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Speaking of Delaware, or an (Unaccepted?) Invitation to Fraud

posted by Jonathan Lipson

I Don't Hate Delaware

After reading my last few posts, you might think I really have a hate on for Delaware. But the truth is I don't. It's just that what the nation's "most important business court" (to paraphrase Vice Chancellor Strine) says and does matters to business lawyers, including those who care about credit and bankruptcy.

You might  expect the same to be true for the Delaware legislature. So, for example, when Delaware enacted its  "Asset Backed Securitization Facilitation Act" ("ABSFA") in 2002, you can understand why Delaware lawyers would say that Delaware is the "jurisdiction of choice" for securitization transactions. Given that ABSFA gave the securitization industry almost everything it wanted, you might expect the industry (and its transactions) to flock to Delaware, which was presumably the legislature's goal in enacting the law in the first place. 

Yet, it appears that hasn't happened. Rather, it appears these transactions continue to be governed by New York law. This is fascinating, since Delaware's ABSFA should be very attractive, both to the securitization industry and to those who may be less savory. This is because, read literally, it would immunize these transactions from virtually any judicial scrutiny. Read fairly, it would sustain transactions even if they were intentional fraudulent conveyances. You can't get much more certainty than that. And, at least ostensibly, certainty was a central quest for the industry in seeking ABSFA.

What is ABSFA and Who Cares? (Non-Geeks Can Skip This Part)

ABSFA purports to solve the "true sale" problem, a legal issue at the heart of all securitization and structured financings (which, for our purposes, we can equate). In simple terms, the true sale problem is that we don't always know whether the transfer of an asset is legally a sale or a pledge (secured transaction). This problem matters--a lot, some would say--because if the transaction is not a sale, then a bankruptcy (or similar proceeding) for the original "seller" of the asset (an "originator," in securitization-ese) would subject it to the various sharing and other collective features of bankruptcy. People who purchase securities in securitizations (essentially, the financing parties) claim that they pay a discount to reflect the fact that the asset is safe from the originator's bankruptcy.

The true sale problem is very old. At the margins, it is genuinely difficult to distinguish a sale from a secured loan. What if the "purchaser" can require the "seller" to repurchase the asset? What if the "seller" guarantees (directly or through an affiliate) that the holders of the securities will receive a certain return, even if the underlying asset is worth less than expected? Courts have struggled with this for years.

In theory, ABSFA solves this problem--and then some. It provides that "[n]otwithstanding any other provision of law,” any property transferred in a "securitization transaction" “shall be deemed to no longer be the property, assets or rights of the transferor." DEL. CODE ANN. tit. 6, § 2703A(a)(1) (2004). Moreover, a bankruptcy trustee for an originator "shall have no rights, legal or equitable, whatsoever to reacquire, reclaim, recover, repudiate, disaffirm, redeem or recharacterize as property of the transferor any property, assets or rights purported to be transferred . . . by the transferor."  Id. at § 2703A(a)(2). The statute does not define the term "securitization" and applies to "any property, assets or rights purported to be transferred, in whole or in part."  Id § 2703A(a)(1).

An Invitation to Fraud?

Read literally, it sounds like ABSFA does a lot more than insure that "sales" won't be recharacterized as "secured loans." It sounds like it means that any contract that recites the statutory incantation--relates to a "securitization" transaction--will be enforceable as a "sale" even if it results, in substance, in: (i) a secured loan, (ii) a voidable preferential transfer, (iii) a voidable constructive fraudulent conveyance, (iv) an illegal dividend distribution, or (v) an intentional fraudulent conveyance.

If corporate managers and directors are as craven as they sometimes seem to be, you would expect them to use ABSFA in order to cash in (or out) in the most strategic ways possible ("Every executive comp. agreement is now a securitization!"). Since it does not define the term securitization, and applies to any property, it could be used in virtually any transaction. This is a statutory invitation to commit fraud.

Yet, No One Seems to Be Accepting the Invitation

If we believe that people are strategic, greedy and so forth, we would expect that a statute that permits them to act on their basest legal instincts would draw them like flies to . . . sugar. So, I've been curious about whether parties actually are moving their transactions to Delaware, by causing them to "choose" Delaware law. Historically, these transactions have usually be governed by New York law (for the nonlawyers: this  simply means the contracts contain a statement about which state's law should be used to interpret and govern the contract). New York has nothing like ABSFA on its books.

In order to figure whether people (clients) behave in this ostensibly rational way, I undertook an entirely unscientific study, by posting a query to the UCC-Law listserv, asking if parties choose Delaware law in securitizations. The overwhelming response was that they do not. Some lawyers indicated that there was modest movement in that direction, but not much.

If ABSFA offers the benefits of certainty for legitimate transactions, and cover for fraudulent ones, why would this be?

