United States: SEC Asset-Backed Securities Proposed Rules

This article first appeared in Global Securitisation & Structured Finance 2004 edition, published by Globe White Page Ltd sponsored by Deutsche Bank, www.globalsecuritisation.com."

The SEC has finally proposed regulations focused solely on the issuance of asset-backed securities, designed for the nuances of this specialised marketplace.

In a historic action, the United States Securities and Exchange Commission issued proposed rules to govern the asset-backed securities industry on May 3, 2004. If adopted, these rules will provide a unitary framework for all public asset-backed issuance in the US, establishing mandatory guidelines and principles for all issuers.While codifying much of existing industry practice, the proposed rules also set forth new requirements that will force industry participants to implement new procedures and to modify how they conduct business. As with any new protocol, implementation will involve additional expense, but these proposed rules should prove beneficial to many.

The current US federal legal framework regulating the securities markets dates to the 1930’s and was a product of the abuses in the securities marketplace that preceded The Great Depression.While Congress and the SEC have continually updated the legal framework, the problem facing the assetbacked industry has been that the basic set of rules governing capital raising has been directed at traditional business organisations and forms of securities that existed prior to the advent of the asset-backed industry. Since asset-backed issuers are not traditional operating companies with actual businesses and managements, but are generally passive investment vehicles, and since assetbacked securities have different characteristics than are typical of conventional stocks and bonds, it is not surprising that the asset-backed industry has been faced with a securities regulatory framework that does not adequately address its operations or concerns.Trying to interpret the US securities laws application to asset-backed securities often has been like trying to fit the proverbial square peg in a round hole.

In the past, in order to address and accommodate the practical concerns of the asset-backed industry, the SEC has adopted some specialised procedures and rules, sometimes formally, through regulations and no-action letters or policy statements, or informally, through the review process when the SEC reviews issuer registration statements prior to offerings. However, until May 2004, the SEC had not adopted a formal set of rules under the Securities Act of 1933 or the Securities Exchange Act of 1934 designed to facilitate assetbacked offerings and satisfy the demands of investors.

The proposed rules cover four main areas: 1)Securities Act registration;2) disclosure; 3) communications during the offering process; and 4) ongoing reporting under the Exchange Act.

The SEC release proposing the new rules is 400 pages; of necessity, this brief description will only outline some of the more important elements.

In the proposed rules, the SEC has defined "asset-backed security" as "a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders; provided that in the case of financial assets that are leases, those assets may convert to cash partially by the cash proceeds from the disposition of the physical property underlying such leases."To be considered an asset-backed security, neither the depositor nor the issuing entity can be an investment company. In addition, the issuing entity’s activities must be limited to passively owning or holding the pooled assets, issuing the asset-backed securities supported by those assets and other activities reasonably incidental to the foregoing. This definition will apply to all registration rules, while formerly a similar definition was applicable to only one manner of registration, that of using a "shelf." The definition has been broadened to include most types of leases and, accordingly, securitisation of leases should be easier to effect. The definition purposefully excludes synthetic securitisations, where payments on the asset-backed securities are not made from a pooled asset, but instead by reference to an asset that is not transferred in the securitisation.Any security that does strictly meet the new definition may still be registered; however, the general and more extensive "standalone" registration Form S-1 would need to be used instead of the generally preferable shelf Form S-3.

Under the proposed rules, non-performing assets cannot be included in an asset pool at issuance. In addition, delinquent assets cannot constitute more than 50%, by dollar amount, of the original asset pool at issuance for registration using the general Form S-1, while delinquent assets cannot constitute more than 20% of the original asset pool at issuance for registration using the shelf Form S-3.

The proposed asset-backed security definition intentionally seeks to avoid transactions involving active management of the asset pool. However, prefunding periods, revolving periods and master trusts—transaction features which previously raised issues as bordering on active pool management—are permitted within specified limitations and with additional disclosure. In general, a transaction may be prefunded up to an amount equal to 50% of the offering proceeds during a period up to one year. However, for use of shelf registration, the prefunding limit is 25% during a period up to one year. For assets that by their nature revolve (e.g., credit cards, home equity lines of credit), there is no limit on the amount of assets that may revolve or the length of the revolving period. For other assets that have fixed terms, additional assets up to an amount equal to 50% of the offering proceeds during a period of one year may be acquired. However, for use of shelf registration, the revolving limit is 25% during a period up to one year. The proposed rules permit master trusts without any limitations.

