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

      Say you have a dog, but you need to create a duck on the financial
      statements. Fortunately, there are specific accounting rules for what
      constitutes a duck: yellow feet, white covering, orange beak. So you
      take the dog and paint its feet yellow and its fur white and you paste
      an orange plastic beak on its nose, and then you say to your
      accountants, “This is a duck! Don’t you agree that it’s a duck?” And
      the accountants say, “Yes, according to the rules, this is a duck.”
      Everybody knows that it’s a dog, not a duck, but that doesn’t matter,
      because you’ve met the rules for calling it a duck.1

I.    Introduction
      When is a sale really a loan? This vexing question comes up often in
bankruptcy, where characterization as one or the other can determine whether
or not transferred assets escape the reach of creditors and bankruptcy
trustees.2 The state of the law on this subject is quite unsettled, with much
left to the discretion of individual courts.3 The picture is further complicated
in the context of securitization transactions, in which loans or accounts re-
ceivable are pooled and transferred.4 Relatively little case law exists to
suggest whether such transactions can properly be characterized as sales or as
secured loans.5 A major concern for investors in securitizations, and for the
ratings agencies who evaluate these deals, is to protect the assets in the event

   * Many thanks to the members of the Texas Law Review, especially Emily Falconer, Ben
Hallmark, and Matt Nance. I am also grateful to Professor Jay Westbrook for suggesting the topic
and for his invaluable research guidance. Finally, my deepest thanks to my wife Tina and son
Jackson for their love and support.
RISE AND SCANDALOUS FALL OF ENRON 142–43 (2003) (quoting an unnamed Enron employee).
CAPITAL MARKETS 37–86 (2004); 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) (both describing the true-sale question in relation to bankruptcy).
   3. See infra Part IV.
   4. For an introduction to securitization, see generally SCHWARCZ ET AL., supra note 2, at 1–17.
Schwarcz and his coauthors describe the history and mechanics of securitization and provide an
example of a typical securitization transaction. Id.
   5. See Stephen J. Lubben, Beyond True Sales: Securitization and Chapter 11, 1 N.Y.U. J.L. &
BUS. 89, 96 (2004) (noting the lack of case law dealing with the true-sale issue in the specific
context of a securitization).
488                                    Texas Law Review                               [Vol. 87:487

of the transferor’s bankruptcy by placing them beyond the reach of the
transferor’s bankruptcy estate and its creditors.6
      In recent years, innovations in structured finance have tempted
companies to use securitization deals to improve their balance sheets by
removing money-losing assets and recording revenue from the “sales.”7
Enron made infamous the use of special-purpose entities (SPEs) as a device
to conceal debt and artificially inflate earnings.8 In many such “sales,” how-
ever, the transferor either retains control and derives benefits from the
transferred assets, or promises to assume their risks via recourse provisions.9
To the extent that such a transaction is improperly accounted for as a true
sale, the company runs the risk of presenting an inaccurate picture of its true
financial condition.10 For publicly traded companies, getting true-sale ac-
counting wrong can bring expensive consequences in the form of action by
the Securities and Exchange Commission (SEC) or by private shareholder
      This Note will explore the true-sale problem in the context of securities
law. By what standard does securities law evaluate a transaction as sale or
loan? Part II sets out the legal bases for SEC enforcement and private share-
holder action, and discusses the SEC’s emphasis on compliance with
generally accepted accounting principles (GAAP). Part III explores GAAP’s
approach to true-sale accounting, which focuses on the degree to which the
transferor retains control over the transferred assets. Part IV discusses
GAAP’s reliance on substantive true-sale law, and the incoherent state of the
latter. Parts V and VI illustrate how the SEC and private securities litigants,
respectively, apply GAAP’s true-sale analysis in practice—and how that ap-
plication, in one important instance, departs from both the strict letter and the

EXTINGUISHMENTS OF LIABILITIES ¶ 152 (2008), available at
140.pdf [hereinafter SFAS 140] (stating that credit-rating agencies and investors in securitized
assets attempt to structure those transactions so that the assets cannot be reached by creditors).
FILINGS BY ISSUERS 45 (2005), available at
[hereinafter SEC REPORT] (noting that some asset transfers appear to be motivated—in whole or in
part—by accounting strategies designed to inflate earnings or conceal losses).
    8. On the subject of Enron, see generally MCLEAN & ELKIND, supra note 1. But see Steven L.
Schwarcz, Securitization Post-Enron, 25 CARDOZO L. REV. 1539, 1541–42 (2004) (arguing that
most securitization transactions are economically beneficial and have been unfairly tainted by
association with Enron’s abuses).
    9. SEC REPORT, supra note 7, at 40–46.
    10. See id. at 100 (defining “accounting-motivated structured transactions” as “those
transactions that are structured in an attempt to achieve reporting results that are not consistent with
the economics of the transaction, and thereby impair the transparency of financial reports”).
    11. See infra Parts V and VI.
2008]                  The True-Sale Problem in Securities Law                                489

intent of the GAAP standards by emphasizing recourse obligation, rather
than effective control, as the defining factor. For both the SEC and private
litigants, the focus is squarely on disclosing the substantive characteristics of
the transactions, particularly the retention of risks and benefits by the
transferor. Finally, Part VII considers various legislative proposals that have
aimed to clarify or simplify true-sale law. However, these are unlikely to
have much impact in the securities context. Precisely because the SEC’s
views on true-sale accounting rarely face judicial scrutiny, it can use its en-
forcement power to impose its own standards.

II.   The Application of Securities Law
     Securities law is, in theory, about disclosure, not substance. It regulates
publicly traded companies by prohibiting false or misleading statements, and
by requiring those companies to file accurate financial reports.12 In practice,
however, the SEC uses its considerable enforcement power to force publicly
traded corporations to comply with its preferred substantive accounting stan-
dards.13 Because the accuracy of financial statements depends upon proper
accounting, the SEC necessarily must take an interest in the definition,
interpretation, and enforcement of accounting standards. The Securities
Exchange Act requires that financial statements be prepared in accordance
with GAAP.14 Failure to properly account for a transaction, by definition,
violates the disclosure obligation. Under SEC regulations, financial state-
ments filed with the Commission that do not comply with GAAP will be
presumed to be misleading or inaccurate.15 On the other hand, technical
compliance with GAAP does not excuse less-than-full disclosure of the
substantive risks of a transaction—particularly, the SEC warns, if the
transaction’s primary purpose is “the attainment of a particular financial
reporting result.”16 In short, the SEC can use GAAP as a sword, but defen-
dants cannot rely on it as a shield.

