Contributed By Orrick, Herrington & Sutcliffe LLP (New York - HQ)
The structured finance market in the United States is broad, covering many different asset types, and while some trends and developments affect the broader market, others reflect conditions in only one or more sectors but not the market in general. Generally, the credit risk retention requirements have been a focus of virtually every sector in the market, as the requirements of the rules are applied to specific and varied factual situations. Determinations as to whether a specific transaction is subject to risk retention, which entity or entities is or are the sponsor, what disclosure is required and when, the valuation of retained interests, and what constitutes impermissible financing or hedging of retained interests are but a few of the questions market participants have struggled with since the effective date of the rules. Other regulatory issues, such as the application of the Volcker Rule, also present some market challenges, but many of those issues seem to be narrowing as the market has had time to adapt and analyse.
Fintech has continued to grow in importance in the market generally, and in structured finance in particular, as more established companies – established being a relative term – roll out securitisation programmes and other funding structures, and new entries attempt to find the favourable financing terms that a securitisation programme can bring. It has also become more common for buyers of consumer loan pools to later securitise those pools or to serve as loan contributors to securitisations sponsored by others. Several issuers have hit more rocky times and curtailed or abandoned their issuance programmes. More esoteric transactions, somewhat harder to track due to confidentiality limitations, also continue to be executed, including a recent whole-business securitisation, relatively uncommon in the United States.
Trends we have observed in more mainstream sectors are described below.
This topic is beyond the scope of our undertaking as Acquisition Finance and Leveraged Finance are not covered in the our structured finance practice and are generally not included within “structured finance” or “derivatives” in the US legal market.
Unlike in many other jurisdictions, there is no single law which governs securitisation transactions in the US. Various laws, not unique to structured finance, govern the transfer of assets, generally on a state-by-state basis, but often based on a common set of principles. For example, the Uniform Commercial Code, which has been adopted with some variations across jurisdictions, governs transfer of and the perfection of liens on specified assets. Real estate transfers, including liens on real estate, are also governed by local law, although there may be some common principles among many jurisdictions. So too the corporate form of the issuing entity, whether a corporation, partnership, limited liability company, business trust or common law trust, is governed by local law. The bankruptcy, tax, ERISA and securities law aspects of transactions do involve federal law to a great extent, and so apply to all transactions in one form or another, but certain special laws, such as the laws governing the REMIC vehicle, applicable to interests in real estate, have been adopted and apply only in specific situations.
A wide range of assets are or have been securitised over the years. Some of the most common include single family mortgage loans, home equity loans, commercial mortgage loans, automobile loans and leases, dealer floorplan receivables, credit card receivables, trade receivables, financing leases, student loans, consumer loans, small business loans, syndicated and middle-market corporate loans, intellectual property rights, healthcare and technology loans. The preponderance of the market is performing loans, although transactions are done using impaired, distressed or similar loans.
The US risk retention rules authorised under the Dodd-Frank Act and adopted jointly by the Securities and Exchange Commission, the Department of the Treasury, the Comptroller of the Currency, the FDIC and the Federal Reserve (the “CRR Rules”) are fully effective. Under the CRR Rules, the “sponsor” of a “securitisation transaction” (defined as the “offer and sale of asset-backed securities by an issuing entity”) or its majority-owned affiliate is required to retain an economic interest in the credit risk of the transaction in accordance with the CRR Rules. Standard risk retention under the CRR Rules may be in the form of an “eligible horizontal residual interest,” an “eligible vertical interest” or a combination of the two. An eligible horizontal residual interest is basically the first loss piece or pieces of the transaction, while an eligible vertical interest is either a single vertical security or a specified equal proportion of each class of interests offered. If the retention is being satisfied by the retention of only an eligible horizontal residual interest, the sponsor must retain an eligible horizontal residual interest in an amount equal to 5% of the “fair value” (determined under GAAP) of all the interests issued in the securitisation transaction. If the retention is being satisfied by the retention of only a vertical interest, the sponsor must retain an eligible vertical interest equal to 5% of each class of interests. If the sponsor retains a combination of the two, the total of the percentage of the fair value of the horizontal interest and the percentage of the vertical interest must equal 5%. In general, the required retained interest must be held until the latest of the following dates:
During the retention period, subject to certain exceptions, the retained interest may not be:
In addition, the rules require certain specific disclosures both before and after the closing, including, with respect to an eligible horizontal interest:
The rules require disclosures for retained vertical interests as well, although since no fair value calculations are required, the required disclosures are considerably simpler.
