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On July 15, 2010, the Senate voted in favor of adopting the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). The Act is far reaching in scope and represents the culmination of months of debate and intense lobbying.
The Act was precipitated by the financial crisis that began in 2007 and therefore its primary goal is to prevent a recurrence. Since the asset-backed securitization market and credit rating agencies have both been the subject of criticism in connection with the financial crisis, it comes as no surprise that Congress has included provisions in the Act that address both of these areas of the financial markets. However, like many other parts of the Act, the provisions regarding asset-backed securities and rating agencies will require a heavy dose of regulations and studies before the full impact of the Act will be understood.
The focus of this Memorandum is Title IX – Subtitle D “Improvements to the Asset-Backed Securitization Process” and Title IX – Subtitle C “Improvements to the Regulation of Credit Rating Agencies”.
Subtitle D of Title IX is entitled “Improvements to the Asset-Backed Securitization Process” and is an attempt by Congress to reform the asset-backed securitization process by instituting requirements for (i) risk retention (“skin in the game”), (ii) increased disclosure and (iii) ongoing periodic reporting. These provisions are summarized below.
Certain of the provisions discussed below overlap with various proposals contained in the SEC’s proposed revisions to Regulation AB and in the FDIC’s Notice of Proposed Rulemaking1 regarding safe harbors for bank-sponsored securitizations. It is unclear how the FDIC and the SEC will adapt their proposals in light of the Act. Attached to this memorandum is a chart that compares and contrasts some of the key overlapping points in these initiatives.
The most significant portion of the Act for participants in the asset-backed securities market is the introduction of a risk retention requirement. The Act provides that by no later than 270 days after the Act is signed by President Obama and enacted into law, the applicable regulators are required to jointly prescribe risk retention regulations that will apply to securitizers of asset-backed securities (“ABS”). It is important to note that while the Act gives specific directives to the applicable regulators on certain aspects, there are many points that are left to the regulators to consider and determine. For this reason there is still uncertainty as to a number of material elements of the new risk retention requirements.
Note: The requirement that the applicable regulators work jointly to prescribe regulations seems to increase the likelihood that the resulting regulations will have uniform application to all types of securitizers, regardless of the regulatory regimes to which they are subject. Consistent regulations would allay industry concerns that insured depository institutions might be disadvantaged by more stringent regulation of securitization activities than non-insured depository institutions.
The final risk retention regulations will become effective:
(a) in the case of securitizations of residential mortgage loans, one year after the final regulations are issued; and
(b) in the case of all other ABS, two years after the final regulations are issued.
Note: Since the applicable regulators are given nine months to finalize regulations, and the risk retention rules will be effective either one or two years thereafter, it appears that the risk retention rules will not come into effect until approximately April 2012 for RMBS, and April 2013 for CMBS and all other forms of ABS.
Congress has charged the Federal banking agencies (the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”) and the Board of Governors of Federal Reserve System (“Federal Reserve”)), the Securities and Exchange Commission (“SEC”), and with respect to securitizations of residential mortgage loans, the Secretary of Housing and Urban Development (“HUD”) and the Federal Housing Finance Agency (“FHFA”), with the responsibility of jointly prescribing the risk retention regulations that will apply to securitizations.
The Act amends the Securities Exchange Act of 1934 (the “Exchange Act”) to formally define the terms “asset-backed securities,” “securitizer” and “originator” in a manner that is generally consistent with industry usage. These terms are key to applying the risk retention rule, which requires that risk be retained by a “securitizer” or “originator” of “asset-backed securities,” as further described in this memo.
“Securitizer” means (i) an issuer of an asset-backed security or (ii) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.
“Asset-backed Securities” —
(a) means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including:
(i) a collateralized mortgage obligation;
(ii) a collateralized debt obligation;
(iii) a collateralized bond obligation;
(iv) a collateralized debt obligation of asset-backed securities;
(v) a collateralized debt obligation of collateralized debt obligations; and
(vi) a security that the SEC, by rule, determines to be an asset-backed security for the purposes of the risk retention requirements of the Act; and
(b) does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.
