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Transferred financial assets must be legally isolated from the transferor, its consolidated affiliates, and its creditors to qualify for sale accounting, as discussed in ASC 860-10-40-5(a).

ASC 860-10-40-5(a)

The transferred financial assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Transferred financial assets are isolated in bankruptcy or other receivership only if the transferred financial assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated affiliates included in the financial statements being presented. For multiple step transfers, a bankruptcy-remote entity is not considered a consolidated affiliate for purposes of performing the isolation analysis. Notwithstanding the isolation analysis, each entity involved in the transfer is subject to the applicable guidance on whether it shall be consolidated (see paragraphs 860-10-40-7 through 40-14 and the guidance beginning in paragraph 860-10-55-18). A set-off right is not an impediment to meeting the isolation condition.

Derecognition of transferred financial assets is allowed only if available evidence provides reasonable assurance that the assets have been put presumptively beyond the reach of the powers of (1) a bankruptcy trustee and (2) creditors of (a) the transferor and (b), if applicable, any consolidated affiliate of the transferor that is not a special-purpose corporation or other entity designed to make remote the possibility that the consolidated affiliate would enter bankruptcy or other receivership. The remainder of this section addresses various implementation issues associated with applying the legal isolation requirement.

3.5.1 Involvement by consolidated affiliates of the transferor

Transferred financial assets must be legally isolated not only from the transferor, but also from its consolidated affiliates (other than those intended to be bankruptcy-remote) included in the financial statements being presented. From the perspective of a parent entity’s consolidated financial statements, a financial asset transferred by the parent (or a subsidiary) to a third party may not be legally isolated if another entity within the consolidated group has continuing involvement with the transferred asset, such as servicing or providing credit enhancement.
A consolidated affiliate is defined in ASC 860-10-20.

Definition from ASC 860-10-20

Consolidated Affiliate: An entity whose assets and liabilities are included in the consolidated, combined, or other financial statements being presented.

An entity that is designed to make remote the possibility that it would enter bankruptcy (a bankruptcy-remote entity, or "BRE") is not considered a consolidated affiliate for purposes of performing the isolation analysis. The typical attributes of a BRE are discussed later in this section.

3.5.2 Isolation: legal analysis

Whether a transfer of financial assets satisfies the legal isolation criterion is a legal determination – not an accounting judgment. A legal analysis that considers (1) the statutes and regulations that would apply in the event of a transferor’s bankruptcy and (2) the laws intended to govern the transfer itself (the choice of law cited in, for example, the transaction’s purchase and sale agreement) is typically required to support the assertion that this criterion has been met. In practice, this analysis often entails evaluating whether the transfer would be upheld as a true sale at law (a true sale opinion) and, in certain circumstances, whether the transferee would be substantively consolidated into the bankruptcy estate of the transferor (a substantive consolidation opinion).
The legal isolation requirement focuses on whether transferred financial assets would be isolated from the transferor even in the event of bankruptcy, regardless of the transferor’s credit rating or financial strength at the transfer date. That is, the legal isolation condition may not be considered satisfied simply because, in view of the transferor’s current credit standing, the likelihood of bankruptcy is deemed remote.
Depending on its terms, a transferor’s contractual right to re-acquire transferred financial assets from the transferee ─ for example, a call option or removal-of-accounts provision ─ may not preclude a determination that transferred financial assets have been legally isolated. However, such a right will preclude sale accounting treatment if it allows the transferor to maintain effective control over the transferred financial assets, as discussed more fully in TS 3.4.

3.5.2.1 When should a legal opinion be obtained?

A legal opinion would not typically be required for a routine transfer of financial assets that does not result in any continuing involvement by the transferor and its consolidated affiliates, including BREs.
If a transferor has continuing involvement with transferred financial assets, there is a presumption that legal opinions specific to the transaction should be obtained to support the legal isolation assertion. When continuing involvement is present, we do not believe that a transfer of financial assets may be categorized as "routine," as contemplated in ASC 860-10-55-18(B)(a). Accordingly, when the transferor or its consolidated affiliates have continuing involvement with the transferred financial assets, a true-sale-at-law opinion is customarily required to demonstrate that the assets have been legally isolated. Additionally, substantive consolidation opinions will often be needed when affiliated entities act as a transferee or are otherwise involved in the transfer through some form of continuing involvement. Each of these opinions is discussed in more detail below.
Listed below are the more common transactions for which we would generally expect a transferor to obtain relevant legal opinion(s) to support its assertion that transferred financial assets have been legally isolated. The listing is not intended to be an all-inclusive enumeration of transactions that would require a legal analysis.
  • Factoring of trade receivables, when the transferor retains servicing rights and obligations, obtains a beneficial interest or provides credit enhancement
  • Transfers of participating interests in loans or other receivables
  • Securitizations of transferred financial assets (including both "private label" securitizations and those involving Federal agencies or government-sponsored enterprises)
  • Transfers of debt or equity securities accompanied by the transferor’s continuing involvement with the securities or the transferee
Provided certain conditions are met, a transferor may rely on a legal opinion rendered on a previous transfer to support its assertion that a subsequent transfer also meets the legal isolation criterion – thus obviating the need to obtain an opinion that specifically addresses the current transaction. The circumstances in which this approach may be appropriate are discussed in TS 3.5.3.
When evaluating evidence to support its assertion that transferred financial assets have been legally isolated, a transferor should consider the points in Figure TS 3-2.
Figure TS 3-2
Framework for determining evidence required to support legal isolation under ASC 860
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3.5.2.2 The "two-step" transfer construct

