The capital access door began to re-open in mid-1995 for Latin American companies able to issue securities backed by future foreign currency revenues. The complex structure of these financings permits the securities to benefit from a credit rating higher than the 'sovereign ceiling' on the debtor's home jurisdiction, which in turn dramatically improves the securities' marketability. In the past year, securitizations of future cash flows have been the most innovative and vigorous segment of the capital markets accessible to Latin American private sector companies, with approximately US$2.8 billion of such transactions completed in 1995 alone (see Box 1). This article explains future cash flow securitization transactions, examines key financial and legal issues and assesses prospects for future developments in the transactions.

Basic transaction structure

Future cash flow securitizations begin with an originating company in an emerging market that SPE, and the obligors on the receivables (or contract rights) agree to make payments directly to an offshore account in the name of the SPE. The transactions usually take one of two forms, depending on the nature of the originator's transfer to the SPE: either the originator sells the assets to the SPE (a 'sale structure'), or the originator grants the SPE a first priority security interest in the assets securing a note issued by the originator to the SPE (a 'note structure').

The SPE issues securities evidencing or collateralized by the right to receive the future foreign currency cash flows. The securities typically come in two varieties: term securities issued to investors which evidence the right to periodic principal and interest payments over the pre- defined term (usually three to seven years) and residual certificates retained by the originating company which evidence the right to receive all remaining cash flows after the term securities have been paid in each period.

Often the SPE will issue several different classes of securities, each with a different maturity, interest rate or method of calculating interest (eg fixed versus floating rate). After issuing the securities, the SPE receives payment on the export receivables or the contract rights, and the originator retains its receivables servicing obligations. In each payment period (usually one month or three months), after the SPE has made all contractual debt service payments, the originator has a right to receive all remaining cash flow. If certain specified events occur (such as insolvency of the originator, a fall in overcollateralization ratios, or cross-default to debt of the originator), the term certificates have a right to all cash flow until fully repaid. In addition, in some transactions the originator retains a full or partial recourse obligation (see figure 1 below).


Figure 1: Future Flow Schematic - Sale of Receivables

The transactions obviously depend on the ability of the originator to produce and sell its export products and/or services until repayment in full of the term securities. If the originator fails to generate export receivables or, in a securitization of contract rights, fails to perform its obligations under the contract, the receivables' obligors or the contract counterparties will stop payments to the SPE. Without revenue, the SPE cannot make payments on the securities. Future cash flow securitizations are a bet on the continued viability of the originator, as under any secured or unsecured term loan. The transactions do not rely entirely on the quality of existing receivables, and accordingly do not involve the issuance of securities that are truly asset-backed.

The structure minimizes the sovereign risks inherent in securities offerings from issuers located in non-investment grade countries by separating the emerging market issuer from the source of the securities' repayment. If the foreign currency revenue to be used to repay the securities never crosses the border into the originator's country, and the offshore SPE issuing the securities has a first claim on the revenues, the securities largely avoid two of the main sovereign risks associated with the originator's country: devaluation risk and repatriation risk.

Investors increasingly look to the credit ratings that securities issues receive from independent rating agencies such as Moody's, Standard & Poor's and Duff & Phelps to determine the securities' level of repayment risk. Generally, a securities issue from an issuer in an emerging market will receive a rating no higher than the country's foreign currency sovereign rating, because even the best company in the country will be affected by the local government's monetary policy and ability to service its own foreign currency debt. As a result, if the local government does not have an investment grade rating for its foreign currency obligations (generally BBB- or better in the Standard & Poor's and Duff & Phelps rating systems), the rating agencies' 'sovereign ceiling' will prevent local companies from achieving an investment grade rating on their own foreign currency obligations.

Future cash flow securitizations, if properly structured, allow a company in an emerging market country to 'vault over' the sovereign ceiling, achieving a foreign currency credit rating higher than the country's sovereign rating. In this way, an emerging market issuer can open the door to longer-term and much cheaper financing than it could otherwise obtain. These benefits will in most cases outweigh the substantial transaction costs and administrative inconvenience incurred in structuring and operating under the securitizations. Future cash flow securitizations depend on complex structures intended to isolate an originator's foreign currency cash flow from the sovereign risks of the originator's home jurisdiction. These structures raise a host of legal issues, summarized below. Key financial and rating agency issues are summarized in Box 3.

