Regulatory overkill, American style

 Michael Rumball -

Emerging from the vast literature generated by the recent financial crisis are two competing narratives attempting to identify the root cause of the crisis. One, emanating from the more conservative side of the political spectrum, emphasizes the role played by governmental policies encouraging and subsidizing the expansion of home ownership among middle and low income households. The other side focuses on the extent to which a free market philosophy came to dominate governmental thinking and led to deregulation and hence catastrophe. Although it will be crucial, from a policy perspective, to eventually ascertain just exactly what were the main drivers of the crisis, due to entrenched partisan and dogmatic differences, it may not be possible to do so until we have achieved some historical perspective. However, what does appear to be common to both narratives is that governmental actions, or, perhaps more precisely, their unintended consequences, were in some way heavily implicated.

Apart from anything else, what the foregoing might suggest is that governments should be cautious about its interventions in the market place. Rather than grand, sweeping reforms, the long-term effects of which governments have notoriously unable to accurately anticipate, what may be  called for are more surgical, incremental reforms, which, if necessary, can be revisited and adjusted from time to time as their effects become manifest.

Nevertheless, and at the risk of setting up a straw man, the position taken by U.S. regulators in respect of the ABS market appears to be that, while the last crisis may well have occurred as a result of problems specific to the real estate sector, as no one can predict the source of the next contagion, it is best to take vigorous prophylactic measures across the board now. Accordingly, they have been widely accused of, and abused for, taking a “one-size-fits all” approach pursuant to which they have crafted rules of universal application.

This approach has attracted vociferous criticism the main line of which generally goes as follows: The financial crisis occurred as a result of poor asset quality due to the application of the originate-to-distribute model characteristic of the RMBS/CMBS sector. The other, non-mortgage-backed sectors, do not use this model and investors in these sectors experienced no spike in losses during the crisis. To apply a solution crafted to address the unique problems of the RMBS/CMBS sectors to these other sectors is both unfair and unnecessary and will lead to the suffocation of those markets.

Despite sympathy for the foregoing, I am not quite sure that it entirely responds to the regulatory position, which is not to say that that position is justified. Perhaps the issue can be better approached from a slightly different angle, one that is based on the proposition that the crisis was symptomatic of a series of faulty credit decisions which made up a chain of events, each link of which was comprised of an aggregation of credit decisions each of which in turn was characterized by a fundamental lack of prudence.

The first link was comprised of decisions made by mortgage originators who advanced loans to borrowers based, in the most extreme cases, on little or no down payment, no documentation, no proof of income and, ultimately, fraud. Whatever the ultimate root-cause of these decisions, it is clear to most, including the regulators, that what stoked them was the enormous demand for product, any product, by investors. Hence, the motivation to originate for the sole purpose of distribution. By not retaining any of the risk, by not keeping any skin in the game, the originators were incentivized to worry less (or not at all) about product quality and more (or entirely) about product quantity, knowing they could pass any losses on.

The next link was characterized by the credit decisions made by purchasers of the mortgages and the issuers of securities backed by the mortgages. The fault with these decisions lay in the lack of proper due diligence on underwriting standards being applied by originators and thus the quality of the purchased mortgages as well as a failure to adequately disclose to purchasers of the securities the problematic underwriting standards and poor asset quality. Their level of imprudence may also in large part be attributable to a belief that they could also pass any problems on to investors. (It has always been a source of some wonder to me that some of the biggest players were nevertheless caught with an enormous amount of these assets/securities when the crisis arose . I am inclined to believe that this was a result of bad timing more than anything else.)

The last link in the credit chain was inhabited by investors in MBS who failed to ensure that they understood the product in which they were investing and their true exposure to faulty underwriting standards, relying too heavily on the credit analysis provided by rating agencies which have subsequently been accused of being hired enablers rather than reliable gate-keepers.

The regulators have consistently maintained that their goals in crafting the ABS proposals were two-fold: to protect investors while at the same time recognizing the importance of maintaining the securitization industry in order not to compromise the availability of credit to consumers. They have been accused, however, of paying little more than lip service to the latter and the solutions evidenced by their proposals would seem to support this accusation.

Accordingly, they have chosen to mandate prudence at each link in the chain. First, they impose prudence on originators by requiring them to have skin-in-the-game and by devising complex and expensive mechanisms to police the accuracy of representations and warranties. Second, they impose prudence on purchasers/issuers by requiring burdensome asset level disclosure and asset reviews. Third, they attempt to impose prudence on investors by attempting to dislodge their reliance on the credit analysis provided by the rating agencies and substituting therefore requirements of doubtful utility or value such as waterfall computer programs and cash-flow certification.

It should, however, have been apparent that the crisis would never have occurred unless each link in the chain of credit decisions leading to it had been faulty. In other words, without all three levels of imprudent credit decisions there would have been no crisis and the final two links are rooted in and totally derivative of (albeit compounding) the original set of credit decisions involving the failure to apply prudent underwriting standards. What necessarily follows from this is that regulators should have been able to achieve their goal of protecting investors by causing a break in the “chain of imprudence” at any single link rather than by taking a shotgun approach which will necessarily involve extensive collateral damage.

For instance, in those sectors, such as autos and credit cards, in which there is no historical evidence of the imprudent application of less than rigorous underwriting standards, and which have historically had both corporate and structural incentives to the exercise of appropriate levels of prudence in the origination of loans,  there is no justification at all for imposing further costs and burdens by the application of rules which have been specifically crafted to address a model and to correct abuses not shared by these sectors. The evil at which the rules are aimed simply did not and does not exist in these sectors. The application of these rules will create no further benefits and will entail only further costs, which should perhaps be viewed as a bright line test for regulatory overkill. Only if and when these other sectors were to evolve in the direction of the RMBS/CMBS sector would the application of similar rules to them be justifiable.

Once the issue of imprudent underwriting standards is satisfied either, in the case of autos and credit cards, by finding no evidence of the application of such imprudent standards, or,  in the case of RMBS/CBMS, by application of the new rules (assuming for present purposes that such rules are adequate and effective for such purposes) the chain of imprudence will have been effectively broken and there is no justification for the imposition of further burdens down the credit chain for the same reason: they will bring no extra benefit but will entail heavy costs. This is especially true for such artificial constructs as the proposed waterfall computer program and cash-flow certification.  (While it may be argued that mandating adequate disclosure (the second link in the chain) should thus be sufficient in the case of RMBS/CMBS, there may be other reasons why it is preferable to instead regulate at the origination link given the levels of malfeasance in the form of predatory lending which seem to have been all too common during the heyday of the crisis.) 

Perhaps a medical analogy is the most fitting conclusion: The regulators have it within their means to neutralize the cancer by the  simple excision of an identifiable tumour; but instead they seem to be insistent upon extensive radioactive and chemical therapy which, while it will certainly eliminate the tumour, may well kill the patient.

SEC's shelf eligibility re-proposal: still a long way to go

Michael Rumball


In April, 2010 the SEC proposed a number of rules relating to shelf eligibility and various disclosure requirements in respect of asset-backed securities (the April 2010 Proposals). Among other proposals, the April 2010 Proposals contained certain eligibility requirements for use of a shelf prospectus including:

 

  • A specified minimum amount of risk retention;
  • A covenant to periodically furnish an opinion of an independent third party regarding instances in which securitized assets were not repurchased following a demand for repurchase based on an alleged breach of representations or warranty; and
  • A certification by the chief executive officer of the depositor as to the adequacy of the cash flows generated by the securitized pool assets.

On July 26, 2011, the SEC issued a proposing release entitled Re-Proposal of Shelf Eligibility Conditions for Asset‑Backed Securities and other Additional Requests for Comment (the July 2011 Re-Proposals) in which it addressed each of the foregoing eligibility requirements as well as certain of its proposals relating to disclosure.

As expected, the risk retention proposal has been dropped. In July 2010, the Dodd‑Frank Wall Street Reform and Consumer Protection Act (the Dodd‑Frank Act) was signed into law. Under the Dodd‑Frank Act, a number of federal regulators, including the SEC, were tasked with jointly prescribing rules relating to risk retention requirements. On March 31, 2011 these regulators issued detailed proposals on the topic. The SEC’s decision to drop its own version of risk retention rules resulted from its view that “disparate risk retention requirements could be confusing and impose unnecessary burdens on the ABS market.”

In a previous posting, we commented upon the practical difficulties associated with the proposed requirement to obtain an opinion relating to repurchase requests and indicated that we felt that the alternative suggested by the Securities Industry and Financial Markets Association (SIFMA) would be a more workable, albeit costly, one. Apparently the SEC was also swayed by the SIFMA suggestion. Accordingly, the new shelf eligibility condition requires that the underlying transaction documents appoint a credit risk manager to review the underlying assets upon the occurrence of certain trigger events and provide its report to the trustee of the findings and conclusions of the review of assets. In addition, the documents are to contain certain provisions relating to the resolution of repurchase requests. While the new proposal does avoid a number of the pitfalls associated with the old one, we do not believe that the added complexity and cost involved in implementing the new proposal are warranted in the Canadian market which has not experienced the sort of problems relating to the enforcement of buy-back provisions which precipitated the regulatory response in the U.S.

In another posting we also discussed the certification requirement which, we argued, would have in essence required the issuer’s CEO to conduct a credit review of the ABS transaction and to assume an uncertain degree of securities law liability for such review. We concurred in the view expressed by many commentators that such a requirement would be inappropriate. A number of commentators were also concerned that the certification could be construed as a guarantee of the assets’ performance or be taken to cover classes of securities not offered, but described, in the prospectus. In response to these and other criticisms, the SEC has now modified the requirements relating to certification. Perhaps most notably, the certification relating to the adequacy of cash flow has been modified to state that “the structure of the securitization, including internal credit enhancements, ….is designed to produce, but is not guaranteed by this certification to produce, cash flows at times and in amounts sufficient to service expected payments on the asset-backed securities offered and sold pursuant to the registration statement”. While such a reformulation addresses certain of the criticisms levelled against the April 2010 Proposals, in our view it still fails to address the fundamental issue regarding the appropriateness of requiring certification relating to asset credit quality in any form whatsoever. In addition, while the re-proposal tightened the certification in certain respects, it expanded it in others relating to the certifying officer’s familiarity with the prospectus disclosure, the structure of the securitization, the relevant transaction documents, the underlying assets and the risks of ownership of the ABS.

As a final note on the shelf eligibility requirements, the SEC is now proposing a new one in keeping with its focus on the enforcement of rights contained in the transaction documents. According to this requirement, the documents must include a provision that requires the issuer to provide a notice in a public filing that an investor requests to communicate with other investors. The SEC believes that this will facilitate investors in directing the trustee to take certain actions on their behalf.

The SEC has not, at this time, revised the April 2010 Proposals relating to asset‑level disclosure. It may be recalled from a previous posting that these were the subject of much criticism from commentators. That emanating from the auto sector was especially strong, complaining that the enormous burden of such disclosure, in a sector where the individual assets in a pool could number in the thousands, dwarfed the meagre benefits that could be gained by investors since the assets in the pool would be largely homogenous. As in the past, the SEC has found cover for its approach in the Dodd‑Frank Act, in this case, the requirement imposed on the SEC to establish rules relating to asset‑level disclosure. However, the specific wording of the statute only requires the disclosure of asset-level data “if such data are necessary for investors to independently perform due diligence” which, in our view, is not an adequate answer to the foregoing criticism.  Nevertheless, at this time the SEC has chosen in the July 2011 Proposals to merely request additional comments relating to the substantive coverage and format of the previously proposed disclosure requirements.

In contrast, the SEC has indicated that it is reconsidering when, and how much, asset‑level data disclosure should be required for privately issued structured products. In the April 2010 Proposals, the SEC required that an issuer deliver, to any investor who requested it, the same information required under the prospectus disclosure requirements which, of course, would now include asset-level data. Several commentators pointed out that the April 2010 Proposals do not specify clear information requirements for certain types of ABS that are not typically offered under Regulation AB, such as CDOs, CLOs, asset-backed commercial paper or synthetic ABS. Commentators also expressed concerns that any novel asset type or structure would face uncertainty regarding their disclosure obligations. In light of these and other comments, the SEC is considering limiting asset‑level data disclosure in private placements to assets of an asset class for which there are asset‑level reporting requirements in Regulation AB, namely RMBS, CMBS, automobile loans or leases, equipment loans or leases, student loans, floorplan financings, and resecuritizations.

One of the more contentious elements of the April 2010 Proposals was that requiring most ABS issuers to file a computer program that would permit investors to run various assumptions through the securitization’s flow of funds to analyze prospective performance in connection with evaluating an investment decision and to monitor actual performance of the ABS after issuance. Market participants, including the author, expressed many concerns with respect to this proposal including the fact that such a program would be inherently imperfect and incomplete, the potential for liability under federal securities laws based on the performance of the waterfall program under any set of variables supplied by investors and the expected cost burden on issuers. In light of the weight of commentary on this issue, the SEC has indicated that it plans to re-propose the waterfall computer program separately at a later date.

It should be apparent, given the range and the significance of the issues still at play, that there is a long way to go yet before we can expect any respite from regulatory uncertainty in this market.

Risk retention tea party

 Michael Rumball  -

One of the main questions that I have returned to at various times over the course of the last year has concerned the true motivation of the U.S. regulators in proposing the various ABS regulations. As these pile up one by one, the cumulative burden placed on the securitization industry is very troubling, especially when combined with other prudential rule-making such as revisions to the Basel capital standards and the implementation of Basel III and the new accounting standards embodied in FAS 166 and 167.   I concluded my year-end piece with the observation that the final rules would reveal the SEC’s true intentions towards the securitization market; whether it wants to regulate a revitalized securitization industry or simply to make sure that it can never cause problems again. At that time, I promised to take stock again as matters develop. It appears that at least two of the heavyweights in the U.S. ABS market have decided that the proposed Dodd-Frank Risk Retention Regulations have in fact revealed those intentions clearly enough for them to take firm action now.

Despite the fact that SEC announced last week that it was extending the comment period until August 1, each of the American Securitization Forum (ASF) and the Securities Industry and Financial Markets Association (SIFMA) chose to file massive comment letters on the original due date. In so doing, they have planted their standard in firm opposition to the Proposed Regulations, presumably hoping to thereby rally opposition around it. Each of them raise the alarm over the threat posed by the Proposed Regulations to the securitization market although they have come at it from slightly different perspectives. ASF’s main concern appears to be that the rules would unduly interfere in areas of the market which in fact continued to perform during the financial crisis (a mantra which, incidentally, has been chanted by us and many others in respect of the Canadian market as a whole). SIFMA, on the other hand, simply contends that the regulators have exceeded the mandate of the Dodd-Frank Act. Both of them see the result as being potentially devastating to the securitization market.

According to ASF:

“Despite the efforts of the Joint Regulators, significant work still needs to be done to evolve the Proposed Regulations into workable solutions. What is at stake is the risk of significant reductions in the availability of auto loans, mortgages, student loans, credit cards, and commercial credit all across America. Given that many engines of the U.S. economy are still sputtering and unemployment remains extremely high, the ASF advocates strongly that these rules not overreach to attempt to “fix” sectors of the securitization markets that did not see any losses during an extreme economic downturn and instead are now powering economic revival in some areas of the economy. Attempts to realign incentives in many types of securitization structures, where those incentives have demonstrated through strong performance to be well-aligned between issuer and investor, only serve to risk harm to the American economy, American consumer and to investors.”

