By Vinod Kothari

In the wake of Enron and the investigations and penalties that followed, two terms the most buzz: complex structured finance transactions and special purpose entities (SPEs). "Complex structured finance" is a relative term. Complexity is (a) in the eye of the beholder, and (b) is mostly retrospective, as it was in the case of Enron.

However, the accounting standard-setters in the U.S. are busy comprehensively revisiting the approach to SPEs. A new accounting rule - FIN 46 - was brought in that specifically excluded qualifying SPEs (QSPEs) for securitization transactions. However, the FASB proposes further amendments to the conditions of QSPEs, which, in the opinion of the industry, would render nugatory the whole concept of QSPEs, as no SPEs in practice would so qualify on a strict interpretation of the proposed rules.

While industry bodies such as the American Securitization Forum and the Bond Market Association have strongly opposed these changes, they have also asked the FASB to give serious thought to a brave new approach: Forget about off-balance sheet accounting altogether, and move to a new approach called the "matched presentation approach." This approach is inspired by the U.K. accounting standard, called FRS 5.

Under this approach, the assets of the SPE will be on the books of the transferor, but will be netted off by the non-recourse liabilities and external equity of the SPE. As a result, SPEs are no more off the balance sheet; they are on the balance sheet, though after netting off (in the sense of the net interest of the transferor being added to the asset value of the transferor). For details, see the ASF's proposal.

Is it not time to do a fundamental re-evaluation at the whole concept of SPEs, and consequently, their accounting? We invite you to share your thoughts on this issue, which, you will agree, is not only crucial to the $6 trillion-strong securitization industry, but also to the whole lot of synthetic leases and other off-balance sheet items.

The questions below are merely to inspire your thought process.

The discussion is not limited to these questions.

* Question 1: The age-old concept of an artificial legal entity is a creature of law that carries on a substantive business activity. Companies or corporations were envisioned centuries ago for carrying on business operations, clothed with an artificial legal personality. In case of special purpose entities, we narrow down the scope of operations of the entity to an extent where it is merely reduced to a bunch of assets - as if the assets are being given an incorporated status. Conceptually, this is still fine: You might have a corporation with multiple businesses, or a narrow line of business, which one can squeeze into the present concept of a special purpose entity. Do you agree with this?

* Question 2: If it is an entity that has either a substantive business or substantive assets, it must also have some identifiable owners. After all, a legal entity comes into existence only based on securitized ownership. Do you think the concept of ownership in SPEs is made virtually redundant by grossly inadequate capital, such that the so-called legal capital cannot be the risk capital of the entity?

* Question 3: Do you think the accounting concept of "equity" as "residual economic interest" in an enterprise, if applied properly, is enough to expand the accounting definition of "equity" to include the risk capital of SPEs, and therefore, consolidation norms may apply to SPEs based on such risk capital rather than economic capital?

* Question 4: Is there any justification for FAS 140 excluding qualifying SPEs from consolidation rules?

* Question 5: Possibly, the securitization industry needs to isolate assets more for the purpose of bankruptcy remoteness than for the purpose of off-balance sheet accounting. That is to say, off-balance sheet accounting is more a result than a reason for isolation of assets into SPEs. (Do you agree?) If this is the case, would things be much better if legal systems allowed isolation of assets without the assets being transferred into a separate vehicle? After all, an SPE is nothing but a legal myth and a mere device of isolation. For example, if the corporate laws allowed a company to have multiple cells within a company, each of which may have their independent assets and liabilities, the need to create artificial separation into SPEs would go away. Bankruptcy remoteness could be achieved on the balance sheet itself. Do you think such a development is needed at this stage? Notably, some countries like Italy have already

put in place enabling laws in this regard.

* Question 6: Do you agree with ASF's suggestion of a matched presentation approach to accounting for SPEs?

Vinod Kothari is an author, trainer and expert on securitization, asset-based finance, credit derivatives and derivatives accounting. To comment on this topic, visit Kothari at www.vinodkothari.com.

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