What type of SPE to form

The starting point for every issue of securities is the identity of the issuer. Most future cash flow securitizations in the emerging markets use a bankruptcy-remote trust or corporation specially organized for the transaction.

Issuance by an offshore SPE helps to isolate the sovereign risks in the transaction by placing the actual issuer and its assets out of the legal reach of the originator's home jurisdiction and by facilitating offshore collection of receivables proceeds. Most future cash flow securitizations to date have been completed through SPEs taking the form of master trusts created under New York law. Investors generally prefer a US issuer because of the greater certainty as to US legal and tax issues and because some investors, such as US insurance companies, face regulatory constraints on their ability to purchase securities issued by foreign entities. For US tax purposes, these master trusts take the form of the 'credit card trusts' commonly created for US credit card securitizations, rather than grantor trusts or owner trusts, to allow flexibility in issuing different classes of securities. These master trusts issue securities usually referred to as trust certificates.

The key US tax issue with a credit card trust structure is whether the originator's transfer of the receivables to the SPE properly should be characterized as a mere collateral device securing a loan to the originator or rather as a sale from the originator to the SPE, which would cause the SPE itself to be subject to taxation. Although the transfer may be characterized as a sale for purposes of bankruptcy law (and perhaps accounting standards) in the originator's home jurisdiction, investors generally will require that the transfer be treated as a secured loan for US tax purposes, so the trust certificates are taxed as debt instruments. The US IRS takes the position that the tax characterization of a trust structure as a sale or secured loan depends on several factors, including particularly:

* whether the scheduled principal and interest on the purported debt (ie the certificates) is reasonably expected to be repaid according to its terms based on the existence of adequate collateral, guarantees or other credit enhancements; and

* on the investors' ability to realize the benefits of the appreciation of the receivables transferred to the trust. (See IRS General Counsel Memorandum 34602, September 9 1971 for a list of factors affecting the analysis).

In almost all future cash flow securitizations, use of this test leads to characterization of the transfer as a secured loan, particularly when the originator retains substantial recourse obligations for the performance of trust certificates. As a result, for US tax purposes the issuer of the securities will not be an independent, taxable entity, but merely a security mechanism.

Formation of an intermediary SPE

Some future cash flow securitizations use not only a New York master trust or other form of SPE, but also an intermediary SPE in a non-US offshore jurisdiction. In the most common two-tier structure, the originator sells receivables to a special purpose trust organized under Cayman Islands law, which issues certificates that are sold in turn to a US master trust.

The principal reason for creating such a structure is to isolate the receivables not only from the sovereign risks of the originator's jurisdiction, but also from US bankruptcy risks. From a US bankruptcy perspective, a two-tier transaction helps ensure that a 'true sale' of receivables from the originator to a non-US entity has occurred that is not subject to the jurisdiction of US bankruptcy courts. If a true sale occurs under applicable local law, the assets transferred to the intermediary SPE are beyond the reach of a bankruptcy court in the originator's home jurisdiction or the US if the originator becomes insolvent.

Without this two-tier structure, there remains a risk that the originator's insolvency might lead to the originator's transfer to the SPE being recharacterized as a security interest by a US bankruptcy court if the originator filed for bankruptcy in the US or its US assets otherwise came under the jurisdiction of a US bankruptcy court in connection with a foreign insolvency proceeding. Acceptance of jurisdiction by a US court is unlikely if the originator lacks US property other than the US bank accounts maintained by the SPE to collect the receivables. Application of US law on the transfer issue should not occur if the transaction documents provide for the originator's local law to govern. However, US bankruptcy courts have wide discretion in their rulings, which leads the rating agencies to prefer the safety of a two-tier structure.

