NEW DEVELOPMENTS IN ASSET-BACKED COMMERCIAL PAPER

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1 NEW DEVELOPMENTS IN ASSET-BACKED COMMERCIAL PAPER Jim Croke Orrick, Herrington & Sutcliffe LLP Copyright 2007 All Rights Reserved OHS East:

2 Biographical Information James J. Croke, Jr., is a partner in the Structured Finance Department Orrick, Herrington & Sutcliffe LLP. of Jim acts as counsel to underwriters and issuers in public offerings and private placements of funded and synthetic asset-backed securities. His structured finance experience includes funded and synthetic securitizations of credit card receivables, high-yield bonds, hedge funds, leveraged and synthetic lease debt, project finance debt, mortgage loans, commercial loans, equipment leases, government receivables, mortgage warehouse lines of credit, trade receivables and numerous other assets. Jim s practice involves both U.S. offerings and offerings in the Euromarkets as well as global underwriting facilities involving simultaneous offerings in the United States and Euromarkets. He has acted as counsel to banks, insurance companies and other sponsors, commercial paper dealers and placement agents in connection with the establishment of more than 130 asset-backed commercial paper conduits and structured investment vehicles. Jim serves annually on the faculty of the Practising Law Institute with respect to its coverage of New Developments in Asset Backed Commercial Paper. Jim has been recognized as one of the top 25 structured finance lawyers in the world by Euromoney s Best of the Best Expert Guide, and as one of the world s leading structured finance lawyers by the International Financial Law Review. A frequent author of articles regarding legal and regulatory issues related to securitization of financial assets, he also participates in numerous professional seminars and conferences, including as a speaker or moderator regarding ABCP conduits, CDO transactions, synthetic securitizations, and related legal and regulatory issues. Education and Background Law Clerk to the Hon. Dudley B. Bonsal, United States District Court Judge, Southern District of New York. J.D., University of Notre Dame Law School. B.S. in Mathematics, graduated cum laude in three years, University of Kentucky. Professional Activities Member, New York and California Bars. Member, Board of Directors, Asset Securitization Forum Jim may be contacted at: Orrick, Herrington & Sutcliffe LLP 666 Fifth Ave. New York, NY Tel: (212) Fax: (212) jcroke@orrick.com OHS East:

3 TABLE OF CONTENTS Page I. INTRODUCTION... 3 II. ASSET-BACKED COMMERCIAL PAPER OVERVIEW... 3 III. THE SECURITIES ACT OF A. Securities Act of Section 3(a)(3)... 6 B. Securities Act of Section 4(2)... 7 C. Integration of Section 3(a)(3) and Section 4(2) Placements... 8 D. Rule 144A... 9 E. Regulation S IV. INVESTMENT COMPANY ACT OF A. Section 3(c)(1) - The Private Investment Company Exemption B. Rule 3a-7 - The Asset-Backed Security Exemption C. Section 3(c)(5) - Commercial Financing And Mortgage Banking Business Exemption D. Section 3(c)(7) - The Qualified Purchaser Exemption E. Comparison Between QPs and QIBs F. No-Action Letter: Foreign Issuers and U.S. Offerings G. No-Action Letter: Resale Procedures and Purchaser Status H. No-Action Letter: Registration as an Investment Company I. Rule 2a J. Effect of FIN45R on Rule 2a V. RISK BASED CAPITAL REVISED BASEL CAPITAL ACCORD A. Scope of the Securitization Framework B. Standardized Approach for Securitization Exposures C. Internal Ratings-Based Approach for Securitizations VI. RISK BASED CAPITAL - U.S. REVISIONS VII. INTERNATIONAL ABCP PROGRAMS A. General B. The Issuance of Sterling Denominated ABCP VIII. INNOVATIVE FUNDING SOURCE FOR PROJECT FINANCE DEALS OHS East:

4 TABLE OF CONTENTS (continued) Page IX. THE USA PATRIOT ACT AND ABCP PROGRAMS Figure 1: Fully Supported Asset Backed Commercial Paper Figure 2: Partially Supported Asset Backed Commercial Paper Figure 3: Cross-Border Funding Alternatives - Conventional Structure - Japan Figure 4: U.S. Assets -- Off-Shore Issuance of Notes Figure 5: Secondary Market Assets - - U.S. and Offshore Issuance of Notes Table 1Long-term rating category Table 2 U.S. ABS risk weights when the external assessment represents a long-term credit rating and/or an inferred rating derived from a long-term assessment Table 3 U.S. ABS risk weights when the external assessment represents a short-term credit rating and/or an inferred rating derived from a short-term assessment Table 4 U.S. Risk Weighting Tables OHS East:

