future-flow securitization rating methodology - nyuigiddy/abs/futflowsec.pdf · future-flow...

RATING METHODOLOGYDuff & Phelps Credit Rating Co.

DCRCHICAGOCHICAGOCHICAGOCHICAGOCHICAGO

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NEW YORKNEW YORKNEW YORKNEW YORKNEW YORK◆◆◆◆◆

LONDONLONDONLONDONLONDONLONDON◆◆◆◆◆

HONG KONGHONG KONGHONG KONGHONG KONGHONG KONG

International

Future-Flow SecuritizationRating Methodology

March 1999

EXECUTIVE SUMMARY

I n a future-flow securitization, a company issuesa debt instrument whose repayment of principaland interest to investors is secured by payments

on future receivables the company expects to gener-ate through its normal course of operation. The typi-cal future-flow originator of the receivables has beenan operationally strong company domiciled in anemerging market country. For sources of financing,such companies rely typically on bank loans or Eu-robond debt. The pricing, term to maturity and,during periods of economic crisis or other marketdisruptions, overall availability of these internation-ally issued foreign currency-denominated debt in-struments have, however, been constrained by con-

cerns that the sovereign government will interferewith a company’s ability to make foreign currencypayments to satisfy its debt obligations.

The application of securitization techniques to acompany’s future foreign receivables, though, helpsto mitigate some sovereign risks and allows other-wise financially sound companies to access interna-tional capital markets at a lower cost of funds thanwould normally be available. In many cases, a future-flow securitization that encompasses strong legal andstructural elements can achieve a rating that is abovethe sovereign ceiling otherwise applicable to foreigncurrency debt obligations issued directly by suchcompany.

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Duff & Phelps Credit Rating Co. Future-Flow Securitization Rating Methodology

Market TrendsThe vast majority of international future-

flow securitizations have been privatelyplaced. Consequently, reliable data on the sizeand nature of the market is limited. However,our research indicates that the first interna-tional future-flow transaction appeared in 1987with the securitization of telephone receiv-ables due to the Mexican telephone company,Telmex. Since then, Duff & Phelps Credit Rat-ing Co. (DCR) has played a leading role in pro-viding ratings for these types of transactions.DCR has rated 64 future-flow securitizationswith an aggregate original principal amounttotaling just over $17 billion1 . The largest assetclass of future-flow securitizations has beenexport receivables with approximately $12.4billion in original principal balance, or nearly72% of total initial principal issuance. Creditcard receivables and remittance receivablesalso account for significant segments of themarket with approximately 17% and 7% of to-tal initial principal issuances, respectively.

DCR continues to believe that internationalfuture-flow securitizations provide a viablefunding option for companies located in coun-tries whose sovereign ratings fall below invest-ment grade (‘BBB-’ or higher) as well as forthose with lower investment-grade sovereignratings. As such, DCR anticipates an increasein future-flow transactions from near invest-ment-grade countries in Central Europe andSoutheast Asia in addition to those in LatinAmerica.

DCR Rating ApproachRating Philosophy

International future-flow securitizations arebroadly defined as structured debt offeringssponsored by a foreign (non-U.S.) originatorand secured by receivables due from desig-nated international obligors. The future receiv-ables generally are sold directly or indirectlyby the originating company to an offshore trustor other issuing vehicle, which in turn issues a

debt instrument. In addition, the obligors aredirected to make payments directly to an off-shore collection account managed by a trustee.Since payments on the receivables do not enterthe issuer’s home country, DCR believes thatthis structure helps to mitigate, although notnecessarily eliminate, the risk that the obligor’ssovereign government will enact restrictions onthe transfer or convertibility of foreign cur-rency, which could adversely effect the trans-action. (These risks are generally referred to inthis report as transfer and convertibility risksand are defined further in the Sovereign Risksection).

DCR believes that in the event of a foreigncurrency crisis, properly structured future-flow transactions are likely to be among thelast to be disrupted by the sovereign. Thisconclusion is based on the fact that major ex-porters are often an important source of for-eign currency for a nation, and interferencewith the future-flow structure by the sover-eign may potentially jeopardize this source offoreign funds. DCR believes that a sovereignwould not want to damage its existing traderelationships.

Further, future-flow transactions are usuallystructured so that the amount of foreign cur-rency flowing back into the originator’s homecountry is a multiple of the amount needed forthe company’s debt service payment. Thus anattempt to divert these funds would result inonly a marginal additional amount of hard cur-rency for the sovereign.

Although the legal structure of future-flowtransactions varies, a common feature is thatobligors are directed to pay an account underthe control of the transaction’s trustee. Assuch, the obligors are unlikely to comply withdemands of the sovereign—directly orthrough the export company—to remit pay-ments back to the affected jurisdiction due tothe risk that investors, as the intended benefi-ciaries of such payment instructions, maycommence legal action to prevent the obli-gors from doing so or may cause them to makea second payment to the trust account on thesame receivable. Consequently, the ratings ofcertain future-flow transactions can exceedthe sovereign ceiling.

However, future-flow structures generallydo not eliminate sovereign risks completely, as,depending on the product or service involvedand the transaction’s structure, the sovereignmay retain some ability to interfere with thetransaction or may implement measures thatadversely affect the originator’s operating envi-ronment.

Types of InternationalFuture-Flow Transactions

■ Credit Card Voucher Receivables■ Remittance Receivables■ Export Receivables■ Airline Ticket Receivables■ Net International Telephone Settlement

Receivables

1 All figures quoted are as of the end of 3Q’98.2 By way of example, the difference between a “BB-” rating and a “BB+” rating is two notches, while the difference between a “BB-” and a “BBB+” rating isfive notches.

