On October 11, 2012 the Division of Swap Dealer and Intermediary Oversight of the Commodity Futures Trading Commission ("CFTC") issued two letters which partially clarified how new regulations relating to the registration of commodity pool operators ("CPOs") would affect securitization vehicles. In an interpretive letter (the "Securitization Exemption Letter"), the CFTC provided permanent relief with respect to those securitization vehicles that satisfy the five conditions set out in the letter. In a "no-action" letter (the "Deferral Letter"), the CFTC provided interim relief relating to certain registration requirements (including as a CPO) until December 31, 2012.
The two letters are described in greater detail below together with some background information which may help determine if and how the regulations are relevant to securitization vehicles.
What is a commodity pool operator?
A "commodity pool operator" is now defined, in part, as "any person engaged in a business that is of the nature of a commodity pool, investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits, accepts, or receives from others, funds, securities, or property, either directly or through capital contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in commodity interests, including any commodity for future delivery, security futures product, or swap". In a typical hedge fund or similar vehicle the CPO is usually the general partner, manager or investment adviser of the vehicle. In the case of a securitization vehicle (in particular, a passive vehicle) there may not be anyone who serves a comparable role. Historically, the CFTC has taken the position that there must be at least one person or entity which assumes responsibility for being the CPO for a commodity pool. Although there is no specific guidance on this point, the sponsor or originator for the securitization is the entity most likely to be considered the CPO for a securitization vehicle.
Do the regulations apply to non-U.S. securitization vehicles?
The purpose of the regulations relating to CPOs is to protect U.S. investors. If the securities issued by a securitization vehicle are not sold to U.S. investors, the regulations should not apply. If securities of a securitization vehicle (wherever organized) were sold or will be sold to U.S. investors and that securitization vehicle holds or will hold swaps, the regulations relating to CPOs will apply unless some form of exemption applies. As with many elements of the new swaps rules, there is no specific guidance provided by the CFTC regarding the extra-territorial application of the rules.
What has changed to make these regulations relevant?
Historically, the United States Commodity Exchange Act ("CEA") and regulations with respect to commodity pools and CPOs applied only with respect to vehicles trading exchange-traded, futures contracts. The Dodd-Frank Wall Street Reform and Consumer Act expanded the regulatory regime relating to commodity pools and CPOs to include swaps. The definition of “swap” under the Dodd-Frank Act includes financial derivatives such as interest rate derivatives and certain foreign currency derivatives, which are frequently used by securitization vehicles. Consequently, the regulations relating to commodity pools were not previously relevant for securitization vehicles, hedge funds and other investment vehicles. The change in law and the CFTC regulations issued pursuant to the law have made these regulations potentially relevant to any securitization vehicle, hedge fund or investment vehicle holding swap positions. The definition of "swap" under the new regulations became effective on October 12, 2012 triggering the application of various new regulations including those relating to registration of CPOs arising from swaps activities.
Are existing transactions exempt?
The regulations do not exclude existing transactions. Consequently, existing securitization transactions need to be evaluated to determine if the new regulations will apply or if a form of exemption is available.
When do the new regulations apply?
The two letters were issued just before the October 12 date upon which some of the regulations would have begun to apply. Prior to issuing the letters, the CFTC had taken actions, at least in some instances, to postpone the compliance date for registration until December 31, 2012. These actions and various statements of representatives of the CFTC still left considerable uncertainty as to the circumstances under which the regulations would apply to some vehicles as of October 12, 2012 and to other vehicles as of December 31, 2012. The Deferral Letter has now clarified that "no action" will be taken until December 31, 2012 against any commodity pool operator which is, solely because of its swap activity, required to register as a CPO if the relevant person meets the conditions set out in the Deferral Letter.
What are the conditions to the Deferral Letter?
