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Securitisation Disclosures and Compliance under Basel II: Part IA Risk-based Approach to Economic Substance Over Legal Form
JOSEPH TANEGA
Attorney at Law; Course Director, LL.M. Corporate Finance Law, University of Westminster School of Law

Banking supervision; Capital adequacy; Securitisation; Tax

the principle of economic substance over legal form is of sufcient specicity for certain areas of law, such as the tax law, it remains undened under the Securitisation Framework. Thus, whilst it is associated with general equitable notions of fairness and transparency, it requires further specication in order to be of practical use to professionals engaged in securitisation. Should the meaning of economic substance over legal form continue to be uncertain, the unfortunate wording will give rise to endless compliance arguments. To ll this gap we propose a risk-based interpretation of economic substance over legal form, which we dub risk symmetry. We hope that the concept of risk symmetry will help supervisors and bankers come to a common understanding of how regulatory capital charges of securitisation exposures can be viewed, not merely from a prescriptive evermultiplying compliance perspective, but also from a sense of ultimate fairness.5 By gaining some insight into the fundamental structure of how and why economic substance over legal form can be interpreted from a risk-based perspective, we have a way of critically analysing, reorganising and simplifying the rather complex requirements of the Securitisation Framework.

Introduction Raison detre of Basel II

In this article we examine securitisation disclosures and compliance as promulgated under the current rules of the International Convergence of Capital Measurement and Capital Standards, A Revised Framework, commonly known as Basel II.1 Since the entire edice of the Securitisation Framework under Basel II (hereafter, Securitisation Framework2 ) is based on the concept of economic substance over legal form,3 we will focus on an interpretation of this concept based on the legal and equitable tradition, and then offer an alternative interpretation which is risk-based and provides us with a method for accessing the complex (and convoluted) Securitisation Framework from a practical perspective. This article, as Part I of a two-part series, serves as a theoretical framework for interpreting securitisation disclosures under the Securitisation Framework. The upcoming article in Part II will focus on an interpretation of the Securitisation Framework in light of the framework set out in this article. Our overall aim in this article is to explain the major principles of the Securitisation Framework by focusing on the disclosures required of internationally active banks engaged in securitisation.4 Whilst
1. Basle Committee on Banking Supervision (June 2004) International Convergence of Capital Measurement and Capital Standards, A Revised Framework, [Basel II] available at www.bis.org. 2. ibid., Part IV. Credit RiskSecuritisation Framework, paras 538643, pp.113136. 3. ibid., para.539, p.113. 4. Basel II applies to internationally active banks, ibid., para.9, p.3.

Banks throughout the world are increasing their exposures to securitisation transactions either as originating sponsors or investors.6 Under Basel II, all internationally active banks will be required to hold regulatory capital against all of their securitisation exposures7 and only under certain strict operational conditions will originating banks be allowed to exclude securitised exposures from their calculation of risk-weighted assets.8 A formative analysis of the operational requirements across the various types of nancial instruments delineated by the Securitisation Framework has yet to be undertaken. Major operational requirements within the Securitisation Framework exist for the treatment of:
5. We emphasise this basic point of equity because protecting fairness is more important than strengthening supervisory discretion in developed nancial markets. The essential risk of the Securitisation Framework is its unintended consequences, for if the original intent of Basel II is to be preserved, namely, to protect the market from systemic risk, we must be mindful that major mishaps in the markets have been caused by over-regulation and regulatory amplication. See J. Tanega, Basel II: Principles of Avoiding Regulatory Failure in Sima Motames-Simidian, ed., Governance and Risk in Emerging and Global Markets (Palgrave, forthcoming 2005). 6. D. Andrews, H. Heberlein, K. Olson, J. Moss and J. Olert, Securitization and BanksA Reiteration of Fitchs View of Securitizations Effort on Bank Ratings in the New Context of Regulatory Capital and Accounting Reform (March 1, 2004), available at www.tchdominicana.com. 7. Basel II, para.560, p.118. 8. ibid., para.554, pp.115116.

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traditional securitisations9 ; synthetic securitisations10 ; clean-up calls11 ; external credit assessments12 ; inferred ratings.13

And, whilst not entitled operational requirements, there are specic conditions set for the treatment of: early amortisation141516 ; second loss position or better in asset-backed commercial paper (ABCP) programmes17 ; eligible liquidity facilities18 ; eligible liquidity facilities available only in event of market disruption19 ; treatment of overlapping exposures20 ; eligible servicer cash advance facilities21 ; internal assessment approach (IAA)22 ; supervisory formula (SF).23 No one has as yet completed the dreary task of counting the actual number of components of all the requirements of the Securitisation Framework, but an estimate of the number of questions for a thorough and detailed compliance checklist of the Securitisation Framework would easily run into the many hundreds. For example, in Table 1 below,

By high-level components, we mean provisions of Basel II which are explicitly stated or crossreferenced. The estimated total number of high-level components for a compliance checklist is 39 because there are a number of sub-paragraph requirements as well as explicit references to other paragraphs which require compliance. Not included in this estimate are veiled references to other provisions of Basel II which should also be taken account. Therefore, the number of internal references that need to be taken account of in order to comprehend the context and meaning of traditional and synthetic securitisations could range between 50 and 100 specic provisions.24 This tiny analysis on the complexity of Basel II is simply to conrm what many analysts and researchers have stated about the Securitisation Frameworkthat it is not only stricter than the original Basel Accord, but that it threatens to destroy securitisation markets.25 The argument runs that the additional burdens of reporting securitisation transactions may make securitisation a more expensive process and thereby reduce the number of transactions at the margin. The formal operational requirements and conditions set out by Basel II will make certain types of securitisation transactions too expensive from a capital adequacy perspective. And, even

