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Securitisation Disclosures and Compliance under Basel II: Part I—A Risk-based Approach to Economic Substance Over Legal Form
Attorney at Law; Course Director, LL.M. Corporate Finance Law, University of Westminster School of Law
Banking supervision; Capital adequacy; Securitisation; Tax
the principle of economic substance over legal form is of sufﬁcient speciﬁcity for certain areas of law, such as the tax law, it remains undeﬁned under the Securitisation Framework. Thus, whilst it is associated with general equitable notions of fairness and transparency, it requires further speciﬁcation in order to be of practical use to professionals engaged in securitisation. Should the meaning of economic substance over legal form continue to be uncertain, the unfortunate wording will give rise to endless compliance arguments. To ﬁll this gap we propose a risk-based interpretation of economic substance over legal form, which we dub ‘‘risk symmetry’’. We hope that the concept of risk symmetry will help supervisors and bankers come to a common understanding of how regulatory capital charges of securitisation exposures can be viewed, not merely from a prescriptive evermultiplying compliance perspective, but also from a sense of ultimate fairness.5 By gaining some insight into the fundamental structure of how and why economic substance over legal form can be interpreted from a risk-based perspective, we have a way of critically analysing, reorganising and simplifying the rather complex requirements of the Securitisation Framework.
Introduction ˆ Raison d’etre of Basel II
In this article we examine securitisation disclosures and compliance as promulgated under the current rules of the International Convergence of Capital Measurement and Capital Standards, A Revised Framework, commonly known as Basel II.1 Since the entire ediﬁce of the Securitisation Framework under Basel II (hereafter, ‘‘Securitisation Framework’’2 ) is based on the concept of economic substance over legal form,3 we will focus on an interpretation of this concept based on the legal and equitable tradition, and then offer an alternative interpretation which is risk-based and provides us with a method for accessing the complex (and convoluted) Securitisation Framework from a practical perspective. This article, as Part I of a two-part series, serves as a theoretical framework for interpreting securitisation disclosures under the Securitisation Framework. The upcoming article in Part II will focus on an interpretation of the Securitisation Framework in light of the framework set out in this article. Our overall aim in this article is to explain the major principles of the Securitisation Framework by focusing on the disclosures required of internationally active banks engaged in securitisation.4 Whilst
1. Basle Committee on Banking Supervision (June 2004) International Convergence of Capital Measurement and Capital Standards, A Revised Framework, [‘‘Basel II’’] available at www.bis.org. 2. ibid., Part IV. Credit Risk—Securitisation Framework, paras 538–643, pp.113–136. 3. ibid., para.539, p.113. 4. Basel II applies to ‘‘internationally active banks’’, ibid., para.9, p.3.
Banks throughout the world are increasing their exposures to securitisation transactions either as originating sponsors or investors.6 Under Basel II, all internationally active banks will be required ‘‘to hold regulatory capital against all of their securitisation exposures’’7 and only under certain strict operational conditions will originating banks be allowed to exclude securitised exposures from their calculation of risk-weighted assets.8 A formative analysis of the operational requirements across the various types of ﬁnancial instruments delineated by the Securitisation Framework has yet to be undertaken. Major operational requirements within the Securitisation Framework exist for the treatment of:
5. We emphasise this basic point of equity because protecting fairness is more important than strengthening supervisory discretion in developed ﬁnancial markets. The essential risk of the Securitisation Framework is its unintended consequences, for if the original intent of Basel II is to be preserved, namely, to protect the market from systemic risk, we must be mindful that major mishaps in the markets have been caused by over-regulation and regulatory ampliﬁcation. See J. Tanega, ‘‘Basel II: Principles of Avoiding Regulatory Failure’’ in Sima Motames-Simidian, ed., Governance and Risk in Emerging and Global Markets (Palgrave, forthcoming 2005). 6. D. Andrews, H. Heberlein, K. Olson, J. Moss and J. Olert, ‘‘Securitization and Banks—A Reiteration of Fitch’s View of Securitization’s Effort on Bank Ratings in the New Context of Regulatory Capital and Accounting Reform’’ (March 1, 2004), available at www.ﬁtchdominicana.com. 7. Basel II, para.560, p.118. 8. ibid., para.554, pp.115–116.
