When the Financial Accounting Standards Board (FASB) released its Exposure Draft, "The Consolidation of Certain Special Purpose Entities," it resulted in a great deal of confusion. What follows is a summary of the most relevant issues stated in the June 28, FASB draft, the results of follow-up meetings and our interpretation of the current FASB thinking.
The FASB Position
FASB has been examining the consolidation issue for several years. However, there can be no doubt that recent events have provided urgency to the process. FASB is primarily responsible to the Securities & Exchange Commission. The SEC dictates how and when U.S. publicly held companies issue financial statements. Given the current politically charged atmosphere, we believe there is virtually no chance that the final FASB guidelines will be relaxed from the current draft. Today's headlines argue much too strenuously in favor of supporting the draft regardless of its conservative nature. In addition, since most of the major issuers of ABCP as well as CLOs are bank sponsored, it is important to understand where the Fed and the OCC stand vis-a-vis regulatory capital as well as financial reporting.
There have been rumors that the Fed may resurrect the use of Regulatory Accounting Practices (RAP). Given its history (the cost of fixing the S&Ls), it is not likely that the Fed will seriously consider RAP as opposed to GAAP. Additionally, new guidelines coming from the Fed as well as the Bank for International Settlements, support traditional GAAP reporting for regulatory as well as SEC (public) purposes.
Consolidation of SPEs
FASB states in its introduction to the draft: "The Board believes that if a business enterprise has a controlling financial interest in an SPE, the assets, liabilities, and results of the activities of the SPE should be included in consolidated financial statements with those of the business enterprise (which is referred to as the primary beneficiary of the SPE in this proposed Interpretation)." One can easily conclude therefore, that the sponsors (primarily banks) of ABCP conduits will be forced to consolidate these SPE issuers on their balance sheets.
In addition, for those conduit sponsors that were anticipating relief in the form of an exception (to the consolidation dictates of the draft) as granted to "Qualified SPEs" - as defined in FASB Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" - we believe that this safe-harbor will apply to QSPEs in very limited circumstances.
The draft can be summarized as follows: if an entity (e.g., a bank) has the downside risk and receives the upside benefit resulting from the operations of an SPE, such SPE WILL be consolidated on to the balance sheet of its sponsor - there will be no exceptions (emphasis added by author).
Market Based Fees
& Variable Interests
Significant discussion centered around the possibility of having third parties provide liquidity lines to ABCP transactions as opposed to traditional providers, their (bank) sponsors. This may provide limited relief. How much can a corporate entity provide to a $600+ billion market - and at what price? The designation of liquidity fees as a "market based fee" is not clear as yet either. In addition, to the extent that the bank sponsor continues to receive the majority of the beneficial interest in a conduit (away from CP note-holders) it will be designated as the "primary beneficiary" and therefore the consolidated owner of the conduit.
Current FASB Thinking
On September 30, the FASB held an open "round table" discussion at which interested parties were invited to make their opinions known. In spite of some rather eloquent opposition, the round table resulted in a firming of the conservative nature of the draft.
Since then, FASB has had a number of follow-up meetings. in reverse chronological order:
* On November 6, the Board suggested that they may move away from a majority (of variable interests) model to a decision-making model as it relates to the designation of the primary beneficiary and the party to which the assets and liabilities of an SPE will be consolidated.
* On October 30, the Board confirmed its view that Multi-sellers, SIVs (conforming with U.S. GAAP) and single seller conduits are going to be consolidated. The only possible exception the board considered would be for an SPE that is really "brain dead," - that is, its sponsor has absolutely no ability to influence the activities of, or the asset/liability composition of the SPE.
* On October 18, the Board discussed issues related to the scope of the Proposed Interpretation, and the application of the variable interests approach, reaching the following decisions.
1. Classify entities into the following two categories: (1) entities for which the consolidation decision should be based on voting interests (companies meeting the broad definition of a "substantive operating enterprise," e.g., a real company with voting shareholders, employees, engaged in other businesses, etc.) and (2) entities for which the consolidation should be based on variable interests (in summary, some piece of the cash flow growing out of the assets held by the SPE).
2. Remove references to subsidiaries of substantive operating enterprises from paragraph 8(c). Thus, a group of assets and liabilities that are held within a separate corporation, partnership, trust, or other structure will be classified into one of the two categories discussed in item 1. Groups of assets and liabilities that are part of a larger structure are not entities subject to consolidation.
3. Include scope exceptions for registered investment companies subject to the Investment Company Act of 1940 and for transfers to formerly qualifying SPEs as described in paragraph 25 of FASB Statement No. 140.
4. Include discussion of common types of variable interest in the final Interpretation.
5. For nonqualifying SPEs, a transferor that holds a subordinated retained interest in the assets transferred to an entity is considered to be a variable interest holder.
6. The evaluation of variable interests will be primarily based on expected losses, but will also consider the ability to receive or obtain benefits from the enterprise's activity.
7. An enterprise should be deemed the primary beneficiary of an entity subject to consolidation based on variable interests if it holds a majority of the variable interests.
8. All parties involved with an entity subject to consolidation based on variable interests should reconsider consolidation if the governing documents or contractual arrangements among the parties change. The primary beneficiary also should reconsider consolidation if it reduces its interest in the entity. Also, if another entity acquires some or all of the primary beneficiary's interest, it should reconsider consolidation.
FORE Partners Capital, LLC (FORE pc) has been established to set up and manage Asset-Backed Securities Finance Companies (SFC's) for its own account as well as for the benefit of others. As an independent asset manager FORE pc has been structured to provide off balance sheet solutions for securitization market participants that may be subjected to balance sheet consolidation under new accounting guidelines.
FORE pc is convinced that the Board will continue in this conservative direction and every indication is that each iteration and interpretation of the guidelines is becoming more stringent and onerous. It is likely that the announcement following the November 6, 2002 meeting will confirm this hypothesis.
It would appear to us that the off-balance sheet treatment for bank-sponsored ABCP conduits as currently designed will cease as of this year end.