Canada: SEC Proposals on ABS: Representations and Warranties, Part II

Well here's one that potentially has direct bearing on the Canadian ABS market. In its original April proposals, the SEC had put forward rather modest disclosure requirements relating to assets that had been the subject of a demand to repurchase or replace for breach of the representations and warranties contained in the transaction documents. On October 4, the SEC revisited these proposals in response to the Dodd-Frank Act which required the SEC "to prescribe regulations on the use of representations and warranties in the market for asset-based securities to require any securitizer to disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer, so that investors may identify asset originators with clear underwriting deficiencies".

The October 4 release is the first in a series of regulations relating to the ABS market which the SEC has been mandated to prescribe under the Dodd-Frank Act. There had previously been some doubt about how the SEC proposals and Dodd-Frank would fit together. Any such doubt has now been erased. The SEC will revise its proposals where necessary to comply with Dodd-Frank. Thus it says, almost in apology, "the Act requires us to implement the requirements discussed in this release".

The SEC's interpretation of the above direction and the resulting translation into regulation may well be a portent of things to come.

First, the rules apply equally to registered and unregistered transactions. They apply not only to all registered and non-registered transactions in the United States but also to any ABS sold offshore by securitizers in the US. More importantly, for Canadian purposes, they apply to all ABS offered by foreign securitizers to U.S. investors. For instance, in many recent Canadian transactions, a tranche of securities has been offered to U.S. investors. Under the new proposal, any such offering would now trigger the disclosure requirements. While the SEC has, in their request for comments, asked whether the disclosure should be required for these transactions at all or only for those as to which more than a certain percentage of any class of Exchange Act – ABS are sold to U.S. persons, one should not be misled. The consistent tenor of this release makes it clear that the SEC views its discretion here as being very limited.

Second, the new proposals apply to all asset-backed securities that fall under the Exchange Act definition, as amended by the Dodd-Frank Act. These include any "fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset" and specifically include collateralized mortgage, debt and loan obligations.

Third, the proposed rule imposes the disclosure obligation on a "securitizer" as defined in the Exchange Act which is (i) an issuer of an asset-backed security or (ii) a person who organizes or initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including an affiliate of the issuer.

Fourth, if the underlying transaction agreements provide a covenant to repurchase or replace an underlying asset for breach of representation and warranty, which is almost invariably the case in securitizations, then the securitizer will be required to provide the information for all assets originated or sold by the securitizer that were the subject of a fulfilled or unfulfilled demand for repurchase or replacement with respect to all outstanding asset-backed securities held by non-affiliates of the securitizer.

Finally, the initial disclosure must provide the repurchase history for the last five years and must be updated monthly on an ongoing basis. There is no materiality threshold proposed. The disclosure is to include a description of the assets which were subject to a demand and those which were or were not repurchased or replaced, the name of the issuing entity and the name of the originator.

To sum up: If someone is contemplating an issuance of asset-backed securities (as defined) either in a public or private transaction from, in or into the United States and that transaction includes a covenant to repurchase or replace assets as a result of a breach of representation and warranty then it will be required to disclose details about all assets (and their originators) securitized by such person (in private or public transactions) over the last five years that were subject to a fulfilled or unfulfilled demand for repurchase or replacement, no matter how material or how justified, and the disclosure is to be updated on a monthly basis.

One question among many which is raised by the proposed rule is what incentives does this regime create for investors and issuers. It may be possible that the latters' imperative will be to preserve their reputation by complying with any repurchase request ,no matter if unjustified, which may in turn encourage investors to view the repurchase mechanism as a possible exit strategy rather than a mere correction. While the SEC acknowledges such possibilities, its only response is "securitizers may devise other disclosures and mechanisms to solve such problems in the long-run, if they occur". One is only left to wonder what it might have in mind.

Towards the conclusion of the release, the SEC weighs the benefits and the costs of the proposals. The benefits are rather straightforward: "The recent financial crisis has revealed various problems with existing representation, warranty and enforcement provisions. Poor underwriting standards coupled with unenforceable representations and warranties by securitizers exacerbated investor losses in ABS. Increasing transparency regarding all demands for repurchase and replacement, including investor demands upon a trustee, will help investors and market participants identify originators with clear underwriting deficiencies. By having better information to judge the origination and underwriting quality of the assets that were previously securitized, investors can make more informed investment decisions".

It is the description of the costs which is sobering in its unflinching recognition of the degree to which, under the brave new world of Dodd-Frank, this consideration has become of subordinate importance. For full effect, I quote selected passages in their entirety:

Although our proposed rules are required by the Act, and we believe the added protections of our rules would benefit investors who purchase securities in these offerings, we are mindful that the imposition of a filing requirement in connection with private placements of ABS in the United States may result in foreign securitizers seeking to avoid the filing requirement by excluding U.S. investors from purchasing portions of ABS primarily offered outside the United States, thus depriving U.S. investors of diversification and related investment opportunities.

In the aggregate, the proposed requirements are likely to affect unregistered ABS more significantly because traditionally these securities have provided less disclosure. Since, as discussed previously, the Act requires disclosures with respect to all ABS issued by a securitizer, registered and unregistered, the initial and ongoing disclosures may significantly increase the direct and particularly indirect costs of issuing unregistered ABS relative to their historical cost structure. The indirect costs include the possibility of revealing information about the quality of assets to competitors. A possible effect of these requirements is that such issuers may look towards alternative forms of financing. Given that those issuers have historically preferred ABS issues, they may consider more expensive and less efficient forms of financing. Some of these incremental financing costs are likely to be passed to consumers and other borrowers whose loans make up the underlying pools backing the ABS. While it is difficult to quantify such incremental costs, researchers have estimated that securitization has generally been beneficial in banking and mortgage industries. However, other factors may be more determinative in deciding what form of financing a business will pursue.

The purpose of the amendments is to increase transparency regarding the use of representations and warranties in asset-backed securities transactions. This should improve investors' ability to make informed investment decisions. Informed investor decisions generally promote market efficiency and capital formation.

However, the proposals could have indirect adverse consequences by changing the willingness of issuers to access securitization markets. If the required disclosures results in revealing information that would benefit competitors, issuers may instead prefer to use other funding sources that do not require such public disclosures.

It appears that the task of balancing the competing interests of market transparency and market efficiency has been greatly simplified. Market efficiency is here equated with informed investment decisions and the costs incurred in enabling them are to be heavily, if not entirely, discounted in the equation. If this results in certain participants deciding to exit the ABS market, so be it.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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