Figure TS 1-5, Figure TS 1-6, Figure TS 1-7, and Figure TS 1-8 in TS 1 reflect the so-called "two-step" transfer arrangement commonly used in securitizations of financial assets to achieve legal isolation. Transactions involving transferees other than securitization entities may also employ the two-step construct, particularly when the transferor retains a significant economic interest in the transferred assets. Under the typical two-step arrangement, the transferor sells financial assets to a wholly-owned bankruptcy-remote entity (BRE) that, it turn, immediately transfers the acquired assets to the third-party transferee (typically a trust, in the case of a securitization). The two-step configuration is intended to legally isolate the transferred financial assets from the transferor and, at same time, makes the securitized assets attractive to investors by allowing the transferor to provide structural credit enhancement to the securitization trust (for example, by arranging for the BRE to hold the most junior notes issued by the trust).
Legal opinions rendered on two-step securitization structures should consider the transaction taken as a whole to provide persuasive evidence that (1) the transfer to the BRE would be upheld as a true sale at law ("true sale") and (2) the BRE would not be substantively consolidated into the bankruptcy estate of the transferor parent. Legal opinions that address these matters are usually requested by rating agencies and other parties involved with these transactions. It is common for management to use those opinions to support the legal isolation assertion for financial reporting purposes.
TS 3.5.2.2 provides more information about the typical two-step transfer arrangement.

3.5.2.3 Characteristics of a BRE

A BRE is structured to make it unlikely that:
  • The entity itself would file for (or be placed into) bankruptcy by its parent or by other parties having an interest in the entity (e.g., any creditors)
  • A court would order the substantive consolidation of the entity into the bankruptcy estate of its parent.
There is no controlling statute or authoritative case law that enumerates the conditions a legal entity must satisfy to be considered "bankruptcy-remote." However, in practice, to be deemed bankruptcy-remote, the entity (typically an LLC incorporated in Delaware, wholly owned by its transferor-parent) generally has the following characteristics:
  • Undertakes only limited activities specified in its formative document(s)
  • Does not incur indebtedness to third parties (or, if such indebtedness is allowed, subject to stringent conditions, such as satisfactory creditor non-petition covenants)
  • Does not commingle its assets with those of its parent or related affiliates
  • Maintains corporate and financial records separate from its parent and its affiliates, including separate bank accounts
  • Observes all corporate formalities on a standalone basis
  • Has at least one director or manager independent of the parent
  • Conducts its activities separate from its parent and affiliates
  • Pays its obligations with its own funds (i.e., it does not use the funds of its parent to satisfy its obligations)
The foregoing is not an all-inclusive list of the restrictive (or prescriptive) attributes of a BRE.

3.5.2.4 True sale opinion

A true sale opinion from a qualified bankruptcy attorney is frequently obtained to support the conclusion that the transferred financial assets have been isolated. As stated in ASC 860-10-55-18A(a), in the context of US bankruptcy laws, "a true sale opinion is an attorney’s conclusion that the transferred financial assets have been sold and are beyond the reach of the transferor’s creditors and that a court would conclude that the transferred financial assets would not be included in the transferor’s bankruptcy estate." In addition, ASC 860-10-55-18C states that, "[f]or entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures (for example, banks subject to receivership by the Federal Deposit Insurance Corporation) in the United States or other jurisdictions, judgments about whether transferred financial assets have been isolated shall be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions.”
A transferor and its consolidated affiliates are not precluded from having recourse exposure to, or an economic interest in, a transferred financial asset for the transfer to be considered a true sale. However, in the US, the level of recourse and/or the nature and extent of any such economic interest are among the principal factors that lawyers consider in determining whether the transfer would be considered a true sale. On the other hand, in certain foreign jurisdictions, a transfer may be considered a legal true sale even if the transferee has substantial (or full) recourse to the transferor for reimbursement of losses stemming from the transferred assets. In those jurisdictions, the transferor’s retention of a transferred asset’s risks and rewards may not be as important to the legal analysis as it is in the US.
Care should be taken as continuing involvement takes many forms, many of which may not, on the surface, appear to constitute retention of risks or rewards. Legal opinions should address all forms of continuing involvement by a transferor and its consolidated affiliates when evaluating whether a transfer would be respected as a "true sale at law."

3.5.2.5 Substantive consolidation opinion

A true sale opinion provides support that the transferred financial assets would not be considered part of the bankruptcy estate of the transferor (that is, the estate of the legal seller). However, a true-sale opinion does not address whether the transferee ─ and thus, by extension, the transferred assets acquired by the transferee ─ could be substantively consolidated into the bankruptcy estate of the transferor. Depending on the circumstances, a substantive consolidation opinion may be required to support the assertion that the transferred assets have been legally isolated.
Substantive consolidation is a judicial doctrine arising from the broad powers of equity granted to bankruptcy courts in the United States. Under this doctrine, in limited circumstances, a bankruptcy court can treat a group of affiliated entities as if they are one, merging their assets and liabilities for purposes of the bankruptcy proceeding. That said, no specific provision of the US Bankruptcy Code expressly authorizes a court to order substantive consolidation. A court will weigh a variety of factors related to the entities proposed to be consolidated when evaluating whether to consider substantive consolidation, which typically will include:
  • Their organizational structure
  • Their inter-corporate or other inter-organizational relationships
  • Their relationships with their respective creditors and other third parties
A court will also evaluate the impact upon the creditors of each entity if consolidation were to be ordered, and whether such parties would be unfairly prejudiced or treated more equitably by substantive consolidation.

