On July 21, 2010, President Obama signed into law a comprehensive financial reform package known as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act"). Passage of the Act reflected approval of a reform package that emerged from a joint congressional conference committee that had been reconciling separate financial industry regulatory reform proposals passed by the U.S. House of Representatives in December 2009 and by the U.S. Senate in May of this year.
Significant areas of regulatory reform include:
- Financial stability standards and regulation of "too big to fail" institutions;
- Orderly liquidation procedures for troubled financial institutions;
- Regulations concerning corporate governance and executive compensation;
- Required rulemaking with respect to risk retention requirements for "securitizers";
- Regulation of advisers to hedge funds and other private investment vehicles1;
- Regulation of over-the-counter derivatives;
- Creation of a Consumer Financial Protection Bureau; and
- Creation of a Financial Stability Oversight Counsel.
Of particular importance to commercial real estate investors, lenders, borrowers and other market participants are the substantial regulatory reforms for the asset-backed securitization process (and, more particularly, the structuring and execution of residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS), collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs)). These reforms are principally focused on two major concepts: risk retention and increased disclosure to investors.
Risk Retention Requirements
Section 941 of the Act requires securitizers and originators to retain an interest (or "skin in the game") in securities generally in an amount of not less than 5 percent, except if the "underwriting standard" promulgated by the regulators "[specifies] the terms, conditions and characteristics as a loan within the asset class that indicate[s] a reduced credit risk with respect to the loan." The Act delegates broad authority to the FDIC, Federal Reserve Board, Office of the Comptroller of Currency (collectively, the "Federal Banking Agencies") and the SEC to develop regulations implementing risk retention rules for specific categories of Asset-Backed Securities (ABS), including certain residential mortgages, commercial mortgages and any other applicable categories thereof (with a special exemption for "qualified residential mortgages"). Hedging or transferring away the required retained credit risk is prohibited by the Act, and the Federal Banking Agencies and the SEC are required to determine the permissible forms and the minimum duration of the required risk retention. The chairperson of the newly created Financial Stability Oversight Council (also promulgated under the Act) is given the authority to coordinate all joint rulemaking required under Section 941. The regulations must be issued in final form within 270 days of the Act's enactment and such regulations become effective one year after publication of the final rules for securitizers and originators of ABS backed by residential mortgages, and two years after publication for all others.
It should be noted, however, that securities backed by commercial mortgages are given special consideration under the Act. The Federal Banking Agencies and the SEC are required to specify the types, forms and amounts of risk retention for particular asset classes, which may include, without limitation: (i) specified risk retention amounts or percentage of the total credit risk of the asset; (ii) retention of a first-loss position by a third-party purchaser, provided that such third-party purchaser holds adequate financial resources, performs specified due diligence and satisfies the same standards of risk retention required of the securitizer; (iii) a determination that the underwriting standards and controls for the asset are adequate; and (iv) a determination of adequate representations, warranties and enforcement mechanisms.
Furthermore, although the Act does not expressly delineate all aspects of the application of the new risk retention requirements as among the various asset types (e.g., CMBS, RMBS, CDOs, CLOs, etc.), the statute does clearly recognize the distinct differences between CDOs and CLOs on one hand, and other traditional ABS (like car loans, student loans, CMBS and RMBS), on the other hand. As a result, the Act specifically provides that "regulations shall … establish appropriate standards for retention of an economic interest with respect to collateralized debt obligations, securities collateralized by collateralized debt obligations, and similar instruments collateralized by other asset-backed securities."
Section 941 of the Act authorizes the SEC to promulgate new regulations on disclosure relating to registered ABS. The regulations will set standards for the format of the data to be provided by issuers, and will require issuers of ABS, at a minimum, to disclose asset level or loan level data, if such data is necessary for investors to independently perform due diligence. Such disclosure regulations would include requirements that securitizers disclose: (i) for each tranche or class of a particular security, information relating to the assets backing that security; (ii) the identity of loan brokers and originators and the compensation structure for such brokers and originators; and (iii) the amount of risk retention by the originator and the securitizer. In addition, the Act also calls for regulations requiring securitizers to disclose both fulfilled and unfulfilled repurchase requests so that investors may identify asset originators with clear underwriting deficiencies. Further, the Act requires credit rating agencies to include in any report accompanying a credit rating a description of the representations, warranties and enforcement mechanisms available to investors, and how these differ from the representations, warranties and enforcement mechanisms in issuances of similar securities. Since many of the significant provisions of the Act have extended implementation periods and delayed effective dates, and will require regulatory action and rulemaking by a number of Federal regulatory authorities to either implement the standards set out in the Act or to adopt new standards, as well as numerous separate studies by different agencies, the full scope and effect of the Act on the U.S. financial system is difficult to predict and may not be known for several years.