United States: Securitization Of Project Finance Loans

The Project Funding Notes were secured by an initial portfolio of 40 project finance loans originated by Credit Suisse First Boston and made to U.S. borrowers and one project finance loan originated by Credit Suisse First Boston and made to a foreign borrower. All loans were U.S.$ denominated and met certain specified eligibility criteria. The respective principal balances of the loans in the initial portfolio ranged from $1 million to $50 million. The credit support for the Project Funding Notes is the subordination of classes thereof with higher numeric designations which was effected by the preferential application of available amounts to payments due on such Notes. The approximate aggregate credit enhancement for the Project Funding Notes was as follows:

In an earlier exception, in July 1994 Energy Investors Fund Funding Corporation ("EIF Funding") sold $125 million of its 9.45% Secured Bonds due July 15, 2011 (the "EIF Bonds"). The sale proceeds of the EIF Bonds were lent to Energy Investors Fund, L.P. (the "Fund"). The EIF Bonds were secured by the Fund's limited partner interests (and rights to acquire limited partner interests) in eight power projects and limited partner interests in entities which own limited partner interests in five power projects. The projects were diversified as to technology and fuel type and sold (or were expected to sell) power to nine utility customers in different regions of the United States. No single power project accounted for more than 17% of the total capital committed by the Fund or was expected to account for more than 18% of the total cash flows projected to be received by the Fund from its project portfolio during the life of the EIF Bonds. At issuance, the EIF Bonds were rated Baa3 by Moody's and BBB- by S&P.¹⁰

D. Techniques To Enhance Securitization

If the issues discussed above present unacceptable risks to investors--or perhaps simply would prevent obtaining an investment grade rating--there are a number of well-established techniques that can be used to enhance the securitization transaction. These techniques are described in this subsection. All of these techniques potentially apply to the securitization of a pool of loans, but only a few (e.g., items 6 and 7 below) are likely to apply to a securitization which occurs by reason of a refinancing.

1. Warranties

In all securitization transactions, the seller of the loans makes warranties to protect the investor against certain basic risks, such as warranties that the loans have been described accurately and that the loans are the legal, valid and binding obligations of their respective borrowers, enforceable in accordance with their terms, subject to no defense, set-off or counterclaim. Absent special circumstances, such conventional warranties will not prevent the sale from being recognized as a bona fide sale on the books of the seller.

2. Credit Enhancement

In most securitization transactions, the principal (and, often, the only) protection against loan loss is provided by the seller in the form of some type of limited credit enhancement. This is sensible as the seller is usually the originator of the loan and therefore is most familiar with it and also the seller is the beneficiary of the sale and logically should bear at least some portion of the burden if the loan is not fully paid. For example, the seller (or sellers) could convey a loan (or loans) to a trust in exchange for senior certificates and junior certificates. The senior certificates would be sold to the investors and the junior certificates would be retained by the seller. A variation would be the sale of a senior participation in a pool of loans, thus providing the investor with the required level of overcollateralization.

With respect to most U.S. sellers, i.e., those subject to GAAP, a securitization of a financial asset or a pool of such assets will be accounted for as a sale if the transferor surrenders control thereof which requires (i) that the transferred assets are isolated from the transferor and its creditors (event in a bankruptcy), and (ii) that the transferee is a "qualifying special-purpose entity."

However, this recourse technique is not likely to be sensible if the seller is a U.S. bank, i.e., a national bank or a state bank, and therefore is subject to the regulatory accounting principles ("RAP") promulgated by the Federal Financial Institutions Examination Council (the "FFIEC"). Prior to March 31, 1997, sale treatment under RAP was considerably more difficult to achieve than sale treatment under GAAP. Whereas FAS No. 125 looks primarily to the transfer of control to determine sale status under GAAP, RAP looked primarily to the transfer of risk. Since March 31, 1997, RAP follows GAAP.

A transfer which does not satisfy the sale treatment requirements must be reported by the selling bank as a borrowing and the transferred assets will remain on the bank's books. Accordingly, such assets must still be supported by the required amount of regulatory capital, which, in most situations, would make the transaction unprofitable to the bank.¹¹ For example, if a bank sells $1 million of loans with recourse in some form equal to 5%, the bank would continue to have to maintain $80,000 (8% of $1 million) against such loans as though it still owned them, even though its maximum exposure would be $50,000 and the estimated loss for loans of this type, based upon the bank's prior collection experience, might be only $20,000 (2%). The rationale for this rule is that the bank has likely retained the bulk of the credit risk and, therefore, must hold capital as if no transfer had taken place.