 J.I.B.L.R., ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS
Electronic copy available at: http://ssrn.com/abstract=1150221
574. p..B. • treatment of overlapping exposures20 .581. In our opinion Basel II. ibid. synthetic securitisations10 . even Table 1: Number of Compliance Components of Operational Requirements for Traditional and Synthetic Securitisations Paragraph 554 555 Item Traditional securitisations Synthetic securitisations Number of sub-paragraphs 5 7 Number of high-level components for compliance checklist 12 27 we estimate the number of high-level components that need to be complied with to satisfy the operational requirements of traditional and synthetic securitisations. • eligible liquidity facilities available only in event of market disruption19 . It must be true that to the extent that the improved alignment of regulatory capital with risk reduces the incentive to securitize. 17. although regulatory capital arbitrage is only one motive for securitization.618 TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J.123–124.R.123. • eligible liquidity facilities18 .117. but that it threatens to destroy securitisation markets. the number of internal references that need to be taken account of in order to comprehend the context and meaning of traditional and synthetic securitisations could range between 50 and 100 speciﬁc provisions..122.13 And. ibid. para.548. ibid.618. para. therefore. in Table 1 below. para. see ibid. pp.121. And. clean-up calls11 . will indeed serve to make origination of securitization less attractive to banks. ibid. 25. 15. The formal operational requirements and conditions set out by Basel II will make certain types of securitisation transactions too expensive from a capital adequacy perspective. ibid.6 above. p. is due to the alternative branching structure of dependent conditions. ibid.122. As Andrews et al. ibid. particular varieties of securitization will become less attractive for banks. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS Electronic copy available at: http://ssrn.L.554. • • • • • traditional securitisations9 .122. the banking credit rating agency: ‘‘It has been suggested that [Basel II and accounting reform] together or separately these changes will deter banks from acting as originators of securitizations. pp. 20.. For conditions where banks are not required to calculate a capital requirement for early amortisations. p.25 The argument runs that the additional burdens of reporting securitisation transactions may make securitisation a more expensive process and thereby reduce the number of transactions at the margin. p.582.’’  J. including full deduction. para. ibid. para.B. 18. para. para...118–119.. para. whilst not entitled ‘‘operational requirements’’. it has been predicted that part of this new reluctance will be prompted by the realization that in so far as Basel II succeeds in more accurately deﬁning banks’ credit risk (also market and operational risks) and in setting regulatory capital requirements accordingly. 24. In particular.. 10. • supervisory formula (‘‘SF’’). the more reporting will be required under the Securitisation Framework. 16. ibid. The estimated total number of high-level components for a compliance checklist is 39 because there are a number of sub-paragraph requirements as well as explicit references to other paragraphs which require compliance. 12. para. p.565. pp..118.578. 13.115.L. 19. • • By ‘‘high-level components’’.129–130. 21... p. p. paras 557–559. • internal assessment approach (‘‘IAA’’)22 . p. there are speciﬁc conditions set for the treatment of: early amortisation141516 .. Not included in this estimate are veiled references to other provisions of Basel II which should also be taken account.24 This tiny analysis on the complexity of Basel II is simply to conﬁrm what many analysts and researchers have stated about the Securitisation Framework—that it is not only stricter than the original Basel Accord. para. Under the Standardised Approach. external credit assessments12 .129. p. Therefore. p. that. ibid. para. 11. ibid. for non-investment grade tranches. 14. as it is now proposed. 9. ibid.. state on behalf of Fitch. the capital requirement for early amortisation provisions is found in ibid.. second loss position or better in asset-backed commercial paper (‘‘ABCP’’) programmes17 . 23.114. banks will reduce the volume of assets they securitize.I. given the stricter (in comparison with Basel I) capital requirements. but an estimate of the number of questions for a thorough and detailed compliance checklist of the Securitisation Framework would easily run into the many hundreds.121–122. paras 623–636.. • eligible servicer cash advance facilities21 . we mean provisions of Basel II which are explicitly stated or crossreferenced.555.590.593.580. pp.620. but rather. 22. The point is the more complex the transaction. Fitch considers. Basel II will in sum reduce the volume of securitization by banks from what it might otherwise have been. n. inferred ratings. para. para.23 No one has as yet completed the dreary task of counting the actual number of components of all the requirements of the Securitisation Framework.. ibid.com/abstract=1150221 . The wide range is not indicative of the author’s inability or unwillingness to count the various provisions. p.R.I..132–135. For example..
As such there is a ﬂexibility regarding the type of exposures that the securitisation rules may be applied to.613.113 which states: ‘‘ .14. available at www. In commenting on the Draft Directive on Capital Adequacy. for example the transfer and/or tranching of credit. must be supported by the opinion of qualiﬁed legal counsel. . 2004). p. paras 1.uk. 27. closing loopholes and gaps between this regulatory intent and market developments since the advent of the Basel Accord in 1988. the question of economic substance over legal form here is that whatever legal language is used to identify the purported ﬁrst priority payment is countered by some form of embedded option or conditionality that converts the ﬁrst payment into second priority.. 29.’’ FSA (2005) Strengthening Capital Standards Including Feedback on CP 189. the UK Financial Services Authority (‘‘UK FSA’’)  J. ‘‘Chapter 2: Agency Problems and Legal Strategies’’ in The Anatomy of Corporate Law. pp.113.sec. Jobst. .31 Are these legal opinions supposed to make a determination that the securitisation transaction in question does not violate the concept of economic substance over legal form? From an equitable and fundamental fairness perspective this might make sense. Simply put. comparing conventional true sale to synthetic securitisations across ﬁve different securitisation structures. ibid. Basel II does not justify this prohibition as is customary in securities regulations under the avowed objective of investor protection.115 requires a traditional securitisation to be supported by a legal opinion. if the liquidity or credit enhancement facility constituted a second priority position in terms of payment even if it were titled as having a ﬁrst payment position. 619 more importantly for market practitioners who are continuously searching and creating efﬁcient solutions. ‘‘The Basle Securitisation Framework Explained: The Regulatory Treatment of Asset Securitisation’’ (March 2005).26 In effect. see H. whether traditional or synthetic. then what third party would be able to provide the appropriate independent advice on whether the securitisation transaction in question met the economic substance over legal form test? According to the Securitisation Framework. 32. see para. For the requirement of a legal opinion to support a synthetic securitisation.fsa.117. .33 This discretion left to the supervisor to make the determination of whether a securitisation is permitted or disallowed on the basis of such a general stated: ‘‘ . 31. not just post hoc.B.ifk-cfs. revised through September 2004. Banks are encouraged to consult with their national supervisors when there is uncertainty about whether a given transaction should be considered a securitisation. and thus destroy the economic rationale for certain types of securitisations which may have legitimate legal form. the variety of legal structures corresponds to a wide range of regulatory capital charges. 