If a US bankruptcy court with proper jurisdiction were to rule that the originator's transfer of receivables to the SPE was not a true sale, investors' prospects for timely repayment would be grim under the US Bankruptcy Code. First, investors would be stopped by the Code's automatic stay provisions from pursuing any recovery actions against the debtor, such as attachment proceedings against the receivables or other property of the debtor. Second, investors would be likely to lose their security interest in receivables generated after the bankruptcy filing, because under the Code property acquired by the debtor after the filing remains property of the debtor's estate and not subject to a lien created under a security agreement entered into before filing (unless the property was 'proceeds' of assets previously acquired and subject to such a prior security agreement). As a result, investors would be 'undersecured' creditors under the Code (ie creditors owed a principal amount of debt greater than the value of their security). Third, to the extent investors are undersecured, the debtor may be able to recover, as a preferential transfer, any debt service payment made within the 90 days before the filing.

Rating agencies should require a two-tier structure, and its increased transaction costs, only if the originator seeks a credit rating for its future cash flow-backed securities that is above its 'shadow' local currency rating. The originator's local currency rating reflects the risk that the originator will become insolvent. If the credit rating for future cash flow-backed securities' issued by the SPE mirrors the originator's local currency rating, the credit rating should reflect fully the risk of the originator's insolvency and any related risk that a US bankruptcy court would become involved as the insolvency proceeds.

Transfer of assets

From a ratings perspective, the nature of the originator's transfer of export receivables or other contract rights represents the legal key to a future cash flow securitization. The rating agencies generally require assurance on three related transfer issues: firstly, that the securitized assets have been validly transferred to the SPE under applicable local law; secondly, that such transfer has been 'perfected' under applicable local law in the sense that a local bankruptcy court would not find that the transfer could be challenged successfully by either the bankrupt originator (and hence other creditors of the originator in bankruptcy) or third party transferees with a claim on the assets; and thirdly that the SPE has a claim on the assets prior in right to all other claims.

If these three conditions are met, the SPE will have a prior claim to the transferred assets ­ under either a sale structure or a note structure ­ free from any legal challenge at all times short of the originator's insolvency. The rating on the securities should reflect the SPE's legal rights, because in most cases the rating will mirror the originator's local currency rating, which in turn reflects the assessed probability of the originator's insolvency.

The originators' transfer to an SPE takes the form of either a sale (in a sale structure) or a secured loan (in a note structure). Although a number of large secured export note transactions have been completed using the note structure, investors may prefer the sale structure because the SPE purportedly owns the assets and the assets may escape originators' bankruptcy proceedings, which tend to be lengthy, contentious and cumbersome in emerging market jurisdictions. Investors should not exaggerate this advantage of a sale structure. Virtually no precedents exist in most countries as to whether a future export 'sale' would be respected in a bankruptcy proceeding, and the insolvent originator's creditors are certain to attack the transfer regardless of its likely characterization. Moreover, an insolvent originator will probably experience a drop in sales and ultimately may face liquidation. The receivables 'sold' to the SPE will not exist if the originator no longer produces and sells its products. Nonetheless, rating agencies may be willing to assign a transaction a rating above the originator's local currency rating in cases where the originator's insolvency would be unlikely to slow the generation of receivables or entail losses caused by a local insolvency proceeding.

Differences between the law of the originator's home jurisdiction and the law of the SPE's organization, and between the rules governing transfers for bankruptcy, tax and accounting purposes in various jurisdictions, provide opportunities for legal 'arbitrage'. Many transfers in single-tier securitizations are sales for bankruptcy purposes in the originator's home jurisdiction, but secured loans for US and home jurisdiction tax purposes and for home jurisdiction accounting purposes (particularly if the originator retains recourse obligations). Two-tier transactions incorporating a true sale from the originator to an offshore intermediary SPE are more likely to be considered a sale for multiple purposes, which may be necessary if the originator has issued debt instruments containing a negative pledge clause that would prohibit granting a security interest in its assets.

In many future cash flow securitizations for emerging market companies, the company guarantees certificate payments (either periodic payments or on final maturity) or otherwise provides recourse for the securities. The degree of recourse available in these transactions would be incompatible with sale treatment of the asset transfer for US bankruptcy purposes. However, many civil law jurisdictions permit a sale with partial or even complete recourse. As a result, these securitizations often take advantage of legal arbitrage that rating agencies and investors find particularly attractive: securities issues that combine a prior claim to the issuer's foreign currency cash flows that is arguably free from court interference on insolvency, and, to the extent these cash flows are inadequate, full recourse to the issuer's remaining assets.

