On January 20th, the SEC finalized its first batch of many rules to come under Dodd-Frank, requiring issuers to perform reviews of the assets underlying their ABS securities and requiring them to disclose fulfilled and unfulfilled repurchase requests for alleged breaches of representations and warranties. These have effective dates beginning with 2012 issuance so, to a certain extent, we can kick the anxiety can down the road for a while. Nonetheless, this is a pretty clear window into what may be a bleak regulatory future. And that’s important now. More on this later.
Rule 193 (release here (pdf)) requires an issuer to know something about the assets it’s securitizing. The issuer is supposed to do diligence to understand the assets it securitizes and tell the investor about the nature of its inquiry. Curiously, and I’m not complaining here, Rule 193 does not purport to define what disclosures need be made, just that there ought to be “robust" and "transparent” diligence behind them. Its inquiry must be “designed and effected to provide reasonable assurances” that the disclosures about the assets are correct.
Hardly shocking. Call me silly, but that seems to be what we do in structured finance. I guess more information about exactly what the issuer did to understand the assets it securitizes could be useful, particularly in asset classes in which the asset level data is sketchy and aggregate. It’s just silly in CMBS when we already deliver vast quantities of granular data in every deal.
An issuer has strict liability for misstatements and omissions in a public deal. So what’s really added here? An issuer can now be liable for bad disclosure about the nature of its diligence process or if its diligence failed to provide “reasonable assurance” that the disclosures were “correct”. Now that’s new and different! I don’t know what “reasonable assurance” means, but I suspect if we round up the usual suspects at the trial bar, they will tell us it means something, by God! One more count in every complaint!
This only applies to registered deals and in the CMBS space registered deals are beginning to look like the dodo. But the SEC staff mused in the preamble to the Rule that a similar regulatory regime for the 144A market might be appropriate and they’re a fixin’ to think about it. Joy.
Also one should not discount the argument that, as the SEC has concluded that this information needs to be provided to meet its standards for adequate disclosure, mischief could be concocted by our usual suspects right now. If this disclosure is appropriate in 2012, why not now?
Another new rule, Rule 15Ga-1 (release here (pdf)), is more straightforwardly and more immediately problematic. Rule 15Ga-1 requires an issuer to disclose, in a very complex and burdensome way, its past history of demands for the repurchase of assets — successful, unsuccessful or otherwise — for breaches of representations and warranties on pool assets. The SEC is also requiring, in Rule 17g-7 (released with Rule 15Ga-1 above), that rating agencies include in their reports a description of the issuer’s reps, the enforcement mechanisms to address breaches and how each differs from such provisions in "similar securities".
All this kicks in by the first quarter of 2012 as well, and it applies to all securitizations, public and private. SIFMA, in its comment letters on these rules (available here and here) stressed how burdensome this was, how little actual probative information it would deliver to investors, by giving investors data about unrelated asset classes and unsuccessful or even unpursued claims, and how, at least in CMBS, put-backs were really extraordinarily rare in any event. And what in the world do rating agencies do with a "similar securities" standard?
All for naught. We’re now going to have to learn to live with this. Note how extraordinary it is that issuers of private 144A deals will now have to make public filings. If that doesn’t blur the distinction between the public and private markets (which I sort of think is what the SEC has in mind), what does?
While Rule 15Ga-1 doesn’t kick in for a year, this will cause issuers a very substantial amount of work, starting now, to get ready for next year. Below the Rule’s headlines, a lot of detailed compliance and mechanics questions will need to be answered in the process. How comforting that the Rule contains an analysis by the SEC of its expectations of the cost of compliance. And here’s the headline: the compliance costs won’t be bad at all! It makes risible reading.
Beyond the additional costs, extra work and potential liability imposed by these Rules, which are bad enough, this first batch of Dodd-Frank regulations tells us that complying with the fullness of Dodd-Frank is going to be a lot worse. In a significant way, Dodd-Frank was built on the basis of unsupported conjecture, received wisdom and ideological certitudes. Dodd-Frank booted much, if not most, of the actual sausage-making to the reconciliation and launched dozens of regulatory processes.
The regulatory handcuffs will magnify the underlying subtext of Dodd-Frank – that we have insufficient regulatory restraints on the behavior of market participants and we need more to avoid a return to the edge of apocalypse. Regulators will regulate. Close calls and unclear, skeletal legislative direction will be settled in favor of more, not less.
Consequently, the industry faces a daunting rear guard action in the 112th Congress to try to mediate what will likely be excessively burdensome and intrusive rules. No matter how well this goes, capital formation will get harder and more expensive. Will all of this really help investors and prevent irrational exuberance and excess?
At least in CMBS, I think not. It’ll make some trial lawyers happy, though.
By Rick Jones.