SIFMA is, if anything, even more scathing:

[The Proposed Regulations] would change market practices, and impose specific economic costs on securitizers, which will likely be passed on to consumers of credit. We are concerned that the impact on certain asset classes would be extreme, and detrimental to borrowers and the broader economy…The need for fundamental reconsideration of the approach taken by the Agencies to fulfilling the statutory mandate that credit risk be retained in most securitizations could hardly be more urgent…We believe that Congress intended what the Dodd-Frank Act provides for, and that is retention of at least 5 percent of the credit risk related to securitized assets – not an artificial mechanism to limit profitability and discourage securitization…We note with concern that some market participants are so disheartened by the approach taken by the Agencies in drafting the proposed credit risk retention rules that they are speaking in terms of having one year, or two years, remaining “to get deals done” — a reference to the effective dates of the risk retention rules for residential mortgage-backed securities and other ABS, respectively. The industry as a whole needs to be able to approach implementation of the proposed rules in a positive, constructive spirit. In order to do that, we will need sensible, reasonable rules that will fulfill the statutory mandate for “skin in the game” while still permitting securitization transactions to take place.”

Each of ASF and SIFMA reserve their main vitriol for the proposed premium capture provision. ASF claims that it exceeds the mandate and legislative intent of Dodd-Frank by adding on to the 5% risk retention requirement the entire value of ABS issued in a securitization over par “effectively nullifying the securitizer’s entire return on the transaction … [and eliminating] all incentives to securitize other than those that securitize purely for financing.”

Furthermore, although the rules purport to permit a number of methods of risk retention in conformity with existing market practices, it is contended that the definitions of, and the requirements for, those methods would in fact not accommodate existing practices, but rather contain “significant differences that would create major disruptions in the ABS market.” According to ASF,

“If the risk retention rules are not appropriately designed to accommodate existing market practices, we risk an immediate and significant reduction in the availability of auto loans, student loans, credit cards and business credit throughout our country without gaining material improvements to the risk retention practices that protected investors even during the worst of the financial crisis. The risk of shutting down the securitization markets is not warranted where investors have been protected by existing risk retention methods. Therefore, it is imperative that the provisions of the Proposed Regulations accommodate existing market practices that effectively align the interests of sponsors with those of investors.

SIFMA also highlights the manner in which risk retention is to be calculated which, they contend, would result in risk retention in an amount far greater than 5 percent of the credit risk of the securitized assets. According to SIFMA, this proposal (together with the premium capture provision) could be “so burdensome that significant segments of the ABS market could simply shut down…The effect of these provisions could be to render many securitizations uneconomical by substantially increasing the amount of risk required to be retained and reducing or eliminating the profitability of securitization transactions…SIFMA has described the potential impact of the proposed risk retention rules as ‘monumental’ and we do not exaggerate.”

Each of SIFMA and ASF call for substantial revision of the proposals. SIFMA contends that the Agencies have failed to properly weigh the costs of compliance and the impact of the Proposed Regulations on the capital markets. While they accept and support the principal of mandatory risk retention required under Dodd-Frank, they suggest that the regulations must implement the statute “in a manner that accomplishes the statute’s purpose without doing more damage to the capital markets than is necessary and reducing the availability of credit”. They believe that the Joint Regulators have rushed to make the Dodd-Frank deadline and in so doing have “missed the mark in many key areas and failed to achieve the recommendations of the risk retention studies mandated by Dodd-Frank”. They need to “step back, and reconsider the proposal, and take the time to get it right”. They each call for a re-submission of the proposals for further consideration and public comment prior to adoption. “We strongly believe that this course of action will better enable the Joint Regulators to ensure that the final regulations achieve the goals of Dodd-Frank while promoting a healthy and vibrant securitization market”.

It thus appears that the battle south of the border has finally been well and truly joined and should make for interesting theatre. However fascinating and entertaining it may turn out to be, however, the fact that we have been spared our own version is something to be thankful for.

SEC and CSA restrictions on the exempt market for securitized products

Michael Rumball -

As reported earlier, the SEC has included in Reg AB II proposals relating to the private market.  These would require that, in order for a reseller of a “structured finance product” to sell a security in reliance on Rule 144A or in order for an issuer of a “structured finance product” to sell a security in reliance on Rule 506 of Regulation D (the so-called “safe harbors”), the underlying transaction agreement must grant to initial investors and transferees, as applicable, the right to request, both initially and on an ongoing basis, the same information that would have been required had the transaction been registered.

As formulated, these proposals could create significant contingent closing risk for issuers leaving them with no practical options but to assume the worst by preparing the necessary disclosure.  Given the enhanced disclosure requirements of Reg AB II, this could be a very difficult proposition, especially for issuers who have traditionally accessed the private market because they are unable to satisfy all public market requirements.  These provisions could be especially problematic for ABCP issuers. It is hard to imagine how an issuer of ABCP would set about complying with many of the requirements of Reg AB II, such as asset level disclosure and waterfall computer programs, in respect of each originator.

It is important to note here, however, that, as of yet, there does not appear to be any restriction on investors agreeing not to request disclosure.  Although this may not benefit issuers of ABCP, whose investors may change on a regular basis, for other issuers this may be the practical way to carry on with investors whom they know and trust.

As we have discussed in previous pieces, the CSA have also decided to more closely regulate the exempt market.  When compared to Reg AB II, the CSA proposals are both less and more restrictive and thus problematic.

The CSA has proposed a new securitized product exemption available only to “eligible securitized product investors”.  In order to qualify for the securitized product exemption, the issuer will be required to deliver an information memorandum to the purchaser which must (i) disclose sufficient information about the securitized product and securitized product transaction to enable a prospective purchaser to make an informed investment decision; (ii) describe the rights of action that the issuer will have against, among others, the issuer, the sponsor and the underwriter for any misrepresentations in the information memorandum; (iii) describe the relevant resale restrictions; and (iv) not contain a misrepresentation.  For short term securitized products, the information memorandum must also be in the prescribed form.

The CSA proposals compare favourably to the Reg AB II proposals in that there is no specific disclosure requirements, at least for medium-term notes. This positive note is somewhat tempered by a residual concern that the combination of requiring sufficient information to enable a prospective purchaser to make an informed investment decision and that there be no misrepresentation may, in practice, not be far distant from the standard of full, true and plain disclosure.   Nevertheless, even if, as we expect, prospectus level disclosure is adopted as the standard for information memoranda, compared to the Reg AB II requirements, the CSA proposals are relatively straight forward.

On the other hand, given the fact that the provision of an information memorandum is a precondition to accessing the exemption and thus cannot be waived, the situation is significantly worse than under Reg AB II.  The new rules would create unsustainable burdens in both the mid-term and short-term note markets.  A number of mid-term note transactions involve single seller trusts established by the originator which purchases or leases the underlying assets and then issues a medium-term note to, for example,  an ABCP conduit.  Under the proposals, the note issued to the ABCP conduit would be a securitized product for which an information memorandum would be required.  This is patently ridiculous where the purchaser is someone whose business it is to structure and thus understand these products.  This is the very model of a sophisticated purchaser who does not need regulatory protection and can, and should have the freedom to, fend for itself.     The only effect of requiring the delivery of an information memorandum in such circumstances would be to increase the cost of doing business.  Accordingly, we believe that it is essential that appropriate exceptions be created to this requirement for “highly sophisticated” investors such as financial institutions and entities administered by them.

The problems posed by the proposed rules for issuers of short-term securitized products are, if anything, even more serious.  Under the proposed regime, ABCP conduits would need to provide detailed disclosure relating to asset pool characteristics and performance and other matters which by definition will change on a regular basis.  The cumulative effect of the proposed rules would seem to require ABCP conduits to maintain current disclosure on a virtually daily basis. The strain on resources, not to mention the effect on costs which would ultimately be passed on to originators, may well be sufficient to effectively destroy an economic model which has been a crucial source of credit in the Canadian market.

Dodd-Frank proposed risk retention rules and safe harbour for foreign transactions

 Michael Rumball -

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:

  1. the securitization transaction is not required to be and is not registered;
  2. 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;
  3. 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
  4. 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.

Proposed new CSA Exempt Distribution Rules - new playing field for securitized products not exactly a field of dreams

Mark McElheran

The proposed exempt distribution rules published for comment by the CSA on April 1, 2011, if enacted as proposed, will have a very significant impact on the exempt market for securitization transactions and would effectively transform the exempt market for securitized products into a quasi-public market. In addition to narrowing the scope of eligible exempt investors (creating a special category of “eligible securitized product investors”, which has been discussed in a previous post), the proposed amendments to NI 45-106 would also impose significant disclosure obligations at the time of issuance and on a continuous basis and create certification requirements as part of a broader statutory civil liability regime. The proposed changes to the exempt market are a significant departure from traditional securities regulatory policy and its emphasis on the protection of unsophisticated investors.

Information Memorandum Requirements

In order to qualify for the securitized product exemption, the issuer will be required to deliver an information memorandum (IM) to the purchaser, which must (i) disclose sufficient information about the securitized product and securitized product transaction to enable a prospective purchaser to make an informed investment decision; (ii) describe the rights of action that the issuer will have against, among others, the issuer, the sponsor and the underwriter for any misrepresentations in the IM; (iii) describe the relevant resale restrictions; and (iv) not contain a misrepresentation. For a short term securitized product, the IM also has to be in the prescribed form.

In its request for comments, the CSA indicated that it developed the prescribed form of IM by reviewing, among other things, existing ABCP information memoranda, the information that the Bank of Canada expects when reviewing to accept ABCP as eligible collateral for its standing liquidity facility and comment letters on the October 2008 ABCP Concept Proposal. A typical IM in the market today is basically a very broad overview of the types of assets that will be acquired by the ABCP issuer and a description of the main parties involved in administering and/or providing support to the ABCP issuer and the expected rating of the ABCP to be issued.

While all of this information is required by the prescribed form, it also requires more extensive detail, in particular with respect to specific transactions. For example, the prescribed form requires disclosure of the investment guidelines applied to the pool assets that limit the types and credit quality of assets and asset originators – while a general set of eligibility criteria can be constructed, these will vary somewhat across asset classes and will also vary somewhat from originator to originator. In addition, if the issuer has acquired pool assets, it is required to provide certain disclosure prescribed by Form 45-106F8 (the prescribed form of periodic disclosure for short-term exempt securitized products). This would include disclosure of each asset type acquired by the issuer (expressed as a dollar amount and as a percent of the issuer’s aggregate assets), the industry of the seller (expressed as a dollar amount and as a percent of the aggregate assets) and the percent of assets in the series acquired by each seller. It would also require disclosure describing the assets, including the average remaining term, number of obligors and weighted average life of the assets and detailed performance data, including default and delinquency data. These information requirements would seem to require that an IM be continually updated to reflect the acquisition of new assets, the amortization of existing assets, and to provide an updated performance report. As ABCP issuers are continuously distributing their securities, compliance with these requirements may pose a very significant challenge. Given the periodic disclosure obligations that are proposed to be imposed on ABCP issuers by way of monthly reports (among other things), it isn’t clear why this information would be required to be contained in the IM.

For securitized products that are not short-term, there are no prescribed requirements but, as noted, the IM will need to disclose sufficient information about the securitized product and securitized product transaction to enable a prospective purchaser to make an informed investment decision. This obligation sounds an awful lot like “full, true and plain disclosure” and is clearly a higher standard than applies generally to offering memoranda under existing securities laws (which require that offering memoranda not contain a misrepresentation). Existing disclosure in the exempt term market for securitized products has often been described as “prospectus-like”; and given this heightened standard, coupled with the increased certification requirements discussed below, this is certain not to change.

One of the CSA’s guiding principles in establishing the securitized product rules was that the rules should take into account the particular features of the Canadian securitization market and be proportionate to the risks associated with particular types of securitized products available in Canada and should not unduly restrict investor access to securitized products. Some may question whether the proposed IM rules, which apply irrespective of the type of asset class or issuer involved, are consistent with this guiding principle.

Certification Requirements/Expanded Statutory Civil Liability

One of the more significant aspects to the IM requirements is the requirement that a certificate be signed by the issuer’s CEO and CFO (or individuals acting in a similar capacity), each promoter and each sponsor, stating that the IM does not contain a misrepresentation. In addition, each underwriter will be required to sign a certificate stating that, to the best of its knowledge, information and belief, there is no misrepresentation in the IM. The certifications are required to be true at both the date the certificate is signed and the date the IM is delivered to the purchaser (the latter requirement being further indication that the IM needs to be continually updated). These certification requirements are part of the intended extension of statutory liability for disclosure in information or offering memoranda for securitized products to include third parties such as sponsors and underwriters. The CSA has noted that the statutory civil liability can be achieved in most jurisdictions by prescribing the IM as an offering document to which statutory civil liability rights apply which would then permit a right of action for damages against anyone signing the IM. In Ontario, legislative amendments would be required for statutory rights of action to be available against sponsors and underwriters. Although the standard of disclosure in a private securitized products transaction will not on its face be the same as in a public transaction (which requires full, true and plain disclosure of all material facts), one would expect that underwriters will cease to draw much of a distinction between public and private offerings of securitized products going forward.

A copy of any IM delivered to a prospective purchaser will need to be delivered to the securities regulatory authority and posted on a website within 10 days after a distribution under the IM. A report for the distribution of a short-term securitized product is not required to be delivered if the report is filed not later than 30 days after the calendar year in which the distribution occurs.

Periodic Disclosure Requirements for Exempt Securitized Products

The proposed rules also impose periodic disclosure obligations on issuers of securitized products. These rules would appear to apply not only to new securitized product issuances but also to existing securitized products. As with the IM rules, a distinction is drawn between short-term securitized products and other securitized products. Issuers that distribute securitized products under the securitized product exemption, other than short-term securitized products, will be required to prepare a prescribed form of payment and performance report similar to what is required to be prepared by a reporting issuer and post it on a website within 15 days of each payment date (and deliver a copy to the securities regulatory authority). The issuer is also required to prepare a timely disclosure report upon the occurrence of certain stated events (which are the same events that a reporting issuer is required to disclose). In essence, the continuous disclosure obligations for reporting issuers and non-reporting issuers who issue securitized products maturing more than one year from the date of issuance have effectively been conformed.

Continuous disclosure obligations will be discussed in a future post but would include payment defaults, rating changes, changes in trustees or servicers, certain triggering events such as early amortization events that would materially alter the payment priority or distribution of cash flows and a “difference of 5% or more occurring in a material pool characteristic of an asset pool for outstanding securitized products from the time of issuance of the securitized products, other than as a result of the pool assets converting into cash in accordance with their terms” (one can only imagine the number of ways that this could be interpreted). This report would need to be posted on a website no later than two business days after the occurrence of the event and investors must be provided with a copy or otherwise advised of the report. Query whether all reportable events will be known to the issuer within two business days of the occurrence of the event, in particular asset performance-related events where reporting to the issuer may lag the occurrence of the event.

