Asset-Backed Securities and Companies in Mortgage-Related Businesses under the Investment Company Act

Transcription

1 Asset-Backed Securities and Companies in Mortgage-Related Businesses under the Investment SEC Issues Advance Notice of Proposed Rulemaking to Amend Rule 3a-7 under the Investment and Concept Release on Section 3(c)(5)(C) of the Investment SUMMARY On August 31, 2011, the Securities and Exchange Commission addressed two key exclusions from the definition of investment company in the Investment of 1940 that are relied upon by issuers of asset-backed securities (ABS) and companies in mortgage-related businesses. In an Advance Notice of Proposed Rulemaking (ANPR), 1 the SEC is asking for public comment on possible new conditions for the exclusion available to certain ABS issuers under Rule 3a-7. The conditions for reliance on Rule 3a-7 include, among other things, that the issuer s publicly offered fixed-income ABS be rated investment grade, that acquisitions and dispositions of assets by issuers relying on the rule not result in a downgrading of those ABS and that issuers of ABS (other than asset-backed commercial paper) must take action necessary for their cash flows to be deposited in a segregated account maintained or controlled by an independent trustee. Areas of particular interest to the SEC include the structure and operation of the asset-backed issuer, the possible review by an independent evaluator of the issuer and its intended operations and the preservation and safekeeping of the issuer s assets and cash flow. The SEC is also soliciting comment on whether securities of ABS issuers that are currently excluded from the definition of investment company under Rule 3a-7 should instead be treated by other issuers as securities issued by investment companies in determining their own status as investment companies for purposes of the 40% test in Section 3(a)(1)(C) of the Investment. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 In a separate Concept Release, 2 the SEC stated that it is reviewing interpretive issues under Section 3(c)(5)(C) of the Investment. That section excludes from the definition of investment company any person who is primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The SEC indicated that its review is focusing on mortgage-related pools, most of which have elected to be treated as real estate investment trusts (REITs) for purposes of their status under the Internal Revenue Code, in light of the development of new and complex mortgage-related instruments. The Concept Release notes various similarities between mortgage-related pools and traditional investment companies and identifies a number of Investment -related concerns that may be relevant to mortgage-related pools, such as asset valuation, use of excessive leverage, conflicts of interest and commingling and misappropriation of assets. The SEC is requesting comment on what steps it should take to provide greater clarity, consistency or regulatory certainty regarding mortgage-related pools under Section 3(c)(5)(C). The SEC states that potential steps could include rulemaking activity, including defining terms used in Section 3(c)(5)(C), creating a safe harbor, issuing an interpretive release and providing exemptive relief. The SEC simultaneously issued a concept release on the use of derivatives by investment companies registered under the Investment. 3 Comments are requested on both the ANPR and the Concept Release on or before November 7, I. RULE 3A-7 Rule 3a-7 under the Investment, adopted in 1992, 4 excludes issuers of ABS that meet certain specified conditions from the definition of investment company. Several of these conditions refer to credit ratings by nationally recognized statistical rating organizations (NRSROs): securities sold by the issuer or any underwriter, other than securities sold to institutional accredited investors, 5 qualified institutional buyers 6 or persons involved in the organization or operation of the issuer or an affiliate, must be fixed-income securities 7 rated, at the time of initial sale, in one of the four highest categories assigned for long-term debt or in an equivalent shortterm category by at least one NRSRO; 8 any acquisition by the issuer of additional eligible assets 9 or disposition of eligible assets must not result in a downgrading of the issuer s outstanding fixed-income securities; 10 and if the issuer issues any securities other than securities exempted from the Securities Act by Section 3(a)(3) thereof, 11 it must take action necessary for the cash flows derived from eligible assets for the benefit of holders of fixed-income securities to be deposited periodically in a segregated account that is maintained or controlled by an independent trustee consistent with the rating of the outstanding fixed-income securities. 12 The SEC states that it does not view the ratings-related conditions in Rule 3a-7 as standards of creditworthiness. Rather, when it adopted the rule in 1992 it believed that existing NRSRO ratings practices -2-

