The rotten foundations of securitization.

Author:Carlson, David Gray

    A bankruptcy trustee is supposed to maximize debtor assets for the benefit of unsecured creditors. Often this task is achieved at the expense of the secured creditors. If a bankruptcy trustee can obtain control over collateral, the trustee might be able to use it without paying rent or interest to the lender. According to the U.S. Supreme Court, only oversecured creditors are worthy of postpetition interest.(1) Undersecured creditors are not.(2) To be sure, the lender is entitled to adequate protection for the collateral contributed to debtor rehabilitation,(3) but lenders are skeptical of this right and certainly hostile to the idea that, for the duration of the bankruptcy proceeding, the lender, if undersecured, is unable to earn income on its investment.(4)

    In the 1980s, disdain of bankruptcy jurisdiction led financial markets to generate a multibillion dollar practice neologized as "securitization."(5) The goal of securitization is for a debtor, called an "originator," to sell accounts, chattel paper, general intangibles, or instruments to a bankruptcy-remote corporation (sometimes called a "special purpose vehicle" or SPV) set up for the sole purpose of buying this property.(6) The SPV raises funds by selling debt or perhaps equity participations in the financial markets.(7) The only obligation of the SPV is the debt or equity obligations the SPV issued to raise funds.(8) The assets are precisely what the SPV has bought from the originator--usually heavily guaranteed by the originator's promise to buy back or replace bad accounts.(9) The form of the transfer from the originator to the SPV--a sale--is supposed to prove that no bankruptcy court can ever claim jurisdiction over the assets again.(10)

    To be more precise, section 541(a)(1) of the Bankruptcy Code indicates that the bankruptcy estate includes "all legal or equitable interests of the debtor in property as of the commencement of the case."(11) If a debtor were to convey to the SPV a mere lien on accounts(12) or chattel paper,(13) the assets would not have escaped bankruptcy jurisdiction.(14) In such a case, the debtor retains an equity interest in the collateral--enough to justify bankruptcy jurisdiction.(15) But since the debtor sells the accounts, the debtor supposedly retains nothing.(16)

    This alleged nonrelationship between debtor and thing sold is sometimes said to be the very key to securitization.(17) If the rating agencies were to perceive a mere hypothetical legal risk of bankruptcy jurisdiction, then the transaction would supposedly become more expensive or, it is sometimes alleged, impossible.(18) These are empirical predictions, of course. One is skeptical that mere hypothetical risks should be worth so much in the market. Nevertheless, securitization theorists have assumed that the cost of funds depends on the purely hypothetical question of bankruptcy jurisdiction.(19)

    The burden of foreclosing any possibility of bankruptcy jurisdiction devolves into some very technical concepts of commercial law. First, lawyers must distinguish between (a) liens upon and (b) sales of intangible personal property.(20) Clearly, the lien is governed by Article 9 of the Uniform Commercial Code (UCC).(21) The commercial world agrees--without careful attention to the text of the Bankruptcy Code--that property encumbered by mere liens is subject fully to bankruptcy jurisdiction. It is assumed that the spirit--if not the language--of the Bankruptcy Code requires the modern secured lender to contribute the use of collateral to the rehabilitation of debtors.(22) It is for this very reason that securitization abandons secured lending and takes up the sale of intangible property as its mode of operation.(23)

    Second, lawyers must distinguish between the sale of accounts and chattel paper and the sale of other intangible property. Article 9 of the UCC governs the sale of accounts and chattel paper in addition to governing the security interests on all personal property.(24) The sale of general intangibles(25) or instruments(26) is not governed by Article 9 but by the common law of assignment.(27)

    A huge portion of the securitization trade involves the sale of accounts and chattel paper. It is admitted that Article 9 governs the sale of this kind of personal property from the originator to the SPV.(28) Yet the securitizers allege that Article 9's jurisdiction over the sale of accounts and chattel paper does not imply that the sold accounts are subject to bankruptcy jurisdiction.(29) Even if personal property subject to security interests is subject to bankruptcy jurisdiction,(30) sold property supposedly is not.(31)

