In "securitization" transactions, a corporation typically sells assets that produce a regular stream of income, such as accounts receivable, to a financing vehicle that raises the funds to pay for the assets by issuing its own debt obligations.  A crucial legal issue in such transactions is usually whether there has been a "true sale" of the assets to the financing vehicle.  It is an essential element to the credit rating of the debt issued by such entity that the securitized assets are its property and thus not exposed to claims of the seller's creditors in an insolvency of the seller.  Because the form of a securitization transaction typically has a number of elements similar to a secured financing, rating agencies require legal opinions that there has been a true sale of the assets.

The Telus Case

The only Canadian judicial decision on the true sale issue is Metropolitan Toronto Police Widows and Orphans Fund v. Telus Communications Inc.  In the Telus case, the plaintiffs claimed that a redemption of bonds made by Telus' predecessor, BC Tel, using the proceeds of a conventional securitization of a portion of BC Tel's accounts receivable to a multi-seller conduit trust sponsored by CIBC Wood Gundy, violated a covenant in the bond indenture (a no financial advantage covenant or "NFAC") against early redemptions "by the application, directly or indirectly, of funds obtained through borrowings having an interest cost to [BC Tel] of less than [the rate of interest on the bonds to be redeemed]".  The redeemed bonds had a market price of $115 per hundred and were redeemed at $103 per hundred, for a loss of $12 per hundred to the plaintiff bondholders.

The Telus case has generated considerable attention in the securitization industry as it has worked its way through the courts.  If the court had agreed with the bondholders and had re-characterized the sale in the securitization transaction as a secured loan, the ability to achieve bankruptcy remote securitizations under Ontario law could have been jeopardized and tens of billions of dollars of asset-backed securities could have faced sharp downgrades by the credit rating agencies.

The Trial Decision

After a painstaking examination of the securitization transaction, the trial judge declined to re-characterize the sale as a secured loan.  He held that the transfer by BC Tel to the trust had been a "true sale" of the receivables, notwithstanding that some elements of the securitization transaction had features that were similar to a secured financing.  As in most securitization transactions, the formula for calculating the deferred portion of the purchase price payable by the Trust for the receivables effectively resulted in BC Tel bearing the interest costs paid by the Trust on the commercial paper issued to fund the initial payment of the purchase price.  Any excess in the amount ultimately collected on the receivables over and above the initial payment plus the interest and other costs would, through the deferred payment mechanism, ultimately be for the account of the seller rather than the Trust.  Since the securitization transaction was a "true sale" of the receivables, the trial court concluded that by definition the sales proceeds did not amount to a borrowing, direct or indirect, by BC Tel. 

The Court of Appeal Decision

Sparing the securitization industry and the Canadian bond markets a potential catastrophe, the Court of Appeal in its decision (released on June 8, 2005) agreed with the trial court that the securitization transaction involved a "true sale" of the receivables and therefore the securitization proceeds were not proceeds of a borrowing directly by BC Tel.  However, the Court of Appeal concluded that the use of the securitization proceeds to redeem the debentures amounted to the application by BC Tel, indirectly, of funds obtained through borrowings by the Trust having an interest cost to BC Tel substantially lower than the interest cost on the bonds.  The Court of Appeal held that the entire securitization transaction had to be looked at as a whole.  It involved not just the sale of assets by BC Tel to the Trust but also the borrowing by the Trust in the commercial paper market to pay for the receivables purchased.  The Court noted that while the NFAC required that the interest cost must be to BC Tel, it did not say that the borrowing must be by BC Tel or by someone related to BC Tel.  The securitization proceeds funded the bond redemption, the securitization proceeds would not have been forthcoming without the borrowing by the Trust and the interest cost of the borrowing was borne by BC Tel under the terms of the receivables purchase agreement.

What's New about the Appeal Decision

In reaching this conclusion, the Court of Appeal seems to be making new law. In neither of the two previous cases discussed by the Court of Appeal in Telus was the redemption found to violate the NFAC.  In the only prior Ontario decision, Manufacturers Life Insurance Company v. Dofasco Inc., the Court held that Dofasco's redemption of debentures was not made in violation of an NFAC almost identical to the one at issue in Telus.  At the time of the redemption, Dofasco had cash reserves greatly in excess of the amount needed to redeem the debentures, but it was also in the process of borrowing money at a lower interest rate for a non-related use.  The Court held that the borrowed money was not indirectly used to redeem the debentures.  The Courts in both Telus and Dofasco cited as persuasive an earlier Delaware decision in Shenandoah Life Ins. Co. v. Valero Energy Corp.  There the issuer was found not to have violated the NFAC where it simultaneously raised borrowed funds at an interest cost lower than the debentures to be redeemed and issued equity.  Each of the debt and the equity components of the reorganization produced more than sufficient funds to redeem the debentures, but the issuer segregated the funds from the equity offering and applied them to the redemption.  The Delaware court discussed examples of "indirect" uses of borrowed money for purposes of redemption.  In the first example, the issuer borrows money to purchase an asset, which it then immediately sells and uses the sales proceeds to redeem the debt.  In the second example, a subsidiary of the issuer borrows at a lower interest rate than the debt to be redeemed and makes a capital contribution to the issuer with the proceeds of the borrowing.  The issuer then uses the capital contribution to redeem the debt.

Neither Dofasco nor Valero Energy suggests that a borrowing by a person not related to the issuer can amount to the issuer "indirectly" using borrowed funds to redeem debt.  The critical difference in Telus seems to have been that the securitization documents explicitly transferred to the issuer the economic benefit of the lower rate of interest on the funds borrowed by the arm's-length third party, once the issuer had used the proceeds of the sale to redeem the higher-cost debt.  However, it is unclear how far the Court of Appeal's reasoning could be extended.  Could it, for example, have reached the same conclusion if BC Tel had redeemed the bonds with proceeds of the sale of real estate excess to its needs and, to BC Tel's knowledge and with its cooperation, the purchaser had paid for the real estate with the proceeds of mortgage financing?

Implications of the Telus Case

Parties engaging in securitization transactions and investors in asset-backed securities will be relieved that the Court of Appeal in Telus has confirmed the trial court's analysis and not called into question the characterization of such transactions as true sales.  However, the case suggests that the courts may interpret anti-redemption provisions in indentures strictly against the issuer – particularly in the context where an issuer utilizes an innovative transaction structure to overcome the intended effect of those provisions.  Any issuer that is considering alternatives for funding the redemption of debt that is protected by covenants similar to that in Telus should consider carefully the implications of the decision.

For further information, contact Michael Clifford (416.863.5501), Jim Rumball (416.863.5524) or David White (416.863.5586).

Davies Ward Phillips & Vineberg LLP, with over 225 lawyers, practises nationally and internationally from offices in Toronto, Montréal, New York and Paris, and is consistently at the heart of the largest and most complex commercial and financial matters on behalf of its North American and overseas clients.

The information and comments contained herein are for the general information of the reader and are not intended as advice or opinions to be relied upon in relation to any particular circumstances.  For particular applications of the law to specific situations, the reader should seek professional advice.