Duff & Phelps Credit Rating Co.Future-Flow Securitization Rating Methodology

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Additionally, in times of severe economicdistress, a sovereign may determine that imme-diately obtaining all available amounts of hardcurrency is a paramount priority and thereforetake extreme measures in an attempt to divertforeign currency cash flows. Therefore, DCRmaintains a philosophy of limiting the ratings ofsuch transactions generally to two to fivenotches2 above the related sovereign’s foreigncurrency rating. In a few exceptional cases, DCRhas rated future-flow transactions more than fivenotches above the sovereign foreign currencyrating, basing the rationale for these ratings onthe transactions’ strong fundamentals and struc-ture.

Unlike traditional securitizations where ahigher rating can be achieved through the iso-lation of quality assets from the credit of theoriginator, the ratings of international future-flow transactions are invariably linked (nottied) to the credit quality of the originator.Originating companies face performance riskin future-flow securitizations because theymust deliver a product or service before thecreation of the actual receivable and they mustalso continue to generate receivables eventhrough periods of economic and/or politicalturmoil.

Therefore, when convertibility and transferrisks are largely mitigated, the ratings of inter-national future-flow securitizations becomeclosely related to the originating company’sability to service its local currency debt obliga-tions (local currency rating). However, de-pending on the type of goods or services gen-erating the receivables, the legal structure ofthe transaction and the existing debt profile ofthe company, an international future-flowsecuritization transaction can, under special

circumstances, achieve a ratingthat is generally one notch higherthan the senior unsecured localcurrency rating of the originatingcompany.

Specifically, if the receivablesare likely to be generated even af-ter the originating company hasdefaulted on its senior unsecureddebt and a legal structure is uti-lized that is consistent with suchanalysis in each applicable juris-diction, DCR will consider trans-action ratings several notches3

higher than the originator’s seniorunsecured local currency rating.

Basic Structural ElementsCollections

Collection procedures should be estab-lished so that payments on receivables are di-rected to a collection account under the con-trol of the transaction’s trustee. In the absenceof a default scenario or certain other triggers,excess collections generated by the receivableswill be remitted to the originator. The sharingof collections on receivables with the origina-tor during the collection period is acceptableonly when there are significant coverage4 andpayment mechanisms in place. These mecha-nisms ensure that debt service will be fundedfirst in the event of deteriorating cash flows.

Currency and Basis RiskThe structure of the transaction must isolate

investors from as many external risks as possible.Therefore, the receivables generally must bedenominated in, or swapped into, the same cur-rency as the transactions to eliminate exchangerate risk. However, certain transactions havehad a limited percentage of receivables denomi-nated in currencies other than the currency of thetransaction. In such a case, the foreign currencymust be a hard currency such as the GermanDeutschemark, British Pound, Ecu., etc. In ad-dition, floating-rate issues should employ eithera hedging instrument, such as an interest rateswap or cap, or high coverage, in order to miti-gate interest rate and basis risks.

Reserve AccountWhere other external risks exist, a debt ser-

vice reserve account may be appropriate toachieve a given rating category. The amount ondeposit in this reserve account should be ad-equate to meet debt service payments in theevent that the obligor is temporarily unable togenerate receivables due to any government ac-

Diagram 1

3 Pakistan Telecom is a good example of such a transaction. The major credit risk in this future-flow transaction is the risk that international long distancecarriers (e.g., AT&T, Sprint, etc.) will not continue to place international long distance calls through Pakistan Telecom, the state-owned monopoly telephonecompany.4 Throughout this methodology, coverage will generally refer to the ratio of the cash flows in a given collection period to the maximum debt service amountto occur during the life of a future-flow transaction. Typically, DCR analyzes the cash flows over a historical time frame when analyzing the transaction’sproposed coverage.

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tion, labor dispute, supply problem, naturalcatastrophe, or other potential temporary pro-duction interruptions.

The size of the reserve fund will be deter-mined based on sovereign risks, the amount ofcoverage in the transaction, the servicer’s collec-tion procedures, the originator’s history of pro-duction delays and the general risk profile of theissue. The size and permitted uses of the reserveaccount must be consistent with the terms of therating.

For example, in transactions rated on the ba-sis of timely payment of interest and ultimatepayment of principal, the reserve account willbe sized to reflect a stipulated number of inter-est payments, and amounts on deposit in it willbe available only to make payments of interestuntil the final payment date, at which point anyremaining amounts may be applied to the pay-ment of principal. Historically, debt service re-serves have been most common in export receiv-able transactions, where they have been sized atamounts equal to three to six months of debt ser-vice.

TermIf the transaction is dependent on a long-term

contract, the issue should fully amortize by thecontract’s maturity date. In most other cases,future-flow securitization programs are struc-tured with five to seven year maturities. Shortertenors may be preferred if the product has anexceptionally short life cycle, the product hascash flows that are volatile, the likelihood of sov-ereign interference is high or if near-term mar-ket pressures are likely to restrict receivableflows. Likewise, longer tenors may be permit-ted in the case of an originator that demonstratesan exceptionally strong competitive positionand an extremely low product obsolescencerisk.

DCR does recognize that in the case of a spe-cific debt issue, an especially short maturity, arapid paydown of principal or a significantamount of existing receivables available at anypoint in time may lead to a material differencein the risk of default.

Trigger EventsMost transactions have specified event trig-

gers that either accelerate amortization of thetransaction or obligate the originator to repur-chase receivables. Accelerated amortizationtriggers will prompt the trustee to trap all cashgenerated from the receivables. Events that cantrigger an early amortization period can includea deterioration in the volume of receivables,breaches of debt covenants and representationsand warranties of the originator or governmentaction that adversely impact the generation of re-ceivables. Higher trigger levels result in a fasteracceleration of the debt repayments as well as ahigher degree of debt service coverage. DCR isof the belief that these triggers provide protec-tion for investors via the early detection of dete-riorating credit qualities of the seller or its re-ceivables.