3.5.2.6 Consideration of other statutes and legal doctrines

For entities subject to the US Bankruptcy Code, ASC 860 discusses legal isolation largely in the context of true sale and substantive consolidation opinions. Risks addressed in these opinions are typically considered most salient when assessing whether "the available evidence provides reasonable assurance" that the transferred financial assets have been placed beyond the reach of a transferor’s bankruptcy trustee or other receiver, as called for in ASC 860-10-40-8. However, there may be other statutes or legal theories that a creditor or bankruptcy trustee may invoke in an attempt to recover a transferred financial asset in connection with a debtor’s bankruptcy. For example, a bankruptcy trustee may seek to annul or overturn a transfer and reclaim the financial assets as property of the transferor’s bankruptcy estate on the grounds that the transfer was fraudulent. The Bankruptcy Code contains fraudulent transfer provisions, and various US states have fraudulent transfer laws.
In their true sale letters, counsel will often assume that the transferor was not insolvent at the date of the transfer, and the transferred asset does not represent consideration intended to satisfy debt previously owed the transferee ("antecedent debt"). In other words, they will "assume away" conditions potentially relevant to the assessment of whether there has been a fraudulent conveyance. In other instances, counsel will explicitly state in their letter that they assume the transfer is not a fraudulent conveyance.
The discussion of legal isolation and related legal opinions in the remainder of this chapter focuses on true sale and substantive consolidation. Management should discuss with counsel the risks that other laws or doctrines could pose in light of the facts and circumstances of the transfer, and assess whether additional evidence—that is, evidence incremental to a true sale opinion and, if applicable, substantive consolidation opinion—is necessary to ensure that management can support its legal isolation conclusion in accordance with the "reasonable assurance" threshold called for in ASC 860-10-40-8.

3.5.3 Reliance on legal opinions previously rendered

A transaction-specific true sale opinion and, if applicable, a substantive consolidation opinion provide the best evidence that the related transfer satisfies the legal isolation criterion. However, in certain circumstances, management may assert that legal opinions rendered on a previous transaction may be relied upon to support its assertion that subsequent transfers also achieve legal isolation. In our view, the presumption that a transaction-specific legal opinion is required to evidence legal isolation may be overcome if:
  • Management has obtained a legal opinion for previous transfers with facts and circumstances (including contractual terms and forms of consideration received) identical (or substantially the same) to the current transaction, and
  • Both the previous transfers and the current transaction are governed by the same bankruptcy statutes/regulations and contract law.
  • Management has concluded that the laws and regulations in the relevant jurisdiction (including case law relating to how those laws and regulations have been interpreted and applied) have remained unchanged since the date of the earlier opinion.
If these conditions are met, the previously-issued opinion may be used to satisfy the legal analysis otherwise required for the current transaction, consistent with the guidance in ASC 860-10-55-18B(b). Caution should be exercised in making this determination. In practice, transactions are rarely structured in an identical way, typically stemming from the need to tailor each to accommodate the commercial requirements of the parties, or in response to changes in market conditions. This may be the case even when the transferee is the same counterparty. The financial assets being transferred may also have different attributes. Since an attorney is typically the only party who can evaluate the bankruptcy-related implications of changes or differences in transactions, management should seek advice from legal counsel as to whether a new opinion is warranted, even when those changes or differences appear to be inconsequential.
When no legal opinion is obtained for a transfer based on a determination that the facts and circumstances of that transaction are identical (or substantially the same) as those that governed a previous transfer of financial assets for which a legal opinion was obtained, and those laws and regulations have remained unchanged, a transferor should document the basis for that conclusion to support its assertion that the current transfer satisfies the legal isolation requirement.

3.5.3.1 Transfers involving revolving structures

A transferor may transfer financial assets on an ongoing basis in accordance with the terms of a master purchase or similar agreement. These forward arrangements are most commonly seen in securitizations of trade accounts receivables or credit card receivables under so-called revolving structures. Transfers of newly-originated receivables to the securitization trust may take place as frequently as daily, and typically continue until such time as the arrangement enters its scheduled amortization phase, at which point transfers cease and the structure winds down.
For these arrangements, it is customary for transferors to obtain true sale and substantive consolidation opinions coincident with the execution of the governing purchase agreement and the initial transfer of receivables under the program. However, each subsequent transfer of receivables under these arrangements must also meet the legal isolation requirement to qualify for derecognition. Accordingly, to support this ongoing assertion, transferors should have a process in place to ensure that it may continue to rely on the opinions received at the program’s inception. This process may include obtaining periodic affirmations from counsel that the opinions previously provided remain appropriate, based on counsel’s updated consideration of relevant statutes, regulations, and case law. Further, any changes in the terms and provisions in the governing agreements may require an updated legal analysis.

3.5.4 Use of external legal counsel

As noted above, whether a transfer meets the legal isolation condition in ASC 860-10-40-5(a) is a legal matter requiring the advice of competent counsel. Appropriate consideration of the complexities of bankruptcy statutes and related case law requires specialized expertise. Further, to serve as competent evidential matter, the form of advice must be a formal opinion that provides "would level" assurance. Would-level opinions rendered by external counsel will have undergone a rigorous process of due diligence and review. As such, we believe that, as a general rule, it would be inappropriate for management to rely on internal white papers, memos, or even opinions prepared by internal counsel to support its assertion that transferred financial assets have been legally isolated.

