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).