On July 1, 2008, the Securities and Exchange Commission (“SEC”) issued proposed rule and form amendments (“Proposed Amendments”) designed to address concerns that references in the SEC’s rules and forms to credit ratings issued by nationally recognized statistical rating organizations (“NRSROs”) may have contributed to an undue reliance by market participants on credit ratings issued by NRSROs.1 These Proposed Amendments are related to the proposals introduced by the SEC on June 25, 2008 that would impose additional requirements on NRSROs to address concerns about the integrity of credit rating procedures and methodologies and require certain changes to rating symbology for structured finance products.2 Certain of the Proposed Amendments specifically impact asset backed securities (“ABS”) offerings and this memorandum highlights such proposals.
Shelf Registration for Issuers of Asset Backed Securities
1. Form S-3 Eligibility
a. Investment Grade Ratings Requirement Eliminated. Under existing requirements, an ABS issuer may register securities under Form S-3 (which permits securities to be offered on delayed or continuous basis) if, among other things, the securities are rated investment grade by at least one NRSRO. The SEC proposes to eliminate the investment grade rating requirement and replace it with alternate provisions described below. Although this would preclude the public offering, on a shelf basis, of investment grade ABS that fail to satisfy the new requirements, it would permit an ABS issuer to register non-investment grade rated securities that satisfy the other eligibility requirements on Form S-3.
b. Minimum Denomination of $250,000. In place of the existing investment grade rating requirement, the SEC proposes to require that initial and subsequent resales of all ABS securities offered under a Form S-3 registration must be made in minimum denominations of $250,000. As currently proposed, this requirement will likely cause issues for subsequent resales of securities where the initial sale was made in a minimum denomination of at least $250,000, but due to seasoning of the deal, the balance of the security at the time of a subsequent resale falls below the $250,000 minimum denomination. In this circumstance, the initial investor would not be able to sell the security as a registered security once the balance of the security drops below $250,000. To remedy this, the SEC could modify the proposed language to require that the $250,000 minimum denomination be determined based on the initial balance of the security.
Issuers of residential mortgage backed securities (“RMBS”) should take note that the minimum denomination proposal would effectively no longer make it possible to offer the non-economic residual classes as registered securities, as such classes typically are issued with a nominal balance (typically $100 or less).
c. Initial Sales to QIBs. In addition to the minimum denomination requirement, the SEC proposes to require that the initial sale (presumably other than to the underwriter) of all ABS issued under Form S-3 be issued to qualified institutional buyers (as defined in Rule 144A(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”)) (“QIBs”). The initial sales to QIBs requirement, coupled with the minimum denomination requirement described above, effectively eliminates the ability to sell ABS to retail investors (which was a feature of some ABS transactions).
2. Shelf Eligibility under Rule 415. As an alternative to shelf registration using Form S-3, Rule 415(a)(vii) of the Securities Act permits “mortgage related securities” to be offered on a continuous or delayed basis, even if the offering cannot be registered on Form S-3 because it does not meet the eligibility requirements of Form S-3. The term “mortgage related securities” is defined as, among other things, “a security that is rated in one of the two highest rating categories by at least one nationally recognized statistical rating organization”.3 Given the dependence on a minimum security rating, the SEC proposes to amend Rule 415(a)(vii) to be aligned with the amendments the SEC proposes for Form S-3 eligibility described above. Specifically, “mortgage related securities”, regardless of security rating, could be offered on a continuous or delayed basis provided that initial sales and resales of the securities be made in minimum denominations of $250,000 and initial sales of the securities be made only to QIBs.
References to Credit Ratings in Regulation AB
1. Item 1100(c)(2)(ii)(B) of Regulation AB. If a “significant obligor” meets the registration requirements of Form S-3 or Form F-3 and the pool assets relating to such significant obligor are non-convertible investment grade rated securities, then the disclosure may include a reference to the financial information of the significant obligor, rather than presenting the full financial information of the significant obligor. The SEC proposes to amend Item 1100(c)(2)(ii)(B) of Regulation AB by removing the reference to investment grade rated securities and allow a reference to the financial information of the significant obligor, rather than presenting the full financial information of the significant obligor if the significant obligor satisfies the requirements of Form S-3 and the pool assets relating to such significant obligor are non-convertible securities, other than common equity, that were issued in a primary offering for cash that was registered under the Securities Act.
