The U.S. Securities Exchange Commission (the “SEC”) released new Regulation AB II Rules (the “Reg AB Rules”) and regulations relating to credit rating agencies (“the NRSRO Rules”) on August 27, 2014. The Reg AB Rules1 revise the disclosure, reporting and offering process for asset-backed securities (“ABS”). Both the Reg AB Rules and the NRSRO Rules generally become effective 60 days after publication in the Federal Register. Issuers must comply with the Reg AB Rules, other than the asset-level disclosure requirements, within one year of publication and have two years to comply with the asset-level disclosure requirements. The NRSRO Rules with respect to the annual reports on internal controls would be effective on January 1, 2015, and the first annual certificate would be required to be filed after the end of the 2015 calendar year.
The key take-aways from the Reg AB Rules include:
- The Reg AB Rules apply only to “asset-backed securities” as defined in the Reg AB Rules, which is narrower than the term is defined in rules applicable to risk retention and other areas of the Dodd-Frank Act. More importantly, the Reg AB Rules apply only to transactions sold in a registered public offering and do not currently apply to private placements, including private placements exempt from registration under Rule 144A, although the SEC indicated that they may revisit private placements in future rulemaking.2
- The SEC also will not require issuers to disclose the loan-level information through password-protected websites that the issuer would have to set up. Instead, the asset-level information is required to be filed on EDGAR in a standardized, tagged data format called eXtensible Mark-up Language.
- Other proposed ideas that did not make it into the Reg AB Rules include a requirement that issuers file a computer program modeling the flow of funds provisions of the transaction and a requirement that the transactions documents, in substantially final form, be filed by the date the preliminary prospectus is required to be filed.
The key take-away from the NRSRO Rules is that they did not implement a system in which a self-regulatory organization assigns rating agencies to determine the credit ratings of ABS transactions. Instead, the NRSRO Rules focus on increasing disclosure and transparency of NRSROs (as described in more detail below).
Asset-Level Disclosure Requirements
The Reg AB Rules require potential issuers to disclose standardized asset-level information for ABS backed by residential mortgages3, commercial mortgages4, auto loans, auto leases and debt securities (including resecuritizations). The Reg AB Rules do not now require asset-level information for other asset types, including equipment loans and leases, student loans, and floorplan financings.5 Issuers must provide the asset-level information in the initial offering, including the preliminary and final prospectus, and on an on-going basis in the Form 10-D, which is required to be filed within 15 days after each required distribution date.
The additional disclosure requirements vary by asset class, but generally include (i) credit quality of obligors; (ii) collateral related to each asset; and (iii) cash flows related to each asset, including the terms, expected payment amounts, and whether and how payment terms change over time. Specifically, the Reg AB Rules contain 74 general item requirements, 270 data points specific to residential mortgage-backed securities, 108 data points specific to commercial mortgage-backed securities, 116 data points specific to automobile loan or lease ABS, and 60 data points specific to debt security ABS.
The Reg AB Rules also addressed a concern that the disclosure of asset-level information could be used to re-identify the related obligor by omitting or modifying certain asset-level disclosure requirements to minimize the risk of re-identification. For example, in residential mortgage-backed securities transactions, the Reg AB Rules require disclosure of a 2-digit zip code, a compromise that allows investors to assess market risk with certain locations while minimizing the re-identification risk. The SEC also consulted with the Consumer Financial Protection Bureau on the application of the Fair Credit Reporting Act to the required disclosures.
ABS Shelf Eligibility and Forms
The Reg AB Rules abolished the investment-grade rating prerequisite for ABS shelf eligibility and replaced it with the following criteria:
- The chief executive officer of the depositor must provide a certification at the time of each takedown regarding the characteristics of the asset pool, the payment and rights allocations, the distribution priorities and other structural features of the transaction. Notably, the SEC responded to concerns that the certification could constitute a guarantee of the future performance of the underlying assets by revising the certification language to reflect that it is a statement of what is known by the certifier at the time of the offering and that he or she has a reasonable basis to conclude that the securitization is structured to produce, but not a guarantee that it will produce, expected cash flows in accordance with the terms as described in the prospectus.
- The underlying transaction documents must include provisions requiring a review of the underlying pool of assets upon the occurrence of, at the minimum, (i) a specified percentage of delinquencies in the pool and (ii) if the delinquency threshold is crossed, an investor vote directing a review (which threshold of approval shall be no more than a simple majority of those investors casting a vote). A report of the reviewer’s findings and conclusions must be provided to the ABS trustee and a summary of such report must be included in the ABS issuer’s Form 10-D.
- The underlying transaction documents must include (i) dispute resolution procedures (either mediation or third-party arbitration) for unresolved repurchase demands and (ii) provisions specifying that if arbitration occurs, the arbitrator will determine which party bears the cost of arbitration, and if mediation occurs, the mediator will assist the parties in mutually agreeing on the allocation of the expenses incurred.
- The underlying transaction documents must include a provision requiring the inclusion in the periodic filings on Form 10-D any request from an investor to communicate with other investors relating to the exercise of an investor’s rights under the terms of the ABS.
The SEC also replaced current Forms S-1 and S-3 with new Forms SF-1 and SF-3 for ABS issuers under the Reg AB Rules, which are specifically designed for use for ABS offerings.
Under the Reg AB Rules, ABS issuers using a shelf registration process on new Form SF-3 must file a preliminary prospectus with the SEC at least three business days prior to the first sale of securities in the offering. Any material changes to the preliminary prospectus must be filed by the ABS issuer with the SEC and delivered to investors at least forty-eight hours before the date and time of the first sale.
NRSRO Reform Rules
The SEC adopted NRSRO Rules6 requiring issuers or underwriters of registered and unregistered ABS rated by a Nationally Recognized Statistical Rating Organization (“NRSRO”) to furnish a Form ABS-15G, at least five business days prior to the first sale of securities in the related offering, including the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter. A Form ABS-15G furnished by an ABS issuer must be signed by a senior officer of the depositor in charge of securitization, while a Form ABS-15G furnished by an underwriter must be signed by a dully authorized officer. Furthermore, any such third-party provider of due diligence services for ABS issuers or underwriters must provide a written certification on new Form ABS Due Diligence-15E to any NRSRO that produces a credit rating to which the services relate. Form ABS Due Diligence-15E requires disclosure of the work performed, including a summary of the findings and conclusions, and the identification of any NRSRO criteria the third-party due diligence provider intended to meet with its services.
Additionally, the NRSRO Rules addressed the following:
- The amount and type of information that must be disclosed regarding NRSRO credit rating performance, histories and methodologies was expanded and standardized.
- An NRSRO is prohibited from issuing or maintaining a credit rating where an employee who participates in determining or monitoring the credit rating also participates in, or is influenced by, sales and marketing considerations.
- An NRSRO must develop policies and procedures for conducting a “look-back” review to determine whether the prospect of future employment with an issuer or underwriter influenced the credit rating determination decision.
- NRSROs are required to establish, maintain, enforce and document standards of training, experience and competence for its employees that participate in the credit rating determination decisions.