Mike Gaddis tackles the perplexing problem of how to distinguish between sales and loans in the context of securitization transactions. Recent innovations in structured finance have allowed some companies—most famously Enron—to label some transactions as sales on its balance sheet, while still retaining effective control over the transferred asset. Such practices can allow a company to give the appearance of boosted sales and reduced liabilities when in fact little has changed. Whether a company's securitization transactions are deemed to be sales or loans can have substantial consequences in bankruptcies, SEC investigations, and private securities-fraud litigation, and yet relatively little case law exists to suggest whether securitization transactions can properly be characterized as sales or as secured loans. This state of confusion poses dilemmas both for companies that wish to avoid SEC enforcement actions and for investors wishing to ascertain the financial states of companies.
Gaddis focuses primarily on the treatment of securitization transactions by the SEC, which has generally looked to generally accepted accounting principles ("GAAP") for treatment of true-sale accounting. GAAP applies a three-part control test to determine whether a transaction is a true sale: (1) the transferred assets must be isolated from the transferor; (2) the transferee must be free to pledge or exchange the assets; and (3) the transferor must not maintain effective control of the assets through a unilateral right to repurchase the assets. A company that reports a transaction as a sale in violation of the GAAP test may be subject to an SEC enforcement action for fraudulent disclosure, although the SEC may still pursue an action against a company that is in technical compliance with GAAP if the SEC deems the substantive characteristics and consequences of the transaction to be contrary to the company's characterization. That is, the SEC may use GAAP as a sword, but companies may not use it as a shield. In one enforcement action involving Doral Financial and FirstBank, the SEC found a substantive violation of GAAP on a recourse obligation although Doral was technically in compliance with GAAP. Both defendants settled, and thus the issue was never addressed by a court. Gaddis suggests that because defendants in such actions almost invariably settle, the SEC is able to use its enforcement powers to define its own substantive standards for true-sale accounting.
Although there is some judicial guidance on distinguishing sales and loans in the contexts of the Uniform Commercial Code and the Bankruptcy Code, no consensus has emerged. At one end, courts have said that if the parties call a transaction a sale then it is a sale, while on the other end, some courts have held that no securitization transactions are sales if that characterization would put the assets beyond the reach of the transferor's bankruptcy estate. Gaddis describes some statutory attempts to resolve the true-sale problem in securities law, but concludes that attempts to date have added little clarity. In effect, a transaction is a sale if the parties say it is, unless the SEC or the courts say it is not.
