securitization dynamics (paper)

KETTERING.TO.EDITOR.2 3/26/2008 4:22:10 PM

1553

SECURITIZATION AND ITS DISCONTENTS: THE DYNAMICS OF FINANCIAL PRODUCT

DEVELOPMENT*

Kenneth C. Kettering**

Abstract: This paper takes as its point of departure the financing technique referred to as “securitization,” a close cousin of secured lending that has grown to enormous size since its origin more than two decades ago. The paper pursues two themes. One is a critique of the legal foundations of securitization, which includes a perspective on aspects of fraudulent transfer law that are well established historically but have been neglected in recent decades. The other is exploration of the implications of this product growing so vast despite its dubious legal foundations. In that regard, the paper explores two points of legal sociology that apply to new financial products generally. The first is that a product can become so widely used that it cannot be permitted to fail, notwithstanding its dubious legal foundations. The second is that the credit rating agencies have become de facto lawmakers, because it is their decision to give a favorable rating to a financial product the credit quality of which depends on a debatable legal judgment that allows the product to grow too big to fail. Two nascent products are identified as candidates for the operation of a similar dynamic. The paper ends with a normative assessment of securitization from a pragmatic perspective, concluding that legislative action is appropriate to ratify the product’s object, with constraints.

CONTENTS Introduction........................................................................................................ 1554 I. The Prototypical Securitization, the Bankruptcy Tax, and Bankruptcy Policy....................................................................................... 1564 II. Securitization: Doctrinal Discontents......................................................... 1581

A. Introduction........................................................................................ 1581 B. Vindicating Bankruptcy Policy Through Fraudulent Transfer Law... 1585

* Copyright © 2008 by Kenneth C. Kettering. All rights reserved. This paper was awarded the Grant Gilmore Award by the American College of Commercial Finance Lawyers. In this paper, unless otherwise indicated, citations to the Bankruptcy Code, title 11 of the United States Code, and to the Uniform Commercial Code (“UCC”), are to the respective versions as amended through the end of 2007. ** Associate Professor, New York Law School. E-mail: [email protected]. The author is a member of the Standard & Poor’s Academic Council. Standard & Poor’s bears no responsibility for views expressed in this paper.


1554 CARDOZO LAW REVIEW [Vol. 29:4

1. The Primordial Rule and Its Nonhindrance Aspect.................... 1585 2. Nonhindrance in Action ............................................................. 1593 3. Shapiro v. Wilgus: Application of Nonhindrance to Undo Manipulation of Insolvency Law ............................................... 1601 4. A Theory of Nonhindrance and the Primordial Rule ................. 1608 5. Nonhindrance and the Prototypical Securitization..................... 1620

C. Vindicating Bankruptcy Policy Through Substantive Consolidation. 1622 III. The Legal Reception of New Financial Products........................................ 1632

A. Products That Are “Too Big to Fail” ................................................. 1632 1. Introduction................................................................................ 1632 2. Judicial, Regulatory and Legislative Reactions to a Product “Too Big to Fail”: Repo and Other Products ............................. 1640 3. The Limits of “Too Big to Fail”................................................. 1655 4. A Case Study: The Standby Letter of Credit.............................. 1661

B. Rating Agencies as De Facto Lawmakers .......................................... 1671 1. On Becoming “Too Big to Fail”. ............................................... 1671 2. The Rating Agencies’ Responsibility for the Legal Judgment that Securitization Works. .............................. 1681 3. Potential Constraints on the Rating Agencies’ Legal Judgments About Products They Rate. ............................ 1687

a. Liability ............................................................................. 1687 b. Reputation ......................................................................... 1693

4. Testing the Hypothesis: Two Predictions................................... 1702 a. Electronic Commercial Paper............................................ 1702 b. Exploiting the Privileged Status in Bankruptcy of Financial Markets Contracts ......................................... 1710

IV. Securitization: A Normative Assessment ................................................. 1716 Conclusion ......................................................................................................... 1727

INTRODUCTION One cannot step into the same river twice, Heraclitus famously

declared.1 One of the points of that ancient Greek koan is that there are two ways to perceive a river: either as a set of separate bits of matter, the elements of which are constantly changing, or as a single thing worthy of being considered an entity in itself. In the same way, when confronting innovation in financial and commercial products, one might study either particular innovations, or the process of innovation. There is no question that scholars of financial and commercial law are typically inclined to the former perspective. Shelves are laden with scholarly writings on particular innovations: tracing their histories, examining their uses, analyzing their doctrinal foundations, and evaluating their merits from different normative perspectives. But studies of the process of innovation, though not unknown, are 1 Plato, Cratylus, in 1 THE DIALOGUES OF PLATO 344-45 (B. Jowett trans. & ed. 3d ed., London, Oxford University Press 1892).


2008] SECURITIZATION AND ITS DISCONTENTS 1555

comparatively few.2 That attention has been lacking does not necessarily mean that

more attention is warranted. Study is warranted only if it produces insight, and it might be that the process of innovation is too chaotic to yield much in the way of insight (unless, perhaps, one is ambitious enough to employ a time scale long enough to permit changes in products to be correlated with social changes). But there are at least some reasons to expect less ambitious studies to produce results of interest. For one thing, a sizable body of literature has considered the process of innovation in financial products from an economic perspective. 3 For another, commentators in the tax realm have an established tradition of recognizing the process of creating tax-driven products as an object of study. Their labors, too, have created a sizeable literature.4 The contrasting attitudes of tax and non-tax lawyers toward innovation are illustrated dramatically by the extent to which they have sought patent protection for the fruits of their genius: since 2003, when the Patent Office issued its first “legal methods” patent, over a dozen patents have been issued for tax-driven products, with applications pending for dozens more, but not a single patent has been issued for any non-tax legal product, and so far as public knowledge goes no applications are pending.5

The reasons for that difference in attitude invite speculation. Perhaps the evolution of new products proceeds at a slower tempo in the realm of finance than in the tax realm, so that innovations in financial products are more likely to be perceived as disconnected episodes than as parts of a process. Perhaps the exploitation of some new tax

2 See, e.g., Charles R.P. Pouncy, Contemporary Financial Innovation: Orthodoxy and Alternatives, 51 SMU L. REV. 505 (1998); Symposium, New Financial Products, the Modern Process of Financial Innovation, and the Law, 69 TEX. L. REV. 1273 (1991); Henry T. C. Hu, Swaps, the Modern Process of Financial Innovation, and the Vulnerability of a Regulatory Paradigm, 138 U. PA. L. REV. 333, 337-41, 392-412 (1989). For a particularly interesting study in the context of corporate law, see Michael J. Powell, Professional Innovation: Corporate Lawyers and Private Lawmaking, 18 LAW & SOC. INQUIRY 423, 429 (1993) (presenting “the development and diffusion of the poison pill as a case study in private lawmaking by entrepreneurial corporate lawyers”). 3 For a discussion of the economic literature on financial innovation, see Pouncy, supra note 2, at 545-76. 4 In particular, the dramatic growth of corporate tax shelter activity in the 1990s inspired a substantial literature on the process of development of such products and appropriate responses to them by the legal system, including several symposia. See, e.g., Symposium, Corporate Tax Shelters (pts. 1 & 2), 55 TAX. L. REV. 125, 289 (2002); Symposium, Business Purpose, Economic Substance, and Corporate Tax Shelters, 54 SMU L. REV. 3 (2001). A root article of the current wave of such literature is Joseph Bankman, The New Market in Corporate Tax Shelters, 83 TAX NOTES 1775 (1999). For a recent contribution to the continuing flow, see Steven A. Dean & Lawrence M. Solan, Tax Shelters and the Code: Navigating Between Text and Intent, 26 VA. TAX REV. 879 (2007). 5 See Andrew A. Schwartz, The Patent Office Meets the Poison Pill: Why Legal Methods Cannot Be Patented, 20 HARV. J.L. & TECH. 333, 346-49 (2007).



products, such as corporate tax shelters, threatens the integrity of the tax system in a way that has no real analogue in the realm of financial products. But in any case the difference is real, and it encourages the thought that financial and commercial scholars might reap intellectual rewards from a greater willingness to treat the process of innovation in those realms as a thing worthy of study, as tax scholars have done in their domain.

The main purpose of this paper is to consider the process of innovation in financial and commercial products. It takes as its point of departure one of the major financial innovations of recent decades, namely the financing technique variously known as “securitization” or “structured finance.” These terms are not well defined, but they have acquired a certain cachet in the marketplace, and so are often applied very loosely to transactions that have almost nothing in common.6 As used in this paper, “securitization” refers to a transaction that, in the first place, involves the issuance to financiers of debt instruments that are backed by a designated pool of assets—typically rights to payment owned by the firm that effects the transaction (referred to herein as the “Originator”).7 That description, by itself, would encompass a simple loan to the Originator secured by the asset pool. The distinctive feature of securitization is that the transaction also is structured to isolate the asset pool from the Originator in such a way that, if the Originator later becomes subject to an insolvency proceeding, the proceeding will not interrupt the continued receipt by the financiers of the payments due to them, as and when due, through realization on the asset pool. If that goal is achieved, the credit risk to the financiers will depend solely on the assets in the pool, and so will be independent of the creditworthiness of the Originator. For brevity that goal sometimes may be referred to as 6 For example, it is often said that securitization began in the early 1970s with the issuance of mortgage-backed securities guaranteed by the Government National Mortgage Association (“GNMA,” a corporation owned by the federal government and thus functionally a federal agency), followed by the issuance of mortgage-backed securities by two government-sponsored enterprises, the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”). See, e.g., Committee on Bankruptcy and Corporate Reorganization of The Association of the Bar of the City of New York, Structured Financing Techniques, 50 BUS. LAW. 527, 537 (1995) [hereinafter Structured Financing Techniques]. Those securities are backed by the relevant agency or government-sponsored enterprise; moreover, because the backing provided by GNMA is explicitly that of the federal government, and FNMA and FHLMC are generally perceived in the marketplace to have the implicit backing of the federal government, credit enhancement for their obligations is nugatory. Such transactions have next to nothing in common with securitization as defined in this paper, the point of which is credit enhancement: that is, to effect a financing against a pool of assets that, because of the isolation of the assets from the Originator, can have a credit rating better than that of the Originator. 7 This description should be understood to include a transaction involving the issuance to financiers of instruments that, while not formally debt, have the cash flow characteristics of debt (such as a beneficial interest in a trust comprised of the pooled assets, which beneficial interest is structured to require distribution of sums equivalent to principal and interest).



“bankruptcy isolation” of the securitized assets. The term “securitization” is thus a misnomer insofar as it suggests

that the issuance of securities is the heart of the matter. The debt instruments issued to the financiers in a securitization transaction might be securities issued into the capital markets, but they need not be; they might just as well be loan obligations owed to a syndicate of banks, involving no securities at all.

Whether a given transaction structure suffices to achieve bankruptcy isolation of a pool of assets obviously depends upon the law applicable to the Originator in the event of its insolvency. This paper considers only Originators whose insolvency proceeding would be governed by the Bankruptcy Code, and thus does not treat banks, savings associations, insurance companies, or other entities whose insolvencies are governed by other laws. 8 Those excluded entities typically are subject to extensive regulation, and the insolvency laws applicable to those entities reflect policies that differ in principle and practice from the Bankruptcy Code. Likewise, this paper does not address Originators whose insolvency proceeding would be governed by non-U.S. law (although it should be noted that the success of securitization in the United States has been followed by widespread use in other countries).9

Securitization transactions, in the foregoing sense, were first employed in the late 1970s using asset pools comprised of mortgages.10 The first public transaction to securitize rights to payment other than mortgages (referred to as an “asset-backed” transaction, as opposed to a “mortgage-backed” transaction, in the somewhat illogical terminology conventional in the market) occurred in 1985.11 This infant was born under a lucky star, and from its birth it grew prodigiously: the volume of securities outstanding in securitization transactions at the end of 2006 aggregated $3.6 trillion.12 The growth of securitization indeed has been 8 See Bankruptcy Code § 109 (defining the entities that are eligible to become debtors under the Bankruptcy Code). 9 For a discussion of securitization in other countries, see generally VINOD KOTHARI, SECURITIZATION: THE FINANCIAL INSTRUMENT OF THE FUTURE 108-86 (3d ed. 2006). 10 The first such transaction is conventionally considered to have been done in 1977 by the Bank of America. See Structured Financing Techniques, supra note 6, at 537. Of course there is nothing completely new under the sun, and for a discussion placing these transactions in historical context, see Joseph C. Shenker & Anthony J. Colletta, Asset Securitization: Evolution, Current Issues and New Frontiers, 69 TEX. L. REV. 1369, 1370-88 (1991). 11 The first public asset-backed securitization transaction is conventionally considered to be the sale of $192 million of lease-backed notes by Sperry Lease Finance Corporation on March 7, 1985, followed by the sale of $100 million of securities backed by automobile receivables by an affiliate of Valley National Corporation on May 15, 1985, and the sale of $60 million of securities backed by automobile receivables by an affiliate of Marine Midland Bank on the same day. 12 See Bd. of Governors of the Fed. Reserve Sys., Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States, Flows and Outstandings, Fourth Quarter 2006, at 79 tbl. L.126 (Mar. 8, 2007), available at



such as to move one scholar to predict the death of secured lending, as being hopelessly overshadowed by its more sophisticated relative.13

This vast inverted pyramid of securitized debt is balanced uneasily on a pinpoint of legal doctrine: namely, that the structure employed for the purpose of isolating the pooled assets from the bankruptcy of the Originator will indeed achieve that purpose. From the beginning that doctrinal conclusion, or aspiration, was a shaky one. Even without detailed study the wobble is apparent from numerous outward signs. For example, in securitization transactions lawyers typically are asked to deliver opinions on the relevant points (or at least some of the relevant points) of bankruptcy doctrine. The opinion given is never a clean unqualified opinion that the structure works; rather, standard practice is to give a “reasoned” opinion, commonly dozens of pages long, which by its form and in its content signals substantial uncertainty about the result.14 In the run-up to the extensive amendments to the Bankruptcy Code that were enacted in 2005, the securitization industry unsuccessfully sought to include amendments that would have validated securitization.15 The industry has procured the enactment by a number of states of securitization-validating statutes that attempt to make an end run around the Bankruptcy Code.16 Capping this is the remarkable fact that there appears to be only a single case, stemming from the bankruptcy filing of LTV Steel at the end of 2000, in which a challenge to the doctrinal foundations of securitization resulted in a contested adjudication—and in that case the court ruled against the product.17 Even that did not discourage the continued growth of securitization, but it was, at the least, a portent.

The dearth of case law is paralleled by the skimpiness of the academic literature casting a critical eye on the doctrinal foundations of the product. A vast amount has been written about securitization, understandably so because such transactions raise legal, tax, accounting, and other issues that are manifold, specialized, and arcane.18 But with http://www.federalreserve.gov/releases/Z1/20070308/z1.pdf. The figure excludes securities backed by federal agencies and government-sponsored enterprises, described supra note 6. See id. at 78, tbl. L.125. The figure apparently includes transactions by banks and other entities whose insolvency proceedings would not be subject to the Bankruptcy Code, but apparently excludes transactions in which the financiers’ interests are not securities. 13 See Edward J. Janger, The Death of Secured Lending, 25 CARDOZO L. REV. 1759, 1760-62, 1777-78 (2004). 14 See infra Part III.B.2. 15 See discussion infra text accompanying notes 322-324 and part IV. 16 The most prominent example of these statutes is Delaware’s Asset-Backed Securities Facilitation Act, DEL. CODE. ANN. tit. 6, §§ 2701A-2703A (2004). See the discussion infra part II.A. 17 In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio 2001). For further discussion of LTV Steel, see infra parts III.A.3 and IV. 18 Treatises include STEVEN L. SCHWARCZ, STRUCTURED FINANCE (3d ed. 2002 & Supp. 2006), SECURITIZATION OF FINANCIAL ASSETS (Jason H.P. Kravitt ed., 2d ed. 1996 & Supp.



few exceptions the literature is by and for practitioners, to assist in the doing of deals, and as such is naturally oriented toward cheerleading rather than skepticism. Legal academics came late to the party, and critical examination came still later. Little attention seems to have been paid to securitization by legal scholars until the early 1990s, and the first substantial treatment, by Tamar Frankel in 1991, was more descriptive than analytic.19 At about the same time Thomas Plank and Steven Schwarcz, both eloquent advocates for securitization, published the first of their many writings from that perspective.20

Only in the late 1990s did skeptical assessments of securitization begin to appear. Apparently the first was by Lynn LoPucki, who in 1996 wrote to argue that a plethora of effective judgment-proofing strategies, securitization and secured borrowing among them, may result in the death of liability as a practical risk for sophisticated firms willing to employ such strategies.21 However, Professor LoPucki’s focus was on his broad thesis about judgment-proofing; as to the doctrinal foundations of securitization he essentially took for granted the party line as enunciated by the product’s advocates.

Two skeptical assessments of the doctrinal foundations of securitization finally appeared in 1998. The more radical of the two was by David Carlson, who asserted flatly that securitization does not achieve its goal of isolating the securitized assets from the bankruptcy estate of the Originator.22 Professor Carlson made an important point about the received interpretation of the Bankruptcy Code, but as discussed later in this paper, he did not make a persuasive case against securitization.23 At about the same time, Lois Lupica offered a broader but less radical critique.24 She focused primarily on the normative 2005) [hereinafter KRAVITT], and TAMAR FRANKEL, SECURITIZATION (Ann Taylor Schwing ed., 2d ed. 2005). Of the vast body of practitioner-oriented periodical literature, noteworthy are the course handbooks regularly published by the Practicing Law Institute, a recent example of which is NEW DEVELOPMENTS IN SECURITIZATION 2006 (Practicing Law Institute 2006). 19 The first edition of Professor Frankel’s treatise on securitization, see FRANKEL, supra note 18, was published in 1991. 20 Professor Plank’s first major article on securitization, written before he joined the academy, was Thomas E. Plank, The True Sale of Loans and the Role of Recourse, 14 GEO. MASON. U. L. REV. 287 (1991) [hereinafter Plank, True Sale]; his most recent article primarily devoted to the product is The Security of Securitization and the Future of Security, 25 CARDOZO L. REV. 1655 (2004) [hereinafter Plank, Security]. Professor Schwarcz’s first major article on securitization, likewise written before he joined the academy, was Steven L. Schwarcz, Structured Finance: The New Way to Securitize Assets, 11 CARDOZO L. REV. 607 (1990); his most recent article primarily devoted to the product is Securitization Post-Enron, 25 CARDOZO L. REV. 1539 (2004) [hereinafter Schwarcz, Post-Enron]. 21 Lynn M. LoPucki, The Death of Liability, 106 YALE L.J. 1, 23-30 (1996). 22 David Gray Carlson, The Rotten Foundations of Securitization, 39 WM. & MARY L. REV. 1055 (1998). 23 See infra Part II.A. 24 Lois R. Lupica, Asset Securitization: The Unsecured Creditor’s Perspective, 76 TEX. L. REV. 595 (1998).



question of whether securitization is efficient in the economic sense of increasing the aggregate net welfare of all individuals in society, asserting that it probably is not efficient. She based that assertion largely on arguments previously advanced to question the efficiency of secured credit: namely, that it externalizes costs to nonconsenting third parties, mainly those of the debtor’s unsecured creditors who are not in a position to adjust the terms on which they extend credit to the debtor. In addition, she briefly sketched weaknesses in the doctrinal foundations of securitization, suggesting (without reaching any firm conclusions) that such transactions may be susceptible to invalidation in the event of the Originator’s bankruptcy on various grounds. For the most part, her discussion focused on doctrinal risks that the securitization industry was well aware of and had convinced itself were adequately addressed by typical securitization structures.25

After Professor Lupica’s questioning of the doctrinal foundations of securitization few scholars have trodden the same path,26 though some have likewise questioned securitization from a normative perspective,27 and others have raised objections to the product that are incidental rather than fundamental, in that they question neither its purpose of achieving bankruptcy isolation of the securitized assets nor the efficacy of the structures used to achieve that end.28 25 Id. at 636-50. Specifically, most of Professor Lupica’s doctrinal discussion is devoted to the “true sale” and substantive consolidation risks referred to later in this introduction. Professor Lupica elaborated her skepticism of securitization in later articles that focused primarily on the changes made in the 1999 revision of Article 9 to accommodate securitization. See Lois R. Lupica, Revised Article 9, The Proposed Bankruptcy Code Amendments and Securitizing Debtors and their Creditors, 7 FORDHAM J. CORP. & FIN. L. 321 (2002); Lois R. Lupica, Revised Article 9, Securitization Transactions and the Bankruptcy Dynamic, 9 AM. BANKR. INST. L. REV. 287 (2001); Lois R. Lupica, Circumvention of the Bankruptcy Process: The Statutory Institutionalization of Securitization, 33 CONN. L. REV. 199 (2000). 26 The only later substantial treatment of doctrinal threats to securitization from a skeptical perspective appears to be Kenneth N. Klee & Brendt C. Butler, Asset-Backed Securitization, Special Purpose Vehicles and Other Securitization Issues, 35 UCC L.J. 23 (2002). 27 See Edward J. Janger, Muddy Rules for Securitizations, 7 FORDHAM J. CORP. & FIN. L. 301 (2002) (arguing, in the same vein as Professor Lupica, that securitization is inefficient because it externalizes risk to unsecured creditors); Christopher W. Frost, Asset Securitization and Corporate Risk Allocation, 72 TUL. L. REV. 101 (1997) (concluding that the evidence as to the efficiency of securitization is insufficient); cf. Claire A. Hill, Securitization: A Low-Cost Sweetener for Lemons, 74 WASH. U. L.Q. 1061 (1996) (arguing that the efficiency benefits of securitization are slight for firms with many financing options but largest for firms with the fewest). 28 One such strand of criticism contends that securitization facilitates “predatory” lending by firms that securitize the resulting loans. Among the earliest expositions of this thesis was Kurt Eggert, Held Up in Due Course: Predatory Lending, Securitization, and the Holder in Due Course Doctrine, 35 CREIGHTON L. REV. 503 (2002). See Kathleen C. Engel & Patricia A. McCoy, Turning a Blind Eye: Wall Street Finance of Predatory Lending, 75 FORDHAM L. REV. 2039 (2007); Christopher L. Peterson, Predatory Structured Finance, 28 CARDOZO L. REV. 2185 (2007); David Reiss, Subprime Standardization: How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market, 33 FLA. ST. U. L. REV. 985 (2006). Another strand of criticism contends that securitization encourages misleading disclosure by Originators,



The upshot is that, despite the enormous volume of outstanding securitization transactions and persistent disquiet about the doctrinal foundations of the product, there has been remarkably little scholarly attention, from a skeptical perspective, to the question of whether a securitization transaction actually achieves its purpose.

One of the two purposes of this paper is to give that question the attention it deserves. Specifically, this paper articulates a basis for skepticism about the doctrinal foundations of securitization that is more persuasive than the risks that the securitization industry has chosen to emphasize. The other and larger purpose of this paper is, as previously noted, to follow Heraclitus and consider the lessons that securitization teaches about the process of innovation in financial and commercial products. Specifically, how did a product with such shaky doctrinal foundations grow so vast, and what does that show about our legal system’s reception of new products?

Part I sets the stage. It outlines the securitization structure that is prototypical of the genre, which will be the reference point for later discussion. It also makes a point that is obvious from the structure, but that advocates of securitization are apt to deny or minimize: namely, that a transaction so structured is economically identical to a nonrecourse loan by the Originator secured by the same assets that are used to support the financing under the securitization structure. The prototypical securitization structure has no purpose, and no significant effect, other than to circumvent the burdens that the Bankruptcy Code places on the lender of a simple secured loan to an Originator who has gone bankrupt. A useful metaphorical shorthand for those burdens is the “Bankruptcy Tax” that the Bankruptcy Code can be thought of as imposing on secured lenders for the benefit of the debtor’s bankruptcy estate. The evasion of the Bankruptcy Tax through securitization can be characterized quite naturally as contrary to the policy of the Bankruptcy Code. Established doctrine would not allow such evasion to be effected directly, by a prepetition agreement between Originator and lender in which the Originator explicitly waives the Bankruptcy Tax; securitization merely seeks to achieve that forbidden result indirectly.

Part II examines selected doctrinal weaknesses of the prototypical securitization transaction. For no clear reason, analysis heretofore has centered on the so-called “true sale” issue—that is, whether the transfer of the securitized assets by the Originator to its special purpose

noting that the accounting machinations perpetrated by Enron Corporation before its bankruptcy in 2001 were based on its use of securitization-like structures. See Robert B. Thompson, Corporate Governance After Enron, 40 HOUS. L. REV. 99, 114-15 (2003). For ripostes to the latter criticism, see Steven L. Schwarcz, Enron and the Use and Abuse of Special Purpose Entities in Corporate Structures, 70 U. CIN. L. REV. 1309, 1314-18 (2002); Plank, Security, supra note 20, at 1657.



subsidiary (referred to herein as the “SPE”), which is a necessary element of the prototypical securitization, achieves the goal of removing those assets from the Originator’s future bankruptcy estate. A simpler and more logical approach open to a court would be to vindicate the above-described bankruptcy policy directly, by holding that the foregoing asset transfer, which is made with no significant purpose or effect other than to thwart that policy, is avoidable as a fraudulent transfer, under the primordial rule that renders avoidable any transfer made by a debtor with intent to “hinder, delay, or defraud” its creditors. The asset transfer from Originator to SPE is not a “fraud” in any ordinary sense, but fraudulent transfer law also applies to transfers that “hinder” or “delay” creditors even if not fraudulent, and courts historically have employed that rule to police behavior they view as undesirable. This use of fraudulent transfer law has become less familiar today than it was in former decades, but it is by no means in abeyance, and it is probably necessary for a system as complex as debtor-creditor law to include some such purposive override to its formal rules. Part II.B is devoted to exploring this important but somewhat neglected pocket of doctrine, both in the abstract and as applied to securitization. The discussion shows that a court so inclined could readily employ that doctrine, consistently with established usage, to defeat the prototypical securitization transaction. Part II.C concludes by showing that a bankruptcy court so inclined could, in the alternative, readily defeat the prototypical securitization structure by ordering the substantive consolidation of the Originator and the SPE, consistently with the doctrinal basis of substantive consolidation, in order to vindicate the aforementioned bankruptcy policy.

Part III turns to the Heraclitian task of considering what we can learn from the triumph of securitization in the marketplace despite its shaky doctrinal foundation. The discussion is in two parts. Part III.A asserts that the doctrinal shakiness of securitization is now irrelevant, because the product has grown too big to fail, in the sense that a judicial ruling against the product would have such drastic adverse consequences for holders of the vast quantity of outstanding securitized debt that a court aware of the stakes is very unlikely to so rule; and should that unlikely event occur, Congress would bail out the product. The discussion explores the “too big to fail” dynamic as it has applied to other financial and commercial products, including particularly repo transactions and standby letters of credit. “Too big to fail” has not been an infallible talisman of success before the courts, but it has been quite potent.

The discussion also addresses the force of the “too big to fail” dynamic on federal financial regulators, who are likely to be important players before the courts in the event of a serious challenge to an



established product, and who will certainly be important players in any proposed legislative bail-out of the product. Even though most federal financial regulators cannot plausibly be portrayed as being captured by the financial services industry they regulate, in the case of a legal threat to a product that has become “too big to fail” the institutional mandates of those regulators will tend to induce them to behave much as though they had been so captured, for they will be inclined to intervene in support of the product in order to preserve the stability of the markets they regulate.

Part III.B addresses the role of the rating agencies in securitization. The reason why Originators obtain financing by doing a securitization transaction, instead of simple secured borrowing, is because the debt issued in a securitization will be rated solely on the basis of the quality and quantity of asset pool that backs it. As a result, securitized debt typically will be rated higher than the Originator’s own rating, which means that investors will demand a lower yield on the securitized debt than they would for debt issued by the Originator. The rating agencies’ willingness to rate securitized debt on the assumption that the securitization structure achieves its purpose of isolating the securitized assets from the future bankruptcy estate of the Originator is what drives securitization. It is that which has allowed the product to grow too big to fail, and so rendered moot the product’s dubious doctrinal foundations. Insofar as the product has now grown too big to fail, therefore, the rating agencies have in fact made the law in this area.

The rating agencies have a financial incentive to be relatively aggressive in their judgments about uncertain legal issues on which a widely-usable financial product depends. That aggressiveness is evident as to securitization, for the ratings issued in securitization transactions reflect a higher confidence about favorable resolution of the legal issues than is warranted by the legal opinions customarily delivered to the rating agencies in such transactions. The principal constraints on aggressive ratings—risk of liability and desire to preserve reputational capital—are weak as applied to judgments about uncertain legal issues on which a widely-usable financial product depends. The light touch of regulation imposed by Congress on the rating agencies in 2006 does not directly alter the rating agencies’ incentive to “round up” legal uncertainties that underpin a widely-usable product. Part III.B concludes with a discussion of two emerging products—electronic commercial paper and products that exploit the privileged status in bankruptcy of financial market contracts—as to which a process similar to that which occurred as to securitization might result in the rating agencies effectively resolving legal uncertainties that underlie these products.

Part IV offers a normative assessment of securitization. It argues



that there are good pragmatic reasons to amend the Bankruptcy Code to provide directly the bankruptcy-isolating result that the securitization structure aims at providing indirectly. Such an amendment would not be a giveaway to Wall Street because, among other reasons, it would be an opportunity to define and limit the kinds of assets that could be rendered subject to such bankruptcy isolation. The legal doctrines that have been advanced to justify securitization apply to assets of any kind, a result that is inconsistent with the premises of bankruptcy policy as they stand today.

I. THE PROTOTYPICAL SECURITIZATION, THE BANKRUPTCY TAX, AND

BANKRUPTCY POLICY Structures for securitization transactions, or at least for transactions

that are advertised as securitizations, are many and varied. This paper focuses on the structure that is commonly viewed as being prototypical, and that indeed is used as the exemplar in the major law school textbook dedicated to teaching securitization.29 The doctrinal discussion in this paper is at a sufficiently high level of generality to be applicable to other securitization structures. Some of the terminology associated with the prototypical securitization was introduced earlier in this paper, but it is well to describe the transaction here even at the cost of some repetition.

In its simplest form, the prototypical securitization begins with the firm that wishes to procure financing against assets that it owns, which are typically rights to payment owed to it. Because that firm ordinarily (though not necessarily) will have originated those rights to payment by lending money to or providing property or services to the obligors, it is convenient to refer to that firm as the “Originator.” The Originator forms a wholly-owned subsidiary conventionally referred to as a “special purpose entity,” or “SPE,” because it is formed for the purpose of the transaction and its operations are limited to those required in connection with the transaction. This SPE is (in further industry argot) “bankruptcy remote,” in that it is created subject to an array of

29 The textbook referred to, STEVEN L. SCHWARCZ ET AL., SECURITIZATION, STRUCTURED FINANCE AND CAPITAL MARKETS (2004), dedicates over 460 pages to reproducing the prospectus and operative documents for a transaction by the Honda Auto Receivables 2003-1 Owner Trust, which employed the prototypical structure. For other outlines of the prototypical structure, see, e.g., Plank, Security, supra note 20, at 1660-66; Petrina R. Dawson, Ratings Games with Contingent Transfer: A Structured Finance Illusion, 8 DUKE J. COMP. & INT. L. 381, 382-89 (1998) (author was Managing Director and Associate General Counsel of Standard & Poor’s); Structured Financing Techniques, supra note 6, at 567-75; Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 STAN. J. L. BUS. & FIN. 133, 135-45 (1994); SCHWARCZ, supra note 18, §§ 3.3.2, 7.4; KRAVITT, supra note 18, § 4.04.



constraints designed to eliminate, to the extent possible, the risk that the SPE might in the future become subject to a proceeding under the Bankruptcy Code, whether involuntarily, voluntarily, or through the SPE being substantively consolidated with its Originator in the event of the Originator’s bankruptcy. Thus, involuntary bankruptcy is countered by provisions in the SPE’s organic documents authorizing it to engage only in activities necessary to the securitization transaction and by obtaining waivers of the right to file an involuntary petition against the SPE from third parties who deal with the SPE. Voluntary bankruptcy is countered by provisions in the SPE’s organic documents requiring a unanimous vote of the SPE’s board of directors to authorize the filing of a voluntary bankruptcy petition and requiring one or more members of the SPE’s board to be independent of the Originator. Substantive consolidation with the Originator is countered by covenants requiring the Originator and SPE to avoid acting in ways that would permit the invocation of any of the usual grounds for substantive consolidation, i.e., the SPE is to comply with proper corporate formalities, its assets are not to be commingled with those of the Originator, and so on.

After the SPE is formed, the Originator conveys the assets being securitized to the SPE. This conveyance, which is the key to the bankruptcy isolation that is sought for the securitized assets, is effected as a sale or a capital contribution. In the simplest structure, which might be referred to as “one tier,” the securitization would then be completed by the SPE issuing debt instruments to financiers, secured by the securitized assets, and immediately passing the proceeds of the financing upstream to the Originator (by way of payment of the purchase price of the securitized assets or distribution on the SPE’s equity, depending on how the conveyance of assets from the Originator to the SPE was effected). For accounting reasons, however, it is common to employ a slightly more elaborate structure referred to conventionally as “two tier.” In the “two tier” structure, the SPE transfers the securitized assets to a second entity, typically a trust formed for the transaction (“SPE-2”), which issues the debt instruments to the financiers and passes the proceeds back to the SPE; the SPE is the residual beneficiary of SPE-2 and so is entitled to the residual value of the securitized assets after the financiers have been paid. In order to comply with the relevant accounting conventions the transfer of the assets from the SPE to SPE-2 need not be a sale for bankruptcy law purposes and it typically is not considered to be. Hence for purposes of bankruptcy analysis the “one tier” and “two tier” structures are practically identical, and for simplicity of exposition this paper will ignore SPE-2.

If the structure is respected, then the stream of payments to the financiers derived from collection of the securitized assets should not be



affected by the subsequent bankruptcy of the Originator. Because the securitized assets are the property of the SPE, they will not be part of the Originator’s bankruptcy estate. Moreover, the SPE should be practically immune from becoming the subject of a bankruptcy proceeding in its own right because of the bankruptcy remoteness conditions to which it is subject. The achievement of this “bankruptcy isolation” of the securitized assets is the purpose of the structure. The credit risk associated with the securitized debt issued to the financiers thus becomes independent of the creditworthiness of the Originator. The credit risk associated with the securitized debt is a function only of the amount and collectibility of the securitized assets and the amount of securitized debt issued against those assets.30 The credit risk associated with the securitized debt when it is issued could be reduced as low as desired by providing a sufficiently high degree of overcollateralization.

That result is very much in contrast to the result if the Originator were to effect the financing as a simple secured debt—that is, if the Originator simply borrowed directly from the financiers, securing its obligation by granting a security interest in the same assets. In that event the assets, still owned by the Originator, would be part of the Originator’s bankruptcy estate in the event of the filing of a petition under the Bankruptcy Code by or against the Originator. The Bankruptcy Code then would impair substantially the financiers’ power to enforce their security interest in those assets—or, to make the same point from the perspective of the Originator and its unsecured creditors, the Bankruptcy Code would preserve for the benefit of the bankruptcy estate certain rights in those assets notwithstanding the financiers’ security interest. In the first place, the automatic stay would prevent the financiers from exercising remedies against those assets.31 As a result of the automatic stay, a secured creditor in a reorganization case is typically compelled to wait a long time before realizing value on its secured claim. Although a secured creditor has the right to have the stay lifted if its interest is not adequately protected, adequate protection has not been construed to require the secured creditor to be paid interest

30 That bankruptcy isolation of the securitized assets causes the credit risk of the securitized debt to be independent of the creditworthiness of the Originator is a good first approximation, but it is subject to qualifications. For example, the transfer of the securitized assets by the Originator to the SPE is typically subject to representations and warranties by the Originator about the identity and nature of those assets, breach of which would implicate the creditworthiness of the Originator. Likewise, the Originator commonly acts as the servicer of the securitized assets (i.e., it administers and collects them), and its creditworthiness would be implicated if it were to reject its duties as servicer in a bankruptcy proceeding, commingle collections of the securitized assets with other funds, or otherwise breach its duties as servicer. Steps can be taken to mitigate these risks, such as building into the financing structure a servicing fee sufficient to discourage the Originator from rejecting its servicing duties in bankruptcy and to permit ready engagement of a substitute servicer. 31 Bankruptcy Code § 362(a).



by way of compensation for the delay in realization that the stay itself forces on the secured creditor.32 Other provisions of the Bankruptcy Code may entitle the secured creditor to postpetition interest to the extent he is overcollateralized, but a secured creditor who is undercollateralized, or who is not sufficiently overcollateralized to be entitled to postpetition interest for the duration of the bankruptcy proceeding, must suffer the delay in realization imposed by the stay without any compensation.33

A second impairment imposed by the Bankruptcy Code on a financing structured as a secured loan to the Originator is that the bankruptcy estate would have the right to use the cash collections received on the collateral, so long as the secured creditor’s interest is adequately protected. 34 From the perspective of the debtor in possession, this is perhaps the most consequential of the rights it is granted by the Bankruptcy Code, for the bankruptcy estate typically is thirsty for cash and collections of such collateral can be used to slake that thirst, subject only to the constraint of providing the secured creditor adequate protection—which might be done by grant of a replacement lien on some illiquid substitute asset, or even by doing nothing at all, if there is a sufficient equity cushion in the collateral. Not surprisingly, in LTV Steel,35 the one reported case in which a debtor in possession challenged a prepetition securitization to which it was party with a view to recharacterizing the securitization as a secured loan, the debtor-in-possession’s motive for doing so was to use the cash collections from the securitized assets in this way.

The Bankruptcy Code gives the bankruptcy estate numerous other rights in collateral that impair the nonbankruptcy rights of the secured creditor, but the two mentioned above are the most likely to be of importance to the bankruptcy estate in the case of assets of the type normally subjected to securitization.36 Borrowing from David Carlson, it is convenient to use the term “Bankruptcy Tax” to refer collectively to the rights that the Bankruptcy Code awards to the bankruptcy estate in 32 Bankruptcy Code § 362(d)(1); United Sav. Ass’n v. Timbers of Inwood Forest Assocs., 484 U.S. 365 (1988). 33 Bankruptcy Code § 506(b). Even an adequately overcollateralized secured party may suffer a loss from the bankruptcy, as there is no requirement that the postpetition interest accruing to such a secured party be paid currently. 34 Bankruptcy Code §§ 363(c)(2), 363(e). 35 In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio 2001). For further discussion of LTV Steel, see infra Parts III.A.3 and IV. 36 For other rights the bankruptcy estate may assert in collateral to the detriment of the secured creditor, see, e.g., Bankruptcy Code § 364(d) (allowing the bankruptcy estate to use collateral to secure postpetition financing, with priority over the prepetition security interest, if the prepetition secured creditor’s interest is adequately protected); id. § 542 (entitling the bankruptcy estate to possession of collateral); id. §§ 1123(a), 1123(b), 1129(b)(2) (permitting the plan of reorganization to restructure secured debt by changing financial terms and collateral, which plan may in certain circumstances be confirmed over the objection of the secured creditor).



collateral owned by the debtor that is subject to a security interest—or, if one prefers the view from the secured creditor’s perspective, the collective set of impairments that the Bankruptcy Code imposes on the rights that the secured creditor has in the collateral under nonbankruptcy law. 37 “Bankruptcy Tax” is useful both as a shorthand and as a metaphor that expresses an important truth: these impairments amount to a tax that the Bankruptcy Code levies on secured credit for the benefit of the bankruptcy estate as a whole. In a business bankruptcy, the main point of this Bankruptcy Tax is to improve the chances that a debtor that seeks to reorganize will be able to do so. The ultimate beneficiaries of the Bankruptcy Tax, therefore, are the unsecured creditors and other constituencies of the Originator that would benefit from a successful reorganization. Securitization thus can be viewed as a method of evading the Bankruptcy Tax.

The relief from the Bankruptcy Tax that securitization is designed to afford is securitization’s reason for being. Because of this relief, securitized debt is rated by the credit rating agencies on the basis of the likelihood that the securitized assets will be sufficiently collectible to make the payments due under the securitized debt. The rating given to the securitized debt thus is independent of the credit rating of the Originator (that is, the rating that would be given to the Originator’s ordinary unsecured debt). The securitized debt thus can achieve ratings much higher than the Originator’s own credit rating. By contrast, simple secured debt issued by the Originator, even if so heavily overcollateralized that the secured creditor will eventually be paid in full, with interest, after a bankruptcy filing by the Originator, will not be rated much higher than the Originator’s own credit rating. The reason is that a rating agency’s rating of a debt instrument is predominantly a prediction of the likelihood that the debt will be paid in accordance with its terms. Ratings do give some weight to the amount of the recovery that the debtholder is likely to receive if the debt goes into default, but that weight is relatively modest. Payments on an Originator’s secured debt will be interrupted by the Originator’s bankruptcy filing, so no matter how well overcollateralized the debt may be, its rating will be based on the Originator’s own rating, with only a modest bump upward, at best, to reflect the increased probability of an eventual good recovery on the secured debt as compared to unsecured debt.38 Neil Baron, the 37 The term “Bankruptcy Tax” and the notion that securitization can be viewed as a species of tax avoidance was set forth in Carlson, supra note 22, at 1064-65. Strictly speaking, Professor Carlson defined the term more narrowly to refer only to the bankruptcy estate’s right to uncompensated use of collateral of an undersecured or insufficiently oversecured creditor. 38 The two predominant rating agencies publish definitions of the traditional letter ratings they award. The definition of each rating grade implies that the rating reflects only the probability of default, but each agency notes elsewhere in the definitions that the likely recovery after default is also a factor. See Standard & Poor’s, Standard & Poor’s Ratings Definitions



principal legal advisor to one of the two predominant rating agencies during the early days of securitization, stated the point as follows:

A rating is a statement that payment will be made in accordance with the terms of an obligation. That means on time. A payment default on a triple-A rated bond is front page news. The fact that investors get paid fully at some later time makes page 11. Timeliness is an element rating agencies are obsessive about.39 Substantially all of the benefits claimed for securitization are

nothing more than consequences of the structure’s purported avoidance of the Bankruptcy Tax, and the resulting willingness of the rating agencies to rate securitized debt on the assumption that payments thereon from collections of the securitized assets will not be interrupted by the bankruptcy of the Originator.40 The primary benefit claimed for securitization is that an Originator can use its securitizable assets to obtain financing at a substantially lower interest rate than the Originator would have to pay on non-securitized debt. That is simply the result of the fact that, because of the bankruptcy avoidance to which securitized (Sept. 21, 2007), available at http://standardandpoors.com (“Issue ratings are an assessment of default risk, but may incorporate an assessment of relative seniority or ultimate recovery in the event of default.”); Moody’s Investors Service, Moody’s Rating Symbols & Definitions, at 8-12 (Mar. 2007), available at http://www.moodys.com. Although both agencies are primarily concerned with the likelihood of default, Moody’s has been said to give more weight than does Standard & Poor’s to the likelihood of a good recovery in the event of default. See Richard Cantor & Frank Packer, The Credit Rating Industry, FED. RES. BANK OF N.Y. Q. REV., Summer-Fall 1994, at 1, 13. On the limited extent to which the prospect of eventual good recovery on defaulted secured debt may improve a debt rating over the issuer’s rating, see also STANDARD & POOR’S, CORPORATE RATINGS CRITERIA 2006, at 45-73 (2006) [hereinafter S&P CORPORATE CRITERIA], available at http://standardandpoors.com. But cf. Standard & Poor’s, RatingsDirect: The Fundamentals of Structured Finance Ratings, at 9 (Aug. 23, 2007), available at http://standardandpoors.com [hereinafter S&P Fundamentals] (asserting flatly that “[o]ur rating speaks to the likelihood of default, but not the amount that may be recovered in a post-default scenario”). Both agencies have in recent years supplemented their traditional letter ratings with further information about some rated debt that effectively disaggregates the traditional rating into separate components reflecting probability of default and prospect of good recovery after default, Standard & Poor’s through “recovery ratings” and Moody’s through separate ratings of “probability of default” and “loss given default.” 39 Neil D. Baron, The Role of Rating Agencies in the Securitization Process, in A PRIMER ON SECURITIZATION 81, 88 (Leon T. Kendall & Michael J. Fishman eds., 1996). Mr. Baron was Standard & Poor’s principal legal advisor on securitization from the inception of the product until the late 1980s; he was General Counsel of Fitch Investors Service, the third largest rating agency, when he wrote the quoted passage. For a similar statement early in the history of securitization, see, e.g., Neil D. Baron, Innovations in Thrift Institution Surety-Type Mortgage-Backed Securities, in STRUCTURED MORTGAGE AND RECEIVABLE FINANCING 65, 68-69 (Practicing Law Institute 1985) (“[I]f a BBB-rated industrial corporation issued $1 million of debt secured by U.S. Government securities with a market value of $2 million, at first glance one might think that the debt could be rated AAA based on the collateral. However, in reality, it is unlikely that the collateral would improve the rating much beyond BBB+, because if a petition were filed with respect to the issuer under the [Bankruptcy] Code, the ability to liquidate the collateral could be impaired by a variety of Code sections.”). 40 For the benefits claimed for securitization, see, e.g., Plank, Security, supra note 20, at 1667-69; Schwarcz, Post-Enron, supra note 20, at 1547, 1560.



debt is purportedly entitled, securitized debt will receive a better rating than would debt incurred directly by the Originator secured by the same assets, and so financiers are content with a lower yield on the former than they would require on the latter.41

Similarly, the product has been extolled on the ground that it promotes disintermediation—that is, it enables an Originator to issue debt securities and tap the capital markets directly, saving itself the middleman’s fees that it would incur if it obtained financing by borrowing from a bank or other financial intermediary. That is at best a half truth. First, if the securitization structure works to avoid the Bankruptcy Tax when the debt issued by the SPE is in the form of securities, it works equally well when the debt issued by the SPE is an obligation to repay a bank loan, and financing provided by banks and other traditional financial intermediaries today often is extended through securitization structures when the Originator is of sufficient size to bear the transaction costs.42 More fundamentally, disintermediation was by no means impossible before securitization structures came into use. An Originator owning assets that today it would securitize might instead issue into the capital markets its own debt securities, directly secured by those same assets. That is no more than a simple variation on a mortgage bond, familiar for more than a century and a half. Securitization structures did not make disintermediation possible; they merely made it more attractive to Originators, as a result of the rating benefit the structures afford. Disintermediation is not a separate benefit that securitization structures bestow upon Originators, but only another consequence of the avoidance of the Bankruptcy Tax.

The financing obtained by an Originator through the use of the prototypical securitization structure is economically equivalent to a nonrecourse loan by the financiers to the Originator that is secured by the assets used to support the financing. The only difference is that the securitization structure purports to be immune from the Bankruptcy Tax while the secured loan does not. In both transactions the Originator retains the residual value of the assets used to support the financing—that is, the value of the assets above what is necessary to pay the financiers their bargained-for return. In the case of the secured loan the Originator retains that residual value by its ownership of the assets. In the case of the prototypical securitization the Originator retains that 41 Even some bankruptcy scholars have misunderstood this point. See, e.g., Karen Gross, A Response to J. J. White’s Death and Resurrection of Secured Credit: Finding Some Trees but Missing the Forest, 12 AM. BANKR. INST. L. REV. 203, 210 (2004) (“Securitizations were not specifically created (as I understand the industry) to deal with bankruptcy or to permit secured lenders to circumvent the Code.”). 42 Indeed, the single case to date in which a challenge to the doctrinal foundations of securitization resulted in a contested adjudication involved bank loans extended though a securitization structure. In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio 2001).



residual value by its ownership of the equity of the SPE that holds the assets.43 In either transaction, as a result of the Originator’s retaining the residual value of the assets, the risk of underperformance of the assets is borne by the Originator to the extent of that residual value. If, as is usual in a securitization transaction, the securitized debt is highly rated by a rating agency, that constitutes an evaluation by experts that it is extremely unlikely that the assets will underperform so far as to result in the financiers not receiving their bargained-for payment stream. In that event, all practical risk of the performance of the assets remains with the Originator and none is shifted to the financiers. Restated from a different perspective: not only is the prototypical securitization economically equivalent to a nonrecourse secured loan to the Originator, but in the usual case in which the securitized debt is highly rated, the financiers bear only a remote risk that the cash flow from the securitized assets will be insufficient to make the bargained-for payments to the financiers.44

The economic equivalence of the prototypical securitization to a nonrecourse secured loan to the Originator is evident from comparison of the two structures, but the legal treatment that securitization seeks to achieve is dependent upon the securitization not being treated like a secured loan to the Originator by the Originator’s future bankruptcy court. Hence securitization’s advocates are apt to minimize or even deny the economic equivalence of the two transactions.45 For example, one scholar has asserted that the restrictive covenants in unsecured loan agreements “almost always” include a negative pledge covenant that restricts the debtor’s ability to incur secured debt, but “rarely” restricts

43 In some versions of the prototypical structure, the Originator also owns a debt obligation owed by the SPE, representing an unpaid portion of the price of the securitized assets sold by the Originator to the SPE, which obligation is subordinated to the financiers’ claims against the SPE. In such a case the Originator holds the residual value of the securitized assets through its ownership of both the equity in the SPE and that debt obligation. The employment of such a debt obligation makes no fundamental difference to analysis, so for simplicity of exposition the discussion herein assumes that the structure does not employ such a debt obligation. 44 The turbulence in the market for securities backed by subprime mortgages in 2007, which resulted in extensive downgrades of such securities by the rating agencies, stands as a caution about the limits of the rating agencies’ ability to judge accurately the probability of a shortfall between the cash flow from a given pool of securitized assets and the payment stream bargained for by the financiers who hold the resulting securities. See infra note 406 and accompanying text. To the extent the rating agencies are fallible in making such judgments, financiers who buy even highly rated securitized debt are subject to credit risk, but that is the same credit risk that is borne by holders of any nonrecourse debt. 45 See, e.g., Plank, Security, supra note 20, at 1685 (arguing that securitization is economically distinguishable from secured debt incurred by the Originator, on the ground that the Originator is liable for the deficiency if the assets that support the financing seriously underperform in the latter transaction but not the former; Plank acknowledges in a footnote, however, that this is not so if the secured debt is nonrecourse, and he also overlooks the fact that, in any case, serious underperformance of the assets is a negligible risk if the securitized debt is highly rated).



the debtor’s ability to enter into securitization transactions. 46 This assertion rests on slender anecdotal evidence, but even if true would merely reflect unsecured lenders’ priorities in negotiating covenants. Credit analysts are not fooled. When credit analysts at rating agencies analyze the creditworthiness of an Originator that has previously done one or more securitization transactions, they treat those securitization transactions just like secured debt, adding the securitized assets and securitized debt back to the Originator’s balance sheet if (as is almost invariably the case) the securitization does not transfer to the financiers any meaningful risk of performance of the securitized assets.47 As stated by Moody’s, one of the two predominant rating agencies:

Due to certain accounting rules established by FASB, a securitization may be considered off-balance-sheet under certain circumstances. However, most companies retain the subordinated interest in the transaction known as the equity tranche or “first-loss” piece, which is where all the risks associated with this asset pool resides. Consequently, should the asset not generate the expected amount of cash because losses have exceeded expectations, the holder of the “first-loss” position would be paid last. . . . [I]f a company retains most of the economic risk associated with its securitizations by retaining the “first-loss” piece, various financial ratios including leverage and cash flows are adjusted to account for securitization debt as the equivalent of on-balance-sheet secured borrowings.48

Credit analysts at the other predominant rating agency, Standard & Poor’s, are equally unblinkered.49

46 Schwarcz, Post-Enron, supra note 20, at 1563. The assertion rests on the personal experiences of two practitioners. Id. at 1564 n.129. A fuller survey apparently remains to be done. 47 The two predominant rating agencies agree that securitization transactions in which meaningful risk of performance of the securitized assets is shifted from Originator to financiers are rare. See, e.g., Moody’s Investors Service, Special Comment: Demystifying Securitization for Unsecured Investors , at 6 n.15 (Jan. 2003) [hereinafter Moody’s, Demystifying Securitization], available at http://www.moodys.com (“There are few examples of securitization having been used successfully for both funding and risk transference purposes.”); Moody’s Investors Service, Special Comment: Securitization and its Effect on the Credit Strength of Companies: Moody’s Perspective 1987-2002, at 2 (Mar. 2002) [hereinafter Moody’s, Credit Strength], available at http://www.moodys.com (“Moody’s has not seen many instances of this.”); S&P CORPORATE CRITERIA, supra note 38, at 120 (it is “much more common” for the Originator to retain the bulk of risks related to the assets). 48 Moody’s, Credit Strength, supra note 47, at 2; see also, e.g., Moody’s, Demystifying Securitization, supra note 47, at 7 (footnote omitted) (“If a securitization fails to transfer meaningful risk, the securitized assets and debt are added back to the originator’s balance sheet and several financial and cash flow ratios are adjusted accordingly. In effect, Moody’s views the securitization as the equivalent of an on-balance-sheet secured financing.”). 49 See, e.g., S&P CORPORATE CRITERIA, supra note 38, at 120 (“To the extent that the securitization accomplishes true risk transference, the transaction is interpreted as resembling an asset sale, whereas in the much more common case where the issuer retains the bulk of risks related to the asset, the transaction is akin to a secured financing.”); id. at 121 (“For transactions in which a company retains the preponderance of risks . . . , we calculate [financial] ratios where



The irony of the situation hardly requires emphasis. When analyzing the creditworthiness of an Originator, credit analysts at the predominant rating agencies steadfastly recognize that the Originator’s securitized debt is economically equivalent to secured debt incurred by the Originator. Yet their colleagues at the same rating agencies who rate the securitized debt itself do so on the blithe assumption that it is quite different from secured debt incurred by the Originator.

As alluded to in the preceding discussion, accounting conventions have awarded to broad classes of securitization transactions the prize, much coveted by Originators, of off-balance-sheet treatment. That is, instead of being accounted for as if it were a secured loan (in which case, among other things, both the securitized assets and securitized debt would be shown on the Originator’s consolidated balance sheet), the transaction is generally accounted for as if it were a sale of the securitized assets (and hence neither the securitized debt nor the securitized assets appear on the Originator’s consolidated balance sheet). This is one attraction of securitization to Originators that, at least in principle, need not necessarily be a direct consequence of the avoidance of the Bankruptcy Tax. The accounting rules applicable to securitization have been revised repeatedly. Before 1996, avoidance of the Bankruptcy Tax was irrelevant to the accounting treatment of the transaction, but since then accounting rules have generally made avoidance of the Bankruptcy Tax a condition of off-balance-sheet treatment.50

One might question the wisdom of accounting rules that permit off-balance-sheet treatment of such transactions when, as just noted,

the outstanding amount of securitized assets are consolidated, along with the related securitized debt—regardless of the accounting treatment.”); Standard & Poor’s, Corporate Criteria—Parent/Subsidiary Links; General Principles; Subsidiaries/Joint Ventures/Nonrecourse Projects; Finance Subsidiaries; Rating Link to Parent (Oct. 28, 2004), available at http://standardandpoors.com (“If a company retains the subordinated piece of a securitization . . . essentially all of the economic risk remains with the seller. . . . [T]here is no point in analyzing such a company differently from the way it would be analyzed had it kept the receivables on its balance sheet.”). 50 Current rules on accounting for securitization transactions are primarily contained in FIN. ACCOUNTING STANDARDS BD., STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 140: ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES (2000), which is proposed to be revised in FIN. ACCOUNTING STANDARD BD., EXPOSURE DRAFT (REVISED)—PROPOSED STATEMENT OF FINANCIAL ACCOUNTING STANDARDS: ACCOUNTING FOR TRANSFERS OF FINANCIAL ASSETS, AN AMENDMENT OF FASB STATEMENT NO. 140 (2005). SFAS No. 140 replaced a release issued only four years previously, FIN. ACCOUNTING STANDARDS BD., STATEMENT OF FINANCIAL ACCOUNT STANDARDS NO. 125: ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES (1996). SFAS 125 introduced the concept of requiring bankruptcy isolation of the securitized assets as a condition of off-balance sheet treatment. Before then accounting treatment nominally rested on murky and inconsistent pronouncements pertaining to sale and to consolidation, of which the most important are summarized in Appendix B to SFAS 125. Each of the foregoing publications is available at http://www.fasb.org.



credit analysts treat them as if they were secured loans and promptly add the relevant assets and liabilities back to the balance sheet. The staff of the Securities and Exchange Commission has expressed marked skepticism about these accounting rules for that reason.51 Moreover, some Originators, desiring to bring their financial reporting in line with economic reality, are choosing to bring their securitizations back onto their balance sheets and accounting for them as secured debt. 52 Whatever the attraction to other Originators of the beautification of their financial statements made possible by these accounting conventions, it cannot plausibly be claimed as a social benefit.

Naturally a securitization structure that varies from the prototypical would call for further analysis, but that does not affect the points just made. For instance, one scholar has suggested that the economic equivalence of securitization to a nonrecourse secured loan is undercut if the SPE to which the Originator conveys the securitized assets is not a subsidiary of the Originator but rather is a subsidiary of some other entity (“X”).53 That is by no means the case. As previously noted, the equity of the SPE in the prototypical structure represents the residual value of the assets that support the financing. A structure in which the equity of the SPE is owned by X, therefore, is simply the economic equivalent of a nonrecourse loan to the Originator secured by those assets, coupled with a conveyance of those assets to X subject to the security interest.54 Of course that residual interest will have significant

51 OFFICE OF THE CHIEF ACCOUNTANT ET AL., U.S. SEC. & EXCH. COMM’N, REPORT AND RECOMMENDATIONS PURSUANT TO SECTION 401(C) OF THE SARBANES-OXLEY ACT OF 2002 ON ARRANGEMENTS WITH OFF-BALANCE SHEET IMPLICATIONS, SPECIAL PURPOSE ENTITIES, AND TRANSPARENCY OF FILING BY ISSUERS (2005), available at http://www.sec.gov/news/studies/soxoffbalancerpt.pdf. Summarizing the current accounting rules on securitizations, id. at 40-49, the Staff concluded that they are “in need of improvement,” id. at 46. The Staff’s first recommendation was to “Eliminate (or at least Reduce) Accounting-Motivated Structured Transactions,” among which it included securitization:

[A]n issuer might contemplate a secured borrowing transaction because it needs capital—a true business purpose. However, if that issuer transfers the assets to an SPE, which then borrows the funds and transfers them to the issuer in a transaction that keeps the debt off the balance sheet while exposing the issuer to virtually the identical risks and rewards as if the simple secured borrowing had been undertaken, the Staff considers the transaction to be accounting-motivated.

Id. at 99-100. See also id. at 102 (disapprovingly noting that “with respect to securitizations, current standards allow issuers to structure transactions to achieve desired accounting results—that is, either sale or borrowing treatment for the items being securitized—for what are economically similar transactions”). 52 See Vincent Ryan, Debt in Disguise, CFO MAG., Nov. 2007, at 78, 84 (naming companies that have shunned off-balance-sheet treatment of their securitization transactions, and quoting Bob Finley, managing director of Fifth Third Bank’s securitization business, on the practice as follows: “Professionals—debt analysts, bankers, and equity analysts—all add [receivables] securitizations back onto the balance sheet in figuring leverage and debt ratios. [Off-balance-sheet treatment is] window dressing at best. Let’s just call it debt”). 53 Plank, Security, supra note 20, at 1684-85. 54 This assumes no other material change to the structure of the transaction. For instance, in



value, as overcollateralization will have been necessary to afford the securitized debt a high rating, and the Originator will not simply give that value away to an unaffiliated X. Pricing that residual interest in a way that shifts the risk of its value to X is likely to be a problem. Losses from failure to collect any of the securitized assets will be borne by the holder of that residual interest, so its value will be very sensitive to small changes in the collectibility of the securitized assets; moreover, collection will be within the control of the Originator to some extent if, as is commonly the case, it acts as servicer of the securitized assets. This, no doubt, is why the rating agencies rarely see transactions that, like the foregoing, shift material risk of nonperformance of the securitized assets away from the Originator.55

It is evident that securitization conflicts with the policy of the Bankruptcy Code as it currently stands. The Bankruptcy Code imposes the Bankruptcy Tax on secured transactions, and one of the central purposes for doing so is to promote reorganization by assuring that the debtor can use collateral, including cash collateral, during the reorganization process, subject to the adequate protection safeguard provided by the Code. A debtor who has engaged in a financing structured as the prototypical securitization has effected the economic equivalent of a secured transaction, but the structure, if respected, would prevent the debtor from using the cash generated by the securitized assets whether or not the financiers can be adequately protected. The whole purpose of the structure, and its only substantial effect, is to evade the Bankruptcy Tax, and thereby deprive the estate and other creditors of the benefits that follow from the Bankruptcy Tax—which, among other things, might make the difference between a successful reorganization and one that fails for want of cash.

The proposition that securitization conflicts with bankruptcy policy argues itself, and so is much less interesting than attempts to deny it. Steven Schwarcz advanced a rebuttal that is worth quoting in full:

[T]he argument that securitization . . . undermines bankruptcy policy is a chimera. The originator, after all, freely makes the choice of its financing transactions. Securitization has a lower cost precisely due to bankruptcy remoteness. If, therefore, the originator chooses securitization in order to benefit from that lower cost, it should not

so-called “orphan subsidiary” transactions, X owns the voting equity of the SPE, but that voting equity is structured to have only a token value because all economic interest in the SPE above a token amount is routed back to the Originator (e.g., by way of fees the SPE is required to pay to the Originator, or by the Originator’s ownership of non-voting equity in the SPE that represents substantially the entire economic interest in the SPE). The economics of a transaction involving such an orphan subsidiary do not differ materially from the prototypical transaction. 55 See supra note 47; see also, e.g., S&P CORPORATE CRITERIA, supra note 38, at 120 (“The fact is, minimizing funding costs for the [Originator] while transferring significant risk to the investor tend to be mutually exclusive.”).



have the right to later complain. Moreover, the very availability of securitization as a financing option, by providing liquidity to otherwise viable originators unable to borrow, has been shown to facilitate the fundamental bankruptcy policy of debtor rehabilitation.56

This sets forth two arguments, which respectively implicate two long-running debates among scholars of bankruptcy and commercial law. Whatever the normative merits of these arguments, they are not consistent with the positive law of the Bankruptcy Code as it currently stands.

