Regulation AB II: A New World for Securitizations

At long last, in August 2014 the Securities and Exchange Commission adopted “Regulation AB II,” a wide-ranging set of amendments to Regulation AB and the other rules relating to offerings of asset-backed securities. ¹Asset-Backed Securities Disclosure and Registration, SEC Release Nos. 33-9638, 34-7298, available at http://www.sec.gov/rules/final/2014/33-9638.pdf. These rules, which grew out of a perception that inadequacies in the regulatory scheme for ABS contributed significantly to the financial crisis, were originally proposed in April 2010, and partially re-proposed in July 2011 to make changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

One of the most important changes will be the requirement to file a standardized asset-level data file in public offerings of several asset classes of ABS – residential mortgages, commercial mortgages, automobile loans, automobile leases, debt securities and resecuritizations. For the first time, ABS shelf issuers will be required to file a preliminary prospectus, no more than three business days before any securities are sold. ABS shelf issuers also will have to contend with several new shelf eligibility requirements in lieu of the investment-grade rating requirement that was eliminated in response to the Dodd-Frank Act. Among other things, the CEO of the depositor will have to provide a certification as to the disclosure in the prospectus and the structure of the securitization.

The SEC deferred consideration of some of the more hotly-debated provisions of the proposal. Investors in Rule 144A offerings of ABS will not at this time have the right to demand all the same information as if the offering were SEC-registered, and the transaction documents in public deals will not have to be to be filed by the filing deadline for the preliminary prospectus.

Asset-Level Data File.

Regulation AB will now require the filing of standardized asset-level data points listed on a new Schedule AL in XML format, but only for ABS with underlying pool assets consisting of residential mortgages, commercial mortgages, automobile loans, automobile leases or debt securities, and for resecuritizations. At this time, the SEC did not require asset-level data disclosure for other asset classes.

The required data points must be filed both at the time of the initial offering and in connection with ongoing period reports as an exhibit to new Form ABS-EE, which will then be incorporated by reference into Form SF-1 or SF-3 (for public offerings) or Form 10-D (for ongoing periodic reports).

One of the primary concerns expressed by commenters regarding this requirement was that this data might be combined with other publicly-available information, permitting the “re-identification” of consumers in violation of applicable consumer privacy rules. As a result, the SEC consulted with the Consumer Financial Protection Bureau in an effort to reduce the disclosure of the most sensitive data. The CFPB also provides written guidance that the Fair Credit Reporting Act will not apply to asset-level disclosures that the SEC has determined are “necessary for investors to perform due diligence” in accordance with the mandates of the Dodd-Frank Act.

The required data points for each asset class include a variety of common, general data points, in addition to data points that are specific to that asset class. The data points for residential mortgage-backed securities were based on the information required by Fannie Mae and Freddie Mac when they buy mortgage loans, as well as the reporting package developed by the securitization industry in Project RESTART. Whether to require asset-level data for automobile loans and leases was somewhat controversial, but in the end the SEC did not agree with industry commenters, reducing the number of required data points but not eliminating them altogether. The data points required for commercial mortgage-backed securities are based on the CREFC Investor Reporting Package, as well as information regularly provided in “Annex A” to CMBS prospectuses. Debt repacks (i.e., securitizations of debt securities) and resecuritizations will require data points disclosing a variety of basic debt security characteristics. In addition, if the underlying ABS in a resecuritization is of a type that itself requires asset-level data, all of those data points will be required in the resecuritization, with a “grandfathering” exception if the underlying ABS were issued before the compliance date.

Changes to Required Static Pool Information.

The existing static pool data requirements are joined by requirements for a narrative description of the information presented, the methodology used in the calculations, how the static pool assets differ from the assets in the securitized pool, and (if applicable) an explanation of the absence of static pool information or the provision of an alternative disclosure. For amortizing asset pools, the SEC now requires that the presentation of delinquencies and losses be made in 30-31 day increments through no less than 120 days, and that there be a graphical presentation of delinquency, loss and prepayment data.

New Disclosures Regarding Transaction Parties.

If the sponsor or any 20 percent originator is required to repurchase or replace any asset for breach of a representation or warranty, and there is a material risk that the effect on its ability to comply with those provisions resulting from its financial condition could have a material impact on pool performance or performance of the ABS, then disclosure of specified financial information about that party will now be required in the prospectus.

Forms 10-K filed by ABS issuers must contain a platform-level assessment of compliance with the Regulation AB servicing criteria by each servicer and by each other party participating in the servicing function, as well as disclosure of material instances of noncompliance identified in the assessment. The SEC now will also require disclosure of whether identified instances of noncompliance involved the servicing of the pool assets for the transaction in question, and any steps taken to remedy any such instance of noncompliance.

Currently, an originator that originated less than ten percent of an asset pool need not be identified in the prospectus. The new rules require that, if the cumulative amount of assets originated by parties other than the sponsor and its affiliates is ten percent or more of the pool, then originators originating less than ten percent of the pool assets also must be identified.

The issuer will have to state in the prospectus the nature and amount of the risk retained by the sponsor, the servicer, the originator, or any affiliate, as well as the amount and nature of any interest or asset retained by any party to comply with legal requirements (e.g., the Dodd-Frank credit risk retention requirements). If the exact amounts of retained interests are not known at the time of the preliminary prospectus, the issuer must disclose the amount and nature of the interests that the relevant parties intend to retain. Also, any hedge that is materially related to the credit risk of the securities and was entered into by the sponsor, the servicer, the originator or any affiliate to offset the risk position held must be disclosed.

New Registration Forms for ABS.

The SEC has adopted new registration forms tailored specifically for ABS offerings. Form SF-3 will replace Form S-3 for shelf registration of “asset-backed securities” within the scope of the definition in Regulation AB, and Form SF-1 will replace Form S-1 for offerings of “asset-backed securities” that do not qualify for shelf registration. Form S-1 will remain available for offerings that do not meet the requirements of the Regulation AB definition of “asset-backed security.”

One of the basic requirements for the Regulation AB definition of “asset-backed security” is that there must be a discrete pool of securitized assets, with only limited exceptions. One of these exceptions currently allows prefunding accounts in a maximum size of 50 percent of offering proceeds (or the aggregate principal balance of the total asset pool whose cash flows support the ABS, in the case of a master trust). The SEC has reduced this limit to 25 percent, in an effort to encourage more complete and accurate disclosure regarding the asset pool at the time of the offering.

Shelf Registration Requirements.

As required by the Dodd-Frank Act, the SEC has eliminated the ABS shelf registration requirement that the securities be rated investment grade by at least one nationally recognized statistical rating organization. In lieu of a rating, an ABS offering will have to comply with several new requirements to qualify for registration on Form SF-3:

• At the time of each takedown, the chief executive officer of the depositor must certify as to the prospectus disclosure and the structure of the securitization;

• The transaction documents must require the appointment of an “asset representations manager” to review assets when certain trigger events occur;

• The transaction documents must require dispute resolution for failure to comply with repurchase requests;

• The transaction documents must require the inclusion of requests by investors to communicate with other investors in distribution reports on Form 10-D; and

• There must be an annual evaluation of compliance with these requirements.

Existing shelf eligibility criteria other than the rating requirement will continue to apply, including that all Exchange Act reports required to have been filed during the 12 months (and any portion of a month) immediately prior to the filing of the registration statement have been timely filed.

CEO Certification.

The new certification, which must be signed by the depositor’s CEO and filed at the time of each takedown, states that:

• The CEO has reviewed the prospectus and is familiar with, in all material respects, the characteristics of the pool assets, the structure of the securitization, and all material transaction documents described in the prospectus.

• Based on the CEO’s knowledge, the prospectus does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading.

• Based on the CEO’s knowledge, the prospectus and registration statement fairly present in all material respects the characteristics of the securitized assets and the risks of ownership of the offered ABS, including risks relating to the assets that would affect the cash flows available to service payments or distributions in accordance with their terms.

• Based on the CEO’s knowledge, taking into account all material aspects of the characteristics of the securitized assets, the structure of the securitization, and the risks described in the prospectus, there is a reasonable basis to conclude that the securitization is structured (but not guaranteed) to produce expected cash flows at times and in amounts to service scheduled payments of interest and the ultimate repayment of principal (or other scheduled or required distributions) in accordance with their terms as described in the prospectus.

• All of these certifications are subject to any and all defenses available to the CEO under federal securities laws, including defenses available to an executive officer that signed the related registration statement.

The Commission did respond in several ways to commenters’ concerns about whether CEOs would be willing to sign the certifications, including by adding materiality qualifiers where appropriate, by confirming that the CEO may rely on the work of subordinates in providing this certification, and by clarifying that the receipt of expected cash flows is subject to the risks described in the prospectus.

Asset Review.

In order to address investor complaints that they had difficulty ensuring the asset repurchase demands were enforced consistently, the transaction documents will need to provide for the appointment of an unaffiliated “asset representations manager” to review the pool assets when certain trigger events occur. The asset representations manager will be selected by the transaction parties at the beginning of the transaction.

