introduction and the asian regional scenario of spv

Legal Infrastructure and overall scenario of Asset Backed securities in Bangladesh

April 5

2011

April 5, 2011 Legal Infrastructure and overall scenario of Asset Backed securities in Bangladesh

Submitted To:

Submitted By:

Name Roll

Md. Abdul Hai 14-011

Samir Abdullah Chowdhury 14-031

Sanjida khanam 14-033

Saimoon Ahmed Moon 14-053

Muhammad Firoz Mahmud 14-089

BBA 14th BatchSec- A

Department of FinanceUniversity of Dhaka University

Date of Submission: April 05, 2011.

Gazi Hasan JamilAssistant Professor,

Department of Finance,Faculty of Business Studies,

University of Dhaka.


INTRODUCTION

One of the main reasons for the success of public private partnership (PPP) projects is the creation of a separate commercial venture named “Special Purpose Vehicle” (SPV). SPV provides a good framework for raising funds, linking participants legally and assuring supply, production and marketing of products. SPV brings together various parties like lenders, financial institutions, public sector and export credit agencies, suppliers and off-takers. There is often a lack of precedents to identify attributes of a SPV and the process is further hampered by undeveloped financial and legal structures of a country. Thus, there is a need to establish clear attributes for a SPV to raise the funding options of PPPs. The evidence shows that not only are there common trends and techniques that are used for SPV development but also some unique features to overcome financial and legal hurdles. The evidence also gives insights for using SPV to improve financing of PPP projects.

But what is actually the SPV is? Before go to deep of the discussion of the SPV and its uses in the financial system, we would like to give you a brief picture of what is SPV.

Special Purpose Vehicle

A special purpose vehicle (SPV) or special purpose entity (SPE) is a company that is created solely for a particular financial transaction or series of transactions. It may sometimes be something other than a company, such as a trust. The SPV's debts may, or may not, be raised with recourse to the “real” borrower.

SPVs/SPEs are often used to make a transaction tax efficient by choosing the most favorable tax residence for the vehicle. This is commonly done with Eurobonds so that foreign investors do not have to pay withholding taxes in the borrower's country of residence.

SPVs are used for other transactions including securitizations and the issue of catastrophe bonds.

More specifically we can also say that as it is also referred to as a "bankruptcy-remote entity" whose operations are limited to the acquisition and financing of specific assets, the SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt. It is also called a subsidiary corporation designed to serve as counterparty for swaps and other credit sensitive derivative instruments. Also called a "derivatives product company."


Enron: the creator

In the recent past, it was the Enron debacle that popularized this word, though for the wrong reasons. The collapse of the Enron SPV notwithstanding, the term SPV continues to be a buzzword in the financial sector. Thanks to Enron, SPVs/SPEs are household words. These entities aren't all bad though. They were originally (and still are) used to isolate financial risk.

Special purpose entities were one of the main tools used by executives at Enron, in order to hide losses and fabricate earnings, resulting in the Enron scandal of 2001. They were also used to hide losses and overstate earnings by executives at Tower Financial, which declared bankruptcy in 1994. Several executives of the company were found guilty of securities fraud, served prison sentences, and paid fines.

Financial tool:

A corporation can use such a vehicle to finance a large project without putting the entire firm at risk. Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt. Essentially, it looks like the company doesn't have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating.

In addition to reducing tax, SPVs can also remove assets or liabilities from balance sheets, transfer risk and (in securitizations) allow the effective sale of future cash flows.

The management of an SPV will need to be structured in a way that takes account of accounting standards that require a company controlled by another to be consolidated as a subsidiary. This is not usually a problem as SPVs require very little in the way of management.

The effect of SPVs on accounts is obviously open to abuse. SPVs have often been used to manipulate published accounts, most notoriously by Enron. Accounting rules have since been tightened to make such abuses harder.

Purpose of the creation of the SPV:

In this world, every activity has a purpose, a reason to be occurred. The main purpose of the vehicles is to get to destinations faster and with more ease! Like this theory, SPV is somewhat created

with this views. SPV has also some reasons to be created.

Some of the reasons for creating special purpose entities are:


• Securitization:

SPEs are commonly used to securitize loans (or other receivables). For example, a bank may wish to issue a mortgage-backed security whose payments come from a pool of loans. However, to ensure that the holders of the mortgage-back securities have the first priority right to receive payments on the loans, these loans need to be legally separated from the other obligations of the bank. This is done by creating an SPE, and then transferring the loans from the bank to the SPE.

• Risk sharing:

Corporate people may use SPEs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk.

• Finance:

Multi-tiered SPEs allow multiple tiers of investment and debt.

• Asset transfer:

Many permits required to operate certain assets (such as power plants) are either non-transferable or difficult to transfer. By having an SPE own the asset and all the permits, the SPE can be sold as a self-contained package, rather than attempting to assign over numerous permits.

• For competitive reasons:

For example, when Intel and Hewlett-Packard started developing IA-64 (Itanium) processor architecture, they created a special purpose entity which owned the intellectual technology behind the processor. This was done to prevent competitors like AMD accessing the technology through pre-existing licensing deals.[citation needed]

• Financial engineering:

SPEs are often used in financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements. The Enron case is possibly the most famous example of a company using SPEs to achieve the latter goal.

• Regulatory reasons:

A special purpose entity can sometimes be set up within an orphan structure to circumvent regulatory restrictions, such as regulations relating to nationality of ownership of specific assets.


• Property investing:

Some countries have different tax rates for capital gains and gains from property sales. For tax reasons, letting each property be owned by a separate company can be a good thing. These companies can then be sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes.

Difference between a SPV and a company:

Technically, an SPV is a company. It has to follow the rules of formation of a company laid down in the Companies Act. Like a company, the SPV is an artificial person. It has all the attributes of a legal person. It is independent of members subscribing to the shares of the SPV.

The SPV has an existence of its own in the eyes of law. It can sue and be sued in its name. The SPV has to adhere to all the regulations laid down in the Companies Act.

Members of an SPV are mostly the companies and individuals sponsoring the entity. An SPV can also be a partnership firm. This, however, is unusual and not popular.

