United States: SEC Adopts Final Rules for Asset-Backed Securities - Part 1

In a release published in the Federal Register on January 7, 2005 ("Adopting Release"), the U.S. Securities and Exchange Commission ("SEC") adopted new and amended rules and forms ("Rules") 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").¹ The Rules codify much of the existing SEC interpretations and staff "no action" letters applicable to securitizations and were generally adopted along the lines of the SEC’s proposed rules and forms (the "Proposal"),² although some significant modifications were made in response to the numerous comments submitted in respect of the Proposal.³

Although the Rules technically apply only to public offerings of ABS in the United States (including foreign ABS publicly offered 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. In particular, participants in 144A offerings of ABS will need to determine their exposure to 10b-5 liability (general antifraud) to the extent that disclosures in the offering document fall short of the Rules now applicable to public offerings of ABS.

The Rules reflect the SEC staff’s recognition since the 1980s of the differences between ABS and corporate securities issued by operating companies. Accordingly, through a series of rules, staff statements, and staff "no action" letters, the SEC’s 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 Rules comprise the SEC’s comprehensive codification and reconciliation of these modifications.

Current Requirements. Since 1992, 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 off the shelf" from time to time.⁴ Prospectus requirements are effected by means of a base prospectus (plus a form of prospectus supplement) included as part of the registration statement, with a prospectus supplement delivered with each distribution of ABS. The Rules codify this approach, with certain modifications as described below.

Definition of Asset-Backed Security. The Rules retain the existing definition (contained in the instructions to Form S-3) of "asset-backed security," with an expansion to cover securitizations of leases (even if the residual value of the leased property must be realized to fully repay the ABS).⁵ The Rules also make the definition of ABS applicable irrespective of the form used for registration (i.e., applicable for both Form S-3 and Form S-1). This definition is further premised on the conditions that (i) neither the depositor nor the issuing entity is an investment company under the U.S. Investment Company Act of 1940 and (ii) the activities of the issuing entity must be restricted to passively holding the pool of assets, issuing the ABS and activities reasonably incidental thereto.

The Rules do not, however, extend the definition of ABS to cover synthetic securitizations (i.e., where exposure to an asset pool is accomplished through a credit derivative), securitizations of delinquent assets⁶ (although securitizations with delinquencies up to 50 percent of the asset pool would still qualify for the definition and delinquencies up to 20 percent would still qualify for shelf registration) or securitizations of nonperforming assets.⁷

For lease-backed securitizations, the Rules impose limits on the percentage of the securitized pool balance attributable to residual values in order to be considered an ABS: residual values may not constitute, for motor vehicle leases 65 percent or more, and for non-motor vehicle leases 50 percent or more, of the original asset pool measured by dollar volume at the time of ABS issuance. For Form S-3 eligibility, residual values may not constitute 20 percent or more of the asset pool by dollar volume at the time of ABS issuance.

The following exceptions are made under the Rules in respect of the "discrete" pool requirement: Master trusts (where multiple issuances of ABS are backed by the same pool of assets) meet the definition of ABS without any predetermined limits, but "series trusts" (where one entity issues multiple series of ABS each backed by a different pool of assets) do not qualify as ABS. Prefunding periods are permitted for up to one year from date of ABS issuance, with permitted prefunding amounts of up to 50 percent of issuance proceeds (or in the case of master trusts, up to 50 percent of the aggregate principal balance of the asset pool that supports the ABS), irrespective of the form used for registration. In respect of revolving periods, for receivables that by their nature revolve (e.g., credit cards), there would be no limits on the revolving period duration or amount of additional assets. For fixed asset receivables (e.g., residential mortgages, auto loans, leases), the revolving period may be up to three years, so long as new pool assets added are of the same general character as the original pool assets.

Securities Act Registration Statements. Under the Rules, ABS may only be registered under the Securities Act using: (i) Form S-3, for ABS that meet the S-3 eligibility criteria (i.e., ABS are investment grade, delinquent assets are less than 20 percent of pool, residual values for non-motor vehicle lease-backed transactions are less than 20 percent of pool balance), 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 will no longer be used.

In the Adopting Release, the SEC adopted new instructions for both Form S-3 and Form S-1 specifically applicable to ABS offerings. 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, these instructions require compliance with provisions of new Regulation AB (see below), which modifies 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.