Issuers of short-term securitized products are required to prepare a periodic disclosure report in the prescribed form dated as of the end of the last business day of each month and within 15 days of the end of each month it is required to delivery a copy to the securities regulatory authority and post a copy to a website. This disclosure report requires a significant amount of information, including very detailed transaction-specific disclosure in regards to asset composition and performance.

If an investor would reasonably require the information to make an informed investment decision, an issuer is also required to provide disclosure of any change to the information disclosed in the most recently delivered report or to the disclosure in the IM as well as disclosure of an event that affects payments or pool performance. This report is required to be delivered to the securities regulatory authority and posted to a website no later than two business days after the date on which the relevant event or change occurred. As noted, for some events there may be a delay between the time when the event occurs and the reporting of that event to the issuer, which would preclude reporting within this timeframe. Also, the requirement to provide timely disclosure of any change to the disclosure in the IM would seem to be a further indication that the IM is intended to be a document that requires continuous monitoring and updating.

Resale Restrictions

The proposed rules would make the first trade of a securitized product that was distributed under the securitized product exemption a distribution, with the effect that the only prospectus exemption that would be available for a resale of a securitized product would be the same securitized product exemption, resulting in a “closed-system” for securitized products.

CSA proposed Securitized Products Rules - exemptions

Jason Kroft and Doug Bryce -

The securitized product rules proposed by the Canadian Securities Administrators (CSA) seek to, among other things, narrow the class of investors who can buy securitized products on an exempt basis. In subsequent blog pieces, we will investigate the disclosure that is required for exempt offering under the new regulatory regime at the time of issuance as well as on a continuous basis post-issuance.

Item 3 of the proposed CSA rules deals with the various amendments to the current prospectus and registration exemption regime in now found in National Instrument 45-106 Prospectus and Registration Exemptions (NI 45-106), as well as the proposed new exemption which is specific to securitized products. In the following, we highlight the changes likely to have the largest impact on the Canadian securitized products market.

 The proposal makes a number of prospectus exemptions currently in NI 45-106 unavailable for distributions of securitized products, specifically:

  1. accredited investor (section 2.3);
  2. private issuer (section 2.4);
  3. offering memorandum (section 2.9);
  4. minimum amount investment (section 2.10);
  5. financial institution or Schedule III bank specified debt (subsections 2.34(2)(d) and (d.1)); and
  6. short-term debt (section 2.35).

These above-listed exemptions would be replaced with a three-part exemption requiring that each investor (i) purchases the securitized product as principal, (ii) fits into the newly proposed definition of an “eligible securitized product investor” and (iii) is delivered an information memorandum on or before their purchase.

An “eligible securitized product investor” is similar in large part to the old definition of “accredited investor” in NI 45-106 and is essentially the same as the definition of “permitted client” in NI 31-03 Registration Requirements and Exemptions, the main differences being the deletion or modification of the asset and income tests applicable to individuals and small investors. Whereas previously, such investors were often able to rely in items (j) through (m) in the definition of “accredited investor” (as set out below), items (k) and (l) have been deleted, and the thresholds in items (j) and (m) have been drastically increased to $5,000,000 and $25,000,000 respectively.

(j) an individual who, either alone or with a spouse, beneficially owns, directly or indirectly, financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000;

(k) an individual whose net income before taxes exceeded $200,000 in each of the two most recent calendar years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent calendar years and who, in either case, reasonably expects to exceed that net income level in the current calendar year;

(l)  an individual who, either alone or with a spouse, has net assets of at least $5,000,000;

(m) a person, other than an individual or investment fund, that has net assets of at least $5,000,000 as shown on its most recently prepared financial statements, and has not been created or used solely to purchase or hold securities as an accredited investor;

Additional amendments have been proposed to the parts of the “accredited investor” definition which are applicable to investment funds. In particular, under the proposed regime investments funds would have to be managed by a person registered as an investment fund manager under the securities legislation of a jurisdiction in Canada, or advised by a person authorized to act as an adviser under the securities legislation of a jurisdiction in Canada. So, for instance, the creation of an investment product by a foreign non-registered entity or even a sophisticated market participant to issue ABS where the investment manager and/or an investment adviser does not have the appropriate securities registrations could be problematic in the exempt space.

The practical implications of narrowing the scope of exempt investors in securitized products remains to be seen. It is possible that the exempt investor rules may not have a material impact on the actual scope of the investor base for securitized products, but time will tell whether that is true. Please contact either of the authors to share your own thoughts on the proposed new regulatory regime for exempt distributions of securitized products.

CSA proposed Securitized Products Rules - definition of securitized products

Michael Rumball -


As indicated in our previous posting, the Canadian Securities Administrators have proposed a new framework for the regulation of securitized products which includes:

•enhanced disclosure requirements for securities issued under a prospectus

•enhanced continuous disclosure requirements

•certification requirements

•rules narrowing the class of eligible investors in the exempt market

•rules prescribing disclosure, both initial and ongoing, in respect of exempt distributions.

We will be providing regular commentary in this forum on the proposed framework and its potential implications for securitization market participants. This is our first such submission and touches upon the initial, threshold, issue of applicability. What all of these proposed rules have in common is that they apply to “securitized products”, which is the subject of a new definition.

There are two general categories of securitized product:

(a) a security that entitles the security holder to receive payments that primarily depend on the cash flow from self-liquidating financial assets collateralizing the security, such as loans, leases, mortgages and secured or unsecured receivables; and

(b) a security that entitles the security holder to receive payments that substantially reference or replicate the payments made on one or more securities of the type described in (a) but that do not primarily depend on the cash flow from self-liquidating financial assets that collateralize the security.

Following each category of securitized product is a purportedly non-exhaustive list of included examples. 

Listed under paragraph (b) are synthetic asset-backed securities and other synthetic financial instruments (synthetic CDOs, CMOs, CLOs, CBOs, etc). While the term “synthetic” is not defined, it appears that the list of examples is meant to illustrate the meaning of paragraph (b). However, most “synthetic” financial instruments can be said to entitle investors to receive payments that primarily depend upon the cash flows from (i) one or more derivatives that provide economic exposure to referenced debt obligations or defined categories of obligations and (ii) the collateral securing such derivatives. The payments do not necessarily reference or replicate a security referenced in paragraph (a). Many credit default swaps reference corporate or sovereign debt obligations, not just ABSs or CDOs and these do not seem to be captured.

What may be of more concern here is that the definition of synthetic securitized product (paragraph (a) may end up capturing a wider variety of instruments than may have been intended. For instance structured notes such as credit-linked notes that reference a basket of corporate debt could conceivably be caught if the basket can in some way be thought of as including “securities of the type described in paragraph (a)” which includes CDOs, etc. Perhaps the real problem is that the terms CDO, CMO, CBO, etc are not defined and have somewhat amorphous meanings themselves.

Any synthetic securitized products caught by the definition would become subject to the disclosure requirements specified in Proposed NI 41-103. These almost entirely deal with topics applicable to asset-backed securities and would be of doubtful applicability to synthetic securitized products. Thus the supplementary disclosure required in respect of the latter remains unclear. This may not be of great concern since in the past almost all, if not all, synthetic securities were offered in the exempt market. It is probable that this would remain the case in the future and the rules relating to disclosure in information memoranda are flexible enough to accommodate synthetic securitized products.

Paragraph (a) presents its own interpretive issues. First, the list of examples not only includes CDOs, CMOs, CBOs, etc but also includes “asset-backed securities”. The “asset-backed security” definition is the same as the current definition in NI 51-102 and is more or less identical to the Reg AB definition, being “a security that is primarily serviced by the cash flows of a discrete pool of mortgages, receivables or other financial assets, fixed or revolving, that by their terms convert into cash within a finite period and any rights or other assets designed to assure the servicing or the final distribution of proceeds to security holders”.

Unfortunately, the definition is not expanded as it is under Reg AB to clarify the interpretation of the phrase “discrete pool of assets” in the context of master trusts, co-ownership interests, prefunding periods and revolving periods. For instance, in the context of the usual co-ownership arrangement used for revolving assets such as credit cards, a single pool could support multiple series of securities. Similarly the application of the definition to the residual value of lease assets is clarified in Reg AB, presumably due in part to the fact that, by their terms, the underlying automobiles do not necessarily convert to cash within a finite period although the related leases do. Thus, for example, if in an auto lease deal, the residual value of the autos represents more than 50% of the securitization value of the asset pool, can the payments owing to security holders be said to be “primarily serviced by” the cash flow from the financial assets, in this case, the leases? Finally consider the example of a CMBS backed by a single very large mortgage. This would not seem to satisfy the “discrete pool of … financial assets” criteria in the definition.

The example of CMBS further highlights a potentially more serious interpretive difficulty. In a CMBS transaction, the offered security represents a direct ownership interest in the underlying assets. The assets cannot really be said to “collateralize the security” unless this phrase is to be interpreted broadly to mean something like “back or otherwise dedicated to payment of the security”. It is clear from Proposed NI 41-103 that CMBS were intended to be subject to the new rules and, since CMBS clearly satisfy the definition of asset-backed security, it appears that the inclusion of this definition as an example under paragraph (a) should be read as colouring the interpretation of paragraph (a), specifically the meaning of the word “collateralizing the security”.

The real problem arises, however, if this broader interpretation is applied beyond the non-controversial case of CMBS to various securities which, while they share certain characteristics of traditional asset-backed securities, are not generally thought of as true asset-backed securities.

The language of paragraph (a) appears to be derived directly (although somewhat grammatically re-arranged) from the new definition of securitized finance product in Reg. AB II (which, it is interesting to note, unlike the CSA rules, only applies to the safe harbour modifications) and the definition of asset-backed security under the Dodd-Frank Act. Concerns have been raised by various commentators in the U.S. about the untoward breadth of these definitions. Many issuers of securities, including financial institutions, mutual funds and certain income trusts and REITs, depending on their underlying structure and asset mix, may hold various financial instruments and the cash flow to support payments to their securityholders may be primarily derived from the liquidation of these assets. Perhaps in most of these cases it can not be said, in any true sense, that the financial assets “collateralize” the security but if that word is given a broad meaning, uncertainty may begin to creep into the analysis.

This sense of uncertainty is heightened when the exclusions adopted by the CSA are critically examined. Excluded from the scope of the proposed ruling are covered bonds (which are undefined) and securities, other than debt securities, issued by a mortgage investment entity. The latter is defined as a person or company

(a) who invests substantially all of its assets in debts owing to it that are secured by one or more mortgages, hypothecs, or other instruments, on real property; and

(b) whose primary purpose or business activity is originating and administering mortgage loans, with the intent of holding such mortgages for the entire term and of using the revenues generated by holding the mortgages to provide a return for its investors.

For present purposes at least, the exclusions themselves are less interesting than the negative implications that they raise. First, a covered bond is generally considered, in the CSA’s own words, as “a primary obligation of the financial institution with the cover or collateral pool serving as credit enhancement” which seems to support a broad interpretation of the concept of “collateralizing” the security. More troubling though, is  the implication that other securities may be caught provided they are, in some sense, “collateralized” by a pool of self-liquidating financial assets even if they primarily rely on the general credit of another party (i.e., the security bears recourse to a specific operating company or other credit source). 

Second, the exclusion of securities, other than debt securities issued by mortgage investment entities, implies that any security (including equity and corporate debt) issued by an entity whose primary business, and thus source for funding payment to investors, is the originating and administering of financial assets other than mortgages on real property, and any debt security, however structured (or for that matter unstructured), issued by a mortgage investment entity, may be a securitized product.

The foregoing discussion is not meant to imply that the CSA intended to subject, for example, recourse securities issued by finance companies to the enhanced disclosure requirements for securitized products. What it does illustrate, however, is that, when the definitions are subjected to techniques of statutory interpretation, certain ambiguities may emerge giving rise to uncertainty. In the context of transactions generally requiring opinions as to compliance with securities laws, such uncertainty may become problematic.

As indicated above, we will continue to offer our observations on various aspects of the CSA proposals over the next couple of months leading up to the June 30 deadline for the submission of comments. We would like to invite all our readers to consider this to be a forum for introducing and airing your own views and concerns. All you need to do is to post a comment on this piece or, if you would prefer, send one of us an e-mail. We would be happy to collect and consider your comments and may raise some of your points (for attribution or not as you may indicate) in future pieces.

Proposed CSA Rules for securitized products create sweeping issuer disclosure obligations and new exempt market regime

On March 25, the Canadian Securities Administrators (the CSA) published for comment the proposed National Instrument 41-103 – Supplementary Prospectus Disclosure Requirements for Securitized Products and National Instrument 51-106 – Continuous Disclosure Requirements for Securitized Products (together, the Proposed Rules), along with proposed amendments to National Instrument 52-109 – Certification of Disclosure in Issuers Annual and Interim Filings, National Instrument 45-106 –Prospectus and Registration Exemptions (NI 45-106) and National Instrument 45-102 – Resale of Securities (collectively, the Proposed Amendments, and together with the Proposed Rules, the Proposal).

According to the CSA, the Proposal contains four main features:

  1. Enhanced prospectus disclosure requirements for securitized products issued by reporting issuers;
     
  2. New prospectus exemption rules for securitized products that require, in most cases, the delivery of an “information memorandum” to investors and narrow the class of investors who can buy securitized products on a prospectus exempt basis.

    Specifically, the Proposal would make a number of prospectus exemptions currently in NI 45-106 unavailable for distributions of securitized products, including: section 2.3 (the accredited investor exemption), section 2.4 (the private issuer exemption), section 2.9 (the offering memorandum exemption) and section 2.10 (the minimum amount investment exemption). These exemptions would be replaced by a new prospectus exemption for investors who are fit into the narrower proposed definition of “eligible securitized product investor”;
     
  3. Prospectus level liability for issuers, sponsors and underwriters, including CEO certification of “information memoranda”; and
     
  4. Continuous disclosure and prescribed monthly reporting obligations for both reporting issuers and issuers in the exempt market.

The Proposal contains significant, and in many cases, onerous requirements which will have a material impact on a Canadian industry with a very positive track record of performance.

The CSA is accepting comments on the Proposed Rule until June 25, 2011.

We will be posting detailed future commentary on these proposed rules with a view to creating the broadest possible discussion among market participants. We encourage you to let us know your views. Stay tuned.

Final Dodd-Frank ABS rules:representations and warranties and review of assets

Michael Rumball -

As described in a number of previous posts (see my posts of October 21, October 28 and November 4), in October, the SEC published two proposals for rules mandated by the Dodd Frank Act: (i) those related to representations and warranties in ABS securities offerings; and (ii) those requiring any issuer of registered ABS to perform a review of the assets underlying the ABS.

The final rules have now been published.

Representations and Warranties

This rule requires

(1) any securitizer to disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer, so that investors may identify asset originators with clear underwriting deficiencies; and
(2) each NRSRO to include, in any report accompanying a credit rating for an ABS offering, a description of (A) the representations, warranties and enforcement mechanisms available to investors; and (B) how they differ from the representations, warranties and enforcement mechanisms in issuances of similar securities”.