The company, as distinguished from an SPV, may be called a general purpose vehicle. A company may do many things which are mentioned in the memorandum of association (MoA) or permitted by the Companies Act.

An SPV may also do the same, but its scope of operation is limited and focused. If it is not so, the SPV had better be called a company. The MoA is quite narrow in the case of an SPV.

This is primarily to provide comfort to lenders who are concerned about their investment.

Establishment:

Like a company, an SPE must have promoter(s) or sponsor(s). Usually, a sponsoring corporation hives off assets or activities from the rest of the company into an SPE. This isolation of assets is important for providing comfort to investors. The assets or activities are distanced from the parent company; hence the performance of the new entity will not be affected by the ups and downs of the originating entity. The SPE will be subject to fewer risks and thus provide greater comfort to the lenders. What is important here is the distance between the sponsoring company and the SPE. In the absence of adequate distance between the sponsor and the new entity, the latter will not be an SPE but only a subsidiary company.

A good SPE should be able to stand on its feet, independent of the sponsoring company. Unfortunately, this does not always happen in practice. One of the reasons for the collapse of


the Enron SPE was that it became a vehicle for furthering the ends of the parent company in violation of the prudential norms of corporate financing and accounting.

Advantages of setting up an SPV:

The biggest advantage is that it helps in separating the risk and freeing up the capital. As a result, the SPV and the sponsoring company are protected against risks like insolvency, which may arise during the course of operation.

The SPV also allows securitization of assets without disturbing the managerial relationship. Under the arrangement, any predictable income stream generated by secure assets can be securitized.

According to some estimates, the worldwide securitization market has increased from $1.2 billion of transactions in 1985, to $544 billion in 2003.

Basically, a company can leverage future earnings to raise funds.

Accounting treatment:

Under US GAAP, a number of accounting standards apply to SPEs, most notably FIN46R that sets out the consolidation treatment of these entities. There are a number of other standards that apply to different transactions with SPEs.

Under International Financial Reporting Standards (IFRS), the relevant standard is IAS 27 in connection with the interpretation of SIC12 (Consolidation—Special Purpose Entities). The IASB published an exposure draft (ED 10) to merge both regulations.

The scenario of ABS in ASIA

To give a snapshot of the situation of the SPV, we select some Asian country where the SPV is used successfully. We choose only five countries to give this view.

ABS in India:

Amidst globalization Banking System in India has attained vital importance. Day by day there has been increasing banking complexities in banking transactions, capital requirements, liquidity, credit and risks associated with them. As such the Indian borrowers have to try new international financial products like SPV to cater their needs in addition to the financial products available through the banks in India. We focus here exclusively on SPV in India.


In India Securitizations guidelines issued in 2006 provided for a conservative treatment of securitization exposures for capital adequacy purposes, especially in regard to the credit enhancement and liquidity facilities. A unique feature of these guidelines is that any profits on sale of assets to the SPV are not allowed to be recognized immediately on sale but over the life of the pass through certificates issued by the SPV. The policy enabled a liquidity facility by the originator or a third party, to help smoothen the timing differences faced by the SPV and was subject to certain conditions to ensure that the liquidity support was only temporary and got invoked to meet cash flow mismatches. Any commitment to provide such liquidity facility, is to be treated as an off- balance sheet item and attracts 100% credit conversion factor as well as 100% risk weight. The facility was specifically prohibited for the purposes of

a) Providing credit enhancement;

b) Covering losses of the SPV;

c) Serving as a permanent revolving funding; and

d) Covering any losses incurred in the underlying pool of exposures prior to a draw down.

There is no separate law for SPV in India.

SPV for E-Governance:

In Patna, Nov 14th, 2009 – Bihar has sought the help of Infosys co-founder Nandan Nilekani, the chief of India’s Unique Identification Database Authority, to improve the state’s e-governance system.

The state has constituted a Special Purpose Vehicle (SPV) with the objective of bringing about an Information Technology (IT) transformation in the state. The SPV was constituted as a tripartite joint venture of state-owned Beltron, Tata Consultancy Services and Infrastructure Leasing & Financial Services (ILFS) at an estimated cost of Rs.380 million.

The SPV is preparing a comprehensive special package for e-governance. Besides, separate e-governance packages have been created for different departments by the joint venture partners, based on specific requirements. The state government has already equipped legislators with sophisticated laptop computers under the national e-governance plan of the central government.

The previous state government, headed by Rabri Devi had brought several departments online and launched an official web site of the state.


Projects through SPV in India:

Tata Power Company and Norwegian firm- SN Power, plan hydro-power projects in India and Nepal.

Each project would be developed through a special purpose vehicle (SPV) and the two partners would have equal say in decision-making and execution of projects. Tata Power and SN Power would equally inject Rs 4,500 crore through equity as well as third party funding if a local company or government is roped in.

The SPV would borrow the rest from international lenders like International Finance Corporation (IFC) and the Asian Development Bank (ADB). The SPV may sell the electricity on a merchant basis or by signing power purchase agreements (PPA).

"We would be able to raise financing through international lenders, which would help enhance the status of the project," SN Power, President and Chief Executive Officer, Oistein Andresen, said.

Pass through certificates issued by SPV:

The Reserve Bank of India (RBI) may ask banks to hold securitized debt for six to seven months on their books before selling them to other market players, said investment bankers originating such instruments.

In securitization, an originator bank repackages loans in the form of marketable securities. These marketable securities are in the form of pass through certificates (PTCs), these are like bonds, issued by special purpose vehicle (SPV) holding the loan. The seasoning or holding period being considered by RBI is mainly for securities made by splicing loans given to a single entity.

Infrastructure companies listing SPVs to derisk business:

More and more infrastructure companies seem to be looking to list their hived-off special purpose vehicles (SPVs).An SPV is entity formed to execute a development project.

Hyderabad-based Madhucon Projects and IVRCL Infrastructure & Projects recently said they are in the process of bringing their SPVs under single holding companies and listing them. Parvesh Minocha, managing director, transportation division, Feedback Ventures, an infrastructure consultancy, said all firms will eventually list their development business division.