For Form S-3, a base prospectus and form of prospectus supplement will be required. Takedowns off the shelf registration must be described within the parameters of the asset type, structural features, enhancements, and other features described in the base prospectus. A separate base prospectus and form of prospectus supplement must be prepared for each asset type or jurisdiction.⁸

The 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 issuing entity) is the statutory "issuer" for purposes of signing the registration statement. As such, each of the depositor’s principal executive officer, principal financial officer, controller, or principal accounting officer and a majority of its directors is required to sign the registration statement for the ABS offering. The same depositor will be considered a different statutory "issuer" in respect of each issuing entity and also in respect of its own securities.

Foreign ABS. The Rules do not establish a different registration regime for ABS issued by foreign entities that are publicly offered in the United States; such foreign ABS are required to be registered on Form S-3 or Form S-1 and are subject to the same disclosure requirements in Regulation AB. In addition, if ABS are issued by a foreign issuer, are backed by foreign assets, or are affected by credit enhancement or other support provided by a foreign entity, then additional information must be disclosed.⁹ Foreign ABS may also be subject to special SEC procedures, such as pre-filing conferences and full review by SEC staff on Form S-1 for first-time foreign issuers.

Exclusion from Exchange Act Rule 15c2-8(b) for Form S-3 ABS.
Recognizing the typically short time frame between finalization of the terms of an ABS transaction and closing, the Rules codify a long-standing SEC exclusion from Exchange Act Rule 15c2-8(b) for Form S-3 ABS to the effect that broker-dealers are not required to deliver a copy of the preliminary prospectus to any person who is expected to receive a confirmation of sale at least 48 hours prior to the sending of such confirmation.

However, in the Adopting Release, the SEC indicated that this issue may be revisited depending on its evaluation of comments in respect of the SEC’s proposed rules on securities offering reform published on November 17, 2004 ("Offering Process Release").¹⁰ In the Offering Process Release, the SEC raised the "unassailable proposition" that materially accurate and complete information regarding an offering should be available to investors at the time they make an investment decision. In the Adopting Release, the SEC states that the availability of adequate information for ABS offerings raises similar legal issues as those discussed in the Offering Process Release.

Registration of Underlying Pool Assets. 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 Rules, registration of the underlying securities is not 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 with the sponsor, depositor, issuing entity, or underwriter of the ABS relating to the underlying securities (e.g., they are not unsold allotments from their distribution) or the ABS; and (iii) neither the issuer of the underlying securities nor its affiliates are affiliated with the sponsor, depositor, issuing entity, or underwriter of the ABS.

Market-Making Transactions. In the Adopting Release, the SEC has determined that it will not require registration and delivery of a prospectus for market-making transactions by affiliates of the issuer or the servicer in respect of ABS.¹¹

Regulation AB. For ABS, the SEC is adopting a new principles-based set of disclosure items in one location within Regulation S-K called Regulation AB, which will form the basis of ABS disclosure in both Securities Act registration statements and Exchange Act reports.¹² The balance that Regulation AB seeks to achieve is to provide enough clarity so that the disclosure concept or objective is understood and can be applied on a consistent basis, while not providing too much detail that could obscure or override the concept or objective or that would result in disclosure that would be immaterial or inapplicable. Pervading across all disclosures are determinations as to materiality, both in terms of material information to be included and immaterial information to be omitted.

Forepart of Registration Statement and Prospectus. Under Regulation AB, the cover page of the prospectus should be limited and brief and the forepart of the prospectus should contain a transaction summary with risk factors. The transaction summary should disclose the flow of funds, credit enhancement, classes of ABS offered, residual or equity interests, any prefunding or revolving periods, amount or formula for calculating the servicing fee, sources of payment, and distribution priorities. Risk factors should focus on the most significant factors that make the ABS offering speculative and risky and explain briefly yet particularly how those risks affect investors. A representative list of risk factors is not provided, as there is a concern that any such list would result in boilerplate and generic disclosures. The entire prospectus should be presented in "plain English."

Transaction Parties. The "sponsor" is the person who organizes and initiates an ABS transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity. In addition to basic identifying information, disclosure is required, inter alia, of: the sponsor’s securitization program; the sponsor’s experience in securitizing assets of the type included in the ABS transaction; any defaults, early amortizations, or performance-triggering events in respect of prior securitizations organized by the sponsor; and the sponsor’s credit-granting or underwriting criteria.