The important points to understand about the new rule relating to securitizers are:

  1. They apply in respect of all registered and non-registered issuances of ABS.
     
  2. The initial proposal has been amended to require a three-year look-back period ending December 31, 2011 (as opposed to the originally proposed five year period).  Whereas the initial proposal was to be triggered upon the first issuance of an ABS containing a repurchase obligation after the implementation of the rule, the final rules will require disclosure by “any securitizer that issued an Exchange Act-ABS during the three year period ended December 31, 2011, that includes a covenant to repurchase or replace an underlying asset for breach of a representation and warranty.”
     
  3. The initial filing will be required to be made on EDGAR by February 14, 2012 and is to be made in the prescribed tabular form setting out, for instance, the names of originators.
     
  4. A provision was introduced to permit a securitizer to omit information that is unknown or not reasonably available without unreasonable effort or expense.
     
  5. After the initial disclosure, periodic disclosure of demand, repurchase and replacement history will be required to be made on a quarterly basis (as opposed to monthly as originally proposed).
     
  6. A securitizer who has not been presented with a repurchase demand in any particular period may, in lieu of providing the required disclosure in tabular form, merely check a box indicating that it has received no demands for the period in question and thereafter may suspend quarterly filings until such time as there is a change in the demand, repurchase or replacement activity, although annual filings will still be required.
     
  7. If no ABS are held by non-affiliates as of the end of the period in question, then disclosure may be terminated upon the filing of a notice to that effect.
     
  8. Similar disclosure will also be required in prospectuses registered under Reg AB although repurchase history disclosure can be limited to those repurchases involving the same asset class and the look-back period will be phased in over the next three years.

Of particular interest to Canadian securitizers, these requirements will apply to any who issued a tranche of ABS in a private or public transaction into the U.S. during the three-year period ending December 31, 2011 and which are still outstanding on such date.  Of course, it will also apply to any Canadian securitizer issuing such ABS into the U.S. in the future. Whether the inconvenience associated with this requirement will temper the appetite for involving U.S. investors in Canadian-based deals remains to be seen.

The NRSRO disclosure rule was adopted as proposed.  As noted in our original piece on the proposed rule, it should be anticipated that rating agencies, in an attempt to make their obligations more manageable, will be motivated to try and introduce a degree of uniformity on the representations and warranties contained in transactions involving “similar securities” (whatever these might be as no guidance is provided in the rule).

Review of Assets

The second rule requires issuers of registered ABS to perform a review of the underlying assets that, at a minimum, must be designed and effected to provide reasonable assurances that the disclosure regarding the pool assets in the prospectus is accurate in all material respects.  If a third party is employed to perform this review and the review is attributed to it in the prospectus then the third party must consent to being named as an “expert” and thus potentially attract expert liability.  In an attempt to address concerns that this would scare off third parties willing to perform these reviews, the SEC has indicated that the issuer can avoid this issue by adopting the findings and conclusions of the third-party review as its own.

In addition, disclosure will need to be made in the prospectus regarding:

  • The nature of the review;
  • The findings and conclusions of the review; and
  • Any assets in the pool that do not meet the underwriting standards, who determined that the assets should nevertheless be included in the pool and the factors that were considered in making the determination.

Why a rule was necessary to require an issuer to conduct due diligence in order to ensure that the disclosure in the prospectus was accurate is somewhat mystifying, at least to me.

The other aspect of the proposed rule, that which would require the pre-filing of third-party due diligence reports obtained by an issuer or an underwriter in connection with any registered or unregistered ABS offering, has been postponed until a later date so that it can be integrated with other related rule changes.

Canadian asset performance - a relative story

Mark McElheran

It remains to be seen whether the reform fever that is presently sweeping through the US securitization market will continue unabated across the 49th parallel but there is no question that these monumental reforms have given rise to a considerable amount of discussion and debate over the appropriateness of similar reforms in Canada. This was perhaps inevitable given the degree of economic integration between the two countries and the fact that both have recently suffered through significant ABS-induced crises (albeit on entirely different scales).

Although these crises may have shared some of the same root causes, the US proposals for reform appear to have been heavily influenced by the US subprime mortgage meltdown and appear to be intended to address the lack of regulatory oversight that permitted the now much-maligned underwriting and product origination and distribution practices in the US subprime mortgage market that arose amid this regulatory vacuum; practices that were not prevalent (if even evident) in Canada. While a more extensive summation of these practices and the US reform proposals can be found in previous postings by Mike Rumball, given the insular nature of these problems, it is important to assess the Canadian market on its own merits in determining the scope and form of future Canadian reforms. We hope, in particular, that Canadian regulators will carefully consider the strong historical performance of Canadian financial assets in the course of determining the necessity, scope and nature of structural reform.

By any number of empirical measures, the Canadian economy tends to lag behind that of the US (both in absolute terms and in relative comparisons). Although the absolute volumes are difficult to compare given the enormous difference in the size of the respective markets, a review of the performance of some of the major asset classes that underlie the Canadian securitization market (such as residential mortgages, credit cards and auto loans and leases, asset classes that are now commonly referred to in the post-CDO era as “traditional assets”) reveals that these Canadian assets significantly outperform similar assets in the US. This being said, US asset performance appears to have suffered from guilt by association with the subprime mortgage market as US asset performance has otherwise been relatively solid.1

Putting aside the subprime mortgage market, prime mortgage defaults began to rise in the US in early to mid 2007, peaking at just over 7% by late 2009/early 2010.  Prior to that, mortgage default rates in the US during the period of 1998 to 2007 generally ranged from 0.70% to 1%.  Canadian mortgage default rates have generally trended in the range of 0.20% to 0.50% during this period and gradually increased from the lower end to the higher end of this band during 2009.

Net loss rates for credit cards show that in the 1998 to 2007 period, Canadian loss rates ranged between 2% and 4% while US loss rates for credit cards ranged between 4% and 6%. The loss rates in both Canada and the US began to climb beginning in late 2007/early 2008, reaching a peak of 10.80% in the US in mid to late 2009 and a peak of 6.38% in Canada in late 2009. Payment rates in Canada also significantly exceed those in the US (suggestive of a lower risk profile); over the past decade the payment rates in Canada have generally ranged between 30% and 35%(although briefly dipping as low as 26% at times in 2009 and 2010) while payment rates in the US have generally ranged between 15% and 20% during this period.

The contrast in the numbers for auto leases and loans are also significant. For issuance years 2005 through 2007, US default rates have peaked to date at approximately 1.65% (2005), 2.5% (2006) and 2.75% (2007) while Canadian default rates over the same period have peaked at approximately 0.30% (2005), 0.65% (2006) and 0.85% (2007). For issuance years 2008 and 2009, default rates in the US peaked at approximately 2.50% (2008) and 0.85% (2009) and default rates in Canada peaked at approximately 0.85% (2008) and 0.40% (2009). It should be noted that these numbers do not reflect any residual value losses.

Astute observers of the Canadian market may also ask why I have made no mention of the performance of the assets that were funded by numerous non-bank sponsored ABCP conduits (which ultimately became the subject of the so called “Montreal Accord”) and point to this “ABS-induced crisis” as a basis for suggesting that reform is required.While this is a valid question, the assets in these conduits which caused the greatest concern were not traditional assets but “non-traditional” assets such as leveraged credit default swaps and certain assets with exposure to US subprime mortgages.

All in all, the asset performance story in Canada is a very positive one. Not surprisingly, strong asset performance has translated into strong ABS performance.While, as noted, there have been some losses incurred in these traditional asset classes, the credit enhanced ABS structures in the Canadian market have survived the test of time.In fact, apart from certain series of debt restructured in connection with the Montreal Accord, no rated ABS debt in Canada has suffered any losses to date.

There are many challenges facing the Canadian securitization market. The uncertainty created by evolving bank regulatory capital standards and the transition of accounting standards to IFRS have together not only acted as a constraint on growth in the market but as a catalyst for contraction until market participants are able to assess the impact of these changes. While some reform is likely inevitable given the current international environment, we hope that change will not be made simply for the sake of change and that any reform proposals will not create additional uncertainty but will be appropriately tailored to the realities of the Canadian marketplace and recognize that Canadian ABS transactions are fundamentally strong.


[1] We gratefully acknowledge that numerical data was provided by DBRS Limited. The numerical figures set out in this article have been rounded or approximated for illustration purposes and are not exact. Any conclusions or opinions expressed in this article are solely those of the author and not of DBRS Limited.

SEC proposals on ABS: An overview

Michael Rumball

While we wait for the other shoe to drop, perhaps it would be worthwhile to review the general state of play and try to better understand what it may mean for the securitization industry. Previous postings reviewed the various SEC proposals for Reg AB II individually. Taken as such they are unsettling. Collectively, they are truly alarming. If implemented these proposals would, most notably, require all participants in the public ABS markets to:

  1. provide mandatory asset-level disclosure of an extraordinarily burdensome nature which may be inappropriate and/or unavailable in respect of several asset classes;
     
  2. perform or arrange for a third party to perform an asset review and disclose the findings and conclusions;
     
  3. disclose all demands for the repurchase of assets due to alleged ineligibility and arrange for related third party opinions on an ongoing basis;
     
  4. require a minimum 5% risk retention in a “vertical slice” across all issued securities;
     
  5. provide investors with a waterfall computer program capable of ABS modeling; and
     
  6. provide CEO certification regarding the sufficiency of the pooled assets to generate the scheduled payments to investors.

 

In addition, the disclosure requirements would, in effect, be extended to private transactions by requiring securitizers to deliver public-level disclosure to private investors on demand.
If the final regulations remain in the form proposed, it is difficult to reasonably contemplate any scenario in which the viability of the securitization financing platform will not be severely compromised.  If one was to judge intentions by actions, one might think that the SEC’s actual agenda was to curb runaway household debt by choking off the supply of credit.  This would be contrary to public policy imperatives which generally recognize that a revitalized supply of credit, which in large part depends upon a reignited securitization market, is a key component to a lasting economic recovery.

The Reg AB II proposals were a response to the SEC’s analysis of the origins of the financial crisis.  According to this view, the collapse of the ABS market was attributable to declining underwriting standards resulting from the dominance of the originate-to-distribute model in the RMBS market and a general lack of transparency in the market which masked the decline.  When unexpectedly severe losses resulted, confidence in ABS ratings in general evaporated, giving rise to the systemic loss of liquidity and credit which characterized the financial crisis.
The SEC’s proposed solutions roughly address each of the elements of the problem as described above.  First, transparency is to be enhanced by improved disclosure.  Second, measures are to be taken to improve the quality of securitized assets.  Finally, investors are to be weaned off of an unwarranted reliance on credit ratings.

Enhanced Disclosure

As an initial step the SEC has proposed mandatory asset-level disclosure in all public shelf transactions.  As indicated in an earlier post, this has raised grave concerns relating to non-RMBS asset sectors since, it has been contended, some of the mandatory disclosure is not applicable beyond RMBS and, given the much greater number of assets in, for example, auto transactions, the sheer volume of disclosure this proposal would entail would be extraordinarily burdensome.

It is reasonably to be hoped that a more tailored approach will be adopted although the amount of required disclosure will undoubtedly increase in any case.  Furthermore, the disclosure should not be mandatory.  Rather issuers should be able to disclose what they can and explain why they are not able to disclose other matters or why such other disclosure is inapplicable or immaterial.

The SEC has also proposed that issuers conduct (or hire third parties to conduct) asset reviews and disclose the results.  Given that this disclosure is mandated under the Dodd Frank Act, it is practically certain that it will be incorporated in the final regulations and will likely also apply in part to private transactions including many offshore transactions.

Finally, the SEC has proposed that any investor in a Rule 144A transaction will be entitled, on request, to the equivalent of the disclosure, including the enhanced disclosure described above, available in a public transaction. As argued in a prior post, this is an uncalled for intrusion upon the right of parties to contract freely and would be materially detrimental to the private market and would be especially crippling to the ABCP market.  It would deprive many issuers of the ability to securitize their assets at all, especially those who access the private market because they are unable to satisfy all public market requirements.  If investors want public-level disclosure they can restrict themselves to investing in the public market.  Otherwise they should be free to agree to accept reduced disclosure.  Issuers should not be put in the position where, despite agreement to the contrary, an investor can, in effect, extort greater disclosure than was bargained for.  Given the complexity of ABS, it may not be unreasonable, however, to restrict the “accredited investor” exemption to those who have some degree of experience in investing in structured products.

There are numerous advocates of the view that the only proper role of securities regulators is to make rules relating to disclosure.  Investors should be given all the information they need to make their investment decisions.  If they need third party help analyzing the data then they can get it.  Beyond this, however, the regulators have no business at all interfering with the structuring of transactions. While this argument has the merit of ideological purity, due to the complexity of ABS transactions and the shock administered by the financial crisis, it may not be conducive to attracting the broad base of investors necessary to support the market.  Accordingly, the SEC may not be wrong in thinking that certain structural requirements may also be necessary.

Improved Underwriting

The centrepiece of the Reg AB II proposals, as well as the Dodd Frank Act provisions relating to securitization, is the proposal relating to risk retention.  As described in a previous post, the SEC has proposed a minimum 5% “vertical slice” of all issued securities be retained by the securitizer.  By requiring securitizers to maintain “skin in the game” and aligning their interests more closely to those of all classes of investors, the SEC hopes to encourage improved underwriting standards and, as a result, improved asset quality.

It is not surprising that this proposal has generated much negative response, mostly depending on the argument that this type of risk retention is not appropriate for those asset sectors, other than RMBS, which did not experience a decline in underwriting standards or elevated losses during the financial crisis.  As outlined another post, this criticism was echoed by the Federal Reserve Board in its Dodd-Frank mandated report. As a result, it is expected that the SEC’s risk retention proposals will be modified to better reflect the legitimate differences between asset classes.

However, given the Dodd-Frank requirements, it is clear that minimum risk retention of some sort will form part of the permanent regulatory landscape.  Both the SEC and Congress were evidently not impressed by arguments that the crisis was solely RMBS-related and thus other sectors should be excluded from the scope of remedial measures.  The lesson they took from the crisis was that system-wide chaos could be generated by events in just one sector and it would be a mug’s game to try to guess in what sector the next crisis may originate.

To further encourage improved underwriting standards, in effect by outing unreliable originators, the SEC has also proposed that disclosure be made in respect of all assets that have been the subject of a fulfilled or unfulfilled demand for repurchase or replacement. Once again, due to its Dodd-Frank imprimatur this proposal is probably and regrettably going to become entrenched in the final regulations and be applicable to private (including offshore) as well as public transactions.  Nevertheless legitimate concerns have been raised about the incentives this proposal may create due to the stigma that may be attached to disclosing any such demand, no matter how unjustified, and the perceived exit opportunities thereby created as an unintended consequence.

In addition, it has been proposed that securitizers obtain a third party opinion in respect of each unfulfilled demand for repurchase.  As argued in a previous post, this proposal is not likely to be effective. It is not clear that qualified third parties could be found to give such an opinion and the rules do nothing to allow trustees to identify breaches or resolve disagreements. It is hoped that this proposal will be discarded or replaced with one more likely to produce the anticipated results.

