In April 2010, the U.S. Securities and Exchange Commission (the “Commission”) proposed (the “April 2010 Proposals”)1 an extensive set of new rules and forms and amendments to existing rules that would effect substantial changes to the offering process, disclosure and reporting requirements for offerings of asset-backed securities (“ABS”). Before the end of the comment period for the April 2010 Proposals, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).2 In light of the new requirements imposed by the Dodd-Frank Act, and in response to comments received on the April 2010 Proposals, the Commission has re-proposed (the “Re-Proposed Rules”) some of the April 2010 Proposals (the “Re-Proposing Release”).3
The changes that the Commission has re-proposed relate primarily to the shelf eligibility criteria for new Form SF-3. In light of the Dodd-Frank Act’s mandate to eliminate regulatory requirements to use credit ratings, the Commission would replace the requirement that ABS offered off a shelf registration statement have an investment grade rating with the following revised requirements:
The Commission also has proposed that ABS issuers be required to file substantially final copies of the transaction documents, including all attached schedules, at the same time as the preliminary prospectus is required to be filed. The April 2010 Proposals would require the preliminary prospectus to be filed at least five business days before pricing.
The Commission has requested additional comment on several other matters. These include the asset-level data requirements of the April 2010 Proposals — particularly, the required data points for equipment loan and lease ABS and equipment floorplan ABS — and whether asset-level data disclosure should be required in private offerings of structured finance products only for classes of assets as to which Regulation AB prescribes specific asset-level reporting requirements.
Shelf Eligibility Requirements
Currently, offerings of ABS may be eligible for shelf registration on Form S-3 if, among other criteria, the securities will be rated investment grade by at least one nationally recognized statistical rating organization (an “NRSRO”). The April 2010 Proposals would have eliminated this requirement for new Form SF-3 and replaced it with several new requirements, including:
The April 2010 Proposals also would have required a quarterly evaluation of compliance with the registrant requirements for shelf eligibility in order to use an existing shelf registration statement.
The Re-Proposed Rules would eliminate the proposed requirement for credit risk retention because the Dodd-Frank Act added an independent requirement for credit risk retention. This requirement currently is the subject of rulemaking by the Commission and other federal agencies.4 The Re-Proposed Rules also would eliminate the proposed undertaking to continue to provide periodic Exchange Act reports, because the Dodd-Frank Act eliminated the automatic suspension of an ABS issuer’s duty to file these reports under Section 15(d) of the Exchange Act and permitted the Commission to suspend or terminate reporting obligations by rule.5 The Re-Proposed Rules would revise the remaining requirements as discussed below.
The Re-Proposed Rules would require a certification by the depositor’s CEO or executive officer in charge of securitization to be filed at the time of each takedown, stating that:
As described above, the April 2010 Proposals would have required a certification to be filed at the time of each takedown by the CEO of the depositor, stating that the assets in the pool have characteristics that provide a reasonable basis to believe that they will produce, taking into account internal credit enhancements, cash flows to service any payments on the securities as described in the prospectus.
In response to the April 2010 Proposals, many commenters expressed concern about the breadth of the proposed certification and suggested that it relate solely to the disclosure in the prospectus, rather than the credit quality of the securities being offered. The Commission stated in the Re-Proposing Release that it “preliminarily believe[s] the certification should not be limited to disclosure,”7 so it did not remove the portion of the certification dealing with the credit quality of the securities. However, the Re-Proposed Rules would add several components to the certification related to the quality of the disclosure in the prospectus. The Commission anticipates that the certifier could rely on the issuer’s review of the assets pursuant to recently adopted Rule 193,8 but would still have to perform an independent review of the structure of the securitization.
