The Board of Directors of the FDIC (the “Board”) has adopted a final rule (the “Final Rule”)1 that will replace its current securitization “safe harbor” rule (the “Securitization Rule”), which remains applicable on a limited basis as described below. This new rule, approved by the Board and released on Monday, September 27, is intended to give investors and rating agencies comfort that the FDIC, as receiver or conservator for a failed bank, will not interfere with securitizations that meet certain requirements. The adoption of the Final Rule culminates a rulemaking process that began with an Advance Notice of Proposed Rulemaking (“ANPR”) in December 2009, and continued with the release of a Notice of Proposed Rulemaking (“NPR”) in May 2010, which sought public comment from securitization industry participants on a proposed set of conditions that the FDIC proposed to impose on banks seeking safe harbor protection.
Most notably, the Final Rule:
- Extends the application of the Securitization Rule on a transitional basis until December 31, 2010 (the “Transition Date”) for all bank-sponsored securitizations;
- Provides that upon the effective date of interagency regulations on securitization risk retention that are adopted as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), such regulations will automatically govern the requirement to retain risk under the Final Rule;2
- Clarifies many of the conditions to availability of the safe harbor, although compliance with some conditions still may not be determinable with certainty at the inception of a securitization; and
- Clarifies how the FDIC will treat securitization transactions as receiver or conservator of a failed bank.
The Final Rule appears to grandfather master trusts and revolving trusts under the Securitization Rule, although this change was not addressed in the Monday Board meeting or in the supplementary information accompanying the Final Rule.
Background: The Securitization Rule and FAS 166/167
Before adoption of the Securitization Rule in 2000, banks (including savings institutions) structured securitization transactions by relying on a legal true sale of the underlying financial assets or a grant of a security interest in the financial assets that could under existing law be liquidated notwithstanding the appointment of the FDIC as receiver or conservator. In response to securitization industry concerns that its power, as receiver or conservator, to repudiate contracts of failed banks could promote uncertainty both as to the rights of investors in bank-sponsored securitizations and as to the accounting treatment of the transfers by banks when there had not been a legal true sale of the financial assets, the FDIC adopted the Securitization Rule.3
The Securitization Rule provides that the FDIC will not “disaffirm or repudiate contracts..., [to] reclaim, recover or recharacterize as property of the institution or the receivership” any securitized assets transferred by a bank in connection with a securitization transaction as long as the transfer achieves sale accounting (“off-balance sheet”) treatment under generally accepted accounting principles (“GAAP”), other than the “legal isolation” criterion of GAAP.4 From 2000 to 2009, most bank-sponsored securitization transactions met sale accounting treatment under Statement of Financial Accounting Standards No. 140 (“FAS 140”)5 and were therefore afforded protection from repudiation under the Securitization Rule, even if the transaction was not a legal true sale from the bank. FAS 140 introduced a concept of “qualifying special-purpose entities” (“QSPEs”), which were considered isolated from sponsors of securitizations.
In June 2009, the Financial Accounting Standards Board released Statements of Financial Accounting Standards Nos. 166 and 167 (“FAS 166 and 167”), which substantially changed the accounting treatment of securitization transactions for accounting periods beginning on or after November 15, 2009.6 FAS 166 and 167 abolished the QSPE concept contained in FAS 140 and focused on control of special-purpose entities rather than on permissible activities. As a result, many standard securitization structures that would have achieved sale accounting treatment under FAS 140 failed to do so under FAS 166 and 167 and were consolidated for financial statement reporting purposes (“on-balance sheet”).
Because the Securitization Rule relies on GAAP standards that, after the implementation of FAS 166 and 167, permit fewer securitizations to achieve sale accounting treatment, the securitization industry asked the FDIC to consider the circumstances under which it might continue to afford these bank-sponsored securitizations protection from its repudiation powers.