The final sentence of the quoted paragraph argues that avoidance of the Bankruptcy Tax provides liquidity for Originators who might be unable to borrow if their financiers had to suffer the Bankruptcy Tax (or, to make the point more generally, lower cost financing for all Originators who use the technique). That amounts to saying that the Bankruptcy Tax is bad policy—that debtors as a class, their unsecured creditors, and other affected constituencies are better off if debtors are allowed to do secured financing that is not subject to the Bankruptcy Tax (at least as to collateral of the type typically used to back securitizations). As a normative argument this is a special case of a more general decades-long academic debate as to the social utility of secured credit, played for lower stakes: the general debate considers the whole bundle of rights possessed by a secured creditor, while securitization involves only the relatively marginal increment of rights represented by the Bankruptcy Tax.57 The normative debate, though deeply interesting, is not to be confused with positive law. Congress has made its normative judgment on this point, and has ordained that secured creditors must bear the Bankruptcy Tax. A court adjudicating a challenge to a securitization transaction under the Bankruptcy Code as it currently stands is not at liberty to ignore that decision.

The other argument made by Schwarcz in the quoted paragraph is that an Originator who chooses to securitize, and thereby obtain the benefit of the lower-cost financing made available to it by the avoidance of the Bankruptcy Tax, should have no right after its bankruptcy to seek to impose the Bankruptcy Tax on the transaction. That amounts to saying that a debtor should have the power to enter into an enforceable prepetition waiver of the Bankruptcy Tax as to a secured financing (again, at least as to collateral of the type typically used to back securitizations), so long as the debtor receives consideration for the waiver. That argument implicates the long-running academic debate over “contract bankruptcy”—that is, the merits of replacing the current mandatory regime of bankruptcy rules with a regime that would allow 56 Schwarcz, Post-Enron, supra note 20, at 1573-74 (footnotes omitted; italics in original). 57 See infra Part IV for further discussion of this point.



each debtor to shape by contract in advance of its failure the rules that will apply to it following its failure. The original academic proposals along these lines, which have received the most attention, call sweepingly for more or less complete contractualization of bankruptcy.58 Less ambitious proposals take the current bankruptcy regime as given but call for more or less broad power of debtors to waive rules of bankruptcy law thought to be primarily designed for their benefit, and Schwarcz’s present argument is of that ilk.59 Academic opinion is, not surprisingly, divided as to the merits of contract bankruptcy whether in the large or in the small. The proponents of the less ambitious proposals generally acknowledge that their arguments are normative and generally look to legislative change to implement them.60

Here too, Professor Schwarcz substitutes argument from a highly unsettled normative debate for positive law. The prototypical securitization is a structural substitute for an explicit prepetition waiver by a debtor of the Bankruptcy Tax that would otherwise apply to its secured financing, made by the debtor at the outset of the financing. Under current law, such an explicit waiver would not be enforceable. It was long an axiom that the rights given by the Bankruptcy Code could not be waived in advance of bankruptcy, and with one exception courts 58 Among the earliest of these proposals was Robert K. Rasmussen, Debtor’s Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 51 (1992). For a review of the literature from a perspective skeptical of contract bankruptcy, see Susan Block-Lieb, The Logic and Limits of Contract Bankruptcy, 2001 U. ILL. L. REV. 503. Recent contributions include an empirical argument against contractualism in Elizabeth Warren & Jay Lawrence Westbrook, Contracting Out of Bankruptcy: An Empirical Intervention, 118 HARV. L. REV. 1197 (2005), which is criticized in Robert K. Rasmussen, Empirically Bankrupt, 2007 COLUM. BUS. L. REV. 179, and an extension of the contractualist argument in Alan Schwartz, A Normative Theory of Business Bankruptcy, 91 VA. L. REV. 1199 (2005). 59 Proponents of more or less broad waiver rights include Marshall E. Tracht, Contract Bankruptcy Waiver: Reconciling Theory, Practice, and Law, 82 CORNELL L. REV. 301 (1997) and Steven L. Schwarcz, Rethinking Freedom of Contract: A Bankruptcy Paradigm, 77 TEX. L. REV. 515 (1999). See also Thomas G. Kelch & Michael K. Slattery, The Mythology of Waivers of Bankruptcy Privileges, 31 IND. L. REV. 897 (1998); Edward S. Adams & James L. Baillie, A Privatization Solution to the Legitimacy of Prepetition Waivers of the Automatic Stay, 38 ARIZ. L. REV. 1 (1996); Rafael Efrat, The Case for Limited Enforceability of a Pre-Petition Waiver of the Automatic Stay, 32 SAN DIEGO L. REV. 1133 (1995). Critiques of contract bankruptcy in the large often include critiques of contract bankruptcy in the small. See, e.g., Lynn M. LoPucki, Contract Bankruptcy: A Reply to Alan Schwartz, 109 YALE L.J. 317, 341-42 (1999). For dedicated critiques of contract bankruptcy in the small, see Daniel B. Bogart, Games Lawyers Play: Waivers of the Automatic Stay in Bankruptcy and the Single Asset Loan Workout, 43 UCLA L. REV. 1117 (1996); Mark F. Hebbeln, Prepetition Waivers of the Automatic Stay in Bankruptcy: The Economic Case For Nonenforcement, 115 BANKING L.J. 126 (1998); William Bassin, Why Courts Should Refuse to Enforce Pre-Petition Agreements That Waive Bankruptcy’s Automatic Stay Provisions, 28 IND. L. REV. 1 (1994). See also NAT’L BANKR. REV. COMM’N, BANKRUPTCY: THE NEXT TWENTY YEARS 478-87 (1997) (recommending that the Bankruptcy Code be amended to state explicitly that prepetition waivers are unenforceable). 60 See Tracht, supra note 59, at 349-55; Schwarcz, supra note 59, at 603-04. But see Kelch & Slattery, supra note 59 (arguing that the accepted view that bankruptcy rules are mandatory is a “mythology”).



have given short shrift to such waivers.61 The exception pertains to prepetition waiver of the automatic stay. Notwithstanding strong dictum to the contrary by appellate courts, 62 a limited number of bankruptcy courts (though apparently no appellate courts) have given some effect to prepetition waivers of the automatic stay in some circumstances.63 Other bankruptcy courts have rejected that position and held prepetition waivers of the stay to be unenforceable.64 Even the courts that give weight to the waiver do not view it as self-executing.65 Moreover, except for the earliest cases, such courts have not viewed the waiver as per se enforceable, but rather as one factor to be taken into account in deciding whether there exists cause to lift the stay.66

Even if one reads generously the cases that give weight to the waiver of the automatic stay, and ignores both the contrary authority and the fact that the securitization structure effects a waiver of rights beyond the automatic stay, those cases do not support the enforceability of an explicit waiver of the type for which the securitization structure substitutes. One fundamental distinction is that cases giving weight to the waiver invariably involve a waiver given in connection with a post- 61 The axiom of nonwaivability dates back at least to the Bankruptcy Act. See, e.g., Fallick v. Kehr, 369 F.2d 899, 904 (2d Cir. 1966); In re Weitzen, 3 F. Supp. 698 (S.D.N.Y 1933). Under the Bankruptcy Code, see, e.g., Klingman v. Levinson, 831 F.2d 1292, 1296 n.3 (7th Cir. 1987); Hayhoe v. Cole (In re Cole), 226 B.R. 647, 651-52 (B.A.P. 9th Cir. 1998) (collecting cases). See also In re Trans World Airlines, Inc., 261 B.R. 103, 113-18 (Bankr. D. Del. 2001) (holding unenforceable a debtor’s prepetition agreement not to reject an executory contract). 62 See, e.g., Ostanto Commerzanstalt v. Telewide Systems, Inc., 790 F.2d 206, 207 (2d Cir. 1986); Ass’n of St. Croix Condo. Owners v. St. Croix Hotel Corp., 682 F.2d 446, 448 (3d Cir. 1982). 63 The first reported case enforcing a prepetition waiver of the stay was In re Citadel Props., Inc., 86 B.R. 275 (Bankr. M.D. Fla. 1988), the reasoning of which could hardly be more dubious: it cited three cases as precedent, but in fact none of the three involved a prepetition waiver of the stay. See Michael St. Patrick Baxter, Prepetition Waivers of the Automatic Stay: A Secured Lender’s Guide, 52 BUS. LAW. 577, 580 & n.13 (1997). Mr. Baxter’s article summarizes the cases reported before its date; for subsequent cases, see In re Frye, 320 B.R. 786 (Bankr. D. Vt. 2005) (holding that a waiver is not per se enforceable but may be given weight; ruling deferred pending evidentiary hearing). See also In re Deb-Lyn, Inc., No. 03-00655-GVL1, 2004 WL 452560 (Bankr. N.D. Fla. 2004) (declining to enforce waiver); In re Desai, 282 B.R. 527 (Bankr. M.D. Ga. 2002) (declining to enforce waiver); In re Excelsior Henderson Motorcycle Mfg. Co., 273 B.R. 920 (Bankr. S.D. Fla. 2002) (enforcing waiver given pursuant to the terms of the plan of reorganization in the debtor’s previous bankruptcy case); In re Drawdy, No. CIV.A. 01-04844-W, 2001 WL 1805998 (Bankr. D.S.C. 2001) (declining to enforce waiver); Mass. Mut. Life Ins. Co. v. Shady Grove Tech Ctr. Assocs. (In re Shady Grove Tech Ctr. Assocs.), 227 B.R. 422 (Bankr. D. Md. 1998) (enforcing waiver given in a workout in a single asset case). 64 See, e.g., In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996); Farm Credit of Cent. Fla. v. Polk, 160 B.R. 870 (M.D. Fla. 1993); In re Sky Group Int’l, Inc., 108 B.R. 86 (Bankr. W.D. Pa. 1989). 65 See, e.g., In re Frye, 320 B.R. at 790; Baxter, supra note 63, at 591. 66 See, e.g., In re Frye, 320 B.R. 786; In re Excelsior Henderson Motorcycle Mfg. Co., 273 B.R. 920; In re Shady Grove Tech Ctr. Assocs., 227 B.R. 422; In re Powers, 170 B.R. 480 (Bankr. D. Mass. 1994); In re Cheeks, 167 B.R. 817 (Bankr. D.S.C. 1994). For early cases upholding waivers in broader terms, see, e.g.,: In re Club Tower, L.P., 138 B.R. 307 (Bankr. N.D. Ga. 1991); In re Citadel Props., Inc., 86 B.R. 275.



default workout, and the courts commonly have emphasized the desirability of encouraging such workouts.67 There does not appear to be a single reported case giving effect to a prepetition waiver of the stay contained in original loan documents, entered into before default, and indeed several courts that have given weight to a waiver given in connection with a workout have gone out of their way to call attention to this distinction.68 These cases thus do not support the enforceability of a waiver of the type for which the securitization structure substitutes.

A second distinction is that courts that have given weight to a prepetition waiver of the stay have been at pains not to do so when that would injure materially the rights of other creditors involved in the case.69 The notion of giving weight to the waiver of the stay originated in, and has been largely confined to, single asset real estate cases, in which the debtor typically has no material creditors other than the secured creditor to whom the waiver was granted.70 Furthermore, courts willing to give credence to a waiver have been inclined to do so only when the debtor’s likelihood of reorganization is low, so that the prospect of improved recovery in a reorganization for other creditors is dim.71 In any case, courts have emphasized that the waiver does not

67 See, e.g., In re Shady Grove Tech Ctr. Assocs., 227 B.R. at 426; In re Powers, 170 B.R. at 483; In re Cheeks, 167 B.R. at 818. A subclass of cases involve stay waivers given by the debtor pursuant to a plan of reorganization in a previous bankruptcy case. See, e.g., In re Excelsior Henderson Motorcycle Mfg. Co., 273 B.R. 920 (Bankr. S.D. Fla. 2002). In such cases enforcement of the waiver furthers the integrity of the previous bankruptcy proceeding rather than a policy of encouraging workouts, but both situations are equally far removed from a waiver given in original loan documents before default. 68 See Baxter, supra note 63, at 600 (“No reported case has ever enforced a prepetition waiver in original loan documents.”). For cases emphasizing the point, see, e.g.: In re Frye, 320 B.R. at 789; In re Excelsior Henderson Motorcycle Mfg. Co., 273 B.R. at 924; In re Atrium High Point L.P., 189 B.R. 599, 607 (Bankr. M.D.N.C. 1995). 69 See, e.g., In re Atrium High Point L.P., 189 B.R. at 607-08; In re Powers, 170 B.R. at 484. See also, e.g., In re S.E. Fin. Assocs. 212 B.R. 1003, 1005 (Bankr. M.D. Fla. 1997) (declining to enforce prepetition stipulation that debtor’s breach of workout agreement would constitute bad faith warranting dismissal of a subsequent Chapter 11 case, on the ground that dismissal would injure other creditors). 70 See Baxter, supra note 63, at 596-98 (gathering cases); see also, e.g., In re Deb-Lyn, Inc., No. 03-00655-GVL1, 2004 WL 452560 (Bankr. N.D. Fla. 2004) (denying waiver of stay in case involving an operating company rather than a single asset real estate debtor); In re Shady Grove Tech Ctr. Assocs., 227 B.R. at 425 (giving weight to waiver of the stay in a single asset real estate case, noting that the case “is essentially a two-party dispute and there are no legitimate interests of other parties, including creditors, which would be adversely effected [sic] by the enforcement of The Waiver”). Some cases have granted, or contemplated the possibility of granting, weight to a prepetition waiver of the stay in cases other than single asset real estate cases, but such cases still typically emphasize the importance of not injuring other creditors. See, e.g., In re Frye, 320 B.R. at 792. 71 See Baxter, supra note 63, at 592 (analyzing the cases and concluding that “[t]he single most important factor in the enforcement of a stay waiver is the prospect of the reorganization of the debtor”); see also, e.g., In re Frye, 320 B.R. at 792-94 (weight must be given to feasibility of debtor’s plan and likelihood of reorganization).



preclude objection by other creditors to lifting the stay.72 A waiver of the kind for which the securitization substitutes is the polar opposite of the waivers that these courts have given weight to, for the Originator typically will be an operating company with many creditors, and the result of respecting such a waiver will be to deprive the Originator of the use of cash that might make the difference between a successful reorganization and a failed one.

The prototypical securitization structure is thus the prepetition waiver that dares not speak its name. It has no purpose and no substantial effect other than to effect a waiver of the Bankruptcy Tax that would be deemed unenforceable, as contrary to bankruptcy policy, if effected directly. Indeed, if Professor Schwarcz’s argument was validly grounded in current law, then instead of employing the securitization structure and incurring the substantial transaction costs associated with the establishment and maintenance of an SPE, financiers would make nonrecourse loans to the Originator secured by the assets that would otherwise be securitized, with the Originator granting the financiers an (enforceable) express waiver of the Bankruptcy Tax, for which the Originator would receive in exchange the benefit of a lower interest rate, just as in a securitization. Securitization structures are universally used precisely because nobody seriously believes that such an express waiver would be enforced.

To legal entrepreneurs seeking to avoid the Bankruptcy Tax on their secured financings, the pragmatic benefits of the securitization structure go beyond the obvious one of disguising the conflict with bankruptcy policy. It also shifts the burden of going forward in the event of the Originator’s bankruptcy. In addition to its other defects, an express prepetition waiver of the Bankruptcy Tax given by the Originator to secured financiers would be of no avail to those financiers unless they place it before the bankruptcy judge and persuade him to enforce it. The securitization structure, by contrast, hums along without interruption after the Originator’s bankruptcy unless the Originator, as debtor in possession, takes action to upset it. Furthermore, the Originator must advance a theory that will persuade its bankruptcy judge to upset it.73 To that subject we now turn.

72 See, e.g., In re Powers, 170 B.R. at 483; In re Sky Group Int’l, Inc., 108 B.R. 86, 89 (Bankr. W.D. Pa. 1989). 73 Part II of this paper is concerned with weaknesses in securitization’s legal foundations, but it should be noted that a bankrupt Originator that elects to go to war with its securitization financiers might also seek to exploit practical weaknesses in the securitization structure. One approach would be to induce the directors of the SPE to authorize the SPE to file a voluntary bankruptcy petition, as was done in the Days Inn bankruptcy discussed in Part IV. Another approach would be to orchestrate the filing of an involuntary petition against the SPE, as was done in In re Kingston Square Associates, 214 B.R. 713 (Bankr. S.D.N.Y. 1997).



II. SECURITIZATION: DOCTRINAL DISCONTENTS

A. Introduction The prototypical securitization structure has as its purpose the

isolation of the securitized assets from the Bankruptcy Tax in the event of the Originator’s subsequent bankruptcy. Any legal doctrine that would defeat that isolation would defeat the purpose of the product.

One such doctrinal threat is that a court might not recognize the purported transfer of the securitized assets from the Originator to the SPE as removing them from the Originator’s subsequent bankruptcy estate. From a black-letter perspective, analysis of this point begins with the observation that the Bankruptcy Code will bring into the Originator’s bankruptcy estate all of the Originator’s legal or equitable interests in property as of the commencement of its bankruptcy case.74 The leading cases are ambivalent as to the respective roles of federal and state law on this point: on the one hand, they say that what constitutes “property of the estate” is a federal question, in the sense that state-law labels do not govern whether a particular right is to be considered “property” for this purpose;75 on the other hand, they also say that state law does determine the substantive attributes of a debtor’s rights, and those state-law attributes are to be respected “unless some federal interest requires a different result.”76 Conventional wisdom in the securitization industry construes these principles as calling for analysis of whether the purported sale of the securitized assets from the Originator to the SPE would, under state law, be respected as such, or whether it would instead be recharacterized as a loan by the SPE to the Originator secured by those assets. If the sale is recharacterized, the conventional wisdom concedes that the securitized assets will be part of the Originator’s bankruptcy estate. If, on the other hand, the sale is a “true sale”—that is, it is not recharacterized—then the conventional wisdom considers that the securitized assets have been successfully removed from the Originator’s subsequent bankruptcy estate, in keeping with the general principle of deference to state law, and the reservation in the cases to the effect that federal interests in some circumstances 74 Bankruptcy Code § 541(a)(1). 75 Bd. of Trade of Chicago v. Johnson, 264 U.S. 1 (1924). 76 Butner v. United States, 440 U.S. 48, 55 (1979). The essential point of Butner is that under § 541(a)(1), a debtor’s property interests in bankruptcy are, in general, the same as its property interests outside of bankruptcy. The rules that define those interests are, in general, matters of state law, and for convenience it is common to speak as though that is always the case, as the Court did in Butner (e.g., “Property interests are created and defined by state law,” id. at 55). To be strictly correct one should refer to “nonbankruptcy law” rather than “state law,” as in some circumstances property interests are defined by nonbankruptcy rules of federal law.



might override that deference is shrugged aside.77 For no very clear reason, the foregoing cluster of issues has been

the chief battleground on which debates over the doctrinal validity of securitization have been fought to date. The rating agencies have always been sensitive to these issues, and as a condition of rating securitized debt they traditionally have required the Originator’s counsel to render a so-called “true sale” opinion to the effect that the transfer of the securitized assets by the Originator to the SPE removes those assets from the Originator’s subsequent bankruptcy estate.78 In LTV Steel, the sole case in which a challenge to the doctrinal foundations of securitization resulted in a contested adjudication, the bankruptcy court issued an interim order based on the premise that the purported transfer from Originator to SPE did not remove the securitized assets from the Originator’s estate.79 At the state level, at least seven states have enacted pro-securitization statutes of varying scope and coherence that effectively provide that a purported sale of receivables in a securitization cannot be recharacterized as a secured loan.80 At the federal level, an unsuccessful anti-securitization effort to amend the Bankruptcy Code to confer upon bankruptcy courts explicit power to recharacterize purported sale transactions as a matter of federal bankruptcy law evidently was a reaction to those state statutes.81 An unsuccessful pro-securitization effort to amend the Bankruptcy Code to create a safe harbor for securitization transactions took the form of a provision that would have codified the industry’s conventional wisdom, with the added bonus of negating the threat of state-law recharacterization.82

Despite the importance of these issues to the securitization industry, they have received remarkably little attention from academic commentators. That inattention has been all but complete on the question of the circumstances in which a purported sale of receivables 77 See, e.g., Peter V. Pantaleo et al., Rethinking the Role of Recourse in the Sale of Financial Assets, 52 BUS. LAW. 159, 182-89 (1996); KRAVITT, supra note 18, § 5.02[G][1]. 78 See, e.g., STANDARD & POOR’S, LEGAL CRITERIA FOR U.S. STRUCTURED FINANCE TRANSACTIONS 15-21 (2006) [hereinafter S&P LEGAL CRITERIA], available at http://standardandpoors.com/. For a discussion of these legal opinions, see infra Part III.B.2. 79 In re LTV Steel Co., 274 B.R. 278, 285-86 (Bankr. N.D. Ohio 2001). 80 See ALA. CODE §§ 35-10A-1 to -2 (2003); DEL. CODE ANN. tit. 6, §§ 2701A-2703A (2003); LA. REV. STAT. ANN. § 10:9-109(e) (2003); N.C. GEN. STAT. §§ 53-425 to -426 (2004); OHIO REV. CODE ANN. § 1109.75 (2003); S.D. CODIFIED LAWS §§ 54-1-9 to -10 (2003); TEX. BUS. & COM. CODE ANN. § 9.109(e) (2004). Whether these statutes would change the result in a bankruptcy case is doubtful. At least two commentators have noted, with differing degrees of enthusiasm, that a bankruptcy court might well recharacterize a purported sale as a matter of federal bankruptcy law notwithstanding such a state statute. See Ronald J. Mann, The Rise of State Bankruptcy-Directed Legislation, 25 CARDOZO L. REV. 1805, 1825 (2004); Schwarcz, Post-Enron, supra note 20, at 1547-48. 81 See discussion infra notes 325-327. 82 See discussion infra notes 322-324 and Part IV.



should be recharacterized as a loan secured by those receivables as a matter of state law. Article 9 of the UCC from its inception has governed outright sales of receivables of some types, as well as loans secured by receivables or other personal property. But the drafters of the original version of Article 9 declined to give any guidance as to the circumstances in which a purported sale of a receivable should be recharacterized; they explicitly relegated that issue to the courts.83 The 1999 revision altered Article 9 in a number of ways favorable to the securitization industry, including by expanding the class of receivables outright sale of which is governed by Article 9,84 and by adding a provision that reinforces the industry’s conventional wisdom by suggesting, as strongly as state law can do so, that a receivable that is the subject of a true sale should be considered to be outside the seller’s bankruptcy estate.85 But the revisers followed the original drafters on the most critical point, by explicitly leaving it to the courts to determine the circumstances in which a purported sale should be recharacterized.86 The relatively slender body of case law on the subject is remarkable for its incoherence, to the degree that judges have declared that the state of precedent is such that they might as well toss a coin to decide such cases.87 Since the rise of securitization only a handful of commentators have attempted to go beyond compiling cases to rationalizing them, and those attempts at rationalization have been tentative at best. 88 The subject begs analysis, which it is beyond the scope of this paper to provide.89

The relationship between the state law attributes of the asset transfer by the Originator to the SPE and its treatment under the Bankruptcy Code has received somewhat more attention from 83 U.C.C. § 9-502 cmt. 4 (1962). 84 Compare U.C.C. § 9-102(1)(b) (1962) (Article 9 generally applies to “any sale of accounts or chattel paper”) with U.C.C. § 9-109(a)(3) (1999) (Article 9 generally applies to “a sale of accounts, chattel paper, payment intangibles, or promissory notes”). See generally Paul M. Shupack, Making Revised Article 9 Safe for Securitizations: A Brief History, 73 AM. BANKR. L.J. 167 (1999). 85 See U.C.C. § 9-318(a) (“A debtor that has sold an account, chattel paper, payment intangible, or promissory note does not retain a legal or equitable interest in the collateral sold.”). The phrase “legal or equitable interest” is an echo of the basic definition of property of the estate in Bankruptcy Code § 541(a)(1). 86 U.C.C. §§ 9-108 cmt. 4, 9-318 cmt. 2. 87 See In re Commercial Loan Corp., 316 B.R. 690, 700 (Bankr. N.D. Ill. 2004) (“With no discernible rule of law or analytical approach evident from the decisions, a court could flip a coin and find support in the case law for a decision either way.”) (internal quotation marks omitted); Elmer v. Comm’r, 65 F.2d 568, 569-70 (2d Cir. 1933) (L. Hand, J.) (“It is possible, as we have suggested, to construe these transactions in either way.”). 88 See Pantaleo et. al., supra note 77; Plank, True Sale, supra note 20; Robert D. Aicher & William J. Fellerhoff, Characterization of a Transfer of Receivables as a Sale or a Secured Loan Upon Bankruptcy of the Transferor, 65 AM. BANKR. L.J. 181 (1991). 89 A work in progress by the author, tentatively entitled True Sale of Receivables: A Purposive Analysis, will address the subject.



commentators. In particular, David Carlson attacked the doctrinal foundations of securitization from that perspective.90 Professor Carlson based his critique on United States v. Whiting Pools, Inc.,91 which held that the bankruptcy estate of a debtor included property of the debtor that had been seized by the Internal Revenue Service before the bankruptcy petition and that was subject to a tax lien in an amount almost three times the property’s liquidation value. The case thus grounded bankruptcy’s dominion over the property on valueless formal rights of the debtor, namely the debtor’s right to a surely nonexistent surplus in the tax sale, and the debtor’s right to receive notice of the tax sale. Whiting Pools can be read to stand for the premise that, so long as a debtor has an in rem relationship to an item of property, no matter how contingent or tenuous, then the item is part of the debtor’s bankruptcy estate. Carlson rightly observed that this premise would be fatal to securitization. Among other things, he noted that the Originator continues to have contingent rights in accounts or chattel paper it sells to the SPE, including the power to convey those assets free and clear to a third party in the event that the SPE neglects to continue perfection of its ownership interest. If the “fantastic” (Carlson’s word) premise of Whiting Pools is accepted, therefore, the transferred accounts and chattel paper would remain part of the Originator’s subsequent estate in bankruptcy.92

This argument proves too much. It leads to the conclusion that there is no way for any owner of accounts or chattel paper to sell them, on any terms, even outside a securitization transaction, in a way that will be respected in the event that the former owner later goes bankrupt. 93 Although one notorious case might be argued to have reached just that conclusion, it is too radical, and radically counterintuitive, to persuade. 94 Professor Carlson’s argument tests Whiting Pools to destruction, and the test simply demonstrates that the simplistic premise of that case cannot stand. While a securitization practitioner may feel a twinge of uneasiness at the questions posed by 90 Carlson, supra note 22. 91 462 U.S. 198 (1983). 92 Carlson, supra note 22, at 1063. 93 For a different and more elaborate critique of Professor Carlson’s argument, see Plank, Security, supra note 20, at 1698-1722. 94 The notorious case is Octagon Gas Systems, Inc. v. Rimmer (In re Meridian Reserve, Inc.), 995 F.2d 948 (10th Cir. 1993). That less than lucid opinion is better read as resting on a rather simplistic misreading of Article 9 that has since been clarified beyond any reasonable prospect of repetition, see infra note 338, than on Professor Carlson’s sophisticated proposition about the all-devouring scope of Whiting Pools. The discussion of this subject in Octagon Gas was dictum in any case, for after the Tenth Circuit’s remand, it proved that the buyer of the account sold in that case had failed to perfect its ownership interest, and there is no question that, absent perfection, a sold account does remain in the seller’s bankruptcy estate. See Bonnet Res. Corp. v. Octagon Gas Sys., Inc. (In re Meridian Reserve, Inc.), Adv. No. 90-0131-BH, 1994 WL 903895 (Bankr. W.D. Okla. 1994). For further discussion of Octagon Gas, see infra notes 337-339.



Whiting Pools, the prospect of a court answering those questions in a way that would abolish bankruptcy recognition of all sales of accounts or chattel paper in all circumstances, inside or outside of a securitization transaction, is unlikely to cause her to lose much sleep.

Moreover, while Professor Carlson rightly identifies the reason for doctrinal uneasiness about securitization—namely, its evasion of the Bankruptcy Tax through mere formal devices, as discussed in part I of this paper—the antidote he prescribes is more formalism, and that of an extreme kind. A challenge to the product would be more solidly based if it explicitly aims at redressing the violation of bankruptcy policy that the product seeks to effect. In fact, there are at least two straightforward doctrinal bases for vindicating bankruptcy policy in that way: fraudulent transfer law and substantive consolidation. Those will be discussed in turn in the remainder of Part II.

B. Vindicating Bankruptcy Policy through Fraudulent Transfer Law

The thesis of Part II.B can be briefly stated. Fraudulent transfer

law can be applied, consistent with established usages, to avoid the asset transfer from Originator to SPE that is the core of the prototypical securitization transaction, in order to vindicate the bankruptcy policy that the securitization structure is designed to circumvent. That result implements an aspect of fraudulent transfer law that may conveniently be dubbed “Nonhindrance.” Nonhindrance is well established historically, but it is not an aspect of fraudulent transfer law that is often encountered today, nor has it received the attention it deserves in the literature—which no doubt explains why securitization has thrived in its despite.

1. The Primordial Rule and Its Nonhindrance Aspect

It is convenient to begin with a brief review of the basic contours

of fraudulent transfer law. Its origin is conventionally traced to the English enactment in 1571 of the Statute of 13 Elizabeth, which prohibited debtors from making any transfer of property with the “intent to delay, hinder or defraud creditors.”95 That statute was penal, but English lawmakers soon adapted its principle to private law, and in that form it was received into American law. Today the vast majority of states have codified the doctrine (albeit nonexclusively) by enacting the

95 13 Eliz., c. 5 (1571) (Eng.), reprinted in 2 GARRARD GLENN, FRAUDULENT CONVEYANCES AND PREFERENCES app. A, at 1069 (rev. ed. 1940).



Uniform Fraudulent Transfer Act (“UFTA”), a post-Bankruptcy Code modernization of the turn-of-the-century Uniform Fraudulent Conveyance Act (“UFCA”) that remains in force in a few laggard states. 96 If a debtor becomes subject to a proceeding under the Bankruptcy Code, its trustee generally has the power to employ applicable state fraudulent transfer law to attack prepetition transfers of property by the debtor.97 The trustee may also attack such transfers under a fraudulent transfer provision integral to the Bankruptcy Code, section 548. The same pattern prevailed under the former Bankruptcy Act, which from its inception in 1898 empowered a debtor’s trustee to attack prepetition transfers under state fraudulent transfer law as well as under a provision integral to the Bankruptcy Act.98 Although differing in details, the UFCA, UFTA, and section 548 are quite similar in structure, and the core of each remains the primordial rule (referred to in this paper by that shorthand name) that declares avoidable any transfer of property made by the debtor with intent to “hinder, delay, or defraud” the debtor’s creditors.99

In centuries of cases applying this primordial rule, judges have noted recurring facts thought to be indicative of the debtor’s intent to “hinder, delay, or defraud” his creditors. These came to be dignified by the name of “badges of fraud,” and as a general rule they were and are said to be merely a nonexclusive list of possible indications of the proscribed intent.100 To a notable degree, however, one badge came to be seen by many courts as presumptively, or conclusively, establishing 96 The UFCA, promulgated in 1918, is reprinted at 7A U.L.A. 2 (1999); the UFTA, promulgated in 1984, is reprinted at 7A U.L.A. 266 (1999). As of late 2007 the UFCA is in force in three states and the UFTA is in force in 43 states. On the non-exclusiveness of the UFTA as a codification of fraudulent transfer law, see UFTA § 1 cmt. 2, § 4 cmt. 8; on the non-exclusiveness of the UFCA, see Lee v. State Bank & Trust Co., 54 F.2d 518 (2d Cir. 1931). 97 Bankruptcy Code § 544(b). It is a condition of application of § 544(b) by the trustee that there be at least one actual creditor in existence who would have the right to avoid the transfer under state law, but satisfaction of that condition is rarely a problem. Under Moore v. Bay, 284 U.S. 4 (1931), if such an actual creditor exists the transfer is avoidable in its entirety, without regard to the amount of that creditor’s claim. 98 The fraudulent transfer provision integral to the Bankruptcy Act as originally enacted in 1898 was § 67e, which simply invalidated a transfer “within four months prior to the filing of the petition, with the intent and purpose on [the debtor’s] part to hinder, delay, or defraud his creditors.” Act of July 1, 1898, ch. 541, § 67e, 30 Stat. 564 (1898) (repealed) [hereinafter Bankruptcy Act], reprinted in 5 COLLIER ON BANKRUPTCY ¶ 548.LH[2] (Alan N. Resnick et al. eds., 15th ed. 2006). 99 UFCA § 7; UFTA § 4(a)(1); Bankruptcy Code § 548(a)(1)(A). Oddly, the Statute of 13 Elizabeth expressed the decisive phrase as “delay, hinder or defraud,” but the first codification of fraudulent transfer doctrine in English bankruptcy law permuted the verbs to “defraud, delay or hinder,” 21 Jac., c. 19, § 7 (1623) (Eng.), quoted in 1 GLENN, supra note 95, § 61e, at 98, and the verbs are permuted yet again in the modern phrasing, “hinder, delay, or defraud,” which appeared in Bankruptcy Act § 67e (1898) and was carried forward in turn by the UFCA, Bankruptcy Act § 67d (1938), Bankruptcy Code § 548 and the UFTA. The subject awaits its critic. 100 There is no canonical list of badges of fraud, but an indicative list is set forth in UFTA § 4(b).



the prohibited intent: namely, a transfer of property by a financially-distressed debtor who does not receive fair value in exchange. The UFCA codified that application of the primordial rule in additional provisions that declared such a transfer to be avoidable per se, without regard to the debtor’s intent.101 The Chandler Act of 1938 rewrote the Bankruptcy Act’s integral fraudulent transfer provision to mirror the UFCA, including these per se rules,102 and the modern codifications of fraudulent transfer law in the UFTA and section 548 of the Bankruptcy Code carry forward substantially similar per se rules.103

Shorthand names have long been attached to the foregoing provisions of the UFCA, UFTA, and Bankruptcy Code. The primordial rule that declares avoidable a transfer of property by a debtor with intent to “hinder, delay, or defraud” his creditors is commonly referred to as the “actual fraud” prong of fraudulent transfer law, and the provisions that declare avoidable per se a transfer of property by a financially distressed debtor who does not receive fair value in exchange are commonly referred to as the “constructive fraud” prong. Pervasive as it is, this shorthand is misleading in two ways. First, to describe the primordial rule as applying to “actual fraud” slights the rule’s application, by its terms and by judicial usage, to non-fraudulent transfers that “hinder” or “delay” creditors. Second, reference to the codified per se rules pertaining to transfer for less than fair value by a distressed debtor as being “the constructive fraud rules” slights the fact that the primordial rule has been held to be violated, presumptively or conclusively, in other circumstances as well. All such circumstances are instances of “constructive” fraud in the literal sense of that word, because the debtor’s mental state is relevant only marginally or not at all.

Commentators on securitization have given little attention to the doctrinal risk posed by fraudulent transfer law, and of that little almost all has been given to constructive fraud (using that phrase in the conventional shorthand sense rather than its broader literal sense).104

101 UFCA §§ 4, 5, 6, 8. For a discussion of the case law preceding this codification, see 1 GLENN, supra note 95, §§ 262-72, at 449-67; for a different perspective, see John C. McCoid II, Constructively Fraudulent Conveyances: Transfers for Inadequate Consideration, 62 TEX. L. REV. 639 (1983). The drafters of the UFCA certainly believed that these per se rules merely codified “the present law in the great majority of states.” NAT’L CONFERENCE OF COMM’RS ON UNIF. STATE LAWS, PROCEEDINGS OF THE TWENTY-EIGHTH ANNUAL MEETING 351 (1918) [hereinafter UFCA Comments]. 102 As amended by the Act of June 22, 1938, ch. 575, § 67d, 52 Stat. 877 (1938) (repealed 1979), commonly called the Chandler Act, the fraudulent transfer provision integral to the Bankruptcy Act was § 67d. See also Nat’l Bankr. Conference, Analysis of H.R. 12889, 74th Cong., 2d Sess. 214 (1936) (“We have condensed the provisions of the Uniform Fraudulent Conveyance Act, retaining its substance and, as far as possible, its language.”). 103 UFTA §§ 4(a)(2), 5(a); Bankruptcy Code § 548(a)(1)(B). 104 See, e.g., SCHWARCZ, supra note 18, § 4.7; KRAVITT, supra note 18, § 5.05[H].



And it is easy to see that the constructive fraud rules pose little threat to the prototypical securitization transaction. The transfer of the securitized assets from the Originator to the SPE reduces the value of the Originator’s assets, but that reduction is balanced by a commensurate increase in the value of the Originator’s equity interest in the SPE. If the SPE is solvent—which should be a safe assumption if it conducts no other operations and the assets transferred to it are sufficient to garner a high credit rating for the securitized debt that it issues—the net effect of the transfer on the value of the Originator should be nil, or close to it. So constructive fraud has, quite reasonably, gotten short shrift as a threat to the prototypical securitization transaction. The rating agencies typically require a legal opinion as to fraudulent transfer in a securitization only if structural wrinkles or other special factors make the risk of constructive fraud attack non-negligible.105

The primordial rule of fraudulent transfer law, commonly but misleadingly referred to today as the prohibition on “actual fraud,” has received almost no attention from commentators on securitization. Even those academics who have looked at securitization with a skeptical eye have tended, with scant consideration, to dismiss fraudulent transfer law as a serious doctrinal threat. 106 That is not surprising, because securitization does not implicate either of the two aspects of the primordial rule that are most commonly encountered in modern practice. The shorthand “actual fraud” conjures up, first and foremost, an image of an Elizabethan deadbeat thumbing his nose at his creditors that is altogether foreign to a prosaic commercial transaction. “Actual fraud” today is most commonly associated with schemes to cheat creditors of payment by unjustly diminishing the net assets of the debtor available to creditors.107 This is reflected in the indicative list of

105 See S&P LEGAL CRITERIA, supra note 78, at 23-24 (“In certain circumstances (for example, if the purchase price paid by an intermediate SPE for assets is less than the reasonably equivalent value of the assets, or where a transferor is insolvent or extremely financially distressed at the time of the transfer), there is a risk that the transfer would be voided as a fraudulent conveyance . . . .”). Furthermore, Standard & Poor’s may require a legal opinion on the subject if it determines that there is a fraudulent conveyance risk. See also discussion infra Part III.B.2. 106 See Klee & Butler, supra note 26, at 65-67 (suggesting that fraudulent transfer law “can be a useful tool in avoiding an asset securitization transaction” but giving as examples only situations in which a simple non-securitized financing likewise would be susceptible to fraudulent transfer attack); Lupica, supra note 24, at 647-49 (suggesting that a “quasi-fraudulent conveyance analysis,” representing an expansion of current fraudulent conveyance doctrine, might be evolved to challenge securitizations); Frost, supra note 27, at 114-15 (asserting summarily that “[f]raudulent transfer law is not a significant source of risk for participants in asset securitization”); LoPucki, supra note 21, at 27 (briefly dismissing fraudulent transfer attack on securitization). 107 Indeed, Professor Glenn over-exuberantly stated, “The real test of a fraudulent conveyance . . . is the unjust diminution of the debtor’s estate.” 1 GLENN, supra note 95, § 195,



badges of fraud contained in the UFTA, most of which are either addressed directly to a transfer that diminishes the debtor’s estate,108 or are grounds for suspicion that the transfer was done for the purpose of diminishing the debtor’s estate,109 or are grounds for suspicion that the transfer, though not estate-diminishing in itself, was part of a scheme the next step of which would diminish the debtor’s estate.110

This aspect of the primordial rule has no application to a securitization transaction of the prototypical sort, for such a transaction does not diminish the net assets of the debtor available to creditors. It no more deprives the Originator’s general creditors of the prospect of payment than would a borrowing by the Originator on the security of the same assets used to back the securitization. Nor does securitization bear any earmarks of a larger scheme to cheat creditors of payment, any more than does a simple secured borrowing.

The other familiar application of the primordial rule is to situations involving deception by the debtor of its creditors.111 Almost all of the badges of fraud in the UFTA’s indicative list that are not addressed to diminution of the debtor’s net assets are addressed to actual or potential deception of creditors about the debtor’s assets.112 As every student of secured transactions learns, courts historically applied this aspect of fraudulent transfer law very broadly, to invalidate a debtor’s transfer of an interest in personal property without delivery of possession to the transferee. Application of the primordial rule in this way amounted to creation by the courts of a species of constructive fraud, for such transfers often were invalidated regardless of any intention to deceive

at 348. The “Elizabethan deadbeat” is, of course, Pierce, the protagonist of Twyne’s Case, (1601) 76 Eng. Rep. 809 (Star Chamber), who is often cited as the exemplar of this kind of fraud. That may be unjust to Pierce, as according to the case report he conveyed his assets to Twyne in satisfaction of a debt he owed to Twyne. If so, the conveyance was preferential but did not cheat Pierce’s creditors. But the tone of the report suggests room for skepticism about the reality of the debt that Pierce allegedly owed to Twyne. 108 See UFTA § 4(b)(8) (“[T]he value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred[.]”). 109 See UFTA § 4(b)(1) (“the transfer or obligation was to an insider”); id. § 4(b)(4) (“before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit”); id. § 4(b)(9) (“the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred”); id. § 4(b)(10) (“the transfer occurred shortly before or shortly after a substantial debt was incurred”). 110 See UFTA § 4(b)(5) (“the transfer was of substantially all the debtor’s assets”); id. § 4(b)(6) (“the debtor absconded”). 111 This species of fraud is also attributable to Pierce, the protagonist of Twyne’s Case, and with more certainty than the species of fraud discussed supra note 107: Pierce conveyed his assets to Twyne in secret, and Pierce remained in possession of the assets afterward and continued to use them as his own. 112 See UFTA § 4(b)(2) (“the debtor retained possession or control of the property transferred after the transfer”); id. § 4(b)(3) (“the transfer or obligation was disclosed or concealed”); id. § 4(b)(7) (“the debtor removed or concealed assets”).



creditors on the part of the debtor. Such transfers were invalidated prophylactically because they were perceived to present too great a likelihood of deception. This hostility to nonpossessory property interests manifested itself in different transactional settings, including, notoriously, attempts to effect nonpossessory secured transactions in personal property. For that reason, nonpossessory secured transactions were essentially unknown until the nineteenth century, when this prophylactic application of the primordial rule began to be displaced by statute. 113 Today, in the context of secured transactions, statutory abolition of this application of the primordial rule is essentially complete, the trade-off for this abolition being the establishment of a public filing system with which secured creditors must usually comply in order to be protected against the debtor’s creditors.114 Nevertheless, the traditional hostility to nonpossessory property interests retains some vitality in other settings, notably the so-called “vendor in possession” doctrine, which may limit recognition of the title obtained by a buyer of goods who leaves possession with the vendor.115 And there is little doubt of the applicability of the primordial rule to a transfer made by the debtor for the conscious purpose of concealing assets or otherwise deceiving creditors.

This aspect of the primordial rule, too, has no application to an ordinary securitization transaction. It may be assumed that the Originator will file financing statements with respect to the asset transfers involved in the transaction to the extent required by Article 9 of the UCC, and perform analogous notice-giving steps called for by any analogous laws that may apply. Otherwise there is nothing inherent in a securitization transaction that implicates any deception of a type to which courts historically have been sensitive when applying the primordial rule. It is true that some corporations have employed transactions structured in a manner akin to securitizations for the 113 The classic exposition is 1 GRANT GILMORE, SECURITY INTERESTS IN PERSONAL PROPERTY (1965), especially id. §§ 2.1-2.2. But cf. George Lee Flint, Jr., Secured Transactions History: The Fraudulent Myth, 29 N.M. L. REV. 363 (1999) (arguing that this received interpretation is a “myth”). There is no doubt that courts have actively used fraudulent transfer law to invalidate nonpossessory property interests, and in this paper it is not necessary to decide whether courts invalidated nonpossessory security interests before the early 1800s as sweepingly as is held by the received interpretation. Hostility to nonpossessory property interests certainly was not manifested uniformly across all transactional settings. For example, it did not prohibit leasing despite the lack of a public filing. See Charles W. Mooney, Jr., The Mystery and Myth of “Ostensible Ownership” and Article 9 Filing: A Critique of Proposals to Extend Filing Requirements to Leases, 39 ALA. L. REV. 683 (1988). 114 For historical development, see 1 GILMORE, supra note 113, especially id. § 2.3, § 8.7, at 274 n.1; for the abolition of this application of the primordial rule in transactions to which UCC Article 9 applies, see U.C.C. § 9-205. See also Jonathan C. Lipson, Secrets and Liens: The End of Notice in Commercial Finance Law, 21 EMORY BANKR. DEV. J. 421, 423-51 (2005). 115 See Mooney, supra note 113, at 726-30, 774; see also U.C.C. §§ 2-402(2), 2A-308(1), 2A-308(3) (limited safe-harbor exceptions to the vendor-in-possession doctrine).



purpose of distorting their financial statements. 116 But courts have never shown any inclination to apply the blunt instrument of fraudulent transfer law as a tool to police deceptive financial disclosure.

In short, the primordial rule against transfers made with intent to “hinder, delay, or defraud” creditors has most familiarly been applied to transfers that diminish the debtor’s estate or that involve deception, actual or potential, of the debtor’s creditors. Securitization does not inherently fall into either of those two familiar categories. Commentators on securitization, advocates and skeptics alike, generally have not looked much further than that. But the primordial rule has also been applied to transfers of other types. In the nature of things, most kinds of debtor behavior that would damage creditor interests sufficiently to warrant challenge fall into one of the two familiar categories, and so cases applying the primordial rule to a transfer of another type are comparatively uncommon. They are, nevertheless, well established. When the primordial rule is applied to a transfer that neither diminishes the debtor’s estate nor involves deception, the result is a fraudulent transfer that is not likely to smell much like a “fraud” as that term is ordinarily used. Hence it is convenient to refer to such an application of the primordial rule as enforcing the rule’s “Nonhindrance” aspect.117

As a matter of form, analysis of the scope of Nonhindrance should begin with the language of the statute. But the phrase “hinder, delay, or defraud” is so vague as to have no real content other than that which courts choose to give it. The language is in the disjunctive, and so renders avoidable a transfer of assets made to “hinder” or “delay” creditors even if not made to “defraud” them. Many courts have emphasized this point, especially when confronting factual settings that do not fall into one of the two familiar categories.118 But this point

116 See supra note 28. 117 Dean Clark’s seminal essay on fraudulent transfer law, Robert Charles Clark, The Duties of the Corporate Debtor to its Creditors, 90 HARV. L. REV. 505 (1977), also uses the shorthand “Nonhindrance,” but in a very different sense. In Clark’s lexicon it denotes collectively all of the normative ideals of fraudulent transfer law, which he identifies as a norm against unjust diminution of the debtor’s estate, a norm against deception, a norm against preferences, and “a general, residual prohibition of conduct which hinders creditors in attempting to satisfy their claims.” Id. at 512-13. The “residual prohibition” referred to by Clark equates to “Nonhindrance” as used in this paper. Clark’s essay says almost nothing about the “residual prohibition” beyond noting its existence. 118 See, e.g., Shapiro v. Wilgus, 287 U.S. 348, 354 (1932); Means v. Dowd, 128 U.S. 273, 280-83, 288 (1888); Consove v. Cohen (In re Roco Corp.), 701 F.2d 978, 984 (1st Cir. 1983); Empire Lighting Fixture Co. v. Practical Lighting Fixture Co., 20 F.2d 295, 297 (2d Cir. 1927); Lippe v. Bairnco Corp., 249 F. Supp. 2d 357, 374 (S.D.N.Y. 2003), aff’d, 99 F. App’x 274 (2d Cir. 2004); United States v. Carlin, 948 F. Supp. 271, 277-78 (S.D.N.Y 1998); Kelley v. Thomas Solvent Co., 725 F. Supp. 1446, 1455 (W.D. Mich. 1988); Klein v. Rossi (In re Midwest S.S. Agency, Inc.), 251 F. Supp. 1, 2 (E.D.N.Y. 1966); In re Hughes, 183 F. 872, 874 (S.D.N.Y. 1910) (construing same language in provision of former Bankruptcy Act pertaining to acts of



means little in the absence of definitions of those three words, which are not provided by any of the codifications of the primordial rule. It would be absurd to seek for the answer in the ordinary meanings (as of 1571, presumably) of the words “hinder,” “delay” and “defraud,” for in this context those words plainly do not have anything like their ordinary meanings. For example, any preferential payment by a debtor to one of its creditors has the effect of “hindering” other creditors in the collection of their debts, as that word is ordinarily used, but courts have long held that intent to prefer is not ordinarily intent to “hinder, delay, or defraud” other creditors.119 Likewise, a debtor’s grant of a security interest to one creditor has the effect of “hindering” other creditors, as that term is ordinarily used, but again, such a grant has never been held to “hinder, delay, or defraud” other creditors per se. Each of the UFTA, UFCA, and Bankruptcy Code obviously contemplates that a debtor may grant a nonavoidable security interest.

Other attempts to squeeze meaning from the statutory words are equally unimpressive. Thus, one respected commentator asserted in passing that a transfer of assets that “hinders” or “delays” creditors cannot be a fraudulent transfer unless it serves a “fraudulent” purpose. 120 That is not what the statute says, and as a verbal formulation it is rarely invoked by the cases, but even if it were accepted it would merely shift the focus to the meaning of “fraud” in this context. And the fact that the primordial rule has been routinely applied to transactions so far removed from ordinary concepts of fraud as to merit the label “constructive” fraud—i.e., not really fraud at all—shows that “fraud” is not an answer to the question of the scope of the rule, but merely a different way of posing the question. bankruptcy); Sherman v. FSC Realty LLC (In re Brentwood Lexford Partners), 292 B.R. 255, 262-63 (Bankr. N.D. Tex 2003); Ferrari v. Bar-Land Corp. (In re Zenox, Inc.), 173 B.R. 46, 49 (Bankr. D. N.H. 1994); Bumgardner v. Ross (In re Ste. Jan-Marie, Inc.), 151 B.R. 984, 987 (Bankr. S.D. Fla. 1993); Buck Stove & Range Co. v. Vickers, 145 P. 904, 904 (Kan. 1915); Firmani v. Firmani, 752 A.2d 854, 858 (N.J. Super Ct. App. Div. 2000); Flushing Sav. Bank v. Parr, 438 N.Y.S.2d 374, 376 (App. Div. 1981), appeal dismissed, 426 N.E.2d 752 (N.Y. 1981); Stein v. Brown, 480 N.E.2d 1121, 1123 (Ohio 1985); Bennett v. Minott, 44 P. 288, 290-91 (Or. 1896); Butcher v. Butcher (In re Estate of Reed), 566 P.2d 587, 590 (Wy. 1977). 119 See, e.g., Van Iderstine v. Nat’l Disc. Co., 227 U.S. 575, 582 (1913). See also 1 GLENN, supra note 95, § 289, at 488 (“If there is in our law one point which is more ungrudgingly accepted than others, it is that the preferential transfer does not constitute a fraudulent conveyance.”). A preferential transfer may be treated as a fraudulent transfer, however, if the transfer is to an insider of the debtor. That principle is codified in UFTA § 5(b) and in the “good faith” element of the definition of “fair consideration” in UFCA § 3(a). See, e.g., Nisselson v. Drew Indus., Inc. (In re White Metal Rolling and Stamping Corp.), 222 B.R. 417, 430 (Bankr. S.D.N.Y. 1998). The hostility to insider preferences is also reflected in the extended preference period applicable to insiders. Bankruptcy Code § 547(b)(4). 120 See 1 GLENN, supra note 95, § 195, at 348. This formulation also appeared in Coder v. Arts, 213 U.S. 223, 242 (1909), in the course of holding that an ordinary preference does not violate the primordial rule, and it has been repeated on occasion in other cases. See, e.g., Stratton v. Sioux Falls Paint & Glass (In re Stratton), 23 B.R. 284, 288 (D.S.D. 1982).



English experience further illustrates the futility of attaching much significance to the statutory words. The traditional “hinder, delay, or defraud” language was repealed in England in 1925 and replaced with a successor statute that referred only to intent to “defraud.”121 English authorities nevertheless recognized that “defraud” in that context should not be interpreted in a limiting sense, but rather in the traditional sense of “hinder, delay, or defraud.”122 The current statutory codification of English fraudulent transfer law, which supersedes the 1925 enactment, abandons all reference to fraud and defines the proscribed conduct in broad and morally neutral terms: “putting assets beyond the reach of a person who is making, or may at some time make, a claim against [the debtor]” or “otherwise prejudicing the interests of such a person in relation to the claim in which he is making or may make.”123

The Nonhindrance aspect of the primordial rule against transfers made with intent to “hinder, delay, or defraud” creditors can be examined profitably only though inspection of the authorities that have applied it. The following section sets forth some examples.

2. Nonhindrance in Action

Although Nonhindrance is not the first aspect of the primordial

rule that comes to mind when considering the rule’s scope, it is the basis of several of the most famous fraudulent transfer cases. One such is Benedict v. Ratner.124 Benedict, decided in 1925, involved the then recently evolved practice of non-notification receivables financing, in which a creditor is secured by the assignment of a receivable and the account debtor is not notified of the assignment, and so continues to make payments to the assignor. In Benedict a corporate debtor assigned

121 Law of Property Act, 1925, 15 & 16 Geo. 5, c. 20, § 172 (Eng.) (repealed 1986). 122 The Cork Report, which paved the way for the comprehensive revision of English insolvency law in 1985 and 1986, described existing English law on this point as follows: “[I]t is not entirely clear what is the meaning of ‘to defraud’ in this context; though it seems that, in practice, the requisite inference of fraud will be drawn whenever the necessary consequence of the transaction is to defeat, hinder, delay or defraud the creditors or to put assets belonging to the debtor beyond their reach.” INSOLVENCY LAW REVIEW COMM., INSOLVENCY LAW AND PRACTICE, 1982, Cmnd. 8558, ¶ 1212, at 276. 123 Insolvency Act, 1986, c. 45, §§ 423-25 (Eng.); the quoted language is from § 423(3). This 1986 enactment also added as a condition to avoidance that the transfer of assets be at an “undervalue,” defined to have roughly the same meaning that the UFTA expresses as lack of reasonably equivalent value. This additional condition has been elastically interpreted by English courts, however. See, e.g., Nat’l Westminster Bank v. Jones, [2001] 1 B.C.L.C. 98 (Ch.) (Eng.), aff’d, [2001] EWCA (Civ) 1541 (holding a transaction to be at an “undervalue” and avoidable even though it did not reduce the debtor’s overall asset position). Commentators have argued for repeal of this additional condition. See REBECCA PARRY, TRANSACTION AVOIDANCE IN INSOLVENCIES §§ 10.26-10.27, at 234 (2001). 124 268 U.S. 353 (1925).



its present and future trade receivables as security to a lender on a non-notification basis. The terms of the arrangement allowed the debtor to use collections of the receivables as it wished, unless and until the lender made demand on the debtor to remit subsequent collections to the lender for application to the lender’s debt. Following the debtor’s bankruptcy, Justice Brandeis, speaking for a unanimous Supreme Court, observed that there had been no fraud in fact, 125 but nevertheless concluded that the assignment was “fraudulent in law and void” under New York law.126 The fatal element was the debtor’s right to retain for its own benefit collections on the assigned receivables. A line of New York cases involving chattel mortgages on a merchant’s inventory had held that such a mortgage was a fraudulent transfer if the merchant-debtor was entitled to sell the inventory and keep the proceeds for its own use. The Court held that the same principle applied to any collateral, and so an assignee of receivables, like a mortgagee of inventory, must exercise “dominion” over its collateral, in this case by requiring all collections to be turned over to the assignee.

Benedict is often misrepresented. Assignments of receivables of the type involved in Benedict at the time were governed only by the common law of contracts, so no public filing or other public notice of the assignment was called for. Some standard texts (and indeed some casebooks) thus present Benedict as a manifestation of the traditional common law hostility toward nonpossessory liens, founded on the traditional notion that the debtor’s other creditors may be deceived by such a secret property interest.127 That is quite erroneous. As Grant Gilmore remarked, “nothing is clearer than that ‘secrecy’ had nothing to do with the Benedict rule.”128 The Court stated explicitly that the rule it applied had nothing to do with “seeming ownership.”129 The rule was

125 Id. at 358 (“There was no finding of fraud in fact.”). Indeed the very first sentence of the Court of Appeals’ opinion, following its statement of the case, was “There is nothing in this record to warrant even a suggestion of fraud.” In re Hub Carpet, 282 F. 12, 14 (2d Cir. 1922). 126 Benedict, 268 U.S. at 360. 127 See, e.g., DOUGLAS J. WHALEY, PROBLEMS AND MATERIALS ON SECURED TRANSACTIONS 9 (7th ed. 2006) (“The evil under attack in Benedict v. Ratner is the secret lien that other creditors do not know about.”) (italics in original); 8 WILLIAM D. HAWKLAND ET AL., UNIFORM COMMERCIAL CODE SERIES § 9-205:1 (2002) (“The basis for the Benedict v. Ratner decision was the old concept that a seller who retains possession of goods following their sale in effect commits a fraud as to his creditors because it gives the appearance that the goods continue to belong to the seller.”) (no italics in original); Jeanne L. Schroeder, Some Realism About Legal Surrealism, 37 WM. & MARY L. REV. 455, 477-85 (1996). This error is, of course, by no means universal. See, e.g., Edward J. Janger, Brandeis, Progressivism, and Commercial Law: Rethinking Benedict v. Ratner, 37 BRANDEIS L.J. 63 (1998); Mooney, supra note 113, at 738-39. 128 1 GILMORE, supra note 113, § 8.4, at 265; see also id. at 262. 129 Benedict, 268 U.S. at 362-63 (“[I]t is not true that the rule stated above and invoked by the receiver is either based upon or delimited by the doctrine of ostensible ownership. It rests not upon seeming ownership because of possession retained, but upon a lack of ownership because of dominion reserved.”).



the same as that applied by the inventory mortgage cases: public recording was statutorily required for such a mortgage to be valid against creditors, but (as the Court twice noted) public recording did not save the mortgage from invalidation as a fraudulent transfer if the mortgagee failed to obtain dominion over the collateral.130 And, for decades after Benedict, non-notification accounts receivable finance was successfully practiced, without any public filing or other public notice, under arrangements that complied with the rule of Benedict by requiring the assignor to turn over to the assignee all collections of the assigned receivables.131

Benedict is thus an application of fraudulent transfer law in its Nonhindrance aspect: assets were not hidden or transferred for less than their value, and neither actual nor potential deception of creditors played any role in the Court’s reasoning or the rule it laid down. Confronted by a novel financing pattern, the Court enforced a policy decision about debtor-creditor law that had nothing to do with true fraud. 132 As Gilmore explained, the Benedict rule implemented a rational policy. By requiring collections of assigned receivables to be remitted to the lender, the Benedict rule necessarily entailed the lender keeping close watch over the debtor’s affairs. That monitoring would inure indirectly to the benefit of the debtor’s other creditors, for the lender would be in a position to call its loan and thus shut down the debtor if the debtor’s financial situation became hopeless. By doing so the lender would head off the incurrence of additional unsecured debt characteristic of a debtor in its financial death throes—a distinct social benefit.133 Decades later, the drafters of Article 9 of the UCC (including

130 Id. at 361 & n.11; id. at 364. For further discussion of the inventory mortgage cases, see 1 GILMORE, supra note 113, §§ 2.3, 2.5. 131 See 1 GILMORE, supra note 113, § 8.1, at 250-53, § 8.3, at 259, § 8.5, at 265-71. 132 “Policy decision” because the Court’s decision was by no means compelled by New York precedent. Justice Brandeis chose to rely on the inventory mortgage cases even though there existed at least one New York appellate case specific to assignment of receivables that laid down a different rule. Justice Brandeis shrugged it off on grounds that would invite a scolding if offered by a first year law student: it had never been cited by any later New York case, had “a strong dissenting opinion,” and “is perhaps distinguishable on its facts” (though he did not say how). Benedict, 268 U.S. at 365. Grant Gilmore went so far as to say, “On a how-to-read-cases level . . . Justice Brandeis was wrong.” Grant Gilmore, The Good Faith Purchase Idea and the Uniform Commercial Code: Confessions of a Repentant Draftsman, 15 GA. L. REV. 605, 622 (1981). 133 See 1 GILMORE, supra note 113, § 8.3, at 259-61. As Gilmore also noted, the opinion says nothing about these or any other policy grounds. Id. at 259. That silence invites debate as to whether Benedict was based on conscious recognition of these policy grounds, or was merely the result of a rather mindless misreading of New York cases. The answer does not affect the status of Benedict as an example of employment of Nonhindrance, but obviously its employment is more satisfying intellectually if the former supposition is true. The former supposition is supported by the fact that Justice Brandeis’ papers show that he devoted a great deal of time and thought to the case, see id. at 258 n.2, and by the enthusiastic acceptance of the Benedict rule by other courts, see id. § 8.5 at 265-71, and Gilmore, supra note 132, at 622-23. Professor Janger, in



Gilmore) disagreed with this policy choice and repealed the rule of Benedict as to transactions governed by Article 9—though Gilmore later came to repent that decision.134 The merits of the particular rule laid down in Benedict, however, are beside the point of the present discussion. The point is that Benedict applied the Nonhindrance aspect of fraudulent transfer law to enforce a policy of debtor behavior that had nothing to do with true fraud. Article 9’s later repeal of the particular rule laid down by Benedict in no way altered the meta-rule of Nonhindrance.

Also familiar is the Supreme Court’s 1917 decision in Dean v. Davis.135 Dean involved an insolvent debtor in business whose debts included unsecured notes held by a bank. The bank believed that the notes bore forged endorsements, and so demanded that the debtor pay them or face arrest. The debtor persuaded his brother-in-law, who knew him to be insolvent, to lend him money on the security of a mortgage on all of his assets, for the purpose of paying the notes. The loan was made and the bank was paid, a preference to the bank. Soon after an involuntary petition was filed against the debtor, and the debtor’s trustee brought an action to set aside the mortgage granted to the brother-in-law. The Court, again speaking through Justice Brandeis, held that the mortgage was not avoidable as a preference, because it was given to secure a substantially contemporaneous advance rather than an antecedent debt (a principle now codified in section 547(c)(1) of the Bankruptcy Code, which is one reason why the case is remembered today). But the Court went on to hold that the mortgage was avoidable under the primordial rule of fraudulent transfer law, because it was granted by the debtor for the purpose of financing a preferential payment in contemplation of bankruptcy.

