When Is a Dog Really a Duck?: The True-Sale Problem in Securities Law*

Say you have a dog, but you need to create a duck on the financial statements. Fortunately, there are specific accounting rules for what constitutes a duck: yellow feet, white covering, orange beak. So you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose, and then you say to your accountants, "This is a duck! Don't you agree that it's a duck?" And the accountants say, "Yes, according to the rules, this is a duck." Everybody knows that it's a dog, not a duck, but that doesn't matter, because you've met the rules for calling it a duck.1 I. Introduction When is a sale really a loan? This vexing question comes up often in bankruptcy, where characterization as one or the other can determine whether or not transferred assets escape the reach of creditors and bankruptcy trustees.2 The state of the law on this subject is quite unsettled, with much left to the discretion of individual courts.3 The picture is further complicated in the context of securitization transactions, in which loans or accounts receivable are pooled and transferred.4 Relatively little case law exists to suggest whether such transactions can properly be characterized as sales or as secured loans.5 A major concern for investors in securitizations, and for the ratings agencies who evaluate these deals, is to protect the assets in the event of the transferor's bankruptcy by placing them beyond the reach of the transferor's bankruptcy estate and its creditors.6 In recent years, innovations in structured finance have tempted companies to use securitization deals to improve their balance sheets by removing money-losing assets and recording revenue from the "sales."7 Enron made infamous the use of special-purpose entities (SPEs) as a device to conceal debt and artificially inflate earnings.8 In many such "sales," however, the transferor either retains control and derives benefits from the transferred assets, or promises to assume their risks via recourse provisions.9 To the extent that such a transaction is improperly accounted for as a true sale, the company runs the risk of presenting an inaccurate picture of its true financial condition.10 For publicly traded companies, getting true-sale accounting wrong can bring expensive consequences in the form of action by the Securities and Exchange Commission (SEC) or by private shareholder litigation.11 This Note will explore the true-sale problem in the context of securities law. By what standard does securities law evaluate a transaction as sale or loan? Part II sets out the legal bases for SEC enforcement and private shareholder action, and discusses the SECs emphasis on compliance with generally accepted accounting principles (GAAP). Part III explores GAAP's approach to true-sale accounting, which focuses on the degree to which the transferor retains control over the transferred assets. Part IV discusses GAAP's reliance on substantive true-sale law, and the incoherent state of the latter. Parts V and VI illustrate how the SEC and private securities litigants, respectively, apply GAAP's true-sale analysis in practice - and how that application, in one important instance, departs from both the strict letter and the intent of the GAAP standards by emphasizing recourse obligation, rather than effective control, as the defining factor. For both the SEC and private litigants, the focus is squarely on disclosing the substantive characteristics of the transactions, particularly the retention of risks and benefits by the transferor. Finally, Part VII considers various legislative proposals that have aimed to clarify or simplify true-sale law. However, these are unlikely to have much impact in the securities context. Precisely because the SEC's views on true-sale accounting rarely face judicial scrutiny, it can use its enforcement power to impose its own standards. II. The Application of Securities Law Securities law is, in theory, about disclosure, not substance. …