In our previous piece on the proposed Waterfall Computer Program requirement, we touched upon the unprecedented extension of securities law liability to the functionality of the computer program. At least in the RMBS context, different people can have different views on the degree to which this is a concern. Contrast, for example, the concerns raised by the comments of the Committee on Federal Regulation of Securities and the Committee on Securitization and Structured Finance of the Section of Business Law of the American Bar Association, dated August 17, 2010, at page 61 with those elicited by our blog piece. Perhaps the main point to be gleaned from these differing views is the uncertainty surrounding the application of the proposals in various situations, which uncertainty is itself a potential problem.
But the main point I want to revisit and expand on here relates more to those sectors other than RMBS, CMBS and credit cards where the sponsor or some other related entity is usually responsible for or is at least capable of modelling and performing financial analysis. As argued previously, the SEC proposals focus unduly on the RMBS sector and do not adequately differentiate between this sector and those sectors where the modeling is likely to be done by third parties, usually underwriters. I think we can assume that underwriters are unlikely to step up to securities law liability in respect of their models. To require the issuers and sponsors to take responsibility for a function in respect of which they have no expertise is fundamentally unfair.
This is not an isolated example of the unprecedented expansion of potential liability contained in the SEC proposals, however. In a separate proposal which, according to the SEC, has been designed to replace the investment grade ratings criteria, the issuer would be required to provide a certificate of the depositor’s chief executive officer regarding the underlying assets to the effect that “to his or her knowledge, the assets have characteristics that provide a reasonable basis to believe that they will produce, taking into account internal credit enhancements, cash flows at and in amounts necessary to service payments on the securities as described in the prospectus”. The officer would also be required to certify that he or she has reviewed the prospectus and the receiving documents for this certification. By means of this requirement, the SEC hopes that the officer in question will review the disclosure more carefully and participate more extensively in the oversight of the transaction, thus leading to enhanced quality of the securitization.
The SEC suggests that the proposed certification “would be an explicit representation by the chief executive officer of the depositor of what is already implicit in the disclosure contained in the registration statement”. With one important difference: CEOs are being asked to predict the future performance of the underlying assets, as opposed to the adequacy of the disclosure, which prediction must be based on assumptions about the future which are not qualified by any of the risk factors and other disclosures found in registration statements which protect the issuer from liability if the offered securities fail to perform. The CEO is essentially being asked to perform a credit review and to assume some degree of liability, again uncertain, in respect of its review. Even though the SEC states that the certification would not serve a as guarantee of payment of the securities, in a situation where there has been default and loss and arguments are being made over what was known or, perhaps more importantly, what should have been known, it is not clear that the knowledge qualifier would provide an effective defence.
One of the main themes of the SEC proposals is that, in the past, there was too much reliance on credit ratings. In order to give investors the appropriate tools to make their own investment decisions, the SEC has proposed greatly expanded asset level disclosure. At this point, the SEC could have said to investors: we have ensured that all pertinent information has been made available to you and it is now up to you to analyze it in making your investment decision. Models created by third parties are available in the marketplace at a price. But, presumably because it realizes that investors are not likely to want to pay this price, it chose not to do this but rather to shift the onus of performing the quantitative modeling and analysis onto the shoulders of issuers and CEOs. To a cynical observer it may appear that all they have accomplished is to potentially replace one object of reliance with another and a potentially less confidence-inspiring one at that. Whatever one may think of their past performance, at least the rating agencies had some experience and expertise in performing this function whereas these issuers and their CEO’s have little or none and are by definition conflicted to boot.
Quite apart from issues of complexity and cost, it is this radical expansion of liability, both corporate and personal, which may have the most adverse impact on the continued interest of issuers in the securitization market.