In review: securitisation law and regulation in USA

All questions

Overview

i Background

The modern US securitisation market is widely considered to have emerged as a product of the federal government’s involvement in the housing market following the Great Depression. The US federal government adopted the National Housing Act of 1934 and established the Federal National Mortgage Association (FNMA, or Fannie Mae) in 1938. Fannie Mae’s purpose was to ‘establish secondary market facilities for residential mortgages, to provide that the operations thereof shall be financed by private capital to the maximum extent feasible’,² which it did by purchasing mortgage loans from lenders, thereby freeing capital that could be used to make more loans. By 1970, in addition to Fannie Mae, the US federal government had established other government-sponsored enterprises (GSEs) that were critical to the rise of modern securitisation in the United States: the Federal Home Loan Mortgage Corporation,³ the Federal Home Loan Bank System, and the Government National Mortgage Association (GNMA, or Ginnie Mae). It was Ginnie Mae that issued the first asset-backed security, pooling the individual mortgage loans together and in 1970, selling securities backed by the mortgaged properties (mortgage-backed securities, or MBSs).⁴

After 1970, the securitisation market expanded rapidly alongside the housing market. More complex securitisation structures were introduced, and while ‘GSEs dominated the MBS market for nearly twenty years’⁵ from the first issuance in 1970 to around 1990, the 1990s saw the introduction of private actors into the securitisation market and the first offerings of ‘private-label’ or ‘non-agency’ MBSs (those offered by private institutions, as opposed to those issued and guaranteed by GSEs and known as ‘agency’ MBSs). This expansion was another critical development in the development of securitisation in the United States. By their peak in 2006, private-label MBS issuances were valued at approximately US$900 billion,⁶ and the value of the MBS market as a whole was in the trillions of dollars.

While MBSs dominated the securitisation market from its inception until the early 2000s, during that period in the United States, other forms of securitisation developed and continued to expand. The mid-1980s saw the introduction of the first ‘asset-backed securities’ (ABSs), a term used generally to refer to the securities issued in a securitisation of asset pools consisting of loans and debt obligations other than mortgages.⁷ While initially a smaller portion of the market than MBSs, ABS issuance did increase markedly after its inception in the 1980s and grew rapidly, along with the rest of the securitisation market, in the early 2000s.

Despite the setbacks resulting from the financial crisis in 2008, securitisation in the United States remains an attractive form of financing for borrowers in various industries, as the cost of gaining liquidity is often lower than that of traditional lending. Both investor concerns and the post-crisis regulatory framework in the United States have required parties to continue to develop new structural features. Nonetheless, issuers and underwriters continue to develop new structures to apply to novel asset classes, as well as applying modified versions of pre-existing structures to traditional ABS assets, such as mortgage, auto and credit card loans. In 2020, important developments in the market occurred due to the effects of the covid-19 pandemic, but the securitisation market has shown significant resiliency and continued to operate effectively throughout 2020 and 2021, with 2021 being a record year in recent years in terms of deal volume and innovation. In addition to the ongoing effects of the pandemic, the U.S. securitisation market is also currently reacting to several macroeconomic events, including inflation and significant strains in the supply chain, that have resulted in market volatility.

ii Common structures

There are two main structures employed in securitisations. The first structure is commonly used in MBSs, though some other asset classes also employ this method. In this structure, a wholly-owned subsidiary of the sponsor⁸ or originator of the assets, known as a depositor,⁹ acquires or receives the assets that will be securitised. The depositor transfers the assets to a trust that is also a wholly-owned subsidiary of the sponsor or originator, and the trust then issues notes¹⁰ backed by the assets.

The second structure is more likely to be found in the securitisation of ‘esoteric’¹¹ assets and is gaining increased use across the market. The key difference between the two structures is that the latter does not include the intermediate step of transferring to a depositor. Instead, the issuer of the notes is a wholly-owned subsidiary of an entity that manages the assets on behalf of the owners of the assets (typically, the manager or parent). The owners of the assets, known as asset entities, are typically wholly-owned subsidiaries of the issuer. The notes issued then are backed not by the assets themselves, but by the equity of the asset entities that own the assets. Some transactions also have a guarantor that is a direct subsidiary of the manager and direct owner of the issuer. The guarantor grants a security interest in its equity interest in the issuer and guarantees the issuer’s and asset entities’ obligations under the transaction documents.