The specific holding of Dean—that a grant of a security interest to secure a loan is avoidable as a fraudulent transfer if the debtor borrows the loan for the purpose of making a preferential payment in contemplation of bankruptcy—seemingly remains good law. That rule was codified into the Bankruptcy Act in 1938.136 The codification was not carried forward into the Bankruptcy Code, but that was not because of disapproval of the rule; rather, it stemmed partly from dissatisfaction with the wording of the codification, which arguably went beyond the rule stated in Dean and created problems for lenders to financially distressed firms, and partly from the feeling that there was no real need his article supra note 127, expressed no doubt that Benedict was the product of Justice Brandeis’ conscious insight, which Janger compared favorably to the monitoring justification for secured credit advanced by modern law-and-economics scholarship. 134 For the rejection of the Benedict rule by Article 9, see U.C.C. § 9-205; for Gilmore’s later repentance, see Gilmore, supra note 132, at 620-27. 135 242 U.S. 438 (1917). 136 Bankruptcy Act § 67d(3) (repealed).



for the rule to be codified at all.137 At the time the Bankruptcy Code was enacted most commentators seem to have agreed that the decision not to carry forward the former codification did not affect the continuing force of Dean,138 and since then a number of courts have affirmed its vitality.139

Again, however, the particular rule set forth in Dean is not the point of the present discussion. The point is that Dean is another application of the Nonhindrance aspect of fraudulent transfer law. The mortgage avoided in Dean involved no deception or concealment, and its grant did not diminish the debtor’s net assets, as it secured the debtor’s obligation to repay funds actually advanced to the debtor. As with Benedict, it is difficult to work up much moral indignation about the act in question; preferences as such have not usually been considered morally opprobrious, and it is hard to see why the financing of a preference should be considered any more so.140 As in Benedict, Justice Brandeis invoked fraudulent transfer law not to undo an act that diminished the debtor’s estate or to prevent deception, but to further another policy he considered important: in this case, fortifying the Bankruptcy Act’s anti-preference policy: “A transfer, the intent (or obviously necessary effect) of which is to deprive creditors of the benefits sought to be secured by the Bankruptcy Act, ‘hinders, delays or defrauds creditors’ within the meaning of § 67e [the Bankruptcy Act’s

137 See REPORT OF THE COMM’N ON BANKRUPTCY LAWS, H.R. Doc. No. 93-137, pt. 2, at 177 (1973) (thus explaining the Commission’s recommendation not to carry forward former § 67d(3)); see also Charles E. Corker, Hazards of Doing Business with an Insolvent: The Dean v. Davis Amendment in the Chandler Act, 1 STAN. L. REV. 189 (1949) (detailing concerns created by the overbroad drafting of former § 67d(3)). 138 See Richard B. Levin, An Introduction to the Trustee’s Avoiding Powers, 53 AM. BANKR. L.J. 173, 183 (1979); Morris W. Macey, Preferences and Fraudulent Transfers Under the Bankruptcy Reform Act of 1978, 28 EMORY L.J. 685, 707 (1979). But see Richard B. Hagedorn, The Survival and Enforcement of the Secured Claim Under the Bankruptcy Reform Act of 1978, 54 AM. BANKR. L.J. 1, 8 (1980). 139 See, e.g., Official Creditors Comm. v. Minden Exch. Bank & Trust Co. (In re Craig), 92 B.R. 394 (Bankr. D. Nev. 1988); Consumers Credit Union v. Widett (In re Health Gourmet, Inc.), 29 B.R. 673 (Bankr. D. Mass 1983); Coleman Am. Moving Servs., Inc. v. First Nat’l Bank & Trust Co. (In re Am. Props., Inc.), 14 B.R. 637 (Bankr. D. Kan. 1981); see also Foxmeyer Drug Co. v. Gen. Elec. Capital Corp. (In re Foxmeyer Corp.), 296 B.R. 327, 337-38 (Bankr. D. Del. 2003) (suggesting in dictum that Dean may be limited to settings in which the recipient of the preference-enabling transfer is also the recipient of the preferential transfer). 140 A preference to an insider of the debtor is often condemned as a fraudulent transfer, however. See supra note 119. The lender in Dean whose mortgage was avoided was the debtor’s brother-in-law, and though he did not receive a preference one might have expected his insider-ish status to have figured in the Court’s analysis. That is not so, however, either in Dean itself, in its later codification in former Bankruptcy Act § 67d(3), or to all appearances in cases applying the Dean rule: all would apply the rule equally to a preference-financing lender who is not an insider. (Indeed, the principle that treats an insider preference as a fraudulent transfer can itself be viewed as another example of the Nonhindrance aspect of fraudulent transfer law, for an insider preference does not diminish the net worth of the debtor, nor does it necessarily entail any deception of creditors.)



integral fraudulent transfer provision at the time].”141 Another setting to which the Nonhindrance aspect of fraudulent

transfer law has been applied is a transfer of assets that diminishes the debtor’s liquidity and so makes it more difficult for creditors to realize upon the debtor’s assets. Straightforward exchange by a debtor of an asset for a less liquid asset, or disposition of liquid property while retaining illiquid property, made for the purpose of making a creditor’s remedies more difficult to exercise, has been held to constitute a fraudulent transfer, notwithstanding that the transfer does not diminish the net value of the debtor’s assets and does not involve any deception or concealment.142 A recurring fact pattern of this kind that strikes close to home for securitization is a debtor’s contribution of assets to a wholly-owned corporation, the stock of which may be more difficult to realize upon by execution than the assets would have been. Because such a contribution may serve a good business purpose independent of its effect on the debtor’s creditors, courts have often declined to avoid such contributions. But if convinced that the reason for the contribution was to make it more difficult for a creditor to enforce its remedies, courts have held the contribution to be a fraudulent transfer.143

141 Dean v. Davis, 242 U.S. 438, 444 (1917). 142 See, e.g., Empire Lighting Fixture Co. v. Practical Lighting Fixture Co., 20 F.2d 295 (2d Cir. 1927) (L. Hand, J.) (sale on credit by one corporation to an affiliate of its plant and chattels, leaving the seller solvent with ample accounts receivable, held avoidable because made for the purpose of hindering creditors of the seller, due to the comparative difficulty of creditors realizing on accounts receivable under then-current execution practice); Klein v. Rossi (In re Midwest S.S. Agency, Inc.), 251 F. Supp. 1 (E.D.N.Y. 1966) (solvent debtor’s gift to his wife of shares of stock in his employer, his only liquid asset, while retaining illiquid assets, for the purpose of protecting the stock from execution, held to be an avoidable attempt to “hinder” or “delay,” even though not an attempt to cheat the creditor of ultimate payment); Glassman v. Glassman, 131 N.E.2d 721 (N.Y. 1956) (holding avoidable an individual’s transfer of cash to fund his account with the state retirement system because it was undertaken to thwart a creditor; there was no suggestion in the report that the creditor could not have attached the debtor’s resulting rights against the state retirement system). 143 See Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215 (1941); Addison v. Tessier, 335 P.2d 554 (N.M. 1959); First Nat’l Bank. v. F. C. Trebein Co., 52 N.E. 834 (Ohio 1898); Kellogg v. Douglas County Bank, 48 P. 587 (Kan. 1897); Bennett v. Minott, 44 P. 288 (Or. 1896); Curran v. Rothschild, 60 P. 1111 (Colo. Ct. App. 1900). Some early cases also suggest that at the time it was procedurally more complex for creditors to reach the corporate stock than the assets contributed in exchange for it, which would add to the illiquidity of the stock. See, e.g., F. C. Trebein, 52 N.E. at 837. See also Rose v. Rose, 271 N.Y.S 5 (App. Div. 1934); Leventhal v. Spillman, 234 F. Supp. 207 (E.D.N.Y. 1964), aff’d mem., 362 F.2d 264 (2d Cir. 1966); United Sewing Mach. Distribs., Inc. v. Calhoun, 95 So.2d 453 (Miss. 1957); Alliance Trust Co. v. Streater, 161 So. 168 (La. 1935); Farkas v. Katz (In re Katz), 54 F.2d 1061 (5th Cir. 1932). KRAVITT, supra note 18, § 5.05[H][2][a], at 5-142 n.567, cites U.S. Shoe Corp. v. Beard, 463 F. Supp 754, 757 (S.D. Ala. 1979) and Carson v. Long-Bell Lumber Corp., 73 F.2d 397, 402 (8th Cir. 1934) as upholding contributions of assets to a subsidiary corporation against fraudulent transfer attack, but both cases also indicated that the result would have been different if the facts had showed that the purpose of the contribution had been to hinder creditors. See generally P. H. Vartanian, Annotation, Transfer of Property by Debtor to Corporation, in Consideration of its Stock, as a Fraud on Creditors, 85 A.L.R. 133 (1933); 1 GLENN, supra note 95, § 287a, at 484.



A particular kind of liquidity-reducing transaction to which Nonhindrance has been applied is a debtor’s grant of a security interest in property of disproportionately high value compared to the amount of debt secured. The history of the application of fraudulent transfer law to such “overcollateralization” transactions is instructive.

Use of overcollateralization as a way to shield assets from levy by judgment creditors was especially problematic at the turn of the last century, because at that time many states followed the common law doctrine that a chattel mortgage operated to transfer title to the chattel to the mortgagee, and in such states there could be no way (or at least no efficient way) for a judgment creditor to attach the debtor’s equity in the chattel.144 In states that followed that doctrine, even a nominal debt secured by a debtor’s assets might insulate the assets from the reach of the debtor’s judgment creditors, absent intervention by fraudulent transfer law. It is not surprising, therefore, that courts came to consider overcollateralization a badge of fraud, and in appropriate cases avoided the secured creditor’s interest as a fraudulent transfer.145 When the UFCA was promulgated in 1918, its drafters elevated that badge of fraud to a per se rule of constructive fraud, through an artificial definition stating that a debtor does not receive “fair consideration” for an interest that secures an obligation if the obligation is “disproportionately small” in comparison to the value of the collateral. That definition, in conjunction with the other provisions of UFCA, has the effect of rendering avoidable any security interest that fails the “disproportionately small” test if the debtor is in a state of financial distress, regardless of the debtor’s intent.146

The universal enactment of Article 9 removed most of the need for fraudulent transfer law to intervene in cases of overcollateralization. That is because Article 9 overrode the common law doctrine just described and gave judgment creditors the power to reach the debtor’s equity in personal property by levying and selling it subject to the

144 See Richard J. Sabella, When Enough is Too Much: Overcollateralization as a Fraudulent Conveyance, 9 CARDOZO L. REV. 773, 781 (1987). As of 1910, seven states did not permit attachment of a chattel mortgagor’s equity in the chattel at all, and seven had statutes permitting attachment, but only if the mortgagee was paid in full before any foreclosure sale by the attaching creditor. Twenty-two states had statutes which followed the modern approach and permitted a judgment creditor to attach the chattel mortgagor’s equity and sell the chattel subject to the lien of the mortgagee. Id. at 782 (citing 2 J. E. COBBEY, A PRACTICAL TREATISE ON THE LAW OF CHATTEL MORTGAGES AS ADMINISTERED BY THE COURTS OF THE UNITED STATES §§ 679-717, at 890-911 (1893)). 145 Cases are gathered in Sabella, supra. note 144, at 783-84; Annotation, Excessive Security for Debt as Affecting Question of Fraud upon Creditors, 138 A.L.R. 1051 (1942); and ORLANDO F. BUMP, A TREATISE UPON CONVEYANCES MADE BY DEBTORS TO DEFRAUD CREDITORS § 58 (J. Gray rev. 4th ed. 1896). 146 This artificial definition is found at UFCA § 3(b), and the constructive fraud provisions that give it the stated effect are UFCA §§ 4, 5, 6, 8.



secured creditor’s security interest.147 Hence, in principle, a secured transaction governed by Article 9 does not diminish (or at least does not significantly diminish) the net value of the debtor’s assets available to judgment creditors, no matter how great the disproportion between the value of collateral and the amount of the debt. In consequence, the drafters of the UFTA in 1984 did not carry forward the UFCA’s special rule making overcollateralization constructively fraudulent. 148 But, notwithstanding the equivalence of asset inflows and outflows to the debtor in a secured transaction, and notwithstanding that compliance with the perfection rules of Article 9 obviates any notion that the security interest is inherently deceptive, the drafters of the UFTA took care to emphasize that an overcollateralization transaction might still be a fraudulent transfer if made by the debtor with intent to “hinder, delay, or defraud” other creditors.149

The drafters of the UFTA gave no examples of overcollateralization transactions that would be avoidable for this reason, but it is not difficult to imagine situations that might qualify. Property subject to a lien is more difficult to market than property that is free and clear, and indeed might be so unmarketable as to be in a practical sense beyond the reach of a judgment creditor, who would get nothing for his time and expense if he pursues an execution sale.150 An example is a lien securing a contingent obligation or an obligation of uncertain size. Another example is a lien covering more than one item of property. Suppose that debtor owns $100 in the form of numerous assets and grants a lien on all of them to secure a $10 debt. Despite the debtor’s massive equity in the property, an unsecured creditor with a judgment for $1 may find it practically impossible to collect it. Under Article 9 and most mortgage laws a buyer of any item of the property at an execution sale will take the item subject to the secured creditor’s lien

147 This rule was laid down by U.C.C. § 9-311 (1962), Comments 1 and 2, which explicitly spelled out this result. Curiously, the 1999 revision, which carried forward that provision as U.C.C. § 9-401, did not carry forward those comments, and revised extensively the statutory text, including by addition of a new subsection (a) which states that, with certain exceptions, “whether a debtor’s rights in collateral may be voluntarily or involuntarily transferred is governed by law other than this article.” Literally read, the provision as thus revised no longer overrides the common law doctrine described in the text. That plainly was not the revisers’ intention, however, as Comment 4 to the revised provision states that “[t]he substance of subsection (a) was implicit under former Article 9.” See also Julian B. McDonnell, Is Revised Article 9 a Little Greedy?, 104 COM. L.J. 241, 258-61 (1999). 148 See UFTA § 4 cmt. 3 (explaining this point). 149 See UFTA § 4 cmt. 3 (“Disproportion between the value of the asset securing the debt and the size of the debt secured does not, in the absence of circumstances indicating a purpose to hinder, delay, or defraud creditors, constitute an impermissible hindrance to the enforcement of other creditors’ rights against the debtor-transferor.”) (emphasis added). 150 See Sabella, supra note 144, at 797-808, which also notes ways in which the rules pertaining to the priority of future advances made by a secured creditor can interfere with a judgment creditor’s ability to realize upon the debtor’s equity in collateral.

Dr. David B. Starkey

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securing its $10 debt. Accordingly, no rational buyer would bid anything unless what is sold is a bundle of assets collectively worth more than $10, which may be legally impossible or economically impractical if the assets are in different jurisdictions or are individually worth little.151 It is not difficult to imagine a court finding a lien granted in situations such as these for the purpose of thwarting unsecured creditors to be an impermissible hindrance.

The problem faced by an unsecured creditor confronted by a security interest on multiple assets of the debtor disappears if a bankruptcy court assumes jurisdiction over all of the debtor’s assets. The increased employment of the federal bankruptcy law in modern times, together with the enactment of Article 9, no doubt explains why cases involving fraudulent transfer attacks on overcollateralization transactions are thin on the ground in recent decades. Such cases nevertheless do continue to arise.152 And it is universally acknowledged that such situations are appropriately policed by fraudulent transfer law in its Nonhindrance aspect.

3. Shapiro v. Wilgus: Application of Nonhindrance to Undo

Manipulation of Insolvency Law Most directly threatening to securitization are cases that have

applied the Nonhindrance aspect of fraudulent transfer law to avoid asset transfers that, like the transfer from the Originator to the SPE in the prototypical securitization transaction, are made by a debtor for the purpose of gaming the insolvency system—that is, making its assets subject to a regime of insolvency law that is more to the debtor’s taste. The leading authority on that subject is Shapiro v. Wilgus,153 decided by the Supreme Court in 1932. In Wilgus the Court declared fraudulent an asset transfer made for such a purpose, even though the transfer not only 151 The drafters of Article 9 recognized the potential need for equitable intervention in such cases, but “le[ft] resolution of this problem to the courts” with no guidance beyond the suggestion that the doctrine of marshaling “may be appropriate.” U.C.C. § 9-401 cmt. 6 (carried forward with slight wording changes from U.C.C. § 9-113 cmt. 3 (1962)). 152 See, e.g., HBE Leasing Corp. v. Frank, 61 F.3d 1054, 1061 (2d Cir. 1995) (remanding for trial as to whether a mortgage given to secure a debt was avoidable either because the debt was “disproportionately small” compared to the value of the property under the New York enactment of UFCA § 3(b) or because the mortgage was granted with intent to hinder, delay, or defraud other creditors); Clarkson Co. v. Shaheen, 525 F. Supp. 625 (S.D.N.Y. 1981) (holding security interest avoidable both under the New York enactment of UFCA § 3(b) and because granted with intent to hinder, delay, or defraud other creditors); Wirtz v. Jensen (In re Rassmussen’s Estate), 298 N.W. 172 (Wis. 1941) (similar); see also, e.g., M. & N. Freight Lines, Inc. v. Kimbel Lines, Inc., 170 S.W.2d 186 (Tenn. 1943) (avoiding, as done with intent to “hinder” and “delay” a judgment creditor seeking to levy on an asset, a debtor’s grant of a chattel mortgage on the asset to secure a valid preexisting debt owed to an employee of the debtor). 153 287 U.S. 348 (1932).



did not diminish the debtor’s net assets or involve deception, but arguably was downright laudable.

Wilgus involved a Pennsylvania lumber dealer who found himself unable to pay his debts as they became due. He was, however, solvent, and he believed, apparently with good reason, that given time he would be able to pay his creditors in full and reap a surplus.154 All but two of his creditors were willing to give him time, and he cast about for a way to hold the two dissenters at bay while continuing to run his business. Today he would be a natural candidate for a Chapter 11 filing, but the federal bankruptcy law of the time did not provide for reorganization proceedings; the only vehicle for analogous relief was an equity receivership. And, while Pennsylvania law at the time allowed a receiver to be appointed for a corporation or a partnership, it did not allow a receiver to be appointed for an individual. So (in the panegyrical words of the Third Circuit) “under the advice of honest and able counsel, he followed the only course open to him to effect his honest purpose of preventing a sacrifice of his property, thwarting all efforts of creditors to get preferences, and insuring the continuance and gradual liquidation of his business and an equal distribution among all his creditors.”155 Specifically, he formed a corporation to which he conveyed all of his property, in exchange for all of the corporation’s capital stock and its assumption of his debts. He then caused the corporation to be placed in receivership through the then-usual technique of an uncontested complaint by a friendly creditor in federal district court; in the usual way, the court promptly appointed a receiver and entered an injunction against attachments and executions. One of the dissenting creditors filed suit and obtained judgment against the dealer individually, and then petitioned the district court to allow the corporate property in the possession of the receiver to be levied upon to satisfy the judgment. The district court denied the petition, and the Third Circuit affirmed, with some hard words for the dissenting (or, as the court would have it, “preference seeking”) creditor.

Justice Cardozo, speaking for a unanimous Supreme Court, reversed, holding that the dealer’s conveyance of assets to the corporation was avoidable as a fraudulent transfer. “[T]he aim of the debtor was to prevent the disruption of the business at the suit of hostile creditors and to cause the assets to be nursed for the benefit of all concerned.”156 That purpose, though laudable, was invalid under the

154 The Court of Appeals declared the debtor’s solvency in no uncertain terms. The Supreme Court more grudgingly referred only to the debtor having a “belief” in his solvency that the court later implied was “well founded.” Shapiro v. Wilgus, 55 F.2d 234, 234 (3d Cir. 1932), rev’d, 287 U.S. at 352, 354. 155 Wilgus, 55 F.2d at 234. 156 287 U.S. at 354.



Nonhindrance aspect of the primordial rule: A conveyance is illegal if made with an intent to defraud the creditors of the grantor, but equally it is illegal if made with an intent to hinder and delay them. Many an embarrassed debtor holds the genuine belief that, if suits can be staved off for a season, he will weather a financial storm, and pay his debts in full. The belief even though well founded, does not clothe him with a privilege to build up obstructions that will hold his creditors at bay. This is true in Pennsylvania under the Uniform Fraudulent Conveyance Act . . . . It is true under the Statute of Elizabeth . . . . Tested by either act, this conveyance may not stand.157 Justice Cardozo took pains to emphasize that the conveyance was a

fraudulent transfer notwithstanding the absence of any purpose on the part of the debtor to cheat his creditors or anything else remotely approaching fraud.158 The creditors might have pursued the stock of the corporation held by the individual debtor, but that fact made no difference to the Court, which did not even mention it. 159 The irrelevance of the creditors’ right to pursue the stock follows from the same concept of illiquidity discussed earlier: stock in a corporation in financial distress and subject to receivership cannot be expected to be as easy for a creditor to realize upon as the hard assets conveyed to that corporation. In effect, the Court applied to the debtor a model of debtor-creditor law that internalized the Pennsylvania rule that a receiver is not available for an individual, and treated the debtor’s attempt to circumvent that rule as an impermissible hindrance of his creditors’ right to grab what they could, preferentially or not.

Wilgus was not rooted in judicial abhorrence of the fact that the equity receivership prevented the dissenting creditors from pursuing their claims, as such. 160 The Court noted that if the debtor had originally been organized as a corporation and a creditor sought such a receivership as allowed by Pennsylvania law, the receivership would not have been an impermissible hindrance, though it would have blocked creditors from pursuing their claims in just the same way.161 157 Id. (citations omitted). 158 Id. at 357 (“We have no thought in so holding to impute to counsel for the debtor or even to his client a willingness to participate in conduct known to be fraudulent. The candor with which the plan has been unfolded goes far to satisfy us, without more, that they acted in the genuine belief that what they planned was fair and lawful. Genuine the belief was, but mistaken it was also. Conduct and purpose have a quality imprinted on them by the law.”). 159 The creditors’ right to pursue the corporate stock, and the fact that the transfer did not diminish the debtor’s net assets, were noted by the trial court in its opinion denying a similar application by another creditor against the same debtor. McLean v. Miller Robinson Co., 55 F.2d 232, 233 (E.D. Pa. 1931). 160 What appears to be the sole reference to Wilgus in the existing pro-securitization literature summarily dismisses it on this mistaken ground. KRAVITT, supra note 18, § 5.05[H][2][a], at 5-142. 161 Wilgus, 287 U.S. at 356 (“Never is [receivership] available when it is . . . a means for the



Rather, Wilgus condemned the debtor’s attempt to manipulate the regime of insolvency law to which his assets would be subject by transferring his assets to a different entity. In so doing, the Court implemented its growing skepticism about the institution of the “friendly” equity receivership for debtors other than railroads and similar public-service enterprises that could not be permitted to cease operation. The Court only hinted at that skepticism in Wilgus, but the abuses associated with such receiverships were much discussed at the time, and the Court’s growing inclination to restrict their use manifested itself in other contemporary cases.162 So again, as in Benedict and Dean, Wilgus employed the Nonhindrance aspect of fraudulent transfer law to implement a policy of debtor-creditor law that the Court considered important, but did not remotely approach fraud in any ordinary sense.163

Wilgus stands for the proposition that an asset transfer made by a debtor for the purpose of opting into a different body of insolvency law is a candidate for avoidance as a fraudulent transfer. That proposition has been applied quite generally to different bodies of insolvency law, and it is employed regularly today in an evolved form.164 Not long after Wilgus, reorganization provisions were added to the Bankruptcy Act

frustration of the public policy of the state or the locality. It is one thing for a creditor with claims against a corporation that is legitimately his debtor to invoke the aid of equity to conserve the common fund for the benefit of himself and of the creditors at large. Whatever hindrance and delay of suitors is involved in such a remedy may then be incidental and subsidiary.”) (citation omitted). 162 Id. at 356; Harkin v. Brundage, 276 U.S. 36, 52 (1928). See generally Henry J. Friendly, Some Comments on the Corporate Reorganizations Act, 48 HARV. L. REV. 39, 41-45 (1934); DAVID A. SKEEL, JR., DEBT’S DOMINION: A HISTORY OF BANKRUPTCY LAW IN AMERICA 104-05 (2001). 163 And it is worth noting that contemporary commentators, including luminaries of the reorganization bar, agreed that Wilgus was an open and shut case. See Friendly, supra note 162, at 44 (the transfer in Wilgus was “plainly a fraudulent conveyance”); Robert T. Swaine, Corporate Reorganization Under the Federal Bankruptcy Power, 19 VA. L. REV. 317, 322 (1933) (Wilgus was “obviously correct”). 164 Soon after Wilgus the Supreme Court replayed its melody in a different key in First Nat’l Bank of Cincinnati v. Flershem, 290 U.S. 504 (1934). In that case, a committee representing a majority of the debenture holders of a solvent corporation procured a default by the corporation, followed by a receivership that proceeded to judicial sale of the corporation’s assets pursuant to a reorganization plan put forward by the committee. Reversing the lower courts, the Court held that the judicially-approved sale was a fraudulent transfer and that dissenting creditors were entitled to payment in full out of the receivership funds.

The purpose of the transaction was to hinder and delay certain creditors. If [the debtor] had sought to achieve the purpose of the reorganization committee by a voluntary transfer of all the assets to a new corporation, the conveyance would have been fraudulent in law as to dissenting debenture holders. It would have been a fraudulent conveyance even if the transaction had been entered upon solely in the interest of the debenture holders, in a well-founded belief that it would prove to their advantage, and although full payment of the indebtedness had been contemplated.

Id. at 518.



that superseded equity receiverships of the style involved in Wilgus.165 Cases applying the new law wholeheartedly employed the principle of Wilgus to invalidate asset transfers made by an entity not eligible for relief under a particular title of the Bankruptcy Act to another entity that was eligible. These cases soon came to cast their analysis less in terms of fraudulent transfer and more in terms of whether the entity filing the bankruptcy petition acted in “good faith,” an explicit condition of filing under many chapters of the Bankruptcy Act. Cases cast in terms of “good faith filing” cited equally Wilgus and other cases that were cast in terms of fraudulent transfer, treating the two doctrines as two faces of the same coin.166

Courts have continued in the same vein under the Bankruptcy Code, applying the principle of Wilgus though usually casting discussion in terms of whether the debtor’s filing was in good faith.167 165 The Bankruptcy Act was amended in 1934 to allow corporate reorganization, and in 1938 the Chandler Act extensively reworked the reorganization provisions into the shape they would retain until the enactment of the Bankruptcy Code in 1978. For the bare bones, see Charles Jordan Tabb, The History of the Bankruptcy Laws in the United States, 3 AM. BANKR. INST. L. REV. 5, 21-23, 28-30 (1995); for a richer discussion, see SKEEL, supra note 162, at 101-27. 166 See, e.g., Sherman v. Collins (In re Collins), 75 F.2d 62 (8th Cir. 1934) (conveyance of assets by corporation to its sole individual stockholder so that stockholder could file petition for composition as debtor under § 74 of the former Bankruptcy Act, for which a corporation was ineligible; held, a fraudulent transfer, citing Wilgus); Milwaukee Postal Bldg. Corp. v. McCann, 95 F.2d 948, 950 (8th Cir. 1938) (individual owner of a building conveyed it to a corporation for the purpose of facilitating an out-of-court restructuring, which failed, following which the corporation filed for relief under § 77B of the former Bankruptcy Act, available only to corporations; held, a “legal fraud upon creditors,” citing Wilgus; petition dismissed as having been filed in bad faith); In re Francfair, Inc., 13 F. Supp. 513 (S.D.N.Y. 1935) (trust contributed mortgaged property to newly organized corporation and caused the corporation to file under § 77B of the former Bankruptcy Act; held, dismissed for lack of good faith, citing Wilgus); Mongiello Bros. Coal Corp. v. Houghtaling Props. Inc., 309 F.2d 925 (5th Cir. 1962) (individuals conveyed their mortgaged property to a corporation for the purpose of filing under Chapter X of the Bankruptcy Act; held, dismissed for want of good faith, citing Wilgus); In re Metro. Realty Corp., 433 F.2d 676 (5th Cir. 1970) (individual contributed mortgaged building to a corporation organized as a medium through which he might qualify for treatment under Chapter X of the former Bankruptcy Act; held, dismissed for lack of good faith, citing Milwaukee Postal and Mongiello Bros.); In re Mallard Assoc., 463 F. Supp. 1259 (S.D.N.Y. 1979) (remanding for a hearing as to whether mortgaged property had been conveyed to a limited partnership formed for the purpose of filing under Chapter XII of the Bankruptcy Act and stating that if so, the case should be dismissed for lack of good faith, citing Wilgus); see also Donald L. Gaffney, Bankruptcy Petitions Filed in Bad Faith: What Action Can Creditor’s Counsel Take?, 12 UCC L.J. 205 (1979). 167 The Bankruptcy Code does not explicitly require good faith as a condition of filing under Chapter 11, but with virtual unanimity courts have implied such a condition, relying on the broad language of § 1112(b) that authorizes dismissal or conversion for “cause.” See, e.g., In re SGL Carbon Corp., 200 F.3d 154, 161 (3d Cir. 1999); In re The Muralo Co., 301 B.R. 690, 696 (Bankr. D.N.J. 2003). But see In re Victoria L.P., 187 B.R. 54 (Bankr. D. Mass. 1995). On the “good faith filing” doctrine generally, see Lawrence Ponoroff & F. Stephen Knippenberg, The Implied Good Faith Filing Requirement: Sentinel of an Evolving Bankruptcy Policy, 85 NW. U. L. REV. 919 (1991). See also In re Wiggles, 7 B.R. 373, 375 (Bankr. N.D. Ga. 1980) (tracing the origins of the concept of good faith in the bankruptcy context to Wilgus). The 2005 amendments to the Bankruptcy Code substantially revised § 1112(b) so as to make conversion or dismissal



Thus, cases involving a transfer of property from an entity not eligible for relief under Chapter 11 to one that is eligible are routinely dismissed (or, sometimes, if the debtor owns a single asset subject to a security interest, the court reaches the same practical result by lifting the stay as to the secured creditor).168 Courts have been highly skeptical of asset transfers made in contemplation of bankruptcy even if the transfer is from one eligible entity to another, a circumstance common enough to have acquired the nickname “new debtor syndrome.” Such cases tend to involve other factors that bear on the court’s attitude toward the debtor’s behavior, and the court’s attitude toward the pre-bankruptcy transfer is difficult to disentangle from those other factors.169 But it is clear that a pre-bankruptcy transfer raises judicial hackles, and some courts have no patience at all with a debtor afflicted with “new debtor syndrome.”170 Other courts have permitted such cases to remain in Chapter 11 if the debtor shows some business reason for the transfer and—importantly—the transfer does not deprive the creditors of any rights they would have had if the original owner had foregone the asset transfer and filed under Chapter 11 itself.171 generally easier to achieve, but the amendments to that provision do not speak directly to “new debtor syndrome” as a basis for conversion or dismissal. 168 Many cases of this ilk involve transfers of assets from an ineligible trust. See In re Assembled Interests Corp., 117 B.R. 31 (Bankr. D. N.H. 1990); In re Forest Activities, Ltd., 81 B.R. 720 (Bankr. S.D. Fla. 1988); Polkin, Inc. v. Lotus Invs., Inc. (In re Lotus Invs., Inc.), 16 B.R. 592 (Bankr. S.D. Fla. 1981); In re Nancant, Inc., 8 B.R. 1005 (Bankr. D. Mass. 1981); see also In re O’Loughlin, 40 B.R. 707 (Bankr. D. Mass. 1984) (dissolution of ineligible trust); In re G-2 Realty Trust, 6 B.R. 549 (Bankr. D. Mass. 1980) (change from nominee trust to business trust); In re 299 Jack-Hemp. Assocs., 20 B.R. 412 (Bankr. S.D.N.Y. 1982) (transfer from ineligible probate estate). 169 Thus, the resulting debtor in “new debtor syndrome” cases usually is a single-asset entity and often is on the verge of foreclosure, and many courts are skeptical of both factors. Moreover, in many cases the resulting debtor is patently incapable of reorganizing, one of the justifications for dismissal expressly set forth in § 1112(b) of the Bankruptcy Code. See, e.g., Udall v. FDIC (In re Nursery Land Dev., Inc.), 91 F.3d 1414 (10th Cir. 1996); Trident Assocs. L.P. v. Metro. Life Ins. Co. (In re Trident Assocs. L.P.), 52 F.3d 127 (6th Cir. 1995); Laguna Assocs. L.P. v. Aetna Cas. & Sur. Co. (In re Laguna Assocs. L.P.), 30 F.3d 734 (6th Cir. 1994) (lifting stay); Albany Partners, Ltd. v. Westbrook (In re Albany Partners, Ltd.), 749 F.2d 670 (11th Cir. 1984). Another factor that muddies the picture is the existence of provisions of the Bankruptcy Code that bear specifically on single-asset debtors. Thus, it has been argued that the 1994 enactment of § 362(d)(3), which requires the automatic stay to be lifted in some circumstances involving single asset real estate debtors, reversed case law imposing a “good faith” requirement in Chapter 11 cases filed by such debtors. That argument was rejected by State Street Houses, Inc. v. N.Y. State Urban Dev. Corp. (In re State Street Houses, Inc.), 356 F.3d 1345 (11th Cir. 2004). 170 See, e.g., Little Creek Dev. Co. v. Commonwealth Mortgage Corp. (In re Little Creek Dev. Co.), 779 F.2d 1068, 1073 (5th Cir. 1986) (new debtor syndrome “exemplifies, although it does not uniquely categorize, bad faith cases.”); AM. BANKR. INST., SINGLE ASSET REAL ESTATE BANKRUPTCIES 34-35 (1997) (“Well, the ‘new debtor syndrome’ cases do not last long in our district, but we don’t see that many of them filed by experienced bankruptcy lawyers because they know there is no point. You are going to be out of court at the first hearing and probably damage your reputation in the process as a lawyer for filing such a case.”) (quoting Bankruptcy Judge Lisa Hill Fenning of the Central District of California). 171 Chattanooga Federal Savings & Loan Association v. Northwest Recreational Activities,



The principle applied in Wilgus and its progeny is potentially lethal to securitization. The transfer of assets from the Originator to the SPE in the prototypical securitization transaction does not, of course, impose upon the Originator’s creditors the identical harm that was imposed on creditors by the transfer in Wilgus. But the essential feature is the same: in both cases the debtor disadvantages its unsecured creditors by removing assets from the ambit of a debt-collection regime not to the debtor’s taste by transferring them to another entity controlled by the debtor. The harm to the debtor’s general creditors from the bankruptcy-isolating transfer in the prototypical securitization—evasion of the Bankruptcy Tax, with the resulting potential for prejudice to the debtor’s ability to reorganize—is as real as the harm suffered by the creditors who dissented from the equity receivership in Wilgus.

Other differences between the receivership-gaming transfer made in Wilgus and the bankruptcy-gaming transfer made in a securitization transaction are equally insubstantial. In Wilgus, as in the typical case involving “new debtor syndrome,” the asset transfer took place soon before the institution of insolvency proceedings, while in a securitization transaction the transfer typically takes place (or at least is committed to take place) long before. But both are equally entered into in contemplation of an insolvency proceeding. The sole purpose, and the only substantial effect, of establishing the SPE and transferring the securitized assets to it is to keep those assets out of the Originator’s

Inc. (In re Nw. Recreational Activities, Inc.), 4 B.R. 36, 40-41 (Bankr. N.D. Ga. 1980), a root case on “new debtor syndrome” under the Bankruptcy Code, is particularly instructive. Citing Wilgus as the guiding authority, the court concluded that the case before it, which involved formation of a corporation to which mortgaged property was contributed shortly before a Chapter 11 filing, did not merit dismissal because, unlike Wilgus, these actions did not deprive creditors of any rights to which they would have been entitled had the original owner filed under Chapter 11 himself. Cases involving “new debtor syndrome” that are not dismissed out of hand regularly emphasize the importance of creditors not being deprived of any rights as a result of the transfer, citing Northwest or one of its progeny. See, e.g., Duvar Apt., Inc. v. FDIC (In re Duvar Apt., Inc.), 205 B.R. 196 (B.A.P. 9th Cir. 1996); In re N.R. Guaranteed Retirement, Inc., 112 B.R. 263 (Bankr. N.D. Ill. 1990), aff’d, 119 B.R. 149 (N.D. Ill. 1990); In re Franklin Mortgage & Inv. Co., 143 B.R. 295 (Bankr. D.C. 1992); Cal. Mortgage Serv. v. Yukon Enters., (In re Yukon Enters.), 39 B.R. 919 (Bankr. C.D. Cal. 1984); Columbia Mortgage Co. v. I-5 Investors, Inc. (In re I-5 Investors, Inc.), 25 B.R. 346 (Bankr. D. Or. 1982); In re Spenard Ventures, Inc., 18 B.R. 164 (Bankr. D. Alaska 1982); In re Levinsky, 23 B.R. 210 (Bankr. E.D.N.Y. 1982).

The 2005 amendments added to the Bankruptcy Code a provision that may codify an aspect of the judicial hostility to “new debtor syndrome,” by directing the automatic stay to be lifted as to real property subject to a mortgage if the court finds that the bankruptcy petition was filed as “part of a scheme to delay, hinder, and defraud creditors that involved . . . transfer of . . . such real property.” Bankruptcy Code § 362(d)(4) (as amended 2005). It is not entirely clear, however, whether the new provision was aimed primarily at “new debtor syndrome” or at other abuses. Cf. Bankr. Disclosure Scam Task Force of the U.S. Bankr. Court for the Cent. Dist. of Cal., Final Report, 32 LOY. L.A. L. REV. 1063 (1999). The significance, if any, of the use of “and” rather than “or” in the traditional “delay, hinder, defraud” litany is neither apparent from the face of the statute nor alluded to by the House report on the 2005 amendments. H.R. REP. NO. 109-31, pt. 1, at 70 (2005).



estate in the event that the Originator becomes the subject of bankruptcy proceeding, and the limitation of the SPE’s affairs to holding those assets and doing what is necessary to carry out the securitization transaction assures that the SPE serves no other function. A second difference is that in the typical “new debtor syndrome” case the debtor is insolvent at the time of the transfer, while the Originator in the typical securitization will be solvent at the time of transfer. That difference is not significant, because the debtor’s insolvency is not an element of the primordial rule of fraudulent transfer law (and indeed the debtor in Wilgus itself apparently was solvent in the balance sheet sense).172 A third difference is that in Wilgus, the dissenting creditors were known at the time of the transfer (though neither they nor any other creditor had obtained a judgment against the debtor or even filed suit), while in the typical securitization transaction it is unlikely that any particular unsecured creditor of the Originator will have expressed unhappiness about the transaction contemporaneously. That too is immaterial. The primordial rule by its terms applies for the benefit of creditors who exist at the time of the transfer, and contains no requirement that they object contemporaneously; moreover, the primordial rule by its terms also applies for the benefit of future creditors, who are unknown and unknowable at the time of the transfer.173

4. A Theory of Nonhindrance and the Primordial Rule

The Nonhindrance aspect of fraudulent transfer law has barely

been noticed by modern commentators, who have tended to shy away from discussing the primordial rule against transfers made with intent to “hinder, delay, or defraud” creditors in its full scope. 174 Scholarly attention to fraudulent transfer law in recent decades instead has centered on transactions in which a debtor engaged in business makes an asset transfer or incurs an obligation in exchange for which the debtor arguably does not receive fair value, such as leveraged buy-outs, foreclosure sales, and upstream guaranties. Analysis of such transactions tends to be dominated, explicitly or implicitly, by the narrower and better defined rules of constructive fraud that are specifically addressed to transfers for less than fair value.175 Hence the 172 See UFTA § 4(a)(1), UFCA § 7, Bankruptcy Code § 548(a)(1)(A). By contrast, the debtor’s insolvency (or comparable state of financial distress) is an element of the so-called constructive fraud rules. 173 See UFTA § 4(a)(1), UFCA § 7, Bankruptcy Code § 548(a)(1)(A). 174 The most notable mention of Nonhindrance seems to be the passing one in Clark, supra note 117. 175 Some commentators explicitly limited their inquiry to the constructive fraud rules, see, e.g., Barry L. Zaretsky, Fraudulent Transfer Law as the Arbiter of Unreasonable Risk, 46 S.C. L. REV.



insights and arguments advanced in modern discourse on fraudulent transfer law generally do not speak to its application to transactions that do not diminish the debtor’s estate. For example, the much-cited paper by Baird and Jackson on the proper domain of fraudulent transfer law argued that leveraged buy-outs ought not be subjected to scrutiny under fraudulent transfer law, largely on the theory that creditors of a business enterprise must always rely on the debtor’s entrepreneurial skill, and that the risks posed to creditors by leveraged buy-outs are not sufficiently different from those posed by other transactions to warrant invocation of the additional (and nonwaivable) control posed by fraudulent transfer law.176 That is essentially an argument about the proper reach of constructive fraud, which can be thought of as being directed at controlling unreasonable risk-taking by a debtor. It is not an argument that speaks to the scope of the Nonhindrance aspect of fraudulent transfer law.

A reason for the paucity of analytic thought on the primordial rule is that it is not really useful to think of it, as it has been applied by the courts, as being a single body of doctrine at all. Rather, it is better thought of as a residual meta-rule through which courts have policed debtor behavior that they consider sufficiently prejudicial to creditors to warrant policing, and that is not policed by more specific legal rules. It is “residual” because, to the extent a fact pattern recurs, legislatures and judges have tended to gravitate toward narrower statutory bases for policing debtor behavior in the given setting, and in practice those narrower rules come to displace the application of the primordial rule. Such disparate statutes as the constructive fraud branch of fraudulent transfer law, the perfection rules of personal property security law, bulk sales laws, and the absolute priority rule applicable to bankruptcy reorganizations, each were enacted to govern situations that originally were policed by the primordial rule of fraudulent transfer law.177 This, indeed, explains the relative unfamiliarity of the examples given in this paper in which the Nonhindrance aspect of fraudulent transfer law has 1165, 1167-68 (1995); others have given a pro forma nod to the primordial rule but in fact limit their discussion substantially to exchanges not for fair value, see, e.g., Marie T. Reilly, The Latent Efficiency of Fraudulent Transfer Law, 57 LA. L. REV. 1213 (1997). Dean Clark, supra note 117, is unusual among modern commentaries in taking the primordial rule seriously. It is surely not coincidental that the contributions by Baird and Jackson, Zaretsky and Reilly are from the law and economics perspective, while that by Clark is emphatically moralist. For a skeptical assessment of law and economics analyses of fraudulent transfer law, see David Gray Carlson, Is Fraudulent Conveyance Law Efficient?, 9 CARDOZO L. REV. 643 (1987). 176 Douglas G. Baird & Thomas H. Jackson, Fraudulent Conveyance Law and its Proper Domain, 38 VAND. L. REV. 829, 851-54 (1985). 177 On the fraudulent transfer origins of bulk sales laws, see Peter A. Alces, The Confluence of Bulk Transfer and Fraudulent Disposition Law, 41 ALA. L. REV. 821, 825-31 (1990); on the fraudulent transfer origins of the absolute priority rule in bankruptcy reorganizations, see Bruce A. Markell, Owners, Auctions and Absolute Priority in Bankruptcy Reorganizations, 44 STAN. L. REV. 69, 74-84 (1991).



been applied: situations that recur tend to evolve their own doctrines, in which case the primordial rule fades into the background. Similarly, if objectionable debtor behavior can be policed through some narrower doctrine, legal contemplation tends to gravitate to that other doctrine. This is illustrated by the cases discussed earlier involving asset reshufflings made by a debtor for the purpose of qualifying for protection under a particular chapter of the former Bankruptcy Act or the Bankruptcy Code. Such cases could be, and sometimes are, analyzed in terms of fraudulent transfer law, but more commonly they are analyzed under the narrower (if hardly more specific) rubric of “good faith filing.”178

From a jurisprudential standpoint, the utility of having available a regulatory tool of last resort for debtor-creditor law, in the form of fraudulent transfer law robustly applied, is evident. In any large complex system of law, reliance on formal rules alone is not apt to lead to acceptable results because ingenious lawyers can manipulate any given set of formal rules in undesirable ways. This point is acutely obvious in the domain of tax law, in which such manipulation takes place at a faster tempo than in creditors’ rights law. Robust application of fraudulent transfer law can be viewed as playing a role in the law of creditors’ rights that is analogous to the role that “economic substance,” “business purpose,” “step transaction,” and similar anti-abuse doctrines, taken collectively, play in tax law.179 Both bodies of doctrine are tools of general applicability to rein in abuses that can occur when actors manipulate the formal rules of the legal systems to which they apply. Both are purposive doctrines, in that they enable courts to trump compliance with those formal rules by reference to the purposes that those rules are meant to serve. Both are probably necessary to the tolerable functioning of the legal systems to which they respectively apply, because no set of formal rules can anticipate all abusive manipulations. 180 Just as application of fraudulent transfer law to address a perceived problem has often been a temporary stage, pending legislative codification of a new set of formal rules to address the problem with specificity, so application of the tax anti-abuse doctrines in a given setting is often a temporary stopgap for a specific formal 178 See supra text accompanying notes 164-171. 179 The tax anti-abuse doctrines are appropriately lumped together, for as one court noted, “[i]t is evident that the distinctions among [them] are not vast.” Rogers v. United States, 281 F.3d 1108, 1115 (10th Cir. 2002). For a current overview of the doctrines, see STAFF OF J. COMM. ON TAXATION, 109TH CONG., OPTIONS TO IMPROVE TAX COMPLIANCE AND REFORM TAX EXPENDITURES 14-17 (Comm. Print 2005); for more detailed treatment, see Joseph Bankman, The Economic Substance Doctrine, 74 S. CAL. L. REV. 5 (2000) and Boris I. Bittker, Pervasive Judicial Doctrines in the Construction of the Internal Revenue Code, 21 HOW. L.J. 693 (1978). 180 On this point in the tax realm, see, e.g., Joseph Bankman, The Tax Shelter Battle, in THE CRISIS IN TAX ADMINISTRATION 19-20 (Henry J. Aaron & Joel Slemrod eds., 2004); Dean & Solan, supra note 4, at 881-82 & n.8.



rule.181 The analogy is not perfect, because robust application of fraudulent

transfer law is more firmly grounded than the anti-abuse doctrines of tax law in at least two ways. One relates to the prevailing norms in the respective legal cultures.182 The proposition that a taxpayer is entitled to minimize its tax liability is deeply rooted in the culture of tax law. Everyone who has taken a course in the subject remembers, if nothing else, Learned Hand’s observation that there is not even a patriotic duty to increase one’s taxes. 183 A certain amount of manipulation by a taxpayer of its affairs for the purpose of tax minimization is viewed as unexceptionable, and indeed as something approaching a natural right.184 By contrast, there is not likely to be an equivalent tradition of innate respect for the goal sought to be realized by a debtor who makes a creditor-injuring transfer that is attacked as a fraudulent transfer. In the case of the prototypical securitization, for instance, there is certainly no tradition that the goal—the avoidance of the Bankruptcy Tax—is a natural right.

A second and more prosaic distinction is that fraudulent transfer is statutory law, while the tax anti-abuse doctrines are judicial creations. Some tax regulations are graced with limited codifications of the anti-abuse doctrines applicable in particular settings, 185 but there is no general codification of the anti-abuse doctrines in the Internal Revenue Code, despite repeated Congressional flirtation with the notion.186 For

181 An example is the IRS’s successful use of the anti-abuse doctrines in several cases to disallow deductions taken by corporations for interest paid on loans against corporate-owned life insurance (“COLI”), a blatant tax shelter, for periods before 1997, when Congress at least partially obviated the shelter by amending § 264 of the Internal Revenue Code to broaden the circumstances in which it disallows the deduction of interest on such loans. Health Insurance Portability and Accountability Act of 1996, Pub. L. No. 104-191, § 501, 110 Stat. 1936; see, e.g., Winn-Dixie Stores, Inc. v. Comm’r, 254 F.3d 1313 (11th Cir. 2001); Dow Chem. Co. v. United States, 435 F.3d 594 (6th Cir. 2006). 182 Study of the creation and evolution of norms in legal culture is a growth industry. For a recent example, see Robert B. Ahdieh, The Role of Groups in Norm Transformation: A Dramatic Sketch, in Three Parts, 6 CHI. J. INT’L L. 231 (2005) (analyzing recent changes in the typical provisions of sovereign debt instruments pertaining to debt restructuring by reference to group dynamics). 183 Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935). It is less often remembered that this inspirational proclamation was dictum, as Judge Hand’s opinion for the court in fact applied common-law anti-avoidance doctrines to disallow the tax treatment sought by the taxpayer. 184 See Linda M. Beale, Tax Advice Before the Return: The Case for Raising Standards and Denying Evidentiary Privileges, 25 VA. TAX. REV. 583, 599-600 (2006); David A. Weisbach, Ten Truths About Tax Shelters, 55 TAX L. REV. 215, 220-22 (2002); David A. Weisbach, Formalism in the Tax Law, 66 U. CHI. L. REV. 860, 870-71 (1999). 185 The best known of these, on account of the intense criticism it provoked (for a discussion of which see Noel B. Cunningham & James R. Repetti, Textualism and Tax Shelters, 24 VA. TAX REV. 1, 32-40 (2004)), is the partnership anti-abuse regulation, Treas. Reg. § 1.701-2 (1995). 186 A recent flirtation occurred in 2005, when the Senate passed a bill codifying the “economic substance” doctrine which the House let die. For discussion of that and earlier failed codification



that reason, application of the tax anti-abuse doctrines has been constrained by doubts about the authority and competence of courts to override the formal rules that have been enacted by the legislature.187

The comparison suggests that, like Voltaire’s God, if a purposive backstop to the formal rules of debtor-creditor law did not already exist in the form of fraudulent transfer law, it would have been necessary to invent it, as the courts did in the domain of tax law. This is not to say that fraudulent transfer law is the only such backstop. As Robert Clark demonstrated, for instance, the doctrines of piercing the corporate veil and equitable subordination implement much the same ideals as have been implemented by fraudulent transfer law.188 But the application of those doctrines is confined to comparatively narrow settings, while fraudulent transfer law is potentially applicable to any transfer of an asset or any creation of an obligation.

Application of the primordial rule, especially in its Nonhindrance aspect, must involve an implicit balancing of harm to creditors against other relevant policies. Yet courts have been perennially disinclined to discuss the policy bases for their decisions in this area, as we saw in Benedict v. Ratner.189 A pure and simple example of this tendency is Coder v. Arts,190 an early case under the former Bankruptcy Act that involved a debtor’s eve-of-bankruptcy grant of a mortgage to secure his antecedent debt to his bank, which his trustee sought to avoid as a preference and as a fraudulent transfer. The Court had no difficulty rejecting the preference theory, as the Bankruptcy Act at the time permitted avoidance of a preference only if the recipient had reasonable cause to believe that it was receiving a preference, which the factfinder had found was not the case.191 As to the fraudulent transfer theory, the Court might have pointed out briefly that Congress had declared the

efforts, see Marvin A. Chirelstein & Lawrence A. Zelenak, Tax Shelters and the Search for a Silver Bullet, 105 COLUM. L. REV. 1939, 1947-51 (2005). The merits of codification of the tax anti-abuse rules has been much debated, with predictable cries from practitioners that codification would introduce undesirable uncertainty into tax planning, see, e.g., Kenneth J. Kies, A Critical Look at the Administration’s ‘Corporate Tax Shelter’ Proposals, 83 TAX NOTES 1463 (1999), and with academics such as Chirelstein and Zelenak asserting that codification would not be sufficient to rein in certain patterns of abuse, such as corporate tax shelters. See also Lawrence Zelenak, Codifying Anti-Avoidance Doctrines and Controlling Corporate Tax Shelters, 54 SMU L. REV. 177, 185-86 (2001). 187 An extreme example is Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716, 756 (2004), vacated, 454 F.3d 1340 (Fed. Cir. 2006), in which the Court of Federal Claims’ unease with these anti-abuse doctrines was so acute as to lead it to reject those doctrines altogether. On appeal the Federal Circuit reminded the lower court that it was bound to follow decisions of superior courts applying those doctrines, but unease with the doctrines no doubt remains. See also, e.g., Chirelstein & Zelenak, supra note 186, at 1947-51. 188 See Clark, supra note 117. 189 268 U.S. 353 (1925); see supra text accompanying notes 124-134. 190 213 U.S. 223 (1909). 191 Id. at 240.



limited circumstances in which a preference might be avoided and that it would undercut that scheme to allow a preference, as such, to be avoided as a fraudulent transfer. But the opinion is innocent of any such policy-oriented observation. Rather, the Court chose to expound at length on the theme that fraudulent transfer law applies only to transfers that are made with intent to commit “actual fraud,” and then to assert that the making of a preferential transfer does not amount to “actual fraud.”192

To an unusual degree, therefore, it is necessary to focus on what the courts actually do, rather than on what they say they are doing, when reading cases that apply the primordial rule. This may account in part for the neglect by commentators of the rule’s Nonhindrance aspect.

The courts’ use of the primordial rule as a regulatory tool of last resort has been further masked by the fact that the rule is cast in terms of the debtor’s intent. Black-letter law has it that determination of intent is a matter of fact, not of law. To the extent that the primordial rule is applied simply by instructing the factfinder to determine whether the debtor’s state of mind in making a given transfer was to “hinder, delay, or defraud” his creditors, without more, the operation of the rule would be erratic. To serve as a regulatory tool the primordial rule must be applied in a way that emphasizes the objective effects of the debtor’s transfer and de-emphasizes the debtor’s subjective state of mind. 193 Courts have employed a number of techniques to objectify the application of the primordial rule.

The longstanding significance given to the “badges of fraud” is one objectification technique. Legal rules that give primacy to a person’s state of mind, such as criminal laws, are not usually accompanied by artificial stipulations about what that is supposed to mean.

A stronger objectification technique is to invoke presumptions. The Swiss Army knife of presumptions, usable in all circumstances, is 192 Id. at 240-45. The Court did cite earlier authorities to the effect that the “hinder, delay, or defraud” litany historically had not been considered to encompass merely preferential transfers, which at least elevated its holding above the tautological. 193 For a brief but pungent discussion of the objectification of fraudulent transfer law, see Frank R. Kennedy, Involuntary Fraudulent Transfers, 9 CARDOZO L. REV. 531, 537-39, 575-577 (1987) (“Contrary to the suggestion that constructively fraudulent transfers are the product of the twentieth-century imaginations of the UFCA draftsmen, there is considerable case law in England and America going back over 200 years avoiding certain transfers as fraudulent without regard to the evidence of the transferor’s actual intent.”). Robert M. Zinman replied in Noncollusive, Regularly Conducted Foreclosure Sales: Involuntary, Nonfraudulent Transfers, 9 CARDOZO L. REV. 581, 583-84 (1987), arguing (in the context now covered by the constructive fraud rules): “[T]he concept of intent was not being read out of the statute. On the contrary, the purpose of the badges, presumptions, and finally the constructive fraud provisions was to develop methods of ferreting out those transactions that are inequitable to creditors by the debtor’s deliberate design or indifference.” Professor Zinman’s reply refutes itself, for a legal standard that polices “transactions that are inequitable to creditors by the debtor’s . . . indifference” is nothing if not objective in nature; it does not police “intent” in any meaningful sense of that word.



that a person is presumed to intend the natural consequences of his actions, and courts have not been shy about invoking it in fraudulent transfer cases. 194 In some settings, courts created presumptions so strong as to be more or less conclusive. The most familiar instance is the presumption of proscribed intent applied when a debtor in financial distress makes a transfer for which he does not receive fair value in exchange, which in time was codified explicitly in the so-called constructive fraud rules. Other instances are plentiful, but they generally have faded from current legal consciousness because they apply to settings in which the primordial rule has been displaced by a more specific statute outside the fraudulent transfer statute itself. For example, before the enactment of Article 9 largely cured the problem with overcollateralization discussed earlier, courts in some states policed overcollateralization under the primordial rule with the aid of strong or conclusive presumptions.195 Likewise, before the enactment of bulk sales laws, bulk sales were policed under the primordial rule through presumptions that in some states were well-nigh conclusive.196

The strongest objectification technique is for the court to make use of the indeterminacy of the “hinder, delay, or defraud” standard by simply defining the behavior in which the debtor engages as being such as to “hinder, delay, or defraud” his creditors. Each of Benedict v. Ratner, Dean v. Davis 197 and Shapiro v. Wilgus, 198 for instance, employed this technique. This technique drops the debtor’s intent from the analysis entirely (short of a plea of insanity by the debtor—i.e., that he did not intend to do what he did). It thus creates an objective rule of law. There is only a rhetorical difference between this definitional technique and the technique of declaring that the debtor’s behavior creates a conclusive presumption that the debtor had the proscribed intent, but for no clear reason judicial use of the latter technique has tended to raise eyebrows in a way that the former has not.

Skittishness about judicial objectification of the primordial rule articulated through conclusive presumptions is evident in the history of

194 An example is the seminal case on application of fraudulent transfer law to a leveraged buy-out, United States v. Gleneagles Investment Co., 565 F. Supp. 556, 580 (M.D. Pa. 1983), affirmed sub nom. United States v. Tabor Court Realty Corp., 803 F.2d 1288, 1305 (3d Cir. 1986). See also, e.g., Dean v. Davis, 242 U.S. 438, 444 (1917); Ferrari v. Barclays Bus. Credit, Inc. (In re Morse Tool, Inc.), 148 B.R. 97, 138 (Bankr. D. Mass. 1992). Courts have employed this presumption from time immemorial when applying the primordial rule. See GARRARD GLENN, RIGHTS AND REMEDIES OF CREDITORS RESPECTING THEIR DEBTOR’S PROPERTY 92 (1915). 195 Cases are gathered in part IV of the Annotation, supra note 145, and in MELVILLE MADISON BIGELOW, THE LAW OF FRAUDULENT CONVEYANCES 695 n.2 (1911). 196 See Thomas Clifford Billig, Bulk Sales Laws: A Study in Economic Adjustment, 77 U. PA. L. REV. 72, 75-80 (1928). 197 242 U.S. 438 (1917); see supra text accompanying notes 135-141. 198 287 U.S. 348 (1932); see supra text accompanying notes 153-163.



legislative attempts to restrain such objectification; and the persistence with which courts have objectified the primordial rule when they have seen fit to do so is evident in their deft maneuvering around those legislative restraints. Both can be seen in the history of the judicial gloss on the primordial rule that eventually evolved into the constructive fraud rules now codified in the UFCA, UFTA, and Bankruptcy Code that render avoidable a transfer for less than fair value by a debtor in financial distress. That gloss had its roots in English cases of the mid-eighteenth century that laid down a sterner rule to the effect that a voluntary conveyance by a person in debt is, as a matter of law, fraudulent against his creditors. 199 That stern formulation was followed by the leading early American case of Reade v. Livingston,200 decided by Chancellor Kent in New York in 1818 and highly influential in other states. Reade v. Livingston provoked a backlash in New York, however, and although it was overruled quite soon,201 the New York legislature reacted to it by attempting to quash any and all judicial objectification of the primordial rule. Specifically, when the New York legislature codified the primordial rule in a chapter of the state’s Revised Statutes of 1829, the codification included a clause declaring that “[t]he question of fraudulent intent in all cases arising under the provisions of this Chapter, shall be deemed a question of fact and not of law.”202

This attempt to restrain objectification of the primordial rule barely impeded the New York courts. Although they did not seriously attempt to return to the particular rule laid down in Reade v. Livingston, the attraction of an objective rule with different content was irresistible, and New York courts proceeded to implement a set of nominally rebuttable presumptions that, by the time the UFCA was adopted, were applied so forcefully that they were in practice effectively equivalent to the UFCA’s constructive fraud rules.203 Thus, for instance, in the 1883 case of Coleman v. Burr,204 the New York Court of Appeals avoided as 199 See, e.g., Townsend v. Windham, (1750) 28 Eng. Rep. 1 (Ch.). For the evolution of this rule, see the authorities cited supra note 101 and Kennedy, supra note 193, at 538-39. 200 3 Johns. Ch. 481 (N.Y. Ch. 1818). 201 Seward v. Jackson, 8 Cow. 406 (N.Y. Sup. Ct. 1826); see also, e.g., Cole v. Tyler, 65 N.Y. 73, 77-78 (1875). 202 2 N.Y. REV. STAT. (1829) p. 137, tit. III, ch. 7, § 4. Curiously this provision, insubstantially reworded, remains on the books in New York, N.Y. PERS. PROP. LAW § 37 (McKinney 2007) and N.Y. REAL PROP. LAW § 265 (McKinney 2007), though it has been held to have been repealed by implication by New York’s enactment of the UFCA. Emmi v. Patane, 220 N.Y.S. 495 (N.Y. Sup. Ct. 1927). That this provision was in response to Reade v. Livingston, see, in addition to the authorities previously cited, BIGELOW, supra note 195, at 202 n.1, and James Angell McLaughlin, Application of the Uniform Fraudulent Conveyance Act, 46 HARV. L. REV. 404, 407 (1933). 203 Certainly Professor Glenn was of this view. See GLENN, supra note 194, at 97-99; 1 GLENN, supra note 95, § 269, at 460 & n.38. 204 93 N.Y. 17 (1883).



fraudulent a conveyance of land from husband to wife, made at a time when the husband had judgments against him on which executions had been returned unsatisfied, notwithstanding that the factfinder had not only failed to find fraudulent intent on the part of the husband, but on the contrary had “found the whole transaction to be fair and honest.”205 Notwithstanding the statute just quoted, the Court of Appeals blandly stated that the husband “must be deemed to have intended the natural and inevitable consequence of his acts, and that was to hinder, delay and defraud his creditors.”206

Painting on a larger canvas, the drafters of the UFCA in their turn likewise sought to restrain courts from objectifying the primordial rule, with equal futility. The drafters consciously sought to “do away with the legal presumptions of fraud,” which, as they saw it, “have been a main cause of existing uncertainty and confusion” in the application of the primordial rule.207 They proceeded to write into the UFCA those of the “legal presumptions of fraud” that they deemed worthy of preservation, in the form of the constructive fraud rules (which included the familiar rules, later carried forward into the Bankruptcy Code and the UFTA, prohibiting transfer by a debtor in financial distress for less than fair value, as well as other rules not so carried forward and less familiar today, such as the rule against overcollateralization discussed previously). 208 They then sought to shut the door on further objectification, by wording the primordial rule against transfers made with intent to “hinder, delay, or defraud” creditors to apply only if the proscribed intent is “actual intent, as distinguished from intent presumed in law.”209

205 Id. at 31. 206 Id. Another example was supplied by Justice Cardozo while on the bench of the New York Court of Appeals, who in describing the New York presumptions applied in the case of a transfer by a debtor stated that “[if] there was no consideration, the fraudulent purpose, in the absence of explanation, is an inference of law.” Ga Nun v. Palmer, 111 N.E. 223, 226 (N.Y. 1916). A bemused lower court judge later suggested that this explicit statement of an “inference of law” had been an “inadvertence” in light of the statute. Landon v. Fisher, 201 N.Y.S. 134, 141 (N.Y. Sup. Ct. 1923); see also Smith v. Reid, 31 N.E. 1082, 1084-85 (N.Y. 1892); cf. Marine Midland Bank v. Murkoff, 508 N.Y.S.2d 17, 20-21 (N.Y. App. Div. 1986) (noting that these presumptions should not be considered to survive New York’s adoption of the UFCA), appeal dismissed, 507 N.E.2d 322 (N.Y. 1987). 207 UFCA Comments, supra note 101, at 353, quoted more fully infra note 209. 208 UFCA §§ 3(b), 4, 5, 6, 8. 209 UFCA § 7. The brief Prefatory Note to the UFCA emphasized the quoted language, stating that “In the [UFCA] as drafted all possibility of a presumption of law as to intent is avoided.” 7A U.L.A. 2, 3 (1999). The comments to the UFCA as presented to the uniform law commissioners for final approval made the point more loquaciously: “The section [that is, § 7] is practically identical with the 13th of Elizabeth. As the other sections of this act deal with conveyances which are fraudulent as to creditors irrespective of intent, this section is expressly so drawn as to relate to conveyances with intent to defraud. In this manner the Act will do away with the legal presumptions of fraud which have been a main cause of existing uncertainty and confusion.” UFCA Comments, supra note 101, at 353.



