Senate Passes Financial Regulatory Reform: Asset-Backed Securities Provisions Modified in Final Bill, Remaining Inconsistencies With House Bill to Be Reconciled by Conference Committee

On May 20, 2010, the U.S. Senate passed a sweeping set of financial regulatory reforms in the form of the Restoring American Financial Stability Act of 2010 (the “Act”).¹ The Act, which passed by a vote of 59-39, culminates months of negotiations between Senate Banking Committee Chairman Christopher Dodd (D-CT) and several ranking Republicans, including Sens. Richard Shelby (R-AL) and Bob Corker (R-TN), as well as several weeks of debate on the Senate floor. Comprising over 1,600 pages of text, the Act would, among other things, create a new systemic risk regulator, establish the authority for the orderly resolution of non-bank financial institutions, consolidate the Office of Thrift Supervision into the Office of the Comptroller of the Currency, regulate hedge fund advisers and derivatives, and create the Bureau of Consumer Financial Protection to regulate the offering of financial products to consumers. Future Bingham client alerts will address other significant market regulatory issues arising from the legislation.

Among the Act’s many provisions are those that would directly and indirectly affect the issuance of asset-backed securities (“ABS”), including a risk retention (“skin in the game”) requirement and several new disclosure requirements for ABS offerings. Since its introduction in the Senate on April 15,² various amendments have modified these requirements and introduced new rules that would affect issuers, sponsors and underwriters of ABS, as well as credit rating agencies that rate ABS and originators that lend to borrowers and create the assets underlying ABS transactions.

While the U.S. House of Representatives passed a bill sponsored by House Financial Services Committee Chairman Barney Frank (D-MA) in December (the “House Bill”),³ it is expected that the conference committee will use the Act as a basis for reconciling the two bills.⁴ Some of the Act’s provisions directly contradict sections of the House Bill, and certain other topics are covered by one bill and not the other. As such, provisions currently in the Act may be amended or omitted by the conference committee before the Act becomes law.

Summary of ABS Provisions in the Act

Subtitle D (“Improvements to the Asset-Backed Securitization Process”) of Title IX (“Investor Protections and Improvements to the Regulation of Securities”) of the Act includes the following sections:

 

• Sec. 941 – Regulation of Credit Risk Retention. The Act, like the House Bill and the Securities and Exchange Commission’s (“SEC’s”) proposed revisions to Regulation AB, would require securitizers to retain an economic interest in a portion of the credit risk transferred as part of a securitization transaction.⁵ “Securitizer” is defined as either an issuer of ABS or a person who organizes an ABS transaction by transferring assets, directly or indirectly, to the issuer. Securitizers would be required to retain at least five percent of the credit risk for securitized assets, although regulators would be empowered to reduce or eliminate this percentage for securitizations of assets that feature certain characteristics indicating reduced credit risk.

   

  The Act does not describe what types or forms of retained credit risk would satisfy the requirement, leaving this task to regulators, although a provision relating to commercial mortgages suggests an array of methods that could satisfy the rule for that asset class. Notably, the SEC’s proposed revisions to Regulation AB would require securitizers to retain at least five percent of each tranche of ABS sold to investors, a so-called “vertical slice,” rather than only a residual or first-loss tranche.

  Other provisions of Section 941 would prohibit securitizers from hedging retained credit risk, provide an exemption for “qualified residential mortgages,” permit the allocation of risk retention obligations between securitizers and originators, and mandate that regulators issue separate rules for different asset classes.

   

• Sec. 942 – Disclosures and Reporting for Asset-Backed Securities. The Act would amend Section 15(d) of the Exchange Act to eliminate the automatic suspension of reporting duties for asset-backed securities. Currently, issuers of ABS and other securities are not required to file ongoing reports during any fiscal year after the year of issuance, when there are fewer than 300 holders of record of the securities at the beginning of that year. In eliminating this automatic suspension rule for ABS, the Act would in effect require periodic reporting, such as Form 10-D distribution reports, for as long as the securities are outstanding.