3 distinguished ABS issuers from registered investment companies and served as a type of proxy for the relevant investor protections afforded under the Investment. Section 939A of the Dodd-Frank Act generally requires the SEC to (i) review its regulations that require an assessment of credit-worthiness of a security or money market instrument or reference or require use of credit ratings and (ii) remove any reference to or requirement of reliance on credit ratings and... substitute in such regulations such standards of credit-worthiness as the SEC deems appropriate. Section 939A s language could be read to require removal of references to credit ratings only if the ratings are used as a standard of credit-worthiness. The ANPR s language is mindful of that reading, explaining each of Rule 3a-7 s references to credit ratings as having a purpose other than creditworthiness and preserving the SEC s ability to retain the use of credit ratings in Rule 3a-7 on that basis. In addition to addressing the requirements of Section 939A, the ANPR responds to market developments since Rule 3a-7 was adopted. In the ANPR, the SEC also withdrew its 2008 proposal to amend Rule 3a Potential amendments to Rule 3a-7 enumerated in the ANPR may replace references to credit ratings with conditions that are tailored to address concerns related to the Investment Company Act, as well as address issues related to the status under the Investment of certain holders of ABS of issuers that rely on the rule. The SEC has requested comments on the ANPR on or before November 7, The ANPR identifies several Investment -related concerns, such as potential conflicts of interest, excessive leverage, valuation, operating without adequate assets and inadequate protection of assets and the possibility of commingling and misappropriation, and examines their potential relevance to issuers of ABS. ABS issuers typically meet the definition of investment company but cannot, as a practical matter, operate under certain of the Investment s restrictions and requirements. The SEC adopted Rule 3a-7 to enable issuers of ABS meeting specified conditions to be excluded from regulation under the Investment. The conditions set forth in Rule 3a-7, and in particular the ratings-related conditions, were intended to address investor protection under the Investment Company Act and assumed that NRSROs, in assigning ratings to fixed-income securities of ABS issuers, expected issuers to have structural safeguards that addressed a number of these concerns. At the time of the rule s adoption, the SEC understood that NRSROs typically: reviewed the assets to be transferred to the issuer or the asset selection methodology; expected an independent auditor to confirm that the asset pool was representative of the sponsor s portfolio; evaluated limitations placed on the substitution of assets and reinvestment of cash flow; analyzed the potential performance of the assets, the risks related to the issuer s cash flow and the cash flow allocation; and evaluated the processes and controls regarding custody of the issuer s assets and cash flow. -3-

4 In the ANPR, the SEC questions whether the references to ratings have served as intended and asks for comment on the type of analysis NRSROs currently conduct in providing ratings for fixed-income securities of ABS issuers and the types of structural safeguards they expect them to have. The ANPR solicits comment on a number of general questions, including: whether there are mechanisms in place that help ensure that NRSROs conduct the type of analysis and review that serve to address Investment concerns; whether the references to ratings should be removed from Rule 3a-7 and what kinds of conditions might supplement or replace them; and whether any of the requirements of the Dodd-Frank Act with respect to ABS or the pending SEC proposals relating to disclosure and the offering process for ABS 14 should be including as conditions for reliance on Rule 3a-7. The SEC asks for comment on possible new conditions for Rule 3a-7 falling into four main areas: (1) structure and operation of the issuer; (2) independent review; (3) preservation and safekeeping of eligible assets and cash flow; and (4) other possible investor protections. Structure and Operation of the Issuer. The ANPR cites as possible abusive practices that may arise at ABS issuers the intentional misvaluation of assets, transferring assets insufficient to produce cash flows needed to meet obligations to securityholders, substituting lower quality assets for pool assets and investing cash flow in a speculative manner. 15 The SEC is requesting comment on the types of conditions that may be appropriate to address these concerns. Specific areas of interest include: whether the rule should specify particular requirements for operational safeguards or take a principles-based approach and why; what specific requirements or limitations would be appropriate; and whether there are other Investment -related concerns, such as pyramiding, that should be addressed by specific conditions in the rule. The ANPR encourages commenters to provide suggested rule text and to discuss the potential economic impact of the approaches it discusses. Independent Review. Citing the importance of the concept of independent oversight or review to the regulatory framework of the Investment, the SEC is considering replacing the rating condition with a requirement for an independent review of the ABS issuer and its intended operations prior to the sale of the fixed-income securities. Such a requirement might call for an opinion from an independent evaluator that it reasonably believes that the issuer is structured and would be operated in a manner such that the expected cash flow generated from the underlying assets would likely allow the issuer to have the cash flow at times and in amounts sufficient to service expected payments on the fixedincome securities. 16 Although the purpose would be different, the scope of the review could be similar to that required in connection with the certification of the chief executive officer of the depositor or the -4-

