As indicated in our previous posting, the Canadian Securities Administrators have proposed a new framework for the regulation of securitized products which includes:
- enhanced disclosure requirements for securities issued under a prospectus
- enhanced continuous disclosure requirements
- certification requirements
- rules narrowing the class of eligible investors in the exempt market
- rules prescribing disclosure, both initial and ongoing, in respect of exempt distributions.
We will be providing regular commentary in this forum on the proposed framework and its potential implications for securitization market participants. This is our first such submission and touches upon the initial, threshold, issue of applicability. What all of these proposed rules have in common is that they apply to “securitized products”, which is the subject of a new definition.
There are two general categories of securitized product:
- a security that entitles the security holder to receive payments that primarily depend on the cash flow from self-liquidating financial assets collateralizing the security, such as loans, leases, mortgages and secured or unsecured receivables; and
- a security that entitles the security holder to receive payments that substantially reference or replicate the payments made on one or more securities of the type described in (a) but that do not primarily depend on the cash flow from self-liquidating financial assets that collateralize the security.
Following each category of securitized product is a purportedly non-exhaustive list of included examples.
Listed under paragraph (b) are synthetic asset-backed securities and other synthetic financial instruments (synthetic CDOs, CMOs, CLOs, CBOs, etc). While the term “synthetic” is not defined, it appears that the list of examples is meant to illustrate the meaning of paragraph (b). However, most “synthetic” financial instruments can be said to entitle investors to receive payments that primarily depend upon the cash flows from (i) one or more derivatives that provide economic exposure to referenced debt obligations or defined categories of obligations and (ii) the collateral securing such derivatives. The payments do not necessarily reference or replicate a security referenced in paragraph (a). Many credit default swaps reference corporate or sovereign debt obligations, not just ABSs or CDOs and these do not seem to be captured.
What may be of more concern here is that the definition of synthetic securitized product (paragraph (a) may end up capturing a wider variety of instruments than may have been intended. For instance structured notes such as credit-linked notes that reference a basket of corporate debt could conceivably be caught if the basket can in some way be thought of as including “securities of the type described in paragraph (a)” which includes CDOs, etc. Perhaps the real problem is that the terms CDO, CMO, CBO, etc are not defined and have somewhat amorphous meanings themselves.
Any synthetic securitized products caught by the definition would become subject to the disclosure requirements specified in Proposed NI 41-103. These almost entirely deal with topics applicable to asset-backed securities and would be of doubtful applicability to synthetic securitized products. Thus the supplementary disclosure required in respect of the latter remains unclear. This may not be of great concern since in the past almost all, if not all, synthetic securities were offered in the exempt market. It is probable that this would remain the case in the future and the rules relating to disclosure in information memoranda are flexible enough to accommodate synthetic securitized products.
Paragraph (a) presents its own interpretive issues. First, the list of examples not only includes CDOs, CMOs, CBOs, etc but also includes “asset-backed securities”. The “asset-backed security” definition is the same as the current definition in NI 51-102 and is more or less identical to the Reg AB definition, being “a security that is primarily serviced by the cash flows of a discrete pool of mortgages, receivables or other financial assets, fixed or revolving, that by their terms convert into cash within a finite period and any rights or other assets designed to assure the servicing or the final distribution of proceeds to security holders”.
Unfortunately, the definition is not expanded as it is under Reg AB to clarify the interpretation of the phrase “discrete pool of assets” in the context of master trusts, co-ownership interests, prefunding periods and revolving periods. For instance, in the context of the usual co-ownership arrangement used for revolving assets such as credit cards, a single pool could support multiple series of securities. Similarly the application of the definition to the residual value of lease assets is clarified in Reg AB, presumably due in part to the fact that, by their terms, the underlying automobiles do not necessarily convert to cash within a finite period although the related leases do. Thus, for example, if in an auto lease deal, the residual value of the autos represents more than 50% of the securitization value of the asset pool, can the payments owing to security holders be said to be “primarily serviced by” the cash flow from the financial assets, in this case, the leases? Finally consider the example of a CMBS backed by a single very large mortgage. This would not seem to satisfy the “discrete pool of … financial assets” criteria in the definition.