Only Forms S-1 and S-3 may be used to register assetbacked securities under the proposed rules and are available to foreign issuers and for securities backed by foreign assets. Forms F-1, F-2 and F-3 that previously were available to foreign issuers of asset-backed securities are no longer permitted to be used. Asset-backed securities issued by foreign issuers, backed by foreign assets or credit enhanced by foreign entities would be subject to the same disclosure regime with specified additional disclosure on material foreign governmental legal, regulatory or administrative matters, tax matters, exchange controls, currency restrictions or other economic, fiscal, monetary or potential factors that could materially affect payments on the securities or the performance of the assets contained in the pool and other material matters relating to the non-US elements of the asset-backed securities.

In order to use the shelf registration process, the proposed rules require the depositor and sponsor of the asset-backed securities to have made all required filings in all of their other existing asset-backed offerings. The proposed Global Securitisation and Structured Finance 2004 265 Wolf, Block, Schorr & Solis-Cohen LLP rules also codify the existing SEC position that unlike in offerings of non-asset-backed securities, under shelf registration of asset-backed securities, preliminary prospectuses are not required to be delivered at least 48 hours prior to the sending of the trade confirmation. For transactions using Form S-1, the 48-hour rule would still apply.

The proposed rules would add to Regulation SK (the current general regulation governing US disclosure), a set of principles-based disclosure items dedicated to assetbacked securities, called Regulation AB. Regulation AB would govern disclosure in registration statements required by the Securities Act and in reports required by the Exchange Act. For the first time, the SEC has presented in one place a comprehensive set of rules for asset-backed securities.

Generally, because asset-backed securities are paid from cashflow from pooled assets, disclosure concerning transaction participants has been limited. In the proposed rules, the SEC has added a requirement that additional information concerning the background, experience, performance and roles of various transaction parties, such as the sponsor (originator or pooler), the servicer and the trustee be disclosed.The SEC has stated that in light of some recent market developments where the insolvency, other inability to perform or breach of obligations by the seller/servicer or trustee has negatively affected the securities, the roles of participants can be as important to the performance of asset-backed securities as the transaction structure and governing documents. Audited financial statements are still not required of the issuing entity.

A description of the sponsor’s securitisation program is now required, including the sponsor’s previous securitisation experience, including information as to any extraordinary events that occurred in prior securitisations, such as defaults, early amortisations or any action taken outside the ordinary course to prevent such events. Also, particularly noteworthy is the requirement to disclose, if material, the extent to which a sponsor relies on securitisation as a funding source (also probably the result of certain failures of sponsors which relied extensively on securitisation to fund their businesses).

Of significant importance is the new requirement to provide "static pool" (also called "vintage") data. Static data indicate the performance of portions of the pool (called static pools) over time. The goal is to demonstrate any patterns in asset origination or acquisition performance that may not be apparent from the typical "snapshot" aggregate data portrayal. For example, data on losses in a rapidly growing pool may not indicate that early originations are experiencing severe losses since on a purely percentage basis the loss number for the total pool is not high. Static pool data showing loss performance by quarterly period or other interval would highlight the actual loss experience of the early originations. The proposed rules require three years of such data with intervals chosen that are material to the asset type. Static pool data is also required on a pool-level basis for the prior securitisations of the sponsor for the same asset type. A narrative description of the data should also be presented. The new requirement for static pool data may be one of the most burdensome and expensive aspects of the proposed rules for sponsors ; however, it may be one of the most appreciated by investors in asset-backed securities.

Based on a series of no-action letters, issuers and underwriters may use various written materials in addition to the formal prospectus after effectiveness of the registration statement, but before delivery of the final prospectus, in an offering of asset-backed securities. This diverges from the traditional securities market where the preliminary prospectus is the only acceptable written material. These materials are referred to as structural term sheets, collateral term sheets and computational materials and include information on the collateral, structure and expected performance of the assets and securities and are used by investors in analysing the proposed offering. The proposed rules specifically authorise their use for asset-backed securities registered on Form S-3 and now require that these materials be filed electronically with the SEC. The proposed rules do not permit the use of these materials for securities registered on Form S-1. The term "ABS Informational and Computational Material" is defined to include all these materials and sets forth the particular information that is permitted. Significantly, loan level information is allowed. Any materials used must be filed on Form 8-K by the later of the date for filing of the final prospectus or two business days of first use and incorporated into the registration statement with attendant liability.

