Capital Markets

SEC Good at Fining, Bad at Collecting

GAO says commission lousy at collecting receivables; changes coming? Plus: securitization market in Germany gets big boost, while in U.S., banks st...
Ben McLannahan and Joseph McCaffertyApril 1, 2003

In late February, the Securities and Exchange Commission filed civil fraud charges against eight former and current managers of Qwest Communications International Inc. Among the punishments the SEC is seeking to impose are civil money penalties and disgorgement of ill-gotten gains.

But even if the executives are found guilty, investors may never get back a dime.

That’s because the SEC has a poor record of collecting on the fines it levies on those who have been found guilty of fraud. In fact, a report by the General Accounting Office found the SEC collected only 14 percent of the $3.1 billion in fines it issued against securities-law violators between 1995 and 2001.

“In the past, the SEC hasn’t done a very good job at collecting on the penalties that it has imposed,” says Alan R. Bromberg, a professor at the Dedman School of Law at Southern Methodist University. He explains that the SEC has typically been understaffed, and that limited resources have kept it from being able to pursue laggard fines.

In addition, a welter of state laws, such as those that protect a residence from collection efforts, make it difficult for the SEC to enforce the fines.

“Wrongdoers often hide assets to hinder collection efforts,” noted Stephen Cutler, director of the SEC’s division of enforcement, in testimony to Congress on Feb. 26.

The SEC is now taking steps to improve its ability to collect fines, including petitioning Congress to enable the agency to pursue expensive homes that are protected by some state laws. “The SEC is also seeking more latitude for civil penalties to be put toward disgorgements and paid back to wronged investors,” says Bromberg. Previously, most of what was collected went to the U.S. Treasury.

Bromberg says the new provisions should improve the SEC’s ability to enforce its penalties. “In the future, you’re going to see an SEC that is more aggressive at collecting the penalties it imposes.”

Liquid Refreshment

Securitization may be set for take-off in Germany, following changes in tax rules governing asset-backed financing.

Under a draft tax law released in March, German-resident special-purpose vehicles (SPVs) will be exempted from trade tax on bank receivables. Subject to approval from the opposition, the rules should be in place by September, with retroactive effect from Jan. 1, 2003.

While welcoming this change, observers are now waiting for stage two, in which the finance ministry will extend similar tax relief to non-bank originators. “The scope of the legislation has to be widened — it should apply to corporate assets too,” says Hubert Schmid, a tax partner at Clifford Chance Pünder in Frankfurt.

At present, larger German corporates currently sell their receivables directly to foreign-registered SPVs. That has held back the German securitization market. Standard & Poor’s reports that of new, funded deals in Europe in 2002, Germany ranked fifth, with $9.6 billion, well behind the U.K. ($51 billion), Italy ($30 billion), the Netherlands ($21 billion), and Spain ($19 billion).

After corporate income tax, trade tax is the most important tax levied on companies doing business in Germany. Effective rates range between 11 percent and 19 percent, as adjusted by add-backs and deductions.

Under the old regime, the biggest add-back for securitization purposes was 50 percent of the interest payable on debt with a term of at least one year. Interest payable on the financing raised by SPVs would often qualify as interest on long-term debt. That meant that an SPV, if deemed to be resident in Germany, would be subjected to a sizeable trade tax burden — even though it may not make a sizeable profit.

“Trade tax has always been a big thorn in the side of German securitization,” notes Martin Krause, a Frankfurt-based tax partner at law firm Linklaters Oppenhoff & Rädler.

Under the new rules, SPVs buying loan receivables from banks in securitization transactions will be treated like the originator banks, and will be exempted from the add-back.

The reforms amount to “a breakthrough for securitization in Germany,” says Ingo Kleutgens, a tax partner at law firm Mayer, Brown, Rowe & Maw in Frankfurt. After all, he notes, what’s good news for German banks is good news for corporates. Now that banks can refinance loans more cheaply through securitization, they can, in theory at least, pass on those cheaper financing costs to corporates through their credit policies.

Many in the market expect trade tax relief for SPVs buying corporate assets “within two or three years”. But in the meantime, the government’s vote of confidence is in itself cause for celebration. “This was the first time a finance minister actually stood up and supported securitization as a tool,” notes Dagmar Schemann-Teuber, managing director of ABS+MBS Consulting, a Dachau-based firm. “That’s the best news of all from the corporates’ perspective.”

The Currency of Time

In March, The Goodyear Tire & Rubber Co. announced it was getting a much-needed cash infusion from JP Morgan Chase & Co. and Citigroup Inc. The banks promised a $1.3 billion asset-backed credit facility with just one catch: it is contingent on Goodyear’s ability to amend loan covenants it has breached with other lenders. Signs look good: Goodyear has already obtained waivers from creditors that buy the company time to forge new deals.

Goodyear is not alone. The soft economy has pushed plenty of businesses into violation of their loan covenants. Some of the lucky ones, including Tweeter, Atlas Air, Conseco, and Beta Brands, have also received waivers.

“An awful lot of companies are busting covenants and obtaining waivers these days,” says Carter Pate, managing partner of PricewaterhouseCoopers LLP’s Financial Advisory Services.

Obtaining a waiver is usually the final step in renegotiating loan terms with lenders. This comes at a price. Typically, banks can charge as much as 1 percent or more of the outstanding loan to rewrite the loan structure, says Pate. He adds that the difficulty of obtaining a waiver depends on the situation; breaking substantial covenants such as free-cash-flow targets will likely result in lengthy negotiations.

Patrick Chow, CFO of Tarrant Apparel Group, says the ease of getting a waiver often depends on the lender. “Banks that understand your business are more sympathetic,” he says. “But no bank wants to put you into default and have a loss.”

Tarrant was forced to obtain a waiver from lenders GMAC and Bank of America Corp. when softness in the apparel business put the Los Angeles-based private-label apparel maker out of compliance with its loan covenants.

When approaching the bank, “you have to be honest with yourself,” warns Chow. “Setting unrealistic objectives and trying to paint a rosy picture to bankers will kill the company.” You don’t want to end up knocking on their door again the next quarter, he adds.