After last week’s relatively optimistic note, its back to grim reality, in this case the Reg AB II proposals relating to the private market. These would require that, in order for a reseller of a “structured finance product” to sell a security in reliance on Rule 144A or in order for an issuer of a “structured finance product” to sell a security in reliance on Rule 506 of Regulation D (the so called “safe harbors”), the underlying transaction agreement must grant to initial investors and transferees, as applicable, the right to request, both initially and on an ongoing basis, the same information that would have been required had the transaction been registered.
While the SEC acknowledges that this proposal is “significant” it claims it to be nonetheless necessary due to the fact that “the recent financial crisis exposed deficiencies in the information available about CDOs and other privately issued structured finance products”. While one can debate whether the financial crisis exposed deficiencies in the available information or rather deficiencies in the market participants’ sense of judgment, it seems at least to be clear that the crisis had something to do with RMBS and CDOs involving RMBS. The latter transactions were unique in their capacity to magnify and, indeed, multiply the risks inherent in the RMBS market which, as it turns out, were copious and, as many have argued, unique to that market sector. Nevertheless, the SEC has seen fit to once again visit the sins of the RMBS sector on the entire ABS market with significant adverse consequences.
Notwithstanding that the obligation to provide the disclosure only arises if requested, this is an illusory qualification. Prudent issuers wishing to qualify for a safe harbour will want to ensure that the transaction proceeds smoothly without being blind-sided by a request for information. In practical terms this means that every issuer of structured finance products will feel compelled to compile and be prepared to provide all of the disclosure that would have been required in a registered public offering, whether or not any investor ultimately requests the information. Viewed in the context of the enhanced asset-level data disclosure and waterfall computer program requirements of Reg AB II, this will entail a significant commitment of money and resources which many issuers will be unable to make. In addition, many issuers choose the private market because they are unable to comply with the full-blown disclosure requirements of registered offerings. This may be because they are unable to fully comply (sure to be even more common under Reg AB II) or, for confidentiality or competition reasons, they are unwilling to comply.
Due to limits in its authority, the SEC was unable to eliminate the basic statutory exemptions which will still be available to those unable or unwilling to satisfy the new rules. However, by removing the safe harbors and thus eliminating the certainty they provided, liquidity in the private market will be signficantly reduced. As a result issuers seeking to access markets without the ability to rely on the safe harbors will almost certainly find a significant decrease in the demand for their structured finance products.
The proposed amendment to the safe harbors will effectively eliminate the distinction between private placements to sophisticated purchasers and registered offerings. It is far more than merely “significant”: rather it constitutes a dramatic departure from the basic premise underlying such transactions. The SEC has apparently determined that, having proven that they could not be trusted to “fend for themselves” in respect of RMBS-based offerings, private investors must be assumed to be incapable of doing so in respect of any sort of ABS offering. In case there was any doubt about what is going on here, the particular nature of this reasoning should make it perfectly clear.
The first and most notable casualties of this scorched earth policy may well be issuers and sponsors of ABCP who have traditionally relied on the Rule 144A safe harbor. It is hard to imagine how an issuer of ABCP would set about complying with the following requirements (just to name a few) under Reg AB II in respect of each originator: asset level disclosure; periodic reporting on asset level performance using standardized data points; filing of a waterfall computer program; disclosure of repurchase obligations. Lacking direct access to the information, issuers would need to obtain it from originators and servicers, thus facing the prospect of unlimited liability for third party data. In addition, since the data would need to be produced on a continuous basis, the issuer’s ability to access the safe harbor in respect of an entire program would always be at the mercy of the ability and willingness of each participating originator to keep up (assuming they were able to produce the initial disclosure). As many originators are not themselves issuers of ABS, they do not have the experience, personnel or systems designed to support this kind of reporting.
Since compliance would seem to be at best precarious, ABCP issuers will be forced to operate outside of the Rule 144A safe harbor. This will result in a substantial decrease in the liquidity of ABCP programs and thus their utility as a financing vehicle and, ultimately, their viability.