CDOs Under Siege Part I: Compliance Under the IAS and Basel II

Electronic copy available at: http://ssrn.com/abstract=1150171

652 GLUKHOVSKOY/TANEGA: CDOS UNDER SIEGE—PART I: COMPLIANCE UNDER THE IAS AND BASEL II: [2006] J.I.B.L.R.

CDOs underSiege—Part I:Compliance under theIAS and BASEL II

KIRILL GLUKHOVSKOY∗ ANDJOSEPH TANEGA∗∗

Banking supervision; Capital adequacy; Debts;International accounting standards; Securitisation

Introduction

Securitisation is a broad term of art used by finan-cial practitioners to describe a set of debt financialinstruments which have evolved from an esotericpart of the capital markets to a ‘‘mainstream finan-cial tool’’.1 Securitisation markets are considered thefastest growing sector of credit markets2 with Col-lateralised Debt Obligations (‘‘CDOs’’) deemed thefastest growing part of this sector.3 According to theEuropean Securitisation Forum, the European secu-ritisation market and structured product issuance inthe first quarter of 2006 reached ¤65.6 billion exceed-ing the last year volume by 40 per cent.4 CDOs’share of the market is ¤10.6 billion or 16.2 per cent.Whilst there has been an increase in the total mar-ket size, there has been a slight decline in publicsector securitisation in Europe, which may in partbe explained by the EU regulatory authorities and

* Diploma in Law, Moscow State University, LL.M. CorporateFinance Law, University of Westminster, School of Law,London. Email: [email protected].** B.A. Princeton University, M.Phil. Oxford University, JurisDoctor University of San Diego School of Law, Course Director,LL.M. Corporate Law, University of Westminster School ofLaw. email: [email protected]. M Fisher and Z. Shaw, eds, Securitisation for Issuers,Arrangers and Investors (2nd edn, Euromoney Books, 2003),p.xiii.2. J. Deacon, Global securitisation and CDOs (John Wileyand Sons Ltd, 2004), p.xi.3. L.S. Goodman and F.J. Fabozzi, Collateralized DebtObligations: Structures and Analysis (John Wiley and SonsInc, 2002), p.vii.4. European Securitisation Forum (‘‘ESF’’), ESF Securi-tisation Data Report. Spring 2006, p.1, available fromwww.europeansecuritisation.com.

financial community’s disapproval of the financial‘‘window-dressing’’ practices of many European gov-ernments and public entities.5 However, given thewidespread use of CDOs amongst banks, primarylenders to government agencies may use securitisa-tion and CDO techniques to transfer or mitigate thesetraditional exposures. In this hyper-evolutionarylandscape, there are two prominent legal features: (1)securitisation transactions are extremely complex intheir legal structure with little or no standardisation;and (2) regulatory authorities of different jurisdic-tions have yet to agree on a common approach totheir regulation.6

Given this market background, the advent ofaccounting rules promulgated by the InternationalAccounting Standards Board (‘‘IASB’’)7 and thepreparation for new regulatory capital rules bysupervisory authorities throughout the world, willsignificantly influence the market’s approachesand attitudes to securitisation. The fact that themarket will have to adapt to the new internationalstandards in accounting and capital adequacy hasbeen recognised by both financial practitioners8 andacademics.9 The purpose of this paper is to examinethe challenges of simultaneous compliance with theInternational Accounting Standards (‘‘IAS’’)10 andthe revised International Convergence of CapitalMeasurement and Capital Standards,11 generallyknown as ‘‘Basel II’’,12 and how these challengesmay affect the process of structuring CDOs.

The major reason for the use of securitisation,and CDOs in particular, is that it is an importantfinancial technique for reducing required regulatorycapital for banks.13 Certain CDO structures achievethis goal through derecognition of financial assets

5. J. Chung, ‘‘EU securitisation may have passed peak,’’Financial Times, December 7, 2005, p.45.6. PriceWaterhouseCoopers, Structuring SecuritisationTransactions in Luxemburg (2004), p.15, available fromwww.pwc.com.7. International Accounting Standards Committee Foun-dation (‘‘IASCF’’), Financial Instruments Reporting andAccounting (October 2005), A User’s Guide Through theOfficial Text of IAS 32, IAS 39 and IFRS 7 (2005), p.1.8. ESF, fn.4 above, p.1; FitchRatings, Basel II: Bottom-LineImpact on Securitization Markets (September 12, 2005), p.1,available from www.fitchratings.com; D. Haley and E. Viegas,‘‘Regulatory Consideration’’ in P. Jeffrey, ed., A Practitioner’sGuide to Securitisation (City & Financial Publishing, 2006),p.139.9. Deacon, fn.2 above, pp.143–144, 147.10. IASCF, fn.7 above.11. Basel Committee on Banking Supervision, The Inter-national Convergence of Capital Measurement and CapitalStandards, A Revised Framework Comprehensive Version(2004, updated June 2006) available from www.bis.org.12. Basel II is not a law per se but rather an internationalstandard that informs national authorities of what types ofregulation should be in place to govern the capital adequacyof banking institutions. See, Basel II, para.2, p.1.13. H.S. Scott, International Finance: Law and Regulations(Sweet & Maxwell, 2004), p.344; A. Batcharov, ‘‘How Can

[2006] J.I.B.L.R., ISSUE 11 SWEET & MAXWELL AND CONTRIBUTORS

Electronic copy available at: http://ssrn.com/abstract=1150171

GLUKHOVSKOY/TANEGA: CDOS UNDER SIEGE—PART I: COMPLIANCE UNDER THE IAS AND BASEL II: [2006] J.I.B.L.R. 653

for both accounting14 and regulatory purposes.15 Inthis article, we will focus specifically on the narrowquestion of how the requirements of the relevantsections of the IAS pertaining to consolidationand derecognition of financial instruments, and theBasel II provisions relating to securitisation, whenimplemented simultaneously together by a listed16

internationally active bank17 will affect the bank’sdecision on whether to issue CDOs.18 To answerthe question, let us first briefly examine the legalsubstance and objectives of CDOs and then discussthe manner in which these new rules and regulationswill affect the banks’ behaviour relating to CDOs.

CDO definition

The securitisation family and the place ofCDOs

Traditionally, simple mortgage pass-through struc-tures were the first securitisation transactions to besuccessfully marketed.19 The term ‘‘securitisation’’also included legal structures where a direct debtor loan was substituted for commercial paper or abond.20 Over time, the term has grown by accre-tion and now has a much more complex meaningcovering a number of structures with various con-ditions and varying nuances.21 For purposes of thisarticle, we confine the definition of securitisation22 to

Securitisation Benefit Your Company?’’ in Jeffrey, fn.8 above,pp.9–19, pp.11 and 14.14. IASCF, fn.7 above, p.120.15. Batcharov, fn.13 above, p.14.16. Regulation 1606/2002 on the application of internationalaccounting standards [2002] O.J. L243/1 (available fromhttp://eur-lex.europa.eu).17. Basel II applies to internationally active banks. See BaselII, para.1, p.1.18. ESF, fn.4 above, p.1.19. PriceWaterhouseCoopers, Guide to Global SecuritisationTransactions, Insights into the Global Structured FinanceMarket (2005), p.1.20. Z. Shaw, ‘‘Introduction and the issuer’s perspective,’’ inFisher and Shaw, fn.1 above, p.3.21. Deacon believes that only asset-backed securities(‘‘ABS’’) such as commercial ABS, consumer ABS, mortgage-backed securities and non-performing loans (‘‘NPLs’’) can becalled pure securitisations, while CDOs overlap with puresecuritisation markets and other asset-backed markets. SeeDeacon, fn.2 above, p.2.22. Basel II defines traditional securitisation as: ‘‘. . . astructure where the cash flow from an underlying pool ofexposures is used to service at least two different stratifiedrisk positions or tranches reflecting different degrees of creditrisk. Payments to the investors depend upon the performanceof the specified underlying exposures, as opposed to beingderived from an obligation of the entity originating thoseexposures. The stratified/tranched structures that characterisesecuritisations differ from ordinary senior/subordinateddebt instruments in that junior securitisation tranches canabsorb losses without interrupting contractual payments

a legal structure with the following essential genericfeatures23:

