Canadian Structured Finance Law : Canadian Structured Finance Law: Securitization/OTC Derivatives Blog by Stikeman Elliott Lawyers & Attorneys

In the last two decades a new breed of investors, institutional short-term or shadow bank investors, has emerged who are just as skittish as pre-30’s bank depositors and whose panics can cause as much or even more damage. The fact that commercial paper investors are intolerant of risk is documented by Covitz, Liang and Suarez, in “The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market” (2012). This is consistent with the reports of commentators on the FSB’s money market fund proposals that there was in fact no run on MMFs but rather a flight to quality as investors shifted from prime MMFs to government-debt MMFs.

How to address the dangers posed to the broader economy by the reactions of these investors to risk is perhaps the central question of financial regulation or, as expressed by Morgan Ricks in “Money and (Shadow) Banking: A Thought Experiment” (2012), “The instability of the short-term funding markets is, arguably, the central problem for financial regulatory policy”. According to certain commentators, the only way to fully address this new source of risk is to expand the regulatory perimeter, including the safety net, in order to embrace the new investments, in effect replicating the adoption of the safety net in the 1930s for the benefit of short term investors of all types.  In my earlier posting, I had floated a more limited suggestion along these lines.

In an IMF Staff Discussion Note dated December 4, 2012 entitled “Shadow Banking and Policy”, Claessens, Pozsar, Ratnovski and Singh referenced several problems facing any such solution:

“It is unclear whether it is appropriate for the government to engage in creating financial market assets with the sole purpose of catering to a particular investment clientele. For example, this may create moral hazard in that the private sector may come to expect that the government will accommodate its demand for specific types of assets. In addition, continually assessing the demand-supply balances to avoid safe claims shortages may be complex, since the definition of safe assets is not clear, constantly changing, and can vary internationally. Also, some demand for safe assets is driven by factors other than the investment needs of cash pools. For example, demand-side policies may implicitly subsidize banks’ investments in market-based debt instruments, which would be distortive. Finally, demand-side policies would do little to deal with systemic risks elsewhere in shadow banking, such as in collateral intermediation.”

The most popular alternative solution is to concentrate on separating shadow banking activities from traditional banks by severing links and establishing firewalls, and then to leave these activities relatively unregulated. A particularly pointed example of such a view is that of Melanie Fein, a former senior counsel to the Board of Governors of the Federal Reserve System. In “The Shadow Banking Charade” (2013) and her comments on the FSB’s money market fund proposals, she outlines in detail the evolution of banking regulations in the 1980’s and 1990’s and the role of regulators in enabling and even encouraging banks to shake off the constraints which traditionally had kept them in line:

“To the extent shadow banking caused the crisis, it did so because banking regulators misjudged the evolution of financial risks within the regulated banking system and allowed large banking organizations to become immersed in shadow banking activities with insufficient capital, liquidity, or supervisory oversight. The crisis in the shadow banking system was a crisis of the regulated banking system.”

In her view, banks themselves are the largest shadow banks and regulations should be directed primarily if not solely at controlling their behavior and not that of non-bank financial intermediaries:

“Shadow banking activities are not inherently risky, although they can become so when conducted by highly leveraged, government-backed institutions perceived as too-big-to-fail…

Shadow banking activities of banking organizations pose greater risk to the financial system than such activities outside the regulated banking system. When conducted by banks and their affiliates, such activities have access to deposits (both insured and uninsured) as a source of funding and leverage. Such activities thereby have greater capacity to multiply risk and threaten the safety and soundness of affiliated banks as well as to weaken the ability of parent bank holding companies to serve as a source of strength to their subsidiary banks. Because these activities occur under the immediate purview of banking regulators, they enjoy the perception of an implicit government guarantee. This guarantee gives them an artificial competitive advantage over other firms and is a source of moral hazard. Shadow banking activities conducted inside the regulated banking system are within the federal safety net and thus pose potential liability to the taxpayers.

The critical undertaking for regulators is to identify which shadow banking activities are appropriate for government-backed banking organizations and which are not. Questions such as whether nonbank affiliates of banks should have access to deposits and the federal safety net are appropriate. The policy question that arose in the 1980s concerning the viability of the traditional model of banking should be re-visited. Federal Reserve officials have said one of the key policy debates under consideration is whether to break up large financial institutions or impose other prohibitions on affiliations of commercial banks with certain business lines. Certainly it is incumbent on regulators to reign in banking organizations deemed too-big-to-fail.”

Doubts about the efficacy of a policy aimed solely at banks’ activities have been raised, again as outlined by IMF staff:

“This view, however, ignores the fact that it may be impossible to fully separate traditional banking from shadow baking, and it would come with large costs. Commercial banks increasingly rely on hard and tradable claims, with the distinct economic benefits of hedging, diversification, and better availability of funding. And even if direct links were severed (e.g., as in how the Vickers proposal in the United Kingdom aims to separate a bank’s retail operations from its other activities), by virtue of its mere size shadow banking activity could still have macroeconomic and systemic implications, since externalities with adverse real-sector consequences can arise regardless. Also, by moving shadow banking outside the regulatory perimeter, policymakers may have less information on how it is operating.”

Notwithstanding the assertions of the contesting parties, the correct approach will ultimately be dependent upon whether or not the primary cause for the massive expansion of shadow banking leading up to the crisis is determined to have been bank arbitrage activities or the demand for alternative safe assets. The answer is still not apparent as IMF staff makes clear:

“Addressing the shadow banking system is a work in progress for regulators and policymakers, and research is yet to catch up fully with the issues.  While driven partly by regulatory arbitrage, the shadow banking system performs a number of economically useful functions. However, research has not been able to differentiate the economic drivers of shadow banking from regulatory arbitrage, making policy recommendations more difficult. Regardless, a multifaceted policy response to systemic risks arising from shadow banking is necessary. Such responses, if effective, may make the shadow banking system smaller in size but unable to perform its useful economic functions in safer ways. Since not all components of the response are yet clear, more policy-oriented research is needed.”

The regulatory agenda being promoted to date reflects this uncertainty. The first targets of the regulators were indeed the banks. As a result of the new capital, liquidity and leverage requirements of Basel III as well as the Volcker- and Vickers-type rules, participation by banks in shadow banking activities will be less attractive. As if these were not sufficient deterrents, the Basel Committee has also specifically targeted the securitization activities of banks in a consultation document dated December 18, 2012 entitled “Revisions to the Basel Securitization Framework”. The response of industry participants to this document has been quite negative, particularly in respect of the proposed capital requirements for investments in high quality senior securitization exposures.

According to the Canadian Bankers Association, the proposed calibration of capital proposals “fail to produce capital requirements that are commensurate with the actual risk of securitization exposures. This is particularly evident with the proposed capital floor level and maturity adjustment, which significantly increase capital charges on longer-dated, senior high quality exposures.” 

The Toronto-Dominion Bank maintained that the proposals fail to recognize the credit protection offered by subordinated note holders and originators with the result that banks will be forced “to reduce their exposures to senior high quality products in favour of riskier products… in order to achieve minimum capital adjusted returns.”

This was echoed by the Canadian Bankers Association:

“As currently proposed, banks would be able to more cost-effectively finance client assets through purchasing the assets outright without the benefit of the paid-in capital support provided by clients in existing securitization structures…  Indeed, the proposed capital floor would eliminate the capital savings from securitization, effectively giving no credit to the bank for transferring away risk… The proposed rules will cause banks, as investors of these securities, to demand a higher yield to achieve an adequate return from the higher capital requirements. In response, two possibilities can ensue:

1. If the issuers do not increase the yield on their issued securities, then banks, as investors will be forced to significantly reduce their exposure to senior high-quality asset-backed securities (ABS) and fill the void with riskier whole loan purchases. The ABS will instead be held by unregulated funds, who can price the risk more economically. This result would be yet another example of how more punitive capital rules have the unintended consequence of motivating banks to hold riskier assets and for safer assets to flow away from regulated financial institutions and into the unregulated shadow banking system.
    
2. If banks, as issuers, have to increase yields on ABS to meet demand, they will likely reduce the use of securitization as a funding vehicle. Instead, banks will be pushed to be more reliant on the unsecured wholesale debt market as a funding channel. As a result, banks will have a less diversified funding base and be more highly levered, thereby creating greater riskiness to the overall financial system.”

In the view of Credit Suisse, “The imposition of rules that materially increase the capital requirements of securitizations could have the unintended consequence of creating disincentives for banks to be active in the securitization markets” (Credit Suisse). It is, however, not at all clear that this was an unintended consequence. Rather it is squarely in keeping with the goal of separating shadow banking activities from banks.

