In its proposing release dated April 7, 20101 (the “2010 Release”), the Securities Exchange Commission (the “Commission” or the “SEC”) proposed a number of rules relating to the offering, disclosure and reporting requirements for asset-backed securities (“ABS”).2 The proposed rules sought to establish new offering procedures and shelf registration eligibility criteria for ABS issuances; expand disclosure requirements relating to ABS offerings; and impose the same disclosure regimen in certain private offerings of ABS as would be required in publicly registered ABS offerings. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act, among other things, required rulemaking that involved significant overlap with the substantive areas proposed to be addressed by the Commission’s 2010 Release. In light of this, the Commission issued a proposing release on July 26, 20113 (the “2011 Release”) pursuant to which it is revising and re-proposing certain of its previously proposed rules and is seeking further input on other proposals. This DechertOnPoint summarizes the proposed rules relating to shelf eligibility and disclosure requirements addressed in this release. The Commission is seeking comments on the 2011 Release within sixty days of the 2011 Release’s publication in the Federal Register, which is expected shortly.
Shelf Eligibility for ABS
To address what the Commission regarded as investors’ undue reliance on credit ratings in making investment decisions, the Commission’s 2010 Release proposed the elimination of the investment grade rating requirement for shelf eligibility and its replacement with a four-part test. Under this proposal, to be eligible for shelf registration:
- the chief executive officer of a sponsor or depositor must provide a certification at the time of each takedown that “the as-sets in the pool have characteristics that provide a reasonable basis to believe that they will produce, taking into account internal credit enhancements, cash flows to service any payments due and payable on the securities described in the pro-spectus;”4
- the sponsor must retain a minimum amount of each tranche of the securitization in the form of a vertical slice of at least 5%, net of hedge posi-tions, as measured at the time of issuance and on an ongoing basis (or in the case of a revolving master trust, the sponsor must retain an “origina-tor’s interest” of at least 5% of the nominal amount of the securitized exposures, net of hedge positions as measured at the time of origination);
- the transaction documents must include a provision that requires the periodic delivery of an independent third-party opinion confirming that the party making representations and warranties regarding the assets has acted consistently with the terms of the transaction documents in declin-ing to repurchase or replace any assets with re-spect to which a breach of representation or war-ranty was alleged; and
- an undertaking by the issuer to file all periodic Exchange Act reports for so long as the related securities are outstanding (replacing the existing practice of ceasing to file such reports at the end of the calendar year in which such securities were issued).
Overlap with Dodd-Frank Act
Since both the Dodd-Frank Act and the Commission’s 2010 Release sought to reform various aspects of the ABS market, it should not be surprising that there were areas of substantive overlap. Two of the Commission’s proposed shelf eligibility criteria—risk retention and ongoing Exchange Act reporting—were also subjects addressed by the Dodd-Frank Act under its more general requirements. Under the Dodd-Frank Act, the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, the Commission and, in the case of residential mortgage assets, the Department of Housing and Urban Develop-ment, have been tasked with jointly prescribing rules relating to risk retention requirements.5 On March 31, 2011, these agencies issued proposed rules that would be applicable to both registered and non-registered ABS. Public comment on these proposed rules was due by June 10, 2011 and final rules are expected to be issued later this year or in 2012. Although the Commission has indicated that it may, in the future, consider whether risk retention beyond the levels required under the Dodd-Frank Act rules should be required for shelf eligibility, it considers the proposed coverage under the Dodd-Frank Act to be adequate at present for this purpose.6 The Dodd-Frank Act also eliminated the automatic suspension of the duty to file under Section 15(d) of the Exchange Act for ABS issuers and granted the Commission the authority to issue rules providing for the suspension or termination of this duty, thus establishing ongoing Exchange Act reporting obligations as the default position with respect to ABS issuers without regard to shelf eligibility.
Revised Shelf Eligibility Proposals: Transaction Requirements
Because the requirements under the Dodd-Frank Act will be applicable to most registered ABS offerings, not just ABS offered through shelf registrations, the Commission no longer regards risk retention and ongoing Exchange Act reporting as necessary conditions for shelf-eligibility. In its July 2011 proposals regarding shelf eligibility, therefore, the Commission has eliminated those two requirements. It has also proposed changes to the remaining requirements as well as the addition of a new shelf eligibility requirement.7 Under the revised proposal, eligibility for shelf registration would require:
- certification at the time of each takedown by the chief executive officer or executive officer in charge of securitization of the depositor concern-ing the disclosure contained in the prospectus and the design of the securitization;
- provisions in the underlying transaction agree-ments requiring the appointment of a credit risk manager to review the underlying assets upon the occurrence of certain trigger events and provi-sions requiring repurchase request dispute reso-lution; and
- a provision in an underlying transaction agree-ment to include in ongoing reports on Form 10-D disclosure of any requests by investors to com-municate with other investors.