The Final Rule provides permanent relief for securitization transactions for which the related transfers of financial assets are made on or before the Transition Date. These transactions will continue to be afforded protection from repudiation under the Securitization Rule if they meet the requirements of the Securitization Rule as they existed before the implementation of FAS 166 and 167. In other words, for transactions for which the related transfer of financial assets occurs on or before the Transition Date, sale accounting treatment under FAS 140 will be sufficient for coverage under the transitional safe harbor even though FAS 140 no longer applies to financial statement presentation.
In addition, the Final Rule provides a transitional safe harbor to “any obligations of revolving trusts or master trusts, for which one or more obligations were issued as of” adoption of the Final Rule, as well as to “any obligations issued under open commitments up to the maximum amount of such commitments as of the date of adoption of [the Final Rule] if one or more obligations were issued under such commitments on or before December 31, 2010.” Other securitizations can be afforded safe harbor protection only under the revised safe harbor of the Final Rule, as described below.
Under the transitional Securitization Rule, the FDIC will not interfere with transfers of securitized assets by use of its power to repudiate contracts of failed banks if (a) the most senior class of the securitization is rated investment-grade by a nationally recognized statistical rating organization or the securities are sold in transactions exempt from registration, (b) the failed bank received adequate consideration for the transfer, (c) the documents effecting the transfer reflect the intent of the parties to treat the transaction as a sale, and (d) the transfer meets all conditions for sale accounting treatment under GAAP, in accordance with FAS 140, other than legal isolation. Securitizations that fall under the transitional safe harbor described above will continue to receive this treatment just as if GAAP sale accounting determination still followed FAS 140.
Mechanics of the New Safe Harbor
The Final Rule provides two different safe harbors, one for securitizations that achieve off-balance sheet treatment and one for those that do not. For securitizations that achieve off-balance sheet treatment under FAS 166 and 167, the FDIC will not interfere with the transfers of securitized assets through its power to repudiate contracts of failed banks. In effect, this safe harbor will function similarly to that of the existing Securitization Rule. However, under the Final Rule, securitizations will have to comply with many additional conditions (discussed below) in order to be protected by the safe harbor.
For securitization transactions that fail to achieve sale accounting treatment, the Final Rule provides a new safe harbor, partly in response to a change in the powers granted to the FDIC. In 2006, Congress amended the Federal Deposit Insurance Act (the "FDI Act") to provide for a 90-day stay7 against enforcement of any contractual rights against a failed bank, including self-help remedies for secured parties. Recognizing that, for securitizations that would no longer qualify under the Securitization Rule, the stay could delay payments to investors for up to 90 days, with interest and principal unpaid in the meantime, the major rating agencies warned that significant downgrades in ratings of existing securities could result from the threat of repudiation of securitization agreements.
For securitizations that do not achieve sale accounting treatment, the Final Rule provides two new protections. First, if the FDIC fails to “pay or apply collections from the financial assets received by it in accordance with the securitization documents” on behalf of a failed bank for 10 business days after receipt of a written notice, then the FDIC consents to the exercise of contractual rights under the securitization agreements, including self-help remedies to foreclose on the securitized assets, provided that no involvement of the FDIC is required (other than consents, waivers or execution of transfer documents as may be reasonably requested in the ordinary course of business).
Second, the Final Rule provides that if the FDIC repudiates a securitization agreement, it must pay damages equal to the par value of the obligations of the securitization outstanding at the date of its appointment as conservator or receiver (less any payments of principal paid to investors to the date of repudiation), plus any unpaid accrued interest actually received through the date of repudiation, within 10 business days, or else it consents to the same exercise of contractual rights. The Final Rule expressly states that the FDIC will not seek to reclaim any interest payments made to investors in accordance with transaction documents. The Final Rule also provides that the FDIC will consent to (or perform itself) any servicing activity required in furtherance of the securitization, including the making of payments to investors to the extent actually received through payments on the securitized assets.
