The Securities and Exchange Commission (the “SEC”) has proposed a variety of rules (the “Proposing Release”)1 relating to nationally recognized statistical rating organizations (“NRSROs”), as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).2 The proposed rules generally would require any issuer or underwriter of registered or unregistered “asset-backed securities,” as newly and broadly defined by the Dodd-Frank Act (“Exchange Act ABS”), that are to be rated by an NRSRO to furnish a form on EDGAR describing the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.
Under the proposed rules, a third-party “due diligence report” is any report containing findings and conclusions of “due diligence services,” which in turn are defined as a review of the pool assets for the purposes of: making findings with respect to the integrity of the asset data; determining whether the assets conformed to stated underwriting standards; making findings with respect to asset value; making findings with respect to legal compliance by the originator; and making findings with respect to any other factor material to the likelihood that the issuer will pay interest and principal timely. The SEC believes that these categories of due diligence services are commonly provided in securitization transactions and are relevant to credit ratings of Exchange Act ABS.
The proposed rules also set forth a form of certification that providers of third-party due diligence services would be required to deliver to each NRSRO producing a credit rating to which those due diligence services “relate.”
The proposed rules include various other proposals augmenting the SEC’s existing NRSRO registration and oversight regime.
Disclosure by Issuers and Underwriters of Findings and Conclusions of Third-Party Due Diligence Reports
New Section 15E(s)(4)(A) of the Exchange Act, as added by Section 932 of the Dodd-Frank Act, requires an issuer or underwriter of Exchange Act ABS to make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. Section 15E(s)(4)(A) applies to all Exchange Act ABS, whether offered publicly or privately, not just the more limited group of asset-backed securities subject to Regulation AB.
In order to implement this requirement, proposed Rule 15Ga-2 generally would require an issuer3 or underwriter4 of Exchange Act ABS that is to be rated by an NRSRO to furnish5 a Form ABS-15G,6 which would have a new section requiring disclosure of the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. The form would have to be furnished to the SEC via EDGAR five business days before the first sale in the offering.
However, the issuer or underwriter would not need to furnish Form ABS-15G for this purpose if it obtains a representation from each NRSRO engaged to produce a credit rating for the Exchange Act ABS that the NRSRO will publicly disclose the findings and conclusions of any third-party due diligence report together with the publication of its credit rating, at least five business days before the first sale in the offering. If the NRSRO fails to timely comply with its representation, the issuer or underwriter would be required to furnish the required information on Form ABS-15G no later than two business days before the first sale in the offering.
In the Proposing Release, the SEC acknowledges that “public disclosure of information relating to an unregistered [Exchange Act ABS] offering could raise concerns regarding the reliance by an issuer or underwriter on the private offering exemptions and safe harbors under” the Securities Act of 1933, as amended (the “Securities Act”), but goes on to state the SEC’s view that the required information can be disclosed “without jeopardizing reliance on those exemptions and safe harbors, provided that the only information made publicly available on the form is that which would be required by the proposed rule, and the issuer does not otherwise use Form ABS-15G to offer or sell securities in a manner that conditions the market for offers or sales of its securities.”
In connection with an earlier-proposed version of Rule 15Ga-2 (the “Original Proposing Release”),7 the SEC noted that Section 15E(s)(4)(A) of the Exchange Act does not specify how it is to apply to offshore transactions, but Rule 15Ga-2 would require issuers and underwriters to disclose information about Exchange Act ABS sold in unregistered transactions outside the United States. In the Original Proposing Release, the SEC wondered if Rule 15Ga-2 might “result in foreign issuers seeking to avoid the . . . requirement [to file Form ABS-15G] by excluding U.S. investors from purchasing portions of ABS primarily offered outside the United States. . . ,” implying that the rule would apply to private offerings of Exchange Act ABS in the United States by foreign issuers. The SEC did not address these matters again in the Proposing Release, so its views on these issues appear to remain unchanged.
The Scope of a Third-Party “Due Diligence Report” and “Due Diligence Services”
A “due diligence report” would be any report containing findings and conclusions relating to specified “due diligence services.” The Proposing Release notes that the SEC intends for “due diligence services” to cover only services typically provided by third-party due diligence service providers in the securitization market, not every type of entity that might perform some kind of diligence function in the offering process. Further, the SEC intends for the definition of “due diligence report” to cover only reports from specialized due diligence services providers that are relevant to the determination of a credit rating of Exchange Act ABS, and a third-party due diligence report is not the same as the required issuer review of the assets under Rule 193. However, the dividing line between a Rule 193 issuer review and a due diligence report is still not completely clear – the SEC acknowledges that an issuer might engage a third party to assist it in its required review of the assets under Rule 193, and states in the Proposing Release that the issuer might obtain a third-party due diligence report from that third party.