CovenantsIn most future receivable transactions there

are general corporate covenants that constrainthe company’s ability to take on additionaldebt and to pay dividends. The most com-mon type of corporate financial covenant isthe requirement for an exporter to maintain atotal-debt-to-total-capital ratio that is less thana specified percent consistent with the ratingassigned.

Excess Coverage/Other Credit Enhancements

Most future-flow transactions incorporateexcess debt service coverage within their

Graph 2

Future-Flow Securitizations: 1991-98

Graph 1

O t h e r

Asia


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structures. The excess cash flow associatedwith the additional coverage serves two func-tions. First, it acts as a buffer against decreasesin cash flows associated with the generationof receivables. This decrease in cash flowsmay result from seasonality, a decrease in theprice of the product, interruption in produc-tion due to strikes or events of nature or a gen-eral decline in the originator’s business.

In addition, it is DCR’s belief that a foreigngovernment may be less likely to interferewith the debt service payments of a future-flow securitization if the amount of flowsneeded to make debt service payments repre-sents a sufficiently small fraction of the totalflows generated by the securitization pro-gram, as the excess flows (i.e., the actual cashflows are a multiple of the amount of fundsneeded for debt service payments), in the ab-sence of an event of default or early amortiza-tion event, will be returned to the home coun-try on a timely basis.

DCR believes that a sovereign will be lessinclined to interfere with significant interna-tional trade relationships, in the face of almostcertain legal challenges, when the amount offoreign currency it stands to gain is signifi-cantly less that what it already receives underthe terms of the future-flow transaction. Con-sequently, transactions with more perceivedsovereign diversion risk (due to the transac-tion structure and/or the nature of thecompany’s product or service) generally willhave higher coverage amounts than those withlower sovereign diversion risk profiles.

DCR’s Rating AnalysisConsiders Many Factors

DCR employs a comprehensive rating ap-proach when considering international fu-ture-flow transactions. Each transaction willinvariably pose unique risks that cannot be an-ticipated or addressed within the scope of thisreport. Therefore, the following paragraphsdiscuss the most common rating factorsassociated with offshore receivable securiti-zations.

Originator Credit Quality

Local Currency RatingGenerally, the initial phase in considering

international future-flow ratings is to assess theoriginator’s ability to service its local currencydebt obligations (performance risk) by assign-ing a local currency rating to the originator.Local currency ratings reflect a company’s abil-ity to service debt obligations denominated inits local currency and consider all credit risksof the company except the risk of convertinglocal currency into foreign currency.

DCR will consider those factors affectingthe company’s ability to generate the cash flownecessary to meet all of its debt service obliga-tions. Such factors include the competitive ad-vantages enjoyed by the company, the intensityof competition, business mix of the company,management expertise, profitability, and capi-tal structure. DCR will also assess the effects ofdevaluation and economic disruptions on theviability of the company. Detailed descriptionsof DCR’s international corporate and bank rat-ing methodologies are described fully in othermethodology publications.

DCR must have a formal rating relationshipwith the originating entity to provide a creditrating of the securitization. The formal ratingrelationship ensures that adequate informationis provided and all relevant risks are addressedin the initial review and subsequent monitor-ing process. This is especially important be-cause many international future-flow transac-tions are issued from emerging markets wheredomestic demand may be volatile, the com-pany may have been recently privatized and/or the company is undertaking sizable capitalspending programs. Those entities sensitive topublic corporate ratings may choose to keeptheir ratings private.

Generation RiskThe rating of a future-flow securitization

structure also addresses the likelihood thatthe originator has the ability and inclinationto generate the required volume of receiv-ables. While the local currency rating ad-equately addresses the ability of the origina-tor to stay in business, it does not ensure thatthe originator will maintain the business linesgenerating the receivables.

For example, there is no assurance that abanking entity will maintain its internationalVisa and Master Card voucher acquiring busi-ness or that an exporter will continue to export aspecific product for an indefinite amount oftime. Therefore, in many transactions there is re-course to the originator and/or debt covenantsobligating the originator to maintain the busi-ness line or core operating assets generating thereceivables.

The originator should have a consistenttrack record of generating receivables withsteady or increasing growth in volumes. In

Future-Flow Rating Factors

■ Originator Credit Quality■ Product Risk■ Obligor Credit Quality■ Sovereign Risk■ Legal Criteria

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cases of cyclical products or industries orwhere long-term relationships with obligorsdo not exist, relatively higher coverage ofscheduled debt service payments may be ap-propriate for given rating categories. In orderto evaluate appropriate coverages for the as-signed rating, DCR will analyze the historicalsales levels of the originator and create severalstress test scenarios based on such historicaldata and the desired rating level.

Competitiveness of Product LineDCR will also assess the originator’s com-

petitiveness in the product line generatingthe international receivables. The originatorshould be a market leader in the product gen-erating the receivables, and the product lineought to be a vital part of the originator’s busi-ness and/or be difficult for the originator todiscontinue. A steel company, for example,securitizing receivables from internationalsales of steel slabs should not be inclined toshift sales from the international market due toa higher demand and higher profit margins inthe local market.

Alternatively, while the processing of inter-national credit card vouchers is neither capitalintensive nor the primary business line of banks,it is generally profitable, is an important sourceof foreign currency and is part of the diversi-fied array of financial services provided for cli-ents. Finally, the originator should be a low-cost producer and should have a competitiveadvantage in the generation of the good or ser-vice.

Other Debt of the OriginatorDCR will also assess the credit quality of the

specific securitization debt relative to the otherdebt obligations of the originator. Infuture-flow transactions, where continued per-formance by the originator is essential, DCR be-lieves that there is an inherent risk that, in anoriginator bankruptcy/default scenario, pres-sure may be brought to bear to re-characterizethe securitization as an unsecured obligation ofthe originator.

