If a debtor becomes subject to bankruptcy proceedings, creditors will, with some exceptions, be automatically stayed from collecting and enforcing against the debtor and any posted collateral. Lifting the stay may be time consuming and costly, and subject to the broad statutory and equitable powers of the bankruptcy court. The court also has the power to:
Creditors may also be restricted from exercising rights that trigger off a debtor’s bankruptcy or financial condition (so-called ipso facto clauses). Unlike many other jurisdictions where bankruptcy effectively amounts to liquidation proceedings, bankruptcy proceedings in the USA also encompass a workout regime (Chapter 11 bankruptcy). Workouts are highly variable and facts and circumstance specific, which makes it difficult to predict the duration of the stay and the impact on a particular creditor.
Consequently, a key aspect of securitisations is to isolate the issuer and its assets from such bankruptcy risks by:
As an alternative to a true sale structure, it is also possible to transfer exposure to the securitised assets using contracts that are protected against the most troublesome bankruptcy powers.
Establishing a bankruptcy-remote special-purpose entity (SPE) is a key aspect of a typical securitisation transaction.
The transaction documents typically include non-petition clauses that restrict involuntary bankruptcy filings against the issuer.
However, an outright prohibition against the SPE itself voluntarily filing for bankruptcy is unenforceable as against public policy and such risk must therefore be mitigated by more indirect means. Limiting the SPE's unrelated activities and restricting the SPE from having employees and unrelated property reduces the risk of unrelated liabilities. Appointing an independent director whose fiduciary duty runs to the SPE and not to its shareholders, and employing an entity type that allows for such redirection of fiduciary duties reduces the risk of a filing for the benefit of its shareholders.
The independent director(s) also provide(s) important protection against dissolution of the SPE, in part by requiring such director’s participation in a dissolution decision and in part by providing that such independent director becomes a “springing member” or “springing partner” if the absence of a member or partner would cause dissolution. The number of independent directors should be at least equal to the minimum number of members or partners required to continue the SPE’s existence.
Substantive consolidation is an equitable doctrine that permits a bankruptcy court to disregard the separateness of an entity that itself is not otherwise in bankruptcy and that provides an alternative pathway for an SPE to become entangled in its affiliate’s bankruptcy proceedings. Although the analysis differs somewhat between various US circuits, in general a bankruptcy court may order substantive consolidation where the separateness of the entities has not been sufficiently respected or where the affairs of the debtor entities are so entangled that unscrambling will be prohibitive and hurt all creditors.
Under older practice, which still applies in some circuits, the courts may rely on a multi-factor analysis. Consequently, the risk of substantive consolidation is generally addressed by requiring the SPE and its credit to be separate from its affiliates based on factors that speak for substantive consolidation identified in the case law. One list of such factors is collected in the Tenth Circuit opinion of Fish v East, 114 F2d 117 (10th Cir 1940):
A second commonly cited list of such factors appears in the case of in re Vecco Constr Indus 4 BR 407, 410 (Bankr ED Va 1980):
An additional factor, articulated by the Fourth Circuit Court of Appeals in Stone v Eacho, 127 F2d 284, 288 (4th Cir 1942), has also been cited by a number of cases, namely whether “by... ignoring the separate corporate entity of the [subsidiaries] and consolidating the proceeding... with those of the parent corporation... all the creditors receive that equality of treatment which is the purpose of the bankruptcy act to afford.”
The presence or absence of some or all of these factors does not necessarily result in substantive consolidation. In fact, many of these elements are present in most bankruptcy cases involving holding company structures or affiliated companies without thereby leading to substantive consolidation. Various courts have noted that some factors may be more important than others; in particular, the “consolidation of financial statements”, “difficulty of separating assets”, “commingling of assets” and “profitability to all creditors”.
For a sale of financial assets to be valid and enforceable against third parties, it has to "attach" and be "perfected" similar to what applies to a security interest in collateral. The rights of a purchaser of such assets attaches if:
Although it is possible for a security interest to attach in some circumstances without a written agreement, it is not practicable to rely on those circumstances always being present in a securitisation transaction.
The available mode of perfection differs based on the type of asset and type of transfer. Broadly speaking, perfection can be:
The general means of perfecting a security interest in financial assets other than a deposit account is by filing a UCC financing statement in the applicable filing office. A security interest in deposit accounts can only be perfected by control. The perfection of a security interest in a financial asset automatically also perfects a security interest in related supporting rights, such as collateral or letter of credit rights. A security interest perfected by control or possession often has higher priority than a security perfected by other means. Nevertheless, since filing a UCC financing statement is easy and cheap, and would provide perfection regardless of whether the transfer is respected as a sale or whether it is characterised as a loan, such filing is typically the primary means of perfection.
True Sale v Secured Loan
If the transfer of an asset is respected as a sale, then such asset will cease to belong to the seller and therefore the buyer’s rights in such assets will typically not be affected by a subsequent bankruptcy of the seller. On the other hand, if such transfer is treated only as a granting of a security interest in collateral, then a bankruptcy of the seller will subject the buyer’s rights with respect to such assets to the automatic stay and other bankruptcy powers. In determining whether a transfer is a true sale or a disguised loan, courts look to a number of factors. Not surprisingly, the more numerous the secured loan characteristics, the greater the likelihood that the transaction is viewed as such. Conversely, the more numerous the sale characteristics, the greater the likelihood that a purported sale will be respected as such. However, not all factors are given equal weight in this analysis.
Key factors include:
The courts have also identified a variety of other factors that do not fall within the categories above but may be indicative of a secured loan, including:
Some states have sought to bolster securitisations by restricting recharacterisation of a purported sale transaction. However, there is significant uncertainty around a bankruptcy court’s acceptance of such statutes, and securitisations are therefore typically structured to comply with the judicially created true sale criteria.
It is common to obtain a true sale opinion in securitisation transactions that evaluates the relevant facts in light of the factors outlined above. Generally the opinion will describe the salient facts and analyse these facts in light of the factors identified by the courts as relevant to the true sale determination. The opinion will usually identify these key factors and draw a conclusion based on the overall analysis and reasoning in the opinion letter.
Most derivatives, certain mortgage repo transactions and many securities contracts are protected against the automatic stay and some of the most troublesome bankruptcy powers. These types of contracts can therefore be used as a means of transferring exposure to the assets underlying a securitisation as an alternative to a true sale. Synthetic securitisations typically use credit default swaps (CDSs) to transfer such exposure. If the CDS counterparty becomes subject to bankruptcy proceedings, the SPE will nevertheless have the right to terminate and close out each swap entered into with that counterparty, and realise against any collateral or other credit support relating to such swap, without being subject to the stay or the prohibition against ipso facto clauses.
It is, however, not common to obtain a bankruptcy opinion for such protected contracts.
In the USA, taxes can theoretically be assessed at federal, state and local level. There is no federal value added tax, sales tax or stamp tax on the transfer of financial assets to a securitisation SPE, but in some cases the transfer of loans or leases accompanied by transfers of the underlying assets securing such loans or leases could trigger certain state or local sales tax.
The sale of loans and other receivables can also trigger certain gains or losses, generally depending on whether the SPE is part of the same tax consolidated group as the transferor, and may, depending on applicable law and the characterisation of the transfer, also have consequences for the transferor’s continued ability to deduct losses from bad loans.
Many of these issues are addressed as part of the structuring of the SPE. For example, a single-member limited liability company (LLC) is, for federal tax purposes, disregarded (in the absence of the SPE electing any contrary tax treatment) and therefore any transfer of assets from a parent to its wholly owned LLC will not be a taxable event. An SPE that is organised as a partnership or an LLC that has elected to be treated as a partnership for tax purposes would not be subject to entity-level tax, but transfers to a securitisation SPE that is treated as a partnership for tax purposes may have different tax consequences than transfers to a disregarded entity and, as such, it is possible to structure the SPE (and use a multi-SPE structure) so as to optimise the securitisation for the desired tax neutrality.
From an investor’s perspective, if an SPE is treated as a partnership for tax purposes, and the notes issued by the SPE to such investor were to be treated as equity for tax purposes, then the noteholder would be taxed individually on its share of the SPE’s income, gain, loss, deductions and credits attributable to the SPE’s ownership of the assets and liabilities of the SPE without regard to whether there were actual distributions of that income. This, in turn, could affect the amount, timing, character and source of items of income and deductions of the noteholder compared to what would be the case if the notes were respected as debt for tax purposes.
An SPE that is subject to entity-level tax, such as a corporation or a partnership that is taxed as a corporation, will potentially incur tax liability for any gains resulting from the sale of financial assets and any income otherwise paid with respect to the financial assets in excess of deductible expenses.
Consequently, the SPE is usually structured to avoid entity-level taxation. For example, this can be done by using a tax-transparent organisational form or by incorporating the SPE in a jurisdiction that does not impose such taxes. SPEs established as single-member LLCs or Delaware statutory trusts can be readily structured to avoid entity-level tax. Partnerships and entities treated as partnerships are also generally treated as pass-through entities for tax purposes, depending on the number of partners, the trading activities in any equity (or securities deemed to be equity for tax purposes) in such partnerships and the availability of relevant safe harbours.