(1) formation of contractual rights over a pool ofcashflow generating financial assets24;(2) with the optimisation (repackaging, tranching)of the economic benefits (cash flows) and risks25

generated by this pool26;(3) with the subsequent transfer of the repackagedbenefits and risks to third parties (referred to asinvestors)27;(4) by issuing debt,28 customarily in the form oftransferable securities29;(5) where the said debt is backed by theunderlying assets30; and(6) where the value of the debt depends on thevalue and/or the performance of the underlyingassets.31

Currently banks and even industrial companies applysecuritisation to various kinds of corporate and retailexposures and receivables.32 Aside from the diversityof underlying assets, securitisation structures differin form and purpose. The most significant distinctionfrom accounting and capital adequacy perspectives isthat drawn between ‘‘traditional’’33 and ‘‘synthetic’’34

to more senior tranches, whereas subordination in asenior/subordinated debt structure is a matter of priorityof rights to the proceeds of liquidation’’ (Basel II, para.539,p.120).23. It is important to note that in restricting the definitionof securitisation, we are mindful that certain elements mayhave a weaker or stronger presence in various types ofsecuritisation structures. Our definition takes account ofthe ‘‘substance over form’’ principle that permeates boththe international accounting standards and the Basel IIsecuritisation framework. For substance over form, see BaselII, para.538, p.120, and IASB, International Financial Report-ing Standards (IFRSs), including International AccountingStandards (IASs) and Interpretations as at 1 January 2005(2005), para.35, pp.39–40. For an in-depth analysis ofthe purpose and designs of securitisation structures, seeH.P. Bar, (2000), Asset Securitisation, Die Verbriefung vonFinanzaktiven als innovative Finanzierrunggstechnink undneue Haruasforderung fur Banken, 3. unveranderte Auglage(Verlag Paul Haupt, 2000); in Russian version—hANS pITERb“\R, sEKX@RITIZACIQ AKTIWOW, sEKX@RITIZACIQFINANSOWYH AKTIWOW—INNOWACIONNAQ TEHNIKAFINANSIROWANIQ BANKOW (Walters Kluwer, mOSKWA,2006).24. Deacon, fn.2 above, p.1.25. S. Hart, ‘‘CDO Litigation a Risk Assessment’’ (2005) 24I.F.L.R. 18.26. Shaw, fn.20 above, p.3.27. ibid., p.3.28. PriceWaterhouseCoopers, fn.6 above, p.5.29. Hart, fn.25 above.30. PriceWaterhouseCoopers, fn.6 above, p.5.31. Shaw, fn.20 above, p.3.32. Deacon, fn.2 above, pp.2–3. Batcharov, fn.13 above, p.11.33. Basel II, para.539, p.120.34. Basel II, para.540, p.120. In some synthetic securitisa-tions, there may be little or no issuance of debt securities, andthe problems associated with debt securities are thereforequite marginal compared to the overall value of exposures



structures. In essence, traditional securitisationsrequire the transfer of ownership or the assignmentof title of the underlying assets from the Originator toa third party, while synthetic securitisations do notand merely refer to underlying reference assets forpurposes of valuation and pricing.

By comparing the operational requirements forboth types of securitisation under Basel II,35 wesee that the essential difference is in the methodsof transferring risk. The recast Banking Consoli-dation Directive,36 which is one of the regulatoryinstruments implementing Basel II across EU creditinstitutions, provides that in traditional securitisa-tions, the ownership of the securitised exposuresmust be transferred from the Originator credit insti-tution to an independent third party.37 Typically, theOriginator accomplishes this transfer of assets by sell-ing, assigning or granting title or ownership over theunderlying assets (for example, the right to receivefuture cash flows) to a third party special purposevehicle (‘‘SPV’’) or special purpose entity (‘‘SPE’’).38

In synthetic structures, risk transfer is achievedthrough the use of credit derivatives or guaranteesand the securitised exposures do not leave the bal-ance sheet of the originator.39 That is, the title orownership of the underlying assets or what is com-monly called the ‘‘reference assets’’ remains with theOriginator. Since synthetic securitisations do not bydefinition involve the transfer of assets, the principleof derecognition of assets as found in the IAS andcapital adequacy regulations simply does not applyto synthetic securitisations. Instead of transferringassets, Originators in synthetic securitisations buyprotection by entering into derivative contracts suchas credit default swaps.40 Unlike synthetic securitisa-tions, since CDOs require the transfer of assets fromthe Originator to a third party SPE, the question ofderecognition of assets is of paramount concern inCDO structures.

CDOs normally refer to legal structures thattake various corporate exposures such as debt,

involved in the securitisation. See M. Choudhry and F.J.Fabozzi, ‘‘Originating Collateralized Debt Obligations for Bal-ance Sheet Management’’ (2003) 9 Journal of Structured &Project Finance 32–52.35. Basel II, paras 553–559, pp.122–124.36. See Directive 2006/48 relating to the taking up andpursuit of the business of credit institutions (recast) [2006]O.J. L177/1 (available from http://eur-lex.europa.eu).37. ibid., Art.4(37).38. See PriceWaterhouseCoopers, fn.6 above, p.6; Jeffrey,fn.8 above, pp.5–6; and Deacon, fn.2 above, p.1. IAS andBasel II both use the ‘‘SPE’’ abbreviation. Basel II, para.552,p.122.39. Directive 2006/48, Art.4(38).40. ibid. See also Jeffrey, fn.8 above, pp.4–5; M. Fisher,‘‘Collateralised debt obligation and synthetic securitisationstructures’’ in Fisher and Shaw, fn.1 above, p.122; Deacon,fn.2 above, pp.2–3. For more details on various relatedstructures, see Deacon, fn.2 above, pp.151–165.

bonds or both as the underlying assets.41 They fallwithin the category of traditional securitisations,despite the market patois of sometimes callingCredit Default Swaps (‘‘CDSs’’) and CollateralizedLoan Notes (‘‘CLNs’’) ‘‘synthetic CDOs’’.42 CDOshave all of the generic features listed above andimportantly, for purposes of technical regulatoryscrutiny, the CDO structure must have the title orownership of the underlying assets decoupled fromthe Originator, which is usually accomplished by theOriginator transferring the beneficial interests of theunderlying assets to an SPE.43 Once the underlyingassets have been transferred to an SPE, the SPEmay then issue securities wherein the cash flowsof securities are directly dependent on the cashflows of the underlying assets. For these underlyingassets to qualify for ‘‘off-balance’’ sheet treatment,these types of structures need to comply with theaccounting standards regarding the de-recognitionof financial assets under the relevant IAS and theoperational requirements for securitisation structuresunder Basel II.44

The purpose and history of CDOs

The recent literature in securitisation structuresdivides CDOs into three main classifications accord-ing to purpose, namely, balance sheet enhance-ment, arbitrage trading and synthetics mainly forhedging and speculation.45 The prototypes of CDOsevolved from basic securitisation transactions in thelate 1980s46 and quickly formed their own marketniche.47 Whilst mortgage backed securities or creditcards receivables are backed by thousands of small-ish debts, thereby establishing a type of statisticalhomogeneity where the default of one debtor can beeasily replaced and predicted, CDOs are backed bya relatively smaller number of largish debts wherehomogeneity is less but nevertheless ‘‘predictable’’,so say the purveyors of such instruments. Whateverthe technical statistical problems of modelling maybe for CDOs we reserve comment, and in any case, themotivation for CDOs is clearly to securitise portfoliosof the Originator’s commercial loans or bonds. In the

41. See Choudhry and Fabozzi, fn.34 above, p.32.42. Fisher, fn.40 above, pp.105 and 122; and FitchRatings,Global Credit Derivatives: Risk Dispersion Accelerates(November 2005), p.5, available from www.fitchcdx.com.43. See PriceWaterhouseCoopers, fn.6 above, p.6; Jeffrey,fn.8 above, pp.5–6; Deacon, fn.2 above, p.1; Basel II, para.552,p.122.44. See Bar, fn.23 above, p.28. For ‘‘Operational Require-ments for Traditional Securitisations’’ see Basel II, para.554,pp.122–123. IASB, fn.23 above, para.35, pp.39–40.45. See Choudhry and Fabozzi, fn.34 above, p.33; and Fisher,fn.40 above, p.122.46. PriceWaterhouseCoopers, fn.20 above, p.2.47. Deacon, fn.2 above, p.2.



