Home Bond Co. v. McChesney [239 U.S. 568, 575 (1916)] saw the courts hold that the pricing mechanism of the transfer being reminiscent of a loan pricing could be a relevant factor in determining the nature of the sale along with the extent of retainment of servicing rights. In re Evergreen Valley Resort, Inc., the transaction was recharacterized due to the originator being able to collect further receivables after a predetermined account was recovered by the buyer. Such contrasting judgements contributed to the judicial uncertainty in the US securitization market. In response, anti-recharacterization laws were passed in many states like Delaware and Texas, but such laws proved ineffective since they failed to adequately define what a ‘securitization’ was. The statutes were also only applicable to securitizations of State receivables which are vastly different from commercial securitizations due to the involvement of the State as a party in the contract. The US along with Canadian jurisdictions use their own versions of a test by balancing the prejudices of the creditors if the underlying are not consolidated against the prejudice of the debtors will suffer from its imposition. However, the underlying safe harbor provisions in the US help prevent market concerns about the ambiguity in recharacterization of securitizations.
While the common-law approach has served the Indian market decently till now, with the rapid growth of the Indian securitization market, the judicial uncertainty regarding proper principles of what constitutes a true sale is bound to create problems. Effective solutions may be the use of a property law based approach, by adding a provision for the transfer of future receivables upon the underlying but considering the nascence of the Indian markets, a codified statute for securitization is far fetched. A much more practical solution would be the addition of safe harbor provisions to protect the immediate interests of the investors. In essence, making it so litigation is a secondary resort for the protection of contractual rights rather than causing it to be the only option.
Conclusion
Securitization's success hinges on the clear classification of asset transfers as true sales, ensuring bankruptcy remoteness and investor protection. India's factor-based approach, despite RBI Guidelines, often leads to judicial uncertainty. Drawing from the US experience, introducing safe harbor provisions could provide clarity and stability. Such provisions would protect investors' interests and reduce reliance on litigation, fostering a more robust and transparent securitization market in India. This approach would enhance confidence and efficiency in the market, crucial for its continued growth.
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