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A Transactional Genealogy of Scandal

A Transactional Genealogy of Scandal

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Published by: Foreclosure Fraud on Aug 14, 2012
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12/28/2013

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University of Pennsylvania Law School 
ILE
INSTITUTE FOR LAW ANDECONOMICS
 
 A Joint Research Center of the Law School,The Wharton School, andThe Department of Economics in the School of Arts and Sciencesof the University of Pennsylvania
ESEARCH
P
APER 
 N
O
.
 
12-26
Business, Economics & Regulatory Policy Working Paper SeriesResearch Paper No. 2126778Public Law & Legal Theory Working Paper SeriesResearch Paper No. 2126778
A
 
T
RANSACTIONAL
G
ENEALOGY OF
S
CANDAL
:
F
ROM
M
ICHAEL
M
ILKEN TO
E
NRON TO
G
OLDMAN
S
ACHS
 
William W. Bratton
 NIVERSITY OF 
 P 
 ENNSYLVANIA
 L
 AW 
CHOOL
 
Adam J. Levitin
G
 EORGETOWN 
 NIVERSITY 
 L
 AW 
 ENTER
 
August 13, 2012
 
V
ERSION
 
This paper can be downloaded without charge from theSocial Science Research Network Electronic Paper Collection at:http://ssrn.com/abstract=2126778
 
A
 
T
RANSACTIONAL
G
ENEALOGY OF
S
CANDAL
:
FROM
M
ICHAEL
M
ILKEN TO
E
NRON TO
G
OLDMAN
S
ACHS
 
W
ILLIAM
W.
 
B
RATTON
A
DAM
J.
 
L
EVITIN
 
Three scandals have fundamentally reshaped business regulationover the past thirty years: the securities fraud prosecution of Michael  Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs“Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticetransactional affinity tying these scandals together—a deal structureknown as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertaketransactions for its creator’s accounting and regulatory benefit.The SPE remains mysterious and poorly understood, despite itsuse in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschewsequity control in favor of control through pre-set instructions emanating  from transactional documents. In theory, these instructions are completeor very close thereto, making SPEs a real world manifestation of the“nexus of contracts” firm of economic and legal theory. In practice,however, formal designations of separateness do not always stand upunder the strain of economic reality.When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and theSPE’s economic reality. The standard legal model looks to equityownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firmconnections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equityownership.
Deputy Dean and Nicholas F. Gallicchio Professor of Law; Co-Director, Institute for Law & Economics, University of Pennsylvania Law School.
Visiting Professor of Law, Harvard Law School; Professor of Law, GeorgetownUniversity Law Center. This paper has benefitted from presentations at the Georgetown LawFaculty Workshop and at the University of Miami Business Law Review Symposium.
 
8/13/2012]
 
 B
 RATTON 
&
 
 L
 EVITIN 
 
2
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory isemerging, not from corporate law or financial economics but fromaccounting principles. Accounting has responded to these scandals byabandoning the equity touchstone in favor of an analysis in whichcontractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws theboundaries of the firm. Transaction engineers need to come to termswith this new functional model as it could herald unexpected liability, asGoldman Sachs learned with its Abacus CDO.
I
 NTRODUCTION
 .......................................................................................... 3
!
I.
 
M
YTHIC
O
RIGINS
:
 
M
ICHAEL
M
ILKEN AND
J
UNK 
B
ONDS
................... 11
!
A. Junk Bonds and S&Ls .................................................................. 12
!
B. The First Collateralized Bond Obligations ................................... 15
!
1. Imperial Savings ......................................................................... 18
!
2.
 First Executive ............................................................................ 21
!
C. Summary ....................................................................................... 26
!
II.
 
T
HE
F
ULCRUM
:
 
BISTRO .................................................................. 27
!
A. Motivations ................................................................................... 28
!
B. Bistro Breakthrough ...................................................................... 31
!
C. Summary ....................................................................................... 34
!
III.
 
T
HE
I
LLEGITIMATE
C
HILD
:
 
E
 NRON
S
S
WAPS
.................................. 35
!
A. Asset Light from Wall Street to Main Street ................................ 36
!
B. A Bistro Opens in Houston ........................................................... 39
!
1. Chewco and LJM ....................................................................... 40
!
2. Bistro Inferno ............................................................................ 42
!
C. Implications .................................................................................. 45
!
IV.
 
T
HE
S
TILLBORN
S
CANDAL
:
THE
SIV
S
............................................. 46
!
A. Structured Investment Vehicles .................................................... 49
!
B. The SIV Panic ............................................................................... 54
!
C. Revenge of the SIV: the Non-Scandal ......................................... 56
!
D. Enron Redux? ................................................................................ 59
!
V.
 
T
HE
IGHTFUL
H
EIR 
:
 
G
OLDMAN
S
ACHS
S
S
YNTHETIC
CDO
S
........ 59
!
A. The Abacus 2007-AC1 Transaction ............................................. 62
!

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