[Federal Register Volume 76, Number 173 (Wednesday, September 7, 2011)]
[Proposed Rules]
[Pages 55308-55321]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-22772]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. IC-29779; File Nos. S7-35-11]
17 CFR Part 270
RIN 3235-AL03
Treatment of Asset-Backed Issuers Under the Investment Company
Act
AGENCY: Securities and Exchange Commission.
ACTION: Advance notice of proposed rulemaking; withdrawal.
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SUMMARY: The Commission is considering proposing amendments to Rule 3a-
7 under the Investment Company Act of 1940 (``Investment Company Act''
or ``Act''), the rule that provides certain asset-backed issuers with a
conditional exclusion from the definition of investment company.
Amendments to Rule 3a-7 that the Commission may consider could reflect
market developments since 1992, when Rule 3a-7 was adopted, and recent
developments affecting asset-backed issuers, including the passage of
the Dodd-Frank Wall Street Reform and Consumer Protection Act (the
``Dodd-Frank Act'') and the Commission's recent rulemakings regarding
the asset-backed securities markets. The Commission is withdrawing its
2008 proposal to amend Rule 3a-7, which was published July 11, 2008.
DATES: Comments should be received on or before November 7, 2011.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/concept.shtml); or
Send an e-mail to [email protected]. Please include
File Number S7-35-11 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-35-11. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's Web
site (http://www.sec.gov/rules/concept.shtml). Comments also are
available for Web site viewing and printing in the Commission's Public
Reference Room, 100 F Street, NE., Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. All comments
received will be posted without change; we do not edit personal
identifying information from submissions. You should submit only
information that you wish to make publicly available.
FOR FURTHER INFORMATION CONTACT: Rochelle Kauffman Plesset, Senior
Counsel, at (202) 551-6840 or Nadya Roytblat, Assistant Chief Counsel,
at (202) 551-6825, Office of the Chief Counsel, Division of Investment
Management, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549.
Table of Contents
I. Introduction and Executive Summary
II. Background
A. Asset-Backed Issuers as Investment Companies
B. Rule 3a-7
III. Discussion
A. Revisiting Rule 3a-7
1. Rating Requirements
2. Possible New Conditions for Rule 3a-7
a. Structure and Operation of the Issuer
b. Independent Review
c. Preservation and Safekeeping of Eligible Assets and Cash Flow
d. Other Possible Investor Protections
i. Other Commission Rules
ii. Eligibility to Use Rule 3a-7
3. Standard for Acquisition and Disposition of Eligible Assets
B. The Effect of the Exclusion Provided by Rule 3a-7
1. Holders of an Asset-Backed Issuer's Securities
2. Eligible Portfolio Company
C. Asset-Backed Issuers Relying on Section 3(c)(5)
IV. General Request for Comment
I. Introduction and Executive Summary
Asset-backed issuers \1\ typically meet the definition of
investment company under the Investment Company Act, but generally
cannot operate under certain of the Act's requirements and
restrictions.\2\ In 1992, the Commission adopted Rule 3a-7 under the
Investment Company Act specifically to exclude from the definition of
investment company certain asset-backed issuers that meet the rule's
conditions.\3\ These conditions were designed to incorporate then-
existing practices in the asset-backed securities market that we
believed served to distinguish asset-backed issuers from registered
investment companies and addressed investor protection under the
Investment Company Act.\4\
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\1\ We use the term ``asset-backed issuer'' in this release to
refer generally to any issuer of fixed-income securities the
payments on which depend primarily on the cash flows generated by a
specified pool of underlying financial assets. See also infra
section III.A.2.d.ii for a discussion of the definition of ``asset-
backed securities'' under other Federal securities laws.
\2\ See infra note 29.
\3\ 17 CFR 270.3a-7.
\4\ The conditions also were intended to accommodate future
innovations in the securitization market, consistent with investor
protection. See Exclusion from the Definition of Investment Company
for Structured Financings, Investment Company Act Release No. 19105
(Nov. 19, 1992) [57 FR 56248 (Nov. 27, 1992)] (``Adopting Release'')
at text accompanying n.8. Rule 3a-7 effectuated the recommendation
made by the Division of Investment Management's staff in its report,
Protecting Investors: A Half Century of Investment Company
Regulation, The Treatment of Structured Finance under the Investment
Company Act 1-101 (May 1992) (``Protecting Investors Report''). The
Protecting Investors Report contains a discussion of the issues
raised by asset-backed issuers under the Investment Company Act and
the state of the asset-backed securities market prior to the Rule's
adoption.
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Rule 3a-7 includes several conditions that refer to credit ratings
by nationally recognized statistical rating organizations (``NRSROs''
or ``rating agencies''). One such condition is that certain of the
asset-backed issuer's fixed-income securities receive certain credit
ratings by at least one rating agency. These conditions were included
in Rule 3a-7 not principally as standards of credit-worthiness, but,
because we believed that rating agencies, when providing a rating
assessing the credit risk of an asset-
[[Page 55309]]
backed issuer, evaluated whether the issuer was structured in a manner
that also addressed investor protection under the Investment Company
Act.\5\
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\5\ See Adopting Release, supra note 4 at n.42 and accompanying
text. See also infra note 38.