Many comments on the April 2010 Proposals opposed the requirement for the certification to be signed by the depositor’s CEO, on the basis that he or she could not be expected to have the knowledge necessary to certify the performance of the securities. In the Re-Proposing Release, the Commission stated that the CEO of the depositor should at least be able to provide oversight of others sufficient to allow him or her to make the required certification, but it did revise the proposed requirement to alternatively permit the certification to be made by the executive officer in charge of securitization of the depositor.9
The proposing release for the April 2010 Proposals indicated that the certification requirement was not intended to serve as a guarantee of payment of the securities, but commentators were concerned that the text of the certification could still be construed as a guarantee of future performance. To address these comments, the Commission revised the certification regarding the credit quality of the offered securities to explicitly state that it is not a guarantee and to focus on the design of the securitization to produce cash flows sufficient to pay the offered securities, rather than a statement that the assets “will produce” cash flows sufficient to pay the offered securities.
Commenters also were concerned that the form of certification in the April 2010 Proposals would apply to junior tranches that are offered at steep discounts to par, precisely because investors know they bear the risk that the assets will not produce sufficient cash flows to service all payments on those securities. In the Re-Proposing Release, the Commission said that “lower tranches typically have not been sold in registered transactions because they did not satisfy the . . . investment grade ratings . . . requirement.”10 In an effort to provide clarity, the Commission revised the text of the certification to clarify that it would only apply to the securities offered and sold under the registration statement. However, the certification language in the Re-Proposed Rules does not appear to contemplate the possibility that more junior tranches of registered ABS may bear credit risk somewhere in between the most senior registered tranches and unregistered subordinated tranches.
Credit Risk Manager and Repurchase Dispute Resolution
The Re-Proposed Rules would require that the transaction documents contain a mandate for the trustee to appoint a credit risk manager which would review the pool assets when certain trigger events occur. The credit risk manager would be unaffiliated with the sponsor, depositor and servicer, and would have access to copies of the underlying loan documents for the asset pool. The trigger events for credit risk manager review of the pool assets for compliance with representations and warranties would be required to include, at a minimum, when credit enhancement requirements (such as required reserve amounts and target overcollateralization percentages) are not met, and the direction of investors pursuant to processes described in the transaction documents and the prospectus. The requirement for a process whereby investors may direct the credit risk manager to review pool assets for breaches of representations and warranties was proposed in response to investor complaints that they often were not empowered to make repurchase demands directly, and that trustees have not enforced repurchase rights consistently.
The Commission requests comment on whether there are asset classes or structures where no target credit enhancement is specified. The Re-Proposing Release does not appear to contemplate structures in which credit enhancement, such as a reserve fund or overcollateralization, is not at its target level on the closing date, but builds toward a target level over time as funds are applied from excess cash flow. Even where credit enhancement is at its target level, the Re-Proposed Rules would appear to trigger credit risk manager review whenever the enhancement is used to fund a temporary shortfall in collections and falls below that target level, even if it is replenished quickly.
No specific procedures for investor direction of the credit manager are proposed because the Commission “preliminarily believe[s] transaction parties should have the flexibility to tailor the procedures to each ABS transaction,”11 though the Commission does request comment on whether several particular mechanisms proposed by commenters should be specified.
The prospectus would be required to disclose the name of the credit risk manager, its form of organization, the extent of its experience and details about its compensation. Further disclosure would be required regarding the credit risk manager’s duties, any limitations on its liability under the transaction documents, any indemnification provisions, any provisions regarding its removal or replacement, and how its expenses would be paid.12 The Re-Proposed Rules also would require disclosure, if material, about any relationships between the credit risk manager and any other transaction parties.
The credit risk manager would be required to report to the trustee on its findings and conclusions with regard to any review of the pool assets, and the trustee could use the report to determine whether to make a repurchase request. If the credit risk manager is required to review assets during any distribution period, the Form 10-D for that period would have to disclose the event that triggered the review. If the credit risk manager provides a report to the trustee during a distribution period, the report would be filed as an exhibit to the Form 10-D for that period. Additional Form 10-D disclosures would be required of the date and circumstances of any resignation, removal or replacement of the credit risk manager, together with all of the disclosures described above with respect to any new credit risk manager.
