Until recently, securitization refinancing mechanisms were inaccessible in Russia for most non-mortgage banks, leasing companies, major lessors and real estate owners, business networks, power grid companies, public agencies and other companies capable of generating a continuous and more or less stable predictable cash flow, i.e. the types of companies typically able to avail themselves of the securitization mechanisms in the US and the Western European jurisdictions.
Finally, the Russian legislation allowed the mechanisms of securitization in connection with refinancing activity of many companies in the real sector.
Below we briefly describe who and how can use the mechanisms of securitization under the new legislation.
The object of securitization
Today, many companies in the real sector, faced with a shortage of funds, may invoke such traditional methods of financing as banking or debt financing, entry to shared financing markets (issuance of additional shares attracting new participants to the charter capital) or debt financing markets (issuance of corporate bonds) financing, factoring and attraction of the state budgetary financial resources.
Of course, not all methods are available to any company at a specific time, so the larger arsenal of tools the company possesses, the higher its chances of finding money from outside investors.
Securitization in its most general form is a bond issuance by the project company, which payments are secured by a constant stream of payments from the main activity of a company (the initiator of the transaction, or the originator). That is, almost any stream of payments may serve as a basis for the securitization transaction, including future payments that can be predicted with reasonable certainty for a certain period. Here are some examples:
- Lease payments;
- Consumer and auto loan payments;
- Payments to microfinance organizations;
- Payments from real property rentals;
- Charges for the supply of electricity, water, gas, etc;
- Charges for rendering of any permanent services (housing and other);
- Export charges (oil, electricity, metals);
- Revenues from the main activity of large companies - retailers (for example, retail chains );
- Payments from subscribers of telecom operators;
- Periodic long-term contractual payments;
- Any other constant and predictable uniform payments.
It should be mentioned that both claims in existing (i.e. already signed) contracts and claims in future contracts may be objects of securitization.
For a long time, Russian legal practice in applying the securitization law was rather inconsistent on the question of the possibility of acquiring future claims: firstly, the possibility of transferring of the future claims is expressly provided only for factoring contracts, while the general rule of assignment does not give any clarification on this matter, and secondly, the courts have different understandings of "future claims", sometimes including there only the claims from the existing obligations, whose period of performance has not come due yet. Sometimes the courts also include in "future claims" the claims from the obligations that have not been created yet. This uncertainty forced Russian companies to use foreign jurisdiction in securitization transactions.
However, the Federal Law 21.12.2013 № 379-FZ " On Amendments to Certain Legislative Acts of the Russian Federation" (hereinafter - the "Law 379-FZ"), which introduced significant changes in the regulation of securitization in Russia, has stipulated that future claims include the claims that have arisen from both existing and future obligations.
It is sufficient if the information on the obligations and the debtors is specified in the documentation in a general way, i.e. through data which allows the creditors to individualize monetary claims and identify persons who are or may become debtors in respect of these obligations.
Thus, now many companies can find claims that may be subject to securitization as part of its indebtedness.
Pro et contra
Securitization has a number of advantages compared to other methods of financing:
Securitization has off–balance – sheet nature, so that the debt is not reflected on the balance sheet of the originator, which may result in improving of financial indicators (coefficients) of the legal entity; Issued bonds can get a higher rating than the originator of the transaction has, which automatically makes them more attractive; A thicker layer of protection of investors from bankruptcy and default of the issuer is achieved, which reduces the cost of borrowing for the originator; The diversification of funding sources and the range of potential investors occurs; The credibility and image of the originator are enhanced; Does not require a lien on fixed assets from the originator, and the originator does not need to comply with numerous covenants, which are typical for credit agreements.
Significant enthusiasm for securitization is often said to be one of the causes of the financial crisis in 2008. However, in our opinion, these risks are less typical for Russia due to limitations placed on the Russian security market, and close supervision of the Bank of Russia.
The following disadvantages of the securitization should be noted:
The complex structure of the transaction compared to a number of other different ways of financing;
Relatively high cost of the preparation and documentation of the transaction; Rather long period from the start to the closing of the transaction (2-3 months); It is necessary that the originator of the transaction has a sufficient pool of similar claims.
How we do it in Russia…
As we have pointed out earlier, securitization involves the issuance of bonds, but in contrast to ordinary corporate bond issuance, such issuance is realized through a special project company (called in a Western manner, as a rule, an “SPV”).
Starting on 01.07.2014, it will be possible under the Russian legislation to create SPVs in the form of specialized financial organizations (hereinafter - the "SFOs"). It should be noted that this is not a new organizational form of legal entities, it is a kind of a status given to the business entity in case it meets certain specified requirements.
The main task of the SFO is to protect the interests of the bondholders.
For this reason, significant restrictions are imposed on the activities of such companies:
The name of such company shall contain a reference to its status as an SFO; Its legal capacity is limited both by law and by the Charter; An SFO can not be voluntarily reorganized and can be eliminated only with the consent of the bondholders; An SFO’s charter capital can not be reduced; The authority of the sole executive body of an SFO is given to a management company; it is prohibited from having employees (which ensures the priority of the claims of the creditors in the event of bankruptcy).