Having accomplished this and thus eliminated the systemic risks posed by bank arbitrage (which is undoubtedly a wildly optimistic prognosis), the regulators could have chosen to pause in order to see how things settled. Only after a period of operating under the new rules would the unintended consequences of this already radical reorganization of financial realties begin to emerge and a more nuanced assessment be made of whether the operation of demand—side factors would leave a shadow banking rump which was systemically important or not. If the latter, then presumably nothing further need be done over and above improving transparency and keeping the sector under close surveillance. If systemic concerns remained or emerged, then measures could be adopted to address these specific risks. One would have thought, given the FSB’s own pronouncements, that this would have been the preferred course of action. In its Integrated Overview of Policy Recommendations, the FSB maintained that “the authorities’ approach to shadow banking has to be a targeted one. The objective is to ensure that shadow banking is subject to appropriate oversight and regulation to address bank-like risks to financial stability emerging outside the regular banking system while not inhibiting sustainable non-bank financing models that so not pose such risks”. In their comments on shadow banking entities, Clifford Chance drew what one would have thought to have been the proper conclusion: “Given that the primary objective is to control systemic risk, regulators should focus only on those activities that can be demonstrably shown to be a significant source of real systemic risk. We do not believe that all activities deemed to be ‘shadow banking activities’ should be regulated, or regulated any more than at present.”

As described in my previous posting, such a ‘targeted’ approach was not in fact adopted. Rather, the regulators apparently decided to also seriously encumber the operation of non-bank shadow banking activities at the outset, without the benefit of any evidence that such activities would remain a significant source of systemic risk once the separation of banks from shadow banking activities took effect. That this has not been lost on shadow banking participants can be clearly seen in the comments delivered on the FSB’s shadow banking proposals.

By far the strongest response emanated from the MMF industry, relating especially to the proposals to eliminate stable NAV funds or impose other quasi-capital requirements. In the view of almost all commentators, these proposals are likely to largely destroy the industry. In making their arguments, they rejected several of the claims and assumptions underlying the FSB proposals. Especially since the most recent round of regulatory changes in 2010, it is claimed that MMFs are extremely transparent. According to commissioner Luis A. Aguilar, “many do not realize that due to the 2010 Amendments, money market funds have become one of the most transparent financial instruments for both regulators and inventors” (Statement on Money Market Funds as to Recent Developments (2012)).  More importantly, it was asserted that MMFs have in fact not proven to be susceptible to runs. As expressed by HSBC Global Asset Management,

“In other words, and contrary to much commentary, there wasn’t a ‘run’ from US MMFs per se: rather investors sought to avoid losses by ‘switching’ their exposure from the banking system to the US government; there was a classic ‘flight to qualify’. The flight came to an end when the Federal Reserve’s Temporary Guarantee Programme effectively made prime MMFs ‘as good as’ treasury MMFs and made further switching unnecessary.”

In any case, according to Federated Investors, Inc., the proposals would be ineffective in accomplishing their stated purpose:

“It is contended that what prevents a run-or resolves it before it causes a panic – is liquidity. Using V-NAV rather than C-NAV, imposing holdbacks or other redemption limits, a two-tiered capital structure, or “bank-like” regulations, does not address this core issue.”

Neither, it is contended, is there any evidence that such requirements would eliminate the first-mover advantage. (See Greene and Broomfield, “Promoting risk mitigation, not migration; a comparative analysis of shadow banking reforms by the FSB, U.S.A. and EU (2013)).

However, perhaps in the spirit of accepting a lesser evil, there was support for the imposition of a redemption gate accompanied by a redemption or liquidity fee. As described by SIFMA,

“The gate, when triggered, would prohibit investors from redeeming and provide a period of time for a fund to restore its liquidity. At the time the gate is lifted, the fund would impose a fee on subsequent redemptions until such time as liquid assets in the fund were restored to a pre-determined level. The gate would operate for a brief period. The purpose of the gate would be to allow time for the fund to implement the liquidity fee and make any other necessary determinations regarding the fund’s next steps. Only a gate can truly stop a run”.

According to J.P. Morgan Asset Management, “the standby character of these proposals appropriately balances the goal of allowing MMFs to operate normally when not under stress, yet promote stability, flexibility and reasonable fairness when stressed.”

Thus, “in the absence of a credible deposit insurance policy for the money market fund industry (emphasis added in light of my previous posting), suspension of convertibility should be the preferred option; for regulators, for fund sponsors and for investors. Liquidity gates and liquidity fees provide the clearest disincentive to institutional investors to seek to gain a first-mover advantage by running from their fund; they also provide the strongest policy tool to stop a run once it is underway, by breaking the downward value spiral.” (Mark Hannam, Institutional Money Market Fund Association, “Money Market Funds, Bank Runs and First-Mover Advantage (2013); a conclusion supported in their comments by HSBC Global Asset Management; SIFMA and Blackrock; but see Federated for the contrary view.) 

In addition, it was suggested that concerns around “sponsor support”, which introduces a level of ambiguity about risk ownership which could have a distortionary effect on the pricing of such risk, should be addressed though banking regulation prohibiting bank sponsors from providing support to their MMFs (See Blackrock, HSBC Global Asset Management, Melanie Fein).

Notwithstanding the vehemence with which MMF industry participants have expressed their views, early signals that they have failed to sway regulators include a statement by Ben Bernanke that “a run on money market funds also remained a possibility”  and signals from the European Commission that is “planning to introduce tighter restrictions on stable value money market funds, which some believe would ‘kill off’ the € 490bn industry”. (On a (unintentionally) humorous (at least so it seems to me) note, Bernanke is also reported on saying that the Fed was “monitoring a wide range of asset markets for signs investors were ‘reaching for yield’ in a way that might pose risks to the financial system, given that interest rates were so low”.)

The other aspect of the FSB proposals to attract substantial negative reaction was the quasi-capital proposal of minimum haircuts for repo transactions. This was broadly seen to be, if not destructive of the market, at least potentially distortionary. It was contended that the proposed methodology of calculating haircuts ignores counterparty risk in favour of concentrating on collateral price volatility. “As historic haircuts would clearly have taken into account counterparty risk alongside collateral price volatility, this could significantly distort future haircut levels. Applying extended haircuts to credit-worthy counterparties on an ongoing basis could result in costly implications for the availability of liquidity to credit-worthy participants” (Deutsche Bank).

As expressed by the Association of British Insurers:

“The imposition of statutory minimum haircuts would introduce new potential risks to the financial system. If they are set at too high a level they pose a systemic risk to market liquidity. [As transactions which would otherwise have been below the levels would be lost]. If they are set too low then there is a potential moral hazard risk that participants may abdicate their responsibility to conduct their own risk analysis and simply gravitate to the regulatory minimum haircut as a market standard. There is also a danger that where ‘haircuts’ are not calibrated to a firm’s individual risk appetites they could lead to pro-cyclical effects.

Indeed, we are concerned that these proposals are being made with little analysis of the potential impacts, including the possibility that these requirements could be costly to introduce and enforce while ultimately creating risks that could equal or exceed those that they are intended to address. We note also that stock lending and repo markets provide an important liquidity and price discovery mechanism for the financial markets and the imposition of statutory haircuts may have the negative impact of discouraging market participants.”

Furthermore, considerable doubt was expressed over whether minimum haircuts would in any case be effective to achieve their intended purpose of reducing the risks of runs:

“It is unclear the extent to which haircuts would ever be an effective tool in reducing the risk of a ‘run on repo’ identified in the recent financial crisis. These occurred as a result of sudden changes in market sentiment driven by a complex range of factors and were limited to a specific asset class and the US market. The role which minimum haircuts would play in preventing a repeat of such a scenario is not obvious – certainly not when placed alongside other regulatory interventions designed to target capital, liquidity and leverage directly” (Deutsche Bank).

It may be worth noting that the FT article noted above also reported that “a second leaked draft from the Commission suggests it is likely to expand this regulatory push to cover all funds engaged in securities lending or repo transactions.”

It remains to be seen whether the proposed regulations will be successful in disentangling shadow banking and commercial banking activities. However, it must be admitted that the efforts in that direction are serious and have a chance of accomplishing their goal, however unsatisfactory this may be to the banking community. What may be accomplished in the non-bank shadow banking world is at this point in much greater doubt. If the views of the commentators are to be given credence, one of the two main goals of the regulators, the elimination of debilitating runs, will not be accomplished, but several well understood shadow banking activities will be rendered unattractive in the process. As a result, investors will inevitably seek alternative homes for their money. As explained by Federated in their letter on MMFs,

“In the event that MMFs are eliminated, it is reasonable to assume that a significant percentage of the assets will move to bank deposits, which would transfer the risk from MMF investors to the insurers of those banking institutions…Fundamental changes to MMF structure and regulation that make MMFs less attractive and useful will increase systemic risk, not reduce it, and will stifle economic recovery, rather than foster it”.