The example of CMBS further highlights a potentially more serious interpretive difficulty. In a CMBS transaction, the offered security represents a direct ownership interest in the underlying assets. The assets cannot really be said to “collateralize the security” unless this phrase is to be interpreted broadly to mean something like “back or otherwise dedicated to payment of the security”. It is clear from Proposed NI 41-103 that CMBS were intended to be subject to the new rules and, since CMBS clearly satisfy the definition of asset-backed security, it appears that the inclusion of this definition as an example under paragraph (a) should be read as colouring the interpretation of paragraph (a), specifically the meaning of the word “collateralizing the security”.
The real problem arises, however, if this broader interpretation is applied beyond the non-controversial case of CMBS to various securities which, while they share certain characteristics of traditional asset-backed securities, are not generally thought of as true asset-backed securities.
The language of paragraph (a) appears to be derived directly (although somewhat grammatically re-arranged) from the new definition of securitized finance product in Reg. AB II (which, it is interesting to note, unlike the CSA rules, only applies to the safe harbour modifications) and the definition of asset-backed security under the Dodd-Frank Act. Concerns have been raised by various commentators in the U.S. about the untoward breadth of these definitions. Many issuers of securities, including financial institutions, mutual funds and certain income trusts and REITs, depending on their underlying structure and asset mix, may hold various financial instruments and the cash flow to support payments to their securityholders may be primarily derived from the liquidation of these assets. Perhaps in most of these cases it can not be said, in any true sense, that the financial assets “collateralize” the security but if that word is given a broad meaning, uncertainty may begin to creep into the analysis.
This sense of uncertainty is heightened when the exclusions adopted by the CSA are critically examined. Excluded from the scope of the proposed ruling are covered bonds (which are undefined) and securities, other than debt securities, issued by a mortgage investment entity. The latter is defined as a person or company
- who invests substantially all of its assets in debts owing to it that are secured by one or more mortgages, hypothecs, or other instruments, on real property; and
- whose primary purpose or business activity is originating and administering mortgage loans, with the intent of holding such mortgages for the entire term and of using the revenues generated by holding the mortgages to provide a return for its investors.
For present purposes at least, the exclusions themselves are less interesting than the negative implications that they raise. First, a covered bond is generally considered, in the CSA’s own words, as “a primary obligation of the financial institution with the cover or collateral pool serving as credit enhancement” which seems to support a broad interpretation of the concept of “collateralizing” the security. More troubling though, is the implication that other securities may be caught provided they are, in some sense, “collateralized” by a pool of self-liquidating financial assets even if they primarily rely on the general credit of another party (i.e., the security bears recourse to a specific operating company or other credit source).
Second, the exclusion of securities, other than debt securities issued by mortgage investment entities, implies that any security (including equity and corporate debt) issued by an entity whose primary business, and thus source for funding payment to investors, is the originating and administering of financial assets other than mortgages on real property, and any debt security, however structured (or for that matter unstructured), issued by a mortgage investment entity, may be a securitized product.
The foregoing discussion is not meant to imply that the CSA intended to subject, for example, recourse securities issued by finance companies to the enhanced disclosure requirements for securitized products. What it does illustrate, however, is that, when the definitions are subjected to techniques of statutory interpretation, certain ambiguities may emerge giving rise to uncertainty. In the context of transactions generally requiring opinions as to compliance with securities laws, such uncertainty may become problematic.
As indicated above, we will continue to offer our observations on various aspects of the CSA proposals over the next couple of months leading up to the June 30 deadline for the submission of comments. We would like to invite all our readers to consider this to be a forum for introducing and airing your own views and concerns. All you need to do is to post a comment on this piece or, if you would prefer, send one of us an e-mail. We would be happy to collect and consider your comments and may raise some of your points (for attribution or not as you may indicate) in future pieces.