    12. SEC enforcement actions are typically based on the statutory authority of the Securities Act
of 1933, 15 U.S.C. §§ 77a–77mm (2006), and the Securities Exchange Act of 1934, 15 U.S.C. §§
78a–78mm (2006). For example, § 17(a) of the Securities Act, 15 U.S.C. § 77q(a), prohibits any
“device, scheme, or artifice to defraud” or any untrue statement or omission of material fact in
connection with the offer or sale of securities. See also Securities Exchange Act § 10(b), 15 U.S.C.
§ 78j(b) (prohibiting “any manipulative or deceptive device or contrivance” in connection with the
purchase or sale of any registered security); id. § 13(a), § 78m(a) (requiring filing of periodic
reports); id. § 13(b)(2), § 78m(b)(2) (requiring accurate accounting and internal controls). SEC
rules provide more detailed regulatory guidelines for the enforcement of these statutory
prohibitions. E.g., 17 C.F.R. §§ 240.10b-5, 240.13a-1, 240.13a-13 (2008).
    13. See infra Part V.
    14. 15 U.S.C. § 78m(b)(2)(B)(ii).
    15. 17 C.F.R. § 210.4-01(a)(1) (2008).
    16. See PNC Fin. Servs. Group, Inc., 10 S.E.C. 1064, 1090 (July 18, 2002) (order instituting
administrative proceedings) (citing 17 C.F.R. § 229.305 (2008), which requires the disclosure of
both quantitative and qualitative market risk, and § 229.305(b)(1), which requires the discussion of
the “objectives, general strategies, and instruments” used to manage risk exposure), available at
490                                   Texas Law Review                                [Vol. 87:487

      When a company draws the SEC’s attention, shareholder lawsuits will
not be far behind. Plaintiffs in private securities litigation rely on many of
the same statutory provisions, but they operate under some significant handi-
caps in comparison to the SEC. The Private Securities Litigation Reform Act
of 199517 (PSLRA) requires plaintiffs to spell out their claims in considerable
detail in their initial pleadings, or else face dismissal.18 Private litigants,
unlike the SEC, must establish at the pleading stage that the company and its
responsible executives acted with scienter, i.e., that they not only violated
securities law but did so knowingly or recklessly.19 GAAP violations,
though helpful to a securities plaintiff in establishing scienter, are insufficient
in and of themselves to state a claim absent other evidence of fraud.20 GAAP
is a less powerful tool in the hands of private litigants, carrying at most sug-
gestive rather than presumptive force.

III. The GAAP Standard for True-Sale Accounting
     To define generally accepted accounting principles, both the SEC and
private securities litigants look to statements issued by the Financial
Accounting Standards Board (FASB).21 The true-sale issue is addressed in
FASB’s Statement of Financial Accounting Standards No. 140 (SFAS 140).22 The general instructions to SEC Regulation S-K,
Item 305(b) explain that the term instruments includes any financial instruments for which fair-
value disclosures are required under GAAP, such as mortgage-backed securities, trade accounts
receivable, investments, and loans. 17 C.F.R. § 229.305(b); see also FIN. ACCOUNTING
ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS ¶¶ 3, 8 (1991) (listing the financial instruments
for which fair-value disclosures are required and the financial instruments for which they are not
    17. Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified in scattered sections of 15 U.S.C.).
    18. See 15 U.S.C. § 78u-4(b) (requiring plaintiffs to specify each statement alleged to have been
misleading, and to “state with particularity facts giving rise to a strong inference that the defendant
acted with the required state of mind”); see also FED. R. CIV. P. 9(b) (requiring that allegations of
fraud be pleaded “with particularity”).
5th ed. 2006), for a discussion of the scienter requirements in securities litigation.
    20. See, e.g., In re Cardinal Health Inc. Sec. Litigs., 426 F. Supp. 2d 688, 741 (S.D. Ohio 2006)
(holding that GAAP violations, when combined with other evidence pointing to actual fraud and
insider trading, were sufficient to state a claim); Fin. Acquisition Partners, LP v. Blackwell, No.
Civ.A.3:02-CV-1586-K, 2004 WL 2203253, at *21 (N.D. Tex. Sept. 29, 2004) (finding that the
plaintiff’s bare allegations of GAAP violations were insufficient to establish scienter); In re Cree,
Inc. Sec. Litig., 333 F. Supp. 2d 461, 477 (M.D.N.C. 2004) (finding that the alleged GAAP viola-
tions were insufficient to support a claim when the plaintiff had failed to allege fraud with
    21. See SEC Policy Statement, Reaffirming the Status of the FASB as a Designated Private-
Sector Standard Setter, 68 Fed. Reg. 23,333 (May 1, 2003) (recognizing FASB’s financial account-
ing and reporting standards as “generally accepted” for the purposes of federal securities law).
FASB’s Statements of Financial Accounting Standards (SFAS) can be found online at http://
    22. SFAS 140, supra note 6. SFAS 140 was issued in September of 2000 and is effective for
transactions taking place on or after March 31, 2001. Id. ¶ 336. Transactions before that date were
2008]                   The True-Sale Problem in Securities Law                                  491