The "depositor" is the person who receives or purchases and transfers or sells the pool assets to the issuing entity. For ABS transactions where there is no intermediate transfer, the sponsor is the depositor. Disclosure is required, inter alia, of: the ownership structure of the depositor; the general character of any activities of the depositor other than securitizing assets; and the depositor’s securitization program (if materially different than that of the sponsor).

The "issuing entity" is the trust or other special-purpose entity created at the direction of the sponsor or depositor that owns or holds the pool assets and in whose name the ABS supported or serviced by the pool assets are issued. Disclosure is required, inter alia, of: the nature of the issuing entity; sale and transfer of the pool assets; permissible activities and restrictions on activities; capitalization; and the issuing entity’s directors and executive officers (if any). Copies of the issuing entity’s governing documents, along with all material agreements for the ABS offering (including the pooling and servicing agreement, indenture and management or administration agreement) are required to be filed as exhibits to the registration statement. Other disclosure items include: security interests for the benefit of the transaction; transaction expenses; market price (if the pool assets comprise securities); and the risks and effects of bankruptcy, receivership, or a similar proceeding with respect to the issuing entity, sponsor, depositor, or other seller of the pool assets.

The "servicer" is any person responsible for the management or collection of pool assets or making allocations or distributions to holders of the ABS.¹³ The Rules also contemplate multiple servicer situations and distinguish: (i) master servicer, (ii) affiliated servicer, (iii) unaffiliated servicer (servicing 10 percent or more of the pool assets), and (iv) any other material servicer. For all servicers referred to under (i), (ii), and (iv) above, disclosure is required, inter alia, of: identifying information and experience of the servicer (e.g., name, experience with assets of any type and with assets of the type included in the current transaction, material changes to policies and procedures in the servicing function, and financial condition to the extent there is a material risk that such financial condition could have a material impact on pool or ABS performance); servicing agreements and servicing practices (e.g., material terms of and duties under the servicing agreement, manner of collection and extent of commingling, any special or unique factors such as servicing of subprime assets, terms relating to any servicer advances required or permitted, process for handling delinquencies, losses, bankruptcies and recoveries, ability to waive or modify terms relating to the assets, any custodial arrangements, and any limitations of liability); and back-up servicing arrangements (e.g., successor servicers, process for transferring, transfer expenses, and identity of the back-up servicer). The servicing agreement is required to be filed as an exhibit to the registration statement. For all servicers referred to under (iii) above, disclosure is required of the identity of such servicers servicing 10 percent or more (but less than 20 percent) of the pool assets, with more detailed disclosures required for such servicers servicing 20 percent or more of the pool assets to the same extent as that required for servicers referred to under (i), (ii), and (iv) above.

A separate definition of "trustee" is not provided. Disclosure is required, inter alia, of: each trustee’s name and form of organization; prior experience with ABS with similar assets; duties and responsibilities; actions required (including notices to be given) upon event of default or other breaches; limitations of liability; indemnification; and terms of removal, replacement, or resignation.

A separate definition of "originator" is not provided. Each entity (apart from the sponsor or its affiliates) originating 10 percent or more (but less than 20 percent) of the pool assets must be identified. For each entity originating 20 percent or more of the pool assets, disclosure is required, inter alia, of: the originator’s form of organization; origination program; experience in originating asset types included in the current transaction; size and composition of the entity’s origination portfolio; and an analysis of the performance of the pool assets such as credit-granting or underwriting criteria.

Static Pool Information. The Rules require disclosure of static pool information, to the extent determined by the registrant to be material. The Rules provide separate starting points for disclosure of static pool information depending on whether the ABS transaction involves an amortizing asset pool or a revolving asset master trust.

For amortizing asset pools, unless the registrant determines that such information is not material, the starting point for disclosure is static pool information regarding delinquencies, cumulative losses, and prepayments for prior securitized pools of the sponsor for that asset type. For unseasoned sponsors (i.e., sponsors lacking three years of securitization experience with the same asset type), the registrant should instead consider providing static pool information, to the extent material, regarding delinquencies, cumulative losses, and prepayments by vintage origination years in respect of originations or purchases by the sponsor, as applicable, for that asset type. All such information should cover, to the extent material and existing, the previous five years, be presented in periodic increments (e.g., monthly or quarterly), and include summary characteristics as applicable and material.¹⁴

For revolving asset master trusts, unless the registrant determines that such information is not material, the starting point for disclosure is static pool data regarding delinquencies, cumulative losses, prepayments, payment rate, yield, and standardized credit scores or other applicable measure of obligor credit quality, as applicable, in separate increments based on the date of origination of the pool assets. Issuers should consider presenting such data at a minimum of 12-month increments through the first five years of the revolving account’s life.