The bankruptcy, tax and accounting treatment of future cash flow securitizations often present uncertainty in the originator's home jurisdiction or in the jurisdiction of an intermediary SPE. Resolving the uncertainty may require approvals from local tax, banking, monetary or securities regulatory authorities. These approvals may require months to obtain.

Perfection of the transfer is the second transfer issue that the rating agencies analyze. Whatever the legal form of the transfer for the purposes of local bankruptcy law, the transfer must be properly perfected under the law of each applicable jurisdiction. Because it may not be clear which law governs perfection of the transfer, lawyers often take care to perfect under each jurisdiction's law that may apply, usually those of the originator's home jurisdiction, the US, the obligors' jurisdiction and the law of the contract (if any) being assigned. In most Latin American countries, the civil law provides that written notice to the obligor perfects a transfer by sale, the type of transfer generally preferred. This notice can usually be stamped or pre-printed on the originator's invoices to its customers, simplifying the transaction's administrative requirements, particularly in securitizations of export receivables where customers change over time. A simple written notice may not be sufficient to perfect a transfer for security purposes, which might be necessary in cases where the originator faces contractual or other legal restrictions on outright sales of its assets.

Perfection of the transfer under US law presents no additional administrative burdens of any significance. Under the Uniform Commercial Code (UCC), the perfection procedure is identical for transfers of assets (assuming the assets constitute 'accounts' or 'general intangibles' under the UCC) by sale and as collateral security. Generally, if the emerging markets transferor has an executive office in a US state, a UCC filing in that state perfects the transfer. If the transferor has no executive office in the US, and the assets transferred consist of accounts or general intangibles for money due or to become due (ordinarily true of future cash flow securitization), then written notice also perfects the transfer for purposes of US law.

Of course, the rating agencies typically are not content with simple written notice of transfer to obligors. The rating agencies require a separate, written contractual commitment by obligors (or at least a substantial portion of obligors) to make payments to the SPE rather than to the originator. This written commitment between each obligor and the SPE knits together the securitization structure and prevents originators from circumventing the structure by later requesting that obligors make payments to the originator. In most jurisdictions, these agreements clearly also perfect the transfer of assets to the SPE.

Priority is the third transfer issue that the rating agencies analyze. In a sale structure, the priority of the transfer should be absolute, because the transferred assets become the unencumbered property of the SPE. In a secured note structure, the security interests of the SPE may be subject in bankruptcy to prior claims of employees, government tax claims or other claims provided under the insolvency statutes of the originator's home jurisdiction.

The rating agencies typically require, as a condition to delivering their ratings letter, that the originator's counsel in its home jurisdiction, in the jurisdiction of any intermediary SPE, in the jurisdiction of the most important obligors and in the US have delivered legal opinions as to the desired effect of the transfer under local law. In addition, the transaction documentation will contain extensive representations and warranties by the originator as to the transfer. The material inaccuracy of these representations and warranties typically constitutes a default event under the transaction documentation, giving rise to a suspension or termination of the originator's right to receive residual cash flows from the SPE until investors have been fully repaid.

Investment Company Act issues

Almost all future flow securitizations involve the use of a US SPE, usually a trust formed under New York law. Almost all SPEs formed in the US fit within the basic definition of an 'investment company' under the Investment Company Act of 1940 ­ "any issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities" ­ because the SEC staff interprets 'securities' broadly to include receivables, certificates of deposit and virtually all other financial assets, even if those assets are not 'securities' for the purposes of other US securities laws. However, if an SPE were required to register as an 'investment company' under the 1940 Act, the Act's exacting requirements as to multiple classes of securities, restrictions on affiliated transactions, custodial control of assets and other matters would render most transactions unworkable. (see Box 4)

Under the newly enacted National Securities Markets Improvement Act of 1996, SPEs in most future flow securitizations will rely on new Section 3(c)(7) under the 1940 Act to exclude the SPEs from the definition of 'investment company'. Section 3(c)(7) generally will eliminate 1940 Act concerns in all securitizations that are not public offerings and that involve trust certificates sold only to 'qualified purchasers', a category that will include entities owning and investing on a discretionary basis not less than US$25 million in investments. However, new Section 3(c)(7) will not become effective until the earlier of April 9 1997 and the adoption of certain rules by the SEC.

