Volume 42 | Number 3 Summer 2007
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II. Securitization of Mortgages in Israel
A. Description
In Israel, mortgage banks are not authorized to provide general banking services, only loans to the public for the purpose of buying real estate. Most of these banks are subsidiaries of commercial banks. Recently, two mortgage banks were merged into their parent companies, so that the mortgage area is now managed by a separate division within the bank.
The banks lend money to the public for the purchase of real estate—homes in most cases. Against the loan, the bank receives a mortgage on the borrower’s property, usually the real estate acquired with the loan. In a securitization transaction, the mortgage bank sells rights it has against specific borrowers to an SPV which is created for the securitization transaction. Under the rules of the Bank of Israel (Israel’s central bank), a mortgage bank may not sell only strong loans—i.e., loans with a low probability of default—and maintain only the weak loans, because this might undermine the bank’s stability. The bank must therefore sell the SPV a portfolio representative of all its borrowers. An exhibit attached to the sale agreement specifies the names of the borrowers whose obligations to make future payments are sold to the SPV. In the standard securitization transaction in Israel, the mortgage bank and SPV stipulate that if a borrower defaults, the SPV will have no recourse against the bank.
The SPV has no tools to handle the logistics of loans. The bank thus provides these services for the SPV for an agreed fee. The services include management of the loans, ongoing communications with the borrowers, collection of the debts, and foreclosure of the mortgages. Since the sale agreement transfers the ownership of the loans portfolio to the SPV, the bank acts as an agent for the SPV. The service agreement provides, generally, that the bank will collect the money from the borrowers on behalf of the SPV and transfer the money collected to the SPV on agreed dates.
Securitization offers the banks various advantages. The immediate payment enables the bank to expand its business. There is also an advantage to the bank’s accounting, since the loans no longer appear on the balance sheet. The institutional entities that finance the SPV are corporations with high liquidity and substantial resources—such as pension funds and insurance companies—that are always looking for new investment avenues. Under the securitization agreement, the mortgage bank acts as a mediator in the financing sector and entitles the investors to repayment of the loans and the interest acquired by the borrowers.
The SPV and its lenders, the debenture holders, want to make sure that events that might take place after the transaction will not have an adverse effect on the future cash flow from the borrowers. The SPV is concerned about the following scenarios:
Insolvency of the bank. The goal here is to prevent a receiver or an administrator from taking possession of the money paid by the borrowers. The SPV seeks to stop this money from becoming part of the receivership asset pool, and to make sure that it both belongs to the SPV and is available to the debenture holders. The SPV also wants to ensure that the bank’s creditors cannot impose liens on the money owed by the borrowers.
A conflicting transaction by the borrower. The borrower might execute a transaction in violation of the mortgage with the bank, such as a transfer of ownership or any other right in the property to a third party. The bank will prevail over such competition because it is named as mortgagee in the Land Registry. The SPV seeks to have the same priority.
Insolvency of the borrower. Before the securitization, the bank is a secured creditor, and has priority over the borrower’s other creditors upon insolvency. This priority is guaranteed by the mortgage, which enables the bank to foreclose on the mortgage directly without having to first obtain court approval.3 The SPV seeks the same protection.
B. Securitization as an Assignment of Rights
To check whether the SPV and the investors can accomplish these goals, the transaction between the bank and the SPV must be analyzed in accordance with the set of laws governing it. To this end, I will now provide a brief review of the laws regulating the assignment of rights.
Generally, a creditor can sell his rights or use them as a security interest. That is, a creditor can either sell his rights or take a loan, submitting his rights against his debtors to the lender as collateral. In a sale of rights, as in the sale of movable or immovable property, the object of sale ceases to be the property of the seller, and becomes that of the buyer. Ownership of the right transfers to the assignee even without any notice to the debtor.4
The other transaction, in terms of security interests, is known as a pledge, meaning “a charge on property as security for an obligation.”5 In the law of Transfer of Obligations it is called a “transfer of a right by way of a charge”6 In a sale of rights, the assignee is the buyer; whereas in an assignment by way of a charge, the assignee is a secured creditor, and the assignor’s other creditors are unsecured creditors. Under the laws regulating security interests, a secured creditor prevails over all other creditors if its security interest is registered in a public registry.7
After the assignment, a creditor of the assignor cannot impose a lien on the transferred rights. In a true sale, the assignor is no longer the owner of the rights, which are henceforth no longer exposed to the imposition of liens by the assignor’s creditors.8 An assignee who is a secured creditor and has registered the security interest also prevails over the holder of a lien.