In a positive development, legislation adopted by Congress in 1994, and subsequently implemented by the banking agencies, now limits the amount of such capital in certain cases to the maximum recourse exposure of the bank and in other cases (where the selling bank's exposure to losses on the pool satisfied some minimum credit quality test) to the maximum credit exposure resulting from the enhancement itself instead of the full risk-weighted capital charge for the amount of the pool enhanced.¹² Under the "low level recourse" rules, if the bank's maximum recourse exposure were less than 8% or if the credit quality of the pool without benefit of the recourse were investment grade (BBB- by S&P, DCR or Fitch; Baa3 by Moody's) or better, the regulatory capital requirement will be limited to that maximum credit exposure. In addition, proposed amendments to the risk-based capital rules¹³ would, if adopted, provide substantial capital relief for investments rated in the highest rating category, but reformulates the required regulatory capital under a complicated system of conditions and alternatives. A review of these proposed amendments is beyond the scope of this article.

3. Sale Of Junior Certificates To Other Investors

Where there is a significant spread between the interest rate payable on the project loan and the interest rate to be payable to certain investors (which should be the case), it may be possible for the risk of loss to be addressed by the creation of senior certificates and junior certificates. The junior certificates would be sold to investors willing to accept a greater risk in return for the possibility of obtaining a greater yield. This structure would not present any RAP problem for a U.S. bank, provided the bank does not retain the junior certificate and did not originate the underlying loan assets in question, and it has been used on a number of occasions to securitize senior bank loans which had been made to finance leveraged buyouts and leveraged recapitalizations. In 1989, for example, 11 financial institutions sold participations in 27 loans to FRENDS II B.V., a special-purpose vehicle, which privately placed $297 million Class A1 notes, $12 million Class A2 notes, and $34 million Class B notes. There was no recourse to the sellers. Bad-debt protection was provided by subordination: the Class A2 notes and the Class B notes were subordinate to the Class A1 notes, and the Class B notes were subordinate to the Class A2 notes. The Class B notes potentially had the benefit of a very high rate of return because of the large spread between the interest rate on the LBO loans and the interest payable on the Class A1 and Class A2 notes. The rating agency was able to evaluate the credit risk by examining each loan. At issuance, S P rated the Class A1 notes "A", the Class A2 notes "BBB", and the Class B notes "BB".

4. Spread Account

If the project loans bear interest which is higher than the yield of the securitized investment, such excess can be deposited in a "spread account" to protect investors against loss. Such a spread account is not treated by RAP as recourse. Furthermore, a selling bank should be able to "seed" such account, by making an initial deposit in such account, without creating recourse under RAP, provided that the bank expenses such payment.

5. Sale At Discount

It should be possible for a bank, without creating recourse under RAP, to sell loans at a discount, provided that it books such loss, which loss might be offset by recognition of income in the amount of the then balance of the unamortized upfront fees. If such discount exceeds actual losses, the purchaser could be obligated to pay such excess to the bank.

6. Third-Party Credit Enhancement

If the transaction is able to absorb the additional cost and still be economic, third-party credit enhancement (e.g., an insurance bond) can be purchased for the benefit of the investors. However, such insurance generally will not be issued unless the insured risk (taking into account first-loss protection provided in the transaction) is at least investment grade (as otherwise the insurer would have to maintain substantial additional capital to preserve its "AAA" rating) and is within the single risk limit of the insurer.

7. Cross-Collateralization

If the project borrowers are owned by the same investors, it may be possible to create limited cross-collateralization as part of a refinancing, as discussed below with respect to the Coso Funding transaction. (see Section V. below) In this type of transaction, the lenders do not sell their loans; instead, the borrowers form an SPE to issue less expensive debt and the proceeds of such debt are used to repay the borrowers' bank debt.

