Debt Mutual Funds
An Attractive Alternative
The securitization of receivables is the sale of a pool of receivables to a dedicated special purpose vehicle (SPV), which finances the purchase by issuing securities on the market. Repayment of principal and payment of interest due under these securities is made with the cash flow generated by the assigned receivables.
The SPV's assets consist of the following:
- the pool of receivables that are purchased under the securitization transaction,
- the cash flow that is generated by the assigned receivables, and
- the liabilities in the securities issued on the market.
Until 1998 only the following entities could assign their receivables to a debt mutual fund:
- credit institutions;
- the Caisse des Dépôts et Consignations; and
- insurance companies.
The purpose of the 1988 law was to allow credit institutions to extend loans while respecting the Cooke ratio, which requires every credit institution to maintain an 8% ratio between its equity and funding commitments. Loan securitization is one of the most efficient ways to promote capitalization and profitability for credit institutions. It reduces the credit institutions' assets without compromising the profitability linked to these assets or affecting their commercial relationship with the assigned debtors.
Because of an insufficient legal framework and specific constraints under French law, corporate companies that wished to securitize their receivables before 1998 had to either (i) use off-shore securitization SPVs or (ii) transfer their receivables to a credit institution. This securitized the receivables in accordance with the law governing debt mutual funds. But two problems remained.
Firstly, an immediate assignment could be regarded as a fraudulent way of circumventing the debt mutual fund legislation. For this reason, the Commission des Opérations de Bourse (the French equivalent of the Securities and Exchange Commission) held that the credit institution acting as intermediary must hold the receivables for several months.
Secondly, the credit institution is legally responsible for collecting the receivables with regard to the debt mutual fund. The receivables' originator acted as sub-servicer of the receivables under the credit institution's responsibility, but the credit institution was not released from all liabilities.
The debt mutual fund legal framework was improved by various amendments and supplements, including the following legislation:
- the new act of July 2 1998;
- the decree of November 6 1998; and
- the act of June 25 1999 regarding savings and financial security.
The Act of July 2 1998 now authorizes corporate companies to securitize their receivables directly to the debt mutual fund. It has lifted three major constraints by:
- allowing the debt mutual fund to borrow;
- lifting the obligation to inform the debtors of the assigned receivables; and
- easing the conditions for the transfer and collection of the assigned receivables.
Debt mutual funds may now purchase receivables that are held by corporate companies directly. These companies have access to an off-balance sheet refinancing, without the costs incurred by an intermediary and under optimal market conditions, provided that appropriate credit-enhancement devices are set up at debt mutual fund level.
This extension of the eligible assets has already allowed the creation of FCC Facto at the end of 1998, which was created to acquire commercial receivables purchased by FactoFrance Heller and Securifact in November 1999. Both transactions were arranged by Gestion et Titrisation Internationales. Until now, no public market has been created, since both transactions were financed through multi-seller conduits and not directly on the public market. Other debt mutual funds are in the process of being set up. Based on US asset-backed securities market practice, this implies that new securitization practices will be implemented and that the volume of securitized corporate receivables will increase.
Since 1988 the scope of receivables that may be purchased by a debt mutual fund has been increased.
The debt mutual fund may purchase future receivables that arise from an agreement which has not been concluded and for which the amount and maturity remain to be determined (eg, future revenues from a determined client). The securitization of these future receivables may raise tax issues (see Current Issues).
The debt mutual fund may also purchase receivables that are frozen, doubtful or subject to litigation. However, in order to protect investors, the units issued by the debt mutual fund may only be subscribed or held by the following persons:
- the seller;
- non-French resident investors; or
- qualified investors.
A 'qualified investor' is considered to be any legal entity with the necessary skills and means to assess the risks related to financial transactions. Mutual funds are deemed to be qualified investors.
The debt mutual fund may also acquire receivables and issue securities denominated in foreign currencies (ie, euro, dollar and sterling). This prepares debt mutual funds for the introduction of the euro and widens the scope of possible originators and investors. It is now possible to set up debt mutual funds that are designed to acquire receivables owed by both French and foreign debtors. These are subject to compliance with the laws applicable to these foreign debtors (specifically in terms of the binding nature of a receivables transfer). This opens the route to pan-European securitization programmes and allows the debt mutual fund to benefit from opportunities in the currency market.
