VideoKenneth Kettering, associate professor at New York Law School, argues that the securitization industry owes its very existence to the willingness of rating agencies to rate ABS securities based on "extravagantly hedged" true-sale opinions. "No competent lawyer ever gave a simple flat opinion that the asset transfers involved in a securitization transaction constitute a 'true sale.' Indeed, given the absence of controlling case law, a lawyer could not responsibly do so," he wrote in a letter to Congress. "These all-but-liability-proof legal opinions underline the fact that the parties to a securitization transaction are knowingly assuming a serious legal risk."
Legislating the Answer
One obvious remedy would be to eliminate that risk through legislation. That was tried last year in an amendment to bankruptcy legislation that would have defined securitization as a true sale, effectively giving it safe harbor from bankruptcy.
The problem with that is that bankruptcy courts would be automatically prohibited from reviewing securitizations that followed certain guidelines. Kettering and 34 other law professors objected on those grounds. The amendment, they told Congress, "permits a debtor and one favored creditor to engage in a secret transaction to remove valuable, liquid assets from the corporate bankruptcy estate of a troubled borrower and place them beyond the reach of the courts and other creditors."
The BMA, which supported the measure, shot back that the amendment would reduce uncertainty, which in turn would reduce costs. It further contended that efficient securitization is a boon to the economy. "Companies that use securitization have been able to significantly reduce their cost of funds, increase liquidity, and obtain greater and more-diversified access to the capital markets," wrote BMA executive vice president John Vogt, adding that the amendment would eliminate "an undesirable degree of residual uncertainty...which raises the overall cost and expense of funding securitized assets."
That argument, scoffs Kettering, is disingenuous, because the industry knowingly took on that risk in the first place. "It is no different than the person who kills his parents and then pleads for mercy on the grounds that he's an orphan," he argues. It's something of a pattern, he adds, for the financial industry to create legally shaky but profitable financial products, and then demand legislative or judicial relief from the legal risks once use of a product is widespread.
At this point, the amendment is off the table — it was stripped from both House and Senate bills, which themselves were later killed. But the amendment was only the latest incarnation of safe-harbor legislation. "I would not be surprised to see it resurrected," says Kettering. "This is going to be a permanent issue."
In the absence of such legislation, challenges to true sale in court continue to be likely — even if the goal is simply to extract other concessions. "Bankruptcy is all about negotiating," says Brozman. "Many times claims are brought simply to gain leverage." If nothing else, the rapid assembly of DIP financing in the LTV case is proof that these challenges are effective.
Such bargaining strategies put the future of ABS in the hands of judges. "I think courts are anxious to preserve the securitization market and doctrine," said James Tancredi, an attorney with Hartford-based Day, Berry & Howard, speaking at the BMA panel. "But they are often driven by distress in troubled businesses to test those doctrines."
The true-sale issue has resurfaced recently — not surprisingly, among the many battles in Enron's sprawling bankruptcy proceedings. The energy company's widespread abuse of securitization structures drove almost all of the current accounting changes affecting securitization, but in this case, it also is generating legal challenges reminiscent of LTV. Enron made use of financial asset securitization investment trusts, or FASITs, a rarely used type of securitization conduit whose primary benefit for Enron appears to have been tax avoidance. As with LTV, however, banks have been forced to fight to keep Enron receivables sold to the FASIT out of the bankruptcy estate.
True sale is not the only potential legal challenge to securitization. Kettering goes so far as to argue that securitization could be challenged under so-called fraudulent conveyance laws. Bankers and structured-finance professionals, not surprisingly, bridle at suggestions of fraud. But, explains Kettering, the legal definition of fraudulent conveyance goes beyond fraud, and includes any transfer of assets intended to hinder or delay creditors' access to those assets. "And aren't securitizations designed to do just that?" he asks.
Even if bankruptcy courts don't buy the argument that a securitization is fraudulent, they can simply impose a "substantive consolidation" on a company and its SPE — essentially overruling the idea that there is any division between them (or their assets). To date, this is rare, although new rules that require consolidation from an accounting perspective may provide creditors with added ammunition in arguing for such a step in the legal realm. Accounting and law are different worlds, says Grant Thornton's Scoles, "but this is an area where they very much come together."
Breaching the Contract
Moreover, bankruptcy courts are courts of equity — unfriendly places for carefully erected financial structures like securitization. Bankruptcy judges have great freedom to interpret the law as they see fit. "Quite frankly, bankruptcy is like Alice in Wonderland," said Tancredi. "It is an elastic process, and notions of fundamental contract law are often out the door. To stand behind your black-and-white legal rights [in bankruptcy court] is sometimes a losing battle."
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