An extract from The Securitisation Law Review, 3rd Edition
OverviewThe UK securitisation marketMarket size
According to publicly available market data, securitisation of UK-originated assets accounts for a sizable proportion of both European placed and outstanding issuances, with residential mortgage-backed securities (RMBS) being the most prevalent asset class in both cases.
In reality, the UK securitisation market is wider than the market for securitisation of UK-originated assets described above, as it is common for assets originated in other jurisdictions to be securitised using English law governed structures (as is usually the case for pan-European trade receivables and collateralised loan obligations (CLO) transactions) or for securitisation transactions to have some form of UK nexus, for instance through one or more parties being incorporated in England or bank accounts being held in England. Additionally, the UK market has, particularly over the past few years, experienced high levels of retained and privately placed securitisation transactions that may not be fully captured in publicly available data.
Over the past 18 months, despite the market challenges posed by the covid-19 pandemic, securitisation activity in the United Kingdom has remained at relatively stable levels, in contrast to the market shock caused by the 2008 financial crisis, which resulted in an almost immediate and abrupt drop in the level of new issuance. In fact, many companies are now looking to securitisation and other similar techniques as regular funding tools as part of their funding strategies.Asset classes
The UK securitisation market has been characterised by the continued existence of certain traditional settled transaction structures alongside periods of intermittent activity across various other product classes.
The UK RMBS market is very well established and is built on market practice consolidated over the years. Other product classes, such as consumer finance securitisation (including securitisation of credit card and auto receivables), trade receivables securitisation and commercial mortgage-backed securitisation (CMBS) are also fairly established.
There has also been a steady level of activity in other specialist product classes over recent years. These include loan portfolio acquisitions, student loan securitisations, whole business securitisations, mobile phone receivables securitisations, intellectual property rights and capital relief trades.
Fintech and the increasing digitalisation of financial services have opened up new opportunities for securitisation, with securitisation of peer-to-peer loans and the establishment of digital origination platforms associated with securitisation programmes being relatively common as of the end of 2019 and thereafter.Basic structure
Securitisation usually entails the transfer of a pool of income-generating underlying assets to a special purpose vehicle (SPV) incorporated in England or in another jurisdiction (often in Ireland, Luxembourg, Jersey, the Netherlands or the Cayman Islands) that in turn issues securities to investors, using the issuance proceeds to pay the purchase price for the underlying assets. Effectively, securitisation is a way of monetising the cash flows generated by the underlying assets.
Under English law,2 the transfer of the underlying assets is usually made by means of one of the following methods:
- equitable assignment;
- legal assignment; and
Other structures reach an effect similar to a transfer of underlying assets through use of other techniques (e.g., declarations of trust, sub-participation and, in synthetic transactions, guarantees and credit derivatives).
In UK securitisation transactions, provided that there are no contractual restrictions affecting the transfer of the underlying assets, the most common method of transfer is through an equitable assignment of the beneficial title in the underlying assets from the seller to the SPV. This method has various advantages, including the fact that the debtor of the underlying asset does not need to be notified of the transfer (and will only be notified after the occurrence of certain events specified in the transaction documentation, which typically include insolvency of the seller) and the possibility of transferring any security associated with the underlying receivables without the need to comply with further formalities. This latter point is particularly useful in the transfer of residential mortgage loans, as transfer of the legal title to the residential mortgage loans through a legal assignment would require the transfer of the mortgage collateral securing the residential mortgage loan to be registered with the HM Land Registry and could trigger potential tax liabilities.
Regulationi General regulatory frameworkDomestic legislation and regulation
Securitisation transactions governed by English law are, following the end of the Brexit transition period (as to which, see Securitisation regulation in the European Union and in the United Kingdom), subject to specific domestic legislation, including a taxation regime specifically designed to allow securitisation SPVs to achieve a certain degree of tax neutrality and that is currently being reformed (see Sub Section ii).
Moreover, the environment in which most UK securitisations are set is highly regulated, both in terms of its participants (which most often include regulated financial institutions), the activities performed by parties to the transactions (for instance, servicing activities that are subject to certain regulatory permissions and to specific regulatory regimes applicable to the underlying assets serviced) and the requirements applicable to the issuance of securities or granting of financing.
Additionally, the insolvency regime is of particular relevance to the structuring of securitisation transactions (see Section V). Changes to the UK corporate insolvency regime in 20203 do not impact the majority of UK securitisation structures but have proved to be relevant in relation to the wider universe of corporate entities within a transaction structure.Securitisation regulation in the European Union and in the United Kingdom
Until 31 December 2020 (the date on which the Brexit transition period concluded), securitisation activity in the United Kingdom was governed by Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December 2017 (EU Securitisation Regulation). From 1 January 2021, the 'on-shored' version of the EU Securitisation Regulation4 (UK Securitisation Regulation) has been applicable to securitisation activity with a UK nexus.