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The Dodd-Frank Act,\6\ enacted in 2010, generally requires the
Commission to review any references to or requirements regarding credit
ratings in its regulations, remove these references or requirements and
substitute other appropriate standards of credit-worthiness in place of
the credit ratings.\7\ Even though the ratings-related conditions in
Rule 3a-7 generally were not intended to serve as standards of credit-
worthiness, we are issuing this advance notice of proposed rulemaking
in response to these requirements and in light of market developments
since Rule 3a-7 was adopted. We also are withdrawing our 2008 proposal
to amend Rule 3a-7.\8\
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\6\ Public Law 111-203, 124 Stat. 1376 (2010).
\7\ Section 939A of the Dodd-Frank Act.
\8\ In 2008, the Commission proposed to replace the references
to credit ratings in Rule 3a-7 with a prohibition on the sale of
securities of issuers relying on Rule 3a-7 to anyone other than
certain institutional investors (``retail sales prohibition'').
References to Ratings of Nationally Recognized Statistical Rating
Organizations, Investment Company Act Release No. 28327 (July 1,
2008) [73 FR 40124 (July 11, 2008)] (``2008 NRSRO Proposing
Release'') at nn.36-47 and accompanying text. Commenters generally
opposed the retail sales prohibition, suggesting, among other
things, that the retail sales prohibition would have unnecessarily
precluded offerings to retail investors and impeded the liquidity
and growth of the asset-backed securities market. See, e.g., comment
letter from Dechert LLP to the Commission (Sept. 5, 2008), File No.
S7-19-08 (``Dechert Comment Letter''); comment letter from Mayer
Brown LLP to Florence E. Harmon, Acting Secretary (Sept. 4, 2008),
File No. S7-19-08; comment letter from the American Bar Association
to Florence E. Harmon, Acting Secretary (Sept. 12, 2008), File No.
S7-19-08. In a 2009 release, the Commission deferred consideration
of this proposal. See References to Ratings of Nationally Recognized
Statistical Rating Organizations, Investment Company Act Release No.
28940 (Oct. 5, 2009) [74 FR 52374 (Oct. 9, 2009)] at text following
n.64. Based, in part, on the comments received, we have decided to
withdraw from further consideration the amendments to Rule 3a-7
proposed in the 2008 NRSRO Proposing Release.
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The Dodd-Frank Act also directed the Commission to undertake a
number of rulemakings related to the asset-backed securities market.\9\
Prior to the passage of the Dodd-Frank Act, in April 2010, the
Commission proposed comprehensive revisions to the offering process,
disclosure, and reporting requirements for asset-backed securities
under the Securities Act of 1933 (``Securities Act'') and the
Securities Exchange Act of 1934 (``Exchange Act'').\10\ The Commission
recognized that many of the problems giving rise to the recent
financial crisis involved structured finance and proposed a number of
changes designed to improve investor protection and promote more
efficient asset-backed markets.\11\ Among other things, the Commission
proposed to amend: the disclosure requirements of Regulation AB to
require that more information be provided to investors about the assets
being securitized; the eligibility requirements for public offerings of
asset-backed securities conducted through ``shelf registration'' by
replacing the existing requirement that the securities receive an
investment grade rating with new requirements; and the safe harbors
under the Securities Act for exempt offerings and exempt resales of
asset-backed securities.\12\ In light of the requirements of the Dodd-
Frank Act and the comments subsequently received on the 2010 ABS
Proposing Release, the Commission has issued a release revising and re-
proposing certain of the proposals in the 2010 ABS Proposing
Release.\13\ The 2011 ABS Re-proposal requests comment on whether, to
be eligible for shelf registration under the Securities Act, an asset-
backed issuer should, among other requirements, meet the conditions of
Rule 3a-7.
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\9\ A summary of these Dodd-Frank Act provisions is available at
http://www.sec.gov/spotlight/dodd-frank/assetbackedsecurities.shtml.
See also Proposed Rules for Nationally Recognized Statistical Rating
Organizations, Securities Exchange Act Release No. 64514 (May 18,
2011) [76 FR 33420 (June 9, 2011)] (proposal requiring third parties
retained to conduct due diligence related to asset-backed securities
to provide a certification containing specified information to the
NRSRO that is producing a rating for the asset-backed securities);
Disclosure for Asset-Backed Securities Required by Section 943 of
the Dodd-Frank Wall Street Reform and Consumer Protection Act,
Securities Act Release No. 9175 (Jan. 20, 2011) [76 FR 4489 (Jan.
26, 2011)] (``Section 943 Release'') (adopting rules requiring
securitizers of asset-backed securities to disclose the history of
fulfilled and unfulfilled repurchase requests related to their
outstanding asset-backed securities and disclosure by NRSROs of
representations, warranties and enforcement mechanisms available to
investors in an asset-backed securities offering); Issuer Review of
Assets in Offerings of Asset-Backed Securities, Securities Act
Release No. 9176 (Jan. 20, 2011) [76 FR 4231 (Jan. 25, 2011)]
(adopting rules requiring issuers of asset-backed securities to
conduct a review of the assets underlying those securities and make
certain disclosures about those reviews).
