United States: SEC Provides New Limitations On Sales Of Asset-Backed Securities

The proposed rules would remove the ratings requirements for Form S-3 shelf registrations of such securities and limit the offering of such securities to "qualified institutional buyers;" the SEC will accept comments for 90 days.

On July 1, 2008, the U.S. Securities and Exchange Commission (SEC) proposed new regulations related to asset-backed and mortgage-backed securities that would remove the ratings requirements for Form S-3 shelf registrations of such securities and limit the offering of such securities to "qualified institutional buyers" (QIBs) as defined in Rule 144(a)(1) under the Securities Act of 1933.

Under current rules, asset-backed securities (ABS) are eligible to be registered on Form S-3 and publicly offered under a shelf registration statement provided they are "investment grade securities." For purposes of the rule, an ABS is an investment grade security if, "at the time of sale, at least one nationally recognized statistical rating organization (NRSRO) has rated the security in one of its generic rating categories which signifies investment grade." The SEC has stated that it is debating "whether the inclusion of requirements related to security ratings in [the SEC's] rules and forms has, in effect, placed an 'official seal of approval' on ratings that could adversely affect the quality of due diligence and investment analysis." At present, registered ABS can be offered to any investor (subject, of course, to the usual suitability rules). The new proposal would compensate for any lack of rating agency review by limiting purchases to QIBs in minimum denominations of at least $250,000. Specifically, as proposed by the SEC, the rule would render ABS offered for cash eligible for registration on Form S-3 provided that the following apply:

  • Initial and subsequent resales are made in minimum denominations of $250,000.

  • Initial sales are made only to QIBs.

  • Delinquent assets do not constitute 20 percent or more, as measured by dollar volume, of the asset pool as of the measurement date.

  • With respect to securities that are backed by assets other than motor vehicle leases, the portion of the securitized pool balance attributable to the residual value of the physical property underlying the leases does not constitute 20 percent or more, as measured by dollar volume, of the securitized pool balance as of the measurement date.

The SEC proposed a parallel rule for mortgage-backed securities. In a separate rule, also proposed on July 1, 2008 the SEC would eliminate the investment grade rating requirement in the case of an ABS issuance made in reliance on Rule 3a-7 under the Investment Company Act of 1940. At present, and subject to other requirements commonly found in ABS offerings, Rule 3a-7 provides that "any issuer who is engaged in the business of purchasing, or otherwise acquiring, and holding eligible assets (and in activities related or incidental thereto), and who does not issue redeemable securities will not be deemed to be an investment company . . . provided that securities sold by the issuer or any underwriter thereof are fixed-income securities rated, at the time of initial sale, in one of the four highest categories assigned long-term debt or in an equivalent short-term category . . . by at least one [NRSRO]." The proposed rules would revise Rule 3a-7 to eliminate this rating requirement, although ABS issued with reliance on this exemption could only be sold to accredited investors and QIBs.

The SEC is not proposing to prohibit securitizations from being offered on a retail basis. Other methods of registration are available (Forms S-1 and S-11 under the Securities Act) and other exemptions from the Investment Company Act (Sections 3(c)(5)(A) and 3(c)(5)(C) for example) exist. But, as a practical matter, it is unlikely these offering methods would be followed. Thus, the proposed rule changes would essentially make the asset-backed and mortgage-backed securitization markets into legally required institutional markets. As such, they probably reflect the current way in which such markets operate. Most purchasers of securitizations are institutional buyers of one description or another.

These proposals come on the heels of the SEC's proposed revisions to the methods by which rating agencies assign credit scores to various securities. Those rules aim to assist investors in distinguishing between securities that are backed by pools of mortgages, car loans and credit-card debt from corporate and municipal bonds and in determining the risks associated with such classes of debt. Under the proposed rule, credit rating agencies would have a choice between two types of disclosure. First, credit rating agencies could publish a report detailing how they derived each rating and how the risks associated with a particular ABS differ from other types of debt. The other option would require the rating agencies to add a designation to their rating symbols to show that the security is an ABS.

Moody's, Standard & Poor's and Fitch Ratings have faced severe criticism after the deterioration in the subprime market called into question the reliability of their triple-A ratings on mortgage bonds. In response to these perceived shortcomings, the SEC has proposed requiring increased disclosure regarding past ratings and the extent to which they accurately predicted the risk of default. In addition, the SEC proposes to ban credit rating agencies from rating a particular bond if they made recommendations to underwriters about how to structure the security.

Tuesday's proposals, together with the proposed reforms to the rules governing NRSROs, indicate that the SEC is continuing to reevaluate the extent to which an agency's rating accurately informs an investment decision. The proposed rules diminish the role of rating agencies, at least in the context of ABS, and limit the sale of such securities to sophisticated investors.

The SEC will accept comments on the new proposals for 90 days. It will be interesting to see the market reaction to the ideas and the extent to which the existing roles of the rating agencies are defended.

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.

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