On December 7, 2012, the Division of Swap Dealer and Intermediary Oversight (the “Division”) of the Commodity Futures Trading Commission (the “CFTC”) released additional interpretive guidance (the “Second Interpretive Letter”)1 significantly broadening its previous interpretive guidance (the “First Interpretive Letter”)2 that certain securitization vehicles are not commodity pools that are required to have a registered commodity pool operator under the Commodity Exchange Act and the rules of the CFTC. Under this new guidance, certain securitization vehicles that do not fall within the scope of the previous guidance because they do not satisfy the operating or trading limitations of Regulation AB or Rule 3a-7 may still be excluded from the definition of “commodity pool,” if their use of swaps is no greater than is contemplated by Regulation AB and Rule 3a-7, and those swaps are not used to create an investment exposure.
The Second Interpretive Letter also extends the no-action advice previously granted by the Division (the “No-Action Letter”),3 in two ways. First, the Division “grandfathers” many securitization vehicles by indicating that it will not recommend enforcement against any operator of such a vehicle for failure to register as a commodity pool operator, so long as the vehicle issued fixed income asset-backed securities before October 12, 2012, has not issued new securities on or after that date, and provides to the CFTC upon request electronic copies of certain of its transaction documents. Second, for securitization vehicles that do not qualify for the relief contained in either Interpretive Letter, the Division extends its previous December 31, 2012 deadline for filing documentation to register as a commodity pool operator, indicating that it will not recommend enforcement action against the operator of any securitization vehicle for failure to register as a commodity pool operator until March 31, 2013.
The Commodity Exchange Act and the rules of the CFTC generally require that, absent an available exemption or exclusion, the commodity pool operator of a commodity pool must be registered with the CFTC. The Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), defines a “commodity pool” as, in pertinent part, “any investment trust, syndicate or similar form of enterprise operated for the purpose of trading in commodity interests, including any commodity for future delivery, security futures product, or swap.”4 Before the Dodd-Frank Act, the definition of “commodity pool” in the CFTC’s regulations did not include any reference to swaps. The new definition became effective on October 12, 2012. As a result, the commodity pool operator registration obligation became effective for sponsors of commodity pools that trade in swaps on October 12, 2012.
Many securitization and other structured finance vehicles include interest rate, currency or other types of swaps. The CFTC staff has made clear its view that, absent relief, any securitization transaction that includes any swap, whether for hedging or otherwise, would fall within the broad definition of “commodity pool” and be required to have a registered commodity pool operator.
Registration as a commodity pool operator subjects the registering entity to oversight by a new regulator, involving both the initial time and expense required to register and the time and expense of ongoing compliance. In some cases, such as ongoing competency testing, it is not yet clear what the CFTC ultimately will require of commodity pool operators that are required to register solely because of their dealings in swaps. These costs and burdens will likely seem unjustified to many securitization sponsors, especially for term securitizations that involve a static and amortizing pool of financial assets and an unchanging, plain vanilla swap. Further, in many securitization structures, it is not altogether apparent which entity would be the most appropriate to subject to registration or how its expenses could be paid.
Moreover, a commodity pool is a “covered fund” for purposes of the Volcker Rule, which would subject it to the covered fund restrictions of the Volcker Rule. These would include the Volcker Rule’s covered fund ownership restrictions (which could limit the ability of banking entities, including bank affiliates, to sponsor or invest in securitizations), proprietary trading restrictions (which could limit the ability of a securitization vehicle that is affiliated with a banking entity to buy and sell securities), and prohibitions on covered transactions with a covered fund (which could restrict banking entities from providing liquidity, servicing advances and other customary extensions of credit to securitization vehicles).
First Interpretive Letter
The First Interpretive Letter concluded that certain securitization vehicles would not be included within the definition of “commodity pool” so that an operator of one of those vehicles would not be a “commodity pool operator” that is required to register. The CFTC imposed five conditions on this exclusion.5
First, the issuer of asset-backed securities must be “operated consistent with the conditions set forth in” Regulation AB, or Rule 3a-7 under the Investment Company Act of 1940 (the “Investment Company Act”), whether or not the offering is in fact regulated thereunder, so long as the issuer, the pool assets and the asset-backed securities (“ABS”) “satisfy the requirements of either regulation.” This condition clearly would be satisfied if the transaction is a registered public offering subject to Regulation AB or if the transaction (whether public or private) qualifies for the exemption from the definition of “investment company” contained in Rule 3a-7.
According to the First Interpretive Letter, the reference to Regulation AB applies “even in connection with private issuances.” This language, combined with the CFTC’s use of the words “operated consistent with,” has been widely viewed as meaning that any private offering of ABS falls within the exclusion so long as the offered securities fall within the Regulation AB definition of “asset-backed security” even if, for example, the offering documents for the securities do not contain all disclosure items that would be required by Regulation AB in a registered public offering of the same securities. The Division appears to have confirmed that view in the Second Interpretive Letter by referring to this condition as “satisfy[ing] the operating or trading limitations contained in Regulation AB and Rule 3a-7.”