In many ways, the legal status of an SFO is similar to a mortgage agent, which is long-known under Russian law.
The general scheme of securitization is presented on the below scheme 1:
The company (the originator of the transaction) assigns monetary claims under existing and/or future contracts, generating cash flow, to the specially created SFO (under an assignment agreement). It should be remembered that an SFO must be independent from the originator - this is one of the basic principles of securitization.
An SFO issues bonds, placing them in the market and thereby attracting funds for payment of the monetary claims received from the originator under the assignment agreement, as well as the payment of the costs associated with its current, though very limited, economic activities.
All further payments received from the former debtors of the originator arrive into the SFO's special assigned account. The possibility of pledge of rights under the bank account is one of the most radical changes in the law, and it comes into force on 01.07.2014. (Note: previously, under the Information Letter of the Higher Arbitration Court from 15.01.1998 № 26, the Russian judicial practice was based on the impossibility of lien of the monetary funds in the account by virtue nature of "non-cash").
Under the new law, monetary funds received from debtors under pecuniary obligations, claims under which are pledged to the bondholders, are to arrive in the assigned account and can be spent by the SFO only on the interest and principal payments on bonds. The issuer's capability of obtaining similar monetary claims on account of these monetary funds may be provided in the issuance documentation. Our legislation is definitely lacking such a rule regarding a pledge by operation of law for realization of internal securitization and security of the interests of bondholders (similarly to mortgage collateral).
Inability to prioritize claims secured by a pledge of movable property is often cited as another disadvantage impeding the development of non-mortgage securitization, aside from the absence of mechanisms of pledge of claims under bank accounts in the current legislation. If in respect of real estate it is always possible to correlate the preceding and subsequent mortgages according to the Unified State Register of Legal Entities, correlating in respect of the pledge of a majority of types of movable property is a problem under the current Russian legislation.
This problem has both a practical and related to it theoretical-legal aspect. From a practical point of view, the mortgagee - bondholder has no opportunity to verify the quality of the pledged movable asset (and a loss of the mortgagor's rights or even a potential chance for subsequent dispute over such asset leads to the rise in the cost of financing for the issuer).
From the perspective of further disputes between several mortgagees, a contradictory position in the practice of the courts should be noted. On the one hand, it is forbidden to foreclose on the mortgaged property, which was acquired from the mortgagor for value received by a person who neither knew nor should have known that the acquired property is subject to a pledge. On the other hand, the legislation does not establish exemptions that would allow for a release of the person who purchased the mortgaged property from obligations passed to him or her from the mortgagor on the grounds that during the acquisition of such property he or she was not aware of
the burdens imposed on him or her. Such uncertainty in court practice could cause unpredictable risks for bondholders.
Law 379-FZ, as well as previously adopted Federal Law dated 02.10.2012 № 166-FZ "On Amendments to Fundamental Principles of the Legislation of the Russian Federation Concerning Notarial Services and Some Legislative Acts of the Russian Federation" attempt to eliminate the urgent question of chattel mortgage introducing a unified information system of notarization. We are leaving beyond the framework of this article the questions of formation and functioning of this notarization system; we are only pointing out the provisions that are relevant to the asset - backed securitization market.
Under the new system, the secured bond issuer shall submit to the unified information system of notarization (the “UISN”) the required information on the pledge that secures issued bonds. On the one hand, this allows the bondholders to control mortgage coverage, however, on the other hand, this precludes recognizing of other mortgagees as acting in good faith. It will make impossible the termination of the pledge or equation of rights (or priority) of such other persons acting in good faith with the bondholders.
Assumption of risk by the originator
A partial assumption of the credit risk by the originator is one of the conventional elements of securitization deal, which is ordinary attained be repurchase of the minor obligations bonds tranche. The principal and interest on such bonds are to be paid only after paying off the investors.
Russian law does not authorize the parties to choose an order of priority for the fulfillment of the contract obligations. Before the adoption of the Federal Law №-379, the subordination of the obligations was allowed only with respect to the mortgage-related securities. Since the 1st of July 2014, the tranching is permitted not only in respect of all types of the secured bonds, but also in respect of the issuer's contracts secured by a single securities portfolio.
Moreover, the originator has acquired the right to assume the risks of no less than 20% of the total amount issued by an SPV (or a specific financial company with respect of 379 - Federal Law terminology) in forms and volumes fixed by the Bank of Russia.
These innovations should allow to simplify the transaction's structure and increase the attractiveness of securities for investors by assumption by the originator of the risk of non-payment.
Thus since 2014, not only the credit institutions will be authorized to use the securitization in order to attract investments, but also many companies from the real sector will be able to avail themselves of this financing mechanism. In addition, the entire transaction can be accomplished under the Russian jurisdiction, which (1) makes this process cheaper for the originator, (2) allows to attract a wider range of local investors and (3) makes the decision making more comprehensible for the management and for the stakeholders.