Therefore, DCR is cautious in differentiat-ing the rating of the securitization from the un-secured, local currency debt rating of the origi-nator even in cases where DCR believes thatcontinuing performance by the originator ismeaningfully stronger than its ability to meetunsecured obligations.

DCR further believes that it is appropriateto differentiate the rating of the securitizationfrom the originator’s unsecured, local cur-rency obligations only in cases where the fol-lowing factors, in combination, are consideredstrong enough: legal structure, triggers, term,covenants, debt service coverage and the ratioof secured debt to non-secured debt.

In addition to the legal status and terms andconditions of the different classes of debt, DCRmust consider the proportions of the differentclasses of debt in order to determine the rela-tive credit strength of the transaction. For ex-ample, the position of the unsecured creditorsis weakened as the proportion of securedcreditors, with specific claims over thecompany’s assets, increases. At a high enoughlevel of secured debt, the position of unse-cured creditors is weakened sufficiently to re-sult in a downgrade of their instruments’ creditquality, reflecting an effective and meaningfulsubordination.

For this reason, if an issuer wishes to engagein a future receivables securitization withoutimpacting its unsecured debt rating, DCR in-evitably must constrain the magnitude ofsecuritization debt and the ability of the com-pany to enter into other secured indebtedness.The constraint on the magnitude ofsecuritization debt will depend on a variety offactors, but generally will ensure that the fu-ture-flow-related debt and other secured in-debtedness represent a small minority of thecompany’s total indebtedness.

Product Risk

GenerallyThe originator’s ability to generate suffi-

cient future receivables to cover debt serviceis as important as the originator’s credit qual-ity in the rating of international future-flowsecuritizations. The product should have astable or increasing demand profile, low pos-sibility of obsolescence and a large, stable in-ternational market. In addition, the exportershould have a competitive advantage both do-mestically and globally in its production. Inthis regard, the impact of known substitutesfor the product, changing consumer prefer-ences, technological forces and other demandfactors will be considered. Seasonality of thereceivables will also be assessed to evaluatewhether sufficient receivables will be gener-ated during periods of traditionally low vol-umes.

Obligor BaseProducts for which demand is from highly

rated industrialized countries and for whichthere generally exists a stable volume of de-mand, as evidenced by an organized com-modities exchange, are viewed favorably froma product risk point of view by DCR. How-ever, transactions involving a product wherethe demand factors generating the receivablesare thin will be viewed much less favorably.For example, the demand factors in an interna-tional credit card transaction emanating from aremote tourist destination are highly suscep-


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tible to changing consumer preferences. DCRwill also evaluate the diversification of prod-uct demand.

Again, for export receivable transactions,commodities are ideal from the product riskpoint of view since the demand for these gen-erally comes from many different industriesand countries. Conversely, such productspresent a greater sovereign diversion risk pro-file.

Unique and Custom ProductsOriginators wishing to securitize receiv-

ables from a unique or custom productshould demonstrate a strong historical com-mercial relationship with its obligors or havein place a long-term sales contract. For ex-ample, in the Rassini Receivables MasterTrust, where the originator has securitized itsexport sales of automobile parts, Rassini uti-lizes long-term sales contracts with the BigThree automotive companies in the UnitedStates. Generally, the long-term unsecuredcredit quality of this sole obligor is at leastequal to that of the transaction’s rating. DCRbelieves that specialty products provide forbetter sovereign risk protection than do com-modities because of the importance that acountry places on an export product with noor few substitutes.

PriceDCR will also assess the impact of price

volatility of the product involved in export re-ceivable transactions. While international de-mand for the originator’s product may bestable, lower prices can reduce receivablesvolumes. Price risk typically is addressed bydedicating excess receivables to the transac-tion, resulting in a higher debt service cover-age. If higher coverages are utilized, a stresstest using a historically low price for the prod-uct will be performed to judge the adequacyof the coverage. Alternatively, long-term salescontracts can be used to ensure minimum vol-umes of receivables and to address other risks.Variations on these structures including theuse of swaps, options and/or hedge agree-ments have been used successfully to miti-gate price risk.

Domestic DemandHigh domestic demand for a product gen-

erating export receivables can also be prob-lematic in the event that it is advantageous foran originator to sell products domesticallyrather than export them. In future-flow trans-actions, DCR evaluates the market trends (i.e.production, consumption, imports, exports,etc.) experienced by the products in theseller’s home country as well as in the globalmarket. DCR would be concerned with a de-creasing trend in the gap between the

product’s domestic production and con-sumption since this could suggest either adecrease in the product’s production or anincrease in the domestic demand for the prod-uct, possibly signaling that the exporterwould find it economically beneficial to sellthe product domestically. DCR also examinestrends in the home country’s historical use ofimposed export restrictions and controls. Bra-zil, for example, in times of domestic shortagehas imposed restrictions on the exporting ofsoy oil. More recently, Indonesia has imposedexport restrictions on some cooking oils.

International DemandInternational demand must also emanate

from countries with sovereign ratings equal toor higher than the desired transaction rating.This helps to mitigate obligor sovereign risks,especially transfer risk. In addition, theoriginator’s country should have a natural com-petitive advantage globally in the generation ofthe product, such as the production of paperpulp in Brazil. Commodity exporters are espe-cially suited in this regard.