Table 1: Number of Compliance Components of Operational Requirements for Traditional and Synthetic Securitisations
Paragraph 554 555 Item Traditional securitisations Synthetic securitisations Number of sub-paragraphs 5 7 Number of high-level components for compliance checklist 12 27

we estimate the number of high-level components that need to be complied with to satisfy the operational requirements of traditional and synthetic securitisations.
9. ibid., para.554, p.115. 10. ibid., para.555, p.118. 11. ibid., paras 557559, p.117. 12. ibid., para.565, p.118119. 13. ibid., para.618, p.129. 14. ibid., para.548, p.114. 15. Under the Standardised Approach, the capital requirement for early amortisation provisions is found in ibid., para.590, p.123. 16. For conditions where banks are not required to calculate a capital requirement for early amortisations, see ibid., para.593, pp.123124. 17. ibid., para.574, p.121. 18. ibid., para.578, pp.121122. 19. ibid., para.580, p.122. 20. ibid., para.581, p.122. 21. ibid., para.582, p.122. 22. ibid., para.620, pp.129130. 23. ibid., paras 623636, pp.132135.

24. The wide range is not indicative of the authors inability or unwillingness to count the various provisions, but rather, is due to the alternative branching structure of dependent conditions. The point is the more complex the transaction, the more reporting will be required under the Securitisation Framework. 25. As Andrews et al., n.6 above, state on behalf of Fitch, the banking credit rating agency: It has been suggested that [Basel II and accounting reform] together or separately these changes will deter banks from acting as originators of securitizations. In particular, it has been predicted that part of this new reluctance will be prompted by the realization that in so far as Basel II succeeds in more accurately dening banks credit risk (also market and operational risks) and in setting regulatory capital requirements accordingly, particular varieties of securitization will become less attractive for banks. It must be true that to the extent that the improved alignment of regulatory capital with risk reduces the incentive to securitize, banks will reduce the volume of assets they securitize. In our opinion Basel II, as it is now proposed, will indeed serve to make origination of securitization less attractive to banks, given the stricter (in comparison with Basel I) capital requirements, including full deduction, for non-investment grade tranches. Fitch considers, therefore, that, although regulatory capital arbitrage is only one motive for securitization, Basel II will in sum reduce the volume of securitization by banks from what it might otherwise have been.

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more importantly for market practitioners who are continuously searching and creating efcient solutions, the variety of legal structures corresponds to a wide range of regulatory capital charges. With different legal forms to accomplish the same securitisation purpose, banks are faced with a range of regulatory capital charges depending on the risk category of the instruments used. To accomplish the same securitisation objective across different types of legal forms may result in a difference in capital charges that amounts to over 100 per cent between the different legal solutions.26 In effect, the capital adequacy requirements of Basel II demark certain types of securitisation on the grounds of economic substance over legal form, and thus destroy the economic rationale for certain types of securitisations which may have legitimate legal form. Basel II does not justify this prohibition as is customary in securities regulations under the avowed objective of investor protection.27 There is no question of having to show a nexus between the transaction in question and an underlying tort or criminal violation as is usually the case in most securities regulations where the public policy of investor protection is paramount. Rather, Basel II remains faithful to the original intent of the rst Basel Accord which is to protect the banking system as a whole by clarifying regulatory capital requirements, closing loopholes and gaps between this regulatory intent and market developments since the advent of the Basel Accord in 1988.28 Basel II attempts to balance the extremes of prescriptive rule-based compliance and the vagueness of a principle-based approach by announcing a general principle that underlies all securitisation rules. Basel IIs prefaces all its rules on securitisation with the edict that:
Since securitisations may be structured in many different ways, the capital treatment of a securitisation exposure must be determined on the basis of its economic substance rather than its legal form.29 (Emphasis added.)

