Regulation AB governs registration, reporting and disclosure requirements for all things asset-backed. The Securities and Exchange Commission appears to be ready to update it significantly, but, nearly four years after changes were originally proposed, it’s not clear exactly what the Commission will do.
The original Reg AB was published in December 2004. It codified years of guidance and practice in the regulation of this market, which did not exist when the Securities Act of 1933 and the Exchange Act of 1934 were created.
In April 2010, the SEC proposed revisions that substantially changed the rules of the game. As summarized by Richard Jones, co-chair of Dechert’s finance and real estate practice group, in a post on the firm’s Crunched Credit blog, “It imported risk retention into shelf registration, imposed draconian liability, creating certification responsibilities on the sponsor’s CEO or unit head, and imposed new self-reporting obligations with onerous penalties for relatively minor matters of non-compliance among others.”
Vote Appears, Disappears from Agenda of SEC Board Meeting
But the Dodd-Frank Act was passed just a few months later, and it became clear regulators would have to focus on bringing the massive new financial-reform law to life. Some thought that Reg AB II would ultimately be shelved, given the conservative structures of asset-based securities issued post financial crisis, and the fact that some of its provisions, including a risk-retention requirement, were co-opted by Dodd-Frank.
In fact, when the SEC re-proposed Reg AB-II in August 2011, the commission did away with the risk-retention provision; the re-proposal also changed some requirements for issuers pursuing shelf filings for asset-backed securities. Two and a half years went by.
Then in January of this year, at the 41st annual Securities Regulation Institute in California, SEC Chairman Mary Jo White said that Reg AB II was on the SEC’s radar screen for 2014. Later that month, the SEC published a notice stating that it would consider adopting some of Reg AB II at its Feb. 5 board meeting.
The notice stated that the revisions “would require asset-backed issuers to provide enhanced disclosures including information for certain asset classes about each asset in the underlying pool in a standardized, tagged format and revise the shelf offering process and eligibility criteria for asset-backed securities.”
Then two days before the board meeting, on Feb 3, the SEC announced it had removed Reg AB II from the agenda.
The Commission declined to comment for this article, although a source familiar with the regulator’s thinking said that the point of rescheduling the meeting was to provide time for additional public comment.
Questions About Swap Flip Clause
There’s also been speculation that Reg AB was removed from the agenda because White had misjudged support for the revisions among the commissioners. There were also reports that commissioners wanted additional time to consider an issue related to swaps used in most ABS and whether the disclosure of certain elements of those transactions should be included in Reg AB II.
The timing may be coincidental, but a letter questioning whether Reg AB-2 will require disclosure of a ubiquitous securitization-swap feature that could force issuers to scramble for cash arrived Feb. 2, a day before the vote was pulled from the Commission’s agenda.
Market participants tracking the issue scoffed at the notion that the recent letter’s concerns--in the public sphere for several years now--were the cause. The difference now, however, may be that William Harrington, a former senior vice president at Moody’s Investors Service who focused on structured finance, is now raising the issue in the context of an active regulatory initiative that aims to increase transparency in the securitization market. Such transparency could require issuers to alter or eliminate such clauses from future deals, and legacy deals could be downgraded.
“It’s a disclosure item, and I think that’s the Reg AB standard—information should be disclosed in a way that sophisticated investors can parse through the risk themselves,” Harrington said in an interview.
Harrington is specifically referring to the “flip clause” prevalent in securitization swaps that issuers use to hedge against non-credit risks, such as interest-rate or currency fluctuations. The clause flips the payments required, should a bank counterparty to a securities swap default, from a senior obligation to a subordinated one.
“A securitization swap with a flip clause has long been the go-to derivative contract for the ABS industry because securitization swaps keep issuance costs artificially low,” Harrington writes in a follow up letter to the SEC dated Feb. 17. “An ABS issuer pays no upfront [fee] to enter into a securitization swap, nor sets aside reserves against counterparty insolvency.”
Harrington argues that flip clauses present a significant risk to issuers because a default by a bank counterparty accelerates swap payments, and U.S. Bankruptcy Judge James Peck held in 2010 that flip clauses are not enforceable under U.S. bankruptcy law. If that ruling is upheld, it means that issuers owing money to a bank counterparty may have to take drastic actions that could hurt investors in order to make payments.
“When a flip clause is not upheld against an insolvent counterparty, as occurred with respect to Lehman Brothers, an ABS issuer must divert funds that had been earmarked for timely payment of interest and principal towards paying a lump-sum termination amount to the insolvent counterparty, instead,” Harrington writes.
In fact, says Harrington, flip clauses present a systemic risk, because a default by one of the major bank counterparties could impact hundreds of securitizations. He adds that fortunately Lehman Brothers provided very few securitization swaps to issuers of cash-flow ABS.
“AIG, however, provided such swaps to many, many issuers who, but for the 2008 bail-outs, would have been obligated to pay large, lump-sum termination amounts to AIG, rather than pay “interest and principal according to its terms and conditions,” Harrington writes.
