Special Purpose Entities

Definition of Special Purpose Entities

Special Purpose Entities (“SPEs” ) are legal entities created -according with the Bond Market Association- for a particular purpose and are used in structuring a wide range of capital markets products across the globe. Special Purpose Entities are also referred to as Special Purpose Vehicles (SPVs). The terms are used interchangeably in the financial markets.

Securitized instrument

From ISDA (2002):

• Securitization Special Purpose Entities are legal entities such as corporations, trusts, or partnerships established for a specific and limited purpose. An Special Purpose Entity essentially acts as a depository for a specific group of assets in a securitization, and in turn, issues securities to the marketplace for purchase by investors.
• Special Purpose Entities do not have the right or ability to engage in any activities other than those rights granted to them in the legal documents creating and governing the securitization transaction and the SPE. Once the Special Purpose Entity is created, it must operate as a wholly independent entity. This generally includes appointing its own directors, paying all of its own expenses, not paying the expenses of the selling entity and not commingling its assets with those of any other entity, including the seller.
• Once assets are transferred to an Special Purpose Entity, they are “legally isolated” and consequently are no longer available to the seller or its creditors. The deposited assets can be used only to make payments on the securities issued to investors and may not be reclaimed by the seller.
• Securitizations would not take place without the ability to establish SPEs. Investors
  do not want to take on any risk associated with the seller. They only are willing to
  take on a specified degree of risk associated with the specific pool of securitized
  assets in which they are investing. In other words, Special Purpose Entities protect investors from the bankruptcy or other adverse credit event affecting the financial institution that
  establishes and/or sells assets to the Special Purpose Entity.
• These securitization Special Purpose Entities are considered “bankruptcy remote” since they are isolated from the financial institution that created and/or sold assets to them, and are precluded from taking on new activities and new financial obligations.

Accountability

From ISDA:

• Depending on the features of the Special Purpose Entity, the assets and liabilities of an SPE may or may not be required to be included, or “consolidated” in the financial statements of the entity that created the Special Purpose Entity.
• Special Purpose Entities often are not permitted to be consolidated in the financial statements of the entity that created that Special Purpose Entity because doing so may make a company appear to be larger than it actually is.
• This would be particularly relevant in the event of a bankruptcy, where any assets deposited into a bankruptcy-remote Special Purpose Entity could not be accessed by the creditors of the entity that created it, even if the Special Purpose Entity has been consolidated in (or appears on) that entity’s financial statements.
• In addition, consolidating an Special Purpose Entity on the financial statements of a company would imply a level of control over the Special Purpose Entity which the company does not exercise.
• Even without consolidating the Special Purpose Entity, any risks associated with SPE transactions are required to be disclosed in a company’s financial statements.
• Lending obligations to Special Purpose Entities are included in disclosures about commitments.
• Securities issued by the Special Purpose Entity, but retained by the financial institution that established the SPE rather than sold to third parties, are included on the balance sheet and
  disclosed in the footnotes to the financial statements.
• Derivative positions (for example, the selling financial institution may be a counterparty to an interest rate swap agreement with the Special Purpose Entity to convert fixed rate assets into floating rate assets, or vice versa) with Special Purpose Entities are recorded on the balance sheet and disclosed in public filings.

Standards for Accounting in the United States

From ISDA:

• The SEC has the legal authority, in the United States, to establish financial accounting and reporting standards for issuers of securities sold to the public, including Special Purpose Entities and their sponsors. The SEC has delegated standard-setting authority to the Financial Accounting Standards Board (“FASB” ), so long as the public interest is served.
• The FASB was established in 1973 and sets financial accounting and reporting standards for publicly and privately held companies.
• The FASB’s Emerging Issues Task Force (“EITF” ) assists the FASB in the early identification of issues affecting financial reporting and with implementation of authoritative pronouncements.
• The SEC, the FASB and the EITF have issued a number of pronouncements on
  accounting for Special Purpose Entities.

Securtizations

This section describes Special Purpose Entities created in connection with securitizations. The U.S. securitization market grow in 2002 to $5.2 trillion, providing necessary liquidity to U.S. financial institutions and their customers, including both individuals and businesses. Special Purpose Entities were a critical component of this process.