former, they are called Collateralised Loan Obliga-tions (‘‘CLOs’’) and in the latter, Collateralised BondObligations (‘‘CBOs’’).48 History tells us that CDOtransactions were mainly bank-led, fulfilling the mar-ket demand for financial products that could providebalance sheet enhancement and improve regulatorycapital treatment.49 These kinds of CDOs have earnedthe apt market rubric of ‘‘balance-sheet CDOs’’.50

Improvements to the balance sheet using CDOsresult in a number of corporate benefits, includingimmediate monetisation of debt and other non-cashfinancial assets51 through non-banking markets,52

enhanced liquidity,53 a reduction of concentrationrisk for a particular kind of debt,54 and increasedreturn on capital.55

In general, it is assumed or suavely argued bythe investment banking fraternity that exchanging apool of assets of various liquidities and credit risksfor cash should improve the bank’s performanceand enhance its credit rating.56 Of course, thisrosy scenario assumes that the default ratio of theunderlying assets over time does not deterioratebeyond contractual expectations (that is, remainswithin the risk tolerance of the Originator) and thatthe credit enhancements for which the Originator isliable are never tapped. In such untoward scenarios,the Originator may find that the amount it excisedfrom the balance sheet and the amount it receivedfrom the sale of the underlying assets may beinsufficient to cover the bad debt provisions or callson its guarantees and other credit enhancements.This is not counting the potential litigation costsof disgruntled investors who would look throughthe SPE structures to sue the Originator whofailed to make adequate provisions to safeguardthe cash flows of the issue over the long term.Thus, whilst balance sheet securitisations promisean accelerated forward pull on the payment offuture cash flows for the benefit of the Originator,given the increased transaction costs of concentratingthe exposures into a single basket, it is logical toexpect a greater concentration of credit risk for thesetypes of instruments, which could conceivably, ifnot inevitably, require a symmetric acceleration ofportfolio default. What little marketing literaturewe have on CDOs does not focus on ‘‘accelerated

48. ibid., p.349. Fisher, fn.40 above, p.112.50. Goodman and Fabozzi, fn.3 above, p.3.51. Batcharov, fn.13 above, p.12.52. ibid., p.15.53. Fisher, fn.40 above, p.112 and Choudhry and Fabozzi,fn.34 above, p.33.54. PriceWaterhouseCoopers, fn.6 above, p.5; Batcharov,fn.13 above, pp.15–16.55. Choudhry and Fabozzi, fn.34 above, p.33.56. FitchRatings Securitization and Banks (February 25,2004), p.4, available from www.fitchdominicana.com.

concentration risk’’, probably because CDOs wouldthen sound more like Russian roulette than the grandtriumphant inventions of off-balance sheet financialengineering.

One of the important elements of balance sheetmanagement57 concerns the proper management ofregulatory capital under Basel II, which is primarily amatter of risk transfer. Basel II establishes particularrisk weights for various kinds of assets held by abank,58 including specific risk weights for varioustypes of securitisation exposures59 and requires banksto hold some capital calculated according to theseweights (regulatory capital), which acts as a bufferagainst losses arising from the bank’s exposures. Thismeans, in effect, the regulatory capital is set asidein the form of cash or cash-like instruments60 whichmust be held on account and not be traded. Since CDOstructures help banks to transfer risk to third partiesconverting various risk-bearing assets into cash,which in turn may attract a zero risk weight underBasel II,61 banks can win in two ways. First, they maygarner capital which is released from deadweightregulatory capital and use for it trading purposes.Secondly, the trading of the released capital mayearn them an enhanced future return. Of course, thisincreased trading facility means less of a safety bufferin terms of set-aside capital, and more recent studiesindicate that securitised issues may result in adverseunintended consequences on the bank’s portfolio inthe form of increased concentration risk that posesconcerns to regulators.62

In order for banks to realise these dual benefits,the CDO structure must have a specified set offeatures. These features are set out in idealised formin the three figures below concerning a balance sheetCDO transaction. Figure 1 focuses on the majorfeatures of a typical CDO structure, Figure 2 onthe SPE itself in terms of ownership and autopilotmechanism and Figure 3, on the loss allocation inCDO structures.63 These three figures taken together

57. Bar, fn.23 above, p.100.58. These risk weights are used to calculate the capitalrequirements. The higher risk weights result in the higherregulatory capital that must be held by a bank in order tofund protection against unexpected loss within the bank’sasset portfolio. See R. Norgate, IRB-Compliant Models inRetail Banking, The Basel Handbook, A Guide for FinancialPractitioner (RiskBooks, 2005), p.290.59. Basel II, para.567, p.126 and para.615, p.135.60. ibid., para.40, p.12.61. ibid., para.554, p.122.62. See I. Fender and J. Mitchell, ‘‘Structured Finance:Complexity, Risk and The Use of Ratings’’ [2005] BISQuarterly Review International Banking and Financial MarketDevelopments 77–78. Available from www.bis.org.63. There are many illustrations of CDO structures profferedby banks, regulatory agencies and management consultingfirms. These figures are adapted from Choudhry and Fabozzi,fn.34 above, p.34; Deacon, fn.2 above, p.44; Bar, fn.23 above,pp.29–34; and Shaw, fn.20 above, p.26.



Figure 1: Typical CDO Structure

illustrate not only the transfer of assets and risks fromthe Originator to an SPE but also the Originator’ssupport of a fully functioning CDO structure. Weprovide a brief description of each figure to elucidatethe information flow and critical legal mechanismsin a CDO transaction.

In Figure 1 above, there are six main participantsin the CDO structure: the Obligors, the Origina-tor/Servicer, SPE, Investors, Trustee and externalcredit enhancers. The Originator pools together theportfolio of underlying assets which are generatingcash flows. Assets may consist of the Originator’s ownexposures or debts purchased from other banks.64 TheOriginator also usually provides servicing of the cashflows received from the Obligors-borrowers, but thisfunction may be outsourced. In Figure 1, the Obligorsare represented by the pool of borrowers of commer-cial loans or bonds issued by the Originator. TheOriginator sells or assigns the cash flows from theObligors to the SPE. The SPE acts as the host com-pany that is the legal owner of the cash flows fromthe obligors. The SPE also issues the CDOs which theInvestors purchase. The proceeds from the Investorsare transferred to the Originator, and from these pro-ceeds the Originator is reimbursed for the underlyingassets and expenses in setting up the structure. Therole of the Trustee is to control the activity of theServicer, to ensure the distribution of cash amongthe investors and to hold a charge over the under-lying assets on behalf of the investors. The ExternalCredit Enhancers provide credit enhancements in theform of guarantees or other contingent payment con-tracts in order to support the credit worthiness of theSPE and reduce the liquidity risk and credit risk ofparticular CDO tranches.

