- within Compliance topic(s)
Originally appeared in SPE Transactions Update - February 9, 2002
Enron Corporation's alleged use of off-balance-sheet special purpose entities ("SPEs") to conceal large amounts of company debt and losses by artificially creating liabilities off the Enron corporate balance sheet has reverberated across a number of industries, including the financial services industry.
In the financial services industry, which relies on the use of SPEs for balance sheet management and fee generation purposes, there is an increasing concern that the regulatory authorities will challenge the use of SPEs in securitization and other similar forms of balance sheet management and related activities. This concern has been heightened by last week's actions of PNC Financial Group, which restated its 2001 financial statements at the direction of the Federal Reserve Board to bring back onto the balance sheet pools of assets previously transferred to several reportedly off-balance-sheet SPEs.
These developments have caused a number of financial institutions to question whether their use of SPEs in their financial management activities will be subject to increased and more sceptical governmental scrutiny, and whether this scrutiny might result in regulatory action to force banks and other financial institutions to reconsolidate the assets and liabilities of entities believed to have been properly moved off their balance sheets.
Financial institutions also are concerned that investors, external rating agencies, accountants and lawyers will be more reluctant to participate in, accept or certify balance sheet management transactions that rely on SPEs. Financial intermediaries active in the structuring of SPE transactions are asking whether transactions that they have structured for others might create liability issues if these transactions subsequently must be unwound by regulatory fiat. Further, the accounting profession, through the Financial Standards Accounting Board ("FASB"), appears to be under increasing pressure to resolve a longstanding debate over the proper accounting standards for the deconsolidation of related corporate entities. One outcome of this discussion may be a significant tightening of the current standards for deconsolidation.
While these developments understandably have raised concerns among financial services and capital markets firms, in our view they should not be viewed as the start of a program by financial regulatory authorities to question wholesale the use of SPEs for balance sheet management and other legitimate financial activities.
Instead, informal communications with senior staff at agencies such as the Federal Reserve Board and the Office of the Comptroller of the Currency indicate that interested financial institutions should look to these recent regulatory developments for guidance on the financial statement treatment of their SPE transactions. Further, institutions should be aware of which types of SPE transactions the federal financial regulatory agencies are likely to scrutinize more closely to assess whether, in their view, there has been a substantive transfer of asset risk from the balance sheet by the transferring institution.
What Are the Regulators Saying?
The nature and substance of the PNC Financial transactions that were challenged by the Federal Reserve Board are still in the process of being fully digested by the marketplace. The principal motivating factor that appears to have led to this regulatory action, however, was the apparent Federal Reserve Board perception that the transactions in question, by reason of a number of embedded contractual guarantees and financial support mechanisms, did not substantively transfer the credit risks of a portfolio of low-quality assets that the banking organization had transferred to a series of SPEs that were putatively owned by a third-party arranger.
The fact that these transactions technically may have qualified as a sale of assets to a non-consolidated entity under generally accepted accounting principles ("GAAP") reportedly was compromised, in the view of federal regulators, by the effective retention by the transferring financial institution of a predominant economic risk of loss in the assets in question.
The actions of the Federal Reserve Board should not be viewed as a general attack on the use of SPEs to move assets off the banking balance sheet. Indeed, federal regulators informally have signaled that it is not their intention to overturn the use of SPEs in ordinary course securitization or structured financing transactions, nor is it their intention to "rewrite" GAAP to tighten the substantive financial accounting requirements for the deconsolidation of SPEs. At the same time, the recent regulatory actions may signal to the marketplace that simple reliance on technical compliance with current accounting standards as a means of disguising the retention of substantive risk of assets transferred to a third party will not be uncritically accepted, and that financial institutions have an obligation to ensure that the accounting for a "sale" to an SPE is in line with the substantive economics of the transaction.
Open Questions
The regulatory response understandably raises issues of interpretation and application. First, the current authoritative accounting literature speaks in some respects to the need for a sales transaction to effect a substantive transfer of economic risks and rewards to a non-consolidated third party. The technical rules governing consolidation currently in place, however, were designed to provide public enterprises with clear and objective guidelines that could be followed to achieve the intended accounting result.