Although the UK Securitisation Regulation adapted the EU Securitisation Regulation for domestic application in the United Kingdom, the changes introduced have been identified as potentially creating a slightly different regime, including: the widening of the definition of 'sponsor' to include both entities located in the EU and outside the EU, the expansion of the jurisdictional scope of the due diligence requirements imposed on institutional investors and the introduction of a parallel simple, transparent and standardised (STS) regime for UK securitisations. In transactions with a cross-border element, some regulatory uncertainties subsist due to overlapping regulation and unclear scope of application.
Securitisation transactions are required to include an element of 'risk retention' – the idea being that a key stakeholder (such as an originator or sponsor) retains at least a 5 per cent interest in the transaction, using one of the methods prescribed in the applicable legislation – the 'skin in the game'. In terms of risk retention structures, the risk retention in UK transactions has, so far, been aligned with the risk retention structures compliant with the EU Securitisation Regulation. However, divergence may ensue, as the European Banking Authority has launched a public consultation on draft Regulatory Technical Standards on risk retention under the EU Securitisation Regulation, signalling potential changes to the EU Securitisation Regulation Regime, which may not be carried across into the UK risk retention framework.
The main risk retention structures under the relevant regulations can be summarised as follows:
- retention of a 'vertical slice' of at least 5 per cent of the nominal value of each class of notes issued;
- in revolving pools, retention of an interest equivalent to at least 5 per cent of the nominal value of the underlying assets comprising the revolving pool;
- retention of at least 5 per cent of randomly selected underlying assets;
- retention of a 'first loss tranche' in the transaction, corresponding to the most subordinated class of exposures in the structure amounting to at least 5 per cent of the securitised exposures; and
- retention of a 'first loss exposure' of not less than 5 per cent of every securitised exposure in the securitisation.
The retained material net economic interest should not be split among different types of retainers and should not be subject to any credit-risk mitigation or hedging (although limited carve-outs are available to allow for the financing of the retention piece).
Market practice has developed specific solutions for allowing risk retention in accordance with the above methods and for ensuring dual compliance with US credit risk retention requirements, where applicable. This is typically achieved through retention of an 'eligible vertical interest' corresponding to at least 5 per cent of the nominal value of each class of notes issued and structured as a 'VRR note' or 'VRR loan interest'.
It is anticipated that regional practices may develop over time in response to the particular requirements and circumstances of the post-Brexit UK securitisation market, potentially including an increasing need to ensure dual compliance with US credit risk retention requirements.ii Taxation
For most securitisation transactions, it is possible to achieve considerable tax neutrality as significant tax exemptions can be relied on for transactions that present certain typical features. However, a case-by-case analysis is required, particularly in more complex structures or where a strong cross-border element is present.Corporate income tax
While securitisation transactions are usually structured to achieve tax neutrality, certain taxation considerations apply in the United Kingdom, including in relation to structuring the SPV in a manner that minimises the liability of the SPV for corporate income tax.
There is a special corporation tax regime for 'securitisation companies' in the United Kingdom. The Taxation of Securitisation Companies Regulations 2006 (SI 2006/3296) (the 2006 Regulations) was introduced to tax securitisation companies on their actual cash profit, rather than on the accounting profit (to address potential distortions in accounting and tax reporting arising from accounting changes in 2005), ensuring minimal tax leakage from a structure where an English SPV is used.
For an SPV to be a 'securitisation company' for the purposes of the 2006 Regulations (as amended by the 2018 Regulations, as defined below), certain conditions need to be met, including:
- the securitised assets being considered financial assets for accounting purposes;
- all the cash received by the SPV within an 18-month time period being distributed (except where reserves of cash are required to be retained, for example for credit enhancement purposes); and
- the SPV satisfying certain requirements in relation to the issuance of securities and its status under UK insolvency law.
The Taxation of Securitisation Companies (Amendment) Regulations 2018 (the 2018 Regulations, jointly with the 2006 Regulations the UK Taxation Regulations) has updated and amended the 2006 Regulations to address the uncertainty regarding the application of certain tax rules to securitisation companies. The changes introduced by the 2018 Regulations include:
- removal of the obligation to withhold income tax in respect of residual payments;
- revisions to the definition of 'financial assets' (for arrangements made after 6 February 2018), to (among other things):
- clarification that derivatives whose underlying subject matters include land or shares and loan relationships with embedded derivatives relating to shares or land are included;
- disregarding of a small and insignificant proportion of non-financial assets inadvertently included in a portfolio of otherwise qualifying financial assets;
- exclusion of securitisation companies from the recovery of unpaid corporation tax provisions; and
- review of the definition of a 'warehouse company' to allow a warehouse securitisation company to transfer assets indirectly to a note issuing company or asset-holding company on a securitisation.