30. A Comparative and Functional Approach (Oxford University Press. supervisors will look to the economic substance of a transaction to determine whether it should be subject to the securitisation framework for purposes of determining regulatory capital. if a liquidity or credit enhancement facility constituted a mezzanine position in economic substance rather than a senior position in the underlying pool. This edict poses a conundrum to the banking lawyer and securitisation specialist looking to create innovative securitisation structures.L.128 under the IRB approach states that ‘‘ . it is the supervisors who are to provide such advice.539. a legal opinion on the legal issues of a securitisation transaction may be limited to ‘‘legal form’’ and avow no comment on ‘‘economic substance’’ of the transaction. banks are faced with a range of regulatory capital charges depending on the risk category of the instruments used.539. the regulatory capital charge varied by 100% from 4% to 2%. transactions involving cash ﬂows from real estate (e. where he provides a worked example. risk. p.728% to 0.1 and 2. the capital treatment of a securitisation exposure must be determined on the basis of its economic substance rather than its legal form.5. See A. p. 28. One might argue that it is a subtle reading of the legal form that leads to an appropriate understanding of the economic substance.27 There is no question of having to show a nexus between the transaction in question and an underlying tort or criminal violation as is usually the case in most securities regulations where the public policy of investor protection is paramount.R. Basel II’s prefaces all its rules on securitisation with the edict that: ‘‘Since securitisations may be structured in many different ways. all securitisations. para. The Securitisation Framework in para. Basel II.TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J. the capital adequacy requirements of Basel II demark certain types of securitisation on the grounds of ‘‘economic substance’’ over ‘‘legal form’’. That is.16%. available at www. .R. pp. then the ‘Base risk weights’ column is applicable’’.I.555(f). ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS . See para. Basel II.) According to the Securitisation Framework.. If this turned out to be the case. For example. but taken to its logical limit.554(b). if warranted. we do intend that the rules be applied based on the economic substance of a structure. para. With different legal forms to accomplish the same securitisation purpose. Consultation Paper 05/3. p. p.32 .28 Basel II attempts to balance the extremes of prescriptive rule-based compliance and the vagueness of a principle-based approach by announcing a general principle that underlies all securitisation rules. Basel II remains faithful to the original intent of the ﬁrst Basel Accord which is to protect the banking system as a whole by clarifying regulatory capital requirements.de. is not this speciﬁc determination a question of professional competence which is beyond the normal purview of the legal profession? Thus.23.gov.g. 4 and 5. Hansmann and R.B. para. To accomplish the same securitisation objective across different types of legal forms may result in a difference in capital charges that amounts to over 100 per cent between the different legal solutions. where the opinion must conﬁrm ‘‘the enforceability of the contracts in all relevant jurisdictions’’. See US Securities Exchange of 1934.L.23–24. rather than its strict legal form.’’29 (Emphasis added. then a higher risk weight would apply. For the distinction of ex ante rules versus ex post standards. Clearly. rents) may be considered specialised lending exposures. and the regulatory capital with interest sub-participation varied from 1. but ex ante. how are we to interpret the concept of ‘‘economic substance over legal form’’ under the Securitisation Framework?30 26.I. Rather. Kraakman.’’ 33. available at www. . p. .gov.
sole proprietorship..R.12. retains any residual risk or is exposed to any residual risk of the asset pool after the sale of the assets. Economic substance over legal form The concept of economic substance over legal form forces us to consider the collision of two discourses: the economic and the legal. However. pp. After reviewing the general legal usage of ‘‘substance over form’’. ‘‘The Role of Securities in the Optimal Allocation of Risk-bearing’’ (1964) XXXI The Review of Economic Studies 91–96.42 the more narrowly focused phrase ‘‘economic substance over legal form’’ comes primarily from the accounting standards with the advent of FRS 5. economic substance implies that the ﬁnancial-economic valuation is more real (connoting ‘‘substantial’’ and ‘‘valuable’’) than the mere legal documentation (connoting mere ‘‘form’’ or ‘‘paper’’). para. 35. the ‘‘interdependence’’. the notion of economic substance usually involves a determination of the value of an asset. Because of the large variety of instruments that may or may not meet the test of economic substance over legal form. ‘‘Nuclear Financial Economics’’ in W.F.546.35 On the other hand. we might ask whether an elucidation of how the concept is used in the legal literature may give us some guidance of how we might apply it to the Securitisation Framework. The asset itself may be characterised according to various reciprocal legal rights and duties.40 In general. 42. 1994).44 36. corporate.asb. amongst ﬁnancial economists and experts of ﬁnance and investment analysis. trust. See True v US. when we speak of legal form. Theory of Value.J. 1995).org.L. 330 F. this may mean the calculation of the net present value of the future cash ﬂows of a particular asset.551.545.34 Supervisory discretion may be necessary during an epochal event. For a discussion of US tax law doctrines of substance over form. . Basel II. available at www.3d 1165. 1175 (10th Cir. especially with regard to accounting for derivatives and off-balance sheet instruments. 37. 40. Risk Management Problems and Solutions (McGraw-Hill. And in theory.550. In Long Term Capital Holdings. 41. Debreu. pp.. p. the bank would suffer an economic detriment. 190 F.36 ‘‘credit enhancement’’. Here.620 TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J.R. including ‘‘clean-up call’’. ibid.B.’’ Greene v US.114. Mahonia Limited v JP Morgan Chase Bank. ‘‘the doctrine will operate where the circumstances satisfy only one of the tests’’. On the one hand. Rather than viewing each step as an isolated incident. p.114–115. ibid.iasb. or some other specially deﬁned form of limited liability ownership. p. we are referring to the form of ownership of the asset. para. We might describe this residual risk as a type of partial or limited recourse whereby the originating bank has sold either an explicit or implicit option which may be exercised in the future and if so exercised.3.H. in the legal profession.uk. every right and duty so long as there is a market for such rights and duties may be translated into ﬁnancial-economic terms of risk. the Securitisation Framework lists some of the major legal forms where residual risk is rampant. Parker.17–35.38 ‘‘excess spread’’. Since Basel II itself does not elaborate on the speciﬁc meaning of economic substance over legal form.114. 43. the steps are viewed together as components of an overall plan. the ‘‘stepstransaction doctrine’’ is deﬁned as ‘‘the steps in a series of formally separate but related transactions involving the transfer of property as a single transaction. decided August 27. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS . where the bank has taken on an irrevocable duty to perform a ﬁnancial promise and has no control over the trigger that crystallises this promise into a duty to perform. p. For example.. can have signiﬁcant consequences for the comparability of the resulting measures of capital adequacy and for the costs associated with the implementation of these approaches’’.39 and ‘‘implicit support’’. This concept is explored by W. see Long Term Capital Holdings. ibid.115.  