A partnership that is deemed to be a publicly traded partnership for US tax purposes could be subject to entity-level tax as if it were a corporation. Applicable tax laws may also cause debt instruments to be characterised as equity interests for purposes of that determination. As such, it is typical to obtain an opinion of counsel relating to the treatment of the notes issued by the SPE as debt for tax purposes and, depending on the activities of the SPE and the level of comfort provided under such opinions, to include additional transfer restrictions on instruments that are, or could be, equity for tax purposes so as to avoid the SPE becoming taxed as a corporation.
Payments based on US-source income to foreign individuals and corporations are potentially subject to withholding tax. Interest paid or accrued by a typical securitisation SPE to a foreign person will – subject to the satisfaction of certain requirements relating to the investor’s US activities and equity or control person relationship with the SPE and related persons – usually be exempt from withholding tax by virtue of falling within the "portfolio interest" exemption from withholding. In circumstances where that exemption does not apply, the withholding tax could still be reduced or eliminated by virtue of applicable income tax treaties.
In addition, the Foreign Account Tax Compliance Act (FATCA) imposes a withholding tax on certain payments (including interest in respect of debt instruments issued by a securitisation SPE and gross proceeds from the sale, exchange or other disposition of such debt instruments) made to a foreign entity if the entity fails to satisfy certain disclosure and reporting rules. FATCA generally requires that:
Foreign entities located in jurisdictions that have entered into intergovernmental agreements with the USA in connection with FATCA may be subject to special rules or requirements.
Another tax issue that arises in connection with the use of foreign SPE issuers that are treated as corporations for US federal tax purposes is whether the SPE is engaged in a US trade or business for US federal income tax purposes. If a foreign securitisation issuer were to be engaged in US trade or business for US federal income tax purposes, it would become subject to US federal income tax and potentially also subject to state and local income tax. To avoid this outcome, foreign securitisation issuers tend to conduct their activities in accordance with detailed guidelines that are aimed at ensuring that they are not engaged in loan origination or otherwise treated as conducting a lending or other financial business in the USA.
In a securitisation transaction it is common for tax counsel to provide an opinion addressing the tax treatment of the issued securities; in particular, whether the offered notes would be treated as debt securities for US federal income tax purposes. The level of comfort is reflected in terms such as "will", "should" and "more likely than not", where will is the highest level of comfort and should still provide a high level of confidence but with a more than insignificant risk of a different conclusion. It is also common as part of the closing opinions for a securitisation to include an opinion that the securitisation entity would not be taxed as a corporation for federal tax purposes. The latter opinion is frequently also required in the case of certain amendments to the corporate documents.
In the case of foreign SPEs that are treated as corporations for US income tax purposes and that rely on not being taxed in the USA, there are various sensitive activities that could give rise to adverse tax treatment. Because of the significant consequences to the securitisation transaction, the rating agencies tend to require an opinion to the effect that the SPE’s activities would not amount to it engaging in a US trade or business.
The intersection of legal and accounting requirements often plays a significant role in structuring a securitisation transaction. For example, whether, and with whom, to consolidate a securitisation SPE can be a complex analysis that hinges on identifying who controls the aspects of the SPE that most significantly impact the SPE’s performance. This analysis will typically focus on the entities that have the ability to direct the SPE’s activities (and may also look at activities that took place prior to the relevant transaction). While that analysis is not a legal analysis per se, it will involve a review of the various contractual rights existing in the transaction documents.
As such, an awareness of the types of features that drive the consolidation analysis is often important in structuring the SPE and drafting the relevant transaction documents.
Legal and accounting criteria also come together as part of the true sale analysis. One of the requirements for achieving sale accounting for financial assets under US Generally Accepted Accounting Principles (GAAP) is that the transferred financial assets have been isolated from the transferor even in bankruptcy or other receivership, and a part of that analysis looks to the legal true sale analysis.
Under the GAAP accounting rules, “a true sale opinion from an attorney is often required to support a conclusion that transferred financial assets are isolated from the transferor and its consolidated affiliates. In addition, a non-consolidation opinion is often required if the transfer is to an affiliated entity” (ASC 860-10-55-18A), although the opinion may not be required if the accountants are comfortable “that the appropriate legal opinion(s) would be given if requested” (id at 55-18B).
The accounting literature includes commentaries on the legal opinion requirements, including the opinion expressly mentioning each area of continued involvement between an originator and its affiliates and the securitisation SPE. The accounting standards also include a discussion of various types of qualifiers and assumptions that are deemed not to be appropriate for accounting purposes. For example, an opinion assuming that the transfer is a true sale for accounting purposes would have to carve out the legal isolation analysis from such assumption. Consequently, a true sale and non-consolidation opinion delivered as part of a securitisation transaction may receive additional comments from accountants relating to assumptions and qualifications that are viewed as potentially problematic under applicable accounting literature.
Securitisation disclosure requirements are in part governed by generally applicable securities laws, and in part by some ABS-specific requirements. The principal laws that govern securities-related disclosures are the Securities Act of 1933, as amended (the "Securities Act"), and the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Securities Act is the principal law governing the offer and sale of securities, and the Exchange Act provides the SEC with broad powers to regulate various market participants and prohibit certain types of conduct in the market, and empowers the SEC to require certain periodic reporting.
Following the 2007–08 financial crisis (the "Global Financial Crisis"), the Exchange Act has been amended to require certain additional disclosure requirements that apply to all ABS, including:
Registered ABS offerings are subject to additional disclosure requirements as set forth in Regulation AB, which was significantly revised and updated in 2014 ("Reg AB II") to address a number of perceived shortcomings in prior practices and to enhance investor protection in the ABS market. In particular, Reg AB II includes expanded asset-level disclosure requirements for registered offerings of securities backed by specified asset classes that reflects a significant departure from the pool-level information that historically has been given and that is still the dominant form of disclosure in private placements. The information must be published at least three days prior to bringing a covered securitisation to market.
Reg AB II enables the SEC to extend the asset-level disclosure requirements to 144A private placements and to additional asset classes. However, the SEC has to date not done so, and the Treasury has recommended against such expansion.
Reg AB II introduced new ABS-specific registration statement forms, Forms SF-1 and SF-3, to reflect the additional disclosure requirements and shelf-eligibility requirements under Reg AB II. The required asset-level disclosure must be provided in a standardised format in a tagged XML format and filed on the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.
Reg AB II deviates from the typical shelf registration practice of using a base prospectus and a supplemental prospectus, and instead requires the filing of one integrated prospectus.
The general construct of the Securities Act is that an offer or sale of securities has to be registered unless made pursuant to an available exemption; ie, a private placement. A security that has been issued in a private placement will typically be subject to resale limitations that may restrict the liquidity of the issued securities. However, transactions that comply with Rule 144A and Regulation S permit “qualified institutional buyers” and foreign persons to freely sell to other “qualified institutional buyers” or other foreign persons.
Only a small minority of new ABS issuances are made in SEC registered form. About 90% of the US securitisation market consists of mortgage-backed securities that were issued or guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac, and are expressly exempt from registration pursuant to the relevant Congressional act by which such entities were formed. Most of the remaining ABS are issued in private placement, typically in a manner that permits resales in compliance with Rule 144A.
Agency securities and private placements are not subject to ABS-specific disclosure requirements other than the disclosure requirements relating to risk retention, repurchase requests, the third-party due diligence disclosure and rating agency communication requirements. However, such securities offerings generally will look to, and to the extent practicable seek to comply with, the disclosure requirements applicable to registered offerings. However, asset-level disclosures of the level of detail required in Reg AB II offerings are not commonly included in private placements.
The Dodd–Frank Act introduced a mandate to the SEC and the bank regulatory agencies to promulgate rules requiring “securitisers” to retain credit risk, which are codified in the relevant sections for the relevant banking regulator (12 Code of Federal Regulations (CFR) part 43 for the Office of the Comptroller of the Currency, 12 CFR part 244 for the Federal Reserve System, 12 CFR part 373 for the Federal Deposit Insurance Corporation (FDIC), 12 CFR part 1234 for the Federal Housing Finance Agency and 12 CFR part 373 for the SEC (the latter also referred to as “Regulation RR”)).
The Risk Retention Rules require a “sponsor” or one of its “majority-owned affiliates” to retain the required risk exposure in one of the prescribed forms under the rules. For most securitisations, risk retention may take any of three standard forms:
The person required to retain the risk is the “sponsor”, defined as a “person who organises and initiates an asset backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer”, a phrase that is substantially identical to the definition of sponsor under Regulation AB.
Notably, the DC Court of Appeals ruled in 2018 that subjecting managers of open-market CLOs to the Risk Retention Rules exceeded the statutory authority under Section 941 of the Dodd–Frank Act and consequently such CLOs are currently not subject to the risk retention requirements.
The Exchange Act allocates enforcement authority for the risk retention rules to the appropriate federal banking agency with respect to any securitiser that is an insured depository institution and the SEC with respect to any other securitiser.