Summary of Additional Conditions to Safe Harbor
In a significant departure from the Securitization Rule, the Final Rule (like the NPR and ANPR) contains many requirements and conditions that are intended to promote higher quality securitizations. Some of these conditions will apply only to RMBS securitizations, while the remaining provisions will apply to securitizations of all asset classes. Failure to satisfy any of the conditions will result in loss of the safe harbor protections, which could result in negative rating agency actions with respect to a securitization depending on the credit rating of its sponsor. The Final Rule organizes these proposed conditions in five categories: capital structure and financial assets, disclosures, documentation and recordkeeping, compensation, and origination and retention.
Conditions Applicable Only to RMBS Securitizations
Capital Structure and Financial Assets:
- No more than six tranches. The structure of RMBS securitizations may not feature more than six credit tranches and may not include subtranches (other than time-based sequential pay or planned amortization and companion subtranches within the senior-most credit tranche), grantor trusts or other structures.
- No external credit support. External credit support or guarantees may not be used at the pool level, though such support at the loan-level (e.g., mortgage insurance) is permitted, and credit support or guarantees may be provided by Fannie Mae, Freddie Mac, Ginnie Mae, or any other government-sponsored mortgage finance agency. Temporary payment of principal and interest through liquidity facilities is permitted, as is use of facilities designed to make temporary payments following the appointment of the FDIC as conservator or receiver.
- Loan-level data. Disclosure of loan-level data is required, including information concerning loan type, loan structure, maturity, interest rate and location of property.
- Affirmation of compliance with origination standards. Sponsors of RMBS securitizations must affirm compliance in all material respects with all applicable statutory and regulatory standards and supervisory guidance8 for origination of mortgage loans. Specifically, the mortgage loans must be underwritten at a fully indexed rate and rely on documented income. Sponsors must also disclose a third-party diligence report on compliance with such standards. The report must also describe compliance with representations and warranties with respect to the loans.
- Disclosure of servicer conflicts of interest. The transaction documents must require servicers of securitized loans to disclose any ownership interest they (or their affiliates) own in whole loans secured by the same real property securing loans in the RMBS pool (e.g., second liens). Ownership of other RMBS backed by such whole loans would not constitute an ownership interest for the purposes of this requirement.
- Loss mitigation authority. Servicing agreements must provide servicers with authority to maximize the net present value of mortgage loans underlying RMBS securitizations by executing loss mitigation strategies. Such authority must include loan modifications to address reasonably foreseeable defaults. The transaction documents must require (i) that servicers act for the benefit of all investors of a securitization trust, not for one particular class of investors, (ii) that loss mitigation actions commence within 90 days of delinquency, unless the delinquency has been cured, and (iii) that servicers maintain records of any servicing actions to permit full review by trustees or other representatives of investors.
- As with several other conditions described below, this condition was modified in the Final Rule so as to mandate only that transaction documents impose particular requirements on transaction parties, not that the requirements themselves actually be satisfied. This change was made in order to “permit a clearer assessment of whether a transaction meets the conditions” of the Final Rule.
- Three-month servicing advance limit. Servicing advances must be limited by the transaction documents to payments of principal and interest for no more than three payment periods, unless alternative “financing or reimbursement facilities” (including reimbursement of the servicer by the master servicer or issuing entity) are available.
- Deferred compensation for rating agencies. Any fees payable to credit rating agencies or “similar third-party evaluation companies” must be payable over a five-year period. An initial payment of 60 percent of the total estimated fee may be made at closing, while the remaining 40 percent must be paid over time based on the performance of surveillance services and the performance of the pool assets.
- Incentives for servicers to maximize NPV. The transaction documents must include provisions to incentivize the servicer to maximize the net present value of the serviced assets. This may be accomplished by payments for specific services, actual expenses, or some combination.
Origination Standards, Repurchase Reserve:
- Repurchase reserve fund. The transaction documents must require the sponsor to establish a reserve fund equal to five percent of the cash proceeds of the transaction in order to cover any repurchases of mortgage loans due to material breaches of representations and warranties. After one year, the remaining balance of the reserve fund may be released to the sponsor.