According to the Securitisation Framework, all securitisations, whether traditional or synthetic, must be supported by the opinion of qualied legal counsel.31 Are these legal opinions supposed to make a determination that the securitisation transaction in question does not violate the concept of economic substance over legal form? From an equitable and fundamental fairness perspective this might make sense, but taken to its logical limit, is not this specic determination a question of professional competence which is beyond the normal purview of the legal profession? Thus, a legal opinion on the legal issues of a securitisation transaction may be limited to legal form and avow no comment on economic substance of the transaction. If this turned out to be the case, then what third party would be able to provide the appropriate independent advice on whether the securitisation transaction in question met the economic substance over legal form test? According to the Securitisation Framework, it is the supervisors who are to provide such advice, not just post hoc, but ex ante.32 ,33 This discretion left to the supervisor to make the determination of whether a securitisation is permitted or disallowed on the basis of such a general
stated: . . . we do intend that the rules be applied based on the economic substance of a structure, for example the transfer and/or tranching of credit, risk, rather than its strict legal form. As such there is a exibility regarding the type of exposures that the securitisation rules may be applied to. FSA (2005) Strengthening Capital Standards Including Feedback on CP 189, Consultation Paper 05/3, para.14.5, available at www.fsa.gov.uk. The Securitisation Framework in para.613, p.128 under the IRB approach states that . . . if a liquidity or credit enhancement facility constituted a mezzanine position in economic substance rather than a senior position in the underlying pool, then the Base risk weights column is applicable. That is, if the liquidity or credit enhancement facility constituted a second priority position in terms of payment even if it were titled as having a rst payment position, then a higher risk weight would apply. Clearly, the question of economic substance over legal form here is that whatever legal language is used to identify the purported rst priority payment is countered by some form of embedded option or conditionality that converts the rst payment into second priority. One might argue that it is a subtle reading of the legal form that leads to an appropriate understanding of the economic substance. 31. Basel II, para.554(b), p.115 requires a traditional securitisation to be supported by a legal opinion. For the requirement of a legal opinion to support a synthetic securitisation, see para.555(f), p.117, where the opinion must conrm the enforceability of the contracts in all relevant jurisdictions. 32. See para.539, p.113 which states: . . . supervisors will look to the economic substance of a transaction to determine whether it should be subject to the securitisation framework for purposes of determining regulatory capital. Banks are encouraged to consult with their national supervisors when there is uncertainty about whether a given transaction should be considered a securitisation. For example, transactions involving cash ows from real estate (e.g. rents) may be considered specialised lending exposures, if warranted. 33. For the distinction of ex ante rules versus ex post standards, see H. Hansmann and R. Kraakman, Chapter 2: Agency Problems and Legal Strategies in The Anatomy of Corporate Law, A Comparative and Functional Approach (Oxford University Press, 2004), pp.2324.

This edict poses a conundrum to the banking lawyer and securitisation specialist looking to create innovative securitisation structures. Simply put, how are we to interpret the concept of economic substance over legal form under the Securitisation Framework?30
26. See A. Jobst, The Basle Securitisation Framework Explained: The Regulatory Treatment of Asset Securitisation (March 2005), p.23, available at www.ifk-cfs.de, where he provides a worked example, comparing conventional true sale to synthetic securitisations across ve different securitisation structures, the regulatory capital charge varied by 100% from 4% to 2%, and the regulatory capital with interest sub-participation varied from 1.728% to 0.16%. 27. See US Securities Exchange of 1934, revised through September 2004, available at www.sec.gov. 28. Basel II, paras 1, 4 and 5, pp.1 and 2. 29. ibid., para.539, p.113. 30. In commenting on the Draft Directive on Capital Adequacy, the UK Financial Services Authority (UK FSA)

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concept is problematic since discretionary decisionmaking may create rather large discrepancies between jurisdictions and within a particular jurisdiction over time.34 Supervisory discretion may be necessary during an epochal event, but reducing the concept of economic substance over legal form to supervisory discretion ies in the face of the global objective of reducing systemic risk via a standardisation of process and certainty of interpretation of what already is a complex set of rules. Since Basel II itself does not elaborate on the specic meaning of economic substance over legal form, there is a need for guidance on how this phrase might be interpreted, taking account of the complex rules embedded within the language of the Securitisation Framework.

Economic substance over legal form

The concept of economic substance over legal form forces us to consider the collision of two discourses: the economic and the legal. On the one hand, amongst nancial economists and experts of nance and investment analysis, the notion of economic substance usually involves a determination of the value of an asset. For example, this may mean the calculation of the net present value of the future cash ows of a particular asset. The asset itself may be characterised according to various reciprocal legal rights and duties. And in theory, every right and duty so long as there is a market for such rights and duties may be translated into nancial-economic terms of risk.35 On the other hand, in the legal profession, when we speak of legal form, we are referring to the form of ownership of the asset, i.e. corporate, partnership, trust, sole proprietorship, or some other specially dened form of limited liability ownership. However, the language of the Securitisation Framework suggests a broader interpretation. Here, economic substance implies that the nancial-economic valuation is more real (connoting substantial and valuable) than the mere legal documentation (connoting mere form or paper). This interpretation provides the supervisor with what one might call the equitable discretion to look at the whole transaction or series of transactions to see whether the bank
34. Basel II states its awareness of the problem that interpreting regulatory and accounting approaches at the national and international level . . . can have signicant consequences for the comparability of the resulting measures of capital adequacy and for the costs associated with the implementation of these approaches. Basel II, para.12, p.3. 35. This concept is explored by W.F. Sharpe, Nuclear Financial Economics in W.H. Beaver and G. Parker, Risk Management Problems and Solutions (McGraw-Hill, 1995), pp.1735, who relies heavily on K.J. Arrow, The Role of Securities in the Optimal Allocation of Risk-bearing (1964) XXXI The Review of Economic Studies 9196, and G. Debreu, Theory of Value, The Cowles Foundation Monograph 17 (1959).