Under the Rules, static pool information may be presented by physical inclusion in the prospectus (including in the form of a CD-ROM) or through incorporation by reference from a filed Exchange Act report (for ABS offerings on Form S-3). Static pool information may also be presented on a web site if certain conditions are met: (i) the prospectus discloses the intention to provide the information through a web site and provides the internet address; (ii) the information on the web site is unrestricted as to access and free of charge; (iii) the information remains available on the web site for a period of not less than five years; and (iv) the registration statement contains an undertaking that the information provided on the web site is deemed to be part of the prospectus included in the registration statement.

Pool Assets. The Rules require a description of the pool assets, including statistical information, which is to be presented in tabular or graphical format (if the same will aid understanding) and broken down by distributional groups or incremental ranges, with each group or range further broken down by variables.¹⁵

The Rules require disclosure, inter alia, of: general information regarding pool asset types and selection criteria;¹⁶ pool characteristics;¹⁷ delinquency and loss information; sources of pool cash flow (including residual value information); representations and warranties and repurchase obligations regarding pool assets; claims on pool assets; and revolving periods, prefunding accounts, and other changes to the asset pool.¹⁸

Transaction Structure. Existing Item 202 of Regulation S-K will continue to provide the core disclosure requirements for describing the securities being offered, although new Item 1113 of Regulation AB will provide additional guidance for disclosures for ABS. These include: the types or categories of securities offered (e.g., interest-only or principal-only); the flow of funds for the transaction (including graphic presentation if doing so will aid understanding); interest rate or rate of return; principal amortization schedule; denominations of the ABS; changes triggered by an event of default; liquidation, amortization, performance, or similar triggers; any required periodic evidence of absence of default; extent of over- or under-collateralization; restrictions on or suitability of investors; and required vote of security holders to amend the transaction.

The Rules also require disclosure, inter alia, of: distribution frequency and cash maintenance; fees and expenses (including a separate table itemizing fees and expenses); disposition of residual or excess cash flow (including ownership thereof if such person is affiliated with any party to the transaction); information regarding additional securities in master trusts (e.g., relative priority, allocation of cash flow, terms of issuance, terms of security holder approval, and authority to determine issuance); optional or mandatory redemption or termination (e.g., terms triggering redemption or termination, party holding the option, amount of redemption, procedures involved, and allocation of recovery amounts);¹⁹ and prepayment, maturity, and yield considerations (e.g., prepayment or interest rate sensitivity for each class of securities).

Significant Obligors. 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"),²⁰ then additional descriptive and financial information would be required as to each such significant obligor: selected financial data at 10 percent or more (but less than 20 percent) of the asset pool, and audited financial statements at 20 percent or more of the asset pool. Exceptions to the requirement to provide financial information include pool assets backed by the full faith and credit of the United States (or, if the ABS are investment grade, by the full faith and credit of a foreign government).

Credit Enhancement and Other Support. The Rules require disclosure of all material credit enhancement and other support for ABS, comprising: (i) any external credit enhancement (e.g., bond insurance, letters of credit, and guarantees); (ii) any mechanisms to ensure timely payments on ABS (e.g., liquidity facilities, lending facilities, guaranteed investment contracts, and minimum principal payment agreements); (iii) any derivatives whose primary purpose is to provide credit enhancement; and (iv) any internal credit enhancement (e.g., subordination provisions, over-collateralization, reserve accounts, cash collateral accounts, and spread accounts). Each agreement relating to material enhancement or support must be filed as an exhibit to the registration statement.

In addition, if any entity or group of affiliated entities providing enhancement or other support is liable or contingently liable to provide payments representing 10 percent or more (but less than 20 percent) of the cash flow supporting any offered class of ABS, then selected financial data must be provided; and if the same represents 20 percent or more of the cash flow supporting any offered class of ABS, then audited financial statements must be provided. Exceptions exist if the obligations of the enhancement provider are backed by the full faith and credit of the United States (or, for enhancement providers having an investment grade rating, by the full faith and credit of a foreign government). Exceptions also exist if the enhancement provider is a guarantee agency under the Higher Education Act of 1965 for student loans under the Federal Family Education Loan Program (FFELP).