Until Section 3(c)(7) becomes effective, the SPEs in most future flow transactions will escape the registration requirements of the 1940 Act by relying on the exceptions to the definition of 'investment company' under either Section 3(c)(1) of the 1940 Act or Rule 3a-7 promulgated under the 1940 Act. Under Section 3(c)(1), an SPE will not be an 'investment company' if no more than 100 persons beneficially own any of the securities issued by the SPE (excluding short- term paper). Enforcing this limitation requires the issuer to monitor ownership of the securities, and clearly may limit the liquidity of the securities. (see Box 5) As a result, issuers prefer to rely on the Rule 3a-7 exemption from the 1940 Act.

Rule 3a-7 was adopted by the SEC in 1992 to facilitate the issuing of securities by SPEs in securitization transactions. Issuers can rely on Rule 3a-7 by meeting four requirements, all easily met in typical asset-backed securities offerings that rely on existing assets as collateral. In future flow securitizations, reliance on Rule 3a-7 may be blocked by one of the four requirements: that the issuer issues securities which entitle their holders to receive payments that depend primarily on the cash flow from 'eligible assets'. Rule 3a-7 defines 'eligible assets' as "financial assets, either fixed or revolving that by their terms convert into cash within a definite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to security holders". The question, in a future cash flow securitization, is whether the future receivables or contract rights being securitized will convert into cash within a definite time period or otherwise assure a timely distribution of proceeds.

Unlike a securitization based on existing receivables, which are an existing obligation to pay cash within a definite time period, future securitizations depend on financial assets that do not yet exist. However, in addition to future receivables and contract payments, future cash flow securitizations almost always include full or partial recourse to the originator. This recourse can be characterized as an additional financial asset of the SPE, essentially the originator's promissory note. These recourse obligations should convert into cash in a definite period and clearly are intended to assure timely distribution of proceeds.

Conclusion

Structuring future cash flow securitizations for an emerging markets issuer requires a major commitment of time from the issuer, as well as the incurrence of high transaction costs to cover fees and expenses of bankers, lawyers, accountants and rating agencies, consultants and other advisers. Issuers will only endure the time commitment and the transaction costs if the securitization offers substantial rewards, either in the form of longer-term financing or lower financing costs. Companies in non-investment grade countries that have strong export earnings or other sources of foreign exchange have found that the investment grade rating provided by properly-structured transactions opens the door to financing sources that would otherwise be closed, and at interest rates and maturities that compare favourably to the wildest days of the emerging market Eurobond excesses of 1993 and 1994.

Emerging market financing has rebounded smartly since the Mexican peso's devaluation in late 1994. Bank lending to blue chip companies in investment grade and near-investment grade countries has been particularly strong. When banks and bond investors once again open their pockets wide to companies in countries farther down the ratings scale, the market will have signalled that there is no need for future cash flow securitizations. Until then, the transactions will continue, particularly for companies in need of long-term funds unavailable in the syndicated bank market.

Box 1: Recent history of emerging markets securitizations

The recent history of future cash flow securitizations from emerging market issuers divides roughly into three periods:

* an initial phase from 1987 to1990 during which Latin American companies made tentative forays into the international capital markets using export securitization structures because cheaper sources of capital were unavailable;

* a second phase from 1991 to1994 during which the volume of export securitization fell as Latin American companies increasingly were able to issue 'plain vanilla' Eurobonds with relatively low transaction costs; and

* a third phase following the devaluation of the Mexican peso during which Latin American companies found that investors' sovereign risk concerns closed all foreign currency financing alternatives other than securitizations.