EWHC 1938 (Comm). 583 (2d Cir. et al. This interpretation provides the supervisor with what one might call the ‘‘equitable discretion’’ to look at the whole transaction or series of transactions to see whether the bank 34. if all the steps are substantially linked. . the ‘‘end result’’. partnership. who relies heavily on K. 1999). 39. Courts have identiﬁed three tests for determining whether to apply the steps transaction doctrine.41 Whilst there is a large literature on ‘‘substance over legal form’’ in tax law.B. Beaver and G. Arrow. 2004.37 ‘‘early amortisation’’. para. 13 F. will attract a capital charge against the bank because the residual risk remains with the bank. i. whether expressed or implied. then whatever legal form this contingent claim takes. para. 44. Basel II. and the ‘‘binding commitment’’ tests. and G.org. In general.e. concept is problematic since discretionary decisionmaking may create rather large discrepancies between jurisdictions and within a particular jurisdiction over time.3d 577. but reducing the concept of economic substance over legal form to supervisory discretion ﬂies in the face of the global objective of reducing systemic risk via a standardisation of process and certainty of interpretation of what already is a complex set of rules. there is a need for guidance on how this phrase might be interpreted. p. ibid. The Cowles Foundation Monograph 17 (1959).548. 38. Basel II states its awareness of the problem that interpreting regulatory and accounting approaches at the national and international level ‘‘ . we shall see how it is applied in a recent UK case on structured ﬁnance.. 2d 122. para. taking account of the complex rules embedded within the language of the Securitisation Framework. Supp. Although not complete. para. Accounting Standards Board (April 1994) FRS 5 Reporting the Substance of Transactions. v United States of America. the language of the Securitisation Framework suggests a broader interpretation..I.43 continuing to the current rounds of development and debate concerning the principles of the International Financial Reporting Standards.L. Sharpe.115.I. International Financial Reporting Standards are available from the International Accounting Standards Board at www. The most relevant for derivatives accounting  J.
Fourth.  S. First.  1 W. ‘‘Off-balance sheet ﬁnancing—should economic substance prevail over legal form?’’ (1986) Co. 1 at 19. Secondly. however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity. he cannot be compelled to pay an increased tax. 621 However.  S. W.L. 45. the so-called ‘‘Westminster principle’’ upholding the and reporting is IAS 39 (1998) Financial Instruments: Recognition and Measurement. in all of the above cases the doctrine of economic substance over legal form is invoked in the context of determining whether a set of pre-arranged transactions might be considered as one transaction.  A. the legal question of determining the accounting treatment of ﬁnancial instruments in terms of giving priority to economic substance over legal form has not been dealt with to any great depth in relation to securitisation exposures since the publication of Basel II.J. 30. however. result in reduced taxation. Dig. See G.L. The more general point is that whilst Basel II relies on the nomenclature of accounting to help determine whether regulatory capital rules are being applied properly. 1010. if taken all together such that the intermediary transactions are cancelled.49 and more recently in Grifﬁn (Inspector of Taxes) v Citibank Investments Ltd. 49. result in higher taxation. and E. Lord Wilberforce’s set of principles in Ramsay (1979) is often quoted and serves as the unswerving sacred cow to which any new analytic legal framework must at least ﬁrst bow acknowledgment.  A.48 Inland Revenue Commissioners v Burmah Oil Co Ltd. For our purposes. 1. nothing under the Westminster principle prevents the tax commissioner from looking at the context of the individual transactions. then.41 above and Long Term Capital Holdings. substance over form doctrine. if taken individually. Ramsay Ltd v Inland Revenue Commissioners. If he succeeds in ordering them so as to secure this result. 62–65. 46. implies a limited intrusion into the freedoms of personal and business life. the application of the concept of economic substance over legal form will turn on a construction of the legal rights and duties of the parties to a contract. 434–436. they all involve a set of transactions which on the one hand. n.42 above. is given by Lord Tomlin in Commissioners of Inland Revenue v Duke of Westminster: ‘‘Every man is entitled if he can to order this affairs so that the tax attaching under the appropriate Acts is less that it otherwise would be .46 In all of these attempts to deﬁne the doctrine of economic substance over legal form.B.C.I. it is the tax commissioner who is arguing for the use of ‘‘economic substance over legal form’’ as a weapon to wipe out and cancel the intermediary legal transactions (‘‘legal forms’’) which are allegedly circumventing tax policy. .52 This strict reading of the tax law means that the tax law must follow a narrow application.C. The effect of this principle is to limit the discretionary power of the tax commissioners who may on occasion attempt to extend the narrow allowance and speciﬁc interpretation of tax regulation. Thirdly. that the substantive arguments in Mahonia will be used to support legal interpretations of the accounting principle of ‘‘economic substance over legal form’’. 300. including Inland Revenue Commissioners v Duke of Westminster.R. Ramsay Ltd v Inland Revenue Commissioners  A. Jones. there lingers an older question in equity of whether a combination of transactions should be viewed in all fairness as one or many transactions.L.TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J. Second. there are some scholarly articles pre-dating Basel II which advocate the interpretation of ﬁnancial transactions in terms of economic substance over legal form. It is the legal interpretation of economic substance that will be determinative. and 51.C.T. 50. n. United States and in other Commonwealth jurisdictions tend to scrutinise a combination of derivatives transactions as requiring some explanation that such are not an attempt to subvert the doctrine of substance over form. This follows from the duty of the tax commissioner to enforce the tax laws.47 W.50 The classic oft-quoted statement.R.I. the relevance of Mahonia is that it provides implicit support for our thesis that the interpretation of economic substance over legal form is strongly related to a detailed analysis of the rights and obligations of a transaction in terms of symmetric and asymmetric risks. Ferran.T. the Westminster principle as quoted above allows for individuals to organise their personal and business arrangements freely so as to minimise their tax liability.. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS .45 Cases in the United Kingdom.T. There is an essential pattern that runs through all of these cases. 974. and indicates that the limitation of what types of transactions may be entered into are not limited by the tax law itself and fall within the scope of laws regarding the legality of contracts. and thus. 48.R. We believe. See Mahonia.  J. and on the other hand. tax law must be explicit and no interpretation based on the ‘‘intendment’’ or ‘‘equity’’ of the tax law is permissible. the question of substance versus legal form has been considered by a number of cases.’’51 Substance over form in the tax law In the United Kingdom. Third. 52. Apart from Mahonia. the tax commissioner should determine whether the transaction is a sham or genuine.C.C.T.L. the legal entity claiming that the preordained transactions should be considered separately stands to beneﬁt in terms of reduced tax if the ‘‘legal form’’ (that is. Fourthly. These principles may be summarised as follows: First. . ‘‘Form and substance in ﬁnancing transactions’’ (1992) 51 C.B. the individual contracts) of the transaction is preserved. L. 47.