8. Use Of SPE To Address RAP Recourse Problem

It has been possible for banks selling project loans to limit the RAP regulatory option exposure arising from recourse arrangements, discussed above, by having a relationship with an SPE which issues debt, typically enhanced by some third-party bank-provided credit enhancement, and which uses the debt proceeds to purchase loans from one or more originators. The bank providing the enhancement has been required to maintain capital against the amount of its recourse, but not against the amount of the enhanced debt. For example, if the SPE purchased $1 million of loans by issuing $1 million of debt supported by a $100,000 bank letter of credit, the bank would be required to maintain capital in the amount of 8% against such $100,000 but not against the $1 million. However, there are two important limitations on the applicability of this technique to the securitization of project finance loans. First, the enhancing bank will almost invariably require the seller to provide adequate "first loss" protection, which if the seller is itself a bank, will require the selling bank to maintain regulatory capital against the full amount of the assets covered by this "first loss" protection. Second, the FFIEC recently has proposed new rules which would treat, for regulatory capital purposes, sales of assets with recourse and third-party credit enhancements as "direct credit substitutes," the effect of which would be to oblige a bank providing a third-party enhancement to maintain the same amount of capital which it would have had to maintain if it had sold such loans, i.e. 8% of $1 million in the foregoing example, or a lesser amount as to any portion of such letter of credit which enhanced the investment beyond investment grade. This proposal, however, is part of a broader FFIEC proposal to treat multi-tier, rated securitization transactions for capital purposes according to the nature and level of credit risk assumed. Nonetheless, if this proposal is adopted in substantially its current form, it will generally be essential to the enhancing bank that the seller, or the sellers combined with some other party such as an insurance company, at least provide sufficient first loss protection to permit the investment to be rated investment grade.

IV. Certain Other Issues In Connection With Securitizing

A. Taxation

This subsection discusses certain U.S. tax issues which must be considered where an SPE is established to purchase or refinance domestic project loans. This type of securitization must be accomplished in a manner that does not result in any taxes being imposed on the SPE entity chosen as the securitization vehicle. Any such taxes would increase the costs of the securitization and likely render securitization uneconomic. The most prominent taxes which may be imposed include federal, state and local income taxes, franchise taxes, transfer taxes, and intangible taxes. However, the single most significant tax that may be imposed is federal income tax.

The federal income tax laws generally subject corporations to tax on their net income. Thus, if a sponsor structures the SPE as a corporation, it is essential that the SPE minimize its net income from the securitization. A sponsor could structure such a corporation to match as closely as possible its interest and other income with its interest and other deductible expenses. Commercial paper issuers have accomplished such a matching by issuing commercial paper in amounts that result in a match of the deductions of the issuer with the income from the assets held by the issuer. In order to minimize net income, however, the rate of return on the assets held by the issuer (after taking into account any expenses of the issuer) must be approximately equal to the rate of interest paid on the commercial paper issued. As a result, the issuer has little or no room to absorb defaults or late payments. Such programs typically require substantial liquidity and credit enhancement which can be costly. However, the costs of such enhancement have not precluded a substantial market from developing and this structure, by utilizing medium term notes together with commercial paper, may prove to be workable for securitization of project loans.

While the federal income tax laws generally tax corporations on their net income, the federal income tax laws do not subject partnerships and certain trusts to tax on their net income. Thus, as an alternative to using an SPE structured as a corporation, a sponsor can structure an SPE as a trust or as a partnership. A trust that qualifies as a "grantor trust" for federal income tax purposes will not be subject to federal income tax. In order to qualify as a grantor trust, a trust must comply with two requirements in the federal income tax laws generally designed to differentiate active businesses being conducted through entities which are in form trusts from the passive nature of a true trust. First, the trustee of a grantor trust may not have the power to vary the investment of the trust. Selecting investments is regarded as a business function inconsistent with the passive nature of a true trust. Accordingly, if the trustee is granted the power to vary the investment, the trust will be taxed as a corporation for federal income tax purposes. Similarly, subject to certain limited exceptions, the trust may not have multiple classes of interests. Multiple classes of interest (e.g. securities with different maturities) evidence an intent to derive a business profit as distinguished from the trust simply being a means of holding property for the benefit of its beneficiaries. Again, if the trust has multiple classes of interests, the trust will be taxed as a corporation for federal income tax purposes.

Notwithstanding the limitations described in the preceding paragraph, a grantor trust may well be a useful entity for securitization of project loans. First, the prohibition against granting the trustee the power to vary the investment should not significantly inhibit the use of grantor trusts to securitize infrastructure loans. This prohibition has precluded sponsors from using grantor trusts to securitize revolving loans, such as credit card receivables and trade receivables. Those securitizations require that the trust continually change its pool of assets. In contrast, however, a sponsor may securitize project loans which can be held in a grantor trust until the loans liquidate. In this respect, securitization of infrastructure loans would be similar to securitization of retail automobile loans and real estate mortgages, in which the trustee does not need to have the power to vary the investment of the trust. Second, although the prohibition against multiple classes of interests may preclude a sponsor from obtaining the advantages gained from issuing securities with differing maturities secured by a single pool of infrastructure loans, the grantor trust rules do permit issuance of a single class of highly rated certificates supported by a subordinate class of interests as an exception to the general prohibition against multiple classes of interests. Thus, a grantor trust may be a useful vehicle where little or no benefit is obtained from issuing multiple classes.