retains any residual risk or is exposed to any residual risk of the asset pool after the sale of the assets. We might describe this residual risk as a type of partial or limited recourse whereby the originating bank has sold either an explicit or implicit option which may be exercised in the future and if so exercised, the bank would suffer an economic detriment. Although not complete, the Securitisation Framework lists some of the major legal forms where residual risk is rampant, including clean-up call,36 credit enhancement,37 early amortisation,38 excess spread,39 and implicit support.40 In general, where the bank has taken on an irrevocable duty to perform a nancial promise and has no control over the trigger that crystallises this promise into a duty to perform, then whatever legal form this contingent claim takes, whether expressed or implied, will attract a capital charge against the bank because the residual risk remains with the bank. Because of the large variety of instruments that may or may not meet the test of economic substance over legal form, we might ask whether an elucidation of how the concept is used in the legal literature may give us some guidance of how we might apply it to the Securitisation Framework. After reviewing the general legal usage of substance over form, we shall see how it is applied in a recent UK case on structured nance, Mahonia Limited v JP Morgan Chase Bank.41 Whilst there is a large literature on substance over legal form in tax law,42 the more narrowly focused phrase economic substance over legal form comes primarily from the accounting standards with the advent of FRS 5,43 continuing to the current rounds of development and debate concerning the principles of the International Financial Reporting Standards, especially with regard to accounting for derivatives and off-balance sheet instruments.44
36. Basel II, para.545, p.114. 37. ibid., para.546, p.114. 38. ibid., para.548, pp.114115. 39. ibid., para.550, p.115. 40. ibid., para.551, p.115. 41. [2004] EWHC 1938 (Comm). 42. For a discussion of US tax law doctrines of substance over form, see Long Term Capital Holdings, et al. v United States of America, 330 F. Supp. 2d 122, decided August 27, 2004. In Long Term Capital Holdings, the stepstransaction doctrine is dened as the steps in a series of formally separate but related transactions involving the transfer of property as a single transaction, if all the steps are substantially linked. Rather than viewing each step as an isolated incident, the steps are viewed together as components of an overall plan. Greene v US, 13 F.3d 577, 583 (2d Cir. 1994). Courts have identied three tests for determining whether to apply the steps transaction doctrine, the end result, the interdependence, and the binding commitment tests. In general, the doctrine will operate where the circumstances satisfy only one of the tests. See True v US, 190 F.3d 1165, 1175 (10th Cir. 1999). 43. Accounting Standards Board (April 1994) FRS 5 Reporting the Substance of Transactions, available at www.asb.org.uk. 44. International Financial Reporting Standards are available from the International Accounting Standards Board at www.iasb.org. The most relevant for derivatives accounting

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However, the legal question of determining the accounting treatment of nancial instruments in terms of giving priority to economic substance over legal form has not been dealt with to any great depth in relation to securitisation exposures since the publication of Basel II. We believe, however, that the substantive arguments in Mahonia will be used to support legal interpretations of the accounting principle of economic substance over legal form. For our purposes, the relevance of Mahonia is that it provides implicit support for our thesis that the interpretation of economic substance over legal form is strongly related to a detailed analysis of the rights and obligations of a transaction in terms of symmetric and asymmetric risks. The more general point is that whilst Basel II relies on the nomenclature of accounting to help determine whether regulatory capital rules are being applied properly, the application of the concept of economic substance over legal form will turn on a construction of the legal rights and duties of the parties to a contract. It is the legal interpretation of economic substance that will be determinative. Apart from Mahonia, there are some scholarly articles pre-dating Basel II which advocate the interpretation of nancial transactions in terms of economic substance over legal form.45 Cases in the United Kingdom, United States and in other Commonwealth jurisdictions tend to scrutinise a combination of derivatives transactions as requiring some explanation that such are not an attempt to subvert the doctrine of substance over form.46 In all of these attempts to dene the doctrine of economic substance over legal form, there lingers an older question in equity of whether a combination of transactions should be viewed in all fairness as one or many transactions.

substance over form doctrine, is given by Lord Tomlin in Commissioners of Inland Revenue v Duke of Westminster:
Every man is entitled if he can to order this affairs so that the tax attaching under the appropriate Acts is less that it otherwise would be . . . If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.51

Substance over form in the tax law

In the United Kingdom, the question of substance versus legal form has been considered by a number of cases, including Inland Revenue Commissioners v Duke of Westminster,47 W.T. Ramsay Ltd v Inland Revenue Commissioners,48 Inland Revenue Commissioners v Burmah Oil Co Ltd,49 and more recently in Grifn (Inspector of Taxes) v Citibank Investments Ltd.50 The classic oft-quoted statement, the so-called Westminster principle upholding the
and reporting is IAS 39 (1998) Financial Instruments: Recognition and Measurement. 45. See G. Jones, Off-balance sheet nancingshould economic substance prevail over legal form? (1986) Co. L. Dig. 6265, and E. Ferran, Form and substance in nancing transactions (1992) 51 C.L.J. 434436. 46. See Mahonia, n.41 above and Long Term Capital Holdings, n.42 above. 47. [1936] A.C. 1. 48. [1979] 1 W.L.R. 974. 49. [1982] S.T.C. 30. 50. [2000] S.T.C. 1010.

