Financial Services Alert - February 22, 2011

The FDIC’s securitization safe harbor rule, 12 CFR 360.6 (the “Safe Harbor Rule”), is intended – like its predecessor – to provide assurance to insured depository institutions (“IDIs”), rating agencies and investors that the FDIC will not seek to reclaim property transferred as part of a securitization, or participated, by an IDI if the relevant transfer in connection with the securitization or participation meets the criteria specified in the Safe Harbor Rule. It provides a transition period safe harbor for certain transactions issued on or prior to December 31, 2010. Securitizations and participations issued on and after January 1, 2011 must meet conditions set forth in the new rule in order to receive the protection of one of the safe harbors that the Safe Harbor Rule creates: a Safe Harbor for Participations, a Safe Harbor for Sales under generally accepted accounting principles (“GAAP”) and two Safe Harbors for Transfers that are Not Sales under GAAP. Notably, the Safe Harbor Rule does not apply to securitizations issued by certain government-sponsored enterprises, affiliates of such enterprises, or entities that are established or guaranteed by those enterprises, nor does it apply to securitizations by the Government National Mortgage Association.

Transition Period Safe Harbor

The Safe Harbor Rule extended the protection of the 2000 securitization safe harbor rule (the “Prior Safe Harbor Rule”) to (1) securitizations and participations issued on or before December 31, 2010, (2) master trusts or revolving trusts for which one or more obligations were issued on or before September 27, 2010 (the date of adoption of the new Safe Harbor Rule) and (3) any open commitment (up to a maximum amount of the commitment as of September 27, 2010) if one or more obligations under the commitment were issued on or before December 31, 2010, if the transfers met pre-November 2009 GAAP requirements for sale treatment (other than the legal isolation requirement) and the requirements of the Prior Safe Harbor Rule.

Safe Harbor for Participations

Under the Safe Harbor Rule, when acting as conservator or receiver, the FDIC will not disaffirm participation contracts or recover assets transferred provided that such participation satisfies the requirements (other than the “legal isolation” requirement) for sale treatment under GAAP. This safe harbor covers a last-in, first-out participation even if such participation fails to meet the criteria of a “participating interest” under GAAP so long as such failure is due solely to such participation being a last-in first-out participation.

Safe Harbor for Securitizations

The Safe Harbor Rule imposes a number of conditions on securitizations to be eligible for safe harbor treatment. These conditions are set forth in paragraphs (b) and (c) of the Safe Harbor Rule (the “Conditions”). Certain Conditions, such as that all securitization agreements be documented in writing, approved by the IDIs board of directors or loan committee and included in the records of the IDI are consistent with requirements for an enforceable agreement against an IDI. Other Conditions must be documented and include the following criteria.

• Risk Retention. Until the effective date of risk retention rules under the Dodd‑Frank Act, which is required to be within 270 days of enactment under Section 941 of the Dodd-Frank Act and which rules will then replace the Safe Harbor Rule’s specific requirements, the securitization documents must require that the sponsor of the securitization retain an interest of at least 5% of the credit risk of the financial assets, which interest cannot be pledged, sold or hedged (except for interest rate or currency risk hedging) during the life of the transaction. (See below for a discussion of the Financial Stability Oversight Council study on the Macroeconomic Effects of Risk Retention Requirements.)
• Disclosure. The documents governing the securitization must contain reporting and other disclosure obligations at issuance and periodically in connection with distributions, at least quarterly. Disclosure contractual obligations must require, at a minimum, compliance with Regulation AB (17 C.F.R. §§ 229.1100-1123) requirements for public offerings even if the securitization is issued in a private placement. They also must require disclosure of the credit performance of the securities and the underlying assets (including data regarding any modifications) and compensation paid to the originator, sponsor, rating agency or third-party advisor, any mortgage or other broker, and the servicer(s), and the extent to which any risk of loss on the underlying assets is retained by any of them.
• Capital Structure Requirements. The documents governing the securitization must require that payments of principal and interest depend mainly on the performance of the securitized assets (as opposed to extraneous market or credit events). Synthetic and “unfunded” securitizations are not eligible for safe harbor protection.

In addition to the requirements generally applicable to securitizations, the Safe Harbor Rule imposes additional conditions on residential mortgage-backed securitizations (“RMBS”). These heightened requirements include: (1) loan-level information such as loan type, loan structure (e.g., fixed rate, balloon, etc.), maturity, interest rate, and location of property must be disclosed to investors; (2) the transferring IDI must confirm, prior to issuance, that the loans that will be securitized comply with all applicable statutory and regulatory standards with respect to mortgage loan origination; (3) a reserve fund of 5% of the cash proceeds of the securitization payable to the sponsor to cover the repurchase of any financial assets required for breach of representations and warranties must be established and set aside for one year; and (4) sponsors must affirm compliance with all applicable legal origination standards for mortgage loans and supervisory guidance governing the underwriting of residential mortgages including that the mortgages are based on documented income.