The rules require a minimum two-pronged trigger for having the asset representations manager review the pool assets for representation and warranty compliance: where a specified delinquency threshold has been reached or exceeded, and investors have then voted to direct the review. The documents can require no more than five percent of the total interest in the pool to initiate a vote and no more than a simple majority vote thereafter. Once a review is triggered, the asset representations manager must, at a minimum, review all assets that are 60 days or more delinquent.

The asset representations manager will be required to report to the trustee on its findings and conclusions. Form 10-D will require the disclosure of the occurrence of any trigger event during the related distribution period, and a summary of any asset representations manager’s report given to the trustee during the related distribution period.

Dispute Resolution.

The transaction documents must provide that, if an asset is subject to a repurchase request made pursuant to the terms of the transaction documents but is not repurchased within 180 days after notice is received of the repurchase request, the party submitting the repurchase request may refer the matter to either mediation or arbitration, in its discretion. The arbitrator will allocate expenses in an arbitration, whereas in a mediation, the mediator will assist the parties in agreeing upon the allocation of expenses.

Investor Communications.

The transaction documents must require the party responsible for making Form 10-D filings to include any request from an investor to communicate with other investors, including the name of the requesting investor, the date the request was received and a description of the method by which other investors may make contact. If the investor is a record holder, the parties are not permitted to require further verification of ownership. Otherwise, the documents may require a written statement of beneficial ownership and no more than one other form of documentation.

Evaluation of Shelf Eligibility.

ABS shelf eligibility currently is determined only when the registration statement is filed.

Under the new rules, as of the 90th day after the end of each fiscal year of the depositor, an ABS shelf issuer will need to evaluate whether all required Exchange Act reports were timely filed by the depositor (or, for ABS backed by the same asset class, by any issuing entity established by the depositor or any of its affiliates). Any failure means that the registration statement will not be available for at least one year from the date the filings were brought current.

Also as of the 90th day after the end of each fiscal year of the depositor, an ABS shelf issuer also will need to evaluate whether the requirements for CEO certification, asset review, dispute resolution and investor communications, and timely filing of all CEO certifications and transaction documents containing the required asset review, dispute resolution and investor communications provisions, were satisfied by the depositor or (or, for ABS backed by the same asset class, by any issuing entity established by the depositor or any of its affiliates). If not, then the failure will be deemed cured 90 days after the required documents are filed.

Preliminary Prospectus in Shelf Offerings.

Currently, a preliminary prospectus is not required to be filed or delivered in an ABS shelf offering. Under the new regime, the issuer must file a complete (other than pricing-related information) integrated preliminary prospectus at least three business days before the first sale to an investor. Any material change to the information in the preliminary prospectus will require the filing of a prospectus supplement that clearly describes the change at least 48 hours before the first sale to an investor.

The exemption for ABS shelf offerings from the general requirement that a preliminary prospectus be delivered at least 48 hours before the sale confirmation is sent has been eliminated.

Integrated Prospectus in Shelf Offerings.

The new rules will eliminate the current shelf practice of presenting disclosure in the form of a base prospectus with general descriptions of assets and structure, and a prospectus supplement that provides more specific information about the particular offering. Instead, shelf registrants will have to file a single integrated form of prospectus in the registration statement, and file a single integrated preliminary prospectus and final prospectus for each takedown.

Shelf Registration Statement Contents.

Shelf issuers will no longer be permitted to include multiple base prospectuses for different asset classes, or multiple depositors, in a single registration statement. A separate registration statement filed by a single depositor will be required for each asset class

Pay As You Go Filing Fees.

ABS shelf issuers will be permitted to “pay as you go,” paying their filing fees for each takedown at the same time that an initial preliminary prospectus is filed.

Transaction Document Filing.

Substantially final transaction documents must be must be filed (generally, on Form 8-K and incorporated by reference into the prospectus) by the filing deadline for the final prospectus.

Changes to Exchange Act Reports.

In addition to the asset-level data reporting requirements described above:

• Form 10-D delinquency and loss disclosures required must be presented in 30-31 day increments through no less than 120 days; and

• Form 10-D must include information about any material change in the sponsor’s (or an affiliate’s) interest in the securities, including a separate statement regarding interests retained in compliance with law (i.e., the Dodd-Frank credit risk retention requirements).

Prefunding Account Limit in Definition of Asset-Backed Security.

The “discrete pool” requirement in the Regulation AB II definition of “asset-backed security” has been amended to reduce the maximum amount of prefunding from 50 percent of offering proceeds (or in the case of a master trust, the aggregate principal balance of the total asset pool whose cash flows support the ABS) to 25 percent.

Transition Period.

The new rules will become effective on November 24, 2014. All of the rules must be complied with by November 24, 2015, except for the new asset-level disclosure requirements, which must be complied with no later than November 24, 2016.