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Credit FAQ: What Are The Main Legal Challenges Facing European Leasing Securitizations?

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Credit FAQ: What Are The Main Legal Challenges Facing European Leasing Securitizations?

Asset-backed securities (ABS) backed by lease receivables have some unique features that differ from those of similar transactions collateralized by other types of secured financing, such as auto loans. These features differ significantly depending on transaction structure and the relevant jurisdiction's applicable laws. In most European lease-backed securitizations, the originator (i.e., the lessor) typically does not transfer legal ownership of the leased assets--such as vehicles or equipment--to the issuing special-purpose entity (SPE). Instead, the lessor sells to the issuing SPE the right to receive lease instalments and proceeds from the sale of the leased assets, rather than the leased assets themselves.

Whether the receivables, existing and future, have been effectively assigned--and whether the assignment and the issuing SPE's rights over the lease and residual value receivables would survive the lessor's insolvency (the legal risk)--has a bearing on whether the issuing SPE will be entitled to receive all lease instalments and asset sale proceeds. The effectiveness of transaction-specific financial incentives introduced as structural mitigants depends on the amount, timing, and terms of such financial incentives and whether they are likely to encourage the relevant parties to continue to perform their contractual obligations if the lessor becomes insolvent.

In this report, S&P Global Ratings discusses trends we have observed, certain legal risks that may arise, and transaction characteristics that mitigate these risks. When we assign credit ratings to a lease-backed securitization, we therefore consider certain additional legal risks.

Frequently Asked Questions

What have been the main trends in the European leasing securitization market in recent years?

Over the past few years, we have rated an increasing number of European transactions backed by leased assets, reversing the decreasing trend started in 2013. We currently rate 11 such transactions in Germany, which has a strong auto lease market and where we rated four transactions in 2021. In 2021, we also rated our first lease transaction in Austria and two in the French market.

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How are residual values treated in leasing transactions?

In transactions where the residual values of the leased assets are securitized, the lessor covenants to arrange for the sale of the assets upon termination of the leases and to pass the sale proceeds on to the issuing SPE. When a lessee defaults under the leasing contract or decides not to exercise the purchase option on the leased assets, they must be repossessed and sold. As the issuing SPE does not own the assets, in our rating analysis of lease-backed securitizations we typically assess the likelihood that the SPE will still receive those sales proceeds if the lessor were to become insolvent. In transactions where the residual values are not securitized, a structural mechanism typically allocates a portion of the asset sales proceeds to the securitization when a lease contract is terminated early. In our rating scenarios, we review the way such flows are assigned to the SPE and their effect on recoveries.

Can leasing receivables be assigned to the issuing SPE and would this assignment remain effective in the insolvency of the lessor?

When a securitization is backed by a pool of loans, the underlying repayment obligations are created by the fact that the originator made funds available to the borrowers. The repayment obligations therefore remain and don't depend on any later action by the originator or whether the originator remains solvent. A lessee's payment obligations under a lease agreement come into existence at the start of the agreement. The payment obligations only continue as long as the agreement remains in force and the lessee continues to enjoy the right to use the leased assets in accordance with the terms of the lease. In a lease-backed securitization, because the seller of the lease receivables remains the owner of the leased assets and continues to act as lessor under the lease contract, the SPE that purchased the receivables is potentially exposed to the risk of lease termination, including if the lessor becomes insolvent.

As with other collateral-backed securitizations, our ratings analysis examines if the securitized receivables have been effectively transferred to the SPE. For lease receivables, this includes assessing whether the transfer of future receivables--the right to receive lease instalments due in the future and, where relevant, sale proceeds--can be achieved under applicable law and will remain fully enforceable including in an insolvency of the lessor. We typically receive legal comfort on these issues and incorporate this in our analysis.

Upon insolvency of the lessor, would the leases be discontinued?

Continuation of lease contracts despite the lessor's insolvency:

Because ownership of the leased assets is generally not transferred to the issuing SPE, the main legal challenge arising in lease-backed transactions is the potential discontinuation of the lease contracts upon the insolvency of the lessor, i.e., whether there is a direct or indirect risk of termination of the lease contracts if the lessor goes into insolvency.

That termination risk would materialize if an insolvency officer or liquidator of the lessor terminates the contracts and asks the lessees to return the leased assets. Even if the lessees were to return the leased assets earlier than the expected date (i.e., at a time when the leased assets are worth more than otherwise assumed), this would not necessarily offset the value of the missed lease instalments. The risk profile of a securitization in which all of the leased assets need to be liquidated at a certain point in time due to lessor insolvency, is different from one that relies on the ongoing collection of lease instalments and the sale of the leased assets at their scheduled maturity dates.

This risk is typically a function of the transaction's legal structure, the law governing the leased assets, and the various types of insolvency proceedings that may be applicable to the lessor. For example, we would consider the extent to which an insolvency officer may be entitled to terminate outstanding leases.

In some transactions, after reviewing legal opinions there may still be uncertainty regarding the continuation of leases following the lessor's insolvency. In these cases, we often see additional structural features aimed at mitigating this risk. If, under applicable law, the insolvency officer has an obligation to maximize the lessor's insolvency estate, these additional provisions (e.g., structural reserves available upon the performance of some duties) could incentivize the insolvency officer to continue the contracts during insolvency proceedings, rather than terminating them and generally to continue performing the lessor's obligations under the securitization transaction agreements. Furthermore, in cases where the residual values are not securitized, we are typically provided with similar comfort that this would not create a further motivation for the insolvency officer to terminate the contracts.