Securitizations Receiving Sale Treatment under GAAP. Under the Safe Harbor Rule, when acting as conservator or receiver, the FDIC will not disaffirm contracts or recover assets transferred in securitizations (and other transactions that do not qualify for the transition period safe harbor) that meet the requirements for sale treatment under GAAP as long as they satisfy the Conditions.

Securitizations Not Receiving Sale Treatment under GAAP. Unlike its predecessor, the Safe Harbor Rule applies to securitizations that do not meet sale criteria under GAAP. When acting as conservator or receiver, where the relevant transfer does not meet sale criteria under GAAP, the FDIC retains the ability to repudiate a securitization agreement or decline to make payments of collections from a securitization’s underlying assets. The two situations – repudiation and monetary default – are treated separately.

• Repudiation. In the event of a repudiation, under the Safe Harbor Rule the FDIC consents to the exercise of contractual rights under the securitization documents (e.g., to take possession of the underlying assets and to exercise self-help remedies), if the FDIC has not paid damages within 10 business days of the effective date of notice of such repudiation, provided that the FDIC is not required to take any action other than to provide typical consents and waivers. Damages, under the Safe Harbor Rule, are measured as par on the date of appointment of the FDIC as conservator or receiver, less payments of principal received by investors, plus accrued and unpaid interest through the date of repudiation. All liens on the relevant assets will be deemed released upon payment of damages. In addition, the Safe Harbor Rule clarifies that the FDIC will not assert that any interest payments made to investors before the repudiation remain the property of the receivership or conservatorship.
• Monetary Default. In the event of a monetary default (defined under the Safe Harbor Rule as the failure to pay principal or interest when due after the expiry of any cure periods) resulting from the FDIC’s failure to pay or apply collections received by it (as servicer or otherwise) that continues for 10 business days after actual delivery of written notice to the FDIC requesting exercise of contractual rights, the FDIC consents, under the Safe Harbor Rule, to the investors’ exercise of their contractual rights (e.g., to take possession of the underlying assets and to exercise self-help remedies), provided that the FDIC is not required to take any action other than to provide typical consents and waivers.

On January 18, 2011, the Financial Stability Oversight Council (the “FSOC”) issued its study on the Macroeconomic Effects of Risk Retention Requirements (the “FSOC Study”).  The FSOC Study, which was mandated by Section 946 of the Dodd-Frank Act, considers the macroeconomic effects of the credit risk retention requirements called for by Section 941 of the Dodd-Frank Act. 

While the FSOC Study mainly provides background information on the securitization market and its impact on the financial crisis and a general discussion of the issues to be considered by regulators in developing a risk retention framework, it also offers the OCC, the FRB, the FDIC, and the SEC (collectively, the “Agencies”) principles and recommendations to consider as they develop regulations to implement the risk retention requirements of Section 941 (the “Risk Retention Regulations”).

The Risk Retention Regulations

Under Section 941, the applicable regulators are required to establish Risk Retention Regulations, including separate underwriting standards, for different classes of assets, including residential mortgages, commercial mortgages, commercial loans and auto loans.  In general, the Risk Retention Regulations must: (1) require a securitizer to retain not less than 5% of the credit risk for any asset that is transferred, sold, or conveyed through the issuance of an asset-backed security (“ABS”) by the securitizer; (2) prohibit a securitizer from hedging or otherwise transferring such risk; and (3) specify the permitted forms and minimum duration of the risk retention. 

In developing the Risk Retention Regulations, the Agencies have broad discretion to establish exceptions to the 5% risk retention requirement, including: (a) a total exemption if all of the assets that collateralize the ABS are “qualified residential mortgages” (which term is to be jointly defined by the Agencies, the Secretary of Housing and Urban Development, and the Director of the Federal Housing Finance Agency); (b) a lesser risk retention requirement if the originator of the underlying assets meets certain underwriting standards prescribed as part of the Risk Retention Regulations; and (c) a set-off of the securitizer’s risk retention obligation by the amount of credit risk retained by the originator of the assets collateralizing the ABS.  In addition, the regulations must provide total or partial exemptions for, among other things, securitizations of assets issued or guaranteed by the Federal government or one of its agencies (not including Fannie Mae or Freddie Mac) or any ABS issued or guaranteed by an state or any political subdivision of any state or territory.

The Risk Retention Regulations may also include other exemptions, exceptions, or adjustments, including for classes of institutions or assets, that the Agencies determine help ensure high quality underwriting standards and (i) encourage appropriate risk management practices by securitizers and originators, (ii) improve the access of consumers and businesses to credit on reasonable terms, or (iii) otherwise are in the public interest and are for the protection of investors. 