There are specific rules and variations on the requirements described above for a number of specific asset types, as well as certain carve-outs and exceptions. For example, revolving pool securitisations, structures typically used in credit card securitisations, as well as other asset types, permit the retention of a seller’s or transferor’s interest in lieu of standard risk retention. The CRR Rules applicable to CMBS allow a third party, the B piece buyer, consistent with long-standing market practice, to retain risk, even though unaffiliated with the sponsor. Mortgage transactions involving qualified residential mortgages (as defined in the CRR Rules) are exempt. There is a safe harbour for non-US transactions meeting certain conditions, including generally that:
The rules have been effective for a relatively short time; as a result, there is no or little authority on their interpretation and market practice is evolving. It can be challenging to determine how the rules will be applied, if at all, in a given transaction. Under the CRR Rules, it is the sponsor’s responsibility to comply with the CRR Rules and, even if another party is retaining risk, it is each sponsor’s obligation to ensure that the CRR Rules are being complied with.
In transfers, assets are typically assigned to the issuing entity, either directly or through one or more intermediate steps. Depending on the type of asset, further steps may be required such as governmental filings, approval by or notation on the records of an agent or other holders, execution of assumption agreements, physical delivery of documents, endorsement, the filing of financing statements or other steps.
Generally, except in transactions involving residential mortgage loans, which require such notice by statute, notification of sale/transfer is not given to the underlying obligors, although there may be exceptions.
Generally, except in unusual situations, retention of risk by the seller of assets is not accomplished through the payment of a deferred purchase price as such. However, the seller may retain or take back such risk through a subordinated or equity interest in the issuing entity, the asset pool or otherwise. Further, payment for the transfer of receivables may be made in cash, by equity contribution or, in limited circumstances, by intercompany debt. All retained risk must be analysed under “true sale” principles such that the risk of loss is effectively transferred to the acquiring entity.
Most transactions involving the sale of assets from the balance sheet of a transaction party are structured to be “true sales” or “absolute transfers” for bankruptcy purposes. However, except for certain transactions involving banks, or other limited circumstances, there is no definitive guidance as to what constitutes a “true sale.” Rather, law firms have developed criteria based on available authorities, including case law directly on point or otherwise applicable by analogy, as to what factors should be considered in determining whether the transfer will be respected or the assets will be deemed to remain part of the transferor’s estate. Those factors may include the nature and amount of consideration for the transfer, whether all legally required steps are taken to identify the assets as having been sold, how the transaction is characterised for tax or accounting purposes, what role or roles continue to be played by the transferor after the transfer, and, perhaps most importantly, what interests or risk are retained by the seller of the assets.
Substantially all of the securitisation transactions involve issuances through a “special purpose entity,” which may be in the form of a corporation, partnership, limited liability company or business or common law trust. Use of special purpose entities has been a cornerstone of the market since its inception and, along with other protections, is intended to ensure that creditors or other holders of securitised interests may look solely to the underlying assets for payment or repayment, without regard to other obligations of the securitiser or other party.
There is no minimum capitalisation requirement for an SPV, although the entity must be adequately capitalised to meet its obligations in order to withstand bankruptcy challenge. Further, for tax purposes, the capitalisation of an entity, which would include the most junior obligations issued in a securitisation, is an important factor in concluding that more senior obligations are “debt” for tax purposes and not ownership interests in the entity or its assets.
Among the critical aspects of a SPV, which are part of the overall bankruptcy-remoteness of the vehicle, are:
Certain jurisdictions in the United States, Delaware prominent among them, have adopted regimes that permit series structures, the ring-fencing of assets and/or multiple issuance vehicles. Such entities have been used in only limited circumstances in the US, although such structures have recently been used increasingly in fintech transactions.
The bankruptcy and insolvency regimes applicable in the United States do have a doctrine of “substantive consolidation,” in which the affairs of the SPV are viewed as so intertwined with the affairs of another party, generally the seller or originator of the securitised assets, that creditors could be misled into thinking that the assets of the SPV would be available to satisfy the debts of the other party, and so the assets of the two entities should be consolidated for bankruptcy purposes. There are substantive consolidation cases dating back many years, and law firms have adopted similar, but not identical, factors on which to base the related documentary restrictions and legal opinions. Such factors include, but are not limited to, the identification of the entities and their assets as clearly separate (including, for example, separate phone numbers, stationery, offices and the like), the observance of legal formalities, the avoidance of commingling of funds, and the capitalisation of the SPV as adequate for its foreseeable obligations (such that it need not look to the other entity for payment of such foreseeable expenses and obligations).