Penalties for Non-compliance
The Federal Deposit Insurance Act (FDIA) provides the bank regulatory agencies with broad enforcement powers against individuals and entities for violation of the applicable banking laws and regulations, including the Risk Retention Rules. As such, the banking agencies may seek cease-and-desist orders requiring cessation and potential corrective actions. The agencies may also impose civil monetary penalties that can range between USD5,000 and USD1 million per day, and it may seek to impose removal and prohibition orders against any “institution-affiliated party” (a potentially broad list of persons), which may remove and potentially bar the person from participating in the business of the relevant banking entity or other specified entities.
The SEC’s enforcement authority and remedies for violations of the Risk Retention Rules would be the same as its general enforcement authority against those for violation of securities laws and regulations and their “control persons”, including permanent or temporary cease-and-desist orders, fines, withdrawal of registrations and restrictions on acting as officers or directors of SEC registered companies and otherwise may strip a person or entity of privileges afforded to registered persons. Any Exchange Act violation could also result in equitable remedies, including the right of rescission. If the violation of the Risk Retention Rules also amounts to a disclosure violation, there could be separate SEC or private action on that basis, as discussed in 4.2 General Disclosure Laws or Regulations.
Wilful violations of the Risk Retention Rules may also give rise to federal or state criminal actions.
The sponsor must file Form 15-G on EDGAR at the end of any quarter in which there has been a repurchase demand made under the transaction documents for breach of representations and warranties. If there have been no such requests, an annual Form 15-G filing must be made certifying to that fact.
Issuers of securities offered and sold in a registered offering, and issuers with assets in excess of USD10 million at fiscal year end and a class of securities (other than exempted securities) held by more than 2,000 persons (or more than 500 persons that are not accredited investors) may be subject to additional reporting requirements, including:
Given that privately placed ABS are not likely to be so widely held that these requirements are triggered, they will, as a practical matter, only apply to securities sold in a registered offering.
Registered rating agencies, referred to as NRSROs, are regulated by the SEC. Sections 15E and 17 of the Exchange Act and the rules promulgated thereunder establish a detailed set of records that must be created and disclosed to the SEC, and mandate that some of this information must be made publicly available free of charge, including the assigned credit rating and any subsequent upgrade or downgrade.
An NRSRO must:
Exchange Act Rule 17g-5 divides conflicts of interest into two categories:
As part of the conflict rules in 17g-5, an NRSRO is required to obtain a representation from the issuer, sponsor or underwriter of an asset-backed security that it will post on a real-time basis information any of them provides to any hired NRSRO in connection with the initial credit rating or subsequent credit surveillance to a password-protected website. The purpose is to allow NRSROs that have not been hired to have access to the same information in real time that is provided to the hired NRSROs.
Rule 17g-7 provides further transparency by requiring the NRSRO to prepare and disclose a comparison of the asset-level representations, warranties and enforcement mechanisms available to investors that were disclosed in the offering document for the relevant ABS and how they differ from the corresponding provisions in other, similar, securitisations.
The SEC has the power to enforce its rules. Penalties for violating the rules can include suspension or revocation of an NRSRO’s registration if the SEC makes a finding under certain specified sections of the Exchange Act that the NRSRO violated the conflicts of interest rule and the violation affected a credit rating.
The US bank regulators have generally implemented the Basel III capital and liquidity rules but with some important distinctions. The US bank capital rules distinguish between “traditional” and “synthetic” securitisations, each with different operational requirements.
The Basel III definition of securitisation is tied to a tranched exposure to a “pool” of underlying exposures. The corresponding rules as implemented in the USA also refer to tranched credit risk, but do not include the pool requirement.
The minimum risk weight that will be given to a securitisation exposure is 20%. Resecuritisations are subject to separate risk weight calculations.
The USA also does not include ABS among high-quality liquid assets (HQLA) in which a bank may invest to cover for its projected net cash outflows over a 30-day period (in the case of the liquidity coverage ratio).
Insurance companies’ capital requirements are subject to state regulation. The National Association of Insurance Commissioners (NAIC) has adopted a risk-based capital (RBC) methodology intended to be a minimum regulatory capital standard based on the insurance company’s risk profile and is one of the tools that give regulators legal authority to take control of an insurance company.
The specific RBC formula varies depending on the primary insurance type and focus on asset risk, underwriting risk and other risk. The formulae are focused on capturing the material risks that are common for the particular insurance lines of business.
The NAIC has its own credit rating scale that largely ties to ratings from NRSROs, except for an alternative methodology applied to non-agency RMBSs and CMBSs. As such, the mapping of ABS assets to a NAIC rating will often dictate the attractiveness of a particular asset-backed security for an insurance company.
Title VII of the Dodd–Frank Act establishes a comprehensive regulatory framework for OTC derivatives to address a number of aspects of OTC derivatives that were identified as causing vulnerabilities in the financial system; in particular, the complexity, lack of transparency and interconnectivity of the OTC market and the lack of consistent margin requirements. This framework is built around the principles of:
In addition, Title VII imposes registration, oversight and business conduct standards for dealers and large participants in the derivatives market.
The regulatory authority is primarily divided between the CFTC and the SEC, with the US banking regulators setting capital and margin requirements for banks. The CFTC has authority over most OTC derivatives, referred to as “swaps” in the Commodity Exchange Act (CEA), whereas the SEC has authority over OTC derivatives that fall within the Exchange Act definition of “security-based swaps”, which covers derivatives linked to single-name loans or securities, narrow-based indexes of loans or securities, or events relating to such loans or securities, or their issuers. The Dodd–Frank Act had the effect of causing swaps to be included in the definition of “commodity pool” under the CEA and under the definition of “security” for purposes of the Securities Act and the Exchange Act.
The industry has been focused on obtaining permanent relief against those aspects of the new regulations that are particularly burdensome for securitisation SPEs.
For example, the CFTC has issued no-action letters exempting from the definition of commodity pool certain securitisation entities that are operated consistent with SEC Regulation AB or Investment Company Act Rule 3a-7. To be eligible for the relief provided under these no-action letters, the securitisation issuer must:
The CFTC has also issued various interpretations that allow certain securitisation SPEs that are wholly owned subsidiaries of non-financial entities to avail themselves of certain exceptions from otherwise applicable clearing and margin requirements available to non-financial end users.
It is also worth noting that the non-recourse language typically included in agreements with SPEs, including derivative agreements, would cause such derivatives to fall outside the standard terms for derivatives that are currently centrally cleared and traded, although that may change should swaps with such terms be included as part of a traded standard.
Finally, the SEC has proposed, but not finalised, conflict of interest rules intended to address conflicts of interest inherent in synthetic securitisations that would have made such securitisations impracticable in many circumstances.
Enforcement and Penalties for Non-compliance
Violations of rules pertaining to security-based swaps promulgated by the SEC will be subject to similar enforcement and penalties as other violations of securities laws, as discussed in 4.2 General Disclosure Laws or Regulations. Violations of the “swaps” rules promulgated by the CFTC will be subject to enforcement and penalties by the CFTC. Furthermore, the CFTC’s authority to penalise manipulation and fraud is similar to the SEC’s authority under Section 10(b) of the Exchange Act.
In addition, the CFTC has anti-avoidance authority to treat as swaps transactions that are wilfully structured to evade the requirements of the Dodd–Frank Act and to bring enforcement actions where such transactions fail to satisfy applicable criteria. Furthermore, the attorneys general of the various US states and territories also have certain authority to bring enforcement actions under Section 13a-2 of the CEA where their citizens are adversely affected. The penalties range from injunction or restraining orders, writs or orders mandating compliance, to fines. The CFTC can also impose equitable remedies, including restitution and disgorgement of gains. Wilful violations and abuse of the end-user clearing exception are felonies punishable by a fine of up to USD1 million or imprisonment for up to ten years, or both, together with cost of prosecution (see CEA Section 13).
The primary investor protections follow from the general and specific securities laws described in this chapter. As noted above, transactions that violate the securities laws may be voidable and may give rise to both private and public enforcement.
Banks are highly regulated entities and are also subject to a separate insolvency regime compared to other entities and they are therefore not eligible for bankruptcy protection. The comprehensive regulation applicable to banks results in a parallel regulatory structure in the context of banks sponsoring securitisations that will apply to certain aspects of a securitisation transaction by banks. The most relevant of the securitisation-specific rules are:
The banks are also subject to risk retention but the rules are the same as those applicable to non-banking entities. General banking rules may also come into play when structuring a bank-sponsored securitisation, such as restrictions on affiliate transactions set forth in Sections 23A and 23B of the Federal Reserve Act and the implementation thereof set forth in Regulation W.
Organisational Forms of SPEs Used in Securitisations
SPEs used in securitisations can theoretically take almost any organisational form, including a limited liability company, a corporation, a trust or a partnership. However, as a practical matter, SPEs organised in the USA overwhelmingly tend to be organised as a limited liability company or a statutory trust. For certain asset classes it is also typical to use securitisation SPEs organised as foreign corporations in a jurisdiction that does not impose entity-level tax on such corporations. The rules governing such entities will be a combination of:
Factors in Choosing an Entity
The primary factors driving the type and jurisdiction of the securitisation entity will be bankruptcy remoteness and tax. Other important factors include market practice and acceptance. As outlined earlier, common law trusts are disfavoured compared to statutory entities for bankruptcy-remoteness purposes in light of the separate existence afforded to such statutory trusts. US domestic corporations are generally disfavoured, in part because of the entity-level tax applicable to corporations and in part because of the mandatory fiduciary duty that directors have to the shareholders, which can cause difficulties in delinking the SPE from its parent.