“Originator” means a person who —
(a) through the extension of credit or otherwise, creates a financial asset that collateralizes an asset-backed security; and
(b) sells an asset directly or indirectly to a securitizer.
(a) Risk Retention Percentage. Subject to certain exceptions or adjustments described below, the regulations are required to provide that securitizers retain a minimum of 5% of the credit risk of any asset transferred into a securitization.
Note: Unlike the proposed revisions to Regulation AB, the Act requires risk retention for all offerings of ABS, not just those offered under a shelf-registration statement.
(b) Prohibition on Hedging. A securitizer is to be prohibited from directly or indirectly hedging or otherwise transferring the credit risk that it is otherwise required to retain.
(c) Form and Duration of Retention. The regulators are to prescribe regulations detailing the form and duration of risk retention required for each asset class.
Note: The SEC’s Regulation AB proposals would require that a “vertical slice” of each class of ABS offered pursuant to a shelf registration statement be retained for as long as any third party owns related securities. While it seems likely (given that the Act grants increased regulatory authority to the SEC) that the risk retention requirement will be increased beyond that indicated in the SEC’s Regulation AB proposals, it is unclear whether the “vertical slice” approach will be retained. It seems unlikely that the duration of the required retention period will be decreased.
(d) Allocation of Risk Retention Between Securitizer and Originator. The Federal banking agencies and the SEC, as they may deem appropriate, may allocate the risk retention requirement between a securitizer and an originator, with the amount of any retention by an originator resulting in a reduction of the retention otherwise required of the securitizer. In determining any such allocation, the regulators must consider (i) whether the assets have terms, conditions and characteristics that reflect low credit risk, (ii) whether the form or volume of transactions in securitization markets creates incentives for imprudent origination of the type of asset and (iii) the potential impact of the risk retention obligations on access of consumers and businesses to credit on reasonable terms.
(e) Exemptions, Exceptions and Adjustments to Risk Retention.
(i) Regulatory Discretion. The regulators may provide for the total or partial exemption from the risk retention requirements for any securitization, as they determine is appropriate in the public interest and for protection of investors.
The regulators may also adopt exemptions, exceptions or adjustments to the rules requiring risk retention and prohibiting hedging of such retention if they help ensure high quality underwriting standards for securitized assets and encourage appropriate risk management practices by securitizers and originators, improve access of consumers and businesses to credit on reasonable terms, or are otherwise in the public interest and for protection of investors.
(ii) Adjustment to 5% Retention Based on Prescribed Underwriting Standards. The regulators are required to establish underwriting standards for each asset class of ABS (e.g., ABS backed by residential mortgage loans, commercial mortgage loans, commercial loans, auto loans and any other asset class that the regulators deem appropriate) that specify the terms, conditions and characteristics of a loan within the asset class that indicate a low credit risk with respect to such loan. The rules adopted by the regulators are required to provide that securitizers may retain less than 5% credit risk if the assets meet the applicable underwriting standards.
(iii) Exemption for Qualified Residential Mortgages. The Act requires that the regulations specify that the risk retention requirements will not apply to an ABS transaction where all of the assets in the ABS are “qualified residential mortgages.” The regulators must jointly define the term “qualified residential mortgages”, taking into consideration underwriting and product features that historical loan performance data indicate will result in a lower risk of default, such as:
In addition, the regulators may not define “qualified residential mortgage” to be any broader than the definition of “qualified mortgage” as defined under Section 129C(c)(2) of the Truth in Lending Act, as amended by the Consumer Financial Protection Act of 2010, and regulations adopted thereunder.
In order for an ABS to fall within the qualified residential mortgage exemption, an issuer will be required to certify to the SEC that the issuer has evaluated the effectiveness of the internal supervisory controls of the issuer with respect to the process for ensuring that all assets that collateralize the ABS are qualified residential mortgages.
Note: The foregoing exception for ABS backed by qualified residential mortgage loans will not apply to resecuritizations.