The Dodd-Frank Act requires the Agencies to issue the Risk Retention Regulations no later than April 17, 2011.  The regulations with respect to residential mortgage-backed securities shall become effective one year after they are published.  With respect to all other asset classes, the regulations shall take effect two years after they are published.  In addition, as noted in the article above regarding the Final FDIC Safe Harbor Rule, IDIs should be aware that upon the effective date of the Risk Retention Regulations, the risk retention requirements of the FDIC Safe Harbor will be superseded. 

Formulating a Risk Retention Framework

The FSOC Study emphasized that the risk retention framework should balance the benefits of risk retention against the potential costs of raising credit prices.  While the FSOC Study offers few concrete recommendations, it suggests that the Agencies consider the following principles in formulating the Risk Retention Regulations:

• align the incentives of securitizers and originators with those of investors without changing the basic structure and objective of securitization transactions;
• provide greater certainty and confidence among market participants;
• promote efficiency of capital allocation;
• preserve flexibility as markets and circumstances evolve; and
• allow a broad range of participants to continue to engage in lending activities, while doing so in a safe and sound manner.

The FSOC Study also discusses the factors the Agencies must evaluate as they determine how to implement a risk retention framework.  

Form of Risk Retention.  There are three possible forms of risk retention that are considered in the FSOC Study: (i) a vertical slice, equivalent to retaining a pro rata piece of every tranche of the securitization; (ii) a horizontal slice, equivalent to a first loss interest in the securitization; and (iii) an equivalent exposure of the securitized pool, which would consist of a random selection of assets from the securitized pool. 

No recommendation among the options is provided, but other organizations that have dealt with this issue have developed regulations or recommendations regarding the form of risk retention.  For example, the FDIC’s new securitization safe harbor rule, discussed in more detail above, currently requires insured depository institutions to retain an interest of at least 5% in each credit tranche or in a representative sample of securitized assets that they transfer.  By comparison, Article 122a of the European Capital Requirements Directive (“Article 122a”), which applies to any European Union credit institution that invests in or holds securitization positions, provides a range of options to the market with regards to the form of risk retention required, including each of the forms considered in the FSOC Study.  The potential effects of the form of risk retention were also considered by the FRB, in its Report to the Congress on Risk Retention issued in October 2010 (the “FRB Report”).

Allocation of Risk.  The Dodd-Frank Act places the primary responsibility for retaining credit risk on the securitizer, but the originator, and in some cases other third-party participants, may be permitted to hold this exposure in the place of the securitizer.  While the FSOC Study does not offer guidance about how to allocate the risk retention between the securitizer and the originator, it highlights that Section 941 contemplates that the Agencies could determine that a first-loss exposure by a third-party purchaser of securities backed by commercial mortgages, under certain conditions, could satisfy the risk retention requirements.  The FSOC Study also notes that the Risk Retention Regulations could allow a third-party guarantor to satisfy the risk retention requirements by taking all or part of the credit risk. 

Amount of Risk Retention.  The FSOC Study notes that the required level of risk retention under the Risk Retention Regulations could be applied uniformly across all securitizations and across time, or the amount could vary based on the quality and characteristics of the particular assets securitized and certain other factors.  The FSOC Study does not take a position in this regard, but rather notes that both options have costs and benefits.  The FRB Report, on the other hand, recommends that the Agencies consider crafting credit risk retention requirements that are tailored to each major class of securitized assets, concluding that “simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the [Dodd-Frank] Act.”

Hedging.  The FSOC Study notes that allowing securitizers and originators to hedge or otherwise transfer the credit risk that is required to be retained would undermine the goals of the Dodd-Frank Act’s risk retention requirements.  Therefore, Section 941 prohibits the direct or indirect hedging of the retained credit risk.  In spite of this prohibition, the FSOC Study recommends that the Risk Retention Regulations permit securitizers and originators to manage risks other than the specific credit risk retained, such as interest rate, foreign exchange, and macroeconomic risks.  This recommendation is consistent with the regulations of the FDIC Safe Harbor, which allows for hedging of interest rate or currency risk.

Section 945 of the Dodd-Frank Act requires the SEC to implement rules that would require issuers of asset-backed securities (“ABS”) to perform diligence on the assets comprising such securities.  On January 20, 2011, the SEC issued final rules covering certain related amendments to Regulation AB.  New Rule 193 and Items 1111(a)(7) and (a)(8) of Regulation AB (“Reg AB”) require issuers of publicly offered ABS to review the securities’ underlying asset pools and to disclose the nature and findings of such reviews.  With a handful of exceptions, the final rules closely track the language of the SEC’s proposed rules, issued on October 13, 2010.  Notably, one exception was to postpone rules to implement Section 15(E)(s)(4) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) which requires issuers and underwriters to make publicly available any third-party due diligence report provided to issuers or underwriters.