Under this scenario, the size of banks already found to pose systemic risks to the global financial system will be augmented. Cash that was not shifted to bank deposits would likely flow into alternative money-equivalent products offered by as yet unregulated, and thus unmonitored, sources of finance – the so-called ‘deep’ shadows.  There is also some danger that, having thus been “laundered” in the deep shadows, this money could flow back into the banking system undetected. These results would seem to be contrary to another pillar of the FSB proposals, that of increased transparency, making unexpected future events more rather than less likely. “This migration would decrease transparency and hinder efforts by authorities to monitor systemic risk” (Greene and Bloomfield). Wouldn’t a more effective approach have been to leave the ‘near shadows’, that is, the usual source of shadow bank financing, sufficiently attractive to non-bank intermediaries to attract enough activity so that any remaining in the deep shadows would not have systemic effect?  That way, if the transparency of the near shadows was enhanced at the same time, impending problems could at least be foreseen more readily.  As it is, non-bank financial activities are more rather than less likely to operate in places unknown and unmonitored until such time as they are revealed in potentially unpleasant ways.

The Bulk Sales Act

But first, some background. By its terms, Ontario’s BSA applies to a “sale in bulk”, which is a sale of “stock in bulk” out of the usual course of business or trade of the seller. “Stock” is defined as goods, wares, merchandise or chattels ordinarily the subject of trade and commerce, in which a person trades or that the person produces or that are the output of a business or with which a person carries on a trade or business. Some sales in bulk are specifically exempted – for example, bulk sales by an executor, an administrator, a guardian of property, a creditor realizing on security, a receiver or trustee for the benefit of creditors or a bankruptcy trustee are all exempt from the application of the BSA. If the buyer fails to comply with the BSA, a sale in bulk is voidable and the buyer is then personally liable to account to the creditors of the seller for the value of the stock in bulk.

Although the BSA doesn’t apply to sales of receivables/intangibles, it potentially applies in the context of a lease securitization transaction where an interest in leased equipment is sold to a special purpose entity as part of a transaction that is structured to be bankruptcy-remote to the seller. Fundamentally, whether the BSA applies to this type of securitization transaction comes down to whether or not a sale undertaken in connection with a securitization transaction is in the seller’s “usual course of business or trade” and until now there has been no judicial authority considering this issue.

Given the potential downside of failing to comply with the BSA (that is, the voiding of the transaction) and the fact that compliance would be onerous (if not impossible as a practical matter), it has become common practice to require an asset seller to obtain an exemption under the BSA as a condition of closing. A judge can exempt a sale in bulk from the application of the BSA if the judge is satisfied that the sale is advantageous to the seller and will not impair the seller’s ability to pay creditors in full. These requirements are not difficult to satisfy in the context of a securitization transaction. Sometimes in a program structured to permit periodic (and often frequent) sales of assets, this order is obtained with respect to all sales that will be made from time to time under the program (which is possible since the sales are conducted under a master agreement on effectively the same commercial terms). Obtaining a blanket order provides cost savings for the asset originator as it eliminates the need to go to court every time it wishes to sell assets.

The Applicant’s Initial Sale

On February 27, the Court released the first of two decisions. The case involved an asset originator that applied for a BSA exemption order in the context of a lease securitization transaction that would extend to the initial sale, as well as future sales under a program. The company’s lawyers took the position that the initial sale under the program was subject to the BSA as it was a “sale in bulk”, but that future sales would not be considered bulk sales. 

Justice Brown found this approach to be inconsistent, stating that the BSA either applied or didn’t apply to all sales under the program. Accordingly, Justice Brown granted an order for the initial sale on the basis that the transaction was advantageous to the seller (permitting it to access new financing) and wouldn’t impair ability to pay creditors, but questioned why the court should have to expend its scarce judicial resources considering BSA exemption orders for these types of financings (or other “securitization variants thereon”) that have become “popular in recent years”. 

In rendering his decision, Justice Brown referred to the 2003 Supreme Court of Canada case of National Trust Co. v. H&R Block Canada Inc., in which the court stated that the BSA applied to any sale of goods “out of the usual course of business or trade of the seller”, which means that any sale of all or substantially all of the assets of a business or a sale of the assets used to operate a business must comply with the BSA. The Court also cited the 2003 decision of the Ontario General Division in Millgate Financial v. BCED Holdings, in which the Court observed that the usual course of business might extend to activities and reorganizations undertaken for the purpose of obtaining financing. 

Justice Brown went on to state that if, notwithstanding the clear language of the Supreme Court of Canada in the National Trust case, the commercial bar lacked the confidence to rely on the principle that the BSA did not apply to these types of financings, then something had to be done. In Justice Brown’s view, seeking such exemptions as a result of unclear language in a very old statute undermined the “efficient workings of our economy” (which isn’t normally thought to be within the purview of the courts).

Thus, while the Court ultimately granted the exemption, it also directed the applicants to bring any future applications on notice to the Attorney General of Ontario so as to allow for a determination of whether this type of financing “sale” falls within the ambit of the BSA.

Subsequent Application

In accordance with Justice Brown’s initial order, the applicant’s subsequent application for a BSA exemption was made on notice to the Attorney General.

As we discussed in our earlier post, the Court ultimately found that the proposed transaction did not fall within the BSA's definition of "sale in bulk". To fall within the definition, such sales must be outside the usual course of business or trade of the seller. The Court, however, distinguished the proposed transaction from those captured by the BSA, characterizing the transaction in this case as a sale “for the purpose of raising financing in the ordinary course of the operations of the applicants' business.” The Court further questioned why the BSA would apply to the proposed transaction when it did not apply to an alternate method of financing, that of simply borrowing money from a financial institution and charging the leases and equipment as security for the loan.

The Court chose to base its decision on the dicta in Millgate Financial rather than that of National Trust:

Although it would be open to me to conclude that the Proposed Transaction was not a sale made out of the ordinary course of business because it involved only 7.5% of the total assets of the applicants – hardly the “all or substantially all” described in the National Trust case – I think it makes more commercial sense to rest my conclusion that the sale is not one made out of the ordinary course on the basis that the purpose and design of the Proposed Transaction is to secure ordinary course financing for the applicants. (at para. 22)

Thus, the Court ultimately found that the BSA “was not intended to regulate, nor by its terms does it result in the regulation of, an ordinary course financing technique such as the type of asset securitization involved in the Proposed Transaction.” In other words, the Court found that, notwithstanding the form of the transaction which utilized the technique of legal sale, it should be considered to be merely an alternate form of financing, falling within the applicant’s usual course of business or trade and thus outside the scope of the BSA.

Thoughts Going Forward

There are no compelling policy reasons for the continued existence of the BSA. This case is but one illustration of how the BSA can cause delay and increased costs for businesses. Unfortunately, somewhat of an onerous burden was placed on the asset originator in this case. However, perhaps the upside to this decision is the renewed hope that there may be some clarity shed by the legislature on this matter in the not too distant future.

Until then, however, the securitization bar must come to grips with how it will deal with the BSA. Hopefully, the strength and clarity of this decision will give the bar the comfort necessary to allow it to give and accept unqualified financing level opinions without the necessity of obtaining BSA orders.

As such, the court concluded that

the sale is not made out of the ordinary course on the basis that the purpose and design of the Proposed Transaction is to secure ordinary course financing for the applicants.

In my view the BSA was not intended to regulate, nor by its terms does it result in the regulation of, an ordinary course financing technique such as the type of asset securitization involved in the Proposed Transaction.

Doug Harrison and Dan Murdoch of Stikeman Elliott LLP acted on behalf of Cle Leasing Enterprises Ltd.

Certain commentators on these proposals strongly objected to the CSA’s “product-centered” approach, maintaining that traditional ABS products (as opposed to higher risk securitization products such as synthetic products and products created under an originate-to-distribute model) are not substantially different from, or have significantly different risk profiles than, other forms of complex debt financing and, accordingly, should not be treated any differently. It appears that the CSA may have taken cognizance of this complaint although their response may trend in the direction opposite from that which commentators may have hoped.

On November 10, 2011, the CSA issued Staff Consultation Note 45-401 in which they announced that they are undertaking a review of the minimum amount (MA) and accredited investor (AI) exemptions (together the “Private Placement Exemptions”). The reason for the review is perhaps revealing: “the global financial crisis and recent regulatory developments have raised questions about the use of [the Private Placement Exemptions].”

In the Consultation Note, the CSA maintains that the Private Placement Exemptions “have been premised on the investor having one or more of:

• A certain level of sophistication,
• The ability to withstand financial loss,
• The financial resources to obtain expert advice, and
• The incentive to carefully evaluate the investment given its size.”