3.5.5 Management’s analysis of a legal opinion

In the absence of any guidance directed specifically to management, the PCAOB and AICPA guidance directed to auditors may be helpful to inform a transferor’s management regarding the appropriate form and content of legal opinions intended to serve as evidence of legal isolation. AU Section 9336, Using the Work of a Specialist: Auditing Interpretations of Section 336 (AU 9336), issued by the AICPA, is intended to assist auditors in assessing the sufficiency of a legal opinion obtained by management to support its assertion that transferred financial assets meet the isolation criterion in paragraph ASC 860-10-40-5(a). PCAOB Auditing Interpretation 11, Using the Work of a Specialist: Auditing Interpretations (As Amended for FYE 12/15/2020 and After) incorporates AU 9336’s content. Among other things, the guidance provides that, when assessing the adequacy of a lawyer’s opinion, consideration be given to the following:
  • Whether the lawyer has experience in such matters: the lawyer should be well-versed in the US Bankruptcy Code and relevant case law, and knowledgeable of other federal, state, or foreign laws that may govern, or bear on, the transfer. For transferors subject to the provisions of the Federal Deposit Insurance Act, management and the auditor should consider whether the legal specialist has experience with the rights and powers of receivers, conservators, and liquidating agents under that Act. Similar specialized expertise may be necessary in other regulated industries (for example, insurance).
  • Whether the legal opinion rendered explicitly considers (1) the laws of the State or country intended to govern the transfer and (2) the laws of the jurisdiction that would govern the transferor’s bankruptcy or receivership. As laws vary from jurisdiction to jurisdiction, a transaction that qualifies as a true sale in one jurisdiction may not qualify as such in another.
  • Whether the transferor’s auditor is precluded from relying on a legal opinion because the letter restricts the use of the findings. The legal opinion should specifically state that the auditor is permitted to rely on the conclusions reached in the letter as evidential matter that supports management’s assertion that the transferred assets have been legally isolated. Alternatively, counsel may grant such permission in a separate cover letter. Generally, if this permission is not granted, the letter is considered to contain an audit scope limitation.
In the United States, findings of a lawyer relating to bankruptcy matters are expressed in the form of a reasoned legal opinion that (1) is restricted to the particular facts and circumstances that are relevant to the transaction and (2) relies on analogy to legal precedents and case law that may or may not involve comparable facts. Management should ensure that the legal analysis assumes facts consistent with the transaction, and that other enumerated assumptions (e.g., regarding certain attributes of the transferor, the transferee, and the transferred assets) are appropriate in the circumstances. Inconsistencies in this regard could lead to a conclusion that legal isolation of the transferred assets under ASC 860 has not been demonstrated. Moreover, a legal opinion that does not consider all forms of continuing involvement by the transferor and any of its consolidated affiliates in the financial statements being presented, or an opinion that does not consider all agreements entered into in connection with the transfer, would not be sufficient to demonstrate that the legal isolation condition has been met.
A legal letter that includes an inadequate opinion, inappropriate limitations and assumptions, a disclaimer of opinion, or conditions that effectively limit the scope of the opinion to facts and circumstances that are not applicable to the transaction would not provide persuasive evidence that the transferred assets have been put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. The same would be true for a legal opinion that merely states, with no corresponding discussion of relevant statutes and case law, that a transfer is a legal true sale and, if applicable, that the transferee would not be consolidated with the transferor in the event of the latter’s bankruptcy.

3.5.5.1 Form of the opinion

To provide reasonable assurance that the assets have been isolated from the transferor and any of its consolidated affiliates and its creditors, the legal opinion should provide "would level" assurance with respect to the subject matter addressed; that is, an opinion as to the decision a court would reach in a properly presented and argued case, and the court followed analogous legal precedents (case law). "Would level" is the strongest degree of assurance that an attorney can provide when opining on bankruptcy matters. Note, however, that even an appropriately-worded "would" opinion may not satisfy the requirements of ASC 860 if the assumptions are not accurate (see TS 3.5.5.3) or if the enumerated qualifications unduly limit the scope of the opinion (see TS 3.5.5.4).
Legal opinions stating that the transfer "should" or "would likely" be" construed to be a true sale at law or that "there is a substantial chance" that a true sale at law has occurred do not provide an adequate level of assurance regarding legal isolation. A legal opinion that includes a conclusion expressed using any of the following language would likewise not provide persuasive evidence:
  • "We are unable to express an opinion…"
  • "It is our opinion, based upon limited facts…"
  • "We are of the view…" or "it appears…"
  • "We would be prepared to make such arguments that…"
  • "There is a reasonable basis to conclude that…"
  • "In our opinion, the transfer would either be a sale or a grant of a perfected security interest…"
  • "In our opinion, there is a reasonable possibility…"
  • "It is our opinion that the company will be able to assert meritorious arguments…"
  • "In our opinion, it is more likely than not …"
  • "In our opinion, the transfer would presumptively be…"
  • "In our opinion, it is probable that…"
An attorney’s conclusions about a hypothetical transaction may not be relevant to an executed transfer subject to ASC 860. Perhaps most importantly in this regard, counsel may not contemplate nor address all facts and circumstances relevant to the executed transaction nor consider all provisions in the transfer’s controlling agreements. As such, legal conclusions with respect to a hypothetical transaction generally do not provide sufficient evidence that transferred financial assets have been legally isolated.

3.5.5.2 Examples of legal opinions (Bankruptcy Code)

Examples of "would level" legal opinions for an entity subject to the US Bankruptcy Code appear below. See TS 3.5.8.1 for excerpts of opinions for an entity subject to receivership or conservatorship under the provisions of the Federal Deposit Insurance Act (FDIA).
True sale opinion
Based on and subject to the assumptions, qualifications and limitations set forth in this letter, in the event that the Seller were to become a debtor under the Bankruptcy Code, it is our opinion that, in a properly presented and argued case, a court of relevant jurisdiction exercising reasonable judgment and considering all relevant factors would hold the transfer by the Seller to the Purchaser pursuant to the Receivables Purchase Agreement of all right, title and interest of the Seller in and to the Receivables and the proceeds thereof to constitute a true sale of such Receivables and not a borrowing by the Seller secured by a pledge of such Receivables and, accordingly, such Receivables would not be property of the Seller’s bankruptcy estate under Section 541(a)(1) of the Bankruptcy Code and not be subject to the automatic stay provisions of Section 362(a) of the Bankruptcy Code.
Substantive consolidation opinion
Based on and subject to the assumptions, qualifications and limitations set forth in this letter, in the event that the Seller were to become a debtor under the Bankruptcy Code, it is our opinion that, in a properly presented and argued case, a court of relevant jurisdiction exercising reasonable judgment and considering all relevant factors would not order the substantive consolidation of the assets and liabilities of the Depositor with those of the Seller.
A legal opinion will normally address bankruptcy matters with respect to the entity that is the legal seller of the financial assets. However, if the transferor’s consolidated affiliates are involved with those assets, opinions that address such matters with respect to those affiliates may be required to support the assertion that the transferred assets have been legally isolated in the context of the consolidated reporting entity (see TS 3.5.6).