Second, the entity’s activities must be limited to passively owning or holding a pool of fixed or revolving receivables or other financial assets that by their terms convert to cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to security holders. The Division was quite clear that “financial asset” “does not include transactions whereby an entity obtains exposure to an asset that is not transferred or otherwise part of the asset pool,” so synthetic ABS do not qualify for the relief provided by the exclusion in the First Interpretive Letter.
Third, the entity’s use of derivatives must be limited to the uses permitted under Regulation AB, including credit enhancement and using derivatives such as interest rate and currency swaps to alter the payment characteristics of cash flows.
Fourth, the entity must make payments to its security holders only from cash flow generated by pool assets and other permitted rights and assets, not from or otherwise based upon changes in the value of its assets.
Fifth, the issuer may not acquire additional assets or dispose of assets for the primary purpose of realizing gain or minimizing loss due to changes in the market value of the entity’s assets.
Although the exclusion is broad, the Division noted that it was not broad enough to include covered bonds, asset-backed commercial paper vehicles, collateralized debt obligations, collateralized loan obligations, insurance-related securities and synthetic securitizations, because at that time the Division was unable to conclude that all such entities (or a portion of their assets, operations or activities) would not properly be considered to be commodity pools.
Interpretive Guidance in Second Interpretive Letter
The Second Interpretive Letter reiterates the Division’s view that the conditions in the First Interpretive Letter are not the exclusive way that securitization vehicles can be excluded from the definition of “commodity pool.” After extended discussions with many industry representatives, the Division concludes, “in princip[le], that certain securitization vehicles that do not satisfy the operating or trading limitations contained in Regulation AB or Rule 3a-7 may be properly excluded from the definition of commodity pool, provided that the criterion with respect to the ownership of financial assets continues to be satisfied and the use of swaps is no greater than that contemplated by Regulation AB and Rule 3a-7, and such swaps are not used in any way to create an investment exposure.”
Therefore, the Second Interpretive Letter contemplates the exclusion of certain securitization vehicles from the obligation to have a registered commodity pool operator even if their offered securities do not fall within the definition of “asset-backed security” under Regulation AB, and they do not qualify for the exemption from the definition of “investment company” under Rule 3a-7. Because “the criterion with respect to the ownership of financial assets” still must be satisfied, the entity’s activities must be limited to passively owning or holding a pool of fixed or revolving receivables or other financial assets that by their terms convert to cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to security holders.
The Division provides four examples of the application of this guidance.
A “standard” asset-backed commercial paper (“ABCP”) conduit might not qualify for the interpretive relief granted by the First Interpretive Letter. ABCP notes generally are not “asset-backed securities” within the meaning of Regulation AB, because they are repaid from the proceeds of new ABCP notes or from liquidity and credit facilities, and may not meet the requirements of Rule 3a-7 because they do not employ independent trustees. However, absent other factors, an ABCP conduit would qualify for the interpretive relief in the Second Interpretive Letter.
A “traditional” cash collateralized debt obligation (“CDO”) generally would not meet the fixed pool requirements of the definition of the Regulation AB definition of “asset-backed security,” Rule 3a-7 or the First Interpretive Letter, because it permits trading in the underlying financial assets. However, so long as the underlying financial assets consist only of “corporate loans, corporate bonds, or investment grade, fixed income mortgage-backed securities, asset-backed securities or CDO tranches issued by vehicles that are not commodity pools,” then absent other factors, the vehicle would qualify for the interpretive relief in the Second Interpretive Letter.
The interpretive exemption would not, however, extend to any structure in which investors have investment exposure to swaps. According to the Division, this means that the payments to investors may not be affected by swaps in any way other than as credit enhancement (within reason), or an interest rate or currency swap. Thus, a CDO that has even a five percent bucket for synthetic assets would not qualify for the interpretive relief in the Second Interpretive Letter, although the CDO’s operator might be able to take advantage of the “de minimis” exemption provided by CFTC Rule 4.13(a)(3).6
A repackaging vehicle that issues credit-linked or equity-linked notes where the repackaging vehicle owns financial assets, but also sells credit protection on a broad-based index or obtains exposure to a broad-based stock index through a swap, would not qualify for the interpretive relief in the Second Interpretive Letter, and may be a commodity pool. Other similar examples include a repackaging vehicle that acquires a bond, issues a tranche of notes, and uses swaps to extend the investment experience of the bond, and a repackaging vehicle that pairs a bond with a swap to provide inflation rate protection. In both cases, because investors would gain a significant portion of their return from swaps, the vehicles would not qualify for interpretive relief and may be deemed to be a commodity pool.
