Canada: Slow And Steady Wins The Race

Originally published in Lewtan

Making regulations is a bit like making furniture. In the children's story Goldilocks and the Three Bears Goldilocks struggled to find a bed that was neither too soft nor too hard. Eventually, of course, she settled on one that was "just right." The Canadian Securities Administrators (CSA) appear to have largely succeeded in crafting a similar level of comfort with the comprehensive set of new rules for securitized products that they unveiled in April after a two-and-a-half-year study.

The CSA, which represent each of the provincial and territorial securities regulators in Canada, have successfully avoided many of the mistakes made by the U.S. lawmakers who drafted legislation for publicly distributed asset-backed securities (ABS). But certain details of Canada's securitization proposals need refinement — primarily, as I argue below, the sections dealing with exempt distributions, where the CSA still need to provide greater flexibility.

One reason why the Canadian securitization proposals are not as cumbersome as those in the United States is because the 2007 credit crisis did not hit Canada as hard. The country's financial markets calamity was the collapse of the $32 billion third-party ABCP market. Exploring new rules for the sale of ABCP was thus what the CSA initially decided to focus on when it released its consultation paper in October 2008.

This was the only regulatory initiative undertaken in Canada for asset-backed securities. By comparison, the U.S. government and regulators have been hyperactive: sections of the far broader Dodd-Frank Act are devoted to securitization and the Securities and Exchange Commission (SEC) has already issued several rules and released other draft rules as a result. In addition, the SEC has proposed amendments to Regulation AB, known as RegAB II, though that appears to have taken a back seat of late. And the Federal Deposit Insurance Corporation has issued its new safe harbor rules for bank-sponsored securitizations.

The slower pace of rule-making adopted by the CSA has allowed them to reflect upon U.S. securitization initiatives and seek a more balanced approach. The CSA's prospectus and continuous disclosure proposals are largely based on the requirements of RegAB with very few additional elements adopted from the latest bout of U.S. regulatory initiatives. In general, these provisions can be fairly summarized as an uncontroversial update of securitization disclosure requirements to meet the standards that have been in effect in the United States for five years. Many of the prohibitions or obligatory requirements contained in the U.S. securitization initiatives are dealt with instead as disclosure items under the CSA's securitization proposals (see box on page 33).

The CSA's proposals for exempt distributions of securitized products, however, are less benign. Like the provisions of RegAB II that would apply to private placements, the exempt distribution rules under the CSA's proposals would, if left intact, probably inhibit the private placement securitization market much more than the CSA apparently intends, according to the background sections of their proposals.

The proposals would eliminate all of the existing prospectus exemptions for securitized products, including ABCP, and replace them with a single "securitized product" exemption.

The exemption has three components. First, sales may only be made to "eligible securitized product investors" (ESPIs), essentially a slightly more restrictive list than the current "accredited investor" designation. Next, the issuer must deliver an information memorandum to each investor and also make it available to prospective investors in the secondary market. Finally, the issuer must prepare and deliver periodic continuous disclosure reports essentially as if the distribution of ABS or ABCP had been executed through the terms of a prospectus.

Crisis Reaction

The securitized product exemption is largely a reaction to the 2007 credit crisis where thousands of Canadian retail ABCP investors found themselves holding illiquid ABCP and unable to gain access to crucial information concerning the assets backing their ABCP or the conditions surrounding the ability of ABCP conduits to draw on liquidity lines. Under the Canadian securitization proposals, information memoranda for shortterm securitized products, including ABCP, would have to be in a prescribed form.

The details of the form are outside the scope of this article but they should be sufficient to address the concerns arising out of the 2007 credit crisis. Although the requirement for information memoranda for short-term securitized products would be new, much of the information required, such as an information memorandum and continuous disclosure for ABCP, is already being provided privately to investors by bank-sponsored ABCP conduits in their monthly reports.

There are a few areas where the form of information memoranda for short-term securitized products arguably goes too far. For example, it is proposed that sponsors must describe the material terms of existing program documents and transaction agreements. This could be quite an onerous task for a multiseller ABCP conduit. Yet it is unlikely that it would provide much useful information to investors.

The most problematic aspect of the exempt distribution rules, though, appears to be a requirement for the sponsor to certify that the information memorandum contains no misrepresentation. Since sponsors of ABCP conduits rely on the servicers of their various programs to provide the information required for the information memorandum, this will effectively make the sponsor of an ABCP conduit a guarantor for the servicers.

The sponsor could, of course, have recourse back to the servicers. But that would be cumbersome, introduce an additional layer of unnecessary risk and would probably limit accessibility to ABCP conduits to only the most creditworthy of servicers. There is no prescribed form for information memoranda for other securitized products, but they must "disclose sufficient information about the securitized product and securitized product transaction to enable a prospective purchaser to make an informed investment decision." This is a novel and vague standard for offering document disclosure.

The securitized product exemption has a few other bugs to work out, too. The definition of ESPI does not include conduits — in other words, trusts — administered by an ESPI. So under the current proposals, banksponsored ABCP conduits may only purchase asset-backed securities if the deal is offered by prospectus.

Another requirement may well stifle the ABS private placement market: the CSA is proposing that the information memoranda for all securitized products must be certified by at least one underwriter to contain no misrepresentations, to the best of the underwriter's knowledge. Currently, underwriters and other agents do not take responsibility for disclosure in private placement offering documents. Forcing them to do so may undermine their desire and ability to participate.

Finally, many private placements of ABS are to sophisticated investors who do not require or desire an information memorandum, particularly where the sale is to a single investor. At the very least, a subset of ESPIs ought to be able to opt out of the information memorandum and continuous disclosure requirements of the securitized product exemption and instead negotiate for whatever disclosure they require.

Market participants have had time to make their views known: the comment period for the Canadian securitizations proposals ends on July 1. Revised proposals should come before the end of 2011, with a further comment period thereafter. Once that is over, the CSA are likely to promulgate the final rules in the first half of 2012. Thankfully, most of the rules are nowhere near as onerous as the restrictions U.S. legislation seeks to impose. And with a few adjustments, it should be possible to rejig the proposed Canadian exempt distribution rules to make them much more accommodating.

Torys has offices in Toronto, New York and Calgary

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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