3.5.5.3 Facts and assumptions

A lawyer will make various assumptions about the underlying transaction when opining on legal isolation. These assumptions typically encompass a wide array of matters, including counsel’s understanding of key provisions in the transaction documents and attributes of the assets sold, as well as assumptions about various procedural matters and organizational protocols that the parties intend to observe. These assumptions are generally cited in the forepart of the letter.
Management must evaluate if a lawyer’s enumeration of facts and assumptions reflect, or are consistent with, the specifics of the transaction. It would be inappropriate for management to conclude that the opinion rendered by counsel is sufficient if it has reason to believe that the attorney’s conclusion is based on incorrect facts and assumptions, or if the letter omits material facts and assumptions that could impact counsel’s analysis. The assumptions in the legal opinion should also be compared to assumptions in the tax analysis to make sure they do not conflict.
Example TS 3-1 illustrates how to analyze a specific assumption in a legal opinion.
EXAMPLE TS 3-1
Analysis of assumptions in a legal opinion
Company XYZ plans to securitize its existing portfolio of customer accounts receivables. The standard terms and conditions in the underlying agreements between Company XYZ and its customers require that the customer receive prior written notification before any transfer of its receivables takes place. Company XYZ has engaged a law firm to issue a true sale opinion on Company XYZ’s proposed securitization. The letter includes the following language under the heading "Assumptions of Fact:"
"We have assumed that there are no agreements to which Company XYZ is a party or by which it is bound prohibiting, restricting or conditioning the sale or assignment of any asset other than such required consents or notices as have been obtained and given."
What are the implications of counsel’s assumption with respect to management’s reliance on the opinion?
Analysis
True sale opinions commonly assume that the seller has complied with all contractual obligations to notify customers of its intent to sell their receivables to another party. For the legal opinion to be valid, Company XYZ must have, in fact, issued the requisite notifications. If not, it would be inappropriate to place reliance on the opinion until such time as the stated assumption is accurate.

In many true sale opinions, counsel will state their assumption that the transfer will be reported as a sale for financial reporting purposes. This assumption is circular, since derecognition is predicated, among other things, on satisfying the legal isolation requirement, for which receipt of counsel’s opinion will be the chief supporting documentation. As such, if the attorney will not delete this assumption, it should be worded to say that counsel assumes the transfer will satisfy the other conditions for sale accounting except for legal isolation, regarding which counsel’s opinion will serve as the principal evidence. Alternative language to this effect is also acceptable.

3.5.5.4 Limitations and qualifications

Counsel will frequently cite various limitations and qualifications with respect to the opinion rendered. Management should ascertain the reasons for any limitations and qualifications, and evaluate their potential implications on the opinion. Management should ensure the enumerated matters do not call into question the sufficiency of the attorney’s analysis and do not compromise the "would level" assurance regarding the legal isolation assertion expressed.

3.5.6 Legal isolation: additional considerations

The analysis of legal isolation can be challenging when various entities within the consolidated group have continuing involvement with transferred financial assets. Similarly, transactions involving multiple jurisdictions or the laws of different countries may pose unusual complexity. This section highlights those circumstances in which multiple legal opinions may be required to support the assertion that transferred financial assets have been isolated from all entities that constitute the consolidated reporting enterprise, other than those entities designed to be bankruptcy remote. In all instances, a transferor should determine what evidence is required to support meeting the legal isolation criterion based on the advice of counsel.

3.5.6.1 Transfers involving multiple legal jurisdictions

In our experience, a transferor may be required to obtain multiple legal opinions when a transfer has any of the following characteristics:
  • The laws intended to govern the transfer (contract law) are not the same as those of the country in which the transferor is organized/domiciled. For example, a transferor subject to the bankruptcy laws of Country X sells receivables to a bank in Country Y, and the parties agree that the transfer agreement is to be governed by the laws of Country Y (or Country Z).
  • Financial assets transferred by an entity to a third party were acquired or originated by another entity within the consolidated group governed by the laws of a country other than that of the transferor. For example, Parent Co and its subsidiaries (all subject to the laws of Country A) transfer originated loans to Subsidiary B (subject to the laws of Country B) in connection with Subsidiary B’s securitization of the loans.