GAAP’s true-sale analysis focuses squarely on the substance, rather than the
form, of the transaction.23 Whether or not the transaction may be accounted
for as a sale depends on the extent to which the transferor has surrendered
control over the transferred asset.24 For a transaction to qualify for true-sale
accounting under GAAP’s control test, three conditions must be met:
           (1) The transferred assets must be “isolated” from the transferor,
     placed “presumptively” beyond its reach and the reach of its creditors.25
     Essentially, this means that the transfer must be legally sufficient to
     protect the assets from being dragged into the transferor’s bankruptcy
     estate.26 The odd consequence of this standard is that an accounting
     judgment depends on a legal prediction as to what a bankruptcy court
     might do, which in turn requires reference to the applicable substantive
     law of a particular jurisdiction.27
           (2) The transferee must be free to pledge or exchange the assets,
     and no condition must constrain its ability to do this or provide more
     than trivial benefit to the transferor.28 In a true sale, the rights and
     benefits of ownership must pass to the transferee.
           (3) The transferor must not maintain effective control over the
     assets through any agreement that both allows and obligates it to
     repurchase or redeem the assets,29 or that allows it unilaterally to take
     back specific assets.30 Recourse—the ability to undo all or part of the
     deal—may disqualify a transaction from true-sale accounting.31 As with
     isolation, the significance of full or partial recourse depends on whether
     applicable substantive law would accord it weight in deciding whether

governed by the now-superseded Statement of Financial Accounting Standards No. 125. See
EXTINGUISHMENTS OF LIABILITIES (1996) [hereinafter SFAS 125]. Aside from somewhat stronger
disclosure requirements in the current version, SFAS 140 and SFAS 125 do not differ significantly
with regard to the issues discussed here. See SFAS 140, supra note 6, ¶¶ 126–27 (discussing SFAS
140’s revisions of SFAS 125).
    23. See SFAS 140, supra note 6, ¶ 130 (stating the FASB’s intent to “reduce . . . confusion by
distinguishing sales from secured borrowings based on the underlying contractual commitments and
customs that determine substance”).
    24. Id. ¶ 9.
    25. Id. ¶¶ 9(a), 27–28.
    26. Id. ¶ 152.
    27. Id. ¶¶ 9(a), 27–28, 152.
    28. Id. ¶ 9(b).
    29. Id. ¶¶ 9(c), 47–49.
    30. See id. ¶¶ 50–54 (“Some rights to reacquire transferred assets . . . regardless of whether they
constrain the transferee, may result in the transferor’s maintaining effective control over the
transferred assets through the unilateral ability to cause the return of specific transferred assets.
Such rights preclude sale accounting under paragraph 9(c)(2).”).
    31. See id. ¶ 113 (“In a transfer of receivables with recourse . . . . [t]he transferor is obligated
under the terms of the recourse provision to make payments to the transferee or to repurchase
receivables sold under certain circumstances, typically for defaults up to a specified percentage.”).
492                                  Texas Law Review                               [Vol. 87:487

     the deal had successfully placed the assets beyond the reach of the
     transferor’s creditors.32 Note, however, that GAAP only considers
     recourse to be important insofar as it may be indicative of control.33 If a
     transferor retains an obligation, but not an option, to repurchase or
     redeem assets, then it has no “control” and true-sale accounting is not
     precluded.34 As we will see, however, the SEC does not consider
     mandatory-recourse provisions to be consistent with true-sale
     accounting—a significant difference between the SEC’s application of
     GAAP, and what GAAP actually says.35
      Regardless of whether the control test is met, GAAP also requires the
holder of securitized assets to disclose the details of any recourse provisions
or interests retained by the transferor.36 Thus, even if a deal is structured to
satisfy the above criteria, it may still be in violation of GAAP if its arrange-
ments are not clearly explained to the investing public.37 Note that GAAP
places the burden of disclosure largely on the transferee holding the securi-
tized assets—because it is the transferee (and its investors) who will lose if
the “sale” is recharacterized and returned to the transferor’s bankruptcy
estate.38 By contrast, the disclosure obligations imposed by federal securities
law and enforced by the SEC apply to both transferor and transferee, insofar
as improper true-sale accounting might cause either party to report a mis-
leading picture of its true financial condition.39

IV. Substantive True-Sale Law
    GAAP offers little guidance as to exactly how substantive true-sale law
should be applied, which is understandable because its standards are written

    32. See id. (“The effect of a recourse provision on the application of paragraph 9 may vary by
jurisdiction. In some jurisdictions, transfers with full recourse may not place transferred assets
beyond the reach of the transferor and its creditors, but transfers with limited recourse may.”).
    33. See id. ¶ 151 (“Under the financial-components approach, the accounting for a transfer is
based on whether a transferor surrenders control of financial assets.”).
    34. The SFAS 140 provides:
       Transfers that include only the right to reacquire, at the option of the transferor or upon
       certain conditions, or only the obligation to reacquire, at the option of the transferee or
       upon certain conditions, generally do not maintain the transferor’s control, because the
       option might not be exercised or the conditions might not occur.
Id. ¶ 217.
    35. See infra notes 78–82 and accompanying text.
    36. See SFAS 140, supra note 6, ¶ 17(h)(2) (requiring a holder of securitized financial assets to
disclose “the transferor’s continuing involvement with the transferred assets, including, but not
limited to, servicing, recourse, and restrictions on interests that continue to be held by the
    37. Cf. SEC REPORT, supra note 7, at 103 (“Many accountants, lawyers, and others seem to
view the goal of financial reporting as achieving technical compliance with the rules without regard
to communicating effectively to investors.”).
    38. See SFAS 140, supra note 6, ¶ 17(h) (outlining the transferee’s disclosure requirements).
    39. See infra notes 68–76 and accompanying text.
2008]                   The True-Sale Problem in Securities Law                                  493

by and for accountants, not lawyers.40 Still, a critical concern for investors
and credit-rating agencies is to predict what might happen if a deal were
challenged in bankruptcy.41 Unfortunately, true-sale law is sufficiently
unsettled to make prediction difficult. In deciding how to characterize a
transaction, federal bankruptcy courts are guided by substantive state law on
loans and sales.42 Article 9 of the Uniform Commercial Code (U.C.C.) dis-
cusses security interests in accounts receivable, and spells out the
consequences of their sale or transfer for purposes of perfection or priority.43
However, it offers no guidelines for distinguishing a sale from a secured
loan.44 That judgment is left to the courts, whose approaches have been far
from consistent. While federal courts attempt to apply the law of the state in
which they sit, the relative (though not perfect) uniformity of U.C.C. enact-
ments across state lines encourages parties to cite favorable precedents (and
ignore unfavorable ones) from other jurisdictions.45 Courts view true-sale
analysis as a fact-intensive determination, rather than as a question of law.46
In bankruptcy, the court’s power to protect equitable as well as legal interests
in the debtor’s property allows an even greater scope for judicial discretion.47
      Courts’ approaches to the true-sale question have spanned a broad
spectrum. At one end is what might be termed a “nominal” approach: if the
parties call it a sale, then it is a sale.48 At the other extreme, a few courts