According to the Proposing Release, “providers of third-party due diligence services most commonly are hired by issuers and underwriters to perform reviews of pools of mortgages that will be securitized into” residential mortgage-backed securities (“RMBS”). As such, proposed Rule 17g-10 identifies four specific categories of due diligence services that the SEC believes are commonly provided in connection with ratings of RMBS, as well as a “catchall” for services that may in the future be provided for other asset classes, but which do not fall within one of the enumerated categories.
The first enumerated category of due diligence services is a review of the underlying assets for the purpose of making findings with respect to the quality or integrity of the information or data about the assets provided by the securitizer or originator. The Proposing Release notes that this could include a comparison of the loan tape data with hard copy documentation in an underlying sampled loan file, or verification that the loan tape contains all the information about the assets required by an NRSRO for its rating process.8
The second enumerated category of due diligence services is a review of the underlying assets for the purpose of determining whether the origination of the assets conformed to stated underwriting or credit standards. The Proposing Release notes that this could entail reviewing whether a sampled loan meets the originator’s underwriting guidelines or, if not, that the originator provided a reasonable and documented exception. This type of review also could encompass an examination of how the originator verified information in a sampled loan – such as, for RMBS, the borrower’s occupancy status, income, assets, or employment status.
The third enumerated category of due diligence services is a review of the underlying assets for the purpose of making findings with respect to the value of collateral securing those assets. The Proposing Release notes that this could entail analyzing how the originator verified the value of the asset – for example, for RMBS, an NRSRO might require that the review consider the quality of the appraiser of the property and the quality of the appraisal. It could include reviewing whether the appraiser used a valuation model, as well as the performance of a separate valuation by the provider if it believes that the original appraised value of the property is less than the value presented by the originator.
The fourth enumerated category of due diligence services is a review of the underlying assets for the purpose of making findings with respect to whether the originator of the assets complied with applicable laws and regulations. The Proposing Release notes that this could entail, for RMBS, analyzing the documentation in a sampled loan file to verify that the loan was made in conformance with “truth-in-lending” requirements.
The “catchall” category would entail a review of the underlying assets for the purpose of making findings with respect to any other factor or characteristic that would be material to the likelihood that the issuer will pay interest and principal timely (i.e., the likelihood of default or delinquency). The Proposing Release notes the SEC’s belief that findings relevant to the likelihood of default would be relevant to determining a credit rating (because the statutory definition of “credit rating” is “an assessment of the creditworthiness of an obligor as an entity or with respect to specific securities”), and that reviews designed to generate findings irrelevant to a credit rating would be outside the scope of the rule.
Form and Content of Required Certification by Provider of Third-Party Due Diligence Services
Whenever third-party due diligence services are provided to an NRSRO, issuer9 or underwriter, Section 15E(s)(4)(B) of the Exchange Act (as added by Section 932 of the Dodd-Frank Act) requires the due diligence services provider to provide to any NRSRO rating any of Exchange Act ABS to which those services “relate” a written certification in a format to be prescribed by rule. Section 15E(s)(4)(C) requires the SEC to “establish the appropriate format and content . . . to ensure that providers of due diligence services have conducted a thorough review of data, documentation, and other relevant information necessary for [an NRSRO] to provide an accurate rating.” To implement this requirement, proposed Rule 17g-10 would require the mandated written certification to be made on Form ABS Due Diligence-15E.
Proposed Form ABS Due Diligence-15E would require the provider to state its identity and address; the identity and address of the issuer, underwriter or NRSRO that engaged it; and the identity of each NRSRO whose published criteria were satisfied by the performance of the provider’s due diligence services. The provider would be required to describe the scope and manner of due diligence that it performed, including: the type of assets reviewed; the sample size and how it was determined; whether the quality or integrity of information provided by the securitizer or originator was reviewed (and if so, how); whether the origination of assets conformed to stated underwriting or credit extension guidelines; whether the value of collateral securing the assets was reviewed (and if so, how); whether compliance of the originator with applicable laws was reviewed (and if so, how); and any other type of review conducted. Most importantly, the provider would be required to summarize the findings and conclusions of its due diligence review.
The certification would have to be signed by an individual duly authorized by the provider of the due diligence services. In signing the certification, the individual would represent that the provider conducted a “thorough review” in performing the described due diligence, and that the information in the certification (including the description of the due diligence performed and the findings and conclusions of that review) are “accurate in all significant respects.”
The proposed rule would require that the certification be provided to any NRSRO producing a credit rating to which the due diligence services relate. The term “relate” is not defined in Section 15E(s)(4)(B) of the Exchange Act or in proposed Rule 17g-10. As such, it is unclear to what extent due diligence services provided in connection with a transaction might be deemed to “relate” to a credit rating, if those services were not required by and their results were not provided to an NRSRO as a part of its rating process. The SEC appears to recognize this deficiency, as the Proposing Release requests comment on how a provider of third-party diligence services might know the identities of the NRSROs to which it is required to provide a certification – including NRSROs producing unsolicited credit ratings.