then the effect would be to increase risk weightings and credit conversion factors. ‘‘West’’). This is because the initial payments of $350 million from Chase to Mahonia and from Mahonia to Enron North America Corporation (‘‘ENAC’’) would be followed by the payment by ENAC to Chase of approximately $356 million six months later. ibid. the concept of economic substance versus legal form appears in the tax cases cited above as a question of whether a set of separate legal contracts that purposefully set out to accomplish a particular tax advantage should be considered as separate legal contracts (in which case less tax would be paid) or as one transaction (in which case more tax would be paid). West argued that the three contemporaneous swaps constituted in economic substance a loan. to determine whether the concept of economic substance over legal form should apply.B. however. 56. be careful not to apply this interpretation without qualiﬁcation to the Securitisation Framework of Basel II.622 TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J. current language of the Securitisation Framework.4 per cent per annum. n.R. at . but rather at the level of component parts of the legal instrument itself. para. the supervisor may look to the actions of the parties. the application of economic substance over legal form test would need to be exercised not at the level of comparing one versus many contracts.564. We shall consider the case only in terms of its relevance in determining the legal meaning of economic substance over legal form. its legal structure is certainly closely related to synthetic securitisations since it dealt with synthetic derivative structures. ‘‘Chase’’). It is for this reason that Mahonia is relevant authority for the interpretation of economic substance over legal form. Mahonia. Conversely. Chase argued that these three transactions were legally distinct with ‘‘no cross referencing between them . no cross default provisions and no cross collateralisation provisions’’.54 On the other hand.56 There were thus ‘‘ . however. The main question was to determine whether West was liable to pay the amount of $165 million under a letter of credit (‘‘L/C’’) that was issued in favour of Mahonia. . in applying the above test blindly to the Securitisation Framework we might be tempted to say that if the separate legal contracts were taken at face value then the tendency would be to allow a lower or minimal risk weighting or credit conversion factor. The judgment was rendered in favour of Mahonia. Although Mahonia concerned a structured ﬁnance transaction and was not concerned with a traditional securitisation. As we shall see. On the one hand. formulating an interpretation concerning the whole set of transactions.B.g. but also with a subtler analysis of whether the separate transactions can in any way be linked to each other. 55.L. Mahonia In Mahonia. (a joint claimant.41 above. . The decision in Mahonia shows a restrictive reading of the concept of economic substance over legal form which is superseded by the Securitisation Framework. . the economic substance versus legal form test is concerned not only with the gross question of whether many contracts should be deemed as one transaction. Economic substance over legal form under the Securitisation Framework requires a different set of principles. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS ..55 The legal consequences of these separate agreements would be that a default by a party in one under one contract would not impact the rights and obligations of the parties in the other contracts. and not just the contractual obligations set out by the parties. the difference being equivalent to a rate of interest of 3. p. Lord Cooke examined this concept in relation to its roots in accounting standards.57 In analysing the speciﬁc provisions of the individual transactions. We should. and showed how West’s argument and Chase’s argument differed in their interpretation of this concept.L.  J. Both these statements. Under the Securitisation Framework. the Securitisation Framework allows for a wider interpretation. For example. In his decision. Lord Cooke presents a penetrating analysis of economic substance over legal form in relation to accounting principles. However..R. Lord Cooke’s analysis in Mahonia relies on explicit linkage between transactions in the form of cross-referencing contractual provisions.I. covering both explicit and implied linkage between separate transactions. see ‘‘implicit support’’ at Basel II. As we shall see. if we were to emphasise the economic substance of contracts reanalysing all the contracts to a securitisation transaction as one transaction. are simply not true since the Securitisation Framework provides rules for determining the risk weights of individual instruments that comply with speciﬁc operational requirements or speciﬁc contractual conditions. In Mahonia.I. 57. ibid. there are differences in the obligations and economic effect 54. at .53 Under the 53. Lord Cooke examined the question of substance over legal form in a structured ﬁnance transaction involving three swap agreements involving WestLB AG (the defendant. a special purpose vehicle incorporated in Jersey. ibid. Mahonia (the claimant) and JP Morgan Chase. . e. Building on these principles. It is the speciﬁc clauses of a contract that deﬁnes the economic substance of the agreement. Lord Cooke found that: ‘‘Whilst the economic effect of full performance is the same as a conventional loan in the ﬁnal outcome. three distinct parties to the transactions as a matter of law and the contracts between them imposed distinct rights and obligations upon each of them’’.118.
