SLIDES: Dodd-Frank: recap and what`s next

January 6, 2015
Presented By:
Gary Kalbaugh
Kenneth Kohler
Oliver Ireland
James Schwartz
©2014 Morrison & Foerster LLP | All Rights Reserved |
IFLR Webinar:
Dodd-Frank: Recap and What’s
Regulatory Developments
Regulatory Developments--2014
• Final Volcker Rule—Final Rule
• Enhanced Prudential Standards for Bank Holding Companies and
Foreign Banking Organizations—Final Rule
• Liquidity Coverage Ratio—Final rule
• Supplementary Leverage Ratio—Final rule
• Money Market Mutual Funds—Final Rule
• Heightened standards for large national banks—Final Guidance
• Net Stable Funding Ratio—BIS BCBS Final
• Total Loss Absorbing Capital—FSB Consultative Document
Final Volcker Rule
• Prohibits banking entities from:
• Engaging in short term proprietary trading of certain financial instruments
• Investing in or sponsoring certain hedge funds or private equity funds
• Entities
• Insured depository institutions
• Bank Holding Companies and subsidiaries
• Foreign Banking Organizations
• Companies that control insured depository institutions
• Instruments
• Securities
• Derivatives
• Funds
• Investment Companies but for 3(c)(1) or 3(c)(7)
Exceptions--Proprietary Trading
• Underwriting
• Market making
• Hedging
• Government Obligations
• Trading for customers
• Trading by insurance companies
• Customer funds
• Asset backed securities
• Underwriting
• Market making
• Establishment
• Des minimis investment
• Hedging
• Insurance Companies
Enhanced Prudential Standards
• Liquidity, risk management and capital requirements for large US
bank holding companies
• Requires foreign banking organizations with a significant US
presence to establish an intermediate holding company over US
• US Bank Holding Companies with $50 billion or more consolidated
• Lesser requirements apply to bank holding companies with $10 billion or
more in assets
• Foreign banking organizations with $50 billion combined US assets
• Lesser requirements for foreign banking organizations with $10 billion or
more in consolidated assets
• Additional requirements for smaller foreign banking organizations that are
publically traded
Intermediate Bank Holding Companies
• Generally treated as US bank holding companies
Liquidity Coverage Ratio
• Establishes liquidity requirements for
• Large internationally active banking holding companies
• Total consolidated assets of $250 billion or more
Lesser requirements for $50 billion or more in consolidated assets
• High Quality Liquid Assets÷Total Net cash outflow ≥1
• Daily calculation
High Quality Liquid Assets
• Three tiers of high quality liquid assets
• Level 1 –100%
• Level 2A 85%
• Level 2B 50%
• Level 2 capped at 40% of total
• Level 2B capped at 15% of total
Out Flows and Inflows
• 30 day measurement period
• Maturity
• Earliest possible for outflows
• Latest possible for inflows
• Flows specified by transaction type
• Inflows capped at 75% of outflows
Modified LCR
• Depository institution holding companies with total consolidated
assets of $ 50 billion but that do not meet threshold for standard LCR
• Total net cash out flow discounted to 70%
• Meet ratio on last day of calendar month
Supplementary Leverage Ratio
• Additional capital requirement for bank holding companies with total
consolidated assets of $700 billion or greater and their insured
depository institution subsidiaries
• Based on total leverage exposure that includes selected off balance
sheet exposures
• 5% with 2 % leverage buffer for the bank holding company
• 6% for insured depository institution to be considered well capitalized.
Money Market Mutual Funds
• SEC rule
• Floating net asset value for institution prime and tax exempt money
market funds
• Fees and Gates
Floating Net Asset Value
• Floating Net Asset Value (NAV)
• Institutional prime and institutional tax exempt MMF must value portfolio
securities at market value, and process share transactions based on a
• Funds can use amortized cost to value portfolio securities only with remaining
maturity of no more than 60 days
• “Basis point rounding”
• Institutional prime and institutional tax-exempt MMF must calculate NAV to
four decimal points (or the equivalent if the NAV is based on a price other
than $1 per share)
Stable Net Asset Value Allowed
• Stable NAV allowed for government and retail MMFs
• Floating NAV requirement does not apply to government MMF and retail
MMF, which may maintain steady $1 NAV
• Government MMFs
• Government fund must invest at least 99.5 percent of its total assets in cash,
government securities or repos collateralized by cash or government securities
• Original proposal allowed for 20 percent bucket for non-government holdings
• Retail MMFs
• Retail funds shareholders must be limited to “natural persons”
• Original proposal: limit redemptions to $1million a day
• Omnibus funds may qualify if they limit investors to natural persons
• Funds must adopt procedures to ensure that beneficial owners of omnibus accounts
are natural persons
Fees And Gates
• MMFs may impose fees and gates after the MMF’s weekly liquid
assets drop below 30% of total assets if MMF’s board (including a
majority of the independent directors) determines it is in the best
interests of the MMF
• Fees of up to 2%
• Gates of up to 10 business days in a 90-day period
• Option is available to fixed NAV MMFs and floating NAV MMFs
Fees and Gates
• Required fees and gates (10% test)
• Non-government MMFs must impose a 1% liquidity fee on
redemptions unless the MMF’s board (including a majority of the
independent directors) determines
• a fee would not be in the best interests of the MMF, or
• a lower or higher fee (not to exceed 2%) would be in the best interests of
the MMF
• MMF must lift fees and gates when MMF’s weekly liquid assets rise
to 30% or more, but Board can left them before then
Standards for Large National Banks
• National banks with total consolidated assets of $50 billion or more
• Smaller national banks where:
• the parent controls at least on other covered bank, or
• The OCC finds complex operations or heightened risk
• Defines roles for:
• Front line units
• Independent risk management
• Internal audit
• Comprehensive statement of risk appetite
• Role of the board of directors
• At least two independent directors
Net Stable Funding Ratio
• Basel Committee on Bank Supervision
• No proposal from US Regulators yet
• Longer term counterpart to the liquidity coverage ratio
• One year measurement period
• Available stable funding÷required stable funding ≥1
Available Stable Funding
• Liabilities and capital weighted as available stable funding
• 100%--Capital and liabilities with maturity is excess of 1 year
• 95%--stable deposits from retail and small business customers with
maturities of less than 1 year
• 50%--other funding with a maturity of less than one year from non
financial customers, operational deposits, funding from sovereigns
and public sector entities, and other funding with maturities of six
months to one year from financial institutions
• 0%--Other liabilities including funding from financial institutions with a
maturity of less than six months, other liabilities without a stated
maturity, net derivative liabilities, and trade date payables for financial
Required Stable Funding
• Assets are assigned a required stable funding factor
• 0%--Cash, central bank reserves, claims on central banks with a
maturity of less than 6 months, trade date receivables from financial
• 5%--Unencumbered Level 1 assets
• 10%--Unencumbered loans to financial institutions secured by Level
1 assets and with rehypotecation rights
• 15%--Unencumbered Level 2A assets and other unencumbered
loans to financial institutions with maturities of less than six months
• 50%--Unencumbered Level 2B assets, HQLAs that are encumbered
for between six months and one year, loans to financial institutions an
central banks with a maturity of six months to one year, operational
deposits, and non-HQLAs with a maturity of less than one year
Required Stable Funding
• 65%--unencumbered residential mortgages and other loans, with a
maturity of one year or more and with a 35% or lower risk weight
• 85%--initial margin for derivative contracts and assets provided to
central counterparty default funds, unencumbered loans with a risk
weight of greater than 35% with maturities , non-HQLA securities with
a maturity of one year or more of one year or more, exchange traded
equities that are not HQLAs, and physical traded commodities
• 100% assets that are encumbered for one year or more, net
derivative assets, other assets with a maturity of one year or more,
non exchange traded equities, fixed assets, deductions from
regulatory capital retained interest, insurance assets subsidiary
interests, defaulted securities, negative replacement amounts for
Total Loss Absorbing Capital
• Financial Stability Board Proposal for Comment
• Designed to facilitate orderly resolution of Global Systemically
Important Banks
• Includes 8 US Banks
• Minimum total loss absorbing capital of 16-20% of risk weighted
assets excluding buffers
• Tier 1 and Tier 2 Capital
• Other eligible TLAC that is not regulatory capital
• Additional TLAC may be required for individual GSIBs based on risk
TLAC Term Sheet
• Issued and maintained by resolution entities
• Unsecured
• Maturity at least one year
• Excludes
• Insured Deposits
• Any liability callable on demand without supervisory approval
• Liabilities funded by the issuer or a related party
• Liabilities with derivative linked features—e.g. structured notes
• Non-contractual liabilities
• Preferred liabilities
• Other liabilities that cannot be written down or converted to equity by
resolution authorities
TLAC Term Sheet
• Junior to excluded liabilities
• No set off
• No redemption without supervisory approval
• Deduct TLAC from other G-SIBs
• Material subsidiaries in other jurisdictions must have “Internal TLAC”
Derivatives Developments
Derivatives Topics to be Covered
• Topics include:
• Overview of status of CFTC and SEC Title VII rulemakings
• U.S. cross-border regulations
• Status of CFTC and SEC cross-border rulemakings
• Current cross-border issues
• Prospects for cross-border harmonization and certain potential
impediments to harmonization
• CFTC and SEC definitions of “U.S. Person”
This is MoFo.
CFTC Status – Accomplishments
• CFTC has made substantial progress toward completion of its
• Finalized CFTC rules include:
Cross-border guidance
Swap dealer registration
Swap data reporting (though apparently still subject to possible revision)
Mandatory swap clearing and end-user exception
Execution mandate (SEFs)
Business conduct standards
Volcker Rule
CFTC Status – Unfinished Business
• Unfinished business for CFTC:
• OTC margin requirements
• Position limits
• Potentially swap data reporting
• CFTC has formed a staff working group for swaps transaction data
reporting, and that group released a broad request for comment
• Additional Clearing Determinations?
• NDFs being discussed
Status of SEC Rules
• In contrast with the CFTC, the SEC has finalized relatively few rules
• The finalized rules include, among others:
• certain cross-border rules;
• joint rules with the CFTC regarding the definitions of swap dealer,
security-based swap dealer, and major swap and security-based
swap participant; and
• joint rules with the CFTC regarding further definitions of the terms
"swap", "security-based swap," and "security-based swap
• SEC has granted broad relief, extending as far as February 2017,
with respect to many substantive requirements
Regulatory Responsibility
• Title VII has bifurcated the regulatory responsibility
• CFTC regulating swaps, swap dealers, and major
swap participants; and
• SEC regulating security-based swaps, security-based
swap dealers and major security-based swap
This is MoFo.
Swaps vs. Security-Based Swaps
• Swaps are subject to the jurisdiction of the CFTC and include interest
rate swaps, floors, caps and collars, commodity swaps, crosscurrency swaps, total return swaps on broad-based security indices
or two or more loans and credit default swaps on broad-based
security indices
• Security-based swaps are subject to the jurisdiction of the SEC and
include swaps on a single security, loan, or narrow-based securities
• “Narrow based security index” means, among other things, an index
with nine or fewer components, or in which a component security
comprises more than 30 percent of the index’s weighting
• The SEC and CFTC have adopted joint rules for the regulation of
mixed swaps, which combine characteristics of both swaps an
security-based swaps
This is MoFo.
Definition of “Swap”
• CFTC rule-making has given further detail to the definitions
• Swaps defined widely:
• Exclusions: certain consumer and commercial transactions,
spot FX, simple FX swaps or forwards or commodity forwards
• Security Based Swaps are swaps on a single security or loan
or narrow-based security index and single-issue CDS
• Treasury Secretary exempts foreign exchange forwards and
swaps from the definition of “swap” for many (but not all)
This is MoFo.
Status of CFTC Cross-Border Guidance
• CFTC issued final cross-border guidance in July 2013
• The guidance is intended to address comprehensively the crossborder application of Dodd-Frank rules for derivatives
• Guidance addresses, among other things, the question of which
substantive requirements apply to which transactions and to
which market participants
This is MoFo.
Status of SEC Cross-Border Rules
• SEC issued comprehensive proposed cross-border rules in May 2013
• SEC followed up on those proposed rules with a subset of final rules
released in June 2014
• The SEC’s final rules create no substantive requirements for market
participants until after relevant substantive rulemakings have been
• They address only a subset of the matters addressed in the CFTC’s
guidance, including the definition of U.S. Person and a procedural
rule for substituted compliance
• SEC final rules do not address which substantive requirements will
apply to which transactions and to which market participants
Statutory Basis for Extraterritoriality
• Dodd-Frank’s provisions for extraterritorial jurisdiction
differ somewhat with respect to the CFTC and the SEC
• CFTC: Under Title VII section 722(d), activities outside the U.S. may be
regulated if:
• they have a direct and significant connection with activities in, or
effect on, commerce of the U.S.; or
• they contravene such rules or regulations as may be prescribed
under the Act, necessary or appropriate to prevent the evasion of the
relevant provisions of the Act
• SEC: Under Title VII section 772(c), a person transacting a business in
security-based swaps outside the U.S. may be regulated if:
• such person transacts such business in contravention of such rules
and regulations as the SEC may prescribe as necessary or
appropriate to prevent the evasion of the relevant provisions of the
This is MoFo.
Background – the G-20 Commitments
• September 2009 - G-20 made a commitment to transparency and
safety in the derivatives market place
“All standardized OTC derivatives should be traded on exchanges […]
cleared through central counterparties […] OTC derivatives contracts
should be reported to trade repositories”
• As a result, the G-20 jurisdictions have been working on parallel, but
not identical, reforms that generally resemble each other but differ in
their details
• However, the swaps marketplace has historically been profoundly
• As a result, the question comes to the forefront: which jurisdiction’s
rules will apply to which swaps?
This is MoFo.
EU CCP Recognition
• An important issue that has been in the financial press recently has been the
EU’s (lack of) recognition of U.S. central counterparties (clearinghouses)
under European legislation
• Question is whether the U.S. regulatory framework is “equivalent” to the EU
• If the EU were to fail to timely recognize U.S. CCPs, there comes a parade of
• U.S. CCPs will not constitute “Qualifying CCPs” for purposes of Basel III riskweighting
• European banks will incur prohibitive costs to clear through U.S. CCPs
• U.S. CCPs would have difficulty in maintaining clearing member relationships with
EU firms
• U.S. CCPs would be ineligible to clear contracts subject to the upcoming EU
clearing mandate
• Deadline for recognition last month was extended by six months, to June 15,
This is MoFo.
EU CCP Recognition (cont.)
• In October, the EU made its first “equivalence” decisions, for the
regulatory regimes of CCPs in Australia, Hong Kong, Japan and
• Why would the EU recognize CCPs in those jurisdictions but not in
the U.S.?
• The stated reason was that, under EMIR, in order for a clearinghouse
located in a non-EU jurisdiction to qualify for recognition, the country
of such clearinghouse must have an effective equivalent system of
recognition for clearinghouses located in the EU
• EU officials interpret this to mean that the U.S. should not require U.S. registration
of EU clearinghouses
• Currently, three clearinghouses are located in Europe but also registered with the
• Regulators’ remarks are also revealing as to some of the broader
issues at play in discussions regarding cross-border harmonization
This is MoFo.
EU CCP Recognition (cont.)
• In the European Commission press release announcing the
recognition of CCPs in Australia, Hong Kong, Japan and Singapore,
Michel Barnier, the European Commissioner for Internal Markets and
Services, was quoted as saying:
• “Today's decisions show that the EU is willing to defer to the regulatory frameworks of third
countries, if they meet the same objectives as EU rules. We have been working in parallel
on assessing twelve additional jurisdictions and finalising those assessments is a top priority.
This includes the United States: we are in close and continued dialogue with our colleagues at
both the SEC and CFTC as we develop our assessments of their respective regimes and
discuss their approaches to deference.”
• The press release continued:
• Equivalence assessments are undertaken using an outcome based approach. This requires
that the relevant rules operating in the third country satisfy the same objectives as in the EU,
i.e. a robust CCP framework promoting financial stability through a reduction in systemic risk.
It does not mean that identical rules are required to be in place…
This is MoFo.
U.S. Relief for EU MTFs
• Earlier last year, an issue arose as to the CFTC’s requirements for
EU-regulated multilateral trading facilities (MTFs)
• MTFs are in many ways parallel to swap execution facilities (SEFs),
defined by the CFTC as trading systems or platforms in which
multiple participants have the ability to execute or trade swaps by
accepting bids and offers made by multiple participants
• Many of the transactions that are subject to mandatory clearing
are required to be executed on SEFs
• In a guidance letter issued in November 2013 the CFTC stated its
expectation that a multilateral swaps trading platform located
outside the United States that provides U.S. persons or persons
located in the U.S. with the ability to trade or execute swaps
would register as a SEF
This is MoFo.
U.S. Relief for EU MTFs (cont.)
• Registration with the CFTC as a SEF is a time-consuming process
• European MTFs requested, and received, no-action relief from the CFTC
with respect to the registration requirement
• However, the CFTC’s no-action letter (CFTC Letter 14-46), issued in April
2014, while offering some relief, appeared to impose on EU MTFs many
arguably idiosyncratic U.S. requirements
• In order to receive relief, an MTF was required to submit a letter containing lists of
regulatory requirements established by governmental authorities in the home
country of the MTF that were in accordance with the SEF regulatory requirements
concerning trading methodology, and that were comparable to, and as
comprehensive as, the SEF regulatory requirements concerning nondiscriminatory access by market participants and an appropriate level of oversight
• The lists were to be accompanied by supporting explanations, on a requirementby-requirement basis, addressing each specified CFTC regulation, as to why such
non-U.S. regulatory requirements were either in accordance with, or comparable
to, and as comprehensive as, each specified SEF requirement
This is MoFo.
U.S. Relief for EU MTFs (cont.)
• Not easy to detect much “deference” to EU regulators in the CFTC
no-action letter for MTFs
• The letter, in requiring a requirement-by-requirement analysis
addressing each specified CFTC regulation, also seems to come
close to requiring, as a precondition to relief, virtually identical nonU.S. regulations
• Not clear that many MTFs have taken advantage of the relief, or why
they would want to adhere to U.S. rules for their non-U.S. customers
This is MoFo.
Swap Market Fragmentation
• In part because of the requirement that many swaps with U.S. market
participants be traded on SEFs, liquidity has fragmented between the
U.S. and other jurisdictions
• Fragmentation results from the decision of the CFTC to finalize its
regulations to implement mandatory clearing and mandatory trading
platform execution of swaps prior to regulators in other jurisdictions,
while at the same time, with its cross-border rules, placing significant
regulatory burdens on market participants in other jurisdictions
transacting or facilitating transactions with U.S. parties
• Disincentives to transact with U.S. parties
Swap Market Fragmentation (cont.)
• CFTC Commissioner J. Christopher Giancarlo, in a September 2014
speech entitled “The Looming Cross-Atlantic Derivatives Trade War:
‘A Return to Smoot-Hawley’”:
• “Since the start of the CFTC’s SEF regime in October 2013, and accelerating with
mandatory SEF trading in February 2014, swaps markets have divided into
separate trading and liquidity pools between those in which US persons are able
to participate and those in which US persons are shunned… Non-US person
market participants are curtailing transactions with US counterparties to avoid
getting caught up in the CFTC’s peculiar US swaps trading rules.”
• “[I]t’s as if the US Center for Disease Control, in order to protect the US population
from an offshore outbreak of a deadly virus, dictated that EU doctors could give
vaccines to American patients only in accordance with US protocols for syringe
sterilization and disposal. How would such a requirement prevent a contagion
from spilling onto US shores? It’s difficult to make the connection. Similarly, it's
difficult to make the connection between the application of US trade execution
rules to offshore trades and risk to the US economy. The prescription is unrelated
to prevention of the disease.”
Harmonization and the CFTC’s Guidance
• Apart from the particular issues relating to SEFs and
MTFs, the CFTCs’ cross-border guidance appears to
contain features that, from the perspective of a non-U.S.
regulator, might well complicate attempts at
Harmonization and the CFTC’s Guidance (cont.)
• Under the cross-border guidance, many of the CFTC’s substantive
rules, including for mandatory clearing and trade (SEF) execution, will
apply to any swap involving a U.S. Person (as defined)
• However, in a transaction between, for example, New York head office of
a U.S. swap dealer and the German head office of a German swap
dealer, the EU’s rules should presumably govern the transaction to the
same extent the U.S. rules do
• If the EU were to take a position parallel to that of the CFTC and require
the application of the EU’s rules to a transaction involving an EU swap
dealer, the transaction would be governed by both U.S. and EU rules
• Any material differences between these two sets of rules could be a
significant issue for the parties to such a transaction and, by extension,
for the swaps market as a whole
Harmonization and the CFTC’s Guidance (cont.)
• Another feature of the CFTC’s cross-border that could frustrate a reciprocal approach
is the CFTC’s stance regarding swaps with non-U.S. Persons located within the U.S
• The CFTC taken the view that the U.S. branch of a non-U.S. swap dealer would be
subject to Transaction-Level requirements, including clearing and SEF execution,
because of the CFTC’s strong interest in regulating dealing activities occurring within
the United States
• However, the CFTC did not recognize an equally strong interest of non-U.S. regulators
in regulating the dealing activities of branches of U.S. swap dealers located in their
• With respect to transactions entered into by U.S. swap dealers acting through nonU.S. branches, the CFTC stated that, if such branches faced a U.S. Person (other than
the foreign branch of another U.S. swap dealer) in a swap, then the CFTC’s own
Transaction-Level Requirements would apply
• Once again, if a foreign regulator were to take a position parallel to that of the CFTC,
requiring that the branches of swap dealers within its geographical jurisdiction adhere
to the foreign regulator’s rules, then a transaction could be governed by both U.S. and
non-U.S. rules
Harmonization and the CFTC’s Guidance (cont.)
• In addition, with respect to such Transaction-Level requirements, the
CFTC has stated that, even if a non-U.S. branch of a U.S. swap
dealer were facing a non-U.S. Person in a swap, then substituted
compliance would apply
• Under the CFTC’s substituted compliance regime, the CFTC’s own
rules apply unless the CFTC determines that the analogous foreign
rules are sufficiently comprehensive and comparable to its own rules
Harmonization and CFTC Advisory 13-69
• Taking the CFTC’s view of its authority one step further, the CFTC in
November 2013 issued a “Staff Advisory” regarding swaps “arranged,
negotiated or executed, or executed by personnel or agents of the non-US
SD located in the United States”
• In the advisory, the CFTC took the position that, because of its supervisory
interest in swap dealing activities within the United States, even where a
swap is between a non-U.S. branch of a non-U.S. swap dealer and another
non-U.S. Person, the CFTC’s Transaction-Level Requirements will apply to
the swap if it is “arranged, negotiated, or executed by personnel or agents of
the non-U.S. swap dealer located in the United States.”
• It appeared that the CFTC would require counterparties to a swap to comply
with certain transaction level requirements even if both were foreign and
entered into a swap through non-U.S. offices, if one entity employed U.S.based front office personnel or agents in relation to the swap
This is MoFo.
Harmonization and CFTC Advisory 13-69 (cont.)
• However, a series of no-action letters have granted relief, currently extended
until September 15, 2015 (or any prior date of CFTC action), to non-U.S.
swap dealers failing to comply with the Transaction-Level Requirements in
relation to swaps with many non-U.S. person
• In addition, the CFTC has issued a request for comment on “whether the
Commission should adopt” the advisory “as Commission policy, in whole or in
• Similarly, the SEC, in its release of its final cross-border rules, stated that it
anticipated soliciting additional public comment regarding approaches by
which the cross-border application of the “security-based swap dealer”
definition could reflect activity between two non-U.S. persons where one or
both are conducting dealing activity within the United States
This is MoFo.
Substituted Compliance
• Basic idea of substituted compliance is that a market participant may
substitute compliance with a local non-U.S. rule for compliance with a
U.S. rule
• To make a substituted compliance determination, the CFTC must
determine that the foreign jurisdiction’s requirements “are comparable
with and as comprehensive as the corollary area(s) of regulatory
obligations encompassed by” the CFTC’s own rules
• The language of substituted compliance informs much of the
discussion around harmonization
• Tension between a requirement-by-requirement approach and a
“holistic” or “outcome based approach”
• The SEC has indicated that it, like the CFTC, will adopt a substituted
compliance regime
This is MoFo.
Substituted Compliance (cont.)
• CFTC substituted compliance determinations to date:
• On December 20, 2013, the CFTC announced comparability
determinations for various entity-level requirements for Australia,
Canada, the EU, Hong Kong, Japan and Switzerland
• However, with respect to transaction-level requirements, the CFTC’s
comparability determinations were limited to a few provisions for Japan
and the EU
• No substituted compliance determinations yet with respect to mandatory
clearing or trade execution
This is MoFo.
U.S. Person Definition
• The definition of “U.S. Person” is a lynchpin under both the CFTC’s
and SEC’s framework
• Whether one or both counterparties to a transaction qualify as
U.S. Persons may determine which substantive regulatory
requirements will apply to such transaction
• In addition, transactions may or may not need to be counted
toward de minimis thresholds for dealer registration, depending
on whether a counterparty is a U.S. Person
This is MoFo.
U.S. Person Definition – CFTC
• CFTC definition of U.S. Person “generally” includes, but may “not be
limited” to:
• natural person resident of the United States or an estate thereof;
• any corporation, partnership, or other forms of enterprise in each case that is
organized or incorporated under the laws of a state or other jurisdiction in the
United States or having its principal place of business in the United States;
• U.S. pension plans;
• any trust governed by the laws of a state or other jurisdiction in the United States
• any commodity pool, pooled account, investment fund, or other collective
investment vehicle that is majority-owned by U.S. Persons;
• any legal entity (other than an entity where all of the owners of the entity have
limited liability) that is directly or indirectly majority-owned by specified types of
U.S. Persons and in which such U.S. Person(s) bears unlimited responsibility for
the obligations and liabilities of the legal entity; and
• Certain individual accounts or joint accounts owned by U.S. Person(s)
This is MoFo.
U.S. Person Definition – SEC
• For purposes of the SBSD and MSBSP determinations, the SEC defines
“U.S. person” as:
• any natural person who resides in the United States;
• any partnership, corporation, trust, investment vehicle, or other legal
person organized, incorporated, or established under the laws of the
United States or having its principal place of business in the United States;
• any discretionary or non-discretionary account of a U.S. person; or
• any estate of a decedent who was a resident of the United States at the
time of death
SEC vs. CFTC Definitions
• The SEC definition of U.S. person is narrower in scope than the CFTC’s, as
contained in the Cross-Border Guidance adopted by the CFTC:
• The SEC’s definition is self-contained, unlike CFTC’s definition, which states that a
U.S. person will “generally” include, “but may not be limited to,” the persons
described within its prongs
• The SEC expressly declined to include within the U.S. person definition collective
investment vehicles that beneficially are majority-owned by U.S. persons, which are
included in the CFTC’s definition
• SEC’s definition does not include any legal person that is directly or indirectly
majority-owned by one or more U.S. persons that bear unlimited responsibility for
the obligations and liabilities of such legal person within its definition, which is
included in the CFTC’s definition
• SEC’s definition does not include pension plans for a U.S. person legal entity that
are included in the CFTC’s definition
• In both definitions, foreign branches, offices or agencies of a U.S. person are
themselves U.S. persons
Exclusion for International Entities
• SEC also expressly excludes certain entities from the U.S. person definition,
which were not excluded by the CFTC
• The excluded entities are the International Monetary Fund, the International
Bank for Reconstruction and Development, the Inter-American Development
Bank, the Asian Development Bank, the African Development Bank, the
United Nations, and their agencies and pension plans, and any other similar
international organizations, their agencies and pension plans
• The CFTC took a different approach to these entities, not excluding them
from the U.S. person definition, but instead exempting them from
substantive rulemakings, including from swap dealer and major swap
participant registration
Securitization Developments
Volcker Rule Securitization Overview
• Banking entities involved as investors in, sponsors of, or
transaction parties (e.g., credit or liquidity providers) with,
securitization issuers are subject to severe restrictions or
divestiture if the securitization issuer is a covered fund
• Congress stated in the Dodd-Frank Act its intention that
the Volcker Rule not limit or restrict the ability of banking
entities to sell or securitize loans
• In the Final Rule, the Agencies generally followed
Congressional intent by making clear that most
securitizations of traditional loan products (e.g., mortgage
loans, auto loans, student loans and credit card
receivables) are not covered funds
Volcker Rule Securitization Overview (cont’d)
• However, the Final Rule creates the possibility that
certain securitization vehicles whose assets include
securities or derivatives (as opposed to loans) may be
covered funds
• The basic definition of “covered fund” is a three-pronged
• For most securitization issuers, the relevant test will be
that set forth in the first prong of the definition – whether
the issuer would be an investment company under the
1940 Act but for the exemptions set forth in
Section 3(c)(1) or 3(c)(7) of the 1940 Act
Volcker Rule Securitization Overview (cont’d)
• Many securitizations rely on other exemptions from the
1940 Act and are therefore not covered funds
• Even if a securitization issuer relied on 3(c)(1) or 3(c)(7),
is another 1940 Act exemption available?
• Section 3(c)(5)(C) – for certain mortgage-backed securities
• Rule 3a-7 – for many traditional securitizations
• Section 3(c)(5)(A) – for certain securitizations of consumer
• Section 3(c)(5)(B) – for certain securitizations of trade receivables
• Rule 3a-5 – for finance subsidiaries whose securities are
guaranteed by parent
Exclusions from Covered Fund Definition –
• If the issuer relied on Section 3(c)(1) or 3(c)(7) of the
1940 Act and another 1940 Act exemption is not
available, it may still avail itself of one or more of the 14
enumerated exclusions from the definition of covered
• Of the 14 exclusions, the “loan securitization exclusion”
is the most likely to be of importance to securitization
sponsors or investors
• There are other exclusions for qualifying asset-backed
commercial paper and qualifying foreign covered bonds
that may apply to certain securitizations
Loan Securitization Exclusion
• This exclusion applies to an issuer of ABS if its underlying
assets are comprised solely of:
• loans (defined as any loan, lease, extension of credit, or secured
or unsecured receivable that is not a security or derivative)
• rights or other assets designed to assure the servicing or timely
distribution of proceeds to security holders or related or incidental
to purchasing or otherwise acquiring, and holding loans, subject
to certain limitations
• certain interest rate or foreign exchange derivatives that
(i) directly relate to the loans in the issuing entity, the related ABS
or certain related contractual rights or assets and (ii) reduce the
interest rate and/or foreign exchange risks related to such loans,
the related ABS or permitted contractual rights or assets
Loan Securitization Exclusion (cont’d)
• certain special units of beneficial interest (“SUBIs”) and collateral
certificates (which are issued by certain intermediate special
purpose vehicles that themselves satisfy the requirements of the
loan securitization exclusion); and
• certain securities constituting cash equivalents and securities
received in lieu of debts previously contracted with respect to the
loans underlying the ABS
• In addition, in order to qualify for the loan securitization
exclusion, the issuer may not hold (i) a security, including
an ABS, or an interest in an equity or debt security other
than as permitted above; (ii) a derivative, other than as
permitted above; or (iii) a commodity forward contract
Covered Fund Problem Areas
• Most covered fund problems arise for Section 3(c)(1) or Section
3(c)(7) funds whose assets include securities or derivatives:
• CDOs backed by securities or derivatives (including CDOs backed by
trust-preferred securities (“TruPS”))
• CLOs that hold debt securities
• Certain CMOs backed by mortgage securities
• Auction rate preferred securities
• Re-securitizations
• Bond Repackagings
• Synthetic ABS
• Synthetic structured products
• Domestic covered bonds
Covered Fund Restrictions
• If a securitization issuer is determined to be a covered fund, banking
entities are prohibited from:
• acquiring “ownership interests” in the securitization issuer,
• sponsoring the securitization issuer, and
• making loans to, or entering into certain other types of transactions with a
securitization issuer for which the banking entity acts as sponsor,
investment manager, investment adviser or commodity trading advisor
• The Final Rule also includes a limited exemption from ownership and
sponsorship restrictions to the extent banking entities retain ownership
interests in sponsored securitizations to comply with risk retention
Definition of “Ownership Interest”
• An ownership interest includes any equity or partnership interest in a
covered fund or any other interest in or security issued by a covered
fund that exhibits any of certain specified characteristics deemed by
the regulators to be indicia of ownership
• Of particular concern is the first of the indicia of an ownership interest
listed in the Final Rule – that the interest has the right to participate in the
selection or removal of a general partner, managing member, director,
investment manager, investment adviser or commodity trading advisor
• Many CLOs and CDOs provide rights to a “controlling class” of senior
debt security holders to participate in the designation of investment
managers, creating the potential that the holders of even the most senior,
highly rated debt securities may be considered to hold “ownership
Interim Final Rule re TruPS CDOs
• The Final Rule caused considerable industry outcry over the definition
of “ownership interest” as applied to CDOs and CLOs—particularly from
community banks that hold CDOs backed by trust preferred securities
• On January 14, 2014 the Agencies issued an interim final rule providing
grandfathering for certain existing TruPS CDOs
• The interim final rule allows the retention of an interest in or sponsorship
of covered funds by banking entities if, among other things, the following
conditions are met:
• The TruPS CDO was established, and the interest was issued, before May 19, 2010;
• The banking entity reasonably believes that the offering proceeds received by the
TruPS CDO were invested primarily in qualifying TruPS collateral issued by banking
entities; and
• The banking entity’s interest in the TruPS CDO was acquired on or before December
10, 2013, the date the Agencies issued the Final Rule implementing the Volcker Rule.
Extensions of Conformance Periods
• On April 7, 2014, the Federal Reserve Board announced
that it would extend the “conformance period” during which
banking entities must dispose of or restructure non-Volcker
Rule compliant CLO investments by two years to July 21,
2017, but only for CLOs in place on December 31, 2013.
• On December 18, 2014, the Federal Reserve Board
extended the conformance period for investing in and
sponsoring covered funds generally to July 21, 2016, and
expressed its intention to further extend the conformance
period for covered funds to July 21, 2017.
• Does not apply to activities conducted on or after January 1, 2014.
• Does not apply to proprietary trading restrictions.
Regulation AB II — History
• On August 27, 2014, the SEC adopted changes to
Regulation AB, commonly referred to as Reg AB II
• Regulation AB was originally adopted in December 2004
• Governs disclosure and reporting requirements for SECregistered securitization transactions
• In April 2010, the SEC proposed substantial revisions in
the wake of the financial crisis, attempting to provide
greater investor protection and restore investor
• The SEC re-proposed its revisions in July 2011 following
enactment of Dodd-Frank Act provisions concerning
asset-level disclosure, broker and originator
compensation and risk retention
Regulation AB II – History (cont’d)
• Partial re-opening of comment period – February 2014
• SEC re-opened comment period on certain aspects of asset-level
disclosure to address privacy concerns
• Final rules adopted by SEC on August 27, 2014
Regulation AB II – Overview
• The most significant changes adopted by the SEC are:
• a requirement to file a complete preliminary prospectus at least three days prior to
sales of any securities (this is referred to as the “speed bump” provision)
• The preliminary prospectus must all of the required information other than
pricing related information
• Any material change requires the filing of a prospectus supplement at least 48
hours before the first sale of securities
• a requirement to appoint an “asset representations reviewer” to review assets for
compliance with representations and warranties and issue a report to the trustee
• report periodically demands by the trustee to repurchase assets for breach of
representations and warranties and any such assets not repurchased
• dispute resolution – the transaction documents must contain provisions for
repurchase claims unsatisfied after 180 days to be referred to mediation or
• investor communications – the transaction documents must include a provision
requiring the party responsible for distribution date Form 10-D filings to include a
request from any investor to communicate with any other investor
Regulation AB II – Overview (cont’d)
• The most significant changes (cont.):
• a requirement to provide in machine readable form asset-level
information for securitizations involving residential mortgage loans,
commercial mortgage loans, auto loans and leases, debt securities and
resecuritizations of these assets
• for each offering, a certification by the CEO
• that the securitization as described in the prospectus is designed to produce
cash flows from the assets in amounts sufficient to service expected
payments on the securities, and
• that the prospectus does not contain an untrue statement of material fact or
omit to state a material fact necessary to make the statements made, in light
of the circumstances under which they are made, not misleading
• Filing of final transaction agreements by the date of the final prospectus
is filed
• new Forms SF-1 and SF-3 for the registration of asset-backed securities
• new registrant and transaction eligibility requirements
Regulation AB II – Overview (cont’d)
• The following significant items from the 2010 proposal were not
adopted by the SEC:
• a requirement to file a computer program for the cash flow waterfall – in
the 2011 re-proposal, the Commission stated that it would address this
requirement separately
• a requirement for the sponsor or an affiliate to retain an interest is the
assets securitized – this is the subject of a separate multi-agency
rulemaking as required by the Dodd-Frank Act
• asset-level information for other assets, including student loans and
equipment leases and loans.
• the extension of the disclosure requirements of Forms SF-1 to private
placements under Rule 506 or Rule 144A
• filing of transaction agreements in substantially final form with the
preliminary prospectus
ABS Offering – Rule 424(h) Preliminary Prospectus
• A complete preliminary prospectus must be filed at least
3 business days prior to first sale of ABS
• Preliminary prospectus must include all information
required in final prospectus, with limited exceptions for
pricing related information such as offering price,
underwriting discounts and commissions, and final
underwriting syndicate
• If any material change from information in the preliminary
prospectus after filing, then a prospectus supplement
must be filed at least 48 hours before date and time of
first sale
SEC Registration – New ABS Forms
• Historically (and currently) ABS offerings have been registered on the
same forms used for most corporate debt and equity offerings – Form
S-1 (for stand-alone offerings) and Form S-3 (for shelf offerings)
• Regulation AB II adopts new forms specifically for ABS – Form SF-1
(for stand-alone offerings) and Form SF-3 (for shelf offerings)
• Issuer’s ability to use Form SF-3 for shelf offerings is subject to new
extensive transaction and registrant eligibility requirements
• Shelf prospectuses and preliminary prospectus can no longer use
“base and supplement” format – prospectuses must be single,
integrated documents
• Form SF-3 shelf registration statement must contain a “form of”
prospectus and may cover only one asset class
SEC Registration – Shelf Eligibility Requirements
• New shelf eligibility requirements are intended to replace current
requirement that securities be rated investment grade by at least one
• This implements a Dodd-Frank Act requirement that SEC remove
references to NRSRO ratings from its rules
• Registrant eligibility requirements
• Depositor and affiliates must have timely filed all 1934 Act periodic
reports in 12 months prior to shelf filing
• Depositor and affiliates must have timely filed all transaction agreements
containing provisions for asset representations reviewer, dispute
resolution and investor communications
• A failure to meet the transaction agreement filing obligations results
means ineligible to use an effective Form SF-3 until 90 days after all
filings are up to date
• Depositor and affiliates must have timely filed all periodic reports for ABS
of the same asset class
SEC Registration – Shelf Eligibility Requirements (cont’d)
• Transaction Eligibility Requirements:
• The ABS to be registered must satisfy the definition of “assetbacked security”
in Reg AB and be offered for cash
• CEO certification
• Appointment of asset representations reviewer
• Dispute resolution provisions
• Investor communications provisions
• Delinquent assets not 20% or more of the pool
• For non-motor vehicle leases, residual value not 20% or more of
the pool
Asset-Level Disclosure – General
• Regulation AB II’s asset-level disclosure requirement is probably the
most far-reaching and controversial part of the rule
• Included in original 2010 proposal
• Dodd-Frank Section 942(b) further mandated asset-level disclosure
• Final rule requires asset-level disclosure – both at time of offering
and in ongoing reporting – for RMBS, CMBS, auto loans, auto leases,
ABS backed by debt securities, and resecuritizations
• All fields must be disclosed – no issuer discretion for materiality
• Issuer may file separate “Asset Related Document” for any additional
or clarifying information, including any additional, non-required data
Asset-Level Disclosure – RMBS
• RMBS has by far the most extensive asset-level
disclosure requirements of any asset class
• For RMBS, there are 270 prescribed data points for each
loan to be disclosed in the prospectus and in ongoing
• Privacy concerns/Re-identification risk
• 2-digit zip code (instead of MSA)
• Some proposed fields removed, including income, sales price,
origination date and borrower bankruptcy and foreclosure history
• Exact credit score, LTV and DTI still required
Asset-Level Disclosure – CMBS
• 152 data points for both prospectus and ongoing reporting
• Based on CREFC Investor Reporting Package
• Some variations from CREFC
• SEC data points will not necessarily change with CREFC changes
• Overall, current CMBS market is probably close to Regulation AB II
• Examples of CMBS-specific data fields are property revenues and
expenses, NOI and net cash flow, the identities of 3 largest tenants
and lease expirations, and information regarding most recent
appraisals or valuations
• Unlike RMBS, required fields include property address and 5-digit zip
Asset-Level Disclosure – Auto ABS
• 72 data points for auto loans
• 66 data points for auto leases
• The auto-related asset-level disclosures may impose the largest new
burden on issuers, as asset-level disclosure has not generally been
required in the auto market even post-crisis
• Required disclosures include loan information, vehicle information
(make, model, year and value), geographic information (by state),
borrower information (credit score, income and employment
verification level, payment-to-income ratio) and loan performance
• Note that borrower income is not required, but credit score is required
• Fields for loans and leases are substantially the same
Asset-Level Disclosure – Other Asset Types
• Debt Securities
• ABS backed by debt securities (a/k/a bond repackaging or
“repacks”) require data regarding the underlying debt securities,
including title of underlying security, origination date, payment
currency, whether callable, payment frequency and interest rate
• Resecuritizations
• ABS backed by other ABS, or resecuritizations, require the same
data as is required for repacks
• Moreover, if underlying ABS is of a type that requires asset-level
disclosure, all asset-level disclosures are required for underlying
• If underlying ABS were issued by a third party, resecuritization issuer may
reference underlying issuer’s public filings
• Asset-level data for underlying ABS not required if such ABS was issued prior to
Regulation AB II compliance date for such ABS (i.e., 2 years after effective date)
Asset-Level Disclosure – Privacy Concerns
• From the initial 2010 proposal, borrower privacy has been a
substantial concern of commenters
• Issuers are concerned with liability to borrowers, customer relationships, and
reputational damage
• Privacy advocates are directly concerned with the privacy of borrowers
• From the outset, the SEC avoided requiring obvious privacy-related
fields, like borrower name and address, but concerns remained that
borrower identities could still be discovered from required fields
• The concern has been greatest with respect to RMBS, because of
concern that identity thieves and marketers could correlate data to
public property records to identify borrowers and their financial
information – “re-identification”
Asset-Level Disclosure – Privacy Concerns (cont’d)
• In 2014 Re-Opening, the SEC floated the idea of making issuers
responsible for privacy and allowing the use of web-protected
websites to disseminate sensitive information
• Re-Opening raised many new liability concerns among issuers, as well
as concerns about equal access to information by investors and
prospective investors
• Final rule rejected the Re-Opening approach, and reverted to original
scheme of filing all asset-level data on Edgar, while carving back
some fields of concern – most notably, requiring 2-digit zip code for
RMBS rather than MSA or 5-digit zip code
• Privacy concerns have not been entirely eliminated, and time will tell
whether any significant privacy breaches occur
CEO Certification
• In connection with each shelf offering, the depositor must file a certification by
the depositor’s CEO that:
• The CEO has reviewed the prospectus and is familiar with, in all material respects, the characteristics
of the securitized assets, the structure of the securitization, and all material transaction agreements as
described in the prospectus
• Based on the CEO’s knowledge, the prospectus does not contain any untrue statement of a material
fact or omit to state a material fact necessary to make the statements made, in light of the
circumstances under which such statements were made, not misleading
• Based on the CEO’s knowledge, the prospectus and other information included in the registration
statement fairly present in all material respects the characteristics of the securitized assets and the
risks of ownership of the offered ABS, including risks relating to the securitized assets that would affect
the cash flows available to service payments or distributions on the ABS in accordance with their terms
• Based on the CEO’s knowledge, taking into account all material aspects of the characteristics of the
securitized assets, the structure of the securitization, and the risks described in the prospectus, there is
a reasonable basis to conclude that the securitization is structured (but not guaranteed) to produce
expected cash flows at times and in amounts to service scheduled payments of interest and the
ultimate repayment of principal (or other scheduled or required distributions, however denominated) in
accordance with their terms as described in the prospectus
• The foregoing certifications are subject to any and all defenses available to the CEO under the federal
securities laws, including defenses available to an executive officer that signed the related registration
CEO Certification (cont’d)
• The SEC “moderated” a number of the above paragraphs from the
initially proposed language by adding materiality qualifiers and
making other adjustments in response to comments
• The final paragraph was added in the final rule to address concerns
regarding personal liability of the CEO providing the certification
• The SEC conceded that the new paragraph does not entirely eliminate the risk of
personal liability
Regulation AB II – Compliance Dates
• Regulation AB II became effective on November 24, 2014
• Offerings of RMBS, CMBS, Auto ABS, ABS backed by
debt securities and resecuritizations must comply with
asset-level disclosure requirements not later than two
years after the effective date
• Any Form 10-D or 10-K filed after one year after the
effective date must comply with all requirements except
asset-level disclosure
Impact of New Rules on ABS Market
• Impact on Rule 144A market
• Will issuers migrate to 144A market to avoid asset-level disclosures?
Will investors accept this?
• Will 144A market incorporate Regulation AB II standards? If so, to what
• How will increased disclosures impact investors? Will asset
managers have an increased responsibility to analyze continuing
reporting? Will “disclosure overload” deter investors?
• Will investors and issuers make the investment in technology and
• In particular, will the investment be made for RMBS when the market is
essentially non-existent?
• How will this impact restarting the private RMBS market?
Risk Retention — Introduction
• In a flurry of regulatory actions on October 21 and 22, 2014, the
Federal Deposit Insurance Corporation (the “FDIC”), the Office of the
Comptroller of the Currency, the Federal Reserve Board, the
Securities and Exchange Commission, the Federal Housing Finance
Agency (the “FHFA”), and the Department of Housing and Urban
Development (collectively, the “Joint Regulators”) each adopted a
final rule (the “Final Rule”) implementing the credit risk retention
requirements of section 941 of the Dodd-Frank Act for asset-backed
securities (“ABS”).
• The section 941 requirements were intended to ensure that both
public and private securitizers generally have “skin in the game” with
respect to securitized loans and other assets.
Risk Retention — Introduction (cont’d)
• The risk retention rules were initially proposed by the Joint
Regulators in March 2011 (the “Original Proposal”) (76 FR 24090
• The rules were re-proposed in August 2013 (the “Re-Proposal”)
(78 FR 57928 (9/20/13)).
• The Final Rule will become effective one year from the date of
publication in the Federal Register (which was 12/24/14) for
residential mortgage-backed securities (“RMBS”) and two years from
the date of publication in the Federal Register for all other ABS.
• The Final Rule generally tracks the requirements of the Re-Proposal
with minor changes made to address comments submitted or to
clarify meaning.
Basic Risk Retention Requirement
• As required by the Dodd-Frank Act, the Final Rule generally requires
“sponsors” of both public and private securitization transactions to
retain not less than 5 percent of the credit risk of the assets
collateralizing any ABS issuance.
• “Sponsor” is defined in the Final Rule as “a person who organizes and
initiates a securitization transaction by selling or transferring assets, either
directly or indirectly, including through an affiliate, to the issuing entity.”
• The Final Rule provides that the credit risk required to be retained and
held by a sponsor or any other person under the Rule may be acquired
and held by any of such person’s majority-owned affiliates, other than
the issuing entity.
• If there is more than one sponsor of a securitization transaction, it is the
responsibility of each sponsor to ensure that at least one of the
sponsors (or at least one of their majority-owned affiliates, as
applicable) retains the required credit risk.
Standard Risk Retention Methods – General
• The Final Rule generally permits risk retention to be accomplished
through one or a combination of methods: an eligible vertical interest,
an eligible horizontal residual interest (“EHRI”), or some combination
of the two (an “L-shaped interest”).
• The percentage of the vertical, horizontal, or L-shaped interest to be
retained by the sponsor must be determined as of the closing date of
the securitization transaction.
• Horizontal risk retention may be accomplished by holding ABS issued
in the transaction or by establishing a cash reserve account for the
• Notably, the Final Rule does not include as a standard risk retention
method the “representative sample” method included in the Original
Proposal but removed in the Re-Proposal.
Eligible vertical interest
• An “eligible vertical interest” must constitute either (i) a single vertical
security entitling the sponsor to the same percentage of amounts
paid on each class of ABS interests, or (ii) an interest in each class of
ABS interests constituting the same proportion of each class of ABS
• The Final Rule eliminated the requirement included in the ReProposal that an eligible vertical interest be valued using the “fair
value” concept applicable to horizontal interest.
• Accordingly, a sponsor using the eligible vertical interest approach
may in effect value the retained interest at par for purposes of the
Final Rule.
Eligible horizontal residual interest
• An “eligible horizontal residual interest,” or “EHRI,” is an ABS interest
in a single class or multiple classes in the issuing entity that represent
the most subordinated claim to payments of principal and interest by
the issuing entity (with the exception of any non-economic REMIC
residual interest, which is not considered an “ABS interest”).
• An EHRI’s terms must provide that, if the issuing entity has
insufficient funds to satisfy its obligation to pay all contractual interest
or principal due, any resulting shortfall will reduce amounts payable
to the EHRI prior to any reduction in amounts payable to any other
ABS interest.
• The Final Rule follows the Re-Proposal in declining to adopt the
“premium capture cash reserve account,” or “PCCRA,” in which
securitizers would have been required to deposit and premium from
the sale of securities as additional credit enhancement.
Eligible horizontal residual interest (cont’d)
• A sponsor utilizing an EHRI to satisfy risk retention requirements
must retain an EHRI having a “fair value” (as determined in
accordance with GAAP methodologies) of at least 5 percent of the
fair value of all ABS interests issued in the transaction.
• The Final Rule contains extensive requirements for disclosure by the
sponsor regarding the fair value of the EHRI and of all ABS interests
issued and regarding its methodology for determining fair value.
• The Final Rule provides sponsors with the option, in lieu of retaining
all or any part of an EHRI, to establish and fund, in cash, an “eligible
horizontal cash reserve account,” or EHCRA, in the amount equal to
the required fair value of an EHRI.
Eligible horizontal residual interest (cont’d)
• Amounts in the EHCRA are to be used to satisfy payments on ABS
interests in the issuing entity on any payment date on which the
issuing entity has insufficient funds to satisfy an amount due on any
ABS interest, or to pay critical expenses of the trust unrelated to credit
risk on any payment date on which the issuing entity has insufficient
funds to pay such expenses, the actual fair value of the retained EHRI
at closing,
• The EHCRA must be held by the trustee until all ABS interests are
paid in full.
L-shaped interest
• If a sponsor opts to retain both an eligible vertical interest
and an EHRI as its required risk retention, the percentage
of the fair value of the EHRI and the percentage of the
eligible vertical interest must equal at least 5 percent.
• These percentages must be determined as of the closing
date of the securitization transaction.
Revolving pool securitizations
• The Final Rule contains special rules for risk retention by sponsors of
“revolving pool securitizations,” a structure often referred to in
industry parlance as the “master trust” structure (whether or not the
issuing entity is actually a trust).
• This structure is widely used for securitizations of credit card
receivables and other revolving assets.
• The Final Rule permits sponsors of revolving pool securitizations to
satisfy their risk retention requirement by maintaining a “seller’s
interest” of not less than 5 percent of the aggregate unpaid principal
balance of all outstanding investor ABS interests in the issuing entity.
Eligible ABCP Conduits
• For issuers of asset-backed commercial paper (“ABCP”),
the Final Rule provides “eligible ABCP conduits” with an
optional method to satisfy risk retention requirements in
lieu of using a standard risk retention option.
• The requirements to qualify as an “eligible ABCP conduit”
are complex, and beyond the scope of this overview.
• The eligible ABCP conduit risk retention option requires
that an originator-seller of assets to an intermediate SPV
retain the 5 percent credit risk exposure, AND that a
regulated liquidity provider (as defined) has entered into a
legally binding commitment to provide 100 percent
liquidity coverage to all ABCP issued by the ABCP issuer.
Commercial MBS
• As in the Re-Proposal, CMBS issuers will have the option of
satisfying risk retention requirements by transferring up to two pari
passu EHRIs, or “B-pieces,” to third-party purchasers (“B-Piece
• A B-Piece Buyer must perform its own due diligence of the underlying
commercial mortgage loans, and may be affiliated with the special
• The B-Piece option may be used to satisfy the entire risk retention
requirement, or may be used in combination with the retention of a
vertical interest by the sponsor.
• The Final Rule requires that an operating advisor be appointed for
any securitization in which the sponsor uses the B-Piece option.
• The Final Rule allows transfers of the B-Piece after five years from
the closing date of the securitization.
Fannie Mae and Freddie Mac ABS
• The Final Rule exempts Fannie Mae and Freddie Mac
from the risk retention requirement if such entity fully
guarantees the timely payment of principal and interest
on all ABS interests issued by the issuing entity in the
securitization transaction, for so long as Fannie Mae or
Freddie Mac, as applicable, is operating under the
conservatorship or receivership of the FHFA with capital
support from the U.S. Government.
• This exemption will also apply to any limited-life regulated
entity succeeding to the charter of either Fannie Mae or
Freddie Mac, provided that the entity is operating with
capital support from the U.S. Government.
Open market CLOs
• The Final Rule treats managers of collateralized loan
obligations (“CLOs”) as sponsors and generally requires
them to satisfy the 5 percent risk retention requirement.
• The Final Rule also includes a transaction-specific risk
retention option for “open-market CLOs” that, subject to
certain conditions, permits lead arrangers of senior
secured syndicated loans held by the CLO to retain the
requisite 5 percent risk, rather than the CLO manager.
Hedging, transfer and financing prohibitions
• Under the Final Rule, the sponsor may allocate its risk retention requirement
to the originator of the securitized assets under the standard risk retention
options, subject to the agreement of the originator and to certain other
• The Final Rule generally prohibits a sponsor from selling or otherwise
transferring any retained interest other than to majority-owned or wholly
owned affiliates of the sponsor.
• Moreover, a sponsor and its affiliates may not hedge their required risk
retention positions or pledge those positions as collateral for any obligation
(including a loan, repurchase agreement, or other financing transaction),
unless the obligation is with full recourse to the pledging entity.
• Certain hedging activities are not prohibited.
• Sponsors and their affiliates are permitted to:
• hedge interest rate or foreign exchange risk, or
• hedge based on an index of instruments that includes ABS, subject to certain
Hedging, transfer and financing prohibitions (cont’d)
• The restrictions on sponsors and their affiliates hedging or transferring
retained interests for specified periods after the securitization remain
unchanged from the Re-Proposal:
• For RMBS transactions, the restrictions will expire on or after the date that is
(1) the later of (a) five years after the closing date or (b) the date on which the
total unpaid principal balance of the securitized assets is reduced to 25 percent of
the original unpaid principal balance as of the closing date, but (2) in any event no
later than seven years after the closing date.
• For all other ABS transactions, the restrictions will expire on or after the date that
is the latest of (1) the date on which the total unpaid principal balance of the
securitized assets that collateralize the securitization are reduced to 33 percent of
the original unpaid principal balance as of the closing date, (2) the date on which
the total unpaid principal obligations under the ABS interests issued in the
securitization are reduced to 33 percent of the original unpaid principal obligations
as of the closing date, or (3) two years after the closing date.
Qualified residential mortgages (QRMs)
• Under the Final Rule, a sponsor will be exempt from the risk retention
requirement for securitizations consisting solely of QRMs.
• The Final Rule defines “qualified residential mortgage,” or QRM, to
mean a “qualified mortgage” or QM, as defined in Section 129(C) of the
Truth In Lending Act and regulations issued thereunder, as amended
from time to time, that is not currently 30 or more days past due.
• The detailed definition of QM is currently set forth in regulations
adopted by the Consumer Financial Protection Bureau (“CFPB”) under
Section 129(C) for purposes of the CFPB’s “ability-to-repay” rules (set
forth at 12 CFR 1026.43).
• After much debate, the Joint Regulators determined not to adapt the
“QM-Plus” concept floated in the Re-Proposal under which QRM would
have been defined as a QM that satisfied additional conditions,
including a minimum down payment requirement.
Qualified residential mortgages (QRMs) (cont’d)
• Thus, under the Final Rule, there is no minimum down payment
requirement for a QRM.
• The Final Rule also added two limited exemptions from the risk
retention requirement for certain residential mortgage loans in order
to conform with the “ability-to-repay” rules of the CFPB.
• The first is an exemption for securitization transactions backed solely
by certain community-focused residential mortgage loans (such as
loans made through state housing agency programs and certain
community lender programs) and servicing assets.
• The second is an exemption for qualifying 3-to-4 unit residential
mortgage loans and servicing assets.
Qualifying commercial loans, commercial real
estate loans, and auto loans
The Final Rule provides an exemption from risk retention requirements
for securitizations consisting of “qualifying” commercial loans,
commercial real estate (“CRE”) loans and automobile loans.
Specifically, securitizations of such “qualifying” assets are subject to a
zero percent risk retention requirement provided that:
• the assets meet the specific underwriting standards set forth in the Final Rule
for each such asset type,
• the securitization transaction is collateralized solely by loans of the same asset
class and by servicing assets,
• the securitization transaction does not permit reinvestment periods, and
• the sponsor provides, or causes to be provided, to potential investors, a
description of the manner in which the sponsor determined the aggregate risk
retention requirement for the securitization transaction.
The underwriting requirements for each of these classes of “qualifying”
assets are included in the Final Rule, and are very stringent.
Certain foreign-related transactions
The Final Rule includes a limited exemption, or “safe harbor,” excluding
from the risk retention requirement certain predominantly foreign
The foreign securitization safe harbor is available only if all of the
following conditions are met:
• registration of the ABS interests is not required under the Securities Act
of 1933,
• not more than 10 percent of the value of all classes of ABS interests
(including ABS interests retained by the sponsor) are sold to U.S. persons,
• neither the sponsor nor the issuing entity is organized under U.S. law or
is a branch located in the United States of a non-U.S. entity, and
• not more than 25 percent of the securitized assets were acquired from
an affiliate or branch of the sponsor organized or located in the United
General exemptions
The Final Rule includes a number of “general exemptions” from the risk
retention requirements, including the following:
• certain U.S. Government-backed securitizations of residential, multi-family, or
healthcare facility mortgage loans
• certain State and municipal securitizations
• certain qualified scholarship funding bonds
• certain pass-through resecuritizations that are collateralized solely by servicing
assets and by ABS for which the requisite credit risk was previously retained or that
were exempt from the credit risk retention requirements
• certain first-pay-class securitizations structured to reallocate prepayment risk and
not credit risk
• securitizations collateralized solely by “seasoned loans” and by servicing assets.
• certain public utility securitizations
• securitizations sponsored by the FDIC acting as conservator or receiver for a
financial institution
• reduced risk retention requirements for certain student loan securitizations
Additional exemptions; periodic review
• The Final Rule provides that the Joint Regulators may jointly adopt or
issue exemptions, exceptions or adjustments to the risk retention
requirements of the Final Rule.
• Notably, the Final Rule does not give such authority to individual
regulatory agencies.
• The Joint Regulators must review the QRM definition, and the related
exemptions for community-focused and 3-4 unit residential mortgage
loans, four years from the effective date of the Final Rule and every
five years thereafter, or at any time upon request by one of the Joint
Regulators, to determine if the CFPB’s QM definition at such time is
still the appropriate definition to use to define QRM and whether such
related exemptions are still appropriate.
Market impacts
• The Final Rule is expected to have a significant impact on
securitization markets generally, although the impact is likely to vary
considerably among specific asset classes and transaction
• The impact of the Final Rule extends to the far reaches of the
securitization markets, both because it covers privately placed ABS
transactions, such as Rule 144A and Regulation D offerings, in
addition to publicly offered ABS transactions, and because it applies
to foreign issuers who are not willing or able to limit their offerings in
the United States to less than 10 percent of the total transaction even
in cases where the offering is predominantly foreign in nature.
• Sponsors, and in turn originators, will have substantial incentives to
produce “qualifying” assets that are exempt from risk retention
requirements when securitized.

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