I would enlarge on the foregoing by incorporating the view of the American Securitization Forum (ASF) in their comment letter on the securitized products proposal and apply it to complex exempt products in general: “Complex … products offered without all of the protections of the prospectus-delivery regime should be limited to investors who have the knowledge and experience to evaluate the securities they are considering for purchase and the ability to ascertain what disclosure, reports and other contractual features they require in connection with a prospective purchase”.

For convenience, the CSA premises and the ASF enlargement are together referred to below as investor sophistication. A completely reliable determination of investor sophistication is inherently a factual exercise which should be conducted on a case-by-case basis. In order for capital markets to function efficiently, however, tests of general application have been devised including the eligible securitized product investor test and the Private Placement Exemptions. As alluded to in the Consultation Note, the regulatory trick is to find a balance between a test which is so lax that it will allow unsophisticated, retail investors to participate in the exempt market and one that is so severe that it will close the market to investors who do not need the protections provided by a prospectus offering, thereby adversely affecting the raising of capital, especially by small and medium sized enterprises.

It is also undoubtedly true that investor sophistication is a somewhat relative concept which may vary in relation to the complexity of the investment. A given investor may be considered sophisticated when assessing of a vanilla corporate debt investment but a complex transaction of one sort of another may be beyond his level of sophistication. (Thus the ASF has proposed the concept of “qualified institutional buyer of structured finance products” to the SEC, which could be adapted to other complex products, and under which an investor would have to satisfy a quantitative test as to structured finance products under management as well as certain qualification standards relating to such investor’s knowledge and experience in the purchase and surveillance of structured finance products.) That the CSA recognize that this has implications beyond securitized products is implied in the Consultation Note where the CSA state that “the size of investment alone does not assure investor sophistication or access to information, particularly where the minimum amount is used to sell novel or complex products without any accompanying disclosure. At most, the size of the investment is an indicator only of the investor’s ability to withstand financial loss.”

The determination of the appropriate thresholds to be utilized in the various exemptions and which exemptions are appropriate in respect of which products will be the subject of much debate between the CSA and market participants and, while of crucial importance to the continued functioning of the exempt market, is not the subject-matter of this piece. My point here is a relatively simple, even fundamental, one; once an acceptable test for investor sophistication has been established, whatever the details may be, the one conclusion that necessarily follows is that there can be no public policy argument for requiring the delivery of disclosure to the investor; in other words, to find that the investor is sufficiently sophisticated is ipso facto to find that he is sufficiently knowledgeable and powerful enough to demand, obtain and understand all of the information necessary to allow him to exercise a prudent investment decision without the necessity of regulatory intervention or oversight. It is in superimposing a disclosure requirement (not to mention the certification requirement) on top of revising the exemption in order to better assure investor sophistication that the CSA are guilty of regulatory overkill in the case of the proposed securitized product rules. They are in essence saying that, although an investor may be sufficiently sophisticated to purchase without imposing disclosure, we are going to impose it anyway. But surely this is ultimately to entirely collapse the distinction between the private and the public markets and an attack on the basic right of contract which, in the absence of cogent public policy reasons to the contrary, should be unimpeded by regulatory intervention. It is of particular interest that the Consultation Note does not explicitly include any such requirements in the context of the Private Placement Exemptions (although there are various seemingly innocuous references to the relevance of disclosure which interested stakeholders should not let pass without comment).

It will be interesting to see how the CSA integrates their approach to exempt products in general with their approach to securitized products. That they will take cognizance of the latter is specifically acknowledged in the Consultation Note where they indicate that they will be considering the comments received in response to the securitized product proposals as part of their general review of the Private Placement Exemptions. “We believe it is important that our assessment of those exemptions be informed by the CSA’s proposals concerning securitized products and the comments of stakeholders with respect to those proposals”. It may be overly optimistic to hope that, in issuing Staff Consultation Note 45‑401, the CSA may in fact be signalling a shift in direction away from the previous product-centered approach towards an approach of more general application. If so, it will be difficult for the CSA to justify a differentiated application of the exemptions between securitized products and other complex products. Indeed, logically, it almost seems inevitable that the true differentiation should be between vanilla products on the one hand and complex products of any sort on the other and the real challenge may well be in devising a workable definition of ‘complex’.

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.

The following are some key highlights emerging from the decision, some of which are discussed in detail below:

• while “material facts” are broader than “material changes” both are based on an objective assessment to be made in a contextual basis;
   
• prior disclosure can establish a “baseline” from which future disclosure decisions may be assessed (in that the company cannot later rely on the lack of impact that an event or occurrence may have if its prior disclosure did not provide adequate information for investors to be able to judge the subsequent event);
   
• disclosure of risks to which a company is subject is not sufficient to satisfy its material change disclosure obligation, if and when the risk actually transpires;
   
• materiality is based on the effect of the information on either the market price or the value of the securities;
   
• an issuer will not be liable for making premature disclosure where an event or occurrence has actually transpired, even though its impact or significance may be uncertain; and
   
• external events or developments that have a direct effect on or consequences for an issuer’s business or operations may constitute a material change.

Preliminary Matters

As a preliminary matter, the OSC considered the difference between “material fact” and “material change”. While material facts are those facts that would reasonably be expected to have a significant effect on the market price or value of securities, a material change also requires a change in an issuer’s business, operations or capital. As such, the OSC confirmed that the definition of “material fact” is broader than that of “material change”, as the former will not necessarily arise from a change in an issuer’s business, operations or capital. The standard of materiality for both concepts, however, is the same and based on an objective standard. Importantly, the assessment of materiality also requires “a contextual determination that takes into account all of the relevant circumstances”. Assessments of materiality should not, however, be made with the benefit of hindsight. Thus, according to the OSC, Coventree’s disclosure decisions, which were made at the time events were unfolding, were not judged in light of the knowledge that a market disruption in the ABCP market actually occurred in August 2007. The OSC also confirmed that the business judgment rule does not apply to decisions regarding disclosure under the Securities Act. As such, Coventree’s disclosure decisions were not protected from scrutiny after the fact by an appeal to business judgment.

Prospectus Disclosure

OSC Staff alleged that Coventree's prospectus, filed with the Commission on November 16, 2006, failed to disclose the fact that Coventree had received a letter from the Dominion Bond Rating Service (DBRS) on November 10 stating that the rating organization would henceforth be taking a more restrictive approach to rating credit arbitrage transactions. This was considered to be particularly important in this context, as Coventree relied on the prospectus exemption for suitably rated short-term debt in order for its conduits to issue the ABCP, and DBRS was the only approved organization rating ABCP with "Canadian style liquidity". Ultimately, however, the OSC found that the DBRS letter did not constitute a material fact, as the letter was: (i) unclear as to the criteria that would be applied in reviews of structured finance asset transactions; (ii) appeared to be a continuation of DBRS's existing "measured approach" to approvals; and (iii) did not affect outstanding transactions.

Despite this conclusion, the OSC did make a number of observations regarding the prospectus that were ultimately relevant in the Commission’s consideration of subsequent disclosure decisions. Of particular interest was the OSC’s pronouncement that the disclosure respecting the proportion of Coventree’s revenues deriving from credit arbitrage transactions (about 80%) was less than full, true and plain. According to the OSC, “full” disclosure is provided when disclosure is made of facts sufficient to permit investors to make an informed investment decision; “true” disclosure occurs if the disclosure is accurate, not misleading and does not omit a fact that is material or necessary to understand the facts as disclosed; and “plain” is disclosure that is understandable to investors in a plain language. The OSC also found that the prospectus failed to communicate that Coventree considered the credit arbitrage business to be “dead or dying”. The OSC’s observations in this respect were relevant insofar as the Commission concluded that the disclosure deficiencies it identified made it much more difficult for public shareholders and potential investors to fully understand the significance of subsequent developments.

DBRS release regarding credit rating methodology

OSC Staff also alleged that Coventree failed to disclose DBRS’s decision in January 2007 to change its credit rating methodology. According to Staff, the DBRS release was a material change and ought to have been immediately disclosed by Coventree.

While Coventree argued that the DBRS release did not change its business or operations in any way, the OSC found that the release imposed a requirement for global style liquidity that had not previously been required. Ultimately, the DBRS release was found to be an escalation of DBRS’s previous concerns regarding the credit arbitrage market and, given Coventree’s reliance on “Canadian style liquidity”, the DBRS release did in fact result in a material change to Coventree’s business.

