Accounting Relief for German True Sale ABS
German accounting requirements for an off balance sheet treatment of receivables in a securitisation transaction (so called ‘true sale’) have often caused concern. A circular published by the German accountants association IDW in 2002 has, since then, been blamed for making true sale transactions under German law very difficult to structure. Now the IDW has amended its circular – with positive results.
In a true sale securitisation transaction a company seeking to raise finance (usually referred to as the originator) sells receivables to a special purpose company (SPC). The SPC in turn issues debt securities to fund the purchase price. The aim of a true sale securitisation transaction is not only to fund the originator but also to ‘remove’ the securitised receivables from the balance sheet of the originator. The receivables are usually sold at a discount on their face value in order to protect the purchaser against the first loss risk. Such discounts are, as a rule, preliminary, ie, they will be refunded to the extent they have not been necessary to cover losses. On the other hand, if the actual defaults exceed the discount, the receivables purchase agreement will most likely provide that the purchaser must ultimately bear the loss exceeding the discount.
On 1 October 2002, the IDW published the circular IDW RS HFA 8 (Circular), which gives guidance on the circumstances under which derecognition is achieved and the receivables ‘disappear’ from the seller’s balance sheet. Although the Circular is not legally binding but a recommendation only, accountants usually tend to apply its rules when certifying a balance sheet. According to the Circular, a true sale requires, in particular, that the seller no longer bear any credit risks whatsoever arising from the sold payment obligations but that those risks have been transferred in full to the purchaser. The Circular states that the seller continues to bear the credit risks if the preliminary discount is unreasonably high because, according to the IDW’s view, there is no genuine risk for the purchaser that the actual default rate would exceed the discount withheld by the purchaser. A rule of thumb not communicated publicly is that a discount of twice the expected future default rate is deemed reasonable. Since the SPC’s sponsors (aiming for a high quality of the debt instruments to be backed by the purchased receivables) push for a high discount, it is customary to take full advantage of this margin. The Circular further provides that the agreed discount is to be accounted for by the seller as a book loss from the sale of receivables and, hence, is to be fully charged to expenses. The Circular does not allow the Seller to capitalise the difference between the discount and the expected default rate (and thus the amounts likely to be refunded that the seller can expect to receive from the purchaser) if the expected default rate coincides with the actual default rate. The seller’s entitlement to a refund only arises if, and to the extent that, future defaults are actually lower than the agreed discount.
Following heavy criticism from market participants and detailed discussions within the True Sale Initiative on 9 December 2003, IDW supplemented the Circular.
First, as a minor change, IDW deleted the exclusion of sales of assets that only come into existence in the future (eg, future claims of a lessor against the lessee under a financial lease) from the application of the Circular. This exclusion was only intended to signify that there was no intention to elaborate explicitly on any particularities related to the sale of receivables from a financial lease agreement (eg, commitments to surrender of use, special assessment of risk, if applicable).
Second, and more important, IDW has decided to abandon the concept of non-capitalisation of prospective refunds by adding a new clause, which is to be worded as follows:
‘When, however, in lieu of a refundable purchase price discount, a structure is agreed upon according to which the purchase price does not take the default risk into account (sale at face value/cash value), but the seller assumes a guarantee for the credit risks and this guarantee is limited to the maximum amount corresponding to the reasonable discount (cf paragraph 16(1) and second bullet point), the claim for payment of the purchase price is to be capitalised in full. An adequate provision for risk is to be made with respect to the obligation arising from the guarantee. As a rule, this should correspond to the amount of the risk provision that would have to have been made without a sale of the obligations. The difference between the risk provision and the maximum amount of the guarantee is to be shown as contingent liabilities (section 251 HGB).
As security for the purchaser of the obligations (holder of the guarantee claim), it can be agreed that the maximum guarantee amount is invested separately and that only those amounts that are no longer needed to cover the risks are to be paid out to the seller (cf paragraph 31 for particularities of revolving transactions). Such an agreement does not prevent the capitalisation of the claim even if the investment is not made in a third party, but on a reserve or guarantee interest-bearing account that is held in favour of the seller by the purchaser.’
As a consequence of the amended section on the accounting of guarantee undertakings quoted above, sellers may experience substantial relief for their balance sheet in a structure including a preliminary discount. Thus, in an assumed transaction on the sale of a certain receivables portfolio with expected future losses of 4%, a seller and a receivables purchaser may not agree on an open discount of 6% and thus a purchase price of 94% but on a purchase price of 100%. To retain some risk, the seller, however, may undertake to guarantee a default rate of 6% of the face value of the sold receivables. In such a structure under the new rule the seller will not have to account for the retained 6% as book losses but can show sales proceeds in the amount of the face value (ie, 100%). The formation of reserves will be required in the amount of the actual expected default rate of (here assumed) 4%. The difference between the 6% discount and the expected default rate of 4% (here 2%) can be shown in the seller’s balance sheet as a contingent liability.
Sven Brandt is a former in-house counsel with Deutsche Bank and Commerzbank. He advises on all types of fixed-income products and structured loans.