There is an essential pattern that runs through all of these cases. First, they all involve a set of transactions which on the one hand, if taken individually, result in reduced taxation, and on the other hand, if taken all together such that the intermediary transactions are cancelled, result in higher taxation. Second, in all of the above cases the doctrine of economic substance over legal form is invoked in the context of determining whether a set of pre-arranged transactions might be considered as one transaction. Third, the legal entity claiming that the preordained transactions should be considered separately stands to benet in terms of reduced tax if the legal form (that is, the individual contracts) of the transaction is preserved. Fourth, it is the tax commissioner who is arguing for the use of economic substance over legal form as a weapon to wipe out and cancel the intermediary legal transactions (legal forms) which are allegedly circumventing tax policy. Lord Wilberforces set of principles in Ramsay (1979) is often quoted and serves as the unswerving sacred cow to which any new analytic legal framework must at least rst bow acknowledgment. These principles may be summarised as follows: First, tax law must be explicit and no interpretation based on the intendment or equity of the tax law is permissible.52 This strict reading of the tax law means that the tax law must follow a narrow application, and thus, implies a limited intrusion into the freedoms of personal and business life. Secondly, the Westminster principle as quoted above allows for individuals to organise their personal and business arrangements freely so as to minimise their tax liability. The effect of this principle is to limit the discretionary power of the tax commissioners who may on occasion attempt to extend the narrow allowance and specic interpretation of tax regulation. Thirdly, the tax commissioner should determine whether the transaction is a sham or genuine. This follows from the duty of the tax commissioner to enforce the tax laws, and indicates that the limitation of what types of transactions may be entered into are not limited by the tax law itself and fall within the scope of laws regarding the legality of contracts. Fourthly, nothing under the Westminster principle prevents the tax commissioner from looking at the context of the individual transactions, and
51. [1936] A.C. 1 at 19. 52. W.T. Ramsay Ltd v Inland Revenue Commissioners [1982] A.C. 300.

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formulating an interpretation concerning the whole set of transactions. Building on these principles, the concept of economic substance versus legal form appears in the tax cases cited above as a question of whether a set of separate legal contracts that purposefully set out to accomplish a particular tax advantage should be considered as separate legal contracts (in which case less tax would be paid) or as one transaction (in which case more tax would be paid). We should, however, be careful not to apply this interpretation without qualication to the Securitisation Framework of Basel II. For example, in applying the above test blindly to the Securitisation Framework we might be tempted to say that if the separate legal contracts were taken at face value then the tendency would be to allow a lower or minimal risk weighting or credit conversion factor. Conversely, if we were to emphasise the economic substance of contracts reanalysing all the contracts to a securitisation transaction as one transaction, then the effect would be to increase risk weightings and credit conversion factors. Both these statements, however, are simply not true since the Securitisation Framework provides rules for determining the risk weights of individual instruments that comply with specic operational requirements or specic contractual conditions. Under the Securitisation Framework, the application of economic substance over legal form test would need to be exercised not at the level of comparing one versus many contracts, but rather at the level of component parts of the legal instrument itself. It is the specic clauses of a contract that denes the economic substance of the agreement. Economic substance over legal form under the Securitisation Framework requires a different set of principles. In Mahonia, Lord Cooke presents a penetrating analysis of economic substance over legal form in relation to accounting principles. Although Mahonia concerned a structured nance transaction and was not concerned with a traditional securitisation, its legal structure is certainly closely related to synthetic securitisations since it dealt with synthetic derivative structures. It is for this reason that Mahonia is relevant authority for the interpretation of economic substance over legal form. As we shall see, the economic substance versus legal form test is concerned not only with the gross question of whether many contracts should be deemed as one transaction, but also with a subtler analysis of whether the separate transactions can in any way be linked to each other. As we shall see, Lord Cookes analysis in Mahonia relies on explicit linkage between transactions in the form of cross-referencing contractual provisions. However, the Securitisation Framework allows for a wider interpretation, covering both explicit and implied linkage between separate transactions.53 Under the
53. e.g. see implicit support at Basel II, para.564, p.118.

current language of the Securitisation Framework, the supervisor may look to the actions of the parties, and not just the contractual obligations set out by the parties, to determine whether the concept of economic substance over legal form should apply. The decision in Mahonia shows a restrictive reading of the concept of economic substance over legal form which is superseded by the Securitisation Framework.

Mahonia
In Mahonia, Lord Cooke examined the question of substance over legal form in a structured nance transaction involving three swap agreements involving WestLB AG (the defendant, West), Mahonia (the claimant) and JP Morgan Chase, (a joint claimant, Chase). The judgment was rendered in favour of Mahonia. The main question was to determine whether West was liable to pay the amount of $165 million under a letter of credit (L/C) that was issued in favour of Mahonia, a special purpose vehicle incorporated in Jersey. We shall consider the case only in terms of its relevance in determining the legal meaning of economic substance over legal form. In his decision, Lord Cooke examined this concept in relation to its roots in accounting standards, and showed how Wests argument and Chases argument differed in their interpretation of this concept. On the one hand, West argued that the three contemporaneous swaps constituted in economic substance a loan. This is because the initial payments of $350 million from Chase to Mahonia and from Mahonia to Enron North America Corporation (ENAC) would be followed by the payment by ENAC to Chase of approximately $356 million six months later, the difference being equivalent to a rate of interest of 3.4 per cent per annum.54 On the other hand, Chase argued that these three transactions were legally distinct with no cross referencing between them . . . no cross default provisions and no cross collateralisation provisions.55 The legal consequences of these separate agreements would be that a default by a party in one under one contract would not impact the rights and obligations of the parties in the other contracts.56 There were thus . . . three distinct parties to the transactions as a matter of law and the contracts between them imposed distinct rights and obligations upon each of them.57 In analysing the specic provisions of the individual transactions, Lord Cooke found that:
Whilst the economic effect of full performance is the same as a conventional loan in the nal outcome, there are differences in the obligations and economic effect
54. 55. 56. 57. Mahonia, n.41 above, at [79]. ibid., at [77]. ibid. ibid.