A reform of the UK Taxation Regulations is underway, featuring proposals to facilitate 'retained securitisation transactions' (i.e., those in which the securities issued are not placed with third party investors but acquired by the originator instead), to review the requirements that securitisation SPVs only hold financial assets and to review the thresholds enabling an SPV to qualify as a 'securitisation company' for the purposes of the UK Taxation Regulations.
General taxation issues, such as potential stamp duty and stamp duty reserve tax on issue or transfer of issued notes and withholding tax and VAT, are also relevant in the context of UK securitisations and may also be impacted by the ongoing legislative reforms.Withholding tax
In the United Kingdom, withholding tax generally applies to payments of interest (as at the date of this article, withholding tax is levied at the rate of 20 per cent). It is therefore important to ensure that appropriate withholding tax exemptions apply to all payments within the securitisation structure to avoid tax leakage.
Generally, payments of interest with a UK source may be paid without withholding of UK tax where the recipient is either a UK resident company or a non-resident carrying on business in the United Kingdom through a branch or agency to which the payment of interest is attributable.
Therefore, if the SPV is located in England, there is generally no UK withholding in respect of the underlying assets. Where payments of interest that arise in the United Kingdom are made to a non-UK resident company (including a securitisation SPV), these payments are usually subject to withholding and the SPV will generally have to apply for relief under an applicable double tax treaty. Non-UK resident SPVs that purchase English assets are generally located in Ireland, Luxembourg or the Netherlands, as each of these jurisdictions has a double tax treaty with the United Kingdom.
Payments of interest made by an English SPV can generally (and subject to certain exceptions) only be paid without withholding of UK tax where the SPV's securities are listed on a 'recognised' stock exchange and are therefore entitled to benefit from the UK 'quoted Eurobond' exemption.Stamp duty
Generally, UK transfer taxes (stamp duty, stamp duty reserve tax and stamp duty land tax) are levied only on transfers of shares, real estate and non-standard loans carrying characteristics that the UK legislation has deemed equivalent to equity. There are currently no other stamp duties or transfer taxes applicable to the issue of notes or transfers of receivables in the United Kingdom.iii Other regulatory regimes
Specific regulatory regimes apply to many underlying assets that are securitised. These regimes will continue to apply during the life of the securitisation and will often have a significant impact on the structuring of the transaction and on the ongoing obligations of the parties. Among the most significant regulatory frameworks to take into account are the Financial Conduct Authority (FCA) Mortgage Conduct of Business (MCOB) rules, applying to mortgage loans and the Consumer Credit Act 1974, the Consumer Rights Act 2015 and the rules and guidance contained in the FCA Handbook, notably the Consumer Credit sourcebook (CONC). It is also important to consider data protection legislation, including the General Data Protection Regulation and Data Protection Act 2018.
Certain transaction parties will also be subject to regulatory requirements set out in the Financial Services and Markets Act 2000 and in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544), such as the requirement for an entity seeking to grant further advances in relation to a mortgage loan to have the appropriate regulatory permissions (although most transactions will effectively deal with this issue by requiring another party in the transaction in possession of all required permissions to make any further advances required under the documentation governing the underlying assets) or the potential requirement for the servicer in an RMBS transaction to be an entity authorised to administer regulated mortgage contracts.iv Other regulatory concerns
Securitisation transactions involve a significant number of parties and components, often with a cross-border nexus. Therefore, changes in domestic or international regulation relating to commercial transactions in general (or in the interpretation thereof), including data protection and taxation, will potentially impact securitisation transactions.
Securitisation transactions will also be impacted by other market and industry-driven events, such as benchmark reforms, including the discontinuation of Libor by the end of 2021, which has been driving parties pre-emptively to transition away from Libor, usually by amending the terms and conditions of notes and the relevant transaction documents to feature a risk-free rate (usually SONIA).
Security and guarantees
In a typical 'true sale' securitisation transaction, the SPV will grant security over all of its assets, including:
- a purported fixed charge over the underlying assets it has acquired from the seller and their related security;
- assignment of its rights under the transaction documents;
- security over its bank accounts; and
- a floating charge, which will extend to all the assets of the SPV and crystallise upon the occurrence of certain events as set out in the documentation (typically following occurrence of an event of default under the transaction documents).