Delaware statutory trusts (DSTs) and Delaware limited liability companies (DLLCs) are often the entities of choice for securitisations. Delaware is viewed as a favourable jurisdiction for forming business entities. Delaware has up-to-date business entity laws that provide for efficient and quick formation, a sophisticated judiciary and a significant volume of decisions that together provides additional certainty and acceptance.
Investment Company Act
As a point of departure, any entity of which more than 40% of its relevant assets (ie, excluding cash or US Treasuries) consists of securities within the meaning of the Investment Company Act (a broad term that includes loans) may have to register as an investment company absent an available exemption. Registered investment companies are subject to leverage and capital structure requirements that are incompatible with a securitisation.
The exemptions most commonly used for securitisations are Rule 3a-7, Section 3(c)(5) and Section 3(c)(7). Rule 3a-7 is available for entities holding primarily self-liquidating assets that are only sold or purchased in accordance with the terms of the transaction, and not for the purpose of capturing market gains or avoiding market losses. The securitisation must also satisfy some additional requirements, including having a trustee with certain minimum qualifications holding either title or a security interest in the assets and investors in securities that are either below investment grade or not fixed-income securities must satisfy certain qualification requirements.
The Section 3(c)(5) exemption is available for issuers securitising accounts receivable, loans to manufacturers, wholesalers, retailers or purchasers of specified merchandise, insurance or services, as well as for mortgages and other liens on and interests in real estate as long as a holder of any such issuer’s securities does not have the right to require early redemption of such securities.
Section 3(c)(7) provides a general registration exemption for issuers that do not publicly offer their securities and limits their investors to “qualified purchasers”. The Volcker Rule discussed below has made it less attractive for securitisation SPEs to rely on Section 3(c)(7), although the exemption is still relied on by actively managed CLOs.
The Volcker Rule prohibits banks from holding an “ownership interest” in, or sponsoring entities that are, “covered funds” for purposes of the Volcker Rule. Ownership interest is a broad term that captures, amongst others, any security with equity-like returns or voting rights (including the right to replace the investment manager, which is typically a right of the senior-most class of investors in the event of such manager’s default). Consequently, in order to be attractive to banks, securitisation entities tended to avoid becoming a “covered fund” under the Volcker Rule. This may change based on the most recent amendments to the rule, which, effective 1 October 2020, clarify that a right to remove an investment manager for “cause” (as defined in the rule) is not an ownership interest.
The covered fund definition only captures entities that would have to register under the Investment Company Act but for the exemption set forth in Section 3(c)(7) or 3(c)(1), or that are commodity pools for which the commodity pool operator has claimed an exemption from registration and record-keeping requirements pursuant to Section 4.7 of the CEA, or that are “substantially similar” commodity pools. Consequently, the traditional means of addressing the Volcker Rule has been to avoid relying on any of these exemptions. If that strategy is not available, there are a number of potential exclusions from the covered fund definition in the Volcker Rule itself, of which the “loan securitisation” exemption is most important in the securitisation context.
While “loans” is a broad term for the purposes of that exclusion, there are significant limitations on an SPE's ability to hold derivatives (other than for the purposes of hedging interest and currency risk) and securities (other than for certain short-term cash-management purposes). However, the recent October amendments to the Volcker Rule allow for a small bond basket, thereby removing one of the restrictions that have prevented CLO managers from engaging in a bond/loan arbitrage that was popular prior to the promulgation of the Volcker Rule.
The most typical credit enhancements include over-collateralisation, subordination of junior tranches, cash reserves and excess yield on the underlying assets compared to what is needed to service the asset-backed fixed-income securities. The exact levels and types of credit enhancement will depend on the ratings requirements relating to the desired ratings levels, in addition to commercial constraints on the securitisation.
Some securitisations also include liquidity facilities that can be used to service the outstanding securities during periods of liquidity shortfalls. These can be provided by third-party liquidity providers or as part of the servicing rights and obligations.
Ginnie Mae, Fannie Mae and Freddie Mac are the principal agencies and government-sponsored entities (GSEs) engaged in the securitisation of mortgages. Ginnie Mae does not itself issue MBSs, but instead provides a guarantee, backed by the full faith and credit of the US government, of securitisations by participating institutions of government-insured mortgages.
Fannie Mae and Freddie Mac are GSEs chartered by Congress for the purpose of providing a stable source of liquidity for the purchase and refinancing of homes and multi-family rental housing. These GSEs purchase loans that satisfy their origination criteria and issue securities backed by pools of such loans that are guaranteed by the relevant GSE. In addition, the GSEs issue some risk transfer securitisations that are not guaranteed.
The GSEs traditionally used separate, but similar, platforms to issue their pass-through securities. Starting 3 June 2019, they have transitioned to a single security and single securitisation platform initiative referred to as Uniform Mortgage-Backed Securities (UMBSTM). The agency securitisation model and the related guarantees allow investors to focus primarily on the payment characteristics of the underlying pools of mortgages rather than the credit risk. In turn, this has allowed for the emergence of a highly liquid "to-be-arranged (TBA) market", where pools of MBSs are deemed to be fungible, and traded, on the basis of a few basic characteristics, such as the issuer, amortisation type (eg, 30 years or 15 years), the coupon rate, the settlement date and the maximum number of mortgage securities per basket.
There is a liquid TBA market for settlement up to three months after the trade date. The actual information about the pool only needs to be provided two business days prior to settlement. As such, the TBA market permits lenders to lock in rates for mortgages before they are originated, which, in turn, allows borrowers access to lower, locked-in rates.
Agency securitisations represent the biggest part of the securitisation market by far.
Investors in securitisations include banks, asset managers, insurance companies, pension funds, mutual funds, hedge funds and high net worth investors. A detailed description of the regulatory and other investment drivers for each of these diverse investor classes is beyond the scope of this summary; however, a few points that affect the structuring and offering of ABS are worth noting. For example, the Basel III capital rules penalise banks that invest below the senior-most position in a securitisation, thereby impacting banks’ willingness to invest in mezzanine tranches and below.
Banks that are primarily constrained by the leverage ratio, as compared to the risk-weighted assets (RWA) ratio, will also typically view highly rated, but lower-yielding, senior securities as less attractive investments, whereas insurance companies and banks that are primarily constrained by the RWA requirements may find the highly rated senior tranche highly attractive due to the small amount of regulatory capital required. Furthermore, FDIC-insured banks may face higher insurance premiums for taking on exposures in securitisations collateralised predominantly by sub-prime and other high-risk assets, which reduces the attractiveness of such securitisations.
Insurance companies’ capital rules typically are more closely tied to ratings. In addition, insurance regulations typically specify concentration limits for various categories of investments. Insurance companies are also often focused on obtaining longer-duration assets. The flexibility to structure securitisations to such needs often makes securitisations particularly attractive to insurance companies.
The typical items of documentation used to effectuate bankruptcy-remote transfers are:
As noted above, title is not dispositve of ownership, nor is it necessary for the consideration to be in the form of cash. Contributions to SPEs in exchange for a corresponding increase in the value of any equity held in such SPE would typically also be good consideration. The key is for the relevant documentation to satisfy the true sale criteria discussed in 1.1 Insolvency Laws (clear identification of sold asset, arm's-length price, representations and warranties as of time of transfer, provisions to ensure perfection of transfer, indemnification and limiting repurchase and indemnification obligations consistent with true sale, specifying the intent to treat the transaction as a sale, and, if applicable, a back-up security grant consistent with true sale).
Participation agreements will also typically include provisions relating to a participation buyer’s ability to give consent and otherwise participate in voting actions relating to the underlying asset, as well as "elevation rights" that establish when either party to the participation can call for reasonable efforts to effectuate a full assignment of title. The FDIC has promulgated non-exclusive safe harbour provisions for participations involving covered banking entities in 12 CFR 360.6 that, if complied with, provide additional comfort that the FDIC, when acting as conservator or receiver, will respect such participations as an assignment.
The typical representations and warranties in the sale agreement address:
The typical enforcement mechanism is notice and indemnification obligations, coupled with a repurchase obligation in the case of a breach of any asset-level representation that has not been cured in a timely manner. Typically, the power to exercise such rights and remedies is given to the trustee with provisions that entitle the trustee to obtain directions backed by indemnification. In private deals, the investor vote required for certain actions is primarily a negotiated point, although in registered securitisations these requirements are more prescribed. For example, Reg AB II specifies that the transaction documents cannot require more than 5% of the principal amount of notes to direct the trustee to exercise its remedies.
Typical perfection provisions include:
There may also be additional representations relating to the nature and characteristics of the relevant assets. In some instances the perfection representations relating to chattel paper may also call for the original being marked as pledged to the trustee to reduce the risk that a third-party acquirer obtains possession without actual knowledge of the prior security interest.