Continuation of the lease contracts upon termination of related services (performance risk):

We consider if lessees have the right to terminate their contracts if related contractual services are no longer performed upon insolvency of the lessor. Such a termination right might arise when leases are sold together with certain maintenance services (such as, in the case of vehicles, repairs, tires, gasoline management, etc.) or where lessees contract for a combined lease and related services package. Regardless of whether such additional services components are securitized, in some jurisdictions lessees have an effective right to terminate the lease contract if the contractually agreed services are not provided. This means they could return the car or equipment and stop paying under the contract.

We have observed that this risk is primarily a function of the transaction's jurisdiction and the laws applicable to the leased assets. When this risk is present, we typically see provisions planning for the appointment of a back-up servicer (BUS) or maintenance coordinator, well ahead of the potential insolvency of the lessor, based on certain financial triggers. Less frequently, back-up servicing agreements are fully set up at closing. These back-up servicing arrangements incorporate the increased complexity of servicing lease contracts and aim to ensure the continuity of related maintenance services upon the lessor's insolvency. They are often complemented by reserves, intended to ensure that the maintenance activities remain profitable for the BUS even if it is activated only at a later stage in the transaction. As the monthly maintenance fees paid by the lessees are usually fixed, whereas the servicing cost of the fleet increases over time with the vehicles or equipment aging, the maintenance activity is usually only profitable when the fleet is young and loss-making when the fleet gets older. The reserves we see are often sized to make sure that the potential replacement servicer is in the same overall economic position as the original servicer.

Is the issuing SPE entitled to receive sales proceeds?

Because the title of the leased assets is generally not transferred to the issuing SPE, it only has a right to receive sales proceeds. Consequently, upon an insolvency of the lessor, the issuing SPE relies on the insolvency officer to facilitate the sale of the leased assets and pass on the proceeds of this sale. As the proceeds from selling the leased assets are usually assigned to the issuing SPE at closing, an insolvency officer would not be entitled to keep the sales proceeds on the leased assets. However, there remains the risk that an insolvency officer would not be incentivized to sell the leased assets promptly if required.

Transactions we see typically mitigate this risk by including, for example, a performance reserve or a performance fee in the waterfall to incentivize the insolvency officer to sell the leased asset promptly.

What other measures are in place to mitigate the specific risks associated with these transactions?

Within these transactions there are different measures in place to mitigate risks, such as maintenance reserves or back-up maintenance/servicer facilitators, in addition to the legal analysis. In table 1 below, we compare our closing assumptions. Equipment lease transactions require more specialized servicing, therefore, you can see that they have back-up servicers in place.

Transaction Characteristics At Closing
Transaction Jurisdiction Asset type 'AAA' gross losses (%) Residual value Maintenance reserve Back-up KTP
Auto ABS French Leases 2021 France Auto 13.9 Yes No No
Bavarian Sky S.A., Compartment German Auto Leases 6 Germany Auto 7.38 No No No
BUMPER UK 2019-1 Finance PLC UK Auto 20.1 Yes Yes Yes
VCL Master Residual Value S.A., Compartment 2 (2019-1 Notes) Germany Auto 11.57 Yes No No
Cronus Finance DAC Greece Auto 38.3 ('A' category) Yes Yes Yes
First Swiss Mobility 2019-1 Switzerland Auto 6.9 Yes No No
First Swiss Mobility 2020-1 Switzerland Auto 6.9 Yes No No
First Swiss Mobility 2020-2 Switzerland Auto 7.05 Yes No No
KMU Portfolio S.A., Compartment 2015-1 Germany Equipment 27.44 No No Yes
Limes Funding S.A., Compartment 2019-1 Germany Equipment 18.55 No No Yes
Limes Funding S.A., Compartment 2021-1 Germany Equipment 16.65 No No Yes
Multi Lease AS S.r.l. Italy Equipment 26.45 ('A' category) No No Yes
Pixel 2021 Fonds Commun de Titrisation France Equipment 28.8 No Yes Yes
Red & Black Auto Lease Germany 3 S.A. Germany Auto 11 No Yes Yes
ROOF AT S.A. (Compartment 2021) Austria Auto 20.8 No No Yes
Swiss Car ABS 2020-1 AG Switzerland Auto 8.35 Yes No No
Swiss Car ABS 2021-1 AG Switzerland Auto 8.25 Yes No No
Temese Funding 2 PLC U.K. Equipment 26.85 Yes No Yes
VCL Master S.A., Compartment 1 Germany Auto 11.79 No No No
VCL Multi-Compartment S.A., Compartment VCL 29 Germany Auto 8.6 No No No
VCL Multi-Compartment S.A., Compartment VCL 30 Germany Auto 8.6 No No No
VCL Multi-Compartment S.A., Compartment VCL 31 Germany Auto 8.6 No No No
VCL Multi-Compartment S.A., Compartment VCL 32 Germany Auto 8.6 No No No
KTP--Key transaction participant.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Florent Stiel, Paris + 33 14 420 6690;
florent.stiel@spglobal.com
Secondary Contact:Alejandro Marcilla, CFA, Madrid + 34 91 389 6944;
alejandro.marcilla@spglobal.com

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