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on the way, because of the asymmetrical58 margin provisions, which depend on price movement and their effect on liquidity.59

In other words, the independent obligations under the separate contracts would give rise to substantial variation in losses to the individual parties,60 which would be unlike a conventional loan agreement. In contrast to this position, Mr Turner, a former head of the US Securities and Exchange Accounting Division, and star expert witness for West, stated that the concept of substance over form was inherent in the DNA of GAAP and that the subjective intent of ENAC was relevant in determining the substance over form of the transaction.61 But Lord Cooke was more persuaded by Professor Ryan who pointed out that where there is no right of setoff, as a matter of law, between liabilities in differing transactions, those transactions must be accounted for separately.62 In a denitive legal interpretation of economic substance over legal form, Lord Cooke stated:
To treat individual transactions as composite is to engage in synthetic accounting which is impermissible. Three transactions cannot be collapsed into one transaction where, as a matter of law, the rights and obligations are separate and can be individually enforced. Proper accounting must reect the individual rights and obligations in the transactions which are a matter of substance and not merely of form. The fact that, if various transactions are fully performed, they may negate one another and the fact that the transactions may have been entered into in contemplation of the others does not effect their legal substance, quite apart from their legal form. Economic substance must reect legal substance.63

bands. For example, after the publication of the original Basel Accord, certain nancial instruments were manufactured to take advantage of the lower risk weighting afforded to short-dated corporate instruments. Thus, the market for 364-day revolving credit facilities ourished because such instruments would attract a risk weight that was effectively at least half that of 365-day credit instruments.66 The general notion of economic substance over legal form may be used to help close the gap on these particular kinds of sneak run instruments. However, the development of the Securitisation Framework through the three rounds of industry consultation67 shows that this piecemeal attempt to stamp out the weeds of regulatory arbitrage has inspired one leading analyst to call the legal history of the Securitisation Framework a pathological evolution.68 One feels that the underlying principle for the regulatory capital requirement in the Securitisation Framework is yet to be spelt out. As we have argued above, the concept of economic substance over legal form under a traditional equitable perspective is perhaps too generic to be of much practical use to practitioners. We propose an alternative interpretation of the principle of economic substance over legal form which is in keeping with the over-arching risk-based approach of Basel II. Whilst the vagueness of the expression may favour the supervisor, empowering him with wide discretionary power to maintain overall control in the face of dynamically developing markets, it cannot satisfy the practitioner who seeks an explanation in terms of stable principles. We offer such an explanation of the concept of economic substance over legal form using the principle of risk symmetry.

Under Basel II, however, the question is not so much whether many contracts should be considered as a single transaction, but rather whether the contract or contracts undertaken by the bank contain explicit or implied provisions which would unfairly allow the bank to take advantage of a lower regulatory capital requirement when in fact it is actually carrying a higher level of risk. The Securitisation Framework has anticipated some of the problems in this area with the concept of implicit support64 and de minimis65 support levels that do not automatically attract regulatory capital. The concept of economic substance over legal form may not solve problems of regulatory arbitrage which are inherent in the structure of risk-weighting
58. We note with interest the use of the word asymmetrical in this context to denote the uneven distribution of risks between the parties. 59. Mahonia, n.41 above, at [91]. 60. ibid., at [89]. 61. ibid., at [166]. 62. ibid., at [187]. 63. ibid., at [187]. 64. Basel II, para.564, p.118. 65. See discussion on clean-up calls, below, and Basel II, para.557, p.117.

The principle of risk symmetry

Before delving into the principle of risk symmetry, we might consider the logical framework in which we nd the concept of economic substance over legal form. The Securitisation Framework depends on the denition of economic substance over legal form, which is not dened internally within Basel II. Therefore, we are compelled to nd an authoritative denition which we might call a legal interpretation
66. For an example of a 364-day revolving credit agreement entered into by Worldcom on June 8, 2001, for an amount of $2.65 billion, see http://contracts.corporate.ndlaw.com. For treatment of revolving asset securitisations, see Jobst, n.26 above, p.12. 67. There have been three rounds of quantitative impact studies and three proposals for consultations in June 1999, January 2001 and April 2003, Basel II, para.1, p.1. 68. Jobst, n.26 above, p.25 states: The pathological evolution of the securitisation framework under the revised Basle Accord reects the successive steps the Basle Committee has taken over time to eliminate arbitrage opportunities from loan securitisation under existing provisions for the regulatory treatment of credit risk under the old 1988 Basle Accord and later amendments.

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Securitisation Framework

Accounting based Mahonia (2003)

Economic Substance over Legal Form Risk Based Basel II (2004)