In both structures, one or more financial institutions will typically purchase securitisation notes with the intention of reselling these notes on the secondary market.¹²

Regulation

i Disclosure

In a typical securitisation, initial purchasers or underwriters will offer securitisation notes to potential investors on the secondary market and will provide such potential investors a preliminary offering memorandum (the POM) that contains transaction terms and disclosures regarding certain risks to the collateral and to the notes. Because potential investors make investment decisions in reliance on the information contained in the POM, once the POM is distributed to potential investors, liability under the Securities and Exchange Commission’s Rule 10b-5¹³ attaches to the issuer and the initial purchasers or underwriters. In response to recent market volatility, initial purchasers are increasingly engaging in the ‘pre-marketing’ of transactions as a way to gauge market interest prior to officially offering the notes. Often, pre-marketing includes distribution of a POM, in which case liability under SEC Rule 10b-5 may attach during pre-marketing even though the notes have not been officially offered.

Another evolving trend is increased reliance on Section 4(a)(2) of the Securities Act of 1933 (the 33 Act) for exemption from certain registration requirements under the 33 Act for privately placed (as opposed to publicly offered) securitisation notes. In general, private placements can be exempt from registration under Rule 506 of Regulation D¹⁴ or Section 4(a)(2). In order to be exempt under Section 4(a)(2), an issuer must provide potential investors with access to the same kind of information that would be provided in a registration statement and each potential investor should be sufficiently financially sophisticated such that it can ‘fend for itself without a registration statement’.¹⁵ In practice, this means that typically no POM is prepared, but direct investors are more active in the process, conduct their own diligence, and often substantially negotiate deal terms.

ii Risk retention

In response to the financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act)¹⁶ was enacted in the United States in July 2010. The Dodd-Frank Act increased regulation of the securitisation market in many respects, including the implementation of new credit risk retention rules in Regulation RR, 17 CFR Part 246. The rules were intended to promote alignment of the interests of sponsors and investors by requiring the sponsor to maintain ‘skin in the game’; that is, the sponsor must retain an economic interest in the credit risk of the securitised assets for a certain period. In 2014, the Securities and Exchange Commission (SEC) and five other federal agencies jointly adopted the final rules, requiring the sponsors of ABSs to retain not less than 5 per cent of the aggregate credit risk of the assets being securitised (the US Risk Retention Rules).¹⁷ The US Risk Retention Rules became effective with respect to residential MBSs on 24 December 2015 and with respect to all other asset classes on 24 December 2016. The Rules were described as the ‘single most important part of the bill’,¹⁸ and were designed to be a fix for certain perceived flaws in MBSs prior to the financial crisis. In February 2018, the US Court of Appeals for the District of Columbia Circuit ruled that an open-market CLO manager is not a ‘securitiser’, and, therefore, the Dodd-Frank Act does require CLO managers of open-market CLOs to comply with the US Risk Retention Rules.¹⁹

An ABS is defined in Section 3(a)(79) of the US Securities Exchange Act of 1934 as ‘a fixed-income or other security collateralised by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset’.²⁰ This definition is broad enough to encompass some securities that may not have traditionally been considered ABSs, but narrow enough to exclude certain types of securitisation transactions, including many that rely on how actively the underlying assets are managed and commercialised rather than a static pool of self-liquidating assets.²¹

Because of the difference in interpretation and lack of case studies, considerable uncertainty exists as to whether certain securities constitute ABSs for the purpose of the US Risk Retention Rules, in particular as regards more esoteric asset classes. When compliance is required (or undertaken in the absence of certainty as to the requirement for compliance), the US Risk Retention Rules provide that the retained interest may be held as an ‘eligible horizontal residual interest’²² or ‘eligible vertical interest’.²³ The risk retention requirement may also be satisfied by a combination of both horizontal and vertical interest.²⁴ Each method requires retention of at least 5 per cent of the nominal value of the interests in the securitisation.²⁵ The US Risk Retention Rules also require certain disclosures regarding the value of the retained interests and, in the case of an eligible horizontal residual interest, the sponsor’s methods of valuation, including the default and payment rate assumptions.²⁶ An eligible horizontal interest is the more attractive option when the credit enhancement required to be maintained to support the rating of the securities requires the sponsor, through the issuer, to retain an interest that is already in excess of 5 per cent of the nominal value of each class issued in the securitisation. An eligible vertical interest may be a less attractive opinion as it would require the sponsor to retain a 5 per cent interest in the more senior class of securities issued by the issuer that could otherwise have been sold to third parties (whereas the eligible horizontal interest would already have been held as noted above).²⁷

