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Abstract

This Article proposes that complex structured finance transactions involving sophisticated investors should adopt an analogous solution to the home construction agreements’ strategy of contracting by reference to blueprints. First, dealmakers should, preferably by choice, place as much of their waterfall distribution specification and related inputs as possible into automated, programmatic representations that will be used to make the actual distribution. In many cases, these agreements already have programmatic representations, so this change should pose relatively few practical challenges logistically. Second, they should, like their counterparts in construction contracts, define the terms of those waterfalls by reference to their functional representations. The contract should be depicted by the same code that will decide the actual distribution, and that coded depiction should be the legally binding contract. By unifying the functional and legal realities of the structured finance products, dealmakers will avoid wasting resources on creating unnecessary and inaccurate legal depictions, and will also reduce the legal and financial risk created by the imprecision and inaccuracy of perception those poor depictions create.

This Article will proceed as follows: In Part II, this Article sets out to restate and expand Professor Henry Hu’s explanation of the intermediary depiction problem with what this Article terms the challenge of perception. Professor Hu observes that the difficulty with the current regulatory disclosure regime is one of imperfect depictions and could be fixed with pure information disclosure. By contrast, this Article contends that so long as there are multiple potentially legally determinative depictions, there will be financial, legal, and systemic risk. Because of that, no regime of additional disclosures can, by itself, reduce those risks; if anything, adding to the number of potentially legally binding disclosures increases risk. Therefore, in Part III, this Article proposes that in complex structured finance agreements’ waterfalls and other similar agreements between sophisticated parties, the functional code that creates the functional reality should, as described above, become the contract by reference in the legal deal document and thus should become the legally determinative reality. This would reduce the confusion that impedes perception of the future reality of the financial product’s cash flow distributions.

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