(iv) Alternatives for Commercial Mortgages. With respect to commercial mortgage loans, the regulations must specify the types, forms and amounts of risk retention, which may include:
Note: The Act only provides that the regulators may include accommodations for the foregoing, but the regulators are not required to do so. It is unclear to what extent the regulators may be willing to reject these concepts, though specified in the Act.
(v) Governmental Guarantee Exemption. The risk retention requirements will not apply to:
Note: For this purpose, securities insured or guaranteed by Fannie Mae, Freddie Mac or the Federal home loan banks are not to be treated as insured or guaranteed by the U.S. or an agency of the U.S.
(vi) Regulations for CDOs Singled Out. The Act specifically identifies collateral debt obligations (“CDOs”), securities collateralized by CDOs and similar instruments collateralized by other ABS (e.g., resecuritizations) as an asset class that the regulators must establish appropriate standards for risk retention.
Note: It is possible that regulators could fashion rules that are more onerous on securitizers of these asset classes.
(f) Asset Class Specific Regulations. Because it would be difficult to implement a one-size-fits-all requirement, the Act requires regulators to prescribe separate risk retention regulations for securitizers of different asset classes.
The Federal Reserve, in coordination and consultation with the other regulators, is required to conduct a study of the combined impact on each asset class of the new credit risk retention requirements, including the effect those requirements will have on increasing the market for Federally subsidized loans and the impact such requirements will have on securitizers under the new accounting rules of FAS 166 and FAS 167. A report on such study is required to be delivered to Congress no later than 90 days after the Act is enacted and the report is required to contain statutory and regulatory recommendations for eliminating any negative impacts on the viability of the asset-backed securitization markets and the availability of credit for new lending.
The Act eliminates the ability of an ABS issuer to “de-list” ABS transactions and suspend periodic reporting. Previously, issuers of ABS in SEC-registered offerings were permitted (under Section 15(d) of the Exchange Act) to suspend periodic reporting under the Exchange Act for ABS offered in a transaction registered under the Securities Act of 1933 (the “Securities Act”). These offerings typically suspended reporting after the end of the year of issuance because the securities are held by less than 300 persons. Nevertheless, the Act does give the SEC the authority to issue rules and regulations that could provide ABS issuers the right to suspend or terminate such ongoing reporting requirements as the SEC deems necessary or appropriate in the public interest or for protection of investors.
Note: The elimination of an ABS issuer’s ability to suspend its Exchange Act filings is effective immediately. Because the ability to suspend reporting is tested on an annual basis, the exclusion of ABS from the suspension provisions in Section 15(d) of the Exchange Act could be interpreted as applying to ABS issued prior to the effective date of the Act, which would have an adverse effect on ABS issuers that previously qualified for suspension and whose transaction documents did not anticipate ongoing reporting. Industry participants believe that the amendments to Section 15(d) were only intended to apply to ABS issued after the effective date of the Act and have requested confirmation from the SEC. Consequences of ongoing reporting obligations include, among others, (i) preparing and filing annual Sarbanes-Oxley certifications by the senior officer in charge of securitization at the depositor or senior servicing officer at the servicer, and (ii) the failure to timely comply with any Exchange Act reporting requirement disqualifies an issuer from filing a new shelf-registration statement (although take-downs from existing shelf registration statements would not be impacted).
The Act requires the SEC to issue regulations addressing the following additional matters:
1. Regulations to enhance the disclosure regarding the assets that back ABS. These regulations are required to address:
(a) standardized formats for providing data to facilitate the comparison of data across securities types of ABS; and
(b) loan-level or asset-level data if such data is necessary for investors to independently perform due diligence.
Note: No time frame is specified for the issuance of these regulations, but much of these disclosure enhancements are addressed by the SEC’s proposed revisions to Regulation AB.2
2. Regulations regarding the use of representations and warranties. These regulations must:
(a) require each rating agency rating an ABS to include in any reports they issue regarding the ABS, a description of (i) the representation and warranties and enforcement mechanisms and (ii) how they compare to the representation and warranties in issuances of similar securities; and
(b) require a securitizer to disclose its fulfilled and unfulfilled repurchase requirements for alleged breaches of representations and warranties so that investors can identify originators with clear underwriting deficiencies.
