Dodd-Frank proposed risk retention rules and safe harbour for foreign transactions
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On March 29, 2011, the SEC together with a number of other federal regulators and agencies proposed rules relating to risk retention for securitizations which had been mandated by the Dodd-Frank Act in order to “provide a sponsor with an incentive to monitor and control the quality of the assets being securitized and help align the interests of the sponsor with those of investors in the ABS”.
The proposed rules, if adopted, will affect nearly every type of ABS transaction, including both registered and private offerings, and will also capture a wider variety of securities than have been regulated under Reg AB due to the expanded definition of asset-backed securities adopted by the Dodd-Frank Act.
The proposed rules require the sponsor of a securitization transaction to retain credit risk equal to at least 5% of the aggregate credit risk of the assets backing the transaction. For most securitizations, risk retention could take any of four forms:
- Vertical Slice: at least 5% of each class of ABS interests issued by the issuing entity;
- Horizontal Slice: a residual interest equal to at least 5% of the par value of all ABS interests issued by the issuing entity;
- L-shaped Option: a combination of the vertical slice and horizontal slice options; and
- Representative Sample: a randomly selected representative sample of assets equivalent, in all material respects, to the securitized assets, equal to at least 5.264% of the total principal balance of the securitized pool.
As an alternative to retaining a horizontal slice, the sponsor may fund a cash reserve account equal to 5% of the par value of the issued ABS. The account must bear first loss in the same manner as the horizontal slice and is subject to various rules relating to the release of funds. Unfortunately, the rules do not allow sponsors to combine a reserve account and a horizontal slice.
Other risk retention options would be available for particular types of transactions:
- Commercial mortgage-backed securities: sponsors of CMBS may satisfy their risk retention requirements by selling a horizontal subordinated interest, or “B-piece” equal to at least 5% of the par value of all ABS interests issued by the issuing entity to a third party;
- Revolving asset master trusts: the sponsor could retain a seller’s interest equal to at least 5% of the total principal balance of the pool assets sharing the same risks as investors, on a proportionate basis; and
- Asset-backed commercial paper conduits: each originator-seller could retain a horizontal residual interest equal to at least 5% of the par value of all ABS interests backed directly by that originator’s receivables;
Each method of risk retention is subject to various technical conditions and restrictions which may undermine its utility. One such restriction, which would discourage the issuance of ABS at a premium, such as interest-only securities, requires the sponsor to establish and fund a “premium capture cash reserve account” that would effectively convert the premium into an additional form of risk retention over and above the otherwise mandated amount.
When enacted, the risk retention rules will be the most significant regulations ever applied to the ABS market and, while it is impossible to predict the full effect of the proposed rules, they are at least certain to impose a financial cost which will inevitably be passed on to consumers in the form of a higher cost of credit.
Exemptions and Foreign Safe Harbour
The proposed rules also include several important exemptions in the case of transactions backed by certain residential mortgages, commercial mortgages, commercial loans or auto loans that meet specified, stringent underlying requirements. More importantly for sponsors of Canadian-backed transactions looking to offer a tranche of ABS in the U.S., a limited safe harbour has been created if certain requirements are met, including:
- the securitization transaction is not required to be and is not registered;
- no more than 10% of the dollar value by proceeds (or the equivalent if sold in a foreign currency) of all classes of ABS interests sold in the securitization transaction are sold to U.S. persons or for the account or benefit of U.S. persons;
- neither the sponsor of the securitization nor the issuing entity is: (A) chartered, incorporated or organized under the laws of a U.S. jurisdiction; (B) the unincorporated branch or office located in the U.S. of an entity not chartered, incorporated or organized under the laws of a U.S. jurisdiction (collectively, a U.S.-located entity); and
- no more than 25% of the assets collateralizing the ABS sold in the securitization transaction were acquired by the sponsor, directly or indirectly, from a consolidated affiliate of the sponsor or issuing entity that is a U.S. located entity.
As indicated in the proposal, “the safe harbour is intended to exclude from the proposed risk retention requirements transactions in which the effects on U.S. interests are sufficiently remote so as not to significantly impact underwriting standards and risk management practices in the United States or the interests of U.S. investors”. It is perhaps worth wondering why no equivalent safe harbour was provided in respect of the earlier Dodd-Frank rule requiring securitizers to file reports relating to repurchase activities resulting from breaches of representations and warranties.