As an alternative to grantor trusts, sponsors of securitization transactions have increasingly used "owner trusts," which are treated as partnerships for federal income tax purposes, to securitize financial assets. Use of an owner trust taxed as a partnership has the advantage of avoiding entity level federal income tax without the constraints imposed by the grantor trust rules. Owner trusts issue both debt and equity classes of interests and thereby obtain the advantages of issuing securities with differing maturities. An owner trust may also be used as a continuing investment vehicle if new asset purchases are desirable. Owner trusts, however, require an even higher degree of tax structuring than other securitization vehicles and thus are generally only used when the sponsor can obtain significant advantages from issuing securities with differing maturities.

In addition to the tax rules relating generally to the taxation of corporations, trusts and partnerships, because the security for certain infrastructure loans will consist, in part, of interests in real estate, certain rules enacted in the Tax Reform Act of 1986 (the "1986 Tax Act") relating to the securitization of real estate mortgages must be considered in structuring a securitization of infrastructure loans. In the 1986 Tax Act, Congress enacted rules which created a special tax law entity for the securitization of real estate mortgages (as real estate mortgage investment conduits or REMICs). Under the REMIC rules, if substantially all of the assets of a securitization vehicle consist of obligations which are principally secured by an interest in real property, the vehicle, if properly structured, may elect to be treated as a REMIC, which is statutorily exempt from federal income tax. The REMIC rules generally define an obligation as principally secured by an interest in real property if the fair market value of the real property securing the obligation is at least 80% of the principal amount of the obligation [(this may be true for some projects, e.g., a toll road)]. Thus, even if an obligation is only partially secured by real property, the obligation may be eligible to be included in a REMIC. While the REMIC rules do not define substantially all, a regulatory safe harbor provides that if 99% of the assets of an entity consist of (i) obligations principally secured by an interest in real property, (ii) qualified reserve accounts and (iii) certain other permitted investments, the entity may qualify for REMIC status. If the REMIC rules are applicable to a securitization of project loans, the REMIC rules generally provide for favorable tax treatment. The REMIC itself is generally not subject to federal income tax and the REMIC may issue multiple classes of securities.

As a corollary to the REMIC rules, however, in the 1986 Tax Act Congress enacted rules which provide that, if 50% or more of the assets of a securitization vehicle consist of obligations which are principally secured by an interest in real property, and the vehicle is not properly structured, the vehicle will be taxed as a corporation (commonly referred to as a taxable mortgage pool) and not as a REMIC or a trust or partnership for federal income tax purposes. The taxable mortgage pool rules will generally apply when the sponsor desires to have multiple classes of interests issued by the vehicle and either the percentage of the assets of a pool being securitized constituting obligations principally secured by real property is above 50% but below the percentage necessary for REMIC qualification or a sponsor desires to create a vehicle which can reinvest (which is prohibited under the REMIC rules). Under the taxable mortgage pool rules, a taxable mortgage pool, although treated as a corporation, may not be included in the consolidated return of any other corporation thus ensuring imposition of entity level tax on the taxable mortgage pool. Accordingly, a sponsor considering securitization of infrastructure loans must consider the implications of the REMIC rules and the taxable mortgage pool rules to the proposed securitization. A sponsor might also consider utilizing the recently enacted financial asset securitization investment trust ("FASIT") provisions of the Internal Revenue Code which permit securitization in a tax pass-through vehicle like REMICS for non-real estate assets.

B. Securities Act Of 1933

The Securities Act of 1933, as amended (the "1933 Act"), requires that all offers and sales of securities in the United States must be made pursuant to a registration statement filed with, and declared effective by, the SEC, unless an exemption from registration is available. The interests in, or debt instruments issued by, the SPE that holds the project loans are generally securities.