    40. See FIN. ACCOUNTING STANDARDS BD., FACTS ABOUT FASB 1 (2007), available at http:// (discussing the mission, organizational structure, and
staffing of FASB).
    41. SFAS 140, supra note 6, ¶ 152.
    42. See, e.g., Wawel Sav. Bank v. Jersey Tractor Trailer Training, Inc. (In re Jersey Tractor
Trailer Training, Inc.), No. 06-02003, 2007 WL 2892956, at *5 (Bankr. D.N.J. Sept. 28, 2007)
(looking to Article 9 of the U.C.C. as the “starting point” for the court’s analysis of a true-sale
    43. See U.C.C. §§ 9-109(a)(1), (3) (2007) (noting Article 9’s application to both “a transaction,
regardless of its form, that creates a security interest in personal property” and “sale of accounts,
chattel paper, payment intangibles, or promissory notes”).
    44. See id. § 9-109 cmt. 5 (“[N]either this Article nor the definition of ‘security interest’ in
Section 1-201 provides rules for distinguishing sales transactions from those that create a security
interest securing an obligation.”). Official Comment 4 to U.C.C. § 9-109 boasts, unhelpfully, of
Article 9’s success in “avoiding difficult problems of distinguishing between transactions in which a
receivable secures an obligation and those in which the receivable has been sold outright” and
leaves classification of particular transactions to the courts. Id. cmt. 4.
    45. See, e.g., NetBank, FSB v. Kipperman (In re Commercial Money Center, Inc.), 350 B.R.
465, 481 (B.A.P. 9th Cir. 2006) (“Although Nevada law governs, neither party has argued that there
is anything distinctive about Nevada’s approach to the issue and both parties treat decisions from
other states as relevant.”).
    46. E.g., id. at 474 (holding that a bankruptcy court’s decision on the loan-versus-sale issue is a
factual question, not a mixed question of law and fact, and thus is reviewed only for clear error).
    47. See In re LTV Steel Co., 274 B.R. 278, 285–86 (Bankr. N.D. Ohio 2002) (using equitable
considerations to conclude that receivables belonged to the debtor’s estate).
    48. See, e.g., Wawel Sav. Bank v. Jersey Tractor Trailer Training, Inc. (In re Jersey Tractor
Trailer Training, Inc.), No. 06-02003, 2007 WL 2892956, at *8 (Bankr. D.N.J. Sept. 28, 2007)
(deciding the case on the ground that the parties clearly intended a “true sale,” and suggesting that
other factors are relevant only when the parties’ intent is not clear).
494                                   Texas Law Review                                [Vol. 87:487

seem to think that no securitization transaction, no matter how structured, can
put assets beyond the reach of a debtor’s bankruptcy estate.49 Some have
adopted a middle ground, ostensibly using the parties’ “intent” as the stan-
dard, but deducing that intent from the substantive provisions of the deal, and
giving little weight to the formal language of the contract.50 Substantive fac-
tors that might cause a court to recharacterize a sale of receivables as a loan
include recourse to the seller, the seller’s retention of loan-servicing
functions, the seller’s collection and commingling of proceeds with its own
funds, the seller’s right to excess collections, and the seller’s right to repur-
chase assets or to change the terms of the underlying loans.51 Generally, to
the extent that the “seller” continues to share in the risks and rewards associ-
ated with the underlying assets, courts that focus on substance are more
likely to reject a true-sale characterization.52
      In such a legal landscape, predicting how any particular court will
evaluate a given transaction is not easy. Fortunately for accountants and the
lawyers who advise them, however, GAAP purports to offer some relief: the

    49. See, e.g., Octagon Gas Sys., Inc. v. Rimmer (In re Meridian Reserve, Inc.), 995 F.2d 948,
957 (10th Cir. 1993) (approving a holding that the account was “property of the debtor’s estate
regardless of the nature of the underlying transaction”). The drafters of revised Article 9 countered
in 2001 with an amendment to the U.C.C. making clear that “[a] debtor that has sold an account . . .
does not retain a legal or equitable interest in the collateral sold.” U.C.C. § 9-318(a). For an
account of this provision as a response to the Octagon decision, see Lois R. Lupica, Revised Article
9, Securitization Transactions and the Bankruptcy Dynamic, 9 AM. BANKR. INST. L. REV. 287,
300–02 (2001). More recently, the odd holding in LTV Steel, 274 B.R. at 285–86, that a debtor
maintained “at least an equitable interest” in the cash proceeds of sold assets it “create[d] with its
own labor,” has raised eyebrows. See Kenneth N. Klee & Brendt C. Butler, Asset-Backed
Securitization, Special Purpose Vehicles and Other Securitization Issues, UCC L.J., Fall 2002, at 23,
57 (stating that the LTV Steel decision “created a good deal of concern in the financial industry”).
By recharacterizing the sale as a loan, the LTV Steel court sought to retain sufficient cash in the
debtor’s estate to make Chapter 11 reorganization viable—and thus to keep a large manufacturer in
business and save thousands of local jobs. LTV Steel, 274 B.R. at 285–86. It should be noted,
however, that LTV Steel was not a final decision on the merits, but simply a rejection of a creditor’s
application for emergency relief from an interim order allowing the debtor to use cash collateral. Id.
at 279, 287.
    50. See, e.g., Bear v. Coben (In re Golden Plan of Cal., Inc.), 829 F.2d 705, 709 (9th Cir. 1986)
(“Whether the parties intended outright sales or loans for security is determined from all the facts
and circumstances surrounding the transactions at issue.”); see also Commercial Money Center, 350
B.R. at 481 (citing Golden Plan for the proposition that a court should look at all of the
circumstances to decide whether a transaction is a sale or a loan); cf. Major’s Furniture Mart, Inc. v.
Castle Credit Corp., 602 F.2d 538, 545 (3d Cir. 1979) (“In cases of this kind it is more important
what parties actually do than what they say they do.”).
    51. In Jersey Tractor Trailer, 2007 WL 2892956 at *7–8, the court helpfully summarized these
factors with references to case law; however, ironically, it went on to decide the case at hand based
entirely on the stated intent of the parties.
    52. Compare Golden Plan, 829 F.2d at 709 (citing the unconditional nature of the transfer—and
its express disavowal of any recourse—as dispositive of true-sale status), with Fireman’s Fund Ins.
Co. v. Grover (In re Woodson Co.), 813 F.2d 266, 271–72 (9th Cir. 1987) (finding a transfer to be a
loan because the transferees bore no risks), and Major’s Furniture Mart, 602 F.2d at 545 (finding
that the transferor’s retention of “all conceivable risks of uncollectibility” supported
recharacterization of the “sale” as a transfer of a security interest).
2008]                   The True-Sale Problem in Securities Law                                495

accounting judgment need only provide a “reasonable assurance” based upon
the evidence available.53