Of particular interest is the OSC’s response to Coventree’s argument that the DBRS release could not have constituted a material change since there was no change in the market price of Coventree’s shares after the information was ultimately disclosed in Coventree’s second quarter MD&A. The OSC rejected this argument, stating that the fact that Coventree’s share price was not affected by the eventual disclosure did not mean that no material change had occurred. Rather, the OSC framed the issue as whether particular information would reasonably be expected to have had a significant effect on the value of securities, despite the lack of effect on the market price of the securities. According to the OSC, “one cannot assume…that the lack of impact on market price means that the information disclosed was not material.” In the immediate case, therefore, the OSC found that the DBRS release would reasonably be expected to have had a significant effect on the value of Coventree’s shares. Also, as described earlier, Coventree’s prospectus disclosure ultimately acted as a form of baseline from which to draw inferences regarding investors’ knowledge. Specifically, the OSC stated that investors did not appreciate how important credit arbitrage and CDO related SFA transactions were to Coventree’s business. Hence, the lack of a change in the market price did not necessarily imply that there had been no material change.

Material change prior to August 13, 2007

OSC Staff also alleged that Coventree failed to disclose liquidity related events in the days leading up to the disruption in the ABCP market that occurred on August 13, 2007, and that these events constituted a material change. In response, it was argued, among other things, that the events in question were external and widely known, and that specific disclosure by Coventree would have been premature. These arguments were, however, rejected by the OSC.

According to the OSC, it would not have been premature to disclose actual events and developments and their consequences to Coventree’s business, even if there was uncertainty as to their causes, future effects, financial impact or duration. As the OSC stated, “[a]n issuer does not subject itself to any liability…for premature disclosure where the disclosure made relates to events and their consequences that have occurred and is accurate, balanced and appropriately qualified.” According to the OSC, the possibility that ABCP market issues could be resolved as part of a negotiated “soft landing”, as believed by Coventree, was contingent, uncertain and highly speculative and did not insulate Coventree from its disclosure obligations.

The OSC also rejected Coventree’s argument that the events in question were external and did not require disclosure as per section 4.4 of NP 51-201 Disclosure Standards. According to the OSC, that provision is premised “on the assumption that investors will be aware of external economic developments and their general effects on reporting issuers.” In this context, the OSC was of the view that public shareholders and potential investors had very limited knowledge of the ABCP market and of events and developments affecting that market (again, looking back in part to the baseline of the prospectus). 

Even if the exemption did apply, the OSC stated that the developments affecting Coventree were uncharacteristic of the effect generally experienced by other issuers in the same industry, due to Coventree’s size and its conduits’ exposure to ABCP and, as such, Coventree would be unable to rely on the provision regardless. According to the OSC, Coventree made a “critical error to the extent that it assumed that these external events or developments could not and did not have direct effects on, and consequences for, its business and operations that constituted changes in that business for purposes of the definition of ‘material change’ in the Act.”

In light of the OSC’s findings, on November 8, the Commission ordered Coventree to pay an administrative penalty of $1 million and costs of $250,000.

Three elements of the proposed new rules attracted the most attention. First, the creation of the new definition of “eligible securitized product investor” and the elimination of the other exemptions were generally attacked as unfairly stigmatizing securitized products and, it was contended, could lead to a patch‑work of different exemption criteria for different products. Certain commentators suggested that sufficient protection would result if all exempt purchases were required to be completed through registrants with their know‑your‑client and know‑your‑product obligations.  The implication in certain of the criticisms from dealers is that investors may come to view securitized products negatively due to the fact that they are to be treated differently under the proposal. It is not readily apparent, at least to me, how this would ever become an issue for investors other than, by definition, those who have been excluded under the new regime. The people most affected by the proposed change may, in fact, be those sitting at various trading desks who will have to be careful not to sell securitized products to non-eligible securitized product investors; but, having said that, I would have thought that their know-your-client and know-your-product obligations would have already necessitated the taking of such care.

The opposition to the proposal was not universal, however, at least in concept. Neither the author nor the American Securitization Forum (ASF) found the elimination of retail investors to be particularly troublesome. As stated by the ASF: “ASF supports the view that complex securitized products offered without all of the protections of the prospectus‑delivery regime should be limited to investors who have the knowledge and experience to evaluate the securities they are considering for purchase and the ability to ascertain what disclosures, reports and other contractual features they require in connection with a prospective purchase”.

Virtually all commentators were united in their criticism of the requirement to provide an information memorandum. This strength of this criticism is only reinforced if the proposed change to the universe of eligible investors is conceded. Having eliminated the retail investor, what remain are precisely the highly sophisticated investors who have the knowledge of what they need and the ability to obtain it through negotiation. The proposal represents an unwarranted infringement on the right to contract and should, at minimum, be capable of being waived. (Similarly, the proposal requiring continuous disclosure in respect of exempt distributions runs afoul of this principle and should also be left to be negotiated by the participants.)

The ASF recommended that the CSA follow the U.S. approach which only requires delivery of an information memorandum if specifically requested by an investor or prospective investor. However, I continue to believe that this is a distinction without a difference. This view has recently been corroborated by the Securities Industry and Financial Markets Association (SIFMA) in their comment letter on the SEC’s Re‑Proposal of ABS Shelf Eligibility Conditions: “As a practical matter, however, this would mean that every issuer of structured finance products would need 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 … The proposed changes … substantially eliminate the principal distinctions between registered public offerings and private offerings … In our view, the scope of the proposal is unjustified and the proposed changes could significantly impair the functioning of the private markets for structured finance products and reduce the availability of credit.”

There did not seem to be as much resistance in principle to the proposal to require minimum disclosure for short-term securitized products although several bank commentators indicated that it should not go beyond what is already required by the Bank of Canada for bank-sponsored conduits’ ABCP to qualify as collateral under the Bank of Canada’s Standing Liquidity Facility. In any case, according to CIBC (and seconded here), it is critical that the prescribed form contain program level information only, and not transaction details: “The costs and challenges in meeting the delivery requirement for updated transaction information in an information memorandum for each sale of ABCP could likely result in the ABCP market being eliminated.”

Finally, and perhaps most importantly, is the proposal which would require issuers, sponsors and underwriters to certify that information memorandum contain no misrepresentation. As indicated by the ASF, the proposal “is without parallel in the U.S. securities laws”. No justification has been forthcoming (or, indeed, exists) for such an extension of liability in respect of these products as opposed to any other exempt investment, however risky. It is one thing to require enhanced disclosure; it is something entirely different and totally unconnected to impose enhanced liability. As indicated by CIBC such an extension “would likely result in the demise of the private placement market for securtized products because it would largely eliminate the distinction between public and private offerings”. In addition to increasing transaction costs (which would be passed on to investors), perhaps more importantly it would naturally “result in a redirection of issuance volumes towards exempt products with lower liability risks or costs associated with them”.

The entry point for the application of the Proposals is the definition of securitized product. Given the importance of this definition it is perhaps surprising that comparatively little attention was paid to it by most commentators. Those who did comment on it did little but indicate that they believed the definition to be too broad and cite a few examples of instruments that should not be caught. These included NHA MBS, Canada Mortgage Bonds, over‑the‑counter derivatives, corporate loans secured by pools of assets, innovative Tier 1 capital structures and structured notes.  Apart from our own submission, very little analysis was provided to the CSA to allow it to structure a principle‑based definition. And we do not believe that the solution lies in merely listing the above as exceptions as, unless the definition itself is refined significantly, there will be too many classes of securities on the margins or in the “grey” zone. As illustrated in our submission, there are a number of other types of securities that could unexpectedly be caught by the definition and specifically listing included or excluded securities may not be an effective solution as such lists may result in further interpretive difficulties.

The extreme breadth of the definition will create a trap for the unwary issuer which may only become apparent upon receipt of a comment letter or, more problematically, a claim from an investor in a private transaction who later, being discontented with the outcome of his investment, is casting about for grounds for reimbursement. Indeed any proposed issuance of securities in the “grey” zone will need to be approached cautiously under the proposed definition. If the issuance is to be by way of prospectus, the new rules are tailored almost entirely to fit traditional ABS and a “grey” zone issuer would be hard‑pressed to understand what specific disclosure is required in respect of its issuance. It would be much worse, however, if the issuance is to be conducted in the exempt market since the issuer would be caught between the rock of not complying, and thereby potentially opening itself up to liability for non‑compliance, and the hard place of complying, and thereby voluntarily taking on unwarranted liability by operation of the new disclosure and certification requirements. The uncertainty surrounding the applicability of the definition of securitized product could virtually eliminate all issuances of these “grey” zone securities as it would be difficult to obtain a legal opinion which would give sufficient comfort on the applicability of and compliance with securities laws. It is therefore incumbent upon the CSA to strive for much greater clarity in this area and we believe that they should submit a new proposal on this point for comment.

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.

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.

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.

Proposed Form 45-106F7 requires identification of each significant party involved in the securitization, namely parties with a significant role in structuring the securitization transaction, the creditworthiness and liquidity of the program, the selection, acquisition, analysis and management of the assets, the distribution of the securitized products and the payment to securitized product holders and requires details in respect of the role and function of such significant party and description of its experience with respect to substantially similar assets. For sponsors, liquidity providers and providers of material program credit enhancement, additional information is required. Where any such significant party is retaining a tranche or portion of a tranche of the issuance, the description of the tranche interest so retained is to be disclosed.