2. Items 1112 and 1114 of Regulation AB. Items 1112 and 1114 of Regulation AB require an ABS issuer to disclose certain financial information regarding significant obligors and significant credit enhancers. Instruction 2 to Item 1112(b) provides that such financial information need not be provided if the obligations of the significant obligor as they relate to the pool assets are backed by the full faith and credit of a foreign government if the pool assets are investment grade securities. Instruction 3 to Item 1114 provides similar relief, in that that such financial information need not be provided if the obligations of the significant credit enhancer are backed by the full faith and credit of a foreign government and the significant credit enhancer has an investment grade rating. Under both existing instructions, if the pool assets are not investment grade securities (in the case of Item 1112) or significant credit enhancer is not rated investment grade (in the case of Item 1114), information required by paragraph (5) of Schedule B of the Securities Act may be provided instead of the required financial information. The SEC proposes to amend both instructions to remove the exceptions based on investment grade ratings and to require disclosure of the information required by paragraph (5) of Schedule B of the Securities Act in all cases where the obligations of a significant obligor or significant credit enhancer, as applicable, are backed by the full faith and credit of a foreign government.4
Rule 3a-7 Under the Investment Company Act
Rule 3a-7 under the Investment Company Act of 1940, as amended (the “Investment Company Act”) provides that an issuer of asset backed securities is excluded from the definition of “investment company”, subject to satisfying certain conditions. This rule exempts issuers of ABS from having to comply with the registration and filing requirements of the Investment Company Act.
Three conditions included in this rule are currently based on specified credit ratings being obtained from a NRSRO. The SEC proposes to amend these three conditions to eliminate the reliance upon credit ratings as follows:
1. The condition in Rule 3a-7(2) provides that ABS offered to the general public must be rated in one of the four highest ratings categories (i.e., investment grade) by at least one NRSRO; provided that (i) ABS that are “fixed income securities”5 may be sold to institutional “accredited investors”6 and (ii) any ABS may be sold to QIBs, in each case regardless of rating or lack of rating on the ABS, if the issuer and the underwriters exercise reasonable care to ensure that such ABS are sold and will be resold to institutional “accredited investors” or QIBs, as applicable. The SEC now proposes to amend the rule to remove from the exemption investment grade rated ABS sold to the general public. As proposed, only issuers that sell ABS to institutional “accredited investors” and QIBs, in each case, in the manner described in the preceding sentence, will be eligible to be exempt from the definition of investment company. In addition, this proposed amendment would likely introduce the need to restrict the sale of investment grade rated ABS to non-U.S. investors in offshore transactions under Regulation S of the Securities Act, so that such non-U.S. investors be limited to “institutional accredited investors” or QIBs, as applicable. Currently, no such transfer restrictions are required.
2. Rule 3a-7(3)(ii) permits an ABS issuer to acquire additional eligible assets or dispose of eligible assets, conditioned upon, among other things, the acquisition or disposition of assets does not result in a downgrading in the rating of the issuer’s fixed-income securities. The SEC proposes to replace the no downgrade standard with a requirement that the issuer have procedures to ensure that the acquisition or disposition “does not adversely affect the full and timely payment of the outstanding fixed income securities”.
3. The final condition in Rule 3a-7 that the SEC proposes to amend is set forth in Rule 3a- 7(a)(4)(iii). This existing condition requires that cash flows from the asset pool be deposited periodically in a segregated account that is maintained or controlled by the trustee “consistent with the rating of the outstanding fixed-income securities”. The SEC proposes to amend this condition by eliminating the reliance on the credit rating and instead require that the cash flows be deposited in a segregated account consistent with the full and timely payment of the outstanding fixed-income securities.
The SEC’s proposal to amend Rules 3a-7(3)(ii) and 3a-7(4)(iii), in each case, would replace an objective bright-line test (i.e., whether the acquisition or disposition results in a downgrading of the securities, in the case of 3a-7(3)(ii) or whether the segregated account meets the requirements of the rating agencies rating the securities, in the case of 3a-7(4)(iii)), with a subjective standard that will be more difficult to meet as it will require a participant in the transaction (likely the trustee or other transaction administrator) to exercise judgment. These changes may increase the risk for issuers of ABS that rely on the Rule 3a-7 exemption that such issuer may be deemed an “investment company” and could increase the costs of executing such transactions due to the increased discretion that would need to be exercised by the applicable transaction parties in determining compliance with the SEC’s proposed changes. This potential risk and increased cost could be ameliorated if the SEC were to clarify in its final release of these rules that when making a determination as to whether the SEC’s proposed requirements under Rules 3a-7(3)(ii) or 3a- 7(4)(iii) are satisfied, the party making such determination would still be able to consider quality benchmarks established by NRSROs in connection with rating the related ABS.7