Off-balance sheet treatment

Many stories linger from the aftermath of the Enron crisis of assets being secretly hidden away from balance sheets, obfuscating exposure to losses and risks to and, in the context of banks, entrenching systemic risks in the banking system. A trend, since the global financial crisis, has seen a broad range of transactions openly and transparently seeking off-balance sheet treatment. For instance, a mobile phone company providing handset financing may wish to take those handset financing receivables off of its balance sheet. Or a leasing company may wish to take physical assets like aeroplanes or vessels, or the leases representing those assets, off its balance sheet. Or a trading corporate with a large pool of trade receivables may wish to raise finance in a manner which takes those trade receivables off of its balance sheet. And in the finance sector, banks, insurance companies and some funds too, are subject to prudential regulation and are advised by their shareholders or regulators to take assets off of their balance sheet in order to de-lever, enhancing systemic stability by doing so.

Which balance sheet?

When a corporate or institution is looking to obtain off-balance sheet treatment as part of a transaction the first point for consideration is to identify which balance sheet the assets need to be removed from. There are typically three:

• the legal balance sheet - in general, an asset will be on this balance sheet if it is available to a company's creditors when the company becomes insolvent. If the asset is not available to the company's creditors then it will not be on its legal balance sheet. The phrase true sale is often associated with removing an asset from the legal balance sheet.

• the accounting balance sheet - in general, an asset will be on this balance sheet if the accounting principles it uses to prepare its financial statements requires it to be included, or will be off this balance sheet if those accounting principles do not require that asset to be included in its financial statements.

• the regulatory balance sheet - in general, for regulated institutions like banks and insurance companies and some funds, an asset is on their regulatory balance sheet if it is on their accounting balance sheet, but it's possible to remove it if a provision of the applicable prudential regulation allows the asset to be excluded for regulatory purposes.

Different balance sheets, different rules

When an asset comes on-, or moves off-, balance sheet form a legal, accounting or regulatory perspective will differ from transaction to transaction and it's important to bear in mind that the three balance sheets are not aligned. There are different rules applicable to each balance sheet and some transactions can involve an asset leaving one balance sheet but remaining on others.

For instance, a funded participation using a Loan Market Association standard form sub-participation agreement will normally take the participated loan off of a bank's accounting and regulatory balance sheets, but leave it on the bank's legal balance sheet.

In contrast, a sale of a trade receivable from a corporate to a factor, subject to a refundable discount, will normally take the trade receivable off of the legal balance sheet of that corporate but leave it on its accounting balance sheet (corporates do not, in general, have regulatory balance sheets).

Or a residential mortgage securitisation can take a pool of mortgage loans off of a bank's legal and regulatory balance sheet, but leave those loans on its accounting balance sheet.

The legal balance sheet

For the legal balance sheet, the starting point is to identify the jurisdiction or jurisdictions in which the company will be subject to insolvency proceedings. Sometimes this will be very simple where the company is headquartered and has operations in only a single country. However, some companies often have global operations and branches and assets in many jurisdictions, which can complicate the analysis because it may be the case that the company can be subject to insolvency proceedings in multiple jurisdictions.

Once the relevant jurisdictions have been identified the insolvency laws in those jurisdictions must be consulted to work out how the transaction can be done in a manner which will not be subject to challenge in those jurisdictions in the event the company goes insolvent. For instance, in Hong Kong, a transaction which is an undervalue or done to prefer a specific group of creditors can be challenged. Or, in England, a transaction which purports to be a sale, but is really just a secured loan disguised as a sale, can be challenged. Once the applicable challenges are known, the transaction can be structured in a manner which is compliant with the treatment the company is seeking, and evidence produced as part of the transaction, such as board minutes, solvency certificates and other written documents, would reflect the real nature of the arrangement and support the legal conclusion.

The accounting balance sheet

As the accounting treatment depends on the relevant accounting principles which the company is subject to, the early involvement of the company's accountants is essential if accounting off-balance sheet treatment is sought. While this is ultimately an accounting matter, the accountants often request certain structural features to be included in the legal documentation to support their accounting conclusions. Common requests received by lawyers include:

• outright sale - ensuring that the relationship between the company selling assets and the assets entirely ends at the point in time the transaction is put in place. For instance, the company selling the assets (eg some loans or a portfolio of vessel leases) is no longer entitled to any cashflows relating to those assets at any point after the sale.

• 100% credit insurance - common in trade receivables financing transactions, ensuring an insurance company involved in the arrangement providing credit insurance in respect of the underlying obligors provides 100% coverage for losses on the underlying receivables.

• control party - common in trade receivables transactions, and other deals involving receivables, such as mobile handset receivables, involving a third party in the arrangement. The third party would have one or both of two functions - first, having the ability to replace the servicer on the transaction (essentially giving the third party the power to decide who can collect in the receivables) and, second, giving the third party exposure to a certain tranche of losses low down in the credit structure, around where the "expected losses" on the assets sit and being thick enough to cover the expected variability on those losses.

The regulatory balance sheet

The starting point for the regulatory balance sheet is the accounting balance sheet. Prudential regulation then makes adjustments for a range of prudential metrics - such as regulatory capital, large exposures, a leverage ratio and others.

A concept of significant risk transfer is typically assessed and, in general, provided significant risk of credit loss associated with an asset is transferred to a third party, that asset can be removed from the regulatory balance sheet. Significant risk can be transferred by moving the proprietary ownership rights in an asset to a third party or having a third party contractually agree to assume the risk of credit loss. Other factors, relating to control, costs and the overall efficacy of the transaction must also be taken into account.

Practical considerations

It is also worth noting that taking assets off of the legal or accounting balance sheets (and sometimes the regulatory balance sheet) can have practical consequences as well. It may be necessary for a company's control over the assets in question to be limited (or possibly removed entirely) or to put in place arrangements which may, upon the occurrence certain events, interfere with its relationships with its customers. The extent to which these might be relevant need to be understood and appreciated at the start of any transaction.

Conclusion

Balance sheet treatment can often be confusing, not least because the cross-border nature of many deals can introduce complexity. However, setting a clear goal at the outset of the transaction, and ensuring the appropriate legal, accounting and regulatory advisers are engaged early will allow a robust structure to be put together, which, if suitably balanced with the practical day-to-day requirements of the company, can achieve the desired result.