\10\ Asset-Backed Securities, Securities Act Release No. 9117
(Apr. 7, 2010) [75 FR 23328 (May 3, 2010)] (``2010 ABS Proposing
Release'').
\11\ Id.
\12\ Id. See infra section III.A.2.d.
\13\ Re-proposal of Shelf Eligibility Conditions for Asset-
Backed Securities and Other Additional Requests for Comment,
Securities Act Release No. 9244 (July 26, 2011) [76 FR 47948 (Aug.
5, 2011)] (``2011 ABS Re-proposal'').
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The Commission also believes that it is appropriate to consider
amending Rule 3a-7, among other things, to determine the role, if any,
that credit ratings should continue to play in the context of Rule 3a-
7. In the aftermath of the recent financial crisis, NRSROs' credit
rating procedures and methodologies raised a number of concerns in
light of the role the NRSROs played in determining credit ratings for
securities collateralized by or linked to subprime residential
mortgages, and the Commission has engaged in various regulatory
initiatives to address these concerns.\14\ The potential amendments to
Rule 3a-7 could include replacing references to credit ratings with
conditions that are tailored to address Investment Company Act-related
concerns. The Commission also is considering amending Rule 3a-7 to
address two issues, detailed below, that have arisen relating to the
potential Investment Company Act status of certain holders of
securities of asset-backed issuers that rely on Rule 3a-7.
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\14\ See, e.g., 2008 NRSRO Proposing Release, supra note 8. See
also Summary Report of Issues Identified in the Staff's Examinations
of Select Credit Rating Agencies (July 2008). The report can be
accessed at http://www.sec.gov/news/studies/2008/craexamination070808.pdf.
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To assist the Commission in its review of the treatment of asset-
backed issuers under the Investment Company Act, the Commission is
issuing this advance notice of proposed rulemaking and soliciting broad
public comment on these issues. The Commission also invites commenters
to address any other issues relating to the treatment of asset-backed
issuers, the protection of investors under the Investment Company Act
and capital formation that they believe may warrant Commission
attention.
II. Background
A. Asset-Backed Issuers as Investment Companies
An issuer of asset-backed securities typically is a special purpose
entity that acquires and holds a pool of income-producing financial
assets and issues non-redeemable debt obligations or equity securities
with debt-like characteristics (``fixed-income securities''), the
payment of which depends primarily on the cash flow generated by the
pooled financial assets. An asset-backed issuer that has more assets,
or expects to receive more income, than needed to make full payment on
the fixed-income securities also may sell interests in the residual or
additional cash flow.\15\
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\15\ For a more complete explanation of the structure of an
asset-backed issuer and the roles of the various parties that may be
involved in the organization and operation of the issuer, see, e.g.,
2010 ABS Proposing Release, supra note 13; Kravitt, Securitization
of Financial Assets, (2d ed. 2009) (``Kravitt''); Asset-Backed
Securities, Securities Act Release No. 8518 (Dec. 22, 2004) [70 FR
1506 (Jan. 7, 2005)] (``2004 ABS Release''); Exclusion from the
Definition of Investment Company for Certain Structured Financings,
Investment Company Act Release No. 18736 (May 29, 1992) [57 FR 23980
(June 5, 1992)] (``Proposing Release'').
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[[Page 55310]]
An asset-backed issuer typically meets the definition of investment
company under Section 3(a)(1) of the Investment Company Act because it
issues securities \16\ and is engaged in the business of investing in,
owning or holding financial assets that are securities \17\ under the
Investment Company Act.\18\ With respect to investment companies
generally, as set forth in Section 1(b) of the Act,\19\ Congress was
concerned, among other things, about companies that were: (i)
Organized, operated, managed, or their portfolio securities selected,
in the interest of company insiders; \20\ (ii) issuing excessive
amounts of senior securities; \21\ (iii) when computing the asset value
of their outstanding securities, employing unsound or misleading
methods, or not being subjected to adequate independent scrutiny; \22\
and (iv) operating without adequate assets.\23\ In addition, the
Investment Company Act reflected concerns that the assets of investment
companies were not adequately protected, with controlling persons of
investment companies commingling the investment company's assets with
their own and then proceeding to misappropriate them.\24\
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\16\ Section 2(a)(36) of the Investment Company Act broadly
defines ``security'' as ``any note, stock, treasury stock, security
future, bond, debenture, evidence of indebtedness, certificate of
interest or participation in any profit-sharing agreement,
collateral-trust certificate, preorganization certificate or
subscription, transferable share, investment contract, voting-trust
certificate, certificate of deposit for a security, fractional
undivided interest in oil, gas, or other mineral rights, any put,
call, straddle, option, or privilege on any security (including a
certificate of deposit) or on any group or index of securities
(including any interest therein or based on the value thereof), or
any put, call, straddle, option, or privilege entered into on a
national securities exchange relating to foreign currency, or, in
general, any interest or instrument commonly known as a `security',
or any certificate of interest or participation in, temporary or
interim certificate for, receipt for, guarantee of, or warrant or
right to subscribe to or purchase, any of the foregoing.''
\17\ See, e.g., SEC, Report on the Public Policy Implications of
Investment Company Growth, H.R. Rep. No. 2337, 89th Cong., 2d Sess.
328 (1966) (stating that notes representing the sales price of
merchandise, loans to manufacturers, wholesalers, retailers and
purchasers of merchandise or insurance, and mortgages and other
interests in real estate are investment securities for purposes of
the Investment Company Act). See also Protecting Investors Report,
supra note 4, at n. 339 and accompanying text.
\18\ Section 3(a)(1)(A) of the Act defines an investment company
as any issuer which ``is or holds itself out as being engaged
primarily, or proposes to engage primarily, in the business of
investing, reinvesting or trading in securities.'' Section
3(a)(1)(C) defines an investment company as any issuer which ``is
engaged or proposes to engage in the business of investing,
reinvesting, owning, holding, or trading in securities, and owns or
proposes to acquire investment securities [as defined by Section
3(a)(2) of the Investment Company Act] having a value exceeding 40
per centum of the value of [its] total assets (exclusive of
Government securities and cash items) on an unconsolidated basis''
(``40% investment securities test''). Section 3(a)(2) of the
Investment Company Act defines ``investment securities'' to include
all securities except (A) Government securities, (B) securities
issued by employees' securities companies, and (C) securities issued
by majority-owned subsidiaries that are not themselves (i)
investment companies and (ii) are not relying on the private
investment company exclusions of that Act. Asset-backed issuers
typically meet the definition of investment company in Section
3(a)(1)(A) and/or Section 3(a)(1)(C). 15 U.S.C. 80a-3(a)(1). See
also infra note 30 (discussing statutory exclusions from the
definition of investment company that may be available to certain
asset-backed issuers).
\19\ 15 U.S.C. 80a-1(b).
\20\ A study conducted prior to the adoption of the Act
documented numerous instances in which investment companies were
managed for the benefit of their sponsors and affiliates to the
detriment of investors. Investment Trusts and Investment Companies:
Hearings on S.3580 Before a Subcomm. of the Senate Comm. On Banking
and Currency, 3d Sess. 89 (1940) (``Investment Trusts Study'').
Section 17 of the Investment Company Act prohibits certain
transactions involving investment companies and their affiliates. 15
U.S.C. 80a-17(a). Other provisions of the Investment Company Act
also effectively limit opportunities for overreaching by investment
company sponsors and affiliates. See, e.g., Section 10(f) of the
Investment Company, which generally prohibits a registered
investment company from knowingly purchasing, during the existence
of any underwriting or selling syndicate, any security a principal
underwriter of which is an affiliated person of the investment
company. 15 U.S.C. 80a-10(f).
\21\ Prior to 1940, some investment companies were highly
leveraged through the issuance of ``senior securities'' in the form
of debt or preferred stock, which often resulted in the companies
being unable to meet their obligations to the holders of their
senior securities. See id. Excessive leverage also greatly increased
the speculative nature of the common stock of the companies. Id.
Section 18 of the Investment Company Act limits the ability of
registered investment companies to engage in borrowing and to issue
senior securities. 15 U.S.C. 80a-18.
\22\ Prior to 1940, investment companies often valued their
portfolios inaccurately, resulting in unfair and discriminatory
practices in the pricing of their securities. See Investment Trusts
Study, supra note 20. The Investment Company Act governs the manner
in which registered investment companies value their portfolios,
including defining ``value'' in Section 2(a)(41), with respect to
securities held by a registered investment company, to be (a) market
value for securities for which market quotations are readily
available or (b) for other securities or assets, fair value as
determined in good faith by the company's board of directors. 15
U.S.C. 80a-2(a)(41).
\23\ See Investment Trusts Study, supra note 20.
\24\ See, e.g., Investment Trusts Study, supra note 20. Prior to
1940, investment company assets were not adequately protected from
misuse by investment company insiders. Id. In many cases,
controlling persons of investment companies commingled the
investment companies' assets with the investment advisers' assets
and then proceeded to misuse the assets themselves. Id. Section
17(f) of the Investment Company Act and the rules thereunder set
forth requirements with respect to the custody of investment company
assets. 15 U.S.C. 80a-17(f). See, e.g., Rule 17f-2 under the
Investment Company Act governing custody of investments by a
registered investment company. 17 CFR 270.17f-2.
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Like most investment companies, asset-backed issuers typically have
no employees and must rely for their operations on their sponsors,
servicers and other persons, each of whom has its own separate and
distinct set of financial and other interests. Furthermore, with the
exception of the role typically assigned to the trustee, the sponsor,
or a person affiliated with the sponsor, potentially could be
responsible for most, if not all, of the operations of an asset-backed
issuer.\25\ This structure presents significant potential for conflicts
of interest. Thus, for example, one Investment Company Act-related
concern is the possibility of a sponsor intentionally overvaluing
assets or ``dumping'' into the asset-backed issuer assets that are
insufficient to produce the cash flow needed to meet the issuer's
obligations to its securities holders, contrary to representations made
to investors.\26\ Another Investment Company Act-related concern is
that a sponsor potentially could substitute inferior assets for the
assets transferred to the issuer at the time of securitization.\27\
Still another Investment Company Act-related concern relates to the
safeguarding of the issuer's assets and the cash flow derived from such
assets from being jeopardized, among other things, by the servicer or
the trustee commingling the assets and the cash flow with their own
assets or by the servicer or trustee investing the issuer's cash flow
in a speculative manner.\28\
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\25\ See, e.g., Proposing Release, supra note 15 at n.95 and
accompanying text.
\26\ See, e.g., SEC v. Patrick Quinlan, et al., 2008 Fed. Sec.
L. Rep. (CCH) ] 95,005 (E.D. Mich. Nov.7, 2008), aff'd, 373 Fed.
Appx. 581 (6th Cir., 2010) (the Commission brought an enforcement
action against the sponsor of a mortgage-backed issuer that placed
in the issuer a large number of mortgages that the sponsor itself
had originated whose loan-to-value ratios exceeded the maximum loan-
to-value ratios stated in the issuer's prospectus, significantly
increasing the riskiness of the investment).
\27\ See Protecting Investors Report, supra note 4 at text
following n.281.
\28\ See id. at text following n.289.
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B. Rule 3a-7
Although asset-backed issuers typically meet the definition of
investment company, as a practical matter, they cannot operate under
certain of the Investment Company Act's requirements and
restrictions.\29\
[[Page 55311]]
As a result, asset-backed issuers often rely on Rule 3a-7 under the
Investment Company Act to be excluded from regulation under the
Act.\30\ The Commission adopted Rule 3a-7 in 1992 specifically to
exclude from the definition of investment company certain asset-backed
issuers that meet the rule's conditions.\31\ These conditions were
intended to reflect the structural and operational distinctions between
registered investment companies and asset-backed issuers,\32\ and
incorporated what we believed to be then-existing practices in the
asset-backed securities market that addressed investor protection under
the Investment Company Act and promoted capital formation.\33\ The
conditions also were intended to accommodate future developments in the
asset-backed securities market, consistent with investor
protection.\34\
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\29\ For example, Section 17(a) of the Investment Company Act
generally would prohibit the sponsor's sale of assets to the asset-
backed issuer. 15 U.S.C. 80a-17(a). In addition, certain asset-
backed issuers could not comply with Section 18 of the Act, which
generally limits the extent to which registered investment companies
may issue senior securities, including debt. 15 U.S.C. 80a-18. See
Proposing Release, supra note 15 at n.36; Protecting Investors
Report, supra note 4 at n.253 and accompanying text.
\30\ Certain asset-backed issuers alternatively may seek to rely
on the exclusion from the definition of investment company set forth
in Section 3(c)(5)(A), (B) or (C) of the Investment Company Act. 15
U.S.C. 80a-3(c)(5). See infra section III.C. The Commission today is
issuing a concept release concerning companies that rely on Section
3(c)(5)(C). Companies Engaged in the Business of Acquiring Mortgages
and Mortgage-Related Instruments, Investment Company Act Release No.
29778 (Aug. 31, 2011) (the ``Section 3(c)(5)(C) Concept Release'').
That release may be relevant to certain asset-backed issuers that
rely on that Section. See infra section III.C.
As yet another alternative, asset-backed issuers that privately
offer and sell their securities may seek to rely on Section 3(c)(1)
or Section 3(c)(7) of the Investment Company Act, commonly referred
to as the ``private investment company exclusions.'' 15 U.S.C. 80a-
3(c)(1); 15 U.S.C. 80a-3(c)(7). Section 3(c)(1) generally excludes
from the definition of investment company any issuer whose
outstanding securities (other than short-term paper) are
beneficially owned by not more than 100 investors and which is not
making and does not presently propose to make a public offering of
its securities. 15 U.S.C. 80a-3(c)(1). Section 3(c)(7) of the
Investment Company Act generally excludes from the definition of
investment company any issuer whose outstanding securities are owned
exclusively by persons who, at the time of acquisition of such
securities, are certain sophisticated investors, called ``qualified
purchasers,'' and which is not making and does not at that time
propose to make a public offering of its securities. 15 U.S.C. 80a-
3(c)(7). See Section 2(a)(51) of the Investment Company Act
(defining the term qualified purchaser). 15 U.S.C. 80a-2(a)(51).
Section 3(c)(7) may be a particularly useful exclusion for asset-
backed issuers that privately offer and sell their securities
because, unlike Section 3(c)(1), it does not limit the number of
investors that may hold the issuer's securities and many investors
in asset-backed securities are large institutional investors that
meet the definition of qualified purchaser under the Act. See, e.g.,
Kravitt, supra note 15 at 12.03[D].
\31\ Prior to the adoption of Rule 3a-7, the Commission had
issued approximately 125 orders under Section 6(c), the Investment
Company's Act general exemptive provision, which provided exemptive
relief to certain asset-backed issuers, primarily those holding
mortgage-related assets. 15 U.S.C. 80a-6(c). See, e.g., Mortgage
Bankers Financial Corp. I, et al., Investment Company Act Release
Nos. 16458 (June 28, 1988), 53 FR 25226 (notice of application) and
16497 (July 25, 1988), 41 SEC Docket 814 (order); Shearson Lehman
CMO, Inc., Investment Company Act Release Nos. 15796 (June 11,
1987), 52 FR 23246 (notice of application) and 15852 (July 2, 1987),
38 SEC Docket 1403 (order). The Commission has not issued any such
orders since Rule 3a-7 was adopted in 1992.
\32\ For example, an issuer relying on Rule 3a-7 may not issue
redeemable securities, because ``investors could confuse the
securities with those issued by open-end management investment
companies.'' Proposing Release, supra note 15, at n. 61 and
accompanying text.
\33\ Adopting Release, supra note 4 at text following n.8.
\34\ Id.
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III. Discussion
A. Revisiting Rule 3a-7
To rely on Rule 3a-7, an asset-backed issuer must issue fixed-
income securities or other securities which entitle the holders to
receive payments that depend primarily on the cash flow from eligible
assets.\35\ The rule provides that the issuer's fixed-income securities
generally must be rated by at least one NRSRO in one of the four
highest ratings categories.\36\ At the time the rule was adopted, the
Commission understood that NRSROs, in providing credit ratings for
fixed-income securities of asset-backed issuers, typically expected the
issuers to have certain structural safeguards.\37\ The Commission
viewed these safeguards as addressing investor protection under the
Investment Company Act.\38\
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\35\ Rule 3a-7(b)(1) defines eligible assets to be financial
assets, either fixed or revolving, that by their terms convert into
cash within a finite time period plus any rights or other assets
designed to assure the servicing or timely distribution of proceeds
to security holders.
\36\ Rule 3a-7(a)(2). When Rule 3a-7 was adopted, almost all
publicly offered fixed-income securities issued by asset-backed
issuers were rated by at least one rating agency, with most issuing
at least one class of fixed-income securities rated in one of the
top two categories. See Protecting Investors Report, supra note 4 at
nn. 187-188 and accompanying text. Rule 3a-7 contains an exception
from the rating requirement that permits non-investment grade or
unrated fixed-income securities to be sold to institutional
accredited investors and any security, without regard to type or
rating, to be sold to qualified institutional buyers or to persons
involved in the organization or operation of the issuer and their
affiliates, provided that the issuer and its underwriters use
reasonable care to ensure that all excepted sales and resales are to
such persons. See Rule 3a-7(a)(2). The exception reflected then-
existing industry practice that subordinate tranches of fixed-income
asset-backed securities issuances, which typically were not highly
rated, if rated at all, and residual interests in the issuer, were
placed with certain sophisticated investors. Proposing Release,
supra note 15 at n.77 and accompanying text.
\37\ Adopting Release, supra note 4, at text following n. 42. As
noted above, the recent financial crisis has exposed various
problems with the ratings process and the NRSROs' procedures and
methodologies. See supra note 14.
\38\ Adopting Release, supra note 4. The Commission also
explained that the rating requirement also served as a means of
distinguishing asset-backed issuers from registered investment
companies. The Commission, however, emphasized that, ``although
ratings generally reflect evaluations of credit risk, the rating
requirement [was] not intended to address investment risks
associated with the credit quality of a financing.'' Adopting
Release, supra note 4 at text following n.41.
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For example, in providing a credit rating for certain asset-backed
securities, the NRSROs, among other things, were understood to
typically: Review the specific assets to be transferred to the issuer
or the method by which the assets were selected; expect an independent
auditor to confirm that the asset pool was representative of the
sponsor's portfolio; and evaluate limitations placed on the
substitution of the issuer's assets and the reinvestment of the cash
flow derived from the assets.\39\ Such expected review by an NRSRO had
the perceived benefit of mitigating opportunities for self-dealing and
overreaching by the sponsor or other insiders of the asset-backed
issuer.\40\ In addition, the NRSROs were understood to analyze the
potential performance of the issuer's assets, the risks related to the
issuer's cash flow and the cash flow allocation with respect to the
payment of the fixed-income securities. Such analysis was viewed as
addressing potential concerns relating to misvaluation of the issuer's
assets and inadequate asset coverage.\41\ The NRSROs also were
understood to review whether the asset-backed issuer's assets would be
available in the event of the sponsor's insolvency, and evaluate the
processes and controls regarding the custody of the issuer's assets and
cash flow. Such review was viewed as addressing concerns relating to
the safekeeping of the issuer's assets.\42\
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\39\ Protecting Investors Report, supra note 4 at nn. 208-211
and accompanying text, n. 218 and accompanying text, and text
following n.292 and prior to n.293.
\40\ Id. at text following n.292.
\41\ Id. at nn.212, 220-221 and 293 and accompanying text.
\42\ Id. at nn.294-295 and accompanying text.
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Rule 3a-7 also imposes limitations on the acquisition and
disposition of the eligible assets that were intended to help ensure
that any changes in the issuer's assets would not adversely affect the
outstanding fixed-income securities holders and guard against self-
dealing and overreaching by the issuer's sponsor or servicer.\43\ The
restrictions also were intended to prevent activities that resemble the
[[Page 55312]]
portfolio management practices employed by registered management
investment companies.\44\ Under the rule, an issuer generally may
acquire additional eligible assets or dispose of such assets only if
that action complies with the terms and conditions set forth in the
issuer's organizational documents.\45\ In addition, any acquisition or
disposition of eligible assets may not result in a downgrading of the
rating of the issuer's fixed-income securities.\46\ The rule also does
not permit the acquisition or disposition of eligible assets for the
primary purpose of recognizing gains or losses resulting from market
changes.\47\
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\43\ See Adopting Release, supra note 4 at n. 66 and
accompanying text.
\44\ Id. at n.62 and accompanying text. See also infra section
III.A.3. For example, Rule 3a-7 does not permit the acquisition or
disposition of eligible assets for the primary purpose of
recognizing gains or losses resulting from market changes. Rule 3a-
7(a)(3)(iii).
\45\ Rule 3a-7(a)(3)(i).
\46\ Rule 3a-7(a)(3)(ii). The Commission explained that tying
the management of the issuer's eligible assets to the rating of the
fixed-income securities addressed the danger of self-dealing,
because any addition or removal of assets that adversely affected
the fixed-income securities holders was understood to result in a
downgrading of the issuer's outstanding fixed-income securities. See
Adopting Release, supra note 4 at n.66 and accompanying text.
\47\ Rule 3a-7(a)(3)(iii).
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Finally, the rule includes conditions addressing the safekeeping of
the issuer's eligible assets and the cash flow derived from such
assets. Among other things, the issuer generally must take reasonable
steps to cause an independent trustee \48\ to have a perfected security
interest or ownership interest valid against any third parties in the
eligible assets that principally generate the cash flow needed for
payment on the fixed-income securities.\49\ In addition, the cash flow
derived from the eligible assets that is received by the servicer must
be deposited periodically in a segregated account that is maintained or
controlled by the independent trustee, ``consistent with the rating of
the outstanding fixed-income securities.'' \50\ This reference to the
rating reflected what the Commission understood to be the practice of
NRSROs, in issuing the rating, to review the capability of the issuer's
servicer to perform its duties, including the risk of loss from the
servicer holding the cash flow derived from the eligible assets.\51\
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\48\ Rule 3a-7(a)(4)(i) generally requires that the trustee be a
bank that meets the requirements of Section 26(a)(1) of the
Investment Company Act and that is not affiliated, as that term is
defined in Rule 405 under the Securities Act, with the issuer or
with any person involved in the organization or operation of the
issuer, that does not offer or provide credit or credit enhancement
to the issuer, and that executes an agreement or instrument
concerning the issuer's securities containing provisions to the
effect set forth in Section 26(a)(3) of the Investment Company Act,
limiting when the trustee may resign. 15 U.S.C. 80a-26(a)(3).
\49\ Rule 3a-7(a)(4)(ii).
\50\ Rule 3a-7(a)(4)(iii).
\51\ See Proposing Release, supra note 15 at n.31. See also
Adopting Release, supra note 4 at text following n.82; Kravitt,
supra note 15 at 7.03[E].
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1. Rating Requirements
As discussed above, Rule 3a-7 contains references to ratings in
three of the rule's conditions. Specifically, an asset-backed issuer
relying on Rule 3a-7 generally must have its fixed-income securities
rated by at least one NRSRO in one of the four highest ratings
categories.\52\ In addition, any acquisition or disposition of eligible
assets may not result in a downgrading of the rating of the issuer's
fixed-income securities.\53\ Finally, the cash flow derived from the
eligible assets that is received by the servicer must be deposited
periodically in a segregated account that is maintained or controlled
by an independent trustee, ``consistent with the rating of the
outstanding fixed-income securities.'' \54\ In each case, the reference
to ratings was intended to be a type of proxy for the relevant investor
protections afforded by the Investment Company Act.\55\ The condition
that the fixed-income securities be rated also was viewed as a means of
distinguishing asset-backed issuers from most registered investment
companies.\56\
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\52\ Rule 3a-7(a)(2).
\53\ Rule 3a-7(a)(3)(ii).
\54\ Rule 3a-7(a)(4)(iii).
\55\ See supra note 38 and accompanying text.
\56\ Id.
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The Commission is considering eliminating the references to ratings
in Rule 3a-7. We question whether such references have served, as
intended, as a proxy to address Investment Company Act-related
concerns, and whether it continues to be appropriate for Rule 3a-7 to
make use of ratings in this manner. Accordingly, we ask for comment on
the type of analysis that rating agencies currently conduct in
providing credit ratings for the fixed-income securities of asset-
backed issuers, and the types of structural safeguards that rating
agencies expect asset-backed issuers to have, that also address
Investment Company Act-related concerns.\57\ Please provide a full
explanation of whether, and if so how, the actions and expectations of
the rating agencies today mitigate the potential for the types of
abuses otherwise addressed by the Investment Company Act.
---------------------------------------------------------------------------
\57\ See supra section III.A.1 (describing the types of review
we believed was conducted by the rating agencies when the rule was
adopted).
---------------------------------------------------------------------------
Do ratings today serve as a proxy for addressing
Investment Company Act-related concerns? If so, are there mechanisms in
place that help ensure that NRSROs conduct the type of analysis and
review of asset-backed issuers' structures and operations that serve to
address Investment Company Act-related concerns?