If the securities are denominated in a foreign currency, the debt mutual fund may enter into any type of hedging transaction (eg, swaps and options). This does not mean that the debt mutual fund may become a speculative vehicle. All hedging transactions may only be concluded for the purpose of matching the cash flow received by the debt mutual fund under the receivables with amounts that must be paid under the securities. These transactions may only be concluded with the following entities:
- the originator or an entity belonging to its group;
- a credit institution; or
- the Caisse des Dépôts et Consignations.
These provisions allow companies to manage their client risk by transferring it to the debt mutual fund.
The 1996 and 1997 amendments also further the development of securitization. They authorize the debt mutual fund to be reloaded, that is, to purchase new receivables after its constitution, and to issue securities from time to time.
Most commercial receivables have a short maturity. It is thus important that the debt mutual fund may purchase new receivables during its lifetime in order to maintain its pool of outstanding receivables. These subsequent purchases are financed either by (i) the collections received under the maturation of the assigned receivables or (ii) the issuance of new securities by the debt mutual fund.
This avoids the costs of establishing new debt mutual funds.
The only caveat is that subsequent purchases of new receivables and issuances of new securities must not negatively effect the level of security granted to investors of previously issued securities. Thus, if the securities are rated, new securities may only be issued if this will not downgrade the rating of the outstanding securities.
Obligation to notify
The assignment of receivables to a debt mutual fund is one of the easiest ways to assign receivables under French law. It is effected simply by the originator's delivery of a document entitled acte de cession de créances, which identifies the receivables, to the management company of the debt mutual fund. The assignment of the receivables becomes effective between the parties and is binding for third parties on the date indicated on the acte de cession de créances at the time of its delivery. The delivery also automatically transfers the security interests attached to the receivables to the debt mutual fund, without need for further formalities.
Under the 1998 act the originator is no longer required to notify the assigned debtors of the transfer of their receivables to a debt mutual fund, as this notice seemed to be detrimental to the commercial relationship between the originator and the assigned debtors.
In compliance with the 1988 act, this means of transfer gives rise to a true sale. It therefore permits off-balance sheet treatment for the originator, without the risk that a court may recharacterize the transfer as a loan granted to the originator and secured by a pledge on its receivables.
Debt mutual fund legislation previously provided that the collection of receivables created after January 1 1995 could not be transferred from the assignor to a third party, unless the underlying agreements include a clause that provides for the transfer. However, since corporates were not entitled to assign their receivables to a debt mutual fund prior to the July 1998 act, this clause was never used. The requirement for the clause has now been abolished.
Assigning matured receivables
Before June 1999 the debt mutual fund was not entitled to assign its receivables except upon its liquidation. This prohibition raised two types of issues.
First, the collection of receivables that are subject to litigation may involve a transaction between the creditor and a guarantor or a partner of the debtor, who will repurchase the receivables for a fraction of their price and collect them from the debtors directly. The fact that a debt mutual fund could not assign defaulted receivables prevented it from entering into these transactions, leaving the debt mutual fund in a less favourable position than other creditors.
Second, the value added tax (VAT) relating to unrecoverable receivables may only be recovered from the treasury by the original creditor of the receivables, provided that the creditor is still the owner of the receivables. Therefore, the original creditor must be entitled to repurchase unrecoverable receivables in order to recover the related VAT.
A recent amendment to the debt mutual fund legislation dated June 25 1999 now provides that a debt mutual fund may assign any receivable that matures, or for which the maturity has been accelerated, at any time.
Umbrella debt mutual funds
Many securitization professionals wanted to create umbrella debt mutual funds similar to the umbrella mutual funds authorized in France in 1998.
This was because investors generally penalize new issuers or new financial products entering the markets by imposing additional margins which reflect the innovation factor. Each newly created debt mutual fund that is regarded as a new issuer may be penalized for refinancing costs.
The debt mutual fund legislation already provided that debt mutual fund securities could give rise to different rights on the capital and interest of debt mutual funds. This seems to allow the segregation of receivables into different classes, each financed by a specific class of securities. But the position was challenged by some lawyers and rating agencies.
For that reason, the June 25 1999 act has expressly allowed debt mutual funds to contain different classes of receivables, just like umbrella mutual funds. Each receivables class is segregated to avoid the defaulted receivables of one class affecting receivables in another class, and is also financed by a specific class of securities.
Umbrella debt mutual funds containing various classes of similar securities should reduce additional margins imposed on new products or issuers and maintain an economy of scale for debt mutual funds.
Off-balance sheet treatment
The debt mutual fund is a secure and flexible way to securitize all corporate receivables, so long as accounting principles recognize the off-balance sheet treatment of the assignment of receivables to debt mutual funds. However, new international accounting principles and French accounting principles may make this difficult.