The Re-Proposed Rules also would require the transaction documents to include dispute resolution procedures. If an asset is subject to a repurchase request made pursuant to the terms of the transaction documents but is not repurchased within 180 days13 after notice is received of the repurchase request, the party submitting the repurchase request could refer the matter to either mediation or arbitration. The party with repurchase obligations would be required to agree to the dispute resolution mechanism selected by the party requesting the repurchase. The Commission requests comment on whether the rules should specify who must pay for the expenses of dispute resolution, and whether the party with repurchase obligations should be required to honor the repurchase request if it fails to agree with the request for dispute resolution.
As described above, the April 2010 Proposals would have required a third-party opinion, at least quarterly, regarding pool assets not repurchased or substituted after a demand was made and whether the failure to repurchase was consistent with the transaction documents. Many commenters thought that this proposal was unduly complex, costly, and would not achieve its goals of strengthening the enforceability of representations and warranties regarding the pool assets. Instead, commenters suggested that a better way to achieve this goal would be to require a review of the pool assets by an independent credit risk manager, a concept accepted by the Commission in the Re-Proposed Rules.
According to the Commission, investors have had difficulty locating other investors to enforce rights contained in transaction documents, including those related to the repurchase of pool assets for breaches of representations and warranties. These difficulties have been exacerbated since most ABS are book-entry securities held in street name through the Depository Trust Company. Therefore, the Commission has proposed that the transaction documents require the party responsible for making periodic filings on Form 10-D14 to include any request from an investor to communicate with other investors relating to their rights under the ABS that is received during the reporting period. The disclosure would include the name of the requesting investor, the date the request was received and a description of the method by which other investors may make contact. Investors could not use these mechanisms for purposes other than communicating with regard to rights under the registered ABS.
An instruction to Form SF-3 would allow transaction parties to specify limited procedures for verifying the identities of beneficial owners making use of these mechanisms. If the investor is a record holder, the investor would not have to provide verification of ownership; if the investor is not a record holder, the transaction documents could require a written statement from the record holder that the investor beneficially held the ABS at the time of the request. Among other requests for comment, the Commission asks whether these procedures are reasonable to demonstrate ownership.
Registrant Requirements and Annual Compliance Check
To the extent that the depositor or any issuing entity previously established by the depositor or an affiliate of the depositor was required to comply with the transaction requirements of Form SF-3 during a 12-month look-back period with respect to an offering of ABS involving the same asset class, the depositor and each such issuing entity must have timely filed all the required certifications and transaction documents containing the required provisions relating to the credit risk manager, repurchase request disputes and investor communications. As originally proposed, these registrant requirements would have related to the risk retention, third-party opinion, officer certification and Exchange Act reporting requirements of the April 2010 Proposals.
In order to conduct a takedown off an effective shelf registration statement, an ABS issuer would be required to conduct a periodic evaluation as to whether it was in compliance with these registrant requirements, as of a date 90 days after the end of the depositor’s previous fiscal year. The April 2010 Proposals would have required the issuer to evaluate its compliance with these requirements quarterly, but in response to comments on the April 2010 Proposals, the Re-Proposed Rules would require only an annual evaluation. Commenters on the April 2010 Proposals also had raised concerns that a one-year penalty for missing these requirements was too extreme, so the Re-Proposed Rules would allow a depositor or issuing entity to cure any deficiency by subsequently filing the missing information. It would be deemed to have met the registrant requirements after the expiration of a 90-day waiting period from the actual filing date.15
In order to conduct a takedown off an effective shelf registration statement, an ABS issuer also would be required to evaluate, as of a date 90 days after the end of the depositor’s previous fiscal year, whether the depositor or any affiliated issuing entity that was required to file periodic Exchange Act reports during the previous 12 months had filed those reports, and filed them in a timely manner (other than reports required only by certain specified items of Form 8-K). This requirement of the Re-Proposed Rules is unchanged from the April 2010 Proposals, including the one-year penalty for failure to comply.