Timing

Rule 193 and the amendments to Item 1111 of Reg AB become effective March 28, 2011 and issuers will be required to conduct reviews and to make the related disclosures for all registered offerings of ABS with initial bona fide offer dates on or after December 31, 2011.

Who is Required to Review and Disclose?

New Rule 193, by its terms, applies to issuers of ABS in registered (or public) offerings.  “Issuers” are defined to include depositors and sponsors of ABS offerings.  “Asset-backed securities,” in turn, are defined using the expansive definition of ABS from Section 3(a)(77) of the Exchange Act, which includes fixed income or other securities, collateralized by any type of self-liquidating financial asset, that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including CDOs, CMOs and any security that the SEC, by rule, determines to be an ABS.  If the issuer is not the originator of the asset pool, the originator may perform the review instead of the issuer only if the two are affiliated.  Reliance on the safe harbors afforded by the Securities Act of 1933, as amended (the “Securities Act”), is not conditioned on compliance with Rule 193 and, as such, the final rules will not apply to issuers of privately placed ABS offerings.  (Other rules, such as the FDIC’s Safe Harbor Rule, may incorporate by reference or otherwise require similar disclosure for private transactions.  See, however, “Final FDIC Safe Harbor Rule” above.)

Scope of Asset Reviews

ABS issuers must ensure that asset reviews are, at a minimum, “designed and effected to provide reasonable assurance that the disclosure regarding the pool assets [disclosed in the prospectus] is accurate in all material respects.”  The proposed rules issued on October 13, 2010 did not contain a minimum standard of review, a position supported by the ABS industry, which noted the difficulty of applying a uniform standard across a broad range of securities.  Rule 193’s minimum standard is intended to be a “flexible, principles-based” standard and it avoids specific criteria, although the SEC’s release provides limited guidance, for example that credit quality and underwriting will be necessary for meeting the standard as they are required in a prospectus.  In response to industry comments, the SEC noted in its release that issuers might be able to satisfy the “reasonable assurance” standard through a sampling of underlying assets in certain situations, but not generally.  If sampling is used, then the issuer must include the sample size and selection criteria in its disclosure.

Notably, in its release of the new rules the SEC states that “the issuer will be required to review whether the disclosure regarding the asset pool is accurate in all material respects,” which it implies is in addition to existing securities laws, such as Section 10(b) of the Exchange Act and Rule 10b-5, that “require that disclosure in the prospectus not contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statement not misleading.”  The standard is not without its critics.  SEC Commissioner Troy A. Paredes, voting against the rule, noted that the SEC’s related release draws analogies to similar standards in Exchange Act Rule 13a-15 and in the Foreign Corrupt Practices Act, which further frustrates any effort to define the standard precisely.

Third-Party Reviewers

Issuers may employ third-party due diligence providers to conduct the Rule 193 asset review.  If the disclosure of the review findings is attributed to a third party in the prospectus, however, then such third party must consent to being named as an “expert” for purposes of Rule 436 of the Securities Act and will, as a result, be subject to Section 11 expert liability under the Securities Act. An issuer may employ a third party to conduct the review and then attribute the findings and conclusions in the prospectus to the issuer itself, provided that the issuer notes the third party’s role and that the issuer does not use the review to market its securities. 

Finding a third-party due diligence provider that is willing to consent to being named as an expert may be a significant roadblock for ABS issuers.  (See the discussion of the concerns of nationally recognized statistical rating organizations (“NRSROs”) over being named experts in connection with credit ratings disclosure in a registration statement relating to an offering of ABS. See the November 30, 2010 Alert.)  Moreover, as the Securities Industry and Financial Markets Association (SIFMA) noted in its comment letter, there could be collateral effects for residential mortgage-backed securities (“RMBS”) transactions in which NRSROs require third-party asset reviews in order for the RMBS transactions to be rated.  If issuers are unable to enlist a third party to review its assets because of the potential expert liability, RMBS transactions might become difficult, if not impossible, to register. 

Prospectus Disclosure Obligations Related to Asset Reviews

Issuers must disclose the nature and findings of their Rule 193 asset reviews in their registration statements.  Under newly adopted Item 1111(a)(7) of Reg AB, issuers must disclose:

• the nature of the asset review, including its scope;
• whether or not the issuer employed a third party to conduct its review;
• whether or not the review was of a sample of assets, and if so, what method of sampling was employed; and
• the findings and conclusions of the review, including criteria against which loans were evaluated, how the loans compared to those criteria, and how those criteria varied, if at all, from the criteria disclosed in the prospectus. 

