Securitisation 2023

Last Updated December 14, 2022

USA

Law and Practice

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Shearman & Sterling has a distinguished history of supporting clients wherever they do business, from major financial centres to growing markets. The firm’s success is built on its clients’ success. Shearman & Sterling has over 850 lawyers globally, speaking more than 75 languages. With lawyers in New York, London, Washington DC, and Frankfurt, Shearman & Sterling’s Structured Finance & Securitization Group assists clients in developing, structuring and executing a broad range of financings, including securitisations, structured products, asset-based lending, tailored leasing and royalty arrangements, and other sophisticated financing techniques. The firm has in-depth experience in all aspects of the public and private offering and distribution of structured finance securities. Highly regarded by major corporations and financial institutions, Shearman & Sterling represents the entire range of global market participants, including issuers, underwriters, investors, trustees, servicers, credit-enhancement providers, lenders, rating agencies and conduits.

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:

  • release the creditors’ rights to excess collateral;
  • allow additional debt to be secured by the collateral;
  • substitute collateral; and
  • reject executory contracts.

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 specific to facts and circumstances, 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:

  • transferring the securitised assets to the issuer in a perfected true sale;
  • reducing the risk of the issuer becoming subject to involuntary or voluntary bankruptcy proceedings; and
  • reducing the risk of the issuer becoming substantively consolidated with any affiliates should they become subject to bankruptcy proceedings.

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 a 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.

Multi-factor Analysis

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), as follows:

  • the parent corporation owns all or a majority of the capital stock of the subsidiary;
  • the parent and subsidiary corporations have common directors or officers;
  • the parent corporation finances the subsidiary;
  • the parent corporation subscribes to all the capital stock of the subsidiary or otherwise causes its incorporation;
  • the subsidiary had grossly inadequate capital;
  • the parent corporation pays the salaries or expenses or losses of the subsidiary;
  • the subsidiary has substantially no business except with the parent corporation or no assets except those conveyed to it by the parent corporation;
  • in the papers of the parent corporation and in the statements of its officers, the subsidiary is referred to as such or as a department or division;
  • the directors or executives of the subsidiary do not act independently in the interest of the subsidiary but take direction from the parent corporation; and
  • formal legal requirements of the subsidiary as a separate and independent corporation are not observed.

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), as follows:

  • degree of difficulty in segregating and ascertaining individual assets and liabilities;
  • presence or absence of consolidated financial statements;
  • profitability of consolidation at a single physical location;
  • commingling of assets and business functions;
  • unity of interests and ownership between the various corporate entities;
  • existence of parent or intercorporate guarantees or loans; and
  • transfer of assets without formal observance of corporate formalities.

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 attach if:

  • “value” has been given;
  • the transferor has rights in the relevant asset, or the right to grant rights in the relevant asset; and
  • there is a signed agreement that reasonably identifies the relevant rights and assets.

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:

  • automatic;
  • by control (or possession); or
  • by the filing of a UCC statement.

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 parties’ intent, though courts typically de-emphasise the language used in a document and instead consider the intent reflected by the economic substance and actual conduct;
  • recourse and collection risk, which generally is the most important factor;
  • the transferor’s retention of rights to redeem the transferred property or to receive any surplus from the asset; and
  • the seller’s continued administration and control of the assets, particularly if the obligor is not notified of the sale (however, under current market practice, sellers often act as servicer of the sold assets and such continued involvement is generally not viewed as dispositive of the loan or sale characterisation).

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:

  • the transferor being a debtor of the transferee on or before the purchase date;
  • the transferor’s ability to extinguish the transferee’s rights in the transferred assets by payments or repurchase by the transferor or from sources other than collections on the asset; and
  • the transferor’s obligation to pay the transferee’s collection costs for delinquent or uncollectible financial assets.