Most transactions are structured such that the issuance vehicle is “bankruptcy remote.” Some of the more critical factors overlap with those described above in the discussion of SPVs. In addition, contracts with the issuance vehicle are generally required to contain “non-petition” clauses pursuant to which the various parties, service providers, creditors and others covenant not to file bankruptcy or insolvency proceedings against the issuer or to join in such proceedings until a specified period (generally coterminous with the “preference” period during which payments may, under certain circumstances, be recaptured from the payees) after payment in full of the securitisation obligations.
While rare in structured finance, as transactions are structured specifically to limit the risk that any sale or transfer of assets may be reversed, avoided or otherwise set aside in an insolvency of the originator, under certain circumstances assets may not have been effectively isolated from the assets of an originator or seller because, among other things:
There have been changes in the regulatory landscape in the US structured finance market over the past ten years on a scale not seen since the market gained traction in the mid-1980s. Even before the Dodd-Frank Act and its mandated changes, there were securities law initiatives, either legislative or at the Securities and Exchange Commission (e.g. Regulation AB II, the JOBS Act, changes under the Investment Advisers Act, and other laws), the banking regulators and other authorities which have significantly affected the market. While the general atmosphere in the current political climate seems to favour deregulation, at least thus far, efforts at deregulation have not yet directly reached the laws and regulations applicable to the structured finance market.
CLNs and structured products in the US are issued directly by banking institutions or by special purpose vehicles such as trusts. Issuances include a wide range of features, such as, for example, range notes, knock-in or knock-out features, collars or caps, and principal protection, in whole or in part. Generally, issuances are tailored to target a specific investment strategy. Issuances are generally standalone and are not tranched. The market for these products is small in relation to other debt markets such as corporate bonds and asset-backed securities. Investors tend to be asset managers and private bank groups looking for investments with particular features for their clients, thus the wide range and specificity of features of the securities. The return on the notes is often linked to an equity index, a currency or basket of currencies or a commodity or basket of commodities.
In the US, structured products face the same regulatory issues as other types of issuance. Securities offered must either be exempt from registration under the Securities Act of 1933 or privately placed. Disclosure requirements are similar to those applicable to other securities offerings. As is the case with other transactions covered in this article, structured product issuances by special purpose vehicles must comply with or otherwise address the requirements of the Investment Company Act of 1940, the CRR Rules and the Volcker Rule. Bank-issued notes may be sold publicly pursuant to the exemption from registration under the Securities Act of 1933 for bank-issued securities, although many structured product notes impose transfer restrictions due to the complexity of the return on the notes. Notes issued by a special purpose vehicle are generally sold in private transactions under Rule 144A or Regulation D under the Securities Act of 1933.
We are not aware of specific licensing issues applicable to the issuance of structured notes, although issues may arise depending on the investors or type of return offered by the notes.
Typical documentation may include a trust agreement (if the issuer is a special purpose vehicle organised as a trust) or similar document, and a note (sometimes issued under an indenture but at other times issued by a bank without an indenture). An offering document and/or pricing supplement is provided in connection with the offering of the securities. If the security is issued by a special purpose vehicle, a financial institution will generally agree to make payments to the vehicle in an amount owed on the security and receive agreed-upon payments from the vehicle. This agreement may be documented under an ISDA but may also be in the form of a commercial contract.
Distribution is often handled by a single underwriter, and the distribution agreements, which may be a placement agreement, an underwriting agreement or a note or certificate purchase agreement, are fairly straightforward. Syndicates are not typically formed to distribute the securities.
Generally the duties of the distributor are the same as for the distribution of other types of securities.
Underwriting compensation is generally built into the price of the securities.
Structured products are not generally listed on exchanges in the US and it appears unlikely that such transactions will be listed in the near future.
Structured product disclosures are subject to the same requirements as other types of securities offerings in the US A detailed discussion of these requirements is beyond the scope of this discussion; however, generally, all material information must be disclosed to potential investors, and the disclosure provided must be accurate and must not fail to include any information material to the investment decision. Structured notes are rarely registered with the Securities and Exchange Commission, and so disclosure rules applicable to publicly issued securities do not apply; however, as is the case with many other privately offered securities, the disclosure documents tend generally to follow the requirements of publicly issued securities to the extent possible.
