HLTs Still Hampered by a 50-Year-Old Law
The securitization of highly leveraged-transaction loans, or HLTs, is one of the new frontiers in structured financing. HLT securitizations completed in the past two years include the two Frends deals created by Continental Bank, the Afer BV offering sponsored by Banque Nationale de Paris, and the Rosa BV offering sold by Nomura Securities.
Early this year, floating-rate securities backed by a $150 million pool of HLT loans - originated by Mellon Bank, Barclays Bank, and Bank of Montreal - were sold, under the name Freedom Finance II, mostly to Japanese investors. To date, a total of about $2.5 billion of HLT loans have been securitized and sold to investors. With about $50 billion of HLT loans remaining on the books of large U.S. banks, more activity can be expected.
Most HLT loan-backed securities - known as collateralized loan obligations, or CLOs - have been issued in the form of medium-term notes, although some commercial paper backed by HLT loans has been issued. CLOs are generally structured so that principal and interest payments on the CLOs match the amortization of the underlying loans.
In Rosa BV, a portion of the cash flow is reinvested for up to seven years, during which time only interest is paid on the CLOs. Typically, CLOs rely on subordination for credit support, but surety bonds have also been use. CLOs are generally brought to market either in a U.S. private placement, as a foreign offering, or a combination of the two.
Domestic issuances of CLOs usually employ a two-tier structure in which a parent entity, typically a limited partnership, and its wholly owned corporate subsidiary issue and sell a senior class and one or more subordinated classes of debt, and a class of limited partnership interests.
In foreign issuances, typically a Netherlands issuer acquires the HLT loans and issues a senior class and one or more subordinated classes of debt securities, which represent substantially all of the value of the HLT loans. The Netherlands issuer also issues a nominally capitalized class of stock, all of which is owned by a Netherlands charitable trust. Foreign issuances also can be structured using Cayman Islands or Bermuda corporations.
To eliminate the effect of differences in the timing and size of interest payments on the various underlying loans, an interest swap arrangement is used to assure timely, consistent cash flow to pay interest on the senior CLOs when due.
The paramount securities-law concerns in HLT loan securitizations arise under the Investment Company Act of 1940. It imposes numerous organizational, accounting, and reporting requirements on "companies" subject to its provisions.
For example, the capital-structure requirements of section 18 of the 1940 act provide that any debt securities issued by investment companies must have 300% asset coverage - a provision that would destroy the economics of an HLT loan securitization.
Securities Act of 1933
Structuring the HLT loan securitization to avoid registration under the 1940 act results in avoidance of the registration requirements of the Securities Act of 1933, as well. For domestic structures, if the issuer is within Section 3(c)(1) of the 1940 act, its securities will also be exempt from registration under the 1933 Act. (Secondary-market sales in the United States may be made in compliance with rule 144A, subject to the 100-holders limitation.)
Similarly, if a foreign issuer makes a foreign public offering which does not involve U.S. jurisdictional means, the offering of its securities will be exempt from registration under the 1933 act as well as the 1940 act.
By the same token, if a foreign public offering is made at the same time as a U.S. private placement, both will be exempt from the registration requirements of the 1933 act as long as the offerings are not "integrated" under the securities laws. Of course, the U.S. private offering will be subject to the antifraud provisions of sections 12(2) and 17 of the 1933 act and section 10(b) of the 1934 act.
Disclosure obligations must be weighed against the competing interest of the lender in complying with its confidentiality agreements with the borrowers. Some issuers have provided only general information about the HLT loans in the disclosure document, but have allowed investors to obtain specific information about borrowers after executing a confidentiality agreement.
At least one issuer has disclosed the names of the HLT loan borrowers and their credit ratings in the initial offering materials. Information generally provided includes the industry group to which the HLT loans were made, borrower leverage ratios, and the original and current principal balances, interest rates, terms to maturity, priorities, and purposes of the loans.
HLT loan-backed transactions are designed to be bankruptcy-remote under U.S. law. This is accomplished by means of limitations on the purpose and activities of the entities holding the HLT loans and issuing the CLOs, and by contractual arrangements prohibiting a bankruptcy filing against these entities by other participants in the CLO issuance.
Where the issuer of CLOs is a foreign corporation, the effect of the bankruptcy-law principles of the appropriate jurisdiction, if any, must also be considered.
The effect of an insolvency of the originator of the HLT loans is considered in terms both of "true sale" and consolidation issues. The true sale analysis is crucial: If a mere financing has occurred, the loans will be deemed part of the originator's estate upon its insolvency.
In the case of a bankruptcy-code entity, the related securities would be subject to the automatic stay and restructuring provisions of the code, thereby endangering the timing and amount of payments on the CLO debt. The bankruptcy code would also permit the insolvent originator's trustee to reduce the amount of, or substitute for, the HLT loans under certain circumstances.
Where a bank is the originator, because banks are not subject to the bankruptcy code, the automatic stay, restructuring, and collateral-substitution provisions of the code would not apply. There is a risk that in the absence of a true sale, the FDIC, as receiver of an insolvent originator bank, might accelerate the CLO debt related to the bank's HLT loans.
A consolidation analysis determines whether the assets of a subsidiary would be consolidated with and deemed part of a bankrupt parent's estate. The rights of creditors to consolidate arise both under the bankruptcy code and under the corporate law principle of "piercing the corporate veil," which may be applied to noncode entities, including banks.
Generally, consolidation may occur where the parent and subsidiary have not maintained corporate separateness. A special purpose CLO issuer also may be subject to consolidation with an originator or sponsor which is not technically its parent if that entity treats the issuer as an alter ego.