   

  In addition, the Act would add Subsection 7(c) to the Securities Act, which would require the SEC to adopt regulations to require ABS issuers to disclose asset-level or loan-level data to investors. These regulations would prescribe the format of such data disclosure in order to “facilitate comparison of such data across securities in similar types of asset classes.”

• Sec. 943 – Representations and Warranties in Asset-Backed Offerings. The Act would require the SEC to issue regulations governing disclosures of any representations, warranties, and enforcement mechanisms in credit rating reports, as well as repurchase requests made to securitizers.

   

   

• Sec. 945 – Due Diligence Analysis and Disclosure in Asset-Backed Securities Issues. The Act would require the SEC to issue rules requiring a due diligence analysis to be included in the registration statement relating to any asset-backed security.

In addition to these provisions specifically relating to ABS, Subtitle C (“Improvements to the Regulation of Credit Rating Agencies”) of Title IX of the Act contains many provisions that relate to the credit rating process. The Act would vest the SEC with broad authority to regulate the manner in which rating agencies operate, including the authority to issue rules regarding disclosure of ratings methodologies, corporate governance, conflicts of interest, securities law liability, and the review of internal controls designed to facilitate accurate ratings. In addition, the Act would require issuers of ABS to apply for an initial credit rating from a centralized organization, the Credit Rating Agency Board, which would assign rating agencies to issuers rather than permit issuers to hire rating agencies on their own. Also, the Act would make it clear that statements by rating agencies are subject to the same enforcement and penalty provisions as are statements made by registered public accounting firms and securities analysts, and that those statements do not have the benefit of the forward-looking statement safe harbor added by the National Securities Markets Improvements Act of 1996.

New Provisions Added During Debate on Senate Floor

Amendments that modified the Act’s provisions relating to asset-backed securities include:

 

• Risk Retention. Two amendments passed by the Senate modified the Act’s proposed skin in the game requirement. 

   

  Senate Amendment 3956, which was offered by Sen. Mary Landrieu (D-LA), would require regulators⁶ to exempt sponsors of securitizations backed by “qualified residential mortgages” from the Act’s risk retention requirement. The amendment would require regulators to define “qualified residential mortgages” by regulation, taking into account “underwriting and product features that historical loan performance data indicate result in a lower risk of default,” such as asset and income documentation, debt-to-income ratios, stability of monthly payments, presence of mortgage insurance, and product type.⁷ Issuers would be required to certify to the SEC that they have evaluated the effectiveness of their internal supervisory controls for ensuring that all assets collateralizing exempt ABS are qualified residential mortgages.

  Senate Amendment 3992, which was offered by Sen. Mike Crapo (R-ID), would require that the risk retention regulations specify the permissible types, forms and amounts of risk retention that would satisfy the requirement for commercial mortgages. Applicable to this asset class only, the amendment gives several examples of mechanisms that could satisfy the requirement, including retention of a percentage of total credit risk of the commercial mortgage asset; retention of the first-loss position by a third-party purchaser who negotiates for the purchase and provides due diligence on all commercial mortgage assets in the pool before issuance of the ABS; a regulatory determination that underwriting standards and controls for the commercial mortgage asset are adequate; or the presence of adequate representations and warranties along with related enforcement mechanisms.

• New Credit Rating Agency Board. Senate Amendment 3991, which was offered by Sen. Al Franken (D-MN), would require the SEC to establish the Credit Rating Agency Board (the “Board”), which would assign rating agencies to issue initial credit ratings for ABS. The Board, whose membership would be composed of at least one representative of the issuer industry, one representative of the credit rating industry, one independent member, and a majority of representatives of the investor industry, would be empowered to select “qualified” nationally recognized statistical rating organizations to provide initial credit ratings to issuers of ABS and structured products based on ABS. Issuers would be precluded from independently approaching rating agencies to obtain an initial rating, though subsequent ratings could be solicited in this manner. The Board also would be empowered to issue regulations requiring an issuer that has received an initial credit rating to request a revised rating each time the issuer experiences a “material change in circumstances.” By assigning rating agencies to issuers, the Board would intend to “reduce the conflicts of interest that exist under the issuer-pays model.”