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:

  • in the case of a foreign financial institution (defined broadly to include a hedge fund, a private equity fund, a mutual fund, a securitisation vehicle or other investment vehicle), the entity must identify and provide information in respect of financial accounts with such entity held directly or indirectly by US persons and US-owned foreign entities; and
  • in the case of a non-financial foreign entity, the entity must identify and provide information in respect of substantial US owners of such entity.

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:

  • disclosure of the form and determination of retained risk as specified in the risk retention rules;
  • reporting of repurchases and replacements of securitised assets in connection with breaches of representations and warranties and of the conclusions and findings of third-party due diligence reports; and
  • disclosure requirements for communications with rating agencies, which, among others, require all information provided to hired Nationally Recognized Statistical Ratings Organizations (NRSROs) in relation to the initial credit rating or any ongoing credit surveillance to be posted to a password-protected website, referred to as the 17g-5 website.

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 is 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:

  • vertical risk retention by holding of at least 5% of each class of “ABS interests” issued;
  • horizontal risk retention by holding junior most interests in an amount equal to at least 5% of the “fair value” of all ABS interests issued; and
  • “L-shaped” risk retention, by holding a combination vertical and horizontal risk retention that adds up to 5%.

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 in 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 attesting 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:

  • annual reports on Form 10-K (with certain ABS-specific modifications specified in Reg AB II);
  • current events on Form 8-K; and
  • Issuer Distribution Reports on Form 10-D.

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.

Broker-dealers may be restricted from providing price quotations for private debt securities by virtue of Rule 15c2-11 unless certain periodic information and information about the issuer and the offering is made available to the public in a manner that complies with the SEC’s no-action letter issued on 30 November 2022. That letter postpones the requirement to comply with the rule until 4 January 2025 subject to satisfying certain requirements with respect to the issuer or the securities. As such, broker-dealers can continue to provide quotations for ABS offered under Rule 144A if they reasonably believe that the issuer will provide the information specified in Rule 144(d)(4) upon request. Such information would be “a very brief statement of the nature of the business of the issuer and the products and services it offers; and the issuer’s most recent balance sheet and profit and loss and retained earnings statements, and similar financial statements for such part of the two preceding fiscal years as the issuer has been in operation (the financial statements should be audited to the extent reasonably available).”

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:

  • post specific portions of its Form NRSRO registration on its website;
  • maintain certain records, including in relation to its control structure, for three years;
  • furnish certain financial reports, including audited financial statements and an annual certification, to the SEC;
  • maintain and enforce written policies and procedures to prevent misuse of material non-public information and to address conflicts of interest; and
  • abstain from engaging in certain abusive or anti-competitive conduct.

Exchange Act Rule 17g-5 divides conflicts of interest into two categories:

  • conflicts that must be disclosed and managed by the NRSRO; and
  • prohibited conflicts.

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.

Banks

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%. Re-securitisations 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

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 an 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:

  • requiring clearing of standardised OTC derivatives through regulated central counterparties;
  • requiring trading of standardised transactions to occur on exchanges or electronic trading platforms when appropriate;
  • increasing transparency through regular data reporting; and
  • imposing higher capital requirements on non-exchange-traded OTC derivatives.

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, 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:

  • hold primarily self-liquidating assets;
  • make payments based on cash flows and not based on changes in the issuer’s assets;
  • not acquire or sell assets primarily for the purpose of realising market gains or minimising market losses; and
  • only hold derivatives for uses permitted under Regulation AB, such as credit enhancement and the use of derivatives to alter the payment characteristics of the cash flow.

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 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 safe harbour provisions of 12 CFR 360.6 relating to transfer of assets in connection with a securitisation, which are discussed in 1.1 Insolvency Laws;
  • the Basel III capital requirements discussed in 4.6 Treatment of Securitisation in Financial Entities; and
  • the Volcker Rule discussed in 4.11 Activities Avoided by SPEs or Other Securitisation Entities.

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:

  • the relevant laws relating to the relevant form of organisation in its jurisdiction of formation;
  • applicable tax laws; and
  • bankruptcy or other applicable insolvency laws.