iii Tax issuesTax characterisation of the notes issued in a securitisation

The notes issued in a properly structured securitisation will generally be treated as debt for US federal income purposes so long as the beneficial owner of the notes is not the issuer or any of its affiliates. The benefits of treatment as debt are twofold:

1. the issuer’s interest expenses are generally deductible; and
2. the interest payments paid to foreign noteholders will generally not be subject to withholding tax.

There are, however, no clear rules for making the distinction between debt and equity; instead, the determination is based on the balancing of a number of factors.²⁸ In 1994, the Internal Revenue Service issued Notice 94-47,²⁹ which laid out the principal factors for making the determination, noting that none is dispositive and that all facts and circumstances must be considered. In general, the factors relate to how much the rights of the noteholders resemble the rights of typical creditors. It is also necessary to look to case law to guide the interpretation of these factors.

In addition, in 2016, the Internal Revenue Service issued final regulations under Section 385 of the Internal Revenue Code³⁰ that may result in recharacterisation of debt issued by US entities owned by multinational parent entities (whether US or foreign-based), with some exceptions. In general, Section 385 requires documentation of factors that are used to determine characterisation, such as the issuer’s obligation to pay a sum certain and the reasonable expectation of the ability to pay. Compliance with the new requirements does not guarantee characterisation as debt, but non-compliance is likely to result in characterisation of equity.

Foreign Account Tax Compliance Act

The Foreign Account Tax Compliance Act (FATCA)³¹ was signed into law as part of the Hiring Incentives to Restore Employment (HIRE) Act,³² requiring that ‘foreign banks . . . disclose their US account holders to the US Government or face significant penalties’. Pursuant to FATCA, if a foreign entity or financial institution does not comply with FATCA requirements, a 30 per cent withholding tax will be applied to certain US-source payments, including, in general, payments of interest on the notes issued in a securitisation.

iv Regulatory complianceAnti-money laundering

The Department of Justice, Internal Revenue Service, Department of Treasury and the Financial Industry Regulatory Authority, among others, all have anti-money laundering-related laws or regulations applicable to financial transactions and financial institutions. These regulations primarily relate to identification of sponsor,³³ record-keeping³⁴ and anti-money laundering compliance policies.³⁵ Securitisation transaction documents typically require that the sponsor demonstrates that it complies with all applicable anti-money laundering laws, regulations or procedures.

Sanctions

The Office of Foreign Assets Control (OFAC) of the US Treasury Department administers and enforces economic and trade sanctions against foreign countries, regimes, and other international actors based on US foreign policy and national security interests. There are several sanctions programmes that vary as to the scope and targeted group, as well as sanctions against specific individuals. Securitisation transaction documents typically require that the sponsor demonstrates that it is not the target of any OFAC investigations and is not in violation of any OFAC sanctions. It is also good practice for entities conducting non-US business to have OFAC sanctions compliance policies.

v Jurisdiction

There is no law or regulation that mandates the jurisdiction that the issuer is formed in or governs the transaction documents; however, commonly, the issuer is formed in Delaware and the transaction documents are governed by the laws of New York. The reasons for choosing Delaware and New York, among others, are ‘the well-developed and therefore more predictable legal framework in these jurisdictions’ and ‘the sophistication of the judiciary in these states.’³⁶ These states also have laws that are beneficial for securitisations. For example, the Asset-Backed Securities Facilitation Act, which Delaware enacted in 2002, effectively deems that all sales of assets as part of a securitisation are true sales.³⁷ Another example is that regardless of whether the transaction involves parties or assets in New York, New York law allows transaction parties to choose New York law to govern transactions valued at US$250,000 or greater³⁸ and to enforce rights and obligations of transactions valued at US$1 million or greater.