In addition to the SEC, Harrington has recently discussed the issue with officials at the Federal Reserve, which oversees many tens of billions of dollars in ABS posted by banks and held on its balance sheet.
Harrington believes that flip clauses should be eliminated entirely. While they are present, however, he believes they should be adequately disclosed along with other key items such as the swaps’ bank counterparties and guarantors, given that counterparty risk is concentrated among relatively few of them.
“Reg AB II is perfect for investors to put this together,” Harrington said, adding that in terms of existing deals carrying flip clauses, “What should really happen is these deals should be downgraded.”
Private Offerings May Lose Appeal
Now people familiar with the matter think that the proposal will be addressed by the end of the second quarter, when the Dodd-Frank risk retention rules are also expected to be finalized.
Until some clarity emerges, market participants will have to be prepared for any or all of the of the proposals revisions to reappear. For the buyside, whatever the SEC eventually puts on the Reg AB-II table is likely a plus, at least in terms of analyzing credits, because the overreaching goal is to improve disclosure and transparency. For issuers and underwriters, excessive transparency can make deals more costly and cumbersome and potentially uneconomical to pursue.
For example, the original proposal would require issuers that rely on Rule 144A of the Securities Act of 1933 to avoid registering a deal with the SEC to provide disclosures similar to those provided on public deals upon request from investors. There would still be some advantages to private offerings, in particular avoiding lengthy SEC reviews, but they would be more costly to bring to market.
“The proposal raised concerns in the industry, because 144A offerings tend to include somewhat less disclosure and can be completed more efficiently than their public counterparts,” said John Arnholz, leader of Bingham McCutchen’s structured finance group.
Such disclosures would have more of an impact on some asset classes than others. Dechert’s Jones said that commercial mortgage-backed securities (CMBS) have long provided copious loan-level information, and so the proposed disclosures would be relatively easy to comply with.
He added that other asset classes, such as residential mortgage-backed securities (RMBS) and credit card ABS, pool thousands of loans, and while they also tend to provide granular information, the sheer number of underlying loans means that disclosure must be approached differently than in CMBS. The new regulations may have a significant impact about how this information is disclosed and the regulators efforts to enhance disclosure could make the process burdensome without attendant benefits to investors.
“A nonperforming loan pool may have 1200 or 1700 underlying assets, and an issuer isn’t going to include a page of information for each one,” Jones said. “Today, they’ll typically provide a tape with information on a 100 or so fields, and the market appears to view that as enough.”
In the wake of the financial crisis it became apparent that transparency was inadequate for complicated ABS transactions such as collateralized debt obligations (CDOs), which often referred to assets in other deals. The original Reg AB proposal sought to address this by requiring more loan-level disclosures. The proposed disclosures would be more burdensome for problematic asset classes such as RMBS, but they would be expanded significantly also for asset classes that performed relatively well through the financial crisis, such as auto or credit-card ABS.
“We would like to emphasize our opposition to loan level public disclosure on the basis of obligor privacy issues, compliance expenses, and competitive concerns,” Mary Ellen Kummar, assistant treasurer at Navistar Financial Corp., a manufacturer of heavy vehicles and engines, said in a comment letter on the original Reg AB proposal.
“We believe continued consideration of loan level disclosure for the equipment floorplan ABS and equipment ABS industry by the Commission would create undue burdens on issuers that far outweigh any benefits to investors.”
Kummar went on to note in her comment on the original proposal that two auto ABS issuers estimated the cost of compliance with the SEC’s loan-level data fields at well over $1 million per issuer.
Some aspects of the original proposal were widely applauded, especially by investors. For example, the proposal sought to slow down the offering process, in part by requiring a preliminary prospectus to be delivered to investors at least five days before the sale of notes.
“Even though these prospectuses can be as thick as a phone book, the securities laws provide little time for investors to read them,” said Arnholz.
Another provision would require issuers to provide a payment “waterfall” computer program that models an offering’s anticipated cash flows, using the Python open-source programming language as a standard. In addition to questions about how issuers would ascertain the accuracy of an issuer’s waterfall program, concerns arose that issuers may be subject to a new liability if a faulty program results in the wrong party getting paid.
A large swathe of the ABS industry commented that the provision was unworkable. Former SEC Chairman Christopher Cos, now a partner at Bingham McCutchon, told participants at a recent ABS conference to expect the waterfall program to be left out of Reg AB-2, perhaps to be re-proposed in a separate rule at a later date.
Another element raising liability concerns was a requirement for the issuer’s CEO or officer in charge of securitization to certify that “the assets have characteristics that provide a reasonable basis to believe they will produce, taking into account internal credit enhancements, cash flows at times and in amounts necessary to service payments on the securities as described in the prospectus.”
That provision appeared in the 2011 re-proposal, as one of several components to replace the investment-grade rating previously required for shelf offerings, given Dodd-Frank’s push to reduce reliance on public ratings.
“We weren’t sure what that meant, and it sounded like a guarantee,” said Jones, adding, “ABS deals assume not all assets will pay off and there will be defaults. Deals are structured to address that risk.”