True Sale

A true sale happens when assets change hands in a way the law recognizes as a genuine, outright disposal by the seller, rather than a loan secured on those assets. Once a true sale has taken place, the assets no longer belong to the seller, so if the seller later becomes insolvent its liquidator or creditors cannot claw them back. This legal separation is the foundation on which securitization and many other structured financings rest.

The question of whether a transfer is a true sale is decided by the law of the relevant jurisdiction and, ultimately, by courts. It is therefore usually supported by a formal legal opinion delivered when a transaction closes.

In a typical securitization, an originator such as a bank, a car-finance company or a credit-card issuer sells a pool of receivables, for example mortgages, auto loans or trade receivables, to a special purpose vehicle (SPV). The SPV pays for the pool by issuing bonds to investors, and the cash collected on the receivables services those bonds.

Investors in these notes want exposure to the receivables, not to the originator. If the originator collapses, they expect payments to continue from the pool. That expectation holds only if the transfer to the SPV was a true sale. If a court instead decided that the arrangement was really a secured loan, the receivables would remain part of the originator's estate, and investors would be treated as secured creditors, exposed to delays, stays on enforcement and competing claims. The concept of bankruptcy remoteness, which also depends on the SPV's own structure and restrictions, starts with a true sale.

Labels do not decide the matter. A document that calls a transaction a "sale" can still be recharacterized as a loan if its economic substance points the other way. The tests differ between legal systems, but recurring factors include:

• Recourse: whether the seller must make the buyer whole if the assets underperform. Extensive recourse suggests a loan.
• Risks and rewards: whether the buyer genuinely bears the credit risk and receives the upside, or whether the seller keeps them through repurchase obligations or residual interests.
• Price: whether the purchase price reflects fair value, or is set in a way that resembles an advance against collateral.
• Right of redemption: whether the seller can recover the assets by repaying the money, a hallmark of a mortgage or charge.
• Control: whether the seller continues to control the assets and the collections, beyond acting as servicer under arm's-length terms.

English law has traditionally given considerable weight to the parties' documented intention, provided the documents are not a sham. United States courts have looked more broadly at the economic substance of the deal. Other jurisdictions have dedicated securitization statutes that set out when a transfer is protected.

A finance company holds auto loans with an outstanding balance of 500 million. It sells them to an SPV for 480 million in cash and a subordinated note, and the SPV issues senior bonds to investors. The finance company continues to collect payments as servicer, for a market-rate fee, and passes collections to the SPV's segregated account. Because the company has no obligation to buy back defaulted loans and the price reflects the pool's expected losses and a haircut, counsel can give a true sale opinion. If the documents instead required the company to replace every defaulted loan, the transfer would look much more like secured borrowing.

A legal true sale does not automatically mean the assets come off the seller's balance sheet. Accounting standards apply their own derecognition tests, focused on the transfer of risks and rewards and control, and these can reach a different answer from the legal analysis. Bank supervisors also apply separate rules for whether securitized assets reduce regulatory capital requirements under frameworks such as Basel III.

A synthetic securitization transfers only credit risk, typically using a credit default swap or guarantee, and involves no true sale of the assets. In Islamic finance, the distinction between asset-backed sukuk, which rely on a true sale to the issuing vehicle, and asset-based sukuk, where investors rely mainly on the originator's purchase undertaking, turns on the same question. True sale issues also arise outside receivables financing, for instance when a company sells timberland to an investment vehicle but keeps managing the forest, where continued control by the seller can invite recharacterization.

True sale structures concentrate legal risk at the outset: if the analysis is wrong, investors find out only in an insolvency. The 2008 financial crisis also showed that originators sometimes supported their off-balance-sheet vehicles to protect their reputation, which raised doubts about whether risk had really been transferred, even where the legal sale was sound.