Characteristics of these three phases, and a sample of the notable transactions from each phase, are summarized below:

Phase I: 1987-90

a Market rationale: Initial entry of Latin America's most creditworthy companies into the international capital markets, relying on dollar-based cash flows; cheaper sources of capital (with lower transaction costs) unavailable.

b Deal characteristics:

(i) 'Financial flow' securitizations by Mexican banks are most common; bank assets securitized are contract rights under credit card servicing contracts with Visa and Master Card.

(ii) Other issuers in 'financial flow' or securitized contract right transactions:

* Mexico/Brazil/Honduras/Costa Rica/Jamaica/El Salvador: international telephone receipts originated by local telephone monopoly from correspondence agreements with AT&T.

* Mexico - Comisión Federal de Electricidad: payment rights under power contracts with San Diego Gas & Electric.

* Mexico/Brazil - national airlines: payments from US air carriers.

* Mexico - Banco Mexicano: US Post Office and American Express-originated money orders placed from the US.

(iii) Issuers in export receivable securitizations:

* Mexico - Pemex: Creation of a master trust structure to securitize future oil receivables.

* Guatemala - Associación Nacional de Café: receivables from exportation of coffee.

Phase II: 1991-94

a Volume of export securitizations falls as Latin American companies gain access to international capital markets. 'Plain vanilla' bond issues have important advantages for issuers in a receptive market: lower transaction costs, simplicity of documentation, no effect on cash management procedures, speed of execution.

b However, local currency-denominated securitizations grow in importance as investors become more comfortable with country risk. Market rationale: Credit enhancement and proper deal structure can overcome risk on local currency receivables.

c Deals:

* Toluca Toll Road Trust (1992): US$300 million securitization of peso receivables from Toluca toll road.

* Tribasa Toll Road Trust 1 (1993): US$110 million securitization of peso receivables from two Mexican toll roads.

* MC - Cuernavaca (1994): US$265 million securitization of peso receivables from the Mexico City - Cuernavaca toll road.

Phase III: 1995-present

a 'Tequila Effect': Eurobond market for Latin American companies disappears after devaluation of Mexican peso.

b Market rationale: Currency risk is dominant concern. Financial flow and export receivable securitizations are a major source of medium-term capital, using structures that resemble those from late 1980s and early 1990s.

c Pioneering Deals:

* Mexico - Banamex Moneygrams: US$206 million securitization of Moneygram contract rights. Tenor: four years.

* Argentina - YPF: US$400 million securitization of oil export receivables generated from sales to ENAP. Tenor: seven-year final maturity/four-year average life.

* Brazil - Aracruz: US$150 million securitization of export receivables from pulp & paper manufacturer. Tenor: seven- and five-year final maturity/five- and three-year average life.

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Box 2: Types of cash flows securitized

Future cash flow securitizations divide primarily into two asset types: securitizations of export receivables and securitizations of payment rights under long-term contracts. According to Duff & Phelps, of the US$8.3 billion in securitizations between 1987 and 1995, approximately 41% consisted of export receivable transactions and the remainder of contract right securitizations.

The most commonly securitized export receivables are generated by commodities, such as crude oil, minerals and petrochemicals, often under long-term supply contracts. If the obligor under the contract defaults in paying for a shipment of the product, future shipments of a semi- commodity can be more easily sold to other buyers than highly-processed products tailored to a particular buyer.

Banks and other financial institutions are the most common issuers in securitizations of future flows from contract rights. In the most popular transactions, banks securitize their right to receive future dollar payments, under contracts with US credit card companies, intended to reimburse the banks for their payments in local currency to local merchants for purchases made with credit cards. In workers' remittance transactions, the banks securitize their right to receive dollar payments, under contracts with money order providers, intended to reimburse the banks for their local currency payments to local residents flowing from cross-border money orders originating in the US. At least one rating agency has indicated that, from a ratings perspective, securitizations of financial flows by banks are preferable to export securitizations because they are less likely to be affected by export controls.