Under the Deferral Letter a person who is required to register in the relevant capacities (including as a CPO) where the requirement to be registered arises solely from its swaps activity must have filed with the National Futures Association (the "NFA") a completed application for registration on or before December 31, 2012. The Deferral Letter does not clarify if or how it affects potential registrants who obtain or could obtain exemptive relief from registration on or before December 31, 2012.
The other condition to the relief in the Deferral Letter specifies that a potential registrant "is subject to and makes a good faith effort to comply with the CEA and the Commission's regulations applicable to its activities as a CPO "as if such person was in fact registered in such capacity". Although not expressly stated, the CFTC would appear to be requiring compliance with applicable anti-fraud rules and recordkeeping requirements.
What are the conditions to the Securitization Exemption Letter?
The exemption provided by the Securitization Exemption Letter is available only if all of the following five conditions are satisfied (the footnotes used by the CFTC are included as they are relevant to understanding how to apply the exemption):
- The issuer of the asset-backed securities is operated consistent with the conditions set forth in Regulation AB1, or Rule 3a-72, whether or not the issuer’s security offerings are in fact regulated pursuant to either regulation3, such that the issuer, pool assets, and issued securities satisfy the requirements of either regulation;
- The entity’s activities are limited to passively owning or holding a pool of receivables or other financial assets4, which may be either fixed or revolving5, that by their terms convert to cash within a finite time period6 plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to security holders;
- The entity’s use of derivatives is limited to the uses of derivatives permitted under the terms of Regulation AB, which include credit enhancement and the use of derivatives such as interest rate and currency swap agreements to alter the payment characteristics of the cash flows from the issuing entity;
- The issuer makes payments to securities holders only from cash flow generated by its pool assets and other permitted rights and assets, and not from or otherwise based upon changes in the value of the entity’s assets; and
- The issuer is not permitted to acquire additional assets or dispose of assets for the primary purpose7 of realizing gain or minimizing loss due to changes in market value of the vehicle’s assets.
The conditions are complex, in part, because they need to be read in light of both the underlying regulations from which some of the conditions have been derived and the footnotes through which the CFTC provided further detail regarding the conditions. More importantly, some of the conditions are open to further interpretation. In particular, the Securitization Exemption Letter does not explain either what the first condition means by the phrase "operated consistent with the conditions set forth in Regulation AB, or Rule 3a-7" or how the first condition is to be applied to a transaction which does not actually "satisfy the requirements of either regulation".
How broad is the relief granted by the Securitization Exemption Letter?
Although the CFTC was asked to provide a wide-ranging exemption for securitization vehicles, it declined to do so. Instead it provided relief premised on satisfying five conditions which incorporate various existing U.S. regulatory provisions affecting securitization and/or investment vehicles. The Securitization Exemption Letter expressly excludes from the exemption the following securitization vehicles: "entities operating to some extent under any covered bond statute, entities involved in collateralized debt obligations, entities involved in collateralized loan obligations, any insurance-related issuances, and any other synthetic securitizations". In addition, the five conditions set out in the Securitization Exemption Letter establish a framework which will exclude many other securitization vehicles, notably including:
- Many ABCP conduits.
- Many CLOs/CDOs (cash and market value).
- Securitizations of non-performing mortgage loans.
- Whole business securitizations.
- Royalty securitizations.
Whether or not a particular securitization vehicle falls within the scope of the exemption will depend on all of the facts and circumstances relating to that vehicle and should only be determined with the assistance of counsel.
What if the relief granted by the Securitization Exemption Letter does not apply?
The Securitization Exemption Letter creates a "safe harbor" from registration as a CPO. It is not the exclusive means by which a potential CPO may determine that it is not required to register as a CPO. There are a several alternatives to be considered if the relief granted by the Securitization Exemption Letter does not apply to a particular transaction.
First, a potential CPO must determine whether it trades in interests that are “swaps” as set forth in the Dodd-Frank Act. Certain insurance type products may not be considered “swaps” and hence insurance linked securities may not be commodity pools. Further, certain foreign exchange derivatives may not be “swaps” and certain equity derivative products are classified as “security-based swaps” and trading thereof does not require registration as a CPO. Please note, however, that the CFTC has indicated that even trading one “swap” could bring a vehicle within the CPO definition, even if it predominantly trades products that are not considered swaps or other commodity interests.
