The SEC has indentified, as a significant contributing factor to the RMBS collapse, the paucity of adequate information which would have allowed investors to make informed investment decisions and the resulting overreliance upon ratings. In a previous piece, we touched upon the SEC’s proposal to require significant asset level disclosure in shelf offerings. Today we will consider a further proposal which the SEC believes to be “an appropriate partial substitute for the investment grade ratings requirement.”
In the aftermath of the RMBS collapse, disgruntled investors attempted to probe the degree to which securitizers may have failed to comply with their representations and warranties relating to the assets in the pool and, more specifically, compliance with underwriting policies. The investors suspected that there must have been widespread breaches of the representations and warranties but in some cases they were frustrated by what they perceived to be the stonewalling of those parties who were the only available source of the information.
In order to enhance the protective nature of the representations and warranties, the SEC has proposed to require the deal documentation to contain a requirement for the representing and warranting party to furnish, on a quarterly basis, a non-affiliated third party’s opinion relating to any asset in respect of which the securitization vehicle’s trustee has asserted a breach of any representation and warranty and which was not repurchased or replaced as a result of such assertion.
The SEC has indicated that this requirement is “designed to help ensure that representations and warranties about the assets provide meaningful protection to investors, which should encourage sponsors to include higher quality assets in the asset pool”.
It seems to me that there are several problems with this proposal. First, it only requires delivery of the opinion after a refused assertion of a breach. This does not address the lack of transparency at the heart of the problem since the trustee may not have sufficient knowledge at the asset level to assert a breach.
Second, it is not clear that any qualified third party could be found to give such an opinion. It would need not only to make a technical assessment that the representation and warranty has been breached, but, in most cases, also the less objective determination of whether the breach is material and adverse. Given the factual and subjective elements involved, these questions would not be appropriate subjects of opinions from either accountants or lawyers and it is difficult to think who would be in a position to render such an opinion.
Finally, unless the transaction documents make it binding on the parties, which is not part of the proposal, the rendering of the opinion would not be a final determination of whether there has been a breach. There is no guidance in the proposed rule as to what is to done if the parties remain at an impasse.
Perhaps the fault with this proposal lies in a basic misconstruing of the purpose of representations and warranties. They are not intended to be used proactively but rather, if there is ever a default and consequent loss in a transaction, to give the trustee personal recourse to the representing party if any breach can be identified.
Nevertheless, if one is determined to alter the fundamental role which representations and warranties play in a transaction one could do worse than consider the alternative proposed by the Securities Industry and Financial Markets Association (SIFMA) comment to the SEC proposals dated August 2, 2010.
SIFMA proposes the appointment of an independent credit risk manager (a CRM) to represent the interests of securityholders. The CRM would be provided with electronic access to all asset-level documents and all underwriting guidelines. The CRM would be paid a risk management fee out of the waterfall alongside other service providers and would be responsible for monitoring performance of the representations and warranties, and investigating, initiating and attempting to settle claims. If the CRM and the seller are unable to agree on whether a breach has occurred, the dispute would be referred to binding arbitration.
Unlike the original SEC proposal, the SIFMA proposal might actually have a chance of being effective. In either case, the proposals would entail a further increase in price and complexity which will do nothing to encourage the use of securitization as a financing alternative. And once again, a blunt instrument is being taken to an entire industry in response to a relatively localized problem.