Reduced Reliance on Ratings

Improved disclosure and improved asset quality are worthy but, in the SEC’s view, insufficient objectives.  Somehow investors must be pried away from reliance upon ratings in making their investment decisions. One might think that the events of the past three years would be sufficient to accomplish this but apparently not. 

Notwithstanding its insistence on increased transparency as a key component of its proposals, it is implicit that the SEC does not believe that investors can be left to their own devices.  Indeed, increased detailed disclosure will make it more and not less difficult for a broad range of investors to understand the already complex investment products on offer.  Therefore, someone else has to be found to fill the rating agencies’ traditional role of gatekeeper.  The SEC’s nominee is somewhat surprising.  Through its proposals requiring CEO certification (thereby compromising the non-recourse feature of ABS funding) and securities law liability relating to waterfall computer programs, as well as the vertical slice risk retention proposal, the SEC has apparently tapped the securitizer.

How this choice is expected to provide comfort to investors is somewhat mystifying. While the potential for increased liability and loss may have a sobering effect on securitizers, the more likely result will be a dampening of their enthusiasm to participate in the market at all rather than to participate more responsibly.  In any case, securitizers are not in a position to provide the qualified and independent credit analysis which is what investors actually need. As recognized by the SEC, most investors in the public sphere are not capable of conducting such a review themselves or interested in hiring a third party to do it for them.  Apparently rating agencies are no longer to be trusted to do so.  The question then is, who should and indeed can perform this essential function?

In their commentary prepared for the C.D. Howe Institute entitled, The Canadian ABS Market:  Where Do We Go From Here?, David Allan and Philippe Bergevin have written that “ABMTN structures and the resulting securities are complex: effective gatekeepers need to be more than qualified and well-intentioned.  They must have the visceral and adrenal acuity that is found only when one faces material economic risk based on their own assessment.”  The authors believe that the natural gatekeepers for ABS transactions are investors in investment-grade mezzanine tranches backed by the same portfolios supporting the senior tranches.  These investors would not rely on rating agency assessments in making their credit determination and would be a much preferred source of protection to senior investors than the rating agencies.  They suggest that the regulators can achieve their purposes by requiring the placement of a mezzanine tranche of a specified minimum size with an arms-length third party as a condition for accessing public markets.

This is a powerful suggestion which has much to recommend it.  In order to attract the depth of mezzanine investor that would be required to support the market, however, the return on investment would need to be significant.  But the resulting certainty may well be worth the price.  In any case, its biggest virtue may be that no other option seems viable at all.  Whether or not it is on the SEC’s radar screen is not known.

I think it is fair to sum up by saying that the original Reg AB II proposals were in many respects overreaching or simply wide of the mark, observations which have been made by numerous commentators.  Whether the SEC is interested in taking such views on board remains to be seen.  The final rules will reveal its true attitude to this market: whether it wants to regulate a revitalized securitization industry or simply to make sure that it can never cause problems again.  We will take stock again as matters develop.  In the meantime, let’s just forget all about it and have a merry holiday season.  Cheers for now.

SEC proposals on ABS: private placement

 Michael Rumball

After last week’s relatively optimistic note, its back to grim reality, in this case the Reg AB II proposals relating to the private market.  These would require that, in order for a reseller of a “structured finance product” to sell a security in reliance on Rule 144A or in order for an issuer of a “structured finance product” to sell a security in reliance on Rule 506 of Regulation D (the so called “safe harbors”), the underlying transaction agreement must grant to initial investors and transferees, as applicable, the right to request, both initially and on an ongoing basis, the same information that would have been required had the transaction been registered.

While the SEC acknowledges that this proposal is “significant” it claims it to be nonetheless necessary due to the fact that “the recent financial crisis exposed deficiencies in the information available about CDOs and other privately issued structured finance products”. While one can debate whether the financial crisis exposed deficiencies in the available information or rather deficiencies in the market participants’ sense of judgment, it seems at least to be clear that the crisis had something to do with RMBS and CDOs involving RMBS.  The latter transactions were unique in their capacity to magnify and, indeed, multiply the risks inherent in the RMBS market which, as it turns out, were copious and, as many have argued, unique to that market sector.  Nevertheless, the SEC has seen fit to once again visit the sins of the RMBS sector on the entire ABS market with significant adverse consequences.

Notwithstanding that the obligation to provide the disclosure only arises if requested, this is an illusory qualification. Prudent issuers wishing to qualify for a safe harbour will want to ensure that the transaction proceeds smoothly without being blind-sided by a request for information.  In practical terms this means that every issuer of structured finance products will feel compelled to compile and be prepared to provide all of the disclosure that would have been required in a registered public offering, whether or not any investor ultimately requests the information.  Viewed in the context of the enhanced asset-level data disclosure and waterfall computer program requirements of Reg AB II, this will entail a significant commitment of money and resources which many issuers will be unable to make.  In addition, many issuers choose the private market because they are unable to comply with the full-blown disclosure requirements of registered offerings.  This may be because they are unable to fully comply (sure to be even more common under Reg AB II) or, for confidentiality or competition reasons, they are unwilling to comply.

Due to limits in its authority, the SEC was unable to eliminate the basic statutory exemptions which will still be available to those unable or unwilling to satisfy the new rules.  However, by removing the safe harbors and thus eliminating the certainty they provided, liquidity in the private market will be signficantly reduced.  As a result issuers seeking to access markets without the ability to rely on the safe harbors will almost certainly find a significant decrease in the demand for their structured finance products.

The proposed amendment to the safe harbors will effectively eliminate the distinction between private placements to sophisticated purchasers and registered offerings.  It is far more than merely “significant”: rather it constitutes a dramatic departure from the basic premise underlying such transactions.  The SEC has apparently determined that, having proven that they could not be trusted to “fend for themselves” in respect of RMBS-based offerings, private investors must be assumed to be incapable of doing so in respect of any sort of ABS offering.  In case there was any doubt about what is going on here, the particular nature of this reasoning should make it perfectly clear.

The first and most notable casualties of this scorched earth policy may well be issuers and sponsors of ABCP who have traditionally relied on the Rule 144A safe harbor.
It is hard to imagine how an issuer of ABCP would set about complying with the following requirements (just to name a few) under Reg AB II in respect of each originator:  asset level disclosure; periodic reporting on asset level performance using standardized data points; filing of a waterfall computer program; disclosure of repurchase obligations. Lacking direct access to the information, issuers would need to obtain it from originators and servicers, thus facing the prospect of unlimited liability for third party data.  In addition, since the data would need to be produced on a continuous basis, the issuer’s ability to access the safe harbor in respect of an entire program would always be at the mercy of the ability and willingness of each participating originator to keep up (assuming they were able to produce the initial disclosure).  As many originators are not themselves issuers of ABS, they do not have the experience, personnel or systems designed to support this kind of reporting.

Since compliance would seem to be at best precarious, ABCP issuers will be forced to operate outside of the Rule 144A safe harbor.  This will result in a substantial decrease in the liquidity of ABCP programs and thus their utility as a financing vehicle and, ultimately, their viability.
 

SEC proposals on ABS: risk retention Part II

 Michael Rumball

Finally some good news. It may be recalled that in April the SEC released its proposals for Reg AB II including proposals relating to risk retention.  These proposals generated heated responses from industry participants mostly due to the requirement that securitizers (other than in credit card transactions) retain a 5% interest in each tranche of offered securities (a so-called “vertical slice”).  The stated purpose of this proposal was to realign incentives among market participants in response to the abuses associated with the “originate–to–distribute” transaction model.  It was rightly remarked that several market sectors, most notably auto and equipment finance, never employed this model but did employ alternative risk retention models which performed as expected during the crisis.

Then on July 15 the Dodd-Frank Act was passed. It also dealt with risk retention but only required the applicable rule-makers to adopt regulations  setting the minimum level of risk retention at not less than 5%.  It did not mandate the form that the risk retention should take but did require the regulators to adopt regulations to establish asset classes with separate rules for each.

The Act also required the Federal Reserve Board to study and report on the cumulative impact of the Act’s risk retention requirements.  This report was issued in October. It recommends that, in order to achieve the aim of the Act, which was to reduce the potential incentives of an originator or securitizer to securitize poor quality  assets, rule-makers should craft credit risk requirements that are tailored specifically to each major asset class. Echoing the comments of other industry participants, it states that “such an approach could recognize differences in market practices and conventions, which in many instances exist for sound reasons related to the inherent nature of the type of asset being securitized”.

In its own thinly-veiled assessment of the SEC proposals, it specifically states that “simple credit risk retention rules, applied uniformly across assets of all types, are unlikely to achieve the stated objective of the Act” and may unnecessarily reduce the supply or increase the cost of credit and thus “curtail credit availability in certain sectors of the securitization market.”

One assumes, or at least hopes, that the next development will involve significant revisions to the SEC’s proposals, which would be a welcome relief from the cumulative constrictive effect of its other proposals.

SEC proposals on ABS: review of assets

Michael Rumball

The second SEC release in response to the requirements of the Dodd Frank Act deals with the requirement of issuers to perform a review of the assets underlying an ABS and to disclose the nature of the review.  It too may have a dampening effect on private placements into the U.S.

One interesting aspect of this release is the apparent willingness of the SEC to interpret the statute narrowly when given the opportunity, in this case, the Act’s requirement that the SEC issue rules “relating to the registration statement”.  The SEC seized upon this to conclude that these rules were meant to apply to registered offerings only and not to unregistered offerings.

Under the new proposal an issuer of ABS in a registered transaction is required to perform a review of the underlying assets.  The SEC does not specify the level or type of review an issuer is required to perform.  It indicates that the nature of the review may vary depending on numerous circumstances and factors, including the nature and number of the assets being securitized.  An issuer may rely on a third party’s review to satisfy its obligation provided the third party is named in the registration statement and consents to being named as an expert.  In either case, the issuer must disclose the findings and conclusions of the review as well as details relating to any asset in the pool which deviates from the disclosed underwriting criteria, including who determined that such assets be included in the pool.

In contrast, the second part of the relevant Dodd-Frank provision, which requires the issuer or underwriter (interpreted broadly to include initial purchasers and placement agents) to publicly disclose, at least five days prior to the first sale, the findings and conclusions of any third party due diligence report obtained by the issuer or underwriter, does not contain the saving language.  Accordingly, in keeping with its interpretation of the intended scope of the provisions regarding representations and warranties, the SEC felt that it had no discretion but to apply the provision to all Exchange Act-ABS, that is all registered and all unregistered ABS.

Again, as was the case in the release in respect of representations and warranties, the rule would apply to offshore offerings by U.S. securitizers and to all foreign offerings into the U.S. As it said then, they “are mindful that the imposition of a filing requirement in connection with private placements of ABS in the United States may result in foreign issuers seeking to avoid the filing requirement by excluding U.S. investors”.  Alternatively, the new rule “may indirectly result in discouraging issuers and underwriters from obtaining third party reviews in unregistered offerings”.

This latter alternative would seem, however, to run counter to a trend, in certain types of transactions, by underwriters and agents to obtain third party reviews in order to bolster their own due diligence defences.  Given that the issuer in a private transaction is not likely to want the details of its portfolio disclosed publicly, the result may well be to  virtually eliminate participation by U.S. investors in these types of Canadian transactions. 

SEC proposals on ABS: representations and warranties, Part III

Michael Rumball

As was reported last week, on October 4 the SEC issued a release to implement the provisions of the Dodd-Frank Act (the Act) relating to representations and warranties. In addition to the disclosure requirements imposed on securitizers, the Act also requires each nationally recognized statistical rating organization (NRSRO) to include in any report accompanying a credit rating with respect to an Exchange Act - ABS a description of (i) the representations, warranties and enforcement mechanisms available to investors, and (ii) how they differ from the representations, warranties and enforcement mechanisms of similar securities.

A few definitional points to begin with:  First, this provision applies to all Exchange Act - ABS which, as we have seen, is very broad and applies to all private as well as public ABS.  Second, it “applies to any report accompanying a credit rating for an ABS transaction, regardless of when or in which context such reports and credit ratings are issued”.  Third, a “credit rating” includes any expected or preliminary credit rating issued by an NRSRO.  This would include a pre-sale report.

The SEC believes that “the proposed disclosures will enhance the comparability of information across issuers in a relatively efficient manner by centralizing this disclosure in NRSRO reports.  As a result, these disclosures will possibly expand the information available to investors and improve transparency regarding the use of representations and warranties in ABS transactions”.  In addition, “the required comparisons of the representations, warranties and enforcement measures in a given ABS transaction to those available in similar transactions may provide an impetus to the development of more standardized representations, warranties and enforcement mechanisms across the ABS markets, which is likely to benefit the efficiency of these markets”.

The SEC admits that, while rating agencies often issue pre-sale reports that include a summary of important features of a transaction, ”they do not usually provide disclosure of how representations and warranties would differ from other similar securities”.  It anticipates that the rating agencies will establish “benchmarks” for various types of securities although it is “not prescribing how an NRSRO must fulfill its responsibility to compare the terms of a deal to those of similar securities”.

It is not surprising that the SEC makes no such prescriptions.  It seems that this release raises more questions than it answers.  For instance, what is a similar security?  An ABS backed by assets of the same asset class?  How material must differences be before they are disclosed?  In the same release it explicitly excluded a materiality threshold that it had previously proposed for the reason that the Act included no such standard.  Similarly, why is there no discussion of the implications for off-shore sales of Exchange Act – ABS as in the other part of the release?  Is there likely to be any spill-over in purely Canadian domestic transactions?

The task facing the NRSROs in light of these and other as yet  not contemplated questions is a rather daunting one.  In order to prevent it from becoming overwhelming, it seems almost inevitable that they will bring tremendous pressure upon issuers to conform representations, warranties and enforcement mechanisms to some uniform standard.  Issuers of course have negotiated and settled the forms of these provisions individually to suit their own priorities, circumstances and positions and will be loathe to deviate from them.  The transition to uniform provisions promises to be a gruelling process.

SEC proposals on ABS: representations and warranties, Part II

Michael Rumball

Well here’s one that potentially has direct bearing on the Canadian ABS market. In its original April proposals, the SEC had put forward rather modest disclosure requirements relating to assets that had been the subject of a demand to repurchase or replace for breach of the representations and warranties contained in the transaction documents.  On October 4, the SEC revisited these proposals in response to the Dodd-Frank Act which required the SEC “to prescribe regulations on the use of representations and warranties in the market for asset-based securities to require any securitizer to disclose fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer, so that investors may identify asset originators with clear underwriting deficiencies”.

The October 4 release is the first in a series of regulations relating to the ABS market which the SEC has been mandated to prescribe under the Dodd-Frank Act. There had previously been some doubt about how the SEC proposals and Dodd-Frank would fit together. Any such doubt has now been erased. The SEC will revise its proposals where necessary to comply with Dodd-Frank. Thus it says, almost in apology, “the Act requires us to implement the requirements discussed in this release”.

The SEC’s interpretation of the above direction and the resulting translation into regulation may well be a portent of things to come.

