In response to the credit crisis and unprecedented defaults in highly rated securitized debt, the Canadian Securities Administrators have recently released proposals to enhance disclosure rules and other investor protections applicable to issuers, sponsors and underwriters of securitized products in Canada. 

In some respects, the proposals simply codify existing disclosure practice for publicly issued securitized products.  As with all public issuances, prospectuses for securitized products have always been required to contain “full, true and plain disclosure.”  Codifying certain basic minimum disclosure requirements will help to standardize prospectuses and eliminate any uncertainty about whether certain information is material to investors. 

New disclosure requirements

There are a few areas of required disclosure which clearly go beyond existing market practice and may cause some participants concern.  These include a new requirement to disclose whether any transaction parties have engaged in any other transaction in the previous 12 months that would result in a conflict of interest with investors.  This would include originators, servicers, trustees, credit enhancers, swap counterparties and liquidity providers.  This rule appears to respond to concerns throughout the credit crisis that market participants were, on the one hand,  promoting transactions to investors or providing liquidity facilities and then through separate transactions taking positions against those transactions. 

Another proposal requires full financial disclosure with respect to significant counterparties, be they obligors, credit enhancers or derivatives counterparties.  Typically, obligors are not part of the securitization process (which happens after the loan is created and documented) and thus it may be difficult to securitize assets with large concentrations of risk in a single obligor – such as in commercial mortgage securitizations.  Large public obligors may already have adequate financial disclosure in the public domain, but private companies may not be willing to publish such information.  Going forward, large loans that are expected to be securitized may well contain covenants on the borrower to assist with disclosure requirements as part of any ultimate securitization of the loan.

Transaction parties would also be required to disclose which interests they have retained in the transaction and whether those exposures have been hedged, as well as the fees and expenses paid to them.  

Continuous disclosure requirements would also be enhanced under the new rules and extended to include disclosure of all securitization transactions of reporting issuers, even those sold on a private placement basis.  Specific new requirements include payment and portfolio reports, disclosure of any servicer breaches and an annual audited servicer report assessing the servicer’s compliance.

Exempt distributions

The proposals may also have a significant effect on exempt distributions.  The class of investors to whom issuers can sell securitized products would be further restricted to exclude smaller investors, and new rules prescribing minimum disclosure on exempt distributions have been proposed.

Currently, an issuer could obtain an exemption from the prospectus requirements by issuing the debt only to “accredited investors.”  The proposals for securitized products create a class of eligible investors similar to the existing accredited investor concept, but with increased income and asset requirements for individuals.  Current exempt distributions or private placements of securitized products do not require any disclosure to investors, and to the extent an issuer elects to provide disclosure, statutory rights of action are only available against the issuer of the securities – typically a special purpose vehicle with no ability to satisfy investors’ claims. The decision to provide an information memorandum on commercial paper issuances or an offering memorandum for medium- and long-term notes has traditionally been for marketing reasons and is not mandated by law. 

The proposals will change this, requiring a disclosure document be issued for both short-term commercial paper issuances and medium- and long-term debt instruments, and by requiring minimum levels of disclosure necessary for investors to make an “informed decision,” as well as certifications from any promoter, sponsor or underwriter that the document contains no misrepresentations. In practice, this may well be interpreted to mean prospectus-level disclosure is required for all securitized products.

Potential ramifications

These proposals could significantly alter the securitization industry – particularly the areas where there is currently little or no investor disclosure, such as with private placements and short-term commercial paper.  Bank-sponsored commercial paper conduits, which have always represented the largest part of the securitized product market, may be most affected.  These “multi-seller” conduits buy assets from a number of different sellers, the identities of which are not disclosed to investors.  Prospectuses have never been practical for these entities because they issue new paper daily and can change assets regularly. As well, disclosure of 10 or 15 different programs and asset originators and pool performance data could run in to the thousands of pages.  Investors for the most part relied on the rating agencies to scrutinize the assets and the programs, and purchased commercial paper on the basis of the rating and the reputation of the sponsor.  Investors also express comfort that a bank sponsor would have the financial ability and reputational incentive to inject money into a conduit in the event of difficulty, as many are thought to have done during the credit crisis.

Going forward, the new proposals may ultimately spell the end of the multi-seller conduit.  If each seller must assume liability for misrepresentations in the offering documents prepared by the bank sponsor, it is unlikely sellers will want to be accountable for disclosure provided by other sellers.  Each seller will want to have its own special purpose issuer to ensure that it would only be liable for its own disclosure.  Simply requiring that sellers in each conduit be identified will discourage some sellers from selling assets into multi-seller conduits since they might be concerned that problems or market perceptions about another seller may affect the price at which their securities trade in the market and even in their ability to place securities.  When the third-party commercial paper conduits ran into trouble in August of 2007, many of the assets were performing well but the concern that bad assets were in the mix resulted in all of the conduits being frozen out of the market.

If bank sponsors are required to assume liability on the disclosure of the conduits – much of which comes from information provided to them by the sellers of the assets – this may discourage banks from sponsoring conduits altogether, preferring to be underwriters where they at least have a due diligence defence to any statutory liability for misrepresentation. 

Private placements of medium- and long-term securities will become subject to greater disclosure and certification requirements and consequently become more costly and cumbersome for issuers, erasing some of the benefits of avoiding public issuances.  Finally, the requirement for certification by promoters (generally the asset originators), sponsors and underwriters will expand the scope of liability beyond the special purpose vehicle.  These increased disclosure requirements and risks for participants will inevitably lead to increased costs for issuers, which may also cause some market participants to seek lower-cost financing alternatives.

Comments have been invited on the new proposals and must be submitted to the CSA by July 1, 2011.