The principal covenants in a securitisation transaction vary, based on the relevant document and the type of securitisation. The covenants will typically address payment obligations, collateral maintenance and perfection obligations, rights and related procedures concerning adding and removing underlying assets, reporting obligations, and various negative covenants intended to maintain the integrity of the securitisation. In addition, there will typically be separate covenants relating to the trustees’ obligations to act and rights not to act in accordance with instructions.
Enforcement is usually a combination of events of default under the indenture, which gives the noteholders the right to direct the indenture trustee to take enforcement actions, and servicer defaults, which give the specified class or classes of noteholders rights to replace the servicer.
The servicing provisions generally relate to continued collection and servicing of the relevant asset and typically include a number of provisions relating to reporting, notice and turnover of collections. In securitisations with revolving periods during which there is a constant replenishment period, the servicer will also typically be required to ensure compliance with applicable pool criteria and provide relevant reports in connection with any collateral removal, additions or substitutions. In addition, for some securitisations, there will often be certain obligations around the delivery of reports and other relevant information to a back-up servicer. The agreement will also often contain provisions that define the servicing standard and further addresses the relevant role and any additional obligations of the servicer.
Where the securitisation involves securities within the meaning of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), such as CLOs, and involve more active or discretionary management of the collateral, the agreement would also typically address requirements and prohibitions under the Advisers Act and rules promulgated thereunder. In CLOs the servicing agreement is typically referred to as a Portfolio Management Agreement, Collateral Management Agreement or Investment Management Agreement (or similar term).
Securitisation transactions often have three types of default provisions:
Amortisation events typically include:
Events of default usually include:
Servicer defaults or termination events typically include:
Principal indemnities cover losses due to a breach by the seller or servicer of their obligations. In addition, it is typical for trustees to be entitled to indemnification under the transaction for any losses and liabilities that may arise other than as a result of their own gross negligence or wilful misconduct and the trustee will also be entitled to indemnification in connection with any directions given by noteholders.
Issuers are typically SPEs that are restricted from engaging in activities unrelated to the securitisation.
Sponsors are typically in the business that generates the relevant underlying receivables or other financial assets and also will typically organise and initiate the ABS transaction and engage in selection of the relevant assets. The sponsor is responsible for compliance with risk retention and other relevant regulatory requirements.
Underwriters (including initial purchasers in a 144A transaction) and placement agents are registered broker-dealers responsible for placing the ABS. In some securitisation transactions they are also responsible for establishing and preparing the relevant securitisation structure and documentation.
Servicers are typically the sponsor or an affiliate of the sponsor. The servicer will typically be responsible for collecting payments under, and ensuring that the issuer complies with, the obligations relating to the collateral. In some securitisations, such as CLOs, the servicing role may be quite active, consisting of purchasing and selling relevant assets, participating in any workouts as required and otherwise managing the collateral in accordance with the terms of the transaction. The servicer typically also produces periodic reports and interfaces with the trustee to ensure the correct application of funds in accordance with the applicable priority of payments waterfall.
Investors constitute a diverse group. In a typical securitisation the investors will have a right to payment and investors will also have certain rights to direct the trustee to take enforcement actions, and the controlling class of noteholders will thereafter have enhanced ability to direct the trustee in accordance with the terms of the transaction documents.
Typically, investors will not have responsibilities per se, although investors may be subject to certain deemed representations relating to their eligibility to invest in the securitisation. Investors in unfunded ABS tranches will typically have contingent funding obligations and may be required to provide additional credit support or face replacement if their credit drops below agreed levels.
Indenture trustees act on behalf of noteholders and typically also act as trustees for the collateral. Owner trustees typically act on behalf of the holders of any trust certificates issued by an issuer trust (if applicable). Trustees typically have a security interest in the underlying pledged assets and act as communications and payment agents. The trustees also undertake other specified administrative tasks, but typically avoid taking any discretionary actions other than pursuant to a direction from the relevant noteholders.
The trustees tend to be large banking associations that satisfy relevant regulatory and ratings agency criteria such as requirements under the Trust Indenture Act (for registered ABS issuances) and as required by Investment Company Act Rule 3a-7, where the issuer relies on that exemption.
Synthetic securitisations are permitted. The Dodd–Frank Act added a new Section 27B to the Securities Act intended to address certain conflicts of interest that, if implemented, could create significant hurdles for synthetic securitisations. However, Section 27B requires implementing rules to be passed within 270 days and to date, no such regulations have been put in place. The SEC launched a proposed set of rules in 2011, but since these rules would effectively have ended synthetic securitisations, they were never finalised.
The SEC regulates the offer and sale of securities issued by a synthetic securitisation and the issuer’s Investment Company Act exemptions are the same as in a traditional securitisation. The derivatives underlying such securitisation are regulated by the SEC if they reference a single security, a single loan or a narrow-based security index and by the CFTC if they are deemed to be swaps (in which case the SPE may also be a commodity pool).
Principal Laws and Regulations
The offering of securities in a synthetic securitisation will be governed by the Securities Act. The SEC has generally indicated that CDSs, the most common type of derivative used in synthetic securitisations, are not self-liquidating financial assets. Consequently, it may be possible to conclude that the payments to the holders of the issued securities do not depend primarily on the cash flow from self-liquidating assets, in which case the issued securities fall outside the “asset-backed security” definition in the Exchange Act, which would mean that risk retention and certain other rules applicable to asset-backed securities would not apply. The nature of the CDS may also impact the Investment Company Act analysis for the issuer.
As noted above, both the SEC and the CFTC have comprehensive regulations around entering into derivatives and such instruments may be subject to clearing, settlement and margin requirements specified in the securities acts and the Commodities Exchange Act.
In its simplest form, a synthetic securitisation will invest the proceeds from issuing securities in permitted investments and sell CDS protection on a particular financial asset. The issuer will receive cash flows from the permitted investments and the CDS protection premiums. If a credit event occurs under a CDS, then the SPE will fund its payment obligation with proceeds from the permitted investments.
According to data provided by the Securities Industry and Financial Markets Association (SIFMA), the most commonly securitised financial assets are:
Common structures used for the various types of securities outlined above include the following.
These are used in agency-guaranteed securitisation and are described in more detail in 4.13 Participation of Government-Sponsored Entities.
Double SPE Structures
In this structure, one SPE acts as the depositor (typically structured as an LLC) and the other SPE is the issuer (typically structured as a trust). It is typically used for retail auto loans, equipment leases, student loans, consumer loans and a number of other asset classes. The issuer trust will typically issue notes to investors and trust certificate(s) to the depositor.
To the extent such securitisations are registered, they have to comply with the Reg AB II requirements described in 4.1 Specific Disclosure Laws or Regulations and otherwise the general disclosure requirements described in 4.2 General Disclosure Laws or Regulations apply.
Student loans originated under the Federal Family Education Loan Program (FFELP) benefit from a government guarantee and securitisations of such loans will therefore have a reduced risk retention requirement of between 0 and 3% depending on the level of the guarantee.
Titling Trust Structures
This structure is typically used in auto lease securitisations and other lease transactions relating to titled goods. A titling trust is established to originate the lease and hold title to the leased assets. Instead of selling the assets and leases to be securitised to a particular issuer, the titling trust segregates such leases and assets, and issues special units of beneficial interests (SUBIs) that represent the interest in such segregated pool. The structure is otherwise typically similar to the two-tier structure described above. The issues and regulations are similar to the general securitisation structure in double SPE structure securitisations, but the titling trust may require additional analysis for purposes of the Investment Company Act exemption compared to the other entities in the structure.
Master Trust Structures
These are typically used in dealer floor plan securitisations and credit card securitisations. The credit from the master trust is revolving in the sense that as the dealer inventory is sold or the credit card customer repays their balance, as applicable, funds are paid to the master trust. These funds are used to service interest and principal on the issued securitisation notes and are otherwise available to acquire new receivables or loans, as applicable.
The structure allows for multiple series of securities to be issued that all share in assets of the master trust. Each series of notes typically has a revolving period during which no principal is paid on the notes, with the notes paying down once the amortisation period starts. The structure also allows for some series to be in their revolving period while other series are in their amortisation period. The master trust receives the proceeds from the repaid loans and uses those proceeds in part to pay interest and principal on the issued notes.
The CLO is actively managed and will acquire and maintain a diversified pool of underlying loans that is managed to conform to a number of concentration limits for the pool, with the goal of maximising return while maintaining the required pool diversification and other relevant transaction criteria. The CLO is actively managed. As noted in 4.11 Activities Avoided by SPEs or Other Securitisation Entities, this has impacts on the Investment Company Act and Volcker Rule analysis.
Open-market CLOs will not be subject to US risk retention requirements, as discussed in 4.3 Credit Risk Retention. The CLO issuer will typically be organised as a Cayman Island company and structure its loan acquisitions in a manner that avoids it being engaged in any US trade or business, as discussed in 2. Tax Laws and Issues.
While the overall ABS market dropped in the first part of the pandemic, with credit cards and CLOs experiencing the largest percentage decline, other asset classes such as student loans and agency MBSs and CMOs increased. These asset classes were buoyed by a number of COVID response programmes, including the CARES Act, which stabilised consumer spending. At the same time, the CARES Act provided a number of provisions protecting consumers against evictions and negative credit reporting and establishing various forbearance provisions, and a number of states passed similar laws that created new challenges for any actual or potential enforcement. In addition, some states pressured creditors to provide such forbearance and foreclosure limitations without outright requiring creditors to do so as a matter of law. Such restrictions and governmental pressure created a basis risk for securitisation issuers, since granting forbearance potentially would cause adverse treatment of such financial assets under the securitisation’s eligible assets and borrowing base determinations.
