Contents
- What are asset-backed securities in Canada?
- How do asset-backed securities work?
- What Canadian laws govern asset-backed securities?
- How can lawyers help clients with asset-backed securities?
- Asset-backed securities: Turning debt into opportunity
When corporations seek alternative funding, one option is securitization through asset‑backed securities. In Canada, various laws apply to asset-backed securities that corporations should be mindful of when engaging in securitizations.
If you're looking for the basics of asset-backed securities, how they work, and the laws surrounding them, this article is for you. For topics not discussed here, you can reach out to a Lexpert-ranked asset securitization lawyer.
What are asset-backed securities in Canada?
Asset securitization refers to the conversion of assets into marketable securities, which are then sold to interested investors. These assets may include streams of cash flows or other forms of receivables.
Asset-backed securities (ABS) are among the types of asset securitization. In an ABS, securities whose income or value is derived from pooled underlying assets are used to "back up" or collateralize these securities. The usual assets used in an ABS are those that generate cash flows from debts, including loans, leases, and other forms of receivables.
ABS take the form of notes or bonds, which pay interest until maturity.
Learn more about asset-backed securities in this short video:
To learn more about the legal aspect of ABS, speak with the best asset securitization lawyers in Canada as ranked by Lexpert.
How do asset-backed securities work?
To understand how ABS work, here's a simplified step-by-step guide on how this type of asset securitization is created:
- Lenders pool debts into one larger package: Individual loans are hard to sell on their own. This is why lenders collect many small income streams into one larger pool through ABS. Each borrower still pays the lender, but the pool will now support a single investment product – the ABS.
- Securitization turns the pool into tradable securities: Then, using securitization, the pool of loans or receivables is converted into investable securities. The pooled assets are then placed into a structure (e.g., a special purpose vehicle), which issues new securities that are now called ABS.
- Issuers bring the ABS to the market: The securities are then issued to investors in the primary market when they want to raise capital. Once these securities are in place, cash flows pass from borrowers to investors. When borrowers make payments (both principal and interest) to their individual loans, they go into the pooled structure, which is then passed to the investors.
We'll discuss more of these steps below.
Creating asset-backed securities
One important part in the creation of ABS is when the lender or the company sells the assets to a special purpose vehicle (SPV). These lenders are also called the "originators."
Investors, in turn, receive payments either at a fixed rate or a floating rate. These payments are made through an account (or a trustee account) funded by the cash flows generated by the pooled assets.
Special purpose vehicles (SPVs)
The SPV acts as the issuer, holding the pooled assets and issuing securities to investors. An SPV may be created in any of these forms:
- trust
- limited partnership
- separate corporation
The SPV may also issue different tranches with varying risk-return profiles.
Forms of asset-backed securities
An asset-backed security that the SPV issues may be in a form of:
- publicly issued ABS: offered by prospectus, which may be exchange‑listed or traded over‑the‑counter
- privately issued ABS: offered without a prospectus and traded privately
Examples of assets in asset-backed securities
Some examples of assets used in ABS include the following, based on the asset pooled together to be traded as securitized assets:
- credit card debt: cash flows or cash receivables arising out of credit card debt by several cardholders
- auto loans: receivables or cash flows generated from several car loan payments (including principal, interest, penalties, and pre-payments)
- student loans: outstanding student loans and interest from different students managed by a financial or educational institution
- intellectual property: cash flows generated by different types of IP (e.g., patents, copyrights, etc.), including the license agreements
Other uncommon types of loan may be used in ABS (which, in the perspective of the originator, is an asset since it will be generating income for them) are:
- equipment leases and loans
- fleet leases
- trade receivables
Difference between ABS and MBS
Mortgage-backed securities (MBS) are the securitization of pooled or packaged home mortgages, deriving their value from the cash flows of payments of home mortgages.
MBS and ABS are closely related; MBS are backed by mortgages, while ABS are backed by other receivables. Nevertheless, MBS and ABS work similarly, and the difference only lies in the assets used to create these securities:
- MBS: backed by home mortgages
- ABS: backed by other forms of loans or financing
Advantages of asset-backed securities
ABS can benefit both the issuer and investor in this way:
- additional source of capital: pooling receivables can convert expected cash flows into upfront funding
- income‑producing securities: investors receive principal and interest from the underlying pool; yields depend on collateral, structure, and tranche
Risks associated with asset-backed securities
As one of the many types of asset securitization, ABS risk varies by collateral, structure, and tranche. Payments depend on underlying borrower performance and deal terms.
Depending on the circumstances, ABS are often structured to be bankruptcy‑remote from the originator, which can mitigate the impact of corporate events, such as mergers and acquisitions (M&A) and financial restructurings.
For the originator, engaging in ABS can diversify funding sources. This provides it with additional capitalization to expand its operations.
Know more about ABS and the risks that come with it with this podcast:
More resources for investors and corporations can be found in our Special Edition on Finance Law.
What Canadian laws govern asset-backed securities?
Currently, there is no single federal law or regulating authority covering securities. This is why regulation of securities is shared between the federal and the provincial governments. Regulation, however, mainly falls under provincial and territorial laws.
Provincial securities regulators
Each province and territory has its own regulating authority for securities and investments. For example:
- Ontario: Ontario Securities Commission (OSC)
- Québec: Autorité des marchés financiers (AMF)
- British Columbia: British Columbia Securities Commission (BCSC)
Other provinces and territories have their own similarly named regulating authority. These authorities are established under provincial and territorial statutes. Together, they form the Canadian Securities Administrators (CSA), which coordinates securities regulation.
Federal regulations on securities
While there are no SPV‑specific federal requirements, SPVs must comply with applicable corporate/trust law. Federally regulated institutions involved in ABS may also be subject to OSFI guidance.
All originators, SPVs, and investors must also be aware of the anti-money laundering laws of Canada during the process of asset securitization. The main federal law for this is the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (PCMLTFA).
Federal bankruptcy and insolvency laws also apply when:
- an SPV is considered "bankruptcy remote"
- the originator has become insolvent or bankrupt
Depending on the circumstance, the federal laws on bankruptcy, insolvency, and financial restructurings may apply, including the:
- Bankruptcy and Insolvency Act (BIA)
- Companies' Creditors Arrangement Act (CCAA)
- Winding-Up and Restructuring Act (WURA)
How can lawyers help clients with asset-backed securities?
There are many ways that lawyers can assist clients, whether they're issuers or investors, when it comes to ABS:
- Help clients understand ABS: Beyond securities laws, contracts drive securitizations. Lawyers can explain cash‑flow waterfalls and who bears losses if borrowers stop paying.
- Explain the risks of ABS: One downside of ABS for investors is that it removes risky assets from the issuer's balance sheets and passes both payments and risk to investors. Lawyers can then help clients understand how this transfer of risk works and walk them through on who bears losses if borrowers stop paying.
- Translate term sheets and deal documents into plain language: ABS involve many moving parts; different asset types, pooling rules, payment structures, and rules on risk allocations. To support clients, lawyers can take the technical language used in term sheets and contracts and explain it in plain terms.
Asset-backed securities: Turning debt into opportunity
For issuers and investors exploring asset‑backed securities, working with an experienced securitization lawyer can give clear legal guidance and translate market practice into clear, practical steps. But with all the benefits and risks that come with these securities, it's important to learn first about the regulations that govern them, each party's legal duties, and the contract terms for each transaction.
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