Second, a potential CPO and its counsel may be able to determine, based on the facts and circumstances applicable to the relevant securitization vehicle, that such securitization vehicle is not a commodity pool and, accordingly, that that there is no requirement to register as a CPO.
Third, in the Securitization Exemption Letter the CFTC invited requests for further relief, stating that:
"for securitization vehicles that cannot satisfy all the criteria stated above, the Division notes that we remain open to discussions with securitization sponsors to consider the facts and circumstances of their securitization structures with a view to determining whether or not they might not be properly considered a commodity pool, or where not sufficiently assured, whether other relief might be appropriate under the circumstances, such as where a fund might be treated as an exempt pool."
Fourth, securitization vehicles may qualify for the "de minimis" exemption under Rule 4.13(a)(3) which exempts from registration CPOs of commodity pools which engage in a limited amount of swaps activity.
What factors may be relevant to determine that a securitization vehicle is not a commodity pool?
In describing which factors may be relevant in evaluating the facts and circumstances of each securitization vehicle, the Securitization Exemption Letter states that “we tend to agree that certain entities that meet certain of the criteria you identify are likely not commodity pools, such as securitization vehicles that do not have multiple equity participants, do not make allocations of accrued profits or losses (other than gains or losses resulting from permitted dispositions of defaulted financial assets) and only issue interests in the form of debt or debt-like interests with a stated interest rate or yield and principal balance and a specific maturity date.”
In addition, the Securitization Exemption Letter refers to the factors articulated by the Ninth Circuit in its decision of Lopez v. Dean Witter Reynolds Inc., as “useful”, although not dispositive.8 The following four factors were cited by the Lopez court in its opinion to be present in a commodity pool:
- an investment organization in which the funds of various investors are solicited and combined into a single account for the purpose of investing in commodity futures contracts;
- common funds used to execute transactions on behalf of the entire account;
- participants share pro rata in accrued profits or losses from the commodity futures trading; and
- the transactions are traded by a commodity pool operator in the name of the pool rather than in the name of any individual investor.9
What is the "de minimis" exemption?
Rule 4.13(a)(3) provides an exemption from registration as a CPO if the following conditions are met with respect to a specific pool:
- Interests in the pool are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States;
- At all times, the pool meets one or the other of the following tests with respect to its commodity interest positions, including positions in security futures products, whether entered into for bona fide hedging purposes or otherwise:
- The aggregate initial margin, premiums, and required minimum security deposit for retail forex transactions required to establish such positions, determined at the time the most recent position was established, will not exceed 5% of the liquidation value of the pool's portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into (the "5% Test"); or
- The aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the pool's portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into (the "100% Test"). For the purpose of this paragraph:
- The term “notional value” shall be calculated for . . . any cleared swap by the value as determined consistent with the terms of part 45 of the CFTC's regulations; and
- The person may net futures contracts with the same underlying commodity across designated contract markets and foreign boards of trade; and swaps cleared on the same designated clearing organization where appropriate; and
- The person reasonably believes, at the time of investment (or, in the case of an existing pool, at the time of conversion to a pool meeting the criteria of this exemption), that each person who participates in the pool is an "accredited investor" as defined under Regulation D of the United States Securities Act, a "qualified eligible person" as defined under CFTC regulations (which definition includes non-United States persons and "qualified purchasers") or certain other specified investors;
- Participations in the pool are not marketed as or in a vehicle or trading in the commodity futures or commodity options markets.
How does the "de minimis" exemption apply to securitization vehicles?