Insolvency of the assignor is not supposed to have any adverse effect on the assignee. The assignor’s receiver cannot add the assigned rights to the general asset pool, because these rights have become the property of the assignee. This rule applies even if the payment of the assigned debts is due only after the receivership order is handed down against the assignor.9 The same is true of an assignment by way of a charge.
However, the status of the assignee as a buyer is better than the assignee’s status as a secured creditor. For instance, the court has the power—as part of the process of helping a company under receivership to recover—to suspend the exercise of security interests, provided that the secured creditor’s rights are adequately protected.10Yet the court has no authority to violate, even temporarily, the rights of an assignee who purchased the company’s rights against third parties. Also, if the rights are assigned via a security interest, the assignee must repay the assignor any money collected from the debtors in excess of the loan.11
It is not easy to define the criteria with which to distinguish between a true sale from a security interest. Israeli case law on this matter is scarce. According to the existing case law, if the assignment agreement provides that an assignor who is unable to collect the debt from the debtor has no recourse against the assignor, then the transaction is a true sale, and if the assignee can collect against the assignor, it is a security interest.12
Indeed, if under the assignment agreement, an assignee who is unable to collect the debt has no recourse against the assignor, the transaction fails to satisfy all the elements of the laws of security interests. Under the Pledges Law a security interest is incidental to the debt—it secures the debt but does not replace the debt.13 A lender who received a security interest and whose debt is not wholly satisfied may exercise the security interest and collect its debt from the proceeds, file a regular suit against the lender to repay the debt, or do both.14 That is, a lender that received a security interest may, at its discretion, seek repayment of the loan from the borrower without exercising the security interest. If the assignee may not sue the assignor, then their relationship is not one of lender and borrower. Israeli law does not recognize an in rem security interest, under which there is no duty upon the borrower to repay the debt. Parties cannot create such an interest in contract, because the list of property rights protected by law is finite—the courts are not authorized to recognize a property interest that was not recognized by the legislature.15
I will now analyze the securitization transaction under the principles governing the transfer of obligations. The bank has contractual rights under the loan agreements to receive various amounts of money from the borrowers and may assign these rights to the SPV. “The right of a creditor . . . is capable of being transferred without the consent of the debtor, unless its transferability is negated or restricted by law, by the nature of the right or by agreement between the debtor and the creditor.”16 Therefore, if the agreement between the borrower and the bank does not prohibit the latter from transacting in the rights, the bank may assign its rights against the borrowers to an SPV. In this transaction, the bank is the assignor, the SPV is the assignee, and the borrowers are the debtors. The outcome of the assignment is that the assignor ceases to be the debtor’s creditor, and the assignee becomes the debtor’s only creditor. After the agreement between the bank and the SPV is executed, the SPV is the creditor of the borrowers, who now have no obligation toward the bank. From a contractual perspective, the SPV becomes the borrowers’ creditor—instead of the bank. From the perspective of property law, the SPV becomes the owner of the rights.
As a creditor of the various borrowers, the SPV may assign its rights without their consent. The pledging of the rights to the investors who lend money to the SPV constitutes an additional assignment. But this assignment is by way of a charge. The issuance of debentures on the stock exchange is a loan that the SPV receives from the investors, and the SPV transfers the rights it has against the borrowers as a security interest.
The assignment of the bank’s rights to the SPV protects the latter from an exposure to any insolvency of the assigning bank or the imposition of a lien by one of its creditors. This protection also applies in the case of an assignment by way of a charge. However, as a purchaser, the rights of the SPV are better protected, as are the interests of its investors. In fact, it is in the bank’s best interest to perform a true sale, because of accounting considerations. After a true sale the bank no longer needs to include the rights against the borrowers in its balance sheets, which in turn may improve its capital adequacy ratio.
In mortgage securitizations in Israel, it is standard to include a provision that expressly stipulates that if the SPV is unable to collect the debt from the borrowers, the SPV will not be entitled to demand that the bank repay the entire principal—the money it paid to the bank for the assignment. Typically, the bank only assumes liability for a very small portion of the principal. Only a full right of recourse that would expose the bank to an obligation to repay the entire amount will be interpreted as a security interest transaction. The typical securitization transaction in Israel is structured as a true sale.