1. Exemptions

Section 4(2) of the 1933 Act and Regulation D thereunder provide exemptions for private placements. A private placement requires a limited number of purchasers and no general solicitation or advertising. Generally, in private placements exceeding $1,000,000, securities may be sold to an unlimited number of "accredited investors" (institutions and wealthy individuals meeting specified criteria) and up to 35 investors who are not accredited investors. Access to all relevant information must be available to offerees and the purchase must be for investment purposes. Securities received in a private placement are called "restricted securities" and may not be resold unless they are registered or another exemption is available. Regulation D provides a safe harbor for the availability of Section 4(2).

Investors receiving securities in a private placement may rely on Rule 144A to resell securities to large institutional investors who are capable of "fending for themselves" without the protection of the registration requirements of the 1933 Act. Rule 144A "underwritings," in which securities are privately placed by the issuer to one or more underwriters and then resold to "qualified institutional buyers" have become a common means of issuing commercial mortgage-backed securities. A transaction which complies with Rule 144A, by the terms of the rule, will not cause the private placement to be deemed a public offering, even if the number of purchasers from the underwriters is very large. "Qualified institutional buyers" include (1) institutions (not individuals) who own and invest on a discretionary basis at least $100 million of securities, (2) dealers in securities (including individuals) registered under the Securities Exchange Act of 1934 (the "1934 Act") who own and invest on a discretionary basis at least $10 million of securities and (3) entities that are wholly owned by other qualified institutional buyers. Banks and savings and loans, in addition to meeting the foregoing criteria, must have an audited net worth of at least $25 million to be qualified institutional buyers.

Section 3(a)(2) of the 1933 Act exempts securities issued or guaranteed by, among others, the United States, state or local governmental instrumentalities, or banks (including a domestic branch or agency of a foreign bank subject to certain federal or state regulation). The Section 3(a)(2) exemption is available with respect to banks only as to securities offered with full recourse to the bank as to principal and interest, either directly or through the use of a guaranty (including by means of a letter of credit). Securities issued by a trust or other entity, even if a bank is the seller to and servicer of the trust's loan portfolio, must be registered unless they are fully guaranteed by the selling bank or another bank.

Section 4(5) of the 1933 Act exempts from registration securities transactions involving offers and sales of certain mortgages and mortgage-backed securities subject to several statutory pre-conditions which have limited the utility of the exemption. To utilize the exemption, the transactions must involve mortgage notes, or participation interests in mortgage notes, secured by a first lien on residential or commercial real estate, and each purchaser must buy at least $250,000 for its own account and pay cash no later than 60 days after the sale. In addition, the mortgages must have been originated by either a commercial bank, a thrift institution or a similar banking institution or a HUD-approved mortgagee. Because of the large amount of securities that must be purchased by each purchaser, as a practical matter, Section 4(5) generally will not permit any transaction not otherwise permissible under Rule 144A.

2. Registration

If there is no available exemption, the securities must be registered under the 1933 Act. Registration involves the preparation and filing with the SEC of a registration statement which discloses the material facts relating to the offering. No offers can be made before the registration statement is filed and no sales can be consummated until the registration statement is declared effective. Registration often creates delays in the transaction, however, the securities may be freely resold by investors thereafter.

SEC rules require detailed financial disclosure about any mortgage loan and/or its obligor if the principal balance of loans to that obligor exceeds 10% of the pool.¹⁴In addition, the SEC staff has developed an unwritten policy that if the principal balance of loans to a single obligor exceeds 40% of the pool, the obligor of such mortgage loans should be a co-registrant with respect to the registration statement and should bear liability for material misstatements and omissions in the prospectus, including misstatements and omissions which do not relate to the obligor or his loans. Because the persons most likely to purchase project loan securities probably will be qualified institutional buyers and obligors of the infrastructure loans generally can be expected not to want their loans included in the pool if they will be required to assume securities law liabilities, it is expected that infrastructure loan securitizations primarily will be sold in private placements, Rule 144A underwritings or other exempt transactions.

3. Other Securities Laws

Issuers must also comply with state securities or "blue sky" laws as well as with National Association of Securities Dealers rules, whether or not the securities are registered with the SEC.

The anti-fraud provisions of Section 10(b) of the 1934 Act and Rule 10b-5 thereunder apply to the sale of securities whether or not such sale was required to be registered under the 1933 Act. Registering a security subjects the issuer to the periodic reporting requirements of the 1934 Act, including annual and quarterly earnings statements and reports of financial condition. The SEC, however, has discretion under Section 12(h) of the 1934 Act to modify or grant full or partial exemptions from these reporting requirements and in fact the SEC has exercised flexibility in modifying the reporting requirements with regard to asset-backed and mortgage-backed securities where the content of normal required information would have little relevance for holders of such securities.

