On October 11, 2012, the Division of Swap Dealer and Intermediary Oversight (the “Division”) of the Commodity Futures Trading Commission (the “CFTC”) released interpretive guidance (the “Interpretive Letter”) confirming 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.1 As of the same date, the Division also issued a no-action letter (the “No-Action Letter”) providing that the CFTC would not take enforcement against any entity that comes within the definition of “commodity pool operator” solely because of swap transactions so long as it meets certain conditions, including filing an application for registration, by December 31, 2012.2
The Commodity Exchange Act and the rules of the CFTC generally require that any “commodity pool operator” be registered with the CFTC. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) broadened the pertinent part of the definition of “commodity pool” from “a pool that is operated for trading in commodity futures on an exchange” to “a pool that is operated for the purpose of trading in commodity interests, including any commodity for future delivery, security futures product, or swap.”3 On August 14, 2012, the CFTC adopted its revised definition of “swap” and thus considers the commodity pool operator registration obligation to have become effective for entities that include swaps on October 12, 2012.
Many securitization and other structured finance structures 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 very 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 proprietary trading restrictions, which could limit the ability of a securitization vehicle to buy and sell securities, and the prohibitions on covered transactions with a covered fund, which could restrict some banking entities from providing liquidity, servicing advances and other customary extensions of credit.4
The Interpretive Letter concludes 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 imposes 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 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 Division, 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,” could mean 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. We expect the industry to coalesce around a general consensus on this issue in the near term.
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 is 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.
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 notes that it is 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 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.
The Interpretive Letter does contain language that may be helpful for vehicles that do not qualify for relief under the specific exclusion from the definition of “commodity pool.” The Division notes that it:
tend[s] to agree that certain entities that meet certain … criteria … are likely not commodity pools, such as securitization vehicles that do not have multiple equity participants, do not make allocations of accrued profits or losses ([o]ther than gains or losses from permitted dispositions of defaulted financial assets …) and only issue interests in the form of debt or debt-like interests with a stated interest rate or yield and principal balance and a specific maturity date.
Market participants and their counsel may be able to conclude that some structures that are not within the explicit exclusion provided by the Interpretive Letter still are not commodity pools, because they meet these parameters.
Just as importantly, the Division specifically states, in boldface type, that it remains open to discussions with sponsors of securitizations that do not meet the requirements for the explicit exclusion provided by the Interpretive Letter in order to determine whether they might properly be considered a commodity pool or might qualify from some other relief, such as an exemption from commodity pool operator registration.
The No-Action Letter provides 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 must complete and file its registration application with the National Futures Association (the “NFA”) by December 31, 2012, including any required Forms 7-R (firm application) and 8-R (individual application), and fingerprint cards for each of its principals and associated persons. On and after December 31, 2012, the applicant is subject to and must make good faith efforts to comply with the CFA and the CFTC’s regulations that apply to its activities as a commodity pool operator, just as if it were fully registered.
Sponsors of existing and proposed securitization vehicles will need to determine whether those vehicles qualify for the exclusion from the definition of “commodity pool” provided by the Interpretive Letter. If not, they will wish to consider whether they can qualify for some other relief.
Sponsors of some securitization vehicles may be able to conclude that the vehicle is not a commodity pool based on the structural factors referenced by the Division in the Interpretive Letter.
Sponsors of some securitization vehicles may be able to take advantage of the “de minimis” exemption provided by CFTC Rule 4.13(a)(3). This rule provides an exemption from the requirement to register as a commodity pool operator for operators of privately offered commodity pools that engage in a de minimis amount of swap or other commodity interest trading that are not marketed as “vehicles for trading in the commodity futures or commodity options markets” and whose participants are accredited investors or satisfy certain other sophistication requirements. A vehicle engages in a “de minimis” amount of commodity interest trading if either the aggregate initial margin, premiums and minimum security deposit required to establish its swap, future and retail forex positions is no more than five percent of the liquidation value of the entire asset pool or the aggregate net notional value of the entity’s positions in swaps, futures and retail forex does not exceed 100 percent of the liquidation value of the entity’s entire asset pool. In order to rely on this exemption, a notice of exemption must be filed with the NFA, as well as an annual affirmation of that notice.
As invited by Division in the Interpretive Letter, sponsors of some securitization vehicles may wish to engage the staff of the Division in a discussion as to whether the particular facts and circumstances justify a conclusion that the vehicle is not a commodity pool or is entitled to other relief.
Sponsors of securitization vehicles containing swaps that cannot quickly conclude that they qualify for an exclusion from the definition of “commodity pool” based on the Interpretive Letter or some other theory, and for which there is no other available relief from the obligation to have a registered commodity pool operator, will need to identify the appropriate entity to serve as the registered commodity pool operator for the vehicle and begin the process of becoming a registered commodity pool operator. The complete application package should be on file before December 31, 2012, which is the deadline identified by the No-Action Letter.
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. However, sponsors of securitization vehicles that do not qualify for an outright exemption from the definition of “commodity pool” under the Interpretive Letter or otherwise, should consider the possible impact of the Volcker Rule on their structure and operations.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Sweet-Charles
This article was originally published by Bingham McCutchen LLP.