Under newly adopted Item 1111(a)(8), issuers must also disclose information regarding all loans that do not meet baseline underwriting criteria or benchmarks, including how they deviate from such criteria, their amount and characteristics, which entity or entities determined the assets’ inclusion in the pool, and what factors were considered for purposes of such determination.  Some issuers may face difficulty in complying with this provision; originators of certain assets do not adhere to a specific set of criteria when approving loan applications and may involve the use of discretion including certain assets in an asset pool.

The SEC promulgated Items 1111(a)(7) and 1111(a)(8) of Reg AB under the authority of Section 7(d)(2) of the Exchange Act, which was added by Section 945 of the Dodd-Frank Act.  Section 7(d)(2), however, only requires the disclosure of the nature of an asset review.  The SEC adopted the additional requirements to disclose the review findings, conclusions and deviating loans without a statutory mandate, a point the ABA highlighted in its comment letter arguing against those additional disclosures.  In its release announcing the final rules, the SEC acknowledged that it had no mandate for the additional disclosures, but stated that they were nonetheless “important for investors to consider.”

                                     *The “issuer” for purposes of Rule 193 is either the depositor or sponsor of the securitization.

On January 20, 2011, the SEC issued final rules implementing Section 943 of the Dodd‑Frank Act.  Section 943 requires the SEC to promulgate regulations governing the use of representations and warranties in the market for ABS.  The rules, adopted by the SEC by unanimous consent, also impose new disclosure requirements on issuers, originators, depositors and nationally recognized statistical rating organizations (“NRSROs”) addressing securitization transactions where the underlying transaction agreements include a covenant to repurchase or replace an underlying asset for a purported breach of the representations or warranties.  Significantly, the rules cover a broad range of both registered and unregistered ABS transactions, and, generally, include the two following components.

• Securitizers of asset-backed securities (as defined in the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) must disclose, and periodically update, historical information on repurchase and replacement requests in connection with purported breaches of representations and warranties in both registered and unregistered offerings.
• NRSROs must disclose information regarding the representations, warranties and enforcement mechanisms in an ABS transaction available to investors in any credit rating report relating to the ABS, including in a report accompanying a preliminary credit rating.

Section 943 of the Dodd-Frank Act was enacted, in part, in response to the perceived lack of effectiveness of the covenants underlying ABS transaction documents.  The SEC’s purpose, as stated in its release, in adopting these rules is to provide investors with historical information on both fulfilled and unfulfilled repurchase requests so that investors may better identify ABS originators with clear underwriting deficiencies. The new reporting requirements are covered in four regulations.

• New Rule 15Ga-1 under the Exchange Act
• Form ABS-15G used for reports to be filed with the SEC under Rule 15Ga-1
• An amendment to Item 1104 of Reg AB requiring disclosure of repurchase request history in prospectuses subject to Reg AB
• An amendment to Item 1121 of Reg AB requiring disclosure of repurchase request history in ongoing reports on Form 10-D

Significantly, these new rules apply only if the transaction agreements underlying the securities contain a covenant to replace or repurchase an asset for a purported breach of the representations and warranties.  The new rules, however, are not limited to disclosure of demands successfully made by trustees under the securities or other transaction documentation.  The new disclosure rules include, as underscored by the SEC in its release, disclosures of investor repurchase and replacement demands.

Timing

The SEC’s rule’s effective date is March 28, 2011.  The compliance period for prospectus disclosures (Rule 15Ga-1) begins February 14, 2012, except for municipal issuers for which compliance is required by February 14, 2015, with a phase-in period on the look-back period.  Item 1104 of Reg AB provides for the same transition period and disclosures under that item as are required with the first bona fide offerings of registered ABS on or after February 14, 2012, but would be subject to the same phase-in of look-back periods during the first two years of compliance.  For prospectuses filed between February 14, 2012 and February 14, 2013, the look-back period extends one year. For prospectuses filed between February 14, 2013 and February 14, 2014, the look-back period extends two years. Subsequently, all prospectuses must include information for the full three-year look-back period.

There is no transition period for new disclosure items under Item 1121(c) of Reg AB.  The compliance period for Form 10-Ds begins with the first filing of Form D after December 31, 2011.

There is only a six month transition period for Rule 17g-7 and NRSROs will be required to include the information mandated by Rule 17g-7 in reports accompanying credit ratings beginning September 26, 2011.