The formalities for creation and perfection of security under English law will depend on the nature of the assets over which security is created.
For most assets other than financial collateral,5 security granted by an English company6 requires registration with Companies House. Lack of registration will cause such security to be void and unenforceable against a secured creditor of the company or a liquidator or administrator in the context of the company's insolvency. When creating fixed security over receivables or deposits in a bank account, sufficient control over such receivables or deposits is required, otherwise there is a risk that the relevant security may be re-characterised as floating security.7
In English securitisations, security is typically granted in favour of a corporate trustee acting on behalf and holding security on trust for the SPV's secured creditors (i.e. the noteholders and other transaction parties). If the security needs to be enforced, the security trustee will enforce the security on behalf of secured creditors and in accordance with the provisions of the transaction documentation. Occasionally, security trustees will be required to exercise their discretion in relation to certain matters not provided for in the transaction documents or in relation to waivers or consents required under the transaction documentation. This will inevitably involve discussions with the transaction parties and is potentially a time-consuming and costly exercise (the security trustee would typically expect to be prefunded or indemnified in relation to any costs, expenses and potential liabilities relating to these processes).
In UK securitisations (unlike some other jurisdictions), receivables sales are not registered as security interests and generally security will not be taken over assets of the seller. It is common for the seller to grant declarations of trust over collection accounts in favour of the SPV.
Priority of payments and waterfalls
Priorities of payments in securitisation transactions will typically include a pre-enforcement waterfall and post-enforcement waterfall. This allows transaction receipts to be applied differently when the transaction is performing and following acceleration of the notes or enforcement of the transaction security (the post-enforcement waterfall is designed to work as a close-out priority of payments). While there is usually a single post-enforcement waterfall, it is relatively normal (depending on underlying asset class) to split pre-enforcement priorities of payment into two separate interest and principal waterfalls for separate application such that revenue receipts are used to satisfy interest and expense payments under the notes, and principal receipts are used to repay principal under the notes. However, the transaction documentation may specify additional trigger events that lead to application of other priorities of payment (by way of an example, on CMBS transactions, where the occurrence of certain loan failure events may trigger the application of a slightly modified pre-enforcement priority of payments).
The priority of payment provisions in securitisation transactions create contractual subordination at note level, which corresponds to the concept of 'tranching', which the UK Securitisation Regulation (as well as the EU Securitisation Regulation) has adopted as the central defining feature of a securitisation transaction. Tranching requires the existence of subordination, and therefore if a priority of payments only provides for pari passu payments under the various classes of notes issued (as opposed to payments in sequential or reverse sequential order), the transaction may not be considered a securitisation for regulatory purposes (and consequently certain requirements such as risk retention may not be applicable).
The priorities of payment also serve the key purpose of identifying the universe of secured creditors of the SPV and determining the order in which the amounts due to them by the SPV are paid during the transaction and upon enforcement of security. One of the typical issues that arises in this respect is the existence of 'flip clauses' in priorities of payments, whereby a swap provider's right of payment will rank subordinated to the payment rights of noteholders upon default by the swap provider. These provisions, once held unenforceable under New York law (although recent court decisions have shown a departure from this position), have been upheld by the English courts as enforceable under English law.8
Although it should be noted that priorities of payments change from transaction to transaction, an example of a few of the key items to be found in priorities of payments is set out in the table below:
|Pre-enforceent prorty of payents||Post-enforceent prorty of payents|
|Fees, epenses and aounts due to thrd partes prodng serces to the SPV (trustees, agents, cash anager, corporate serces proder, etc.)||Principal due under the notes||Fees, epenses and aounts due to thrd partes prodng serces to the SPV (trustees and ther appontees and receers, agents, cash anager, corporate serces proder, etc.)|
|Interest due under the notes||Ecess to be re-appled through the reenue pre-enforceent prorty of payents as aalable reenue recepts n the net nterest payent date.||Interest and Principal due under the notes|
|Top-up of reseres||SPV proft aount*|
|SPV proft aount*||Surplus (deferred consderaton to seller, resdual certfcate payents to resdual certfcate holders, etc.)|
|Surplus (deferred consderaton to seller, resdual certfcate payents to resdual certfcate holders, etc.)|
|* Prortes of payent relatng to transactons where an SPV s structured n accordance wth the UK Taaton Regulatons wll norally contan an te correspondng to the SPV proft aount, whch wll correspond to the taable corporate ncoe of the SPV for corporate ncoe ta purposes.|
Isolation of assets and bankruptcy remoteness
Securitisation transactions typically require the underlying assets to be insulated from insolvency risks associated with the relevant seller and the SPV to which the underlying assets have been transferred. These risks will arise if the sale of assets can be challenged or set aside upon insolvency of the seller or if the SPV is declared insolvent, respectively.i Seller insolvency risks
In typical UK securitisation structures, the transfer of the underlying assets from the relevant seller to the SPV is structured so that it should not, upon insolvency of the seller, be re-characterised by a court as a secured loan (in relation to which security would be unenforceable due to lack of compliance with registration requirements); this corresponds to what parties in the market tend to call a 'true sale' (often resulting in the de-recognition of such assets from the balance sheet for the relevant seller for accounting purposes).