The apparent intention of the Federal Reserve Board and other regulators to place more emphasis on the economic substance of a transaction raises the question as to whether the regulators may in effect be "rewriting" GAAP in SPE transactions, where they believe that the substance of a transaction varies from its form. In turn, FASB is examining the proposition that accounting rules pertaining to consolidation should be more "principles based" (in other words, based more on the economic and financial substance of a transaction and less on purely technical criteria), and it is possible that the banking regulators - and the SEC - may through regulatory action encourage the accounting profession to move in this direction, or tighten the current technical requirements for deconsolidation under GAAP.
This does not mean that banking institutions should ignore the current technical rules or try to guess how these rules might change (if at all) in the future. It does mean, however, that they should pay more attention to the substantive allocation of risks and rewards, while at the same time complying with the current accounting literature, in their financial management activities involving the use of SPEs.
Second, the interplay in the case of SPE transactions between GAAP and the federal regulatory agencies' regulatory reporting and capital rules currently is not fully developed. The federal banking authorities already have in place a series of relatively complex regulatory capital rules - especially in the realm of securitization transactions - that are specifically designed to ensure that a banking organization's capital properly supports the retained risks of assets on and off the organization's financial statements.
While recent regulatory indications are that these rules ordinarily are the preferred means of addressing the retention of credit and other risk on the banking book in "plain vanilla" securitization transactions involving the use of SPEs, how and where the regulators may choose to invoke the more drastic remedy of "reconsolidation" in the face of these regulatory capital requirements is at this point unclear.
Third, it appears that transfers of certain types of assets, and certain kinds of SPE transaction structures, may generate greater regulatory scrutiny than other types of assets or structures. For instance, the transfer of low-quality assets to a third-party SPE as a device to move the assets off the balance sheet, or dampening earnings or market volatility associated with those assets, is more likely to draw enhanced supervisory attention than, for example, transactions involving investment-grade assets. Similarly, structured finance transactions or facilities that (i) include low-quality asset "put" or buyback features, (ii) are purely private transactions that are not subject to the external discipline of the capital markets (whether in the form of independent third-party investor or rating agency participation), or (iii) do not have a clearly defined business purpose, may subject the sponsoring banking organization to a closer regulatory review of the allocation of the substantive risks and rewards of such transactions.
Appropriate Response Strategies
Overall, we believe that the appropriate response of the banking industry to these developments should be one of reasoned and reasonable caution, and not alarm. We do not believe that banking organizations that have transferred assets to an SPE in a properly structured securitization transaction that is supported by appropriately reasoned legal and accounting opinions and certifications, and where they have allocated the appropriate level of "recourse" capital where some level of risk is retained, routinely should be concerned that such transactions will be challenged on consolidation grounds.
SPE transactions, however, that present one or more of the higher-risk elements mentioned above (e.g., low-quality assets, relatively high risk retention levels or transactions with asset buyback elements), should lead sponsoring financial institutions and their advisers to be especially attentive not only to compliance with applicable GAAP and legal isolation requirements - which are indispensable prerequisites in all SPE "true sale" transactions - but also to examine the overall structure and economics of an SPE transaction with a view to understanding the substantive allocation of financial risks and rewards among the participants. Moreover, all banking organizations should be prepared for the possibility of changes in GAAP requirements applicable to SPE transactions, as FASB attempts to fashion a workable solution to the consolidation conundrum during the year 2002.
In conclusion, recent regulatory events should not be cause for jettisoning or curtailing the use of SPEs in legitimate structured finance and other balance sheet management and fee generation activities. None of the information that we have gathered suggests that there is any reason to believe that the widely distributed ABS, CMBS, synthetic lease, CDO and other structured finance products that are recognized by the capital markets and the financial regulatory agencies as accepted financial management mechanisms are at risk. At the same time, in the current regulatory climate, banking organizations should encourage their employees, and their financial and legal advisers, to "step back" from an SPE transaction during the development and documentation stages and ask themselves whether the transfer of the assets to the SPE fairly represents an adequate transfer of the risks and rewards of the bank's assets to an unaffiliated third party.
Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.
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