Some industry watchers believe a good mix of businesses is essential in listing such an entity so that investors can minimize risks.


Norms for highway projects pact changed through SPV:

The threshold limit in the conflict of interest clause in the model concession agreement (MCA) for highway projects has been increased from 5 per cent to 25 per cent, which was recommended by the B K Chaturvedi Committee, set up to find ways to expedite various road projects in the country.

This will allow any two special purpose vehicles (SPVs) with a common partner having up to 25 per cent stake for bidding for the same project.

Earlier, any two SPVs in which any developer had more than 5 per cent shareholding each were barred from bidding for the same project. It was increased to 5 per cent in July this year from the earlier 1 per cent.

ABS in Japan:

Actually it is not special purpose vehicle in Japan; it is special purpose company there.

A special purpose company ( tokutei mokuteki kaisha, abbreviated SPC or TMK) is a type of corporation which can be formed under Japanese law. SPCs were enacted by the Diet of Japan in Law No. 105 of 1998.

The main features of an SPC are:

An SPC can only be used for the fluidization (i.e. securitization) of assets (shisan no ryūdōka). It cannot manage or dispose of assets, although it can commission these activities to a third party manager.

If certain conditions are met, an SPC can write off the assets it distributes as losses for tax purposes, thus exempting those distributions from corporate taxation.

SPCs are the only corporate entity which can make tax-free distributions under Japanese tax law as of 2006, and are an attractive alternative to general partnerships, tokumei kumiai, trusts or other tax-free alternatives in a number of investment transactions.


Investing in an SPC:

An SPC may issue any of five types of securities in exchange for an investment:

1. Preferred investment certificates ( yūsen shusshi shōken), equity securities similar to shares of preferred stock, where the bearers have rights to share in the profits of the company, but cannot participate in decision-making

2. Special bonds ( tokutei shasai ken)

3. Special commercial paper ( tokutei yakusoku tegata)

4. Convertible special bonds (tenkan tokutei shasai)

5. Special bonds with subscription rights for new preferred investment certificates (shin yūsen shusshi shōken hikiuke ken tsuke tokutei shasai)

ABS in china:

Once a foreign investor finds a good project and potential partner in China, a highly useful option now available is the Special Purpose Vehicle (SPV). Using this option the investor may form the overseas SPV joint venture with the partner and with it acquire and hold 100% equity of the existing Chinese company. As a result, the Chinese company will eventually become a wholly foreign owned enterprise, or WFOE.

Compared with directly setting up a joint venture (described below) in China, the SPV method has these advantages:

The SPV has 100% control of the WFOE, so the foreign investor may transfer interests in the project by selling its shares in the SPV without Chinese government approval (which is otherwise required if the transferring target is shares in a Chinese JV).

The investor is allowed to set up the SPV as a tax haven and avoid tax related to the transfer of SPV shares. By contrast, for China JVs, income tax is payable by the seller for such kind of deals.

China still has control on foreign exchange, especially in sophisticated deals with a share swap between a Chinese entity and an overseas company, so JVs are subject to strict government approval. With an overseas SPV this problem may be avoided.

If the SPV or its parent company goes public in an overseas market, e.g., NASDAQ, the case will not involve Chinese government approval. By contrast, if Chinese JV seeks listing in a foreign stock market, it must obtain approval from the China Securities Regulatory Commission (CSRC), China’s securities watchdog.


Note, however, with SPVs the Chinese partners should obtain approval from the government when they invest overseas to set up the SPV with the foreign investor. They are also required to report any substantial changes and developments related to such overseas investment.

When the SPV acquires the Chinese company, a public appraisal firm must perform a compulsory appraisal prior to the acquisition of the target shares. The Chinese partner cannot transfer the shares at a price “significantly lower than the appraisal result”. If the Chinese partner is State-owned, a competent government agency may also need to approve the case. In addition, like other acquisition deals, the foreign investor should conduct careful due diligence on the target company before entering into the final acquisition agreement.

Although SPV structures will continue to provide benefits, it may become more important than in the past for an SPV to have some degree of economic substance.

New Challenges to Special Purpose Vehicles for Investing in China:

The tax authorities in China are challenging the most common structure by which foreign companies hold direct investments in China: the use of a special purpose vehicle (SPV) established in a jurisdiction that has a favorable tax treaty with China.

The tax benefits of an SPV holding company are twofold.

First, the SPV may benefit from preferential withholding tax rates under the treaty on dividends and other forms of passive income. For example, the tax treaties with Hong Kong, Singapore and several other jurisdictions reduce the withholding tax rate on dividends from 10% to 5%.

Second, if the foreign investor wishes to dispose of the investment in China, it may sell the shares of the SPV without paying income tax in China on the capital gain from the sale. Typically, the jurisdiction where the SPV is established will also exempt the capital gain from local taxation or levy tax at a low rate.

In regulations just issued, as well as in two tax cases reported at the end of 2008, the State Administration of Taxation (SAT) has signaled an intention to scrutinize the use of SPVs and, in some circumstances, to deny corresponding tax benefits in China. The Chinese State Administration of Taxation (SAT) has removed tax privileges afforded under various double taxation treaties to foreign investors who misuse the system of ‘special purpose vehicles’ as a means of reducing their tax liabilities or circumventing exchange controls.

China, at present, has lower tax rates with Singapore, Hong Kong, Mauritius, Barbados and Ireland. This circular of SAT enables the tax authorities to scrutinize not just the form but also the substance of the ownership structures of SPVs to satisfy themselves that the investors have bona fide residence in these countries to take advantage of the tax treaties signed by China.


This is to combat the tax evasion tactics of Chinese expatriates, who form the largest group of foreign investors, but still maintaining their nexus within China. The proposed SAT’s intervention is to remove SPV tax privileges in respect of those SPVs which are controlled by Chinese expatriates, but who are deemed to be de facto PRC resident.