V.    Application of the GAAP Standard in SEC Enforcement Actions
     Substantive legal analysis of the true-sale question in a securities
context is hampered by a near-total dearth of case law. SEC civil
enforcement actions tend to settle long before a court has the opportunity to
reach a final judgment on the merits.54 In a typical settlement, defendants
admit no wrongdoing, but consent to payment of a civil fine and agree to
submit to an injunction requiring them to set up sufficient internal controls to
ensure future compliance with GAAP.55 The SEC’s interpretation of
GAAP’s true-sale analysis, though never judicially tested, has become the de
facto rule.
     Because it is almost never tested on the merits, the SEC can get away
with brevity and vagueness in its pleadings.56 In challenging a transaction’s
true-sale status, SEC pleadings generally invoke GAAP but do not delve into
the specifics of the GAAP analysis prescribed by SFAS 140.57 Far from un-
dertaking the substantive-law inquiry called for in GAAP’s treatment of

     53. See SFAS 140, supra note 6, ¶¶ 27–28 (recommending that “all available evidence” be
considered in order to provide “reasonable assurance” that the asset will be beyond the reach of
creditors); see also id. ¶ 153 (“[T]he Board concluded that having to consider only the evidence
available should make that requirement workable.”). Lawyers preparing true-sale opinions on
behalf of ratings agencies, however, may not be so lucky. Standard & Poor’s guidelines require
such opinions to state their conclusions with confidence by saying “would” rather than “should,”
disallowing qualifiers such as “not free from doubt”—and, whatever else they do, the guidelines
mandate that the opinions must not mention LTV Steel! STANDARD & POOR’S, LEGAL CRITERIA
supra note 2, at 79–80. On the ethical duties and professional-responsibility compliance issues
facing lawyers who prepare true-sale opinions in securitization transactions, see generally Steven L.
Schwarcz, The Limits of Lawyering: Legal Opinions in Structured Finance, 84 TEXAS L. REV. 1
     54. See JAMES D. COX ET AL., SECURITIES REGULATION 773 (4th ed. 2004) (“[M]ost SEC
enforcement proceedings (over 90 percent) are settled, not litigated.”).
     55. For more discussion of the cases examined in this Note, see PNC Fin. Servs. Group, Inc., 10
S.E.C. 1064, 1090 (July 18, 2002), available at
See also Press Release, SEC, Doral Financial Settles Financial Fraud Charges with SEC and Agrees
to Pay $25 Million Penalty (Sept. 19, 2006) [hereinafter Doral Press Release], available at http://; Press Release, SEC, First Bancorp Settles SEC
Financial Fraud Charges Involving “Non-Conforming” Mortgages (Aug. 7, 2007) [hereinafter First
BanCorp Press Release], available at
     56. While the SEC’s recitations of GAAP violations tend to be short and simple, private
litigants, forced to meet PSLRA’s heightened pleading requirements, typically go into much greater
detail. In the Doral case, discussed infra, the SEC’s complaint is a scant sixteen pages while the
private plaintiffs’ complaint, alleging essentially the same facts, runs to a full 167 pages.
     57. See, e.g., Complaint at 9, SEC v. Doral Fin. Corp., No. 06-CV-7158 (S.D.N.Y. Sept. 19,
2006) [hereinafter Doral SEC Complaint], available at
2006/comp19837.pdf; Complaint at 4–5, SEC v. First BanCorp, No. 07-CV-7039 (S.D.N.Y. Aug. 7,
2007) [hereinafter First BanCorp SEC Complaint], available at
complaints /2007/comp20227.pdf.
496                                  Texas Law Review                               [Vol. 87:487

isolation and recourse, securities complaints that raise the true-sale issue
typically do not even make reference to state substantive law.58 Because
companies that draw the SEC’s attention tend to be involved in a variety of
serious accounting irregularities, if not outright frauds, the true-sale issue
may get relatively little space.59
      Although the SEC has not formally joined the judicial and academic
debate over what makes a true sale, its enforcement priorities are strongly
suggestive of its views on the matter. As is appropriate for an agency whose
purpose is to enforce accurate disclosure of companies’ true financial
conditions, the SEC is concerned with the substantive characteristics and
consequences of transactions, and gives little weight to what the parties call
them.60 The SEC will challenge true-sale accounting when the risks and re-
wards associated with the assets remain with the “seller,” because such
arrangements tend to obscure the true state of the transferor’s finances.61
      Among Enron’s numerous other accounting violations, the SEC took
issue with one of its SPE arrangements.62 GAAP required that at least 3% of
the equity capital in an SPE come from an outside investor.63 But Enron
orally promised the investor, CIBC Bank, that its 3% stake would be
repaid.64 The SEC argued that because the transferee was thus protected
from risk, it did not count as a true sale.65 The SEC made the same com-
plaint about a similar arrangement in the PNC case, where advance payment
of a “management fee” to the outside investor effectively offset its 3% stake,
and where PNC retained the risks and benefits of an investment denominated
in its own preferred stock.66