Financial Future Flows andCurrency Exposure

Financial future-flow transactions do nothave price risk in the same sense as export receiv-able transactions. However, exchange-rate riskinherent in international credit card securitiza-tions poses an analogous hazard. The value ofdollar expenditures will rise and fall in relationto the volatility in the exchange rate. Thus, un-less the price of goods and services rises, or over-all tourism expenditures rise in response to aweak currency, receivable volumes will de-cline. Again, stress tests are used to measure theimpact of exchange-rate risk in these transac-tions. DCR research indicates that the effects ofadverse changes in exchange rates on credit cardvolumes is relatively short lived as local pricesfor hotels and other goods and services tend torecover rapidly to international levels.

Obligor Credit QualityGenerally

The obligor profile of international future-flow securitizations should be commensuratewith the transaction’s rating. The obligors ofexport receivable transactions are those pur-chasers of the originator’s products or services.The obligors of financial future-flow transac-tions are the clearing entities, such as Visa orMasterCard in the case of credit card transac-tions. For the international telephone net settle-ment transactions, the obligors are the interna-tional telecommunications carriers such asAT&T, MCI, BT, etc. Securitizations have in-volved single or few dedicated obligors, mul-tiple dedicated obligors, or all of the originator’sobligors.

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Few ObligorsThe obligor(s) in a securitization involving

only a single or few dedicated customers pref-erably should enter into long-term sales con-tracts and should have a senior unsecured creditrating at least equal to that of the transaction. Inthe event that the long-term contracts do not ex-ist or have significant noncredit-related cancel-lation events, DCR will evaluate the strength ofexisting contracts, the originator’s historical re-lationship with the obligor(s) and the economicincentives of the obligor to purchase from theoriginator.

For instance, in international credit card re-ceivable transactions, an originator’s standingas a member bank enabling it to process creditcard vouchers with Visa and/or MasterCardcan be withdrawn. Therefore, the originatingbank should covenant to remain a memberbank and there must be historical evidence andeconomic incentive to suggest that it can carryout this covenant.

Alternatively, a cancellable contract or acontract with a shorter term than the rated se-curities is more problematic. In such a case,there should be meaningful, noncontractual in-centives for the customer to purchase from theoriginator. Such incentives would include, forinstance, the high costs or delays that an automanufacturer would incur when changingpart suppliers.

Multiple ObligorsThe obligors of a securitization involving

multiple dedicated customers will be ana-lyzed carefully. Not all such obligors need tobe of equal or greater credit quality than theproposed transaction. Excess coverage, obli-gor substitution or diversification require-ments can be used to achieve high transactionratings. For example, remittance transactions,which often involve a group of clearing banks,should have a provision that ensures that atleast one of the clearing banks has a credit rat-ing equal to or greater than the transaction orthat clearing banks with deteriorating creditratings are replaced by clearing banks withstrong ratings.

All Customers are ObligorsSecuritizations involving all of an

originator’s customers typically involve com-modity exporters whose obligors are usuallynumerous and well diversified. These transac-tions must have sufficient coverage to compen-sate for the ebb and flow of the originator’s ob-ligors. So long as the product has a ready inter-national market, the obligor profile of thesetransactions generally is not constraining to therating.

Other FactorsOther circumstances that help mitigate ob-

ligor risk are treaties that obligate theoriginator’s central bank to make payments onexports in the event of obligor default and let-ter-of-credit backing or insurance on the ex-port receivables. Although long-term contrac-tual relations are viewed favorably by DCR, es-pecially in the case of unique products or a lim-ited number of obligors, they are not necessar-ily required so long as the originator has astrong long-term commercial relationship withits obligors.

Sovereign RiskGenerally

Nations continually face the challenge ofmaintaining sufficient foreign exchange to meetobligations denominated in foreign currency.To do so, a nation’s exports, capital inflows andhard currency reserves must exceed its imports,debt service and other capital outflows. In ana-lyzing cross-border corporate and structuredtransactions, DCR must assess the extent towhich the risk that a severe disequilibrium ofthose foreign exchange flows could impact debtservice payments to investors. Although DCRbelieves that several structural features in a fu-ture-flow transaction may serve to mitigate sov-ereign risk, they do not eliminate it because itmay be difficult to eliminate completely thesovereign’s ultimate ability to interfere with thetransaction.

Transfer and Convertibility RiskIn response to shortages of foreign ex-

change, many governments have sought tolimit outflows of foreign currency. For in-stance, governments have, in some cases, re-stricted the transfer of foreign currency out ofthe country (transfer risk) for certain catego-ries of payments (principal payments, interestpayments, dividend repatriation, trade pay-ment, etc.) or for certain categories of payer(government entity, private sector, foreign-owned, etc.). For example, Venezuela im-posed extensive capital controls in July 1994.While debt service payments were permitted,delays in obtaining authorizations resulted inmissed payments by some corporate borrow-ers. Some governments have also restrictedconversion of local currency to foreign cur-rency (conversion risk) in order to limitspeculative pressure on the local currencyand economy. In August 1998, Russia, for ex-ample, imposed a moratorium on all privatesector and commercial bank external debtpayments.

Because receivable payments in future-flow securitizations do not enter theoriginator’s home country, they are generallynot subject to direct convertibility and trans-fer risks. DCR recognizes, however, that un-der extreme duress a government can direct


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obligors to pay the central bank directlyrather than the trust. To clarify why this con-cern is mitigated in these transactions, it ishelpful to understand that governments gen-erally avoid jeopardizing their sources of for-eign currency which, if interrupted, couldhave negative implications for the country orprovide only marginal economic benefit.

For example, in the past when some formof currency controls were imposed by thegovernments of several nations, DCR’s re-search indicates that most countries exemptedthird-party contracts and trade financing fromcurrency controls for fear that such interfer-ence would limit the levels of a nation’s inter-national trade. Brazil, as an example, ex-cluded trade financings from its debt resched-uling in the 1980s. In addition, since the ma-jority of the payments on the export receiv-ables returns to the originator in a future-flowtransaction, it is unlikely that a governmentwould find it worthwhile to risk the poten-tially disruptive effects on trading relation-ships or even a lengthy and well-publicizedlitigation.