Accounting Standards

Principle of Risk Symmetry

Figure 1: Logical Dependencies of Economic Substance over Legal Form of the concept. As we saw in Mahonia, the concept of economic substance over legal form comes from accounting standards. However, the accounting standards themselves are in a state of evolutionary development,69 and have yet to be tested in their ability to capture the essential nature or provide guidance on how they might be interpreted for securitisation exposures under Basel II. Our thesis is that the concept of economic substance over legal form may best be interpreted in terms of a risk-based approach which we call risk symmetry. This series of dependences is illustrated in Figure 1. It is no accident that the Securitisation Framework depends on the accounting concept of economic substance over legal form. As Lord Cooke stated in Mahonia, the concept can be traced to accounting standards.70 Since Table 8 requires disclosure of the accounting policies regarding securitisation exposures,71 we agree that there is a strong inference that concept of economic substance over legal form as found in the Securitisation Framework is linked to accounting standards. However, the accounting standards themselves are not sufcient to dene the concept itself in terms of providing specic criteria which would help us recognise which, when, where, what, how or why securitisation exposures justiably attract regulatory capital. The operational requirements and specic conditions of the Securitisation Framework set out rules for recognition of specic instances which would and would not attract regulatory capital. But there are potentially an innite number of discrete types of securitisation instruments, transactions and exposures which could
69. Basel Committee on Banking Supervision, Consultative Document: Supervisory guidance on the use of the fair value option by banks under International Financial Reporting Standards (July 2005) available at www.bis.org. The Basel Committee states the draft supervisory guidance is not intended to set forth additional accounting requirements beyond those established by the IASB. One of the main recommendations is that . . . national supervisors recognise gains and losses from the application of the fair value option in Tier 1 capital, with the exception of gains and losses arising from changes in own credit risk liabilities. Ibid., para.9, p.6. 70. Mahonia, n.41 above, at [94]. 71. Basel II, Table 8, p.187.

be created. The Securitisation Framework explicitly recognises this limitless variety72 and it is in anticipation of future innovation that it has provided the supervisor with wide discretion through the concept of economic substance over legal form to determine which legal structures will or will not attract regulatory capital. However, if the ultimate test of whether a securitisation exposure should attract regulatory capital is dependent wholly on supervisory whim or wisdom, then it suffers from subjectivism and will fast become desultory. To alleviate this supervisory risk, we propose a risk-based approach to the denition of economic substance over legal form. It is a modest attempt to provide an objective test that could be used by regulator and practitioners alike. The principle of risk symmetry describes the baseline case where the set of contracts is such that the originator bank has no residual risk to make good the nancial obligations of the original obligors to the investors of the SPE (Figure 2). We interpret the edict of economic substance over legal form as a way of taking account of the symmetrical risks imposed by a securitisation transaction. Where a bank is involved as an originator, it stands to take an immediate benet from the sale of its obligors stream of nancial obligations (assets and future receivables). Here the true sale of the assets from the bank to the SPE achieves risk symmetry or neutrality, in that the bank is transferring all the benets of the future cash streams to the SPE and receiving the same less transaction costs. If the bank has sold or completely assigned its interest in the asset pool to the SPE, then logically it has no exposure and should not be liable for any regulatory capital requirement. Let us take this as the limiting base case. Exceptions to this we shall call risk asymmetriesthat is, the originating bank has either explicitly or impliedly agreed to conditions which increase its risk of loss in relation to the transaction as a whole. The decision tree of how the risk symmetric principle would be applied to the Securitisation Framework is set out overleaf in Figure 3.
72. ibid., para.538, p.113.

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Risk Symmetry

Obligors

Originator

SPE

Investors

Risk Exchange is Complete Originator excludes securitisation exposures from calculation of regulatory capital = 0% risk weighting

Figure 2: Risk Symmetry in Securitisation

Principle of Risk Symmetry

Set of Basel II Securitisation Framework Rules: Operational Requirements & Specific Conditions

Fulfilled

Not Fulfilled

Risk Symmetric Position

Risk Asymmetric Position

No Regulatory Capital Required

Regulatory Capital Required

0% Risk Weighting

Discrete Risk Weightings & Credit Conversion Factors

Figure 3: Decision Tree of Securitisation Framework using the Principle of Risk Symmetry From the gure above, the principle of risk symmetry being an interpretation of the concept of economic substance over legal form applies to all possible securitisation transactions, and therefore, would apply to all the situations covered and anticipated by the set of rules under the Securitisation Framework. A limited number of different types of securitisation exposures are circumscribed by the operational requirements and specic conditions in the Securitisation Framework. If the operational requirements and specic conditions are fullled, then we have a risk symmetric position and no regulatory capital is required. If these requirements and conditions are not fullled, then we have a risk asymmetric position, which will attract regulatory capital. What evidence do we have that risk symmetry and risk asymmetries can be found either explicitly or implicitly in the Securitisation Framework? There is no explicit language in Basel II expounding this view. We merely offer this distinction as a method, a bridge if you will, that helps us cross the divide between the general language of economic substance over legal form and the many specic rules stated in the Securitisation Framework. The distinction also helps us clarify, reorganise and simplify the rather detailed rules regarding capital adequacy requirements under the Securitisation Framework. One the one hand, the risk symmetry principle can be inferred from the denitions of the securitisation participants and their relationships to each other in a typical securitisation transaction. See, for example, the denitions of originating bank,73 special purpose vehicle,74 transferor,75 and transferee,76 together with the denition of traditional securitisations as payments to investors dependent upon the performance of the specied underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures.77 These denitions are fragments that can be pieced together to form a network of legal relationships that form the securitisation structure. And if a bank follows all the operational requirements for risk transference as per paras 554, 555 and 556, then

73. 74. 75. 76. 77.

ibid., para.543, pp.113114. ibid., para.552, p.115. ibid., para.554(b), p.115. ibid., para.554(d), p.116. ibid., para.539, p.113.

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Risk Asymmetry Credit Enhancement [ 546] Special Conditions Traditional Securitisations [ 554(f)] Special Clean-up Call Early Clauses [ 557] Amortisation Synthetic [ 548] Securitisations [ 555(e)]

Implicit Support [ 564] Effective Control [ 554(b)]

Bank required to include securitisation exposure in calculating regulatory capital Risk weighting can vary from 7% for Senior AAA Tranche to 650% for Ba3, and as a deduction from Tier 1 for Tranches below Ba3 [BIS (30 Jan 2004) Changes to the Securitisation Framework].