This attempt to restrain objectification by legislatively emphasizing the factual nature of the intent determination was essentially the same as the New York legislature’s response to Reade v. Livingston nine decades previously, and its equal futility was promptly demonstrated. The UFCA was promulgated in 1918, but state enactments naturally took time, and Benedict v. Ratner, decided in 1925, had applied New York’s pre-UFCA fraudulent transfer law. New York coincidentally enacted the UFCA in 1925, and soon afterward cases arose involving non-notification accounts receivable financing arrangements in which the lender failed to exercise dominion over the proceeds of the assigned receivables, contrary to the rule laid down in Benedict. The lenders in two such cases argued, not unreasonably, that New York’s enactment of UFCA, with its requirement of “actual intent, as distinguished from intent presumed in law,” had overruled Benedict. In a pair of decisions that put the issue to rest nationwide, the Second Circuit declined to accept that restraint on the objective application of the primordial rule. The earlier of the two cases applied the somewhat radical theory that Benedict was founded on a New York common law of fraudulent transfers that had not been displaced by enactment of the UFCA.210 In the later case, asked to overrule the earlier, Learned Hand settled on the true formula of defining the debtor’s behavior to be such as to “hinder, delay, or defraud” his creditors, thereby preserving application of the UFCA to the transaction while sidestepping intent. 211 No similar argument was even raised subsequently in Shapiro v. Wilgus, which applied the Pennsylvania enactment of the UFCA and which similarly objectified the primordial rule through the definitional technique.

The drafters of the Bankruptcy Code and the UFTA eventually conceded defeat in this implicit duel with the courts by dropping from those statutes’ versions of the primordial rule the requirement that the intent be actual “as distinguished from intent presumed in law” 212 Those statutes still say “actual intent” rather than just “intent,” but that flourish means nothing: it is manifestly ineffective in restraining objectification through the definitional technique when courts choose to apply it.213

In short, “intent” in fraudulent transfer law historically has meant

210 Lee v. State Bank & Trust Co., 54 F.2d 518, 520 (2d Cir. 1931). 211 Irving Trust Co. v. Fin. Serv. Co., 63 F.2d 694, 695 (2d Cir. 1933) (“[N]o intent need be imputed, no fiction used. The only open question is whether the injury to the creditors falls within the term, ‘fraud.’”). 212 UFTA § 4(a); Bankruptcy Code § 548(a)(1)(A). 213 Courts have not generally considered the milder objectification technique of applying rebuttable presumptions of intent to be precluded. See, e.g., United States v. Tabor Court Realty Corp., 803 F.2d 1288, 1304-05 (3d Cir. 1986); United States v. Mazzeo, 306 F. Supp. 2d 294, 311 (E.D.N.Y. 2004). But cf. McLaughlin, supra note 202, at 424-25 (noting that the UFCA does not explicitly preclude rebuttable presumptions of intent but arguing that it should be so applied).



as much or as little as courts want it to mean in a given case, and in this way courts have used the primordial rule to enforce objective rules of debtor behavior when they deem it appropriate. The expression of the primordial rule in terms of the debtor’s intent no doubt owes its origin to the penal nature of the original Statute of 13 Elizabeth. But its continuance down the centuries, after the detachment of fraudulent transfer law from penal consequences, 214 surely owes much to the expediency of phrasing in terms of “intent” a legal standard that calls for objective analysis that the lawmaker is unable to articulate in detail.

An example of the same trope playing the same role in a simpler context is the legal standard for determining whether a purported lease of goods should be recharacterized as a conditional sale (using that term broadly to encompass the post-UCC concept of “sale with retained security interest”). Under pre-UCC common law, courts commonly stated that the character of the transaction depends upon the intent of the contracting parties. But courts then typically proceeded to ignore the parties’ states of mind, instead basing their holding on analysis of the substantive attributes of the transaction and the court’s view of whether those features showed sufficient substantive equivalence between the purported lease and a conditional sale. 215 The artificiality of the reference to intent was noted and decried by commentators, but nobody at the time seems to have stated what is obvious in retrospect: that the reference to intent was a polite fiction employed to paper over the absence of a well-developed theory for analyzing the substantive equivalence of leases and conditional sales.216 Such a theory was slow 214 The detachment from penal consequences is not complete, for § 727(a)(2) of the Bankruptcy Code denies discharge in Chapter 7 to a debtor who, with intent to hinder, delay, or defraud his creditors or an officer of the estate, has transferred, removed, destroyed, mutilated, or concealed property of the estate, or has permitted any of these actions to take place, during the year preceding the bankruptcy action. But courts have recognized that, because of the different purposes of fraudulent transfer law and § 727(a)(2), the latter provision should be construed more narrowly than the former notwithstanding the use of the identical “hinder, delay, or defraud” litany in each. See, e.g., Finalco, Inc. v. Roosevelt (In re Roosevelt), 87 F.3d 311, 317 (9th Cir. 1996). 215 For extensive discussion of pre-UCC cases, see 3 LEONARD A. JONES, THE LAW OF CHATTEL MORTGAGES AND CONDITIONAL SALES §§ 952-63 (Renzo D. Bowers 6th ed. 1933 & Supp. 1956). Hervey v. Rhode Island Locomotive Works, 93 U.S. 664 (1876), an early leading case, is a good example. Hervey involved a written lease of a locomotive for one year, at which time, given compliance with the terms of the lease, title was to vest in the lessee. The Court had no trouble concluding that this was not a true lease, but even in this extreme case the Court made a ritual genuflection to “intent”:

It is true the instrument of conveyance purports to be a lease, and the sums stipulated to be paid for rent; but this form was used to cover the real transaction. . . . It was evidently not the intention that this large sum should be paid as rent for the mere use of the engine for one year. If so, why agree to sell and convey the full title on the payment of the last installment?

Id. at 673. 216 See Abraham J. Levin, The Intention Fallacy in the Construction of Title Retaining Contracts, 24 MICH. L. REV. 130, 149 (1925) (asserting the fictitiousness of the traditional


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to develop, as substantial commercial leasing markets did not develop in the United States until the late 1950s, and “intent” served as a verbal umbrella under which courts operated as experience accreted.217 The drafters of the UCC, operating in that environment of scant commercial leasing, were content to leave the distinction between lease and conditional sale to judicial development, and they did so by codifying into the UCC the common law rhetoric that nominally made “intent” decisive.218 But influential members of the founding generation also expressed the hope that nobody would be foolish enough to read the statutory reference to “intent” literally, and for the most part courts were too sensible to do so.219 In later decades commercial leasing boomed, and judicial experience accumulated rapidly. By the late 1980s it was found possible and desirable to revise the UCC to abandon the reference to intent and substitute a set of objective guidelines that, while still leaving much to the courts, give substantially more guidance than did the original version.220

This is not to say that universal harmony now prevails on the distinction between a lease and a conditional sale. But, while there remains room for argument about where the line should be drawn (and indeed some have argued that the line should not be drawn at all), nobody today has a good word to say about the former “intent”

reference to the intention of the parties, and that “unavowed and inarticulate principles . . . have kept the courts in the right course”). 217 As to the absence of a substantial commercial leasing market in the United States until the late 1950s, and the effect of that fact on the drafters of the UCC, see William D. Hawkland, The Impact of the Uniform Commercial Code on Equipment Leasing, 3 U. ILL. L. FORUM 446, 446, 467 (1972). 218 See U.C.C. § 1-201(37) (1962) (“Unless a lease . . . is intended as security, reservation of title thereunder is not a ‘security interest’ . . . . Whether a lease is intended as security is to be determined by the facts of each case; however, (a) the inclusion of an option to purchase does not of itself make the lease on intended for security, and (b) an agreement that upon compliance with the terms of the lease the lessee shall become or has the option to become the owner of the property for no additional consideration or for a nominal consideration does make the lease one intended for security.”). For the drafting history and background, see Peter F. Coogan, Leases of Equipment and Some Other Unconventional Security Devices: An Analysis of UCC Section 1-201(37) and Article 9, 1973 DUKE L.J. 909, and 1 GILMORE, supra note 113, §§ 3.6, 11.2. 219 See 1 GILMORE, supra note 113, § 11.2, at 338 (“It is clear enough that ‘intended’ in the provision just quoted has nothing to do with the subjective intention of the parties, or either of them.”); Coogan, supra note 218, at 916 n.12 (“The test certainly must be applied in accordance with the outward appearance of the facts rather than in accordance with the intent held by one or both of the parties. . . .”). On cases applying this standard, see 4 JAMES J. WHITE & ROBERT S. SUMMERS, UNIFORM COMMERCIAL CODE § 30-3, at 16-23 (5th ed. 2002 & Supp. 2006). 220 The revision was made by amendment to U.C.C. § 1-201(37) in 1989 as part of the adoption of Article 2A of the UCC; the 2001 revision of Article 1 carried forward substantially the same language as U.C.C. § 1-203. See also 4 WHITE & SUMMERS, supra note 219, § 30-3 at 16 (“Unlike the original drafters, the new drafters were educated by twenty-five years of cases. We have learned both from the bad and the good court decisions. Now, far more clearly than anyone could in 1950, we see fundamental distinctions between a lease and a security agreement.”).



standard.221 Today it is evident that the “intent” standard was merely a placeholder to cover the near-total lack of understanding of the lease-conditional sale distinction that prevailed in former times, to which it would be foolish to cling now that understanding has improved.

Just as it was in the doctrine governing recharacterization of leases as conditional sales, “intent” in fraudulent transfer law is in some measure a fig leaf to conceal the fact that the doctrine is not well defined, and use of the term in the statute amounts to a delegation of authority to the courts to define the doctrine—or at least it has been so treated by the courts when they have seen fit to do so. The difference between the two settings is that distinguishing a lease from a conditional sale is a single narrow issue, with the result that a moderate amount of experience was sufficient to enable the doctrine to be defined well enough to allow the fig leaf to be discarded. By contrast, the limitless generality of fraudulent transfer law precludes any definition more systematic than that previously offered: it is the residual tool by which courts have policed undesirable debtor behavior when no more specialized tool is at hand. The primordial rule of fraudulent transfer law has survived for so long because of its infinite elasticity, and a good part of that elasticity comes from the ease with which its language can be manipulated so that decisionmaking power can be delegated to the factfinder in a given case, or not.

5. Nonhindrance and the Prototypical Securitization

The preceding observations help to put Shapiro v. Wilgus222 into

context, as one case in a long tradition in which courts have employed the primordial rule of fraudulent transfer law as a regulatory tool to enforce policies of debtor-creditor law that they have considered important. Those general reflections are of only indirect interest to securitization, however, for, as previously discussed, the principle of Wilgus alone would amply justify application of the primordial rule to avoid the bankruptcy-gaming transfer of securitized assets from the Originator to the SPE in the prototypical securitization transaction.223

Indeed, the case for avoidance of that bankruptcy-gaming transfer is even stronger than the case for avoidance of the receivership-gaming transfer made in Wilgus in at least two ways. First, the policy vindicated by avoidance in the case of securitization—the Bankruptcy

221 A sizable literature on the distinction between lease and conditional sale appeared during run-up to Article 2A in the 1980s. For an introduction, see Mooney, supra note 113, at 689-97. 222 287 U.S. 348 (1932). 223 For discussion of Wilgus, see supra Part II.B.3.



Tax—is an explicit legislative mandate. 224 By contrast, the policy vindicated by avoidance in Wilgus—the Court’s growing skepticism about the institution of the “friendly” equity receivership for entities other than railroads and like public-service businesses—was not a legislative mandate or an established policy, but merely a somewhat tentative sense of the Court. 225 Second, the immediate result of avoidance in Wilgus was to reward holdout creditors for their obduracy by allowing them to obtain preferential payment of their debts, a result that the lower courts choked on. By contrast, avoidance of the asset transfer made in the prototypical securitization will allow the Originator’s estate to make use of collections on the securitized assets so long as the financiers who lent against those assets are adequately protected—a result that might make the difference between a successful reorganization of the Originator and one that fails for want of cash.

If the primordial rule were held to apply to the asset transfer from the Originator to the SPE, the SPE would not in general have a plausible defense to avoidance. A basic tenet of fraudulent transfer doctrine, carried forward by each of the modern codifications, is that a good faith transferee for value is protected from recovery.226 That defense will not avail the SPE, for although it will have given value in exchange for the securitized assets, even fair value, it cannot plausibly claim to have acted in good faith. It is no more than the Originator’s tool in implementing the evasion of the Bankruptcy Tax, which is the purpose of all concerned in establishing the SPE and transferring the assets from the Originator to it. 227 If the Originator’s bankruptcy filing occurs sufficiently long after the securitization transaction closed the SPE might be able to invoke a statute of limitations defense, but that would not be available in the very common case of a securitization of a rolling pool of receivables, transferred by the Originator to SPE as they arise.228

224 See supra Part I. 225 See supra text accompanying notes 160-164. 226 See UFCA § 9(1), UFTA § 8(a), Bankruptcy Code § 548(c). The Bankruptcy Code’s version of this defense is weaker than the version in the two uniform laws, for § 548(c) protects a good faith transferee only to the extent of the value given by the transferee (by giving such transferee a lien to secure that value), while the two uniform laws afford a complete defense to a good faith transferee who has given fair value in exchange for the transfer. 227 Professor LoPucki, supra note 21, at 27, assumed that the SPE would be entitled to this defense. That cannot be correct. If “good faith” means anything, then an SPE established for the purpose of receiving a transfer that, by assumption, is a fraudulent transfer, must lack it. Among other things, Professor LoPucki incorrectly assumed that the transfer from Originator to SPE is “an arms-length transaction.” Id. That is not the case in the prototypical securitization, in which the SPE is the Originator’s subsidiary. Even in “orphan subsidiary” transactions in which the SPE’s voting equity is owned by an entity not affiliated with the Originator, the transaction is not arm’s length, because substantially all collections on the securitized assets in excess of amounts required to service the securitized debt are routed back to the Originator. See supra note 54. 228 The limitation period for an action to avoid a transfer pursuant to the primordial rule under the UFTA is generally four years. UFTA § 9(a). The UFCA leaves the limitation period to non-



If courts accept the foregoing argument and hold that the transfer of a securitized asset from the Originator to the SPE is a fraudulent transfer, that would be the death of the prototypical securitization technique. In the event of the Originator’s bankruptcy, that transfer could be avoided and the securitized asset drawn into the Originator’s bankruptcy estate, where it would be subject to the Bankruptcy Tax.229 Insofar as the SPE, after receiving that avoidable transfer of the securitized assets, granted a security interest in those assets to the financiers who hold the securitized debt (or, equivalently, nominally sold the assets to them in a transaction that does not qualify as a true sale), that security interest would not be upset if the financiers are deemed to be in “good faith, and without knowledge of the voidability of the transfer avoided.”230 Interestingly, it is by no means obvious that the financiers’ security interest would qualify for protection under that standard even in a public financing, for the offering documents prepared in such a financing typically describe the structure of the financing and even warn that legal risks might arise from the structure in the event of the Originator’s bankruptcy. 231 Poetic justice aside, it would seem unduly harsh to strip the financiers of their security interest. They would be quite unhappy enough paying the Bankruptcy Tax.

C. Vindicating Bankruptcy Policy Through Substantive Consolidation

As we have seen, despite its potency, fraudulent transfer law has

not been viewed by the securitization industry as a substantial threat to securitization. Quite different is the industry’s attitude toward substantive consolidation. Substantive consolidation is the doctrine by UFCA law; in New York, the most populous remaining UFCA state, the limitation period is generally six years. See Miller v. Polow, 787 N.Y.S.2d 319, 320 (N.Y. App. Div. 2005). The nonbankruptcy limitation period will apply in bankruptcy to the extent the trustee enforces nonbankruptcy fraudulent transfer law under Bankruptcy Code § 544(b). See, e.g., Buncher Co. v. Official Comm. of Unsecured Creditors of Genfarm L.P. IV, 229 F.3d 245, 250-51 (3d Cir. 2000). The Bankruptcy Code’s integral fraudulent transfer provision, § 548, was amended in 2005 to extend from one to two years before the filing of the bankruptcy petition the period during which transfers can be challenged. 229 Bankruptcy Code § 550(a)(1) permits the trustee to recover for the benefit of the estate property that has been fraudulently transferred from “the initial transferee of such transfer or the entity for whose benefit such transfer was made.” 230 Bankruptcy Code § 550(b)(1). A possible alternative threat to the financiers’ security interest would be the argument that § 550(a)(1) applies to it, and so permits it to be avoided without regard to the financiers’ good faith or knowledge, either on the theory that the SPE is a “mere conduit” such that the financiers are the true “initial transferees,” see, e.g., Christy v. Alexander & Alexander of N.Y. Inc. (In re Finley, Kumble, Wagner, Heine, Underberg, Manley, Myerson & Casey), 130 F.3d 52, 57 (2d Cir. 1997), Luker v. Reeves (In re Reeves), 65 F.3d 670, 676 (8th Cir. 1995), or on the theory that the financiers are “the entity for whose benefit such transfer was made.” 231 See infra note 261.



which a court overseeing the bankruptcy of a given entity may order the assets and liabilities of another entity—typically an affiliate of the bankrupt entity—to be merged into a single common estate.

In its origins, substantive consolidation is intimately entwined with fraudulent transfer law, for in Sampsell v. Imperial Paper & Color Corp., 232 the case conventionally taken as the fountainhead of substantive consolidation, and the Supreme Court’s only engagement with the doctrine to date, the Court validated its application as a remedy for a fraudulent transfer. That root case merits review.

The debtor in Sampsell was one Downey, an individual doing business as a retail merchant who had incurred a large debt to a supplier, Standard. Downey formed a corporation, the stock of which was owned by himself and family members, and conveyed his inventory of wallpaper and paint to the corporation. For more than two years thereafter Downey and the corporation continued in business (the corporation dealing in wallpaper and paint and Downey in other goods), with their assets and businesses kept separate, and during that period another supplier, Imperial, sold wallpaper to the corporation on credit. At the end of that period, Downey (though not the corporation) filed a voluntary petition in bankruptcy.233 In the bankruptcy, on the motion of Downey’s trustee the referee ordered what amounted to a substantive consolidation of Downey’s bankruptcy estate with the assets and liabilities of the corporation, on the ground that the corporation was “nothing but a sham and a cloak” employed by Downey “for the purpose of hindering, delaying and defrauding his creditors.” 234 Imperial was not a party to that proceeding, but it later filed a claim against Downey and asserted that because it was a creditor of the corporation it had a prior right to distribution of funds resulting from the liquidation of the corporation’s assets. A unanimous Supreme Court, in an opinion by Justice Douglas, affirmed the order of the referee rejecting Imperial’s claim to priority in the corporate assets. Observing that “the theme of the Bankruptcy Act is equality of distribution,” and that “[t]o bring himself outside of that rule an unsecured creditor carries a burden of showing by clear and convincing evidence that its 232 313 U.S. 215 (1941). 233 Facts are generally taken from 313 U.S. at 215-17. The Supreme Court’s opinion does not mention the separateness of the assets and businesses of Downey and the corporation, but the Ninth Circuit made a point of that. See Imperial Paper & Color Corp. v. Sampsell, 114 F.2d 49, 51 (9th Cir. 1040), rev’d, 313 U.S. 215 (1941). 234 Sampsell, 313 U.S. at 217. The referee’s order appears to have been framed as a direction that the corporate property be turned over to Downey’s trustee, id., but it appears to have taken for granted that Imperial would be entitled to submit its claim against Downey’s estate, as there was no objection to Imperial doing so later; the only dispute was over whether Imperial’s claim would be paid pari passu with general unsecured creditors of Downey, as the trustee argued, or would be entitled to priority to the extent of the corporate assets, as Imperial argued, id.; see also id. at 219 (referring to the referee’s order as “the order consolidating the estates”).



application to his case so as to deny him priority would work an injustice,”235 Justice Douglas held that Imperial had failed to make such a showing because, among other things, it “had at least some knowledge as to the fraudulent character of Downey’s corporation.”236

Justice Douglas’ opinion is enigmatic, so much so that some commentators have suggested that it is merely an application of fraudulent transfer law.237 That, at least, is not so. Had the case merely applied fraudulent transfer law, the property that Downey fraudulently transferred to his corporation could have been ordered returned to Downey; but as the Ninth Circuit pointed out, the property that Downey had transferred to the corporation had long since been disposed of by the corporation by the time of Downey’s bankruptcy filing.238 Even if the property owned by the corporation at the time of Downey’s bankruptcy were treated as if it were the property fraudulently transferred by Downey two years previously, the ordinary remedy prescribed by fraudulent transfer law would be to avoid the transfer, which would have resulted in the transfer of the corporation’s property to Downey’s estate and left Imperial with a worthless debt owed to it by a corporation stripped of assets.239 That is not what the bankruptcy referee contemplated or the Supreme Court approved, for no one questioned Imperial’s right to submit its claim against Downey’s bankruptcy estate and to share equally with Downey’s general unsecured creditors. 240 The Court effectively validated substantive consolidation of Downey’s estate and the corporation as a proper response to the earlier fraudulent transfer.241 It did not discuss why that outcome was to be preferred over application of the ordinary fraudulent transfer remedy, but nobody was arguing for the latter position. Perhaps the harshness of the latter position to Imperial spoke for itself, so far as equity is concerned.

The Court was equally taciturn about the authority on which its holding rested. Substantive consolidation was not explicitly authorized 235 Id. at 219. 236 Id. at 221. 237 See Douglas G. Baird, Substantive Consolidation Today, 47 B.C. L. REV. 5, 15 (2005); Sabin Willett, The Doctrine of Robin Hood: A Note on “Substantive Consolidation,” 4 DEPAUL BUS. & COM. L.J. 87, 93-94 (2005). 238 Sampsell, 114 F.2d at 52. 239 Had the asset transfer from Downey to the corporation been avoided, the corporation might have been entitled to the return (or to a claim for the return) of the property it gave to Downey in exchange, but it appears that substantially all that the corporation gave in exchange was its stock. Sampsell, 313 U.S. at 216-17. 240 Id. at 221. 241 “Effectively” because the phrase “substantive consolidation” had not then been coined (though the Court did refer to the case as “consolidating the estates,” see supra note 234). According to Judge Ambro’s review of the doctrine in In re Owens Corning, 419 F.3d 195, 206 n.11 (3d Cir. 2005), the term “substantive consolidation” was first used in a judicial opinion in 1977.



by the Bankruptcy Act when Sampsell was decided, and is not explicitly authorized by the Bankruptcy Code today. The doctrine is in the nature of an equitable override of the ordinary axiom that each entity’s assets and liabilities stand on their own. In recent times the Supreme Court has expressed skepticism in other settings about the authority of federal courts generally, and bankruptcy courts in particular, to exercise substantive powers on the basis of a claimed equitable competence that is not founded on an explicit statutory grant.242 Commentators have been much engaged in interpreting those entrails as they may apply to substantive consolidation, with predictably mixed results.243 It is fair to assume that substantive consolidation is one setting in which equitable powers will continue to be recognized, given the doctrine’s application in Sampsell, its explicit endorsement by the majority of the Courts of Appeal, and its use in a multitude of reported cases.244 No reported case has repudiated the doctrine, and despite the cases’ liturgical repetition that the doctrine is to be applied “sparingly,”245 a study found that it has been applied in a majority of recent large public bankruptcy cases.246 A pedigree so long and deep is its own authority.

Most cases in which substantive consolidation has been applied do

242 In bankruptcy, see Norwest Bank Worthington v. Ahlers, 485 U.S. 197 (1988), which held that a bankruptcy court cannot invoke equitable powers to confirm a reorganization plan that violates the absolute priority rule based on an equityholder’s promise of future labor. See also In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004) (reversing a bankruptcy court’s order permitting the debtor to pay “critical vendors” in full under an equitably-justified “doctrine of necessity”). The Supreme Court recently did find a good word to say about equitable override of the language of the Bankruptcy Code in Marrama v. Citizens Bank of Massachusetts, 127 S.Ct. 1105 (2007), which held that a dishonest debtor does not have an absolute right to convert a case from Chapter 7 to Chapter 13, notwithstanding the contrary language of Bankruptcy Code § 706(a). Outside of bankruptcy, skepticism of equitably-founded substantive judicial power manifested itself in Grupo Mexicano de Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999), which held that federal courts do not have power to enjoin prejudgment transfers of assets, on the ground that such a remedy did not exist when federal courts were created in 1789. 243 For arguments that the lack of explicit authorization for substantive consolidation in the Bankruptcy Code renders the doctrine illegitimate, see, e.g., Alan M. Ahart, The Limited Scope of Implied Powers of a Bankruptcy Judge: A Statutory Court of Bankruptcy, Not a Court of Equity, 79 AM. BANKR. L.J. 1 (2005); J. Maxwell Tucker, Grupo Mexicano and the Death of Substantive Consolidation, 8 AM. BANKR. INST. L. REV. 427 (2000); for defenses of the doctrine, see, e.g., William H. Widen, Corporate Form and Substantive Consolidation, 75 GEO. WASH. L. REV. 237, 310-323 (2007), and Adam J. Levitin, Toward a Federal Common Law of Bankruptcy: Judicial Lawmaking in a Statutory Regime, 80 AM. BANKR. L.J. 1, 55 (2006). 244 For endorsements of substantive consolidation by Courts of Appeals, see In re Owens Corning, 419 F.3d at 206-07. 245 Id. at 208-09 (citing, among others, Union Sav. Bank v. Augie/Restivo Baking Co. (In re Augie/Restivo Baking Co.), 860 F.2d 515, 518 (2d Cir. 1988)). 246 William H. Widen, Prevalence of Substantive Consolidation in Large Bankruptcies from 2000 to 2004: Preliminary Results, 14 AM. BANKR. INST. L. REV. 47, 53-54 (2006), states the somewhat weaker conclusion that substantive consolidation has been applied in over 10% of recent large public bankruptcy cases and in an outright majority of the largest of those, but Professor Widen has advised the author that his further investigations, soon to be published, support the stronger conclusion stated in the text.



not bear much resemblance to Sampsell. Broadly speaking they tend to fall into one of two familiar categories. The first are cases in which the assets and affairs of the two entities to be consolidated are so scrambled that unscrambling them is impossible, or at least the incurrence of the administrative costs of unscrambling would make all creditors of both entities worse off. 247 The second, whose heritage draws on the nonbankruptcy jurisprudence of piercing the corporate veil, are cases in which before the bankruptcy petition the two entities disregarded their corporate separateness in a substantial way, especially if the result was to encourage creditors of the two entities to rely upon them as being a single entity.248 Conventional wisdom agrees on three principles: first, that respect for separate corporate forms is the baseline rule of law, in bankruptcy as well as outside it; second, that substantive consolidation by definition dilutes the recovery of the unsecured creditors of one of the two consolidated entities—the one that is more solvent than the other—and correspondingly increases the recovery of the unsecured creditors of the other entity; and third, that it would be inequitable to inflict such a redistribution upon an innocent creditor, especially one who in fact reasonably relied on the separateness of the two entities in making its credit decision. It is therefore generally thought that substantive consolidation is to be granted only if there is an excellent justification for doing so that minimizes inequities of the kind just mentioned.

It is obvious that substantive consolidation of an SPE with its Originator following the Originator’s bankruptcy would defeat the purpose of the prototypical securitization transaction. The result would be to pool the assets and liabilities of the SPE with those of the Originator, thereby drawing the securitized assets into the Originator’s bankruptcy estate. The security interest in the securitized assets in favor of the holders of the securitized debt would not be avoided, but because those assets would be part of the Originator’s bankruptcy estate that

247 A leading exposition of this theme is Chemical Bank New York Trust Co. v. Kheel (In re Seatrade Corp.), 369 F.2d 845 (2d Cir. 1966). See also Alexander v. Compton (In re Bonham), 229 F.3d 750, 767 (9th Cir. 2000). 248 Two leading cases on this theme are In re Augie/Restivo Baking Co. and Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987). For brevity the text speaks in terms of “corporate” separateness, but cases apply the doctrine indifferently to entities of all types. See, e.g., In re Owens Corning, 419 F.3d at 208 n.13. The differences between substantive consolidation and piercing the corporate veil are less obvious than the similarities. Thus, federal courts are quick to note that substantive consolidation is a matter of federal law and so is not constrained by state law standards for veil-piercing. Moreover, substantive consolidation has larger consequences than veil-piercing, in that substantive consolidation typically merges the assets and liabilities of the two entities, while piercing the corporate veil only makes the shareholder liable for the obligations of the subsidiary (and, commonly, only as to particular obligations of the subsidiary, not all of them). See, e.g., id. at 206.



security interest would be subject to the Bankruptcy Tax.249 The SPE is unlikely to be the subject of a bankruptcy proceeding in it own right, as steps will have been taken to make the SPE unlikely to have creditors who might file an involuntary petition, and unlikely also to file a voluntary petition at the behest of the Originator.250 That the SPE is not subject to a bankruptcy proceeding should not prevent substantive consolidation, however; Sampsell itself substantively consolidated a nonbankrupt entity with a bankrupt one.251

Accordingly, in structuring securitization transactions much attention is lavished by the industry on charms intended to ward off substantive consolidation in the event of the Originator’s bankruptcy. That is done through a set of covenants made by the SPE, the Originator, or both, commonly referred to as “separateness covenants,” that aim at avoiding bad facts of the kinds alluded to by cases that have analyzed substantive consolidation under the two familiar theories referred to earlier. Specifically, the separateness covenants aim at assuring that the assets of the Originator and the SPE will not be so scrambled as to defeat unscrambling, and that the Originator and the SPE will not be deemed to have disregarded the SPE’s formal separateness in any substantial way. Thus, the SPE typically covenants to the effect that the SPE’s assets will not be commingled with those of the Originator or any other person; the SPE will follow proper corporate formalities in its operations generally (and, in particular, in its dealings with the Originator); the SPE will pay fair value for all property and services it obtains from the Originator; the SPE will maintain its own books and records and have its own separate financial statements prepared; the SPE and the Originator will each hold themselves out to third parties as being separate entities; and so on, with details being multiplied to the taste of the parties and the rating agencies that are asked to rate the deal.252 249 For the proposition that substantive consolidation does not affect a valid lien, see, e.g., Fed. Deposit Ins. Corp. v. Hogan (In re Gulfco Investment Corp.), 593 F.2d 921, 926-27 (10th Cir. 1979); Talcott v. Wharton (In re Continental Vending Machine Corp.), 517 F.2d 997, 1001-02 (2d Cir. 1975); Helena Chem. Co. v. Circle Land & Cattle Corp. (In re Circle Land & Cattle Corp.), 213 B.R. 870, 876 (Bankr. D. Kan. 1997). 250 For a brief discussion of the measures commonly taken to make the SPE “bankruptcy remote” in this way, see the discussion supra accompanying note 29; for a fuller statement of a rating agency’s requirements on the subject, see S&P LEGAL CRITERIA, supra note 78, at 39-51. 251 For other cases noting that a nonbankruptcy entity may be substantively consolidated with a bankrupt one, see, e.g., In re Owens Corning, 419 F.3d at 208 n.13; Alexander v. Compton (In re Bonham), 229 F.3d 750, 765 (9th Cir. 2000). Somewhat oddly, despite Sampsell, not all courts are convinced. See, e.g., In re Circle Land & Cattle Corp., 213 B.R. at 877; In re Alpha & Omega Realty, Inc., 36 B.R. 416 (Bankr. D. Idaho 1984). For an extensive compilation of cases, see In re Bonham, 226 B.R. 56, 83-93 (Bankr. D. Alaska 1998), aff’d, 229 F.3d 750 (9th Cir. 2000). 252 See S&P LEGAL CRITERIA, supra note 78, at 47 (enumerating the separateness covenants required by Standard & Poor’s as a “general matter”). A set of separateness covenants actually



Securitization’s advocates have tended to portray substantive consolidation as a risk that can be controlled completely by compliance with such formalities.253 As a standard condition of rating securitized debt the rating agencies have required comfort in the form of a legal opinion from the Originator’s counsel to the effect that, assuming compliance with the separateness covenants, the Originator’s bankruptcy court would not order the SPE to be substantively consolidated with the Originator. 254 As with the other bankruptcy-related opinion typically required by rating agencies in securitization transactions (to the effect that the transfer of the securitized assets from the Originator to the SPE is a “true sale” that will not be recharacterized as a transfer for security), these “nonconsolidation” opinions are typically very long “reasoned” opinions designed to warn the recipient of the uncertainty of the result and to insulate the opinion-giver from liability. The analysis in such opinions, too, typically focuses on compliance with such formalities.255

Even if, as the securitization industry supposes, substantive consolidation could be avoided merely by compliance with such formalities, one wonders how likely it is that an SPE actually will be found to have complied with them if and when its Originator files for bankruptcy. In public securitization transactions, at least, it is not clear that any independent monitoring of the SPE’s compliance with its separateness covenants typically occurs. The guidelines for structuring SPEs published by one of the two predominant rating agencies sets forth a lengthy list of separateness covenants, but says nothing about monitoring compliance with them. 256 From the standpoint of the Originator and the SPE, compliance is profitless fiddle-work, and it is not difficult to imagine failure to comply resulting merely from carelessness of no improbable degree—quite aside from the possibility

used may be found in the documents pertaining to the securitization challenged in the LTV Steel litigation. See Emergency Motion for (1) Order Granting Interim Authority to Use Cash Collateral and (2) Scheduling and Establishing Deadlines Relating to a Final Hearing; Memorandum of Points and Authorities and Affidavits of John Delmore and James W. Croll in Support Thereof, In re LTV Steel Company, Inc., No. 00-43866 (Bankr. N.D. Ohio 2000) (docket no. 28, filed Dec. 29, 2000) [hereinafter LTV Cash Collateral Motion]; the separateness covenants are in Exhibit B, § 7.2(k). The LTV Steel bankruptcy docket and pleadings are available at http://ltv.williamslea.net/search.asp (last visited Jan.15, 2008). 253 See, e.g., Schwarcz, Post-Enron, supra note 20, at 1543 n.22 (“[T]his risk appears minimal because substantive consolidation is a risk that can be controlled in securitization transactions by maintaining appropriate formalities (including limiting certain types of intercompany transactions) between the transferor and transferee.”). 254 See S&P LEGAL CRITERIA, supra note 78, at 16-18. 255 For further discussion of bankruptcy-related opinions given in securitization transactions, see infra Part III.B.2. For a model form of a nonconsolidation opinion, see Structured Financing Techniques, supra note 6, at 595-606. That form is fairly representative of opinions typically rendered in practice, in the author’s experience. 256 S&P LEGAL CRITERIA, supra note 78, at 39-52.



of the Originator or SPE failing to comply accidentally-on-purpose during the run-up to the Originator’s bankruptcy. In LTV Steel, the only case to date that has given rise to a reported opinion challenging securitization’s evasion of the Bankruptcy Tax, the Originator in fact did aver to its bankruptcy court that it had failed to comply with its separateness covenants, and asserted that the SPE was subject to substantive consolidation for that reason.257

But in any case, compliance with the formalities imposed by separateness covenants amounts to straightening the deck chairs on a sinking ship, for nowhere is it written that the only justification for invoking substantive consolidation is failure to comply with such formal requirements. Substantive consolidation of Downey and his corporation was approved by the Supreme Court in Sampsell not because of any commingling of assets, confusion of creditors, or failure to comply with any other formalities associated with separate existence, but rather to vindicate a different policy: specifically, to remedy the fraudulent transfer Downey previously made to his corporation. The bankruptcy-gaming asset transfer from the Originator to the SPE in the prototypical securitization can quite readily be characterized as a fraudulent transfer, as discussed previously. Hence invoking substantive consolidation to remedy that fraudulent transfer would simply follow the same path originally trodden by Sampsell. Indeed, it would be needless formalism to insist that the asset transfer from the Originator to the SPE be characterized as fraudulent as a predicate to invoking substantive consolidation. The doctrine is an equitable one, invoked to assure the sensible functioning of the bankruptcy system. If the Bankruptcy Tax is taken seriously as an important element of the Bankruptcy Code, thwarting the attempt at circumventing it is, in itself, sufficient basis for invoking substantive consolidation against the prototypical securitization transaction.258

The injustice of diluting the recovery by an innocent creditor who 257 LTV Cash Collateral Motion, supra note 252, at 11. For reasons not apparent from the motion the debtor relied on other arguments to attack the evasion of the Bankruptcy Tax and did not move for substantive consolidation, though it reserved its right to do so. Id. at n.11. 258 For other arguments for the same result, see Klee & Butler, supra note 26, at 61-65; Peter J. Lahny IV, Asset Securitization: A Discussion of the Traditional Bankruptcy Attacks and an Analysis of the Next Potential Attack, Substantive Consolidation, 9 AM. BANKR. INST. L. REV. 815, 878-85 (2001). In addition, by way of analogy, in other settings courts have ignored corporate separateness when employed for the purpose of evading regulatory or tax laws. See, e.g., Papa v. Katy Indus., Inc., 166 F.3d 937, 941 (7th Cir. 1999) (Posner, C.J.) (exemption from antidiscrimination laws for small employers does not apply to an enterprise that splits itself up into separate corporations for the purpose of qualifying for that exemption, even if the normal standards for piercing the corporate veil are not satisfied: “The privilege of separate incorporation is not intended to allow enterprises to duck their statutory duties”); Nesbit v. Gears Unlimited, Inc., 347 F.3d 72, 84-88 (3d Cir. 2003); Bast v. Orange Meat Packing Co. (In re G&L Packing Co.), 20 B.R. 789 (Bankr. N.D.N.Y. 1982). See also Mary Elisabeth Kors, Altered Egos: Deciphering Substantive Consolidation, 59 U. PITT. L. REV. 381, 438-40 (1998).



relied on the separate existence of two consolidated entities is the reason for caution about substantive consolidation. In all likelihood, however, the SPE employed in the prototypical securitization has no innocent unsecured creditors who would be harmed in that way by the substantive consolidation of the SPE and the Originator. One of the standard elements of “bankruptcy remoteness” that an SPE is obligated to follow in securitization transactions, in order to minimize the risk of the SPE becoming subject to a bankruptcy proceeding on its own account, is that the SPE is not to engage in any business or activity other than those associated with the securitization transaction. 259 It is therefore likely that the only significant creditors of the SPE are the financiers that hold the securitized debt, and the Originator itself. Neither of those have just reason to complain about substantive consolidation of the SPE and the Originator. The Originator’s estate is benefited, not harmed, by substantive consolidation. The financiers will not have their recovery diluted by substantive consolidation, because the financiers are secured by the securitized assets and will continue to have the benefit of their security after substantive consolidation. The only adverse effect upon the financiers is that their collateral will be subjected to the Bankruptcy Tax. And the financers cannot justly complain about that. Securitization’s defenders have suggested that the financiers are innocents whose reliance upon the separate existence of the SPE should be respected.260 That suggestion has force only if the Bankruptcy Tax is viewed as an optional exaction and its evasion as legitimate. If the Bankruptcy Tax is taken seriously as a levy that secured creditors ought not be permitted to contract out of, the suggestion is the equivalent of the legendary parent-slayer’s plea for mercy as an orphan. To cap all, the financiers are unlikely even to be able to claim ignorance of the risk posed by substantive consolidation of the SPE and Originator, even if the securitized debt is publicly issued, for the offering documents for such transactions typically contain specific warning of the risk.261

Even if the SPE does have creditors other than the securitization financiers and the Originator, their existence need not prevent substantive consolidation. Rating agency guidelines may permit an SPE

259 See supra note 250. 260 See KRAVITT, supra note 18, § 5.05[G][2], at 5-123. 261 For example, the prospectus to the Honda Auto Receivables 2003-1 Owner Trust transaction, reprinted as appendix 4 to Professor Schwarcz’s casebook, supra note 29, at 322-24 (under the heading “Certain Legal Aspects of the Receivables—Certain Bankruptcy Considerations”), sets forth specific warnings of the risk and consequences of substantive consolidation, among other bankruptcy risks. The point is also highlighted as a “Risk Factor” near the beginning of the prospectus on pages 13-14. The “Risk Factors” are omitted from the reprint in the casebook, but the prospectus is available in the SEC’s “Edgar” archive at http://www.sec.gov/.



to issue additional debt subject to fairly stringent conditions, which include being nonrecourse to the SPE or its assets other than cash flow in excess of amounts necessary to pay holders of the rated debt, and agreement by the creditor not to file an involuntary bankruptcy petition against the SPE.262 To the extent that such a creditor’s debt is secured, substantive consolidation does not dilute its recovery. To the extent that such a creditor’s debt is unsecured, substantive consolidation would dilute that creditor’s recovery if the SPE is more solvent than the Originator. It is not clear that equity should be concerned about that dilution, for such a creditor cannot be ignorant of the SPE’s nature as a bankruptcy-gaming tool of the Originator. But the possible existence of such a creditor need not prevent substantive consolidation in any case, for the dilution can be avoided if the court orders the substantive consolidation of the SPE with the Originator with the proviso that, in the event that there are innocent unsecured creditors of the SPE who reasonably relied on the SPE’s separateness from the Originator, such creditors should receive distributions on those claims equal to what they would have received absent consolidation, with the remainder of the SPE’s assets and liabilities to be consolidated.

Such a “partial” substantive consolidation would by no means be unprecedented. Sampsell itself distinguished between substantive consolidation and the priorities of creditors’ claims against the consolidated estate in that way. Though Justice Douglas held that Imperial, creditor of Downey’s corporation, was entitled only to a pro rata distribution from the consolidated estate of Downey and the corporation, he was quite prepared to entertain the proposition that an innocent creditor of the corporation would be entitled to priority in the corporation’s assets.263 Imperial, burdened with guilty knowledge, did not qualify as an innocent creditor. Later cases have applied similar reasoning and stated that when substantive consolidation is ordered, innocent unsecured creditors who relied on the separateness of an entity being consolidated are entitled to a distribution calculated as if the consolidation had not occurred.264

262 See S&P LEGAL CRITERIA, supra note 78, at 40-41, 46. 263 See, e.g., Sampsell v. Imperial Paper & Color Corp., 313 U.S. 215, 219 (1941) (“[W]here the relationship between the stockholder and the corporation was such as to justify the use of summary proceedings to absorb the corporate assets into the bankruptcy estate of the stockholder, the corporation’s unsecured creditors would have the burden of showing that their equity was paramount in order to obtain priority as respects the corporate assets.”). In addition, see the passage quoted supra note 235. 264 See, e.g., Stone v. Eacho (In re Tip Top Tailors, Inc.), 127 F.2d 284, 290 (4th Cir. 1942), rehearing denied, 128 F.2d 16, 16 (4th Cir. 1942); Fed. Deposit Ins. Corp. v. Hogan (In re Gulfco Investment Corp.), 593 F.3d 921, 929 (10th Cir. 1979) (citing Fish v. East, 114 F.3d 177 (10th Cir. 1940)); Alexander v. Compton (In re Bonham), 229 F.3d 750, 768-69 (9th Cir. 2000). See also Kors, supra note 258, at 391, 450-51 (1998) (citing other instances approvingly, though noting that in ordinary circumstances it is unlikely that some but not all creditors will have



To summarize: The crux of the matter, so far as the doctrinal strength of securitization is concerned, is the legitimacy of contracting out of the Bankruptcy Tax. As discussed in Part I, the argument that this violates the policy of the Bankruptcy Code is a straightforward one. If, as in LTV Steel, the Originator seeks to collapse its securitization in order to use the cash flow from the securitized assets, ruling for the Originator might spell the difference between a successful reorganization and one that fails for want of cash. In that setting, a court that views the securitization as violating the policy of the Bankruptcy Code in all likelihood has a choice of doctrinal tools— including at least fraudulent transfer or substantive consolidation—to vindicate bankruptcy policy.

III. THE LEGAL RECEPTION OF NEW FINANCIAL PRODUCTS

A. Products That Are “Too Big to Fail”

1. Introduction The preceding discussion shows that the doctrinal foundations of

the prototypical securitization transaction are shaky. Yet securitization has proceeded apace for more than twenty years, blossoming into an immense volume of transactions that comprises a sizable proportion of all publicly-traded debt securities, to say nothing of private lending transactions that employ the same technique. What does this show about the reaction of the legal system to innovation in financial products?

The first point is that in all probability the soundness of the doctrinal foundations of securitization is a moot question: an academic exercise in the most dismissive sense of that term. If a securitization transaction were challenged successfully in an Originator’s bankruptcy proceeding, so that a court holds authoritatively that the legal doctrines on which the edifice of securitization was constructed do not achieve the hoped-for result (the force of “authoritatively” being to exclude rulings that industry can persuade itself do not have precedential force, such as the interim order on use of cash collateral issued by the lone bankruptcy judge in LTV Steel), the result would be cataclysmic. Such a holding would mean that there is no justification for rating the instruments issued in any of the gigantic volume of other similarly-structured transactions on the basis of the credit quality of the pool of assets that back the instruments, as opposed to the lower rating of the reasonably relied on the separateness of consolidated entities).



Originator. Such a universal downgrade would cause all of those outstanding instruments to lose value, reflecting their lower credit quality. The value so lost, amounting to uncounted billions of dollars, would evaporate, and the holders of those instruments would suffer accordingly. It seems improbable that a court that is fully aware of these consequences would be willing to accept the responsibility of causing them by ruling that the legal doctrines relied upon to support securitization do not do their job. In other words, the product has simply become too big to fail.

“Too big to fail” is a phrase commonly used in a different sense. Ordinarily it is used to denote a firm that has become so large that the government cannot afford to let it fail because the consequences of its failure would be too severe. The term is most familiarly applied to banks and other actors in the financial markets, no doubt because the concern that failure of such a firm would have cascading effects on other firms is applicable more generally than the kinds of concerns that might motivate a government bail-out of other entities.265 By contrast, in the preceding paragraph “too big to fail” is applied not to a firm, but to a product—specifically, a product whose legal underpinnings are questionable. These different settings give rise to different problems. If a firm is perceived to be “too big to fail,” the problem that arises is moral hazard. The firm’s creditors will be apt to ignore the firm’s intrinsic creditworthiness and instead treat it as being as creditworthy as the sovereign that will step in to avert its failure. In turn, absent the need to satisfy creditors of the firm’s creditworthiness, the firm’s management will be prone to take excessive risks. By contrast, the problem that arises when a product grows “too big too fail” is political. If a court is unwilling to cause the upheaval that would result from knocking down the legal foundations of a widely-used product, when the court would have so held had the product been less widely established, that distorts the traditional model of how the legal system operates. Indeed, as will be discussed later, to the extent that a court is

265 For a thorough discussion of the “too big to fail” problem in the context of banks, see GARY H. STERN & RON J. FELDMAN, TOO BIG TO FAIL: THE HAZARDS OF BANK BAILOUTS (2004); for its origins, see Robert L. Hetzel, Too Big to Fail: Origins, Consequences, and Outlook, FED. RES. BANK OF RICHMOND ECON. REV., Nov.-Dec. 1991, at 3; for an argument that regulatory changes that have allowed the creation of diversified financial conglomerates have made the problem worse, see Arthur E. Wilmarth, Jr., The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased Risks, 2002 U. ILL. L. REV. 215. For a discussion of federal bailouts in the 1970s on “too big to fail” grounds of four entities that were not in the financial services business (Chrysler, Lockheed, Conrail and New York City), see U.S. GEN. ACCOUNTING OFFICE, GUIDELINES FOR RESCUING LARGE FAILING FIRMS AND MUNICIPALITIES (1984). See also Lawrence A. Cunningham, Too Big to Fail: Moral Hazard in Auditing and the Need to Restructure the Industry Before it Unravels, 106 COLUM. L. REV. 1698 (2006) (discussing the possibility that the four remaining accounting firms competent to audit the majority of public companies have become “too big to fail”).



swayed by the “too big to fail” dynamic, and to the extent that the growth of a product to the status of “too big to fail” can be attributed to identifiable private actors, the power to determine the validity of the product might be said to have effectively passed from the judiciary to those private actors.266

Though the differing meanings of “too big to fail” as applied to a product or a firm barely intersect, they do have one important attribute in common: the legal actors whose decisions are apt to be influenced by a product or firm being “too big to fail” ordinarily have every reason to deny that influence, regardless of the truth. The moral hazard that arises when a firm is perceived to be “too big to fail” is a consequence of the expectations of the firm’s creditors that a government bail-out will protect them from loss resulting from the firm’s failure. Hence the moral hazard can be averted if those expectations are dispelled. For that reason, governmental actors in the United States banking sector routinely seek to create the impression that no bank is “too big to fail.” Thus, the 1991 amendments to the federal deposit insurance laws were surrounded by a cloud of rhetoric to the effect that they largely solved the “too big to fail” problem, even though analysis shows that they will have little or no effect on the behavior of policymakers when they debate the bailout of the largest banks. 267 Likewise, senior policymakers in the sphere of bank regulation, such as members of the Federal Reserve Board, often make public pronouncements to the effect that “no bank is too big to fail.” Realistic commentators—including former policymakers, after they have shed their policymaking responsibilities—dismiss such pronouncements as so much propaganda.268 266 See infra Part III.B. It should be noted that the discussion of the “too big to fail” dynamic in this paper is almost entirely descriptive. The philosophical implications of the phenomenon are beyond the scope of this paper. 267 See STERN & FELDMAN, supra note 265, at 149-58. At the time of their writing the authors were, respectively, the president and vice-president of the Federal Reserve Bank of Minneapolis. 268 The resulting dialectic can be entertaining. Thus, Roger Ferguson, then vice-chair of the Federal Reserve Board, announced at a conference that “No institution is too big to fail,” echoing a speech given the previous week by the then chairman of the Federal Reserve Board, Alan Greenspan. Rob Blackwell, “Too Big to Fail” Deniers Have a Tough Audience, AM. BANKER, June 4, 2001, at 1. Reacting to those statements, Alan S. Blinder, a former vice-chairman of the Federal Reserve Board who had since left for the private sector, said: “Everybody knows that there are institutions that are so large and interlinked with others that it is out of the question to let them fail. . . . [The Federal Reserve Board’s efforts to deny the “too big to fail” concept are] not quite true—but if you are a federal regulator, you want to say it early and often.” Id. Similarly, at the hearing to confirm his appointment to the Federal Reserve Board, Donald Kohn avowed that, “No depository institution should be insulated from market forces by being considered ‘too big to fail.’” Nomination of Donald L. Kohn: Hearing before the S. Comm. on Banking, Housing and Urban Affairs, 107th Cong. (2002), available at http://banking.senate.gov/02_07hrg/ 073002/kohn.htm. A commentator reporting on the hearing remarked, “Perhaps fortunately, nobody in the markets actually believes that doctrine, but political correctness never did have much to do with the real world, did it?” Bernanke and Kohn Accepted, CENTRAL BANKING



The determination of whether a financial product with questionable doctrinal foundations achieves the end desired by its users will be made, at least in the first instance, by the judge or judges of the court in which the issue is litigated. If the court is swayed by the “too big to fail” dynamic into upholding a product that it otherwise would have stricken down, there are good reasons for the court to refrain from saying so. The same point about suppressing undesirable expectations that applies to firms “too big to fail” applies in this setting as well. It would be perverse for a judge to send a signal to legal entrepreneurs that they can manipulate the outcome of litigation to their advantage if they can grow a product sufficiently before it is tested in the courts. Furthermore, an admission to being influenced by the “too big to fail” dynamic could be an embarrassment to a court, for “too big to fail” is not among the principles of judicial decisionmaking that the legal culture traditionally has viewed as legitimate, and indeed it may smack perilously of a craven capitulation to the interests of financiers.

That the “too big to fail” dynamic may prop up a financial product’s shaky doctrinal underpinnings is thus an elephant in the living room, an evident fact about which there is an official conspiracy of silence. Partly to compensate for that silence, this paper later presents a case study in which the “too big to fail” dynamic demonstrably played a significant, and possibly decisive, role in saving a new financial product from its questionable doctrinal underpinnings.269 Certainly the efficacy of the “too big to fail” dynamic is widely believed in, as much was made of the disastrous consequences of a ruling adverse to the product in the briefs of the litigants in LTV Steel and in other cases in which the dynamic plausibly could be invoked.270 PUBLICATIONS, NEWSMAKERS, Aug. 9, 2002, available at http://www.centralbanking.co.uk/ newsmakers/archive/2002/aug09.htm. Likewise, the incoming chairman of the Federal Reserve Board stated at his confirmation hearing that “the agencies have made clear that no bank is too-big-too-fail [sic].” Nomination of Ben S. Bernanke: Hearing Before the S. Comm. on Banking, Housing and Urban Affairs, 109th Cong. 71 (2005). To a reader of the hearing transcript the statement has the air of a high priest reciting a liturgy for propitiatory purposes, quite independent of belief in its literal truth. 269 See infra Part III.A.4. 270 For invocation of the “too big to fail” dynamic in LTV Steel, see Memorandum of Securitization Amici Curiae in Opposition to Emergency Motion for Order Granting Interim and Final Authority to Use Cash Collateral at 17-20, In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio 2001) (No. 00-43866) (docket no. 502, filed Feb. 20, 2001) (dilating for more than three pages on the “too big to fail” theme, e.g.: “A decision in this high-profile case accepting LTV’s extreme legal arguments and disregarding the structure of the LTV transactions could cause a seismic disruption in the capital markets. . . . Billions of dollars in asset-backed securities have been rated on the assumption that two-tier securitization structures, comparable to those used by LTV, successfully isolate assets of a special purpose subsidiary from the financial troubles of its parent. If these assumptions are called into question, many ratings could be withdrawn or dramatically reduced. The impact on the market value of the securities would be immediate.”); Brief of The New York Clearing House Association L.L.C. as Amicus Curiae in Opposition to Debtor’s Emergency Motion for an Order Granting Authority to Use Cash Collateral at 4, id.



In contrast to the silence that prevails in the domain of financial products, the “too big to fail” dynamic has achieved at least an underground recognition in the domain of tax products. In that setting it is sufficiently familiar to have acquired a nickname, the “Wall Street Rule,” and it takes the form of a widely-held assumption that, in general, the Internal Revenue Service (“IRS”) acquiesces in the tax treatment of any product if the dollar amount involved is of sufficient magnitude. 271 Although a formal study appears to be lacking, the anecdotal evidence of widespread and long-held belief in the “Wall Street Rule” makes it difficult to believe that it does not have some substance.272 Just as policymakers in the banking sector do their futile best to persuade the world that no bank is “too big to fail,” the chief counsel of the IRS has proclaimed that, while the “Wall Street Rule” is “widely known in the tax world,” it is “not legally or equitably binding on the IRS”273—another case of protesting too much that, by officially trumpeting the lack of legal force behind the principle, tends to confirm its practical influence on the IRS’s behavior.

Comparing the operation of the “too big to fail” dynamic upon the IRS when confronted by an aggressive tax-driven product with its operation upon courts when confronted by a financial product that aims aggressively at enhancing a creditor’s position in the event of the debtor’s insolvency (a “bankruptcy-driven product,” for short) is a useful exercise. A product will have more opportunity to grow “too big to fail” the longer the time lag between the introduction of the product into the market and the occasion for the legal decisionmaker to determine its validity. That time lag may tend to have a greater

(docket no. 507, filed Feb. 20, 2001) (“LTV is willing to disregard the adverse impact of its Motion on thousands of companies with millions of employees, as well as the millions of investors with interests in securitizations through pension funds, mutual funds, and other investment vehicles.”). The docket and pleadings in LTV Steel, including the two items just cited, are available at http://ltv.williamslea.net/search.asp (last visited Jan. 15, 2008). For invocation of the dynamic in other cases, see infra notes 339 & 352. 271 “In general” because, among other things, the dynamic evidently does not apply to disfavored products, such as tax shelters. See Lee A. Sheppard, Having it Both Ways on Feline Prides, 106 TAX NOTES 632, 632 (2005) (“There may be no Wall Street Rule for retail tax shelter promoters, but there is a Wall Street Rule for Wall Street.”). 272 See, e.g., Lee A. Sheppard, Wall Street Rules: Feline Prides Get IRS Imprimatur, 100 TAX NOTES 619 (2003) (attributing an IRS ruling validating a new tax product to the “Wall Street Rule”); Jasper L. Cummings, Jr., Letter to the Editor, A Short History Lesson, 86 TAX NOTES 1169, 1169 (2000) (“As early as 1986, Prof. Harvey Dale of NYU quoted to me the de Kosmian rule: once $100 million of an instrument has been issued to the public, the IRS is presumed to have agreed to the issuer’s characterization of the instrument.”); Robert S. Bernstein, Wall Street Rule Broken; IRS Challenges Commodity Mutual Funds, 33 CORP. TAX’N 36 (2006) (noting that the IRS had issued a ruling disallowing a particular tax technique that would draw into question the tax qualification of certain large mutual funds, despite the “Wall Street Rule”). 273 Emily A. Parker, Acting Chief Counsel, Internal Revenue Serv., Address at the TEI/LMSB Financial Services Industry Conference (Sept. 22, 2003), available at http://www.irs.gov/pub/irs-utl/tei-92203.pdf.



variance in the case of a tax-driven product than in the case of a bankruptcy-driven product. The IRS has the opportunity to contest an aggressive tax product as soon as the product is used and its use is reflected on a taxpayer’s tax return. Although taxpayers using such a product may often take care to avoid drawing the IRS’s attention,274 the IRS’s ability to detect the product and take a position on its validity ultimately is constrained only by the resources the IRS has available for enforcement, and it would seem reasonable to suppose that the likelihood of detection must increase steadily with the passage of time. Moreover, the IRS has an incentive to pursue enforcement against aggressive tax products when detected, as every dollar of additional tax collectible as a result of such enforcement is captured by the IRS. Absent other public choice considerations, therefore, the IRS would seem to have every reason to set the bar of “too big to fail” rather high.

By contrast, the opportunity for determination of the validity of a bankruptcy-driven product will occur only if and when a debtor that has employed the product files for bankruptcy. In theory, an ordinary creditor A, who is disadvantaged by the benefit that the product confers upon creditor B who employs the product, might sue to challenge the product as soon as the debtor employs it. But in practice that will never happen, if only because collective action considerations will constrain creditor A from doing so: the benefits of such a suit, if successful, will run to all creditors of the debtor but the cost will be borne solely by creditor A. (Indeed, the restraining force of the collective action dynamic upon unsecured creditors when confronted with a technique that expands the availability of secured credit, whether adopted by secured creditors on the basis of an expansive interpretation of current law or validated by legislation enacted at the behest of secured creditors, may be the ultimate reason for the steady expansion of the legal availability of secured credit during the last two centuries.) A bankruptcy or other collective insolvency proceeding dissolves the collective action problem, and so offers a practical opportunity for adjudication of the validity of the bankruptcy-driven product. But the time lag between the introduction of the product and the first bankruptcy proceeding of a debtor that has used the product is largely a 274 See, e.g., Lee A. Sheppard, ABA Mulls Over Treatment of Credit Default Swaps, 105 TAX NOTES 156, 156 (2004) (“The corollary of the Wall Street rule is that Wall Street doesn’t tell the government what it is doing or ask for advice on how to treat it while it is building the market for the product.”); see also Mark P. Gergen, The Logic of Deterrence: Corporate Tax Shelters, 55 TAX L. REV. 255 (2002) (arguing that the optimal number of users of a particular tax shelter, from the users’ standpoint, is relatively small, to keep the likelihood of detection small, but each promoter has an incentive to market a shelter beyond that optimal number). Not surprisingly, the government’s attempts to control tax shelters have focused in substantial part on improving methods for disclosure by taxpayers. See, e.g., American Jobs Creation Act of 2004, Pub. L. No. 108-357, §§ 815-817, 118 Stat. 1418 (amending §§ 6111, 6112, 6707 and 6708 of the Internal Revenue Code to create new rules on reporting of certain suspect classes of transactions).



matter of the luck of the draw. Entrepreneurs who employ an aggressive bankruptcy-driven product thus can hope that such a bankruptcy will not occur soon after the product’s introduction, and may be able defer the day of reckoning by settling challenges rather than risking an adverse determination while the market for the product is being built.275

These considerations suggest that the “too big to fail” dynamic should be expected to have less force as applied to tax-driven products than as applied to bankruptcy-driven products. That the “too big to fail” dynamic is recognized to any degree as a force in tax law thus confirms the intuition that its gravitational pull also would tug at a court confronted with a bankruptcy-driven product.

All law is applied politics, but some principles of judicial decisionmaking are more political than others. A coherent distinction can be drawn between the conception of the judicial function as deciding cases on the basis of the legal methodologies traditionally accepted by professional legal culture (such as close reading of statutory texts, making inferences from the structure and functions of the governing statute, giving due weight to precedent, and so on), as opposed to other bases of judicial decisionmaking, which may be referred to by way of distinction (and perhaps also by way of pejorative) as “political.” The “too big to fail” dynamic is political in that sense. As such it may seem heretical to practicing lawyers steeped in financial and commercial law, who tend to take doctrine more seriously than do lawyers practicing in some other fields. Likewise, scholars working in financial and commercial law have tended not to pay as much attention to influences on judicial decisionmaking extrinsic to the traditional legal model as have their peers working in other areas.276 In the domain of constitutional law and other areas of public law, by contrast, scholars are thoroughly accustomed to viewing judges as political actors. Indeed many such scholars, especially those trained as political scientists, view the notion that judges decide cases by applying traditional legal methodologies as downright naïve.277 They instead posit alternative models of judicial decisionmaking, such as the “attitudinal” hypothesis 275 For a summary of literature on a litigant’s ability to shape precedent by electing to litigate only cases with the best potential for success, see Frank B. Cross, Decisionmaking in the U.S. Circuit Courts of Appeals, 91 CAL. L. REV. 1457, 1491-97 (2003). See also infra text accompanying notes 393-395. 276 This is merely a tendency, not a rule, of course. For a counterexample, see LYNN M. LOPUCKI, COURTING FAILURE (2005) (asserting that bankruptcy judges have been competing for large reorganization cases and that bankruptcy doctrine has been warped as a result). See also, e.g., Assaf Likhovski, The Duke and the Lady: Helvering v. Gregory and the History of Tax Avoidance Adjudication, 25 CARDOZO L. REV. 953 (2004) (discussing extra-legal factors that have shaped the judicial creation of tax anti-avoidance doctrines). 277 For a collection of such views, see Frank B. Cross, Political Science and the New Legal Realism: A Case of Unfortunate Interdisciplinary Ignorance, 92 NW. U. L. REV. 251, 264 (1997).



that a judge comes to a case with a formed ideology and will decide the case on the basis of that ideology, or the “public choice” hypothesis that a judge will reach the result supported by the most influential groups in society that have an interest in the outcome, and so on.278

Of course it is not an accident that attention to nontraditional models of judicial decisionmaking is more prevalent in commentary on public law than financial and commercial law. In the domain of constitutional law, for example, the traditional tools of judicial decisionmaking are less determinate because the relevant texts tend to be old and vague, making it hard for judges to reach decisions by a process reasonably characterized as interpretation; moreover, the difficulty of amendment renders judicial decisions more powerful than they are in domains governed by statute or common law.279 One need not abandon belief in the general primacy of the traditional model of judicial decisionmaking in financial and commercial law, however, in order to accept that a court might nonetheless be swayed by a force extrinsic to the traditional model if that force is sufficiently powerful, and that the “too big to fail” dynamic may well qualify in an appropriate case.

The “too big to fail” dynamic may exert its influence more openly on the more overtly political branches of government—the legislature and the regulatory agencies—and those influences may feed back into the judicial decisionmaking process. Thus, financial regulators unwilling to face the consequences of a judicial ruling adverse to a product that is “too big to fail” may join the litigation and add their own potent voices to the chorus imploring the court. The legislature may negate the judicial ruling by enacting legislation to validate the product. Moreover, the knowledge that a judicial decision adverse to an established product may well be rendered futile by subsequent validating legislation may in turn be another factor inclining the court to uphold the product. 280 These cross-currents can be explored by examining the financial product that is probably the paradigmatic

278 For an explication of the “attitudinal” model of judicial decisionmaking, see JEFFREY A. SEGAL & HAROLD J. SPAETH, THE SUPREME COURT AND THE ATTITUDINAL MODEL (1993); on the “public choice” model, see, e.g., Joseph D. Kearney & Thomas W. Merrill, The Influence of Amicus Curiae Briefs on the Supreme Court, 148 U. PA. L. REV. 743, 783-88 (2000); and for an overview of different models, see Cross, supra note 275. See also Cass R. Sunstein et al, Ideological Voting on Federal Courts of Appeals: A Preliminary Investigation, 90 VA. L. REV. 301 (2004) (presenting evidence that voting by judges on federal courts of appeals can be predicted on ideological bases in cases involving many issues, including, e.g., piercing the corporate veil). 279 This is hardly a new idea. For a recent exposition, see Richard A. Posner, The Supreme Court, 2004 Term—Foreword: A Political Court, 119 HARV. L. REV. 31, 39-54, 79-80 (2005). 280 Cf. Cross, supra note 275, at 1482-91 (canvassing the literature espousing a “strategic choice” model of judicial decisionmaking, which posits that judges are mindful of the positions and powers of other institutions and avoid issuing rulings that may be reversed or evaded).



modern example of one that became “too big to fail”: the repurchase agreement, or “repo.”

2. Judicial, Regulatory and Legislative Reactions to a Product

“Too Big to Fail”: Repo and Other Products A repo is a sale of a security (the traditional norm being a U.S.

Treasury or federal agency security) and a simultaneous agreement to repurchase the security at a specified price on a later date. This sale and resale is economically equivalent to a loan from the original buyer (the “repo buyer”) to the original seller (the “repo seller”) secured by the underlying security, the principal amount of the imputed loan being the original purchase price and the excess of the repurchase price over the original purchase price being equivalent to interest. The product was in fact originated by the Federal Reserve Banks for the very purpose of disguising their making of secured loans. The first large use of repos was during World War I, when Federal Reserve Banks used them to extend credit to member banks in order to avoid a wartime stamp tax that would have applied to loans evidenced by promissory notes.281 Likewise, after the war, Federal Reserve Banks used repos to extend credit to dealers in certain then-novel money market instruments, in order to finesse the fact that the Federal Reserve Act did not authorize the Federal Reserve Banks to lend to such dealers.282 Repos went into abeyance during the Great Depression and World War II, but reappeared in the 1950s, when the Federal Reserve began to use them regularly as a way of fine-tuning the money supply.283 At about the same time, private parties began doing repos with each other in increasingly large volume, and a substantial reason for that development was that many parties extending credit in this way were not authorized to make loans, or were subject to regulatory restraints on lending that they sought to avoid through the form of buying and selling securities.284 281 See Edward C. Simmons, Sales of Government Securities to Federal Reserve Banks under Repurchase Agreements, 9 J. FIN. 23, 25 (1954). For a compilation of sources on the history of repos, see Kenneth D. Garbade, The Evolution of Repo Contracting Conventions in the 1980s, FED. RES. BANK OF N.Y. ECON. POL’Y REV., May 2006, at 27. 282 See Simmons, supra note 281, at 26. 283 See id. at 32-34. 284 See MARCIA STIGUM, THE REPO AND REVERSE MARKETS 108 (1989) (“[M]any, perhaps most, potential investors in repo were not empowered to make collateralized loans, but they could buy and sell all the securities they needed to stay fully invested.”); H. Boone Porter, III, Substantive Regulation of, and Accounting for, Repurchase and Reverse Repurchase Agreements Transactions, in REPURCHASE AND REVERSE REPURCHASE AGREEMENTS 1985, at 341 (Practicing Law Institute 1985) (“Repurchase agreements evolved, in large part, as a market solution to a regulatory accounting concern, i.e., the need to circumvent the borrowing limits



The legal premise upon which repos rested—that because a repo is in form a sale and resale it should not be treated as a secured loan—was always dubious. Centuries of case law, faithfully codified by Article 9, holds that parties cannot contract out of the application of secured transactions law to a transaction that is, in substance, a secured transaction. No matter what form the parties give to a transaction, if it is in substance a secured loan it should be characterized as such.285 To the extent that repos were used to evade regulatory strictures on lending, the risk to users posed by the possibility of recharacterization generally would be temporary, as the risk would resolve itself if and when the applicable regulators signaled their willingness to wink at the form of the transaction. The critical case, however, is bankruptcy, for the recharacterization of a repo as a secured loan would have dramatic adverse consequences for the financier (the repo buyer) in the event that the borrower (the repo seller) goes bankrupt. If the repo were recharacterized as a secured loan, then, among other things, the automatic stay would prevent the repo buyer from liquidating the repoed security and applying the proceeds to the secured debt, absent the approval of the bankruptcy court—and in a volatile market the delay involved in obtaining that approval could turn a repo buyer’s oversecured position into an undersecured one. Whether a repo buyer would suffer the consequences of recharacterization in bankruptcy could not be resolved until the product was tested in bankruptcy court. And, because the main participants in the repo market historically were entities that rarely become the subject of insolvency proceedings—banks, regulated broker-dealers, investment companies, and units of government—it was not until the early 1980s that significant litigation on point finally ensued.286 By that time the product had grown very large indeed.287 If the “too big to fail” dynamic has any force, it should have been manifest in that setting.

Battle was joined in earnest in 1982 with the bankruptcy of Lombard-Wall, Inc., a government securities dealer, whose bankruptcy judge fired a shot heard round the world. Specifically, five days after

statutorily imposed upon national banks prior to the enactment of the Garn-St. German Act [of 1982].”). 285 In the current recension of Article 9 this principle is codified in U.C.C. § 9-109(a)(1) (“[T]his article applies to . . . a transaction, regardless of its form, that creates a security interest in personal property or fixtures by contract. . . .”) (emphasis added). 286 Inconclusive pre-1982 litigation on point is summarized in Jeanne L. Schroeder, Repo Madness: The Characterization of Repurchase Agreements Under the Bankruptcy Code and the U.C.C., 46 SYRACUSE L. REV. 999, 1010-11 (1996). 287 See Bankruptcy Reform: Hearings Before the Senate Judiciary Comm., 98th Cong. 328 (1983) [hereinafter Senate 1983 Repo Hearings] (statement of Peter Sternlight, Executive Vice President of the Federal Reserve Bank of New York) (“It is difficult to determine the total size of the repo market, but one can safely estimate that the aggregate daily amount of repo transactions amounts to several hundred billion dollars.”).



the debtor’s bankruptcy filing, Judge Ryan issued a temporary restraining order freezing the securities held by the debtor’s repo buyers, implicitly recharacterizing as secured loans the repos the debtor had done as repo seller.288 In the teeth of amicus briefs passionately arguing the contrary filed by the Federal Reserve Bank of New York and a host of industry parties, Judge Ryan confirmed that order in an oral ruling from the bench a month later.289 The damage to creditors caused by the ruling was negligible, as all of Lombard-Wall’s largest repo counterparties were in fact allowed to liquidate their positions within a few days after commencement of the case.290 Yet the ruling disquieted the Federal Reserve Board enough to cause it, with the vigorous support of industry, to press on Congress draft legislation amending the Bankruptcy Code to exempt broad classes of repo transactions from virtually all of the adverse consequences of bankruptcy. Congress obediently enacted those “repo amendments” in 1984, and broadened them substantially in 2005 at the request of the major federal financial regulators, acting together as the “President’s Working Group on Financial Markets.”291

Although the repo amendments settled most of the issues arising from the bankruptcy of a party to a repo, they did not settle all of them, as the repo amendments did not apply to all repo transactions. The proper characterization of a repo thus remained a live question as to nonqualifying repos. The subsequent bankruptcy of another securities dealer, Bevill, Bresler & Schulman, Inc., occasioned a decision on the subject in 1986 by District Judge Debevoise that was the opposite in all ways of Judge Ryan’s, starting with the fact that Judge Debevoise’s decision was embodied in an opinion that fills 63 pages of the Bankruptcy Reporter. 292 Ruling not on a motion for a temporary 288 In re Lombard-Wall, Inc., No. 82-B-11556 (Bankr. S.D.N.Y. 1982). Lombard-Wall filed its bankruptcy petition on August 12, 1982, and the court issued the temporary restraining order on August 17. See Gary Walters, Note, Repurchase Agreements and The Bankruptcy Code: The Need For Legislative Action, 52 FORDHAM L. REV. 828, 830 n.9 (1984); Lombard Securities with Buy-Back Plan are Frozen by Court, WALL ST. J., Aug. 18, 1982, at 7. 289 The bench ruling was made on September 16, 1982. See Tim Carrington, Securities in Lombard-Wall Case Termed Loan Collateral by a Bankruptcy Judge, WALL ST. J., Sept. 20, 1982, at 10; Walters, supra note 288, at 830 n.9. In the meantime, amicus briefs arguing the contrary had been filed by at least the Federal Reserve Bank of New York, Goldman Sachs & Co., Salomon Brothers, Inc. and the Investment Company Institute (the trade association of mutual funds). See id. at 833 n.28, 843 n.94. The Federal Reserve Bank of New York’s amicus brief is reprinted in REPURCHASE AND REVERSE REPURCHASE AGREEMENTS 303 (Practicing Law Institute 1982). 290 See Bankruptcy Law and Repurchase Agreements: Hearings on H. 2852 and H. 3414 Before the Subcomm. on Monopolies and Commercial Law of the House Comm. on the Judiciary, 98th Cong. 109 (1984) [hereinafter House 1984 Repo Hearings] (testimony of Peter D. Sternlight, Executive Vice President of the Federal Reserve Bank of New York). 291 See infra notes 301-304. 292 Cohen v. Army Moral Support Fund (In re Bevill, Bresler & Schulman Asset Mgmt. Corp.), 67 B.R. 557 (Bankr. D.N.J. 1986).



restraining order but on comparatively leisurely motions for summary judgment, Judge Debevoise held that the repos involved in that case should not be recharacterized as secured loans. Bevill Bresler remains the leading case on the subject, with subsequent cases generally following its reasoning.293 The Federal Reserve Bank of New York again intervened as amicus in Bevill Bresler to argue against recharacterization, and it has similarly intervened in several later cases implicating the issue.294

Courts, financial regulators and Congress thus each played an important role in validating the bankruptcy treatment of repos desired by the market. It is instructive to consider in turn how the “too big to fail” dynamic affected each of them.

Judicial Response. In the case of the judicial response to the repo,

two points stand out. The first is that the “too big to fail” dynamic does not confer invincibility, for even in the very favorable setting of the Lombard-Wall case—a very large product the market characterization of which was supported not only by the major players in the industry but by the Federal Reserve Bank of New York—“too big to fail” did not sway Judge Ryan. The event is analogous to the bankruptcy judge’s refusal to respect the form of the securitization transaction at stake in LTV Steel, which likewise occurred in the context of motions hastily litigated in the immediate wake of the debtor’s bankruptcy filing. While the “too big to fail” dynamic might not outweigh a bankruptcy judge’s extreme disinclination to allow the estate to become unglued as a result of an adverse ruling made in great haste at the outset of a case, Bevill Bresler might be taken to suggest that “too big to fail” may have more weight in litigation conducted at a more moderate pace, in which the judge has the leisure to digest fully the unpleasant and unfamiliar collateral consequences of a ruling adverse to market expectations about a large product.

The second point is that the blessing of industry’s preferred characterization of repos in Bevill Bresler rests upon the product being too big to fail, though the opinion avoids rubbing the reader’s nose in that fact. The opinion brushes off with little ado the traditional notion 293 See In re Criimi Mae, Inc., 251 B.R. 796, 800-01 (Bankr. D. Md. 2000); Granite Partners, L.P. v. Bear, Stearns & Co., 17 F. Supp. 2d 275, 300-03 (S.D.N.Y. 1998); Jonas v. Farmer Bros. Co. (In re Comark), 145 B.R. 47, 53-54 (B.A.P. 9th Cir. 1992); Thomson McKinnon Sec., Inc. v. Residential Res. Mtg. Inv. Corp. (In re Residential Res. Mtg. Inv. Corp.), 98 B.R. 2 (Bankr. D. Ariz. 1989). Criimi Mae troubled the repo industry by suggesting that the terms of a standard form of repo agreement used in the industry raised factual questions about the parties’ intent, but the opinion nevertheless purported to accept the “objective intent” framework of Bevill Bresler. 294 Later reported cases in which the Federal Reserve Bank of New York filed amicus briefs arguing against recharacterization of repos include at least Nebraska Department of Revenue v. Loewenstein, 513 U.S. 123 (1994), and County of Orange v. Fuji Securities, Inc. (In re County of Orange), 31 F. Supp. 2d 768 (C.D. Cal. 1998).



that a transaction economically equivalent to a secured transaction should be recharacterized as such. Instead it declares that the characterization of the transaction depends upon the intent of the parties. 295 If “intent of the parties” were given its common-sense meaning, then the parties’ election to label a repo transaction a sale and resale would settle the matter. That, however, would abolish altogether the deeply-embedded principle that parties cannot contract out of secured transactions law, and Judge Debevoise plainly was not prepared to take so radical a step. As we have seen, “intent” is an infinitely malleable standard, and Judge Debevoise made use of that malleability to impose a nominal limiting principle. Specifically, he introduced the concept of “extrinsic indicia of intent”—the same rhetorical move historically employed in fraudulent transfer law to finesse awkward difficulties of definition296—and declared that in this setting “intent” must be gleaned not only from the parties’ words but from those “extrinsic indicia.”297 And the facts that he chose to declare “extrinsic indicia of intent” boil down to the existence of a large established market in repos whose participants expected the product not to be recharacterized.298 This amounts to nothing more than a veiled and non-incendiary way of saying that the product had grown too big to fail.

Moreover, it is difficult to read the opinion without a strong suspicion that the outcome was determined by the “too big to fail” dynamic, and that the opinion’s reasoning was constructed to support the outcome rather than vice versa. The leading academic commentary on characterization of repos, for example, has no use for Judge Debevoise’s reasoning, but states that he “undoubtedly made the right decision,” because “[t]he repo market is simply too enormous and 295 Bevill Bresler, 67 B.R. at 597 (“[T]he proper characterization of repo and reverse repo agreements does not rest solely on an evaluation of the economic substance of the individual transactions. Rather, the intent of the parties viewed in the context of the entire market in which these transactions take place is the controlling consideration. . . .”). 296 See supra Part II.B.4. 297 Bevill Bresler, 67 B.R. at 597 (“This intent must be gleaned from the express terms employed in the transaction documents as well as relevant extrinsic evidence of intent, including trade custom and usage, market realities, and the parties’ course of conduct and performance.”). 298 In addition to the passage quoted in the preceding footnote, Judge Debevoise wrote:

The express language of purchase and sale contained in the test case repo and reverse repo agreements is entirely consistent with the practices and expectations of the securities industry. The repurchase market is a large and highly evolved market which is uniquely structured to meet the short-term liquidity, financing and investment needs and objectives of particular entities. The purchase and sale format for repo and reverse repo transactions adopted throughout the industry is an integral part of this structure, and serves a vital market function by assuring that the securities underlying the transaction remain freely and easily transferable. The unequivocal purchase and sale language in the [repo agreements in question] is compelling evidence that the parties intended their transactions to be conducted in conformity with standard industry customs and practices.

Id. at 598.



important.”299 Financial Regulators’ Response. The repo experience also

suggests that if a financial product with shaky legal underpinnings becomes sufficiently well established, those who are invested in the success of the product may find powerful allies in the financial regulators, who may lobby both judges (by intervening as amici curiae in support of the product) and legislatures (by supporting legislation to validate the product). The Federal Reserve (that is, the Federal Reserve Board and the Federal Reserve Banks) intervened in both of these ways to make the world safe for repos. It is true that the Federal Reserve had a direct interest in supporting the liquidity of the repo markets in U.S. government and federal agency securities, in which markets it regularly deals for the purpose of implementing monetary policy.300 But, beyond that, its reasons for intervening included a desire to preserve a product that, in its eyes, had grown too big to fail. That broader motivation appears in the statements by representatives of the Federal Reserve to Congress of reasons for adopting the repo amendments to the Bankruptcy Code in 1984.301 It is also shown by the fact that those amendments, both as initially drafted by lawyers for the Federal Reserve Board and as finally enacted, applied to repo transactions in instruments other than U.S. government and federal agency securities.302 Such other instruments were not traded by the Federal

299 Schroeder, supra note 286, at 1014. In that article and its supplement, Jeanne L. Schroeder, A Repo Opera: How Criimi Mae Got Repos Backwards, 76 AM. BANKR. L.J. 565 (2002), Professor Schroeder advanced an alternative argument in support of the proposition that an ordinary repo transaction should not be recharacterized, based on the purported essential nature of a secured transaction. As I have noted elsewhere, however, the premise of Schroeder’s argument is inconsistent with Article 9’s treatment of repledge transactions, and the 1999 revision of Article 9 makes the inconsistency blatant. See Kenneth C. Kettering, Repledge Deconstructed, 61 U. PITT. L. REV. 45, 192-213 (1999). 300 The Federal Reserve Bank of New York particularly emphasized this interest in its amicus brief in Bevill Bresler. See Memorandum of Law of the Federal Reserve Bank of New York as Amicus Curiae at 8-10, Cohen v. Army Moral Support Fund (In re Bevill, Bresler & Schulman Asset Mgt. Corp.), 67 B.R. 557 (D.N.J. 1986) (No. 85-1728). 301 See, e.g., Letter from Paul A. Volker, Chairman of the Federal Reserve Board, to Robert J. Dole, Chairman of the Subcommittee on Courts, Senate Committee on the Judiciary (Nov. 20, 1983), in Senate 1983 Repo Hearings, supra note 287, at 305 (giving as reasons for adopting the 1984 repo amendments, first, that absent the amendments “[t]he failure of a major market participant and the inability of other parties to liquidate their investment promptly could ripple outward through the securities market,” and second, that the usefulness of the repo market as an instrument of monetary policy would be lessened if the repo market were not attractive to market participants). A similar sense of the Federal Reserve’s priorities in pushing the 1984 amendments runs through the testimony of its representatives at that and other Congressional hearings on the legislation. See id. at 304-48 (testimony of Peter D. Sternlight and Don Ringmuth, respectively Executive Vice President and Assistant General Counsel, Federal Reserve Bank of New York); House 1984 Repo Hearings, supra note 290, at 47-65 (testimony of Peter D. Sternlight). 302 The repo amendments added to the Bankruptcy Code in 1984 applied to “repurchase agreements,” defined in § 101(36) to include repos of “certificates of deposit, eligible bankers’



Reserve for the purpose of implementing monetary policy, and representatives of the Federal Reserve told Congress frankly that their coverage by the amendments was an accommodation to the large established repo market in such instruments.303 Likewise, the major federal financial regulators, acting together as the President’s Working Group on Financial Markets, originated and supported the 2005 amendments to the Bankruptcy Code that extended the reach of the repo amendments to still broader classes of underlying instruments, even more remote from implementation of monetary policy.304

What motivates financial regulators to support a widely-used financial product that has shaky legal underpinnings? A possible answer would invoke the theory of agency capture, which posits that regulatory agencies tend to become pawns of the firms they regulate.305 That answer is not satisfactory. Despite the enduring popularity of the theory with economists and legal scholars of the economic school, it fails to explain much agency behavior adverse to regulated firms.306 It

acceptances, or securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States.” Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353, § 391(2), 98 Stat. 333 (1984) (since amended). The draft of these provisions submitted to Congress by the staff of the Federal Reserve Board was of the same scope (except that it covered all bankers’ acceptances). For that draft, see The Manville Bankruptcy and the Northern Pipeline Decision: Hearing Before the Subcomm. on Courts of the Senate Comm. on the Judiciary, 97th Cong. 337-42 (1982). 303 See House 1984 Repo Hearings, supra note 290, at 106, 110 (Peter D. Sternlight, Executive Vice President of the Federal Reserve Bank of New York, stated that bankers’ acceptances and certificates of deposit should be covered by the repo amendments because the instruments are “fairly widely traded” and repos in them “facilitate the functioning of these markets,” but “[t]he case for their inclusion in the proposed amendments is not as strong as it is for Treasury and Federal agency securities”). 304 As amended in 2005, the repo provisions of the Bankruptcy Code were expanded to apply to repos in mortgage-related securities, mortgage loans and interests therein, and foreign sovereign debt. Bankruptcy Code § 101(47) (defining “repurchase agreement”). This change was first introduced into Congress in the Financial Contract Netting Improvement Act of 1998, H.R. 4239, 105th Cong. (1998), which was speedily superceded by a similar bill bearing the same name, H.R. 4393, 105th Cong. (1998). The House report on that bill notes that the bill implements legislative proposals forwarded to Congress by the major federal financial regulatory agencies, acting together as the President’s Working Group on Financial Markets. H.R. REP. NO. 105-688, pt. 1, at 1 (1998). At hearings on the bill, representatives of the major financial regulators reiterated the provenance of these provisions and strongly urged their enactment. H.R. 4062—The Financial Derivatives Supervisory Improvement Act of 1998 and H.R. 4239—The Financial Contract Netting Improvement Act: Hearings Before the H. Comm. on Banking and Financial Services, 105th Cong. 119, 123-24, 294, 304, 380, 405-15 (1998) (statements to this effect by senior representatives of the Federal Reserve Board, the Department of the Treasury, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation) [hereinafter 1998 Financial Contract Hearings]. 305 The literature on the capture theory is vast. Two root expositions are George Stigler, The Theory of Economic Regulation, 2 BELL J. ECON. & MGMT. SCI. 3 (1971), and Sam Peltzman, Toward a More General Theory of Regulation, 19 J.L. & ECON. 211 (1976). 306 See, e.g., David B. Spence & Frank Cross, A Public Choice Case for the Administrative State, 89 GEO. L.J. 97, 121-23 (2000) (citing numerous authorities for the proposition that “agency capture is no longer regarded as a valid descriptive theory of bureaucratic behavior” and



is particularly unpersuasive in this setting, for models of agency capture typically posit that capture is effected largely through lobbying directed at legislators and other actors in the political branches that are susceptible to interest-group pressure. But the Federal Reserve Board, in particular, is structured to be independent of day-to-day influences from the political branches and is generally regarded as being quite independent in fact.307 Other federal financial regulators are similarly structured as independent agencies, and even those that are part of the executive branch enjoy more independence than do most executive agencies.308

An alternative answer would take the financial regulators at their word when they say that their actions are motivated by a desire to minimize systemic risk to the financial markets. “Systemic risk” is a term currently much used but rarely defined clearly or explicitly. It is generally understood to refer more or less to the same kind of cascading failures of firms that is the referent of the notion that a firm may become “too big to fail.”309 Certainly much of the rhetoric that the Federal Reserve directed to Congress in support of the repo amendments to the Bankruptcy Code in 1984 was in substance about their alleged virtue of minimizing systemic risk (though the phrase itself

noting that political scientists are much less enamored of the theory than economists and legal scholars). 307 For an extensive discussion, see Steven A. Ramirez, Depoliticizing Financial Regulation, 41 WM. & MARY L. REV. 503 (2000). 308 For instance, the Federal Deposit Insurance Corporation (“FDIC”), like the Federal Reserve Board, is an independent agency that does not rely upon Congressional appropriation, funding itself from user fees and investment income. See FDIC, Who is the FDIC?, http://www.fdic.gov/about/learn/symbol/index.html (last visited Jan. 16, 2008). The Office of the Comptroller of the Currency (“OCC”) is part of the Department of the Treasury, but it likewise enjoys fiscal independence. See OCC, About the OCC, http://www.occ.treas.gov/aboutocc.htm (last visited Jan. 16, 2008). The OCC is independent in other ways not usual for an executive agency; for instance, the Secretary of the Treasury is prohibited from delaying or preventing the issuance of any OCC rule. 12 U.S.C. § 1 (2000). The Securities and Exchange Commission has fewer indicia of independence, its commissioners evidently serving at the pleasure of the President, 15 U.S.C. § 78d (2000), and it being funded by annual Congressional appropriations, id. § 78kk. It nevertheless has been argued vigorously that the SEC has avoided capture by the firms it regulates. See Joel Seligman, Self-Funding for the Securities and Exchange Commission, 28 NOVA L. REV. 233, 252-53 (2004). 309 For example, the President’s Working Group on Financial Markets, comprised of the heads of the Federal Reserve Board, the Treasury Department, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, issued two massive reports in 1999 that were largely concerned with mitigation of “systemic risk” in different settings. See PRESIDENT’S WORKING GROUP ON FIN. MKTS., OVER-THE-COUNTER DERIVATIVES MARKETS AND THE COMMODITY EXCHANGE ACT (1999); PRESIDENT’S WORKING GROUP ON FIN. MKTS., HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT (1999). But neither report managed to define the term explicitly. The intended meaning must be gleaned from its use. Thus, for instance, the April 1999 report, at page E-1, refers to “the ‘systemic’ risks that the failure of one financial institution will cause a ‘domino’ effect on other institutions and disrupt the financial markets.”



evidently had not yet been coined).310 The same grace was extended by federal financial regulators, for the same stated reasons, to the bankruptcy treatment of another young but vast financial product, namely over-the-counter derivatives. In 1990 the Bankruptcy Code was amended to exempt over-the-counter derivative contracts from the usual consequences of a bankruptcy filing by one of the parties to the contract through a set of exemptive provisions parallel to those added in 1984 for the benefit of repo transactions. Thus, these 1990 “swap amendments” allow the solvent counterparty to a derivative contract to terminate the contract, foreclose on collateral and apply it to the debtor’s obligation under the contract, all generally exempt from the trustee’s avoiding powers. These exemptive provisions were supported by the major federal financial regulators.311 Moreover, all of the major federal financial regulators not only supported but initiated the 2005 amendments to the Bankruptcy Code that expanded both the swap amendments and the repo amendments.312 They did so explicitly in the name of minimizing systemic risk.313

The hypothesis that financial regulators will support legal change to accommodate a given product for the purpose of minimizing systemic risk no doubt contains a measure of truth, but as a description of their behavior it is seriously incomplete. For one thing, the notion of “systemic risk,” as applied to a given financial product, is a suspiciously elastic one. Because the threat of a financial meltdown is so intimidating, “systemic risk” might persuasively be invoked even in situations in which the threat of meltdown posed by a particular product is remote. And it is difficult to imagine how one might definitively disprove the assertion that a given product poses a “systemic risk.”

Moreover, the positions taken by the regulators in these instances go far beyond any reasonable conception of what is necessary to minimize cascading insolvencies, because the repo and derivatives amendments to the Bankruptcy Code apply to any transaction of such a type regardless of its size and regardless of the size of the parties to the transaction. It is not plausible to suppose that repo or derivatives transactions of small size or with a small debtor are apt to cause a

310 See supra note 301 and sources cited therein. 311 Act of June 25, 1990, Pub. L. No. 101-311, 104 Stat. 267 (amending scattered sections of the Bankruptcy Code in respect of swap agreements and forward contracts); Interest Swap: Hearing on S. 396 Before the Subcomm. on Courts & Admin. Practice of the S. Comm. on the Judiciary, 101st Cong. 34-50 (1989) (reprinting letters supporting a predecessor of the enacted bill from the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Federal Reserve Board). 312 These changes, advanced by the major financial regulators acting jointly as the President’s Working Group on Financial Markets, were part of the same legislation that expanded the repo exemption, discussed supra note 304 and the accompanying text. 313 See 1998 Financial Contract Hearings, supra note 304, at pages cited.



cascade of insolvencies among the debtor’s counterparties.314 Furthermore, other actions by financial regulators, particularly

their intervention as amici curiae in private litigation, are not explained by aversion to systemic risk. To be sure, no special explanation is necessary for a regulatory agency’s intervention to promote a particular interpretation of a statute it is charged with administering, for such interpretation runs to the core of the agency’s job. Such interventions are commonplace, and are unremarkable from an institutional perspective.315 But financial regulators have also intervened in private litigation for the purpose of promoting interpretations of statutes that they are not charged with administering. Some of those interventions might be explained at least in part on the basis of minimizing systemic risk, such as the Federal Reserve Banks’ repeated filing of amicus briefs for the purpose of requesting courts not to recharacterize repos as secured loans for purposes of the insolvency laws. Other interventions, however, cannot plausibly be explained on that basis. For example, in the last two years alone Federal Reserve Banks have intervened as amici in private litigation for the purpose of arguing, in one case, that a foreign bank with United States branches or agencies should not be entitled to employ ancillary proceedings under the Bankruptcy Code instead of state insolvency law, 316 and in a second case, that consequential and punitive damages should not be available against a bank that has violated Article 4A of the UCC in connection with a wire transfer because such damage awards “could conceivably lead to higher transaction costs associated with funds transfers.” 317 In such 314 See Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 YALE J. ON REG. 91, 98 (2005) (making a similar point). 315 This is not to say that such interventions might not be questioned in other respects. For example, the Office of the Comptroller of the Currency has intervened in private litigation often in recent years to promote interpretation of the National Bank Act as broadly preempting state laws, to the chagrin of consumer advocates. See, e.g., Keith R. Fisher, Toward a Basal Tenth Amendment: A Riposte to National Bank Preemption of State Consumer Protection Laws, 29 HARV. J.L. & PUB. POL’Y 981, 994-98 (2006). For a recent case of this sort in which the Comptroller so intervened before a district court, on appeal, and (with the Department of Justice) on further appeal to the Supreme Court, see Watters v. Wachovia Bank, 127 S. Ct. 1559 (2007). 316 Jugobanka A.D. v. Superintendent of Banks (In re Agency for Deposit Ins., Rehab., Bankr. & Liquidation of Banks), 310 B.R. 793 (S.D.N.Y. 2004), reconsideration denied, 313 B.R. 561 (S.D.N.Y. 2004), aff’d sub nom, In re Deposit Ins. Agency, 482 F.3d 612 (2d Cir. 2007) (holding, contrary to the urging of the Federal Reserve Bank of New York, which intervened as amicus curiae at each stage of the litigation, that foreign banks with United States branches or agencies could employ an ancillary proceeding under Bankruptcy Code § 304 instead of New York insolvency law). 317 Brief of Amici Curiae the Fed. Reserve Bank of N.Y. et al. in Support of Appellant Corestates Bank, N.A. at 3, Pioneer Commercial Funding Corp. v. Am. Fin. Mortgage Corp., 579 Pa. 275 (2004) (No. 53-EAP-2003). This is by contrast to other Article 4A litigation in which the Federal Reserve Banks, as the owners and operators of Fedwire, have a direct interest, not merely a free-lance interest, in the outcome. Thus, in two celebrated recent cases, Winter Storm Shipping, Ltd. v. TPI, 310 F.3d 263 (2d Cir. 2002), and Aqua Stoli Shipping Ltd. v. Gardner Smith Pty Ltd., 460 F.3d 434 (2d Cir. 2006), the Federal Reserve Bank of New York intervened as



interventions these arms of the Federal Reserve are simply acting as free lances to fight for the good, as they see it, with respect to the legal infrastructure of the financial markets. The overall success rate of the federal government and its agencies when they intervene as amici is rather high, and that suggests that the views of the financial regulators are apt to carry weight with a court. 318 And at least some courts confronted with such interventions plainly have given great weight to the position espoused by the regulator.319

Perhaps the behavior of the financial regulators may be best explained by the hypothesis that one of their missions is the avoidance or mitigation of shocks to the financial markets, and that they will tend to view shocks resulting from disappointment of widely-held expectations about the legal characteristics of a given product to be no different from any other. As a result, financial regulators would be motivated to intervene before courts or legislatures in support of market expectations as to the legal characteristics of any financial product that is sufficiently established in the marketplace. Under this hypothesis it is not necessary to suppose that legal failure of the product would entail systemic risk, in the sense of posing a realistic risk of cascading bankruptcies (although systemic risk might still be advanced as an argument in support of the product, given the intimidating nature of that argument and the difficulty of disproving it). In the case of a bankruptcy-driven product such as repo and securitization, support for the legal characterization expected by the market requires a judgment that exalts the interests of secured financiers of a debtor, by removing their collateral from the debtor’s bankruptcy estate, and discounts the interests of the other constituencies that might benefit from a successful reorganization of the debtor that might be thwarted by the exclusion of the collateral from the debtor’s estate. Financial regulators would be naturally inclined to make that judgment, for it is not part of their mission to protect the interests of unsecured creditors and others who fall into those constituencies. Regulators, it is said, are perennially amicus curiae to oppose maritime attachment of electronic fund transfers passing through New York banks, in part because such attachments might require Federal Reserve Banks to review Fedwire payments individually to see whether any such payment is captured by a maritime attachment order. 318 See Joseph D. Kearney & Thomas W. Merrill, The Influence of Amicus Curiae Briefs on the Supreme Court, 148 U. PA. L. REV. 743 (2000) (statistical survey of all Supreme Court cases argued between 1946 and 1995, demonstrating that the Solicitor General, when filing as amicus curiae on behalf of the United States, has enjoyed great success); see also David S. Ruder, The Development of Legal Doctrine through Amicus Participation: The SEC Experience, 1989 WIS. L. REV. 1167, 1181 (noting that in the nine cases in which the SEC filed amicus briefs before the Supreme Court in the preceding eight years, its views were adopted by the Court in eight). 319 An example is Nebraska Department of Revenue v. Loewenstein, 513 U.S. 123 (1994), a case involving state taxation of interest from repurchase agreements in U.S. Treasury securities, in which the Court’s conclusions mirrored the positions set forth in the brief amicus curiae filed by the Federal Reserve Bank of New York.



afflicted by a tunnel vision that induces them to be committed to their agency’s mission and to ignore other interests.320 That affliction would reinforce financial regulators’ inclination to support the legal outcome that would validate market expectations as to bankruptcy-driven products such as these.

An inclination of financial regulators to support market expectations, particularly with respect to bankruptcy-driven products, would also explain why those regulators have taken some legal positions with respect to established financial products that might, if anything, tend to increase systemic risk. A case in point is the “swap amendments” to the Bankruptcy Code, first enacted in 1990, that broadly exempted over-the-counter derivative contracts from the automatic stay, avoidance powers and other ordinary consequences of a bankruptcy proceeding on the part of one of the contracting parties. As noted earlier, these provisions were expanded in 2005 at the behest of the financial regulators, explicitly in the name of mitigating systemic risk. Those very provisions had induced the Federal Reserve Bank of New York to orchestrate a bail-out of a large hedge fund heavily invested in derivatives contracts, Long-Term Capital Management (“LTCM”), when it flirted with bankruptcy in 1998. Financial regulators feared that if LTCM did fail, the counterparties to its derivatives contracts, many who were holding securities pledged by LTCM, would celebrate their freedom from the ordinary strictures of bankruptcy by immediately closing out all of LTCM’s positions and liquidating the pledged securities. The results, according to the financial regulators, might have included a substantial distortion of market prices, large losses “or worse” for LTCM’s counterparties and other market participants, and perhaps even “the seizing up of markets.”321 That was systemic risk come home to roost, and it was the direct result of the enactment in 1990 of the “swap amendments” to the Bankruptcy Code, which had been supported by the financial regulators themselves.

By supporting the addition of the swap amendments to the Bankruptcy Code, therefore, the financial regulators were not suppressing systemic risk. They were simply making it easier for 320 See, e.g., STEPHEN BREYER, BREAKING THE VICIOUS CIRCLE: TOWARD EFFECTIVE RISK REGULATION 11-19 (1993). 321 Hedge Fund Operations: Hearing Before the House Comm. on Banking and Financial Services, 105th Cong. 22-24 (1998) (testimony of Alan Greenspan, Chairman of the Federal Reserve Board, explaining and defending the bail-out). Edwards & Morrison, supra note 314, likewise make the point that the LTCM episode shows that “systemic risk” justification for exempting derivatives contracts from the ordinary consequences of bankruptcy is a red herring. Their interest lies in considering other possible economic justifications, not enunciated by the financial regulators, for giving derivatives contracts special treatment under the Bankruptcy Code, rather than in considering what the financial regulators’ support for that special treatment suggests about the behavior of the financial regulators.



parties to derivative contracts to control their credit risk effectively. For a party to control its credit risk with respect to such a contract it typically must monitor continuously the contract’s value, and in appropriate cases require the counterparty, when out of the money, to pledge securities or otherwise provide credit support for its obligations under the contract. Compliance with the ordinary requirements of bankruptcy law throws a wild card into that scheme, as the solvent counterparty would not be entitled to close out the contract or liquidate collateral without court approval. Given the volatility of many derivative contracts an adequately collateralized position might well turn undercollateralized while such approval is sought, and the potential applicability of the avoidance powers to collateral posted shortly before the bankruptcy filing adds a further uncertainty to the management of this credit risk. The swap amendments remove those risks. By supporting the swap amendments, therefore, the financial regulators were moving to conform the legal infrastructure more closely to market expectations with respect to the very large market in over-the-counter derivatives.

The upshot is that, while agency capture is not a persuasive explanation of the behavior of financial regulators with respect to the legal foundations of new financial products, their natural inclination to avoid market shocks is apt to lead them to support market expectations with respect to the legal characteristics of a sufficiently well-established product. That is especially so in the case of a bankruptcy-driven product as to which the costs of respecting the desired legal characterization are borne by constituencies that are not themselves players in the financial markets. The behavior of the financial regulators predicted by this hypothesis as to a well-established financial product is much the same as would be predicted by the capture theory. The prediction merely rests upon the attribution to the regulators of purer motives than those contemplated by the capture theory.

The financial regulators’ behavior with respect to the legal foundations of securitization is consistent with this hypothesis. During the years of debate that culminated in the enactment of major amendments to the Bankruptcy Code in 2005 two unsuccessful efforts were made to include changes directed at securitization transactions, in one case to support them and in the other to thwart them. In both cases the major financial regulators actively supported the product.

The first episode involved a provision that would have created a safe harbor for broad classes of securitization transactions, by amending section 541 of the Bankruptcy Code to exclude from the Originator’s bankruptcy estate receivables transferred by the Originator to an SPE so long as certain modest conditions are satisfied. Although the provision was aimed primarily at the “true sale” issue, it would have negated the



argument, set forth earlier in this paper, that the technique violates the policy of the Bankruptcy Code and so can appropriately be avoided by applying the doctrines of fraudulent transfer or substantive consolidation. This provision was first introduced in 1998 and was subsequently reintroduced in successive iterations of proposed bankruptcy reform legislation.322 The Federal Reserve Board endorsed this provision.323 The provision might well have been enacted but for the fortuitous collapse of the scandal-ridden Enron Corporation, some of whose accounting machinations were carried out by use of securitization-like techniques. That fortuity lent weight to criticism of the securitization safe harbor by bankruptcy academics, and as a result the sponsors of the legislation removed the securitization safe harbor in early 2002.324

The second episode occurred a few months later, when legislators disposed to ride further the Enron wave introduced a bill that would have amended the Bankruptcy Code to cut back the rights of secured creditors in a number of respects. One provision of the bill targeted the “true sale” aspect of the securitization technique, by introducing a new but undefined federal standard for recharacterizing a purported sale of receivables or other assets to be a secured loan.325 Among those who rushed to stamp out these provisions were the major federal financial regulators, who sent a joint letter to both sponsors of the bill asking that those provisions be eliminated.326 Their prayer was duly granted.327

322 The securitization safe harbor provision was first introduced in S. 1914, 105th Cong. § 215 (1998), and H.R. 4239, 105th Cong. § 12 (1998); it was reintroduced in various other bills in the next Congress, including H.R. 833, 106th Cong. § 1012 (1999). 323 Bankruptcy Reform Act of 1999 (Part III): Hearing on H.R. 833 Before the Subcomm. on Commercial and Admin. Law of the H. Comm. on the Judiciary, 106th Cong. 349-50 (1999) [hereinafter House 1999 Bankruptcy Hearings] (testimony of Oliver Ireland, Associate General Counsel of the Federal Reserve Board). Although endorsed by the Federal Reserve Board, the provision was not among those recommended by the President’s Working Group on Financial Markets. Id. 324 In the 107th Congress, the securitization safe harbor was incarnated as § 912 of the two major bankruptcy reform bills then pending, S. 420, 107th Cong. (2001), and H.R. 11, 107th Cong. (2001), and it was in the context of those bills that the criticism and eventual removal of the provision took place in early 2002. For discussions of this episode from two different academic perspectives, see Jonathan C. Lipson, Enron, Asset Securitization and Bankruptcy Reform: Dead or Dormant?, 11 J. BANKR. L. & PRAC. 101 (2002); Plank, Security, supra note 20, at 1730-33. For further discussion of this provision, see infra Part IV. 325 Employee Abuse Prevention Act of 2002, S. 2798, 107th Cong. § 102 (2002); H.R. 5221, 107th Cong. § 102 (2002). This bill was introduced on July 25, 2002 by Senator Richard J. Durbin and Representative William D. Delahunt and was commonly referred to as the “Durbin-Delahunt Bill.” 326 Letter from Paul H. O’Neil, Sec’y of the Treasury, Alan Greenspan, Chairman of the Bd. of Governors of the Fed. Reserve Sys., Harvey L. Pitt, Chairman of the Sec. & Exch. Comm’n, and James E. Newsome, Chairman of the Commodity Futures Trading Comm’n, to The Honorable William D. Delahunt (Sept. 19, 2002) (copy on file with author). 327 For a history of this episode (which, however, focuses primarily on provisions of the Durbin-Delahunt Bill other than § 102), see Steven L. Harris & Charles W. Mooney, Jr., The



This history suggests that, in the event that the doctrinal foundations of securitization are seriously challenged in the future, those invested in the survival of the product are likely to find the financial regulators willing allies in dealing with the courts and Congress.

Legislative Response. The final lesson of the repo experience with

respect to the “too big to fail” dynamic is an obvious one: if a product with shaky doctrinal foundations has grown sufficiently large, its users may have little difficulty inducing the legislature to validate the product. It is remarkable how aggressively developers of new financial products sometimes seem to rely on the prospect of such a legislative bail-out as to legal issues on which the law is so adverse to the product that judicial relief seems dubious. The foregoing evaluation is, of course, subjective. Practitioners and others who have spent much time and effort mastering the intricacies of a new product become invested in the product intellectually and even emotionally, and are apt to judge the legal risks associated with the product more optimistically than an outsider. Still, a fairly clear illustration of this point can be seen in the history of over-the-counter derivative contracts.

The market in over-the-counter derivatives grew from essentially nothing to enormous size in the course of the 1980s, and a great deal of legislative tinkering ensued to accommodate the product. Much of that tinkering, like the swap amendments to the Bankruptcy Code in 1990, made the product more attractive to use, but did not address concerns about its validity. One significant concern about the validity of the product in its early years was its consistency with the Commodity Exchange Act, which generally prohibited off-exchange “futures” contracts but allowed off-exchange “forward” contracts; those terms were so ill-defined that it was very unclear whether an ordinary swap agreement fell into the prohibited category. That legal risk was manageable, however, for the Commodity Exchange Act is administered by a regulatory agency whose views on its meaning would carry great weight with a court, and that agency was reasonably well disposed to interpretations satisfactory to the market. A succession of agency rulings and policy statements gave comfort to the market until more lasting statutory and regulatory safe harbors were implemented in the early 1990s.328 Unfortunate Life and Merciful Death of the Avoidance Powers under Section 103 of the Durbin-Delahunt Bill: What Were They Thinking?, 25 CARDOZO L. REV. 1829 (2004). 328 For a summary of the positions taken by the Commodity Futures Trading Commission (“CFTC”) with respect to the application of the Commodity Exchange Act to over-the-counter derivatives during the early years of the product, see Barry W. Taylor, Swaps: Commodity Laws in Transition, in ADVANCED SWAPS AND DERIVATIVE FINANCIAL PRODUCTS (Practicing Law Institute 1991); Thomas A. Russo et al., Federal and State Regulation of Swap Transactions, in



But an issue about the validity of the product as to which no such comfort was available arose from the widespread existence of state “bucket shop” laws. Such laws typically make it a crime to enter into a contract to make or receive a future payment based upon the change in price of a specified commodity or security, if the parties do not intend to deliver the underlying commodity or security. These laws were enacted in response to widespread use of such contracts as a form of gambling in the late 1800s and early 1900s, and the definition of the contracts proscribed by such laws is essentially a definition of the modern cash-settled over-the-counter derivative contract. Commentators had no better comfort to offer users of the product than the Calabresian suggestion that the bucket shop laws were anachronistic and widely ignored by players in the financial markets.329 One may be permitted to doubt that a court would have been impressed by these arguments, but the issue was quietly put to rest when amendments to the Commodity Exchange Act in 1992 broadly preempted these state anti-gaming laws.330 Nothing succeeds like success.

3. The Limits of “Too Big to Fail”

That a financial product with shaky doctrinal underpinnings has

grown large by the time those underpinnings are tested in court may be a thumb on the scale of justice, but it does not guarantee success. We have seen that the “too big to fail” dynamic may be less potent in emergency litigation than in a relatively unhurried proceeding in which the court has time to absorb this relatively unusual fact. Moreover, in some cases the extra-legal pressure exerted by the “too big to fail” dynamic in support of a product might be counterbalanced by extra-legal pressure to reject the product. Thus, the ruling against the securitization in LTV Steel has been attributed by some commentators to the bankruptcy judge’s belief that his failure to allow the debtor to use the cash collateral claimed by the holders of the securitized debt would have resulted in the immediate cessation of operations by the debtor, id. Lasting comfort came with the enactment of the Futures Trading Practices Act of 1992, Pub. L. No. 102-546, § 502(a), 106 Stat. 3590 (initially codified at 7 U.S.C. § 6(c)(1) (1994)), which gave the CFTC the power generally to exempt transactions from the Commodity Exchange Act. The CFTC promptly exercised that power to issue rules broadly exempting over-the-counter derivatives transactions. See, e.g., Exemption for Certain Swap Agreements, 58 Fed. Reg. 5587 (Jan. 22, 1993) (codified at 17 C.F.R. pt. 35). 329 See Taylor, supra note 328, at 55-62; Russo, supra note 328, at 162-66. Regarding “Calabresian,” see GUIDO CALABRESI, A COMMON LAW FOR THE AGE OF STATUTES 7 (1982) (calling on judges to treat statutes as part of the common law and repeal those that have become obsolete). 330 Futures Trading Practices Act of 1992, Pub. L. No. 102-546, § 502(c), 106 Stat 3590 (initially codified at 7 U.S.C. § 16(e)(2)(A) (1994)).



with the loss of thousands of jobs and termination of thousands of retirees’ health benefits.331

Perhaps the most dramatic modern example of a situation in which extra-legal pressures outweighed the force of entrenched legal expectations with respect to a financial product was the Washington Supreme Court’s 1983 decision that effectively sanctioned the repudiation of $2.25 billion in municipal revenue bonds issued by the Washington Public Power Supply System (“WPPSS”). WPPSS, a public agency of the state of Washington, had issued the bonds to finance the construction of two nuclear power plants. The debt service for the bonds was to be supplied by eighty-eight participating municipalities and other public authorities, located mainly in Washington, which entered into “take or pay” contracts that obliged them to buy power from the two plants, and to fund debt service on the bonds even if the plants were never completed. When massive cost overruns and changing demand patterns confronted the participants (and, thus, the citizens who bought their power through those participants) with the prospect of paying enormous sums for electricity they did not need or that would never be generated at all (as the plants eventually were mothballed before completion), the citizenry, with the support of local politicians, mobilized into what one commentator called a “mass insurgency,”332 cutting across all ideological and social lines, that vociferously sought to repudiate their WPPSS liability. One front of the battle was fought in the courts, and there the Washington Supreme Court came to the rescue of the irate citizens by ruling that the “take or pay” contracts were unenforceable because the participants lacked the legal authority to enter into them.333 This favorable ruling evidently came as a surprise even to some of the plaintiffs.334 The dissenting justices went about as far as they decently could go in hinting

331 The opinion itself sets forth these as consequences that would follow from a contrary ruling. In re LTV Steel Co., 274 B.R. 278, 286 (Bankr. N.D. Ohio 2001). For commentary playing down the significance of the ruling as a legal matter by emphasizing the role of this extra-legal factor, see Plank, Security, supra note 20, at 1697; Robert Stark, Viewing the LTV Steel ABS Opinion in its Proper Context, 27 J. CORP. L. 211, 227-28 (2002); and Moody’s Investors Service, Special Report: True Sale Assailed: Implications of In re LTV Steel for Structured Transactions, at 2 (Apr. 27, 2001), available at http://www.moodys.com/. 332 WAYNE H. SUGAI, NUCLEAR POWER AND RATEPAYER PROTEST 1 (1987). Dr. Sugai’s book is devoted to analyzing the ratepayer revolt. For other histories of the WPPSS debacle, see JAMES LEIGLAND & ROBERT LAMB, WPP$$: WHO IS TO BLAME FOR THE WPPSS DISASTER (1986); DAVID MYHRA, WHOOPS!/WPPSS (1984). 333 Chem. Bank v. Wash. Pub. Power Supply Sys., 666 P.2d 329 (Wash. 1983) (en banc). Strictly speaking, that ruling applied only to some of the participants, but on appeal after remand the Washington Supreme Court relieved the remaining participants of their WPPSS obligations on the grounds of mutual mistake and commercial frustration. Chem. Bank v. Wash. Pub. Power Supply Sys., 691 P.2d 524 (Wash. 1984) (en banc). 334 See Can Chemical Salvage Something from “WHOOPS”?, BUS. WK., Aug. 29, 1983, at 64.



that the ruling was attributable to the majority’s desire to appease inflamed local public opinion, 335 and academic writing afterward appears to have been unanimous in concluding that the court had bent established doctrine for the occasion.336

Another limitation on the “too big to fail” dynamic is that a court cannot be swayed by it if the court is not even aware that its ruling may undermine the validity of an established product. Two cases of recent decades that famously panicked users of established financial products are of that pattern. One is Octagon Gas Systems, Inc. v. Rimmer,337 in which the Tenth Circuit stated that an account that had been sold to a buyer was nevertheless property of the seller’s bankruptcy estate when the seller later filed for bankruptcy. That proposition is fatal to the prototypical securitization transaction, which is founded on the premise that a sale of assets from an Originator to an SPE will remove those assets from any future bankruptcy estate of the Originator. Octagon Gas hit the securitization industry like a tsunami, the tide rising so high as to cause the two major rating agencies to decline to rate securitization transactions by Originators located in the Tenth Circuit.338 It is clear, however, that the court had no idea that its ruling would have any such far-reaching consequences. The opinion is devoid of any hint of awareness that it would be of any great interest to anyone other than the parties involved. The transaction involved in the case was not a 335 See, e.g., Chem. Bank, 666 P.2d at 349 (Utter, J., dissenting) (“It is natural for anyone viewing the enormity of the mismanagement in this project and the calamitous impact of its failures on utilities and ratepayers to seek ways to negate the impact.”). It is also worthy of note that the unfortunate lawyers who, when the bonds were issued, had rendered the standard opinions that the participants’ entry into the contracts had been duly authorized, were eventually held not to be liable to the bondholders, although on grounds (such as lack of privity) that did not entail explicit consideration of whether the opinions had been substantively justified. Mirotznick v. Senseney, Davis & McCormick, 658 F. Supp. 932 (W.D. Wash. 1986). 336 See Robert L. Tamietti, Chemical Bank v. WPPSS: A Case of Judicial Meltdown, 5 J. ENERGY L. & POL’Y 273, 298 (1984) (“The court used an intellectually dishonest ploy in what can only be called an unabashed attempt to rescue Pacific Northwest ratepayers from an abominable situation.”); David P. Wohabe, Note, Chemical Bank v. Washington Public Power Supply System: The Questionable Use of the Ultra Vires Doctrine to Invalidate Governmental Take-or-Pay Obligations, 69 CORNELL L. REV. 1094 (1984); Greg Degginger, Comment, Chemical Bank v. Washington Public Power Supply System: An Aberration in Washington’s Application of the Ultra Vires Doctrine, 8 U. PUGET SOUND L. REV. 59 (1984); Richard Shattuck, Note, A Cry for Reform in Construing Washington Municipal Corporation Statutes, 59 WASH. L. REV. 653 (1984). 337 Octagon Gas Sys., Inc. v. Rimmer (In re Meridian Reserve, Inc.), 995 F.2d 948 (10th Cir. 1993). 338 For a contemporary discussion of Octagon Gas and its effect on the securitization industry, see Thomas E. Plank, When a Sale is Not a Sale: A Critique of Octagon Gas, 48 CONSUMER FIN. L.Q. REP. 45 (1994). The Permanent Editorial Board for the Uniform Commercial Code rushed to pour oil on the troubled waters by issuing a commentary disapproving of Octagon Gas, see PEB Commentary No. 14 (June 10, 1994), reprinted in 3A U.L.A. 178 (2002), and in due course the 1999 revision of Article 9 pronounced a further anathema in U.C.C. § 9-318. For a “moderately cynical” view of this episode by a current member of the PEB, see James J. White, Chuck and Steve’s Peccadillo, 25 CARDOZO L. REV. 1743, 1749 (2004). See also supra note 94.



securitization or anything remotely touching the capital markets; it was a prosaic assignment of a fractional interest in proceeds of sales of natural gas. None of the briefs made any mention of any broader consequences at stake. And, while the losing party later made much of the ensuing uproar in the securitization industry in its unsuccessful petition to the Supreme Court to review the case, the Court may well have dismissed those arguments as hyperbolic, not least because the losing party was unable to persuade any industry representatives to join in as amicus to help sound the alarm.339

Of the same pattern is Twist Cap,340 a case poignant for the way in which a routine-seeming ruling by a lone bankruptcy judge, in a pedestrian case having no visible relationship to the capital markets, caused those markets to howl in anguish. Twist Cap involved a company that had caused its bank to issue standby letters of credit of modest size for the benefit of two of its otherwise-unsecured suppliers, with the company granting its bank a security interest in some of its assets to secure its obligation to reimburse the bank if and when the letters of credit were drawn upon. In time the company filed for bankruptcy, and promptly after its filing it sought and obtained a temporary restraining order forbidding the bank from honoring draws on the still-undrawn credits. Within four months the matter was settled amicably, with the company consenting to the honor of draws on the credits. Nobody would have heard of Twist Cap but for the fact that between the issuance of the restraining order and the settlement the bankruptcy court, without the benefit of briefing by the parties, issued an order continuing the restraining order as a preliminary injunction, accompanied by a brief opinion stating that the honoring of draws would result in the beneficiaries receiving a voidable preference.341 When this modest ruling appeared in the advance sheets the reaction of the capital markets was volcanic. Much larger letters of credit were by then routinely used to back commercial paper and other debt securities, and the Twist Cap theory would imply that draws on such credits should likewise be enjoined in the event of the debtor’s bankruptcy if the debtor had secured its reimbursement obligation to the issuer of the credit. As a result, at least one of the two dominant rating agencies announced that it would decline to rate commercial paper backed by

339 Petition for a Writ of Certiorari at 7-8, 11-14, Rimmer v. Octagon Gas Sys., Inc., 510 U.S. 993 (1993) (No. 93-576). Joe E. Edwards, counsel for the losing party, assured the author in a telephone interview on October 10, 2006 that he had made strenuous efforts, without success, to enlist players in the securitization industry as amici in support of the certiorari petition. 340 Twist Cap, Inc. v. Se. Bank (In re Twist Cap, Inc.), 1 B.R. 284 (Bankr. M.D. Fla. 1979). 341 For a fuller account of the background and later history of Twist Cap than appears in the brief published opinion, see Helen Davis Chaitman & Jeff Sovern, Enjoining Payment on a Letter of Credit in Bankruptcy: A Tempest in a Twist Cap, 38 BUS. LAW. 21 (1982).



letters of credit.342 A flood of critical literature poured out; other courts weighed in with contrary views; even the unfortunate bankruptcy judge who decided Twist Cap effectively disavowed it in a case he decided five years later; and the financial community moved on, satisfied that this heresy had been extirpated.343 The important point for present purposes is that neither the judge nor the parties had any idea when that modest decision was issued that it would have any such repercussions in the capital markets.344

Octagon Gas and Twist Cap are not counterexamples to the “too big to fail” thesis. They merely show that the litigation process does not always deliver to the court information as to how its ruling might affect established products. Genuine counterexamples, in which a court knowingly resolved doctrinal doubts against a widely-used financial product, in a relatively unhurried proceeding, and in the absence of strong countervailing extra-legal pressures, seem quite rare. But they do exist. Perhaps the premier example is the Supreme Court’s 1943 decision in Corn Exchange National Bank v. Klauder,345 which crippled non-notification accounts receivable financing (that is, the collateral assignment of receivables in which the account debtors who owe the receivables are not notified of the assignment). Non-notification receivables financing had had a poor reputation in the marketplace in the early 1900s, being viewed as a financing of last resort and thus a sign of financial distress, as well as a fertile source of secret liens (as such assignments were then governed by the common law and were not subject to a UCC-style requirement of public filing in order to perfect).346 Nevertheless, by the 1940s the product had shed much of its bad odor, and by the time Klauder rendered the product unusable in most states one unhappy commentator reported that the use of the product had reached “gigantic figures.”347

342 See id. at 22; Douglas G. Baird, Standby Letters of Credit in Bankruptcy, 49 U. CHI. L. REV. 130, 132 (1982). 343 Judge Paskay, who decided Twist Cap, limited it to its facts in In re St. Petersburg Hotel Associates, 37 B.R. 380 (Bankr. M.D. Fla. 1984), and with admirable candor cited the many cases that had in the meantime taken positions contrary to Twist Cap, as well as two of the flood of critical articles. His further observation that Twist Cap had “created a great furor among banks and other institutionalized [sic] lenders,” id. at 382, should not be lost to posterity. As a comment on the mental stability of the financial institutions that had worked themselves into a panic over Twist Cap it may not be excessive. 344 Telephone interview with William Knight Zewadski, counsel for the beneficiaries (Oct. 23, 2006). 345 318 U.S. 434 (1943). On Klauder generally, see 1 GILMORE, supra note 113, §§ 8.6, 25.6, 45.3. 346 As to the traditionally bad reputation of the product, see infra notes 354-355. 347 Maximilian Koessler, Assignment of Accounts Receivable, 33 CAL. L. REV. 40, 49 (1945). According to a report cited by the Court, total lending against accounts receivable on a non-notification basis in 1941 was estimated to be about $1.5 billion, Klauder, 318 U.S. at 438 n.10, the equivalent of about $21 billion in 2007 dollars.



The doctrinal point on which Klauder turned was an unintended consequence of a 1938 amendment to the then-Bankruptcy Act to the effect that, for the purpose of the preference provision of that Act, a transfer of an item of property was not deemed to occur until a good faith purchaser could not obtain rights in that item superior to the rights of the transferee.348 The reason for the amendment had had nothing to do with non-notification receivables financing. Rather, the amendment was directed at invalidating a doctrine of “relation back,” now of only historical interest, which (translated roughly into modern terminology) had the effect of shielding from preference attack consensual liens that were granted long before the debtor’s bankruptcy but not perfected until just before the debtor’s bankruptcy.349 The 1938 amendment did the job of invalidating “relation back,” but for no apparent reason beyond the stylistic preferences of its drafters its language was not limited to that setting. To the surprise of the financial community, Klauder held that the language also invalidated as a preference a non-notification assignment of a receivable if the law of the relevant state provided—as the common law of most states then either clearly or arguably provided—that a hypothetical subsequent assignee without notice of the earlier assignment would have priority over the first assignee.350

Although Klauder rested on a fairly straightforward application of fairly plain statutory language, the Court was not compelled to reach the result that it did. Knowing that the statutory language had been aimed at a different target, a Court of Appeals in an earlier case, and a dissenting judge in the Court of Appeals that ruled on Klauder, had construed the statute in a way that would have saved non-notification receivables financing. That construction appealed to one justice, and could have been followed by the rest of the Court.351 Moreover, the Court was well aware of the practical consequences of its ruling. The

348 Bankruptcy Act § 60(a), as amended by 52 Stat. 896 (1938) (formerly codified at 11 U.S.C. § 96) (repealed). 349 For a discussion of the “relation back” doctrine and the fact that its abolition was the target of the 1938 amendment to § 60(a), see 1 GILMORE, supra note 113, §§ 8.6, 45.3; Milton P. Kupfer & Irvin I. Livingston, Corn Exchange National Bank & Trust Company v. Klauder Revisited: The Aftermath of its Implications, 32 VA. L. REV. 910 (1946). 350 According to one survey, when Klauder was decided the law in only seventeen states was such as to clearly or probably give a non-notification assignee priority over a subsequent assignee without notice of the earlier assignment, and so only in those seventeen states was a non-notification assignment reasonably safe from avoidance under the Klauder rationale. Kupfer & Livingston, supra note 349, at 914-15 & n.15. As to the surprise of the financial community at Klauder, see, e.g., id. at 910, and the vitriolic critique in Accounts Receivable Financing, AM. BANKER, Apr. 3, 1943, at 1, 2 (referring to Klauder as “revolutionary”). 351 Adams v. City Bank & Trust Co., 115 F.2d 453 (5th Cir. 1940) (construing § 60(a) so as to save non-notification receivables finance); In re Quaker City Sheet Metal Co., 129 F.2d 894 (3d Cir. 1942) (Jones, J., dissenting), aff’d sub nom. Corn Exch. Nat’l Bank v. Klauder, 318 U.S. 434 (1943) (Roberts, J., dissenting). For a contemporary lament to this effect, see Koessler, supra note 347, at 47-49, 72-82.



secured creditor in Klauder beat the “too big to fail” drum loudly in its brief,352 and the Court’s opinion, quoting some of the figures therein cited, acknowledged the “large magnitude” of the business and that the consequences of its decision “may . . . be serious.”353 But the Court elected to do justice though the heavens may fall.

Klauder thus stands as a warning to legal entrepreneurs about the limits of “too big to fail.” Nevertheless, the warning is twice diluted. In the first place, there are hints in the opinion that the Court’s thinking was flavored by the ill repute in which non-notification receivables financing traditionally had been held.354 The hints were sufficiently strong that contemporary commentators were moved to air their suspicions that the Court’s decision had been shaped in part by what amounted to a reflexive prejudice.355 Few financial products are likely to be similarly burdened. Second, receivables financiers speedily had the product validated legislatively. Klauder was followed in short order by a wave of statutes, enacted by most states whose laws might put non-notification assignees at risk under the Klauder rationale, that changed the priority rules of those states to protect such assignees from the Klauder result. A final nail in Klauder’s coffin was tapped home in 1950, when Congress amended the Bankruptcy Act to negate the construction given it by Klauder, but the state statutes had already done the job by that time.356 “Too big to fail” won in the end, and the end was not even very long delayed.

4. A Case Study: The Standby Letter of Credit

The saga of the standby letter of credit shows how the “too big to

fail” dynamic played an important, and perhaps decisive, role in saving a new financial product from its shaky legal underpinnings. Although legal decisionmakers may be reluctant to admit to being swayed by the 352 Brief for Petitioners at 32-35, Corn Exch. Nat’l Bank v. Klauder, 318 U.S. 434 (1943) (No. 452). 353 Klauder, 318 U.S. at 437-38. 354 Thus, the Court went out of its way to repeat the traditional characterization of such financing as a last ditch resource symptomatic of financial distress, id. at 439-40, a characterization that by the 1940s was no longer accurate. See Koessler, supra note 347, at 57-59; George E. Flinn, Note, 29 CORNELL L. Q. 105, 105-06 (1943). 355 “Prejudice” was the word chosen by Garrard Glenn, who began a discussion of Klauder by saying that he thought that the this prejudice had “subconsciously influenced” the Court’s decision adverse to the receivables financier in its earlier major case on non-notification financing, Benedict v. Ratner, 268 U.S. 353 (1925). Garrard Glenn, Mercantile Collateral Law—Present-Day Changes, 11 LAW & CONTEMP. PROBS. 281, 284 & n.11 (1945). In similar vein, see Koessler, supra note 347, at 81. 356 On the legislative aftermath of Klauder, see 1 GILMORE, supra note 113, §§ 8.6, 8.7, 45.3, 45.4; Allan F. Conwill & William W. Ellis, Jr., Much Ado About Nothing: The Real Effect of Amended 60(a) on Accounts Receivable Financing, 64 HARV. L. REV. 62 (1950).



“too big to fail” dynamic, unusual circumstances give us direct evidence of the role that dynamic played in the decisionmaking process in this instance. It is therefore worth exploring at some length.

The standby letter of credit owes its existence, or at least its wide use, to a quirk of United States banking law: unlike banks in most other countries, banks in the United States traditionally have not been considered to have the power to guarantee the obligation of a customer. 357 That is not a consequence of any explicit prohibition contained in the law under which a bank is chartered (the National Bank Act in the case of national banks, state banking codes in the case of state-chartered banks), but instead follows from the fact that those statutes do not include issuance of guarantees within banks’ enumerated powers and the further fact that those statutes traditionally were construed narrowly.358 As a result, a long line of cases, ripest in the early 1900s but acknowledged still to be in force to the present day, hold that a bank’s guaranty of its customer’s obligation is ultra vires, with unpleasant consequences that may include the unenforceability of the guaranty.359 Courts early recognized a few modest exceptions to this prohibition on bank guarantees, such as a bank’s guarantee of an obligation in which the bank has an independent interest in performance, and a bank’s assumption of the guaranty-like liability arising from the bank’s endorsement of a negotiable instrument in connection with the bank’s transfer of the instrument. But those early exceptions did not come anywhere close to swallowing the rule.

As water flows to the sea, so financiers are drawn to fee income, in this case the fees that a bank could earn by lending its credit but for this prohibition. Just as securitization evades the Bankruptcy Tax by a combination of formal devices, so ingenious bankers hit on a way to evade the prohibition on guarantees through a device that in form is not a guaranty, but serves exactly the same function. The chosen device was the letter of credit.

A letter of credit is a promise by an issuer (typically a bank) to pay

357 This is the conventional view of the origins of the standby, though other views have been expressed. See James F. Byrne, Foreward to Boris Kozolchyk, Bank Guarantees and Letters of Credit: Time for a Return to the Fold, 11 U. PA. J. INT’L. BUS. L. 1, 4 (1989). 358 There may be states whose banking codes deviate from the pattern of the National Bank Act in respect of guarantees, but if such exceptions exist they are few. 359 See, e.g., W. Petroleum Co. v. First Bank Aberdeen, 367 N.W.2d 773 (S.D. 1985); Kimen v. Atlas Exch. Nat’l Bank, 92 F.2d 615 (7th Cir. 1937); C. E. Healey & Son v. Stewardson Nat’l Bank, 1 N.E.2d 858 (Ill. App. 1936); Border Nat’l Bank v. Am. Nat’l Bank, 282 F. 73 (5th Cir. 1922); Bowen v. Needles Nat’l Bank, 94 F. 925 (9th Cir. 1899). For an acknowledgment of the continuing force of the rule, see, e.g., Office of the Comptroller of the Currency, Interpretative Letter No. 1022 (Feb. 15, 2005). For an overview, see MICHAEL F. MALLOY, FUNDAMENTALS OF BANKING REGULATION § 5.04 (1998). For an historical perspective, see Richard A. Lord, The No-Guaranty Rule and the Standby Letter of Credit Controversy, 96 BANKING L.J. 46 (1979).



a specified sum upon the presentation to the issuer of documents that comply with the terms of the letter of credit.360 As a rule the issuance is procured by a customer of the issuing bank, who is obliged to reimburse the bank for the payment the bank makes when it honors the letter of credit. The principal use to which letters of credit traditionally have been put in modern times has been to facilitate contracts for the sale of goods over long distances, where buyer and seller are unfamiliar with each other and neither wishes to take the risk of the other having both the goods and the purchase money.361 In that traditional pattern, in its simplest form, the buyer of goods requests his bank to issue a letter of credit in favor of the seller; the credit is written to be payable in the amount of the purchase price upon the seller’s presentation to the issuing bank of such documents as an invoice, bill of lading, inspection certificate, and proof of insurance pertaining to the goods. The existence of those documents assures that the goods are what they are supposed to be and that they have been properly shipped by the seller to the buyer. A letter of credit of this traditional type (now commonly called a “trade” or “commercial” letter of credit) thus serves to facilitate payment; it also serves a function akin to an escrow, as neither buyer nor seller has both the money and the goods at the same time. When the parties enter into the transaction they expect that the credit will be drawn upon. The issuing bank’s credit exposure typically is only that of a secured creditor, as the issuing bank typically will obtain a security interest in the goods covered by the documents to secure its customer’s reimbursement obligation. Banks have long issued letters of credit in this transactional setting, and it has long been established that banks in this country are authorized to issue them.362

Sometime after World War II, it dawned on members of the American banking community that the letter of credit could be adapted to serve the same function as a guaranty. The technique is simplicity itself: if a bank’s customer owes an obligation to an obligee, the bank can put its credit behind its customer’s obligation by the simple

360 This definition is simplified, in that some letters of credit are honored by an action other than payment of money, such as the issuer’s acceptance of a draft drawn by the issuer’s customer on the issuer. This paper is not intended as a comprehensive treatment of the law of letters of credit or banking law, so in the interest of brevity and clarity other details not significant to the theme under discussion will hereafter be passed over in silence. The standard reference on the American law of letters of credit today is JOHN F. DOLAN, THE LAW OF LETTERS OF CREDIT (rev. ed. 2003). 361 For discussion of the practical and legal incidents of the trade letter of credit, see id. and HENRY HARFIELD, BANK CREDITS AND ACCEPTANCES (5th ed. 1974). The latter work, inclusive of its previous editions, was the standard reference on the subject for many decades. 362 There was debate as to whether national banks had the power to issue letters of credit before 1913, when the Federal Reserve Act was enacted, but issuance of letters of credit was established practice by state banks, at least, long before then. See BORIS KOZOLCHYK, COMMERCIAL LETTERS OF CREDIT IN THE AMERICAS § 24.03 (1966).



expedient of issuing to the obligee a letter of credit the terms of which require the bank to pay upon presentation of a document consisting of no more than a statement by the obligee that the customer has defaulted on its obligation to the obligee. The resulting letter of credit is not literally a guaranty: it is governed not by the law of suretyship, but rather by the distinct body of law (today, Article 5 of the UCC) that applies to letters of credit.363 But it is quite obvious that, unlike a trade letter of credit, a letter of credit of this sort serves exactly the same function as a guaranty—so much so that in the early years of their use, such credits were commonly referred to as “guaranty” letters of credit (a term that was eventually displaced by the anodyne “standby,” which was understandably preferred by persons committed to the legal validity of the product once concerns about validity came to the fore in the early 1970s).364 Unlike a trade letter of credit, but like a guaranty, a standby letter of credit typically is not issued with the expectation that it will be drawn upon. Unlike a trade letter of credit, but like a guaranty, a standby letter of credit has the credit characteristics of an unsecured loan, as the customer’s reimbursement obligation to the issuing bank in the event that the standby is drawn upon is a mere unsecured obligation of the customer. The functional equivalence of the standby letter of credit and the guaranty is so patent that, when banks began to issue standbys to back publicly-offered debt securities, the Securities and Exchange Commission without the smallest hesitation agreed that such a standby is a guaranty within the meaning of the Securities Act exemption for securities “issued or guaranteed” by a bank.365 Few at the time marked the irony of the lawyers involved in such transactions simultaneously taking the position that a standby letter of credit is a 363 See RESTATEMENT (THIRD) OF SURETYSHIP AND GUARANTY § 4 & cmt. C (1996) [hereinafter RESTATEMENT]. The practical differences between these two bodies of law can approach the vanishing point. For example, it is often said that the two are distinguished in that a guaranty is a “secondary” obligation as to which the guarantor has the right to assert the underlying obligor’s defenses on the underlying obligation he owes to the beneficiary of the guaranty, while a letter of credit is a “primary” obligation as to which the issuer is not entitled to assert the underlying obligor’s defenses. See, e.g., U.C.C. § 5-105, cmt. 1; DOLAN, supra note 360, ¶ 12.03[1][c]. But a guarantor can (and often does) contract out of the right to assert the underlying obligor’s defenses. See RESTATEMENT §§ 6 & 34 cmt. a. Likewise, a guarantor can (and often does) contract out of any conditioning of its obligation on an unsuccessful attempt by the beneficiary to collect from the underlying obligor. See id. §§ 15(b) & 50 cmt. c. 364 See Paul R. Verkuil, Bank Solvency and Standby Letters of Credit: Lessons from the USNB Failure, 53 TUL. L. REV. 314, 314 n.1 (1979). Even Henry Harfield, one of the product’s creators, referred to it as a “guaranty” letter of credit in its salad days. See, e.g., Henry Harfield, Code, Customers and Conscience in Letter of Credit Law, 4 UCC L.J. 7, 13 (1971) (referring to “the new breed of so-called ‘guaranty credits’”). 365 Securities Act of 1933 § 3(a)(2), 15 U.S.C. § 77c(a)(2) (2000). Early examples from among a vast number of SEC no-action letters to the effect stated in the text include United California Bank, SEC No-Action Letter, [1971-1972 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 78,104 (Mar. 16, 1971), and Chemical Bank, SEC No-Action Letter, [1971-1972 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 78,543 (Dec. 1, 1971).



guaranty for securities law purposes but is not a guaranty for banking law purposes.366

The point of using a standby letter of credit is to evade the rule that banks are not authorized to issue guarantees, by having the bank instead issue an instrument of a species—the letter of credit—that banks have been held to have the power to issue. But the standby has the function and risk characteristics of a guaranty, not those of the traditional trade letter of credit that was in contemplation when bank authority to issue letters of credit was established. The viability of this new product thus depended upon the hope that legal decisionmakers—that is, bank regulators and courts—would look no further than its form.

The precise origins of the standby in the United States are impossible to pinpoint from publicly-available sources, as standbys were so thoroughly unregulated for many years after they came into use that banks were not even required to report the volume they issued until 1973.367 Anecdotal evidence has it that the product entered the market in the 1950s,368 and a 1957 student note quoted a banker at an unnamed bank who had “helped to develop the technique” to the effect that standbys then comprised some 10% of that bank’s aggregate commercial credits.369 As of December 1973, the first date as of which regulators collected issuance data, just under $7 billion of bank-issued standbys were outstanding, almost half of which were issued by five large banks.370 That high degree of concentration is understandable, as well-known and highly-rated banks have a strong competitive advantage in getting their standbys accepted as security.371 And though we do not know the first transactional uses of the product, we do know

366 The irony did not, however, escape later critics who urged Congressional action against standbys. See 120 CONG. REC. 29,801 (Aug. 22, 1974) (letter from Timothy D. Naegle to Senator Edward W. Brooke); Timothy D. Naegle, Standby Letters of Credit and Other Bank Guarantees, in S. COMM. ON BANKING, HOUSING AND URBAN AFFAIRS, 94TH CONG., COMPENDIUM OF MAJOR ISSUES IN BANK REGULATION (Comm. Print. 1975). Mr. Naegle, chief scourge of standbys when Congress took up the issue in the mid-1970s, was a lawyer in private practice who represented a subsidiary of Prudential Insurance Company of America. See Regulation of Standby Letters of Credit: Hearing on S. 2347 Before the S. Comm. On Banking, Housing and Urban Affairs, 94th Cong. 101, 273 (1976) [hereinafter Standby Hearings]. 367 See Peter Lloyd-Davis, Survey of Standby Letters of Credit, 65 FED. RES. BULL. 716, 716 (1979); Standby Hearings, supra note 366, at 133 (statement of Charles J. McGee, Senior Vice President of Manufacturers Hanover Trust Co.). 368 See, e.g., Standby Hearings, supra note 366, at 24, 26 (statement of Charles J. McGee on behalf of the American Bankers Association); Byrne, supra note 357, at 4. 369 Comment, Recent Extensions in the Use of Commercial Letters of Credit, 66 YALE L.J. 902, 902 n.1 (1957). A piquant early use of standbys was to secure the ransom from Cuba of the prisoners captured in the Bay of Pigs expedition. See The Story Behind the Fat Ransom, BUS. WK., Feb. 9, 1963, at 84-86. 370 Standby Hearings, supra note 366, at 240-41 (Federal Reserve staff report). The inflation-adjusted equivalent of $7 billion 1973 dollars is $32 billion 2007 dollars. 371 See Barbara Berman, Off Balance Sheet Risk in Banking: The Case of Standby Letters of Credit, FED. RES. BANK OF SAN FRANCISCO ECON. REV. Winter 1986, at 19, 20-21.



its chief inventors: one of the very largest banks in the United States and its outside counsel, Henry Harfield.372

As with securitization, no litigation challenging the doctrinal basis of the product (or at least none that gave rise to reported decisions) occurred early in the product cycle, so the product was well established by the time the opportunity for such litigation finally arose in the 1970s. The absence of such litigation is not surprising, as a bank that issued a standby and later sought to escape liability on it by arguing that it was unenforceable because ultra vires would destroy its ability to employ the product thereafter. That would amount to killing the goose that laid the golden eggs. The issuance of standbys was until the mid-1970s subject to no quantitative regulation whatever, at least in the case of national banks. Hence a bank that issued a standby could collect a fee from its customer without incurring any current cost.

Until the early 1970s the attitude toward standbys of the primary regulator of national banks, the Office of the Comptroller of the Currency (“OCC”), was one of benign neglect. The OCC does not seem to have issued until 1971 a clear statement that, in its view, national banks are authorized to issue standbys, but it had previously taken an “office position” to that effect, evidently based on the view that a standby is just like any other letter of credit.373 This obliviousness to the difference in the risk that a bank assumes when it issues a standby, as compared to a traditional trade letter of credit, created a regulatory arbitrage that made the issuance of standbys a bonanza for banks. Although a bank that issues a standby takes the same credit risk that it takes when it makes a loan (as the bank bears the risk that its customer will not reimburse the bank if the standby is drawn upon), standbys were not viewed by the OCC as being subject to the aggregate and per-customer lending limits that applied to loans.374 Even more to the point,

372 See Bryne, supra note 357, at 4 (“The standby represents a deliberate attempt engineered in the early 1950’s in large part under the auspices of Leonard A. Back of Citibank and Henry Harfield of Shearman & Sterling who almost single-handedly led and shaped U.S. letter of credit law during the vital decades that standbys were coming to the fore.”). Citibank, N.A. bore the names “The First National City Bank of New York” and “First National City Bank” from 1955 through 1976, the period of this case study, and Shearman & Sterling was its principal outside law firm. 373 The OCC published this statement of position in the first set of OCC interpretative rulings to be codified in the Code of Federal Regulations, at 12 C.F.R. § 7.7016 (1972). The issuing release stated that § 7.7016 was a “New Section” not reflected in the Comptroller’s Manual for National Banks (which had been published in 1963 as a compilation of the OCC’s rulings), and further stated that § 7.7016 “embodies the office position distinguishing a letter of credit from a guaranty.” 36 Fed. Reg. 17,000, 17,000 (Aug. 26, 1971). 374 See Failure of the U.S. National Bank of San Diego: Hearings Before the Subcomm. on Bank Supervision and Insurance of the H. Comm. On Banking and Currency, 93rd Cong. 14-15 (1974) [hereinafter USNB Hearings] (testimony of James E. Smith, Comptroller of the Currency); Paul R. Verkuil, Bank Solvency and Guaranty Letters of Credit, 25 STAN. L. REV. 716, 727-28 (1973).



a bank that issued a standby, unlike a bank that made a loan, did not incur a charge to its capital, as the minimum capital standards of the day applied only to on-balance-sheet assets and liabilities, and so a standby, as an off-balance-sheet contingent obligation, did not count against the bank’s capital requirements.375

This bonanza probably explains why, when the newly-appointed and energetic Comptroller of the Currency, James Saxon, established an advisory committee in 1962 to formulate bankers’ wish list of desired revisions to national banking laws and policies, the resulting list included no wish to clarify the power of national banks to issue standby letters of credit.376 The large sophisticated banks that were the main issuers of standbys may well have judged it foolish to jeopardize the delightfully laissez-faire regulatory environment by drawing attention to the product. Qualms about the legal foundations of the product had no practical significance to banks so long as beneficiaries accepted the standbys they issued, and beneficiaries evidently did accept them without any grumbling that left traces in the historical record.377 And the issuing banks may well have calculated that the product was sufficiently established to be well positioned to survive via the “too big to fail” dynamic should the legal problems ever pass from the realm of the potential to the actual—as indeed proved to be the case.

The OCC is not the only federal regulator of banks. The Federal Reserve Board (“FRB”) is the primary federal regulator of state-chartered banks that are members of the Federal Reserve System, and the Federal Deposit Insurance Corporation (“FDIC”) is the primary federal regulator of state-chartered nonmember banks whose deposits it insures. Because the FRB and FDIC, unlike the OCC, do not charter banks, they cannot speak directly to the corporate powers of the banks they regulate, but they do have authority to prevent banking practices that they consider unsound. During this period a twinge of disquiet about standbys emerged from the FDIC, which between 1968 and 1972 took the position that because standbys were functionally identical to guarantees, their issuance violated an FDIC regulation that forbade the banks it regulated from issuing guarantees (subject to narrow exceptions similar to those traditionally applicable to national bank guarantees

375 See Henry D. Gabriel, Standby Letters of Credit: Does the Risk Outweigh the Benefits?, 1988 COLUM. BUS. L. REV. 705, 712-13, 728-31; Berman, supra note 371. 376 ADVISORY COMM. ON BANKING, COMPTROLLER OF THE CURRENCY, NATIONAL BANKS AND THE FUTURE (1962). 377 The Government National Mortgage Association and the Federal National Mortgage Association did determine to cease to accept standbys as security in 1975, in part as a result of these legal concerns, but that occurred after the events of the early 1970s that brought the issue to the fore. See Standby Hearings, supra note 366, at 6-7 (statement of David M. deWilde, then president of GNMA).



under the National Bank Act).378 The FDIC staff retreated from that position in 1972, however, largely on account of the competitive disadvantage to which it put their charges compared to the national banks regulated by the OCC.379

The day of reckoning arrived in 1973 with the failure of the United States National Bank (“USNB”), the largest bank failure in the United States up to that time.380 A contributing cause of USNB’s insolvency was $90 million of standby letters of credit issued by it, many to guarantee loans that other lenders had made to borrowers affiliated with USNB’s president, an individual who by the time of USNB’s failure was the subject of an array of very public proceedings pertaining to fraud and tax evasion. The OCC declared USNB to be insolvent in October 1973 and, as required by law, appointed the FDIC its receiver, but the likelihood of that event had been apparent for some months previously, and during that period the FDIC sought for other banks to bid on the purchase and assumption of USNB’s assets and liabilities. The high bidder, Crocker National Bank, effected such a purchase and assumption immediately after USNB was placed into receivership. During the run-up to the receivership, however, it became apparent that potential purchasers were unwilling to acquire and assume assets and liabilities associated with USNB’s president. In particular, they would not agree to assume the aforementioned standby letters of credit absent a guarantee of reimbursement by the FDIC.

This was the moment of truth for standbys. The FDIC was unwilling to pay on those tainted standbys, so rather than assign them to Crocker at the price of extending such a guarantee, the FDIC decided to retain them as obligations of the receivership estate and fight the estate’s obligation to pay them when drawn upon. The FDIC did so by taking the position, ultimately rejected by the courts, that standbys not drawn upon before USNB was declared insolvent were not provable claims entitled to receive a distribution from the estate.381 The FDIC was well aware that it also had a perfectly credible additional argument

378 See id. at 20 (statement of Frank Wille, Chairman of the FDIC). 379 Id. This competitive disadvantage was the first reason given by Chairman Wille for his staff’s discarding of the policy in 1972; he went on to mention the staff’s qualms as to whether their decision to bar standbys as “guarantees” was within the FDIC’s power, given that the FDIC is not a chartering authority. 380 On the USNB insolvency and the role of the tainted standby letters of credit in it, see First Empire Bank v. Fed. Deposit Ins. Corp., 572 F.2d 1361, 1363-66 (9th Cir. 1978), and Verkuil, supra note 364, at 314-18. See generally USNB Hearings, supra note 374, especially at 42-46 (statement of Frank Wille, Chairman of the FDIC). 381 Not only did the FDIC ultimately lose on its provability argument, the courts also held that provisions of the National Bank Act mandating equal treatment of creditors of an insolvent bank made it wrongful for the FDIC to exclude the standbys from the purchase and assumption agreement with Crocker, with the result that the FDIC had to pay the standbys in full, with interest. First Empire Bank v. Fed. Deposit Ins. Corp., 572 F.2d 1361 (9th Cir. 1978).



that the standbys were unenforceable because ultra vires. To the surprise of the court that later adjudicated the litigation, the FDIC declined to advance that argument. 382 A participant in the internal debate on that point within the FDIC and OCC attested long afterward that the FDIC made that decision simply because the standby letter of credit was by then a product that was too big to fail: a holding that standbys were ultra vires would have demolished the value of all outstanding standbys and wreaked more havoc in the financial markets than the FDIC was willing to be responsible for.383

That decision crystallized the position on standbys taken by the three federal bank regulatory agencies.384 Before the USNB insolvency and independently of it the risks posed by standbys had risen high on the regulators’ agendas, and they met repeatedly in the spring of 1973 to try to formulate a coordinated regulatory approach. The FRB staff favored the position that standbys should be treated as guarantees and hence ultra vires for commercial banks; the OCC staff acknowledged the authority for that position but resisted it, partly on the ground that the OCC had published the contrary position just two years previously. The agencies thus deadlocked and reached no agreement that spring. But in the fall the agencies met again, and the FDIC in the meantime having decided to write off the ultra vires argument in connection with USNB’s receivership, the other regulators followed suit. They settled on issuing modest regulations, promulgated by them concurrently in preliminary form in early 1974 and in final form in August 1974, that merely subjected undrawn standbys to the legal limits on loans to a single borrower and required outstanding standbys to be disclosed in footnotes to the banks’ financial statements.385 “Too big to fail” had 382 The court’s surprise is indicated by its noting twice that the FDIC had not chosen to raise the ultra vires argument. Id. at 1365, 1367; see also Verkuil, supra note 364, at 316 (also pointedly noting the availability of the ultra vires argument). 383 Telephone Interview with C. Westbrook Murphy, then Deputy Chief Counsel of the OCC (Sept. 21, 2006). This point did not emerge during the hearings Congress later held on the USNB insolvency, see USNB Hearings, supra note 374, which may be viewed as a confirming instance of the proposition that legal decisionmakers are reluctant to avow “too big to fail” as a basis for making a legal judgment about a financial product. See supra Part III.A.1. This observation is not intended to imply that the bank regulators who testified at the hearings were in any way evasive, as they were not questioned on this point; they simply did not volunteer it. 384 History owes the inside story of these interagency discussions to Senator Proxmire, who asked each of the three federal bank regulators to relate the history of those discussions. See Standby Hearings, supra note 366, at 17-23. The three resulting narratives are Rashomon-like; the rendition in this paragraph is based upon the response by George W. Mitchell on behalf of the FRB. Id. at 17-18. See also Harry J. Arnold, Jr. & Edward Bransilver, The Standby Letter of Credit—The Controversy Continues, 10 UCC L.J. 272, 284 n.50 (1978) (a brief fourth narrative, contributed by the then-General Counsel of the FDIC). 385 In the case of the OCC, see 39 Fed. Reg. 28,974 (Aug. 13, 1974) (final release promulgating 12 C.F.R. § 7.1160 and other provisions); in the case of the FRB, see 39 Fed. Reg. 29,916 (Aug. 19, 1974) (final releases amending 12 C.F.R. § 208.8(d) and other provisions); in the case of the FDIC, see 39 Fed. Reg. 29,178 (Aug. 14, 1974) (final release promulgating 12



decisively won the day. With that the standby lived happily ever after. Later a few solvent

banks were bold enough to try to escape liability on their standbys by raising the ultra vires argument, but such an argument from a bank that has collected a fee for issuing an obligation it later seeks to repudiate has small equitable appeal, and with the federal bank regulators having made their peace with the standby that argument fell on deaf judicial ears.386 Some members of Congress, concerned by the USNB failure and perturbed by what they saw as too-lax regulation of standbys, proposed legislation and held hearings in the mid-1970s, but nothing came of that beyond the creation of a record useful to historians.387 The hypothesis that a financial regulator dealing with a product “too big to fail” will tend to behave in much the same way as it would if it had been captured by the firms invested in the product finds an amusingly blatant confirmation in the fact that, when a concerned senator sent a letter to the OCC questioning the authority of national banks to issue standbys, the OCC responded by sending to the senator a legal opinion on the subject by none other than Henry Harfield, counsel to the bank that was then the most prolific issuer of standbys.388

Within a few years the OCC acknowledged blandly that the rule against bank-issued guarantees “is being devoured by the exceptions engrafted upon it.”389 Soon after the wheel turned full circle when a court upheld another new bank product, that of issuing bond insurance, against an ultra vires challenge, on the ground that such insurance is analogous to issuance of a standby letter of credit, which the court (with C.F.R. § 337.2 and other provisions). 386 See, e.g., Prudential Ins. Co. v. Marquette Nat’l Bank, 419 F. Supp. 734 (D. Minn. 1976); Am. Empire Ins. Co. v. Hanover Nat’l Bank, 409 F. Supp. 459 (M.D. Pa. 1976), aff’d mem., 556 F.2d 564 (3d Cir. 1977); Republic Nat’l Bank v. Northwest Nat’l Bank, 578 S.W.2d 109 (Tex. 1979); see also FDIC v. Freudenfeld, 492 F. Supp. 763 (E.D. Wisc. 1980) (holding that a national bank’s issuance of a letter of credit can be challenged as an ultra vires guaranty only by the federal government). 387 The significant legislative actions are cited in the footnotes to the present discussion. For an orderly summary, see Verkuil, supra note 364, at 318-23. 388 120 CONG. REC. 29,795-29,800 (Aug. 22, 1974) (correspondence between Sen. Edward W. Brooke, Comptroller of the Currency James E. Smith, and Henry Harfield). The OCC also released Mr. Harfield’s opinion letter publicly, and it is reprinted in [1974 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 96,301 (July 1, 1974). Not surprisingly, the OCC did not choose to release the rebuttal prepared by Timothy D. Naegle, which appears at 120 CONG. REC. 29,800-05 (Aug. 22, 1974), though a commentator analyzing the exchange concluded that Naegle had “convincingly . . . chip[ped] away at the very foundations of Harfield’s argument on legality of standby letters [by] examining Harfield’s citations and exhibiting them as a vain grasping at straws.” Melvin R. Katskee, The Standby Letter of Credit Debate—The Case for Congressional Resolution, 92 BANKING L.J. 697, 704 (1975). As of June 30, 1974 Citibank (then First National City Bank), which was represented by Mr. Harfield’s law firm, had a larger dollar volume of standbys outstanding than any other U.S. bank, accounting for 20% of the aggregate dollar volume of standbys then outstanding. See Standby Hearings, supra note 366, at 240-42. 389 OCC Interpretative Letter No. 218 (Sept. 16, 1981), [1981-82 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 85,299.



an irony that surely was unconscious) stated “[b]anks have long been permitted to provide.”390

This case study is not presented for the purpose of contending that the decision to allow banks to issue standby letters of credit was a bad one as a policy matter; in any event that issue today is one with Nineveh and Tyre. Nor is it contended that the “too big to fail” dynamic is the only reason why legal decisionmakers let the product live. (Quite aside from arguments on the merits, the record confirms that, as legislators lamented after the smoke had cleared, a contributory role was played by a regulatory race for the bottom, brought about by the regulation of competing banks by different agencies.391) The main point of this case study is simply that the “too big to fail” dynamic in this case did play an important, and possibly decisive, role in saving a product whose legal underpinnings were doubtful. Moreover, the “too big to fail” dynamic validated the product even though the product fitted poorly into the surrounding legal environment. As previously noted, the standby was virtually unregulated until 1974, and the modest regulations then adopted did not remove the regulatory arbitrage resulting from the fact that the issuance of standbys, unlike the making of loans, did not result in a charge against the bank’s capital. It took fifteen years longer to impose a capital cost on a bank that issued a standby.392 The “too big to fail” dynamic is not sensitive to nuances of policy.

B. Rating Agencies as De Facto Lawmakers

1. On Becoming “Too Big to Fail” The preceding discussion of how the “too big to fail” dynamic can

shore up a financial product’s shaky legal underpinnings is reminiscent of the recipe for rabbit stew that famously begins with the direction, “First, catch the rabbit.” The discussion begs the question of how it comes about that a product with shaky legal underpinnings becomes widely used in the first place. That question does not admit of a 390 Am. Ins. Ass’n v. Clarke, 865 F.2d 278, 282 (D.C. Cir. 1988). 391 See 121 CONG. REC. 28,855-28,856 (Sept. 16, 1975) (statement of Sen. Proxmire); Standby Hearings, supra note 366, at 2 (statement of Sen. Proxmire); see also Verkuil, supra note 364, at 324-25 & n.43 (agreeing with Sen. Proxmire’s assessment). That regulation of competing banks by different agencies promotes a regulatory race for the bottom is a familiar insight. See, e.g., Elizabeth F. Brown, E Pluribus Unum—Out of Many, One: Why the United States Needs a Single Financial Services Agency, 14 U. MIAMI BUS. L. REV. 1, 53-57 (2005). 392 That came as a by-product of the so-called “risk-based capital framework” adopted by the federal bank regulatory agencies in 1989. See Neal S. Millard & Brian W. Semkow, The New Risk-Based Capital Framework and Its Application to Letters of Credit, 106 BANKING L.J. 500 (1989). Of course there remains the question whether the capital charge is priced adequately to cover the risk involved, but that is another story.



common answer for all products or a simple answer for any given product. Many ingredients may go into a successful stew of this nature, and some ingredients may be unique to the particular product.

In the first place, a product with shaky legal underpinnings will not become widely used if a judicial ruling adverse to the product occurs soon enough after the product’s introduction to inhibit its growth. Even an early adverse ruling might not inhibit a product’s growth if the product’s promoters can shrug it off as lacking sufficient authority. LTV Steel was not decided early in securitization’s history, but it does stand as an example of a ruling that was viewed as shruggable, as it was a mere denial by a bankruptcy judge of an emergency motion to modify an interim order on the use of cash collateral, speedily followed by a negotiated settlement.393

To some extent the absence of early litigation challenging the legal underpinnings of a given product must be a matter of luck. But factors other than luck may come into play. Some such factors may be unique to the product, and Part IV of this paper discusses factors unique to securitization that may have contributed to the absence of early litigation challenging its legal underpinnings. Litigation-inhibiting factors of more general applicability might also apply. For example, promoters of a product might be able to control the occurrence of adverse precedent by settling rather than litigating challenges to the underpinnings of the product. Scholars have found “clear, but not overwhelming” evidence of analogous strategic behavior in litigation of various types: repeat players may tend to settle actions with unfavorable facts and litigate actions with favorable facts, with a view to manipulating the creation of favorable precedents.394 The extent, if any, to which strategic settlements have played a role in the development of new financial products generally, or securitization in particular, awaits investigation.

Another possible litigation-inhibiting factor of general applicability is systemic conflicts of interest on the part of elite law firms. In the case of securitization, elite law firms commonly serve both as counsel to the debtor in possession in large Chapter 11 cases (which are the only bankruptcy cases likely to involve debtors that have done securitization transactions), on the one hand, and also as counsel to the investment bankers that market the securitization product, or as counsel to issuers 393 In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio 2001). KRAVITT, supra note 18, at § 5.05[M], notes various bankruptcy cases involving securitization or securitization-like structures, none of which other than LTV Steel appears to have resulted in a judicial ruling on a contested matter. 394 Frank B. Cross, In Praise of Irrational Plaintiffs, 86 CORNELL L. REV. 1, 14 (2000). Study of “litigant-driven” theories of judicial decisionmaking may be dated from George L. Priest & Benjamin Klein, The Selection of Disputes for Litigation, 13 J. LEGAL STUD. 1 (1984); for a current overview, see Cross, supra note 275.



in other securitization transactions who have rendered legal opinions as to the validity of such transactions, on the other hand. A challenge to the efficacy of a securitization transaction is most likely to be made by an Originator, as debtor in possession, after its bankruptcy, but the lawyers for such an Originator have good reason to avoid mounting such a challenge if they would thereby disoblige other clients (or potential clients) who market the product, or if they would thereby call into question legal opinions that the lawyers themselves previously rendered in other transactions. The role of similar “positional” conflicts of interest on the part of elite law firms in shaping practice has been remarked in other settings.395 Investigation of the subject is, however, also beyond the scope of this paper.

More amenable to analysis than the absence of early adverse litigation is a second ingredient necessary to securitization’s widespread use: namely, the decision by the rating agencies to rate securitization transactions on the assumption that the structural contrivance employed to defeat the Bankruptcy Tax would stand up if challenged in the bankruptcy of the Originator. Securitization is, and always has been, a rating-driven product. That is, the point of the prototypical securitization transaction is that it allows the Originator to obtain financing through the issuance of a debt or debt-equivalent instrument whose rating is based on the collectibility of the pool of assets transferred to the SPE, independent of the Originator’s own credit rating. The Originator can structure the transaction to obtain any desired rating on the resulting instrument, by appropriately setting the ratio of assets in the pool to the amount of debt issued. Ordinarily the Originator structures the transaction so that the instrument is rated at a high investment grade, superior to the Originator’s own credit rating. The Originator thereby obtains financing at the lower interest rates associated with highly-rated debt. If the rating agencies had not made the legal judgment that the prototypical securitization transaction will survive challenge in the Originator’s hypothetical future bankruptcy, securitization would never have gotten off the ground, for the resulting instrument would be rated in the same way as a simple debt instrument directly issued by the Originator and directly secured by the asset pool, and so be rated at or only marginally higher than the Originator’s own

395 See Andrew Ross Sorkin, When Conflicts Arise, Lawyers May Be a Source, N.Y. TIMES, Apr. 22, 2007, § 3, at 6 (noting that elite law firms advising public companies in mergers and acquisitions “may not be pressing hard enough” against practices adverse to those companies “because, in part, the lawyers have been responsible for helping to push such practices when they are working on the other sides of deals for their Wall Street and private equity clients”). The rules of professional responsibility that nominally apply in such settings are murky. See Helen A. Anderson, Legal Doubletalk and the Concern with Positional Conflicts: A “Foolish Consistency”?, 111 PENN ST. L. REV. 1 (2006).



credit rating.396 If, as seems likely, securitization has now grown “too big to fail” in the sense previously described—that is, courts will be disinclined to upset the weighty expectations that have been founded on the product, regulators will be inclined to intervene before courts and legislators for the purpose of heading off the market disruptions that would follow from a contrary ruling, and Congress in the last resort would bail out the product—that is a direct consequence of the rating agencies’ willingness to make the legal judgment that the structure works. In a practical sense, therefore, the law on this subject has been made by the rating agencies.

In short, the rating agencies have virtually the power of lawmakers in circumstances such as this, in which the “real” law is uncertain and the “too big to fail” dynamic operates to entrench their legal judgments. This observation abounds with interest, and also with ironies.

One irony is that this observation seems not to have been made previously, even though the role of the rating agencies in the financial markets has been subject to intense scrutiny in recent years. The rating agencies have never been well loved by the world at large. Instead they have been envied for the overwhelming predominance of the two dominant players, Moody’s and Standard & Poor’s, feared for the power they wield through their ratings, and chided for a host of alleged sins of commission and omission. 397 Unfortunately for them, one perennial complaint—that they fail to adjust ratings in time to be of use to investors—came home to roost in a politically-charged way in 2001, when the dominant rating agencies continued to rate the ordinary debt of Enron Corporation as investment grade until four days before Enron filed for bankruptcy. Enron’s failure was the impetus for a tidal wave of legislative and administrative activity, one ripple of which eventually engulfed the rating agencies: in 2006 federal legislation imposed a small measure of regulatory oversight on rating agencies, which until then were essentially unregulated.398 Between the impetus and the enactment 396 See supra text accompanying notes 38-39 397 “Moody’s” is the universal nickname for the century-old rating business which since 2000 has been conducted by Moody’s Corporation, a publicly traded company. “Standard & Poor’s” (or “S&P”) is the universal nickname for the only slightly younger rating business which since 1966 has been conducted as a division of The McGraw-Hill Company, a publicly traded company. Their most significant but much smaller competitor, Fitch, is currently a division of Fimalac, S.A., a French corporation. For general overviews of the credit rating industry, see JOHN C. COFFEE JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE 283-314 (2006); TIMOTHY J. SINCLAIR, THE NEW MASTERS OF CAPITAL: AMERICAN BOND RATING AGENCIES AND THE POLITICS OF CREDITWORTHINESS (2005); and Lawrence J. White, The Credit Rating Industry: An Industrial Organization Analysis, in RATINGS, RATING AGENCIES, AND THE GLOBAL FINANCIAL SYSTEM 41 (Richard M. Levich et al. eds., 2002). 398 Credit Rating Agency Reform Act of 2006, Pub. L. No. 109-291, 120 Stat. 1327 (adding to the Securities Exchange Act of 1934 a new § 15E, 15 U.S.C. § 78o-7, related definitions to § 3(a), 15 U.S.C. § 78c(a), and making other scattered changes). Regulations implementing the legislation were issued in Oversight of Credit Rating Agencies Registered as Nationally



passed a flood of investigations into the role of the rating agencies in the financial markets, including at least nine separate Congressional hearings399 and a major Congressional staff report,400 as well as the usual reports on the legislation as enacted and predecessor bills;401 in addition, the Securities and Exchange Commission (“SEC”) held its own hearings, 402 issued a Congressionally-mandated report, 403 and floated proposals for changing the regulatory treatment of rating agencies before Congress took the subject into its own hands.404 Legal scholars likewise piled on the rating agencies, adding substantially to the modest pre-Enron literature. 405 Even after the 2006 legislation, Recognized Statistical Rating Organizations, 72 Fed. Reg. 33,564 (June 18, 2007) [hereinafter CRARA Regulations]. 399 Assessing the Current Oversight and Operation of Credit Rating Agencies: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. (2006); The Credit Rating Agency Duopoly Relief Act: Hearing on H.R. 2990 Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 109th Cong. (2005); Legislative Solutions for the Rating Agency Duopoly: Hearing Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 109th Cong. (2005); Reforming Credit Rating Agencies: The SEC’s Need for Statutory Authority: Hearings Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 109th Cong. (2005); The State of the Securities Industry: Hearings Before the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. (2005); Examining the Role of Credit Rating Agencies in the Capital Markets: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. (2005) [hereinafter Examining the Role]; The Ratings Game: Improving the Transparency and Competition Among the Credit Rating Agencies: Hearings Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 108th Cong. (2004); Rating the Rating Agencies: The State of Transparency and Competition: Hearing Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 108th Cong. (2003) [hereinafter Rating the Rating Agencies]; Rating the Raters: Enron and the Credit Rating Agencies: Hearing Before the S. Comm. on Governmental Affairs, 107th Cong. (2002) [hereinafter Rating the Raters]. 400 STAFF OF THE S. COMM. ON GOVERNMENTAL AFFAIRS, 107TH CONG., REPORT: FINANCIAL OVERSIGHT OF ENRON: THE SEC AND PRIVATE-SECTOR WATCHDOGS (Comm. Print Oct. 8, 2002) [hereinafter PRIVATE-SECTOR WATCHDOGS], supplemented by STAFF OF THE S. COMM. ON GOVERNMENTAL AFFAIRS, 107TH CONG., REPORT: ENRON’S CREDIT RATING: ENRON’S BANKERS’ CONTACTS WITH MOODY’S AND GOVERNMENT OFFICIALS (Comm. Print Jan. 2, 2003). 401 S. REP. NO. 109-326 (2006) (on the bill enacted); H.R. REP. NO. 109-546 (2006) (on a predecessor bill). 402 U.S. SEC. & EXCH. COMM’N, HEARINGS ON THE CURRENT ROLE AND FUNCTION OF CREDIT RATING AGENCIES IN THE OPERATION OF THE SECURITIES MARKETS (Nov. 15 and Nov. 21, 2002), available at http://www.sec.gov/spotlight/ratingagency.htm [hereinafter SEC Hearings, cited by date]. 403 U.S. SEC. & EXCH. COMM’N, REPORT ON THE ROLE AND FUNCTION OF CREDIT RATING AGENCIES IN THE OPERATION OF THE SECURITIES MARKETS (Jan. 2003), available at http://www.sec.gov/spotlight/ratingagency.htm [hereinafter SEC CRA Report]. 404 Concept Release: Rating Agencies and the Use of Credit Ratings Under the Federal Securities Laws, Securities Act Release No. 8236, 68 Fed. Reg. 35,258 (June 12, 2003); Proposed Rule: Definition of Nationally Recognized Statistical Rating Organization, Securities Act Release No. 8570, 70 Fed. Reg. 21,306 (Apr. 25, 2005). 405 Professor Frank Partnoy has written extensively, both before and after the deluge, from a



further Congressional and administrative investigations of the rating agencies were soon provoked by the collapse of the market for, and the rating agencies’ extensive downgrades of, securities backed by subprime mortgages, which securities, many observers contended, had been rated originally on the basis of unduly optimistic assumptions about the collectibility of the underlying assets.406 In all this torrent of investigation, nobody seems to have noticed the role of the rating agencies as de facto lawmakers in circumstances such as those applicable to securitization, though from a systemic standpoint it seems at least as significant as any of the topics on which investigations dwelt.

The de facto lawmaking power of the rating agencies in the securitization setting might be viewed as a special case of a broader thought: that securities ratings may in some circumstances operate as self-fulfilling prophesies. That broader thought has often been expressed with respect to a rating agency’s decision to downgrade the rating of a given company’s traditional debt securities on the basis of doubts about the company’s creditworthiness. Such a downgrade might itself precipitate the company’s failure, by increasing the interest rate demanded on subsequent debt issues by the company, by diminishing the confidence of creditors and suppliers, or by activating “rating triggers” in covenants previously made by the company that have adverse consequences for the company if its debt ratings fall below a legal perspective on the role of the rating agencies in the financial markets. See Frank Partnoy, How and Why Credit Rating Agencies are Not Like Other Gatekeepers, in FINANCIAL GATEKEEPERS: CAN THEY PROTECT INVESTORS? (Yasuyuki Fuchita & Robert E. Litan eds., 2006) [hereinafter Partnoy, Not Like Other Gatekeepers]; Frank Partnoy, The Paradox of Credit Ratings, in RATINGS, RATING AGENCIES, AND THE GLOBAL FINANCIAL SYSTEM (Richard M. Levich et al. eds. 2002) [hereinafter Partnoy, Paradox]; Frank Partnoy, The Siskel and Ebert of Financial Markets?: Two Thumbs Down for the Credit Rating Agencies, 77 WASH. U. L.Q. 619 (1999) [hereinafter Partnoy, Two Thumbs Down]. For post-Enron contributions by other legal scholars, see COFFEE, supra note 397; Clare A. Hill, Regulating the Rating Agencies, 82 WASH. U. L. Q. 43 (2004); and Steven L. Schwarcz, Private Ordering of Public Markets: The Rating Agency Paradox, 2002 U. ILL. L. REV. 1. See also Reiss, supra note 28 (noting that major rating agencies do not rate securities backed by pools of residential mortgages if any of the mortgages are originated in states that have predatory lending laws that, in the view of the rating agencies, might impose unacceptable risks on an assignee of the mortgage, and arguing that this gives the rating agencies an effective veto over predatory lending legislation); cf. Engel & McCoy, supra note 28, at 2098-2100 (emphasizing that the rating agencies’ refusal to rate in such cases has applied only to predatory lending laws with unquantifiable damage provisions). 406 Hearings on the subject were held in the House and Senate in September 2007. The Role of the Credit Rating Agencies in the Structured Finance Market: Hearing Before the Subcomm. on Capital Markets, Insurance and Government Sponsored Enterprises of the H. Comm. on Financial Services, 110th Cong. (2007) [hereinafter House 2007 CRA Hearing]; The Role and Impact of Credit Rating Agencies on the Subprime Credit Markets: Hearing Before the S. Comm. on Banking, Housing and Urban Affairs, 110th Cong. (2007). Separate investigations were instituted by the SEC and the attorneys general of New York and Ohio. See Aaron Lucchetti, Ratings Firms’ Practices Get Rated, WALL ST. J., Sept. 7, 2007, at C1. Concurrently, the attorney general of Connecticut issued subpoenas to the three largest rating agencies as part of a broader antitrust investigation. See Rupini Bergstrom, Bond Raters Get Subpoenas, WALL ST. J., Oct. 27, 2007, at B2.



specified level. Despite the nature of each as a self-fulfilling prophesy, however, the case of the “premature downgrade that kills the company” does not really have much in common with the case of the “aggressive legal judgment that becomes entrenched by the ‘too big to fail’ dynamic.” For one thing, the case of the lethal premature downgrade seems more a theoretical concern than a practical one, for the common complaint about downgrades has been that they come too late, not too early. Indeed, the rating agencies’ conservativism about downgrading traditional debt securities has been defended precisely on the ground that such conservativism is necessary to avoid the risk of a lethal premature downgrade.407 Moreover, a premature downgrade affects but one company. By contrast, to the extent the rating agencies’ legal judgment about a new financial product becomes entrenched, the effect can be to reshape the entire financial marketplace, as has happened with securitization.

A second irony in the rating agencies’ role as de facto lawmakers with respect to securitization stems from the failed attempt between 1998 and 2002 to amend the Bankruptcy Code to provide a safe harbor for broad classes of securitization transactions. As noted previously, this failed amendment would have excluded from “property of the estate” receivables, securities, and other financial assets transferred by the debtor in connection with an asset securitization in which at least one series of securities is rated investment grade by a rating agency.408 Among the many criticisms levied at the proposal, the National Bankruptcy Conference charged that it “inappropriately permits rating agencies . . . to make the legal determination of whether an asset is property of a bankruptcy estate.”409 Inappropriate indeed; but the rating agencies already have exercised that power without benefit of a legislative delegation, through the operation of the “too big to fail” dynamic that has entrenched their judgments of current law on the subject.

A third irony can be savored by comparing commentators’ obliviousness to the de facto lawmaking role of the rating agencies with the perennial scrutiny given to other entities that some commentators have christened “private legislatures.” The principal targets of that scrutiny have been the National Conference of Commissioners on Uniform State Laws (“NCCUSL”), whose reason for being is the preparation of uniform laws for proposal to the state legislatures,

407 See, e.g., SEC Hearings (Nov. 21, 2002), supra note 402, at 175 (testimony of Paul Saltzman, Executive Vice President and General Counsel, The Bond Market Association); id. at 125 (testimony of Professor Steven L. Schwarcz). 408 See supra text accompanying notes 322-324. 409 House 1999 Bankruptcy Hearings, supra note 323, at 376 (1999) (prepared statement of Professor Randal C. Picker on behalf of the National Bankruptcy Conference).



together with The American Law Institute (“ALI”), as sponsor of restatements of the law and as co-sponsor of the Uniform Commercial Code, the statute that has been the chief magnet for such scrutiny. Now-standard critiques of these “private legislatures” run from comparatively mild charges that they are innately conservative and institutionally prone to produce statutes comprised of a blend of rules and standards that only coincidentally would coincide with the general welfare,410 to blunt accusations of bias and interest group capture.411

Of course the performance of those “private legislatures” matters, but the stakes should not be exaggerated. As applied to NCCUSL and the ALI, “private legislature” is merely a metaphor. Their work product does not have the force of law; it has only such force as legislatures and courts elect to give it. It is backed by nothing more than the prestige of its authors, than which few things are more brittle. Spectacular recent debacles in the uniform law process, such as the general revulsion by the states from the Uniform Computer Information Transactions Act,412 the near-complete lack of legislative interest in the 2003 amendments to UCC Article 2,413 and the unanimous rejection by the states of the major substantive change made to UCC Article 1 by the 2001 revision,414 underscore what has always been the case: NCCUSL and ALI merely propose; the legislatures dispose. State legislatures by no means enact every model statute concocted by those bodies, and those that they do

410 See Alan Schwartz & Robert E. Scott, The Political Economy of Private Legislatures, 143 U. PA. L. REV. 595 (1995). For an extension of these arguments to the United Nations Convention on Contracts for the International Sale of Goods and its sponsor, the United Nations Commission on International Trade Law, see Clayton P. Gillette & Robert E. Scott, The Political Economy of International Sales Law, 25 INT’L REV. L. & ECON. 446 (2005). 411 Such accusations began promptly after the appearance of the first infant version of the UCC, see Frederick K. Beutel, The Proposed Uniform [?] Commercial Code Should Not Be Adopted, 61 YALE L.J. 334, 357-63 (1952), and have reappeared with the regularity of a tolling bell after most of the major revision projects. For a discussion that includes a substantial (though by no means comprehensive) review of the extensive literature, see Robert K. Rasmussen, The Uneasy Case Against the Uniform Commercial Code, 62 LA. L. REV. 1097 (2002). 412 UCITA was promulgated as a stand-alone uniform law by NCCUSL in 1999 after the ALI declined to consent to its issuance as part of the UCC, and it was promptly amended several times in an unsuccessful attempt to appease critics. It was enacted (with amendments) by two states, Maryland and Virginia, but at least four other states (Iowa, North Carolina, Vermont and West Virginia) were so repelled by it that they took the extraordinary step of enacting so-called “bomb shelter” statutes aimed at making UCITA unenforceable against their residents. In 2001, 33 state attorneys general signed a letter declaring UCITA to be fundamentally flawed, and in 2003 NCCUSL announced that it would no longer promote its enactment. For an overview of UCITA’s unhappy history, see Deborah Tussey, UCITA, Copyright, and Capture, 21 CARDOZO ARTS & ENT. L.J. 319, 323-26 (2003). 413 As of late 2007, the 2003 amendments to Article 2 have been enacted nowhere, and it does not appear that a bill to enact them is pending in the legislature of any state. 414 As of late 2007, 29 states have enacted the 2001 revision of Article 1, and each of them declined to enact the new choice of law rule set forth in U.C.C. § 1-301 (2001), instead retaining the choice of law rule set forth in pre-2001 U.C.C. § 1-105. Nine of the enacting states also declined to enact the new definition of “good faith” set forth in U.C.C. § 1-201(b)(2) (2001).



enact are frequently amended, or supplemented by other legislation that substantially modifies the model statute.415

By contrast, rating agencies have a much stronger claim to the title of unacknowledged legislators of, if not the world, at least questions of law relevant to a financial product for which no clear answer is provided by traditional lawmakers and as to which the rating agencies are in a position to cause the product to grow too big to fail by their endorsement of a favorable answer to the question. Unlike NCCUSL and ALI, whose products shape the law only to the extent that the soft currency of their prestige entices legislatures and courts, the rating agencies deal in the much harder currency of the facts that they can create in the financial markets through their ratings, which the legislatures and courts may not reasonably be able to ignore.

Insofar as the rating agencies’ judgments of uncertain questions of law become entrenched in this way, the rating agencies’ institutional competence as lawmakers compares poorly indeed with that of such bodies as NCCUSL. NCCUSL operates as a quasi-public entity and has a fair claim to representativeness (its members being appointed from the several states, typically by the governor of that state); while its drafting committees have been accused of various sins their technical skill is undeniable; and the drafting process is uniquely open to observation and comment by any interested person. The rating agencies, being ordinary for-profit business enterprises, have none of those attributes: they have no special expertise on matters of law, they do not seek public input into the ratings they issue, and they have no reason to be particularly concerned about the interests of the constituencies that potentially might be harmed by a bankrupt Originator’s successful avoidance of the Bankruptcy Tax (that is, the unsecured creditors, shareholders and others who might fare better in a successful reorganization of the Originator that might occur only if cash flow from the securitized assets were available to the estate).

The most important point, however, is that the structure of the rating agencies’ business provides them with an inherent inducement to accept aggressive judgments on legal issues that govern the rating of a broadly-usable financial product, such as securitization. Since the early 1970s the dominant rating agencies have received their compensation for the ratings they issue in the form of fees paid by the issuers of rated securities.416 The vast bulk of the rating agencies’ revenues from their 415 See, e.g., U.C.C. § 9-201(b) (Article 9 defers to applicable consumer protection law). 416 Moody’s and Standard & Poor’s began to charge corporate issuers for ratings in 1970 and 1972, respectively. The motivation for the change was the rise of photocopying, which posed a serious threat to the subscriber-pays business model on which the rating agencies had traditionally operated. The opportunity for the change was supplied by the default of the Penn Central railway on its commercial paper in 1970, which so alarmed investors as to induce other issuers actively to seek ratings on their own debt. That increase in demand enabled the rating



ratings business derive from those fees.417 That the rating agencies are compensated by the issuers of the rated securities, rather than by the investors who rely on the ratings, entails an inherent conflict of interest: it creates an inducement for a rating agency to award the rating that the issuer wants, lest the issuer decline to seek (and pay for) a rating from that rating agency at all. This conflict of interest exists as to all rated securities, including traditional debt securities, and its effects were much canvassed in the various Congressional and administrative inquiries noted earlier.

The dominant rating agencies acknowledge the existence of this conflict, but argue that it is adequately controlled because fees from no one issuer account for more than a minute fraction of an agency’s aggregate revenues; hence, according to the agencies, any incentive they may have to shade a rating to mollify a given issuer is outweighed by their incentive to provide accurate ratings in order to preserve their reputations among users of their ratings.418 Whatever the strength of that argument as to the rating of a traditional debt security, as to which the rating depends predominantly upon factual judgments about the financial condition and prospects of the particular issuer, that argument has little force as applied to a rating on a widely-useable financial product, like securitized debt, that depends upon a judgment about an uncertain issue of law. That is because the stakes involved in such a judgment are much higher than the fees payable from a single issuer. If a rating agency were unwilling to make that legal judgment favorably to the product, no issuer using the product would pay that rating agency to agencies to charge issuers for ratings. See Cantor & Packer, supra note 38, at 4; White, supra note 397, at 47; SEC Hearings, supra note 402, at 144-45 (Nov. 15, 2001) (testimony of Leo C. O’Neill, president of Standard & Poor’s). 417 See SEC Hearings (Nov. 15, 2002), supra note 402, at 116 (testimony of Leo C. O’Neill, President of Standard & Poor’s); id. (Nov. 21, 2002), at 92-93 (testimony of Raymond W. McDaniel, President of Moody’s); Moody’s Corporation, Annual Report (Form 10-K), at 3 (Feb. 28, 2007). 418 See, e.g., SEC CRA Report, supra note 403, at 41-42; S&P FUNDAMENTALS, supra note 38, at 6-7. Regulations issued pursuant to the 2006 legislation forbid a rating agency registered under that act from rating the securities of an issuer from which the rating agency receives more than 10% of its annual revenues. CRARA Regulations, supra note 398, 72 Fed. Reg. at 33,623 (to be codified at 17 C.F.R. § 240.17g-5(c)(1)). The maximum fee concentration for the dominant rating agencies in fact is typically no more than 2%. See SEC CRA Report, supra note 403, at 41 & n.113.

The rating agencies also assert that the conflict of interest arising from their issuer-pays business model is mitigated by their internal policies that preclude their analysts from having any direct financial interest in the outcome of their ratings. Id. at 41-42. Regulations issued under the 2006 legislation require such policies. See CRARA Regulations, supra note 398, 72 Fed. Reg. at 33,623 (to be codified at 17 C.F.R. § 240.17g-5(c)(2)). Again, whatever the strength of that argument as applied to traditional debt securities, it has nothing to do with the tendency of the issuer-pays business model to create a bias on the part of the rating agency toward aggressive legal judgment about new financial products. The rating agencies’ further assertion that the conflict of interest is mitigated by their need to preserve their reputations is discussed infra Part III.B.3.b.



rate it, so the rating agency would foreclose itself from rating any securities of that type and thus would foreswear the fees it would otherwise be able to obtain from rating that whole segment of the securities market. In the case of securitization, the sums involved are vast. For instance, the revenues received by Moody’s from rating such “structured finance” transactions accounted for more than 45% of its total ratings revenues in 2006.419 And issuers of securitized debt are notoriously able and willing to shop for ratings—that is, an issuer will present a proposed transaction to multiple rating agencies and then select (and pay) only some of them, based upon which are willing to grant the rating desired by the issuer.420

So, while rating agencies may have the de facto power of lawmakers in the circumstances described above, their qualifications for the role are hardly appealing.

2. The Rating Agencies’ Responsibility for the Legal Judgment that

Securitization Works That the rating agencies are responsible for the critical legal

judgment that securitization works may be questioned by some, quite possibly including the rating agencies themselves. But it is not a new observation. Some observers understand the point so well as to take it for granted, noting it in passing but not recognizing its implications.421 Some elaboration upon the practices that have been followed with respect to rating and disclosure for securitized debt is therefore in order.

The process of rating securitized debt is quite unlike the process of rating traditional debt. In the case of traditional debt, pre-rating dialogue between the rating agency and the issuer is of limited significance, because an issuer typically is unable to adjust its creditworthiness before issuance. By contrast, rating of securitized debt is characterized by extensive pre-rating dialogue. The process typically begins with the issuer specifying the desired rating, and the rating 419 See Moody’s Corporation, Annual Report (Form 10-K), at 21 (Feb. 28, 2007). 420 See House 2007 CRA Hearing, supra note 406 (prepared statement of Mark Adelson, Adelson & Jacob Consulting, LLC, at 10) (“It is indisputable that securitization issuers . . . engage in rating shopping. They do so openly.”); Kemba J. Dunham, Moody’s Says It Is Taking Hit, WALL ST. J., July 18, 2007, at B7 (Moody’s reported that “it was passed over and not hired for 75% of the commercial mortgage-backed securities rating assignments issued in the past few months as a result of its requirement that issuers add an extra layer of credit enhancement.”). 421 See COMM. ON THE GLOBAL FIN. SYS., BANK FOR INT’L SETTLEMENTS, THE ROLE OF RATINGS IN STRUCTURED FINANCE: ISSUES AND IMPLICATIONS 9 (2005) [hereinafter BIS REPORT] (“One of the key roles served by rating agencies in structured finance markets is to make judgments about the soundness of the legal structure of a transaction, including the degree to which de-linking [that is, isolation of the securitized assets from a potential future bankruptcy proceeding of the Originator] has been legally effective.”); id. at 21.



agency indicates whether the structure and level of credit support proposed by the issuer will suffice to achieve that rating.422 The rating agency will require the issuer’s counsel to deliver opinions, addressed to the rating agency, pertaining to the risk that the securitization structure might be deemed property of the Originator’s estate in the event of the Originator’s bankruptcy. That legal risk is typically the subject of substantial disclosure to investors in the offering documents for the securities.423

The reason why the rating agencies are responsible for making the legal judgment that securitization works is simply that their award of ratings on the basis that it does work goes well beyond the conclusions warranted by the legal opinions customarily given to the rating agencies by the issuers’ counsel in securitization transactions.

In the first place, as noted earlier, the bankruptcy-related legal opinions required by the rating agencies from the issuer’s counsel in securitization transactions typically run to only two issues: first, that the transfer of the securitized assets from the Originator to the SPE constitutes a “true sale” that operates to remove those securitized assets from the hypothetical future bankruptcy estate of the Originator (and hence the transfer will not be recharacterized as a transfer by the Originator of an interest in those assets securing an obligation owed by the Originator to the SPE; second, that in the event of the bankruptcy of the Originator the SPE would not be substantively consolidated with the bankruptcy estate of the Originator.424 Both of these issues indeed must be so resolved in order for the securitization structure to do its job of keeping the securitized assets from the Originator’s hypothetical future bankruptcy estate. But while necessary, they are not sufficient, for the securitization structure can be challenged on other theories. In particular, as we have seen, these opinions do not address the most direct attack: that because the structure has no purpose or significant effect other than to avoid the Bankruptcy Tax, it is avoidable under fraudulent transfer law as an impermissible attempt to “hinder” the rights of the Originator’s unsecured creditors. Rating agencies do not typically require the issuer’s counsel to render an opinion on the application of fraudulent transfer law to a securitization transaction.425 422 See BIS REPORT, supra note 421, at 15; SEC Hearings, supra note 402, at 50 (Nov. 21, 2002) (testimony of Raymond E. McDaniel, President of Moody’s); see also S&P Fundamentals, supra note 38, at 1-6 (denying that such pre-rating dialogue makes the rating agency an advisor and repudiating suggestions that it is dangerous). 423 See supra note 261. 424 See S&P LEGAL CRITERIA, supra note 78, at 13-22. 425 Id., at 23-24, states that S&P may ask for a legal opinion on fraudulent transfer in the unusual transaction whose structure implicate the constructive fraud prong of fraudulent transfer law. See supra note 105. Personal observation and discussion with lawyers involved in securitization indicates that legal opinions from issuer’s counsel as to the inapplicability of the “actual fraud” prong of fraudulent transfer law to securitization transactions have been requested



Hence, insofar as they issue ratings that are based on the assumption that securitization works as a legal matter, the rating agencies have made on their own authority the legal judgment that the structure will not fall to a fraudulent transfer attack.

Even as to the “true sale” and nonconsolidation issues as to which the rating agencies do require legal opinions to be rendered by issuer’s counsel, the real judgment that these legal issues will be resolved favorably to the product is made by the rating agencies. That is because the legal opinions typically rendered by issuer’s counsel communicate substantial uncertainty about the outcome, but the rating agencies nevertheless rate these transactions as though the outcome were virtually certain.

The “true sale” and nonconsolidation opinions that have been rendered many thousands of times in securitization transactions are sui generis artifacts quite unlike the comparatively crisp opinion ordinarily delivered at the closing of a financing, and indeed constitute a minor art form. Aesthetic enjoyment is denied to the masses, however, for it is not easy for persons not involved in such transactions to obtain specimens of such opinions.426 That is because it is not customary to make these opinions publicly available even in transactions resulting in publicly-issued securities (as could be done, but is not, by filing those opinions as exhibits to the registration statement). Moreover, the organized bar has made little effort to simplify the giving of these opinions by drafting standard forms427—a lacuna susceptible to various explanations but that a cynic might view as stemming at least in part from a feeling on the part of the bar that it is just as well to avoid drawing unnecessary attention to the fact that, as one commentator airily put it, these opinions tend to be “inconclusive with respect to certain technical aspects of a given transaction.” 428 In fact, these opinions are invariably “reasoned” opinions—that is, they set out at great length an analysis of all cases and other authorities that bear on the episodically, but it does not appear that such opinions ever were commonly given or, if given, were given in a meaningful way. Thus, a bar committee greatly influential on legal opinion practice has noted that requests for such opinions in securitization transactions are often resisted, or the opinion giver simply assumes the absence of actual fraud (as is done in the model opinion presented by that committee). See TriBar Opinion Comm., Opinions in the Bankruptcy Context: Rating Agency, Structured Financing, and Chapter 11 Transactions, 46 BUS. LAW. 717, 727-29 & n.47, 743 (1991) [hereinafter TriBar Bankruptcy Opinions Report]. 426 A fairly typical specimen of such a legal opinion, albeit considerably shorter than the norm, was rendered by counsel to the issuer in the receivables securitization challenged in LTV Steel (rated AAA by Standard & Poor’s) and is publicly accessible because it was filed as an exhibit in that litigation. See LTV Cash Collateral Motion, supra note 252, ex. J, at 494. 427 Bar groups have published indicative forms of substantive consolidation opinion. See TriBar Bankruptcy Opinions Report, supra note 425, at 738-44; Structured Financing Techniques, supra note 6, at 595-606. But analogous attempts at a “true sale” opinion appear to be lacking. 428 BIS REPORT, supra note 421, at 21.



issue, pro or con, before concluding with a statement of the opinion-giver’s opinion on the matter. As one scholar has observed, the typical legal opinion of the type given in a securitization transaction is a “mini-treatise, comprising 40-60 single-spaced pages.”429

The typical opinion of this type communicates substantial uncertainty to the opinion recipient about the resolution of the “true sale” and nonconsolidation issues addressed by the opinion—as acknowledged even by commentators unequivocally supportive of securitization. 430 The whole purpose of rendering an opinion in reasoned form is to communicate uncertainty to the opinion recipient. A reasoned opinion passes the buck to the recipient by giving the recipient the warning implicit in the opinion giver’s refusal to issue a “clean” opinion, and by inviting the recipient to make its own judgment about the legal issue by evaluating the reasoning presented by the opinion-giver.431 Moreover, these opinions are at pains to spell out explicitly the uncertainty of the legal judgment involved. The opinion rendered as to the receivables securitization that was subsequently litigated in LTV Steel, for example, is wholly typical in warning that the “the opinion expressed below is not based on controlling precedent and we do not purport to predict the conclusion that would be reached by a particular court considering the question.”432 The guidelines for legal opinions in transactions of this type issued by one of the dominant rating agencies acknowledge that the opinions will explicitly warn of the uncertainty of the result (though for occult reasons the agency prefers certain phrasings of that warning to others).433 The overall 429 Steven L. Schwarcz, The Limits of Lawyering: Legal Opinions in Structured Finance, 84 TEX. L. REV. 1, 6 n.28 (2005); see also id. at 13-14 (“All structured-finance opinions are reasoned opinions, typically ranging twenty to fifty pages in length. . . .”). 430 See, e.g., TriBar Bankruptcy Opinions Report, supra note 425, at 736 (“A reasoned opinion is sufficient to put the opinion recipient on notice as to the uncertainties and limitations . . . inherent in opining on those bankruptcy law matters covered in the opinion . . . .”); Schwarcz, supra note 429, at 13-14; see also John C. Coffee Jr., Can Lawyers Wear Blinders? Gatekeepers and Third Party Opinions, 84 TEX. L. REV. 59, 66 (2005) (in this context, “[t]he law firm anticipates that its extensive qualifications will protect it from liability”). 431 See, e.g., DONALD W. GLAZER ET AL., GLAZER AND FITZGIBBON ON LEGAL OPINIONS § 3.3, at 77-78 (2d ed. 2001) (“[T]he inclusion of reasoning reflects a determination by the opinion preparers that the opinion recipient should have the opportunity to obtain from its own counsel an assessment of the reasoning on which the opinion is based.”); Comm. on Legal Opinions, Am. Bar Ass’n Section on Bus. Law, Guidelines for the Preparation of Closing Opinions, 57 BUS. LAW. 875, 879 (2002) (“Although closing opinions ordinarily do not set forth any legal analysis, opinion givers may include their legal analysis in an opinion when they believe it involves a difficult or uncertain question of professional judgment . . . .”); ARTHUR NORMAN FIELD & JEFFREY M. SMITH, LEGAL OPINIONS IN BUSINESS TRANSACTIONS, § 2.6, at 2-6 (2d ed. 2003) (“The reasoned opinion is . . . a guarded one. It stresses the lack of direct authority or the conflict of authority regarding an issue . . . . The opinion recipient’s lawyer, who receives such an opinion, is on notice to provide special guidance to the opinion recipient on the issue involved.”). 432 LTV Cash Collateral Motion, supra note 252, Ex. J, at 494. 433 Thus, S&P LEGAL CRITERIA, supra note 78, at 163, declares it acceptable for an opinion to



content of these opinions was summarized by one practitioner as follows:

[The true sale opinion is] a completely academic exercise. You lay out the law in the discussion . . . and then you lay out the facts and the facts actually say pretty much the same thing in every opinion, with little wrinkles of course. And then you say, “Oh, there’s this thus and such factor which actually might cut the other way” and that’s just to show that you’re actually thinking about it. And then you get to the end and you say, “Well, of course we can’t absolutely say it for sure, but our best judgment is such and such is going to happen.” And everybody says, “Great,” and they stick it in a drawer. And it’s absolutely meaningless. I mean, if you really look at it carefully, it says nothing.434 For present purposes it is not necessary to decide whether “it says

nothing” is hyperbole or the bare truth. It is enough to make the conservative observation that, through both their form and their content, opinions of these types communicate a substantial degree of uncertainty about the outcome. If the rating agencies’ legal conclusions about whether securitization works were based on these opinions, they would not give the ordinary securitization transaction the high rating that follows from the assumption that the securitized assets are isolated from the potential future bankruptcy estate of the Originator. Rather, they would discount that rating to reflect the legal uncertainty that the securitization structure would be respected in the event of the Originator’s bankruptcy. But the rating agencies do not do that. Instead, given these legal opinions they rate these transactions on the assumption that, to a virtual certainty, the structure will be proof against attack in the event of the Originators’ bankruptcy. This point is reflected in the formal guidelines for rating structured finance transactions published by one of the dominant rating agencies, which states that in “true structured financings” the rating is based on the creditworthiness of the securitized assets, without regard to the creditworthiness of the Originator; it does not refer to any discount of that rating to reflect legal uncertainty.435 It is also evident from the ratings actually awarded to the debt issued in transactions structured as the prototypical securitization, which quite commonly are awarded the very highest rating.436 That could not be the case if this legal risk were state “although a court may find otherwise” or to refer to the TriBar Bankruptcy Opinion Report, supra note 425, which abundantly notes the uncertainty of the legal issues in question; on the other hand, an opinion stating that the “issue is not free from doubt” or that the conclusion is “more probable than not” is “generally” not acceptable. 434 Jonathan C. Lipson, Price, Path & Pride: Third-Party Closing Opinion Practice Among U.S. Lawyers (A Preliminary Investigation), 3 BERKELEY BUS. L.J. 59, 94 (2005) (quoting an attorney interviewed on June 10, 2005, publicly identified as “Attorney K-1”). 435 See S&P LEGAL CRITERIA, supra note 78, at 10. 436 For example, the securities issued in the securitization transaction used as an exemplar in



given a significant weight. The rating agencies have shown at least fitful awareness by the

mismatch between the uncertainty conveyed by the legal opinion they may receive on a given product and the virtual certainty that their ratings may assume. A notable clash on the subject occurred when Moody’s in 1983 published an article distinguishing between “reasoned” opinions and “unqualified” opinions, and asserting that the giving of an “unqualified” opinion means that the opinion giver believes that the legal risk attendant on the issue opined on has been “substantially eliminated.”437 In response the TriBar committee, the organized bar’s leading authority on opinion practice, rapped Moody’s knuckles sharply, stating among other things that the purpose of a reasoned opinion is to communicate uncertainties, which is the case whether or not the opinion is qualified, and warning Moody’s in no uncertain terms that its assertion was “without analytical basis, and that it is inappropriate for any opinion recipient to believe, or advertise, that no risk exists in a transaction because an unqualified opinion has been received.”438 Since then the rating agencies seem not to have made any serious effort to change opinion practice, or the meaning given to the opinions typically rendered, but have contented themselves with occasional pious statements that legal risks should be reflected in ratings in the same way as credit risks439—though without actually changing their practice of rating more aggressively than is warranted by the legal opinions customarily given with respect to the legal issues at the foundation of securitization.

In short, the rating agencies’ willingness to “round up” the legal uncertainties associated with securitization in favor of the success of the product, and to issue ratings on securitized debt on the assumption that the principal law school casebook on the subject, SCHWARCZ, supra note 29, were four series of asset-backed notes aggregating over $1.5 billion in principal amount issued by Honda Auto Receivables 2003-1 Owner Trust. Each was rated in the highest long-term or short term rating category, as applicable, by each of Moody’s, Standard & Poor’s, and Fitch. 437 Moody’s Investors Service, Moody’s Approach to Rating Bank-Supported Debt Securities, MOODY’S BOND SURVEY, Jan. 3, 1983, at 3979. 438 TriBar Bankruptcy Opinion Report, supra note 425, at 734-36. 439 See the brief and highly abstract assertion of this point in Standard & Poor’s, Ratings: Credit Where Credit is Due: Examining the Legal Landscape of Structured Finance Transactions (Feb. 23, 2004), available at http://standardandpoors.com. This assertion is, of course, inconsistent with the practice described in Standard & Poor’s criteria on rating securitization transactions, which do not contemplate any discount for legal uncertainty. It also leaves loose ends hanging. For instance, it states:

[L]egal risk must be graded by reference to the grading scale. In the same way that a “BBB” transaction can absorb greater credit risk (probability of credit losses on the pool) than a “AAA” transaction, a “BBB” transaction can absorb a greater legal risk (probability that a bankruptcy trustee successfully challenges the transactions’ security package) than a “AAA” transaction.

Id. A transaction by an Originator rated below AAA should not qualify for an AAA rating at all, if the legal uncertainties at the foundation of securitization are given serious weight.



it is virtually certain that the structure will be respected in the event of the Originator’s bankruptcy, is the penny in the fuse box that has allowed the product to grow, and to keep growing to the point where it is now in all probability too big to be allowed to fail.440

3. Potential Constraints on the Rating Agencies’ Legal Judgments

About Products They Rate We have seen that, in rating securitization transactions, the legal

judgment implicit in the ratings awarded by rating agencies is more aggressive than the opinions typically rendered would support. We have also seen that, because they receive their compensation from the issuers of the securities they rate, the rating agencies have a fiscal incentive to be aggressive in making the favorable legal judgments on which a new product depends, and that the factors cited by rating agencies as mitigating the conflict of interest inherent in the issuer-pays business model do not apply to such legal judgments, because favorable judgment on those legal issues allows the rating agency to give favorable ratings to a whole segment of the securities market and not merely a single issuer.441 What, then, if anything, constrains the rating agencies’ legal judgment on uncertain issues of law upon which new products depend?

a. Liability

One potential constraint is the risk of liability to disappointed

investors if courts do not reach the same legal judgment as did the rating agencies. To all appearances, however, the rating agencies have been eminently successful in avoiding liability on account of allegedly incorrect ratings they issue. As to securities law theories, a 2002 Congressional staff study stated that rating agencies are “officially shielded from liability for all but fraud under the securities laws” and are “not held even to a negligence standard of care for their work.”442

440 Professor Schwarcz has asserted that the rating agencies are “conservatively biased against innovation.” Schwarcz, supra note 405, at 18. The supporting evidence he cites, however, is slender indeed: he states that “some rating agencies remain skeptical whether an SPV that purports to purchase only an undivided interest in, as opposed to whole, receivables is able to gain ownership of the interest purchased.” Id. at 19 (internal citations omitted). This skepticism by “some” rating agencies has not prevented the technique from being used, for Professor Schwarcz notes that the technique is in fact “widely used” in securitization transactions, which presumably have been rated by other rating agencies. Id. at 19 n.118. 441 See supra text accompanying notes 416-420. 442 PRIVATE-SECTOR WATCHDOGS, supra note 400, at 104-05. Strictly speaking, these



As to tort theories, such as negligent misrepresentation, in the relatively few reported cases in which anyone has tried to pursue the rating agencies, “the only common element . . . is that the rating agencies win.” 443 Often the rating agencies’ success has been based on commonplace defenses such as lack of duty to an aggrieved investor (with whom the rating agency typically is not in any meaningful contractual privity),444 or the unreasonableness of an investor relying on a rating (a defense for which the rating agencies have laid a good foundation by their warnings to investors that ratings are merely opinions and do not constitute investment advice).445

The 2006 legislation, far from enhancing the rating agencies’ exposure to liability for inaccurate ratings, may be their best friend. It does not create any new private right of action.446 Moreover, it might be read to immunize the rating agencies completely from tort liability on account of allegedly inaccurate ratings. A last-minute amendment, made on the Senate floor after the legislation had been reported out of committee, added a sentence stating that “[n]otwithstanding any other provision of law,” no state or political subdivision “may regulate the substance of credit ratings.”447 This language preempts state law to

statements were made in reference to a rating agency that qualifies as a “national recognized statistical ratings organizations,” or “NRSRO.” “NRSRO” status is discussed later in this Part III.B.3.a. Securities Act Rule 436(g)(1), 17 C.F.R. § 230.436(g)(1) (2007), expressly exempts NRSROs from liability under § 11 of the Securities Act of 1933. Regulation F-D, which generally prohibits issuers from making selective disclosure of material information, expressly allows issuers to make selective disclosure to rating agencies (whether or not NRSROs). 17 C.F.R. § 243.100(b)(2)(iii) (2007). 443 Partnoy, Paradox, supra note 405, at 79. For a more recent discussion, see Partnoy, Not Like Other Gatekeepers, supra note 405, at 83-89. 444 First Equity Corp. v. Standard & Poor’s Corp., 869 F.2d 175 (2d Cir. 1989). 445 Quinn v. McGraw-Hill Companies, Inc., 168 F.3d 331, 336 (7th Cir. 1999). 446 Securities Exchange Act of 1934 § 15E(m)(2) (as added in 2006); see also id. § 15E(c)(1) (giving the SEC “exclusive authority” to enforce the new legislation in the event that a rating agency registered under the legislation issues ratings in contravention of the procedures it discloses pursuant to the legislation). 447 The language appears in § 15E(c)(2) of the Securities Exchange Act of 1934, as added by the 2006 legislation, which reads in full as follows:

(2) Limitation—The rules and regulations that the Commission may prescribe pursuant to this title, as they apply to nationally recognized statistical rating organizations, shall be narrowly tailored to meet the requirements of this title applicable to nationally recognized statistical rating organizations. Notwithstanding any other provision of law, neither the Commission nor any State (or political subdivision thereof) may regulate the substance of credit ratings or the procedures and methodologies by which any nationally recognized statistical rating organization determines credit ratings.

The amendment that added the language preempting state regulation of the substance of credit ratings or rating methodologies is at 152 CONG. REC. S10,050 (daily ed. Sept. 22, 2006). Legislative commentary on it appears to consist of one brief vague paragraph in the floor debates that contains no interpretative grist. Id. at S10,012 (statement of Sen. Sarbanes). Before the amendment the language that now comprises the second sentence was narrowly drawn only to forbid the SEC from issuing rules or regulations purporting to regulate the substance of credit



some extent, but whether the preemption extends to the application of ordinary tort law to an allegedly inaccurate rating depends upon whether that is considered to be “regulat[ing] the substance” of a rating—a question about which reasonable minds might differ. A broad reading of what it means to “regulate the substance” of a rating is discouraged, though not foreclosed, by language added elsewhere by the same floor amendment that preserves the power of state securities commissions to bring enforcement actions against rating agencies with respect to “fraud or deceit.”448 It would be ironic for preemption of tort liability to be the result of the legislation, for the hearings held and reports written leading up to it reflect a Congressional desire to impose some modest controls on the rating agencies; they never broached the notion that the general welfare would be promoted by awarding the rating agencies immunity from any risk of tort liability on account of their ratings. But in an era of “plain language” interpretation that reading cannot be ruled out.

The rating agencies also have had substantial success with a defense based on the First Amendment. They have consistently taken the position that they are financial publishers whose ratings are equivalent to newspaper editorials, so that a rating is an unfalsifiable opinion that is wholly protected, or at worst is an assertion about a matter of public interest that is protected by the “actual malice” standard laid down in New York Times Co. v. Sullivan.449 Several courts, though not all, have accepted that argument. 450 Congress took this First Amendment argument quite seriously during the deliberations that led to enactment of the 2006 legislation regulating rating agencies, as an early version of the legislation was substantially revised in response to

ratings or rating methodologies. 448 Securities Exchange Act of 1934, § 15E(o)(2) (as added in 2006). 449 376 U.S. 254, 279-83 (1964). 450 See Compuware Corp. v. Moody’s Investors Servs., Inc., 499 F.3d 520 (6th Cir. 2007) (affirming grant of summary judgment in favor of rating agency sued by issuer over an allegedly erroneous downgrade and ratings report); Jefferson County Sch. Dist. No. R-1 v. Moody’s Investor’s Servs., Inc., 175 F.3d 848 (10th Cir. 1999) (affirming dismissal of suit by bond issuer alleging erroneously unfavorable assessment of its creditworthiness by rating agency); Newby v. Enron Corp. (In re Enron Corp. Sec. Derivative & “ERISA” Litig.), No. MDL-1446, 2005 U.S. Dist. LEXIS 4494 (S.D. Tex. Feb. 16, 2005) (granting motions by rating agencies to dismiss tort claims by Enron creditor grounded on their allegedly too-favorable ratings of Enron debt), motion for reconsideration denied, 2007 U.S. Dist. LEXIS 41091 (S.D. Tex. June 5, 2007); County of Orange v. McGraw Hill Cos., Inc., 245 B.R. 151 (C.D. Cal. 1999) (granting summary judgment for rating agency as to one series of bonds but denying summary judgment as to another series in suit by issuer alleging that rating agency gave an erroneously too-favorable rating on the issuer’s bonds). But see Commercial Fin. Servs., Inc. v. Arthur Andersen LLP, 94 P.3d 106 (Okla. Civ. App. 2004) (rejecting First Amendment defense and reversing ruling dismissing rating agencies from action alleging a too-favorable rating); LaSalle Nat’l Bank v. Duff & Phelps Credit Rating Co., 951 F. Supp. 1071 (S.D.N.Y. 1996) (rejecting First Amendment defense and denying rating agency’s motion to dismiss claims based on its allegedly too-favorable rating).



First Amendment objections raised by the rating agencies.451 This First Amendment defense has not yet been litigated often

enough to allow of confident prediction as to what the courts ultimately will make of it. Despite the First Amendment’s absolute wording, courts have never given countenance to arguments against the constitutionality of the core of the securities laws, even though those laws are largely concerned with regulating the content of speech (and by prior restraint, to boot).452 Nevertheless, the First Amendment has been held by the Supreme Court to protect the editorial content of newspapers and newsletters from encroachment by the securities laws.453 The ratings issued by rating agencies might be distinguished in several ways from editorials or news stories written by ordinary financial publishers, but whether those distinctions would strike the courts generally as being constitutionally significant remains to be seen. For one thing, as some courts have observed, the dominant rating agencies usually are paid by the issuer of the rated security to write their “editorials,” unlike ordinary journalists, who are (one hopes) not usually paid by the subjects of their journalism.454 Other courts have suggested that rating agency activities associated with the structuring of a

451 An early version of the legislation, H.R. 2990, 109th Cong. (2005), would have prohibited a rating agency from conducting business absent registration with the SEC and arguably would have authorized the SEC to deny registration if it disapproved of the rating agency’s methodologies for determining ratings. After vigorous objection by Standard & Poor’s, embodied in a memorandum entitled “A Constitutional Analysis of H.R. 2990,” dated July 2005, available at http://standardandpoors.com/spf/pdf/media/HR_%202990.pdf, the legislation as enacted was changed in both respects: registration is required only if a rating agency desires the status of a “nationally recognized statistical rating organization” (“NRSRO”) whose ratings will qualify under federal laws and regulations that give favorable treatment to securities favorably rated by an NRSRO; and the SEC is expressly forbidden to regulate the substance of ratings or the methodologies by which ratings are determined. See Securities Exchange Act of 1934 § 15E (as added in 2006). 452 For a discussion of this point, see Frederick Schauer, The Boundaries of the First Amendment: A Preliminary Exploration of Constitutional Salience, 117 HARV. L. REV. 1765, 1777-80 (2004). 453 See, e.g., Lowe v. Sec. & Exch. Comm’n, 472 U.S. 181 (1985) (holding that the Investment Advisers Act of 1940 did not apply to the publisher of a financial newsletter, partly in order to avoid considering the First Amendment defense; three concurring justices explicitly held the publisher protected by the First Amendment). For recent discussions of First Amendment protection for securities-related speech, see Lloyd L. Drury III, Disclosure is Speech: Imposing Meaningful First Amendment Constraints on SEC Regulatory Authority, 58 S.C. L. REV. 757 (2007); Antony Page, Taking Stock of the First Amendment’s Application to Securities Regulation, 58 S.C. L. REV. 789 (2007). 454 See Commercial Fin. Servs., 94 P.3d at 110; LaSalle Nat’l Bank v. Duff & Phelps Credit Rating Co., 951 F. Supp. 1071, 1095-97 (S.D.N.Y. 1996). Compare Am. Sav. Bank v. UBS PaineWebber, Inc., (In re Fitch, Inc.) 330 F.3d 104, 109-10 (2d Cir. 2003) (holding that the Fitch rating agency was not entitled to journalist’s privilege against a subpoena under the New York Press Shield Law, in part because Fitch rarely rated deals it was not hired to rate), with Pan Am Corp. v. Delta Air Lines, Inc., (In re. Pan Am. Corp.) 161 B.R. 577, 583 (S.D.N.Y. 1993) (holding that Standard & Poor’s was entitled to journalist’s privilege, and noting that Standard & Poor’s practice was to rate nearly all public debt issues whether or not it was paid to do so).



transaction, as contrasted with merely rating the transaction after issuance, are too dissimilar from ordinary journalistic activity to merit the legal protection awarded to journalists. 455 That distinction is potentially applicable to securitization transactions, given issuers’ usual practice of consulting the agencies that will be asked to rate the deal at the time the deal is structured, in order to assure that the deal will receive the desired rating.

The 2006 legislation does foreclose one argument that a disappointed investor might raise against constitutional protection for rating agencies: namely, that a rating agency’s election to register under the 2006 legislation, which (as will be discussed momentarily) entitles it to the status of a “nationally recognized statistical rating organization” (“NRSRO”) whose ratings are entitled to privileged treatment under a host of statutes and regulations, should be viewed as a waiver of any First Amendment protection that might otherwise apply, on the theory that it is a reasonably implied condition of awarding a rating agency’s ratings privileged legal status that the quality of its ratings be susceptible to some control through tort law.456 The new legislation precludes that argument, because it provides that registration under the legislation does not operate as a waiver of any “right, privilege, or defense” that the rating agency “may otherwise have under any provision of State or Federal law.”457

The First Amendment issue is intriguing if only because of its novelty in the land of finance. But it is not the heart of the matter, for even if the First Amendment is ignored, the rating agencies’ conventional defenses to liability—lack of duty to investors with whom they are not in privity, and unreasonableness of investors’ reliance on ratings when investors are warned that they are not investment advice—are quite potent under traditional principles of tort law. It is by no means evident that the virtual immunity that follows from those traditional principles is bad policy, either. The few previous academic discussions are, predictably, divided. 458 Those arguing for more 455 See Am. Sav. Bank, 330 F.3d at 110-11 (construing journalist’s privilege under New York Press Shield Law). 456 A similar argument might have been made before the 2006 legislation, as NRSRO status was created in 1975. However, before the 2006 legislation NRSRO status was conferred by the SEC through its issuance of a no-action letter designating a given rating agency as qualifying, and it appears that the status was awarded to the dominant rating agencies without their having taken affirmative steps to request it. See Examining the Role, supra note 399, at 54 (statement of Kathleen A. Corbett, President, Standard & Poor’s). 457 Securities Exchange Act of 1934, § 15E(m)(1) (as added in 2006). 458 Compare Partnoy, Not Like Other Gatekeepers, supra note 405, at 89 (suggesting that the only reason why rating agencies are less at risk for liability than other gatekeepers is that “no authoritative body has carefully considered the question of credit rating agency liability”), and Partnoy, Two Thumbs Down, supra note 405, at 711 (arguing that rating agencies “should not have their cake and eat it too. Such agencies should not simultaneously benefit from ratings-dependent regulation and be insulated from lawsuits alleging negligence or misrepresentation”),



stringent standards of liability have tended to view the question through the lens of the broader question of the appropriate degree of liability that should be imposed on all gatekeepers to the financial markets. “Gatekeeper” is a fuzzily defined term coined by scholars in the 1980s to refer to persons who put their reputations behind a particular security or its issuer and by so doing reduce the information asymmetry between issuer and investor: investment bankers, accountants, and attorneys who participate in a securities offering are at the core of the notion, but it can be extended to taste. 459 The medicine that legal scholars have commonly prescribed as a prophylactic for poor gatekeeping is stricter personal liability for gatekeepers.460 It would be a mistake, however, to apply that prescription reflexively to the rating agencies. The academic discourse on gatekeepers has centered on their role in preventing misdisclosure or nondisclosure of material facts about the issuer of a security. Ratings, however, are not factual disclosures about the issuer. They are predictions of the likelihood that the rated security will default; they are inherently forward-looking, and as with any prophesy, they are inherently subjective. Even the securities laws broadly immunize issuers themselves from civil liability on account of forward-looking statements they make. 461 And if liability to disappointed investors is too blunt an instrument with which to chastise rating agencies for their inaccurate prophesies as a general matter, liability arising from a rating of securitized debt that was based upon an overly optimistic assessment of the legal risk involved in the securitization structure seems particularly unsuitable, given that the risk is disclosed abundantly in the offering materials for the debt.

In any event, risk of liability is only a weak constraint upon a with Schwarcz, supra note 405, at 2 & n.5 (arguing that governmental regulation of rating agencies is unnecessary because they are sufficiently motivated to perform well by their desire to preserve their reputations; explicitly not considering tort liability), and Gregory Husisian, Note, What Standard of Care Should Govern the World’s Shortest Editorials?: An Analysis of Bond Rating Agency Liability, 75 CORNELL L. REV. 411 (1990) (arguing on similar grounds against extension of tort liability for negligent misrepresentation to rating agencies). 459 The root of modern legal discourse on gatekeepers is a series of articles by Ronald J. Gilson and Reinier H. Kraakman in the mid-1980s, including Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 VA. L. REV. 549, 613-21 (1984), and Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J.L. ECON. & ORG. 53 (1986). See generally COFFEE, supra note 397. For a recent discussion emphasizing the differences between different players who have sometimes been lumped together under the rubric of “gatekeepers,” see Arthur B. Laby, Differentiating Gatekeepers, 1 BROOK. J. CORP. FIN & COM. L. 119 (2006). 460 See, e.g., John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301 (2004); Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime, 79 WASH. U. L.Q. 491 (2001). 461 See Securities Act of 1933 § 27A, 15 U.S.C. § 77z-2 (2000); Securities Exchange Act of 1934 § 21E, 15 U.S.C. § 78u-5 (2000); see also Securities Act Rule 175, 17 C.F.R. § 230.175 (2007); Securities Exchange Act Rule 3b-6, 17 C.F.R. § 240.3b-6. For other arguments against enhanced liability for rating agencies, see COFFEE, supra note 397, at 302-04.



rating agency’s judgment about an uncertain legal issue upon which the rating of a given product depends, for a good many dominoes would have to fall in a direction adverse to the rating agency before that risk would materialize.

b. Reputation

A second potential constraint upon aggressive judgment on

uncertain legal issues by a rating agency in issuing its rating is its wish to protect its reputation from the damage it might suffer in the event that a court ultimately disagrees with that judgment. In the recent investigations into the role of the rating agencies in the capital markets, the rating agencies asserted their overriding business need to preserve their reputational capital as a universal answer to any and all concerns raised about their ratings. 462 Certainly there is no shortage of commentary demonstrating essentially unbounded faith in the power of this factor to spur accurate ratings.463 But there are at least two lines of thought, one peculiar to legal judgments made by a rating agency on uncertain issues of law, and the other applicable to all ratings, including those on traditional debt securities, that undercut the strength of this reputational constraint on rating agencies when they make legal judgments about products they rate.

In the first place, it is doubtful that a rating agency’s reputation would be damaged by an adverse judicial ruling on the question of whether the securitization structure achieves its purpose of isolating the securitized assets from the bankruptcy estate of the Originator. That is simply because the responsibility for the erroneous legal judgment can be assigned credibly to the issuer’s legal counsel, as a result of the rating agencies’ practice of requiring issuer’s counsel to opine on key issues of bankruptcy law on which the legal analysis depends. Whether a moralist with all the facts would find that the responsibility in fact properly rests with the opinion-giving counsel is doubtful, for we have seen that the legal opinions that are typically rendered in securitization transactions communicate substantial uncertainty about the bankruptcy issues the opinions address. Moreover, the opinions do not typically address other bankruptcy issues that might collapse the securitization structure, such as the fraudulent transfer attack discussed in part II of this paper, so the answer to the question of responsibility may depend upon the precise basis of the court’s adverse ruling. But so far as 462 See, e.g., SEC CRA Report, supra note 403, at 23. 463 See, e.g., Schwarcz, supra note 405. For a discussion of the role of reputational capital in markets, with special reference to rating agencies, see Partnoy, Two Thumbs Down, supra note 405, at 628-36



reputation is concerned, it is doubtful that the world at large would draw these fine distinctions.464 At a minimum, the existence of these legal opinions would do much to blur damage to the reputation of the rating agency. Of course, the same would potentially apply to other financial products rated on the basis of a judgment about an uncertain legal issue that is supported by a hedged legal opinion, as will be discussed later in this paper.

More generally, a notable 1999 paper by Frank Partnoy set forth reasons to question the importance of a rating agency’s reputation for accuracy to its business as to all the debt securities it rates, traditional or structured. 465 Partnoy argues that a rating agency’s reputation for accuracy is of importance to an investor only if the investor wishes to use the information provided by the rating and relies upon the rater’s reputation as a reason to trust the quality of that information. But there is evidence that a security’s rating at any time provides little or no information about the security’s riskiness beyond the information otherwise in the market, which will be reflected in the security’s credit 464 The opinion-giving lawyer may be more concerned about the liability risk he assumes by rendering the opinion than the damage it might cause to his reputation. It is beyond the scope of this paper to discuss in detail the liability risk associated with the rendering of a reasoned legal opinion similar to those typically given in securitization transactions. Based on review of the very few reported cases involving a lawyer’s liability on a third-party legal opinion (that is, an opinion rendered to a person other than the lawyer’s client) and discussion with professionals at insurance carriers and other specialists in the area, the risk of liability on a plausibly reasoned opinion with which a court ultimately disagrees appears to be virtually nil in the absence of bad facts of a kind not likely to be present in the typical securitization transaction: e.g., the opinion-giver assumes facts that he knows or has reason to know are false, or the opinion is being used to facilitate fraudulent disclosure. For recent discussions of liability on third-party legal opinions, see Jonathan M. Barnett, Certification Drag: The Opinion Puzzle and Other Transactional Curiosities, 33 J. CORP. L. 95, 112-18 (2007), and Lipson, supra note 434, at 102-09; for a compilation of the scanty reported case law, see Comm. on Legal Opinions, Am. Bar Ass’n, Section of Bus. Law, Annual Review of the Law on Legal Opinions, 60 BUS. LAW. 1057 (2005).

It should be noted that a secondary effect of the “too big to fail” dynamic is that after the first few times a new financial product is used, a number of legal opinions supporting the product will have been rendered. That will further reduce any liability risk on the part of subsequent opinion-givers, because the standard for liability on a third-party legal opinion is generally thought to be that the opinion-giver “must exercise the competence and diligence normally exercised by lawyers in similar circumstances,” RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS § 52(1) (2000), and an unlucky opinion-giver who is sued on his opinion should be confident about demonstrating compliance with that standard if he can point to close precedents for the very opinion he gave. The same dynamic mitigates reputational damage to the unlucky opinion-giver. The opinion-givers in the first few transactions, by contrast, do not have that added layer of protection, making their role peculiarly entrepreneurial. 465 Partnoy, Two Thumbs Down, supra note 405. The Senate committee that reported on the 2006 legislation characterized this paper as “groundbreaking.” S. REP. NO. 109-326, at 7 n.21 (2006). Notwithstanding that praise, Congress did not adopt Partnoy’s policy prescription, which was to abolish the NRSRO regime and eliminate regulatory dependence upon credit ratings, with the relevant statutes and regulations revised to rely on other measurements of the riskiness of a debt security, such as credit spreads. Other scholars have echoed Partnoy’s prescription. See Rating the Raters, supra note 399, at 144-46 (testimony of Professor Jonathan R. Macey); Rating the Rating Agencies, supra note 399, at 35 (testimony of Professor Lawrence J. White).



spread at that time (that is, the difference between the yield on the security at its current market price and the yield on a virtually risk-free security, such as a U.S. Treasury security, of comparable maturity). Yet ratings are valued and continue to be obtained. Why, then, are ratings valued if they have little or no marginal informational content? Partnoy’s answer is that the principal reason why ratings are valued is not because of their informational content, but rather because numerous laws and regulations refer to ratings issued by a rating agency that qualifies as an NRSRO, and give more favorable regulatory treatment to the holder of a security that is rated highly by an NRSRO than a security that is rated lower or not at all. To say the same thing more briefly, using Partnoy’s terminology, the NRSRO’s rating of a security operates as a regulatory license bestowed by the rating agency on the holder of the security insofar as the holder is subject to rating-dependent regulation. To the extent that investors value the rating not as a source of information but as a regulatory license, it follows that the NRSRO’s reputation for accuracy is of no real importance to its business; all that matters is that it retain its status as an NRSRO.

Whatever else might be said of Partnoy’s analysis, at a minimum it identifies a choice example of the working of the Law of Unintended Consequences. By incorporating NRSROs’ ratings into statutes and regulations, legislators and regulators handed an immensely valuable franchise to the rating agencies, with consequences that surely were not foreseen when the NRSRO concept was created. Although precedents for rating-dependent regulation existed earlier, the NRSRO concept was created by the SEC in 1975 in its net capital rule for broker-dealers, which requires broker-dealers to hold less capital against debt securities they own that are rated investment grade by an NRSRO than against debt securities not so rated.466 The public record leading up to the creation of the NRSRO regime reflects no consideration whatever by the SEC of the wisdom of this delegation of power to the rating agencies. 467 In following years, federal and state legislators and regulators introduced NRSRO ratings into scores of other statutes and regulations in analogous ways, and to all appearances with equally little consideration of the consequences.468 466 17 C.F.R. § 240.15c3-1 (2007). 467 See Exchange Act Release No. 9891, 38 Fed. Reg. 56 (Dec. 5, 1972) (net capital rule as initially proposed; did not include the NRSRO concept); Exchange Act Release No. 10,525, 38 Fed. Reg. 34,331 (Nov. 29, 1973) (revision introducing the NRSRO concept without comment beyond a bare note of the fact); Exchange Act Release No. 11,004, 39 Fed. Reg. 41,546 (Nov. 11, 1974) (further revision); Exchange Act Release No. 11,497, 40 Fed. Reg. 29,795 (June 26, 1975) (final rule). 468 According to PRIVATE-SECTOR WATCHDOGS, supra note 400, at 102, written in 2002, NRSRO ratings are referenced by at least eight federal statutes, 47 federal regulations, and over 100 state laws and regulations. There appears to be no published compilation of ratings-dependent regulations. For overviews, see SEC CRA Report, supra note 403, at 5-10; Partnoy,



The value of the franchise thus created for the rating agencies was increased by the oligopolistic structure of, and high barriers to entry into, the NRSRO market, the result of the SEC’s election to keep the number of NRSROs small and the process for qualifying for designation as an NRSRO opaque.469 Until the 2006 legislation the term “NRSRO” was not defined, and no formal procedure for qualifying for the status existed. The SEC staff simply announced through the issuance of a no-action letter that the staff would recommend that no enforcement action be taken against persons subject to the SEC’s regulations who treat a given rating agency as an NRSRO. When it created the NRSRO concept in 1975 the SEC initially recognized as qualifying only the two dominant rating agencies, Moody’s and Standard & Poor’s, and their perennial smaller competitor, Fitch. Between 1975 and 1991 an additional four small NRSROs were designated, but by 2000 those had been acquired by other NRSROs, leaving only the three originally designated. After the start of the legislative hue and cry following the collapse of Enron in 2001 the SEC found it expedient to designate two more NRSROs, making a total of five by the time the 2006 legislation was enacted. Still, by that time the two dominant rating agencies continued to share about 80% of the industry market as measured by revenues, justifying the reference to the industry as a “duopoly” in the titles of some of the legislative hearings as more than political hyperbole.470

The argument that ratings are not valued for the information they provide (to which the rating agency’s reputation would be important) but rather as regulatory licenses (which requires only NRSRO status) was set forth in Partnoy’s original paper in unqualified form. The absolutist tone of the original paper provoked some commentators to evaluate it in comparably absolute terms.471 That casts the discussion

Two Thumbs Down, supra note 405, at 686-703. Reference to ratings in private arrangements, such as contracts and investment mandates, is also quite common and has the effect of boosting demand for ratings, independent of their informational content, in the same way as does ratings-dependent regulation. 469 The numerous hearings leading up to the 2006 legislation included extensive inquiry into these regulatory barriers to entry. For discussions of these regulatory barriers and the structure of the industry up to the start of the post-Enron legislative hue and cry, see Hill, supra note 405, at 46-65; SEC CRA Report, supra note 403, at 8-10; and White, supra note 397, at 44-47. For the post-Enron NRSRO designations before the enactment of the 2006 legislation, see A.M. Best Co., SEC No-Action Letter, 2005 WL 711823 (Mar. 3, 2005); Dominion Bond Rating Serv. Ltd., SEC No-Action Letter, 2003 WL 402819 (Feb. 24, 2003). 470 See Examining the Role, supra note 399, at 1-2, 4 (noting that Moody’s and Standard & Poor’s share approximately 80% of the market by revenues and they and Fitch share approximately 95%). On “duopoly,” see supra note 399. 471 See, e.g., Carol Ann Frost, Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the Agencies, 22 J. ACCT. AUD. & FIN. (forthcoming Summer 2007), available at http://papers.ssrn.com/abstract=941861 (characterizing Partnoy’s argument as an “extreme” one that “should be interpreted with great care”).



into the wrong terms, for there is no need to choose between the information-and-reputation model and the regulatory license model as descriptions of the rating agencies’ business; the truth might be comprised of some of each. Partnoy later acknowledged this when he noted that he does not deny the importance of reputation to a rating agency’s business.472 The question is not properly “yes or no,” but rather “to what extent.”

Some evidence supports the thesis that reputation is of limited importance to the business of the rating agencies, but the evidence is mixed. For example, direct evidence against the importance of reputation is that demand for ratings and the profitability of the rating businesses has not visibly suffered from well-publicized fiascos in which debt well-rated by the dominant rating agencies promptly went into default.473 Evidence that investors, or a large proportion of them, have little faith in the accuracy of ratings indirectly supports the limited importance of the rating agencies’ reputation, for if investors do not believe in the accuracy of the ratings, they have no reason to care about the reputation of the raters. Surveys of investors in fact show widespread skepticism of ratings.474 On the other hand, there is also significant direct evidence that investors do value ratings as something more than regulatory licenses. For instance, issuers typically purchase two ratings, whereas one rating would suffice to comply with most ratings-dependent regulation. 475 Likewise, the debt market reacts differently to debt with two ratings than to debt with one rating, and reacts differently to ratings by different NRSROs, facts difficult to

472 See Partnoy, Paradox, supra note 405, at 68. Notwithstanding that clarification, Professor Partnoy continues to maintain that the regulatory license model is a more important component of the rating agencies’ business than the information-and-reputation model. Id. at 81. 473 A banner season for such fiascos was 2001-2002, during which at least six occurred (one of them Enron), while revenues and profits of the dominant rating agencies continued to rise afterward. See Examining the Role, supra note 399, at 55-56 (statement of Sean J. Egan); Partnoy, Not Like Other Gatekeepers, supra note 405, at 62-68. For a review of other fiascos, see SINCLAIR, supra note 397, at 149-72. Less dramatic complaints continue. For instance, in 2005 the rating agencies were criticized for rating General Motors and Ford debt investment grade at a time when the market priced that debt at credit spreads equivalent to junk status. See Who Rates The Raters?, THE ECONOMIST, Mar. 26, 2005, at 19. 474 See, e.g., ASS’N FOR FIN. PROF’LS, 2004 CREDIT RATING AGENCY SURVEY 2 (2004), available at http://www.afponline.org/ (reporting that only 60% of organizations surveyed believe the ratings they use for investment purposes are accurate, and 38% believe that the ratings they use for investment decisions are timely); Hill, supra note 405, at 65 & n.110 (citing additional surveys). 475 See Hill, supra note 405, at 66. The two-rating norm is by no means inflexible, however. For example, in the case of what were probably the three earliest public asset-backed securitization transactions, see supra note 11, the first and second were rated only by Standard & Poor’s and the third only by Moody’s. Likewise, until the mid-1980s, Standard & Poor’s was the only agency rating private label (i.e., non-governmentally sponsored) mortgage backed securities; Moody’s began to do so only in 1986. See Cantor & Packer, supra note 38, at 20.



explain under the regulatory license theory.476 At least one study of rating downgrades on traditional debt instruments concluded that such downgrades are motivated by reputational concerns and are not importantly influenced by conflicts of interest.477

An indirect approach to judging the importance of reputation to the rating agencies is to evaluate whether a rating in fact provides useful information to investors. Much of Partnoy’s complaint is devoted to this theme, and he offers a variety of arguments for the limited informational content of ratings, including institutional arguments aimed at showing that the rating agencies’ analysts cannot be expected to outperform investors’ own analysts, and empirical evidence of various types that can be interpreted as showing that ratings have low accuracy.478 This argument must be treated with caution, however, for even if it were established that ratings have little or no informational content beyond the information reflected in the security’s credit spread, that would not establish that investors do not in fact rely upon ratings (and, presumably, value the reputation of the raters accordingly), whether from sheer irrationality, reasons of transaction cost, institutional inertia, or for other reasons. Moreover, in analyzing the informational content of credit ratings it is peculiarly difficult to separate the effect of the rating from other available information, leading to problems of causality that lend themselves to fallacious reasoning. Studies by financial economists to date on the informational content of credit ratings have been inconclusive, with different studies pointing in different directions.479

Evaluating the extent to which investors value ratings for their informational content rather than as a regulatory license is a different study in the case of structured finance transactions—that is, transactions that depend critically on their legal structure, such as securitized debt—than in the case of traditional debt instruments. The information 476 See Hill, supra note 405, at 66 (citing supporting studies). 477 See Daniel M. Covitz & Paul Harrison, Testing Conflicts of Interest at Bond Rating Agencies with Market Anticipation: Evidence that Reputation Incentives Dominate (Board of Governors of the Fed. Reserve Sys., Finance and Economics Discussion Series No. 2003-68, Dec. 2003), available at http://www.federalreserve.gov/Pubs/feds/2003/. 478 See Partnoy, Two Thumbs Down, supra note 405, at 651-81. 479 See, e.g., Arnoud W.A. Boot et al., Credit Ratings as Coordination Mechanisms, 19 REV. FIN. STUD. 81, 81-82 (2006) (“[T]here appears to be fundamental disagreement on whether ratings play a meaningful economic role and, relatedly, whether ratings (and rating changes) have a real informational content. In fact, the empirical evidence surrounding credit ratings seems far from conclusive.”); John Ammer & Nathanael Clinton, The Impact of Credit Rating Changes on the Pricing of Asset-Backed Securities, in STRUCTURED CREDIT PRODUCTS 159, 159 (William Perraudin ed., 2004), available at http://papers.ssrn.com/abstract=567743 (evidence about the importance of credit ratings to debt markets is “conflicting and inconclusive”); Doron Kliger & Oded Sarig, The Information Value of Bond Ratings, 55 J. FIN. 2879, 2899 (2000) (“Is rating information indeed pricing relevant and useful? This question has been the subject of extensive research, but no uniform answer has emerged.”).



required to evaluate the creditworthiness of securities of the former sort and the latter sort differ substantially. Credit evaluation of a debt security backed by a pool of receivables (for example) turns chiefly upon prediction of the cash flow performance of that pool, a subject involving fewer variables and more amenable to purely quantitative analysis than the evaluation of the credit quality of unsecured debt issued by a corporate issuer. 480 Moreover, credit evaluation of securitized debt involves legal judgments about whether the structure will stand up in the Originator’s bankruptcy that are not called for in evaluation of traditional debt. In principle the reliance an investor places upon the factual judgment implicit in a rating might differ from the reliance it places upon the legal judgment implicit in the rating.

To date, much less attention has been paid to investor reliance upon ratings in the context of structured products than in the context of traditional debt, and of that limited attention virtually none has run to the question of the extent to which investors rely upon ratings specifically for the legal judgments implicit in them. A survey of investors conducted under the auspices of the Bank for International Settlements (and hence not limited to United States investors) provides some support for both the information-and-reputation model and the regulatory license model: overall market reliance upon ratings is “somewhat higher” as to structured products than traditional debt, though “not overly so”; on the other hand, for relatively sophisticated investors ratings “merely complement” their own analysis and modeling, and investors acknowledge that at least part of the reason they demand ratings is to comply with regulations or other external constraints rather than as a source of information. 481 Financial economists have done only limited empirical work on the significance of ratings to structured products, but one study on the effect of changes in the rating of certain kinds of structured products on the market price of the securities concluded that market participants may rely on ratings more as a source of information for such securities than for traditional debt securities, at least in the case of downgrades, a conclusion that would seem to lend support to the information-and-reputation model.482 Empirical evidence seems wholly lacking on the extent to which investors rely on ratings for the legal judgment implicit in them. Because it is not customary to make publicly available the bankruptcy-related legal opinions that are delivered to the rating agencies in public

480 For an elaboration of this point, see BIS REPORT, supra note 421, at 14-16. 481 Id. at 3, 22, 42; cf. Aaron Lucchetti & Serena Ng, How Rating Firms’ Calls Fueled Subprime Mess, WALL ST. J., Aug. 15, 2007, at A1 (quoting industry sources to the effect that many institutional investors bought securitized debt backed by pools of subprime mortgages based on their ratings, without analyzing the asset pools themselves). 482 See Ammer & Clinton, supra note 479.



securitization transactions in the United States, at least, independent legal diligence by investors would have to start from scratch, which suggests that investors would not be avid to undertake it.483

Whatever the ultimate strength of Partnoy’s contention that the regulatory license model better describes the rating agencies’ business than the information-and-reputation model, it is of only marginal importance to evaluation of reputation as a constraint on rating agencies’ legal judgments about products they rate. The dominant rating agencies have in fact rated the securitization product on the basis of a more aggressive legal judgment than is supported by the legal opinions they receive. That aggressiveness does not demonstrate any substantial carelessness about their reputations, given the blurring of responsibility that those legal opinions provide. And, as we have seen, the rating agencies’ incentive to make aggressive judgments about uncertain legal issues pertaining to products they rate is potentially much greater than any incentive they might have to bend upward a rating on a traditional debt instrument in order to mollify a given issuer. The weakening of the reputational constraint that follows from the regulatory license model is not essential to a plausible explanation of the rating agencies’ behavior. There is nothing in this analysis that suggests that the same resultant from this vector of forces would not apply to another uncertain legal issue upon which a different widely-usable product depends.

The light touch of regulation imposed on the rating agencies by the 2006 legislation has no direct effect on the ability or incentives of the rating agencies to rate new financial products on the basis of aggressive legal judgments. The main thrust of the legislation is to lower the regulatory barrier to qualification as an NRSRO by making the process for qualification more definite, faster, and more transparent. Qualification by no-action letter is abolished, and any rating agency wishing to qualify as an NRSRO (including those currently qualified) must file and have approved by the SEC an application for qualification.484 The legislation is also much concerned with imposing transparency on NRSROs, as the application must set forth considerable information, including the applicant’s procedures and methodologies for determining credit ratings; the information contained in the application will, in general, be publicly available and must be updated if it becomes 483 Any reasonably sophisticated counsel for a financial institution in the United States today is likely to be familiar with the bankruptcy issues associated with the prototypical securitization transaction, but that was not necessarily the case in the critical early days before the product grew “too big to fail.” Moreover, a transaction today may be considerably more complex than the prototypical transaction. See also Rating the Raters, supra note 399, at 52 (testimony of Steven L. Schwarcz) (“[In a structured finance deal] the legal structure is not known to and certainly not fully understood by most market participants.”). 484 Securities Exchange Act of 1934, §§ 15E(a), 15E(l) (as added in 2006).



materially inaccurate.485 Although the legislation gives the SEC the power to issue rules to prohibit practices by rating agencies it considers to be “unfair, coercive, or abusive,”486 that power is qualified by the emphatic prohibition of any regulation by the SEC of the substance of credit ratings or methodologies for creating ratings.487 Nor does the legislation of its own force interfere with the business model employed by the dominant rating agencies under which the issuer of the rated security pays for the rating, which offers a standing inducement to the rating agencies to be aggressive in their legal judgments about new products.488 The legislation’s reaction to rating agencies’ conflicts of interest consists mainly of the very unexacting requirement that an NRSRO disclose in its application any conflicts of interests to which it may be subject.489 The legislation does grant the SEC broad power to issue rules prohibiting conflicts of interest relating to the issuance of ratings, but the regulations issued by the SEC on the subject show that prohibition of the issuer-pays business model is the furthest thing from its mind. The regulations merely require a rating agency that is paid by issuers to comply with the aforementioned disclosure requirement and to maintain written policies and procedures to “address and manage” the resulting conflict of interest.490

The 2006 legislation might have an indirect effect on rating agency incentives to rate new financial products on the basis of aggressive legal judgments if the legislation results in new NRSROs and the creation of a more competitive market in ratings than has existed heretofore.491 One can only speculate how greater competition would affect the rating business. However, any NRSRO that employs the issuer-pays business model and that aims at a broad rating business would continue to have a strong incentive to rate on the basis of aggressive legal judgments, receiving reasoned legal opinions from issuer’s counsel and rounding the legal uncertainty upward, absent some other fundamental change in the rating business.

485 Id. § 15E(a)(1)(B), (b) (as added in 2006). 486 Id. § 15E(i)(1) (as added in 2006). 487 Id. § 15E(c)(2) (as added in 2006). 488 See supra text accompanying notes 416-420. 489 Securities Exchange Act of 1934, § 15E(a)(B)(vi) (as added in 2006); see also S. REP. NO. 109-326, at 8 (2006). 490 Securities Exchange Act of 1934, § 15E(h)(2) (as added in 2006); CRARA Regulations, supra note 398, 72 Fed. Reg. at 33,622-23 (to be codified at 17 C.F.R. §§ 240.17g-5(a), (b)(1)). 491 As of late 2007, a total of eight firms have been granted NRSRO status pursuant to the 2006 legislation. See U.S. Sec. & Exch. Comm’n, Spotlight on NRSROs (Nov. 14, 2007), http://www.sec.gov/divisions/marketreg/ratingagency.htm.



4. Testing the Hypothesis: Two Predictions

It was sheer coincidence that the two dominant rating agencies

changed their business model from one in which they were paid by subscribers to one in which the issuers of rated securities pay for the ratings in the early 1970s, only a few years before the SEC created the NRSRO concept in 1975. 492 It very well may not have been coincidence that the securitization transactions employing bankruptcy-avoiding structures of the kind discussed in this paper began in the late 1970s and early 1980s.493 The shift to the issuer-pays business model created the inducement for rating agencies to take an optimistic view of uncertain legal issues associated with new financial products they are asked to rate. Absent the dominant rating agencies’ decision to rate securitized debt on the assumption that its structure works as a legal matter, it seems very unlikely that the product would have grown as it has, to the point where it is now in all probability too big to fail. It is natural to consider the extent to which a similar dynamic may apply to products other than securitized debt.

Ratings issued by a rating agency may often involve judgments about legal issues. But it should be relatively rare for the issue to be one as to which the rating decision may effectively shape the law through the operation of the “too big to fail” dynamic. In the first place, the dynamic would apply only if the outcome of the legal issue is uncertain. In the second place, the issue would have to relate to a product that is so widely useable as to be a candidate to grow “too big to fail.”

A theory is nothing unless testable predictions follow from it. By way of testing the hypothesis about the role of rating agencies as de facto lawmakers with respect to securitization, the following discussion identifies two nascent products as to which rating agencies might well prove to be the de facto arbiters of fuzzy law in the same style.

a. Electronic Commercial Paper

One such issue of fuzzy law is the standard for creating and

maintaining electronic commercial paper. “Electronic commercial paper” is a convenient shorthand for a recently-created set of legal artifacts that are digital analogues of certain writings traditionally given privileged status by commercial law. Specifically, the traditional legal

492 On the history of the issuer-pays business model, see supra note 416. 493 See supra text accompanying notes 10-12.



rules pertaining to a writing that constitutes chattel paper under Article 9 of the UCC, a negotiable instrument under Article 3, or a negotiable document of title under Article 7, make much turn on possession of the writing. If a person possesses the writing, and satisfies other conditions, the traditional rules shower him with legal benefits: in the case of chattel paper, the benefits include perfection of his security interest and priority advantages; 494 in the case of a negotiable instrument, priority advantages and the status of a holder in due course (which, if achieved, would afford protection from competing claims to the instrument and freedom from most defenses to payment the issuer might assert against the original payee);495 and in the case of a negotiable document of title, benefits comparable to those of a holder in due course of a negotiable instrument.496

With the march of technology financiers became desirous of saving the cost of storing and retrieving paper documents by dematerializing them into electronic records. Yet financiers were loath to surrender the benefits that the traditional legal rules bestow upon the possessors of paper tokens of these privileged types. On their face those desires are antithetical. The requirement of possession under the traditional rules is no idle formality, but serves the necessary function of assuring that no more than one person at a time can be entitled to the benefits bestowed by those rules. In ordinary circumstances electronic records could not serve that function because they are infinitely reproducible.

Legal ingenuity rose to the occasion in a series of recent statutes, closely patterned on each other, that synthesize these conflicting goals. Each of these statutes authorizes a subset of the documents privileged by these traditional rules to be maintained in the form of electronic records. The critical feature of these statutes is the concept of “control” of the electronic record, which imposes by fiat on the electronic world the same concept of “a unique original” that arises naturally in the traditional world of paper tokens. Generally speaking, these statutes define a person to be in “control” of an electronic record only if a

494 U.C.C. § 9-313(a) (perfection by possession of tangible chattel paper); id. § 9-330 (purchaser of tangible chattel paper who takes possession may qualify for priority over a previously perfected security interest); id. § 9-203(b)(3)(B) (possession of tangible chattel paper may substitute for a written security agreement). 495 Id. § 9-330 (purchaser of negotiable instrument who takes possession, whether or not a holder in due course, may qualify for priority over a previously perfected security interest); id. § 3-305 (holder in due course of a negotiable instrument is not subject to most defenses of the obligor); id. § 3-306 (holder in due course of a negotiable instrument takes free of competing claims to the instrument); id § 9-331 (preserving the rights of a holder in due course under § 3-306 against the holder of a perfected security interest). 496 Id. § 7-502 (in general, holder to whom a negotiable document of title has been duly negotiated acquires good title to the document and to the goods covered by it); id. § 9-331 (preserving the rights that id. § 7-502 gives to a holder against the holder of a perfected security interest).



unique “authoritative copy” of the record exists, that “authoritative copy” identifies the person as its owner of record, and the owner of record identified by that “authoritative copy” cannot be changed without the consent of the current owner of record.497 These statutes award a person who achieves “control” of the record most of the legal benefits that he would have if the record were reified into a writing of which he were in possession.

The prototype of these statutes was Revised Article 9, approved by its sponsors in 1998, which devised the foregoing statutory pattern for application to “electronic chattel paper.” 498 In rapid succession followed three later statutes, of differing scope, each centered on a definition of “control” patterned closely on the definition set forth in Revised Article 9. The broadest of these successor statutes was the 1999 uniform state law on digital signatures, the Uniform Electronic Transactions Act (“UETA”), which applies the concept to “transferable records,” defined to mean an electronic record that, if written, would qualify as a note under UCC Article 3 or a document of title under UCC Article 7. 499 The federal digital signature law enacted in 2000, 497 The definition of “control” of electronic chattel paper in U.C.C. § 9-105 reads as follows:

Section 9-105. Control Of Electronic Chattel Paper. A secured party has control of electronic chattel paper if the record or records comprising the chattel paper are created, stored, and assigned in such a manner that:

(1) a single authoritative copy of the record or records exists which is unique, identifiable and, except as otherwise provided in paragraphs (4), (5), and (6), unalterable;

(2) the authoritative copy identifies the secured party as the assignee of the record or records;

(3) the authoritative copy is communicated to and maintained by the secured party or its designated custodian;

(4) copies or revisions that add or change an identified assignee of the authoritative copy can be made only with the participation of the secured party;

(5) each copy of the authoritative copy and any copy of a copy is readily identifiable as a copy that is not the authoritative copy; and

(6) any revision of the authoritative copy is readily identifiable as an authorized or unauthorized revision.

498 See id. § 9-102(a)(31) (defining “electronic chattel paper”); id. § 9-105 (defining “control” of electronic chattel paper); id. § 9-203(b)(3) (control of electronic chattel paper may substitute for a written security agreement); id. § 9-314 (security interest in electronic chattel paper may be perfected by control); id. § 9-330 (equating control of electronic chattel paper with possession of tangible chattel paper for the purpose of rules giving purchaser of chattel paper priority over a previously perfected security interest). 499 See UETA § 16 (1999) (defining “transferable record,” “control” thereof, and specifying the benefits attendant upon achieving “control”). Under UETA § 16(d), (e), a person who achieves “control” of a “transferable instrument” that would, if written, be a negotiable note under Article 3, is treated as having the same rights as a holder of an equivalent writing under the UCC, and thus can qualify for the benefits given to a holder in due course and also for priority over a previously perfected security interest under U.C.C. § 9-330 (successor to pre-1999 § 9-308, cited by UETA). Rather oddly, “control” of a “transferable record” constituting a note does not confer the benefit of perfection of a security interest in the transferable record, a benefit that the holder of an equivalent written negotiable note of course would have under U.C.C. § 9-313(a). The comments to UETA suggest that, as a result, a person who takes control of a



commonly referred to as “E-Sign,” contains a concept of “transferable record” that closely tracks UETA, though limited to mortgage notes.500 Most recently, UCC Article 7 was revised in 2003 to accommodate “electronic documents of title.”501 Each of UETA, E-Sign and Revised Article 7 copies the definition of “control” set forth in Revised Article 9 almost verbatim, with one substantive difference: in Revised Article 9 that definition is exclusive, while in the three later statutes that definition (with insignificant editorial changes) is a safe harbor to a brief vague general definition of “control.” Given the vagueness of the general definition and the complete novelty of the subject, it is doubtful what content, if any, a court would deem the general definition to have beyond the safe harbor, so a prudent financier relying upon those statutes in all likelihood would seek the shelter of the safe harbor.502 For practical purposes, therefore, compliance with the definition of “control” first set forth in Revised Article 9 is likely to be vital as to electronic commercial paper governed by any one of these four statutes.

There is a fundamental problem with that definition of “control,” however: it is doubtful that the definition can be satisfied if its language is read literally. The definition requires that the electronic record must be “created, stored and assigned” in such a way that, among other things, “a single authoritative copy” of the record exists which is “unique, identifiable and, [subject to certain exceptions], unalterable.”503 Other copies may exist, but they must be identifiable as not being the “authoritative copy.” That language, most naturally read, would require that, among other things, it be impossible to copy the “authoritative copy.”504 But it does not seem to be the case that a digital

transferable record may be defeated by a trustee in bankruptcy of a person previously in control unless perfection has been achieved independently by filing or the taker qualifies as a holder in due course. See UETA § 16, cmt. 6. UETA has been enacted by 46 states as of late 2007. 500 See Electronic Signatures in Global and National Commerce Act (“E-Sign”), Pub. L. No. 106-229, § 201, 114 Stat. 464 (2000) (codified at 15 U.S.C. § 7021) (defining “transferable record” and “control” thereof, and specifying the benefits attendant upon achieving “control”). 501 See U.C.C. § 1-201(b)(16) (defining “document of title” and “electronic document of title”); id. § 7-106 (defining “control” of electronic document). The pivotal substantive provision, id. § 7-502, which gives the holder of a negotiable document of title priority over competing claims to the document and the goods it covers, was spread by the revision to apply to a person in control of a negotiable electronic document of title mainly through amendments to definitional provisions upon which § 7-502 depends, chiefly § 7-501(b) (defining how to negotiate a negotiable electronic document of title), and id. § 1-201(b)(15) (defining “delivery”). Revised Article 7 has been enacted by 28 states as of late 2007. 502 See, e.g., R. David Whitaker, Rules under the Uniform Electronic Transactions Act for an Electronic Equivalent to a Negotiable Promissory Note, 55 BUS. LAW. 437, 449 n.51 (1999) (“[S]traying too far from the [safe-harbor standard] is not advisable for anyone seeking certainty in the application of [UETA] § 16.”). 503 U.C.C. § 9-105. As noted in the text, the same language appears in the safe-harbor definitions of “control” in UETA § 16(c), E-Sign § 201(c), and U.C.C. § 7-106(b). 504 For brevity, the present discussion focuses on the requirement that the authoritative copy be “unique,” but the impossibility of preventing by technological means error or fraud by those



file can be rendered impossible to copy with current technology or any technology in prospect. A person operating a computer can generate as many copies as he likes of a given file stored on that computer. It is not difficult to detect improper copying by an outside party, such as a person who obtains a printout of the electronic record and from it reverse engineers a duplicative electronic record; so-called “digital watermarks” embedded in the printout would permit identification of such a copy as a duplicate. But the practical threat of improper copying of electronic commercial paper comes not from outsiders, but rather from insiders—that is, persons who have access to the digital file that constitutes the authoritative copy and who misuse that access. The most notable frauds involving old-fashioned written commercial paper were all perpetrated by insiders who had access to the originals.505 There is no reason to expect superior virtue to prevail among insiders who have access to electronic commercial paper. Indeed, an iniquitous insider having access to electronic commercial paper has an advantage over his paper-bound predecessor, as an electronic record, unlike a written document, can be duplicated with absolute perfection. Software controls on copying installed on the computer normally used to access the digital file would be ineffective against an insider who has custody of the physical medium on which the file is stored, if he uses a different computer, or different software on the same computer, to circumvent those controls.

The fact that “control” of electronic commercial paper calls for protection against error or malfeasance by insiders radically distinguishes this subject from most topics of discourse in the realm of electronic commerce, which center upon protection against malfeasance by outsiders—hackers, or end-users who attempt wrongfully to copy protected content. Though fundamental, the distinction has been widely overlooked or minimized. Thus, one academic commentator suggested that computer systems can be built that are capable of restricting access to resources stored in the computer, relying on principles of system security developed by U.S. government security experts during the Cold War.506 In fact, the authority cited for that proposition deals exclusively

entrusted with running the system bears equally on satisfaction of other elements of the definition of “control.” 505 Thus, for instance, until its collapse in 1996, Bennett Funding Group, Inc. raised hundreds of millions of dollars from fictitious and double-financed lease chattel paper, in substantial part simply by photocopying originals. See Report of Richard C. Breeden, Trustee, Submitted Pursuant to 11 U.S.C. § 1106, In re Bennett Funding Group, Inc., No. 96-61376, at 28-37 (Bankr. N.D.N.Y. Dec. 30, 1998). The massive fraud at O.P.M. Leasing Services, Inc., uncovered in the early 1980s, involved analogous fabrication and duplication of lease chattel paper. See STEPHEN FENICHELL, OTHER PEOPLE’S MONEY 98-99 (1985). 506 Jane K. Winn, What is a Transferable Record and Who Cares?, 7 B.U. J. SCI. & TECH. L. 203, 211 (2001).



with security against outside hackers.507 A cautionary lesson can be learned from actual experience with a system that (one hopes) was near the pinnacle of Cold War security: for many years during the height of the Cold War the technical locks (so-called “permissive action links”) that prevented unauthorized launches of American nuclear-tipped intercontinental missiles had the unlock code set to all zeros. The Strategic Air Command quietly so ordered its launch crews, evidently being less concerned about unauthorized launches than about the potential for this safeguard to interfere with implementation of wartime launch orders.508 The moral, of course, is that a system can be no more secure than the persons entrusted with running the system are faithful.

The infelicity of the definition of “control” of electronic chattel paper is not surprising when it is considered that this language received only a brief public airing before it was set in stone. The addition of electronic chattel paper to Revised Article 9 was not contemplated at the outset of the revision process, and it first appeared in drafts only a few months before the revision was approved by the UCC’s sponsors.509

The official comments to Revised Article 9, when eventually released after the sponsors’ approval of the statutory text, salvage the statutory definition of “control” by declaring that it should be read in a somewhat artificial way. The comments implicitly recognize that satisfaction of the “control” requirements does not require that it be impossible to violate those requirements. Rather, the comments in effect require only that there be a degree of practical assurance that the “control” requirements will in fact be complied with, and thus (among other things) that the persons who have physical dominion over the electronic record will not err or breach their trust. How that is to be done is left open. 510 The comments rely on “the marketplace” to develop suitable methods of compliance, but that avowal delivers less flexibility than it may seem to promise, as the comments go on to say that parties are not free to establish control simply by agreeing that the

507 Michael Lee et al., Electronic Commerce, Hackers and the Search for Legitimacy: A Regulatory Proposal, 14 BERKELEY TECH. L.J. 839, 850-55 (1999) (cited in Winn, supra note 506). 508 See Bruce Blair, Bruce Blair’s Nuclear Column: Keeping Presidents in the Nuclear Dark (Feb. 11, 2004), http://www.cdi.org/blair/permissive-action-links.cfm. Dr. Blair was a missile launch officer in the Air Force during the early 1970s, when the policy described was still in force. 509 “Electronic chattel paper” (originally called “intangible chattel paper”) and the concept of “control” thereof first appeared in the January 1998 draft of Revised Article 9. Revised Article 9 was approved by the UCC’s sponsors, the American Law Institute and the National Conference of Commissioners on Uniform State Laws, in May 1998 and July 1998, respectively. For further observations on this history, see Jane Kaufman Winn, Electronic Chattel Paper under Revised Article 9: Updating the Concept of Embodied Rights for Electronic Commerce, 74 CHI.-KENT L. REV. 1055, 1057-58 (1999). 510 U.C.C. § 9-105, cmt. 4.



elements of control are satisfied.511 “Control” thus is not left to the agreement of the interested parties; it is to have some irreducible objective content that courts are to police. Achievement of control, the comments say, may be through “a combination of suitable technologies and business practices.”512 This suggests that some combination of technological safeguards (along the lines of software that would render improper copying or tampering difficult or that would automatically maintain an audit trail), plus institutional safeguards (such as maintenance of the record by an independent custodian), ought to suffice.513 But the comments give small guidance as to the necessary type and degree of protection, beyond an adjuration that “the standards applied to determine whether a party is in control of electronic chattel paper should not be more stringent than the standards now applied to determine whether a party is in possession of tangible chattel paper”—a comparison of apples to oranges if ever there was one.514

The legal question of what steps suffice to establish “control” of electronic commercial paper under these statutes is a prime candidate to be resolved by acceptability to the rating agencies. As with other financial assets today, electronic commercial paper is likely to wind up in a securitization pool backing rated securities. The rating agencies are well aware of the legal uncertainty associated with the concept of control, and have indicated that they will require a satisfactory legal opinion that control exists in any transaction involving a significant quantity of electronic commercial paper.515 The legal opinion rendered in what appears to be the first such rated transaction is—

511 Id. (“[A]chieving control under this section requires more than the agreement of interested persons that the elements of control are satisfied. For example, paragraph (4) contemplates that control requires that it be a physical impossibility (or sufficiently unlikely or implausible so as to approach practical impossibility) to add or change an identified assignee without the participation of the secured party (or its authorized representative). It would not be enough for the assignor merely to agree that it will not change the identified assignee without the assignee-secured party’s consent.”). 512 Id. See also UETA § 16, cmt. 3 (1999). 513 Certainly commentators engaged with these legal artifacts think so. See, e.g., Winn, supra note 509, at 1064-66; The ABA Cyberspace Comm. Working Group on Transferable Records, Emulating Documentary Tokens in an Electronic Environment: Practical Models for Control and Priority of Interests in Transferable Records and Electronic Chattel Paper, 59 BUS. LAW. 379, 385-89 (2003); The Working Group on Transferability of Electronic Financial Assets et al., Framework for Control over Electronic Chattel Paper—Compliance with UCC §9-105, 61 BUS. LAW. 721 (2006). 514 U.C.C. § 9-105, cmt. 4. One might question whether this “no more stringent than paper” standard is consistent with the “physical impossibility (or sufficiently unlikely or implausible so as to approach practical impossibility)” standard mentioned earlier in the comment, as quoted supra note 511. One might also question whether the “no more stringent than paper” standard is sound policy, as circumvention of the “control” requirements potentially could result in skullduggery as to a whole portfolio of electronic chattel paper in one swoop, while duplication of or other tampering with a writing must occur one document at a time. 515 See S&P LEGAL CRITERIA, supra note 78, at 67-68.



understandably, given the preceding discussion—a lengthy reasoned opinion, reminiscent of the treatise-like opinions given on the bankruptcy aspects of securitization. 516 And, as with those bankruptcy opinions, the conventions of opinion-giving impose upon the rating agencies, as recipients of such an opinion, the burden of satisfying itself as to the conclusions stated therein. 517 In all probability, further transactions will be rated with increasing frequency as the nascent electronic commercial paper industry begins to mature. Depending upon how the industry evolves and how concentrated it becomes, it may be the case that only a small number of electronic commercial paper systems will be in operation, in which case a judicial ruling that a particular system did not achieve “control” in a case arising after the insolvency of one user of the system would necessarily imply that all the other users of the system would lack “control” as well, resulting in downgrade of all rated securities backed by electronic commercial paper maintained through that system, with disastrous effect on the holders of those securities. Even if the industry does not achieve a high degree of concentration, the techniques relied upon by different system operators may well be sufficiently similar that a judicial ruling that a given system is insufficient would likewise apply to other systems, likewise resulting in downgrade of the rated securities backed by electronic commercial paper maintained through such other systems.

Thus the same “too big to fail” dynamic that applies to the bankruptcy isolation issues upon which securitization is founded is poised to apply to the definition of “control” of electronic commercial paper. After a sufficiently large quantity of securities are outstanding that have been rated on the assumption that “control” has been achieved, a court is increasingly unlikely to rule to the contrary and thereby cause a downgrade of those securities ruinous to their holders. Much is likely to depend upon the happenstance of how soon in the product cycle such litigation arises. But the longer the product evolves on its own, and the larger the quantity of rated securities issued in reliance upon a given approach to “control,” the less likely it is that a court would upset the expectations and investments based on that reliance.

516 See Prospectus Supplement, Nissan Auto Receivables 2006-C Owner Trust (July 25, 2006). Following the same practice customarily applied to legal opinions pertaining to bankruptcy isolation, the elaborate legal opinion on “control” in that transaction has not been made publicly available, but its author kindly permitted me to review a redacted copy. 517 See supra Part III.A.2.



b. Exploiting the Privileged Status in Bankruptcy of

Financial Markets Contracts A second emerging issue that rating agencies may be placed to

resolve, as a practical matter, through their ability to invoke the “too big to fail” dynamic, is the scope of the provisions of the Bankruptcy Code that give specially favorable treatment to certain financial markets contracts. The vagueness of the definition of one of those favored contracts, “swap agreements,” coupled with changes made by the 2005 and 2006 amendments to the Bankruptcy Code and some fundamental facts of financial life, together present the possibility that transactions equivalent to a secured loan might escape the Bankruptcy Tax by being structured to fit within those protective provisions.

Congress has provided broad exceptions from most of the ordinary consequences of bankruptcy for various classes of financial markets contracts, and has seen fit to add to those favored classes from time to time. The Bankruptcy Code of 1978 gave that privileged treatment to “commodity contracts” and “forward contracts”; to these favored classes were added “security contracts” in 1982, “repurchase agreements” in 1984, and finally “swap agreements” in 1990.518 The core benefits conferred by each exemption, though refined and expanded by subsequent amendments, have not changed in essentials since each was enacted. First, if a debtor that is party to such a transaction becomes subject to a case under the Bankruptcy Code, the counterparty may exercise contractual rights to terminate the transaction, net out any termination settlements, and exercise remedies against collateral held by the counterparty, all without regard to the automatic stay.519 Second, a prepetition transfer of money or other property to the counterparty in connection with the transaction is 518 A separate set of protective provisions applies to each of these classes of protected transactions, and the protective provisions applicable to each are scattered throughout the Bankruptcy Code. For swap agreements, the main protective provisions are Bankruptcy Code §§ 101(53B), (53C), (22A) (defining “swap agreement,” “swap participant,” and “financial participant”), § 362(b)(17), 362(o) (exempting from the automatic stay and other Bankruptcy Code stays setoffs and realization against collateral pertaining to swap agreements), §§ 546(g), 548(d) (exemptions from avoidance), and § 560 (protecting the exercise of rights to terminate and accelerate swap agreements and to offset termination payments relating thereto). For a detailed survey of the provisions of the Bankruptcy Code and bank and thrift insolvency laws applicable to each class of protected transactions under current law, see Seth Grosshandler et al., Securities, Forward and Commodity Contracts and Repurchase, Swap and Master Netting Agreements under U.S. Insolvency Laws (Apr. 18, 2007), in ADVANCED SWAPS AND OTHER DERIVATIVES IN 2007 (Practicing Law Institute 2007). 519 Bankruptcy Code §§ 362(b)(6), 362(b)(7), 362(b)(17), 555, 556, 559, 560. A caveat is that under §§ 555 and 559 these benefits are not available to the counterparty of a repurchase agreement or securities contract with an insolvent stockbroker that is liquidated under the Securities Investors Protection Act.



effectively immune from avoidance unless made with actual fraudulent intent.520 The 2005 amendments to the Bankruptcy Code harmonized the protective provisions applicable to each privileged class with each other and with parallel provisions applicable to insolvent banks and thrift institutions, and extended their scope in many respects (being especially concerned with ensuring that parties may enforceably agree that termination settlements may be netted among all protected classes of financial markets contracts).521 Further revisions, billed as “technical changes” to the 2005 amendments, were enacted without hearings or fanfare in 2006.522

These benefits are, of course, applicable only to a transaction that falls into one of the privileged categories. Moreover, the Bankruptcy Code limits the availability of these benefits to particular kinds of counterparties. In the case of securities contracts, commodity contracts, and forward contracts that limitation has some bite, as the Bankruptcy Code generally limits the full range of benefits to narrowly-circumscribed classes of financial professionals (though the 2005 amendments expanded the class of protected counterparties to include any sufficiently large and active participant in financial market contracts of the protected types).523 The limitation is illusory in the case of swap agreements and repurchase agreements, however, as the definitions of the protected counterparties in transactions of those types include any counterparty.524

An extension of credit could be made in the form of a transaction that very plausibly fits within one of these exemptions, or through a set of exempted transactions. The fuzzy definitions of key terms used in these exemptions, notably “swap agreement,”525 supply one basis for that conclusion. The Bankruptcy Code defines that term at considerable length, and the 2005 and 2006 amendments added still more verbiage, but the definition is largely vacuous because it consists mostly of a long list of popular names of products that are to be included within the definition. Those terms are not themselves defined, and so presumably 520 Bankruptcy Code §§ 546(e), (f), (g), 548(d), 553. 521 The 2005 amendments were enacted as Title IX of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat. 23 (2005) (“BAPCA”), which amend scattered sections of the Bankruptcy Code. For an overview of the amendments in an historical perspective, see Michael A. Krimminger, The Evolution of U.S. Insolvency Law for Financial Market Contracts (June 13, 2006), available at http://ssrn.com/abstract=916345. 522 Financial Netting Improvements Act of 2006, Pub. L. No. 109-390, 120 Stat. 2692 (2006). “Technical changes” is the characterization of the House report on the bill as introduced, H.R. REP. NO. 109-648, at 1 (2006). 523 The 2005 amendments achieve this result by entitling a “financial participant” to protection in transactions of these types, and Bankruptcy Code § 101(22A) defines “financial participant” to include, among other, any entity that is party to a specified volume of financial markets contracts. 524 Bankruptcy Code § 101(46) (defining “repo participant”); id. § 101(53C) (defining “swap participant”). 525 Bankruptcy Code § 101(53B).



will have whatever meanings players in the market choose to give them. Moreover, the list is not exclusive, as “other similar agreements” are also to be included within the definition, so long as those “other similar agreements” are “of a type that has been, is presently, or in the future becomes, the subject of recurrent dealings in the swap market.”526 Read literally this language cedes the content of the definition to the players in the market.

Even without any stretching of definitions, however, it is a fact of financial life that a combination of undisputedly exempt financial contracts can have net cash flows that are exactly equivalent to a loan.527 The whole derivatives market is an exercise in selling cash flows that are geared to any eventuality or contingency that one can name, and a set of cash flows equivalent to a loan is simply one more for financial engineers to deconstruct.

Congress was at least dimly aware of some of the foregoing facts before enacting the 2005 amendments to the Bankruptcy Code. The legislative history of those amendments contains a pious adjuration to the effect that the benefits given by the swap exemption should not be extended to “non-financial market transactions, such as commercial, residential or consumer loans . . . because the parties purport to document or label the transactions as ‘swap agreements.’”528 But even if weight is given to this legislative history in the teeth of statutory provisions that contain no such qualification, the quoted statement gives no clue as to how the line is to be drawn between a financial markets contract that just happens to involve an extension of credit, and a “commercial loan.” More fundamentally, the quoted statement merely purports to say that no “commercial loan” that is documented as a swap agreement should be treated as a “swap agreement” for bankruptcy purposes. It does not purport to deny favored treatment for bankruptcy purposes to a set of financial market contracts that, taken together, have the economic characteristics of a loan.529 526 Bankruptcy Code § 101(53B)(ii)(I). Formally an “other similar agreement” must also satisfy further conditions set forth in clause (II) of § 101(53B)(ii) in order to qualify as a “swap agreement,” but clause (II) is so broad and so vague that it is difficult to imagine a financial transaction that would not satisfy its terms. 527 For examples, see Edward R. Morrison & Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 AM. BANKR. INST. L. REV. 641, 653-59 (2005). 528 H.R. REP. NO. 109-31, at 129 (2005). 529 The 2005 amendments to the Bankruptcy Code pertaining to financial markets contracts were first introduced in Congress (in form slightly different than ultimately enacted) in the Financial Contract Netting Improvement Act of 1998, H.R. 4393, 105th Cong. (1998), and the Business Bankruptcy Reform Act, S. 1914, 105th Cong. (1998). A report was issued on the House bill, and the report contains the same language warning against extension of the swap exemption to “non-financial market transactions” as is quoted from the House report on the 2005 amendments as finally enacted. H.R. REP. NO. 105-688, at 14 (1998). The report also states that the 1998 act implements legislative proposals forwarded to Congress by the principal federal



The notion of dressing up an extension of credit in the form of one or more financial markets contracts was current before the 2005 amendments to the Bankruptcy Code.530 But it had a relatively quiet and somewhat disreputable existence, in its raw form being associated with more or less fraudulent attempts to disguise the making of a loan rather than an honest open attempt to exploit the benefits given to financial markets contracts by the Bankruptcy Code.531 No doubt that is because the practical scope for exploiting those bankruptcy benefits before the 2005 amendments was rather slender. To be sure, a financier who entered into one or more financial markets contracts collectively comprising a loan, or a transaction close to a loan, with a counterparty who later went bankrupt, would be pleased to have the prepetition transfers it receives enjoy immunity from avoidance on a theory of preference or constructive fraud. But of greater interest to such a financier would be the ability to exercise remedies against collateral securing that obligation without being prevented by the automatic stay. Before the 2005 amendments a party to a swap agreement (for instance) was exempt from the automatic stay only against “cash, securities, or other property of the debtor held by or due from such [party]” to secure the swap agreement.532 The “held by” requirement practically limited the stay exemption to pledged collateral in the form of securities and other financial instruments.

The 2005 and 2006 amendments expanded this exemption from the automatic stay to a spectacular degree. As amended in 2005, the exemption applied to “cash, securities, or other property held by, pledged to, under the control of, or due from” the solvent counterparty that secures the debtor’s obligation under an eligible financial markets financial regulatory agencies, acting together as the President’s Working Group on Financial Markets. Id. at 1. Hearings were held on both of these bills, at which representatives of some of the federal financial regulators testified, but none of them discussed this point. 530 See, e.g., Harold S. Novikoff, Special Bankruptcy Code Protections for Derivatives and Other Capital Market Transactions, in UNDERSTANDING THE BUSINESS, BANKRUPTCY AND SECURITIES ASPECTS OF DERIVATIVES 117 (Practicing Law Institute 1995) (noting this point but venturing no answer). 531 Thus, for example, the examiner in the Enron Corp. bankruptcy noted that Enron had engaged in structured commodities sales transactions that effectively amounted to approximately $5 billion in debt for the purpose of understating the debt it reported on its financial statements. See Second Interim Report of Neal Batson, Court-Appointed Examiner at 58-66, In re Enron Corp., No. 01-16034 (Bankr. S.D.N.Y. January 21, 2003) (discussing so-called “prepay transactions”). Likewise, in 1996 Sumitomo Corp. alleged that two major banks made loans through a “rogue trader” at Sumitomo that were structured as copper swaps specifically to help disguise the unauthorized activity from the trader’s superiors. See Michael S. Bennett & Michael J. Marin, The Casablanca Paradigm: Regulatory Risk in the Asian Financial Derivatives Markets, 5 STAN. J. L. BUS. & FIN. 1, 32-33 (1999). 532 For swap agreements, see Bankruptcy Code § 362(b)(17) (as constituted before the 2005 amendments). Similar language appeared in the exemptions to the automatic stay applicable to other financial markets contracts. See Bankruptcy Code § 362(b)(6), (7) (as constituted before the 2005 amendments).



contract.533 The legislative report accompanying the legislation stated that this broader language was intended to apply to receivables owned by the debtor which the debtor uses to secure its obligations under the swap agreement.534 Indeed, the legislative report can be read to say that the statutory language was intended to exempt from the automatic stay the enforcement of a security interest in any collateral securing an obligation under a financial market contract. 535 The 2005 statutory language, even read optimistically, would hardly seem to bear that unfettered construction. But that mismatch between legislative report and statutory language was speedily fixed by the 2006 amendments, which rewrote these provisions in a way that now exempts from the stay, simply and broadly, the enforcement of a security interest in collateral of any kind securing an obligation under a financial markets contract.536 533 Bankruptcy Code § 362(b)(17) (as constituted after the 2005 amendments but before the 2006 amendments). Similar language appeared in the exemptions to the automatic stay applicable to other financial markets contracts. See Bankruptcy Code §§ 362(b)(6), (7) (as constituted after the 2005 amendments but before the 2006 amendments). 534 H.R. REP. NO. 109-31, at 132 (2005) (“Subsection (d) [of BAPCA § 907, which amends the various provisions of Bankruptcy Code § 362(b) that exempt from the automatic stay actions in connections with financial markets contracts] also clarifies that the provisions protecting setoff and foreclosure in relation to [financial markets contracts] free from the automatic stay apply to collateral pledged by the debtor but that cannot technically be ‘held by’ the creditor, such as receivables and book-entry securities, and to collateral that has been repledged by the creditor and securities re-sold pursuant to repurchase agreements.”). 535 H.R. REP. NO. 109-31, at 132 (2005) (“Subsection (d) [of BAPCA § 907] amends section 362(b) of the Bankruptcy Code to protect enforcement, free from the automatic stay, of setoff or netting provisions in swap agreements and . . . in security agreements or arrangements related to one or more swap agreements . . . . This provision parallels the other provisions of the Bankruptcy Code that protect netting provisions of [other financial markets contracts]. Because the relevant definitions include related security agreements, the references to ‘setoff’ in these provisions, as well as in section 362(b)(6) and (7) of the Bankruptcy Code, are intended to refer also to rights to foreclose on, and to set off against obligations to return, collateral securing [financial markets contracts].”) (emphasis added). 536 Bankruptcy Code §§ 362(b)(6), (7), (17) (as constituted after the 2006 amendments). The three exemptions are similarly worded; paragraph (17), applicable to swap agreements, reads as follows:

(17) under subsection (a) of this section, of the exercise by a swap participant or financial participant of any contractual right (as defined in section 560) under any security agreement or arrangement or other credit enhancement forming a part of or related to any swap agreement, or of any contractual right (as defined in section 560) to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with 1 or more such agreements, including any master agreement for such agreements;

The reference to the definition of “contractual right” in § 560 does not appear to be limiting. The House report on the 2006 amendments states flatly that this language is intended to “protect enforcement, free from the automatic stay, of collateral, setoff or netting provisions” in financial markets contracts and security agreements pertaining thereto, “including self-help foreclosure-on-collateral rights.” H.R. REP. NO. 109-648, at 7 (2006). The exemption as written would seem to apply to exercise of judicial remedies against collateral as well as self-help. As used in the Bankruptcy Code, “security agreement” of course includes a mortgage on real property. See Bankruptcy Code § 101(50).



The 2005 amendments crowned the favors showered on a counterparty to a swap agreement with a bankrupt debtor with a remarkable one: the counterparty’s failure to perfect a security interest in collateral that secures the debtor’s obligations under a swap agreement now is not a basis for avoiding that security interest under the trustee’s strong-arm power. This point is not heralded in the legislative history, but it follows from other quiet rewordings effected by the amendments, chiefly the revision of the definition of “swap agreement” to include any security agreement that secures an obligation under a swap agreement. 537 This benefit is probably of negligible practical benefit to a counterparty compared with the exemption from the automatic stay and other benefits previously mentioned, as a counterparty would be foolish to neglect to perfect its security interest lest a competing secured party or lien creditor obtain priority over the counterparty’s unperfected security interest.538 But the point has great symbolic significance, as it advertises in the most blatant way that a creditor who qualifies for the “swap agreement” exemption is exalted above even the most basic of the bankruptcy constraints that bind creditors of lesser breeds.

The result is a low-hanging fruit, waiting to be plucked by an aggressive financier. Financier and customer would enter into one or more financial markets contracts that, collectively, constitute the economic equivalent of a loan (or, perhaps, with a slight difference introduced in deference to the language in the legislative history that frowns on too-bald an equivalence). Customer would secure its obligations under those contracts with a simple grant of a security interest in collateral of any kind. If the customer ever were to file for bankruptcy, the financier could exercise its remedies against the 537 Bankruptcy Code § 546(g), as amended in 2005, exempts from the trustee’s avoidance power under § 544, as well as virtually all other avoidance powers (excepting avoidance on the basis of a fraudulent transfer made with actual fraudulent intent), any “transfer, made by or to a swap participant . . . under or in connection with any swap agreement and that is made before the commencement of this case.” Bankruptcy Code § 101(53B)(vi) includes within the definition of “swap agreement” any “security agreement or arrangement or other credit enhancement related to any agreements or transactions referred to in [the other clauses of the definition of ‘swap agreement’].” Before the 2005 amendments “swap agreement” was not defined to include a related security agreement, and § 546(g) exempted from avoidance only a transfer “under a swap agreement,” which led practitioners to document associated security interests by building them into the same document that evidenced the swap agreement, in order to support the argument that collateral transfers would therefore be “under [the] swap agreement.” 538 Moreover, it might be argued that the unperfected counterparty is not protected against the debtor’s bankruptcy trustee. After the 2005 amendments, it seems clear that under Bankruptcy Code § 546(g) the debtor’s bankruptcy trustee may not “avoid” under the strong-arm power of § 544(a) a transfer under a security agreement that secures a swap agreement. But § 544(a) does not merely vest the trustee with the power to avoid a security interest that is avoidable by a hypothetical lien creditor; it also gives the trustee “the rights and powers” of a hypothetical lien creditor and so, arguably, gives the trustee the rights of a superior lienholder against the counterparty’s unperfected security interest.



collateral without regard to the automatic stay. The result is much the same as would be reached through the structure of a securitization transaction, but it avoids the transaction costs associated with establishment and maintenance of a special-purpose entity, as well as such legal risks as substantive consolidation.

It remains to be seen whether the 2005 and 2006 amendments will induce financiers to exploit aggressively the financial contracts provisions of the Bankruptcy Code, along the foregoing lines, to avoid the Bankruptcy Tax in secured lending transactions. Quite possibly the legal and economic attractions of this novel approach will prove insufficient to outweigh the comfort of the familiar and much-used securitization technique. But if this novel approach does gain traction, supported by heavily-reasoned opinions of reputable law firms sufficient to induce acceptance by rating agencies, in the same way as occurred with securitization, one might well expect to see this technique grow “too big to fail,” just as occurred with respect to securitization, absent a failure early in the product cycle that brings the matter to litigation before it becomes too well established. Preliminary rumblings are already audible, as one of the major rating agencies in late 2006 revised its guidelines on legal requirements for rating structured finance transactions to proclaim its willingness to “consider” rating transactions as bankruptcy-proof based on employment of financial contracts provisions of the Bankruptcy Code as thus amended.539

IV. SECURITIZATION: A NORMATIVE ASSESSMENT

Heretofore this paper for the most part has been descriptive, both

as to securitization and as to its place in the stream of legal innovation. If securitization truly is “too big to fail,” then it is here to stay, and normative evaluation of the product might be thought pointless. That is perilously close to nihilism. Normative evaluation is justified as an act of faith, if nothing else.

At least one scholar has argued that securitization is economically efficient, and can be proven to be so though relatively simple models of a high degree of generality; and in a glide from “is” to “ought” that has become a familiar move in the law-and-economics minuet, this asserted

539 S&P LEGAL CRITERIA, supra note 78, at 29, added to the 2006 edition a discussion of the 2005 amendments that concludes as follows: “As a result of these new amendments, it might be possible to structure a securitization transaction without considering the bankruptcy risk of the transferor, even if the assets are not transferred in a true sale. Standard & Poor’s will consider proposals to structure securitization transactions based on the Bankruptcy Code Amendments.” See also Jim Croker et al., Into the Lite, INT’L FIN. L. REV., Feb. 2007, at 13 (the 2005 and 2006 amendments to the Bankruptcy Code “have created a boom in derivative-driven structures”).



efficiency is argued to be sufficient justification for the product.540 A priori efficiency arguments of that sort are doomed to failure. They are merely transpositions into a minor key of the larger question of the efficiency of secured credit. By relieving the financiers of the burden of the Bankruptcy Tax, securitization does no more than enhance the rights of secured creditors. Analysis of the efficiency of securitization thus involves the same parties and interests that are involved in analyzing the efficiency of secured credit, but with smaller stakes: in the case of securitization, the stakes are the Bankruptcy Tax; in the case of secured credit, the stakes are the whole bundle of rights possessed by a secured creditor. Academics have debated the economics of secured credit at great length for more than twenty-five years, and one result that is reasonably clear is that the case for its efficiency is indeterminate. Plausible models show that, in principle, an efficiency gain can be attributed to secured transactions, but data do not exist (and are not likely to exist) to show definitively that gains outweigh losses.541 There is no reason to expect a more definitive answer to the efficiency argument when the stakes are the comparatively small ones involved in securitization than in the case of secured credit as a whole. Normative arguments about securitization, as about secured credit, therefore must rest upon more empirical and pragmatic bases.542

Pragmatic consideration begins with the most striking fact about securitization: namely, the almost complete absence of litigation challenging the legal underpinnings of the product during the period of more two decades since it came into use. As previously noted, the only adjudicated challenge to securitization that has been reported was in LTV Steel,543 and that litigation was anything but definitive: it went no further than a bankruptcy court’s denial of a securitization financier’s 540 See Schwarcz, Post-Enron, supra note 20, at 1553-69. Other commentators evaluating the efficiency of securitization have reached the opposite or indeterminate conclusions. See supra notes 24-27. 541 This point was definitively established in Paul M. Shupack, Solving the Puzzle of Secured Transactions, 41 RUTGERS L. REV. 1067 (1989). See also, e.g., Robert E. Scott, The Truth About Secured Financing, 82 CORNELL L. REV. 1436, 1462 (1997) (“[S]ecured credit is a regime of offsetting effects—some efficiencies and some inefficiencies—in a combination that is largely unknown and is likely to remain an uncertainty for the foreseeable future.”). The voluminous literature on the efficiency of secured lending is generally considered to have begun with Thomas H. Jackson & Anthony T. Kronman, Secured Financing and Priorities Among Creditors, 88 YALE L.J. 1143 (1979). For assessments from three substantially different perspectives, compare Jay Lawrence Westbrook, The Control of Wealth in Bankruptcy, 82 TEX. L. REV. 795, 838-43 (2004), with David Gray Carlson, Secured Lending as a Zero-Sum Game, 19 CARDOZO L. REV. 1635 (1998), and Steven L. Harris & Charles W. Mooney, Jr., A Property-Based Theory of Security Interests: Taking Debtors’ Choices Seriously, 80 VA. L. REV. 2021 (1994). 542 For other scholars who have similarly taken to heart the conclusion that research on secured credit should be empirical, not deductive, see, e.g., Claire A. Hill, Is Secured Credit Efficient?, 80 TEX. L. REV. 1117, 1122-23 (2002); Carlson, supra note 541, at 1739; Harris & Mooney, supra note 541, at 2036. 543 In re LTV Steel Co., 274 B.R. 278 (Bankr. N.D. Ohio 2001).



motion to vacate the court’s interim order allowing the Originator to use the cash collateral constituting proceeds of the securitized assets. The bankruptcy court never had occasion to issue a final order on the matter, as the Originator and the securitization financiers reached a settlement involving the “roll-up” of the securitization facilities into a court-approved debtor-in-possession (“DIP”) loan facility.544

There is no easy way to determine the reasons why such litigation has so rarely been brought.545 But plausible-seeming explanations do suggest themselves. The motive for a bankrupt Originator to challenge a securitization structure almost certainly would be its desire to use the cash collateral arising from the securitized assets to finance its reorganization. The most likely result of a successful challenge is that the securitized assets would be drawn back into the Originator’s bankruptcy estate, with the result that the securitization financiers would be treated as creditors of the Originator, secured by the securitized assets. As in the abortive LTV Steel litigation, therefore, the reward to the Originator of successfully challenging the securitization structure would be a court order empowering the Originator to use the cash collateral representing the proceeds of the securitized assets, so long as the securitization financiers’ interest is adequately protected.546 In the early days of the Bankruptcy Code many reorganizing debtors had sufficient unliened cash flow to finance their reorganization without obtaining additional funds early in the case. Increasingly that is not so, and reorganizing debtors now commonly arrange for DIP financing before filing and procure court approval of that DIP financing as one of their first-day orders. 547 In principle, a bankrupt Originator might follow in the footsteps of the Originator in LTV Steel and challenge a securitization to which it is party, with the goal of using the resulting cash collateral, as an alternative to obtaining funding through a DIP facility. In practice, however, that strategy seems likely to offer the Originator small advantage and serious drawbacks. To the extent that the securitized assets have significant value in excess of the amount necessary to adequately protect the securitization financiers, the

544 For discussions of LTV Steel, see Plank, Security, supra note 20, at 1686-98 (the author of which was an expert witness in the case, see id. at 1657 n.9), Stark, supra note 331 (also written by a lawyer involved in the case, see id. at 211 n.*), and Moody’s Investors Service, supra note 331. 545 The following discussion is limited to litigation-inhibiting factors unique to securitization. For more general factors that may have come into play, see supra text accompanying notes 393-395. The following discussion assumes that those general factors were not of great significance. 546 See Bankruptcy Code §§ 363(a) (defining “cash collateral”), 363(c) (use of cash collateral), 363(e) (requirement that secured party whose cash collateral is used be adequately protected). 547 See David A. Skeel, Jr., The Past, Present and Future of Debtor-in-Possession Financing, 25 CARDOZO L. REV. 1905, 1906 (2004) [hereinafter Skeel, DIP Financing]; David A. Skeel, Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 U. PA. L. REV. 917, 925-26 (2003).



Originator could monetize that value without challenging the securitization structure. Specifically, that value would be held by the Originator in the form of its equity interest in the SPE that holds the securitized assets (plus any subordinated debt owed to the Originator by the SPE representing the unpaid purchase price of the securitized assets). Those assets could be offered as collateral to a DIP financier without fuss.

By contrast, seeking to collapse the securitization structure for the purpose of using excess cash collateral directly might strangle the reorganization in its cradle. The Originator would not be able to obtain a final order giving it access to cash collateral generated by the securitized assets unless it prevailed in litigation against the securitization financiers to strike down the securitization structure, and at a time when cash, and the undivided attention of management, may be most critically needed. Moreover, the Originator’s failure to demonstrate access to adequate cash at the start of the reorganization proceeding through a DIP facility or other consensual arrangement may well signal to the bankruptcy court, and to trade creditors, that its prospects for a successful reorganization are not bright.548 Collapsing the securitization structure might offer the Originator the prospect of using all of the cash collateral generated by the securitized assets, not merely the excess over an amount necessary to adequately protect the securitization financiers, but that would be the case only if the Originator can offer adequate protection in some other form, such as equity in other assets; and that equity could be monetized without incurring the effort and risk of litigation by instead offering it as collateral to a DIP lender.

Of course this explanation does not account for the fact that the Originator did challenge the securitization transactions to which it was party in LTV Steel. Observers have attributed that to various unusual circumstances, including conflicting positions among the various securitization financiers that led to their effective acquiescence in the bankruptcy court’s initial cash collateral order, and the fact that the

548 See, e.g., Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. PA. L. REV. 1209, 1238 (2006) (“[L]itigation over [cash collateral orders] could imperil the reorganization effort at an early stage. More importantly, courts are unlikely to grant such orders over vigorous opposition” (citing DEBRA GRASSGREEN, FIRST-DAY MOTIONS MANUAL: A PRACTICAL GUIDE FOR THE CRITICAL FIRST DAYS OF A BANKRUPTCY CASE 48 (2003) (“Counsel should attempt to negotiate the [cash collateral] order with the creditor and present an agreed order because a cash collateral dispute may give the court an unfavorable impression of the debtor’s reorganization prospects.”))); Skeel, DIP Financing, supra note 547, at 1918 (“Entering Chapter 11 without financing in place is a recipe for trouble. Debtors that go this route often face an immediate cash crunch and their managers will waste valuable time at the outset of the case as they try to secure financing.”); Leonard M. Rosen et al., Debtor in Possession Financing, in BANKRUPTCY LAW AND PRACTICE UPDATE 90-91 (Practicing Law Institute 2001) (noting adverse effect on trade creditors).



Originator in LTV Steel had securitized not only its trade receivables, but also its inventory, leaving it unusually short of liquid assets to offer as collateral to a DIP lender.549 In any case, the Originator’s experience in LTV Steel is not particularly encouraging to other bankrupt Originators who might contemplate challenging securitization transactions to which they are party, for the litigation ended when the Originator entered into a DIP facility with its securitization financiers, the financial terms of which reportedly were more costly to the Originator than the securitization facilities.550

The preceding discussion of why securitization structures have almost never been challenged by bankrupt Originators is speculative.551 But the absence of such challenges is strong evidence that the imposition of the Bankruptcy Tax on securitized assets has little practical value to Originators as a class. The vast market for securitized debt shows that the ability to effect securitization transactions that will stand up in the Originator’s bankruptcy is of enormous value to Originators. Accordingly, on pragmatic grounds it seems sensible to amend the Bankruptcy Code to shore up the demonstrably valuable ability of Originators to do securitization transactions by eliminating the unvalued power of a bankrupt Originator to defeat the transaction. The two decades of experience with securitization transactions may be thought of as an unplanned natural experiment testing whether, in this setting, Originators as a class place significant value on the Bankruptcy Tax—that is, the power to unwind securitization structures in order to access the cash flow from the securitized assets. The results of the experiment to date are in, and the all but complete absence of litigation

549 See Plank, Security, supra note 20, at 1691, 1697 (noting divisions among the securitization financiers and the resulting lack of objection to the bankruptcy court’s initial cash collateral order ); Moody’s Investors Service, supra note 331, at 5 (same); Stark, supra note 331, at 227. 550 As to the increased cost to the Originator of the DIP facilities in LTV Steel as compared to the cost of the securitization financings, see KRAVITT, supra note 18, § 5.05[M][11], at 5-190.6; Moody’s Investors Service, supra note 331, at 8.

Some partisans of securitization have taken comfort from LTV Steel on the ground that the consent order entered by the bankruptcy court approving the agreed-to DIP facilities included, at the request of the financiers, a summary finding that the sales of receivables and inventory to the two SPEs involved in the two securitization transactions were “true sales.” See Plank, Security, supra note 20, at 1690, 1698; SCHWARCZ, supra note 18, § 4:1, at 4-4 n.7. Such comfort is ill-founded. Not being a contested adjudication, a consent order has no stare decisis effect. Moreover, even if the order had been contested, an order of the Bankruptcy Court for the Northern District of Ohio would have no stare decisis effect even in a subsequent case in the same court, much less in any other court. See 18 JAMES WM. MOORE ET AL., MOORE’S FEDERAL PRACTICE § 134.02[1][d] (3d ed. 2006). 551 For anecdotal discussion of various securitization transactions involving Originators that have gone bankrupt, noting several in which the securitized debt was paid down immediately by a DIP facility or was paid down in accordance with its terms, see Moody’s Investors Service, Special Report: Bullet Proof Structures Revisited: Bankruptcies and a Market Hangover Test Securitizations’ Mettle (Aug. 30, 2002), available at http://www.moodys.com/.



by Originators seeking to exercise that power indicates that the answer is “no.”552

As to the form that legislative validation of securitization might take, the abortive attempt to validate securitization that Congress rejected in 2002 was disastrously bad in detail and in overall concept.553 That proposed legislation, known as “Section 912” after the section of the bills that contained it immediately before it was put to rest, was challenged from different perspectives by four letters written by different groups of academics, the first of which drew a spirited epistolary defense by an industry group.554 Those letters, together with subsequent literature, note many flaws in that proposal. It is unnecessary here to address anything other than the heart of the matter. Section 912 would have validated the securitization structures that Wall Street has assembled out of shreds, patches and duct tape, instead of starting with the result that the structure seeks to achieve—that is, doing secured lending without incurring the Bankruptcy Tax—and validating that result directly.

Thus, Section 912 effectively validated as a “true sale” a prepetition transfer of “eligible assets” (i.e., the assets to be securitized) by an Originator to an “eligible entity” (i.e., an SPE). Hence Section 912 required the establishment of an SPE to which the securitized assets would be transferred, unlike a simple secured loan. Moreover, as a condition of qualification, the transferred assets would have had to be “used as the source of payment of securities” (emphasis added). Hence 552 Professor Edward Janger has argued against creating clear safe-harbor rules for securitization on the ground that that “muddy rules” that currently apply to securitization allow judges to sort between efficient and inefficient securitization based on potential harm to creditors of the Originator. See Janger, supra note 13, at 1760-61 & n.18; Janger, supra note 27. Professor Janger does not, however, offer any persuasive reason to suppose that judges would be effective at such sorting, or explain why such a case-by-case approach makes sense in a world in which Originators as a class have not attached significant value to their ability to challenge securitization structures. 553 On the abortive 2002 attempt to validate securitization, see the discussion supra accompanying notes 322-324. 554 The first of the four letters from academics was from Allen Axelrod, Professor Emeritus, Rutgers School of Law, and 34 other academics (including myself), to Senator Patrick Leahy and Representative F. James Sensenbrenner (Jan. 23, 2002) [hereinafter Axelrod Letter]; the second was from Edward J. Janger, Associate Professor of Law, Brooklyn Law School, and three other academics (including myself), to the same addressees (Jan. 28, 2002); the third was from Jonathan C. Lipson, Assistant Professor of Law, University of Baltimore, and eight other academics, to the same addressees (Feb. 1, 2002); and the fourth was from myself, Kenneth C. Kettering, Associate Professor, New York Law School, to the same addressees (Feb. 5, 2002) [hereinafter Kettering Letter]. Industry’s response to the first of the four letters was a letter from John R. Vogt, Executive Vice President, The Bond Market Association, to the same addressees (Jan. 30, 2002). All five letters are reprinted in Controversy Over Asset Securitization Provision in Proposed Bankruptcy Legislation, 22 BANKR. L. LETTER No. 3 (Special Issue) March 2002, available at 2002 WL 335172. The discussion in this part builds upon the Kettering Letter. For later discussions of Section 912, see Lipson, supra note 324; Janger, supra note 27; Plank, Security, supra note 20, at 1730-36.



Section 912 would not have applied to payment of promissory notes of the sort issued in a simple secured loan, which are not securities. In addition, the securities backed by those securitized assets would have had to include “at least one class . . . rated investment grade by one or more nationally recognized statistical rating organizations, when the securities were initially issued by an issuer.” The latter condition can be satisfied trivially in any securitization transaction, and so the only effect of the condition would have been to require the procurement of a rating from at least one rating agency, and hence payment to that rating agency of the necessary fee.555 It is not clear that the drafters of Section 912 wrote that condition with the conscious purpose of extracting economic rents for the rating agencies, however, for the condition is in keeping with the general thrust of Section 912, which mirrors contemporary securitization practice.

A more rational approach to validating securitization transactions would be to amend the Bankruptcy Code to lift directly the Bankruptcy Tax on loans secured by eligible assets of the Originator. This would mean, at a minimum, providing an exception to the automatic stay for enforcement of remedies in such a secured loan, or going further and removing the security interest entirely from the Originator’s bankruptcy estate.556 This approach is superior to that taken by Section 912 for at least two related reasons.

In the first place, it dispenses with the hocus-pocus of creation of an SPE to which the relevant assets are transferred, which serves no purpose other than to achieve by indirection the result that would follow directly from such an amendment. The SPE structure, involving multiple transfers and multiple entities, greatly complicates the transaction and entails substantial transaction costs, which are pure social waste. In particular, the establishment and maintenance of an SPE, which must be rendered “bankruptcy remote” by elaborate requirements, including the installation of independent directors, entails 555 To see this, consider the securitization of a pool of receivables having a face amount of $1 million. The transaction could be structured so that the topmost priority class of securities issued against the pool represents a $1,000 interest. Even if the receivables are low-grade, such a degree of overcollateralization makes it all but certain that collections on the pool will be at least $1,000, plus interest, assuring an investment grade rating for that topmost class (and if in doubt, one could simply reduce the size of the topmost class). Section 912 extended its blessings to a transaction in which any one class of securities, however small, backed by the pooled receivables is rated investment grade. Other classes of securities, which may represent the vast bulk of the interests in the pool, could have any rating at all or be unrated, without affecting the applicability of Section 912 to the transaction. Various commentators objected that the “one class rated investment grade” condition of Section 912 delegated power to rating agencies to make the legal decision that a “true sale” occurred. See, e.g., Axelrod Letter, supra note 554; Lipson, supra note 324, at 109. A more cogent objection is that the condition is substantively meaningless because it can be satisfied trivially. 556 I proposed this approach in the Kettering Letter, supra note 554. It has since been seconded by Plank, Security, supra note 20, at 1738-41.



significant expense, both direct and indirect (such as management to minimize the tax consequences of its establishment and use).

Second, the suggested approach would democratize securitization by making its benefits available to Originators who do not have the size or sophistication to engage in secured borrowing through a transaction structured as a securitization and to bear the related transaction costs. The enormous success of the market for securitized debt shows that lenders value highly the insulation from the bankruptcy of the Originator that is purportedly offered by the securitization technique. Originators that are not large or sophisticated enough to employ these securitization techniques are unable to reap the same benefits. The suggested approach would level the playing field and make the same economic advantages available to Originators who undertake capital formation à la Main Street (through simple secured borrowing) as are now available to those Originators who have the size and sophistication to undertake capital formation à la Wall Street (through employment of securitization structures).557

A further reason to amend the Bankruptcy Code along the foregoing lines would be to define and limit the types of assets that could be made the subject of a secured loan entitled to isolation from the bankruptcy of the debtor. The original and most usual assets that are securitized are rights to payment (more briefly, “receivables”) owned by the Originator. But the purely formalistic arguments advanced by advocates of securitization in support of the efficacy of the prototypical securitization structure in the Originator’s bankruptcy do not depend in any way upon the nature of the assets being securitized. Thus, for example, before its bankruptcy the Originator in LTV Steel had securitized not only its trade receivables (by conveying them as they arose to an SPE that borrowed against them), but also its inventory (by likewise conveying finished and unfinished inventory to a separate SPE which borrowed against it). True to the formalistic arguments by which securitization is presently justified, its scholarly partisans have affirmed the applicability of the securitization technique to property of any kind.558

That line of thought is inconsistent with the fundamental policy

557 Professor Schwarcz, writing as of 1994, stated that “public securitization is rarely cost effective for transactions of less than $50 million and is more common for transactions in the $100 million or higher range.” Schwarcz, supra note 29, at 139. The numbers would no doubt be higher today. 558 See, e.g., Schwarcz, supra note 29, at 152 (noting with approval the application of securitization techniques to assets other than receivables, including inventory); Plank, Security, supra note 20, at 1698 n.176 (expressing skepticism that the challenge to the inventory securitization in LTV Steel would have prevailed had it been pursued); see also LoPucki, supra note 21, at 25 (noting a variety of similar expressions of faith by practitioner-commentators in the applicability of securitization techniques to assets of any kind).



that justifies corporate reorganization. Traditionally, reorganization has been justified as a way of preserving the going concern value, if any, of the bankrupt firm. That is, if the assets of the firm have more value in their current configuration, as assets owned by the firm, than they would have in a piecemeal liquidation, then the firm is worth reorganizing, because a successful reorganization would preserve the difference in value—the going concern surplus—for claimants against the firm.559 Therefore, when evaluating the wisdom of allowing a particular asset to be isolated from the bankruptcy estate of the Originator for the purpose of allowing creditors secured by that asset to exercise their remedies without hindrance, whether the isolation is effected by securitization structures as used today or by amendments to the Bankruptcy Code, it is important to consider whether the asset has more value when owned by the firm than in the hands of another owner (a “firm-specific asset,” in economists’ argot). To allow a firm-specific asset to be isolated from the Originator’s bankruptcy estate and given over to the unrestrained mercies of secured creditors would be inconsistent with the policy just mentioned, for disposition of that firm-specific asset at the behest of the secured creditors would, by definition, deprive the Originator’s bankruptcy estate of the going concern surplus associated with that asset. In other words, this fundamental policy implies that securitization, or amendments to the Bankruptcy Code that have equivalent bankruptcy-isolating effect on an asset that is subject to a security interest, should not be permitted if the asset in question is firm-specific and the effect of bankruptcy isolation may be to deprive the Originator’s bankruptcy estate of the going concern surplus of that assets.560 559 See, e.g., H.R. REP. NO. 95-595, at 220 (1977) (“The premise of a business reorganization is that assets that are used for production in the industry for which they were designed are more valuable than those same assets sold for scrap.”). See generally CHARLES JORDAN TABB, THE LAW OF BANKRUPTCY 5-10, 757-61 (1997). There is a sizable literature challenging the traditional justification for reorganization on various grounds, but the debate appears to be purely academic, as there is no visible legislative enthusiasm for any radical changes to the fundamental premises of Chapter 11 reorganization. Hence from a pragmatic standpoint it seems reasonable to take those premises as given, and this paper does so. 560 This does not imply that there can be no objection in bankruptcy policy to bankruptcy-isolating an asset that is not a firm-specific asset. The going concern value of a firm, if it has any, is not necessarily tied up in identifiable firm-specific assets; it may consist of a network of relationships that are not property in any legal sense. For a dialogue on this point, see Douglas G. Baird & Robert K. Rasmussen, The End of Bankruptcy, 55 STAN. L. REV. 751 (2003); Lynn M. LoPucki, The Nature of the Bankrupt Firm: A Response to Baird and Rasmussen’s The End of Bankruptcy, 56 STAN. L. REV. 645, 651-52 (2003); and Douglas G. Baird & Robert K. Rasmussen, Chapter 11 at Twilight, 56 STAN. L. REV. 673, 689 n.55 (2003). From this it might be argued that bankruptcy isolation of an asset that is not firm-specific ought not to be permitted if other bankruptcy policies intervene: for instance, if the proceeds of the asset are needed to finance the firm’s reorganization and parties with an interest in those proceeds can be adequately protected. As previously discussed, however, it does not appear that this is empirically the case, at least when the securitized assets are rights to payment.



The need to preserve firm-specific assets justifies distinguishing between securitization of receivables and securitization of other assets, such as the inventory securitized in LTV Steel. It seems intuitively plausible that receivables typically are not firm-specific (i.e., their collectibility does not depend to any substantial degree on who owns them),561 whereas inventory typically is firm-specific (i.e., its value is greater in the hands of the firm that produced it than in someone else’s hands—almost certainly in the case of work in progress, and quite possibly even in the case of finished goods, especially if specialized). Intuition further suggests that inventory is firm-specific often enough that good policy would preclude its securitization in all cases, on the ground that to determine through litigation whether the general proposition is true in each particular case would impose social cost greater than the social gain.

Securitization of assets other than receivables, if respected, could also change received bankruptcy policy in other ways. An example would be securitization of assets that are the core operating assets of the firm. This point is illustrated by the 1991 bankruptcy of Days Inns of America, Inc. In that case the Originator was a motel franchisor that had securitized, through various SPEs, its core assets, namely its trademark, the franchise agreements it had with its franchisees, its reservation system, and various marketing and advertising resources. After the Originator’s later bankruptcy filing, a buyout firm made an offer to buy the business, and the Originator promptly managed to cause the SPEs to file for bankruptcy themselves (notwithstanding that they were solvent and had not defaulted on the securitized debt, and notwithstanding the standard “bankruptcy remoteness” arrangements to which each SPE was subject, which included a requirement of unanimous action by the SPE’s board of directors, of which at least one was independent, to authorize a bankruptcy filing). The holders of the securitized debt negotiated a settlement with the Originator under which they agreed to be paid 95% of their claims, and declined to object to the debtors’ motion to the bankruptcy court to approve the sale, which was duly approved.562 Had the securitization structure been respected, the decision whether to sell the securitized assets, and thereby effect what

561 Conventional wisdom has it that as to some types of payment obligations, such as trade receivables, obligors who know that their obligations have been assigned pay them with less frequency than they would otherwise. That conventional wisdom does not derogate from the statement made in the text. Assignees who fear such a deterioration in collectibility can take steps, such as the use of lockboxes, to assure that the obligors on the receivables remain ignorant of the assignment. 562 For discussions of the Days Inn episode, see Structured Financing Techniques, supra note 6, at 561-63; Malcolm S. Dorris & Edward J. O’Connell, Problem Cases in Bankruptcy, in NEW DEVELOPMENTS IN SECURITIZATION 477-81 (Practicing Law Institute 1994); SCHWARCZ, supra note 18, § 2.2.1, at 2-11-2-15.



amounted to a liquidating plan of reorganization, could have been vetoed by the securitization financiers, unless the buyer was willing to take subject to their interest. Moreover, if the securitized debt had gone into default, the securitization financiers might well have had the power to effect the sale unilaterally, by foreclosing their security interest in the securitized assets, without the approval of the bankruptcy court (much less the procedures called for to approve a plan of reorganization).563 Respecting the bankruptcy isolation of such assets would thus change bankruptcy administration in fundamental ways.

Although the formalistic arguments made to support securitization would apply to assets of any sort, the securitization industry is well aware that a bankruptcy court is unlikely to view all securitized assets similarly. The rating agencies, in their pragmatic way, do not seem to have troubled much about the lack of an articulated doctrinal basis for distinguishing between different kinds of assets. Rather, in analyzing securitization of assets other then receivables the rating agencies appear to have tended to focus on the extent to which the Originator would have an economic motivation to challenge the securitization in the event of the Originator’s bankruptcy. For most of the history of securitization, the dominant rating agencies seem to have been fairly sparing in concluding that securitization transactions involving assets other than receivables qualify as bankruptcy-isolated for rating purposes, although ad hoc, case-by-case judgment seems to be the rule.564 In recent years, however, those rating agencies have become more liberal in rating such transactions, lately extending so far as to rate

563 Bankruptcy Code § 363(b) authorizes the sale of property of the bankruptcy estate outside the ordinary course of business with bankruptcy court approval. In the early days of the Bankruptcy Code some courts took the position that a sale of substantially all assets could not be approved except as part of a plan of reorganization. See, e.g., Pension Benefit Guar. Corp. v. Braniff Airways, Inc. (In re Braniff Airways, Inc.), 700 F.2d 935 (5th Cir. 1983). Though that attitude may linger in a few courts, today it is generally accepted that a debtor may sell substantially all of its assets under § 363 given a “good business reason,” but such sales should nonetheless be closely scrutinized by the court. See, e.g., Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063, 1071 (2d Cir. 1983). See generally George W. Kuney, Let’s Make it Official: Adding an Explicit Preplan Sale Process as an Alternative Exit from Bankruptcy, 40 HOUS. L. REV. 1265 (2004); Baird & Rasmussen, supra note 560, at 751-52. 564 Thus, Standard & Poor’s uses the term “hybrid transaction” to refer to a securitization of assets held in an SPE that are “actively managed” by a parent Originator, which term is directed at non-receivables securitization. S&P LEGAL CRITERIA, supra note 78, at 145. A chapter of its legal criteria is devoted to the structuring of such “hybrid” transactions, with notes on selected types (including securitization of future sales of an air carrier’s tickets, film production and distribution, trademark license royalties, and timberland), id. at 145-51, but the chapter emphasizes that “[h]ybrids are, by their nature, individualized transactions, and Standard & Poor’s will analyze each according to its own features. Issuers and their advisers are invited to contact Standard & Poor’s to discuss particular transaction structures.” Id. at 146. Throughout, the chapter emphasizes that for the rating of the debt to be above that of the parent Originator, the incentive of the Originator to challenge the transaction in bankruptcy must be “highly reduced.” Id. at 146.



transactions involving the securitization of the non-financial core assets of a firm. These transactions, referred to variously as “corporate securitizations” or “whole business securitizations,” were first undertaken in Europe but are spreading to the United States, with one of the dominant rating agencies having already published criteria for rating such transactions.565 A widely-noted 2006 transaction, for instance, involved a securitization of core assets analogous to those involved in the Days Inn transaction, involving a franchisor’s intellectual property and its rights to royalty payments and lease payments from franchisees. While that transaction can be distinguished from Days Inn, it is surely a harbinger of things to come.566

Accordingly, a properly crafted amendment to the Bankruptcy Code validating the goal of securitization by lifting the Bankruptcy Tax from loans secured by assets specified to be eligible for the purpose would by no means be a giveaway to Wall Street. In addition to the other benefits previously mentioned, it would be an opportunity to rein in the practice of isolating assets from the debtor’s bankruptcy, by validating that practice as to assets for which the practice is benign, as appears to be the case with receivables and other payment obligations, and discouraging or prohibiting the practice as to assets of other types. Absent legislative attention, the subject will be remitted largely to the sensibilities of the rating agencies—and, as we have seen, that may amount to allowing them to create law by fait accompli.

CONCLUSION

As noted in the introduction to this paper, one scholar impressed

by the growth of securitization reported “the death of secured lending” in an article of the same name.567 Like the celebrated report of Mark Twain’s death, that report is greatly exaggerated. A securitization transaction of the prototypical sort discussed in this paper is no more

565 See Standard & Poor’s, Corporate Securitization Ratings: Reaching New Frontiers—Global Credit Survey 2007, at 37-43 (Feb. 2007), available at http://standardandpoors.com/. 566 The transaction referred to, in which the Originator was Dunkin’ Brands, Inc. (“DBI”), is summarized in Standard & Poor’s, DB Master Finance LLC (Presale credit report, May 16, 2006), and is placed in context with other recent transactions in Standard & Poor’s, Ratings: Securitization Gets a Taste of Royalties (Oct. 16, 2006). Both publications are available at http://standardandpoors.com/. One difference between the DBI and Days Inn transactions is that the securitized debt issued in the DBI transaction did not owe its AAA rating directly to bankruptcy isolation of the securitized assets but rather to a surety policy issued by an AAA-rated bond insurer. However, based on conversations with persons involved in the transaction, it appears that insurer would not have issued the policy but for the employment of the securitization structure, which in itself was sufficient (in the view of the rating agency) to warrant rating the transaction investment grade. 567 Janger, supra note 13.



than a secured loan that has ducked into a telephone booth and donned Superman garb, emerging impervious to the bankruptcy constraints that bind ordinary secured loans. Securitization is merely one more episode in the long chronicle of the evolutionary drive of secured credit to actualize itself fully. That drive became urgent at the beginning of the Industrial Revolution, and to all appearances is insatiable.568 In the course of that evolution secured credit has appeared in some peculiar guises, with matters of form sometimes elevated to high significance in practitioners’ efforts to create factitious distinctions that a judge might wink at.569 The securitization industry might well congratulate itself on its success in similarly creating the impression that securitization is something fundamentally different from secured credit. But we need not be taken in.

As also noted in the introduction to this paper, some scholars have come to have doubts about securitization, but skeptical academic discourse on the product did not appear until long after the product was introduced. Whether the delay is attributable to a tempo of innovation that legal scholars detached from the marketplace cannot reasonably hope to keep up with, or to the general decline in the esteem in which the legal academy holds doctrinal work, 570 or to other causes, is debatable. What is not debatable is that academic criticism of the product was far too little and too late to impede the product’s growth to its current vast size, a size that, as this paper demonstrates, in all probability makes the product too big to fail. So this paper also serves, finally, as a disquieting case study of the irrelevance of legal scholarship to the process of legal evolution.

568 Thus, for example, on the theme of how secured credit broke through many of the restraints placed on it by the enactment of the Bankruptcy Code in 1978, see James J. White, Death and Resurrection of Secured Credit, 12 AM. BANKR. INST. L. REV. 139 (2004). 569 Part I of Gilmore’s treatise is largely a chronicle of such episodes during the rise of the American law of secured credit from its infancy in the early 1800s until the coming of UCC Article 9 in the mid-1900s. For example, the Pennsylvania Supreme Court held in Clow v. Woods, 5 Serg. & Rawle 275 (Pa. 1819), that a mortgage of personal property by a debtor who retains possession is avoidable per se as a fraudulent transfer, and seven years later in Martin v. Mathiot, 14 Serg. & Rawle 214 (Pa. 1826), held likewise as to a conditional sale. But these holdings did not discourage the Philadelphia bar from finding a way to slake their clients’ thirst for secured credit. They promptly drafted a new set of papers, called the “bailment lease,” functionally indistinguishable from a conditional sale agreement, at which the court was persuaded to wink in Myers v. Havey, 2 Pen. & W. 478 (Pa. 1831). See 1 GILMORE, supra note 113, § 3.6, at 77-78; James A. Montgomery, Jr., The Pennsylvania Bailment Lease, 79 U. PA. L. REV. 920 (1931). 570 See, e.g., Larry T. Garvin, The Strange Death of Academic Commercial Law, 68 OHIO ST. L.J. 403, 424-25 & nn.42-47 (2007).

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