3. Regulations relating to due diligence on publicly offered ABS. These regulations will address publicly offered ABS and require an ABS issuer to:
(a) perform a review of the assets underlying the ABS; and
(b) disclose the nature of such review.
Note: It remains to be seen how the regulators will implement this directive.
4. Third-Party Due Diligence Reports. The Act also requires that issuers and underwriters of ABS make publicly available the findings and conclusions of any third-party due diligence report that they obtained. See also “Rating Agency Regulation—Transparency—Third Party Reports” below.
The Act prohibits an underwriter, placement agent, initial purchaser or sponsor of an ABS (or any of their subsidiaries or affiliates), during the one-year period after the first closing of a sale of such ABS, from engaging in any transaction that would involve or result in a material conflict of interest with respect to any investor in a transaction arising out of such activity.
The SEC is required to issue rules not later than 270 days after enactment of the Act regarding the implementation of this prohibition. The prohibition will take effect on the date the rules are issued by the SEC.
This prohibition does not apply to:
1. risk mitigating hedging activities in connection with positions held as a result of the placement or sponsorship of the ABS; or
2. purchases and sales of the ABS pursuant to commitments made by such parties to provide liquidity for the ABS or bona fide market-making activities.
The Act deletes Section 4(5) of the Securities Act , which exempted certain mortgage securities and notes from the registration requirements of the Securities Act.
Note: This was not often relied upon as an exemption from the Securities Act registration requirements.
Subtitle C of Title IX is entitled “Improvements to the Regulation of Credit Rating Agencies” and institutes reforms in the regulation, oversight and accountability of nationally recognized statistical rating agencies (“NRSROs”). The Act expresses Congressional concerns with the conflicts of interests faced by credit rating agencies and with the inaccuracy of ratings on structured finance products, which “contributed significantly to the mismanagement of risks by financial institutions and investors,” resulting in the need for “increased accountability on the part of credit rating agencies.” As a result, most of the provisions of Subtitle C are directed at the rating agencies themselves, who will be under heightened SEC scrutiny and increased regulation, rather than the issuers or underwriters who request ratings or the investors who rely on ratings. These provisions are summarized below and highlight the nature and scope of attention that will be focused on credit rating agencies going forward. The Congressional findings conclude that the inaccuracy of ratings on structured products adversely impacted the health of the economy in the United States and around the world. The consistent theme of the provisions of Subtitle C is to identify and eliminate conflicts of interest and restore confidence in the ratings process.
1. Each NRSRO must implement an internal control structure. The SEC will establish rules requiring an annual report from the rating agency describing the responsibility of management in establishing and maintaining effective internal controls, assessing the effectiveness of its internal controls, and an attestation of the CEO.
2. The NRSRO must have a designated compliance officer who may not perform credit ratings and whose compensation is not linked to the agency’s financial performance. The compliance officer will submit annual reports to the SEC describing the agency’s compliance with securities laws and its own internal policies and procedures.
3. The NRSRO must have a board of directors consisting of one-half, but no fewer than two, independent directors, including users of ratings.
1. The SEC will promulgate rules to prevent sales and marketing considerations from influencing ratings.
2. If a former employee of an NRSRO is hired by an issuer, underwriter or sponsor of a security rated by the NRSRO, the rating agency must review its ratings for any such entity or securities in which such employee participated during the one year period prior to the rating action to determine whether any conflicts existed.
3. Each NRSRO must report to the SEC the names of certain former employees of the agency who, within the previous five years, became an employee of any issuer, underwriter, or sponsor of a security rated by such agency, and who participated in the rating process during the twelve months prior to such employment. The SEC will make this information publicly available.
