What does an issuer of asset-backed securities (ABS) need to do to prepare for the compliance date for Rules 15Ga-2 and 17g-10, the new nationally recognized statistical rating organization (NSRSO) due diligence rules? This post provides a brief overview.
- What do the rules require?
Rule 15Ga-2 requires any issuer or underwriter of registered or unregistered “asset-backed securities,” as broadly defined by section 3(a)(79) of the Securities Exchange Act, that are to be rated by an NRSRO to prepare a Form ABS-15G describing the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. The Form ABS-15G must be furnished on EDGAR at least five business days before pricing.
A “third-party due diligence report” is any report containing findings and conclusions relating to third-party “due diligence services,” which in turn are defined as a review of the pool assets for the purposes of making findings with respect to the accuracy of the asset data, whether the assets conformed to stated underwriting standards, asset value, legal compliance by the originator, and any other factor material to the likelihood that the issuer will pay interest and principal as required.
Rule 17g-10 requires that providers of third-party due diligence services deliver a Form ABS Due Diligence-15E certification to each NRSRO producing a credit rating to which those due diligence services “relate.” This means that the form must be delivered directly to any NRSRO that requests it, in writing, but the delivery obligation will be accomplished primarily by providing it to the party responsible for maintaining the transaction’s Rule 17g-5 website. An amendment to Rule 17g-5 requires Form ABS Due Diligence-15E to be posted promptly to the website after it is received.
- When is the compliance date for the new rules?
The compliance date for the rules is June 15, 2015.
According to discussions that the Structured Finance Industry Group (SFIG) has had with the staff of the Securities and Exchange Commission (the SEC), this means that for Rule 15Ga-2, any transaction that prices on or after June 22, 2015 (meaning that the deadline for furnishing Form ABS-15G would be on or after June 15, 2015) must comply with Rule 15Ga-2.
According to SFIG’s conversations with the SEC staff, the requirement to deliver a certification on Form ABS Due Diligence-15E is triggered by the date the diligence is completed, which ordinarily would be the date the related report is provided. Therefore, if the report is provided on or after June 15, 2015, the certification is required; if provided before June 15, it is not.
This disparity may lead to some bothersome transition issues. For example, under Rule 17g-7, an NRSRO taking a rating action must either cross-reference to the Form ABS Due Diligence-15E provided by any third-party due diligence services provider whose work it has reviewed or prepare its own description of the information reviewed and a summary of the findings and conclusions. If an NRSRO is required to do this for a transaction where a due diligence services provider was not required to prepare a Form ABS Due Diligence-15E, it is not clear how the NRSRO will prepare or obtain the required description and summary.
- What contractual arrangements should be negotiated to facilitate compliance?
An ABS issuer should clarify with the investment banks that serve as its regular underwriters, initial purchasers, or placement agents who, as between the issuer and the underwriter, will be responsible for ensuring compliance with the NRSRO due diligence rules. We expect that, when negotiating its engagement letter with an issuer, an investment bank will ask the issuer to be responsible for compliance, to ensure that it receives reliance letters where appropriate, and to indemnify it for any compliance failures and for any materially misleading or omissive information in publicly available documents. Whatever agreements are reached also may be reflected in representations and closing conditions set forth in the underwriting, initial purchase, or placement agency agreement.
Issuers should review all third-party services obtained in connection with their programs to determine which fall within the scope of “due diligence services.” For each in-scope provider, the issuer should negotiate and document in its engagement letter how the provider’s report and certification Form ABS Due Diligence-15E will be used to prepare the related Form ABS-15G (and a consent to use them to do so), delivery timelines, and responsibility for redacting any personally identifiable information from any portion of the report or the certification that may become public, whether via cross-reference in an NRSRO rating action report or incorporation into a Form ABS-15G.
- How will these rules affect the offering process?
Because Form ABS-15G must be furnished five business days before pricing, and because the party responsible for preparing that form cannot do so until it has received the final due diligence report (and, likely, the related Form ABS Due Diligence-15E), many in-scope third-party due diligence services will have to be completed significantly earlier in the offering process than they have been traditionally.
- Do the rules cover services other than traditional due diligence services?
Yes. For example, accountants’ agreed-upon procedures letters have not traditionally been considered to be due diligence services, but they often involve a comparison of the loan level data file to the loan document files. The industry consensus is that such functions are in-scope, and the major accounting firms are developing procedures (including splitting their reports on these services into a separate letter) that will allow them to comply.
Other types of services are posing thornier issues, for example, legal services that involve the review of underlying pool assets; custodial services that some issuers and underwriters may believe also perform a diligence function; and obtaining updated credit reports, credit scores, or appraisals. Industry sentiment is that many of these items should not be considered within the scope of the new rules, but a strong consensus on the rationale for their exclusion has yet to emerge.
- Are other significant interpretive issues presented by the rules?
Yes. One significant issue is the scope of the findings and conclusions that must be included within the Form ABS-15G, how that may differ from the summary of findings and conclusions that will be included in the provider’s Form ABS Due Diligence-15E, and (if it does differ) which portions of the provider’s report will need to be included in the Form ABS-15G to encompass all of the required findings and conclusions. An issuer should analyze all of these issues with respect to each provider determined to be in-scope, then work out an agreement with the provider that gives the issuer access to and permission to use all of the required information in preparing its Form ABS-15G. Another matter to be worked out with each provider is who will redact from the provider’s report and Form ABS Due Diligence-15E any personally identifiable information that could get into the public domain (as a result of the public EDGAR posting of Form ABS-15G, or because an NRSRO incorporates Form ABS Due Diligence-15E into its ratings report) will be redacted. The agreed conclusions should be reflected in the terms of engagement of any third-party provider.
The rules cover “interim” reports but not drafts. Industry consensus seems to be coalescing around a view that only the final version of a report must be reported upon, so long as all information in any interim report appears in the final version. The SEC has given no guidance as to how to determine whether a particular earlier report is an interim report or merely a draft. An issuer might be able to minimize the uncertainty by making sure that anything delivered by the provider is unsigned and clearly labeled as a discussion draft only until all material issues have been resolved.
Another significant issue is how to comply with the rules when due diligence services originally performed in connection with the acquisition or warehouse financing of the pool assets are determined to relate to a later issuance of ABS. The rules only cover due diligence services performed on the actual assets selected for the pool, so one approach that is gaining traction would require the provider to provide a new report after the final pool cut, incorporating only information regarding the selected assets. Whether superseded information regarding the selected assets must be included presents a more complicated interpretive issue. Should an acquisition or warehouse financing report be viewed as effectively an interim report for a later take-out securitization? An acquisition or warehouse financing report ordinarily is delivered in final form, but at the time it is delivered generally will not relate to a specifically contemplated issuance of rated ABS. Mere error corrections probably need not be addressed, but analytical changes by the provider, in response to sponsor comments or otherwise, are proving more controversial.
These and many more issues remain under discussion in a variety of industry working groups, including SFIG’s NRSRO due diligence task force and its various asset-class working groups. SFIG is in the preliminary stages of preparing a market guide addressing many of these issues, but it is not likely that a consensus will be reached on some of the thornier questions in advance of the compliance date for the new rules. That means that issuers will need to determine their own positions and approaches in consultation with their counsel.