See discussion on clean-up calls. The Securitisation Framework has anticipated some of the problems in this area with the concept of ‘‘implicit support’’64 and de minimis65 support levels that do not automatically attract regulatory capital. For an example of a 364-day revolving credit agreement entered into by Worldcom on June 8.L. Thus. at .. The fact that. a former head of the US Securities and Exchange Accounting Division.25 states: ‘‘The pathological evolution of the securitisation framework under the revised Basle Accord reﬂects the successive steps the Basle Committee has taken over time to eliminate arbitrage opportunities from loan securitisation under existing provisions for the regulatory treatment of credit risk under the old 1988 Basle Accord and later amendments’’.65 billion. n. at .TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J. For treatment of revolving asset securitisations. it cannot satisfy the practitioner who seeks an explanation in terms of stable principles.68 One feels that the underlying principle for the regulatory capital requirement in the Securitisation Framework is yet to be spelt out.564. n. We propose an alternative interpretation of the principle of economic substance over legal form which is in keeping with the over-arching risk-based approach of Basel II.1.corporate. the development of the Securitisation Framework through the three rounds of industry consultation67 shows that this piecemeal attempt to stamp out the weeds of regulatory arbitrage has inspired one leading analyst to call the legal history of the Securitisation Framework a ‘‘pathological evolution’’. Whilst the vagueness of the expression may favour the supervisor. 60. the independent obligations under the separate contracts would give rise to substantial variation in losses to the individual parties. at . certain ﬁnancial instruments were manufactured to take advantage of the lower risk weighting afforded to short-dated corporate instruments. empowering him with wide discretionary power to maintain overall control in the face of dynamically developing markets. The concept of economic substance over legal form may not solve problems of regulatory arbitrage which are inherent in the structure of risk-weighting 58. para. and Basel II. ibid. p. ibid. because of the asymmetrical58 margin provisions. Proper accounting must reﬂect the individual rights and obligations in the transactions which are a matter of substance and not merely of form.117. 61.62 In a deﬁnitive legal interpretation of economic substance over legal form. There have been three rounds of quantitative impact studies and three proposals for consultations in June 1999.com. 62. Under Basel II. the rights and obligations are separate and can be individually enforced.B.ﬁndlaw.557.41 above.60 which would be unlike a conventional loan agreement. 67. we are compelled to ﬁnd an authoritative deﬁnition which we might call a legal interpretation 66. Mr Turner. ibid. Basel II. see http://contracts. Lord Cooke stated: ‘‘To treat individual transactions as composite is to engage in ‘synthetic accounting’ which is impermissible.I.1.’’59 In other words. p. ibid.L.  J. We note with interest the use of the word ‘‘asymmetrical’’ in this context to denote the uneven distribution of risks between the parties..R.66 The general notion of economic substance over legal form may be used to help close the gap on these particular kinds of ‘‘sneak run’’ instruments. Basel II. the question is not so much whether many contracts should be considered as a single transaction.26 above. 2001. In contrast to this position. 65. Three transactions cannot be collapsed into one transaction where. but rather whether the contract or contracts undertaken by the bank contain explicit or implied provisions which would unfairly allow the bank to take advantage of a lower regulatory capital requirement when in fact it is actually carrying a higher level of risk. Mahonia. n. Therefore. which depend on price movement and their effect on liquidity.. as a matter of law.. quite apart from their legal form. which is not deﬁned internally within Basel II. see Jobst. at . we might consider the logical framework in which we ﬁnd the concept of economic substance over legal form.118. para. The principle of risk symmetry Before delving into the principle of risk symmetry.12. As we have argued above.’’63 bands. stated that the concept of ‘‘substance over form’’ was inherent ‘‘in the DNA of GAAP’’ and that the subjective intent of ENAC was relevant in determining the substance over form of the transaction.B. para. We offer such an explanation of the concept of economic substance over legal form using the principle of risk symmetry.R. p.. after the publication of the original Basel Accord. for an amount of $2. The Securitisation Framework depends on the deﬁnition of economic substance over legal form.26 above. 64. the market for 364-day revolving credit facilities ﬂourished because such instruments would attract a risk weight that was effectively at least half that of 365-day credit instruments. between liabilities in differing transactions. if various transactions are fully performed. however.I. those transactions must be accounted for separately’’.61 But Lord Cooke was more persuaded by Professor Ryan who pointed out that where ‘‘there is no right of setoff. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS . at . as a matter of law. 623 on the way. below. Jobst. For example. Economic substance must reﬂect legal substance. and star expert witness for West. However. January 2001 and April 2003. 59. p. they may negate one another and the fact that the transactions may have been entered into in contemplation of the others does not effect their legal substance. the concept of economic substance over legal form under a traditional equitable perspective is perhaps too generic to be of much practical use to practitioners. p. 63. 68.