DCR believes that the rationale for the for-eign government to avoid interfering withcross-border flow structures is valid so longas the debt service requirement of the transac-tion forms a small portion of the exporter’sforeign exchange earnings potential and solong as the transaction’s debt service require-ment comprises a small portion of thesovereign’s total foreign exchange liabilities.

Redirection RiskIn addition to transfer risk, a future-flow

transaction faces sovereign redirection risk.DCR believes that there are two forms of sov-ereign redirection risk. The first of these is re-ferred to as payment diversion risk. This is therisk of the sovereign government’s directingan exporter to surrender all foreign currencyearnings to the central bank or directing off-shore obligors to effect payments to a desig-nated account maintained by such centralbank. This risk can be mitigated through therequirement that Notice and Acknowledg-ments be executed by a large percentage of anexporter’s customers instructing the custom-ers to enact payment to an offshore accountthat is registered in favor of the investors andis maintained by a corporate trustee. Ideally,the Notice and Acknowledgments should bebroad in scope and extend payment instruc-tions to any other entity through which pur-chases of the designated product may bemade.

The other form of redirection risk is prod-uct diversion risk. One example of this riskwould occur if a sovereign government were

to redirect a company’s exports to customerswho have not signed Notice and Acknowl-edgments and require that these customerspay a designated offshore collection accountmaintained by the sovereign’s central bank.

Likewise, the sovereign may attempt to di-rect the originator’s exports to a newly cre-ated shell company or trading company whilethe originator continued to sell the productto its existing clients through newly createdcontracts between the sovereign governmentand these existing obligors. This risk is oftenaddressed by including possible exporter re-course performance covenants. Various eco-nomic disincentives to breaching such cov-enants also may exist, such as adverse interna-tional capital markets perceptions and nega-tive effects on the exporter’s short-term li-quidity position.

Notice and AcknowledgmentsThe risk of sovereign redirection is reduced

when obligors have irrevocably agreed to paythe trust pursuant to a Notice and Acknowl-edgment agreement. In the absence of atransaction’s containing irrevocable Noticeand Acknowledgment agreements, a nation’scentral bank may redirect payments on the fu-ture-flow receivables merely by directing theexporter to have the new receivables paid di-rectly to the central bank.

DCR further believes that Notice and Ac-knowledgments are especially critical in trans-actions involving the sale of commodities nototherwise subject to sales contracts. A govern-ment may consider such situations more at-tractive targets for redirection because exportvolumes should not be adversely affectedgiven the large universe of alternative buyersand because third-party contracts would notbe disturbed.

Export/Import ControlsIn addition to restricting the free exchange

and movement of currencies, governments havealso, at times, controlled the free exchange ofgoods through export or import controls, withthe goal of easing a balance of payments dis-equilibrium.

Sovereign’s Willingness to PayIn general, DCR evaluates the likelihood of a

country’s imposing currency controls on tradefinancings or directing obligors to pay the cen-tral bank rather than the trust. DCR considersthese risks in light of the country’s history ofsimilar actions and concern for international in-vestment.

Sovereign CeilingAs part of the sovereign foreign currency

rating, DCR assesses the probability of acountry’s imposing currency and/or capital

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controls. Generally, ratings of internationaltransactions that do not sufficiently mitigateconvertibility and transfer risk are constrainedby the foreign currency rating of the originator’scountry (the sovereign ceiling).

Rating Above the Sovereign CeilingIn certain cases it is possible for a future-

flow transaction to achieve a foreign currencyrating above the sovereign ceiling. Althoughnot completely removed, sovereign transferand convertibility risks can be adequately miti-gated through certain structural elements.Therefore, properly structured transactionshistorically have received ratings from one tofive notches above their respective sovereignceilings.

There are several factors that contribute tothe degree to which a transaction is rated overthe sovereign ceiling. The type of future-flowtransaction itself is an important factor sinceDCR believes that it is fundamentally more dif-ficult for a sovereign to interfere with thecash flows of a credit card or telephonesecuritization that it is for it to do so in a remit-tance transaction. The underlying sovereignrating and underlying economic factors of thecountry are also considered.

To illustrate, DCR has rated transactionsfrom Mexico further above the sovereign ceil-ing than transactions from lower-rated coun-tries such as Indonesia. Finally, DCR analyzesother structural features such as thetransaction’s final maturity, offshore reserveaccount, legal protection, capability to gener-ate U.S.-dollar cash flow and strength of the un-derlying corporation or bank.

Nature of the ProductThe nature of the product will also be con-

sidered. Products that generate high volumesof foreign exchange, are not important to na-tional security or are a significant source of do-mestic employment are, in general, less likelyto be restricted by the sovereign. Conversely,products that are net imports to a country, im-portant to the national defense or otherwisesensitive to trade disputes are more likely to besubject to export controls.

OtherOther sovereign risks include unique

events within a particular country that couldinterfere with the originator’s ability to thegenerate receivables. Such risks include, butare not limited to: nationalization of a com-pany or industry, domestic hyperinflation,civil unrest, terrorism and/or labor distur-bances.

The primary goal of international future-flow structures is to safeguard asset cash flowfrom sovereign currency controls, thus allow-ing transaction ratings above the host

country’s foreign currency rating. However,other sovereign considerations such as the riskof the government’s interfering with exportsales contracts, imposing export controls ornationalizing a company cannot be entirelymitigated. Therefore, DCR will limit the de-gree to which transactions are rated above thesovereign ceiling. The determination of thislimiting factor will depend on all of the ratingfactors described herein.

