The tale of a four-legged dog

The following riddle has been attributed to Abraham Lincoln: If you call a dog's tail a leg, how many legs does the dog have?

Answer: Four legs. Calling a tail a leg doesn't make it a leg.

What's the relevance of this to transactional lawyers? We occasionally come across transactions that are called one thing, but are really another. We need to be ready to look past nomenclature and window dressing and see the realities of every situation we face.

Example: Your client has delivered equipment to a counterparty, who has promised to pay the purchase price for the equipment over time. The purchase agreement specifies that your client retains title to the equipment until the purchase price is fully paid. Does your client actually continue to own the equipment? The answer is no, notwithstanding the terms of the parties' agreement: Section 2-401(1) of the Uniform Commercial Code tells us that the retention by a seller of title to goods that have been delivered to a buyer is actually a security interest.

Be on the alert when you hear the word "deem" being thrown around loosely. Often, it's a signal that someone is about to call a dog's tail a leg. Here's an illustration: Your client, a private equity firm, wants to take some cash out of a company that it owns. You explain to your client that if this is done through having the company pay a dividend, the minority investor that owns 10% of the common stock of the company would get 10% of the dividend payment. That's no good, says your client. Can't we just deem the payment to be a management fee? Probably not, unless there is a valid agreement between the company and your client providing for the payment of such a fee. Not only would this approach give the minority investor a valid beef, but the IRS might take issue with the "management fee" being treated as a deductible business expense.

A recent news story — about the now-defunct Lehman Brothers using a transaction called "Repo 105" — involves a five-legged dog that has historically been treated as having four legs having five legs after all! Confused? Good. That was the idea.

Let's unwind this by looking first at a repurchase agreement (also called a "repo"), a very common transaction among financial institutions. Party A has a financial asset, let's call it a $1 million U.S. Treasury note, and needs cash on a short-term basis. It enters into a repurchase agreement with Party B in which Party B "buys" the Treasury note for $1 million, and agrees to "sell" it back a week later for $1,000,500. Despite the fact that repurchase transactions like this are clothed in the language of sale, they are usually treated for accounting and legal purposes as secured financings: Party B is not actually buying the note, it is lending Party A $1 million, getting a security interest in the note and receiving an interest payment at the end of a week of $500. What we have here is a five-legged dog that everyone knows has only four legs.

Now, what did Lehman Brothers do? It entered into repurchase transactions that it actually accounted for as sales. Why? To dress up its balance sheet by making it appear it had less debt. It worked like this: shortly before the last day of a reporting period (let's say on December 28), it engaged in a large repo transaction, which was designed to be reversed on January 3. On December 28, it would use the proceeds of the repo transaction to pay down debt (which it would have to reborrow on January 3 in order to repurchase the securities that were the subject of the repo). Its balance sheet as of December 31 therefore misleadingly showed its debt levels to be less than they actually were, by an order of magnitude of tens of billions of dollars. All by doing transactions that were called sales, which should have been treated as financings, but in fact were actually treated as sales after all.