C. Investment Company Act Of 1940

Until November 1992, it would have been difficult for an SPE that securitized project finance loans and made a public offering of any of its securities to avoid registration as an investment company. Fortunately, the SEC recognized that no policy objective of the Investment Company Act of 1940 would be furthered by subjecting SPEs involved in these types of activities to the Act and adopted Rule 3a-7 at that time. Rule 3a-7 was not adopted specifically to permit securitizations of project loans, but the fact that this Rule removed one impediment to public securitizations of certain commercial loans (particularly small business loans) was a benefit that the SEC mentioned in its adopting release.

By complying with Rule 3a-7 it is easy for an SPE primarily engaged in purchasing or otherwise acquiring, and holding, project finance loans to avoid registration as an investment company. Rule 3a-7 exempts from registration issuers that are engaged in the business of acquiring and holding "eligible assets"--which are defined as financial assets (such as project finance loans) that by their terms convert into cash within a finite time period plus certain related rights (which would include collateral for project finance loans). All that Rule 3a-7 requires of such an entity is that it comply with certain restrictions as to the types of securities it issues and the buying and selling of assets (e.g., the securitized project loans) and that it appoint an independent trustee to serve certain identified purposes with respect to the loans. Issuers that issue only commercial paper complying with the requirements of Section 3(a)(3) of the 1933 Act are exempt from the independent trustee requirement. The requirements imposed by this Rule were generally intended to, and generally do, correspond to existing practices in the securitization market.

The restrictions on types of securities that may be issued in reliance upon Rule 3a-7 are as follows: "Fixed income" securities that are rated investment grade by at least one nationally recognized rating agency (that is not an insider to the transaction) may be sold to anyone (subject only to compliance with the 1933 Act and state securities laws). Any fixed income securities may be sold to institutional investors that are "accredited investors" (as defined in Regulation D under the 1933 Act), without any rating requirement. Any securities may be sold to qualified institutional buyers (as defined in Rule 144A under the 1933 Act) and to persons involved in the organization or operation of the issuer (or affiliates of such persons), whether or not they are fixed income securities. For these purposes, "fixed income securities" means securities which entitle holders to a stated amount of principal and/or interest that is determined by reference to a fixed rate, a standard floating index rate, auctions or a contractual allocation of cash flow on the underlying assets.

In the unlikely event that a particular transaction cannot comply with the requirements of Rule 3a-7, another potential exemption is provided by Section 3(c)(1) of the Investment Company Act, which requires that there be no more than 100 beneficial holders of the SPE's securities (other than commercial paper) and that all securities of the SPE be sold in private placements.

D. Investment By Pension Funds

As noted above, pension funds are logical providers of the long-term financing required by infrastructure projects. Private pension plans subject to the Employee Retirement Income Security Act of 1974 ("ERISA") are prohibited from engaging in transactions with persons (so called "parties in interest") who have certain relationships to the plan. Parties in interest include the employer sponsoring the plan, plan administrators, custodians, trustees, investment managers and other service providers, and certain persons who are affiliated with any of the foregoing. A plan that purchases securities of an SPE holding project finance or other infrastructure loans may be deemed to be engaged in a prohibited transaction if one or more of the borrowers is a party in interest to that plan, unless the security purchased by the plan (a) does not constitute an equity interest in the vehicle for ERISA purposes, (b) is part of an offering of securities which is registered under the 1934 Act and is issued to at least 100 persons independent of one another and of the issuer, or (c) is part of a class of securities less than 25 percent of which is held by benefit plans (for this purpose, benefit plans include ERISA plans as well as plans that are not subject to ERISA, such as plans sponsored by government entities). There is uncertainty under the ERISA regulations regarding the debt or equity status of a security issued by an SPE formed for the purpose of securitizing loans, and therefore, it may be difficult to rely on the debt characterization of the securities to avoid the ERISA issues. In addition, registration of the securities may be burdensome and costly, and it may not be possible to establish that the 100 independent person requirement has been met. Relying upon the 25 percent rule would significantly limit the ability to market project finance backed securities to plans.