First, the rules apply equally to registered and unregistered transactions. They apply not only to all registered and non-registered transactions in the United States but also to any ABS sold offshore by securitizers in the US. More importantly, for Canadian purposes, they apply to all ABS offered by foreign securitizers to U.S. investors. For instance, in many recent Canadian transactions, a tranche of securities has been offered to U.S. investors. Under the new proposal, any such offering would now trigger the disclosure requirements. While the SEC has, in their request for comments, asked whether the disclosure should be required for these transactions at all or only for those as to which more than a certain percentage of any class of Exchange Act – ABS are sold to U.S. persons, one should not be misled. The consistent tenor of this release makes it clear that the SEC views its discretion here as being very limited.

Second, the new proposals apply to all asset-backed securities that fall under the Exchange Act definition, as amended by the Dodd-Frank Act. These include any “fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset” and specifically include collateralized mortgage, debt and loan obligations.

Third, the proposed rule imposes the disclosure obligation on a “securitizer” as defined in the Exchange Act which is (i) an issuer of an asset-backed security or (ii) a person who organizes or initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including an affiliate of the issuer.

Fourth, if the underlying transaction agreements provide a covenant to repurchase or replace an underlying asset for breach of representation and warranty, which is almost invariably the case in securitizations, then the securitizer will be required to provide the information for all assets originated or sold by the securitizer that were the subject of a fulfilled or unfulfilled demand for repurchase or replacement with respect to all outstanding asset-backed securities held by non-affiliates of the securitizer.

Finally, the initial disclosure must provide the repurchase history for the last five years and must be updated monthly on an ongoing basis. There is no materiality threshold proposed. The disclosure is to include a description of the assets which were subject to a demand and those which were or were not repurchased or replaced, the name of the issuing entity and the name of the originator.

To sum up: If someone is contemplating an issuance of asset-backed securities (as defined) either in a public or private transaction from, in or into the United States and that transaction includes a covenant to repurchase or replace assets as a result of a breach of representation and warranty then it will be required to disclose details about all assets (and their originators) securitized by such person (in private or public transactions) over the last five years that were subject to a fulfilled or unfulfilled demand for repurchase or replacement, no matter how material or how justified, and the disclosure is to be updated on a monthly basis.

One question among many which is raised by the proposed rule is what incentives does this regime create for investors and issuers. It may be possible that the latters’ imperative will be to preserve their reputation by complying with any repurchase request ,no matter if unjustified, which may in turn encourage investors to view the repurchase mechanism as a possible exit strategy rather than a mere correction. While the SEC acknowledges such possibilities, its only response is “securitizers may devise other disclosures and mechanisms to solve such problems in the long-run, if they occur”. One is only left to wonder what it might have in mind.

Towards the conclusion of the release, the SEC weighs the benefits and the costs of the proposals. The benefits are rather straightforward: “The recent financial crisis has revealed various problems with existing representation, warranty and enforcement provisions. Poor underwriting standards coupled with unenforceable representations and warranties by securitizers exacerbated investor losses in ABS. Increasing transparency regarding all demands for repurchase and replacement, including investor demands upon a trustee, will help investors and market participants identify originators with clear underwriting deficiencies. By having better information to judge the origination and underwriting quality of the assets that were previously securitized, investors can make more informed investment decisions”.

It is the description of the costs which is sobering in its unflinching recognition of the degree to which, under the brave new world of Dodd-Frank, this consideration has become of subordinate importance. For full effect, I quote selected passages in their entirety:

Although our proposed rules are required by the Act, and we believe the added protections of our rules would benefit investors who purchase securities in these offerings, we are mindful that the imposition of a filing requirement in connection with private placements of ABS in the United States may result in foreign securitizers seeking to avoid the filing requirement by excluding U.S. investors from purchasing portions of ABS primarily offered outside the United States, thus depriving U.S. investors of diversification and related investment opportunities.

...

In the aggregate, the proposed requirements are likely to affect unregistered ABS more significantly because traditionally these securities have provided less disclosure. Since, as discussed previously, the Act requires disclosures with respect to all ABS issued by a securitizer, registered and unregistered, the initial and ongoing disclosures may significantly increase the direct and particularly indirect costs of issuing unregistered ABS relative to their historical cost structure. The indirect costs include the possibility of revealing information about the quality of assets to competitors.  A possible effect of these requirements is that such issuers may look towards alternative forms of financing. Given that those issuers have historically preferred ABS issues, they may consider more expensive and less efficient forms of financing. Some of these incremental financing costs are likely to be passed to consumers and other borrowers whose loans make up the underlying pools backing the ABS. While it is difficult to quantify such incremental costs, researchers have estimated that securitization has generally been beneficial in banking and mortgage industries. However, other factors may be more determinative in deciding what form of financing a business will pursue.

...

The purpose of the amendments is to increase transparency regarding the use of representations and warranties in asset-backed securities transactions. This should improve investors’ ability to make informed investment decisions. Informed investor decisions generally promote market efficiency and capital formation. 

However, the proposals could have indirect adverse consequences by changing the willingness of issuers to access securitization markets. If the required disclosures results in revealing information that would benefit competitors, issuers may instead prefer to use other funding sources that do not require such public disclosures.

It appears that the task of balancing the competing interests of market transparency and market efficiency has been greatly simplified. Market efficiency is here equated with informed investment decisions and the costs incurred in enabling them are to be heavily, if not entirely, discounted in the equation. If this results in certain participants deciding to exit the ABS market, so be it.

SEC proposals on ABS: representations and warranties, Part I

Michael Rumball

The SEC has indentified, as a significant contributing factor to the RMBS collapse, the paucity of adequate information which would have allowed investors to make informed investment decisions and the resulting overreliance upon ratings. In a previous piece, we touched upon the SEC’s proposal to require significant asset level disclosure in shelf offerings. Today we will consider a further proposal which the SEC believes to be “an appropriate partial substitute for the investment grade ratings requirement.”

In the aftermath of the RMBS collapse, disgruntled investors attempted to probe the degree to which securitizers may have failed to comply with their representations and warranties relating to the assets in the pool and, more specifically, compliance with underwriting policies.  The investors suspected that there must have been widespread breaches of the representations and warranties but in some cases they were frustrated by what they perceived to be the stonewalling of those parties who were the only available source of the information.

In order to enhance the protective nature of the representations and warranties, the SEC has proposed to require the deal documentation to contain a requirement for the representing and warranting party to furnish, on a quarterly basis, a non-affiliated third party’s opinion relating to any asset in respect of which the securitization vehicle’s trustee has asserted a breach of any representation and warranty and which was not repurchased or replaced as a result of such assertion. 

The SEC has indicated that this requirement is “designed to help ensure that representations and warranties about the assets provide meaningful protection to investors, which should encourage sponsors to include higher quality assets in the asset pool”.

It seems to me that there are several problems with this proposal.   First, it only requires delivery of the opinion after a refused assertion of a breach.  This does not address the lack of transparency at the heart of the problem since the trustee may not have sufficient knowledge at the asset level to assert a breach.

Second, it is not clear that any qualified third party could be found to give such an opinion.  It would need not only to make a technical assessment that the representation and warranty has been breached, but, in most cases, also the less objective determination of whether the breach is material and adverse. Given the factual and subjective elements involved, these questions would not be appropriate subjects of opinions from either accountants or lawyers and it is difficult to think who would be in a position to render such an opinion.

Finally, unless the transaction documents make it binding on the parties, which is not part of the proposal, the rendering of the opinion would not be a final determination of whether there has been a breach.  There is no guidance in the proposed rule as to what is to done if the parties remain at an impasse.

Perhaps the fault with this proposal lies in a basic misconstruing of the purpose of representations and warranties. They are not intended to be used proactively but rather, if there is ever a default and consequent loss in a transaction, to give the trustee personal recourse to the representing party if any breach can be identified.

Nevertheless, if one is determined to alter the fundamental role which representations and warranties play in a transaction one could do worse than consider the alternative proposed by the Securities Industry and Financial Markets Association (SIFMA) comment to the SEC proposals dated August 2, 2010. 

SIFMA proposes the appointment of an independent credit risk manager (a CRM) to represent the interests of securityholders.  The CRM would be provided with electronic access to all asset-level documents and all underwriting guidelines.  The CRM would be paid a risk management fee out of the waterfall alongside other service providers and would be responsible for monitoring performance of the representations and warranties, and investigating, initiating and attempting to settle claims.  If the CRM and the seller are unable to agree on whether a breach has occurred, the dispute would be referred to binding arbitration.

Unlike the original SEC proposal, the SIFMA proposal might actually have a chance of being effective. In either case, the proposals would entail a further increase in price and complexity which will do nothing to encourage the use of securitization as a financing alternative.  And once again, a blunt instrument is being taken to an entire industry in response to a relatively localized problem.

SEC proposals on ABS: Expansion of potential liability

Michael Rumball

In our previous piece on the proposed Waterfall Computer Program requirement, we touched upon the unprecedented extension of securities law liability to the functionality of the computer program. At least in the RMBS context, different people can have different views on the degree to which this is a concern. Contrast, for example, the concerns raised by the comments of the Committee on Federal Regulation of Securities and the Committee on Securitization and Structured Finance of the Section of Business Law of the American Bar Association, dated August 17, 2010, at page 61 with those elicited by our blog piece. Perhaps the main point to be gleaned from these differing views is the uncertainty surrounding the application of the proposals in various situations, which uncertainty is itself a potential problem. 

But the main point I want to revisit and expand on here relates more to those sectors other than RMBS, CMBS and credit cards where the sponsor or some other related entity is usually responsible for or is at least capable of modelling and performing financial analysis. As argued previously, the SEC proposals focus unduly on the RMBS sector and do not adequately differentiate between this sector and those sectors where the modeling is likely to be done by third parties, usually underwriters. I think we can assume that underwriters are unlikely to step up to securities law liability in respect of their models. To require the issuers and sponsors to take responsibility for a function in respect of which they have no expertise is fundamentally unfair.

This is not an isolated example of the unprecedented expansion of potential liability contained in the SEC proposals, however. In a separate proposal which, according to the SEC, has been designed to replace the investment grade ratings criteria, the issuer would be required to provide a certificate of the depositor’s chief executive officer regarding the underlying assets to the effect that “to his or her knowledge, the assets have characteristics that provide a reasonable basis to believe that they will produce, taking into account internal credit enhancements, cash flows at and in amounts necessary to service payments on the securities as described in the prospectus”. The officer would also be required to certify that he or she has reviewed the prospectus and the receiving documents for this certification. By means of this requirement, the SEC hopes that the officer in question will review the disclosure more carefully and participate more extensively in the oversight of the transaction, thus leading to enhanced quality of the securitization.

The SEC suggests that the proposed certification “would be an explicit representation by the chief executive officer of the depositor of what is already implicit in the disclosure contained in the registration statement”. With one important difference: CEOs are being asked to predict the future performance of the underlying assets, as opposed to the adequacy of the disclosure, which prediction must be based on assumptions about the future which are not qualified by any of the risk factors and other disclosures found in registration statements which protect the issuer from liability if the offered securities fail to perform. The CEO is essentially being asked to perform a credit review and to assume some degree of liability, again uncertain, in respect of its review. Even though the SEC states that the certification would not serve a as guarantee of payment of the securities, in a situation where there has been default and loss and arguments are being made over what was known or, perhaps more importantly, what should have been known, it is not clear that the knowledge qualifier would provide an effective defence.

One of the main themes of the SEC proposals is that, in the past, there was too much reliance on credit ratings. In order to give investors the appropriate tools to make their own investment decisions, the SEC has proposed greatly expanded asset level disclosure. At this point, the SEC could have said to investors: we have ensured that all pertinent information has been made available to you and it is now up to you to analyze it in making your investment decision. Models created by third parties are available in the marketplace at a price. But, presumably because it realizes that investors are not likely to want to pay this price, it chose not to do this but rather to shift the onus of performing the quantitative modeling and analysis onto the shoulders of issuers and CEOs. To a cynical observer it may appear that all they have accomplished is to potentially replace one object of reliance with another and a potentially less confidence-inspiring one at that. Whatever one may think of their past performance, at least the rating agencies had some experience and expertise in performing this function whereas these issuers and their CEO’s have little or none and are by definition conflicted to boot.

Quite apart from issues of complexity and cost, it is this radical expansion of liability, both corporate and personal, which may have the most adverse impact on the continued interest of issuers in the securitization market.

SEC proposals on ABS: Asset-level disclosure

Michael Rumball

To any reader of military history the following adage is very familiar: the military always prepares to fight the last war. One could say that this adage applies equally well to the SEC proposals. The more one plows through them the more one is struck by how its formulation of the problems, and thus the solutions proposed, have been dictated by the specific character of the 2007-09 RMBS collapse. For instance, it is received wisdom that at the root of the collapse was the deteriorating underwriting standards of originators. The SEC appears to believe that this deterioration might have been revealed earlier had there been adequate asset-level disclosure. Accordingly, it proposes to make mandatory in any public issue and for all asset classes (other than credit cards, for which certain groupings are contemplated) certain very specific disclosure points.

As we have seen previously, in formulating its proposals, the SEC has not adequately taken into account the fact that the RMBS market was unique in various ways. First, as discussed in an earlier blog piece, it made almost unique use of the originate-to-distribute model. RMBS was also typified by very complex structuring of securities with multiple tranches which, in many cases, were completely distributed. As a result, small changes in pool performance could have major impacts on those specific narrowly-tailored securities. Products involving mortgage loans also involved many fewer discrete assets of a much larger per-asset size than transactions involving most other asset classes. Finally, mortgage assets are subject to refinancing risk and involve protracted liquidation.

In contrast, assets such as vehicle ABS are homogenous, short term, not particularly interest rate sensitive, generally not subject to financing risk and are liquidated quickly. Pools typically contain many more assets than would a RMBS pool. The securities involved are much simpler and less structured and the tranches are ‘thicker’ than RMBS and much less sensitive to changes in pool performance. It is rare for these structures to be tranched and distributed beyond the mid-to-high investment grade level. The more senior the investor, the less it is subject to the types of risks that require asset-level data to properly assess.

Perhaps most importantly, there has been no evidence that there was deteriorating underwriting standards in other sectors. This is probably because of the fact that originators had always kept more “skin in the game”, as discussed in our earlier blog piece, than RMBS originators. Any increase in obligor defaults in these other sectors have been more attributable to general economic downturn and, even at the height of the recession, were not of such a magnitude as to threaten default in respect of offered securities.

For a detailed review of the problems which the application of rigid asset-level disclosure would cause for other sectors see the comment letter submitted on August 2, 2010 by U.S. auto finance companies and posted on EDGAR. Some of their more salient concerns are as follows:

  1. The credit models applied by finance companies are proprietary and competitively sensitive and there is significant risk that the required disclosure could be reverse engineered by competitors.
     
  2.  Disclosure of asset-level data could pose significant threats to consumer privacy and the originators’ related legal obligations.
     
  3. The burden placed on issuers would be extraordinary given the number of loans in the usual vehicle ABS transaction (approximately 50,000). Producing the stipulated 59 or 61 required data points would mean producing approximately 3 million separate bits of information. (For a floor plan transaction this could be as much as 13.6 million data points.) By contrast, a typical RBMS offering would include 3,317 loans and require 534,037 data points.
     
  4. The data points are mandatory yet many of them are simply not applicable outside of RMBS.

It is feared that the requirement to provide asset-level data may deter securitizations, restrict capital formation and eliminate market access for some issuers without supporting meaningful additional due diligence by investors or otherwise providing a benefit to investors.

SEC Proposals on ABS: waterfall computer program

Michael Rumball

A number of the SEC Proposals on Asset-Backed Securities have attracted much criticism but perhaps none more so than the proposed requirement for issuers to file on EDGAR, as part of an ABS offering, a waterfall computer program of the contractual cash flow provisions of the securities being offered.  If enacted, it is not unreasonable to posit that this single aspect of the proposals might be sufficient to drive issuers out of the public market.

The proposed rule’s policy objective is to provide to potential investors the wherewithal to conduct their own evaluation of the securities so that they can make an informed decision on whether to participate in the offering without undue dependence on the opinions of credit rating agencies.  The underlying premise here appears to be that investors’ lack of understanding of complicated securitization structures resulted in poor investment decisions in the past.

Contrary to the SEC’s underlying premise, that “issuers’ already produce such a code to structure the ABS deal”, this is apparently not the case and the overwhelming consensus seems to be that to build such a model would be enormously complex and expensive.
Some of the problems cited are the following:

  • While existing cash flow models have been constructed and utilized by underwriters and third-party vendors, issuers have generally not done so.
  • The existing programs do not generally (if at all) use the Python open-source programming language mandated by the SEC.
  • These models allocate cash and losses on an aggregate basis and not on a loan level basis as required by the SEC proposal.
  • It may not even be possible to build the type of program required by the SEC for master trust or co-ownership structures where there are unknowable variables related to other series of securities which share recourse to a common pool.
  • The existing models do not meet the standards of precision that the SEC specifies but rely on various simplifications since they are designed to enable investors to understand how cash flows can be expected to perform generally in different scenarios.  They are not designed to reflect every kind of input and output related to the structure, no matter how immaterial, and they may not be able to model all structures and scenarios or address unknown variables.
  • The issuer would need to engage significant resources in order to maintain and update the program and provide instructions on use and customer service

More than one commentator has observed that this proposal would in effect require issuers to become software developers and distributors, a role for which they are likely to be particularly unsuited. Rather it would seem to be more  likely that issuers would turn to third-party service providers.

The waterfall computer program proposal also raises significant legal issues.  The proposal requires that the program be filed with, and incorporated by reference into, an issuer’s registration statement.  It is unclear to what extent this would mean that the design features and the output of the computer program would be treated as issuer “statements” attracting the same liability as all other statements. Various nightmarish scenarios can be imagined.  For instance, if a programming error caused the program to generate faulty results would this be a misstatement?  If an investor could not figure out how to run the program, would the issuer be liable for a material omission?

Perhaps the most fundamental issue of all is raised by the requirement that the “code must provide the user with the ability to programmatically input the user’s own assumptions regarding the future performance and cash flows from the pool assets”.  But any such code, like any credit assessment model, must itself invariably be predicated upon certain assumptions, based on a subjective assessment of the remoteness of various risks, involving the selection of variables that are deemed sufficiently material to merit modelling.  To build an open-ended model which is able to anticipate assumptions of others and quantify all risks no matter how remote may not even be possible.  Yet one is left to wonder whether the failure to do so would be a material omission under the SEC proposals.

In the past modeling was the domain of those with experience in the area such as underwriters and credit agencies.  To shift responsibility for this to issuers who have no expertise in the area and, at the same time, to impose a strict liability regime with respect to outputs generated not by the issuer but by investors is well beyond what is fair and reasonable in the context of an ABS issue.  Given the complexity of the required programs, the necessity for reliance on third parties and the uncertain liability issues, it is unclear how issuers (or underwriters for that matter) would ever be able to get sufficiently comfortable with their due diligence on the programs to sign the required certificates.

SEC proposals on ABS: risk retention

Michael Rumball

The market meltdown of 2007-2008 was a complex event and the causes will be debated for many years.  Nevertheless, one of the early frontrunners for the title of “the root cause” is the “originate-to-distribute model”.  In order to satisfy investors’ seemingly insatiable appetite for ABS or ABS derived securities in the years leading up to the meltdown, sponsors and originators needed vast amounts of assets.  As opposed to the existing model of established originators using securitizations as a means to finance their traditional lending, loans were originated for the sole purpose of providing fuel for the securitization machine.  In order to keep the machine running at capacity, assets further and further down the credit spectrum were sought out resulting in the calamities with which we are by now very familiar.

The SEC has identified the separation of the originators of the loans from the bearers of ultimate default risk, which is the hallmark of the originate-to-distribute model, as a “misalignment of incentives between the originator of the assets and the investors in the securities, which misalignment may have contributed to lower quality assets being included in securitizations that did not have continuing sponsor exposure to the assets in the pool”.  In other words, in shedding the default risk, the screening incentives of the originators were diluted.  In order to address this concern and create an incentive to include better quality assets in the pool, the SEC has proposed that sponsors retain exposure to the risks of the assets.

So far so good.  The trouble starts with its solution to the problem:  as a condition to shelf eligibility, the sponsor or an affiliate must retain a net economic interest in each securitization either by way of a minimum 5% of each of the tranches of securities sold to investors or, in the case of revolving master trusts, retention of a minimum 5% originator’s interest in the pool of assets (in each case net of certain hedge positions).  This has become known as a “vertical slice”, to distinguish it from a “horizontal slice” where the sponsor retains a subordinate piece of the securitization.

The real problem with this approach is its “one size fits all” character.  The collapse of the securitization industry in the United States was really the collapse of one sector-residential real estate.  While it is true that this sector did increasingly utilize the “originate-to-distribute” model and while it may well be true that vertical slice risk retention would be an appropriate and effective means of aligning sponsor and investor risks in this sector,  this was never the model used in many other sectors, most importantly the auto sector.  Moreover, in Canada, even the rmbs sector had not fully committed to that model although it may be arguable that it would eventually have gotten there, given more time.

The SEC has asserted that “horizontal risk retention … could lead to skewed incentive structures, because the holder of only the residual interest of a securitization may have different interests from the holders of other tranches in the securitization and, thus, not necessarily result in higher quality securities”.  But surely this is an over-simplification.  In U.S. auto securitizations and in most Canadian public securitizations the sponsor does in fact retain considerable exposure to the risks of the assets:  the assets are originated by the sponsor as part of an ongoing operating business, the originator continues to own assets that are substantially identical with those included in the securitized pool, the pool itself overcollaterizes the offered notes and the originator services the securitized and non-securitized assets itself (or by sub contract) to the same standards.  In order to maximize the bottom of the waterfall proceeds which represent its profit, the originator is motivated to structure and service the deal to minimize losses.  These would seem to provide strong motivations for originators to ensure high quality assets in the pools.

Provided that the breadth of the horizontal slice is sufficient to absorb multiples of expected losses, this would seem to be a perfectly adequate and appropriate manner in which to align the originator’s interests with those of investors.  To mandate “vertical slice” risk retention in all circumstances would be unnecessarily restrictive and would likely have an adverse effect on the market by increasing borrowing costs for sponsors and/or reducing credit availability for consumers.

CSA provide update on upcoming securitization proposals

The Canadian Securities Administrators (CSA) today published CSA Staff Notice 45-307 Regulatory Developments Regarding Securitization, in which they announced their intention to publish proposals respecting securitized products in the fall. The Notice follows work completed by the CSA subsequent to the publication of their consultation paper on ABCP in October 2008, and states that the CSA's focus "has broadened to encompass all securitized products". The CSA are also considering international regulatory developments in developing their proposals, including recent IOSCO and SEC reports and recommendations.

According to the Notice, the CSA are specifically contemplating changes to the current approach to the issuance of securitized products in the exempt market, enhancements to the disclosure requirements for securitized products distributed by prospectus and changes to continuous disclosure for reporting issuers that have distributed securitized products.

The CSA also announced that they expect to publish proposals relating to the regulation of credit rating organizations this summer.

Plenty of Good Cheer as Canadian ABS Industry Convenes in NOTL

Insight Information recently held the 13th Annual ABS 2010 Canadian Structured Finance Forum from Sunday, June 6 to Tuesday, June 8, 2010 at Queen's Landing in Niagara-on-the-Lake, Ontario.  Mark McElheran moderated a panel entitled "Evolution of Product Distribution: Private Placements" in which Mark put to a panel of market participants the thoughts presented in the analysis piece co-authored by Doug Klaassen, Mark and David Allan and posted here last week .  These other panelists included Yatendra Killer of Honda Canada Finance Inc., Marie-Claude Morrissette of Nissan Canada Inc. and Jonathan Zamir of Bank of America Merrill Lynch.

There were over 250 delegates in attendance. While this number was down significantly from the pre-credit crunch days, this was a significant increase from the attendance at the 2009 conference held in Banff, Alberta. The fact that Niagara-on-the-Lake is an hour's drive from the Toronto airport didn't hurt given the significant number of attendees arriving from Toronto and New York (and other more or less exotic locales), nor did the myriad of opportunities for various tours and receptions in the surrounding wineries.  There was a significant amount of optimism in the air and the mood of the conference was surely brighter than it has been the last few years (and this was the case even before the cocktails were poured!). While perhaps not as engaging as the nearby Shaw Festival, the sessions were surprisingly well attended given the warm and sunny weather that graced the conference (which stood in stark contrast to the unpredictable (and largely soggy) weather that veterans of the conference have experienced for years in Banff and Whistler). 

One theme that emanated from the sessions and from discussions with various attendees is that there are signs of life emerging in the ABCP conduit market which has been largely dormant (and shrinking) since the end of 2007.  This being said, a number of conduit sponsors observed that there is a scarcity of quality securitizible assets in the marketplace - perhaps the adage "once burned twice shy" would be an apt description for the behaviour of  issuers that suffered from a scarcity of securitization capacity during the credit crisis.  In addition to the scarcity of supply, those assets which are available are being chased not only by conduit sponsors but also by the term private placement market which has been steadily growing since the end of 2007.  Nonetheless, given the very strong historical performance of Canadian ABS, it is hoped that issuers (and more investors) will return to the fold as the industry continues to renew itself.  But before we leave everyone with the impression that it is all smooth sailing and sunny skies in the forecast, there were those sessions on Basel III and IFRS which temper the expectations of many and point towards a somewhat unsettled forecast for the future of the Canadian ABS market.

Canadian budget has implications for the structured finance market

Mark E. McElheran

The 2010 Canadian federal budget was delivered on March 4, 2010. The budget contains a number of interesting developments and implications for the Canadian structured finance market.

CSCF ends amid signs of life in the securitization market

The budget confirmed that the Canadian Secured Credit Facility (CSCF) provided by the Business Development Bank of Canada (BDC) will, as originally contemplated, conclude at the end of March 2010. In the view of the federal government, the CSCF is having a positive impact on the availability and cost of financing for vehicles and equipment. BDC has posted details of completed transactions (all of which have been completed by way of public prospectus offerings) on the BDC website.

New financing initiative for equipment and vehicles

While the CSCF may be drawing to a close, the budget announced the creation of the Vehicle and Equipment Financing Partnership as part of the Business Credit Availability Program, which forms part of Canada's Economic Action Plan. This program will be funded and managed by the BDC with an initial allocation of $500 million in funding. The program is intended to provide financing for small and medium-sized finance and leasing companies. Further details are to be announced in the coming weeks. Hopefully this program, in conjunction with an increasingly vibrant securitization market, will provide a much needed boost to this sector.

Covered bonds

A number of Canadian banks have already entered the European and domestic covered bond market but news from the budget indicates that there may be increased activity ahead. The government has indicated that it intends on developing a legislative framework for the issuance of covered bonds in order to encourage investment and assist federally regulated financial institutions in diversifying their funding sources. There are no indications as of yet as to the anticipated timeline, but this is an encouraging sign for the covered bond market, which has a lengthy history in Europe but has only in recent years been accessed by Canadian issuers.

A change in the GST landscape

Generally speaking, financial services are exempt from GST, whereas services in the nature of management, administration, marketing or promotional activities are subject to GST. The budget introduced proposed changes to the definition of "financial service" and specified certain "asset management services" that are expressly carved out of the definition of financial services. Asset management services are services rendered by a particular person in respect of the assets or liabilities of another person that is a service of (a) managing or administering the assets or liabilities, irrespective of the discretionary authority vested in the particular person; (b) providing research, analysis, advice or reports in respect of the assets or liabilities; (c) determining which assets or liabilities are to be acquired or disposed of; or (d) acting to realize performance targets or other objectives in respect of the assets or liabilities. While it remains to be seen how significant the impact of these changes will be, market participants are encouraged to review their agreements to determine whether any previously exempt services have become taxable. 

CRA responds to the new GST/HST legislative proposals on financial services

Alan Kenigsberg and Jean-Guillaume Shooner

On February 11, 2010, the Canada Revenue Agency (the "CRA") released GST/HST Notice No. 250 (the "CRA Notice") in response to the proposal to change the definition of "financial services" in the Excise Tax Act (the "Act") announced in a News Release and Backgrounder issued by the Department of Finance on December 14, 2009 (the "Backgrounder"). The Department of Finance stated that such proposal is intended to "clarify" and confirm the government's policy intent that certain services such as management, administration, marketing and promotional services do not constitute financial services and are therefore subject to GST/HST.

In the CRA Notice, the CRA states that the proposals to change the legislation "reaffirm the longstanding policy intent and provide certainty with respect to the application of GST/HST". Surprisingly, the CRA uses the CRA Notice to completely reverse a number of its own published positions with respect to what constitutes an exempt service of "arranging for" a financial service. Financial institutions and businesses dealing with financial institutions should carefully examine whether or not they are affected by these policy changes, and whether services previously considered exempt from GST/HST are now taxable.

The new legislative proposals

According to the Backgrounder, the legislative proposals, once drafted, will specifically provide that the following activities will not constitute exempt financial services under the Act and will therefore be subject to GST/HST: (i) investment portfolio management and administration activities, (ii) certain facilitatory services that are preparatory to an actual or intended financial service such as market research, product design, document preparation or processing, customer assistance, advertising, promotional or similar activities; and the collection, collation or provision of information, and (iii) credit management services such as credit checking, valuation, authorization services, making decisions relating to a grant or an application for credit, creating and maintaining records relating to a grant or an application for a grant of credit on behalf of the credit provider, and monitoring payment records or dealing with payments. The Backgrounder also states that "The proposals would apply to all supplies of these services made after today, as well as to past transactions where the suppliers treated these services as taxable."

The CRA Notice Investment portfolio management and administration services

In the CRA Notice, several examples are provided to illustrate the CRA's interpretation of how certain investment management services will be subject to GST/HST once the proposed changes have been drafted and enacted. In one example, the CRA examines services rendered by an investment dealer who arranges to purchase units of a mutual fund for an investor and who receives a commission for such purchase as well as a "trailer commission or fee" paid annually from the fund manager. It is specified in this example that the prospectus states that the trailer commission or fee is "being paid in recognition of the investment advice and ongoing administrative services rendered by the investment dealer to the investors". Based on these facts, the CRA concludes that these services would not be a supply of a financial service, and that the trailer commission or fee would be subject to GST/HST. This answer is contrary to the CRA's previously published position in GST Policy Statement P-119 (dated February 22, 1994) where the CRA stated in an identical fact situation that trailer commissions or fees are not subject to tax.

According to the Backgrounder, the amendments will apply to all supplies of investment management services rendered under an agreement where (i) consideration for the supply becomes due or was paid without becoming due after December 14, 2009; or where (ii) all the consideration for the supply became due or was paid on or before December 14, 2009, unless the supplier did not charge, collect or remit GST/HST in respect of the supply or in respect of any other supply that includes an investment management service and that is made under the agreement. In other words, according to the Backgrounder, the amendments, once drafted, should treat all future supplies of these services, all current supplies which have not yet been billed, and all past supplies where the manager charged GST/HST, as being taxable.

Notwithstanding the wording in the Backgrounder, the CRA appears to be taking a fairly aggressive stand on the retroactivity of the legislation. Indeed, in the CRA Notice, the example is provided of an investment manager who enters into an agreement with an investor to provide management advice, collects and remits GST/HST for a certain period of time under the agreement, and then decides to stop collecting and remitting GST/HST in June 2009 under that same agreement. According to the CRA, the investment manager would still have been required to collect and remit GST/HST in respect of the consideration paid by the investor for the investment management services provided prior to December 14, 2009, notwithstanding they may have stopped charging GST/HST based on case law which held that their services were not subject to GST/HST. In this example, the CRA essentially takes the position that if tax was ever charged under a particular agreement, all services that have ever been rendered under that agreement will retroactively become taxable. This is particularly troubling, as companies which stopped charging GST/HST on their supplies in good faith, will now be subject to interest and penalties for failing to collect a tax which the courts had said was not payable. Further, they will now have to go back to their customers to claim several months of additional GST/HST, if they are able to do so under their agreements.

Finally, we had indicated in a previous Tax Law Update that, based on the proposals to change the legislation, the rebate claim of a person for GST/HST charged by an investment manager in good faith on discretionary investment management fees would now appear to be obsolete. In this respect, the CRA mentions that rebate application forms for GST/HST "paid in error" with respect to GST/HST paid on investment management services will not be processed at this time, and if the proposals to change the legislation are enacted as they are described in the Backgrounder, such rebate claims will be denied.

Facilitatory services and credit management services

The CRA also provides certain factual examples to illustrate how GST/HST will apply to so-called facilitatory services and credit management services pursuant to Finance's proposals. Several of the examples set out in the CRA Notice appear to be virtually identical to examples previously published by the CRA in GST/HST Policy Statement P-239 dated January 30, 2002 ("P-239"), with the only real difference being that where the CRA formerly stated that these services were exempt financial services, the CRA now states that they are taxable.

In the first example of facilitatory and credit management services, an automobile dealership has a financing department where employees assist customers in obtaining financing for the purchase of an automobile (i.e. obtaining credit information, completing loan application forms, explaining the different types of loans, determining the interest rate, making recommendations to the bank, etc.). For every loan provided to a customer, the dealership receives a commission from the financial institution. While the CRA formerly considered that this service fell within the definition of "arranging for" a financial service, and was thus exempt from GST/HST, the CRA is now of the view that such supply would be taxable for GST/HST purposes.

In the second example, a corporation that provides specialized group insurance coverage for members affiliated with particular organizations such as banks and large retailers hires a telemarketing agency to conduct the necessary insurance coverage-placing activities with the group members. The telemarketing agency explains the insurance coverage available, answers questions regarding the insurance coverage, screens the eligibility of the person, prepares the application and forwards the completed applications to the corporation who grants final approval. The telemarketing agency is compensated on a per-hour basis. In this example, the CRA has also changed its position from P-239 and now considers that these supplies will be taxable.

In a third example, a corporation wants to sell the business carried on by its subsidiary and enters into an agreement with a business broker service whereby the broker will facilitate the sale of the shares of the subsidiary. In this respect, the broker has to perform various services including: obtaining "listing" for the sale of the business; assisting the corporation in calculating the price at which the subsidiary's shares will be offered; assisting the corporation in putting together financial and operating information; advertising the subsidiary's business as being for sale; contacting potential purchasers; acting as intermediary between the corporation and the purchaser in negotiating the terms of purchase and sale; etc. Again, contrary to what is provided for in P-239, the CRA states that such brokerage services would now be taxable.

The CRA also provides numerous other examples of services which will now be considered taxable. We note that the CRA did not provide a single example of a service which would still be considered to be "arranging for" a financial service under paragraph (l) of the definition of "financial services" in the Act and thus exempt from GST/HST, and based on the CRA's interpretation of the proposed (but not yet drafted) legislation, it is unclear what services would still be exempt from GST/HST under this provision. In this respect, the CRA confirmed to the authors during a phone conversation that facilitatory services offered by an intermediary in the financial services industry, such as mortgage brokerage services, are likely to be taxable under the new regime.

Reassessment by the CRA

In respect of all the legislative proposals, the Department of Finance indicated in the Backgrounder that any reassessments based on the proposed amendments would have to be made on or before the later of: (1) the day that is one year after the day the proposed amendments enter into force; and (2) the last day of the period for reassessment otherwise allowed under the Act for making the reassessment. While we would expect that the additional one year period should only apply to periods which are not already statute-barred, the wording in the Backgrounder implies that the CRA could assess periods which were already statute-barred so long as the assessment is made within a year of the proposed amendments receive royal assent. In the CRA Notice, the tax authorities simply restate Finance's comments without any further explanation. In any event, service providers to financial institutions who previously regarded their services as exempt should be aware that they might be reassessed beyond the normal reassessment period.

The authors would like to thank Glenn A. Cranker for his collaboration in writing this article.

New bankruptcy law amendments may impact securitization

Mark E. McElheran and Philip J. Henderson

On September 18, 2009, a number of amendments to Canada's Bankruptcy and Insolvency Act (BIA) and Companies Creditors Arrangement Act (CCAA) came into force. The amendments were passed in 2005 and 2007 but, aside from a few provisions that became effective in July 2008, the amendments sat dormant, awaiting proclamation into force. Pursuant to Order in Council P.C. 2009-1207, almost all of these amendments have now been brought into force. Some of these provisions will be of interest to participants in the securitization market.

The BIA and CCAA now expressly permit a reorganizing debtor to disclaim or resiliate certain types of agreements (section 65.11 of the BIA and section 32 of the CCAA). The procedure is set forth in the statutes and permits other parties to contracts upon receiving notice of a proposed disclaimer (which must first be approved by the trustee or monitor) to apply to the court within 15 days of receiving notice for an order that the disclaimer does not apply. If the trustee/monitor does not approve of the proposed disclaimer, the reorganizing debtor must apply to the court in order to disclaim the agreement. In determining whether to make an order for disclaimer/resiliation, the court must have regard to the following factors: (a) whether the trustee or monitor approved the proposed disclaimer or resiliation; (b) whether the disclaimer or resiliation would enhance the prospects of a viable proposal (or compromise or arrangement) being made in respect of the debtor; and (c) whether the disclaimer or resiliation would likely cause significant financial hardship to a party to the agreement.

The provisions on disclaimer and resiliation expressly do not apply to eligible financial contracts, commercial leases, financing agreements if the debtor is the borrower or a lease of real property or an immovable if the debtor is the lessor.

There has been some concern expressed in the marketplace based upon a literal reading of the statute that the express exclusion of leases of real property from the disclaimer provisions may by implication permit lessors of personal property to disclaim or resiliate (which is a term adopted from Québec civil law) leases of personal property. This would have a potentially negative impact on the securitization of vehicle and equipment leases, which remains an important asset class within the Canadian securitization market. Although there is always some degree of uncertainty in interpreting statutes prior to any judicial interpretation of the provisions, the current view of many insolvency practitioners is that the amendments were not intended to create new law in the area of disclaimer of contracts but to codify existing practice in the area. In particular, there is nothing to suggest that the intention of the legislation was to interfere with previously acquired property rights. We will watch with interest as courts are called upon to interpret these new provisions in future cases.

OSC issues staff notice providing guidance for Contracts for Difference and FX Contracts

Mark E. McElheran and Philip J. Henderson

In response to numerous inquiries, the Ontario Securities Commission (OSC) issued a notice on October 27 outlining OSC Staff's view on the applicability of securities laws to offerings of Contracts for Difference (CFDs), foreign exchange contracts (FX contracts) and similar OTC derivative products. While the notice focused on CFDs, the guidance is intended to apply generally to FX contracts and OTC derivatives as well. Further, it is OSC Staff's intention that the interim guidance provided will remain effective until such time that a harmonized approach to the regulation of OTC derivatives is developed by the Canadian Securities Administrators and/or Ontario introduces derivatives legislation.

According to the notice, OSC Staff consider CFDs to be securities and, as such, CFD providers offering such products to Ontario investors must comply with Ontario's registration and prospectus requirements absent statutory exemptions or exemptive relief. In reaching its conclusion, OSC Staff considered the Supreme Court of Canada decision in Pacific Coast Coin Exchange v. Ontario (Securities Commission), [1978] 2 S.C.R. 112 and the subsequent jurisprudence. In particular, OSC Staff referred to the parallels between the facts of Pacific Coast "and the current trend towards offerings of CFDs to investors through the internet."

According to OSC Staff,

[t]hese parallels include the fact that the products involve contracts that are marketed as a form of investment, the contracts involve similar forms of underlying interest, the contracts make extensive use of margin in order to magnify profits and losses, and there is significant reliance by the investor on the CFD provider to act as a counterparty, design and operate the internet platforms, and hedge risk appropriately in order to ensure the CFD provider is able to satisfy its payment and performance obligations.

The notice also noted that the relevant caselaw "emphasizes the need to consider the economic realities of the transaction and to focus on the substance rather than the form of a transaction."

However, as the prospectus requirement may not be well-suited for certain types of OTC derivative products, OSC staff "may be prepared to recommend relief" under certain circumstances. The situations in which an exemption may be provided are discussed in the notice and such an exemption was recently granted to CMC Markets U.K. and its Canadian affiliate. In that case, the OSC decided to allow CMC Canada to distribute CFDs and FX contracts to Ontario investors without having to file a prospectus provided that, among other things, CMC U.K. remained registered with the U.K. Financial Services Authority, CMC Canada maintained its registration as an investment dealer with the OSC and as a member of Investment Industry Regulatory Organization of Canada and all distributions were conducted pursuant to the rules of Quebec's Derivatives Act (QDA) and the Autorité des marchés financiers. In granting the exemption, the OSC stated that the requested relief would "substantially harmonize the Commission's position on the offering of CFDs to investors in Ontario with how those products are offered to investors in Quebec" under the QDA.

Recent changes to the Canadian Secured Credit Facility (CSCF) may prompt usage

Mark E. McElheran and Philip J. Henderson

On September 17, 2009, the Business Development Bank of Canada (BDC) announced revised parameters to the $12 billion CSCF that was established earlier this year as part of the Government of Canada's Extraordinary Financing Framework. Uncommitted CSCF funds will be offered on a "first-come, first-served" basis until March 31, 2010 with the stated intent of providing continued support for participants in the auto and equipment financing sectors. Based on information from a price-discovery process that BDC undertook in August and on industry feedback, the facility is now being offered to participants at 150 basis points above Government of Canada funding costs. It is anticipated that the new pricing may result in renewed interest in the facility which to date has remained untapped.

Canadian withholding tax on interest - Recent developments

Kevin Kelly

As reported in Stikeman Elliott's April 12, 2007 Structured Finance Update, it was announced in the March 2007 Federal Budget that an agreement in principle had been reached between Canada and the U.S. that would update the Canada-U.S. tax treaty with the effect of eliminating withholding tax on interest paid on arm's length cross-border financings between Canada and the U.S. It was also announced in the Federal Budget that the Income Tax Act would be amended to eliminate Canadian non-resident withholding tax on interest paid by Canadian residents to all arm's length foreign residents, regardless of their country of residence. The amendments to the Income Tax Act were intended to be conditional on the implementation of the changes to the Canada-U.S. tax treaty and were initially proposed to be effective once the arm's length exemption in the Canada-U.S. tax treaty came into effect. The measures announced in the Federal Budget were welcome news as the proposed changes with respect to Canadian non-resident withholding tax will facilitate a Canadian resident's access to foreign debt financing without the structural limitations currently imposed by the so-called "5/25 exemption" contained in the Income Tax Act.

More recently, the Fifth Protocol to the Canada-U.S. tax treaty was signed on September 21 and will enter into force on the later of January 1, 2008 and the date on which the Protocol is ratified by each of Canada and the U.S. The withholding tax exemption for arm's length interest contained in the Protocol will be effective at the beginning of the second calendar month following the month in which the Protocol enters into force. This will be March 1, 2008 at the earliest, but it has become increasingly clear that ratification of the Protocol will not take place in 2007 and the timing of such ratification remains uncertain, although still expected some time in 2008.

Draft amendments to the Income Tax Act were released on October 2 by the Canadian Department of Finance to effect the elimination of Canadian non-resident withholding tax on interest payments made by Canadian residents to arm's length foreign residents, regardless of their country of residence. Consistent with the statements made in the Federal Budget, this exemption was originally proposed to take effect on or after the date on which the arm's length exemption in the Protocol came into effect (as discussed above, March 1, 2008 at the earliest). Given the uncertainty with respect to the timing of the ratification of the Protocol, the effective date for the withholding tax exemptions was uncertain.

These draft amendments to the Income Tax Act were recently introduced in the House of Commons on November 13 with a surprising change to the effective date. The proposed withholding tax exemption in the Income Tax Act is now proposed to apply to interest payments made after 2007, regardless of the date that the Protocol comes into effect. The effect of this recent change is that the withholding exemption in the Income Tax Act for arm's length interest effectively overrides the need for U.S. residents to resort to the ratification of the Protocol for such an exemption in most circumstances. Consequently, assuming that the proposed amendments to the Income Tax Act are enacted as proposed, interest payments made by Canadian residents to arm's length persons not resident in Canada (including U.S. residents) will be eliminated for any such payments made on or after January 1, 2008. If the draft legislation receives Royal Assent after 2007, it will be effective retroactive to January 1, 2008.

Ratification of the Protocol will still be important with respect to other measures contained therein (i.e., provisions dealing with LLCs and other hybrid entities, limitations on benefits, and the eventual elimination of withholding tax on non-arm's length interest).

It is also important to note that the proposed withholding tax exemption in the Income Tax Act (as well as the proposed exemption in the Protocol) deals only with interest or amounts that are deemed to be interest for the purposes of the Income Tax Act. That is, these exemptions do not apply to dividends, royalties, rents, lease payments, distributions from trusts, etc. In addition, these exemptions are also subject to a limitation with respect to interest that is considered to be of a participating nature (and what constitutes participating interest in the Protocol is narrower than what constitutes participating interest in the Income Tax Act).