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IFLR Webinar: Dodd-Frank: Recap and What’s

Next

January 6, 2015Presented By:

Gary KalbaughKenneth Kohler

Oliver IrelandJames Schwartz

22

Regulatory Developments

33

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

44

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

55

Coverage• 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)

66

Exceptions--Proprietary Trading

• Underwriting

• Market making

• Hedging

• Government Obligations

• Trading for customers

• SOTUS

• Trading by insurance companies

77

Exceptions--Funds• Customer funds

• Asset backed securities

• Underwriting

• Market making

• Establishment

• Des minimis investment

• Hedging

• SOTUS

• Insurance Companies

8

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 subsidiaries

9

Coverage• US Bank Holding Companies with $50 billion or more consolidated

Assets.

• 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

1010

Intermediate Bank Holding Companies• Generally treated as US bank holding companies

1111

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

1212

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

1313

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

1414

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

1515

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.

1616

Money Market Mutual Funds• SEC rule• Floating net asset value for institution prime and tax exempt money

market funds• Fees and Gates

1717

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 floating

• 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)

1818

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

1919

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

20

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

21

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

22

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

2323

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 transactions

2424

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 transactions

• 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

2525

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 derivatives

2626

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 factors

2727

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

2828

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”

• 75-90%

2929

Derivatives Developments

This is MoFo. 30

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”

31

CFTC Status – Accomplishments • CFTC has made substantial progress toward completion of its

mandate• 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)• Recordkeeping• Business conduct standards• Volcker Rule

32

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

33

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 agreement“

• SEC has granted broad relief, extending as far as February 2017, with respect to many substantive requirements

This is MoFo. 34

Regulatory Responsibility• Title VII has bifurcated the regulatory responsibility

between:• CFTC regulating swaps, swap dealers, and major

swap participants; and• SEC regulating security-based swaps, security-based

swap dealers and major security-based swap participants

This is MoFo. 35

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, cross-currency 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 index

• “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. 36

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) purposes

This is MoFo. 37

Status of CFTC Cross-Border Guidance • CFTC issued final cross-border guidance in July 2013

• The guidance is intended to address comprehensively the cross-border 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

38

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 completed

• 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

This is MoFo. 39

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 Act

This is MoFo. 40

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 international

• As a result, the question comes to the forefront: which jurisdiction’s rules will apply to which swaps?

This is MoFo. 41

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 framework

• If the EU were to fail to timely recognize U.S. CCPs, there comes a parade of horribles:

• U.S. CCPs will not constitute “Qualifying CCPs” for purposes of Basel III risk-weighting

• 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, 2015

This is MoFo. 42

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 Singapore

• 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 CFTC

• Regulators’ remarks are also revealing as to some of the broader issues at play in discussions regarding cross-border harmonization

This is MoFo. 43

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. 44

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. 45

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 non-discriminatory access by market participants and an appropriate level of oversight

• The lists were to be accompanied by supporting explanations, on a requirement-by-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. 46

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 non-U.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

47

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

48

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.”

49

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

50

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

51

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 jurisdictions

• With respect to transactions entered into by U.S. swap dealers acting through non-U.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

52

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

This is MoFo. 53

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. 54

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 part”

• 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. 55

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. 56

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. 57

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. 58

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)

59

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

60

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

61

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

62

Securitization Developments

63

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

64

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 test

• 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

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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

receivables• Section 3(c)(5)(B) – for certain securitizations of trade receivables• Rule 3a-5 – for finance subsidiaries whose securities are

guaranteed by parent

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Exclusions from Covered Fund Definition – General

• 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 fund

• 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

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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

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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

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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

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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 requirements

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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 interests”

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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 (“TruPS”)

• 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.

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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.

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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 SEC-

registered 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 confidence

• 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

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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

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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 arbitration

• 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

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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

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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

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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

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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

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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 NRSRO

• 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

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SEC Registration – Shelf Eligibility Requirements (cont’d)

• Transaction Eligibility Requirements:• The ABS to be registered must satisfy the definition of “asset-

backed 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

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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 fields

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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 reporting

• 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

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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

requirements

• 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 code

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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 data

• Note that borrower income is not required, but credit score is required

• Fields for loans and leases are substantially the same

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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 assets• 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)

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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”

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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

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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 statement

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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

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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

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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 extent?

• 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 people?

• 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?

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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.

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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 (4/29/11)).

• 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.

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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.

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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 transaction.

• 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.

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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 interests.

• The Final Rule eliminated the requirement included in the Re-Proposal 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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 Buyers”).

• A B-Piece Buyer must perform its own due diligence of the underlying commercial mortgage loans, and may be affiliated with the special servicer.

• 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.

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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.

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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.

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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 conditions.

• 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

limitations.

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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.

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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.

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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.

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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.

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Certain foreign-related transactionsThe Final Rule includes a limited exemption, or “safe harbor,” excluding from the risk retention requirement certain predominantly foreign securitizations.

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 States.

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General exemptionsThe 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

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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.

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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 structures.

• 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.