Significant Changes From Original Proposing Release
As set forth in the Original Proposing Release, Rule 15Ga-2 and certain related proposed rules originally would have required the issuer of registered Exchange Act ABS to disclose the findings and conclusions of any third party engaged to perform a review of the assets in the prospectus, while the relevant disclosure by an issuer in an unregistered offering of Exchange Act ABS and by an underwriter in a registered or unregistered offering of Exchange Act ABS would have been required to be filed via EDGAR in Form ABS-15G.
The SEC received numerous comments on this initial proposal arguing that Section 15E(s)(4) of the Exchange Act should be considered as a whole, and that it would be inappropriate to consider subsection (A) divorced from Congress’ intent to further regulate NRSROs and the credit ratings process. The SEC responded to these comments by deferring action on this proposal and re-proposing Rule 15Ga-2 in the Proposing Release.
As a result of those comments, the re-proposal of Rule 15Ga-2 more narrowly construes subsection (A) of Section 15E(s)(4) to relate to the credit ratings process. Among other things, the SEC has refined the scope of third-party due diligence reports subject to the proposed rule through its definition of “due diligence services” and the interpretive language found in the Proposing Release, as discussed above.
As Rule 15Ga-2 has been re-proposed, the required disclosure would not have to be included in the prospectus, which avoids the need to determine whether the third-party due diligence provider is an “expert” required to consent to being named in the registration statement and thus be subject to liability under Section 11 of the Securities Act. Also, Form ABS-15G would be furnished rather than filed, as would have been required under the original proposal.10
Additional Proposals Augmenting the Existing NRSRO Registration and Oversight Regime
Other rules proposed in the Proposing Release would:
Comments on the proposed rules will be due to the SEC 60 days after publication of the Proposing Release in the Federal Register.
For assistance, please contact any of the following lawyers:
Reed D. Auerbach, Practice Group Leader, Structured Transactions
1 Proposed Rules for Nationally Recognized Statistical Rating Organizations, SEC Release No. 34-64514, available at http://sec.gov/rules/proposed/2011/34-64514.pdf.
2 The Dodd-Frank Act is available at http://banking.senate.gov/public/_files/Rept111517DoddFrankWallStreetReformandConsumerProtectionAct.pdf. Our summary of the Dodd-Frank Act is available at /Media.aspx?MediaID=10963.
3 The Proposing Release states that for these purposes, the term “issuer” means the sponsor of the transaction as well as the depositor.
4 The term “underwriter” generally is not used in connection with private offerings of securities. In connection with the earlier proposal of Rule 15Ga-2 described below, the SEC stated that “underwriter” refers to parties that perform functions in private offerings of Exchange Act ABS that are similar to those performed by underwriters in public offerings of Exchange Act ABS, including initial purchasers and placement agents. While the SEC did not address this issue in the Proposing Release, presumably “underwriter” should continue to be interpreted in the same manner.
5 As noted by the SEC in the Proposing Release, information that is “furnished” rather than “filed” is not subject to the liability provisions of Section 18 of the Exchange Act. However, this is of little practical moment, as Section 18 is used only infrequently as a basis for securities fraud claims due to the difficulty of proving all of its elements and the various procedural obstacles. Information that is “furnished” remains subject to Rule 10b-5 under the Exchange Act, which is much more commonly used as a basis for securities fraud claims.
6 Form ABS-15G has already been adopted for purposes of disclosures regarding fulfilled and unfulfilled repurchase requests for alleged breaches of representations and warranties.
7 Issuer Review of Assets in Offerings of Asset-Backed Securities, SEC Release Nos. 33-9150, 34-63091, 75 Fed. Reg. 64182 (Oct. 19, 2010), available at http://sec.gov/rules/proposed/2010/33-9150fr.pdf. Our summary of the Original Proposing Release is available at /Media.aspx?MediaID=11379. However, in adopting the final issuer review rules, the SEC deferred consideration of the third-party diligence report disclosure rules. Issuer Review of Assets in Offerings of Asset-Backed Securities, SEC Release Nos. 33-9176, 34-63742, 76 Fed. Reg. 4231 (Jan. 25, 2011), available at http://sec.gov/rules/final/2011/33-9176fr.pdf. Our summary of the adopting release for the issuer review rules is available at /Media.aspx?MediaID=11901.
8 This category illustrates the difficulty in determining whether a particular report would constitute a due diligence report subject to proposed Rule 15Ga-2. Consider an accountant’s agreed-upon procedures letter. While such a letter would appear to fall within the literal scope of this first category of due diligence services, it generally is obtained by an underwriter for purposes of its own due diligence to protect against liability under Sections 11 and 12(a)(2) of the Securities Act and Rule 10b-5 under the Exchange Act, is not provided by a specialized due diligence services provider, and ordinarily is not required by or relevant to the credit rating of the security by an NRSRO.
9 Proposed Rule 17g-10 would specifically define “issuer” to mean the sponsor of the transaction as well as the depositor.
10 See note 5 above.