In order to avoid the risk of consolidation, CLO issuers follow corporate-separateness guideliness prescribed by bankruptcy counsel and, in cases where a bank is the parent, an opinion of the general counsel to the Federal Deposit Insurance Corp.
Another method of avoiding consolidation is to place a majority of the equity of the CLO issuer (which may, for purposes of this analysis, include one or more classes of subordinated debt) with a person or entity other than its parent or the originator or sponsor.
If the loan is found to be a fraudulent conveyance, the security could be reclaimed for the borrower's estate, adversely affecting the value of the CLO which was secured in part by that loan. It is also possible that the HLT loan could be entirely voided or equitably subordinated to other creditors.
The accounting treatment desired by the originators of the HLT loans is a major factor affecting the CLO structures. Generally, if the loan transfer is structured as a financing, immediate recognition of accounting losses on underwater loans is avoided.
The loans remain on-balance-sheet, subject to risk-based and leverage capital requirements. Conversely, a sale triggers accounting losses on underwater loans. The sale may be either recourse or nonrecourse.
If the loans are sold without recourse, a bank originator/ seller would not have any capital requirement with respect to the loans. If the loans are sold with recourse, a bank originator/ seller will be required to convert the loans to balance sheet assets for risk-based capital computation purposes. In addition, for the present time, a transfer with recourse will be treated as a financing for leverage capital computation purposes.
For entities that use generally accepted accounting principles, whether a transfer constitutes a sale is determined under Statement of Financial Accounting Standard 77.
Under SFAS 77, the originator cannot obtain sale treatment if it retains an economic interest in the loans. This would occur, for example, if it held recharacterized subordinated debt of a foreign issuer that has only a nominally capitalized equity class, or recharacterized subordinated debt of a U.S. partnership or trust where the partnership interests are deemed to have insufficient economic substance.
Continued originator involvement in a transaction, for example, through the provision of liquidity facilities or swaps or management of the collateral, may prevent GAAP sale treatment.
Transfer of the "equity" in the transaction is also a key factor in obtaining sale treatment for the originator under regulatory accounting principles and for capital computation purposes. Under regulatory accounting principles and capital rules, many types of retained recourse can prevent the treatment of the transaction as a sale.
In one prospective HLT loan-backed transaction, federal bank regulatory authorities indicated that a recourse arrangement would be created by the issuer's right to put the HLT loans back to the originating back if withholding taxes were imposed on interest payments on the loans.
Definitions of Recourse
The federal banking agencies, through the Federal Financial Institutions Examination Council, are currently considering new regulations defining recourse that could greatly enlarge the definition for capital purposes.
HLT loans may be transferred from the originator to the issuer by means of a participation, rather than a sale of the entire loan. Under GAAP and regulatory accounting and capital guidelines, the transfer of a 100% participation can qualify as a sale.
The transfer of a smaller fractional participation, or a strip, should also enable the originator to obtain sale treatment for the transferred portion, with any retained portion remaining on balance sheet, so long as the transferred and retained portions rank equally in priority.
Transfer of a senior participation interest may qualify under GAAP as a sale. For regulatory capital purposes, the retention of a subordinated piece by the originator constitutes recourse with capital implications.
The question whether HLT-backed securities may be purchased by certain U.S. institutional investors is determined under the various laws governing legal investment.
Banks and Thrifts
National banks, federally chartered savings institutions, and many state-chartered institutions have some authority to invest in debt securities, although most laws require the securities to be "marketable" (that is, capable of being sold with reasonable promptness at fair market value).
It is possible that securities privately placed in the United States under Rule 144A will be able to meet the "marketability" test. This issue is currently under review by federal bank regulators.
For thrifts, investment authority is further limited to investment-grade rated debt and debt of corporate issuers only (thereby precluding investment in most subordinated CLO tranches and in CLOs issued by partnerships or trusts).
Banks and thrifts may be able to invest in CLOs, including subordinated CLO tranches, under their general commercial lending authority. The institution would generally be required to underwrite the CLO debt as it would a loan, which may require a level of analysis of the specifics of the underlying HLT loans that may not be possible based merely on the disclosure documents.
Pension-fund investments are subject to a "prudent man" standard and to Department of Labor proscriptions on investment in subordinated debt. Accordingly, only highly rated senior tranches are eligible for purchase by pension funds.
Sales to pension funds are subject to general prohibited transaction/prohibited extension of credit rules.
Legal investment regulations applicable to insurance companies vary among jurisdictions. However, most insurance companies have specific authority to invest in debt securities only where there is a corporate issuer that meets a 5-year historic earnings test.
This five-year earnings test will be impossible for a newly formed issuer to meet except under a look-through analysis which subjects the HLT borrowers to the test.
Most insurance companies are also restricted from investing in debt of a foreign company, except certain limited investments where the debt is originated in a country where the company is authorized to do business or has outstanding policies.
Certain insurance companies have broader authority. For example, New York life insurance companies may invest in debt of a U.S. corporation or other entity so long as the issuer is solvent and the investment meets a prudent individual standard.
Finally, most insurance companies have leeway or basket provisions permitting any type of investment, but the dollar amount of basket investments is limited.
In light of the numerous restrictions on U.S. investors and the adverse impact of the worsening economy, upcoming CLO issues are likely to be structured with foreign buyers in mind.
PHOTO : Ms. Cahill is a partner with the New York law firm of Cadwalader, Wickersham, & Taft. Ms. Chalfin is an associate at the firm.