1. The SEC will establish an Office of Credit Ratings (“OCR”), whose stated purpose is to administer SEC rules to:
(a) protect users of credit ratings and in the public interest;
(b) promote accuracy of ratings issued by NRSROs; and
(c) ensure that ratings are not unduly influenced by conflicts of interest.
2. The OCR will conduct annual examinations of each NRSRO and make a summary of its findings publicly available.
3. The annual examination will include a review of whether the agency conducts its business consistent with its own policies, procedures and methodologies; its management of conflicts of interest; its supervisory controls; its processing of complaints; and its policies regarding post-employment activities of its former staff.
1. The SEC will adopt rules requiring that each NRSRO disclose comparable information regarding its ratings, including performance information, so that users can compare the performance of credit ratings issued by different agencies.
2. Each rating must be accompanied by a detailed description of the rating, including the assumptions and methodologies underlying the rating, the data used in determining the rating, and how servicer or remittance reports are used to conduct surveillance.
(a) The form of the report will also include qualitative information, such as information regarding the uncertainty of the ratings, including information on the reliability, accuracy and quality of the underlying data, and a description of the scope and findings of third party reports used in establishing the rating.
(b) Quantitative information is also required, including information regarding performance, probability of default and expected losses, sensitivity to certain assumptions, and a description of five assumptions that would have the greatest impact on the rating if the assumptions were false or inaccurate.
3. Third party reports: Issuers or underwriters of ABS must make publicly available the findings and conclusions of any third party reports. Any report used by a NRSRO must be accompanied by a certification from the author of the report in order to ensure that the report is based on a thorough review of data and other relevant information necessary for the NRSRO to provide an accurate rating. The certification must be made publicly available by the NRSRO.
Note: The SEC has given verbal clarification to the American Securitization Forum that the Act requires the SEC to issue rules within one year of enactment addressing how and under what circumstances third party reports should be made publicly available.
4. In issuing their ratings, NRSROs should consider credible and potentially significant information received from sources other than an issuer or underwriter.
1. Private Right of Action and “State of Mind”. The Congressional findings related to Subtitle C conclude that the activities of credit rating agencies should be subject to the same standards of liability as auditors and analysts. Thus statements made by a credit rating agency will be subject to the enforcement and penalty provisions applicable to accountants and securities analysts. In an action for securities fraud by a private plaintiff against a credit rating agency, the required “state of mind” is that the credit rating agency knowingly or recklessly failed to conduct a reasonable investigation of the facts it relied upon or to obtain reasonable verification of the facts from other competent sources independent of the issuer and the underwriter.
Note: Transaction parties providing indemnification to the rating agencies should carefully consider expanded rating agency liability to investors to which indemnifying parties may be exposed.
2. SEC Sanctions. The SEC may sanction or penalize the NRSRO or its employees for misconduct. The SEC may suspend or revoke the NRSRO’s ability to rate a class of securities if it finds that the agency does not have adequate resources “to consistently produce credit ratings with integrity.”
3. Rescission of Rule 436 (g). For public offerings registered under the Securities Act, initial ratings by NRSROs will now be considered part of the registration statement. As with accountants who include their report on audited financial statements in the registration statement (or prospectus), the consent of the rating agency must be filed with the SEC prior to use of the rating information in connection with the offering of securities. No longer exempt from the liability provisions of Section 11 of the Securities Act, a NRSRO will have liability for information regarding its rating unless it can sustain the burden of proof that it had no reasonable grounds to believe that the information was untrue or misleading.
Note: On July 15, 2010, Moody’s Investors Service released a commentary describing the effect of the Act on its activities, and noted that “given the potential legal consequences, we cannot consent to the inclusion of ratings in prospectuses and registration statements without further study.” In a statement issued on July 16, 2010, Standard & Poor’s said that it would “explore mechanisms outside of the registration statement to allow ratings to continue to be disseminated to the debt markets” and also noted that its ratings on new issues and pre-sale reports would be available on their website. ABS issuer’s, on the other hand, noted that they are required under Items 1103 and 1120 of Regulation AB to disclose in a prospectus the ratings of their registered ABS. In response to the resulting standstill in registered ABS issuance and in order to facilitate a transition for ABS issuers, on July 22, 2010, the SEC issued a no-action letter in which the SEC stated that it will not recommend enforcement actions if an ABS issuer fails to comply with Items 1103 and 1120 of Regulation AB and omits the disclosure of the ratings of registered ABS from a prospectus. The no-action letter is due to expire on January 24, 2011. ABS issuers can still disclose the ratings of offered ABS in a free writing prospectus in accordance with Rule 433 of the Securities Act without obtaining and filing rating agency consents.
