1998 saw a number of significant regulatory and accounting developments affecting the asset-backed markets. From the Securities and Exchange Commission ("SEC"), we saw the effective date for the technical amendments to Rule 2a-7 relating to asset-backed securities ("ABS"), the implementation of plain English and publication of the long-awaited "aircraft carrier" proposals. On the bank regulatory front, public comments were submitted on the Federal bank regulators' 1997 recourse project proposals, and the Federal Deposit Insurance Corporation ("FDIC") has been active in an accounting issue relating to transfers of financial assets by banks and other FDIC-insured institutions. Continuing activity relating to several of these developments can be expected in 1999.
Rule 2a-7. In December 1997, the SEC published the "final" technical amendments to Rule 2a-7 under the Investment Company Act of 1940 1. These amendments are referred to as "final" because they completed a more than two year process in which the SEC first proposed changes to Rule 2a-7 relating specifically to ABS, adopted those changes in a form that provoked a number of questions and concerns among ABS industry participants, delayed the effectiveness of the amendments pending further review and modifications, proposed technical amendments and finally in December 1997 adopted further changes that addressed many of the industry's most serious concerns. The final amendments were effective on February 10, 1998, but money market funds did not have to begin complying with the special provisions relating to ABS until July 1, 1998.
Rule 2a-7, which regulates money market funds, matters to ABS market participants (especially asset-backed commercial paper conduits) because it affects the ability of money market funds to purchase ABS. Among other things, Rule 2a-7 generally requires money market funds to diversify their holdings, avoiding excessive concentrations of investments in securities issued by any one issuer or guaranteed by any one guarantor. The challenge in applying those diversification requirements to ABS was deciding at what level the diversification requirements should apply.
Most ABS are backed by a well-diversified pool of financial assets. ABS market participants argued that when a money market fund buys an ABS, the Rule 2a-7 issuer diversification tests should apply at the level of the underlying receivables, in which case most ABS would not present diversification issues under Rule 2a-7. However, the SEC was concerned about structural risk involved in ABS and settled on a general rule that the special-purpose entity that issues an ABS is the "issuer" for diversification purposes. This limits a money market fund's exposure to structural risk with respect to any particular transaction.
However, the SEC was also concerned that obligors (particularly businesses) could be represented in the asset pools held by multiple special-purpose entities and could also be direct issuers of securities that money market funds might buy. This could lead to inadvertent issuer concentrations in excess of the normal limits.
Tracking all obligors in each ABS pool was clearly unworkable, so the SEC decided on a materiality approach. Under this approach, any person (a "Ten Percent Obligor") whose obligations make up 10% or more of the assets of a special-purpose entity that has issued ABS ("Primary ABS") must be treated as having issued a proportionate share of the Primary ABS. In addition, if a Ten Percent Obligor is itself a special-purpose entity issuing ABS ("Secondary ABS"), then any Ten Percent Obligor of such Secondary ABS will also be deemed to be an issuer of the portion of the Primary ABS that such secondary Ten Percent Obligor represents.
An important exception to the above rule is that a "Restricted SPE" (which is generally a special-purpose entity that has only one investor other than its sponsor) is not treated as a proportionate issuer even if it is a Ten Percent Obligor. However, a Restricted SPE that is a Ten Percent Obligor of any Primary ABS must still be looked through to determine if it has any Ten Percent Obligors that must be treated as proportionate issuers under the Secondary ABS rule described above.
These rules could theoretically lead to all kinds of splitting of ABS for purposes of tracking by money market funds. As a practical matter, though, most money market funds have said that they are unwilling to track Ten Percent Obligors. Consequently, ABS issuers that want to sell to money market funds have had to avoid having Ten Percent Obligors that have to be treated as proportionate issuers. Plain English. The SEC's plain English rules 2 took effect October 1, 1998. Under these rules, registrants must use the SEC's plain English writing principles in the front and back cover pages, the summary and the risk factors section of prospectuses. Registrants must use language in these identified portions of the prospectus that substantially comply with several specific plain English principles:
Registrants may include pictures, logos, charts, graphs or other design elements in these specified portions of the prospectus, or elsewhere, so long as the design is not misleading and the required information is clear.
In the balance of their prospectuses, registrants must use language that complies with the following standards:
In preparing their prospectuses, registrants must avoid:
ABS issuers have found compliance with the plain English rules challenging, in light of the complex structures of many ABS transactions and the number of significant legal issues that are material to these transactions. Since compliance only became mandatory on October 1, 1988, and the base prospectuses in shelf registration statements filed prior to that date were grand fathered, many issuers have not fully completed their transition to plain English. This is a process that will continue into 1999. The Aircraft Carrier. The SEC's long-awaited "aircraft carrier" proposal was released in November, 1998 3. Comments are due by April 5, 1999.