The re-proposed certification requirement differs in a few respects from the requirement in the Commission’s April 2010 proposal. First, the certification would now no longer be required to be given by the CEO of the sponsor or depositor, but may also be given by an executive officer in charge of securitization. More importantly, the substance of the certification has been modified. As originally conceived, the certification was to affirm that the officer had reviewed the prospectus and underlying transaction documents and that the characteristics of the assets provided a reasonable basis to believe that they would produce cash flows sufficient to service the payments on the ABS as described in the prospectus. Due to concerns that this could be construed as a guarantee of the assets’ performance or could be taken to cover subordinated classes not offered by, but described in, the prospectus, the Commission has proposed clarification to the performance portion of the certification. Now, the certifying officer need only certify that the securitization is designed to produce cash flows at the times and in amounts necessary to service the expected payments on the ABS being registered in the prospectus and includes an express disclaimer that the certification does not amount to a guarantee of performance.8
While the re-proposal tightened the certification in this respect, it expanded it in others. Under the revised proposal, the certifying officer must affirm his or her familiarity with the structure of the securitization in greater detail than before, addressing not just the disclosure documents and the underlying transaction documents, but the assets themselves and other arrangements entered into to effect the securitization. More importantly, the certification has been expanded to include coverage of the prospectus’ disclosure. The officer must certify that the prospectus does not contain any untrue statement of material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading. The certification must also state that, based on the officer’s knowledge, the prospectus and other information in the registration statement fairly present the characteristics of the securitized assets and the risks of ownership of the ABS described therein.9
Credit Risk Manager
The Commission’s original proposals also attempted to address the quality of the assets underlying ABS issuance by requiring the delivery, whenever the sponsor or depositor declined to repurchase an asset following a claimed breach of a representation or warranty with respect to such asset, of an opinion of third party counsel stating that such refusal to repurchase was consistent with the terms of the transaction documents. The 2011 Release continues to emphasize the importance of asset quality and the enforceability of related representations and warranties in the transac-tion documents, but no longer requires the delivery of an opinion to support this. Instead, the revised proposals would require, as a condition of shelf eligibility, that the underlying transaction documents include provisions mandating the appointment of a “credit risk manager” unaffiliated with the issuer, depositor or sponsor. The credit risk manager would be required to review the securitization’s underlying assets for conformity with stated eligibility criteria either following the occurrence of certain structural triggers relating to the credit enhancement levels in the securitization or following a request by investors for such a review.10 The results of this review would be reported to the issuer’s trustee.
In addition to this reporting requirement relating to the results of the credit risk manager’s review, the 2011 Release also imposes a number of disclosure obliga-tions in connection with this shelf eligibility require-ment. First, certain information relating to the credit risk manager, such as its identity, corporate structure, experience in providing similar services and the compensation it receives in connection with the securitization, must be disclosed in the prospectus. Further, the prospectus must include details of the duties required of the credit risk manager under the transaction documents. Lastly, the 2011 Release indicates that ongoing reporting on Form 10-D would have to include disclosure of whether any events triggering the credit risk manager’s review had occurred in the most recent reporting period, together with a copy of the full report submitted to the trustee being attached as an exhibit to such Form 10-D filing.11
A final element of the Commission’s revision of this shelf eligibility requirement is the proposal, under the 2011 Release, that transaction documents promote asset quality by including provisions regarding dispute resolution. These would be applicable if an asset were subject to a repurchase request based on its alleged failure to satisfy the representations and warranties in the transaction documents but the party obligated to repurchase an asset upon such breach declined to do so within 180 days of the repurchase request. At that time, the revised proposals would permit the requesting party to refer its request, at its election, to mediation or arbitration. The requesting party’s choice of dispute resolution procedure would be binding upon the party against whom enforcement was sought.12 The 2011 Release contains little detail regarding the conditions under which a repurchase request could be made and how the dispute resolution process could be invoked.