New Disclosure Requirements for Securitizers

Under the rules promulgated by the SEC, “securitizers” of “asset-backed securities” are required to disclose fulfilled and unfulfilled demand, repurchase and replacement history across all trusts aggregated by securitizer.  “Asset-backed security” is defined using the expansive definition of ABS from Section 3(a)(77) of the Exchange Act, which includes fixed income or other securities, collateralized by any type of self-liquidating financial asset, that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including CDOs, CMOs and any security that the SEC, by rule, determines to be an ABS.  (This is the same definition used for new Rule 193 and related amendments to Item 1111 of Reg AB, which are discussed above.)  The definition is broader than the definition of ABS under Reg AB and encompasses securities that are exempt from registration as well as securities guaranteed or issued by government sponsored entities (or GSEs) and municipal securities.

The term “securitizer” is defined to include issuers as well as entities that organize and initiate a covered ABS transaction by transferring assets, either directly or indirectly, including through an affiliate, to the issuer.  Thus, the rule applies to both sponsors and depositors.  To avoid duplicative disclosures by sponsors and affiliated depositors, the final rule provides that if the disclosures filed by a sponsor include the required disclosures for its affiliated depositors, then those affiliated depositors need not file separately.  This exception, however, applies only to affiliated depositors and does not extend to issuers under Reg AB who must still file separately.

New Rule 15Ga-1

Under new Rule 15Ga-1, a securitizer will be required to provide information for all assets securitized that were the subject of a demand for repurchase or replacement. Rule 15Ga-1 requires securitizers to provide information in the tabular format specified, including the following information;

• Name of the issuing entity, grouped by asset class and listed in order of the issuing entity’s formation date;
• Indication by check mark whether the transaction was registered and the Central Index Key (or CIK) number of each issuing entity;
• Name of each originator of the underlying assets, grouped by asset class and issuer; and
• The number, outstanding principal balance and percentage by principal balance of each of the following:
  • Assets originated by each originator in the pool at the time of securitization for each issuing entity;
  • Assets that were the subject of a demand to repurchase or replace for breach of representations and warranties, including demands made upon a trustee;
  • Assets that were repurchased or replaced for breach of representations and warranties;
  • Assets where the repurchase or replacement request is pending specifically due to the expiration of the cure period;
  • Assets where the demand is in dispute;
  • Assets that were not repurchased or withdrawn because the demand was withdrawn; and
  • Assets that were not repurchased or withdrawn because the demand was rejected.

To address concerns that a securitizer may not be able to obtain the complete information required to be disclosed from a trustee, the SEC allows a securitizer to include a footnote that the securitizer was unable to obtain all information with respect to investor demands upon a trustee that occurred prior to July 22, 2010 (the effective date of the Dodd-Frank Act) and state that the information disclosed does not include investor demands on a trustee prior to that date.  In addition, the rule permits a securitizer to omit information, with an explanatory footnote, that is either unknown or not reasonably available without unreasonable effort or expense.  Securitizers are also required to provide additional explanatory information in footnotes to the table, as necessary, to explain the information presented. 

The final rule modifies the look-back period for disclosing demand history from five years, as originally proposed, to three years in response to comments citing, in part, the difficulty in obtaining historical data from other transaction parties.  Some commentators had urged the SEC to adopt the rule prospectively only.  The SEC did not take that approach, but does (as described above under “Timing”) provide a phase-in for the look-back periods for prospectus disclosures.

Application to Municipal Securitizers

In a change from the proposed regulations, municipal ABS securitizers are provided an additional three-year phase-in period to comply with Rule 15Ga-1 and will be permitted to provide their information on EMMA, the Municipal Securities Rulemaking Board's centralized public database for information about municipal securities issuers and offerings.  Municipal securities stakeholders had urged the SEC, in comments on the proposed rules, to wholly exempt municipal securitizers from the disclosure requirements.

Form ABS-15G

Securitizers are required to file the information mandated by Rule 15Ga-1 in a new report on Form ABS-15G covering a three-year look-back period for the initial disclosures and subsequently covering quarterly periods on quarterly reports on Form ABS-15G.  The initial report on Form ABS-15G must be filed by any securitizer that issued or sponsored ABS during the three-year period ending on December 31, 2011 and cover that three-year period. The initial report must be filed no later than February 14, 2012.  If the securitizer has no activity to report during the three-year period, then the securitizer may “check the box” on the Form ABS-15G.

Securitizers must then file quarterly, no later than 45 calendar days after the end of a calendar quarter, on Form ABS-15G to report on demand, repurchase and replacement activity.  The rule also provides for termination of the reporting obligations when the last payment is made on the last ABS outstanding held by a non-affiliate that was issued by the securitizer or an affiliate.

The SEC clarified that filing Form ABS-15G will not affect the issuer’s reliance on a private exemption or safe harbor.  The SEC noted the clarification in response to concerns that providing narrative information, particularly in footnotes to the demand history table, could jeopardize an issuer’s reliance on an exemption or safe harbor. 

