Securitization Rules Offer Differing Definitions Of ‘U.S. Person'

With the long-awaited U.S. rules requiring a level of risk retention in securitizations recently going into effect, an added wrinkle has been created by a slight difference in how "U.S. person" is defined in different regulations.

A decades-old benchmark for securities transactions, Regulation S is a Securities and Exchange Commission (SEC) safe harbor regulation that allows issuers to offer securities for sale outside the U.S. to foreign investors without being subject to registration requirements under Section 5 of the Securities Act of 1933. Enacted in 1990, the now-familiar regulation was designed to enhance the liquidity of American markets through the sale of U.S. stocks to foreign investors. Regulation S is one of the principal methods by which issuers, including securitization issuers, can avoid registration under U.S. securities laws.

In reaction to the financial crisis, the Dodd-Frank Wall Street Reform and Investor Protection Act of 2010 required the SEC and other federal agencies to enact rules requiring securitizers to retain an economic interest in the credit risk in the assets subject to a securitization transaction. The result was Regulation RR, which became effective for all asset-backed securities transactions in late 2016. Generally, Regulation RR requires the sponsor to retain 5% of the credit risk of securitized assets and is subject to significant transfer, hedging and financing restrictions. Similar to Regulation S, Regulation RR provides for an exemption for its risk retention requirements based on a definition of U.S. person.

However, there are slight differences between how each regulation defines a U.S. person, creating the possibility of some added complexity. The most significant difference is that the definition of U.S. person in Regulation S includes an entity "formed by a U.S. person principally for the purpose of investing in securities not registered under the (Securities) Act, unless it is organized or incorporated, and owned, by accredited investors ... who are not natural persons, estates or trusts." This definition's exclusion of certain accredited investors as U.S. persons has traditionally given certain U.S. investors access to non-U.S. securitizations via offshore transactions — provided they met the accredited investor thresholds outlined in the SEC's Regulation D and were not natural persons, estates or trusts. The definition of U.S. person in Regulation RR does not contain this exclusion. As a result, an entity that is not a U.S. person under Regulation S for registration exemption purposes may be a U.S. person under Regulation RR and therefore a foreign securitization transaction might not be exempt from the risk retention rules. Complicating matters further, many trading desks are set up to determine whether trading counterparties are or are not U.S. persons for only Regulation S and often do not have systems in place to easily determine the status of a counterparty under Regulation RR.

The differences between the definition of a U.S. person in each regulation may seem minor but can create significant issues for parties and execution of transactions. Securitization issuers and sponsors alike must be aware of this variation and review their agreements and systems to ensure compliance with all relevant regulations.

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