In keeping with this focus on enforcement of rights contained in the transaction documents, the 2011 Release added a new requirement for shelf eligibility that the Commission believes will facilitate investors in directing the trustee to take certain actions on their behalf. Under this requirement, transaction documents would need to include a provision requiring the party responsible for filing periodic reports on Form 10-D to include disclosure regarding any request by an investor during the applicable reporting period to communicate with other investors. This disclosure would only be required in the context of requests to communicate with respect to the investors’ rights under the terms of the ABS. The disclosure required in these circumstances would include the name of the requesting investor, the date of the request to communicated with other investors and the method by which other investors may contact such investor. To buttress these contractual obligations, the Commission is also proposing to include requirements in amendments to Regulation AB and Form 10-D.13
Revised Shelf Eligibility Proposals: Registrant Requirements
Unlike the transaction requirements for shelf eligibility, where the 2011 Release includes significant revisions, the Commission has proposed relatively few changes for the registrant requirements. The Commission is retaining the proposals set out in the 2010 Release subject only to modifications to reflect the changes made to the transaction requirements in the 2011 Release. Therefore, under the 2011 Release, if the depositor or any issuing entity previously established by the depositor or its affiliate is or, during the twelve-month look-back period, was required to comply with the transaction requirements for Form SF-3 with respect to a previously ABS offering in the same asset class, such depositor and each such issuer must have timely filed the required certifications and transaction documents containing provisions regarding the credit risk manager, dispute resolution and investor communi-cation as required in the 2011 Release’s transaction requirements.14
Revised Shelf Eligibility Proposals: Form SF-3 Eligibility Assessment
The Commission’s 2010 Release proposed to require, as a condition to conducting a takedown off an existing shelf registration statement, that an ABS issuer conduct an evaluation at the end its fiscal quarter preceding such takedown of whether the ABS issuer was in compliance with the transaction requirements for shelf-eligibility. In response to comments it received on this proposal, the Commission is revising this proposal as part of the 2011 Release to require such an evaluation only on an annual basis. Under the revised proposal, an ABS issuer would need to conduct such an assessment as of 90 days following the end of the related deposi-tor’s fiscal year. The 2011 Release also modifies the penalty imposed for missed transaction requirements. Under the new proposal, the Commission would permit the depositor or ABS issuer to cure its failure to timely file any materials under the transaction requirement for shelf eligibility by making a subsequent filing of such materials. If such curative filing were made, the depositor or ABS issuer would be allowed to continue to use its shelf registration statement after a 90-day waiting period following the date the required filings were made. The penalty under the 2010 Release had been a one-year period for missed filings.15
For the most part, the Commission has not revised its proposals from the 2010 Release relating to required disclosures, including proposals regarding loan-level disclosures. Rather, the 2011 Release requests additional comments relating to the substantive coverage and format of the previously proposed disclosure requirements. One area where the 2011 Release does revise the proposed disclosure require-ments is with respect to the exhibits required to be filed with Rule 424(h) filings. The 2010 Release proposed to require the filing of a preliminary prospectus supple-ment in connection with a takedown off an existing shelf at least five business days prior to the first sale in the related offering. Under this proposal, the exhibits filed with respect to an ABS offering would be required to be filed, and made part of the registration statement, no later than the date the final prospectus is required to be filed pursuant to Rule 424.16 Under the 2011 Release, the Commission is proposing to require that substan-tially final forms of the underlying transaction docu-ments must be filed and made a part of the registration statement by no later than the date the preliminary prospectus supplement is filed. The Commission regards this proposal as an important mechanism to provide investors with adequate time to review the underlying documents in connection with making an investment decision. If the transaction documents filed with the preliminary prospectus remain unchanged at the time the final prospectus is required to be filed, an issuer would not be required to re-file these documents. Lastly, regarding disclosure, in the 2010 Release, the Commission had proposed requiring most ABS issuers to file a computer program that would permit investors to run various assumptions through the securitization’s flow of funds to analyze prospective performance in connection with evaluating an investment decision and to monitor actual performance of the ABS after issuance. Market participants expressed several concerns with respect to this proposal, including the worry that such an algorithm would be inherently imperfect and incomplete, the potential for liability under federal securities laws based on the performance of the waterfall program under any set of variables supplied by investors and the expected cost burden on issuers. In light of the weight of commentary on this issue, the Commission has indicated that it plans to re-propose the waterfall computer program separately from its proposals in the 2011 Release regarding shelf eligibility, offering process and other disclosures. 16 Id. at 61.
The Commission’s 2011 Release may be regarded as a milestone on what will doubtless be an arduous journey to a final set of rules. While the Commission should be commended for its proposed revisions to its original shelf eligibility proposals, both in addressing the potential overlap with the Dodd-Frank Act and in its responsiveness to comments received, many of the concerns that existed under the original proposals (e.g., concerns regarding certification of asset credit quality, the impact of repurchase challenges on servicing functions and issues surrounding asset-level disclosure) continue to present problems under the revised requirements. Given the range and significance of the issues, both with respect to shelf eligibility and disclosure, on which the Commission is seeking further input, we anticipate there are miles still to go in this rulemaking process. What is almost certain is that there will be considerable debate and substantial feedback during the comment period for these proposed rules. We will continue to update you as appropriate throughout this process.