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 in the absence of 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.

Volcker Rule

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, among 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 on 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 have 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 on 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 most senior 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 are typically 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:

  • asset sale agreements;
  • participation agreements; and
  • asset contribution agreements.

As previously noted, 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:

  • satisfaction of specified eligibility criteria when sold;
  • absence of other encumbrances;
  • transfer of title;
  • all required consents and authorisations having been obtained;
  • compliance with law; and
  • various additional tailored representations.

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:

  • a requirement on filing financing statements;
  • provisions requiring notification and potentially opinions prior to any changes in the name or jurisdiction of the organisation;
  • control over securities accounts, deposit accounts and electronic chattel paper;
  • delivery or custody of chattel paper, securities and instruments; and
  • representations that the secured party has a perfected security interest.

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 address 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:

  • early amortisation events that cause accelerated pay-downs of principal and terminate reinvestment or revolving periods (temporarily or permanently);
  • servicer termination events that give rise to a right to terminate the servicer; and
  • events of default that give rise to a right to accelerate the transaction and exercise remedies, including the ability to enforce against collateral (sometimes with collateral sales being subject to additional consent requirements, unless a sale would generate sufficient proceeds to pay the secured notes in full).

Amortisation events typically include:

  • shortfalls in reserves or over-collateralisation;
  • outstanding amounts exceeding applicable collateral borrowing value;
  • delinquencies or charge-offs in excess of specified thresholds; and
  • servicer termination events.

Events of default usually include:

  • failure to pay principal or interest due on specified classes of notes after applicable cure periods;
  • the trustee failing to have a first-priority perfected security interest in all (or a material portion) of the collateral;
  • the issuer becoming a covered fund under the Volcker Rule, required to register under the Investment Company Act, or subject to entity-level taxes and potentially other regulatory events;
  • breach of representations or covenants that continue beyond applicable cure periods; and
  • the issuer becoming subject to insolvency proceedings.

Servicer defaults or termination events typically include:

  • failure, after expiry of the applicable cure periods, to turn over collections when required to do so;
  • misrepresentations or breach of covenants;
  • insolvency; and
  • often, the occurrence of an event of default.

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.

Regulation

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.

Principal Structures

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:

  • agency MBSs;
  • auto;
  • commercial loans;
  • non-agency residential mortgages;
  • commercial mortgage loans;
  • equipment leases;
  • credit cards; and
  • student loans.

Common structures used for the various types of securities previously outlined (see 8.1 Common Financial Assets) include the following.

Pass-Through Securitisations

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 must 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 previously described. 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.

CLO-Type Structures

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. 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.

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Trends and Developments


Authors



Morgan, Lewis & Bockius LLP is a global law firm with approximately 2,200 legal professionals in 31 offices across North America, Europe, Asia and the Middle East. The firm’s structured transactions practice serves the financing needs of the world’s most sophisticated businesses. The team is a recognised global leader in the structured finance industry, domestically and internationally. Its clients, both issuers and underwriters, are among the most highly respected global financial services institutions and the practice understands the evolution of structures because it was involved in many of the industry’s significant firsts. In addition to a robust, dedicated structured transactions practice, it offers key practice area expertise to support transactions, including tax, the Employee Retirement Security Act (ERISA), litigation, broker-dealer, real estate and investment company practice lawyers. Morgan Lewis lawyers wrote the books that structured finance lawyers rely on: “Offerings of Asset-Backed Securities” and “The Federal Securities Law of Asset-Backed Securities”.

The 2020 election has resulted in a number of new rule proposals and changes by the US Securities and Exchange Commission (SEC) and other regulators. Many of these changes do not appear to be focused primarily on asset-backed securities (ABS) or the securitisation markets, but present unforeseen and challenging consequences. The extent to which regulators will address securitisation industry feedback on rules that are not yet final remains to be seen.