Figure 4: Risk Asymmetries in Securitisation it may exclude the securitised exposure from the calculation of risk-weighted assets. This is the baseline risk symmetric case, where the risk weighting of the securitisation exposure is 0 per cent. On the other hand, evidence for risk asymmetries can be found as exceptions to the general rule and thus, in these specic situations, the bank will attract a higher risk weighting or higher credit conversion factor for the instrument in question. To illustrate, we provide a simple diagram showing how these distinctions might be viewed. See Figure 4: Risk Asymmetries in Securitisation above. Suppose an originating bank were to support or protect the payment of such future cash streams to the investors, then it would be promising to perform on the basis that was beyond the obligations created by the pool of obligors. In this case, its risk position is asymmetric, and it would need to show that it had taken on this risk by way of higher risk weight if it is a traditional securitisation, or high credit conversion factor if it is a synthetic securitisation, or even by way of deduction of Tier 1 capital.78 In sum, if a securitisation transaction includes risks whether actual or implied which could backow to the bank, that is, making the bank responsible for any further liability for failure of the nancial obligations of the obligors, then the bank retains a risk asymmetry and the banks position is not riskneutral. Whilst this principle of risk asymmetry is not stated explicitly in Basel II, its essence can be found in various rules of the Securitisation Framework that attempt to reach risk symmetry, for example implicit support,79 excess spread,80 early amortisation,81 and clean up calls.82 The principle of risk symmetry enables us to see how a securitisation transaction can be viewed in
78. 79. 80. 81. 82. ibid., para.561, p.118. ibid., para.551, p.115. ibid., para.550, p.115. ibid., para.548, p.114. ibid., para.545, p.114.

terms of a continuum of reciprocal risks rather than just apportioned in terms of regulatory risk buckets. Part of the regulatory pathology of Basel II is that whilst its purported intention is to reduce the opportunity for regulatory arbitrage, its adherence to obviously arbitrary risk categories and risk levels simply generate more opportunities for regulatory arbitrage. And the concept of economic substance over legal form left undened only adds to the murkiness and tempts mischievousness. It would be much simpler to view securitisation exposures as a set of contracts where the risk symmetry between the originator and investors means that the originator retains no residual risk, and where there is an asymmetry (for example, recourse, implicit support and so on), that this should be evaluated separately according to the actual contractual terms. In this way, the market participants would have a broad stable risk-based principle from which to determine regulatory capital, and at the margin, be free to develop new products that are demand specic.

The need for more legal substance over economic formulae

The major problem with providing specic risk weightings and CCFs for various types of legal instruments is that whilst these rules set out how to calculate the regulatory capital with mathematical precision, the rules themselves do not specically dene the types of legal instruments to which these calculations apply with any great legal precision. Although economic substance over legal form is the underlying principle of the Securitisation Framework, one of the great gaps of the Securitisation Framework is the lack of denition of the actual legal forms to which economic substance attaches. We note that Basel II has attempted to ll this obvious gap by providing operational requirements for the various

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instruments which would be allowed favourable risk weights and CCFS (for example, guarantees and credit derivatives under para.587 must full the minimum operational conditions as per paras 189 to 194). But these operational requirements do not in themselves dene the legal instruments in question, and therefore, there exists an ambiguity about what specically the Securitisation Framework is actually referring to by using the terms liquidity facilities, guarantees, credit derivatives and so on. For example, in attempting to dene securitisation exposures, the Securitisation Framework states that these can include but are not restricted to the following: asset-backed securities, mortgage-back securities, credit enhancements, liquidity facilities, interest rate or currency swaps, credit derivatives and tranched cover as in paragraph 199.83 There are no adequate legal denitions of these terms in the body of Basel II. Therefore, turning the principle of economic substance over legal form on its head, we might argue that whilst we understand how to apply the mathematical formulae for the calculation of regulatory capital, we still do not know with certainty which legal forms these calculations might be applied to. Given the complexity of the some of the mathematical formulae, it does not appear inordinately unreasonable to ask the Basel Committee whether the legal substance of the economic forms should be given increased weight in evolving appropriate regulatory standards. In keeping with the ndings of this article, it is recommended that the International

Convergence of Capital Measurement and Capital Standards include legal denitions of securitisation instruments in order to assist in the determination of economic substance.

Summary and conclusion

In this reading of the Securitisation Framework of Basel II, we have dened the pivotal concept of economic substance over legal form in light of general equitable and legal principles, and posed an alternative interpretation based on risk symmetry. The complexity and costs of compliance of the Securitisation Framework appear to be open-ended, and risk destroying a high growth international nancial market. The principle of risk symmetry could be used simply to reorganise and provide a greater degree of certainty in interpreting the meaning of economic substance over legal form with regard to specic instances of securitisation exposures. It is clear, however, that whilst this abstract principle may help us understand how and why certain types of exposures should attract regulatory capital, there remains an ambiguity about what types of legal instruments the Securitisation Framework should actually be applied to. To help cure this defect, we recommend strengthening the legal basis, the very denition of standard legal forms, in order to preserve fundamental fairness of securitisation transactions and restrain the temptation of unnecessary supervisory interference.

83. ibid., para.541, p.113.

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