False Security?

Corporate insolvencies are testing whether securitization is a stable structure or a flimsy facade.

To date, this has generally worked. In fact, a trade-receivables securitization went unchallenged in the case of WorldCom, the largest bankruptcy in history. Yet the past decade has seen increasingly frequent attacks on securitization. Although rarely reported in the business press, these attacks have often sent shudders through the industry. Companies whose bankruptcies resulted in challenges to their securitizations or huge losses to investors in the securities include National Century, NAL Financial Group, Heilig-Meyers, LTV Steel, NextCard, Contimortgage, Conseco, Commercial Financial Services, and, of course, Enron.

Most prominent among these was the case of LTV Steel. On December 29, 2000, LTV declared bankruptcy and simultaneously filed an emergency motion asking for access to receivables and inventory that had long been securitized by a consortium of banks. The transactions, argued LTV, were not true sales but “disguised financings.” To the collective horror of the banks, the judge allowed LTV interim access to the cash and scheduled a hearing to discuss the merits of LTV’s argument. The structured-finance industry predicted dire economic consequences if LTV were to prevail.

Alarmed, Abbey National and the other banks quickly drew up debtor-in-possession (DIP) financing that was contingent on the company’s agreeing that the securitization had in fact been a true sale. That averted the crisis, but didn’t resolve the issue. Asked recently by CFO whether the true-sale question still posed a challenge to securitization, Tina Brozman, former chief judge of the U.S. Bankruptcy Court for the Southern District of New York, said, “It hasn’t been resolved to my knowledge.”

To date, however, cases such as LTV generally have been dismissed as aberrations by the securitization industry. Last year, Standard & Poor’s insisted that attorneys submitting true-sale opinions to the rating agency stop referring to LTV, noting that the court never made a final decision and that such citations inappropriately cast doubt on the opinion. Seven months later, in a delicately worded press release, S&P withdrew that prohibition — apparently because lawyers refused to ignore such an obvious legal land mine.

Kenneth Kettering, associate professor at New York Law School, argues that the securitization industry owes its very existence to the willingness of rating agencies to rate ABS securities based on “extravagantly hedged” true-sale opinions. “No competent lawyer ever gave a simple flat opinion that the asset transfers involved in a securitization transaction constitute a ‘true sale.’ Indeed, given the absence of controlling case law, a lawyer could not responsibly do so,” he wrote in a letter to Congress. “These all-but-liability-proof legal opinions underline the fact that the parties to a securitization transaction are knowingly assuming a serious legal risk.”

Legislating the Answer

One obvious remedy would be to eliminate that risk through legislation. That was tried last year in an amendment to bankruptcy legislation that would have defined securitization as a true sale, effectively giving it safe harbor from bankruptcy.

The problem with that is that bankruptcy courts would be automatically prohibited from reviewing securitizations that followed certain guidelines. Kettering and 34 other law professors objected on those grounds. The amendment, they told Congress, “permits a debtor and one favored creditor to engage in a secret transaction to remove valuable, liquid assets from the corporate bankruptcy estate of a troubled borrower and place them beyond the reach of the courts and other creditors.”

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