Weighing in at close to 600 pages (in its public reference copy form), the aircraft carrier proposes substantial modernizing changes to the SEC's regulations and forms under the Securities Act of 1933 and the Securities Exchange Act of 1934. The proposals cover five major topics:
While ABS offerings will ultimately be affected by changes in all of these five areas, the release is not primarily an ABS release. It does not propose a specialized ABS registration form or other disclosure and registration requirements specifically related to ABS-another project that has been in the works at the SEC for some time now. The release confirms that the staff's ABS disclosure project is still under way and requests comment on a number of points intended to help the SEC staff in that effort. The proposed reforms to the registration system are designed to make registration more attractive to issuers, without compromising investor protection. The SEC acknowledges the growing importance of the Rule 144A market and the attractiveness of that market for certain issuers and transactions. In large part, the proposed reforms are aimed at keeping registration attractive in comparison to the available alternatives.
The proposals make a basic distinction between two forms of registration statement:
A third form (Form C) would be used for business combinations and exchange offers.
Under proposed Form B, the streamlining would go well beyond what is currently available under Form S-3. For instance, SEC staff would not review Form B registration statements prior to the offering. The issuer would have full control over the selection of the effective date. This would effectively eliminate the need for shelf registrations, but shelves would still be permitted.
A key question for ABS issuers is whether ABS will automatically have access to the streamlined Form B process in the same way that they generally now have access to Form S-3 and shelf registration. This is by no means certain, as the majority of the specific ABS topics on which comments were requested relate to this issue. Those questions are paraphrased below:
The proposal to focus additional attention on Exchange Act filings could also eventually have specific repercussions for ABS, since most ABS issuers either do not make Exchange Act filings or operate under a specialized filing regime that has evolved under a series of no-action letters.
Regulatory activity relating to the aircraft carrier will continue into 1999 and probably beyond, given the scope of the proposed changes.
The FFIEC's Recourse Project. In November 1997, the constituent agencies of the Federal Financial Institutions Examination Council ("FFIEC") 4 published a proposal 5 relating to the appropriate levels of risk-based capital for various credit exposures relating to ABS transactions. One of the central themes in this proposal was the FFIEC agencies' attempt to establish what they would view as a proper relationship between the risk-based capital required for recourse (including subordinated classes of securities) retained by banks 6 that securitize their own assets, on one hand, and subordinate securities purchased and other positions assumed by banks with respect to securitizations of assets originated by others, on the other hand.
Under current rules, a bank that sells assets but retains virtually any risk of loss must hold risk-based capital as if the assets had not been sold. The main exception is that, under the "low level recourse" rule, the required capital will not exceed the maximum retained exposure. On the other hand, banks (excluding thrifts for this purpose 7) that buy subordinated tranches in securitizations of assets originated by others or provide credit enhancements for those securitizations hold capital only against the face amount (or "credit equivalent amount" 8 in the case of off-balance sheet items) of their credit exposure, rather than the full amount of the related assets.
The FFIEC agencies have long been concerned that there may be some similarity between the risks that may be retained by a seller of financial assets and the risks that may be assumed by the purchaser of a subordinated security or a third party credit enhancer and that the different capital treatments of these risks do not constitute "equivalent capital for equivalent risk." The method for achieving such equivalency (by requiring more capital against at least some purchased subordinated interests and third party credit enhancements) was the main topic of the November 1997 proposal. The proposal also contemplated that less capital would be required against certain very highly rated ABS.
The November 1997 proposal reflected a major evolution in the FFIEC's approach to this issue as compared to a 1994 proposal. The 1994 proposal had largely assumed that all third party credit enhancements and purchased subordinated interests involved risks that are substantially equivalent to the risk retained by a seller in a sale with recourse. Public comments on the 1994 proposal apparently persuaded the agencies that this often is not the case. The main reason for this is that purchasers of subordinated interests and third party credit enhancers, unlike sellers with recourse, virtually never assume first loss risk 9. As a result, the 1997 proposal included three alternative methods for differentiating among various positions to determine the appropriate capital treatment. The first was a "ratings-based approach" in which the FFIEC agencies would have used credit ratings from the major rating agencies to measure relative exposure to credit risk and to determine the associated capital requirement. This was the center piece of the proposal, with the other two methods having been proposed as ways to handle unrated positions.