how or why securitisation exposures justiﬁably attract regulatory capital. para. we propose a risk-based approach to the deﬁnition of economic substance over legal form. However. Mahonia. The Securitisation Framework explicitly recognises this limitless variety72 and it is in anticipation of future innovation that it has provided the supervisor with wide discretion through the concept of economic substance over legal form to determine which legal structures will or will not attract regulatory capital. then it suffers from subjectivism and will fast become desultory.187. Basel II. ‘‘Consultative Document: Supervisory guidance on the use of the fair value option by banks under International Financial Reporting Standards’’ (July 2005) available at www.9.6. the accounting standards themselves are not sufﬁcient to deﬁne the concept itself in terms of providing speciﬁc criteria which would help us recognise which. If the bank has sold or completely assigned its interest in the asset pool to the SPE.B. in that the bank is transferring all the beneﬁts of the future cash streams to the SPE and receiving the same less transaction costs.113. The decision tree of how the risk symmetric principle would be applied to the Securitisation Framework is set out overleaf in Figure 3.R. what.B. The Basel Committee states the ‘‘draft supervisory guidance is not intended to set forth additional accounting requirements beyond those established by the IASB’’. p. The operational requirements and speciﬁc conditions of the Securitisation Framework set out rules for recognition of speciﬁc instances which would and would not attract regulatory capital. However. One of the main recommendations is that ‘‘ . 70. the concept of economic substance over legal form comes from accounting standards. transactions and exposures which could 69. the originating bank has either explicitly or impliedly agreed to conditions which increase its risk of loss in relation to the transaction as a whole. then logically it has no exposure and should not be liable for any regulatory capital requirement. 71. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS .L.bis. But there are potentially an inﬁnite number of discrete types of securitisation instruments. Here the true sale of the assets from the bank to the SPE achieves risk symmetry or neutrality. at . As we saw in Mahonia.I.71 we agree that there is a strong inference that concept of economic substance over legal form as found in the Securitisation Framework is linked to accounting standards.L. the accounting standards themselves are in a state of evolutionary development.69 and have yet to be tested in their ability to capture the essential nature or provide guidance on how they might be interpreted for securitisation exposures under Basel II. . n.41 above. It is no accident that the Securitisation Framework depends on the accounting concept of economic substance over legal form.. This series of dependences is illustrated in Figure 1. Basel Committee on Banking Supervision.538. Ibid. The principle of risk symmetry describes the baseline case where the set of contracts is such that the originator bank has no residual risk to make good the ﬁnancial obligations of the original obligors to the investors of the SPE (Figure 2). with the exception of gains and losses arising from changes in own credit risk liabilities’’. para. 72.I.70 Since Table 8 requires disclosure of the accounting policies regarding securitisation exposures. ibid. p.R. We interpret the edict of economic substance over legal form as a way of taking account of the symmetrical risks imposed by a securitisation transaction. it stands to take an immediate beneﬁt from the sale of its obligors’ stream of ﬁnancial obligations (assets and future receivables). be created. the concept can be traced to accounting standards. To alleviate this supervisory risk. It is a modest attempt to provide an objective test that could be used by regulator and practitioners alike. Let us take this as the limiting base case. p. when.  J. As Lord Cooke stated in Mahonia. ..624 TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J.org. if the ultimate test of whether a securitisation exposure should attract regulatory capital is dependent wholly on supervisory whim or wisdom. national supervisors recognise gains and losses from the application of the fair value option in Tier 1 capital. Our thesis is that the concept of economic substance over legal form may best be interpreted in terms of a risk-based approach which we call risk symmetry. Exceptions to this we shall call risk asymmetries—that is. Securitisation Framework Accounting based Mahonia (2003) Economic Substance over Legal Form Risk Based Basel II (2004) Accounting Standards Principle of Risk Symmetry Figure 1: Logical Dependencies of Economic Substance over Legal Form of the concept. where. However. Where a bank is involved as an originator. Table 8..
L. If these requirements and conditions are not fulﬁlled.R. which will attract regulatory capital.. then 73.539. p. that helps us cross the divide between the general language of economic substance over legal form and the many speciﬁc rules stated in the Securitisation Framework.TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J. ibid. para.554(d).L. the deﬁnitions of ‘‘originating bank’’.543. 74. para. See.. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS .115.I. for example. would apply to all the situations covered and anticipated by the set of rules under the Securitisation Framework.R.  J.’’77 These deﬁnitions are fragments that can be pieced together to form a network of legal relationships that form the securitisation structure.76 together with the deﬁnition of traditional securitisations as ‘‘payments to investors dependent upon the performance of the speciﬁed underlying exposures. A limited number of different types of securitisation exposures are circumscribed by the ‘‘operational requirements’’ and ‘‘speciﬁc conditions’’ in the Securitisation Framework.74 ‘‘transferor’’.115.554(b).B. p. reorganise and simplify the rather detailed rules regarding capital adequacy requirements under the Securitisation Framework. ibid. the principle of risk symmetry being an interpretation of the concept of economic substance over legal form applies to all possible securitisation transactions. 75.73 ‘‘special purpose vehicle’’. p. a bridge if you will.75 and ‘‘transferee’’. One the one hand. then we have a risk asymmetric position..113.B. If the operational requirements and speciﬁc conditions are fulﬁlled. What evidence do we have that risk symmetry and risk asymmetries can be found either explicitly or implicitly in the Securitisation Framework? There is no explicit language in Basel II expounding this view. para. then we have a risk symmetric position and no regulatory capital is required. para. and therefore.116. 77. as opposed to being derived from an obligation of the entity originating those exposures. ibid.. ibid. And if a bank follows all the operational requirements for risk transference as per paras 554. para.. ibid. 625 Risk Symmetry Obligors Originator SPE Investors • Risk Exchange is Complete • Originator excludes securitisation exposures from calculation of regulatory capital = 0% risk weighting Figure 2: Risk Symmetry in Securitisation Principle of Risk Symmetry Set of Basel II Securitisation Framework Rules: Operational Requirements & Specific Conditions Fulfilled Not Fulfilled Risk Symmetric Position Risk Asymmetric Position No Regulatory Capital Required Regulatory Capital Required 0% Risk Weighting Discrete Risk Weightings & Credit Conversion Factors Figure 3: Decision Tree of Securitisation Framework using the Principle of Risk Symmetry From the ﬁgure above.552. pp. We merely offer this distinction as a method. the risk symmetry principle can be inferred from the deﬁnitions of the securitisation participants and their relationships to each other in a typical securitisation transaction.113–114.I.. 76. 555 and 556. p. The distinction also helps us clarify.