The swap tests under Rule 4.13(a)(3) are written in terminology more applicable to commodity pools and hedge funds that mark-to-market their assets on a daily basis and produce a daily net asset value (which is typically used for purposes of determining liquidation value). The typical securitization vehicle does not have any equivalent to a net asset value. A significant difference between the vehicles for which the exemption was written and a securitization vehicle is that investors in non-securitization vehicles are typically equity investors. The capital contributed by the investors is used to make investments sometimes in conjunction with incurring third party debt which is used to fund further investments. For these types of funds, liquidation value/net asset value is determined net of the debt incurred by the relevant pool. In the case of most securitization vehicles the debt issued to investors is the only "investment capital" and is invested in assets without incurring further third party debt.
If liquidation value/net asset value were to be determined for securitization vehicles in the same manner as it is determined for non-securitization vehicles (deducting the debt owed to investors from the assets of the securitization vehicle), the liquidation value of most securitization vehicles would be a nominal amount. Although the CFTC has had discussions with securitization industry participants which suggest that the de minimis exemption may be available for securitization vehicles, it has not clarified how securitization vehicles are to apply the tests under Rule 4.13(a)(3).
There are further interpretation issues with respect to the 5% Test relating to the meaning of initial margin and premiums as applied to securitization vehicles for which swap obligations are secured (with other obligations of the vehicle) by all assets of the vehicle.
When does a "de minimis" exemption filing need to be made?
To utilize the de minimis exemption, a CPO must make a notice filing with the NFA. The Deferral Letter does not address when a filing for an exemption must be made. However, other statements by the CFTC indicating that swap positions are not required to be included in the calculation of the de minimis exemption until December 31, 2012 provide support for the position that filings for the exemption are not required to be made until on or prior to such date. Clients should be aware of the uncertainty relating to when an exemption filing is required to be made. However, due to the timing of the CFTC action and the overall uncertainty regarding the regulations (both before and after the issuance of the two letters by the CFTC), many market participants have yet to claim potentially available exemptions or to determine finally their registration status.
How do the CPO regulations relate to the Volcker Rule?
The Volcker Rule limits the types of activities in which certain banking entities and nonbank financial companies (for purposes of this paragraph, collectively, "banking entities") can engage with a "covered fund" under the rule. Under the current proposed regulations for the Volcker Rule a "commodity pool" is a "covered fund". In general, most securitizations involving banking entities as an originator or sponsor include activities which would be prohibited under the Volcker Rule. Unless the final regulations under the Volcker Rule limit how the regulations apply to securitization vehicles, securitization vehicles involving banking entities as an originator or sponsor and which constitute commodity pools will conflict with the Volcker Rule.
Securitization vehicles meeting the five conditions of the Securitization Exemption Letter are expressly excluded under the letter from being commodity pools and consequently will not be subject to the Volcker Rule restrictions that apply in relation to commodity pools. Similarly, if a potential CPO and its counsel correctly determine that a particular securitization vehicle does not constitute a "commodity pool", that securitization vehicle would also be outside the scope of the commodity pool related provisions of the Volcker Rule. In comparison, a securitization vehicle utilizing the de minimis exemption would still constitute a commodity pool and be subject to the related restrictions under the Volcker Rule.
What are the implications of the Securitization Exemption Letter for synthetic structures, such as synthetic collateralized debt obligations and synthetic collateralized loan obligations?
The Securitization Exemption Letter’s definition of financial asset precludes synthetic collateralized debt obligations or synthetic collateralized loan obligations from qualifying for the safe harbor even were such structures able to meet the other conditions set forth in the Securitization Exemption Letter. While a conclusion based upon a facts and circumstances analysis that such synthetic structures may not be required to register as CPOs may prove difficult, there may be certain circumstances where it can be determined that such vehicles are not commodity pools, particularly where such structures exhibit the factors described by the CFTC in the Securitization Exemption Letter (e.g. limited equity, no pro-rata sharing of profits and losses, and debt like features), the reference pool is comprised solely of self-liquidating financial assets and new underlying exposures are not added to the reference pool after the date of formation. In any event, an analysis of these structures will have to be done on a case by case basis.