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Box 3: Key financial issues/rating agency concerns

A successful transaction structure isolates and reduces the sovereign risk inherent in any future cash flow securitization. The commercial risk relating to the originator remains and will be carefully analyzed by the rating agencies. Duff & Phelps, Moody's and Standard & Poor's have all published summaries of their analytical methodology for future cash flow securitizations. Although the methodologies differ somewhat, the rating agencies share a common approach.

The originator

The analysis begins with the emerging market company originating the export receivables or owning the contract rights from which foreign currency payments rights derive. The rating agencies look at the company's financial and commercial health to assess the likelihood of the company being able to continue to produce the export receivables or perform its obligations under the contract being securitized. This analysis essentially requires the rating agency to develop a 'shadow' rating of the company's local currency debt obligations, which will estimate the probability that the company will be able to service its local currency debt on a timely basis. This shadow rating serves as a rough proxy for the performance risk inherent in the transaction. Assuming that other aspects of the securitization are acceptable ­ the commercial risk ratings of the obligors under the receivables are satisfactory and the various aspects of sovereign risk have been minimized ­ the shadow local currency rating usually approximates the foreign currency rating assigned to the securities. In some cases, where a local insolvency is unlikely to affect the company's ability or willingness to generate receivables or perform under the contract being securitized, the rating agencies may consider assigning a foreign currency rating higher than a company's local currency rating.

The product/the receivables/the purchase contract

Commercial risk characterizes the second set of issues examined by the rating agencies. The securities being rated rely on payments received by the SPE from customers of the originator. All or at least a majority of customers should be strong financially, with a long-term dependence on the originator's products. If there are only a few customers, purchases should be made under a strong, long-term purchase contract, or, alternatively, the customers should have few other suppliers. If the originator has many customers, their diversification in terms of industry, location and product may be more important than the existence of purchase contracts. The rating agencies will expect the originator to supply three to five years of payment history from its customers, detailing its experience with write-offs for non-payment, purchase price reductions for defective goods, regularity of payments, and other matters. This data has particular importance in transactions where no written purchase contract exists.

Over-collateralization is a key aspect of the commercial risk in a future cash flow securitization. The rating agencies generally require customers to sign an agreement with the SPE issuing the securities, whereby each customer acknowledges that the receivables it owes have been transferred by the originator to the SPE and agrees to make payments on the receivables directly to the SPE. The rating agencies will require that the SPE's expected periodic receipts are a substantial multiple of the SPE's debt service obligations.

The amount of the over-collateralization multiple varies according to the type of securitization, the nature of the product in an export securitization, the strength of the purchase contract and other aspects of the transaction. Generally, however, the rating agencies will require over- collateralization ratios of between three and six.

Terms and structure of the securities issued

A third general area analyzed by the rating agencies ­ the terms and structure of the securities issued ­ relates to a mixture of performance and sovereign risk. Generally, the rating agencies will examine the basic terms of the issue to ensure neither the originator nor the government authorities in the originator's home jurisdiction will have an economic incentive to circumvent the securitization structure either by the originator's own actions or by government action. (Attempts to circumvent the structure might include requests to customers to pay the originator rather than the SPE, sales by the originator to new customers that have not agreed to pay the SPE, government export controls and government moratoria on debt payment.) Further, the terms of an issue will include contractual provisions designed variously to knit together the securitization structure, control the originator's behaviour and provide an early warning of financial stress in the transaction. Relevant issues include the following:

* Amount: the principal amount of the securities offered in comparison to the principal amount of the originator's other debt obligations (the rating agencies prefer securities offerings that represent a small proportion of the originator's total debt, because the originator and the local authorities will have less incentive to circumvent the securitization structure);

* Maturity: the maturity of the security being offered (the rating agencies prefer shorter maturities and securities that amortize by regular principal payments, because long tenors and bullet maturities raise greater refinancing risk and are less predictable);

* Reserve account: the creation of a debt service reserve account, which must be fully funded before making distributions to the issuer in any payment period (the account generally is fully funded from the offering proceeds, in an amount ranging from three to six months' debt service, at the date of the securities' issuance);

* Covenants: the imposition of performance, financial and receivables-related covenants, an amalgam of the covenants generally found in Eurobond offerings for emerging markets issuers and in asset-backed securities offerings;

* Default triggers: the establishment of specified default events that will trigger a suspension or a definitive termination, until payment in full of investors' term securities, of the originator's right to receive residual cash flow after regular debt service payments on the term securities (examples include issuer insolvency, cross-default, judgment default and other events resembling typical Eurobond defaults, as well as 'triggers' relating to declines in the degree of over- collateralization by receivables paid or generated).