A separate treatment and method of disclosure is prescribed for derivatives, such as interest rate and currency swaps, that are used to alter the payment characteristics of the cash flows from the issuing entity and whose primary purpose is not to provide credit enhancement related to the pool assets or the ABS. If the aggregate significance percentage²¹ related to any entity or group of affiliated entities providing such derivative instruments is 10 percent or more (but less than 20 percent), then selected financial data must be provided; and if the same is 20 percent or more, then audited financial statements must be provided. The agreement relating to the derivative instrument must be filed as an exhibit to the registration statement.

Other Basic Disclosure Items. The Rules also require certain other disclosures, such as tax matters, legal proceedings,²² affiliations among parties in an ABS transaction,²³ material related party transactions,²⁴ ratings and the reports required by the transaction agreements (including whether web site access will be provided in respect thereto).

Alternatives to Present Third Party Financial Information. As discussed above, there are instances when additional financial information regarding third parties is required in ABS filings, including financial information about significant obligors and significant providers of enhancement or other support. The Rules codify the SEC’s practice of permitting alternative methods to present or refer to this information if it exists in other SEC filings of the third party.

The first alternative allows incorporation by reference into the ABS filing of the third party’s financial information contained in Exchange Act reports if the following conditions are met: (i) the third party is subject to Exchange Act reporting requirements; (ii) the third party has been current with its Exchange Act reporting for the past 12 months; (iii) the reports incorporated include the third party financial statements; and (iv) if incorporated by reference into a prospectus or registration statement, the prospectus also states that all documents subsequently filed by the third party prior to the termination of the ABS offering also will be deemed to be incorporated by reference into the prospectus. As with all materials incorporated by reference into a registration statement, written consent for use of the incorporated material must be obtained.²⁵

The second alternative (which applies only to unaffiliated significant obligors) allows an ABS filing to reference the significant obligor’s Exchange Act reports in lieu of providing such information if the following conditions are met: (i) the significant obligor is unaffiliated with the sponsor, depositor, issuing entity, and underwriter and does not have any type of agreement with them relating to the ABS transaction; and (ii) the significant obligor meets one of the eligibility categories relating to Form S-3 eligibility.²⁶

ABS Informational and Computational Material. 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 that meets the Securities Act prospectus requirements is delivered before or with those materials.

The SEC staff 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 Rules codify the basic concept of these "no action" letters by permitting the use of ABS information and computational material after the effectiveness of a Form S-3 registration statement but before delivery of the final Section 10 prospectus, provided that certain filing requirements are met and certain conditions are fulfilled. The Rules do not apply in respect of ABS registered on Form S-1.

The Rules merge the term sheets and computational materials (as referred to in the "no action" letters) into the single concept of "ABS informational and computational material." This term is defined to mean a written communication consisting solely of one or some combination of the following:

• Factual information regarding the ABS being offered and the structure and basic parameters of the securities.

• Factual information regarding the pool assets underlying the ABS.

• Identification of key parties to the transaction.

• Static pool data.

• Statistical information displaying for a particular class of ABS: the yield, average life, expected maturity, interest rate sensitivity, cash flow characteristics, total rate of return, option-adjusted spread, or other financial or statistical information relating to the class or classes under specified prepayment, interest rate, loss, or other hypothetical scenarios.

• Names of underwriters participating in the ABS offering.

• Anticipated schedule for the ABS offering and a description of marketing events.

• Description of the procedures by which the underwriters will conduct the ABS offering and the procedures for transactions in connection with the ABS offering with an underwriter or participating dealer.

The Rules impose two conditions for use of ABS informational and computational material: (i) the communications must be filed as described below; and (ii) the communications must include prominently on the cover page: the issuing entity’s name, the depositor’s name, the SEC file number for the related registration statement, a statement that the communication is ABS informational and computational material used in reliance on the exemptive rule, and a legend urging investors to read the relevant documents filed or to be filed with the SEC 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 Rules adopt a single unified filing rule in respect of ABS information and computational material, 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.²⁷

Finally, the Rules 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 the SEC’s Electronic Data Gathering, Analysis and Retrieval system ("EDGAR").

Footnotes

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