Asset Securitization Under Revised Art. 9
As discussed in last month's column, one of the most significant practical effects of the Article 9 revision is that many types of collateral and transactions not currently affected by Article 9 will be governed by the revised act. Although several of the revisions, like the provisions dealing with security interests in deposit accounts, merely expand the types of collateral that can be the subject of an Article 9 security interest, the asset securitization provisions extend Article 9 to new types of transactions that are not traditional security interests.
Over the past decade, securitization transactions have become an increasingly popular form of obtaining financing. There are a number of reasons why securitization has become so popular. However, from a bankruptcy and credit perspective, the major advantage of securitization is that it allows income-producing assets to be isolated from the credit of the business that originated those assets. For example, if a business generates valuable accounts, one way to structure the business's financing would be to loan against the accounts and obtain a traditional Article 9 security interest in those accounts. However, the lender would have to be concerned about the business's credit and could have many of its rights altered if the business filed for bankruptcy.
Securitization is an alternative that reduces the credit and bankruptcy risk. In a securitization transaction, a new "bankruptcy remote" entity called a "special purpose vehicle" (SPV) would be created. The business (the "originator") would transfer the accounts to the SPV in a "true-sale" transaction. The SPV would issue securities backed by the value of the transferred accounts. The funds generated from the sale of those securities would be used by the SPV to pay the originator for the purchased accounts. Finally, the investors in the SPV would be paid from the income generated by the collection of the transferred accounts. By separating the assets from the originator, securitization allows the financing to be based on the quality of the assets and not on the originator's credit. Further, since the accounts were sold by the originator, the bankruptcy of the originator has little impact on the financing transaction. Finally, if the SPV is properly constituted, it has no reason, and possibly no ability, to file bankruptcy itself.
The problem under current law is that the legal framework for securitization is based primarily on common-law principles that frequently are uncertain and may impose cumbersome and impractical requirements. By bringing most securitization transactions within Article 9, these common-law rules are replaced by a clear set of legal standards that are designed to encourage and protect securitization transactions.
Article 9 Applies to True Sales
Although current Article 9 generally applies to secured transactions, two classes of sales are covered by current law. Under current §9-102(1)(b),1 sales of "accounts" and "chattel paper" are governed by Article 9. The reason for this was that account and chattel-paper financing was often accomplished by selling the accounts at a discount, and it was difficult to distinguish between sales and financing transactions.
While this provision would appear to bring account and chattel-paper securitization transactions within the current Article 9 framework, it had the opposite effect in the Tenth Circuit. In the much criticized case of Octagon Gas Systems v. Rimmer, 995 F.2d 948 (10th Cir. 1993), the court reasoned that Article 9's treatment of such sales as secured transactions meant that the buyer obtained only a security interest. Under this view, accounts and chattel paper could not be "sold," making securitization of such assets difficult or impossible. Revised §9-318(a) is designed to overrule Octagon by providing that a debtor who has sold an income-producing asset does not retain a legal or equitable interest in the collateral sold. See, also, §9-109, cmt. 5.
With the Octagon problem solved, revised Article 9 provides the legal framework for securitization merely by expanding the classes of sales covered by the act. This expansion is accomplished in two ways. First, the definitions of "accounts" and "chattel paper" are expanded to include a broader array of assets. Second, the revision adds sales of "payment intangibles" and "promissory notes" to the scope of Article 9.
Although the definition of "accounts" under current law is limited to certain payment rights for goods sold or leased or for services rendered, the revised act greatly expands the accounts definition to include, inter alia, rights to payment for providing energy, lease payments for property other than goods, license fees, health-care-insurance receivables, credit or charge card receivables, and lottery winnings. Compare current §9-106 with §9-102(a)(2). This is a major expansion of the types of income-producing assets that can be subject to an Article 9 securitization transaction. In addition, the "chattel paper" definition has been expanded to include a new non-tangible category of chattel paper called "electronic chattel paper." See §9-102(11 & 31).
Two new classes of assets have been added to the types of sales that are subject to Article 9. They are "promissory notes" and "payment intangibles." See §9-109(a)(3). The term "payment intangible" is broadly defined as a "general intangible under which the account debtor's principal obligation is a monetary obligation." See §9-102(a)(61). This term would cover loan participations and may be broad enough to cover virtually any financial asset not already covered by the terms account, chattel paper and promissory note.2
Thus, the expansion of Article 9 to cover sales of accounts, chattel paper, promissory notes and payment intangibles will bring most financial-asset securitization transactions within Article 9. However, Article 9 will not apply to all sales of these types of assets. Section 9-109(d) excludes most sales that do not involve financing. For example, Article 9 will not apply where the assignment is for the purposes of collection only or where it is a part of the sale of the business. See, e.g., §9-109(d)(4 & 5).
Perfection of Securitization Transactions
The principal effect of bringing securitization transactions within the scope of Article 9 is that the Article 9 perfection and priority rules will determine whether the SPV has priority over other creditors of the originator, other transferees of the assets, the originator's trustee in bankruptcy.
The priority rules under the revised act are very similar to the priority rules under current law. The revision continues the "first-to-file-or-perfect" rule that determines the priority of conflicting security interests3 in the same collateral. However, the priority rules for lien creditors and trustees in bankruptcy have been modified slightly. Although current law requires that the security interest be "perfected" before the creditor becomes a lien creditor in order to obtain priority, the revised act will give the security interest priority from the earlier of the time of perfection or the time of filing of the financing statement if the debtor has authenticated the security agreement. See §9-317(a)(2)(A & B). The impact of this change is that the secured creditor's priority could date from a point prior to the time the collateral even came into existence.
As discussed in the March and April 2000 columns, the new rules for filing financing statements should make it simple to properly perfect a securitization transaction by filing. While perfection by filing will be the primary means of perfection in securitization transactions, special rules will apply to certain types of transactions.
With two exceptions, the rules for perfecting an Article 9-covered sale are the same as those for a traditional security interest. The exceptions are that both a sale of a payment intangible and a sale of a promissory note are perfected automatically without the need for filing a financing statement. See §9-309(3 & 4) & §9-310(b)(2). These exceptions will protect securitizations in those assets from bankruptcy attack even if the SPV fails to take any action to perfect. However, since these exceptions only apply to true sales, a financing statement should be filed in order to avoid the argument that the transaction was not a true sale. Note that under revised Article 9, a security interest in a promissory note can be perfected by filing. See §9-312(a).4
Since the August column, the revision has been signed into law in Illinois and Rhode Island. In addition, the act is awaiting signature in North Carolina and the District of Columbia. A total of 27 states plus the District of Columbia have passed or enacted revision bills, and 12 additional states have pending bills.
1 All citations are to the revised 1999 version of Article 9 of the Uniform Commercial Code, unless otherwise indicated. Citations to the currently applicable 1972 version of Article 9 are indicated by the term "current." Return to article
2 Schwarcz, Steven, "The Impact on Securitization of Revised UCC Article 9," 74 Chi.-Kent L. Rev. 947, 948 (1999). The Schwarcz article provides an excellent analysis of securitization under Article 9. Return to article
3 The term "security interest" would apply to a securitization transaction within the scope of Article 9. See §9-109, cmt. 5. Return to article
4 While both automatic perfection and perfection by filing for promissory notes will give the SPV priority over lien creditors and the originator's bankruptcy trustee, the failure to take possession of the instrument can result in a subsequent purchaser or secured party gaining priority. See §9-330(d). Return to article