There is not a defined set of rules prescribing the requirements of a 'true sale'. However, market practice and case law have firmed up a set of key principles that can be distilled to a single requirement: the transfer of the risk of the beneficial title to the assets from the seller to the purchaser should put the purchaser in the position of owner of such assets. Unlike in other jurisdictions, English courts tend to place great emphasis on the intention of the parties, often allowing certain pockets of asset risk to be retained by the seller (for instance, in relation to repurchase obligations arising in relation to assets that breach certain 'eligibility' representations and warranties given on the date of transfer). The interpretation of 'true sale' principles is very fact specific and requires detailed analysis.ii SPV insolvency risks
Bankruptcy remoteness in UK securitisation is typically achieved through use of an SPV. In typical 'true sale' transaction structures, the beneficial title to underlying assets is assigned to a newly incorporated SPV structured as an 'orphan company'. To achieve this result, the share capital of the SPV is, directly or indirectly, held by a corporate entity unconnected to the transaction parties (usually a corporate services provider) on trust for discretionary purposes.
Additionally, transaction documentation usually contains a number of provisions limiting the risk of SPV insolvency and the risk of consolidation with the seller, such as (but not limited to):
- covenants restricting the future activities of the SPV to those contemplated in the transaction documents, including restrictions on ownership of assets or of having employees;
- covenants requiring the SPV to be owned by a party unconnected with the transaction and independently managed;
- representations and warranties to ensure the SPV has not previously been engaged in any activities or owned any assets; and
- limited recourse and non-petition provisions designed to prevent SPV creditors from filing insolvency petitions against the SPV.
In certain types of transactions, particularly whole business securitisation, the above principles may require some adjustment, although it is usual to have a certain degree of bankruptcy remoteness at issuer level. It should also be noted that securitisation of English underlying assets may be structured with an international element, which will require consideration of the laws and market practice of other jurisdictions.
If a transaction is rated, rating agencies tend to analyse isolation of assets and bankruptcy remoteness very closely, as an effective isolation of assets and bankruptcy remoteness may allow for the credit rating of the relevant notes issued (or loans, as applicable) to be higher than the seller's credit rating due to the dissociation of risk from the seller and the limited scope for any creditors to seek recourse against the issuer. Any cross-border elements or deviations from the standard structure or issuer covenant package may introduce considerable complexity and risk and will require detailed analysis.
To date, the past 18 months have allowed UK securitisation to prove its resilience in challenging market conditions. The covid-19 pandemic brought about a flurry of consent requests relating to waivers and amendments regarding existing transactions, mostly to accommodate the impact of payment holiday schemes introduced by the FCA in relation to a number of assets (consumer credit, residential mortgages and motor finance) and to deal with various practical issues arising from lockdown. As the payment moratoria schemes are phased out and the economic circumstances deteriorate, it is expected that an increasing number of defaults will require transactions to further adjust.
The end of 2020 was marked by the end of the Brexit transition period, with substantial uncertainty in relation to a number of aspects of the post-Brexit regime applicable to securitisation and the prospect of potential regulatory divergence between the United Kingdom and the European Union, which started to materialise with the most recent amendments to the EU Securitisation Regulation9 (creating, inter alia, an STS regime for synthetic securitisations), which have not yet been reflected in the UK Securitisation Regulation.
However, throughout all of this, securitisation activity in the United Kingdom has increased, demonstrating the strength and resilience of the market.
While central bank funding is expected to be a crucial element for the maintenance of the UK securitisation market (as parties will need access to eligible collateral to access central bank funding schemes), the availability of central bank funding at attractive conditions has also been traditionally associated with a decrease in the incentive to securitise in certain product classes where underlying assets can be directly used as collateral in such operations at lower cost.
However, securitisation is seen as a robust funding source and appetite for securitised products looks set to remain strong. It is expected that sustainable investment and fintech will continue to have a major impact on the future of securitisation and that the post-covid-19 economy will benefit from the attractiveness of securitisation as a flexible funding tool.