3.5.6.2 Multiple entities in a group have continuing involvement

Multiple legal opinions may be required when a transfer of financial assets involves various members of a consolidated group. A subsidiary within a consolidated reporting group that is not bankruptcy remote may transfer financial assets to a third party and conclude that, in its standalone financial statements, the transaction meets ASC 860’s conditions for sale accounting, including legal isolation. To conclude that sale accounting remains appropriate in the consolidated GAAP financial statements of the parent, the parent must conclude that the transfer continues to meet the three sale accounting conditions in ASC 860-10-40-5 in the context of those financial statements. Thus, the parent must conclude that the transferred financial assets are legally isolated viewed not only from the lens of the legal seller’s financial statements, but also from the parent’s perspective and that of any consolidated subsidiaries involved with the transferred assets.
In these circumstances, there must be sufficient legal evidence to conclude that a court charged with adjudicating the bankruptcy of the parent company would hold that the assets transferred by a subsidiary would not be considered the property of the bankruptcy estate of the parent and its subsidiaries (other than those subsidiaries intended to be bankruptcy remote), taking into account the various forms of involvement by those subsidiaries with the transferred assets.
A transferor subsidiary may be domiciled outside the US and subject to the laws of a foreign jurisdiction while its parent or ultimate parent may be subject to the US Bankruptcy Code. The fact that the transferor is an overseas entity does not mitigate the requirement that there be sufficient legal evidence to support the legal isolation assertion in the consolidated financial statements of the US parent. Accordingly, at the consolidated level, the legal isolation evaluation should consider all forms of the continuing involvement on the part of all consolidated affiliates with the transferred assets. As such, opinions obtained to support legal isolation for purposes of the standalone financial statements of the transferor foreign subsidiary may need to be augmented by additional legal analysis that considers whether, in the event that the parent was involved in a proceeding under the Bankruptcy Code, a court would re-characterize the transfer of financial assets executed by the foreign subsidiary. Additional analysis may be particularly warranted if other consolidated affiliates or the parent were previously involved with the financial assets sold by the foreign subsidiary, and/or if the foreign subsidiary (and any other entities in the consolidated group) have continuing involvement with the assets post-transfer.
Example TS 3-2 illustrates the evidence (legal opinions) required in a group situation.
EXAMPLE TS 3-2
Consideration of legal isolation – various entities within consolidated group having continuing involvement with transferred financial assets
Subsidiary A, wholly owned by Parent Co, transfers a group of originated loans to Investor Co, an unrelated third party, in exchange for cash and a beneficial interest in the transferred loans. A subsidiary of Subsidiary A will service the loans post-transfer. In addition, Parent Co provides limited recourse (credit enhancement) to Investor Co on the transferred loans. There are no other forms of involvement by Parent Co and its subsidiaries with the transferred loans or Investor Co.
Parent Co prepares consolidated financial statements, and Subsidiary is required to submit standalone financial statements to certain lenders. Both entities have concluded that the transfer of the loans will meet the conditions for sale accounting, subject to obtaining satisfactory opinions from counsel to demonstrate legal isolation. Parent Co and its subsidiaries are each subject to the US Bankruptcy Code.
In assessing whether this criterion is met, what evidence (legal opinions) should be obtained by Subsidiary A and Parent Co for purposes of their respective sets of financial statements?
Analysis
ASC 860-10-40-4 affirms the general decision principle that the sale accounting analysis must consider all forms of continuing involvement by the transferor and any of its consolidated affiliates included in the financial statements being presented. Consistent with this principle, ASC 860-10-40-8 also requires that the analysis of the legal isolation requirement consider not only the transferor but also its consolidated affiliates included in the financial statements being presented.
Accordingly, the legal analysis prepared for purposes of Subsidiary A’s stand-alone financial statements should consider Subsidiary A’s continuing involvement with the transferred loans – in this instance, its beneficial interest in the loans as well as the servicing retained, as the latter is performed by an entity consolidated into Subsidiary A’s financial statements.
For purposes of Parent Co’s consolidated financial statements, management would be required to obtain a legal analysis that addresses whether, if the parent and its subsidiaries were subject to a proceeding under the US Bankruptcy Code, the transferred loans would be respected as a true sale at law. As part of its true sale analysis, counsel should address how it believes a court would consider the parent’s obligation to provide credit enhancement when evaluating whether the transferred loans should be considered part of Parent Co’s consolidated bankruptcy estate.
In this example, depending on the judgments reached by counsel, it is possible that management may conclude that the transfer of the loans to Investor Co meets the legal isolation condition only in the context of Subsidiary A’s standalone financial statements. In that case, Subsidiary A would report the transfer as a sale. However, in Parent Co’s consolidated financial statements, the same transaction would be reported as a secured borrowing.

3.5.6.3 Set-off rights

A set-off right is a common law right of a party that is both a debtor and a creditor to the same counterparty to reduce its obligation to that counterparty if that counterparty fails to pay its obligation. ASC 860-10-40-5(a) is explicit that “A set-off right is not an impediment to meeting the isolation condition.” The reasoning behind this provision, is that the existence of set-off rights is not considered by a court when assessing whether a transaction would be deemed to be a true sale. In the event of the bankruptcy or receivership of either the obligor or the transferor of the financial asset, both parties could retain the ability to exercise a set-off right involving a financial asset that had been transferred. In the event of the bankruptcy of the transferor, the transferee may have only an unsecured claim against the transferor for its share of the amount set off (rather than a claim to the cash flows from the originally transferred asset).
When developing this guidance, the FASB contemplated whether set-off rights related to a transferred financial asset should be severed in order to meet the isolation requirement. However, they were advised that it may not be possible to sever set-off rights related to transferred financial assets. For example, certain consumer protection rules prevent consumers from waiving their ability to exercise set-off rights against a seller of goods financed under a contract with the seller. In other cases, it may be impractical or infeasible for a transferor to sever set-off rights related to transferred financial assets because doing so would require the involvement of an obligor on the original financial assets who may not even be aware of or otherwise involved in the transfer. The Board was advised that a court likely would compel a transferor that benefited from an exercise of set-off rights on a transferred financial asset to pass through a proportionate share of that benefit to any transferee that held a share of the related original financial asset. In addition, set-off risks are assessed and included in the price for the transaction like other dilutive risks, such as warranties and returns. Hence, the Board ultimately decided that set-off rights would not be an impediment to meeting the isolation requirement or the participating interest definition.