Hong Kong:

Hong Kong is a very favorable location in which to establish a shareholder company (usually termed a special purpose vehicle or SPV) for investment in China. Hong Kong company usually been used as a Special Purpose vehicle (SPV) to invest Mainland China. Hong Kong is one of the quickest locations to incorporate a business. Although a HK company is not a legal entity in Mainland, lots foreign investors, especially investors from Europe and North America still chose to setting up a Hong Kong company as SPV to invest China.

Hong Kong's corporate law is strongly based on the British Legal System, the setting up of a Hong Kong is str. Local businesses are regulated and Hong Kong regards itself as a low tax centre rather than a tax haven. Taxes are levied on profits which is 16.5% since Financial Year 2008/2009. Under special circumstances, a Hong Kong company may even declare business transactions as offshore which are subject o 0% tax in Hong Kong.

As Hong Kong's role as a major trading and gateway to China mainland and Asia, some companies formed in Hong Kong are for trading purposes generally, while some use it as HQ of its operations in China mainland.

Doesn't like other China cities, Hong Kong has no restrictions on capital transfer in/out of Hong Kong (No Foreign Currency Control).

ABS in Malaysia:

In the question of “what legal structure should the SPV take?” the guidelines answered that

“What The ABS Guidelines are neutral on the legal form of an SPV and market participants are free to decide the most suitable SPV form in any securitization structure. SPVs can be established as either companies or as trust structures. Where the SPV is established as a company, the amount of its paid-up capital would be determined by the promoters.”

Following the release of the Guidelines on the Offering of Asset-Backed Debt Securities (ABS Guidelines) on 11 April 2001, the Securities Commission (SC) will periodically issue responses to FAQs to clarify and facilitate better understanding among affected parties and the public in general in relation to securitization transactions.

http://www.pathtochina.com/hong_kong_company_formation_introduction.htm


The guidelines answered all the essential questions about the securitization and SPV.

As such an SPV would be considered resident in Malaysia for tax purposes as required under the ABS Guidelines. Nevertheless, the acquisition of Ringgit assets by an entity incorporated in Labuan and the issuance of Ringgit denominated asset-backed debt securities by it to domestic residents, would among others, be subject to the approval of the Controller of Foreign Exchange. Parties should also be aware that the Offshore Companies Act 1990 places some restrictions on the activities of such offshore entities.

Recent activity:

In Dec 23, 2010 the Finance Ministry of Malaysia will set up a special purpose vehicle (SPV) to raise funds for the RM36 billion mass rapid transit (MRT) projects in the Klang Valley. They may issue bonds or use capital market instruments.

ABS in Pakistan:

Following the October 1999 coup, the military regime unveiled a reform driven agenda causing an unprecedented amount of regulatory and enabling legislation in Pakistan. Law making in Pakistan has now become a more consultative and transparent process with cluster participation and input being a key feature. However, state policy has often defeated by persistent bottlenecks in the administrative machinery and wherever official and lower level corruption are endemic.

In some ways ABS is not a whole new feature in Pakistan. Indeed, corporate debt issues by leasing companies that were secured by way of assignment of specific lease rentals had an uncanny resemblance to ABS. However, these did not qualify as true ABS since the assignment of lease receivables did not constitute a ‘true sale’ by way of an SPV. Assigned receivables also, were not removed from the balance sheet of the issuer.

In what can best be called a piecemeal effort, THE COMPANIES (ASSET BACKED SECURITIZATION) RULES, 1999 open up the securitization market in Pakistan through Statutory Regulatory Order 1338(I)/99. Only eleven sections long, the Rules fail to cover much ground in terms of detail but open up tremendous scope of ABS activity in their interpretation. The skeletal law leaves therefore, tremendous room for expansion and development of ABS in Pakistan where securitization provides a means of liquidating certain assets (normally long-term receivables) on the balance sheet of a financial institution by issuing marketable securities against these assets. It, therefore, represents a process whereby the balance sheet can be unlocked by freeing up capital tied-up in long-term assets that are essentially illiquid in nature.


Setting Up of the SPV:

Aside from government owned entities, the Rules allow any Public Limited Company (SPC) or a Trust (SPT) to register with the Securities & Exchange Commission of Pakistan (SECP) for the purposes of becoming an SPV.

The SPC must adhere to the comprehensive provisions of the Companies Ordinance 1984 which created the now defunct Corporate Law Authority (CLA). The CLA has since been replaced by the SECP (created under the Securities and Exchange Commission of Pakistan Ordinance, 1997); which now continues to be a strong regulator of Equity and Investment in Pakistan. The Ordinance governing SPCs also covers matters of Winding up & Insolvency, Schemes for Amalgamation and Disclosure. In addition to this, an SPC must have a paid up capital of at least one hundred thousand rupees (approx. US$1666).

Operations of ABS in Pakistan:

A Trust is by far the most appropriate choice of SPV to issue Asset Backed Certificates by process of ABS which has been defined in the Rules as:

"A process whereby any SPV raises funds by issue of Term Finance Certificates (TFCs) or any other instruments with the approval of the Commission (SECP), for such purpose and uses such funds by making payment to the Originator and through such process acquires the title, property or right in the receivables or other assets in the form of actionable claims"

The Pakistan Code of Good Corporate Governance, notified by the SECP in the wake of Enron’s collapse, has no applicability to SPTs although it is a mandatory requirement to implement for all public listed companies since early this year. Any securitization activity in Pakistan must also be in conformity with the Islamic principles of finance and investments which prohibit interest based lending, but encourage management of risk in expectation of profit or mark-up.

The Rules define "future receivables" to include all such receivables against which income may accrue or arise at a future date. An inclusionary structure therefore leaves the playing field for ABS wide open. External credit enhancement can be obtained for the securitization structure by means of Pool & bond insurances (to cover any losses on the pool of assets), Letters of credit from banks (to cover losses up to a certain amount) and corporate guarantees (either from a third party or from the Originator).

Advertisements, prospectuses and other invitations to the public to invest in a scheme, including public announcements, must be submitted to the SECP for approval prior to their issue. The approval may be varied or withdrawn but not before a hearing. SPVs may at all times take legal recourse against the orders of the SECP.

The wheels turn slow in Pakistan, but they do turn. And where packaging the parts and selling them leads to a value greater than the whole, Pakistan’s emergence as a lucrative ABS market


for foreign investors heralds an important stage in the evolution of its financial sector and economy.

ABS in Philippine:

Unlike other Asian countries, the Philippines had not really had major reforms in its insolvency procedures since the Asian crisis. About the only major changes in the Philippine legal landscape that relate to nonperforming loans (NPLs) and corporate bankruptcies are: 1) the transfer of jurisdiction over corporate rehabilitation cases from the Securities and Exchange Commission (SEC), a quasi-judicial government body, to the Regional Trial Courts (RTCs) in 2000; and 2) the signing of the Special Purpose Vehicle (SPV) Act, which provides fiscal incentives for banks to solve their NPL problems, in January 2003.

Thus while the other severely affected countries like Indonesia and Thailand had taken advantage of the crisis to modernize their insolvency laws, the Philippines still awaits the dawn for major legal bankruptcy reforms.

The Short-term Solution: Special Purpose Vehicle (SPV)

To provide relief from the huge burden of nonperforming assets, the government passed the Special Purpose Vehicle (SPV) Law in December 2002 and signed in January 2003. The Law provides fiscal incentives for the transfer of NPAs from banks to SPVs which, as envisioned, would then dispose of them with greater flexibility and speed than banks. SPVs are private-sector owned asset management companies, much like the AMCs that were set up by the four other crisis-affected economies (i.e. KAMCO, Danaharta, IBRA, and TAMC) that purchased the bad assets in these countries’ banking system and eventually disposed of them. Lack of government funds and the seemingly non-systemic nature of the banking problems in the Philippines have led to the private-sector led initiative that is encouraged by the SPV Law, instead of the establishment of government-funded centralized AMC. India and Taipei, China are the two other Asian countries that went by way of the private-sector owned AMCs.

Current Performance under SPV Law:

Records of the BSP show that there are P520 billion of NPAs as of June 30, 2002, representing 14.9% of the banking system’s gross assets of P3.5 trillion. Of this, about P80 billion are expected to be sold before the expiration of the current SPV Law in April 2005, roughly P30 billion of which have already been completed, while the rest are awaiting the completion of required documents and the issuance of COEs. A total of 8 COEs have been issued to banks for SPV transactions worth more than P20 billion, 52 COEs for dacion en Pago with loan equivalent of P9 billion, and 82 COEs for sale to individuals worth P345 million.


There is the use of SPV in many other Asian countries, but from the above discussion we can easily say that, though in many countries the SPV is still new to apply, but every country sees it as a useful mechanism in financial system. Or it is better to say that to use the financial system appropriate.

Asset Backed Securities in Bangladesh:

Securitization is an innovation in financial markets. Securitization has played an exclusive function in all developed and developing capital markets. Around the world, asset-backed securities markets have also been growing rapidly. A dozen or more countries in Asia, including Japan, Hong Kong, Thailand, Indonesia, India and the Philippines have all seen the introduction of asset-backed securities. Though Bangladesh has launched some ABS in different time, it is not very well known mode of financing. Moreover market mechanism is not shaped yet. ABS can facilitate Bangladesh in various sectors like Infrastructure finance, Housing finance, FI’s fund mobilization and reducing capital requirement, capital market development.

The first ever asset securitization in the country has been launched by Industrial Promotion and

Development Company (IPDC) of Bangladesh on November 08, 2004. But the idea of introducing asset securitization in the country developed back in 1999 when the World Bank Group was working on the problems of non-bank financial institutions (NBFIs) in mobilizing funds from the market. Then the World Bank team, along with the Government of Bangladesh (GOB) designed the Financial Institutions Development Project (FIDP), which floated the idea that NBFIs might issue asset-backed securities. With the help and cooperation from different national and international bodies, the first issue of ABS in Bangladesh took place after four stagnant years in 2004. But after the first issuance, no significant development took place in this market though very good prospect exists. Industrial Promotion and Development Company (IPDC) of Bangladesh opened a new era of fund mobilization especially for the NBFIs (IPDC, 2005) through the issuance of asset-backed securities. The move will obviate the dependency of IPDC on costly bank funds and provide it funds at low cost.

Practices of Asset Backed Securitization in Bangladesh

IPDC

Parties


Originator: Industrial Promotion and Development Company (IPDC).

SPV: Investment Corporation of Bangladesh (ICB) has been made trustee for the special

purpose entity (SPE) which issued BDT 35.9 crore worth zero coupon bonds against debt receivables of IPDC.ICB being the trustee will be handling the transaction by receiving the payments and forwarding these to IPDC as per agreements after certain time period.

Investor: Dhaka Bank, Jamuna Bank, Mutual Trust Bank, Southeast Bank and International Leasing and Financial Services Ltd. have already invested in the BDT 35.9 crore IPDC asset-backed securitized bonds in private placement arrangement.

No Credit Rating Agency: As the instrument is floated through private placement arrangement and credit rating is not mandatory for private placement, there is a credit rating agency involved in the process. This is true because only the institutional investors can participate in these issues. IPDC is also planning to introduce similar instruments through initial public offering (IPO) to be traded in secondary market.

IPDC

(Originator & servicer)

Structure of IPDC’s securitized bond


The world’s first micro credit securitization deal was closed by BRAC in September 2006.BRAC

is one of the largest MFI’s in the world with over five million borrowers, primarily women. Average loan size is approximately $ 162 and the rate of repayment is 99.27 %. This novel

BRAC

ICB (SPV)

Dhaka Bank, Jamuna Bank, Mutual Trust Bank, Southeast Bank and

International Leasing and Financial Services Ltd.

