Too Complex to Perceive? Drafting Cash Distribution Waterfalls Directly as Code to Reduce Complexity and Legal Risk in Structured Finance, Master Limited Partnership, and Private Equity Transactions

Abstract

The intricate procedural and data-driven decision trees that play a critical role in complex financial contracts like cash distribution waterfalls in structured finance agreement indentures (e.g., collateralized debt obligations (CDOs)), master limited partnership agreements, and private equity fund agreements are inefficiently depicted as written contracts. As Professor Henry Hu explains in Too Complex to Depict? the difficulty of translation — or depiction — between original mathematical models, plain English prospectuses, legal contracts, and programmed execution means that often the written depictions that form the basis of disclosures do not accurately define the act of execution. To overcome this, the SEC proposed an amendment to Regulation AB that would require disclosure of special-made cash flow waterfalls programs for asset-backed securities (ABS) to escape the limitations of language. British and Australian regulators have already implemented a similar code disclosure regime. Likewise, Professor Hu goes further and supports a “perfect information” model that presumably would require disclosure of the actual computer programs used by, e.g., CDO trustees to execute cash distributions.These proposals and implementations create a new problem: perception. In the status quo, problems of depiction mean that the two disclosed documents — contract and prospectus (or offer memorandum) — must be interpreted by the parties to determine what the reality of execution of the deal — calculating cash payments — will or should look like. The SEC and Professor Hu add a third, distinct, legally binding depiction: the code. While that code might accurately depict execution before a dispute, in the event of a dispute, all three depictions will be in play and could influence what the future reality of cash distribution will be. Each additional legally relevant disclosure increases the challenge for dealmakers trying to predict what will happen in the event of a dispute.This Article proposes reducing the number of legally relevant depictions of largely procedural arrangements to one: the code. Rather than add the code as yet another disclosure, in deals between sophisticated investors concerning these complex products, the dealmakers should not only disclose the code but negotiate about the code directly. Following the model of construction contracts that incorporate blueprints, financial contracts should incorporate the code that will be used to calculate the cash distribution. This solves the problems of depiction and perception because the code both describes and executes the agreement, and in turn reduces risk in these deals.Part I.A. describes the exemplar product: the CDO. Part I.B expands Professor Hu’s description of the intermediary depiction problem by explaining the problem of perception of the future legal reality and its impact on business risk. Part II.A proposes reducing human discretion in procedural financial arrangements to facilitate coded automation of those processes, and in turn incorporating that code into the contract. Part II.B then explains how the SEC should adjust its prospectus paradigm and remove unsophisticated investors from certain product markets to permit this proposal. It then suggests the SEC should mandate this deal-making model. Finally it addresses the challenge that the bankruptcy regime poses for this proposal.