3.5.7 How two-step structures meet the legal isolation requirement

In many instances, a key motivation of the typical securitization transaction is to achieve a lower cost of funding. The credit risk in the securities issued to third parties (beneficial interests) directly affects the interest rate that the securities must pay to attract investors. A reduction in the credit risk to all or certain of those investors can take the form of credit enhancement to the assets through a third-party guarantee, subordinating the claims of certain investors to the underlying assets’ cash flows to other (senior) investors, or both. Further, investors do not want exposure to the credit risk (bankruptcy) of the securitization’s sponsor/transferor; investors may demand a higher interest rate to compensate them as such risk increases.
To facilitate the execution of securitization transactions at the lowest possible funding cost, the "two-step" transfer construct is commonly used in the marketplace. As discussed in ASC 860-10-55-22, the two-step securitization structure, taken as a whole, is generally judged under present US law to successfully isolated the transferred assets beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership.
In two-step securitization transactions, the key considerations in assessing whether legal isolation has been achieved are whether, relative to the first step (that is, the legal sale of assets by the transferor(s) to an affiliated BRE):
  • the transfer of the financial assets by the seller(s) to the BRE would be upheld as a true sale at law in the event of a seller’s bankruptcy, and
  • the BRE would not be substantively consolidated into the bankruptcy estate of its parent.
The integrity of the two-step transfer construct to support legal isolation hinges on obtaining the "would level" true sale and substantive consolidation opinions discussed in TS 3.5.5.1. This requirement stems from the fact that, typically, the BRE’s subsequent transfer of the acquired assets to the securitization trust or other legal vehicle may not be upheld as a true sale. This is because the extent and nature of credit or yield protection provided by the BRE to the trust’s third-party investors (say, through the BRE’s retention of the trust’s subordinated notes) may suggest that the BRE’s transfer has the characteristics of a secured borrowing. Consequently, a risk exists that a bankruptcy court could find the exchange between the BRE and the trust to be a financing, rather than a true sale. However, the two-step construct mitigates this re-characterization risk provided that (1) the transfer of financial assets to the BRE is a true sale, and (2) by design, a BRE has a remote possibility of entering into bankruptcy, either by itself or by substantive consolidation in the event of bankruptcy by its parent. As such, in these circumstances, even though the BRE is frequently included in a transferor’s consolidated financial statements, ASC 860’s legal isolation condition is satisfied.
Because the true sale opinion addresses only the first step in most of these transactions, frequently there is no corresponding legal analysis that may be leveraged when evaluating whether the second step transfer (that is, the exchange between the BRE and securitization trust or third-party transferee) involves an entire financial asset (or group of such assets) or, conversely, a portion of a financial asset subject to the participating interest definition. Entities should focus on the legal form of the asset (interest) sold by the BRE, and what rights that asset conveys to the transferee, when evaluating whether an entire financial asset, or only a portion, has been transferred in the second step. If only a portion has been exchanged, the participating interest guidance in ASC 860-10-40-6A must be considered first in the sale accounting evaluation.

3.5.8 Transferors subject to FDIC receivership

As conservator or receiver, the FDIC has the authority to repudiate or disaffirm contracts of an insured depository institution (IDI) with respect to transfers of financial assets involving a securitization or a participation. However, provided certain conditions are met, the FDIC provides a "safe harbor" that limits the exercise of that authority. These limitations are intended to provide certain protections to investors, particularly those that hold beneficial interests in financial assets securitized by an IDI. The FDIC rules clarify the application of the safe harbor to securitization and participation transactions that meet the criteria for sale accounting and, to a greater extent, to those transactions that do not result in the IDI’s derecognition of the underlying transferred financial assets.
The safe harbor rule is published in 12 CFR section 360.6.

3.5.8.1 Examples of legal opinions (FDIA)

As discussed in AU 9336.14, management can choose between two alternate forms of legal opinions that provide acceptable legal isolation assurance to transferors of financial assets subject to receivership or conservatorship under the provisions of the FDIA. The first example is excerpted below; see AU 9336.14 for the second example, which is rarely seen in practice.

Excerpt from AU 9336.14

"We believe (or it is our opinion) that in a properly presented and argued case, as a legal matter, in the event the Seller were to become subject to receivership or conservatorship, the transfer of the Financial Assets from the Seller to the Purchaser would be considered to be a sale (or a true sale) of the Financial Assets from the Seller to the Purchaser and not a loan and, accordingly, the Financial Assets and the proceeds thereof transferred to the Purchaser by the Seller in accordance with the Purchase Agreement would not be deemed to be property of, or subject to repudiation, reclamation, recovery, or recharacterization by, the receiver or conservator appointed with respect to the Seller."

AU 9336.14 also provides an example of a substantive consolidation opinion that may be required when the transferee is an affiliate of a transferor subject to the FDIA (e.g., a BRE in a two-step transaction involving an IDI).

Excerpt from AU 9336.14

"Based upon the assumptions of fact and the discussion set forth above, and on a reasoned analysis of analogous case law, we are of the opinion that in a properly presented and argued case, as a legal matter, in a receivership, conservatorship, or liquidation proceeding in respect of the Seller, a court would not grant an order consolidating the assets and liabilities of the Purchaser with those of the Seller."

3.5.9 Legal opinions that address foreign laws and regulations

The legal isolation criterion in ASC 860 applies to all transfers of financial assets, irrespective of whether a transferor is subject to the US Bankruptcy Code or, alternatively, subject to the bankruptcy statutes and related laws and regulations of a foreign jurisdiction. Accordingly, other than for routine transfers of financial assets that entail no continuing involvement by a transferor or its affiliates, there is a presumption that a foreign legal opinion is required to support an assertion that financial assets transferred by a foreign entity have been legally isolated.
The laws and conventions that a foreign court would consider in concluding whether financial assets transferred by a foreign entity have been legally isolated may differ significantly from those in the US. Further, legal opinions rendered outside the US frequently omit an extended analysis of relevant case law and/or factors that a court or bankruptcy trustee would consider in its assessment of the transaction. Nevertheless, as a general rule, the requirements and considerations of bankruptcy opinions rendered in the US apply similarly to foreign legal opinions. The sections that follow highlight matters to consider when evaluating whether a foreign legal opinion provides the requisite "reasonable assurance" that transferred financial assets have been legally isolated.