64. In the latter case a bank serves as the sponsor. SeeDirective 2006/48, Art.4(42).

Figure 2: SPE Ownership and Autopilot Mechanism

A typical SPE structure is illustrated in Figure2. The SPE itself is usually held by a holdingcompany which in turn is held by an offshore trustor occasionally a charity. Following Basel II, therecast Capital Requirements Directive, ‘‘CRD’’ definesa securitisation SPE as:

‘‘. . . a corporation trust of other entity, other thana credit institution, organised for carrying on asecuritisation or securitisations, the activities of whichare limited to those appropriate to accomplishing thatobjective, the structure of which is intended to isolatethe obligations of the SSPE from those of the originatorcredit institutions, and the holders of the beneficialinterests in which have the right to pledge or exchangethose interests without restriction.’’65

Since the Originator does not control the SPEin terms of having a controlling shareholding orboard membership, contractual methods are usedto restrict the SPE’s activities for the benefit of theOriginator.66 In most cases, an agreement is made

65. For the definition of SPEs, see Basel II, para.552, p.122,and Directive 2006/48, Art.4(38).66. However, the question of what constitutes control interms of power and influence is a matter of continuingcontroversy and relates to the deeper issue concerningsubstance over form. See Gololobov and Tanega, ‘‘Sham



Originator-the underlying

assets100%

-£1000 mln

Loss allocationbefore a securitisation

Senior trancheAAA

£750 mlnExtraordinary Loss

>25%

Mezzanine tranchesA1; Ba1£150 mln

Unexpected Loss–>10%

Residual Interest/First Loss position

-£100 mlnExpected Loss–first 10%

Loss allocationin a securitisation

C

D

O

SPE

Investors

Investors

Originator

Loss

Figure 3: Loss Allocation in CDO Structures

between the SPE and the Originator which typicallysets out an ‘‘autopilot’’ mechanism according towhich the SPE has virtually no power in respect of asecuritisation structure and most of the transactionaldetails for purposes of execution occur with very littlediscretion on the part of the SPE. The Originatorpays a fee for this hosting arrangement. Thus, theSPE serves as a passive host to the securitisation,acting as the identifiable legal entity holding thetitle or contractual rights over the underlying assets.Whether or not the SPE might be conceptualised insubstance as an agent on behalf of the Originator, thelegal form is that the SPE acts as an independent legalentity with which the Originator enters into a ‘‘truesale’’ or ‘‘assignment of rights’’ of the underlyingassets. The SPE acts as the legal device that enablesthe underlying assets to be segregated from thebusiness risks of the Originator. By virtue of a setof contracts, the Originator’s business risks are inlegal form separated from the specific risks of theunderlying assets which have now been transferredto the SPE. The result of this legal structure isthat the SPE’s bonds carrying none of the businessrisks of the Originator have a higher rating thanthat of the Originator. Of course, this miraculoustransformation by legal form of illiquid assets toliquid assets requires the close co-operation of theOriginator, SPE, credit rating agency and investmentbanks on the ‘‘sell side’’ and institutional investors,such as insurance companies and pension funds on

SPEs: Part I—The Legal Issues of International AccountingStandards on the Consolidation of Special Purpose Entities’’(2006) 17 ICCLR 304.

the ‘‘buy side’’. To date, some controversy remainswith regard to the right of set-off by Obligors whoas the original creditors of the underlying assetshave a proportionate right to discharge all or aportion of the debt from the benefits gained bythe Originator.67 Much more serious legal claims,however, are likely from parties on the ‘‘buy side’’who depend on the representations made by the ‘‘sellside’’ as to the credit quality, valuation, pricing andactual market liquidity of the securities in question.However, in terms of fairness and equity, it appearshardly credible that the ‘‘buy side’’ should be able tocomplain so long as the risks have been disclosed viathe risk factors required by the prospectus and whereit can be shown that their particular requirements(‘‘market demand’’) were met by the Issuer.

In Figure 3, we illustrate how loss allocation mightbe structured for a hypothetical CDO transaction.Following the figure, prior to the securitisation, anOriginator who owns a pool of underlying assetsis exposed to all losses that these assets maycause. After effecting the securitisation, the assetsand their concomitant risks are reallocated (thatis, ‘‘repackaged’’ or ‘‘tranched’’) into three types oftranches: senior, mezzanine, and equity (or residual)interest. In some cases, there may be more than one

67. See Mahonia Ltd v JP Morgan Chase Bank [2004] EWHC1938, where the court deemed the right of set-off was properunder certain conditions. See also Financial Accounting Stan-dards Board, ‘‘Statement of Financial Accounting StandardsNo. 140, Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities’’ (September 2000),available from www.fasb.org.



mezzanine tranche.68 For example, let us say that agiven senior tranche will receive most of the cashflows generated by the underlying assets. However,its risk exposure is limited to extraordinary risks,when losses are from the underlying top 25 percent of the cash flows. In the same transaction, themezzanine tranches might receive 15 per cent of thecash flows and are exposed to losses only if thelosses are between 10 per cent and 15 per cent of thecash flows, which represents a risk level greater thanthat which is normally expected. And finally, theequity tranche (or residual interest first-loss position)represents 10 per cent of the cash flows and absorbsthe first 10 per cent of the losses, which is equivalentto the normally expected risk exposures. With thisstructure, the senior tranche may be highly rated(AAA or AA) because its value would be affected onlythe manifestation of catastrophic risk and enjoys alarger share of the cash flows with a lower probabilityof losses.

Taking into account these basic structures andthe parties involved, practice dictates that the legaldocuments for the entire transaction be preparedin advance of the CDO structure going live onthe markets. The following description is not inany chronological order and simply shows themain contractual links between the parties in anasynchronous manner. Following Figure 1, Link 1represents the sale of the CDOs to the Investors bythe SPE. In Link 2, the Originator transfers the rightsof the cash flows from the underlying assets to the SPEfor cash received from the Investors. In Link 3, theOriginator retains the residual interest from the SPE,in other words, the Originator has step-in rights andrights to any payments left over in the SPE after theSPE has made all payments required. In Link 4, theTrustee holds in the trust security for the transactionfor the benefit of the Investors. In Link 5, the Trusteeestablishes a charge over the underlying assets onbehalf of the Investors. In Link 6, External CreditEnhancers provide external credit enhancements inthe form of guarantees or contingent contracts to theSPE to increase the SPE’s creditworthiness. Finally,in Link 7, the Originator’s support represents otherforms of contractual support provided to the SPE inthe form of clean-up calls, further guarantees andother forms of contingent contracts. Throughout thisprocess, the bankers work closely with the creditrating agencies to determine the conditions requiredfor the structure to receive the targeted credit rating.69

In a ‘‘true sale’’ or ‘‘clean break’’ structure,70 fromthe moment the Originator-bank transfers the poolof assets to the SPE and receives from the SPE

68. Bar, fn.23 above, pp.229–230.69. See Fender and Mitchell, fn.62 above, p.73.70. Basel II, para.791, p.221.

proceeds of the sale of the CDOs to Investors, theOriginator-bank is no longer exposed to the financialrisks represented by the assets. The assets now belongto the SPE and substantially all cash flows from theObligors go to the Investors of the CDOs through theSPE. Before the transaction, the underlying assetshad been exposures requiring adequate capital to beheld by the Originator, while after the transaction,they have become transformed into net positive cashflows to the Originator-bank. Whilst this descriptionis rather simplistic of what actually occurs inCDO transactions where negotiations are likely tobe fraught with non-optimal compromises, the endresult is what banks and regulators are likely to acceptbecause of its overall risk symmetry.71 That is, the riskof loss from the transaction follows the ownership ofthe assets, and where there is a substantial transferand apportionment of this risk amongst the parties,the regulators are more likely to deem the transactionas a true sale or clean break.

An outstanding problem, however, is that investorsobviously are adverse to the bank’s interest andall the while, will carefully evaluate the risk andreturn of investing in particular CDOs. Institutionalinvestors prefer instruments of the highest creditquality and liquidity72 and these parameters arescrutinised closely by the credit rating agenciesthrough a multi-stage and somewhat opaque ratingprocess.73 If there are insufficient levels of creditenhancement and a lack of incremental liquidity thenthe unfortunate result for the Originator is that theCDO receives a lower rating74 and may find a worsetake-up on placement. Therefore, banks have nooption but to improve (or as market participants liketo say, ‘‘optimise’’) the credit quality of instrumentsthey offer to the market. In practice, banks havetwo techniques which may help them accomplishthis: (1) tranching cash flows according to variouslevels of risk and return (see Figure 3) and (2)providing additional support to CDO structures aftertheir inception.75 However, these techniques may notprove sufficient to sway investors if there remainslarge regulatory risk.