Legal CriteriaGenerally

DCR reviews a number of legal issues to-gether with its outside legal counsel in thecourse of the transaction analysis to ensure thatthe assumptions that underlie the transaction’sstructure are supported by the legal documen-tation. In particular, DCR and its counsel relyon the legal opinions given by transactioncounsel concerning the laws chosen to governmost of the legal documents (which is typicallyNew York law) as well as local counsel in theoriginator’s home country and, if applicable,local counsel from any relevant offshore juris-dictions.

All such opinions must be addressed toDCR or be accompanied by reliance letters al-lowing DCR to rely on such opinions. DCRbelieves that reliance on legal opinions in theoriginator’s jurisdiction, in particular whennovel structures are presented or originatorsare located in jurisdictions without a signifi-cant number of prior similar DCR-relatedtransactions, is easier when more than one lo-cal counsel opinion is available to address is-sues of general application, such as the natureof the receivables transfer. Opinions as to theoriginator-specific matters, such as due orga-nization and compliance with covenants, canbe addressed adequately by one counsel.

DCR reserves the right to satisfy itself thatcounsel is either sufficiently experienced insuch matters or, in regard to the originator’s ju-risdiction where directly applicable experi-ence may not be available, is of sufficient so-phistication so that DCR is justified fully in re-lying on the opinions of such counsel.

Receivables TransferDCR reviews future-flow transactions to de-

termine the rights of the trustee, acting on behalfof investors, to collect on the receivables. In allbut a few transactions, these rights have arisenfrom the sale of receivables. In reviewing thesetransfers, there exist two issues of principal im-portance: the priority of the trustee’s rights, ascompared to the rights of other parties to the cashcollections and the timing of the exercise of thoserights by the trustee as well as any potential le-gal delays related to the receipt of the collec-tions. These two issues are of particular impor-


11 ◆◆◆◆◆

tance in two contexts, sovereign interference(which is discussed immediately following thissection) and the creditors’ rights/ bankruptcyissues.

In all future-flow transactions, DCR needsto be assured that the trustee has a superior in-terest in the receivables compared to the inter-est of other creditors and evaluates the riskthat such interest may be subject to non-insol-vency- related and timing delays, such asthose that may arise due to sovereign or cor-porate reasons.

In transactions for which a rating above thelocal currency rating of the originator is soughtand where bankruptcy laws in any of the re-lated jurisdictions provide for a debt morato-rium, automatic stay or other similar delays inthe exercise of the creditors’ rights, DCR willneed to review the potential applicability ofsuch laws to the transfer of the products andreceivables prior to bankruptcy or, dependingon the transaction and desired rating, prior toliquidation but after the onset of reorganizationproceedings.

In general, it is difficult for most U.S. lawfirms to opine that the typically structured fu-ture-flow transaction meets the criteria to rendera U.S. law true-sale opinion. Conversely, coun-sel in most foreign jurisdictions have been ableto issue such opinions without qualification ex-cept as to customary fraudulent conveyancematters.

Therefore, where the risk of re-characteriza-tion of a true-sale transaction has existed in anapplicable jurisdiction other than that of theoriginator, issuers generally have taken one ofthree approaches to insulate future-flow trans-actions from the bankruptcy risk of the issuer.

In each case, the law contractually chosen togovern the characterization of the true sale is oneunder which an appropriate opinion can be ren-dered. The first and most common method formost transactions is an intermediate true sale toa special purpose entity (SPE), with the SPEbeing either the issuer of the rated debt or thetransferor to a U.S. trust.

Although the transfer from the SPE to thetrust may be viewed as a financing for bank-ruptcy purposes, a filing for bankruptcy shouldnot occur since the SPE should have no othercreditors. This particular method is also utilizedin similarly structured transactions in theUnited States.

A second alternative that permits the origi-nator to transfer its rights in the receivables di-rectly to a U.S. trust has been utilized when theoriginator is exempt from most applicable pro-visions of the U.S. Bankruptcy Code (the Code).The most common example of this approach hasbeen foreign banks that are engaged in bankingactivities in the United States. U.S. counsel must

opine to the applicability of this exemption. Asa further protection, DCR will require the trans-action documents to contain covenants requir-ing the foreign bank to notify DCR in the eventthat the bank ceases those U.S. operations thatoriginally provided for the exemption.

The third method is to move the collectionaccount to a jurisdiction that does not have anautomatic stay or comparable delay risk. In thiscase, DCR will require local counsel from suchjurisdiction to advise of the absence of these le-gal processes.

Where any phase of a transaction is structuredas a pledge of receivables, including a pledgeby a SPE, DCR will expect to receive a first secu-rity interest opinion from counsel in each juris-diction relevant to such analysis.

Sovereign Risk IssuesAs noted above, DCR’s analysis of sovereign

risk issues is by necessity transaction-specific and is based on a complex matrix ofboth legal and nonlegal analysis. DCR views thefollowing features in the legal documents andstructure favorably when assessing sovereignrisk:

■ A sale structure rather than a pledge or un-secured right to cash flow structure.

■ A forward-sale structure, meaning thatcounsel can opine that all existing and futuretransferred assets have been sold as of the clos-ing date or at least when they come into exist-ence without further action on the part of theoriginator.

■ The creation of receivables offshore by anoffshore entity rather than by the originatorwithin its domestic jurisdiction.

■ Sales of products to nonaffiliated custom-ers and receivables to a nonaffiliated SPE ortrust.