Conforming Amendments to Reg AB

New amendments to Item 1104 of Reg AB require issuers to provide Rule 15Ga-1 information in the body of the prospectus for the prior three years for all assets securitized by the sponsor that were the subject of a repurchase demand.  Disclosures in the prospectus must not be more than 135 days old and the issuer must include a reference to the CIK number of the securitizer.  By amendment to Item 1121, issuers must also file the information required by Rule 15Ga-1 in ongoing reports to Form 10-D.

The amendments to Reg AB build on the SEC’s pending proposed rule, issued on April 7, 2010, that would significantly revise Reg AB (often referred to as Reg AB II) and other rules with respect to the offering process, disclosure and reporting obligations for ABS public transactions.  The amendments to Items 1104 and 1121 track closely the 2010 proposed amendments, which would require originators and sponsors to disclose the amount of publicly securitized assets originated or sold by the sponsor, including information on demand repurchase and replacement history.  Notably, the amendments to Items 1104 and 1121 do not subject disclosures to a materiality threshold.

New Disclosure Requirements for NRSROs

The SEC also adopted Rule 17g-7 requiring NRSROs to include in any credit rating report a description of the representations, warranties and enforcement mechanisms available to investors, as well as a description on how they differ from the representations, warranties and enforcement mechanisms in issuances of similar securities.  The rule seemingly stands in contrast with other recent regulatory efforts that appeared intended to limit the role of NRSRO’s credit ratings (and had, at least initially (until suspended), the consequence of significantly limiting the availability of NRSRO credit ratings) in the ABS markets.  (See “SEC Staff Extends Indefinitely No-Action Relief Permitting Omission of Credit Ratings from Registration Statements under Regulation AB” and “Dodd-Frank Wall Street Reform and Consumer Protection Act - Public Company Impact”.)  In fact, one NRSRO noted the inconsistency in its comments to the proposed rule and urged the SEC to limit the role of NRSRO’s as much as permitted by statute.  The SEC, however, adopted Rule 17g-7 substantially in the form proposed.

For purposes of this rule, the SEC has broadly defined “credit rating” to include “preliminary credit ratings” including any rating, any range of ratings or “any other indications of a rating used prior to the assignment of an initial credit rating for a new rating.”  The rule also applies to both solicited and unsolicited credit ratings.  Commentators, particularly credit rating agencies, requested clarification on the term “similar securities,” but the SEC declined to provide guidance, noting in its release that the determination of what constitutes “similar securities” is ultimately one best left to the discretion of NRSROs.

The FRB issued a final rule (the “Final Rule”) to implement the conformance periods during which banking entities and nonbank financial companies supervised by the FRB must bring their activities and investments into compliance with the provisions of the Dodd‑Frank Act that restrict proprietary trading and certain relationships with and investments in hedge funds and private equity funds, commonly known as the “Volcker Rule.”  A summary of the proposed version of the Final Rule appeared in the November 23, 2010 Alert.  The Final Rule becomes effective April 1, 2011.

The FRB adopted the Final Rule in substantially the same form as proposed.  However, there are some important differences between the proposal and the Final Rule:

• The Volcker rule contemplates an extended transition period with respect to existing contractual commitments as of May 1, 2010 to remain invested in a hedge fund or private equity fund invested principally in illiquid assets.  The FRB expanded the conditions under which an asset may be considered an “illiquid asset” to include situations where an asset is subject to contractual restriction on sale or redemption for a period of three years or more.
• The FRB has clarified that, in determining whether a fund is contractually committed to principally invest or has an investment strategy to principally invest in illiquid assets, a banking entity may take into account written representations made in the fund’s offering documents (in addition to those contained in the fund’s organization documents).
• The proposed rule would have required a banking entity to submit a request for an extension of time to conform to the Volcker Rule 90 days prior to the expiration of the applicable time period, but the Final Rule requires that such submissions be made 180 days in advance.  The FRB clarified that it expects to act on requests for an extension of time within 90 days of submission.
• The FRB made modifications to the Final Rule to clarify that, in determining whether the FRB may grant an extension of time to conform to the Volcker Rule, the FRB may consider whether divestiture or conformance of the activity or investment would involve or result in a material conflict of interest between the banking entity and unaffiliated clients, customers or counterparties.  The FRB has also clarified that it may also consider a firm’s prior efforts to divest or conform its activities or investments, including, with respect to an illiquid fund, whether the banking entity has made reasonable best efforts to terminate or obtain a waiver of its contractual commitments to take or retain an equity, partnership or other ownership interest in, or provide capital to, an illiquid fund.
• The FRB has clarified that, if a banking entity is granted an extended transition period to take or retain an investment in an illiquid fund, the banking entity may continue to serve as general partner, managing member or sponsor of the fund to the extent such service is related to the banking entity’s retention of its permitted ownership interest.  However, it may not act as general partner, managing member or sponsor with respect to a fund if it did not serve in that role as of May 1, 2010.