- Compliance with underwriting standards. The transaction documents must require that securitized mortgage loans have been originated in all material respects in compliance with all statutory, regulatory, and originator underwriting standards in effect at the time of origination. The transaction documents must include a representation that securitized loans were underwritten based upon the borrowers’ ability to repay the mortgage loan, in accordance with its terms.
Conditions Applicable to All Asset Classes
Capital Structure and Financial Assets:
- Disclosures for underlying securities. Resecuritizations or collateralized debt obligations will not obtain the protection of the safe harbor unless the transaction documents require that disclosures complying with Regulation AB (as further described below) are available to investors for all underlying assets supporting the securitization.
- Limitation on derivatives. The transaction documents must require that principal and interest distributions to investors be primarily based on the performance of underlying assets and may not be contingent on events that are independent of the financial assets. However, securitizations that include interest rate and currency derivatives are eligible for safe harbor protection. Unfunded or synthetic securitizations may not obtain safe harbor protection.9
- Regulation AB disclosures. The transaction documents must require that disclosures be made to investors that, at a minimum, comply with Regulation AB (including any future changes made by the SEC), including loan-level or pool-level data, as appropriate by asset class.
- Sponsors of privately offered securitizations, which currently are not required by the SEC to make such disclosures, must comply with Regulation AB in order to obtain safe harbor protection under the Final Rule.
- Unlike the SEC’s proposed revisions to Regulation AB, this condition will apply to all private offerings, including statutory private placements. The SEC’s proposal would impose a similar disclosure requirement in transactions exempt from registration in reliance on Rule 144A or Rule 506 of Regulation D.
- Structure and other disclosures. The transaction documents must require that the capital structure, priority of payments, subordination features, and representations and warranties (along with remedies for breaches thereof) of a securitization be disclosed to investors by the time the obligations are issued. The transaction documents also must require similar disclosure regarding any liquidity facilities or credit enhancements, waterfall triggers, and servicing policies governing servicing of delinquent assets.
- Ongoing performance data. The transaction documents must require that sponsors provide investors with credit performance information regarding the underlying assets, including delinquency and modification data, any additions or removals of assets, servicing advances, and losses to particular tranches.
- Compensation and retained interest disclosures. The transaction documents must require that disclosure detailing compensation paid to originators, sponsors, rating agencies, mortgage brokers, and servicers be made at issuance. In addition, the transaction documents must require that any credit risk retained by any of these parties be disclosed, and that any changes to compensation or retained interests be disclosed to investors as long as their interests are outstanding.
Documentation and Recordkeeping:
- Authority under transaction documents. The transaction documents must define the contractual rights and responsibilities of the respective parties and must clearly distinguish between any multiple roles performed by any party. Each party must be afforded sufficient authority to fulfill its duties.
- Standardized documentation. The transaction documents must “use as appropriate any available standardized documentation for each different asset class.”
- In supplementary information accompanying the release of the Final Rule, the FDIC states that “[i]t is not possible to define in advance when use of standardized documentation will be appropriate, but certainly when there is general market use of a form of documentation for a particular asset class, or where a trade group has formulated standardized documentation generally accepted by the industry, such documentation must be used.”
Retention of Risk:
- Skin in the game. Prior to the effective date of interagency regulations on risk retention to be issued as required by the Dodd-Frank Act, transaction documents must require sponsors to retain at least five percent of the credit risk of the securitized assets, either by retaining at least five percent of each tranche sold to investors or by retaining a “representative sample” of the securitized assets equal to at least five percent of the principal balance of the securitized assets. Sales, pledges or hedges of this retained credit risk are not permitted, except for the hedging of interest rate or currency risk. Upon the effective date of such interagency regulations under the Dodd-Frank Act, those regulations will exclusively govern the requirement to retain risk under the Final Rule.
- Arm’s length. Securitization transactions must be negotiated at arm’s length and transaction documents must require that obligations issued in a securitization may not be predominantly sold to affiliates or insiders of the sponsor, other than its wholly-owned, consolidated subsidiaries.
- Agreements in writing. The transaction documents must be in writing, must be approved by the sponsor’s board of directors or loan committee, and must have been continuously in the official record of the sponsor.