The calendar year 2023 also should see a continued focus on the transition from the use of the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR).

Regulatory

Rule 15c2-11

Rule 15c2-11 under the Securities Exchange Act of 1934 (“Exchange Act”) 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.

Under Rule 15c2-11 the broker or dealer must review a number of items of specific information, which are required to be “current and publicly available”, before quoting a security. 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 (“Securities Act”), together with any subsequent Exchange Act periodic reports, suffices. Therefore, the rule does 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 any part of the preceding two fiscal years that the issuer has been in existence. ABS issuers generally do not prepare financial statements. The rule specifies a number of other items of required information which are not as troublesome, but which 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 specified 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 December 2021, which established a tiered set of compliance dates in an effort to allow brokers and dealers time to bring themselves into compliance. Phase 1 extended from 3 January 2022 through 3 January 2023. Phase 2 was scheduled to extend from 4 January 2023 through 4 January 2024, and Phase 3 was scheduled to begin on 5 January 2024 and extend indefinitely. Phases 2 and 3 would effectively have required Rule 144A issuers of ABS to make the required Rule 144A information publicly available, a requirement to which many market participants objected.

In response to that further feedback, the SEC staff issued a revised no-action letter in November 2022. This no-action letter withdrew the December 2021 letter, but effectively extended Phase 1 under the December 2021 letter until 4 January 2025. At the time of this writing in January 2023, there is no longer any relief that extends after that date.

Under the most recent no-action letter, 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 specified 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 relief are the following.

  • The issuer is subject to Exchange Act reporting requirements and the issuer has filed all required periodic reports during the prior 12 months or any shorter time it has been required to file reports. This option reinforces the notion that registered ABS where the issuer is subject to Exchange Act reporting requirements do not pose compliance issues under the Rule 15c2-11(b). Whether this option covers registered ABS that are subject to Exchange Act reporting requirements but where those requirements were suspended before ABS issuers had to file for the “life of the deal” poses an interpretive question.
  • The security is a corporate fixed-income or asset-backed security offered pursuant to Rule 144A, so long as the broker-dealer reasonably believes the issuer will provide the information required by Rule 144A upon request. Therefore, quotations of Rule 144A ABS generally are allowed without further inquiry by the broker-dealer.
  • There is “current and publicly available information (consistent with Rule 15c2-11(b)) about the issuer”, and “the staff would consider the Information Requirement discussed in Section II.C. of the Rule 144A Adopting Release... to be consistent with Rule 15c2-11(b)”. According to that section of the Rule 144A adopting release, “[i]nstead of the financial statements and other information required about issuers of more traditional structures, the Commission would interpret the information requirement to mandate provision of basic, material information concerning the structure of the securities and distributions thereon, the nature, performance and servicing of the assets supporting the securities, and any credit enhancement mechanism associated with the securities”. Market participants have coalesced around a view that, if the issuer of a Rule 144A asset-backed security were to undertake to make the required Rule 144A information publicly available and to keep it current, that would suffice for broker-dealers to quote those securities.

The letter does not directly address privately offered securities that do not rely on Rule 144A, such as a “pure private”/Section 4(a)2) deal or an institutional accredited investor/Regulation S only deal. Logically, issuers of ABS offered under another exemption could undertake to make Rule 144A information publicly available and therefore enable those securities to be quoted under the last option above. However, many broker-dealers appear to have concluded that their quotation procedures for these securities do involve publishing them (or submitting them for publication), so that the rule does not apply.

In sum, Rule 15c2-11 rule does not appear to pose problems for brokers or dealers desiring to quote registered public ABS, at least so long as they are currently reporting. Brokers or dealers may continue to quote Rule 144A ABS without further restriction until 4 January 2025, but as that date approaches it is not clear the extent to which broker-dealers will be comfortable continuing to participate in those offerings when a known issue could impact their liquidity.