(Investors)

Selling debt receivables

Sale proceeds

Issued BDT 35.9 crore worth zero coupon bonds in

different tranches

Proceeds of issue of bonds


securitization deal has been structured by RSA Capital, Citigroup, FMO and KfW.. RSA Capital, a fully owned subsidiary of RSA Security is the lead arranger. The Netherlands Development Finance Company (FMO), KfW and Citibank are the co-arrangers of this transaction. BRAC's micro-credit receivables are in Bangladeshi Taka (BDT). A local currency transaction cuts out any currency mismatch and associated exchange risk to the local client. BRAC will also replenish all non-performing loans in the trust and there is a 150 % collateralization of receivables

Originator & Servicer: BRAC will be the originator as well as the service provider for the transaction.

Trustee: A special purpose vehicle (SPV) is set up to purchase the receivables from BRAC and issue Pay Through Certificates (PTC) to investors. Eastern Bank Limited of Bangladesh is the trustee for the transaction.

Tranches: The transaction consists of 12 tranches and each tranche matures in 12 months.

Credit enhancement: An amount equivalent to $ 15 million is disbursed each six months and the tranches are credit enhanced through 50% over-collateralization.

Account Bank: Citibank, N.A. Bangladesh is the Account Bank for the trust.

Financing cost: Financing cost of this deal is approximately 12%, about 200 basis points lower than BRAC’s traditional source – bank loans.

Investor: The investors in these transactions are FMO, Citibank and two leading local bank, Pubali Bank Ltd and City Bank. The investors have agreed to provide an aggregate of Bangladesh Taka - BDT 12.6 billion (USD 180 M) for BRAC over a period of six years.

Guarantor: Citibank’s investments are guaranteed by FMO and counter guaranteed by KfW.

Parties


Rating: The transactions are rated by Credit Rating Agency of Bangladesh, the local Moody’s affiliate.

Advantages:

The transaction is advantageous to BRAC in following ways

1. Diversification of its funding sources,

BRAC

(Originator and servicer)

Eastern Bank Ltd

(Trustee)

FMO, Citibank, others

(Investors)

CRAB

(Credit rating agency)

Selling microcredit receivables Sale proceeds

Issue bonds in different tranches Proceeds of issue

of bonds

Rates SPV

Structure of BRAC’s securitized bond


2. Reduction of on-balance assets

3. Disbursement of more loans to a larger number of micro entrepreneurs.

Three Crucial Factors:

Firstly, BRAC’s portfolio size is large and diverse - $ 348 million in disbursed loans are outstanding and spread over 4.48 million poor entrepreneurs.

Secondly, the organization’s skilled and qualified work-force at the head and

the field offices ensures a repayment rate of nearly 99 percent. The organization also employed

qualified personnel in the MIS department thereby guaranteeing effective data management.

Finally, the strength and the credibility of the dependent parties – RSA Capital, FMO, KfW, and

Citibank played a key role in the success of the deal

ULC issued Tk 0.40 billion worth asset backed zero coupon bonds in 2005 through private placement.

Originator: ULC

Trustee / SPV: As per Trust deed dated February 7, 2005 between United Leasing Company Limited (ULC) and Investment Corporation of Bangladesh (ICB) a Trust in the name of “ULC

ULC

Parties


Securitization Trust 2005-A” was formed and ULC sold lease receivable of Tk. 400 million to the Trustee (ICB) to issue Asset Backed Zero-Coupon Bonds.

Bond Classes:

Class A bond: The Trustee issued 37 Class A Bond.

Class B Bond: The trustee also issued 3 Class B Bonds of Tk.10 million each of which ULC purchased 3 class B Bonds bearing 7.90% interest as credit enhancement to secure the interest of class A bond holders.

Credit enhancement: Any loss due to non-collection of lease receivable in respect of class-A bonds held by the investors will be adjusted against the amount of class B bonds held by United Leasing Company Limited. All Class A Bonds have been redeemed by January 2009. The redemption of the Class B Bond starts from February 2009.

Structure of ULC’s securitized Bond


IDLC of Bangladesh Limited (IDLC), a leading joint-venture multi-product financial

IDLC

ULC

(Originator)

“ULC Securitization Trust 2005-A”

(SPV)

Other Investors

Selling lease receivables Sale proceeds

Issued Tk 0.40 billion worth asset backed zero coupon bonds

Class B bonds Class A bonds

Proceeds of issue of


institution formally launched Asset Backed Securitized Zero Coupon Bonds with an issue

value of BDT 190 million on February 9, 2005 (IDLC, 2005). This marks a significant

achievement in the company’s quest to mobilize funds, at lower cost, as part of its continuing

commitment to assist in the industrial development of Bangladesh. The FIDP of Bangladesh

Bank initiated the debt instrument to enable financial institutions to mobilize funds against

credit receivables, with World Bank support.

Originator: IDLC of Bangladesh Limited (IDLC)

SPV: IDLC Securitization Trust 2005 is formed to serve as the Special Purpose Entity

(SPE),which will issue Zero Coupon Bonds against lease receivables of IDLC. The Investment

Corporation of Bangladesh (ICB) is nominated as the trustee of the issue and ICB, being the trustee will handle the transaction by receiving the subscription payments and forwarding these to IDLC as per agreements.

Investor: Commercial Bank of Ceylon Limited, BRAC Bank Limited, The City Bank Limited, Green Delta Insurance Company Limited and Reliance Insurance Limited have subscribed to the issue under private placement.

Parties:

Structure of IDLC’s securitized bond


IIDFC

IDLC

(Originator)

ICB

(SPV)

Commercial Bank of Ceylon Limited, BRAC Bank Limited, The City Bank Limited,

Green Delta Insurance Company Limited

and Reliance Insurance Limited.

(Investors)

Selling lease receivables

Issued BDT 190 million worth asset backed zero coupon

bonds

Sale proceeds

Proceeds of issue of bonds


The Industrial and Infrastructure Development Finance Company Limited (IIDFC), a leading non-banking financial institution (NBFI), has submitted an application to the Bangladesh Bank (BB), the country’s central bank, seeking permission to issue zero-coupon bonds worth BDT4.0 billion.

1. Administering cost: For a large number of investors (in case of IPO), definitely this cost will be much higher.

2. Huge compliance requirement: Compliance requirement is huge, as the issuers

need to comply with various regulatory authorities, such as SEC, Bangladesh Bank, or

National Board of Revenue (NBR).