C. Registration of the Assignment
In case of bankruptcy or receivership, the interests of a secured creditor will not be protected unless the assignment has been registered. Section 97 of the Bankruptcy Ordinance stipulates the following:
(a) Where a person has transferred existing or future rights to another and is subsequently adjudged bankrupt, the transfer shall be of no effect against the trustee as regards claims which were not settled before the commencement of the bankruptcy unless the transfer was registered at the time and in the manner prescribed by regulations.
(b) The provisions of subsection (a) shall not apply to a transfer of claims against debtors specified in the instrument of transfer and the due date of settlement of which coincides with or precedes the time of the transfer, or in existing or future rights under contracts specified in the instrument of transfer, or of rights the transfer of which is included in the transfer of a business in good faith and for consideration.17
Section 97 imposes a duty of registration with respect to a general assignment that does not specify the contracts to which the assignment applies or the names of the debtors. The registration requirement does not apply where the contracts or debtors are specified in the instrument of assignment.18 If the names of the borrowers whose debts are assigned are adequately specified, the true sale transaction does not have to be registered. Typically, an addendum to the agreement between the bank and the SPV specifies the names of the borrowers and the dates of their contracts with the banks.
D. Notice to the Debtors
As a rule, the agreement between the bank and the SPV does not require the borrowers’ consent. The laws governing the assignment of rights do not obligate the assignor or the assignee to notify the debtor of the assignment. However, notice to the borrowers of the assignment could strengthen the SPV’s protection. A debtor may not raise claims against the assignee arising from other transactions he has with the assignor if these claims accrued after notice of the assignment was given.19 Some borrowers, especially those who also have savings plans or provident funds at the bank, may also have various causes of action against the bank. Notification to the borrowers regarding the assignment protects the SPV against any new arguments that the borrowers may have against the bank.
A special provision passed into law in 2003 with respect to the securitization of mortgages states the following: “Should a mortgage be registered under this Section, the transferring corporation shall immediately give notice of the transfer to the borrower and the owner of the real estate securing the registered mortgage.”20 The notice requirement applies regardless of whether the mortgage registry is amended. The purpose of the law is to protect the borrower/owner of the real estate that serves as mortgage in the case of securitization. The notice affects the protection granted by law to the borrower/owner, and therefore the borrower/owner must be notified.
Under the laws of assignments, “[t]he transfer of a right does not alter the right or the conditions thereof.”21 Therefore, provisions allowing early mortgage payoff will remain in full force and effect. The duty to send the borrowers periodic reports no longer rests with the bank, but with the SPV. Such reporting is not an independent duty of the bank but an incidental duty to the ownership of the right against the borrowers, and the duty transfers to the SPV accordingly. Under the service agreement, reporting will continue to be carried out by the bank.
E. The Bank as Trustee
The bank and the SPV execute a service agreement under which—in consideration of an agreed fee—the bank will continue to collect the money from the borrowers, and transfer it to the SPV shortly thereafter. The bank might be liable toward the SPV if it is negligent in collecting the money. This liability has no effect on the classification of the assignment agreement as a true sale or as a security interest. Keeping the service agreement as separate from the sale agreement might help thwart any allegation that the transaction was not a true sale.
From a property law standpoint, the money held by the bank is the property of the SPV. In one instance, Israel’s Supreme Court expressed its opinion that where the debtor paid the debt to the assignor instead of the assignee, the assignor was holding the money in trust for the assignee.22 The standard service agreement used in Israel expressly stipulates that the bank is a trustee for the issuer.
The creditors of a trustee have no recourse against the assets held in trust. The Trust Law states: “Trust property shall not be distrained save for debts resting on that property or arising out of activities of the trust.”23 Thus, the bank’s creditors have no access to the money that the bank holds in trust for the SPV: “A trust has effect vis-à-vis any person who knows or ought to know about it, and where a note has been entered under section 4, vis-à-vis the whole world.”24 If the bank is dissolved, the receiver might argue that the trust agreement between the bank and the SPV is not binding upon the receiver, because the receiver was not aware of its existence.
In order to protect the trust, the following actions can be taken:
a. Incorporating a provision in the service agreement that expressly states that the bank will hold the money obtained from the borrowers in trust for the issuer or the investors;
b. Holding the money received in a separate trust account and prohibiting the bank from transacting in this money in any way—apart from a transfer to the SPV;
c. Registering the transaction between the bank and the SPV with the Companies’ Registrar. Such registration could inform third parties of the SPV’s rights and thus satisfy the requirement regarding third parties’ knowledge as required to protect the trust.