SEC cybersecurity disclosure proposal

In March 2022, the SEC proposed a set of cybersecurity disclosure rules for public companies. The proposed rules would require a number of new disclosures for registrants, including:

  • periodic reporting about previously reported incidents, risk policies and procedures, director oversight of risks, and management’s role in assessing and managing risks; and
  • annual reporting or proxy disclosure about directors’ cybersecurity expertise.

The proposed rules do not distinguish ABS issuers from corporate issuers, and their application to ABS issuers in the form proposed would be problematic in several respects. There are extensive fundamental and technical differences between ABS and corporate issuers, not the least of which is that ABS issuers engage in limited activities that pose limited cybersecurity risks. Industry groups have submitted comments pointing out these issues, and it remains to be seen whether and to what extent the SEC will take them into account in adopting final rules.

SEC climate change disclosure proposal

In March 2022, the SEC proposed a set of climate change disclosure requirements for public companies. The proposed requirements would impose a significant number of new disclosure requirements for registrants, including disclosure of:

  • oversight and governance of climate-related risks;
  • how climate-related risks, including those that are reasonably likely to have a material impact on business or financial statements, may affect business;
  • how climate-related risks have affected or are likely to affect strategy, business model and outlook;
  • processes for identifying, assessing and managing climate risks and how those processes fit into overall risk management;
  • impact of climate-related events and transition activities (such as policy changes) on the financial statements and financial estimates; and
  • specific greenhouse gas emission metrics.

As drafted, the proposed rules do not apply to ABS issuers, although the SEC solicited comment on whether they should apply and in what form. The proposed disclosures do not appear particularly relevant to ABS issuers and would be problematic if made applicable to ABS issuers in their current form. For example, ABS issuers have a finite life, strict limits on their activities and no active governance. As a result, the proposed rules could result in the disclosure of a number of immaterial risks for ABS issuers. Industry groups submitted comments pointing out these issues, and the final scope of the rules remains to be seen.

CFPB litigation

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). Examples of such conduct alleged by the CFPB are that tens of thousands of collection lawsuits were brought by the Trusts against borrowers without possession of the requisite legal documentation to prove that the Trusts actually owned the loans and that the related servicer filed false or misleading affidavits in such debt collection lawsuits against the applicable students. The Trusts hold more than 800,000 private education student loans totalling approximately USD12 billion, all of which were originated by private banks prior to 2008. None of the Trusts acted or acts as the related lender, originator or servicer of such student loans; they are merely passive ownership entities that distribute collections to the related securitisation debt and equity investors while hiring third parties to undertake the requisite ongoing administrative and servicing activities on their behalf. While it was stipulated that the alleged misconduct resulted from actions taken by the Trusts’ servicers and sub-servicers in the course of their debt collection activities, and not by any actions taken by the Trusts themselves, the CFPB named only the Trusts as defendants in this lawsuit after having previously settled 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 (A) any person that engages in offering or providing a consumer financial product or service; and (B) any affiliate of a 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 themselves do not directly service the loans, they “engage in” loan servicing through third-party servicers who perform those functions on their behalf. The District Court subsequently granted a motion for an interlocutory appeal, which was granted by the US Third Circuit Court of Appeals on 3 May 2022. The case is currently stayed and briefs have been filed, including an amicus curiae brief filed by the Structured Finance Association in support of the Trusts’ position. A decision by the Third Circuit is expected by mid-2023.

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. As a result, the ruling, if upheld on appeal, would allow the CFPB to proceed with an enforcement action directly against the Trusts for liability for actions undertaken by the Trusts’ servicers (on behalf of the Trusts) and not by the Trusts themselves. It is important to note that the issue before the Third Circuit is whether the Trusts are indeed “covered persons” and thus could be vicariously liable for the conduct of their agents, the servicers.