The regulatory risk is that banks must run agauntlet between ensuring that the transaction meetsall the requirements of a true sale or clean break underthe IAS and Basel II rules (thereby creating a ‘‘risksymmetric structure’’), and ensuring that all credit

71. J. Tanega, ‘‘Securitisation: Disclosures and Complianceunder Basel II: Part I—A Risk-based Approach to EconomicSubstance over Legal Form’’ [2005] J.I.B.L.R. 623–626.72. Bar, fn.23 above, p.32.73. H.M. Heberlein, ‘‘The rating agency’s approach’’ inFisher and Shaw, fn.1 above, Exhibit 2.4, pp.33–55, p.39.74. Bar, fn.23 above, p.221.75. The Securitisation Framework of Basel II penalises post-hoc agreements because they destroy the risk symmetry of theoriginal transaction. See Tanega, fn.71 above, p.627.



enhancements76 and post-closing support activitiesdo not disrupt or destroy the viability of theiroriginal risk symmetric structure. If the latter were tooccur, this would bring adverse consequences to theOriginator under the accounting and capital adequacyrules, whereby the SPE would need to be treated on aconsolidated basis with the Originator and the wholeamount of the transaction would be treated with veryhigh risk weightings or credit conversion factors,77

making the transaction less efficient overall. In effect,CDOs as an off-balance technique to bring cash flowsforward to the Originator-bank could fail in partbecause of excessive costs of compliance under BaselII, or could fail catastrophically if regulators wereto treat the CDO arrangement as a vain attempt tocircumvent the rule on the consolidation of SPEs orrisk transfer.

True sale or clean break

A ‘‘true sale’’ or a ‘‘clean break’’ as a concept orpolicy represents the general idea that the originatorof CDOs must formally separate the underlying assetsby transferring them to a SPE.78 Due to the constraintsof space, we will not deal with the particularitiesof what constitutes ‘‘true sale’’ or ‘‘clean break’’ inspecific jurisdictions.79 Rather, taking a top-downinter-jurisdictional approach, we will focus on whatmight be considered the specific criteria for ‘‘truesale’’ or ‘‘clean break’’ under the IAS and Basel II.We will develop these ideas as we examine specificpoints of these standards below.

In general, the most important issue to considerwhen reviewing a contemplated transaction throughthe prisms of the IAS and Basel II is the principleof the predominance of substance over form. Basel IIrefers specifically to this principle as fundamentalto all forms of securitisation.80 The InternationalFinancial Reporting Standards (‘‘IFRS’’) and the IAS

76. According to Deacon, ‘‘[c]redit enhancement is amechanism that provides support for a debt obligation andserves to increase the likelihood that the debt obligation willbe repaid. . . . In relation to securitisations, usually subjectto strict Capital adequacy rules requiring that any creditenhancement provided by the originator be deducted fromcapital.’’ Deacon, fn.2 above, p.470.77. Basel II, paras 562 and 564, p.125, para.594, p.131, andparas 786 and 788, p.220.78. FSA, ‘‘Securitisation and Asset Transfer, Section2’’ (June 2001) in Interim Prudential sourcebook:Banks, Vol.2, para.7, p.2, para.8, p.3, available fromhttp://fsahandbook.info.79. See Deacon, fn.2 above, pp.255–423 and also Bar,fn.23 above, pp.528–547 for a survey of relevant laws invarious jurisdictions. For particular forms of the transactionsthat qualify for a clean break in the UK, see also FSA,‘‘Securitisation and Asset Transfer, Section 5’’ (June 2001)in Interim Prudential sourcebook, fn.78 above, pp.1–4.80. See Basel II, para.538, p.120.

refer to the ‘‘substance-over-form’’ principle as one ofthe cornerstones of the whole system of internationalfinancial reporting and accounting,81 applicable toeach and every standard comprising the IFRS and theIAS. Curiously, neither the IAS nor Basel II explainsthis principle with any great specificity, leavingit largely to regulators and market practitionersto determine its denotations and connotations.82

Supposing that the transaction passes the economicsubstance-over-form test, then the transaction wouldbe treated as a true sale or clean break, with theunderlying assets being transferred to the SPE whichin turn supports the tranched instruments boughtby Investors and the proceeds of the sale thereofless transaction costs flowing back to the Originator.This could be called a basic risk symmetric positionwhere the interpretation of the transaction from aneconomic substance perspective is aligned to thelegal form of the transaction. Legal conditions whichchange this risk symmetric position or post hocnovations to the original transaction could changethe economic substance of the transaction. It isthese asymmetric risks which exercise regulatorsand pose the largest problem to the fair treatmentof securitisation structures.

Credit enhancement and other featuresaffecting accounting and capital treatment

One form of asymmetric risk is the introduction ofcredit enhancements to the CDO transaction. Theproblem with the term ‘‘credit enhancement’’ is thatit carries various meanings, including the actualenhancement of credit quality of the final investmentproduct and liquidity enhancements.83 Since all suchfeatures of CDOs serve the purpose of obtainingimproved credit ratings,84 for purposes of convenientclassification, it would be apt to divide them intothree types85:

• over-collateralisation or subordination wherethere is an excess asset value or cash flow fromthe underlying pool;

81. See IASB, fn.23 above, para.35, p.39.82. For a legal interpretation of the doctrine of economicsubstance over legal form, see Tanega, fn.71 above.83. Bar, fn.23 above, p.223. However, Basel II textually sep-arates credit enhancement and liquidity facilities (para.560,p.125). The existing Interim Prudential sourcebook estab-lishes that a liquidity facility compliant with certain condi-tions is not a credit enhancement (FSA, ‘‘Securitisation andAsset Transfer, Section 10’’ (June 2001) in Interim Prudentialsourcebook, fn.78 above, paras 2–3, pp.1–3). Nevertheless, thesourcebook contains specific prohibitions against the provi-sion of liquidity facilities by Originators, since such facilitieswould be considered as a means of funding and would ineffect cancel the clean break provision (see, ibid., para.4, p.3).84. Bar, fn.23 above, p.249.85. See Shaw, fn.20 above, p.60 and Bar, fn.23 above, p.225.



• Originator enhancement; and• third party enhancement (for example, letter ofcredit or insurance).

It is the enhancement provided by an Originator,however, which usually affects the accountingand capital adequacy treatment of a particulartransaction86 because of the possible retention bythe Originator of a certain share of the benefits andrisks represented by the pool of assets designatedto the securitisation.87 These instruments may causefull or partial ‘‘de-derecognition’’ or re-recognitionof the underlying assets on the originator’s balancesheet. Basel II contains a rather long list ofoperational requirements and specifies several typesof CDO structural elements which may lead torisk asymmetry,88 i.e. the retention of exposuresto securitisation and, consequently, triggering thecapital adequacy requirements for the retained risks.The IAS is less detailed in this respect, but alsoprovides some explicit limitations on certain featuresemployed in CDOs which we discuss below.

An exception to the general rule of re-recognitionis that some features are acceptable as far they donot provide any substantial credit enhancement, forexample servicing rights or clean-up calls. In Table 1,we provide a summary of some credit enhancementtechniques and other related features.In the following parts of this article, we discuss theaccounting standards and regulatory capital rulesmay interpret these CDO features and where theylead to risk asymmetry.

The impact of IAS on CDOs

IAS 39, IAS 27 and SIC-12

In 1988, the International Accounting StandardsCommittee (now the IASB) initiated work on thedevelopment of accounting standards for deriva-tives and other financial instruments. Just afterBarings’ calamity in early 1995, the IASB issuedIAS 32 ‘‘Financial Instruments: Disclosure andPresentation’’.16 It then took another eight years tocomplete the work on the revised IAS 39 ‘‘Finan-cial Instruments: Recognition and Measurement’’published in 2003.17 Even though the EU Interna-tional Accounting Standards and IAS 39 in particularare already obligatory accounting standards for all

86. ibid., p.61.87. ibid., p.217.88. Tanega, fn.71 above, p.622.16. I. Hague, Applying International Financial ReportingStandards: Financial Instruments (LexisNexis Tolley, 2003),p.3.17. ibid., p.2.