■ Retention of significant excess cash flows bythe originator (as discussed above), not only byway of restrictions on the use of future issu-ances collateralized by the same receivables,but also by way of similar restrictions on re-tained interests in the receivables (whethercharacterized as a seller certificate in a trust, asubordinated deferred purchase price or oth-erwise). Generally, for additional pari passu in-terests in such collections DCR requires a rat-ings confirmation on prior rated deals and forsubordinated interests requires either a ratingsconfirmation or an acceptable overall limit onthe ratio of total debt secured by the receivablesto total collections over the same periods to beset forth in the original transaction documents.The remaining bottom piece of the receivablescollections (that is, after all permitted pari passuand subordinated interests), or rights thereto,

◆◆◆◆◆ 12


retained by the originator cannot be sold butmay be pledged subject to the requirement thatcollections first must reenter the originator’sjurisdiction.

■ Notices to customers as to the sale and pay-ment instructions, which are acknowledgedby the customer. Due to the fact that these No-tices and Acknowledgments are key require-ments, they are discussed in more detail below.

In a typical future-flow transaction, the ob-ligors of the receivables are delivered a writtennotice whereby the originator instructs the ob-ligors to effect all payments to a collection ac-count that is under the control of a trustee. Theobligors acknowledge receipt of this notice bycountersigning it. This form of written noticeis commonly referred to as a Notice and Ac-knowledgment.

These Notice and Acknowledgments servesix principal functions. The first is that they in-form the obligors that payments are to be madedirectly to an account held for the benefit of theinvestors rather than being remitted to theoriginator in its home country. Included in theNotice and Acknowledgments are the precisepayment instructions for the relevant trust ac-count.

Second, to the extent that U.S. law is rel-evant, the Notice and Acknowledgment may,in some circumstances, be necessary in orderto protect the interest of the trustee in the receiv-ables under the UCC by advising the obligorsthat the receivables have been sold or pledged.It should be noted that if the assignor of the re-ceivables is located in a jurisdiction outside theUnited States or Canada and the receivables areproperly characterized as an account or gen-eral intangible for the money due, the securityinterest of the trustee may be performed by no-tice. This method of perfection may be the onlyone relevant under the UCC in circumstanceswhere the assignor’s home country does nothave a filing system and U.S. filings cannot bemade because the assignor does not have a U.S.office.

Third, Notices and Acknowledgments maybe necessary in order to enable counsel in cer-tain foreign jurisdictions to provide opinionswith respect to the sale of the receivables.Fourth and fifth, Notices and Acknowledg-ments may be necessary to mitigate productdiversion risk and payment diversion risk, re-spectively. Sixth, Notices and Acknowledg-ments may be required (if U.S. law does notgovern the issue) because of provisions withexport customers restricting assignments ofpayments. However, regarding this latterpoint, in transactions with multiple obligors,DCR will generally rely on representations and

warranties and in some cases legal opinions asto such matters.

DCR is sometimes asked to consider the useof Notices without the need for customer Ac-knowledgments. Notices alone generally ad-dress the first three reasons for such documentsas set forth above but do not necessarily pro-vide comfort that the obligors are contractuallyobligated to pay the collection account, as men-tioned in the fourth and fifth issues referencedto above.

In lieu of Acknowledgments in transactionswith a highly diverse obligor base, DCR willconsider the receipt of legal opinions from ju-risdictions with high obligor concentrationsas to the enforceability of the proposed form ofNotice.

In all cases, DCR will require the receipt oflegal opinions as to the enforceability of No-tices and Acknowledgments against the origi-nator from counsel in the originator’s jurisdic-tion and the jurisdiction the laws of which arechosen to govern the Notice and Acknowledg-ment (which in transactions with many obli-gors may be as to the form thereof). In transac-tions with one or few obligors, DCR generallyrequires a full opinion on customary corporateorganization, authorization, power and au-thority and due execution and delivery, as tosuch obligor or obligors.

Other Legal MattersIn a typical future-flow transaction, DCR re-

ceives various legal opinions from counsel inthe originator’s jurisdiction, from counsel inthe jurisdiction of any SPE and where the col-lections are held and from counsel in the juris-diction under which the transaction docu-ments are governed. In addition to the mattersdiscussed above regarding true sales, first pri-ority security interests and Notice and Ac-knowledgments, opinions from each appli-cable jurisdiction for each transaction partyaddress:

■ The submission to foreign jurisdiction, orif this is not possible, international arbitration.

■ Organization, power and authority, anddue authorization, execution and delivery oftransaction documents.

■ Enforceability of transaction documents.

■ Enforceability of foreign judgments.

■ That no conflicts exist with organizationdocuments or laws of jurisdiction.

■ Withholding tax, transaction tax and taxa-tion of SPE matters.

■ All necessary governmental consents.


13 ◆◆◆◆◆

■ That no material litigation is pending orthreatened.

■ That there is no immunity from legal pro-cess.

The specific requirements for a particulartransaction may necessitate additional opin-

ions. Legal opinions may be subject to custom-ary qualifications and assumptions. In addi-tion to the matters discussed above, DCR mayalso require transaction documents to containcertain representations and warranties and cov-enants customary for transactions of thistype. DCR

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Authors

Christopher J. DonnellyGroup Vice President

Latin American Structured Finance(212) 908-0237

[email protected]

Rohinton B. DadinaVice President


Michael C. MorcomAnalyst


DCR wishes to acknowledge Emil Arca, a partner at Dewey Ballentine,for his contributions to this rating methodology.


15 ◆◆◆◆◆

Information herein was obtained from sources believed to be accurate and reliable; however, we do not guarantee the accuracy, adequacy or completeness of anyinformation and are not responsible for any errors or omissions or for the results obtained from the use of such information. Issuers of securities rated by Duff &Phelps Credit Rating Co. have paid a credit rating fee, based on the amount and type of securities issued. Duff & Phelps Credit Rating Co. ratings are opinions oncredit quality only and are not recommendations to buy or sell any security. Copyright © 1999 Duff & Phelps Credit Rating Co. All rights reserved. Contents maybe used by news media with credit to Duff & Phelps Credit Rating Co.

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