The French normalizing accounting authority, which is similar to the International Accounting Standards Committee (IASC), now requires the inclusion of a dedicated entity in consolidated financial statements, if (i) the entity is controlled by one or more subsidiaries of the originator and (ii) the controlling entities are shareholders or partners of the dedicated entity.
According to the IASC, consolidation of a dedicated entity is required in the case of any control, factual or legal of the originator on the dedicated entity. Under French accounting principles, however, consolidation is only required in the case of a legal control on the dedicated entity. Otherwise, in the case where the originator has factual control on the dedicated entity, complete information regarding the dedicated entity's assets, liabilities and incomes must be presented in an annex.
Under French accounting principles, there are three non-restrictive requirements to identify the control of an entity:
- "The company has real management and decision-making power over the dedicated entity or its assets, even if this power is not exercised. For example, the company may wind-up the dedicated entity, amend its articles or on the contrary, oppose an amendment;
- The company may substantially benefit from the dedicated entity's profits, whether through cash flow or various rights (the right to a fraction of net assets, the right to dispose of assets, the right to a majority of residual assets in the event of liquidation); and
- The company bears the risks related to the dedicated entity; this is particularly the case if outside investors benefit from a guarantee from the company or the dedicated entity, reducing substantially their risk exposure."
Some debt mutual funds are nothing but dedicated entities as described above, that is:
"a separate legal structure specifically created to manage a transaction or a group of identical transactions for the account of a company. The dedicated entity is structured or organized in a way that its activity is solely exercised for the account of that company, that provides asset, goods, services or capital to the entity".
But this does not mean that debt mutual funds will no longer achieve an off-balance sheet treatment. This will still be the case for multi-seller debt mutual funds. With respect to debt mutual funds set up by one seller, care should be taken when structuring the transaction, The auditors' approval should be sought at each major step of the transaction. Off-balance sheet solutions have always been found for securitization transactions.
The accounting principles that apply to credit institutions are more favourable, since they only deduct from the numerator of their Cooke ratio the portion of the risks they retain as originator.
The securitization of commercial receivables is still beset by the problem of VAT related to securitized receivables. If VAT is due upon collection of the receivables by the originator, the tax authorities may pretend that the payment to the originator of the purchase price of the receivables (and related VAT) enables the treasury to require payment of VAT, even if the receivables have not yet been paid by the debtors. In that case, the originator would lose most of the benefits of the securitization in terms of cash flow.
On the other hand, if VAT is due on the delivery date of the goods or on invoicing, it is due without waiting for the assigned debtors' payment. In this case, the main problem is VAT recovery on defaulted or matured receivables since the treasury requires that this recovery is made by the originator, who must also be the owner of the receivables.
This problem is common to securitization and factoring. In the case of factoring, a tax instruction dated September 29 1994 ruled that the originator may recover the VAT on defaulted or matured receivables even if the factor is still the receivables owner.
In securitization, this solution does not exist. But since the June 25 1999 amendment, the debt mutual fund may transfer defaulted or matured receivables back to the originator. This remedy, although more complex than for factoring, at least avoids the waste of the VAT credit by allowing the originator to recover the VAT.
The assignment of future receivables may cause a variation of the net assets of the originator (since the future receivables are not accounted for as assets on the originator's balance sheet), that is, a profit immediately taxable under Article 38 of the French General Tax Code. The consequence may be an acceleration of the tax paying process for the originator.
To reduce this adverse effect, the originator of future receivables should be authorized to set aside provisions for deductible charges that correspond to the charges that would have been necessary to generate the future revenues if the originator had not sold the future receivables. Currently the tax authorities have no clear position on this matter.
Standard bank loans are often risky since they cause greater dependence on the banks, which may terminate the loans under certain conditions. They are also costly and the interest rate depends solely on the borrower's credit.
The securitization of commercial receivables is an attractive alternative for corporate companies. It allows them to finance their activities by issuing securities on the basis of their business, at competitive costs and without any connection to the credit risk of the borrower.
Recent amendments to the French securitization framework will give rise to new practices and an increase in the volume of commercial receivables securitizations. Many transactions today combine domestic and offshore securitization, such as multi-seller conduits that finance on the commercial paper market the purchase of securities issued by debt mutual funds.
For further information on this topic please contact Gilles Saint Marc at Gide Loyrette Nouel by telephone (+33 1 40 75 29 34) or by fax (+33 1 40 75 69 77) or by e-mail ([email protected]).
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