Notably, the FRB declined to make several changes requested by commenters:

• The FRB did not adopt the suggestion of some commenters that the Final Rule allow the FRB to grant up to three one-year extensions of the conformance period at one time but, instead, made a modification in the Final Rule to clarify that the FRB will only grant up to three separate one-year extensions of time.  With respect to the single five-year extension for illiquid funds, the FRB clarified that it retains authority to grant an extension for less than the full five year period.
• The Final Rule continues to classify a fund as “illiquid” only if at least 75% of its consolidated total assets are or are expected to be comprised of illiquid assets.  The FRB declined to adopt the suggestion of some commenters that this threshold should be significantly lower.   In addition, the FRB declined to adopt the suggestion of some commenters that an asset should be considered illiquid if it cannot be sold at a reasonable price either because of the size of the position or market conditions.  Instead, the FRB confirmed that the definition of “illiquid asset” refers to assets that are illiquid by their nature.

Some commenters suggested that a banking entity should only be required to use “commercially reasonable efforts” to obtain any third party consents and approvals necessary to terminate existing contractual commitments to a fund.  However, the Final Rule retains a “reasonable best efforts” standard.

On February 1, 2011, FINRA issued Regulatory Notice 11-05 announcing the effectiveness of amendments to the Code of Arbitration Procedure for Customer Disputes that make changes to the methodology for selecting the panel for customer arbitrations.  The amendments, which replace Rules 12402 through 12406 with new Rules 12402 and 12403 and renumber Rules 12407-12414, became effective as of February 1, and apply to all customer cases in which FINRA had not sent lists of arbitrators to the parties by that date.

Rule 12401, which is unchanged, provides that in cases involving claims of $25,000 or less, the panel consists of one arbitrator.  In cases involving claims of $25,000 up to $100,000, the panel consists of one arbitrator unless the parties agree in writing to three arbitrators.  In cases involving claims of more than $100,000, the panel consists of three arbitrators unless the parties agree in writing to one arbitrator.  New Rule 12403, which applies to cases having three arbitrators, provides customers with two options for panel composition in arbitration.  The first option, which was available under the prior rule, is the majority-public panel; it calls for a panel composed of a chair-qualified public arbitrator, a public arbitrator and a non-public arbitrator.  The new second option is the all-public panel, which calls for a panel composed of a chair-qualified public arbitrator and two public arbitrators.  Under the new procedure for selecting arbitrators pursuant to the all-public panel option in Rule 12403(d), FINRA will generate lists of public and non-public arbitrators, but non‑industry parties may ensure an all-public panel by striking all non-public arbitrators on the list.

Non-public arbitrators are arbitrators with connections to the securities or commodities industries, as a result of having worked in those industries or having represented the industries, for example, as an attorney or accountant, for a substantial part of the person’s time.  Public arbitrators are persons who would not be considered non-public arbitrators and are not associated with or related to such a person (as more fully described in Rule 12100(u)).  Chair-qualified arbitrators, as defined in Rule 12400(c), are public arbitrators who have completed chairperson training provided by FINRA and are either bar-qualified attorneys or have served as an arbitrator through award on at least three arbitrations administered by an SRO.

The new amendments do not apply to disputes that involve only industry parties.

The U.S. District Court for the Southern District of Iowa (the “District Court”) found that shareholders of a fund of funds (the “Shareholders”) did not have a private right of action under Section 36(b) of the Investment Company Act of 1940, as amended (the “1940 Act”), to challenge fees paid by underlying funds owned by the fund of funds to the underlying funds’ adviser and its distributor affiliate because the Shareholders were not “security holders” of the underlying funds.  Under Section 36(b) of the 1940 Act, an investment adviser to a registered fund is deemed to have a fiduciary duty with respect to compensation for services the fund pays to the adviser or its affiliates.  A security holder of the fund may bring an action on the fund’s behalf against the fund’s adviser for a breach of the adviser’s fiduciary duty under Section 36(b).

The District Court’s analysis focused on whether the plaintiffs were in fact security holders of the underlying funds within the meaning of the 1940 Act.  Noting that the issue before it was one of first impression, the District Court disagreed with the Shareholders’ argument that their interest in the underlying funds was a security by virtue of being an “investment contract” because, among other things, there was no agreement or instrument between the Shareholders and any underlying fund that functioned as a security.  The District Court also reasoned that the Shareholders did not hold shares of the underlying funds through their fund of funds investments because the Shareholders did not “enjoy any incidents of ownership or possession” of any security of the underlying funds, such as voting rights, dividends or liquidation rights.  On the grounds that they had failed to plead that they were security holders of the underlying funds, the District Court dismissed the Shareholders’ Section 36(b) claim.