- Ordinary course. Securitizations must be entered into in the ordinary course of business and not in contemplation of a bankruptcy or with any intent to hinder, delay or defraud creditors.
- Adequate consideration. Transfers of securitized assets must be made for adequate consideration.
- Perfection of transfer or security interest. The transfer of assets or security interest must be properly perfected under the Uniform Commercial Code or other applicable state law.
- Separate agreements. The agreement evidencing the transfer of assets from the sponsor, as transferor, must be separate from any agreements evidencing the duties of the sponsor, if any, in any other capacity.
- Recordkeeping requirements. The transaction documents must require sponsors to maintain electronic or paper copies of closing documents and recent 10-K filings, and separately identify securitized assets within any internal databases. In addition, the documents must prohibit any sponsor that also serves as servicer from commingling securitization funds with its own. The transaction documents must also require that records be made available for review by the FDIC upon request.
- Unknown or unavailable information. The proposed rule would permit omission of information that is not available to the sponsor after “reasonable investigation,” provided that the type of information omitted and the reason for the omission is disclosed.
Uncertain Application of the Safe Harbor
Although several of the changes made in the Final Rule were designed to reduce the risk that a securitization believed to have the benefit of safe harbor protection at closing will later fail to qualify, some uncertainties remain in the final text. Under the Final Rule, securitizations may still lose the benefits of the safe harbor at a later date as a result of, among other things:
- A determination that the transaction documents were not based on “available standardized documentation” for the related asset class;
- Prior to the effective date of the interagency risk retention rules mandated by the Dodd-Frank Act, a determination that the sample of financial assets retained to satisfy the risk retention requirement was not a “representative sample”;
- Prior to the effective date of the interagency risk retention rules mandated by the Dodd-Frank Act, the transfer or impermissible hedging of the retained interest in any credit tranche or the “representative sample” of financial assets; or
- The release of the balance of the repurchase reserve fund to the sponsor prior to one year after the date of issuance.
For assistance, please contact any of the following lawyers:
John Arnholz, Partner, Structured Transactions
Reed D. Auerbach, Practice Group Leader, Structured Transactions
Jeffrey R. Johnson, Partner, Structured Transactions
Matthew P. Joseph, Partner, Structured Transactions
Steve Levitan, Partner, Structured Transactions
Edmond Seferi, Partner, Structured Transactions
Charles A. Sweet, Partner, Corporate, M&A and Securities
Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area
Edwin E. Smith, Partner, Financial Restructuring, Co-chair, Financial Services Area
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:
1 Available at http://fdic.gov/news/board/10Sept27no4.pdf.
2 The interagency risk retention regulations required by the Dodd-Frank Act will take effect one year, for securitizations of residential mortgages, or two years, for securitizations of other assets, after publication in the Federal Register.
3 12 C.F.R. § 360.6.
4 In order to receive the benefit of the Securitization Rule, a securitization transaction is required to meet all conditions for GAAP sale accounting treatment other than the “legal isolation” condition, as well as certain additional requirements described in this alert; the legal isolation condition under GAAP was intended to be satisfied by the Securitization Rule.
5 Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.
6 Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R).
7 The duration of the stay is 90 days for receiverships and 45 days for conservatorships. See Section 11(e)(13)(C) of the FDI Act, 12 U.S.C. § 1821(e)(13)(C), added by Section 718(a) of the Financial Services Regulatory Relief Act of 2006, Public Law 109-351, 120 Stat. 1966, 1977 (2006) (effective October 13, 2006).
8 This includes the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007.
9 The FDIC does not define “unfunded” or “synthetic” securitizations, but the FDIC does state in the supplementary information accompanying the release of the Final Rule that it “does not view the inclusion of existing credit lines that are not fully drawn in a securitization as causing such securitization to be an ‘unfunded securitization.’” The FDIC further states that “[t]he provision is intended to emphasize that the Rule applies only where there is an actual transfer of financial assets.”