The disclosure must include diagrams setting out the structure of the securitization under the securitization program and simplified diagrams as to the cash flows of the securitization program.

The form requirements include (among other things) a detailed description of the program including a description of the investment guidelines applied to the pool assets, the amount and nature of liquidity support, the amount and nature of program-wide credit enhancement and any other protections afforded to securitized product holders.

In addition, a summary of the pool assets is required. For each series of short-term securitized product to be distributed, the IM is required to disclose the range of asset types that may be included in the pool, the manner in which the issuer will gain access to underlying asset exposure and the due diligence or verification procedures that have been or will be applied in respect of the pool assets. Disclosure is required as to whether any of the pool assets include CDOs or similar obligations, credit default swaps and other credit derivatives, synthetic assets or derivatives or sub-prime assets. If the pool assets include any of the foregoing, enhanced disclosure is required including a description of those assets and the process for obtaining those assets.

The IM will need to describe the short-term securitized product, its distribution and offering including the material terms thereof as well as the flow of funds for the securitization program including payment allocations, payment dates and payment priorities and, vis a vis certain assets, the ranking of the securitization program in priority of payments if it would reasonably be required by a prospective purchaser to make an informed investment decision.

The disclosure document must describe conflicts of interest that exist or may be reasonably anticipated between or among significant parties and a securitized product holder, all fees and expenses to be paid or payable out of the cash flows from the pool assets and the identity of the parties receiving those fees or expenses. This could be problematic to the extent that it means disclosing confidential arrangements or proprietary business terms. In order of significance, the document will need to disclose risk factors to enable the prospective purchaser to make an informed investment decision with respect to the short-term product including credit and liquidity risks, legal risks that may exist (such as true sale and bankruptcy remoteness issues and other claims or contingent claims on the pool assets) and tax risks, among others. The CSA provides only an indicative list of the types of risk factors that should be included. Each issuer preparing an IM will need to consider the distinct risk factors applicable to its own program.

The issuer will need to describe the material terms of the existing program documents and transaction agreements. This may prove to be a challenge. If the information memorandum is to be distributed on or before each purchase and the conduit is a multi-seller, multi-asset ABCP conduit intended to acquire a diverse range of asset interests and to finance and refinance those assets over time with short term instruments, one can expect new transaction-specific or asset-specific agreements to be entered into with some frequency. The ABCP conduit issuer will need to regularly revisit the IM disclosure as a consequence. We’ll revisit this issue in further detail later in this blog entry.

The other prescribed terms (in addition to those terms of general application to short or longer term products) include description of financial leverage and the credit rating of securitized product. Each memorandum (whether for short-term issuances or otherwise) must provide a description of the statutory or contractual rights of action or misrepresentation in favour of the purchaser, the resale restrictions that apply and include certifications from the issuer’s CEO or CFO (or equivalent), promoter and sponsor as well a signed certificate from each underwriter. While the foregoing summarizes the salient aspects of some of the important prescribed terms, this blog entry doesn’t identify every single disclosure term.

I’d like to share some further observations on the foregoing form requirements. After having completed a survey of a selection of ABCP conduit information memoranda, I believe the proposed form requirements will mean that for many ABCP conduit sponsors or administrators the current information memoranda in use will prove to be deficient after the proposed rules come into effect for ABCP conduit information memoranda. By and large, most current ABCP conduit information memoranda describe in general terms and broad language the aspects of the program that existed at the program inception and were not anticipated at the initial preparation of the IM to be reasonably capable of change or at least were described in a manner that such disclosure would remain correct after the passage of time and in particular after the introduction of new assets and originators into the securitization program. I don’t think this manner and approach to IM disclosure will continue to suffice.

I believe that it will no longer be the case that an ABCP conduit administrator will be able to create a series specific IM on the initial creation and issuance of a series of notes and only revise or revisit the IM when there are material amendments to the terms and attributes of the series. The requirement to describe pool assets and transaction terms in particular will require frequent reconsideration of the IM requirements. This means that ABCP conduit sponsors will potentially need to revisit their IMs and enhance the disclosure whenever new deals are originated and transaction documents are finalized and will need to report on related performance of such assets. In addition to the time and expense that may be so associated, the question that I have is whether the requirements imposed by the prescribed terms can practically be achieved.

In the context of short-term securitized product conduits (such as ABCP conduits), I presume that the ABCP conduit is issuing instruments of varying maturities and refinancing or rolling those notes regularly, perhaps as frequently as daily. Given this presumed frequency of issuance and purchase of securitized instruments, is the obligation to deliver an IM (in prescribed from and containing no misrepresentation) to each ABCP purchaser at or before the time of purchase intended to be interpreted such that the ABCP distribution desk of a sponsor of an ABCP conduit is required to issue an IM to a purchaser of the ABCP on any day that a purchaser purchases including the rolling, renewal or refinancing of previously issued and created CP (ie. on the initial creation and each roll date thereafter).   If this is the intention, it will mean each ABCP trader and the associated ABCP conduit administrator will need to confirm that the IM contains no misrepresentation and satisfies the prescribed terms as often as daily. This will then mean that from an operational and practical perspective the ABCP conduit is being asked to maintain current product disclosure virtually at all times – an administrative exercise that places the issuers of short-term securitized product (such as ABCP conduits) in Canada in an arena all by themselves. As it has with the continuous disclosure regime proposed for exempt purchases of securitized products, the CSA has imposed disclosure obligations on the short-term securitized product market that do not exist in any other exempt debt or equity market in Canada.

Accordingly, the CSA have not adopted the more controversial aspects of the U.S. Proposals such as mandatory risk retention, asset-level disclosure and waterfall computer programs. Even in respect of those parts of the U.S. Proposals that have been broached by the CSA proposals, the contrasting regulatory approaches have yielded markedly different results.

Repurchase Requests

The U.S. authorities have devoted much energy to the topic of repurchase requests, in part as a result of lawsuits over the enforcement of covenants to repurchase assets as a result of alleged breaches of representation and warranty and the difficulties encountered by investors in obtaining the necessary information from sponsors. In an effort to identify originators with clear underwriting deficiencies, the U.S. Proposals contain various rules ranging from the requirement to file periodic reports in respect of all fulfilled and unfulfilled repurchase requests to a requirement to obtain a third-party opinion in respect of any unfulfilled repurchase request.

The equivalent CSA proposal is limited to prospectus disclosure requirements. It applies to any offering where the underlying transaction documents contain an obligation to repurchase or replace assets due to a breach of representation and warranty (that is, virtually all ABS transactions). Disclosure is required in respect of each transaction in which (i) the originator under the present distribution or one of its affiliates was the originator, (ii) the assets involved were of the same class as those involved in the distribution and were themselves the subject of a public distribution and (iii) the assets were the subject of a demand to repurchase or replace for a breach of representation and warranty pursuant to the transaction agreements made at any time during the previous three years. In addition, disclosure is required as to the outcome of the demand and, if the demand has been rejected on the basis that the assets did not violate a representation and warranty, “whether an opinion of a third party not affiliated with the originator had been furnished to the trustee or issuer that confirmed that the assets did not violate the representation and warranty”. The requirement that any demand to repurchase be made “pursuant to the transaction documents” is important. In the U.S. much comment has been devoted to whether arbitrary demands not based on the rights afforded under the documents need be reported. The answer seems to have been clarified under the CSA proposal. 

Curiously, a separate but identical provision applies to “each party that is required to repurchase or replace a pool asset for breach of a representation and warranty”.  Given the breadth of this latter provision, the one discussed above, which applies solely to originators and their affiliates, seems redundant. 

Finally, information regarding the financial condition of each party with a repurchase obligation must also be provided if there is “a significant risk that the party’s financial condition could have a material impact on its ability to comply with the provisions relating to the repurchase obligations”. The precise nature of the required disclosure is uncertain and should be clarified unless all that is intended in the traditional statement that there can be no assurances that the party will be able to meet its obligations.

Asset Review

The U.S. Proposals also require issuers of registered ABS to perform a review of the underlying assets and to make disclosure regarding the nature, findings and conclusions of the review. The CSA proposal simply requires disclosure as to (i) “whether the pool assets have been reviewed for compliance with selection criteria or are the subject of a report by a third party to verify the accuracy of the loan or other asset information disclosed in the prospectus” and (ii)”if the pool assets have been reviewed for compliance or are the subject of a report by third party, the identify of the reviewer or third party, the scope of the review or report, and the result of findings of the review or report”. 

