Introduction

One of the most cost effective ways of fund raising for any company is through securitisation. The Asia Pacific Structured Finance Association issued a report last month “depicting a promising and lucrative picture for developing Hong Kong into a securitisation hub”. Hence, it should not be surprising that a great number of finance companies have securitised, or are already looking to securitise, their respective loan portfolios.

Through a series of articles, we will address some of the legal issues a finance company will face when attempting to securitise its loan portfolio. The very first being how to the legally and effectively “move” its loan portfolio to a single purpose company (“SPC”).  

What is a loan?

A loan, which is a debt, is a “chose in action”. And a “chose in action” in favour of one person against another is a personal right possessed by the former against the latter that is recognised and enforceable in law and by the courts. However, it is merely a right against a person and does not confer any proprietary interests (whether legally or beneficially or by way of security) in any assets of such person.

How do we “move” a loan?

A “chose in action” can be “moved” from one person to another in 3 ways, (a) by novation, (b) by legal assignment, and (c) by equitable assignment.

For the purposes of this article, the person who possesses the “chose in action” (being the “Loan”), and wishes to “move” it, is the “Transferor”, the person who wishes to receive the rights under the Loan is the “Transferee”, and the person to whom the Loan is made is the “Borrower”.

Novation

A novation is an agreement between the Transferor, the Transferee and the Borrower with the following terms.

1.        The Transferor transfers all of its rights and obligations under the Loan to the Transferee.

2.        The Transferee receives all of the rights and obligations of the Transferor under the Loan from the Transferor.

3.        The Borrower agrees to each of 1 and 2 above.

This is the most complete way of “moving” the Loan and it provides the greatest protection to the Transferee in law because no person under any circumstances can challenge its rights under the Loan.

Legal Assignment

A legal assignment is an agreement between the Transferor and the Transferee, where the Transferor agrees to transfer, and the Transferee agrees to receive, all of the Transferor’s rights under the Loan, with notice of such agreement to the Borrower and in full compliance with section 9 of the Law Amendment and Reform (Consolidation) Ordinance (Cap. 23) (“Section 9”).

However, this form of “moving” the Loan does not allow the obligations of the Transferor under the Loan (for example, the obligation to continue to lend under an overdraft loan facility) to be transferred to the Transferee. So this method cannot be used if there are continuing obligations of the Transferor under the Loan and the Transferor or the Transferee cannot accept that they remain with the Transferor.

Equitable Assignment

An equitable assignment is an agreement between the Transferor and the Transferee, where the Transferor agrees to transfer, and the Transferee agrees to receive, all of the Transferor’s rights under the Loan, without notice of such agreement to the Borrower or otherwise not in full compliance with Section 9.

However, this form of “moving” the Loan raises four considerations.

1.        An equitable assignment, just like a legal assignment, cannot transfer the obligations of the Transferor under the Loan to the Transferee.

2.        Any person who entered into a novation with the Transferor and the Borrower, or a legal assignment with the Transferor with notice to the Borrower, in respect of the Loan (the Transferor in each of these cases acting fraudulently because it knows that its rights under the Loan have already been transferred to the Transferee under an equitable assignment) will have priority over the Transferee, provided that such person did not have notice (express, implied or constructive) of such equitable assignment.

3.        In the event that two equitable assignments have been entered into with the Transferor (acting fraudulently) and each assignee did not have notice (express, implied or constructive) of the other equitable assignment, then the assignee who first gives notice to the Borrower will have priority over the other.

4.        An equitable assignee cannot sue the Borrower in its own name and the Transferor must be joined in the action either as a claimant or a defendant (depending whether the Transferor is cooperative).

Conclusion

The “movement” of loan assets from the finance company to the SPC can be effected at law by the three methods described above, albeit with different protection accorded to the SPC and ultimately the securitisation investors.

RMBS (residential mortgage backed securities) issued all over the world have been commonly structured with equitable assignments because most banks have been reluctant to notify their borrower clients that their respective loans have been sold by their banks to third parties. This will certainly also be the case with Hong Kong finance companies.

However, the relevant parties with vested interests will have to, from a commercial perspective, consider whether the finance company (who will be the transferor) will act fraudulently given the circumstances surrounding each transaction.

Some risk mitigating factors against such potential fraud would be (a) reputation of the finance company, (b) reputation of the management of the finance company, (c) potential consequences for the finance company and its management for committing such fraud, and (d) how difficult it will be for another transferee or assignee to claim that it had no express or implied or constructive notice of the assignment in favour of the SPC.