3. Lack of knowledge of investor: It is expected that general investors may lack knowledge of a complicated instrument like ABS, although this problem can be easily solved by investment bankers of the country.

Reasons of absence of public placement in Bangladesh

Prospects of Bangladesh in ABS


In the Bangladesh context, securitization is the only ray of hope for funding resource starved infrastructure sectors like Power, Public Transport. Public Private Partnership (PPP) is very much talked issue now a days. The basic idea behind this PPP is simply creating opportunity for the private investor to participate in public sector. When any private entity wants to invest in public sector then this entity will be provided the right of that public property for a certain time to make pay off. This idea is quite new in Bangladesh. To make PPP fruitful GOB need to build huge capacity in terms of rules, regulation, monitoring etc. Moreover pricing conflict between public and private entity, protecting competition of market economy, private sector incentive issues are very much complex to deal. Asset Securitization can be implemented more easily. Unlike equity transfer in PPP, ABS issue debt securities backed by future revenue flow. And ABS is more efficient in respect to time, flexibility, fund generation etc.

Banks and financial institutions can securitize a pool of housing loans to raise fund at cheaper cost and make their balance sheets free.

Moreover housing companies can directly make securitization to achieve disintermediation. This also helps FIs to invest individual deposit more efficiently.

The government could support the ABS program through providing insurance to the ABS program as a contingent credit enhancement.

The banking sector of the country experienced a total of Taka 226.2 billion non-performing loan (NPL). Securitization can play a critical role to mitigate the burden of NPL largely. Banks and FIs can sell their non-performing loans to the SPE; the SPE would then pool the loans and issue asset-backed securities. It is superior way to give healthy look to the balance sheet than NPL rescheduling. In case of securitizing the NPLs the issuance of zero coupon bonds are usually favored on the ground that the estimated amount loans to be sold to the SPE and the size of the ABS program may not be economical to have monocline insurers insure the interest payments. The use of zero-coupon bonds would compensate for the questionable timing of the cash flow obtained from the sale of the properties.

Suggestions for SPV


Asset and Investment Management Services (AIMS) of Bangladesh Limited suggests creating the Special Purpose Vehicle (SPV) Trust as a ‘not-for-profit’ entity for getting tax-exempt status. It also suggests that the NBFIs shall not go for public issue in their several tranches, which will save their issue cost including underwriting commission to a great extent. AIMS also holds that a conduit SPV structure, pooling of assets from different NBFIs, may also reduce issue cost while enhancing credit quality of the securitized instruments.

Despite the restrictions imposed on the commercial banks that accept funds, the infusion of public funds is essentially a direct subsidy to the banks. The infusion of public funds provides the banks with the necessary capital needed to write-off the non-performing loans on an accounting basis; however, the non-performing loans, as well as the collateral, remain with the banks. Therefore, the banks need to dispose of these assets to truly solve the NPL problem. Our proposal is such that the commercial banks sell their non-performing loans to a jointly established SPC (Special Purpose Companies – like SPV); the SPC would then pool the loans and issue asset-backed securities (ABS).

First:

Under the proposed structure, banks could mix any proportion of performing and non-performing loans, depending on market demand. Banks however, may have some reluctance to sell performing loans to the SPC due to cultural, social, political and economic reasons and to consideration of this, the proposal leaves a provision of allowing the banks to determine the proportion of performing and non-performing loans sold to the SPC.

The Proposal of Securitization through NPL sale


Banks establish and sell Loans to SPC

In the proposed plan, a group of banks will first establish a SPC by investing a small amount of

capital, and then sell their loans to the SPC. For example, the book value of bank A’s loans is

100; the probability of recovering the loans is very low; the loan has collateral of an estimated

fair market value of 60; after establishing the SPC, bank A sells the loans to the SPC at 60; bank

A will recognize a tax-deductible loss of 40 at the time of the sale and the loans (100) will be

removed from bank A’s balance sheet; however, SPC won’t be able to purchase loans from all the banks at a time due to small initial capital; Initially it would buy loans on a pro-rata basis and

gradually grasp all the NPLs of participating banks through issue proceeds of securitization

The benefits of this scheme are-

I. Banks remove the NPLs from their balance sheet; and

II. The loss of sale creates tax benefit immediately to the banks


Second:

The next step is for the SPC to sell the collateral underlying the loans. If the SPC tries to sell all of the collateral real estate properties in the market at once, it is likely that the weak country’s real estate market would deteriorate further (assuming the loans were real estate loans). The SPC should avoid an immediate sale of the properties that may damage the real estate market. Such action may not only push the national economy further into trouble, but also decrease the proceeds from the sale of the properties. Therefore, the SPC should pool the loans and issue ABS, using the proceeds from the sale of the properties as collateral or as cash flow.

The sale of loans to the SPC de-links the loans from the banks, and in that case, the rating of the ABS would be based solely on that of the SPC, whose only assets are the pool of properties. But the lack of liquidity in the real estate market is an obstacle to creating high demand from investors for ABS. To address the risk of default on interest payments by the SPC due to insufficient cash flow generated by the properties, arrangements can be made with insurers such as Sadharan Bima Corporation to insure the interest payment. However, given the estimated amount of loans to be sold to the SPC and the size of the ABS program, insurers may not find it economical to insure the interest payments. Thus, the ABS issued by the SPC may be zero coupon bonds (ABS issued in Bangladesh so far are zero coupon bonds). The use of zero-coupon bonds would compensate for the questionable timing of cash flow obtained from the sale of the properties.

Third:

Finally, SPC can get relief of purely bad loans by making factoring arrangement with local factors like IDLC and ILFSL.