The proposed rules also codify an existing SEC no-action position that allows the use of research reports that otherwise would be prohibited during an offering because they would be deemed offering materials that do not meet the requirements of a formal prospectus.The new rule would only be available to asset-backed securities registered on Form S-3. This rule would allow a broker or dealer, even if a participant in the offering, to publish research reports pertaining to an asset-backed security provided that certain specified conditions are satisfied.

Asset-backed issuers are required to file reports under the Exchange Act, unless an issuance qualifies for suspension of the filing obligation by having fewer than 300 holders, which most asset-backed issuances do. However, the transaction documentation for many offerings requires continued reporting. The current Exchange Act reporting regime was designed for operating companies and is not relevant to asset-backed issuers.Accordingly, the SEC through exemptive orders and no-action letters has modified the customary reporting regime to require only the filing of a modified annual report on Form 10-K, the filing of Forms 8-K containing the monthly distribution reports provided to investors and the filing of Forms 8-K for extraordinary events. Quarterly reports on Form 10-Q and insider reports under Section 16 have not been required.

The proposed rules codify this regime, while making certain significant changes. Annual reports still would be filed on Form 10-K and reports of extraordinary events would still be filed on Form 8-K. A new Form 10-D would be required to file monthly distribution reports and would contain certain additional non-financial disclosures. Foreign asset-backed securities issuers would report on the same Forms as US domestic issuers. The proposed rules clarify that the depositor would be filing and signing the reports as "issuer" for purposes of the asset-backed securities of the issuing entity. The same depositor could be acting as issuer in this regard for more than one issuing entity and would be required to file separate reports for each issuing entity. Each takedown off the shelf with a new issuing entity would require new Edgar filing codes. Investors would benefit by easier access to filings by avoiding the need to search through myriad reports of a depositor to find those that apply to a particular offering. The servicer is allowed to sign the reports on behalf of the issuer instead of the depositor.

Form 10-D is introduced by the proposed rules. According to the SEC, one advantage of the new Form is that it will allow investors to distinguish reports that contain distribution and pool performance information from those that contain information on extraordinary events. Also, the proposed rule explicitly requires the issuer to furnish information regarding changes in assets in transactions with prefunding periods, revolving periods and master trusts. Updated information regarding significant obligors and providers of credit enhancement would be required, but in certain circumstances such information may be incorporated by reference from other SEC filings.

Form 10-K would require as an exhibit a statement of the servicer regarding its compliance with the servicer’s obligations under the applicable servicing agreement. Revisions to the modified Sarbanes-Oxley certification for asset-backed issuers are also contained in the proposed rules. Under the current reporting regime, the SEC has also required as an exhibit to the Form 10-K an assessment of an independent accountant regarding servicing compliance.The details of the assessment varied depending on the particular exemptive order or no-action letter upon which the issuer relied. In the proposed rules, the SEC has standardised the required assessment. An independent accountant must issue a report on an assertion of compliance on servicing criteria by the entity that signs the Form 10-K. In addition, the proposed rules specify the content and scope of the assessment of compliance with the servicing criteria, which covers four areas: 1) general servicing; 2) cash collection and administration; 3) investor remittances and reporting; and 4) pool asset administration. Information regarding material instances of non-compliance with the criteria would be required to be disclosed in the Form 10-K.

The proposed rules will enhance the efficiency of the US asset-backed marketplace by codifying much of existing practice under the securities laws, by providing a fixed starting point for all market participants and by requiring that all participants be governed by identical rules. Implicit in the SEC proposal is recognition of the market’s maturation. Many of the new provisions will be particularly helpful to investors, but will result in additional costs to market participants.

The above discussion only summarises selected provisions of the proposed rules. All market participants are encouraged to review the proposal and to provide comments. Comments are due July 12, 2004. The proposed rules are available on the SEC website at: www.sec.gov. The breadth of the proposal is likely to lead to extensive comments, so it is not certain what the effective date of the proposed rules will be and whether the SEC may publish subsequent revisions prior to final adoption.

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.