Securitization, an act of issuing securities backed by a pool of revenue-producing assets, has existed for more than half a century. What started as an attempt to make the American Dream accessible has exploded, with securitized products now saturating the fixed-income assets market.

Some key benefits of securitization are the lower cost of funds, monetization of assets, and non-recourse to the originator or seller of the receivables. Most securitizations are structured under the premise that they would be derecognized from the sponsor’s or transferor’s balance sheet and would provide capital relief and the opportunity to free up capital to fund the growing demand for credit products.

However, getting derecognition treatment is a function of accounting, and one must play by accounting rules to get over that hurdle.

The assets being securitized drive the structural characteristics of the securitization, including the flow of the transaction and parties involved. In a securitization transaction, the sponsor/transferor transfers the financial assets to a bankruptcy remote entity – or BRE – which in turn transfers them to a special purpose vehicle. The SPV then issues securities backed by underlying assets for the benefit of investors.

The underlying principle for getting derecognition for a securitization transaction is the “surrender of control” over the transferred financial assets. In other words, if the control over transferred assets has been surrendered, the transferor should derecognize the transferred assets. Surrender of control is predicated on the transferor’s continuing involvement with the transferred assets.

The notion of continuing involvement is significant and is one of the most challenging aspects of the derecognition analysis. Quite often, the transferor maintains continuing involvement in the transferred financial assets, such as through a recourse arrangement, credit enhancements, or servicing of transferred assets. Although continuing involvement doesn’t necessarily preclude derecognition, one should carefully evaluate the level and form of involvement to determine whether it would impede the surrender of control notion.

The evaluation of continuing involvement is both a matter of law and facts. As part of evaluating it, the first hurdle is legal isolation and is a matter of law. In this step, the sponsor/transferor ensures that the transferred assets have been legally isolated from the transferor even in the case of bankruptcy or receivership.

Legal Isolation

One of the key criteria to meet the legal isolation test is to ensure that the entity to which the assets are transferred for securitization isn’t consolidated with the transferor. If the transferee would be consolidated by the transferor, regardless of whether all other provisions of ASC 860 are met with respect to a particular transfer, the transferred financial assets wouldn’t be derecognized in the consolidated financial statements.

A two-step construct is used by most securitization structures to overcome this hurdle. Under the first step, the company transfers the assets to a wholly owned BRE, which in turn, as a second step, transfers them to an SPV.

The two-step approach is important to get the legal isolation opinion from a legal counsel. The first step constitutes a true sale between the company and the BRE, while the second step most likely won’t qualify for true sale due to credit enhancements offered by the transferor to make securitized assets attractive to investors. These enhancements may include over-collateralizing, retaining the residual tranche, or even funding a reserve to be used in the event of default.

Although the two-step securitization structure involves two transfers, legal opinions only cover the first transfer (from the transferor to the BRE). That said, the risk of a bankruptcy court finding the second transfer as a financing transaction and not to be a true sale is mitigated by the BRE’s design, which makes the possibility of the BRE being forced into bankruptcy or substantively consolidated into the bankruptcy estate of its parent transferor remote. Despite the BRE being consolidated with the transferor, a “would-level” substantive consolidation opinion from a competent legal counsel will help meet the legal isolation criterion.

Exchanging or Pledging Assets

A restriction on the rights of the investors to pledge or exchange the asset would invalidate the surrender of control notion and may necessitate keeping the transferred assets on the balance sheet. This form of continuing involvement is a matter of fact and requires careful analysis. The inability to pledge or exchange the assets due to a lack of liquidity or regulatory limitation doesn’t invalidate the condition.

That said, securitization entities generally don’t have the right to exchange or pledge the transferred assets as the cash flows from those assets are required to meet the obligations to the investors. Accordingly, the guidance requires to “look through” to the ultimate investor’s right to determine whether there is any restriction on the investor’s ability to pledge or exchange the securities.

Maintaining Effective Control

The transferor should relinquish the control over transferred assets to get derecognition. Situations where effective control is maintained include a forward repurchase agreement, a call option held by the transferor, and a put option held by the transferee. All agreements that have been entered into contemporaneously or in contemplation of a transfer should be carefully evaluated to avoid the possibility of maintaining control through separate agreements.

Securitization structures have evolved and may involve a simple pass-through mortgage-backed security to much more complex structures, such as multi-seller asset-backed commercial paper conduits that include credit enhancements, liquidity arrangements, risk subordination features, swaps, and other derivatives. These may involve intricate relationships among the players involved. Securitization accounting rules are equally complex and heavily nuanced, but the right technical accounting professional can ensure the complexities are navigated correctly.

Originally published in Bloomberg Tax