    In Octagon Gas Systems, Inc. v. Rimmer (In re Meridian Reserve, Inc.),(32) Judge Bobby Baldock set off an international fire storm of rage and indignation with the following humble statement: "The impact of applying Article 9 to Rimmer's account is that Article 9's treatment of accounts sold as collateral would place Rimmer's account within the property of [the] bankruptcy estate."(33)

    This statement--quite unnecessary to the holding of the case--has been denounced in the financial press and in the law reviews.(34) The Permanent Editorial Board of the UCC has issued a "commentary" purporting to advise the federal courts on their own jurisdiction, in the hope of providing ammunition to the friends of securitization against the mere idea that bankruptcy courts may exert control over securitized assets,(35) Meanwhile, the rating agencies have decided to ignore Octagon Gas, when the originator is outside the Tenth Circuit, on the theory that it is "bad" law.(36)

    This Article will argue that, in spite of the hue and cry through the streets of corporate finance, the Octagon Gas case was decided rightly: on its facts, its dictum, and its policy implications.

    Now many reading this Article will protest that, since the market supposedly reacts to merely hypothetical risks, the bare suggestion that securitization's premises are false will cause an originator's cost of funds to increase. Hence, mere investigation of law is a mistake, on wealth maximization principles. To such claims, the author is obviously insouciant. First, whether prices rise is an empirical prediction. If the rating agencies determine that the actual risk of an originator's bankruptcy is small, the rating agencies, bound in by competitive pressure, will eventually issue a fair rating at or near the current risk, so that, in the long run, the price of funds will not rise. As securitization usually involves highly solvent originators, an increase in price is by no means a foregone conclusion. Second, if truly risky originators find their cost of funds rising, this may in fact have desirable social consequences. Risk of bankruptcy constitutes what economists style an externality. A higher interest rate for future funds may discourage a firm from exposing the public to further externalities. As such, higher interest rates are a social good, even if privately regrettable. It is the surest sign of bad economic theory to equate higher private costs with social inefficiency. Though the law reviews are full to overflowing with suggestions for reducing transaction costs in the name of the public good, sophisticated economists know better.(37)

    The critique that follows will strike many as rarified indeed. The critique points out that, when we adhere to the words of the Bankruptcy Code and not to what people say about those words or what they wish the Code said, bankruptcy jurisdiction turns on whether any debtor interest in a thing exists--no matter how remote or improbable. In short, the distinction between bankruptcy jurisdiction does not turn on the lien-sale distinction, as is usually supposed. Rather, even sold accounts are subject to bankruptcy jurisdiction, provided some "legal or equitable" debtor property interest in the thing sold can be located. If some hypothetical connection between debtor and thing can be located, then bankruptcy jurisdiction is justified.

    Because we traffic in the hypothetical, whatever is possible is real. The exercise we are about to undertake will resemble the fantastic excesses of the Rule Against Perpetuities with which all first-year law students are familiar. Just as contingent future interests in property are tested according to whether octogenarian women can have children or great-grandfathers can have unborn widows, so we will test sales of accounts and chattel paper according to the most astonishing hypotheticals, in order to discover whether debtors have retained some property connection with the accounts and chattel paper they have sold. If so, then bankruptcy jurisdiction plausibly exists.

    At least three property interests in the debtor exist after the sale of accounts or chattel paper. First, the debtor retains a power to convey chattel paper to subsequent purchasers who take possession in the ordinary course of their business free and clear of the SPV buyer's rights.(38) This is so even after the SPV perfects its purchase by filing a financing statement as required by Article 9.(39)

    The second power is the power to collect. Ordinarily, the SPV appoints the originator as collecting agent for accounts.(40) The mere existence of this collecting power constitutes a power to "use" the accounts--though this power is fiduciary in nature. Nevertheless, I will show that the Bankruptcy Code can plausibly be read to make legal title--held for the benefit of another--the foundation of bankruptcy jurisdiction.

    The third power belongs to the bankruptcy trustee, who is a hypothetical judicial lien creditor in bankruptcy.(41) This strong-arm power establishes an interest in sold accounts and chattel paper even aider the buyer perfects.(42) That the trustee has power over sold accounts or chattel paper by means of the strong-arm power is obvious enough when the buyer has not perfected.(43) It is equally true that, even after perfection, a...

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