Under the ratings-based approach:
The two proposed means of dealing with non-rated positions were (i) a "ratings benchmark approach," in which the FFIEC would set credit enhancement requirements and other transaction standards that would have to be met in order for an unrated position to avoid a full gross-up for risk-based capital purposes; and (ii) an "internal information approach," in which experienced banks would be permitted to use their own historical information and/or internal bank models to determine the appropriate capital treatment for various ABS positions. Industry comments on the November 1997 proposal were generally critical of both the ratings-based approach and the ratings benchmark approach, with much support for internal information or bank model approaches. A final rule on these matters had been expected in 1998, but did not appear. The lack of a consensus supporting the ratings-based approach seems to have been a key reason for this delay, since the ratings-based approach was the centerpiece of the November 1997 proposal.
It appears now that staff of some of the FFIEC agencies are looking further into the feasibility of a internal information/bank model approach. In the meantime, considerable support for a move towards a bank model approach to risk-based capital in general and/or other significant revamping of the Basle risk-based capital accord has appeared. In light of these developments, it is quite likely that more will be heard on this issue in 1999, though it remains quite possible that a final resolution will not be reached in this millennium.
FDIC Statement of Policy on Securitizations and Loan Participations. On December 30, 1998, the Federal Deposit Insurance Corporation ("FDIC") published a proposed statement of policy relating to the FDIC's treatment of securitizations by depository institutions that subsequently fail, as well as loan participations 10. The deadline for comments is March 1, 1999.
The statement of policy is meant to resolve an issue relating to bank securitizations (and loan participations) under Statement of Financial Accounting Standards No. 125 ("SFAS 125"). The issue relates to the application to banks of the SFAS 125 requirement that financial assets be isolated from the transferor and its creditors (even in insolvency) in order to achieve sale treatment. For non-banks, the isolation test generally translates into a requirement that there be a "true sale at law." However, SFAS 125 does not require a true sale for FDIC-insured banks (or other FDIC-insured depository institutions), based upon the belief of the Financial Accounting Standards Board ("FASB") that assets transferred by such an institution that subsequently failed could only be obtained by the receiver if it makes the investors completely whole, that is, the investors must be paid compensation equivalent to all the economic benefits contained in the transferred assets, including the bargained-for yield, before the FDIC could obtain those assets.
On December 22, 1997, the FASB staff issued a statement noting that the FASB had had recently become aware that the FDIC's powers are broader than was contemplated by SFAS 125. This created some uncertainty about the application of SFAS 125 in bank transactions (particularly securitizations and loan participations) where no true sale opinion is delivered. Since then, the FASB staff has investigated the issue, including by consulting various legal specialists and talking with the staff of the FDIC 11.
The draft statement of policy seeks to resolve this issue by stating that the FDIC "will not attempt to reclaim, recover, or recharacterize as property of" a failed institution (a) financial assets transferred in securitizations and (b) loan participations, in each case so long as certain conditions are met. It is hoped that this effectively isolates the specified assets from the transferor and its creditors and receiver in a manner that will be satisfactory to the FASB. While this resolution does not mesh well with the existing wording of SFAS 125, it is further hoped that as part of its current project to amend SFAS 125 the FASB will make changes to accommodate isolation under the statement of policy.
Before submitting the statement of policy to the Board, FDIC staff shared two drafts with an industry working group, a group of legal experts and representatives of the FASB and of the Auditing Issues Task Force. Many of the changes requested by the industry working group are reflected in the attached draft, which is the draft that is to be published for comment. Activity on this issue will continue in 1999, as the public comment period will elapse during the early part of the year.
1 17 Fed. Reg. 74968 (Dec. 9, 1997).
2 63 Fed. Reg. 6370 (February 6, 1998).
3 63 Fed. Reg. 67174 (December 4, 1998) (the main release); and 63 Fed. Reg. 67331 (December 4, 1998) (a companion release relating to mergers and acquisitions, including Form C).
4 The constituent agencies are the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision.
5 62 Fed. Reg. 59944 (November 5, 1997).
6 For convenience for reference, I have used the terms "banks" to cover all of the various types of banks and other depository institutions regulated by the FFIEC agencies.
7 Under the Office of Thrift Supervision's version of the risk-based capital rules, a thrift that purchases a subordinated interest in a pool of another originator's assets must hold the same capital as if the thrift had originated those assets and sold them with recourse.
8 A "credit equivalent" amount is the notional principal amount assigned to a non-balance sheet item for purposes of adding that item to the denominator of a banks' risk-based capital ratio.
9 This discussion excludes mortgage-backed securities.
10 63 Fed. Reg. 71926.
11 Pending resolution of this issue, the FASB staff has indicated that it is reasonable for parties to conclude that the FDIC's powers do not preclude sale accounting for bank transfers.
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