European publicly traded companies starting froma financial year commencing on or after January1, 2005,18 the IASB continues to work on furtherimprovements to these standards. The latest amend-ments to IAS 39 were issued in June 200519 andthe International Financial Reporting InterpretationCommittee (‘‘IFRIC’’) issued their guidance in respectof servicing rights and revolving structures in secu-ritisation transactions.20 IAS 39 sets out rules onhow to account for financial instruments at everystage of their existence, including: (1) recognitions;(2) measurement of gain and loss; and (3) removalfrom a balance sheet.21 The last issue is of particularrelevance to this article.

Another international accounting standard thatshould be read in tandem with IAS 39 is IAS 27‘‘Consolidated and Separate Financial Statements’’as of 2003, which provides guidance on consolidatedaccounting and reporting ‘‘for a group of entitiesunder the control of a parent’’,22 and its interpretationin SIC-12 ‘‘Consolidation—Special Purpose Entities’’issued in 1998 and amended on November 11,2004.23 SIC-12 provides a framework for a somewhatconceptual interpretation of CDO structures and othersecuritisations.

The IASB states that it had designed the IAS 27and IAS 39 with the intention that the consolidationrules should be applied first.24 On the one hand andat first glance, this appears logical since it wouldbe nonsense to prepare a sophisticated ‘‘true sale’’transaction if the SPE to which assets would betransferred were consolidated with the Originator,since the Originator would be none other than thetransferor of the assets.25 On the other hand, SIC-12sets out guidance which is not entirely practical forstructuring CDOs. Although for the purposes of thisarticle, we will follow its advice to see where it leadsus.

Consolidation issues in CDO transactions

The main problem with SIC-12 is that it is too laconicto be helpful to those seeking guidance on details.26

Although it specifically refers to securitisation SPEs

18. Regulation 1606/2002, Art.4.19. IASCF, fn.7 above, p.109.20. ibid., p.125.21. Hague, fn.16 above, pp.10–15.22. IASB, fn.23 above, p.1139.23. ibid., pp.2141–2148.24. ibid, para.7, p.2143; and IASCF, fn.7 above, IAS 39.15,p.123.25. PriceWaterhouseCoopers, fn.6 above, p.17; P. Jeffrey,‘‘International Accounting Standards: Accounting for Securi-tisations’’ in Jeffrey, fn.8 above, p.81.26. Jeffrey, fn.25 above, p.79.



Table 1: Credit enhancement and other features of CDO transactions

I. At the inception and during the life of the CDO

Retention of residual interest (juniortranche or first-loss position or equity,in some cases—credit-enhancinginterest-only strip89

This forms one of the elements in tranching thecash flows and is a risk to the owner of theportfolio of underlying assets. The Originator retainsthe junior or first-loss position expressed in theresidual interest in the pool of assets transferredto the SPE which means that Originator will bearany losses incurred by a failure of the underlyingassets. The junior tranche is the lowest element inthe payment waterfall, receiving what is left frommore senior tranches—thus, the term ‘‘residual’’.90

If the portfolio does not perform well enough togenerate cash to satisfy all distributions, the holderof the residual interest will bear this loss first. Afterappropriate distributions to other tranches, there justmight be not enough money to pay the holder of theresidual interest any interest and/or principal. First-loss also means that this position is exposed to thestandard risks of the portfolio, which are expected,while other tranches are exposed to unexpected andextraordinary risks which have considerably lessprobability of occurrence.91

The upside for the holder of the residual risk is thatif the portfolio generates sufficient cash, the residualinterest may be profitable.92 And the equity part ofa CDO structure may be sold by the Originator to athird party.93

It is important to note that under Basel II para.547,p.117 a credit-enhancing interest-only strip (‘‘I/O’’)is defined as ‘‘. . . an on-balance sheet asset that (i)represents a valuation of cash flows related to futuremargin income, and (ii) is subordinated’’. Thus, theinterest-only strip has equity-like features in termsof its valuation against future cash flows and itssubordinated position.

Over-collateralisation Over-collateralisation refers to the value of theunderlying assets in a CDO structure exceedingthe value of the issued securities.94 This normallycomprises the cash flows from the underlying assetsthat exceed in normal conditions the expenses ofthe structure and payments to investors, creating areserve to be used in cases of default.95

The conditions of particular structures mayrequire the Originator to maintain a pre-set over-collateralisation margin should the underlying assetsdepreciate.96

Cash Collateral Accounts (CCA) The Originator receives a credit from a thirdparty and invests it in high credit quality short-term instruments which are pledged to an SPE asadditional collateral. The SPE has the right to sellthese assets if there are defaults in the underlyingportfolio.

89 Basel II, para.547, p.121.90 P. Moles and N. Terry, The Handbook of International Financial Terms (Oxford UniversityPress, 1999), p.466.91 Bar, fn.23 above, p.217. FSA, ‘‘Securitisation and Asset Transfer, Section 9’’ (November2004) in Interim Prudential sourcebook, fn.78 above, para.9(a), p.3.92 Ibid. p.220.93 Fisher, fn.40 above, p.132.94 Basel Committee on Banking Supervision, Asset Transfers and Securitisation (September1992), p.4, available from www.bis.org.95 Bar, fn.23 above, p.227.



Table 1: Continued

While some commentators consider the CCA to bean external enhancement since it is a credit froma third party, others claim that it is an internalenhancement.97 The important point is that the riskof loss for the CCA transaction resides entirely withthe Originator even if it is hedged by some othermeans.

II. In addition to the original CDO structure

Increase in the retained first-lossposition

These are provisions which ‘‘. . . allow for increasesin a retained first loss position or credit enhancementprovided by the originating bank after the transac-tion’s inception . . .’’.98 So, if the Originator acceptsthis provision, it may effectively absorb more lossesthan initial quantity set at the inception of the CDOstructure.

Spread and Reserve Accounts Unlike CCAs, these accounts are financed withexcess cash flows from the underlying assets andare drawn when the assets do not produce enoughcash. In some structures such unused reserves arereturned to the Originator at the dissolution of thestructure.99 Basel II defines the portion of cash flowswhich must be accounted for purposes of regulatorycapital in para.550:

‘‘Excess spread is generally defined as gross financecharge collections and other income received by thetrust or special purpose entity (SPE, specified inparagraph 552) minus certificate interest, servicingfees, charge-offs, and other senior trust or SPEexpenses.’’1

Liquidity facilities The liquidity enhancer agrees to provide funds tocover breaks in cash flows from the underlying assets.These might occur because of falling performance ofthe underlying assets, maturity mismatches or othercircumstances.2 The liquidity facilities include aloan facility3 or other media of funding which servesthis particular purpose.4

Originator Recourse (Default Repur-chase)

This is the obligation of the Originator to repurchasedefaulting assets from the portfolio.

This credit enhancement rule is not widely usednow, since it precludes rating agencies from ratingCDOs higher than the Originator’s rating.5

NB: This credit enhancement should not be confusedwith the obligation of the Originator to repurchase(i.e. the ‘‘buy-back obligation’’) wrongly sold assets(i.e., non-conforming to the selection criteria of thestructure) or the originator’s ‘‘indemnities’’ for abreach of warranties in respect to assets’ quality.6

Indemnities See above ‘‘Originator Recourse (Default Repur-chase)’’

Buy-back See above ‘‘Originator Recourse (Default Repur-chase)’’

96 Basel Committee on Banking Supervision, fn.94 above, p.4.97 Bar, fn.23 above, p.237.98 Basel II, para.554(f), p.123.99 Bar, fn.23 above, p.230.1 Basel II, para.550, p.122.2 FSA, fn.79 above, para.1, p.1.3 Basel Committee on Banking Supervision, fn.94 above, p.5.4 Directive 2006/48, Annex IX, Pt 1, para.1.



Table 1: Continued

Substitution This is similar to Originator Recourse but requiressubstituting an asset with another by the Originatorin order to improve the portfolio’s overall creditquality.7

Increase in the yield payable toinvestors or other credit enhancementproviders

‘‘. . . increase the yield payable to parties otherthan the originating bank, such as investors andthird-party providers of credit enhancements, inresponse to a deterioration in the credit quality ofthe underlying pool . . .’’,8 which means that theOriginator assumes the risk of the credit quality’sdeterioration instead of third parties and protectsthem by increasing the return on their investmentsin CDOs.