3.5.9.1 Scope and content of foreign legal opinions

Counsel outside the US may not be familiar with a requirement to obtain a legal opinion to support a financial reporting conclusion. This stems from the fact that legal isolation is a requirement unique to US GAAP’s sale accounting framework; under IFRS, for example, the derecognition model for transferred financial assets does not include this criterion. In some cases, a foreign legal opinion may be prepared at the request of rating agencies or the transferee. However, these opinions may require enhancement to ensure that their scope comports with the requirements in ASC 860 – for example, to ensure that, where applicable, the analysis and opinion expressed considers consolidated affiliates of the transferor’s involvement with the transferred assets.
The discussion of legal isolation in ASC 860 is written in the context of US law. Thus "true sale" and the doctrine of substantive consolidation may not be relevant legal concepts in other jurisdictions. Further, statutory and regulatory regimes in other countries can vary widely. For this reason, a foreign attorney’s conclusions regarding legal isolation may be expressed in a manner (and using terms) unfamiliar to transferors accustomed to legal opinions prepared in the United States. Nevertheless, legal isolation is not specific to legal jurisdiction, in which case a foreign bankruptcy opinion can be used to provide the equivalent of would-level assurance with respect to the following matters:
  • The assets have been irrevocably transferred in accordance with an enforceable contract
  • A court or party with jurisdiction over the foreign entity would hold or conclude that the transferred assets have been legally isolated from the foreign transferor, even in the event of the latter’s bankruptcy or receivership
  • In a bankruptcy or receivership proceeding, a court or party with jurisdiction over the foreign entity would not recharacterize the transfer as a secured borrowing

3.5.9.2 Choice of law considerations

For a variety of reasons, the laws specified in a transfer arrangement as governing the transfer of financial assets may be those of a country other than the country in which the transferor is organized and domiciled. For example, a transferor subject to the laws of Spain may periodically sell receivables to a bank (organized in another country) in accordance with a master purchase and sale agreement governed by English law. Accordingly, the Spanish transferor should discuss with counsel whether, in addition to obtaining a legal opinion that addresses the application of Spanish insolvency laws to the transaction, an opinion that addresses relevant matters in the context of English law is also required. For example, if the opinions expressed by counsel with respect to Spanish bankruptcy matters (or legal isolation more generally) are materially predicated upon assumed findings of an English court regarding the application of English law to the purchase and sale agreement, a legal analysis by English counsel to support the propriety of those assumptions may be warranted. Absent an opinion from English counsel in these circumstances, the opinion provided by Spanish counsel may not meet ASC 860’s "reasonable assurance" threshold regarding legal isolation.

3.5.9.3 Assumptions and qualifications

Similar to legal opinions issued in the US, foreign legal opinions will enumerate numerous assumptions of fact and various qualifications regarding the conclusions expressed. Opinions rendered with respect to transferors domiciled in Europe frequently cite numerous assumptions and qualifications relating to the controlling civil law regimes in the applicable country and the regulatory framework within which the entity operates. Among others, these assumptions frequently stipulate that the transferor has complied with various procedures mandated by law or regulation to effect the transfer.
Given the extent and nature of these assumptions and qualifications, it is particularly important that the transferor fully understands the potential implications on the attorney’s opinion. As discussed in TS 3.5.5, management should review all assumptions for propriety. If counsel has assumed that the transferor has or will observe certain protocols or perform certain procedures, management should ensure that those actions have or will be undertaken. Finally, as also noted in TS 3.5.5, management should conclude that the nature and scope of the qualifications do not call into question whether the opinions expressed omit consideration of laws or legal doctrines that could materially impact the legal isolation assertion.

3.5.9.4 Auditor reliance language

Similar to practice in the US, a foreign attorney may restrict the use of its letter to only those parties who have engaged it, and state that only they may rely on it. In these instances, if a transferor intends to provide a foreign bankruptcy opinion to its auditors as evidence in support of its legal isolation assertion, management should ensure that the letter (or a cover letter) expressly permits it to provide the opinion to its auditors.
Language that authorizes management to make a bankruptcy opinion available to its auditors is commonly seen in opinions written in the US, having been negotiated between the accounting and legal professions years ago. Inclusion of standard language to this effect is a widely-accepted practice. Outside the US, management may need to negotiate with foreign counsel to include this permission language in its opinion (or in a cover letter).
3 Unless the context suggests otherwise, references in this chapter to "bankruptcy" and "bankruptcy law" should be read to also include receivership, conservatorship and similar insolvency regimes.
4 Unless indicated otherwise, matters in this chapter dealing with legal isolation are discussed in the context of laws and regulations in the US (Federal and state).
5 In most "two-step" transfers, counsel does not (or cannot) render a true sale opinion on the BRE’s conveyance of the financial assets to the ultimate transferee (e.g., a securitization trust). Therefore, if the BRE was to be placed into bankruptcy (or included in the bankruptcy estate of the parent-transferor), a risk exists that the BRE’s transfer of the assets to the ultimate transferee could be recharacterized as a financing. The BRE construct, accompanied by a would-level substantive consolidation opinion, provides assurance that this risk is remote.
6 The AICPA has a task force that is currently focused on improving the guidance in AU 9336, in order to better align it with auditing literature and address certain aspects not currently addressed.
7 This example stipulates that Subsidiary A sells the loans directly to Investor Co (a "one-step" exchange). If the parties utilized a "two-step" transfer construct involving a BRE, the legal isolation analysis would involve consideration of matters of true sale and substantive consolidation in the context of Subsidiary A’s transfer of the loans to the BRE.
8"Foreign entity" or "foreign transferor" refers to legal entities whose bankruptcy or receivership would be governed by laws or regulations other than those of the US. Similarly, a "foreign legal opinion" or "foreign bankruptcy opinion" refers to an opinion written by counsel that addresses the relevant bankruptcy-related laws and regulations of the jurisdiction to which the foreign entity or foreign transferor is subject.

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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