5 executive officer in charge of securitization of the depositor that the SEC recently proposed as an alternative to the ratings criteria for ABS to be eligible for shelf registration. 17 Specific topics on which the SEC solicits comment include: the scope of any required independent review and the applicable standards; independence requirements and other applicable qualifications for the independent evaluator; the steps the issuer should be required to take to determine whether someone is qualified to serve as independent evaluator; what types of entities may likely serve as independent evaluators, and whether NRSROs should be allowed to serve in this capacity; whether the independent evaluator s opinion should be included as an exhibit to any registration statement, thereby requiring it to be named as an expert and be subject to potential liability under the Securities Act; the potential economic impact of an independent evaluator requirement; and whether the requirement for an independent evaluator should not apply in certain circumstances, such as to issuers that sell securities only to qualified institutional buyers. Preservation and Safekeeping of Eligible Assets and Cash Flow. The SEC is asking for comment on whether the conditions relating to the preservation and safekeeping of the assets and cash flow of ABS issuers should be strengthened. The ANPR notes, for example, that the current rule does not limit either the practice of servicers commingling cash flows from ABS issuers with their own assets or timing mismatches between collections and distributions. It also notes irregularities that have come to light with regard to determining the ownership of securitized mortgages. The SEC is also seeking comment on the nature and adequacy of current cash flow management practices of ABS issuers. Specific areas raised for comments include: how long servicers typically hold cash flow, whether time limits should be imposed and, if so, how long they should be; whether servicers should be required to keep cash flow in a segregated account; and whether the rule should restrict how cash flows are invested. The ANPR also asks whether the rule should include a condition requiring that the eligible assets and the cash flow they generate be available to pay the fixed-income securities notwithstanding the bankruptcy or insolvency of the sponsor, depositor or servicer. Other Possible Investor Protections. The ANPR notes that there may be existing or proposed provisions under the Securities Act and the Securities Exchange Act applicable to ABS issuers that may help mitigate potential Investment -related concerns about self-dealing by insiders, misvaluation of assets and the safekeeping of assets and cash flow, even though they are intended for different purposes. Examples include: -5-

6 Securities Act Rule 193, adopted pursuant to Section 945 of the Dodd Frank Act, which generally requires an ABS issuer to perform a review of the assets underlying any ABS that will be registered under the Securities Act that, at a minimum provides reasonable assurance that the disclosure in the issuer s prospectus regarding its assets is true and correct in all material respects; 18 the proposed shelf eligibility condition that the underlying transaction agreements for an ABS issuer require a credit risk manager ; Section 27B of the Securities Act, added by Section 621 of the Dodd-Frank Act, which prohibits various parties from engaging in any transaction that would involve or result in a conflict of interest with respect to any investor in a transactions for a period of one year after the date of the first closing of the sale of the ABS; and the proposed risk retention requirements for sponsors of ABS. 19 The SEC is asking for comment on whether any of these existing or proposed provisions could serve as substitutes for references to ratings in Rule 3a-7 and the potential impact of incorporating them on issuers of asset-backed commercial paper and other issuers that may currently rely on Rule 3a-7 but do not register their securities under the Securities Act. The SEC also is asking for comment on the management activities of ABS issuers under Rule 3a-7, and whether it should modify the rule s conditions addressing the acquisition and disposition of eligible assets. Investment Status of Companies Holding Securities of Rule 3a-7 Issuers. The SEC is soliciting comment on whether it should limit or clarify the extent to which the exclusion provided by Rule 3a-7 may be used by holders of securities issued by Rule 3a-7 issuers. It states that when it adopted Rule 3a-7, it did not focus on the manner in which the exclusion may affect the holder of securities issued by an issuer relying on the rule. The SEC notes that the term investment securities as used in Section 3(a)(1)(C) of the Investment excludes securities of majority-owned subsidiaries which are not investment companies and are not relying on the exception from the definition of investment company in Section 3(c)(1) or (7). Thus majority investments in the equity securities of issuers of ABS relying on Rule 3a-7 are not currently counted as investment securities for purposes of the 40% test in Section 3(a)(1)(C) 20 because such issuers are excluded from the definition of investment company. Thus, Rule 3a-7 has enabled companies to be established to capture the yield spread on CLOs and CDOs by purchasing equity and residual interests in CLOs and CDOs, and the SEC states that [t]he activities of some of these companies suggest that they are in the business of investing in securities. The SEC is seeking information on the extent to which issuers are relying on Rule 3a-7 to determine their own status as investment companies under the Investment and considering the impact on modifying Rule 3a-7 to provide that issuers relying on the rule are investment companies but are exempted from the Investment s requirements. The exclusion of issuers relying on Rule 3a-7 from the definition of investment company has also made it possible for business development companies to treat them as eligible portfolio companies. 21 The SEC is -6-