   

  In a separate amendment (Senate Amendment 3774, which was offered by Sen. George LeMieux (R-FL)), certain references to credit ratings in the Federal Deposit Insurance Act, the Investment Company Act of 1940, and the Securities Exchange Act of 1934, among others, would be removed and replaced with standards to be established by regulation.

   

• Mortgage Originator Conflicts of Interest and Minimum Underwriting Standards. Senate Amendment 3962, which was offered by Sen. Jeff Merkley (D-OR), would amend the Truth in Lending Act to prohibit compensation of mortgage originators that would give rise to certain conflicts of interest, as well as require that mortgage lenders verify that each borrower has “a reasonable ability to repay the loan, according to its terms” and including all other assessments. The amendment would ban practices that tie originator or broker compensation to any term of the loan (other than principal amount), including yield spread premiums. Originators would also be barred from financing origination fees and costs through the interest rate, except for third-party settlement charges not retained by the originator or for an origination fee or cost that is the sole compensation to the originator from the consumer. In order to verify a borrower’s ability to repay the loan, an originator would determine the borrower’s “reasonable ability to repay the loan” based on, among other things, verification of the borrower’s income or assets through tax or payroll records (or other documents that provide “reasonably reliable evidence” of income or assets). Originators who verify the borrower’s ability to repay using the maximum rate permitted under the loan during the first five years of repayment would be presumed to have complied with the requirement.

   

Key Differences to Be Reconciled by Conference Committee

As stated above, the House Bill and the Act differ both in spirit and in approach on many topics, and will need to be reconciled in a conference committee in the coming weeks. Several of these key differences relate to asset-backed securities, including:

 

• Risk Retention. The Act (as modified by the Landrieu and Crapo amendments, SA 3956 and 3992, respectively) would require that securitizers retain at least five percent of the credit risk for any asset transferred through the issuance of ABS, subject to certain conditions. The House Bill also contains this five percent requirement, although the conditions and exceptions contained within its text differ from those within the Act. The “qualified residential mortgages” exemption, added to the Act by SA 3956, does not appear in the House Bill, which would subject all transfers of financial assets to its risk retention requirements.

   

  Under the House Bill, regulators would be permitted to decrease (for assets that meet characteristics that reflect reduced credit risk or are subject to as-yet-unannounced underwriting and due diligence standards) or increase (“if the underwriting. . .or due diligence by the securitizer is insufficient”) the required retention percentage. The Act would only permit regulators to lower the risk retention levels for assets that meet underwriting standards that indicate reduced credit risk.

  The Act would require any regulations prescribed to mandate risk retention to establish separate rules for securitizations of different classes of assets. This requirement is not contained in the House Bill. Additionally, the Act would require the OCC, FDIC, and SEC to allocate risk retention obligations by reducing the securitizer’s obligation for any risk required to be retained by the originator, a requirement also absent from the House Bill. Instead, the House Bill would require all creditors who transfer loans in the secondary market, even as whole loan sales unrelated to any securitization, to retain five percent of the associated credit risk.

  While both the House Bill and the Act would require that any risk retention regulations be issued soon after the date of enactment,⁸ the Act also would require that all regulations issued under the section relating to ABS become effective one year (for securitizations of residential mortgages) or two years (for all other classes of ABS) after final rules are published in the Federal Register.

   

• Rating Agencies. The Franken amendment to the Act (SA 3991) introduced the concept of a Credit Rating Agency Board that would assign rating agencies to issuers for the purpose of providing initial credit ratings; the House Bill contains no such concept. However, the House Bill would eliminate Rule 436(g) under the Securities Act, which states that credit ratings used in disclosure documents are not part of the registration statement as expert statements, thus exempting rating agencies from Securities Act liability for the ratings they provide. The House Bill would subject rating agencies to potential Securities Act liability for ratings disclosed in the registration statement.