This other 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. It is important to note that because this decision came from a Federal court sitting in Delaware, if upheld by the Third Circuit, it could potentially have much broader consequences to the securitisation marketplace affecting a variety of asset classes (such as securitisation trusts that own auto loans, mortgages, credit card receivables, unsecured personal loans, etc) 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 in different jurisdictions are likely to give the decision significant weight in a case presenting the same general questions. One additional open question, which will not be answered in the short-term, is, if the Trusts are eventually deemed liable, whether the CFPB would seek to force such Trusts to require the related investors to disgorge previously made distributions and how it would go about enforcing such actions.

Private funds proposed rules

In February 2022, the SEC proposed new rules under the Investment Advisers Act of 1940 (“Advisers Act”) with the stated purpose of providing transparency to investors in private funds regarding the cost of investment in, and performance of, those private funds. The SEC’s proposed rules would require that registered investment advisors to private funds obtain audited annual financial statements of, and provide quarterly statements regarding fees, expenses and performance for, each private fund it advises, and investment advisers would be required to deliver a fairness opinion in connection with adviser-led “secondary transactions” in which existing fund investors are offered the option to exchange their investments for interests in other entities managed by the same adviser or related persons. The proposed rules would also prohibit private fund advisers from engaging in certain compensatory and other practices which have the effect of creating conflicts of interests between private funds and their advisers. Because most collateralised loan obligation (CLO) transactions rely on Section 3(c)(7) of the Investment Company Act of 1940, as amended, for an exemption from “investment company” status, those CLOs constitute “private funds” within the meaning of the Advisers Act, and the proposed rules may therefore become applicable to those CLOs and related collateral managers, if adopted in their proposed form. Because there are differences between CLOs and other private funds, the potential application of certain aspects of the proposed rules to existing and future CLO transactions remains unclear.

NAIC risk-based capital recommendations

In May 2022, the National Association of Insurance Commissioners (NAIC) issued a letter recommending adjustments to the risk-based capital (RBC) treatment of CLO investments held by insurance companies, in order to eliminate a perceived arbitrage opportunity. The NAIC’s letter described a hypothetical example in which an investment in all of the tranches in a CLO transaction would be subject to a lower RBC factor than a direct investment in the CLO’s underlying collateral, and they expressed their position that the RBC factor each such investment should be equal. The NAIC also recommended the addition of two new RBC factors of 75% and 100%, in order to account for the “tail risk” in any structured finance tranche. These recommendations, if adopted, could result in significantly higher capital charges for insurance company investments in CLO transactions.

Transition to SOFR

In 2014, the Board of Governors of the Federal Reserve System (the Federal Reserve) and the Federal Reserve Bank of New York (the New York Fed) formed the Alternative Reference Rate Committee (ARRC) to identify possible alternative reference rates for US dollar LIBOR and to identify best practices for implementation of a new reference rate. In June 2017, the ARRC identified SOFR as its preferred alternative to LIBOR for many purposes, including securitisations. SOFR is a secured rate derived from borrowing and lending activities on US treasuries.

The ARRC, after issuing consultations and soliciting feedback, recommended fallback language for securitisations to facilitate a benchmark transition from LIBOR to SOFR in May 2019. The ARRC’s recommendations suggested the use of a “waterfall” of fallback language to deal with the potential discontinuance or effective unavailability of LIBOR. Variations on the ARRC recommended fallback language are now commonly included in US securitisations.

Under the ARRC’s recommended language, a transition from LIBOR to SOFR in a securitisation is triggered upon the declaration of a specific benchmark transition event:

  • public statement by LIBOR’s administrator, ICE Benchmark Administration Limited (IBA), or its UK regulator, the UK Financial Conduct Authority, that the actual cessation of LIBOR has occurred or is expected;
  • a public statement or publication of information by the IBA that LIBOR is no longer “representative” as an index (known as a “pre-cessation trigger”); or
  • with respect to transactions where the underlying pool assets bear floating rates, a transition of a specified percentage of those assets from LIBOR based to adjusting using an alternative index.

