United States: Adoption Of Amendment To ERISA Prohibited Transaction Underwriter Exemptions For Mortgage-Backed And Asset-Backed Securitizations (The “Underwriter Exemptions”)

On November 13, 2000, the U.S. Department of Labor ("DOL") published in final form an amendment to the ERISA Underwriter Exemptions in the Federal Register (the "Amendment").¹ These changes came about through efforts by The Bond Market Association, similar to the effort that resulted in Prohibited Transaction Exemption ("PTE") 97-34.² The Amendment was finalized in much the same form as the proposed amendment published on August 23, 2000.³ With the few exceptions described below, the effective date for the Amendment is August 23, 2000.

The Amendment provides two new kinds of relief. In the case of "designated transactions" in which certain specified types of assets underlie the securities, subordinated securities rated investment-grade (at least as high as the generic "BBB-" category) will be permitted to be sold under the Underwriter Exemptions (provided that all the other requirements for application of the exemptions are met).⁴ The designated transactions are those involving (i) commercial mortgage-backed securities, (ii) residential mortgages and various types of home equity loans, (iii) manufactured housing contracts, and (iv) motor vehicle loans.

With respect to residential and home equity loans, the Amendment permits inclusion of assets with LTVs in excess of 100%. However, securities backed by such collateral (a) must be senior (i.e., non-subordinated) securities and (b) must be rated in either of the two highest generic ratings categories by a rating agency.

In addition to the relief described above for designated transactions, the DOL has granted additional relief applicable to all covered transactions:

1. Debt securities which otherwise meet the requirements of the Underwriter Exemptions will be eligible for coverage. This allows plans to purchase covered debt securities without reliance on the five Investor-Based Exemptions,⁵ such as the QPAM exemption. Further, in the case of debt (but not equity) securities, the issuer may be a partnership, owner trust, SPC or LLC, not just the REMICs, FASITs and grantor trusts previously permitted under the Underwriter Exemptions.⁶ The Amendment contains insolvency-related restrictions that must be included in the organizational documents for any of these additional forms of permitted issuers.
2. The same relief with respect to interest rate swaps recently granted by the DOL in individual exemptions for credit card-backed securitizations⁷ has been extended to fixed-pool transactions which otherwise meet the requirements of the Underwriter Exemptions. If the transaction contains a swap contract, and if the swap counterparty defaults and the trustee cannot obtain an appropriate replacement counterparty, the Underwriter Exemptions will cease to apply. However, the Amendment provides for a six-month period after notification of the default for holders to dispose of the securities.
3. In keeping with paragraph (b), the inclusion under the Underwriter Exemptions of yield supplement agreements as permitted assets has been expanded to cover certain yield supplement agreements that feature notional principal contracts and clarify that such agreements may use the ISDA contract form. Relief under this provision (under the provision referred to in paragraph (b) above) is retroactive to April 7, 1998.
4. A six-month grace period is provided for correction of a situation (i.e., resolution by replacement of the trustee or the no-longer-independent member of the restricted group) where a corporate acquisition causes the trustee of a transaction closing on or after January 1, 1998 to cease to be independent of the "restricted group"⁸ under the Underwriter Exemptions. In the case of mergers creating this problem which occurred after January 1, 1998 but before August 23, 2000, the Amendment provides for a six-month period in which to correct the problem; i.e., through February 23, 2001.
5. Reflecting DOL Advisory Opinion 99-05A, the Underwriter Exemptions have been amended to reflect that Farmer Mac bonds will be considered government guaranteed mortgage certificates and therefore permitted assets.

Finally, the Amendment discusses defeasance of a commercial mortgage loan by substitution of government securities for existing collateral. The Amendment describes two forms a defeasance transaction may take. In the first form, a new borrower (an SPE) assumes the original note, which remains outstanding (albeit with the underlying collateral changing from real estate to government securities). The second form of defeasance is used to defease commercial mortgage loans while preserving the benefit of a mortgage tax paid in respect of the existing debt. In this structure, a new note collateralized by government securities is created and assigned to the securitization vehicle in exchange for the original note backed by the real property. The Amendment provides that this second type of defeasance will be covered by the Underwriter Exemptions retroactive to January 1, 1999. While the Amendment does not specifically discuss the application of the Underwriter Exemptions to the first type of defeasance, the understanding is that the continuing existence of the original note means that the fundamental "fixed pool" requirement of the Underwriter Exemptions is not violated. Consequently, no additional relief is necessary to cover the first type of defeasance.