7 soliciting comment on the impact of a possible amendment of Rule 3a-7 to provide that issuers relying on the rule would not be eligible portfolio companies for business development companies. The ANPR also notes the disparate treatment of ABS issuers relying on Rule 3a-7 and ABS issuers relying on the statutory exemption provided by Section 3(c)(5)(C). When it proposed Rule 3a-7 in 1992, the SEC requested comment on whether it should seek statutory amendments to Section 3(c)(5) that would preclude ABS issuers from continuing to rely on that section, but in response to commenters concerns it decided not to pursue any regulatory changes with respect to Section 3(c)(5) at that time. Now that the market and the SEC have gained almost 20 years of experience with Rule 3a-7, the SEC believes it is appropriate to revisit the ability of ABS issuers to rely on Section 3(c)(5). In particular, it is seeking comment on whether there are structural or operational reasons why certain types of ABS issuers must rely on Section 3(c)(5) rather than Rule 3a-7. II. SECTION 3(c)(5)(C) Also, on August 31, 2011, the SEC issued a concept release and request for comments with respect to Section 3(c)(5)(C) of the Investment (the Concept Release). Section 3(c)(5)(C) excludes from the definition of investment company any person who is primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate and does not issue redeemable securities. The SEC stated that it is reviewing interpretive issues relating to the status of mortgage-related pools under the Investment in light of their evolution and the development of new and complex mortgage-related instruments. The review is focusing on, among other things, real estate investment trusts (REITs). 22 To facilitate its review, the SEC is requesting information from the public about mortgage-related pools and soliciting views on the application of Section 3(c)(5)(C) to mortgage-related pools, including steps it might take in this area. The SEC s stated goals in this effort are to (1) be consistent with the Congressional intent underlying the statutory provision, (2) ensure that it is administered in a manner that is consistent with the policies underlying the Investment, the public interest and the protection of investors, (3) provide greater clarity, consistency and regulatory certainty and (4) facilitate capital formation. The SEC has requested comments on the Concept Release on or before November 7, The SEC expressed concern that certain companies today resemble registered management investment companies and may not be the kinds of companies that were intended to be excluded from the definition of investment company by Section 3(c)(5)(C). The Concept Release notes various similarities between mortgage-related pools and traditional investment companies, such as pooling investor assets and providing professional asset management, asset-based compensation and the public perception of some mortgage-related pools as investment vehicles rather than companies engaged in the mortgage banking -7-

8 business. The Concept Release identifies a number of concerns that the Investment seeks to address that may be relevant to mortgage-related pools, such as: asset valuation; use of excessive leverage; conflicts of interest; and commingling and misappropriation of assets. The Concept Release reviews the limited legislative history of Section 3(c)(5)(C), as well as staff noaction letters and other interpretations of this provision. The Concept Release notes that the exemption was intended to exclude issuers that did not resemble, or were not considered to be, issuers that were in the investment company business. 23 Staff guidance in this area has generally focused on whether at least 55% of an issuer s assets consist of mortgages and other liens on and interests in real estate (called qualifying interests ) and the remaining 45% of the issuer s assets consist primarily of real estate-type interests, with no more than 20% of the issuer s assets in miscellaneous investments. Qualifying interests generally consist of assets that represent an actual interest in real estate or are loans or liens fully secured by real estate, as well as assets that can be viewed as being the functional equivalent of, and provide the holder with the same economic experience as, an actual interest in real estate or a loan or lien fully secured by real estate. At the same time, an issuer that is primarily engaged in the business of holding interests in the nature of a security in another person engaged in the real estate business generally may not rely on Section 3(c)(5)(C). However, the staff has viewed whole pool certificates issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae as qualifying interests, while taking the view that certain subordinate participations in commercial real estate first mortgage loans, called B-Notes, are real estate-type interests rather than an interest in the nature of a security issued by a person engaged in a real estate business. In the Concept Release, the SEC is requesting basic information about companies that rely on Section 3(c)(5)(C), such as their strategies for acquiring and managing investments, the types of investors that invest in them and their role in the mortgage markets, how mortgage-related pools are similar to or different from investment companies, how the types of potential abuses that the Investment was intended to prevent might be associated with mortgage-related pools and whether such potential abuses are addressed by industry practices and other regulatory schemes. The Concept Release further notes that mortgage-related pools generally treat bridge loans, certain construction and rehabilitation loans, wrap-around mortgage loans and investments in distressed debt as qualifying interests, while as to other instruments there appears to be a degree of uncertainty or differing views as to the availability of Section 3(c)(5)(C). The SEC is concerned that mortgage-related pools are making judgments about their status under the Investment without sufficient SEC guidance and that staff no-action letters may have contained, or led to, interpretations that are beyond the intended -8-

