In many structured finance transactions, the commercial intention among the parties is to effect a transaction resulting in a purchase and sale between a buyer (the party contributing funds) and a seller (the party contributing revenue streams from financial assets). Whether the commercial transaction that intends a sale, rather than a secured loan, for instance, is actually a sale for legal characterisation reasons has important implications for legal, tax and accounting purposes. Whether the assets in question, in the event of a bankruptcy or insolvency, of the asset originator form part of the estate of such originator, or are concluded to have been sold to the purchaser entity in an off-balance sheet transaction, is a question of critical importance. Creating a legal “true sale” can have real cost of funding and commitment availability implications for the deal in question. In this article, we want to introduce you to the key components of “true sale.”
Few components are as important to securitization or structured finance transactions as the existence of a “true sale” from the asset originator to the purchaser (whether such purchaser is a bank or other financial player or a special-purpose vehicle (“SPV”) created for this deal). In order to effect a securitization transaction, an originator has to remove (or “derecognize”) the securitized assets from the left side of its balance sheet (i.e. the credit column), and raise funds secured by those assets without incurring any additional liabilities on the right (i.e. debit) side. Accordingly, when closing a securitization transaction, counsel is often relied upon to provide a true sale opinion. The BC Tel case, discussed below, is the leading Canadian case on true sale considerations.
Metropolitan Toronto Police Widows and Orphans Fund v. Telus Communications Inc.
The principles behind what constitutes a “true sale” under Canadian law are derived from a relatively scarce body of case law. The main source of Canadian jurisprudence outlining the criteria regarding what constitutes a “sale”, or more specifically a “true sale”, is the Ontario Superior Court of Justice (the “ONSC”) decision in Metropolitan Toronto Police Widows and Orphans Fund v. Telus Communications Inc.[1] (“BC Tel”). In BC Tel, the action before the ONSC stemmed from the redemption by BC Tel of mortgage-backed Series AL Bonds (the “Bonds”) on December 30, 1997. The Bonds were redeemed through the application of the proceeds received by BC Tel from the securitization of its accounts receivable. The securitization of BC Tel’s accounts receivable was facilitated by RAC Trust, a special purpose vehicle sponsored by CIBC/Wood Gundy (“RAC”). The plaintiffs contended that the application of the proceeds from the securitization of the accounts receivable towards the redemption of the Bonds contravened the terms of the “No Financial Advantage Covenant” (or “NFAC”) contained therein, which forbade the application of “borrowed funds” towards the redemption of the Bonds. The plaintiffs’ argument hinged on whether the securitization transaction undertaken by BC Tel and RAC should be classified as a “loan”, as opposed to a “true sale”, thus rendering the proceeds thereof “borrowed funds”, in contravention of the NFAC.
Justice Ground spent a large part of the decision addressing the issue outlined above, and whether or not the securitization was, in fact, a direct borrowing by BC Tel. This is where the “true sale” as opposed to “loan” characterization was addressed. In his decision, Justice Ground found that: “It is the function of the court to determine the real nature of the transaction by considering not only the intention of the parties as evidenced by the language of the contract but the evidence as to how the transaction in fact transpired and the conduct of the parties in the performance of the contract.”[2] Accordingly, Justice Ground determined that the case at bar had been intended to be a “true sale”, due to the fact that the underlying agreement referred to the arrangement as a “sale” and that the parties, for the purposes of effectively completing the securitization transaction, required the transaction to be classified as a “true sale.”[3]
Justice Ground outlined the four main criteria in distinguishing between a “true sale” and a “loan” or “financing” transaction:
- the transfer of ownership risk and the level of recourse;
- the ability to identify the assets sold;
- the ability to calculate the purchase price; and
- whether the return to the purchaser will be more than its initial investment and a calculated yield on such investment.
In addition to the aforementioned factors, the intentions of the transacting parties, as informed by the factual matrix and surrounding the particular transaction, as well as the form of contract used by the transacting parties, may inform the court in determining whether a particular transaction constitutes a “true sale”, or a form of “loan” or “financing.”
Furthermore, in addition to the factors outlined above, where there is an assignment of accounts receivable, as was present in the subject transaction in BC Tel, other factors are taken into account in determining whether a transaction constitutes a “true sale”, including:
- the right to retain surplus collections;
- a right of redemption by the vendor/assignor;
- the responsibility for collection of the accounts receivables; and
- the ability of the vendor/assignor to extinguish the purchaser/assignee’s rights from sources other than the collection of the receivables.
It is important to note that although the final ONSC decision was overturned by the Ontario Court of Appeal (“ONCA”) on account of the ONCA’s finding that the securitization constituted an “indirect borrowing”, Justice Ground’s reasoning with respect to the elements of a “true sale” were undisturbed by the ONCA. As such, the “true sale” factors, as delineated in BC Tel, have been accepted as authoritative by subsequent courts.
Coutinho & Ferrostaal GmbH v. Tracomex (Canada) Ltd.
Another decision in which the BC Tel “true sale” principles were applied, was in the British Columbia Supreme Court’s (“BCSC”) decision in Coutinho & Ferrostaal GmbH v. Tracomex (Canada) Ltd. (“Coutinho”). [4] In Coutinho, Trac Chile acquired a tract of old railroads for scrap metal for about $1.2 million from C&F on a delayed payment basis. Prior to paying off the installments owed to C&F on account of its purchase, Trac Chile went ahead and “sold” the rails to a third party, Imbamar, for $462,494. The purchase contract included a repurchase option that allowed Trac Chile to buy the rails back after 180 days for $554,993, which amounted to a 20% premium on the original purchase price.
Although the agreement referred to the arrangement as a “sale”, Justice Voith of the BCSC found that all the elements of a “financing” or “loan” were apparent, and the substance of the transaction pointed towards the transaction being a “financing” and not a “true sale”. The contract in question contained customary financing clauses, such as the right to repurchase, and was discussed as a “financing”, during the course of negotiations. In addition to the substance of the transaction resembling that of a “financing”, there was no transfer of the ownership risk to Imbamar, as is required in a “true sale”, as per BC Tel. This was due to the fact that Trac Chile continued to bear the costs of liability insurance for the subject rails, and was also required, if it repurchased the rail, to reimburse Imbamar for the storage costs it had incurred.[5] Furthermore, in addition to the lack of ownership risk being transferred to the purchaser, the option to repurchase contained a premium on the original purchase price, which is in contravention of Justice Ground’s fourth “true sale” factor in BC Tel, namely, whether the return to the purchaser will be more than its initial investment and a calculated yield on such investment.
The above case summary and commentary provided an overview of the key components of true sale according to the leading Canadian court cases. Your Miller Thomson national Structured Finance and Securitization team is available to provide practical advice to our clients to assist in the structuring, documentation and implementation of deals that are intended by the parties to constitute a “true sale.” Please reach out to your Miller Thomson Structured Finance and Securitization contacts for assistance.
[1] 2003 CanLII 25909 (ON SC).
[2] Ibid at para 39.
[3] Ibid at para 40.
[4] 2015 BCSC 787 (CanLII).
[5] Ibid, at para 225.