As indicated above, the amended Underwriter Exemptions provide new options in structuring transactions. The inclusion of swap contracts in the transaction will not prohibit "qualified plan investors" from obtaining relief under the Underwriter Exemptions.⁹ In the case of "designated transactions," the elimination of the condition that eligible classes not be subordinated means, for example, that sequential senior classes no longer need to be collapsed and contemporaneously receive distributions pro rata if the subordination is exhausted (assuming that the ratings remain at acceptable levels).¹⁰ The inclusion of debt securities as eligible for relief means that transactions can be structured as debt. In the case of real property securitizations, the ability to include loans with LTVs greater than 100% expands the assets that can be included without eliminating ERISA eligibility for the senior classes (provided that such classes are rated in one of the two highest generic ratings categories).

The Amendment covers all transfers occurring on or after August 23, 2000. Consequently, plans can purchase and hold REMIC, FASIT or grantor trust certificates from previously closed transactions as long as such classes are rated BBB- or better at the time of such transfer. However, pooling and servicing agreements (which generally restrict transfers of such certificates) may need to be amended to allow such purchases. There are a number of approaches to making such amendments; the specifics of individual pooling and servicing agreements regarding the making of amendments may dictate the most efficient course of action. Affected parties should consult their corporate counsel in this regard.

1 PTE 2000-58, 65 Fed. Reg. 67765.

2 PTE 97-34, 62 Fed. Reg. 39021 (July 21, 1997), expanded the Underwriter Exemptions by, inter alia, providing for prefunding accounts that meet specified criteria and extending the Underwriter Exemptions to cover senior interests in static FASITs (i.e., FASITs that do not permit substitution of collateral).

3.65 Fed. Reg. 51454.

4 Prior to the Amendment, the Underwriter Exemptions provided that the following six conditions be satisfied: (1) the acquisition of certificates by a plan must be on terms that are at least as favorable to the plan as they would be in an arm’s-length transaction with an unrelated party; (2) the rights and interests evidenced by the certificates must not be subordinated to the rights and interests evidenced by other certificates of the same trust; (3) the certificates at the time of acquisition by the plan must be rated in one of the three highest generic ratings categories by Standard & Poor’s, Moody’s or Fitch; (4) the trustee cannot be an affiliate of any member of the "restricted group" (i.e., each underwriter, each insurer, the sponsor, the trustee, each servicer, any obligor with respect to obligations or receivables in the trust constituting more than 5% of the initial principal balance of the trust, or any affiliate of any of these); (5) the sum of all payments made to and retained by the underwriter must represent not more than reasonable compensation for underwriting the certificates; the sum of all payments made to and retained by the pool sponsor pursuant to the assignment of the obligations or receivables to the trust must represent not more than the fair market value of such obligations or receivables; and the sum of all payments made to and retained by the servicer must represent not more than reasonable compensation for such person’s services under the pooling and servicing agreement and reimbursement of such person’s reasonable expenses in connection therewith; and (6) the investing plan either must represent (in the context of a private placement) that it is, or must be put on notice (in the prospectus in the context of a public offering) that it must be, an "accredited investor" as defined in Rule 501(a)(1) of Regulation D of the Securities and Exchange Commission under the Securities Act. Additionally, PTE 97-34 provided special rules for prefunding accounts. See supra note 2. With respect to "designated transactions," the Amendment eliminates the second of these conditions and modifies the third condition to include securities in any of the four highest generic ratings categories.

5 The Investor-Based Exemptions include PTE 84-14 (the QPAM exemption), PTE 96-23 (the INHAM exemption), PTE 91-38 (the bank collective fund exemption), PTE 90-1 (the insurance company separate account exemption) and PTE 95-60 (the insurance company general account exemption).

6 Plans must continue to be aware of the tax characterization of securities, especially subordinated securities. It is possible for a subordinated tranche of notes to meet the ratings requirement of the Underwriter Exemptions and still be treated as equity for tax purposes, thus subjecting plan investors to unrelated business income tax with respect to an investment in the tranche.

7 Under the terms of the credit card-backed securitization exemptions, classes of certificates to which a swap agreement applies can only be acquired and held by "qualified plan investors," i.e., plan investors on whose behalf the purchase decision is made by an independent fiduciary that is (a) a QPAM, (b) an INHAM or (c) a plan fiduciary with total assets under management of at least $100 million at the time such certificates are acquired.

8.The "restricted group" is defined supra note 4.

9.See supra note 7.

10 In certain transactions, there may be compelling business or legal reasons not to take advantage of this structuring option.