Filing of Transaction Documents
Under the April 2010 Proposals, a preliminary prospectus would be required to be filed for each ABS shelf takedown at least five business days prior to first sale in the offering (i.e., pricing). While some industry commenters requested that this time period be reduced, the Re-Proposing Release indicates that the Commission has not yet reached a conclusion on this issue.
The April 2010 Proposals would have required all exhibits, including substantially final forms of transaction documents and their attached schedules, to be filed by the date the final prospectus is required to be filed pursuant to Rule 424. In response to investor comments that exhibits should be available for review before they are required to make an investment decision, the Re-Proposed Rules would require the transaction documents, in substantially final form and including all attached schedules, to be filed by the date the preliminary prospectus is required to be filed.16 As noted above, if the Re-Proposed Rules are adopted as proposed, this filing deadline would be five business days before pricing.
The April 2010 Proposals included extensive asset-level data disclosure requirements for both prospectuses and periodic Exchange Act reports. Following these proposals, the Dodd-Frank Act added a statutory mandate for the Commission to adopt regulations requiring ABS issuers to disclose, for each tranche or class of a security, information regarding the assets backing that security. The Commission believes that the asset-level data requirements of the April 2010 Proposals effectively implement the requirements of the Dodd-Frank Act, so these proposals remain outstanding.
The Commission does, however, request additional comment on various aspects of its asset-level data disclosure proposals.
Despite the Commission’s efforts to proactively address privacy issues by requiring the disclosure only of ranges or coded responses to provide information regarding location of the debtor or collateralized property, credit scores, income and debt amounts, it still received comments expressing privacy concerns, so the Commission requests additional comment on those matters.
The Commission states that it has not made any determination regarding the final asset-level data disclosure rules for any asset class. In particular, the Commission notes the comments it received suggesting that grouped account data would be more appropriate for automobile loan and lease ABS, auto floorplan ABS and student loan ABS. For equipment loan and lease ABS and for equipment floorplan ABS, the Commission received mixed comments, many of which expressed ongoing competitive and privacy concerns. The Commission specifically requests additional comment on its asset-level data proposals with respect to these asset classes. Among other things, the Commission asks if it is possible to require asset-level data and still address these concerns; if so, which data elements would need to be revised or eliminated; and whether a grouped account data approach similar to that recommend by commentators for automobile ABS could be used.
The April 2010 Proposals would have required that asset-level data disclosures be filed if any material pool characteristic of the actual asset pool at the time of issuance differs by 1 percent or more from the description of the asset pool filed in the prospectus. Because of the apparent confusion of some commenters over the application of this requirement to prefunding and revolving periods, the Commission requests comment on whether the Re-Proposed Rules should be clarified to explicitly state that this requirement applies to prefunding and revolving periods and to the substitution of assets.
Privately-Issued Structured Finance Products
The April 2010 Proposals would impose extensive new disclosure requirements for issuers and resellers of structured finance products, as broadly defined, to use the safe harbors from registration provided by Rule 506 of Regulation D and by Rule 144A under the Securities Act. The transaction documents for these offerings would be required to grant to any purchaser, holder or prospective purchaser of the offered securities the right to request the same information that would be required if the offering were registered on Form S-1 or proposed Form SF-1, and the same ongoing information that would be required if the issuer were required to file ongoing periodic Exchange Act reports. This would include the proposed asset-level data disclosure requirements.
Many commenters expressed concerns that it is not clear what information would be required for types of structured finance products that are not typically offered in registered offerings under Regulation AB, such as collateralized debt obligations, collateralized loan obligations, asset-backed commercial paper and synthetic ABS, as well as other novel asset types and structures. Recognizing these concerns, the Commission requests comment on whether the rules should require asset-level data disclosure only where a privately offered structured finance product is backed by an asset class for which there are prescribed asset-level data requirements in Regulation AB. As currently proposed, this would include residential mortgages, automobile loans and leases, equipment loans and leases, student loans, floorplan financings, corporate debt and resecuritizations.