9 scope of the exclusion and inconsistent with investor protection. Accordingly, the SEC is requesting guidance from mortgage-related pools, investors and the public on the current state of guidance and interpretation concerning Section 3(c)(5)(C). Particular areas of focus include the appropriateness of the 55% 45% approach referenced above; the SEC s view on agency whole pool certificates; and whether guidance is needed with respect to other mortgage-related instruments. Finally, the SEC is requesting comment on what steps, if any, it should take to provide greater clarity, consistency or regulatory certainty regarding mortgage-related pools under Section 3(c)(5)(C). Potential steps could include rulemaking activity, including defining terms used in Section 3(c)(5)(C), creating a safe harbor, issuing an interpretive release and providing exemptive relief. * * * ENDNOTES Treatment of Asset-Backed Issuers under the Investment, Release No. IC (August 31, 2011). Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments, Release No. IC (August 31, 2011). Use of Derivatives by Investment Companies under the Investment of 1940, Investment Release No (August 31, 2011). See our September 15, 2011 memorandum entitled Concept Release on Use of Derivatives by Funds. Exclusion from the Definition of Investment Company for Structured Financings, Investment Release No (Nov. 19, 1992). See paragraphs (1), (2), (3) and (7) of Rule 501(a) under the Securities Act. See Rule 144A(a)(i) under the Securities Act. Fixed-income securities are securities that entitle the holder to receive: (i) a stated principal amount, (ii) interest on a principal amount (which may be a notional principal amount) calculated by reference to a fixed rate or to a standard or formula which does not reference any change in the market value or fair value of eligible assets, (iii) interest on a principal amount (which may be a notional principal amount) calculated by reference to auctions among holders and prospective holders, or through remarketing of the security, (iv) an amount equal to specified fixed or variable portions of the interest received on the assets held by the issuer or (v) any combination of the foregoing, provided that substantially all of the payments to which the holders of such securities are entitled consist of the foregoing amounts. Rule 3a-7(b)(2). Rule 3a-7(a)(2). Eligible assets are financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to security holders. Rule 3a-7(b)(1). Rule 3a-7(a)(3)(ii). Section 3(a)(3) exempts from the Securities Act any note, draft, bill of exchange, or banker's acceptance which arises out of a current transaction or the proceeds of which have been or are to be 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. Copyright Sullivan & Cromwell LLP

10 ENDNOTES (CONTINUED) Rule 3a-7(4)(iii). See References to Ratings of Nationally Recognized Statistical Rating Organizations, Investment Release No (July 1, 2008). Asset-Backed Securities, Securities Act Release No (April 7, 2010); and Re-proposal of Shelf Eligibility Conditions for Asset-Backed Securities and Other Additional Requests for Comment, Securities Act Release No (July 26, 1011). See our April 23, 2010 memorandum entitled SEC Asset-Backed Securities Reform and our September 1, 2011 memorandum entitled ABS Shelf Eligibility Criteria. The ANPR cites as an example a 2008 enforcement action (SEC v. Patrick Quinlan, et al., 2008 Fed. Sec. L. Rep. (CCH) 95,005 (E.D. Mich. Nov.7, 2008), aff'd, 373 Fed. Appx. 581 (6th Cir., 2010)) against the sponsor of a mortgage-backed issuer that placed in the issuer a large number of mortgages that the sponsor itself had originated whose loan-to-value ratios exceeded the maximum loan-to-value ratios stated in the issuer's prospectus, significantly increasing the riskiness of the investment. The ANPR presents as an alternative that the issuer could provide such a certification after considering the views of an independent evaluator. See supra note 14. See our January 31, 2011 memorandum entitled Disclosure of Repurchase Requests and Issuer Review of Assets in ABS Offerings. Credit Risk Retention, Securities Exchange Act Release No (Mar. 30, 2011). See our April 1, 2011 memorandum entitled Credit Risk Retention. Section 3(a)(1)(C) includes in the definition of investment company any issuer which is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis. See Section 2(a)(46)(B) of the Investment. According to the Concept Release, based on a summary review by the staff of filings under the Securities Exchange Act, as of April 2011 approximately 49 REITs disclosed that they were primarily engaged in the business of holding mortgages and/or mortgage-related instruments, most of which indicated that they or their subsidiaries were relying on Section 3(c)(5)(C), and 57 companies disclosed that they were investing in both real estate and mortgages and mortgagerelated instruments, about half of which indicated that they or their subsidiaries were relying on Section 3(c)(5)(C). The Concept Release cites a statement in the legislative history from 1940 that the provision specifically excludes companies dealing in mortgages

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