    58. See infra notes 66–78 and accompanying text.
    59. For an extreme example, see the SEC’s complaint against the Enron officers, in which the
true-sale issue merits only two paragraphs in a sixty-page pleading, Second Amended Complaint at
15, SEC v. Lay, No. H-04-0284 (S.D. Tex. July 8, 2004) [hereinafter SEC Enron Complaint],
available at
    60. See SEC REPORT, supra note 7, at 101–02 (arguing for an “objectives-oriented” approach
that looks to the underlying reality and purpose of the accounting standards, as against rule-based,
bright-line standards that “allow financial engineers to achieve technical compliance with the
standard while evading the intent of the standard”).
    61. See, e.g., id. at 11 (contrasting GAAP’s “control approach” with a “risks and rewards
analysis” that asks how various events might affect the value of investors’ holdings in an entity).
    62. SEC Enron Complaint, supra note 59, at 15.
    63. Id. at 9.
    64. Id. at 15.
    65. Id.
    66. PNC Fin. Servs. Group, Inc., 10 S.E.C. 1064, 1090 (July 18, 2002), available at In this case, the issue was not the true-sale
analysis under SFAS 140, but whether the SPE transferee was sufficiently distinct from PNC to
avoid “consolidation,” which would force PNC to list the SPE’s assets and liabilities on its own
balance sheet. Id. Consolidation, of course, would defeat the whole purpose of the transaction,
which was to enable PNC to keep the debts off its books.
    For the GAAP test for nonconsolidation that was in effect at the time of the financial statements
at issue in the Enron and PNC cases, see EMERGING ISSUES TASK FORCE, FIN. ACCOUNTING
2008]                    The True-Sale Problem in Securities Law                                    497

     The Enron and PNC cases concerned SPEs, special entities created by a
transferor solely for the purpose of accommodating a securitization.67 But
similar issues and problems can arise in arm’s-length transactions between
independent parties. The mortgage-securitization deal between Doral
Financial and FirstBank offers an excellent case study, in which we can
observe the SEC pursuing mirror-image actions against both transferor and
transferee based on improper true-sale accounting.68 Doral, the leading mort-
gage lender in Puerto Rico, pooled and securitized its mortgages and sold
them to FirstBank.69 The contract contained limited-recourse provisions, by
which Doral promised to repurchase or substitute mortgages that became de-
linquent in their first two years, up to a maximum of 10% of the total
principal.70 It was later revealed, however, that Doral’s managers had orally
promised FirstBank that they would extend the repurchase guarantee beyond
two years, to the full term of the loans.71 This promise turned “limited re-
course” into full recourse and disqualified the transaction from true-sale
treatment. Effectively, FirstBank had made a loan to Doral and taken the
mortgages as security.
     Both sides benefited—on paper—from accounting for the deal as a sale.
Doral recognized revenue from the “sale,” overstating its income by nearly
$600 million.72 FirstBank profited by earning $100 million in risk-free
interest, thanks to other secret provisions by which Doral assumed the risk of
interest-rate fluctuations.73 By characterizing the mortgages as “bought”
rather than as security for a loan to Doral, FirstBank was able to overstate its
own assets for purposes of complying with the Federal Deposit Insurance
Corporation’s (FDIC) capitalization requirements—thus allowing it, in turn,

90-15.pdf. This report notes that the general consensus of the FASB’s Emerging Issues Task Force
was that “3 percent is the minimum acceptable investment” to prevent consolidation of an SPE. Id.;
cf. id. at 11 (noting that a different consolidation test applies to financial statements filed in or after
2003). The SEC’s concerns in this context are, however, essentially the same as with SFAS 140:
whether the risks and benefits stay with the transferor. Id.
     67. GAAP’s special accounting rules for SPEs and Qualifying Special Purpose Entities
(QSPEs) are beyond the scope of this Note. See generally SFAS 140, supra note 6, ¶ 35–46;
SCHWARCZ, supra note 2, at 89–98.
     68. See complaints cited supra note 57. Both companies were also targets of shareholder
litigation over the same issues, and the pleadings in the private suits offer much more detail. See
generally Consolidated Amended Complaint, In re Doral Fin. Corp. Sec. Litig., No. 1:05-md-
01706-RO (S.D.N.Y. June 22, 2006), available at
2006622_r01c_051706.pdf; Amended Class Action Complaint, Fox v. First BanCorp, No. 05-CV-
2148 (D.P.R. Feb. 13, 2006) [hereinafter Fox Complaint], available at
     69. Doral SEC Complaint, supra note 57, at 3, 9.
     70. First BanCorp SEC Complaint, supra note 57, at 3–4.
     71. Doral SEC Complaint, supra note 57, at 9; First BanCorp SEC Complaint, supra note 57, at
4; Fox Complaint, supra note 68, at 68–74.
     72. Doral SEC Complaint, supra note 57, at 10.
     73. First BanCorp SEC Complaint, supra note 57, at 1, 4.
498                                  Texas Law Review                              [Vol. 87:487

to borrow more from other banks.74 Correctly recharacterizing the
transaction as a loan would have caused FirstBank to fall below the FDIC’s
threshold for “well-capitalized” status, with various unpleasant
consequences.75 Needless to say, the SEC took a dim view of a transaction
that was deliberately designed to conceal its true impact on the parties’ bal-
ance sheets. The SEC charged that the deal substantively violated GAAP by
providing for full recourse and that the secret nature of the deal violated both
companies’ disclosure obligations.76 Both defendants quickly settled.77
      The SEC’s interpretation of GAAP on the issue of recourse merits
closer attention, because it contradicts what GAAP actually says. Doral had
obligated itself to buy back loans in case of default—a trigger event beyond
its control—and the SEC cited this obligation as a violation of GAAP.78 But
SFAS 140 specifically provides that a repurchase obligation for the
transferor, by itself, does not preclude true-sale accounting.79 Only an
obligation combined with an option, or an option alone, violates the third
prong of GAAP’s control test.80 Why this difference? GAAP—reflecting
the concern of underwriters and ratings agencies to make deals bankruptcy-
proof—is primarily concerned with whether the transferor can be said to ex-
ercise control over the assets, because too much “effective control” might
tempt a judge to recharacterize the agreement as a lease and return the assets
to the transferor–debtor’s estate.81 For the SEC and for the investing public,
though, both of which care more about a company’s fortunes before it
reaches the point of bankruptcy, control is not the issue. Rather, the problem
is obligation—the danger that the transferor could find itself responsible for
future losses caused by trigger events beyond its control, and that those li-
abilities would come as a surprise because everyone thought they had been

