‘The new form of corporate alter ego’: SPEs, encore | FT Alphaville

‘The new form of corporate alter ego’: SPEs, encore

We qualify ‘new’. This paper is a full 30-year history of the special-purpose entity in banking, from Mike Milken to the Abacus CDO, via Bistro — up to the denouement of FAS 167.

Penned by William Bratton and Credit Slips blogger Adam Levitin, it also points out that corporate law continues to lag the accountancy profession in understanding the implications of SPEs. That weakness is important when the original purpose of many SPEs — for banks to replace equity with contracts as a means of controlling assets taken off-balance sheet, in order to gain relief from regulatory capital — is as relevant as ever.

A taste…

The SPE scandals all involved the use of third-party contracts, rather than equity, to exercise control, thereby escaping traditional equity-based regulation. The SPE scandals show that control can be exercised by contract as well as by ownership, a transactional development that accounting principles have begun to recognize, but neither law nor finance. Indeed, accounting, rather than corporate law or financial economics now determines the boundaries of the SPE and the firm. The new accounting approach rejects the formalism that enabled transactional arbitrage via SPEs, drawing the line between the firm’s insiders and outsiders on a case-by-case basis based on allocations of risk and directive power. This functional conception of the firm may also point to expanded liability: traditional fiduciary duties may apply to contractual relationships in addition [to] equity relations, as Goldman learned with Abacus…

The Abacus SPE is a firm without human agents. All functions are performed by contract counterparties like indenture trustees and paying agents, and the tasks they perform are ministerial, set out ex ante in contractual instructions. Here at last we encounter a gapless contractual firm—the documentation provides complete instructions. Abacus is, in short, the apotheosis of the Jensen and Meckling “nexus of contracts” firm.

Related links:
Theory of the firm – Jensen and Meckling (1976)
Accounting for credit risk before the crisis – David Murphy, for FTAV
Back to the BISTRO for today’s securitisations – FT Alphaville