Risk Retention

Two days prior to the release of the CSA proposals, the SEC and various other federal banking regulators issued a massive set of proposed rules under the Dodd-Frank Act requiring securitization sponsors to retain an economic interest in the assets that they securitize. The proposed rules apply to virtually all securitizations whether public or private. They provide for several forms in which risk can be retained as well as limited exceptions for pools of assets that satisfy specified credit criteria and restrictions on hedging of the retained interests. The impact of these rules promises to be significant, imposing costs and burdens on the securitization industry which will inevitably be passed on to consumers in the form of a higher cost of credit. In stark contract to the U.S. Proposals, the CSA have chosen not to require minimum risk retention but, in keeping with the general thrust of its proposals, have restricted themselves to merely requiring disclosure as to whether any party to the transaction for whom disclosure has been provided under the prospectus “is retaining a portion of a tranche or tranches, and if so, … the amount retained for each tranche [and] whether that person or company has directly or indirectly hedged, or taken any other action, that seeks to transfer in whole or in part the credit risk associated with a retained portion.”

Although the CSA have not proposed the introduction of Dodd-Frank-style rules, they have asked for comments on certain features of the U.S. Proposals: “We have done so where we think that further feedback and analysis is required to determine (a) whether the proposed requirement will achieve its intended aims and, if so, how to appropriately design the requirement or (b) whether it is appropriate in the Canadian context. In particular, we are seeking comment on the following types of requirements:

• requirements that securitizations be structured in a particular manner, such as requiring that sponsors or other transaction parties retain a minimum tranche or tranches of the securitization (a “skin-in-the-game requirement”);
• requirements for due diligence, such as requiring the issuer to review the pool assets;
• requiring or restricting the involvement of particular parties in a securitization, such as imposing independence requirements or restrictions on conflicts of interest; and
• requirements for new disclosure that we think would be a major departure from what is already being provided pursuant to transaction agreements, such as asset-or-loan-level disclosure, provision of a computer waterfall payment program, and requiring sponsors or originators to file reports on fulfilled and unfulfilled repurchase requests across all securitizations.”

The introduction of any such requirements in Canada should be strongly resisted. The U.S. Proposals were made in response to specific industry conditions which by and large were not present in Canada. Contrary to what is apparently believed by the CSA (see their assertion that the model is “fundamental to securitized products”), the ‘originate-to-distribute’ model of securitization which has attracted so much adverse attention in the U.S. was not in fact prevalent in Canada (or, for that matter, in most asset classes in the U.S.), at least not in the manner or to the degree which is said to have caused so much damage. In transactions involving most asset classes, Canadian sponsors (mostly originators) in fact retained a significant amount of “skin-in-the-game” as a result of underwriting and rating agency requirements and industry standards and expectations. The financial crisis was arguably the product of the radical and unregulated application of this model in the RMBS sector alone and, as recognized by the CSA, there was no the subprime housing bubble in Canada. Nor have Canadian securitizations in general suffered anywhere near the level of losses that were experienced in the U.S. U.S. commentators have forewarned of the danger to the U.S. securitization market represented by the cumulative burdens which would be imposed by the implementation of the U.S. Proposals. Such burdens would be even less tolerable in the Canadian market which is much shallower than its U.S. counterpart. If they were to be imposed in Canada, it may prove fatal to both the ABS industry and any positive effect of the industry on the supply of credit, a benefit cited by the CSA itself.

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.

 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.

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.

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.

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.

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.

Do you think these goals are realistic?

Query whether my goals for the structured finance markets are more or less ambitious. It seems to me conventional wisdom in Canada now that securitization reform is inevitable and desirable. It would seem to some that even overly broad, ineffective and potentially harmful reform is preferred to the state of uncertainty and confusion that many identify in the current securitization environment in Canada. My own wish is that there is still time for a thoughtful discourse around regulatory reform in the Canadian securitization space and that regulators, investors, structurers and others interested in securitized product might carefully examine our market. I'd like to see an examination of the need for regulatory reform within the securitization markets in Canada that considers the performance of our assets, the composition of our deals and the profile of market participants, among other factors. My goal would be that reform (when it emerges) is contextualized, nuanced and appropriate. My partner, Mike Rumball, has written a great deal this Fall on this site about some of the potential perils of accepting holus bolus the rules and regulations developed under Dodd-Frank or by the SEC, particularly insofar as our experience and challenges in Canada have been different. Those differences should be exposed in a meaningful way. I share the view that some commentators have identified that the Canadian market - with smaller dealers, few players and different tolerance for risk, for example - may not be able to absorb the Dodd-Frank rules without adverse consequences. I'd like to see a report produced by a reputable source that identifies asset class by asset class how our public and private deals performed in the securitization market. If similar findings have already been produced, I have unfortunately missed such publication and from the conversations I've had I suspect many others also missed it. Many argue that a "Made In Canada" response to securitization reform is idealistic - our markets are too small and our regulatory and similar bodies are too busy to create a tailored response to this issue. In a time of ambitious new year's goals I am hopeful that those with the power and authority to affect regulatory and legal change to the way that securitization deals are completed, evaluated and governed will take an informed view of the situation and that our readers will share with us and them valuable insights in how to reform responsibly.

On the accounting front, I've been reading the accounting drafts relating to derecognition and consolidation of financial assets. I don't strongly recommend this reading and might refer you to Margaret Grottenthaler's summer reading list as a preferred alternative selection. Nonetheless, my new year's wish is that the accounting profession might creatively develop (together with other market professionals) some guidance as to the types of securitization deals that will satisfy off-balance sheet treatment even under IFRS. I've heard too often that conventional securitization deals won't satisfy the new principles-based rules under IFRS for off-balance sheet purposes and that we just have to get used to it. I accept the policy proposition that accounting treatment shouldn't be the principal driver for financing transactions but I still think there is room to craft sound commercial deals and achieve positive accounting results in our securitization markets.

A special word about heightened disclosure. It seems that in the post-credit crunch world 'more is more' when it comes to disclosure to investors. I appreciate the need to allow investors to make informed decisions about investment products with access to relevant information but I am also wary that there is a cost and expense to originators and market participants to verify, analyse and report disclosure. As one who sometimes cynically fears that much of the public disclosure available in securities offerings is seldom read, I hope that when rules around disclosure are developed for application for Canadian securitization markets there is an appreciation that adding more disclosure obligations on originators and structurers of securitization product may be a barrier to getting more deals executed.

Just a few thoughts. I hope some, if not all, of these wishes take place in 2011. I promise to let you know if my dream of owning a Bugatti or appearing on Entourage comes true.

Our readers will recall that the Rule provided, among other things, that NRSROs must maintain on a password-protected Internet Web site a list of each structured finance product for which it currently is in the process of determining an initial credit rating and identifying the type of structured finance product, the name of the issuer, the date the rating process was initiated and the Internet Web site address where the arranger of the subject issuance provides information to the hired NRSRO for the subject issuance that can be accessed by other NRSROs.  One of the goals of the foregoing Rule was to provide information accessible to NRSROs that were not hired for a subject structured finance issuance so as to enable such other NRSROs to be able to complete alternate or shadow ratings or review of the issuance.  The Rule is part of the broader U.S. reform initiative that is seeking to manage perceived conflicts of interest in the rating retainer arrangements and processes between asset originators and credit rating agencies. The underlying logic is that by providing access to all interested rating agencies to information about a proposed rated structured finance product, rating agencies might be in an informed position to assess the ratings ascribed to structured finance issuances generated by other rating agencies and thus avoid rating agency determinations that are not capable of review, criticism or confirmation by others.  Whether in fact the rating agencies and their processes (and allegations of conflict of interest) are to blame for the failures in U.S. securitization is a subject that I believe requires a nuanced and careful examination but in any event the U.S. Congress certainly doesn't need to be convinced that the credit rating agencies are at least partly responsible for the excesses and failures in the structured finance market in recent years.  But that's the subject for another blog...

Our anecdotal information suggests that many structured finance arrangers in Canada were not prepared in June of this year to have due diligence and similar information available on dedicated web sites for non-hired NRSROs as required under the Rule and many would not have been ready to meet the previous effective date for the Rule as of this coming December 2nd.  One of the issues that structured finance arrangers were struggling with is how to manage, collect and record exchanges with rating agencies so as to be able to be in a position to effectively populate the required dedicated Internet Web site with information shared with the hired rating agency about the structured finance product in question.  Some commentators have suggested that the requirement to have the information about the rated product available for scrutiny on a dedicated site may have a chilling effect on the tone, manner and scope of exchanges among the arranger, the rating agency and the originator.  We'd see, so the argument goes, less candid and informal exchanges among participants engaged with the proposed issuance to help develop the product criteria or attributes, fewer oral communications and more scripted responses.