    74. Fox Complaint, supra note 68, at 17–20.
    75. Id.
    76. Doral SEC Complaint, supra note 57, at 9; First BanCorp SEC Complaint, supra note 57, at
4. FirstBank did not improve its position when it attempted to conceal the true nature of the
interest-rate provisions by backdating documents. First BanCorp SEC Complaint, supra note 57, at
    77. See press releases cited supra note 55. Settlements of the private shareholder suits in both
cases, with substantial payouts, soon followed. See Notice of Pendency and Proposed Settlement of
Class Action at 1, In re First BanCorp Sec. Litig., No. 3:05-cv-02148-GAG (D.P.R. Aug. 13, 2007),
available at (settling for $74.25 million); Notice of
Pendency and Proposed Partial Settlement of Class and Derivative Actions at 1, In re Doral Fin.
Corp. Sec. Litig., No. 1:05-md-01706-RO (S.D.N.Y. May 2, 2007), available at http://www.gilardi.
com/pdf/dfnl1not.pdf (settling for $129 million).
    78. Doral SEC Complaint, supra note 57, at 9; First BanCorp SEC Complaint, supra note 57, at
    79. SFAS 140, supra note 6, ¶ 217.
    80. Id. ¶¶ 9(c), 217.
    81. Id. ¶¶ 9(a), 152–53.
2008]                   The True-Sale Problem in Securities Law                                499

safely transferred off the company’s books.82 To the extent that the SEC’s
priorities differ from those of the FASB, the SEC redefines GAAP to suit its
own ends. In this way the SEC uses its enforcement powers, theoretically
limited to matters of procedure and disclosure, to get its way on a substantive
issue. Whether the SEC’s interpretation of GAAP would withstand judicial
scrutiny is probably an academic question, because it seems unlikely a de-
fendant company will ever fight back long enough for a court to reach the

VI. Application of the GAAP Standard in Private Securities Litigation
      Although private securities actions face tough procedural hurdles under
the PSLRA, a claim based on improper true-sale accounting, stated
specifically enough, can be legally sufficient to survive a motion to dismiss.83
Cases that make it past this stage typically settle without any resolution on
the merits.84 The settlement agreements—the fairness of which must be
justified to the court in class actions—regularly cite the uncertainty of further
      Generally, private actions take the same approach to true-sale analysis
as the SEC, with the difference being that heightened pleading requirements
force private plaintiffs to spell out their arguments more clearly and
specifically.86 Like the SEC, private litigants emphasize substance over form
in true-sale analysis, because their causes of action are founded on
defendants’ failure to disclose the true nature of a transaction.
      The Spiegel case is illustrative.        A retailing company pooled,
securitized, and sold the receivables of its store credit-card accounts.87 The
shareholders’ complaint, closely following GAAP’s control test, alleged that
Spiegel retained control of the transferred accounts in a variety of ways. It

    82. See SEC REPORT, supra note 7, at 8 (stating as the report’s purpose the improvement of
“transparency” in financial statements, which it defines as “reporting that provides investors and
other users of financial statements with appropriate information to assess the material risks,
rewards, rights, and obligations associated with arrangements”).
    83. See, e.g., In re Spiegel, Inc. Sec. Litig., 382 F. Supp. 2d 989, 1023 (N.D. Ill. 2004) (mem.)
(order upholding claims against all but one defendant) (finding that the plaintiff’s claim of a true-
sale violation was stated with sufficient specificity). For a detailed discussion of the complex
factual and procedural background of this case, see id. at 996–1011.
    84. Updates on the settlement status of the cases discussed here can be found at the Stanford
Securities Class Action Clearinghouse, For information about a
particular case, click the Search link and enter the name of the defendant company.
    85. See, e.g., Lead Plaintiff’s Unopposed Motion and Memorandum of Law for Preliminary
Approval of Settlement at 5, In re First BanCorp Sec. Litig., No. 3:05-cv-02148-GAG (D.P.R., July
24, 2007), available at
(“Plaintiffs . . . recognize the expense and length of continued proceedings . . . [and] are also
mindful of the inherent problems of proving, and the possible defenses to, the violations of the
federal securities laws asserted in the Complaint.”).
    86. See supra note 18 and accompanying text.
    87. Spiegel, 382 F. Supp. 2d at 1000–03.
500                                    Texas Law Review                               [Vol. 87:487

retained the ability to appoint trustees and to change terms on the underlying
credit accounts; it could decide when to write off individual delinquent
accounts; and it collected the receivables and was free to commingle the cash
with its own funds.88 Although Spiegel was obligated to buy back the
accounts, the company’s financial disclosures falsely described the
transactions as non-recourse, and concealed the fact that various “payout
events” might require Spiegel to divert much of its own cash flow to pay off
investors.89 In its preliminary ruling on the defendants’ motion to dismiss,
the court decided that the plaintiffs had met the high pleading threshold be-
cause their allegations of GAAP violations were backed by detailed and
specific challenges to the company’s financial models.90

VII. Statutory Responses to the True-Sale Problem
       The drafters of the Uniform Commercial Code attempted to place sales
of accounts beyond the reach of bankruptcy courts by adding § 9-318, which
declares that a debtor “does not retain a legal or equitable interest in the col-
lateral sold.”91 However, the U.C.C. does not provide any rules for
distinguishing between receivables that are truly “sold” and those that are
merely transferred as collateral for a loan.92 Some states have attempted to
fill that gap by adopting “true-sale statutes,” under which the stated intent of
the parties is more or less controlling, regardless of a transaction’s sub-
stance93—in other words, calling a dog a duck is legally sufficient to make it
so. It is unclear what weight, if any, such a statute would carry in the federal
bankruptcy context.94
       From time to time, there are calls for a sweeping federal solution to the
true-sale problem.95 An early version of the Bankruptcy Reform Act