The ARRC has confirmed that the March 2021 IBA USD LIBOR announcement constituted a benchmark transition event and amended its recommended fallback language to reflect that occurrence. The occurrence of a benchmark replacement event means that the applicable benchmark replacement has taken place for the USD LIBOR rates that have ceased to be published on the date of cessation, which was the related benchmark replacement date.

Key differences

SOFR differs from LIBOR in several key respects. First, SOFR is an overnight rate, while LIBOR has been available in many different 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. 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 International Swaps and Derivatives Association (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 will cease or has ceased or will or has become no longer representative.

At the time the ARRC fallback 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 daily on each business day. Therefore, the only variations of SOFR actually available to use until July 2021 were:

  • daily simple SOFR in arrears, calculated using simple interest over the current interest period;
  • SOFR compounded in arrears, calculated by compounding interest over the current interest period; and
  • SOFR compounded in advance, calculated by compounding interest over a set period of days.

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’s approach was not meant to be a binding directive, but merely an example of how an ABS product 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 ARRC has cast doubt on 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:

  • in legacy contracts (including ABS transactions) that have adopted the ARRC’s recommended fallback language;
  • in business loans where “transitioning from LIBOR to an overnight rate has been difficult”; and
  • in “certain securitizations that hold underlying business loans or other assets that reference the SOFR Term Rate and where those assets cannot easily reference other forms of SOFR”.

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”. 

SOFR has been used routinely in CLOs, where the pool assets consist generally of floating rate commercial loans, but the ARRC has expressed displeasure over the recent use of term SOFR as the benchmark for other floating-rate ABS backed by fixed-rate receivables.

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 fallback 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 passed new legislation that provided a statutory remedy to these problems. While New York law governs the vast majority of LIBOR-utilising contracts, the statute did not and could not address LIBOR transition issues in all legacy contracts.

To provide broader relief, Congress passed the Adjustable Interest Rate (LIBOR) Act (the LIBOR Act), which was signed into law in March 2022. The LIBOR Act covers contracts that reference LIBOR tenors other than the uncommon one-week and two-month tenors, and provides as follows.

  • For contracts without any fallback provision (other than the disregarded fallback provisions described below), or with fallback provisions that do not identify a specific USD LIBOR benchmark replacement or identify a “determining person” with authority to select a benchmark replacement, a benchmark replacement recommended by the Federal Reserve will automatically replace the LIBOR benchmark in the contract after 30 June 2023.
  • The recommended benchmark replacement will be based on SOFR, including any recommended spread adjustment and benchmark replacement conforming changes.
  • Benchmark replacement conforming changes are changes that the Federal Reserve determines would address one or more issues surrounding the replacement of the contract’s benchmark, or (for non-consumer contracts) that are necessary or appropriate to implement the new benchmark in the reasonable judgment of the “calculating person” responsible for calculating that benchmark under the contract.
  • Certain types of LIBOR fallback provisions will be disregarded:
    1. provisions that base the LIBOR replacement in any way on a LIBOR value, except to account for the difference between LIBOR and the benchmark replacement; and
    2. provisions that require a poll, survey, or inquiries for quotes or information concerning inter-bank lending or deposit rates.
  • There is no effect on contracts that already contain fallback provisions that identify a benchmark replacement that is not based in any way on USD LIBOR, or as to which the parties agree in writing to opt out of the application of the LIBOR Act.
  • Any identified determining person will have the authority to replace the LIBOR rates with the SOFR-based benchmark replacement selected by the Federal Reserve. If the determining person does not select any non-LIBOR benchmark replacement, the benchmark replacement selected by the Federal Reserve will automatically replace the LIBOR rates in the contract.
  • Any person (including a determining person or calculating person) is protected from liability for:
    1. selecting or using a SOFR-based benchmark replacement selected by the Federal Reserve;
    2. implementing benchmark replacement conforming changes; or
    3. determining benchmark replacement conforming changes, for contracts other than consumer loans.
  • The Trust Indenture Act of 1939 is amended to provide that the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security shall not be deemed to be impaired or affected by any change occurring by the application of the LIBOR Act to any indenture security.
  • Any state laws relating to the selection of a benchmark replacement or limiting the manner of calculating interest (insofar as such a provision applies to the selection or use of a benchmark selected by the Federal Reserve or benchmark replacement conforming changes) are pre-empted. Therefore, the New York statute is now only relevant to contracts that reference the omitted one-week or two-month LIBOR tenors.