Unlike a direct subsidy such as purchasing banks’ preferred shares, the government might provide insurance to the ABS program in the form of a contingent credit enhancement. Different

government bonds or treasury bills held by the Bangladesh Bank may be used to enhance the credit of the ABS program. If the SPC fails to generate sufficient cash flow from the sale of the

properties or from the properties’ cash flow, the government can liquidate part of the treasuries or government bonds to make the payment. The ABS might be issued in senior, junior and subordinate portions varying by the amount of the guarantee. For example, in Bangladesh ULC sold lease receivable of Tk 0.40 billion to the trustee (ICB) to issue asset backed zero-coupon bonds. Thereafter the trustee issued 37 class A and 3 class B bonds of which ULC purchased 3 class B bonds bearing 7.90% interest as credit enhancement to secure the interest of class A bond holders. Any loss due to non collection of lease receivable in respect of class A bonds held by the investors would be adjusted against the amount of class B bonds held by ULC.

Lack of active debt market:

Lack of a sophisticated debt market is always a drawback for securitization due to the absence of benchmark yield curve for pricing. ABS is a complex secondary market based debt instrument and it is very tough to introduce it in a completely new channel. The bond market has played a limited role in the Bangladesh economy in compared to the neighboring countries. In Bangladesh the outstanding bond volume over GDP was only 1.4%, compared with India (34.8%), Pakistan (30.9%), Sri Lanka (53.6%), and Nepal (9.8%) in the year 2005. The share of the Bangladesh bond market in South Asia (0.2%) is also the smallest among the five countries.

Credit Enhancement:

Hindrances of Asset Securitization in Bangladesh


(Source: South Asia Bond Markets: Bangladesh, Yibin Mu, Version April 2007, World Bank.)

The main impediments to the Bangladesh debt market are-

Weak regulatory framework, Supply-side constraints such as a lack of the benchmark bonds.\ Demand-side constraints such as the limited investor base. A lack of intermediaries with expertise in debt products. A lack of confidence in corporate borrowers, market distortions which are caused by the

National Savings Scheme (NSS) offering above-market returns and a lack of interest from private companies, including financial intermediaries and large business, in launching new debt products due to high fees.

The development of the debt market would naturally increase the securitization activity in Bangladesh.

Inadequate Strength of credit rating industry:

In Bangladesh legislation was established in 1996 to provide a framework for credit ratings, as well as there are two domestic credit rating agencies capable of rating securitized products.

CRISL Credit Rating Agency of Bangladesh (CRAB).

The capabilities of the domestic credit rating agencies are questioned by those familiar with

international rating agencies. This is partly due to compensation arrangement. On the one

hand, rating fees approximate $3,623 and annual fees come in at about $1,450 .

(Source: South Asia Bond Markets: Bangladesh, Yibin Mu, Version April 2007, World Bank.)

Low fees, by international standards, contribute to making ratings affordable for Bangladesh companies and increasing usage.


On the other hand, lower revenues translate into lower pay for employees and less investment in software and systems for analysis.

But securitization market needs highly qualified and credible credit rating to motivate investors and mobilization of participants.

Lack of appropriate legislation:

There are no laws specially governing securitization transactions in Bangladesh. The idea of introducing asset securitization in the country originated in 1999. Since then Bangladesh Bank as a regulator has not provided any guideline regarding asset securitization. But Bangladesh Bank issued only a tentative guideline on mortgage-backed securitization which is insufficient to promote the securitization. Moreover, the Asset Backed Securities Issue Rules, 2004 under Securities and Exchange Commission Act, 1993 is unable to depict the trading guideline. Besides the two regulators Government of Bangladesh also failed to support the securitization process such as Government had the scope to securitize their receivables from infrastructure and housing sector. No bill has been tabled in the parliament of Bangladesh yet to transform an act for securitization.

The following are the key areas where legislators should focus:

True Sale (Isolation from bankruptcy of the originator):

The central idea of a securitization transaction is to isolate the assets of the originator from originator’s balance sheet and seek a higher credit rating than the originator’s own rating. A key

requirement for that is to achieve a “true sale” of the assets to the Special Purpose Entity.


Transfer of collateral:

Financial Institution cannot transfer the underlying collateral securities of immovable property attached with the receivables though they are allowed to sell or transfer the cash flows associated with the receivables to other interested investors. This lapse of in the law should be eradicated.

Bankruptcy remote SPE:

The special purpose entity that buys assets from the originator should be a bankruptcy remote agent for distributing the income from the assets to the investors. No clear vehicle has emerged for performing bankruptcy remote securitization. This should be addressed by the securitization act.

Stamp Duties:

Stamp Duties on transfer of assets in securitization can often make a transaction unviable. Article 40 of the First Schedule of the Stamp Act of 1899, states that the stamp duty is not required in case of a new mortgage but is silent about any modification of mortgages which is essential in case of ABS.

Taxation & Accounting:

At present there are no special laws governing recognition of income of various entities in a securitization transaction. Furthermore tax disparity between zero coupon bonds and other fixed income securities lessens the competitive advantage of ABS. Accounting rules and standards practiced in Bangladesh is also lacked in ABS issue. Bangladesh is yet to introduce Financial Accounting Standards Board (FASB) Statement No. 140: “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” – a replacement of FASB Statement No. 125,” (September, 2005) & IAS 39: Financial Instruments: Recognition and Measurement (IAS, 2005).


Lack of Investor Appetite:

Investor awareness and understanding of securitization is very low. Most of our investors are not sufficiently sound in understanding company fundamentals. Knowledge of the investors about structured finance and derivative is close to zero. SEC, Dhaka Stock Exchange and Chittagong Stock Exchange often arrange investor awareness programs, but those are not sufficient to build up economy wide awareness and knowledge of numerous investors.

.

Despite obstacles, there is a huge potential for asset securitization in Bangladesh in banking sector, as well as in other sectors such as housing finance companies, which can securitize their mortgages, credit card companies, which can securitize credit card receivables, micro finance companies, which can securitize micro credits (As BRAC ) or ministry of communication can securitize toll receivables of Jamuna Bridge and other infrastructures. Securitization thus has a potential of becoming alternative to loans from foreign countries. Further, through securitizing future flows of remittances sent by the Bangladeshi workers abroad, financial institutions can issue Islamic Shariah based securities in Middle East countries and can reap the benefit of low cost financing. All these would ultimately pave the way for faster progress in financial sector reforms and a higher growth of the economy.

Conclusion

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