We can separate the universe into two groups: (i) those who engage in securitizations that will ultimately result in the issuance of publicly traded securities, and (ii) "private" transactions. We cannot know much about private transactions, since nothing is on record about them. My guess is that this is where fraud would most likely occur. Yet, so far as I can tell, neither the Delaware courts nor the bankruptcy courts have ever published an opinion on ABSFA at all. If people were using ABSFA to commit fraud, you would imagine some of it would end up in court.

I would guess that the "public" transactions are probably--probably--more likely to be legitimate, in the sense that they would not involve intentional fraud. Although I am not a securities law guru, my guess is that ABSFA would not preempt the federal securities law, and that large institutions are not likely to engage in serious misconduct in reliance on ABSFA. (I know, I know, many would tell me to see Enron for a refresing alternative view).

Nevertheless, even non-fraudulent transactions should be as susceptible to "true sale" challenges as any others--a challenge Delaware's ABSFA would defeat. This is where things get interesting (or at least interesting to me). If the lawyers I heard from are correct, then one or both of two things is likely true: Either no one has much confidence in the Delaware statute, after all, or non-Delaware (mostly New York) lawyers just won't give up the work, and it is not (yet) worth it to clients to make the change.

My guess is that both are true.

First, the force of the law:  The Delaware law is only effective if it is not preempted by federal law (e.g., bankruptcy law). Of course, the Supreme Court in Butner told us that in bankruptcy, property rules are usually determined by state law. Butner v. United States, 440 U.S. 48, 55 (1979). Thus, in theory, the Bankruptcy Code should defer to ABSFA in a securitization under Delaware law. But the doctrines of "preemption" and "property" are pretty manipulable by result-oriented judges. Moreover, a bankruptcy trustee could argue that a transaction was not a "securitization", and thus outside the scope of ABSFA. Finally, one could argue that the contractual choice of law should not be binding on the bankruptcy estate, especially if the transaction participants have no meaningful presence in Delaware.

The more instrumental--LoPuckish, if you will--explanation is that people with a significant stake in structuring and executing these transactions--e.g., lawyers--are not in Delaware. According to the lawyers I spoke to, many of the providers (the underwriters) are apparently based in New York, as are the rating agencies. Many--although certainly  not all--of the lawyers who work on these transactions are also based in New York, or have large securitization practices there. While New York lawyers are probably competent to work on governance matters related to Delaware corporations, unless they are admitted to practice in Delaware, they generally stay away from too much work under Delaware contract law, which is what we're talking about when we talk about ABSFA.

Thus, there may develop a tension between lawyers and clients over choice of law. One lawyer said that the answer here is probably that these transactions were first done under New York law 20-30 years ago, that this is the law that people became comfortable with, and while Delaware's ABSFA may offer greater efficiency and certainty, the savings are not enough to make the change. Since New York lawyers--who are frequently doing the deals--have no incentive to encourage their clients to make the change, it doesn't happen.

Which is probably a good thing. As I have written elsewhere, statutes like ABSFA are unnecessary and probably dangerous. See Jonathan C. Lipson, Enron, Asset Securitization and Bankruptcy Reform:  Dead or Dormant?, 11 J. BANKR. L. & PRAC. 101 (2002).

But, this leaves a final question: If this sort of legislation is neither good policy nor even useful to those it would supposedly benefit, why was it enacted at all? One lawyer suggested that credit card companies based in Delaware might have lobbied for it. This might make sense, although to the extent credit card receivables are "originated" by federally regulated banks (which I think is usually the case), I would be surprised if anyone believes Delaware law trumps FIRREA or other federal law on bank insolvency (banks cannot be "debtors" under the Bankruptcy Code; when they fail, they are usually taken over by federal or state regulators).

An Invitation to Inquiry

So, we are left with a puzzle: Does ABSFA matter and, if not, what's it doing there? 

I am in the process of designing a more thorough empirical study here using data from public transactions filed in the EDGAR system, among other things. It would, in part, emulate the similar study by Eisenberg and Miller on choice of law in other types of contracts. If anyone has thoughts about this, please feel free to contact me at jlipson@temple.edu.

Next: Debt to the Future

Comments

From a law standpoint, the preemption question is the most interesting to me. After Submicron, Fairchild, and others have affirmed the federal courts' "right" to recharacterize, as a matter of federal law (federal common law?), one has to wonder whether that might be the hook needed for preemption to prevail even over a given state's purported attempt to invade the field of bankruptcy with a state legislative enactment purporting to limit a trustee's exercise of his/her statutory powers and duties under the Code.

Then there is the question whether any law firm would be willing to stake its insurance (or its balance sheet) on an opinion letter regarding an asset securitization crafted in reliance on the Delaware law, given the current state of current Circuit authority on the doctrine of recharacterization.

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