On April 1, 2011, the Canadian Securities Administrators (“CSA”) published a concept paper that outlines its proposal to overhaul the regulation of “securitized products” in Canada (the “Proposal”).
While it is generally recognized that Canadian banks and asset-backed securities fared comparatively well during the recent financial crisis, the Proposal notes that our economy was not immune and specifically points to the freezing of $32 billion of non-bank asset-backed commercial paper. With this Proposal, the CSA have broadened their earlier focus on asset-backed commercial paper and followed the U.S. lead by proposing significant and extensive changes to the rules that govern the distribution of securitized products in Canada, whether by prospectus or private placement.
The Proposal “sets out a new framework for the regulation of securitized products in Canada”. It will stimulate debate on how asset-backed securities and other securitized products should be regulated in Canada and on the impact the Proposal would have on entities that currently raise capital through the sale of asset-backed products, whether publicly under a prospectus or in the exempt market, including private sales to banks and currently unregulated financings by leasing and other commercial finance companies.
Application of the New Rules
The new regulatory framework would apply to most “securitized products”. This will be an extremely broad category of securities that will include traditional “asset-backed securities”, whose payments are derived from cash-generating financial assets, such as loans, leases and other receivables. It will also extend to securities where payments are derived from “synthetic assets” such as credit default swaps and other derivatives.
New Exempt Distribution Rules
The Proposal would significantly narrow the class of investors able to invest in securitized products on a prospectus-exempt basis. A number of traditional prospectus exemptions would no longer be available under the new regime, including the accredited investor exemption, the private issuer exemption, the offering memorandum exemption, the minimum amount investment exemption, the financial institution exemption and the short-term debt exemption.
The eliminated exemptions would be replaced by a new prospectus exemption for distributions of securitized products to an “eligible securitized product investor”. The definition of such term will be essentially the same as that of “permitted client” in National Instrument 31-103, and is intended to limit the class of investors who are able to buy securitized products in the exempt market to certain “highly sophisticated” investors.
Access to this narrow exemption will require, for the first time, that the issuer deliver an information memorandum to each investor on or before the time of purchase. The disclosure requirements will depend on the securitized product which is being distributed. As well, non-reporting issuers will have a new obligation to provide periodic and timely disclosure to investors who purchase securitized products on a prospectus-exempt basis. The impact of requiring an information memorandum will be strongly felt by finance companies who obtain their liquidity by selling portfolios to banks and on finance company to finance company sales of equipment finance contracts.
Enhanced Disclosure Obligation
A key element of the Proposal involves enhanced disclosure requirements for securitized products issued by reporting issuers. These new requirements are intended to be consistent and comparable with international initiatives. The Proposal creates a framework for disclosure at the time of distribution as well as continuous reporting obligations for both reporting issuers under a prospectus and exempt market issuers under an information memorandum. Issuers will find that the disclosure requirements are quite detailed and extensive, and should be carefully reviewed to determine whether they are unnecessarily onerous or impractical, and warrant an appropriate comment to the CSA. Examples of matters that may have to be disclosed, depending on the type of securitized product offered, include:
- certain types of relationships among the parties to a securitization and whether any party was engaged in a transaction that would involve a material conflict of interest with respect to an investor;
- significant obligors, as well as financial information with respect to them;
- asset pool information regarding the securitized assets, including selection criteria, material pool characteristics, delinquent and non-performing assets, sources of pool cash flow and claims on pool assets; and
- static pool information, if “material”.
Areas of Potential Regulation
The Proposal notes that its regulatory framework for securitized products is intended to take into account the particular features of the Canadian securitization markets and that its rules were prepared with the view that they be “proportionate” to the risks associated with the types of securitized products that are available in Canada. For this reason the Proposal does not include a number of controversial changes that are contained in recent regulatory and statutory securitization initiatives that have been or are about to be added in the U.S. Nevertheless, the Proposal leaves open the possibility that these initiatives may also be introduced here and requests detailed comments on the advisability of doing so. Some of these initiatives include:
- requiring “securitizers” to retain a portion of the credit risk for securitized assets (“skin-in-the- game”);
- prohibiting certain potential conflicts of interest;
- replacing the approved credit rating criterion for the short form and shelf prospectus systems.
- requiring disclosure of asset- or loan-level data; and
- requiring issuers to perform due diligence on securitized assets.
Statutory Civil Liability
The Proposal introduces prospectus level liability to the exempt market. If the information memorandum required in connection with the sale of securitized products in the exempt market contains a misrepresentation and insufficient information, investors would have a right to sue the issuer, the issuer’s directors and officers, the sponsor and each underwriter for damages (whether or not the investor is able to establish reliance on the misrepresentation). Insufficient information would arise if the information memorandum does not contain prescribed information in accordance with the form requirements involving a short-term securitized product as set out in the Proposal or where the issuer fails to disclose sufficient information about the securitized product and transaction to enable a purchaser to make an informed investment decision in connection with all other types of securitized offerings.
It is possible that the new civil liability regime, together with the increased disclosure obligations, may cause certain entities to avoid securitization out of concern that an error or omission may be construed as a misrepresentation and give rise to significant liability.
Comments on the Proposal will be accepted by the CSA until July 1, 2011. It is expected that a number of participants in the Canadian securitization market will provide extensive comments with a view to having the Proposal revised to better reflect the realities and needs of the Canadian market.