4. Repeal of Exemption from Regulation FD. Regulation FD is designed to prevent selective disclosures by SEC-reporting issuers or issuers of securities registered under the Exchange Act of non-public material information to selected persons. Regulation FD does not apply to issuer communications with among others, rating agencies. However, within 90 days after enactment of the Act, the SEC is required to amend Regulation FD to remove the exemption for rating agencies.
Note: Other exemptions from the disclosure requirements will continue to apply and may be relied upon by issuers and rating agencies, including the exemption provided by 17 C.F.R. 243.100 (b)(2)(ii) for disclosure “to a person who expressly agrees to maintain the disclosed information in confidence.”
1. Certain references to ratings as a criteria for various provisions of the securities and other federal laws will be removed. Instead, the applicable regulatory agency will have the discretion to establish appropriate credit-worthiness standards. This change will go into effect two years after the date of enactment of the Act.
Note: Among other things, this change will affect shelf registration eligibility requirements, which previously limited registered ABS securities to those rated investment grade. Depending on the nature and subjectivity of the new criteria, shelf registration may become more complex or difficult.
2. Within one year after the date of enactment of the Act, each Federal agency must review references to credit ratings in its regulations and modify such regulations to remove any reference to the requirement of, or reliance on, ratings. The references to ratings will be replaced by standards of credit-worthiness deemed appropriate by each Federal agency.
Note: Among other things, this will affect one of the common exemptions from registration under the Investment Company Act of 1940 used for many ABS issuances.
The Act requires that certain studies and reports be undertaken, including:
1. Report on Strengthening Agency Independence. The SEC must study the conflicts of interest raised by NRSROs providing services other than ratings and the impact of prohibiting a NRSROs from providing services other than ratings to an issuer. The report on the results of the study is due no later than three years after the date of enactment of the Act.
2. Study on Alternative Business Models. The Comptroller General must conduct a study on alternative means of compensation to create incentives to NRSROs to provide more accurate ratings. The report on this study is due no later than 18 months after the date of enactment of the Act.
3. Study and Implementation of Assigned Credit Ratings. The SEC must carry out a study of the rating process for structured finance products and the conflicts of interest associated with the issuer-pay model. It will evaluate the feasibility of establishing a system under which rating agencies are assigned to rate structured finance products; study the range of metrics that could be used to determine the accuracy of ratings; and consider alternative means of compensating rating agencies. The report is due 24 months after the date of enactment of the Act. After the report is submitted, the SEC will, as it determines necessary or appropriate in the public interest or for the protection of investors, establish a system providing for an independent body to be responsible for assignment of NRSROs that will rate structured finance products in a manner that prevents transaction parties from selecting the NRSRO that will provide the ratings. The SEC is required to implement the system added by the Franken Amendment to H.R. 4173 as passed by the Senate, unless it determines that another system would better serve the public interest and protection of investors.
* Cadwalader has prepared a short summary of the Act and a series of memoranda focused on the Act’s application to specific industries, entities and transactions. To see these other memoranda please see a Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Appendix A links to the various topic-focused memoranda) or visit our website at http://www.cadwalader.com/list_client_friend.php.
1 See Clients & Friends Memo: SEC Proposes Significant Enhancements to Regulation of Asset-Backed Securities and Clients & Friends Memo: FDIC Seeks “Stronger, Sustainable Securitizations” by Imposing Additional Conditions to Eligibility for Securitization Safe Harbor.