CFTC Extends CPO Registration Deadline and Grants Relief for Most Traditional Securitizations

October 17, 2012 CFTC Extends CPO Registration Deadline and Grants Relief for Most Traditional Securitizations Key Takeaways: > CFTC extends to December 31, 2012 the registration deadline for CPOs now required to register because of their swap activities. > CFTC confirms securitization vehicles operated consistently with the requirements of Regulation AB or Investment Company Act Rule 3a-7, and which meet certain other criteria, are not commodity pools (even though they contain swaps) and their operators are not required to register as CPOs. > This includes most traditional securitizations. > There is no blanket exclusion for various other products, including, among others, covered bonds, repackagings, CLOs and CDOs, although the CFTC invites discussion of specific structures on a case-by-case basis. > The operators of non-exempt securitizations constituting commodity pools will be required to register as CPOs absent further exemptive relief. Contents Securitizations as commodity pools?... 2 CPO Registration... 3 The Securitization Letter... 3 General Relief Criteria.. 4 Select Regulation AB and Rule 3a-7 criteria... 4 Transactions not granted blanket relief... 6 The Registration Relief Letter... 6 Ramifications of the Volcker Rule... 7 What to do?... 8 > Volcker Rule considerations arise for banks and their affiliates in connection with many securitizations and other similar structures, even those that are not commodity pools. Currently proposed rules implementing the Volcker Rule would mean that: > Banking entities will be barred from sponsoring or investing in many securitization vehicles, subject to a number of exceptions. > Banking entities that sponsor, manage, advise or offer a securitization would be barred from entering into a number of transactions with that securitization vehicle, including many swaps and the provision of loans and liquidity facilities. CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 1

Securitizations as commodity pools? The Dodd-Frank Act defines the term commodity pool to include any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests, including any... swap. 1 The Commodity Futures Trading Commission (the CFTC ) has traditionally taken an expansive view of what constitutes a commodity pool. 2 Indeed, a single swap contract is enough to bring an entity within the definition of commodity pool. 3 Most securitizations and many similar products (e.g., repackagings, covered bonds, etc.) make use of derivatives either for hedging or liquidity purposes or to alter the timing characteristics of the underlying assets, and sometimes to provide investors with exposure to certain assets (e.g., through a total return swap or credit default swap, etc.). The statutory definition of commodity pool would, if read in line with the CFTC s traditionally expansive view, have meant that virtually all securitizations and structured products (including already existing transactions) which included any derivatives whatsoever in their structure would be commodity pools requiring, absent an exemption, that they be operated by a registered commodity pool operator ( CPO ). 4 Although the potential for CPO registration in and of itself has been the cause of widespread consternation for market participants using securitizations and similar products to access to the US capital markets, the potential catastrophic consequence of such an outcome under the Volcker Rule, 5 as discussed in more detail below, has been of even greater concern for some market participants. Even apart from the CPO problem, the Volcker Rule may significantly impact market participants activities that have little or no connection to the US merely because those participants 1 Dodd-Frank Act 721(a)(5). Prior to the Dodd-Frank Act, the CEA did not contain a definition of commodity pool, though it did define the term commodity pool operator. The CFTC had adopted a definition of commodity pool by regulation. See 17 C.F.R. 4.10 (d). Securitization Letter (as defined below in note 8 and accompanying text), at 2-3. For example, in some instances, structures where the only futures exposure in the pool arose from losses on hedging being passed through to investors have been viewed as commodity pools. See Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 Fed. Reg. 11252, 11258 (Feb. 24, 2012) ( If swaps were excluded, any swaps activities undertaken by a [commodity pool operator] would result in that entity being required to register because there would be no de minimis exclusion for such activity. As a result, one swap contract would be enough to trigger the registration requirement. ) (the CPO Rule ), available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-3390a.pdf. Many securitizations use swaps to manage interest rate, foreign exchange or other risks. As a simple example, if the pool assets of a securitization are fixed-rate loans but investors want to buy floating rate securities, the securitization vehicle may enter into a fixed-to-floating rate interest rate swap so that it could meet investor demand. While the securitization vehicle may only enter into one swap that will last for the duration of the securitization, under the CFTC s broad interpretation, it would be considered to operated for the purpose of trading in that swap and will be a commodity pool. Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ), Pub. L. 111-4173, 124 Stat. 1376 (2010) (codified at 12 U.S.C. 1851), is commonly referred to as the Volcker Rule (and together with the Proposed Volcker Regulations, the Volcker Rule ). The Federal Reserve Board of Governors and other federal financial regulators have issued a proposal rule to implement the Volcker Rule (the Proposed Volcker Regulations ). See Prohibitions and Restrictions on Proprietary Trading and Certain interests in, and Relationships With, Hedge Funds and Private Equity Funds, 76 Fed. Reg. 68846 (Nov. 7, 2011), available at http://www.gpo.gov/fdsys/pkg/fr-2011-11-07/pdf/2011-27184.pdf. These implementing regulations have not yet been finalized, though some of the financial regulators staff have indicated that final rules will be issued by the end of the year. 2 3 4 5 CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 2

have a presence in the US, including, for example, in some instances, their ability to sponsor, invest in and transact with even non-commodity pool securitization and other vehicles. CPO Registration Registered CPOs are subject to a variety of reporting, recordkeeping, supervision and other obligations under the Commodity Exchange Act, as amended (the CEA ) and related rules. 6 As such, the operators of securitization vehicles that are commodity pools will face significant compliance burdens and costs. In addition, for many securitization vehicles, there may be no easily identifiable operator to register with the CFTC. Such securitization vehicles may have trustees and service providers, but those entities are arguably not operating the vehicle since the vehicle does not have any operations, at least not as that term is understood in the context of an investment fund, since the vehicle s pool assets are not actively managed. 7 The Securitization Letter Responding to industry requests, the CFTC s Division of Swap Dealer and Intermediary Oversight (the DSIO ) issued an interpretive letter (the Securitization Letter ) late last week stating that certain securitizations are not commodity pools and that their operators are not commodity pool operators under the CEA. 8 Although the relief s scope is narrower than many had hoped for, the vast majority of traditional securitizations are now outside the definition of commodity pool. Absent such relief any securitization (including existing securitizations) having even a single derivative could have constituted a commodity pool, which would have had major ramifications under both the CEA and the Volcker Rule. Notwithstanding the breadth of the relief granted vis a vis traditional securitizations, its scope is limited and will not encompass a 6 7 8 Among other things, under the CEA, a CPO must (1) register its associated persons with the National Futures Association (the NFA ), (2) provide pool investors with a two-part disclosure document, and file the same document with the NFA 21 days before it is used, (3) furnish investors with monthly or quarterly statements prepared in accordance with U.S. generally accepted accounting principles, (4) abide by a number of investment and advertising restrictions, and (5) maintain several types of records concerning its business. See generally 17 C.F.R. 3.12, 4.20 4.25, available at http://www.ecfr.gov/cgi-bin/textidx?c=ecfr&sid=6ad1a40b53cbd18eec10fc0594bb0646&rgn=div5&view=text&node=17:1.0.1.1.4&i dno=17#17:1.0.1.1.4.2. The CFTC has delegated to the National Futures Association the processing of CPO registrations. Among other things, a CPO must file a Form 7-R and become a member of the NFA. For more information on NFA registration requirements, please see http://www.nfa.futures.org/nfaregistration/cpo/index.html. See Letter from Tom Deutsch, Executive Director, American Securitization Forum, to Gary Barnett, Director, DSIO requesting relief from commodity pool regulation for securitization vehicles (Aug. 17, 2012), available at http://www.americansecuritization.com/uploadedfiles/asf_commodity_pool_exclusion_request_ 8_17_12.pdf. CFTC Staff Letter No. 12-14 (Oct. 11, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-14.pdf; see also CFTC Staff Letter no. 12-13 (Oct. 11, 2012) (granting similar no-action relief with respect to certain real estate investment trusts), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-13.pdf. CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 3

substantial number of existing and future securitizations and other similar structures resembling securitizations, both in the United States and around the world. General Relief Criteria Criteria Securitizations Must Satisfy to Qualify for Relief Under the Securitization Letter > The securitization vehicle must be operated consistently with the conditions established by Regulation AB 9 or by Investment Company Act Rule 3a-7, 10 even if the offerings are not in fact regulated under those regulations, 11 such that the issuer, pool assets and issued securities satisfy the requirements of either regulation; > The securitization vehicle is limited to passively holding a fixed or revolving pool of receivables or other financial assets that by their terms convert to cash within a finite period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to investors; > The securitization vehicle may only use derivatives as permitted by Regulation AB (e.g., for credit enhancement or to alter the payment characteristics of cash flows such as interest rate swaps or currency swaps); > Payments to investors must come from cash flow generated by pool assets and other permitted rights and assets, not from or based upon changes in the value of the entity s assets; and > The securitization vehicle is not allowed to acquire additional assets or dispose of assets for the primary purpose of realizing gain or minimizing loss due to changes in the market value of pool assets. 12 Select Regulation AB and Rule 3a-7 criteria Only securitizations the issuer, pool assets and issued securities of which satisfy the requirements of either Regulation AB or Rule 3a-7 are eligible for the relief provided by the Securitization Letter. Some of the criteria for eligibility are described in the tables below. The criteria described below are not a complete description of every relevant aspect of Regulation AB or Rule 3a-7 and a careful review of the particulars of either or both against the facts of any particular transaction should be conducted before taking a view as to whether or not the conditions to the relief provided in the Securitization Letter have been satisfied. 9 17 C.F.R. 229.1100. Most of Regulation AB s provisions impose disclosure requirements on issuers in public offerings of asset-backed securities. 10 17 C.F.R. 270.3a-7. It would appear that the intent behind referencing Regulation AB and Rule 3a-7 is to exempt most traditional securitizations from the definition of commodity pool. 11 The Securitization Letter explains that, for example, a securitization vehicle issuing securities in a private offering could comply with Regulation AB in order to utilize this exemption. Interpretive Letter at 4. 12 Id. at 4-5. CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 4

Select Regulation AB Criteria > The securitization vehicle must be limited to passively owning or holding the pool of assets, issuing the asset-backed securities supported or serviced by those assets, and other activities reasonably incidental thereto; > The securities issued are primarily serviced by a pool of receivables or other financial assets, fixed or revolving, that by their terms convert to cash within a finite time period, plus any rights or assets designed to assure the servicing or timely distributions of proceeds; > At the time the pool assets are transferred to the securitization vehicle, no more than 50% of the assets are delinquent; > At the time the pool assets are transferred to the securitization vehicle, none of the assets are non-performing; > Pool assets are not actively managed, though master trusts, revolving structures and pre-funding arrangements are permitted; and > The securitization vehicle is not an investment company under the Investment Company Act. Rule 3a-7 Criteria > The securitization vehicle must issue fixed-income securities 13 entitling their holders to receive payments that depend primarily on the cash flow from the vehicle s pool assets; > The securitization vehicle may not issue redeemable securities; 14 > The pool assets are financial assets, fixed or revolving, that by their terms convert to cash after a finite period of time, plus any right or other assets designed to ensure timely distributions to investors; > The securities issued must be rated in any of the four highest-rated long-term debt categories (or equivalent short-term debt categories) by a nationally recognized statistical ratings organization or, depending upon the attributes of the securities, may only be sold to accredited investors or qualified 13 Fixed-income securities means any securities that entitle the holder to receive: (i) A stated principal amount; or (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; or (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; or (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 amounts described in paragraphs (b)(2) (i), (ii), (iii), and(iv) of this section; provided, that substantially all of the payments to which the holders of such securities are entitled consist of the foregoing amounts. 17 C.F.R. 270.3a-7(b)(2). 14 A redeemable security is any security, other than short-term paper, under the terms of which the holder, upon its presentation to the issuer or to a person designated by the issuer, is entitled... to receive approximately his proportionate share of the issuer s current net assets, or the cash equivalent thereof. 15 U.S.C. 80a-2(a)(32). CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 5

Rule 3a-7 Criteria institutional buyers, provided that there are restrictions in place to prevent transfer of the securities so sold to other types of investors; > The securitization vehicle may only acquire or dispose of pool assets (1) in accordance with the terms of documents pursuant to which the vehicle issued securities, (2) such that the vehicle s outstanding securities are not downgraded, and (3) for a primary purpose other than to recognize gains or decrease losses resulting from market value changes; and > An independent trustee meeting certain requirements, including having a perfected security interest, must be appointed to take certain actions on behalf of security holders. Transactions not granted blanket relief The Division expressly rejected requests to include in the Securitization Letter blanket relief for a number of other products. Transactions for Which Blanket Relief was Expressly Not Provided > Existing transactions not within the enumerated criteria > Covered bonds > Collateralized debt obligations ( CDOs ) > Collateralized loan obligations ( CLOs ) > Insurance-related issuances > Synthetic securitizations 15 > Repackagings 16 The Registration Relief Letter The DSIO separately granted no-action relief from registration (until December 31, 2012) to all market intermediaries who would otherwise have been required to register with the CFTC solely because of their swap activities (the Registration Relief Letter ). 17 Operators of securitizations or similar products not covered 15 Id. at 4. 16 The Securitization Letter does not specifically address repackagings, but most repackagings are unlikely to fit within the scope of the blanket relief granted. 17 CFTC Staff Letter No. 12-15 (Oct. 11, 2011)), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-15.pdf. Although the CFTC scaled back some of the exemptions from CPO registration available for the sponsors of private funds after adoption of the Dodd-Frank Act, a number of definitional and registration exemptions continue to exist. For instance, the operators of offshore funds without U.S. investors are not required to register as CPOs. See, e.g., CFTC Staff Letter No. 03-04 (Jan. 14, 2003). Even if a securitization sponsor were able to invoke such an exemption, however, the securitization vehicle would still be a commodity pool subject to the Volcker Rule restrictions discussed below. CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 6

under the Securitization Letter (or not otherwise granted relief by the CFTC) will have until the end of the year to register or cause someone to be registered as a CPO in respect of their securitizations. Ramifications of the Volcker Rule Under the Volcker Rule, Banking Entities 18 are prohibited from investing in or sponsoring Covered Funds, 19 subject to various exceptions, and are likewise prohibited under the Super 23A limb of the Volcker Rule from entering into socalled covered transactions ( Covered Transactions ) 20 with Covered Funds that the Banking Entity sponsors, 21 manages, advises or organizes and offers. 22 Whether or not a securitization or similar product is a commodity pool, it may still be a Covered Fund, implicating the Volcker Rule s prohibition on sponsorship and investment and precluding Banking Entities from entering into Covered Transactions with it. If a securitization is a commodity pool, in addition to implicating the CPO registration requirements discussed above, it is automatically within the Covered Fund definition, effectively prohibiting Banking Entities from investing in or sponsoring it, subject to certain exceptions, and, under the Proposed Volcker Regulations, precluding them from entering into Covered Transactions with it, including, among other things, many swap transactions. 23 This outcome would have a significant adverse affect on the wide variety of products that would be ensnared by these restrictions and which Congress arguably did not intend to capture within the scope of the Volcker Rule. 24 From a practical perspective, whilst the implementing regulations of the Volcker Rule are 18 The capitalized terms used in this paragraph have the meaning assigned to them in the table below. 19 12 U.S.C. 1851(a)(1); Proposed Volcker Regulations.10(a) 20 Covered Transactions are defined with reference to Section 23A of the Federal Reserve Act. 12 U.S.C. 371c. That provision includes within the meaning of Covered Transaction (1) loans or extensions of credit to an affiliate, (2) the purchase of an affiliate s securities, (3) asset purchases from an affiliate, (4) the acceptance of an affiliate s securities as collateral, (5) the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate, and (6) derivative transactions that create an exposure to an affiliate s credit. The prohibition on Covered Transactions between Banking Entities and the Covered Funds that they sponsor, manage, advise or organize and offer allows Banking Entities to engage in prime brokerage services with those Covered Funds. Prime brokerage transaction would be defined under the Proposed Volcker Regulations as one or more products or services provided by a [] [B]anking Entity to a Covered Fund, such as custody, clearance, securities borrowing or lending services, trade execution, or financing, data, operational, and portfolio management support. Proposed Volcker Regulations.10(b)(5). 21 Sponsorship is defined broadly in the Proposed Volcker Regulations to include (1) serving as general partner, managing member, trustee or commodity pool operator of a covered fund, (2) having the ability to select or control the majority of the directors, trustees or management of a covered fund, and (3) sharing the same name (or a variation thereof) with a covered fund for marketing, promotional or other purposes. Proposed Volcker Rule Regulations, at 68950. To the extent that they had the power to control the management of a Covered Fund, a third-party servicer that is a Banking Entity may be considered a sponsor of the fund and find itself subject to the Super 23A restrictions. 22 12 U.S.C. 1851(f)(1). 23 In addition, any permissible transactions between a sponsoring Banking Entity and a Covered Fund must comply with Section 23B of the Federal Reserve Act, which requires such transactions to be conducted on an arm s length basis. 24 The Dodd-Frank Act explicitly provides that [n]othing in [the Volcker Rule] shall be construed to limit or restrict the ability of a banking entity... to sell or securitize loans in a manner otherwise permitted by law. 12 U.S.C. 1852(g)(2). CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 7

only at the proposal stage, as currently written, the Super 23A Provisions would appear to preclude even foreign Banking Entities from providing credit support to or entering into many swaps with a securitization or similar vehicle sponsored by that Banking Entity offshore, even where there is no other connection to the United States (e.g., no sales into the United States and no involvement of that Banking Entity s U.S.-based personnel). Banking Entities 25 are: > U.S. insured depository banks; > U.S. bank holding companies; Volcker Rule defined terms > Foreign banks with a U.S. branch or agency; and > Any affiliate of any of the foregoing. Covered Funds is defined to include: > An issuer that relies on Sections 3(c)(1) or 3(c)(7) to avoid registration under the Investment Company Act of 1940; > A commodity pool; and > An issuer organized or offered outside of the United States that would be a [C]overed [F]und... were it organized or offered under the laws, or offered to one or more residents, of the United States. In the context of securitizations, prohibited Covered Transactions include: > entering into swap transactions with the securitization vehicle that exposes the Banking Entity to the Covered Fund s credit; > making loans to the securitization vehicle; > making repurchase commitments for breaches of representations and warranties; > providing a liquidity facility to a securitization vehicle; and > acting as servicer of a securitization. What to do? The Securitization Letter expressly states in BOLDFACED text that the DSIO is open to discussions with respect to transactions that do not satisfy the enumerated criteria for relief, with a view to determining whether or not they might not be properly considered a commodity pool. 26 The DSIO also offered the possibility that further exemptive relief might be made available even if it found that other securitization vehicles should be considered commodity pools. 27 Given that the scope of the relief provided covers most traditional securitizations, 25 12 U.S.C. 1851(h)(1); Proposed Volcker Regulations.2(e). 26 Id. at 5. 27 Id. CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 8

we read this as an expression of willingness by the DSIO to consider providing relief for other products which do not satisfy the enumerated criteria on an ad hoc basis. We do not think it should be construed to mean that the DSIO has decided all products that do not fit the enumerated criteria are necessarily commodity pools. Indeed, we think there are good arguments that many types of covered bonds and repackagings should not be considered commodity pools. Further, final rules implementing the Volcker Rule could grant securitization vehicles an exemption from the definition of Covered Fund or otherwise provide relief with respect to the Super 23A requirements and the Private Fund Prohibition. 28 28 The ASF submitted a comment letter concerning the Proposed Volcker Regulations arguing, among other things, that securitization vehicles should be exempt from the definition of Covered Funds, which would eliminate problems for them under the Volcker Rule. The letter is available at http://www.federalreserve.gov/secrs/2012/march/20120315/r-1432/r- 1432_021312_104987_420899667517_1.pdf. CFTC Grants Exemptions to Some Securitizations from the CEA and the Volcker Rule 9

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