Advances by an Originator When there is a gap between the amounts of the cashflows incoming from the underlying portfolio andthe amount payable to the investors in a particulardistribution period, a CDO structure can provide forthe obligation of the originator to fill this gap withits own funds, which are then refunded from futurecash inflows. Effectively, it is a cash advance facility,which provides investors with uninterrupted cashflows even if such an interruption may occur dueto maturity or other characteristics of the underlyingassets.9

Implicit support ‘‘Implicit support arises when a bank provides sup-port to a securitisation in excess of its predeterminedcontractual obligation’’,10 which is non-contractualand ‘‘include the purchase of deteriorating creditrisk exposures from the underlying pool, the saleof discounted credit risk exposures into the poolof securitised credit risk exposures, the purchase ofunderlying exposures at above market price or anincrease in the first loss position according to thedeterioration of the underlying exposures.’’11 It isimportant to emphasise that the Basel II languagedoes not define a closed list of the implicit supportobligations.

In fact, the listed measures are substantially thesame as some already listed above. The differenceis that these are not obligations provided for by thedocumentation implementing the CDO structure, butrather by the ad hoc activities of the originating bank.

Servicing The Originator may retain the function of theservicer meaning that the Originator will monitor theperformance of the portfolio, collect the receivablesand perform other functions that it would normallyperform with the difference that it is under a servicecontract with the SPE and running CDO structure onbehalf of the SPE and for the benefit of the investors.Reporting obligations are also included. Whilst thisfunction is normally retained by the Originator, itmay be transferred to a third party, and in practice,there is an alternate servicer or back-up servicerwhich would take on these duties in case of theoriginal servicer’s failure of performance.

5 Bar, fn.23 above, p.232.6 Z. Shaw, ‘‘Credit enhancement, structural issues and cashflow analysis’’ in Fisher and Shaw,fn.1 above, pp.57–102, p.61.7 Basel II, para.554(f), p.123.8 ibid.9 ibid., para.582, p.129.10 ibid., para.551, p.122.11 ibid., para.790, p.221.



Table 1: Continued

Early amortisation ‘‘. . .once triggered, [early amortisation provisions]allow investors to be paid out prior to theoriginally stated maturity of the securities issued. Forrisk-based capital purposes, an early amortisationprovision will be considered either controlledor non-controlled.’’12 If the provision is deemedcontrolled then no capital charge is required.13

Whilst the provision is customary for securitisationsof revolving credit facilities,14 it is conceivablethat they would also apply to structures involvingunderlying assets with long dated maturities.

III. Termination of a CDO structure

Clean-up call ‘‘An option that permits the securitisation exposures(e.g. asset-backed securities) to be called beforeall of the underlying exposures or securitisationexposures have been repaid. In the case of traditionalsecuritisations, this is generally accomplished byrepurchasing the remaining securitisation exposuresonce the pool balance or outstanding securities havefallen below some specified level. . . .’’15 The purposeof this feature is to allow for the graceful bowing out(termination) of a CDO structure, when its cash flowsare no longer sufficient to cover all operational costsand promised contractual returns.

The rights for any receipts at thedissolution of a structure

A CDO structure may provide for the release to theOriginator of any and all proceeds that remain afterthe dissolution of the structure and the satisfactionof all creditors and investors. This element relates tothe equity position of the Originator, but since it mayinfluence the outcome of the accounting and capitaladequacy analysis of a particular transaction ratherdetrimentally from the Originator’s standpoint, itdeserves to be considered separately. Sometimes,these rights come in the form of over-collateralisationarrangements, spread or excess accounts.

12 ibid., para.548, pp.121–122.13 ibid., paras 548–549, pp.121–122.14 ibid., para.801, p.223.15 ibid., para.545, p.121.

as one of the principal objects of its regulation,27

it does not provide clear guidance on what actualfeatures of securitisation transactions in general andCDOs in particular may lead to the consolidationof an SPE with an Originator.28 In principle, twomajor concepts must be borne in mind whendesigning a CDO transaction: (1) the substance-over-form doctrine and (2) control. The definition ofcontrol according to IAS 27 and its implementationin respect of SPEs ‘‘in the light of the substance-over-form principle’’29 is illustrated in Figures 4 and 5below.

27. IASB, fn.23 above, para.1, p.2143.28. PriceWaterhouseCoopers, fn.6 above, p.17; Jeffrey, fn.25above, p.79.29. IASB, fn.23 above, p.2147.

The upper half of the figure demonstrates how theconcept of ‘‘control’’ is pivotal to the scheme. Controlmay be either in an explicit form when more than50 per cent of the voting rights are owned with someminor exceptions by an entity, or it may be in a moredisguised form, when 50 per cent or less voting rightsare owned whilst simultaneously allowing variousmeans for the exercise of control. The lower halfof the figure (below the dotted line) represents howthe concept of control is implemented in relationto SPEs. In brief, since SPEs are not usually ownedby their ‘‘users’’ (that is, where the participationin terms of shareholding by the Originator appearsto be nil), the fact of control over the SPE mustbe established through an analysis of the substanceof their relations with the ‘‘users’’. We provide ananalytical framework for substance-over-form issuesin Figure 5 below.



Control* IAS 27.13

Normal: >50% But if ≤ 50%

> Power to govern financial and operational policies (by a statute or an agreement)

* Including potential voting rights (IAS 27.14-15 and IAS 27.IG2)-

>50% of votes at aboard's or othersimilar body'smeetings whicheffectively governsan entity

Except for specialcircumstances. when >50% do

not constitute control

Power refers to the ability to do or effect something. ...Entity hascontrol... when it currently has the ability to exercise that power,regardless of whether controlis... actively demonstrated or is passive... .(IAS 27.IG2)

Substance of the relationships Originator-SPE indicates CONTROL (SIC-12.8)“Autopilot”−predetermination

of activities of SPE (SIC-12.9) Additional circumstances (SIC-12.9.a-d, SIC-12 Appendix)

SPE conducts activitieson behalf of theoriginator, according to itsspecific business needsso that the Originatorobtains benefits from theSPE’s operation

Originator has thedecision-making powersto obtain the majority ofthe benefits of theactivities of the SPE or an‘autopilot’ mechanism

Originator has rightsto obtain the majority ofthe benefits of the SPEexposing itself to risksincident to the activities ofthe SPE through anymechanism

Originator retains themajority of the residual orownership risks related tothe SPE or its assets inorder to obtain benefitsfrom its activities.

IAS 27

SIC-12

50% of votingrights based on anagreement

Approval of > 50%of board or othersimilar body whicheffectively governsan entity

Figure 4: Consolidation of SPEs According to IAS 27 and SIC-12

Following Figure 5, the substance-over-form issuecan be dissected in terms of the activities of the SPE,the decision-making powers of the originator overthe SPE, the benefits flowing to the Originator andthe risks retained by the Originator. The definitionof activities, decision-making, benefits and risks arefound in the top boxes, with examples in the lowerboxes as per Appendix to SIC-12.

Both the current capital adequacy framework andBasel II require that the originator credit institutionsdo not participate in SPEs.30 Hence, there is noproblem with a traditional part of the controldefinition given by IAS 27, that is, where an entityhaving possession of more than 50 per cent of votingrights (directly or indirectly)31 results in control overthe SPE. Rather, it is the special cases where anentity having less than 50 per cent participationin the SPE may pose significant problems to theOriginator. SIC-12 significantly broadens the scopeof the circumstances where SPEs may be consideredcontrolled entities. Since there is no lower limit onwhat constitutes ‘‘less than fifty percent’’ in IAS 27or SIC-12 and taking into account the interpretationgiven in IAS 27.IG2,32 which defines control in terms

30. Basel II, para.552, p.122.31. IASB, fn.23 above, para.13, p.1141.32. ibid., p.1148.

of active or passive demonstration of power, it isquite possible under a fair and literal reading of therules to say that there is a significant risk that anSPE in a typical CDO structure may be consolidatedwith the Originator even if the Originator has zeroparticipation in the SPE. There is even an opinion thatthis is the natural interpretation to many structures33

and that there are good reasons to think so. The nexttwo examples of control given in SIC-12 illustrate theproblems for the Originator.