114.I. implicit support and so on).82 The principle of risk symmetry enables us to see how a securitisation transaction can be viewed in 78. or high credit conversion factor if it is a synthetic securitisation.115. Risk Asymmetry Credit Enhancement [¶ 546] Special Conditions Traditional Securitisations [¶ 554(f)] Special Clean-up Call Early Clauses [¶ 557] Amortisation Synthetic [¶ 548] Securitisations [¶ 555(e)] Implicit Support [¶ 564] Effective Control [¶ 554(b)] • Bank required to include securitisation exposure in calculating regulatory capital • Risk weighting can vary from 7% for Senior AAA Tranche to 650% for Ba3.R. para. And the concept of economic substance over legal form left undeﬁned only adds to the murkiness and tempts mischievousness.551.R. ibid. and it would need to show that it had taken on this risk by way of higher risk weight if it is a traditional securitisation. the rules themselves do not speciﬁcally deﬁne the types of legal instruments to which these calculations apply with any great legal precision. ibid.550. recourse. the bank will attract a higher risk weighting or higher credit conversion factor for the instrument in question. We note that Basel II has attempted to ﬁll this obvious gap by providing ‘‘operational requirements’’ for the various  J.L. p. p. In this way.80 ‘‘early amortisation. that is. The need for more legal substance over economic formulae The major problem with providing speciﬁc risk weightings and CCFs for various types of legal instruments is that whilst these rules set out how to calculate the regulatory capital with mathematical precision. This is the baseline risk symmetric case... in these speciﬁc situations. and as a deduction from Tier 1 for Tranches below Ba3 [BIS (30 Jan 2004) Changes to the Securitisation Framework].L. See Figure 4: Risk Asymmetries in Securitisation above.B. its risk position is asymmetric. that this should be evaluated separately according to the actual contractual terms.115. where the risk weighting of the securitisation exposure is 0 per cent. evidence for risk asymmetries can be found as exceptions to the general rule and thus.B. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS . On the other hand. To illustrate. the market participants would have a broad stable risk-based principle from which to determine regulatory capital.114. ibid.118. if a securitisation transaction includes risks whether actual or implied which could backﬂow to the bank. p.561. 82.626 TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J.. then the bank retains a risk asymmetry and the bank’s position is not riskneutral.I. p. then it would be promising to perform on the basis that was beyond the obligations created by the pool of obligors. 81. para. be free to develop new products that are demand speciﬁc. 80.. terms of a continuum of reciprocal risks rather than just apportioned in terms of regulatory risk buckets. one of the great gaps of the Securitisation Framework is the lack of deﬁnition of the actual legal forms to which economic substance attaches. In this case. and where there is an asymmetry (for example.’’81 and ‘‘clean up calls’’. we provide a simple diagram showing how these distinctions might be viewed. or even by way of deduction of Tier 1 capital.78 In sum.’’79 ‘‘excess spread’’. ibid.545. 79. para.548. para. its adherence to obviously ‘‘arbitrary’’ risk categories and risk levels simply generate more opportunities for regulatory arbitrage. Whilst this principle of risk asymmetry is not stated explicitly in Basel II. para. making the bank responsible for any further liability for failure of the ﬁnancial obligations of the obligors. Figure 4: Risk Asymmetries in Securitisation it may exclude the securitised exposure from the calculation of risk-weighted assets. ibid. its essence can be found in various rules of the Securitisation Framework that attempt to reach risk symmetry. Part of the ‘‘regulatory pathology’’ of Basel II is that whilst its purported intention is to reduce the opportunity for regulatory arbitrage. for example ‘‘implicit support. p. and at the margin.. Although economic substance over legal form is the underlying principle of the Securitisation Framework.. It would be much simpler to view securitisation exposures as a set of contracts where the risk symmetry between the originator and investors means that the originator retains no residual risk. Suppose an originating bank were to support or protect the payment of such future cash streams to the investors.
The complexity and costs of compliance of the Securitisation Framework appear to be open-ended. In keeping with the ﬁndings of this article. turning the principle of ‘‘economic substance over legal form’’ on its head.TANEGA: SECURITISATION DISCLOSURES AND COMPLIANCE UNDER BASEL II:  J. there remains an ambiguity about what types of legal instruments the Securitisation Framework should actually be applied to. ‘‘guarantees’’. it does not appear inordinately unreasonable to ask the Basel Committee whether the ‘‘legal substance’’ of the economic forms should be given increased weight in evolving appropriate regulatory standards. credit enhancements. the very deﬁnition of standard legal forms. mortgage-back securities. para. in attempting to deﬁne ‘‘securitisation exposures’’.83 There are no adequate legal deﬁnitions of these terms in the body of Basel II.587 must fulﬁl the minimum operational conditions as per paras 189 to 194)..I. however. we still do not know with certainty which legal forms these calculations might be applied to. Given the complexity of the some of the mathematical formulae. and therefore. there exists an ambiguity about what speciﬁcally the Securitisation Framework is actually referring to by using the terms ‘‘liquidity facilities’’.113.B. ISSUE 12 SWEET & MAXWELL AND CONTRIBUTORS . and risk destroying a high growth international ﬁnancial market. ibid. the Securitisation Framework states that these ‘‘can include but are not restricted to the following: asset-backed securities.  J.L. 627 instruments which would be allowed favourable risk weights and CCFS (for example. But these operational requirements do not in themselves deﬁne the legal instruments in question.541. 83. and posed an alternative interpretation based on risk symmetry.I. p. credit derivatives and tranched cover as in paragraph 199’’.R. It is clear. we might argue that whilst we understand how to apply the mathematical formulae for the calculation of regulatory capital.R.. ‘‘credit derivatives’’ and so on. in order to preserve fundamental fairness of securitisation transactions and restrain the temptation of unnecessary supervisory interference. interest rate or currency swaps. liquidity facilities. For example. we recommend strengthening the legal basis.L. Summary and conclusion In this reading of the Securitisation Framework of Basel II. that whilst this abstract principle may help us understand how and why certain types of exposures should attract regulatory capital. guarantees and credit derivatives under para. The principle of risk symmetry could be used simply to reorganise and provide a greater degree of certainty in interpreting the meaning of economic substance over legal form with regard to speciﬁc instances of securitisation exposures.B. it is recommended that the International Convergence of Capital Measurement and Capital Standards include legal deﬁnitions of securitisation instruments in order to assist in the determination of economic substance. To help cure this defect. Therefore. we have deﬁned the pivotal concept of economic substance over legal form in light of general equitable and legal principles.