5 I. INTRODUCTION This article provides an overview of certain legal issues related to asset-backed commercial paper ( ABCP ) transactions and some of the significant recent developments in the regulatory environment affecting ABCP. This article also briefly considers the effect of these developments on certain legal issues related to international ABCP transactions involving the U.S. To put this overview in context, this article commences with a brief introduction to ABCP conduit structures, including an analysis of the difference between a fully supported and a partially supported structure. The assistance of Nikiforos Mathews, an of counsel at Orrick, Herrington & Sutcliffe LLP, in the preparation of this article is acknowledged with thanks. The assistance of Christopher Byrne of Ogiers and Anthony Walsh of Matheson Ormsby Prentice, with respect to preparing and updating sections of this article relating to Jersey and Irish legal developments, respectively, is acknowledged with thanks as well. II. ASSET-BACKED COMMERCIAL PAPER OVERVIEW ABCP is a term typically used to describe a debt security with an original term to maturity of no longer than 270 days (or, sometimes, 397 days), the payment of which is supported by cash flows from assets or one or more liquidity or credit support providers, or both. ABCP programs are often categorized as either fully supported or partially supported programs. (A) Fully supported ABCP is issued under a program that provides for an entity other than the issuer of ABCP to undertake to repay the entire face amount of commercial paper notes ( Notes ) pursuant to some form of financial guarantee (e.g., a surety bond, letter of credit, total return swap, third-party guarantee or irrevocable unconditional liquidity facility). The credit rating of the commercial paper is primarily determined by reference to the credit rating of the institution providing the financial guarantee and not by the cash flow from the underlying assets. Please see Figure 1 (B) Partially supported ABCP is issued under a program where repayment of the commercial paper primarily depends on the cash flow to be realized on a pool of assets, as well as liquidity and credit enhancement provided by third parties. Please see Figure 2 A bankruptcy remote special purpose multi-participant commercial paper entity ( SPE ) is established to issue the commercial paper by the initiative of the arranger of the program, typically a financial institution or operating company that wants to engage in off-balance sheet asset finance. The SPE is not owned by the arranger nor is it affiliated with the arranger. It is OHS East:

6 typically owned and managed by a third-party engaged in the business of owning and managing this type of special purpose finance vehicle. The SPE generally does not have any active or functional employees and the arranger or another party will usually serve as an administrator of the SPE and, as agent for the SPE, assist the SPE in performing its contractual obligations under the related program documents. The SPE s single purpose is to issue Notes and to use the proceeds of such issuance to purchase financial assets or make loans, which may be secured by financial assets. The Notes are typically assigned credit ratings by one or more rating agencies. The rating agencies will analyze the ability of the SPE, as the issuer of the Notes, to pay principal and interest in full on the maturity date of the Notes. In ABCP programs, this analysis requires an evaluation of the assets (in the case of a partially supported program), the credit enhancement and liquidity support arrangements (in the case of both a partially supported and a fully supported program) and the quality and experience of the administrator and other providers of services to the SPE. If the credit rating of the arranger is not high enough to permit it to provide credit enhancement or liquidity support to the SPE (to the extent such support is needed in order to obtain the desired rating on the Notes), the arranger may utilize a cash or otherwise collateralized structure and/or obtain credit enhancement and liquidity (either directly or through a confirmation) from a more highly rated third-party bank. Fully supported ABCP is supported by a third-party support provider which supplies both liquidity and credit protection for investors in all circumstances relevant to the timely payment in full of the Notes. Generally, the support provider will provide both the credit enhancement and the liquidity support for the program by a commitment to make loans to the SPE to pay any and all maturing Notes or to buy assets or participations in assets from the SPE when the SPE needs funds to pay maturing Notes. In partially supported ABCP programs, it is typically not possible to rely solely on the cash flow from the assets to repay maturing Notes because the payment on the assets and the maturity of the Notes are usually not matched in terms of timing and amount. In addition, payments on the assets may be paid to the SPE only once a month, or less frequently, whereas Notes may mature at various times during that month or other, longer, period. Therefore, a liquidity facility will provide for the timely repayment of the Notes up to the amount of nondefaulted assets (i.e., the liquidity banks do not cover the credit default risk of the assets). Partially supported ABCP programs also generally provide for some pool-specific credit enhancement such as overcollateralization that protects against the first losses experienced on the particular pool of assets and program-level credit enhancement that is available to cover losses experienced on any pool of assets financed by the SPE. Program-level credit enhancement is usually in the form of a letter of credit, a surety bond, a total return swap, a cash collateral account, or an irrevocable unconditional liquidity facility (e.g., a liquidity facility in which the banks are required to fund in all meaningful circumstances). Innovations and Developments in the ABCP Context In the past few years, ABCP programs have started using various innovative structures for improved credit enhancement and/or liquidity. For example, ABCP programs sometimes provide for the issue of subordinated notes as an additional form of credit enhancement. The SPE issues both Notes and subordinated notes, using the funds from the subordinated notes to support the SPE s ability to pay maturing Notes. This type of credit enhancement raises several OHS East:

7 interesting issues. As with any asset-backed subordinated notes, there are questions relating to the classification of the notes as debt or equity, with the concomitant tax implications. As the subordinated notes are of a lower credit quality, they are more likely to default and lead to a claim against the SPE by the holders of those notes, jeopardizing both the SPE s ability to make timely payment of the Notes and the bankruptcy remoteness of the SPE. Innovations to ABCP structures have also been implemented to improve the overall liquidity of the ABCP programs. Due to (i) the rapid growth of the ABCP market and the related amount of outstanding ABCP and (ii) rating agency criteria that require adequate liquidity be available to support the timely payment of ABCP at maturity, arrangers of ABCP programs have increasingly been looking for alternative sources of liquidity. These alternative liquidity ABCP program structures now in the market include: (i) market value structures in which the market value of the assets financed by the SPE is continuously monitored and maintained at a level greater than the face amount of ABCP outstanding (and the SPE may then obtain liquidity, if required, through the disposition of the assets); (ii) extendable or callable ABCP structures that provide for an extension of the maturity date of ABCP if, on the related expected maturity date or call date, the SPE for some reason is not able to access sufficient liquidity through the issue of additional ABCP (and the SPE may, during the extension period, take one or more steps to manage its cashflow and assets (including the disposition of such assets) so as to provide for the timely payment of ABCP, including the extended or uncalled ABCP) on or before the legal final maturity date; and (iii) structured liquidity note programs in which the SPE or another special purpose company issues liquidity notes to raise funds that may be used to provide the SPE with liquidity if the SPE does not have sufficient funds to provide for the timely payment of ABCP that matures on any day. Repurchase Agreements in ABCP Programs In addition to the above referenced innovations, the use of repurchase agreements (both as liquidity facilities and as forms of asset financing agreements) has become much more typical in ABCP programs. In part, this is due to 2005 revisions to the U.S. Bankruptcy Code which now permit bankruptcy-remote financing of certain types of assets under eligible repurchase agreements. The use of repurchase agreements may introduce market value risk into the ABCP conduit s credit analysis/profile. Investors and third parties with exposure to these conduits may have exposure to some or all of this risk, consistent with the particular transaction structure and the related rating agency analysis of the program. If a repurchase agreement provides for full recourse to a highly-rated seller, the ABCP may be rated based on the obligations of the seller, in which case investors could be isolated from market value risk associated with the assets. The rating agencies may in this case focus on the rating of the seller (or guarantor, as applicable) in assigning a rating to the ABCP. Alternatively, if the repurchase agreement represents a limited recourse obligation of the seller, under which the purchaser has recourse only to the assets, the ABCP conduit s ability to pay the ABCP may be dependent upon the market value of the assets held by the ABCP conduit. In this case, the analysis of the rating agencies will focus on the market value of the assets, rather than on the ability of the seller to repurchase asset(s) from the ABCP conduit. OHS East:

8 It is also possible to structure programs in which repayment of the ABCP is reliant upon a combination of the seller s ability to repurchase asset(s) from the ABCP conduit and the market value of the assets held by the ABCP conduit. Under this hybrid approach, the analysis of the rating agencies will focus on the market value of the assets held by the ABCP conduit and on the ability of the seller to perform under the repurchase agreement. To the extent that the substantive rights of the holders of securities issued in connection with one of these alternative liquidity structures differs from the rights of holders of more traditional ABCP, the required legal disclosure used in connection with the offer and sale of such securities will differ from traditional ABCP disclosure. In the absence of traditional liquidity support, the rights of holders of the securities to receive full and timely payment may be more dependent on the legal structure of the financing and the performance (and possibly the market value) of the financed assets. The following two sections address important provisions of the Securities Act of 1933, as amended (the Securities Act ) and of the Investment Company Act of 1940, as amended (the Investment Company Act ), each of which are relevant to the structuring of any ABCP deal. However, some portions of the following discussion may not be relevant to certain ABCP transactions because the applicability of the securities laws to an ABCP transaction depend, in large measure, on the investment goals and final structure of the ABCP program. III. THE SECURITIES ACT OF 1933 A. SECURITIES ACT OF SECTION 3(a)(3) Section 3(a)(3) ( Section 3(a)(3) ) of the Securities Act exempts from the registration and prospectus delivery requirements of the Securities Act any note, draft, bill of exchange, or bankers acceptance which arises out of a current transaction or the proceeds of which have been or are used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited[.] In order to qualify for the Section 3(a)(3) exemption from the registration and prospectus delivery requirements of the Securities Act, the proceeds of the commercial paper must be used only for current transactions. The current transaction test will generally be satisfied when the proceeds of the commercial paper issuance are used in producing, purchasing, carrying or marketing goods or in meeting current operating expenses of a business. However, the test is generally not satisfied when the proceeds are used for permanent or fixed investments, such as land, buildings, or machinery, nor for speculative transactions or transactions in securities (except direct obligations of the U.S. government). In addition, the Section 3(a)(3) exemption applies only to prime quality negotiable commercial paper of a type not ordinarily purchased by the general public, that is, paper issued to facilitate well-recognized types of current operational business requirements and of a type eligible for discounting by U.S. Federal Reserve banks. OHS East:

9 B. SECURITIES ACT OF SECTION 4(2) Commercial paper that does not meet the Section 3(a)(3) requirements may nevertheless be sold without registration under the Securities Act in reliance upon the Section 4(2) of the Securities Act ( Section 4(2) ) private offering exemption from the registration requirements of the Securities Act. Unlike Section 3(a)(3), Section 4(2) calls for a private placement of the securities. Section 4(2) states that registration and prospectus requirements shall not apply to transactions by an issuer not involving any public offering. In order to satisfy the Section 4(2) private placement test, the commercial paper offering must be conducted in such a manner so as not to constitute a public offering. This is essentially a question of fact requiring an examination of the following factors: (1) The offerees should be sufficiently sophisticated to be able to understand and bear the risks of the investment and should be provided access to the type of information that is necessary to make an informed investment decision. (2) There should not be any general solicitation or advertising, and there should not be any other public offering that could be integrated with the private placement. Offers are generally made only by direct contact between the commercial paper placement agent s sales representatives and the person at the purchasing institution responsible for making the investment decision. (3) Commercial paper issued in a Section 4(2) program can generally only be sold to accredited investors, as defined in Rule 501(a) under the Securities Act, and comparable foreign institutions. There is no specific limit on the number of such offerees. Minimum investments of $200,000 are generally required. To the extent there are any non-institutional investors participating in the offering, however, there is a greater risk that a public offering will be deemed to occur where there is more than a limited number of such non-institutional investors participating. (4) The issuer is responsible for ensuring that the initial purchasers do not become conduits for a wider distribution of the securities being privately placed. Each Note must bear a legend stating that it has not been registered and that it may not be sold or otherwise transferred except to or through the originating placement agent. This restriction on transfer is also referred to in the private placement memorandum. Relying on the exemption from registration available under Section 4(2) will not necessarily provide an ABCP issuer with a concurrent exemption from registration under state securities laws (or "Blue Sky" laws). Any commercial paper notes that are privately placed in compliance with Rule 506 of Regulation D under the Securities Act will be exempt from the registration requirements of Blue Sky laws. In certain states, the issuer will be required to submit a notice filing in connection with the offering. Commercial paper notes that are sold in a Section 4(2) private placement, but that are not expressly sold pursuant to Rule 506, will not automatically be exempt from Blue Sky registration requirements but such commercial paper notes can nonetheless be sold in each state without registration to specified classes of institutional investors. OHS East:

10 C. INTEGRATION OF SECTION 3(a)(3) AND SECTION 4(2) PLACEMENTS An integration problem can arise if an issuer decides to convert a commercial paper program from a Section 3(a)(3) program to a Section 4(2) program or to simultaneously conduct a Section 3(a)(3) offering and a Section 4(2) offering. The exemption from the registration provisions of the Securities Act for Section 4(2) offerings requires that the offering does not constitute a public offering. However, for purposes of Section 4(2), a Section 3(a)(3) offering is viewed as the equivalent of a public offering. Accordingly, in order to effect a good private placement of commercial paper under Section 4(2) concurrently with, or immediately following, an offering of commercial paper under Section 3(a)(3), care must be taken to avoid the integration of the Section 4(2) offering with the Section 3(a)(3) offering, since integration of the Section 4(2) offering into the Section 3(a)(3) offering would make it impossible to satisfy the non-public offering requirement of the Section 4(2) exemption. The loss of the exemption provided by Section 4(2) would mean that if no other exemption were available, the offering would be in violation of the registration requirements of Section 5 of the Securities Act. The factors generally applicable to the question of integration are set forth in Rule 502 ( Rule 502 ) of Regulation D under the Securities Act. Under Rule 502, the question of whether separate sales of securities are part of the same offering (i.e., are considered integrated) depends on the particular facts and circumstances. Rule 502 sets out five factors to be considered in determining whether offers and sales should be integrated: (1) Whether the sales are part of a single plan of financing. (2) Whether the sales involve the issuance of the same class of securities. (3) Whether the sales have been made at or about the same time. (4) Whether the same type of consideration is received. (5) Whether the sales are made for the same general purpose. These integration issues may be overcome if it can be shown that despite the fact that the original issuance of commercial paper was effected under Section 3(a)(3), it could have been effected pursuant to Section 4(2) as well. Because the commercial paper market is essentially an institutional market, most placements of commercial paper are made solely to accredited investors or qualified institutional buyers ( QIBs ) and are generally placed by dealers with large investors in placements that do not involve general solicitation or advertising. Therefore, if an issuer s current Section 3(a)(3) program has been effected in such a way that it is able to satisfy both the Section 4(2) test and the Section 3(a)(3) test, then such an issuer may be able to modify its program documents and effect a Section 4(2) offering going forward. If, however, the issuer s Section 3(a)(3) offering has not, to date, been conducted in a fashion which would also qualify the offering for the exemption provided by Section 4(2), such issuer s ability to convert its Section 3(a)(3) offering into a Section 4(2) offering may be subject to some restrictions, including providing for a period (e.g., 6 months or some other appreciable time) during which the Section 4(2) restrictions are substantively adopted and the OHS East:

11 Section 3(a)(3) exemption requirements continue to be satisfied. Thereafter, an issuer should be able to issue all of its commercial paper under the Section 4(2) exemption. D. RULE 144A (1) Background In 1990, the Securities and Exchange Commission ( SEC ) adopted Rule 144A ( Rule 144A ). Rule 144A is designed to foster a more liquid and efficient secondary trading market in restricted securities for institutional investors while providing appropriate safeguards to ensure the continued integrity of the retail securities market. Rule 144A provides a non-exclusive safe harbor exemption from the registration requirements of the Securities Act for the resale of certain restricted securities to specified institutions by persons other than the issuer of such securities. Typically, the transactions are structured such that the initial purchaser (generally an investment bank) purchases the securities as principal in a Section 4(2) private placement and then immediately resells such securities to QIBs in exempt transactions. (2) Resale Requirements To qualify for the safe harbor exemption of Rule 144A, an offer or sale must meet four basic conditions relating to the type of securities to be sold, the institutions to whom the securities may be sold, the types of information required to be furnished, if any, and the purchaser s awareness of the seller s reliance on Rule 144A. (a) The securities offered or sold under Rule 144A may not be of the same class as securities of the issuer that are listed on a U.S. securities exchange or quoted in a U.S. automated inter-dealer quotation system. (b) The securities must be offered or sold only to QIBs or to an offeree or purchaser that the seller and any person acting on its behalf reasonably believes is a QIB. (c) There is generally no requirement that prospective purchasers be provided with specific information with respect to the issuer of the securities offered or sold under Rule 144A. If, however, the issuer is neither (i) a reporting company under the Securities Exchange Act of 1934, as amended (the Securities Exchange Act ), (ii) a foreign private issuer that is exempt from reporting under Rule 12g3-2(b) under the Securities Exchange Act by virtue of furnishing the SEC with home-country published reports nor (iii) a government of any foreign country or of any political subdivision of a foreign country eligible to register securities under Schedule B of the Securities Act, the holder of the securities offered or sold and any prospective purchaser designated by the holder must have the right to obtain from the issuer certain basic information regarding the issuer. (d) The seller of the securities, and any person acting on its behalf, must take reasonable steps to ensure that the purchaser is aware that the seller may rely on the Rule 144A safe harbor. OHS East:

12 E. REGULATION S Securities that are privately placed in the U.S. may be resold outside the U.S. without registration provided the requirements of Regulation S ( Regulation S ) of the Securities Act are satisfied. In order to qualify for Regulation S, the offering must occur off-shore and there must be no directed selling efforts in the U.S. Since the SEC s adoption of Regulation S and Rule 144A in 1990, a significant number of issuers have made global offerings of their securities under offering structures that have included an offering outside the U.S. in compliance with Regulation S and a private placement of a portion of the securities within the U.S. in compliance with Rule 144A. If properly structured, such a non-u.s. offering and the contemporaneous private placement and Rule 144A resales will be exempt from registration under the Securities Act. IV. INVESTMENT COMPANY ACT OF 1940 The Investment Company Act is one of the many pieces of legislation to consider in an ABCP structured financing because, without certain exemptions contained in the Investment Company Act, a structured financing vehicle would ordinarily be required to register as an investment company. A structured financing vehicle will invariably fall within the definition of investment company under the Investment Company Act because it is an issuer of securities and is primarily engaged in the business of investing in, owning and holding securities. However, as noted in the SEC s release accompanying what was then the proposed Rule 3a-7 ( Rule 3a-7 ) under the Investment Company Act, structured financings are generally not well suited to operating as registered investment companies under the Investment Company Act s requirements. The cost of complying with the registration and compliance requirements of the Investment Company Act would generally remove the economic benefits which are offered in a structured finance transaction. A. SECTION 3(c)(1) - THE PRIVATE INVESTMENT COMPANY EXEMPTION Section 3(c)(1) ( Section 3(c)(1) ) of the Investment Company Act excepts from the definition of investment company: [a]ny issuer whose outstanding securities (other than shortterm paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. The staff of the SEC have indicated that Section 3(c)(1) reflects Congress s [sic] belief that federal regulation of private investment companies is not warranted. This may be due to the fact that the cost of compliance for small investment clubs would make them uneconomical OHS East:

13 or that well capitalized investment pools with sophisticated investors should be able to avoid substantive regulation under the Investment Company Act. 1 (1) The term Short-term paper is defined in Section 2(a)(38) of the Investment Company Act to mean any note, draft, bill of exchange, or banker s acceptance payable on demand or having a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof payable on demand or having a maturity likewise limited. The effect of the inclusion of this carve out in Section 3(c)(1) is to permit an issuer that only issues short-term notes, such as commercial paper with maturities of 270 or fewer days and satisfies the other requirements of Section 3(c)(1), to avoid registering under the Investment Company Act. (2) The term beneficially owned is not specifically defined in the Investment Company Act but the staff of the SEC have given meaning to this term through no-action letters. One criterion used by the staff of the SEC to determine whether a person has beneficial ownership of the securities of an issuer relying on the exemption provided by Section 3(c)(1) is whether that person has the ability to decide whether, or how much, to invest in those securities. For example, the staff of the SEC take the position that each participant in a participant-directed defined contribution plan may be treated as a beneficial owner because those participants decide whether, or how much, to invest in the private investment company. By contrast, involuntary and noncontributory holders of beneficial interests in employee benefits plans are not considered holders of outstanding securities, because in such plans the beneficiaries have no ability to decide whether or how much they will invest in the private investment company. (3) For the purposes of the term one hundred persons, each person is counted if that person beneficially owns debt, equity or any other security of the issuer, other than short-term paper. (4) (a) An offering will qualify as an offering that is not a public offering if that offering qualifies as nonpublic under Section 4(2) or Rule 506 of Regulation D under the Securities Act. Furthermore, the SEC has stated that resales of securities of private investment companies pursuant to Rule 144A do not constitute a public offering of securities. (b) An offer will be public for purposes of Section 3(c)(1) if it is public for purposes of the Securities Act. The SEC takes the position that an offer may be public for purposes of Section 3(c)(1) if the issuer: relies on the intrastate offering exemption in Regulation A of the Securities Act (Conditional Small Issues Exemption); 1 Division of Investment Management, SEC, Protecting Investors: A Half Century of Investment Company Regulation, (May 1992) at 103. OHS East:

14 relies on exemptions available in respect of Rule 504 or Rule 505 under the Securities Act (Limited Offers of Sales of Securities not exceeding certain dollar thresholds); publicly advertises the offer; or uses the facilities of an exchange to place the securities. Rule 3c-5 ( Rule 3c-5 ) under the Investment Company Act permits directors, executive officers, general partners and certain knowledgeable employees of an issuer relying on Section 3(c)(1) to acquire securities issued by the issuer without being counted for purposes of the hundred person limit (refer to the more detailed discussion below). An attribution provision has been included in the Investment Company Act to prevent a group of investors from circumventing the hundred person limit by creating a single company or entity specifically for the purpose of investing in an investment company and being counted as only 1 of the 100. Section 3(c)(1)(A) of the Investment Company Act provides that a private investment company will be required to look-through a company (i.e., count each of that company s security holders (other than holders of its short-term paper) as if they were beneficial owners of the securities of the private investment company) if: (1) the company owns 10% or more of the voting securities (a security presently entitling the owner of such security to vote for the election of directors) of the private investment company; and (2) the company is an investment company, or would be an investment company but for the exceptions contained in Section 3(c)(1) or Section 3(c)(7) ( Section 3(c)(7) ) of the Investment Company Act. The following additional look-through rules apply: (1) The SEC will look-through a company that is created to avoid the hundred person limitation. The staff of the SEC have taken the position that if the entity is a sham created to avoid the limitation, then they may look-through it whether the entity owns 10% of the issuer s voting securities or not. (2) The staff of the SEC have taken the position that it may be necessary to look-through a company owning 10% or more of the non-voting securities of such private investment company. This view is presumably based on the notion that control of an entity may be effected other than through the ownership of voting securities of such entity. However, the staff of the SEC will decide this issue on a case-by-case basis. (3) For some years the staff of the SEC relied on a 40% test to determine whether a purchaser (that relied on Section 3(c)(1)) was formed solely for the purpose of investing in a Section 3(c)(1) issuer. The test essentially provided that, if the purchaser s investment in the Section 3(c)(1) issuer constituted more than 40% of the committed capital of the purchaser (regardless of whether or not the securities held were voting securities), it would be necessary to look-through to the holders of the purchaser s OHS East:

15 securities for the purposes of deciding whether the hundred person limit had been satisfied. In a 1996 no-action letter, the staff of the SEC modified their position and provided that since the 40% test is not a statutory requirement, an investment in a Section 3(c)(1) issuer by a purchaser that constitutes more than 40% of the committed capital of such purchaser would not automatically place a Section 3(c)(1) issuer in violation of the Investment Company Act. While the percentage of a purchaser s assets invested in a Section 3(c)(1) issuer is relevant to this analysis, exceeding a specified percentage level, by itself, is not determinative, and a determination of whether there has been a violation under the Investment Company Act will depend on an analysis of all the surrounding facts and circumstances. Also note that a private investment company (and any company or companies it controls) is prohibited from purchasing or acquiring more than 3% of the total outstanding voting stock of a registered investment company. B. RULE 3a-7 - THE ASSET-BACKED SECURITY EXEMPTION The SEC recognized that prior to the enactment of Rule 3a-7, the question of whether a securitization vehicle was exempted from the Investment Company Act turned on the nature of the assets securitized and not on the structure of the securitization transaction or the credit quality of the underlying assets. Rule 3a-7 was designed to mitigate this inconsistency. Adopted in 1992, Rule 3a-7 is intended to exclude virtually all structured financings from the definition of investment company. In practice, however, Rule 3a-7 is seldom relied on in ABCP transactions because the substance and structure of most ABCP transactions would not satisfy all of the requirements of Rule 3a-7. C. SECTION 3(c)(5) - COMMERCIAL FINANCING AND MORTGAGE BANKING BUSINESS EXEMPTION Paragraphs (A) and (B) of Section 3(c)(5) ( Section 3(c)(5) ) of the Investment Company Act provide that issuers primarily engaged in purchasing or otherwise acquiring notes, drafts, acceptances, receivables and other obligations representing part or all of the sales price of merchandise, insurance and services or in making loans to manufacturers made in connection with the purchase of specified merchandise and services are exempt from the Investment Company Act. Paragraph (C) ( Paragraph C ) of Section 3(c)(5) provides the same exemption for issuers that hold mortgages and other liens on and interests in real estate. For an issuer to be primarily engaged, it must invest at least 55% of its assets in eligible loans and receivables under paragraphs (A) and (B) under Section 3(c)(5) or qualifying interests under Paragraph C. The SEC requires Paragraph C companies to invest an additional 25% of their assets in real estate related assets. To be eligible under paragraphs (A) and (B) of Section 3(c)(5), the loans and receivables must represent part or all of the sales price of merchandise, insurance or services. The credit must be for specific goods and services. It should be noted that: OHS East:

16 (1) qualifying assets include auto loans, credit card receivables and equipment leases, so long as the loans and receivables or extensions of credit relate to the purchase price of specific goods or services; and (2) general consumer or commercial loans do not qualify. Under the mortgage banking provision contained in Paragraph C, securities that are qualifying interests must represent an actual interest in real estate or be a loan or lien actually backed by real estate. Note that: (1) These include fee interests, leaseholds, mortgage loans, deeds of trust, loans backed by interests in oil and gas properties and portfolios consisting of several different types of qualifying interests. (2) Whole pool certificates may be qualifying interests if: (a) they are issued by a Government Agency (Federal National Mortgage Association ( Fannie Mae ), Government National Mortgage Association ( Ginnie Mae ), etc.); or (b) they are privately issued and the holder of securities will share the same economic risks and benefits as a person holding the underlying mortgages (i.e., risk of prepayment, power to foreclose). (3) Partial pool certificates, mortgage placement fees and securities issued by entities that invest in real estate or that are engaged in the real estate business do not qualify. (4) In general, however, the interests referenced in (3) may qualify as part of the 25% investment in real estate related assets. D. SECTION 3(c)(7) - THE QUALIFIED PURCHASER EXEMPTION Section 3(c)(7) creates an exception from the definition of the term investment company for an issuer: (1) that is not making and does not propose to make a public offering of its securities; and (2) all of whose outstanding securities are owned exclusively by qualified purchasers (each a QP ). The term qualified purchaser, in summary, is defined in Section 2(a)(51)(A) of the Investment Company Act to mean: (1) a natural person or family company owning not less than $5 million in investments; OHS East:

17 (2) certain trusts not formed for the specific purpose of acquiring the securities offered; and (3) any other person (e.g., an institutional investor) that owns and invests on a discretionary basis not less than $25 million in investments. A company will not be deemed to be a QP if it was formed for the specific purpose of acquiring the securities offered by a Section 3(c)(7) fund unless each beneficial owner of the company s securities is a QP. The term QP does not include a company that, but for the exemptions provided by Section 3(c)(1) or Section 3(c)(7) would be an investment company (an excepted investment company ) unless the following persons have consented to its treatment as a QP: (1) all beneficial owners of its outstanding securities (other than short term paper), determined in accordance with Section 3(c)(1)(A) of the Investment Company Act, that acquired such securities on or before April 30, 1996 ( pre-amendment beneficial owners ); and (2) all pre-amendment beneficial owners of the outstanding securities (other than short term paper) of any excepted investment company that, directly or indirectly, owns any outstanding securities of such excepted investment company. The Rules also contain certain grandfathering provisions providing for the conversion of a Section 3(c)(1) fund to a Section 3(c)(7) fund provided certain notices are given to beneficial owners of the securities along with an opportunity to redeem. The exemption provided by Section 3(c)(7) may prove useful to issuers that otherwise would rely on Section 3(c)(1) but are constrained by the hundred person limitation requirement imposed by Section 3(c)(1). E. COMPARISON BETWEEN QPs AND QIBs The definition of QP in the Investment Company Act is different from the definition of a QIB as defined in Rule 144A under the Securities Act. Consistency between the definitions may have facilitated the establishment of programs pursuant to which an offering effected under Section 4(2) and Rule 144A under the Securities Act would have simultaneously provided exemption from the registration requirements of the Investment Company Act under Section 3(c)(7). However, while Rule 2a51-1 ( Rule 2a51-1 ) under the Investment Company Act provides that a QIB under Rule 144A of the Securities Act is generally deemed to be a QP, it provides for two important exceptions: (1) with respect to dealers, the SEC has prescribed that the dollar threshold for a dealer to qualify as a QP is $25,000,000, rather than $10,000,000, as required by Rule 144A. OHS East:

18 (2) an employee investing pursuant to a self directed employee benefit plan (such as a 401(k) plan under the Internal Revenue Code of 1978) generally would not be considered to be a QP for purposes of Rule 2a51-1; rather, an employee could invest in a Section 3(c)(7) fund through a self-directed plan only if the employee is a QP. However, if the decision to invest in a Section 3(c)(7) fund is made by the plan trustee or other plan fiduciary of a defined benefit or other retirement plan that makes investment decisions for the plan, and the plan owns at least $25,000,000 of investments that is not subject to participant direction, the plan would be a QP with respect to investments made by the plan trustee or other plan fiduciary. Accordingly, particular care needs to be taken when effecting a private offering in compliance with Section 4(2) and Rule 144A under the Securities Act while simultaneously relying on the exemption provided by Section 3(c)(7) of the Investment Company Act in order to ensure that the securities are owned by persons who are both QIBs and QPs. Significantly, the final version of Rule 2a51-1 as adopted conforms the standard for determining whether a purchaser is a QP to the standard set forth in Rule 144A and Regulation D under the Securities Act for determining whether a purchaser under those rules is a QIB. Rule 144A and Regulation D under the Securities Act each require a seller to have a reasonable belief that the purchaser is a QIB. The final Rule 2a51-1 provides that: The term qualified purchaser as used in Section 3(c)(7) of the [Investment Company Act] means any person that meets the definition of qualified purchaser in Section 2(a)(51)(A) of the [Investment Company Act] and the rules thereunder, or that a Relying Person reasonably believes meets such definition. A Relying Person is defined under the Investment Company Act as a Section 3(c)(7) company or a person acting on its behalf. The SEC has adopted, and the Rules set forth in detail, a definition of investments (for the purposes of determining whether a prospective QP meets the dollar threshold applicable to it) and how the value of such investments is to be calculated. Rule 3c-5 has been adopted to permit knowledgeable employees of a fund and certain of its affiliates to acquire certain securities issued by the fund without being counted for the purposes of the hundred person limitation in Section 3(c)(1) or for the QP determination under Section 3(c)(7). Rule 3c-5 defines knowledgeable employees as the directors, executive officers and general partners of the fund or an affiliated person of the fund that oversees the fund s investments. It also treats persons who serve in capacities similar to directors, such as trustees and advisory board members, as knowledgeable employees. Rule 3c-5 provides that any employee who has performed substantially similar functions or duties for or on behalf of another person during the preceding 12 months is deemed to be a knowledgeable employee. F. NO-ACTION LETTER: FOREIGN ISSUERS AND U.S. OFFERINGS On February 28, 1997, the SEC made publicly available a significant and fairly detailed no-action letter which addresses some of the issues relevant to global offerings of securities by non-u.s. issuers - in particular, where the U.S. portion of the offering is effected in accordance with either Section 3(c)(1) or Section 3(c)(7) and the non-u.s. portion of the offering is effected in accordance with Regulation S. In summary, the SEC s no action letter: OHS East:

19 (1) states that a foreign issuer may privately offer and sell its securities to QPs in the U.S. in accordance with the provisions of Section 3(c)(7) without violating Section 7(d) of the Investment Company Act (just as such an issuer is permitted to privately offer and sell its securities in the U.S. pursuant to the provisions of Section 3(c)(1) and the related Touche Remnant doctrine); (2) provides a detailed analysis of the meaning to be given to the term U.S. person in the context of securities offered and sold outside the U.S. in compliance with Regulation S; (3) indicates that Section 7(d) of the Investment Company Act does not prohibit a foreign issuer from conducting a private U.S. offering in compliance with Section 3(c)(1) or Section 3(c)(7) simultaneously with an offshore public offering in compliance with Regulation S. However, the SEC has confirmed that with respect to offers and sales outside the U.S. to U.S. persons (as described in this no-action letter), such U.S. persons must be counted with respect to the QP requirement (for a Section 3(c)(7) offering) and the hundred person limitation (for a Section 3(c)(1) offering) as the case may be; and (4) provides that a foreign issuer must generally count as U.S. resident beneficial owners all U.S. persons (as described in the referenced no-action letter) who have purchased securities directly or indirectly from the foreign issuer, its agents, affiliates, or intermediaries. As a corollary, the SEC has noted that a foreign issuer need not count towards the hundred person limit (under Section 3(c)(1)) or the QP determination (under Section 3(c)(7)): (a) non-u.s. persons who purchased the securities outside the U.S. and then moved to the U.S.; or (b) anyone who purchased securities outside the U.S. in secondary market transactions not involving the issuer or its agents, affiliates, or intermediaries. G. NO-ACTION LETTER: RESALE PROCEDURES AND PURCHASER STATUS In an April 1999 no-action letter, the Office of Chief Counsel of the Division of Investment Management (the Division ) of the SEC indicated the SEC s view that a Section 3(c)(7) Fund (as defined below) or other Relying Person may be able to develop procedures for resales in the 144A market that, if followed, would be sufficient for it to form the requisite reasonable belief under Rule 2a51-1 with respect to the status of a purchaser of its securities as a QP. The Division issued the letter in response to a December 1997 no-action request by the American Bar Association (the ABA ). The Division stated: (1) that any procedures developed for resales in the 144A market for purposes of Rule 2a51-1 must be designed to provide a means by which the Section 3(c)(7) Fund or other Relying Person can make a reasonable determination that all of the purchasers of the Section 3(c)(7) Fund s securities were QPs at the time that they acquired the securities; and OHS East:

20 (2) that whether a particular set of procedures would be sufficient for a Section 3(c)(7) Fund or other Relying Person to form the requisite reasonable belief depends on the facts and circumstances. The Division noted in a footnote that a Relying Person might include, for example, a participant of the Depository Trust Company ( DTC ), provided that the participant is acting on the Section 3(c)(7) Fund s behalf. However, the Division refused to grant no-action relief with respect to the procedures outlined in the ABA no-action request. The Division also stated that the SEC staff, as a matter of policy, will not respond to requests to assess whether any particular set of procedures are sufficient to permit a Section 3(c)(7) Fund to form such a reasonable belief consistent with Rule 2a51-1. In the same letter, the SEC also stated that it would not read into Section 3(c)(7) an exemption from QP requirements for holders of short-term paper. Although the Division has not issued any Rule 2a51-1 guidelines for satisfying Section 3(c)(7) in book-entry securities offerings, securities lawyers have considered criteria which could support the delivery of Section 3(c)(7) opinions in connection with such offerings. Some examples of these criteria are as follows (such list not to be exhaustive): (a) Offering Memorandum - Investor Representations: includes the following disclosure and QIB/QP representations: Investor is a QIB/QP; Investor is not a broker-dealer owning less than $25 million in securities of unaffiliated issuers; Investor is not a participant-directed employee plan, such as a 401(V) plan under the Internal Revenue Code of 1978; QIB/QP is acting for his own account or the account of another QIB/QP; Investor was not formed for purpose of investing in issuer; Investor holds at least the minimum denomination of securities; and Investor will provide notice of transfer restrictions to subsequent purchasers. (b) Large Minimum denomination: for example, minimum denomination set at $500,000. (c) Distribution Agreement: indicates that distributor is a QIB/QP and that distributor will only sell, in the primary offering or in any secondary market transactions, to persons reasonably believed to be QPs. (Distributors should be OHS East: