United States: SEC Proposes New Rules For Asset-Backed Securities

On May 3, 2004, the U.S. Securities and Exchange Commission ("SEC") proposed new and amended rules and forms (the "Proposal") to address comprehensively the registration, disclosure, and reporting requirements for publicly offered asset-backed securities ("ABS") under the U.S. Securities Act of 1933 ("Securities Act") and the U.S. Securities Exchange Act of 1934 ("Exchange Act"). Much of the Proposal seeks to codify (and expand) existing SEC interpretations and staff "no action" letters.¹ The SEC is soliciting comments from industry participants within 60 days of the Proposal's publication in the Federal Register.

Although the new ABS rules would technically apply only to public offerings of ABS in the United States, the market will nonetheless need to consider how the new regime may affect private ABS offerings made in reliance on Rule 144A.

The Proposal reflects the SEC staff's recognition since the 1980s that ABS differ from corporate securities issued by operating companies. Accordingly, through a series of rules, staff statements, and staff "no action" letters, the U.S. standard registration, disclosure, and reporting requirements for securities issued by operating companies have been substantially modified for ABS offerings to focus on items such as transaction structure, quality of the asset pool, servicing, and cash flow distribution. The Proposal is the SEC's first attempt at a comprehensive codification, reconciliation, and expansion of these modifications.

Since 1992,² shelf registration for delayed or periodic offerings of investment-grade ABS has been permitted on Form S-3 (which, in the case of ABS, allows incorporation by reference of subsequent information contained in Exchange Act reports), so that public offerings of ABS may be effected via "takedowns" of tranches off the shelf from time to time. Prospectus requirements are effected by means of a base prospectus (and usually a form of prospectus supplement) included as part of the registration statement, with a prospectus supplement delivered with each "takedown" of a tranche of ABS. The Proposal contemplates the continuation of this approach, with certain modifications as described below.

The Proposal retains the existing definition (contained in the instructions to Form S-3) of "asset-backed security," with an expansion to cover ABS backed by leases (even if the residual value of the leased property must be realized to fully repay the ABS).³ The Proposal states, however, that this definition would not cover synthetic securitizations (i.e., where exposure to an asset pool is accomplished through a credit derivative), delinquent assets (although delinquencies of up to 20 percent of the asset pool would still qualify for the definition), or nonperforming assets (because they do not "by their terms convert into cash within a finite period," but rather must be managed). The proposed rules also clarify that the definition covers master trusts (but not where a master trust consists of "subtrusts" with discrete asset pools allocable to each subtrust) and allows for prefunding and revolving periods within certain limits.⁴ However, synthetic CDOs would not be eligible (since they rely on a credit derivative), and managed cash CDOs would not be eligible either (since they do not involve a discrete pool of assets). The Proposal fails to distinguish a completely synthetic transaction (where a single swap arrangement references a pool of assets or names) from transactions involving discrete pools of cash-generating assets including single-name credit default swaps.

Under the Proposal, ABS are eligible for registration under: (i) Form S-3, for ABS that meet the S-3 eligibility criteria,⁵ thus qualifying for shelf registration and delayed or periodic offerings; or (ii) Form S-1, for securities falling within the definition of ABS but not eligible for Form S-3. Form S-11 would no longer be used. The Proposal does not contemplate a different registration regime for ABS issued by foreign entities that are publicly offered in the United States; Form S-3 or Form S-1 would still be used, although foreign ABS would be subject to additional disclosures and SEC procedural requirements (e.g., pre-filing conferences and full review by SEC staff on Form S-1 for first-time foreign issuers).

Reflecting the SEC’s recognition of the different nature of ABS from corporate securities issued by operating companies, and therefore the types of information that are meaningful to ABS investors, new proposed Regulation AB would modify the standard disclosure requirements to dispense with certain types of corporate and operational information (notably, audited financial statements for the issuer, and management's discussion and analysis of operations and financial condition) and to include information concerning the transaction structure, asset pool, servicing, and cash flow distributions (see the section below entitled "Disclosure").

The proposed ABS rules continue existing industry practice by specifying that the depositor (often the sponsor or an affiliated intermediary that receives the pool assets and transfers them to the special purpose issuing entity) would be the statutory "issuer" for purposes of signing the registration statement. As such, each of the depositor’s CEO, CFO, controller, or principal accounting officer and a majority of its directors would be required to sign the registration statement for the ABS offering. The same depositor would be considered a different statutory "issuer" in respect of each issuing entity and also in respect of its own securities.

If the assets being securitized are themselves securities as defined under the Securities Act, then the offering of those underlying securities must also be registered or exempt from registration under the Securities Act. Under the proposed rules, registration of the underlying securities would not be required if: (i) the depositor is free to publicly resell the underlying securities without registration (i.e., they are not "restricted securities"); (ii) neither the issuer of the underlying securities nor its affiliates have any agreement or arrangement relating to the underlying securities or the ABS (e.g., they are not unsold allotments); and (iii) neither the issuer of the underlying securities nor its affiliates are affiliated with the depositor, servicer, issuing entity, or trustee of the ABS.

For ABS, the SEC proposes a new principles-based set of disclosure items in one central location within Regulation S-K called Regulation AB, which would form the basis of disclosure in both Securities Act registration statements and Exchange Act reports. Regulation AB would set forth: items of general applicability (Item 1100); definitions (Item 1101); requirements for registration statement forepart and prospectus cover page (Item 1102); transaction summary and risk factors (Item 1103); disclosures regarding transaction parties — sponsors, depositors, issuing entities, servicers, trustees, and originators (Items 1104 - 1109); pool asset information (Item 1110); significant obligors (Item 1111); transaction structure (Item 1112); credit enhancement and other support (Item 1113); other information — tax, legal proceedings, reports to security holders and SEC-filed reports, affiliations and certain relationships, and related transactions and ratings (Items 1114 - 1118); distribution reports on new Form 10-D regarding cash flows, asset pool performance, cash flow allocation, and payment distributions (Item 1119); accountant's reports on compliance with servicing criteria (Item 1120); and servicer compliance statements (Item 1121).

Under proposed Regulation AB, the forepart of the prospectus should contain a transaction summary with risk factors. The entire prospectus should be presented in "plain English" and without boilerplate, with disclosure of all information that is relevant and material to ABS investors.

Descriptions are required in the registration statement of the identity, organizational structure, background, experience, relevant businesses, and past ABS-related performance records (e.g., static pool data) of the transaction parties involved in origination and servicing ("servicing" being defined to include both management and collection of pool assets as well as administration of allocations and distributions to security holders) and trustees. In regard to the issuing entity, a description of its organizational structure, but no financial information, is required. Agreements with transaction parties should be filed as exhibits to the registration statement.

Disclosure is required as to the composition and characteristics of the pool assets: asset type, asset material terms, underwriting criteria, selection criteria, relevant legal and regulatory provisions, statistical information (e.g., total number and dollar amount, by group and/or range and/or geographic region, with averages and weighted averages of balances outstanding, coupon, age, remaining term, loan-to-value ratios, credit scores, obligor concentrations, etc.), delinquency and loss information, and static pool data. For lease-backed transactions, the manner and assumptions for calculating residual values should be described. Where asset pools are prefunded or revolving, disclosure should include the relevant periods, aggregate amounts and percentages, criteria for adding or removing assets, tests and measurements for management of pool quality (e.g., collateral cover, interest cover), and termination triggers. Representations and warranties of the asset transferor and remedies for breach thereof (e.g., repurchase obligations) should also be disclosed.

Disclosure is required as to the transaction structure: the various classes of ABS securities being offered, tranching structure, subordination, amortization schedule, early amortization triggers, overcollateralization, cash flow allocation and distribution priorities, reserve accounts, credit enhancement, fees and expenses, collection periods, distribution dates, interim investments, disposition of excess spread, clean-up calls, etc.

If an asset pool contains a sufficiently high concentration of the assets of a particular obligor or group of related obligors (each a "significant obligor’),⁶ then additional descriptive and financial information would be required as to each such significant obligor: selected financial data at 10 percent or more of the asset pool, and audited financial statements at 20 percent or more of the asset pool. Similarly, all internal and external credit enhancements must be disclosed (with relevant agreements filed as an exhibit), and if sufficiently high concentrations of external enhancement support an asset pool (such as a monoline wrap), then additional descriptive and financial information as to each such external enhancement provider would be required: selected financial data if the enhancement supports 10 percent or more of the pool payments, and audited financial statements if the enhancement supports 20 percent or more of the pool payments. The Proposal contemplates that such financial information of significant obligors and enhancement providers may either be incorporated by reference into the ABS filing or simply referenced to their Exchange Act filings.

Other disclosures, such as tax matters, legal proceedings, affiliations among parties in an ABS transaction (e.g., servicer is often an affiliate of the sponsor), related transactions, and ratings, would also be required.

The Securities Act restricts the types of communications that a registrant or those acting on its behalf (e.g., underwriters) may use during a registered public offering. Before the registration statement is filed, no offers are permitted. After the registration statement is filed but before it is declared effective, oral offers are permitted but written offers must conform to the Securities Act Section 10 prospectus requirements. After the registration statement is declared effective, additional written materials may be used for the offering but only if a final prospectus meeting the Securities Act prospectus requirements is delivered before or with those materials.

The SEC in the past issued a series of "no action" letters that permit term sheets (both structural and collateral) and computational materials (containing statistical data on the pool assets) to be provided to potential ABS investors after the effectiveness of a registration statement but before availability and delivery of the final prospectus. These "no action" letters contained filing requirements for use of such materials and provided that no confirmations of sale may be sent until such filing requirements were met.

The Proposal seeks to codify the basic concept of these "no action" letters by proposing that ABS information and computational material may be used after the effectiveness of a registration statement for an offering of ABS registered on Form S-3 but before delivery of the final Section 10 prospectus, provided that certain filing requirements are met and certain conditions are fulfilled. The proposed rule would not apply in respect of ABS registered on Form S-1.

In enunciating this rule, the SEC proposes to merge the term sheets and computational materials into the single concept of "ABS informational and computational material"⁷ and to adopt a single unified filing rule in respect thereof, as follows: ABS informational and computational material — (i) relating to a class of ABS provided to each prospective investor indicating interest in purchasing such class of ABS and (ii) provided to any other prospective investor after the final terms have been established for all classes of the ABS offering — must be filed on Form 8-K (and thereby incorporated by reference into the registration statement) by the later of the due date for filing the final prospectus and two business days of first use. Unlike the "no action" letters, there is no requirement that such filing must be made before a confirmation of sale may be sent. There may well occur multiple filings of ABS informational and computational material in respect of an ABS offering, although ABS informational and computational material that does not contain new or different information from that which was previously filed need not be filed.⁸ In addition, the SEC proposes to eliminate the electronic filing exemption in respect of such materials so that all ABS informational and computational material would be required to be electronically filed on EDGAR.⁹

Two conditions are proposed for the ABS informational and computational material: (i) they must be filed as described above; and (ii) they must include prominently on the cover page: the issuing entity’s name, the depositor’s name, the SEC file number, a statement that the material constitutes ABS informational and computational material used in reliance on the proposed rule, and a legend urging investors to read the documents filed because they contain important information and explaining to investors that such documents are accessible at no charge on the SEC’s Web site or may be obtained from the issuer or underwriter.

The Proposal notes that the current SEC rules creating safe harbors for distribution of broker/dealer research reports in the context of a public offering¹⁰ do not correspond well to ABS offerings. The SEC now proposes that the publication or distribution by a broker or dealer of a research report with respect to investment-grade ABS meeting the other criteria of Form S-3 will not be deemed to constitute an offer for sale or offer to sell such ABS registered or proposed to be registered, even if the broker or dealer is a participant in the registered offering, if certain conditions are met.¹¹

As with the current Securities Act registration requirements, the current Exchange Act reporting requirements were designed for disclosures by operating companies. Nonetheless, post-issuance reporting in respect of ABS is critically important to ABS investors in their monitoring of asset pool performance and the performance of the transaction parties, thereby contributing to the liquidity of ABS. The transaction documents for ABS offerings generally require (as a matter of private contract) that periodic servicing and cash flow distribution reports be sent to ABS investors and/or made available on Web sites. As a result, the SEC staff has issued "no action" letters permitting a modified Exchange Act reporting system for ABS, whereby reports on Form 8-K are filed based on the frequency of distribution reports (generally monthly) in lieu of quarterly reports on Form 10-Q, along with a modified annual report on Form 10-K (e.g., audited financial statements are generally not required for the issuing entity, but the accountant’s report on compliance with servicing criteria and the servicer compliance statement are both required to be filed as exhibits).

The following Exchange Act reporting requirements, to the extent they are applicable to any particular ABS, would apply alike to both U.S. domestic- and foreign-issued ABS (including the Exchange Act forms to be used as described below). In other words, the Proposal does not contemplate a separate Exchange Act reporting system for foreign ABS.

Similar to the Securities Act proposal, the SEC proposes that the depositor constitute the "issuer" under the Exchange Act for purposes of ABS, because "it places responsibility for Exchange Act reporting with the party most able to oversee the reporting requirements."¹² As such, the depositor would be required to sign the Exchange Act reports, although an authorized representative of the servicer may also sign on behalf of the issuing entity as an alternative.

Since Form 8-K was designed for reporting of extraordinary events, the SEC is now proposing that a new Form 10-D be used in lieu of Form 8-K to report periodic distributions and pool performance information for ABS, to be filed within 15 days after each required distribution date. The Form 10-D report would be required regardless of whether the required distribution was actually made or whether a distribution report was in fact delivered pursuant to the transaction documents. New Form 10-D would also contain other information specified in Regulation AB (e.g., significant obligors and significant enhancement providers), as well as information consistent with non-financial disclosures on Form 10-Q under the current modified reporting system (e.g., legal proceedings, sales of securities, use of proceeds, submission of matters to a vote of security holders, defaults on senior securities).

The proposed form amendments include a separate instruction for Form 10-K to specify how that form is to be used for an annual report for ABS. This report is proposed to be signed either by a senior officer in charge of securitization of the depositor or on behalf of the issuing entity by a senior officer in charge of servicing for the servicer. The instruction would identify those items (certain types of corporate and operational information) that may be omitted (notably, issuing entity selected financial data, financial statements, and MD&A), and would identify the additional items from Regulation AB that must be included, being: significant obligor financial information (Item 1111(b)), significant enhancement provider information (Item 1113(b)(2)), legal proceedings (Item 1115), affiliations and certain relationships and related transactions (Item 1117), compliance with applicable servicing criteria (Item 1120), and a servicer compliance statement (Item 1121).

The current modified reporting system generally requires a report by an independent public accountant attesting to the servicer’s assertion that it has complied with a defined set of servicing criteria. The SEC now proposes to require an assertion by a "responsible party" (defined to be the same entity whose officer signs the Form 10-K report, i.e., the depositor or the servicer) on compliance with specified servicing criteria in respect of which a public accounting firm would issue a report as to that responsible party’s assertion of such compliance. Prior to making such assertion, the responsible party would first be required to make an assessment as to the extent of its compliance, and in this regard, rather than a transaction-by-transaction assessment, it may make a single "platform" level assessment as to its compliance for all ABS transactions backed by assets of the same type as those backing the ABS covered by the Form 10-K report. Material instances of non-compliance with such criteria should then be disclosed. The Proposal requests comment by industry participants as to what such servicing criteria should consist of and how they should be developed.¹³

The Proposal envisions a servicer compliance statement signed by an authorized officer of the servicer, to the effect that a review of the activities of the servicer and its performance under the servicing agreement has been made under the officer’s supervision, and that to the best of the officer’s knowledge and except as otherwise disclosed, the servicer has fulfilled its obligations under the agreement in all material respects throughout the reporting period.

The SEC staff has also issued a February 21, 2003 statement as to how ABS issuers can comply with the certification requirements under Section 302(a) of the Sarbanes Oxley Act (Exchange Act Rules 13a-14 and 15d-14). The Proposal codifies this.¹⁴

The Proposal contemplates the retention of Form 8-K reporting requirements for ABS (with its four-business-day reporting deadline) and the inclusion of a separate instruction in that form to specify how it is to be used for ABS. Like Form 10-D, the depositor or the servicer must sign Form 8-K reports. The instruction would identify those items that may be omitted as well as the additional items specific to ABS that must be included, such as ABS informational and computational material, change of servicer or trustee, change in credit enhancement or other external support, failure to make a required distribution, sales of additional securities, and Securities Act updating disclosure.¹⁵

Jones Day intends to submit a comment letter on the Proposal and encourages clients and friends to contact us with any observations or concerns.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.