In other asset classes – in particular, CLOs – workout specialists sought to take advantage of the limitations on eligible assets in the applicable securitisation documentation by structuring workouts of the underlying assets in a manner that would result in distribution of assets or securities that were not permitted to be held by the relevant securitisations, with the plan of acquiring such assets when the ABS issuer was forced into a sale of the impermissible assets. However, in the CLO space, many of the CLOs managed to amend their structure to permit them to hold a broad range of securities issued in a debt restructuring.
New Assets Being Securitised
For many industries, such as retail and travel (in particular, airlines and cruise ships), the pandemic had a significant adverse impact on the liquidity of operating companies. For some of these companies, securitisation techniques provided a means to raise additional debt using assets that were not commonly securitised, such as frequent-flyer programmes. Such programmes produce significant cash flows from co-branding arrangements, and by appropriately isolating and securitising the miles programme assets, airlines have been able to access the investment-grade market despite the difficulties the airlines have been facing during the pandemic.
Securitisation techniques have even been used to finance retail inventory during times when retail stores were closed due to pandemic shutdowns. Common for many of these securitisation structures was structuring the securitisation such that if the sponsor were to become subject to Chapter 11 bankruptcy, the sponsor would still be highly likely to continue to perform its obligations as they related to the securitisation transaction. Such securitisation structures often combine assets that are critical to a company’s successful reorganisation in Chapter 11 with the use of arrangements such as intellectual property licences and real estate leases, for which the Bankruptcy Code provides protections to the licensee or lessee, or other arrangements that permit the securitisation to continue to operate despite the sponsor’s bankruptcy and despite the sponsor’s continued operation being central to the deal continuing to perform.
The pandemic has, so far, not caused material new permanent regulation or legislation for securitisations. However, a number of temporary programmes and regulations helped stabilise the market, including securitisations. For example, the Federal Reserve dusted off many programmes developed during the 2008–09 financial crisis, such as the Term Asset-Backed Securities Loan Facility (TALF) programme established by the US Treasury and the Federal Reserve, which provided an important backstop for several asset classes.
The announcement of the revival of TALF injected significant confidence in the market, even though the first TALF loans were not made until several months later. Under the revived TALF programme, a special-purpose entity funded by the US Treasury and the Federal Reserve would make up to USD100 billion in non-recourse loans with up to three-year maturity, secured by eligible ABS, as a funding backstop to eligible borrowers. TALF-eligible asset classes were:
Notably absent from TALF were unsecured consumer loans and the ability for TALF to backstop actively managed CLOs.
During the recovery years after the financial crisis of 2007–08, market participants spent a large amount of time and energy responding to significant legislative and regulatory developments. These included revisions to Regulation AB (the regulatory framework for registered public offerings of ABS), which is commonly known as Regulation AB II, and the rule-making required under the Dodd–Frank Wall Street Reform and Consumer Protection Act (the "Dodd–Frank Act"), such as US credit risk retention rules, the Volcker Rule (which generally prohibits certain banking entities from having ownership interests in covered funds and from engaging in proprietary trading), the nationally recognised statistical rating organisation (NRSRO) due diligence rules (which impose pre-pricing filing requirements in respect of third-party due diligence reports received in connection with public and private deals rated by NRSROs) and the repurchase demand reporting rules (which require ongoing filings describing pool asset repurchase demand activity for public and private deals).
Following the 2016 presidential election, federal rule-making momentum dissipated, with only modest changes to the regulatory framework for securitisations. It remains to be seen what direction the federal regulators will take with the Biden administration.
2022 should see a continued strong focus on planning for, and the implementation of, the transition from the use of LIBOR to another interest rate reference index. In the USA, the Alternative Reference Rate Committee (ARRC), which was formed in 2014 by the Board of Governors of the Federal Reserve System (the "Federal Reserve") and the Federal Reserve Bank of New York (the "New York Fed"), has recommended the Secured Overnight Financing Rate (SOFR) as its preferred alternative to LIBOR for many purposes, including securitisations. In addition, 2022 will likely see additional regulatory action by federal and state authorities, including further guidance regarding intended interpretations of recent regulatory and legislative initiatives.
Rule 15c2-11 under the Securities Exchange Act of 1934 (the "Exchange Act") regulates the publication of quotations in OTC markets. This rule allows brokers or dealers to initiate or resume trading quotes on OTC securities not listed on a national securities exchange by requiring them to obtain and review specified issuer information prior to publishing or submitting for publication a quotation on the securities. Until recently, Rule 15c2-11 has always been understood by market participants to apply only to equity securities.
The SEC adopted amendments to Rule 15c2-11 that became effective in September 2021 to, among other things, “provide greater transparency to investors and other market participants by requiring that information about the issuer and its security be current and publicly available before a broker or dealer can begin quoting that security”. During the amendment process, it came to the attention of market participants that the SEC was taking the position that the rule applies, and has always applied, to fixed-income securities.
There are a number of difficulties with applying Rule 15c2-11 to fixed-income securities, and particularly to ABS. Before quoting a security, the broker or dealer must review a number of items of specific information, which is required to be “current and publicly available”. An issuer’s most recent annual report filed under the Exchange Act or, for an issuer that has not yet filed an annual report, the prospectus from its registration statement under the Securities Act of 1933 (the "Securities Act"), together with any subsequent Exchange Act periodic reports, suffices. Therefore, the rule should not pose an issue for registered ABS sold after the effectiveness of the post-crisis changes to Rule 15d-22(b) that require ABS reporting for the “life of the deal”.
Otherwise, among the items of the required information are the issuer's most recent balance sheet (as of a date less than 16 months before the publication or submission of the quotation) and statements of profit and loss and retained earnings (for the 12 months preceding the date of the most recent balance sheet), and similar financial information for the part of the issuer’s preceding two fiscal years that it has been in existence. ABS issuers generally do not prepare financial statements. The rule specifies a number of other items of required information that are not as troublesome, but that generally are not made publicly available for issuers of securities that were not registered under the Securities Act, whether made under Rule 144A or otherwise. (Rule 144A(A)(4) requires a holder or prospective purchaser of securities to have the right to receive, upon request, certain information about the issuer and the securities, but this information need not be made public.)
In response to feedback from industry groups, the SEC issued a no-action letter in September 2021 stating that it would not take enforcement action against those that did not comply with Rule 15c2-11 with respect to fixed-income securities (including ABS) until 3 January 2022. However, this letter reaffirmed the SEC’s stated view that “[s]ince its original adoption in 1971, [Rule 15c2-11] has applied to all securities including fixed income securities except for ‘exempt securities.’” Broad application of the rule appears to be a priority of some commissioners, though others have acknowledged the difficult position in which the fixed-income industry finds itself.
After further input, the SEC issued a replacement no-action letter in December 2021. The letter focuses not, as many in the industry had hoped, on exempting ABS or other fixed-income securities, but on establishing a tiered set of compliance dates in an effort to allow brokers and dealers time to bring themselves into compliance.
Phase 1 extends from 3 January 2022 through 3 January 2023. During Phase 1, the SEC staff will not take enforcement action against a broker-dealer that publishes, or submits for publication, quotations for fixed-income securities if the broker-dealer reasonably has determined that the security or its issuer meets one of several criteria, or there is “current and publicly available financial information (consistent with Rule 15c2-11(b)) about the issuer". Among the reasonable determinations that qualify for Phase 1 relief are the following.
Phase 2 extends from 4 January 2023 through 4 January 2024. During Phase 2, the SEC staff will not take enforcement action against a broker-dealer that publishes, or submits for publication, quotations for fixed-income securities if the broker-dealer reasonably has determined that the security or its issuer meets one of a narrower list of specified criteria, or (again) there is “current and publicly available financial information (consistent with Rule 15c2-11(b)) about the issuer". Phase 2 retains the option for reporting issuers but deletes the option for securities offered under Rule 144A, leaving all non-registered ABS to rely on the provision for securities where there is current and publicly available 15c2-11(b) information about the issuer.
Phase 3, the final phase, begins on 5 January 2024. During Phase 3, the SEC staff will not take enforcement action against a broker-dealer that publishes, or submits for publication, quotations for fixed-income securities if the “security qualifies for Phase 2 and... there is a website link, on the quotation medium on which the security is being quoted, directly to the current and publicly available information about the issuer (consistent with Rule 15c2-11(b)), provided that the broker or dealer has determined at least on an annual basis that the website link and its underlying information is current". Thus, Phase 3 differs from Phase 2 only in so far as it not only requires the applicable information to be publicly available, it requires the information to be capable of being linked, and actually linked, from the broker’s or dealer’s quotation.