The April 2010 Proposals would require most ABS issuers to file a “waterfall computer program” giving effect to the flow of funds from the assets to the investors. The Commission acknowledges that many commenters opposed this proposal due to the lack of its clarity, cost and liability concerns, and that it received many helpful suggestions as to how to revise this requirement. The Commission intends to re-propose this requirement separately.
The Commission also reminds readers that it believes that the compliance date for the new rules should not extend more than a year past their adoption date, though it requests comment on whether any of the proposals should be phased in (giving examples of six months to two years for that process) and whether to implement a tiered approach relating to a characteristic other than the size of the sponsor.
For assistance, please contact any of the following lawyers:
Reed D. Auerbach, Practice Group Leader, Structured Transactions
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
1 Asset-Backed Securities; Proposed Rule, SEC Release Nos. 33-9117, 34-61858, 75 Fed. Reg. 23328 (May 3, 2010), available at http://sec.gov/rules/proposed/2010/33-9117fr.pdf. Our guide to the April 2010 Proposals is available here.
2 The Dodd-Frank Act is available at http://banking.senate.gov/public/_files/Rept111517DoddFrankWallStreetReformandConsumerProtectionAct.pdf. Our summary is available here.
3 Re-proposal of Shelf Eligibility Conditions for Asset-Backed Securities and Other Additional Requests for Comment, SEC Release Nos. 33-9244, 34-64698 (July 26, 2011), available at http://sec.gov/rules/proposed/2011/33-9244.pdf.
4 Credit Risk Retention; Proposed Rule, SEC Release No. 34-64148, 76 Fed. Reg. 24090 (Apr. 29, 2011), available at http://sec.gov/rules/proposed/2011/34-64148fr.pdf. Our guide to this proposal is available here.
5 See also Suspension of the Duty to File Reports for Classes of Asset-Backed Securities under Section 15(d) of the Securities Exchange Act of 1934, SEC Release No. 34-63652, 76 Fed. Reg. 2049 (Jan. 12, 2011) (proposing rules that would terminate reporting obligation only when no registered ABS of the relevant class are held by non-affiliates of the ABS depositor), available at http://www.sec.gov/rules/proposed/2011/34-63652fr.pdf. Our summary of this release is available here.
6 Internal credit enhancement includes guarantees on the underlying loans, such as federal government guarantees applicable to student loans. Re-Proposing Release, at 14 n. 33. External credit enhancements, such as insurance, could not be taken into account. Re-Proposing Release, at 22 n. 55.
7 Re-Proposing Release, at 15.
8 See Disclosure for Asset-Backed Securities Required by Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, SEC Release Nos. 33-9175, 34-63741, 76 Fed. Reg. 4489 (Jan. 26, 2011), available at http://www.sec.gov/rules/final/2011/33-9175fr.pdf. Our client alert regarding this release is available here.
9 The April 2010 Proposals already would have required the senior officer in charge of securitization for the depositor to sign the registration statement for ABS issuers, in lieu of the principal accounting officer or controller, but the Commission believes that the officer signing the certification should be an “executive officer” with the meaning of Rule 405 under the Securities Act of 1933, as amended (the “Securities Act”).
10 Re-Proposing Release, at 20.
11 Re-Proposing Release, at 33.
12 While the Re-Proposed Rules do not explicitly require that the trustee appoint the credit risk manager at the inception of a securitization, such a requirement is implicit in these prospectus disclosure requirements.
13 The parties could specify a shorter period if they wish.
14 The depositor, or on behalf of the issuing entity by a duly authorized representative of the servicer. See Form 10-D, General Instruction E.1.
15 This cure provision would only be useful for a mere failure to file — if the transaction documents do not contain the required provisions relating to the credit risk manager, repurchase request disputes and investor communications, they would need to be amended to include the required provisions prior to filing.
16 “[A]ny change to the agreements[s] could only be minor” and “a material change in the information, other than offering price, would require a new . . . filing.” Re-Proposing Release, at 63 n. 120.