    88. Third Consolidated Amended Complaint at 99–113, In re Spiegel, Inc. Sec. Litig., No. 02-
C-8946 (N.D. Ill. May 23, 2006), available at
    89. Id. at 29.
    90. Spiegel, 382 F. Supp. 2d at 1023. The case settled soon thereafter. Stipulation of
Settlement at 2, Spiegel, Inc. Sec. Litig., No. 02-C-8946 (N.D. Ill. Nov. 3, 2006), available at http://
    91. U.C.C. § 9-318(a) (2007).
    92. See id. § 9-318 cmt. 2.
    93. See, e.g., DEL. CODE ANN. tit. 6, § 2703A(a)(1) (2002); OHIO REV. CODE ANN.
§ 1109.75(A)(1) (West 2001) (both providing that any assets “purported to be transferred” in a
securitization transaction “shall be deemed” no longer to be property of the transferor); TEX. BUS. &
COM. CODE ANN. § 9.109(e) (Vernon 2002) (providing that “the parties’ characterization of a
transaction as a sale . . . shall be conclusive that the transaction is a sale and is not a secured
transaction”). For a discussion of these statutes as they apply to securitization transactions, see
SCHWARCZ ET AL., supra note 2, at 76–78.
    94. See Schwarcz, supra note 8, at 1547–48 (discussing the uncertain prospects for these state
statutes in federal bankruptcy courts).
    95. See, e.g., Steven L. Schwarcz, The Impact of Bankruptcy Reform on “True Sale”
Determination in Securitization Transactions, 7 FORDHAM J. CORP. & FIN. L. 353, 362–64 (2002)
2008]                   The True-Sale Problem in Securities Law                                  501

included a proposed § 912, which would have amended the Bankruptcy Code
to protect most asset-backed securitizations by placing them, once and for all,
definitively beyond the reach of the debtor’s bankruptcy estate.96 Had it
passed, § 912 would have made things much simpler for accountants strug-
gling with the “isolation” element of GAAP’s control test.97 It would have
put federal law squarely on the nominal, rather than the substantive, side of
the true-sale debate. Such a safe harbor would have been good news for par-
ticipants in securitization deals—but not necessarily for the investing public,
to the extent that it helped companies obscure the true state of their finances
by hiding recourse liabilities. However, § 912 fell victim to the fallout from
the Enron scandal. After commentators pointed out that its provisions would
have protected and encouraged some of the same kinds of SPE transactions
that had been exploited by Enron’s executives, § 912 was quietly
withdrawn.98 The backlash from the Enron scandal shifted the political
winds so sharply that some in Congress proposed legislation to expand,
rather than contract, the ability of federal bankruptcy courts to recharacterize
sales as secured loans and recover the assets for creditors.99

(arguing in favor of a legislative “safe harbor” that would place asset-backed securitizations beyond
the reach of the transferor’s creditors in bankruptcy).
    96. Bankruptcy Reform Act of 2001, S. 220, H.R. 333, 107th Cong. § 912 (2001). The Act
proposed two new subsections to § 541 of the Bankruptcy Code. Id. One stated that an “eligible
asset” transferred by the debtor “to an eligible entity in connection with an asset-backed
securitization” will not be considered the property of the debtor’s estate. Id. § 912(b)(8). The other
stated that the validity of such a transfer would be determined solely by the debtor’s stated intent to
remove the asset from the estate, and that the presence of recourse or repurchase obligations, or the
characterization of the transaction for tax, accounting, or regulatory purposes, is not relevant. Id.
§ 912(f). For a discussion of the proposed § 912 and its implications for the true-sale doctrine, see
generally Jonathan C. Lipson, Enron, Asset Securitization, and Bankruptcy Reform: Dead or
Dormant?, 11 J. BANKR. L. & PRAC. 101 (2002). Lipson’s article discusses the benefits and
disadvantages involved in applying the proposed § 912 to existing asset-securitization issues in light
of the Enron scandal. Id.
    97. SFAS 140, supra note 6, ¶¶ 9(a), 27, 152–53.
    98. See Lipson, supra note 96, at 102–03 (discussing the political climate that defeated the
proposal). However, some commentators supported the proposed reform and believe that Congress
overreacted in withdrawing it. E.g., Schwarcz, supra note 95, at 353.
    99. In 2002, Senator Richard Durbin and Representative William Delahunt introduced the
Employee Abuse Prevention Act, which, among other things, would have allowed bankruptcy
courts to recharacterize sale transactions if their “material characteristics” were “substantially
similar” to those of secured loans. S. 2798, H.R. 5221, 107th Cong. § 102 (2002). The bill died in
committee. See Library of Congress, THOMAS,
2002 (providing the status of the House and Senate versions of the Employee Abuse Prevention
Act). The legislation would have allowed federal bankruptcy judges to consider recharacterization
based entirely on their own judgment of the substance of the transaction, without any reliance on
state substantive law. See Schwarcz, supra note 8, at 1544–45 (criticizing the Durbin–Delahunt bill
for “replac[ing] generally applicable and settled state law with a vague federal test”).
502                                Texas Law Review                 [Vol. 87:487

VIII. Conclusion
      Those looking for certainty and consistency will find true-sale law
maddening. GAAP’s standard for true-sale accounting depends on a
substantive law that is itself an incoherent patchwork.100 SEC enforcement
actions and private securities lawsuits invoke GAAP but gloss over its com-
plexity, ignoring the jurisdiction-specific substantive-law analysis called for
in SFAS 140.101 Even if § 912 or similar federal legislation had been enacted
to change the underlying substantive law, it would have made little differ-
ence. After all, the SEC has shown that it can ignore specific GAAP
provisions when it wishes.102 The SEC is unlikely to be forced to defend the
merits of its positions in federal bankruptcy court—or, for that matter, in any
other court.103 In the absence of substantive guidance from the courts, the
SEC has filled the vacuum by making its own true-sale law. It remains free
to use GAAP as a sword, but its targets cannot shield themselves behind
GAAP’s true complexity, since even technical compliance does not relieve a
company of its disclosure obligation.104 Precisely because courts never reach
the merits of the issue, the SEC is able to impose and enforce its own inter-
pretation of GAAP—and, in the case of recourse obligation, without regard
to what GAAP actually says.105 Even if all securitizations were characterized
as “sales” as a matter of law, the SEC would still be able to insist on full dis-
closure of any substantive arrangements that left risks or benefits with the
transferor. Companies that used such transactions to hide liabilities and in-
flate earnings would not likely face any less jeopardy than they do now.
Even if the law calls it a duck, failing to disclose to investors the risk that it
will bark and chase after cars may land the company in the doghouse.
                                                              —Michael Gaddis

  100.   See supra Part IV.
  101.   See supra Parts V and VI.
  102.   See supra notes 78–82 and accompanying text.
  103.   See supra notes 55–59 and accompanying text.
  104.   See supra note 16 and accompanying text.
  105.   See supra notes 78–79 and accompanying text.