We are not aware of pending reforms applying specifically to the issuance of structured notes.
Licensing or similar governmental approvals generally are not required for market participants to enter into OTC derivatives in the US. However, both parties must qualify as “eligible contract participants” (as defined in the US Commodity Exchange Act, as amended) (“CEA”) to enter into an OTC derivative transaction. Also, parties acting as dealers must be registered with the Commodity Futures Trading Commission as “swap dealers” and thereafter comply with ongoing regulatory requirements. Moreover, reporting and other requirements apply in connection with “swaps” (as defined in the CEA) entered into by registered swap dealers or by US persons.
Certain entities are restricted by law or regulation in the types of OTC derivatives they may enter into. For example, municipal entities must have the requisite statutory authority to enter into such transactions, or else those transactions may be deemed to be ultra vires (e.g. Orange County litigation in 1996). Also, federal credit unions are permitted by a final rule issued by the National Credit Union Administration (“NCUA”) in 2014 to enter into only limited derivatives transactions for the purpose of mitigating interest rate risk, provided that they meet certain eligibility criteria and apply for and receive “derivatives authority” from the NCUA.
Other industry-standard agreements are sometimes used in the US, primarily for foreign exchange transactions (e.g. IFEMA, FEOMA), but the 2002 ISDA Master Agreements (and, to a lesser extent, 1992 ISDA Master Agreements) govern the vast majority of OTC derivatives transactions.
Where the counterparties are both US persons, because of the strong protection granted under US bankruptcy laws allowing close-out and netting there are no specific circumstances where the election of automatic early termination is generally recommended. However, “belt-and-suspenders” language is sometimes included (primarily where municipal entities are involved) that purports to apply automatic early termination if the relevant bankruptcy event “is governed by a system of law that does not permit termination to take place after the occurrence of the relevant Event of Default with respect to a party.”
A New York Law legal opinion commissioned by ISDA (last updated as of December 1, 2015) and issued by Mayer Brown offers an opinion on the enforceability of the netting and close-out provisions available. This country legal opinion examines the treatment under the United States Bankruptcy Code, Federal Deposit Insurance Act, New York Banking Law, Orderly Liquidation Authority statute and Federal Deposit Insurance Corporation Improvement Act of 1991 of privately negotiated derivatives transactions documented under an ISDA Master Agreement but, among other things, excludes from its scope insurance companies, credit unions, governmental entities such as the Federal Reserve Banks and certain GSEs (such as Freddie, Fannie and Ginnie), international organisations and foreign sovereigns. The country opinion does not contain broad qualifications, and generally concludes that “close-out netting provisions will be upheld to permit broad forms of netting arrangements, thereby providing a firm legal foundation for calculating exposures on a net basis” for derivatives documented under an ISDA Master Agreement in connection with insolvency proceedings under the Bankruptcy Code, FDIA, NYBL and OLA.
In 2017, the Federal Reserve Board (“FRB”) adopted a final rule requiring US global systemically important banking institutions (“GSIB”) and the US operations of foreign GSIBs to amend “qualified financial contracts” (defined to include derivatives but exclude QFCs that do not contain default rights or restrictions that could undermine the orderly resolution of a GSIB), to prevent their immediate cancellation or termination if the GSIB enters bankruptcy or a resolution process. The final rule:
The ISDA is creating a resolution stay protocol (the 2018 ISDA Resolution Stay Protocol) to facilitate the multilateral amendment of QFCs between GSIBs and their market counterparties in connection with the FRB’s final rule. Compliance with the final rule will phase in beginning January 1, 2019, with GSIBs being required to conform their QFCs with other GSIBs within one year and their QFCs with most other financial counterparties within 18 months. GSIBs would have two years to conform QFCs with community banks and all other counterparties.
There are different insolvency regimes for different types of entities in the United States, such as cases under the Bankruptcy Code, receiverships and conservatorships for banks, the “orderly liquidation” of systemically important companies under the Dodd-Frank Act, and receivership, conservatorship, and liquidation of insurance companies. The stay powers are different under each regime, but as a general matter, upon the commencement of an insolvency proceeding there will be an immediate stay, either by operation of law or by court order, of all actions by creditors to collect debts owing to them (including secured debts) or to terminate contracts to which the insolvent entity is a party, unless the permission of the applicable court has been obtained. A number of these insolvency regimes, but not all, contain exceptions that permit, under certain circumstances, a party to certain types of derivative or similar agreements with an insolvent company to terminate the agreement and liquidate collateral.
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