Therefore, a plan investing in securities backed by a pool of project or other infrastructure loans would generally need to consider the impact of ERISA's prohibited transaction rules. In the typical securitization transaction, it should be possible for a plan investor to review and monitor the underlying loans for compliance with the prohibited transaction requirements. If this is not practical, these requirements may impose a barrier to investment by plans unless an exemption is available from the prohibited transaction rules. The Department of Labor has authority to issue exemptions from the prohibited transaction requirements if it determines that the exemption is in the best interest of the plan and protective of the rights and interests of the participants and beneficiaries of the plan. The Department of Labor has issued class exemptions that may permit plan assets to be invested in project loan-backed securities through an insurance company separate account, bank collective fund or outside registered investment adviser. In addition, many of the principal underwriters have been granted limited exemptions for asset-backed securities for which any such firm serves as underwriter or placement agent. Project loan-backed securities would need to meet a number of conditions and limitations in order to qualify for these exemptions, including the limitation of the exemption to unsubordinated "pass through" certificates issued by a trust, and the conditions that the certificates be rated within one of the top three generic rating categories by one of the principal rating firms and that the loans be fully secured.

State and local government sponsored plans are not governed by ERISA, and therefore, are not subject to the ERISA prohibited transaction restrictions. Certain government plans are, however, subject to ERISA-like prohibitions, or to investment limitations that may limit their ability to invest in commercial loan pools.

E. Swap Breakage

It is highly likely that a project loan originated by a bank or other financial institution will include some form of interest rate exposure protection. This may take the form of an interest rate cap or collar, or a more standard floating rate-to-fixed rate interest rate swap (generically hereinafter called a "hedge"). If the project lender is also the hedge counterparty, the lender may also need or want to get the hedge off of its books when the loan is sold. For example, if the lender is a bank, RAP may require the loan to remain on the bank's books unless the hedge has also been transferred.

associated with the original hedge counterparty and must now satisfy itself that a proposed new swap counterparty is at least as good a risk as the current counterparty.

With forethought, the financial institution making the original infrastructure loan could contractually provide in the initial documentation of the transaction for the subsequent transfer of the hedge under certain specified circumstances. The parties could agree, for example, that the hedge may be transferred to another financial institution of a certain minimum size having a credit rating at least as good as the originating lender's. The parties could further agree that, at the time of such transfer, the lender must pay any cost of implementing the new hedge and, if the old hedge were "in the money" vis-à-vis the original lender, the transferee lender would pay the original lender the value of the old hedge. The payment of the hedge value would go the other way, of course, if the original lender were "out of the money" at the time of transfer.

It is common for a hedge to provide that if the borrower prepays the underlying debt, the hedge terminates and whichever party is "out of the money" must pay the other party the value of hedge. In the present interest rate environment, many borrowers find themselves on the losing side of existing hedges and thus the refinancing of a project loan could result in the incurrence by the borrower of substantial hedge termination costs.

V. Examples Of Securitization Of Project Finance Loans

A recent example of a securitized pool of project finance loans is the $560 million financing for Coso Funding arranged in 1994 by Lehman Bros. In this transaction, a newly formed, special purpose entity, Coso Funding, issued notes backed by loans the proceeds of which were used to refinance the original financing of three geothermal power projects. Cash flows from all three projects support the Coso Funding notes, so that if one project experiences problems, excess cash flow from the other projects may make up the difference. Made easier by common ownership of the three projects and the fact that the projects were substantially similar, this transaction was rated investment grade by Duff & Phelps and clearly indicates the potential for such pooled transactions. Also, see the description of the EIF Funding transaction (Section II.C. above).

In addition, there have been numerous examples of the securitization of a single project financing. For example, in connection with the sale/leaseback financing by Midland Cogeneration Venture L.P. of its 1340MW natural gas-fired, cogeneration project, two special purpose entities, Midland Funding Corporations I and II, issued over $2 billion of senior and subordinated secured lease obligation bonds. Certain of these bonds were privately placed with institutional investors while other bonds were registered in a public offering. The proceeds of the sale/leaseback financing were used to refinance the original project financing and to return capital to the project sponsors.

More recently, in an offering under Rule 144A to qualified institutional buyers, Sithe/Independence Funding Corp. sold $717.2 million of senior secured debt to finance the development and construction of a 1000MW natural gas-fired, combined cycle cogeneration plant near Oswego, New York. Unusually, the debt was rated investment grade by S&P even though it finances construction. S&P assigned this rating based upon an unusually strong construction contract with GE and Ebasco Services and because of GE's "AAA" rating. This transaction is a rare exception to the general rule which will require that a project be complete and have satisfactorily demonstrated some performance before permanent financing for the project will be rated investment grade by a rating agency.

