Canada: CSA Proposed Securitized Products Rules - Significant Counterparties

Under the proposed securitized product rules disclosure is also required in respect of certain significant counterparties in a transaction. For the most part the rules follow the pattern set out in Reg AB. The most significant feature of the proposed rule is it requires a certain degree of financial disclosure about the counterparties, depending upon whether the counterparty is considered to be, what will be called for present purposes, a "significant counterparty" or a "very significant counterparty". For significant counterparties, such disclosure is limited to the selected financial information contained in the MD&A disclosure required of reporting issuers plus the same information for any subsequent interim period ended more than 60 days before the date of the prospectus. For a very significant counterparty, however, the financial statements that would have been prescribed under securities legislation had it been the issuer of securities under a prospectus will need to be provided. The calculation of the threshold levels varies according to the counterparty in question.

Significant Obligors

A "significant obligor" is, generally speaking, an obligor (or group of affiliated obligors) in respect of pool assets representing 10% or more of the asset pool. A very significant obligor is one whose assets represent 20% or more of the pool. In addition, if a significant obligor is an issuer of securitized products and the applicable pool assets are securitized products, then disclosure will need to be made about the underlying securitized products as if the significant obligor were the issuer.

The foregoing requirements do not apply in respect of pool assets that that are guaranteed by the Government of Canada. One further exception to Reg AB which has been omitted, however, is that in respect of pool assets backed by the full faith and credit of a foreign government if the pool assets are investment grade securities. By implication disclosure is required under the CSA rules in respect of such assets.

Certain of the other items of disclosure required in respect of significant obligors may involve a somewhat disconcerting degree of reliance upon the obligor. Apart from the requirement to describe the character, history and development of its business, perhaps the most notable example of this is the requirement to disclose "any adverse financial developments since the date of the significant obligor's most recent financial statements".

It should be noted there are two other categories of significant obligors: first, a property or group of related properties and, second, a lessee or group of affiliated lessees. It is not immediately clear, at least to me, what the latter category adds to the general obligor category or how exactly a property can be considered to be an obligor and what the implications of doing so are for the required disclosure. Presumably since these categories of the definition are also present in the Reg AB equivalent, the U.S. experience in this respect will be instructive. One implication that is specified for a significant obligor which is a property is that instead of providing the equivalent of MD&A disclosure, only the net operating profit required by such disclosure need be provided.

Credit Enhancers

A significant credit enhancer is an entity (or group of affiliated entities) whose credit enhancement represents 10 – 20% of "the cash flow supporting one or more classes of the securitized products being distributed". A very significant credit enhancer represents 20% or more.

Although the wording is derived from that used in Reg AB, the phrase "cash-flow supporting one or more classes of securitized product" could be clarified somewhat. Is it the securitization value of the assets, that is, the discounted present-value of all future expected cash flow? Is it the hedged or unhedged cash flow? In some cases, enhancement supports payments on the issued securities and other obligations of the issuer as opposed to the cash flow of the assets and it would seem more appropriate in such cases to make the calculations on that basis.

Derivative Counterparties

In the case of derivatives, a significant counterparty is an entity (or group of affiliated entities) the maximum probable exposure to whom represents 10 – 20% of the aggregate principal balance of the pool assets and a very significant counterparty is one the maximum probable exposure to whom represents 20% or more of such aggregate principal balance.

Once again this rule is modeled on the one in Reg AB. However, certain alterations to the wording used in Reg AB may cause some interpretive difficulties. First, there is the obvious error in the reference to the "exposure of the derivative counterparty" rather than the exposure to the derivative counterparty which is the only relevant consideration. The previous paragraph assumes that this will be corrected.

Second, Reg AB applies to each derivative instrument used "to alter the payment characteristics of the cash flows from the issuing entity." The CSA rules would apply to each derivative instrument used "to alter the payment characteristics of the payments made on the securitized products." The payment characteristics of the securities are what they are and would not be not altered by the derivative instrument. Only the payment characteristics of cash flow from the assets is, in a sense, altered.

Finally, the amount used to calculate the percentage of the maximum probable exposure is the aggregate principal balance of the pool assets or, "if the derivative instrument relates only to certain classes of securitized products, of the aggregate principal of those classes." The phrase "only to certain classes" replaces "only to one or more classes" in Reg AB. This change may raise a certain degree of uncertainty in a case where the derivative instrument relates to all classes of securitized products.

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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