The contractual terms of offerings, particularly covenants and default events, vary substantially among future cash flow issues and reflect extensive negotiations among the issuer, its bankers, the rating agencies and often 'lead' investors. Unlike Eurobonds issued by emerging markets investors before the Mexican peso devaluation, no 'standard' package of terms exists; each issue's terms are tailored to the originator, the obligors, and the nature of the receivables or contract rights securitized.

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Box 4: Tax issues

Future cash flow securitizations raise a host of tax issues for the originator and the SPE, which often affect the viability of transactions. In addition to the issue of entity-level taxation for the SPE discussed above, tax issues relate to withholding tax on interest, stamp tax on asset transfers and capital gains tax on asset transfers. The resolution of these issues often turns on whether the originator's transfer to the SPE can be characterized as a sale or security grant. Generally, an originator's sale of assets will require payment of a capital gains tax, while a secured loan will require payment of a withholding tax on interest. In addition, the existence or rate of stamp tax may vary depending on whether a transfer is a sale or security grant.

Because transactions often can follow either the sale or security path, local counsel should determine in a transaction's earliest stage which has more favourable tax consequences. Local counsel may determine that transactions that have mixed sale/security characteristics cannot be clearly defined as a sale or security grant for local tax purposes, particularly when the desired treatment for local bankruptcy purposes (eg a sale) differs from the desired characterization for local tax purposes (eg a secured loan). In these cases, a ruling from local tax authorities may be required to confirm the desired tax treatment.
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Box 5: Legal investment issues

US insurance companies have been major purchasers of securities issued in future cash flow securitizations. As an investor class, the insurance companies make a vital contribution to many issues' success, because they tend to purchase long-term securities (ie 5-12 year tenor) to match their long-term liabilities.

State laws and regulations govern the type of securities insurance companies may purchase. Although laws and regulations vary among states, insurance companies generally face strict limits on the amount of non-investment grade securities and foreign securities that may be purchased. For example, under the Model Investments Law now being drafted by the National Association of Insurance Commissioners (NAIC) the non-investment grade share of the portfolio of a life and health insurance company cannot exceed 20%, the foreign share of the portfolio cannot exceed 20%, and the share of the portfolio accounted for by investments in any single foreign jurisdiction that does not have a sovereign rating of at least NAIC-1 (ie at least A­ on a Standard & Poors or Duff & Phelps scale) could not exceed 3%. These restrictions typically are cumulative, such that the foreign limitations and non-investment grade limitations both apply.

Insurance companies clearly have an interest in classifying future cash flow securities as US investments to avoid using their limited allotment of foreign investments for the securities. Some insurance companies have classified the securities as US investments in reliance on the fact that the securities' issuer ­ the SPE ­ was a US trust.

The NAIC, an insurance company self-regulatory body responsible for US insurance companies' investment valuation issues, has not taken a formal position on whether future cash flow securitization using a US SPE should be classified as US or foreign investments. Few state insurance commissions have taken a position on the issue. However, it appears that staff at the state insurance commissions that have considered the issue believe the emerging market originators of the future receivables, not the US SPEs, should be considered the issuer of the securities in future cash flow transactions, which reflects the economic substance of the transactions. The NAIC's Model Investments Law provides that securities issued by a US 'shell business entity', if the obligor or the securities is a foreign entity, will be considered a foreign investment. Once passed in any state, the Model Investment Law is unlikely to affect classifications by local insurance companies of completed emerging market securitizations using US SPEs. But even before the Law's implementation, the Model Investment Law's approach may influence how state insurance regulators classify the transactions, and that influence is likely to become more pronounced as state regulators become more familiar with the approach.

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by: Douglas A. Doetsch, Mayer, Brown & Platt, Chicago, Nov. 1996

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