The Federal Reserve was required to promulgate implementing regulations not later than 180 days after the date of its enactment. Those rules, which were proposed in July 2022 and adopted in December 2022, will become effective 30 days after their publication in the Federal Register.

The rules generally apply the following SOFR-based rates, plus the spread adjustment set forth in the statute:

  • for consumer contracts and most other contracts, SOFR (in place of overnight LIBOR) or term SOFR of the relevant tenor;
  • for derivatives, 30-day average SOFR compounded in arrears (the SOFR rate used in the ISDA protocol);
  • for certain contracts for which a Federal Housing Administration-regulated entity is a party, SOFR (in place of overnight LIBOR) or 30-day average SOFR (or, for Federal Home Loan Bank advances, the SOFR rate used in the ISDA protocol as described above); and
  • for Federal Family Education Loan Program (FFELP) loan ABS, either 30-day average SOFR (for one-, six-, and twelve-month LIBOR) or 90-day average compounded SOFR (for three-month LIBOR).

The rules otherwise largely mirror the statute, but with some clarifications, which include:

  • clarifying that a determining person includes a person with a contingent future right to select a LIBOR replacement;
  • identifying certain specific benchmark replacement conforming changes that are protected;
  • specifying that a determining person may select the Board-selected benchmark, together with any applicable benchmark replacement conforming changes;
  • expressly providing that the statute’s protections apply to any LIBOR contract for which the Board-selected benchmark replacement becomes the benchmark replacement, either by operation of law or by the selection of a determining person; and
  • clarifying that the rules preempt any state or local law or standard relating to the selection or use of a benchmark replacement or benchmark replacement conforming changes.
Morgan, Lewis & Bockius LLP

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Shearman & Sterling has a distinguished history of supporting clients wherever they do business, from major financial centres to growing markets. The firm’s success is built on its clients’ success. Shearman & Sterling has over 850 lawyers globally, speaking more than 75 languages. With lawyers in New York, London, Washington DC, and Frankfurt, Shearman & Sterling’s Structured Finance & Securitization Group assists clients in developing, structuring and executing a broad range of financings, including securitisations, structured products, asset-based lending, tailored leasing and royalty arrangements, and other sophisticated financing techniques. The firm has in-depth experience in all aspects of the public and private offering and distribution of structured finance securities. Highly regarded by major corporations and financial institutions, Shearman & Sterling represents the entire range of global market participants, including issuers, underwriters, investors, trustees, servicers, credit-enhancement providers, lenders, rating agencies and conduits.

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Morgan, Lewis & Bockius LLP is a global law firm with approximately 2,200 legal professionals in 31 offices across North America, Europe, Asia and the Middle East. The firm’s structured transactions practice serves the financing needs of the world’s most sophisticated businesses. The team is a recognised global leader in the structured finance industry, domestically and internationally. Its clients, both issuers and underwriters, are among the most highly respected global financial services institutions and the practice understands the evolution of structures because it was involved in many of the industry’s significant firsts. In addition to a robust, dedicated structured transactions practice, it offers key practice area expertise to support transactions, including tax, the Employee Retirement Security Act (ERISA), litigation, broker-dealer, real estate and investment company practice lawyers. Morgan Lewis lawyers wrote the books that structured finance lawyers rely on: “Offerings of Asset-Backed Securities” and “The Federal Securities Law of Asset-Backed Securities”.

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