The SEC is seeking comments from interested parties on the Rule and particularly its application to non-U.S. structured finance transactions. The extra-territoriality of the US financial reform legislation (including the Dodd-Frank securitization reforms) has been a subject of previous blog posts by my partner, Mike Rumball, and the application of this Rule in the future to Canadian deals is another example of the potential broad application of current US reforms. We will be watching the application of this Rule to Canadian deals and will report back on this blog on future related developments.

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.
 

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.

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.

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.

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.

As is the case with all aspects of securities regulation, the proposed reforms of the ABS market do not aspire to relieve all ABS investors of the burden of caveat emptor. The new expectations to be imposed upon issuers and sponsors of ABS are proposed only as conditions upon those who wish to avail themselves of the procedural and market capacity benefits available in the context of short form public issuance. In essence, the new rules say that if you wish to access the debt market in an expedited fashion to be able to capitalize upon windows of opportunity for public issuance, your investors must be given adequate minimum levels of disclosure to assess the risk of the proposed investment, must have some assurance that the CEO of the entity that originated the underlying assets believes that the investor will be paid out by the assets in due course and must be assured that the program sponsor is exposed to a material risk of loss that ranks at least equal to that assumed by the public investor. These new requirements, among others, are entirely restricted to public issues. To the extent that an ABS issuer can find sufficient investor capacity without utilizing the prompt offering system to issue debt securities, the proposals require little more than evidence that private market investors have been expressly offered prospectus level disclosure.

There are obvious merits to these proposals, and there are also costs and complexities for the issuance process raised by them. However, apart from the analysis of the balance between these benefits and costs, it is interesting to consider the effectiveness of the carrot offered to ABS issuers by these proposals.  Implicit in the SEC’s regulatory thinking is the assumption that short form offering capability for ABS issues is such an essential component of cost-effective capital market access that this condition of utilization will be a sufficient lever to effect major reform of the ABS market. 

In the context of the pre-crisis ABS market, such an assumption appears entirely reasonable. The issuance data reported in the database maintained by trade publication Asset-Backed Alert shows that in the calendar years 2005-2007, issuance of public ABS (excluding MBS and CMBS) in the US was consistently far in excess of private placement (Rule 144A) offering volumes, being over eight times more in 2005, over four times more in 2006 and still just under three times more in 2007. With the advent of the depths of the debt crisis in 2008, public and private ABS issuance reached virtual parity, and 2009 saw 144A issuance outstrip public issuance by 15%. More striking still, for the first quarter of 2010, Asset-Backed Alert has reported over US$21 billion of 144A ABS issuance versus only US$9 billion of US public ABS.

The story in Canada is no different in Canada. DBRS has reported that rated ABS private placements now constitute 4.0% of all outstanding ABS by dollar volume, a remarkable statistic given that rated private placements had not been offered in the Canadian ABS market before 2007. The recent rise of private placements in the Canadian market is even more striking when one considers that the portion of the current Canadian ABS outstandings categorized as public ABS includes C$3.7 billion purchased by the Business Development Bank of Canada as the administering agency for the Canadian Secured Credit Facility, the government program created to assist in rekindling demand for automobile and equipment receivable-backed ABS. CSCF issues were public in form only, utilizing the short form offering system only to meet the requirement for CSCF participation but were otherwise distributed very narrowly, and were in most cases purchased by BDC alone. Outside of this notional CSCF public issuance, the Canadian ABS market has only seen five public issues since 2007, including one retail and one wholesale automobile receivable-backed deal brought by Ford Canada, a retail automobile receivable-backed deal brought by GMAC and recent credit card-backed issues from each of Royal Bank of Canada and CIBC.

The reasons for this change in the balance between public and private market issuance could reflect growing market unease over looming regulatory changes to the rules governing public issuance. The dramatic change in US issuance patterns in the first quarter of 2010, during which the general disclosure recommendations proposed in the IOSCO report would have been available to the market, would seem to support such a conclusion. However, it is also apparent that average transaction size for US private placements increased only marginally from its historic level of roughly US$500 million, so it could also be that the shift away from public issuance merely reflects the economic realities of bringing smaller transactions to market.

In the Canadian market context, the rise of the private placement market may also be a manifestation of an underlying aspect that reflects a more profound refocusing of distribution efforts. Anecdotal reports would suggest that material portions of at least the shorter-dated tranches of some of these private issuances (and companion tranches issued in connection with CSCF issues) have found their way into the hands of US investors. This new source of liquidity for Canadian ABS has arisen almost simultaneously with the January 1, 2008 elimination of the federal withholding tax on interest paid to US-resident investors by Canadian-resident debt issuers, lending significant credibility to those that have long advocated that such a change in Canadian tax policy would be a transformative development for the Canadian ABS market.

Given the emerging trends in the evolution of the ABS market in both Canada and the US, a starting point for the debate about the efficacy of the SEC proposals for the reform of the ABS market might well lie not with the merits of the substance of the proposals but rather with the question of the effectiveness of short term public issuance eligibility as the means of introducing any reforms to that market. In the Canadian context, an even more specific market transformation might need to be addressed, given that it appears that it might be the depth of the US market for the private placement of Canadian-originated asset-backed offerings rather than access to short form issuance of public ABS that will dictate the immediate prospects for market growth. In either case, securities regulators might need to face the more problematic task of imposing reforms upon private market players in an effort to address the substantive market deficiencies that have been identified in the context of the most recent market crisis.

Among other changes, the amended Rule 17g-5 requires that certain arrangers that pay for a credit rating of a structured finance product maintain information on a password-protected web site for the benefit of qualifying NRSROs, whether or not the NRSRO had been hired to determine an initial credit rating or to monitor a credit rating of the structured finance issuer in question and to represent to the hired NRSRO as part of the engagement of such NRSRO that such web site had been established in compliance with the requirements of the SEC Rule. Under Rule 17g-5(a)(3), an NRSRO is prohibited from issuing or maintaining a credit rating when it is subject to certain conflicts of interest (including being hired by an arranger to determine a credit rating for a structured finance product) unless the NRSRO, among other things, (i) maintains on a password-protected  web site a list of each structured finance product for which it currently is in the process of determining an initial credit rating in chronological order and identifying the type of structured finance product, the name of the issuer, the date the rating process was initiated and the web site address where the arranger represents that the information provided to the hired NRSRO can be accessed by other NRSROs; and (ii) obtains from the arranger a written representation that can reasonably be relied upon that the arranger will, among other things, disclose on a password-protected web site the information that it provides to the hired NRSRO to determine the initial credit rating (and monitor that credit rating) and provide access to the web site to other NRSROs. The Rule establishes a compliance date of June 2, 2010, subject to the conditional exemption described in the following paragraph.

In an Order dated May 19, 2010 (SEC Release No.34-62120), the SEC has temporarily exempted NRSROs from the requirements of SEC Rule 17-g-5(a)(3) where certain conditions are satisfied. Under the Order, an NRSRO is not required to comply with Rule 17g-5(a)(3) until December 2, 2010 with respect to credit ratings where (1) the issuer of the structured finance product is a non-U.S. person; and (2) the NRSRO has a reasonable basis to conclude that the structured finance product will be offered and sold upon issuance, and that any arranger linked to the structured finance product will effect transactions of the structured finance product after issuance, only in transactions outside the U.S. The SEC intends that a “U.S. person” for purposes of the exemptive relief will have the same meaning as under Regulation S of the Securities Act of 1933. Whether an NRSRO has a “reasonable basis” to conclude that a structured finance transaction is not a U.S. transaction will be determined on the facts and would presumably involve conversations between the NRSRO and the arrangers and marketers of the structured finance instrument in question as to the intentions vis-à-vis the marketing, trading and re-sale of such instrument.

As background to the Order, the SEC stated that it had learned from certain foreign securities regulators that many foreign arrangers were not prepared to address the requirements imposed by the amended SEC Rule 17g-5 in terms of establishing the requisite web sites and implementing other systems requirements necessary to make the required disclosures in light of local laws that may impact adherence to the SEC Rule. The corresponding effect of imposing on NRSROs the requirements of Rule 17g-5(a)(3) would have been to require conditions to NRSROs’ issuing or monitoring credit ratings of structured finance products that non-U.S. arrangers were not able to address or accommodate. The SEC relief is designed to address those entities that are not U.S. persons within the meaning of the Act and complete non-U.S. transactions. The SEC will be monitoring the use of the temporary exemption to evaluate whether it is being used for transactions that meet the above-described conditions. The SEC is specifically seeking comments as to the application of Rule 17g-5(a)(3) to non-U.S. transactions.

While NRSROs in the structured finance market have temporary relief in respect of non-U.S. transactions, actions will need to be taken to prepare for compliance with the SEC Rule by structured finance arrangers and NRSROs with Canadian activities prior to the end of the temporary relief period.