In sum, Rule 15c2-11 does not appear to pose problems for brokers or dealers desiring to quote registered public ABS, so long as they are currently reporting. Brokers or dealers may continue to quote Rule 144A ABS without further restriction until 3 January 2023, but the extent to which broker-dealers will be comfortable continuing to participate in those offerings when a known issue could impact their liquidity starting on that date is not clear. In the view of the authors, brokers and dealers may quote Rule 144A ABS after that date if the issuer undertakes to make the required Rule 144A information publicly available and to keep it current, though the extent to which other ABS industry participants share this view is uncertain. The path forward for ABS offered under other exemptions from registration is less clear.
Valid when made
The case Madden v Midland Funding, LLC, decided in May 2015 by the United States Court of Appeals for the Second Circuit – which encompasses federal courts sitting in the States of New York, Connecticut and Vermont – disrupted the securitisation industry by ruling that the purchaser of a defaulted loan was not entitled to rely on Section 85 of the National Bank Act (NBA). This affected national banks and federally chartered savings and loan institutions (and, by implication, Section 27 of the Federal Deposit Insurance Act (FDIA), which is applicable to state-chartered banks and financial institutions). If that ruling applied broadly to all third-party purchasers (including securitisation trusts), third-party purchasers would not be able to rely on the state usury law solely in the state where the originating bank is located and would need to comply with state usury laws (at least in the states of New York, Connecticut and Vermont). The US Supreme Court declined to hear an appeal, and in the years that followed, no other federal Circuit Court has issued a decision that followed the Madden ruling. Nevertheless, the Madden decision remains good law and is binding on federal courts in the Second Circuit.
In response to the uncertainty in credit markets as a result of the Madden decision, on 2 June 2020, the Office of the Controller of the Currency (OCC) issued a final rule to clarify the “valid when made” doctrine. This OCC final rule amends 12 CFR 7.4001 and 12 CFR 160.110 of the regulations under the NBA by adding a new section that states: “Interest on a loan that is permissible under [12 USC 85 and 12 USC 1463(g)(1), respectively] shall not be affected by the sale, assignment, or other transfer of the loan” (the “OCC Valid When Made Rule”, which became effective on 3 August 2020).
The Federal Deposit Insurance Corporation (FDIC) issued a substantially similar rule on 25 June 2020. The FDIC’s rule may be found at 12 C.F.R. § 331.4(e) of the FDIA, and states that “[w]hether interest on a loan is permissible under [the Federal Deposit Insurance Act] is determined as of the date the loan was made” and “[i]nterest on a loan... shall not be affected by a change in State law, a change in the relevant commercial paper rate after the loan was made, or the sale, assignment, or other transfer of the loan, in whole or in part” (the “FDIC Valid When Made Rule”, which became effective on 21 August 2020).
The OCC oversees federally chartered national banks and savings institutions, and the FDIC oversees state-chartered banks and savings institutions. Together, these two rules (collectively, the “Valid When Made Rules”) alleviate the substantial uncertainty created by the Madden decision regarding the enforceability of certain loans once they are transferred by the originating bank to a non-bank entity. The rules do not eliminate all the uncertainty in the market caused by the Madden decision, however, because the rules are not binding on the courts and may be challenged in court by consumers, state regulators and/or consumer advocacy groups. While courts generally give great deference to the OCC and FDIC rule-making guidance, they are not required to do so. So there remains a possibility that a court may not follow the directives provided in these new regulations. Thus far, however, the district courts in the Second Circuit that have considered the question have given effect to the OCC and FDIC rules.
In response to the Valid When Made Rules, on 29 July 2020 the Attorneys General of California, Illinois and New York filed suit against the OCC in the US District Court for the Northern District of California. The lawsuit has been named “People of the State of California, et al. v The OCC”. In their complaint the Attorneys General claim that the OCC over-reached its rule-making authority in that by issuing the “valid when made” rule it:
Soon thereafter, eight Attorneys General (the states of California, Illinois, Massachusetts, Minnesota, New Jersey, New York and North Carolina, plus the District of Columbia) filed suit against the FDIC in the same US District Court for the Northern District of California. This lawsuit, known as People of the State of California, et al v FDIC, was filed on 20 August 2020 and similarly challenges the FDIC’s rule on the “valid when made” doctrine. Both cases are ongoing and briefs have been filed on both sides (including amicus curie briefs) but no decisions were handed down in 2021.
The other major regulatory action by the OCC that would have affected the securitisation industry had this rule remained in force was its issuance of a regulation on 27 October 2020, which became temporarily effective on 29 December 2020, regarding the determination of which entity is the true lender in a bank partnership programme (the “OCC True Lender Rule”).
It is commonplace in the fintech/marketplace lending space for the programme operator, an entity that typically is not itself a licensed lender, to partner with a national or state-chartered bank to make consumer loans (usually over the internet). The bank partner is most often the entity that is tasked with funding the loan, establishes its credit policies for such loans, and is named as the lender in the loan documentation. However, many programmes require the bank partner to sell most or all of such loans originated through the programme operator’s systems to the programme operator or another third-party purchaser soon after each loan is originated. This structure has led to multiple legal challenges to the designation of the bank partner as the true lender in the transaction.
If the bank partner is not the true lender, then applicable state usury and licensing laws would apply to the programme operator or third-party purchaser of each such loan that the court may determine to be the true lender. Violations of usury or licensing laws carry penalties under state laws ranging from a reduction in interest to complete forfeiture of principal and interest (paid or to be paid). Cases have been decided for plaintiffs and defendants in multiple judications.
The OCC True Lender Rule would have created a simple test for determining whether the bank partner is the true lender in the transaction. In short, a bank would have been deemed to have made the loan when, as of the date of origination, the bank is named as the lender on the loan agreement or the bank funds the loan. In situations where more than one bank could be the true lender (eg, when one bank is named as the lender in the loan agreement but another bank has funded the loan), the true lender would have been deemed to be the bank that is named as the lender in the loan agreement. The OCC True Lender Rule would have applied only to national banks and federal savings associations. The FDIC stated that it did not have the power to issue a parallel rule, so this rule would not have been applicable to state-chartered banks regardless.
On 6 January 2021, a consortium of Attorneys General from seven states (New York, California, Colorado, Massachusetts, Minnesota, New Jersey and North Carolina) and the District of Columbia filed a lawsuit in the Southern District of New York against the OCC, challenging the OCC True Lender Rule. This lawsuit has been named People of the State of New York v The Office of the Comptroller of the Currency. Much as they did against the OCC and the FDIC with respect to the OCC’s and FDIC’s Valid When Made Rules, the lawsuit sought to invalidate the OCC True Lender Rule on multiple grounds. This litigation has been mooted by the joint resolution of disapproval passed by Congress and signed by the President, as discussed below.
On 26 March 2021, a Congressional Review Act (CRA) joint resolution of disapproval was introduced in the United States Senate and House of Representatives. The CRA was the legislative branch’s expression that it disagreed with the OCC’s True Lender Rule. Under the CRA, Congress may repeal rules and regulations issued by federal agencies by passing a joint resolution of disapproval, although it generally also needs to be signed by the President to be enacted (subject to the usual veto override mechanics). The CRA was passed by both Houses of Congress and was signed by President Biden on 30 June 2021. The result of the passage of the CRA is that the OCC’s True Lender Rule was retroactively invalidated as though the rule had never taken effect; and going forward the OCC (and, by implication, the FDIC) may not promulgate a replacement rule or regulation that is substantially similar to the one repealed without subsequent statutory authorisation from Congress.
As a result, all cases involving true lender issues continue to be reviewed by the various courts on a case-by-case basis with no one standard applicable to all the states. At the present time there has been no attempt by any federal agency to propose a different true lender rule. It is also important to note that the CRA did not invalidate the Valid When Made Rules issued by the OCC and FDIC, which remain in full force and effect and subject to the ongoing litigation described above.
In addition to the Colorado litigation settlement that was discussed in this firm's “Securitisation 2021 USA Trends and Developments” article for Chambers, several states passed measures in 2021 that targeted the bank partnership model by imposing aggressive “true lender” standards that may be difficult to meet on all loans or, more commonly, on loans that exceed certain interest rate thresholds. Other states amended licensing laws in 2021 in a fashion that could require passive owners of consumer loans (or of consumer loans above a certain interest rate) to be licensed in addition to loan originators and servicers. None of these states has interpreted these new laws as requiring such licensure, but neither have they definitively foreclosed such an interpretation. Further developments can be expected.
In September 2017, the Consumer Financial Protection Bureau (CFPB) filed suit against 15 National Collegiate Student Loan Trusts (the “Trusts”), alleging that the Trusts had violated the Consumer Financial Protection Act (CFPA) by engaging in unfair and deceptive practices in connection with the servicing and collection of the private education (not federally guaranteed) student loans owned by each of the Trusts (but not originated nor serviced by any Trust entity). While it was stipulated that the alleged misconduct resulted from actions taken by the Trusts’ servicers and sub-servicers during their debt collection activities, and not by any actions taken by the Trusts, which remained solely as passive owners of the loans, the CFPB named only the Trusts as defendants in this lawsuit after settling with the servicers involved.
