As reported earlier, on July 26, 2011 the SEC issued for comment a proposing release entitled “Re-Proposal of Shelf Eligibility for Asset-Backed Securities and Other Additional Requests” (the Re-Proposal). The Re-Proposal put forward modifications to the proposals originally issued in April 2010 relating to those Shelf Eligibility Conditions dealing with certification and asset repurchases. The comment period for these re-proposals expired on October 4.
As expected, the most contentious element of the Re-Proposal was that portion of the certification dealing with expected cash flow from the securitized assets. It may be recalled that the original proposal required the chief executive officer of the issuer to certify that “the securitized assets backing the issue have characteristics that provide a reasonable basis to believe that they will produce, taking into account internal credit enhancements, cash flows at times and in amounts necessary to service any payments of the securities as described in the prospectus”. While the Re-Proposal purports to address some of the criticisms levelled against the original proposal, it continues to address, in somewhat modified form, the ultimate performance of the offered securities. As argued earlier in this space, commentators continue to insist that “certification should only address the disclosure included in the prospectus, rather than a belief as to the future cash flows from the pool assets or the quality of the ABS”.
“prospectuses for ABS offerings do include extensive disclosure concerning the risks and uncertainties that could adversely affect the timing and sufficiency of cash flow, and it is precisely those disclosed risks and uncertainties that prevent the certifying person from being able to know that the securitization will produce cash flows at times and in amounts sufficient to service payments on the ABS. Taken on the whole, the certification as revised and re-proposed remains an assessment by the certifying officer of the expected future performance of securitized assets and the ABS, but without any qualification by reference to the risks and uncertainties described in the prospectus that could affect that conclusion.”.
Others also observed that what is being proposed is fundamentally a forward-looking statement but without the requisite cautioning statements that otherwise accompany and provide a safe harbour for forward-looking statements.
Commentators generally indicated that such a requirement is beyond the ability of the certifying officer, fundamentally unfair and would have a chilling affect on the use of, if not a complete barrier to, shelf registration.
Even the investor members of ASF and the Securities Industry and Financial Markets Association (SIFMA) derived no comfort from such a certification as they recognized that it was of little value as a substitute for the credit analysis provided by rating agencies since the necessary analysis by the officer is likely to be beyond his expertise as well as being inherently conflicted. As indicated by the Asset Management Group of SIFMA,
“As investors, we would like nothing more than to have individual officers stand firmly behind the product of their employers. Yet we fear that such broad certification requirements will discourage able executives from taking executive positions for fear of being personally embroiled in private litigation and government enforcement actions if the securities fail to perform as expected. At this point in the recovery cycle, we think it is essential to facilitate new mortgage market securitizations and not impose unnecessary barriers to new issuances. If executive officers feel like they personally will be made the scapegoat for unmet performance, it is reasonably likely that they will not participate in the securitization process.”
The other shelf eligibility re-proposal, relating to the appointment of a credit risk manager, garnered a mixture of general support for the concept and criticism of certain of the constituent elements; specifically the two minimum conditions under which asset review would be required: first, if “the credit enhancement requirements, as specified in the underlying transaction agreements, are not met”, and second, “at the direction of investors pursuant to the processes provided in the transaction agreement and disclosed in the prospectus”.
The ASF argued that it was a mistake to attempt to mandate a one-size-fits-all minimum objective test which may, in fact, not even be applicable in respect of certain transactions. It proposed that this test be replaced by a requirement that the transaction documents provide for a review of the pool assets upon the occurrence of a trigger based on objective factors as specified in the transaction documents and disclosed in the prospectus.
“This will allow the market to develop the most appropriate objective triggers for particular types of ABS transactions, which should be designed to cause review at a time that pool asset performance indicates that the cost of review is warranted, while preserving the flexibility to adopt alternative triggers on a going forward basis as market participants evaluate the effect of this relatively new mechanism and the efficacy of different triggers in different types of transactions.”
The second trigger also attracted its fair share of criticism, most persuasively on the grounds that it would be subject to abuse, as it represents a riskless and cost-free option for investors and would create the potential for conflict among investors within the same ABS transactions. Accordingly, it was suggested that a minimum percentage of investors should be needed to invoke the trigger and frivolous claims should be discouraged by requiring unsuccessful claimants to pay the costs of review.
Although the Re-Proposal did not alter the original proposal relating to asset-level disclosure, but merely requested additional comments on certain specific features of that proposal, certain commentators (including, most vehemently, the Vehicle ABS sponsors) took the occasion to reiterate their strident opposition to requiring asset-level disclosure for all asset groups by pointing out that Congress had already addressed this point in the Senate Report on Dodd-Frank: “The Committee does not expect that disclosure of data about individual borrowers would be required in cases such as securitizations of credit cards or automobile loans or leases, where asset pools typically include many thousands of credit agreements, where individual loan data would not be useful to investors, and whose disclosure might raise privacy concerns.”
Finally, certain commentators took the opportunity to weigh in once again on the private placement proposals. According to SIFMA,
“We are acutely aware that during the financial crisis investors – as well as transaction sponsors – incurred large losses on certain structured securities that, as a result, may now be perceived as types of securities having a high level of risk. However, the proposed changes in regulations applicable to private offerings to institutional investors would, in almost all private offerings of ABS and other structured finance products as they are commonly conducted substantially eliminate the principal distinctions between registered public offerings and private offerings to sophisticated institutional investors, by requiring issuers to covenant to provide initial disclosure consistent with that in [a registered]… offering and ongoing reporting as if the issuer were required to report under… the Exchange Act. This broad regulation of exempt private transactions would represent a historic shift in Federal regulation of the securities markets, requiring that every issuer of structured finance products provide the full, broad range of disclosure required to be provided in public offerings for the protection of every investor, including individuals and small institutions, to even the largest, most sophisticated institutional investors in a private offering.
In our view, the scope of the proposal is unjustified, and the proposed changes could significantly impair the functioning of the private markets for structured finance products and reduce the availability of credit. We believe that there remains an important role for negotiated transactions in which securities are purchased by institutional investors that have the resources and experience to fend for themselves.”
The comments on the Re-Proposal illustrate the continuing lack of consensus among market participants and regulators over the proper scope of governmental regulation of the securitization industry. Although not in detail applicable to the current Canadian process, the general principles expressed above should also resonate north of the border.