Project finance loans outside the United States have also been securitized. For example, in a transaction closed in November 1993, Salomon Bros. completed a $110 million offering of notes issued by the Tribasa Toll Road Trust 1, which holds two Mexican toll road concessions. The proceeds of these notes were used to refinance the indebtedness of these two toll road projects. An interesting feature of this transaction was the separation of "contractual" and "scheduled" amortization. Failure to make "scheduled" amortization serves to "trap" cash in the SPE (by cutting off dividends and other distributions to the project sponsors) but does not constitute a default allowing acceleration of the notes. A failure to make "contractual" amortization does constitute such a default.

VI. Summary

There is a huge unmet need for project financing both domestically and internationally. Various types of securitization transactions can be used to assist in meeting this need. For example, after a project has been constructed and is performing satisfactorily, an SPE could issue debt and equity securities and use the proceeds to purchase infrastructure loans from the original lender. Alternatively, at such time, the SPE could use the proceeds to refinance a project at a lower rate. In both cases, the banks and other financial institutions which originated the project financing and evaluated and took the construction and similar risks, would be paid out, thereby making these funds available to be lent to finance other projects.

The principal problem in connection with the securitization of most commercial loans, namely the difficulty in estimating risk of loss, should generally be solvable because project financing typically relies primarily upon the credit either of one highly-rated user such as a public utility or upon multiple users such as toll road users where experience and user-demographic studies confirm the high probability of sufficient future revenues. Furthermore, in those situations where the credit of the SPE securities needs to be enhanced, there are well-established techniques that generally can be used to do so. Nevertheless, securitizing project loans involves a significant number of unique problems and will necessitate, among other things, the analysis of the economic and legal structure of each such loan and its commercial context.

J. Paul Forrester is a partner in the Chicago office of Mayer, Brown & Platt, an international law firm. The author would like to thank his Mayer, Brown & Platt colleagues for their contributions to this article, especially his partners, Jason H.P. Kravitt and Richard M. Rosenberg, who co-authored an earlier version of this article which appeared in the February 1994 issue of The Financier and his partners, Charles M. Horn and William A. Levy, who helped update the article. The views expressed in this article are the author's and should not be attributed to Mayer, Brown & Platt or any of its clients.

1 Vol. 67, Oct. 1993 issue and Special Supplement.

2 Financing the Future: Report of the Commission to Promote Investment in America's Infrastructure (Feb. 23, 1993). The Commission was formed to study the feasibility and desirability of creating a type of infrastructure security to permit the investment of pension funds to finance the design, planning and construction of infrastructure facilities in the United States under Section 1081 of the Intermodal Surface Transportation Efficiency Act of 1991.

3 Environmental Conditions in Central Europe, EPA Journal (July-August 1990).

4 IDD Private Placement Letter, Vol. 16, No. 11, March 16, 1998 at p. 1.

5 Project Finance Portfolio Rating Criteria Outlined, Standard & Poor's CreditWeek, Oct. 4, 1993, at 41.Feature."

6 Independent Power Project Finance Rating Criteria, Credit Comments, Standard & Poor's CreditWeek Reprint, Jan. 1993, at 1.

7 Rating Approach to Project Finance, Duff & Phelps Credit Rating Co., March 1996.

8 See "Political Risk Plagues Alternative Energy Project", Private Power Executive/November-December 1996.

13 Notice of Proposed Rule Making and Advance Notice of Proposed Rule Making issued May 1994 by Federal Financial Institutions Examination Council.

14 See Simplification of Registration Procedures for Primary Securities Offerings, SEC Release No. 33-6964 [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) 85,053, at 83,389, 1992 SEC LEXIS 2691, at *22 (Oct. 22, 1992). See also Financial Statements of Properties Securing Mortgage Loans, SEC Staff Accounting Bulletins, Topic 1-I, 7 Fed. Sec. L. Rep. (CCH) 74,101, at 64,208 (1993) (Audited financial statements of borrower are required when loan to borrower exceeds 20% of the registrant's assets).

15 Credit risk refers to the risk that a counterparty will be unable to fulfill its obligations under a hedge due to bankruptcy, illegality, a change in tax or accounting laws, etc. Market risk arises from the possible difficulty of finding a counterparty with swap needs mirroring one's own. This would be a particular problem with long-term hedges such as those associated with infrastructure projects.