This litigation has been ongoing through various motions. In particular, the Trusts moved to dismiss the lawsuit on the grounds that the CFPB lacked enforcement authority over the Trusts because they are not “covered persons” as defined in the CFPA. Under the CFPA, a “covered person” includes (i) any person that engages in offering or providing a consumer financial product or service and (ii) any affiliate of such a person, if such affiliate acts as a service provider to such person. On 13 December 2021, the federal District Court in Delaware denied the Trusts’ motions to dismiss the complaint on the grounds that the securitisation Trusts meet the definition of “covered persons”, because even if they do not directly service the loans, they “engage in” loan servicing through third-party servicers that perform those functions on their behalf.
The court did not decide whether the Trusts have any liability for the actions of the servicers – only that the CFPB has enforcement jurisdiction over the Trusts. The question of the Trust’s “vicarious liability” for the servicers’ conduct remains a critical open point and is likely subject to further years of litigation before it is decided – or may not be decided at all if the case is settled. Because this decision came from a federal court sitting in Delaware, it could have broader consequences to the securitisation marketplace than a decision in a different judicial district, as most special-purpose entities (trusts and limited liability companies) that are formed for securitisation purposes are organised in Delaware and are thus subject to suit in the same court under the CFPB’s authorising statute. While the decision does not constitute binding precedent, other judges are likely to give the decision significant weight.
Alternatives to LIBOR
The interest rates on many ABS (and on many other financial instruments) adjust in accordance with an index based on the average of the inter-bank offered rates for US deposits of certain durations in the London market based on quotations of major banks (LIBOR). LIBOR is calculated and published for various currencies and periods by the benchmark’s administrator, ICE Benchmark Administration Limited (IBA), which is regulated by the UK Financial Conduct Authority (FCA).
In November 2017, the FCA announced that the panel banks that submit information to the IBA have undertaken to continue to do so only until the end of 2021 (the LIBOR phase-out date). In March 2021, the IBA announced that it would cease the publication of most LIBOR tenors, including the 1-week and 2-month US dollar LIBOR tenors, after 2021, but that 1-, 3-, 6- and 12-month USD LIBOR tenors would be continued until 30 June 2023.
The elimination or effective unavailability of LIBOR has implications not just for floating-rate ABS but also for pool assets that have floating interest rates. This could lead to disconnected floating rates between the ABS and the related collateral if the reference rate is not addressed in both.
Transition to SOFR
In June 2017, the ARRC identified the SOFR, which is a secured rate derived from borrowing and lending activities on US treasuries, as its preferred alternative reference rate. The ARRC recommended fall-back language for securitisations to facilitate a benchmark transition from LIBOR to SOFR in May 2019, including the use of a "waterfall" of fall-back language to deal with the potential discontinuance or effective unavailability of LIBOR.
Under the recommended language, a transition from LIBOR to SOFR in a securitisation would be triggered upon the declaration of a specific benchmark transition event:
The ARRC has confirmed that the March 2021 IBA US dollar LIBOR announcement constituted a benchmark transition event, and amended its recommended fall-back language to reflect that occurrence. The occurrence of a benchmark replacement event means that the applicable benchmark replacement will take effect on the related benchmark replacement date, which for US dollar LIBOR tenors will be the date the rates cease to be published.
Under the waterfall for determining the appropriate replacement index, the default choice if only some LIBOR tenors become available is an interpolated benchmark (ie, a linear interpolation between the longest available LIBOR that is shorter than the corresponding tenor and the shortest available LIBOR that is longer than the corresponding tenor). However, if an interpolated benchmark cannot be produced, the ARRC set forth the following alternatives, the first available of which would become the replacement benchmark:
The ARRC provisions also include a waterfall for the determination of the benchmark replacement adjustment:
If the benchmark replacement rate falls back to compounded SOFR, the ARRC recommendations favour compounding in arrears, even though that means that the applicable reference rate will not be known until the end of the interest period. The ARRC recommendations acknowledge that an issuer may wish to instead use compounded SOFR, determined in advance based on the SOFRs for the prior interest period. While this methodology would result in the applicable reference rate being known before the interest period, it would be a lagging rate.
The ARRC recommendations provide that a contractually "designated transaction representative" is responsible for making most LIBOR transition-related decisions, including declaring that a benchmark replacement event has occurred, the selection of the applicable benchmark replacement, and the ability to amend all required transaction agreements to effect those determinations. In the absence of manifest error, the decisions of the designated transaction representative are conclusive. Variations on the ARRC recommended fall-back language are now commonly included in US securitisations.
SOFR differs from LIBOR in several key respects. First, SOFR is an overnight rate, while LIBOR has been available in many tenors (eg, one month, three months) and is forward-looking. While the ARRC suggests that the first alternative should be a forward-looking term SOFR with a matching term to LIBOR, no such rates were available at the time the ARRC released its recommendations.
SOFR is a secured rate derived from borrowing and lending activities on US treasuries, while LIBOR is based on a survey of quotations from participating banks regarding what they believed the going-forward unsecured interest rate should be. Because SOFR is effectively a risk-free rate, it requires a spread adjustment – known as the "applicable benchmark replacement adjustment" in ARRC parlance – to match LIBOR’s unsecured and riskier calculation. While the ARRC’s recommended waterfall provisions acknowledge that need, the steps of the proposed benchmark replacement adjustment waterfall are fairly conclusory. The ARRC has recommended a spread adjustment methodology for non-consumer products based on a historical median over a five-year lookback period calculating the difference between US dollar LIBOR and SOFR, which matches the methodology recommended by the ISDA for derivatives. In the event that a pre-cessation event is operative, the ARRC's recommended five-year historical median spread adjustments will be determined at the same time as the ISDA's spread adjustments, which will be at the time of any announcement that LIBOR has ceased or will be, or has become, no longer representative.
At the time the ARRC fall-back recommendations were released, term SOFR rates were purely theoretical: SOFR was primarily an overnight rate, measuring the cost of borrowing cash overnight as collateralised by US Treasury securities in the repurchase agreement market. The New York Fed publishes daily SOFR and 30-, 90- and 180-day SOFR averages, which are compounded on each business day. Therefore, the only variations of SOFR available to use until July 2021 were:
In March 2021, the ARRC published a white paper containing an “approach” to using SOFR in new issuances of ABS and other securitised products. This approach was based not on term SOFR, but on 30-day average SOFR with a monthly reset period, set in advance of the interest accrual period. The ARRC chose 30-day average SOFR because it is likely to more closely match the current interest rate environment than longer tenors – 90- and 120-day average SOFR may be stale by the end of the period. The ARRC approach did not use daily SOFR because of its potential volatility, and used a rate set in advance because such a rate is known at the beginning of the interest period, an advantage in creating a stable and liquid market. While an in-arrears methodology would result in accrued interest more accurately reflecting the actual interest rate environment during the accrual period, the ARRC noted that issuers would face challenges setting such a rate in a timely manner after the accrual period. The ARRC’s approach was not meant to be a binding directive, merely an example of how ABS products could be created using average SOFR.
In May 2021, the ARRC selected CME Group as the administrator for forward-looking term SOFR rates, and in July 2021, the ARRC formally recommended CME Group’s term SOFR rates. The use of term SOFR rates will require a licence from CME Group. CME Group has announced that it will limit licences to use in “cash products” until 30 June 2023, but that there will be no charge for the licence during this period. The ARRC, however, cast some doubt on such a broad use of term SOFR in its recommended “best practices”. According to the ARRC, “use of the SOFR Term Rate should be in proportion to the depth of transactions in the underlying derivatives market and should not materially detract from volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct the SOFR Term Rate itself over time and as the market evolves initially”. The “best practices” only recommend the use of term SOFR in these circumstances to date:
The ARRC did not recommend term SOFR for “most securitizations”, stating that “as a general principle [it] recommends that market participants use overnight SOFR and SOFR averages given their robustness, particularly in markets where we have seen that there can be successful adoption of these rates such as floating rate notes, consumer products including adjustable rate mortgages and student loans, and most securitizations”.
Problems of LIBOR transition for existing securitisations
While new securitisation documents can provide for an effective alternative reference rate, LIBOR transition has posed more difficult problems for many existing ABS and their underlying pool assets.
Many existing securitisations provide that if LIBOR is terminated or ceases to function, the applicable interest rates may become fixed based on the last LIBOR available. A large number of these deals present no readily apparent amendment mechanism to incorporate the ARRC’s recommended fall-back provisions. Also, there is likely to be basis risk between the cash flows on ABS and the underlying pool assets if floating interest rates on both do not adjust simultaneously and based on the same reference rate.
To address some of the legacy deal issues, at the recommendation of the ARRC, in March 2021 the New York State legislature (because New York law governs the vast majority of LIBOR-utilising contracts) passed legislation that provided a statutory remedy to these problems.
Similar legislation, which would pre-empt state law regarding LIBOR transition (and therefore would apply more broadly than the New York law), is in process at the federal level. The proposed legislation passed the US House of Representatives in December 2021 but was still under consideration by the US Senate as of the date of this writing.
Even where securitisation documents or legislation provide for an effective alternative reference rate for legacy LIBOR-based ABS, the interest rate provisions for the underlying pool assets will likely have been determined prior to the securitisation and may have been drafted by entities unaffiliated with the sponsor. Therefore, close co-ordination between securitisation sponsors and the originators of financial assets that are likely to be securitised continues to be recommended.