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.
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.
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.