   

  In addition, both the House Bill and the Act seek to curb regulatory reliance on credit ratings. The Act, as modified by the LeMieux amendment (SA 3774), would replace various references to rating agencies in several statutes with requirements that the appropriate regulators issue rules to accomplish similar goals. The House Bill already included text similar to the LeMieux amendment when it was passed in December. Subtitle B of Title V of the House Bill, entitled “Accounting and Transparency in Rating Agencies Act,” generally would enhance regulation of rating agencies by empowering the SEC to review internal processes and methodologies for determining ratings, requiring several independent board members to serve for any nationally recognized statistical rating organization, requiring the SEC to prohibit conflicts of interest, and many other provisions.

Next Steps

Congressional leaders intend to reconcile the House Bill and the Act in a financial regulatory reform conference committee throughout June. The conference committee will be led by Sen. Dodd and Chairman Frank, and will largely be comprised of members of the Senate Banking Committee and House Financial Services Committee.⁹ Chairman Frank reportedly proposed a schedule whereby the conference would begin on June 9, with five working sessions between June 15 and June 23. The conference would conclude on June 24, and the House of Representatives would vote on the finalized legislation on June 29. A final bill would be sent to be signed by President Obama by the July 4 congressional recess.

For assistance, please contact any of the following lawyers:

 

John Arnholz, Partner, Structured Transactions
john.arnholz@bingham.com, 202.373.6538

Reed D. Auerbach, Practice Group Leader, Structured Transactions
reed.auerbach@bingham.com, 212.705.7400

Jeffrey R. Johnson, Partner, Structured Transactions
jeffrey.johnson@bingham.com, 212.373.6626

Matthew P. Joseph, Partner, Structured Transactions
matthew.joseph@bingham.com, 212.705.7333

Steve Levitan, Partner, Structured Transactions
steve.levitan@bingham.com, 212.705.7325

Edmond Seferi, Partner, Structured Transactions
edmond.seferi@bingham.com, 212.705.7329

Charles A. Sweet, Partner, Corporate, M&A and Securities
charlie.sweet@bingham.com, 202.373.6777

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
roger.joseph@bingham.com, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring, Co-chair, Financial Services Area
edwin.smith@bingham.com, 617.951.8615

Timothy P. Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area
timothy.burke@bingham.com, 617.951.8620

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¹ Available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173eas.txt.pdf.
² A discussion of the original draft legislation as of March 17, 2010, is available at /Media.aspx?MediaID=10510.
³ Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Congress (2009).
⁴ In accordance with congressional procedure, the Senate replaced the language of H.R. 4173, originally containing the text of the House Bill, with the Act’s language previously included in S. 3217, and passed it. This procedural step allows the conference committee to make modifications to the Act’s language to reconcile the two versions of the bill.
⁵ The Act would add Section 15G to the Exchange Act, which would require federal banking agencies and the Securities and Exchange Commission to issue regulations prescribing the risk retention rules described.
⁶ Includes the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Securities and Exchange Commission, the Department of Housing and Urban Development, and the Federal Housing Finance Agency.
⁷ The amendment provides several product types that may not be appropriate for the exemption (as considered by the regulators), including those that feature balloon payments, negative amortization features, prepayment penalties, and interest-only payments.
⁸ Within 180 days for the House Bill and within 270 days for the Act.
⁹ On May 25, Senate leaders announced that their delegation to the conference committee will include Democrats Christopher Dodd (CT), Tom Harkin (IA), Patrick Leahy (VT), Blanche Lincoln (AR), Tim Johnson (SD), Jack Reed (RI), and Charles Schumer (NY), as well as Republicans Richard Shelby (AL), Saxby Chambliss (GA), Bob Corker (TN), Mike Crapo (ID), and Judd Gregg (NH). Chairman Frank proposed that the House appoint its delegation on June 8, and recommended to House Speaker Nancy Pelosi that Congressmen Paul Kanjorski (PA), Melvin Watt (NC), Luis Gutierrez (IL), Maxine Waters (CA), Greg Meeks (NY), Dennis Moore (KS), and Carolyn Maloney (NY) serve as the Democratic contingent, along with himself, while reserving spaces for five Republicans.