In a covered bond transaction, neither the collateral pool, nor the special purpose vehicle in a structured model, would be a commodity pool, if it contains no commodity interests other than any swaps which are used only for purposes permitted by Regulation AB (i.e., credit enhancement or interest or exchange rate swaps), and bondholders are entitled to receive only payments of interest and principal, without any condition to payment based upon any derivative exposure.
If the swaps in any securitization structure are used to provide credit support “to the extent contemplated by Item 1114 of Regulation AB,” these swaps should not be viewed as creating investment exposure and should not require commodity pool operator registration. However, according to the Division, if the use of swaps is “commercially unreasonable as credit support,” then a commodity pool may exist. The Division provides an example of a trust that owns floating rate bonds issued by a distressed jurisdiction rated “CCC,” which enters into a swap that provides credit support sufficient to obtain “AA” pricing. In this case, because the swap is a significant aspect of the investment, the securitization vehicle would be a commodity pool.
As in the First Interpretive Letter, the Division states, in boldface type, that it remains open to discussions with sponsors of securitizations to consider the facts and circumstances of their structures with a view to determining whether or not they might not be properly considered a commodity pool, or whether other relief might be appropriate, such as treating a fund as an exempt pool.
No-Action Advice in Second Interpretive Letter
After the issuance of the First Interpretive Letter and the No-Action Letter, and after discussion with many industry participants, the Division concluded that many securitization vehicles formed before October 12, 2012 would face significant operational difficulties if they were required to have a registered commodity pool operator. Therefore, the Division has concluded not to recommend enforcement action against any operator of a legacy securitization vehicle for failing to register as a commodity pool operator if three criteria are met and remain satisfied.
First, the issuer must have issued fixed income securities before October 12, 2012 that are backed by and structured to be paid from payments on or proceeds received in respect of, and whose creditworthiness primarily depends upon, cash or “synthetic assets” owned by the issuer. The Division did not define the term “synthetic assets,” but it appears to be susceptible to broad (albeit reasonable) interpretation.
Second, the issuer has not issued and will not issue new securities on or after October 12, 2012.
Third, the issuer will, promptly upon request of the CFTC and in any event within five business days, provide electronic copies of the following transaction documents: (1) its most recent offering disclosure document, (2) all amendments to the principal documents since the securities were issued, (3) the most recent distribution statement to investors, and (4) if the securities were offered in reliance on Rule 144A under the Securities Act of 1933, a copy of the information that would be provided to prospective investors to satisfy Rule 144A(d)(4). If the issuer does not provide the required information, it must demonstrate that it cannot obtain that information through reasonable commercial efforts.
The No-Action Letter provided temporary relief from the obligation to register as a commodity pool operator “where the requirement to register as such arises solely from the swaps activity of such person.” In order to qualify for this relief, the commodity pool operator was required to, among other things, complete and file its registration application as a commodity pool operator by December 31, 2012. The Second Interpretive Letter extended that relief for securitization vehicles that are unable to take advantage of the interpretive relief in either Interpretive Letter. The Division states that it will not recommend enforcement action against the operator of any securitization vehicle for failure to register as a commodity pool operator until March 31, 2013.
While a securitization vehicle that qualifies for the interpretive exemption in either Interpretive Letter is not a commodity pool, a securitization vehicle relying on the no-action advice in the No-Action Letter or the Second Interpretive Letter, or on the “de minimis” exemption, may still be deemed to be a commodity pool, and also a “covered fund” under the Volcker Rule. The Volcker Rule implementing regulations are not yet final, and the regulators responsible for proposing and adopting those regulations may yet provide an exemption from the covered fund restrictions for some securitization vehicles that are determined to be commodity pools. Sponsors of securitization vehicles that do not qualify for an outright exemption from the definition of “commodity pool” should consider the possible impact of the Volcker Rule on their structure and operations.
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1 CFTC No-Action Letter No. 12-45 (Dec. 7, 2012), available at http://cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-45.pdf. Our client alert regarding the First Interpretive Letter is available at http://www.bingham.com/Alerts/2012/10/CFTC-Issues-Exclusion-from-Commodity-Pool-Regulation.
2 CFTC Interpretation Letter No. 12-14 (Oct. 11, 2012), available at http://cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-14.pdf. Our client alert referenced in the previous footnote also discusses the No-Action Letter.
3 CFTC No-Action Letter No. 12-15 (Oct. 11, 2012), available at http://cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-15.pdf.
4 See Dodd-Frank Act Section 721(a)(5).
5 For more information, see our summary of the proposed Volcker Rule regulations, available at http://www.bingham.com/Alerts/2011/10/~/media/Files/Docs/Client-Alert-Volcker-Rule-Summary_6650pdf.ashx.
6 The “de minimis” exemption is discussed further in our previous client alert referenced in footnote 1.
This article was originally published by Bingham McCutchen LLP.