The first is the direct reference in SIC-12 to‘‘autopilot’’34 as a basis for consolidating an SPE withan Originator. The definition of securitisation SPEsunder Basel II and, respectively, the CRD and BIPRU935 requires the activities of an SPE to be limited towhat is appropriate for the purposes of the respectivetransactions. One might argue that the essence of

33. IASCF, fn.7 above, AG38, p.173; Jeffrey, fn.25 above,pp.80–82.34. According to SIC-12, ‘‘autopilot’’ is defined as ‘‘. . . thepolicy guiding the ongoing activities of the SPE cannot bemodified, other than perhaps by its creator or sponsor’’(para.1) and when the entity can obtain control over theSPE and obtain the majority benefits of its activity throughdelegated decision-making powers (para.10.(b) and section(b) of Appendix).35. The Prudential Sourcebook for Banks, Building Societiesand Investment Firms. Directive 2006/48, Art.4(36)–(37);FSA, fn.78 above, p.400.



Figure 5: Substance over Form Analysis

what constitutes the nature of the ‘‘autopilot’’ is justexactly this. However, the carve-out in IAS 27.13(b)that permitted excluding SPEs with ‘‘. . . severelong-term restrictions which significantly impair itsability to transfer funds to the parent’’ from theperimeter of consolidation was struck out in 2003as such restrictions do not mean that control isnot possible.36 Unfortunately, with the CRD cominginto force in 2007,37 Originators of CDOs who needto comply with both the IAS and the CRD willfind themselves literally squashed between two setsof regulations. The way forward for the Originatorthrough this Scylla and Charybdis is to ensure thatthe autopilot mechanism does not necessarily leadto the Originator being deemed the holder of themajority of benefits or assets of the SPE, as definedby the limited SIC-12 examples.38 However, a strictinterpretation of SIC-12 applying across the use of anyand all autopilot mechanisms could severely impactthe way in which SPEs can be controlled without riskof consolidation.

The second example provided in the Appendixto SIC-12 that may lead to interpretation problemsrelates to the consolidation of SPEs. It requires thatSPEs be consolidated where they are ‘‘. . . principallyengaged in providing a source of a long-term capital

36. IASB, fn.23 above, BC15, p.1151, and para.15, p.2145.37. Directive 2006/48, Art.158.38. IASB, fn.23 above, para.10(b), p.2144.

or funding to support an entity’s ongoing major orcentral operations’’.39 CDOs are sometimes viewedas a source of financing or refinancing.40 Thus, fromthe substance-over-form standpoint the fact that SPEsin CDO structures issue long-term debt to investorsmay be considered as a basis for consolidation inparticular transactions.41 Whilst this language mayhave been intended for other types of transactionsmentioned in SIC-12.1 (such as lease, developmentor research activities), there is no reason to prohibitit from being applied to CDO transactions.

Our analysis of IAS 27 and SIC-12 indicates thatpractitioners should be mindful of the potentialadverse impact of these rules on CDO structures.We summarise these in a brief checklist below:

(1) Does the SPE have the legal status of anindependent entity such that the Originatorexercises no actual or potential contingentcontrol over the SPE’s activities and where suchexercise of control exists, could the Originatorbecome the owner of the benefits or assets of theSPE?(2) What is the actual substance of the SPE’srelationship with the Originator? Factors toconsider include:

39. ibid., p.2147.40. Deacon, fn.2 above, p.215.41. IASB, fn.23 above, para.2, p.2143.



(a) What is the nature and extent of thecorporate holdings and support provided bythe Originator to the SPE?(b) What is the nature and extent of thecontractual services provided by the SPE tothe Originator?(c) What are the economic links betweenthe SPE and the Originator throughout thevarious the stages of the CDO transaction?These stages include:

(i) inception (pre-formation and post-formation of legal instruments);(ii) normal operation to full performance;and(iii) termination (default, dissolution anddischarge of duties).

However, SIC-12, which effectively requires theOriginator to transfer the majority of risks andbenefits of the underlying assets to SPE investorsas a prerequisite, makes it rather impractical toimplement the consolidation standards first and thenafterwards, the derecognition rules. We shall considerthe reasons for this in Part II of this two-part serieswhen we examine the meaning of derecognition.Before we leave this topic, however, it is worth sayingin passing a word or two about why accountingstandards matter in complex financial structures,and in particular, anticipating the question of whyaccounting standards concerning consolidation andSPEs should be a matter of concern for financial lawpractitioners.

The relevance of accounting standardsto practitioners

Aside from the obvious, that international account-ing standards form the basis for how the accountingprofession treats SPEs and consolidation, the rele-vance of accounting standards to legal and financialpractitioners is that they set out the analytical frame-work on how questions of legal substance may bedetermined by a court of law which is faced withcompeting interpretations of the economic substanceof particular transactions. Thus, if a financial lawpractitioner is not yet persuaded that internationalaccounting standards relating to complex financialtransactions such as structured finance and securi-tisations are becoming more and more the provinceof legal analysis, one should be mindful of the deci-sion of Mahonia42 where the court used US GAAPrather than the IAS to find an overarching analyticalframework for consolidation issues. Importantly, the

42. See fn.67 above.

issues of actual and implied control were examinedin depth by the court, evoking an analysis similar toour checklist above.

For practitioners, the virtue of having the newbright lines of the IAS is one of convenience andefficiency for if, for example, any of the elements ofa particular transaction match the descriptions andexamples of SIC-12, then the Originator is requiredto consolidate the SPE. In this ideal world of perfectcompliance, high transaction costs would be avoidedand any further tests to determine the viability ofa consolidated tainted structure would be unneces-sary. If the transaction in question breached any of thebright lines of regulation, this would provide unam-biguous answers to the Originator who would thenlook to other means of structuring the transaction.43

For example, PriceWaterhouseCoopers contends thattransactions between an SPE and an Originatorshould be completely disregarded, because ulti-mately, assets are transferred to investors.44 Thisapproach, however, is probably not entirely suit-able for CDOs. A typical CDO structure is based onthe assumption that an SPE owns the underlyingassets and issues its own debt securities to investors,pledging the underlying assets to investors. Thus,the investors who hold debt do not have ownershiprights in respect of the underlying assets. Further, thefirst and most important test for the transfer of con-tractual rights would fail if PriceWaterhouseCoopers’approach were to be implemented for CDOs. This isyet again one of those not too infrequent instancesin which the IAS language predetermines the legalform for the economic substance of the transaction.The same lesson applies to Basel II, which throughits specific standard setting requirements, ironicallyand perhaps unintentionally, determines the legalform of the economic substance of capital adequacytransactions.45

Another reason to be chary about the new brightlines of regulation for CDOs is that given thecomplexity of legal issues and numerous partiesinvolved per transaction, the structures are greatlysensitive to the stability of the legal frameworksin which they operate. Thus, the new rules whichmay have been created ostensibly to promote‘‘transparency’’ and ‘‘fairness’’ may actually havethe pernicious and unintended effect of chokingoff perfectly legitimate markets which cannot forwhatever reason find quick enough adaptations to thenew ‘‘toughened’’ but misconceived rules. We willpropose a few areas of positive adaptation towardsthe end of Part II of this series.

43. PriceWaterhouseCoopers, fn.6 above, p.17.44. ibid.; Jeffrey, fn.25 above, p.82.45. Basel II, para.554, pp.118–119.



Conclusion

The purpose of this two-part series is to examinethe potential effect and legal implications of relevantinternational accounting standards and Basel II onCDOs. In Part I, we have focused mainly on thepurpose, use and elementary components of typicalCDO structures in light of the principles and relevant

rules concerning the consolidation of SPEs foundin the internationally accounting standards, namely,IAS 39, IAS 27 and SIC-12, and parts of Basel II.In Part II, we will continue the analysis of CDOs inrelation to the concept of derecognition under theinternational accounting standards, and examine therequirements of Basel II for consolidation, clean breakand retained securitisation exposures.


Documents

CDOs Under Siege Part I: Compliance Under the IAS and Basel II