Did the revelations concerning the NRSROs' processes,
policies and methodologies arising out of the recent financial crisis
also suggest that ratings failed to serve as a proxy for addressing
Investment Company Act-related concerns?
Even if the actions and expectations of the rating
agencies with respect to asset-backed issuers today mitigate the
potential for Investment Company Act-related concerns, does it continue
to be appropriate to rely on ratings as a proxy for addressing
Investment Company Act-related concerns in Rule 3a-7?
Should some or all of the references to ratings be removed
from the rule? Should the references to ratings be replaced with other
conditions? What would be the economic impact of removing the
references to ratings in Rule 3a-7 and of any suggested new conditions?
Should Rule 3a-7 continue to require that the fixed-income
securities be rated regardless of whether any other conditions are
added to the rule? To the extent that the ratings requirements in the
rule are perceived to be or are useful as a measure of credit-
worthiness, what substitute standards should the Commission consider
adopting in accordance with Section 939A of the Dodd-Frank Act? \58\ We
ask commenters to fully explain their views.
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\58\ See supra note 7 and accompanying text (Section 939A of the
Dodd-Frank Act generally requires the Commission to review any
references to or requirements regarding credit ratings in its
regulations, remove these references or requirements and substitute
other appropriate standards of credit-worthiness in place of the
credit ratings).
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We note that, as discussed in greater detail below, various
provisions of the Dodd-Frank Act and Commission rules thereunder, as
well as the 2010 ABS Proposing Release and 2011 ABS Re-proposal, set
forth requirements relating to certain asset-backed issuers and certain
persons involved in the organization and operation of asset-backed
issuers, that may serve to address the same Investment Company Act-
related concerns as those that underlie the references to ratings in
Rule 3a-7.\59\ As detailed below, we ask for comment on whether any
such requirements should be included as conditions to the exclusion
from the
[[Page 55313]]
definition of investment company provided by Rule 3a-7.\60\
---------------------------------------------------------------------------
\59\ See infra section III.A.2.d.
\60\ Id.
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We also note that, although Rule 3a-7 generally states that fixed-
income securities of an asset-backed issuer must be rated by at least
one NRSRO in one of the four highest rating categories, the text of the
rule does not require fixed-income securities of a Rule 3a-7 issuer to
be rated, provided that the securities are sold and resold only to
certain sophisticated investors.\61\ We request comment on whether and,
if so, to what extent, any issuer has relied on Rule 3a-7 to offer
fixed-income securities to the sophisticated investors specified in the
rule without any tranche of the issuer's fixed-income securities being
rated in the categories specified in the rule. If so, please explain
whether these securities were offered publicly or privately.
---------------------------------------------------------------------------
\61\ See supra note 36.
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2. Possible New Conditions for Rule 3a-7
We ask for comment on the conditions that should be added to Rule
3a-7 to directly address investor protection under the Investment
Company Act.\62\ These investor protection issues generally can be
characterized as falling into the following areas: (i) Concerns about
self-dealing by insiders, misvaluation of assets and inadequate asset
coverage as they relate to the structure and operation of the asset-
backed issuer; (ii) the benefits of an independent review of the asset-
backed issuer's structure and intended operations in addressing these
concerns; and (iii) preservation and safekeeping of the asset-backed
issuer's eligible assets and cash flow.
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\62\ We note that this approach was suggested by a commenter
that had responded to the Commission's request for comment in the
2008 NRSRO Proposing Release. See comment letter from Shearman &
Sterling LLP (on behalf of its client Merrill Lynch Depositor Inc.)
to Florence E. Harmon, Acting Secretary (Sept. 24, 2008), File Nos.
S7-18-08 and S7-19-08 (``if the Commission feels it necessary that
Rule 3a-7 be amended, our client feels that the Commission's
proposal that the rating requirement be replaced with alternative
specific requirements regarding abuses that the Investment Company
Act is designed to address, such as self-dealing and overreaching by
issuers, misvaluation of assets, and inadequate asset coverage, is
worth further consideration by the Commission * * *'').
---------------------------------------------------------------------------
Each of these investor protection issues is discussed in greater
detail below. Although the Commission has identified these particular
issues, the Commission requests and encourages commenters to provide
both thoughts about the types of investor protection concerns under the
Investment Company Act presented by asset-backed issuers and
suggestions as to the types of conditions that should be included in
Rule 3a-7 to address these concerns. We also ask for comment on the
changes in the asset-backed securities market since 1992, whether such
changes present other issues or concerns under the Investment Company
Act that we have not described, and how Rule 3a-7 should address them.
We ask that commenters fully explain their recommendations, including
how any suggested conditions would directly address investor protection
under the Investment Company Act, and well as how such suggestions
might affect capital formation. We also ask commenters to provide
suggested rule text.
a. Structure and Operation of the Issuer
In many respects, the Investment Company Act is generally intended
to address the structural and operational integrity of an issuer in
relation to the securities being issued.\63\ In the context of an
asset-backed issuer that may use the exclusion provided by Rule 3a-7,
the concern is with the possibility of abusive practices, such as self-
dealing and overreaching by insiders, misvaluation of assets, and
inadequate asset coverage.\64\ For example, the asset-backed issuer's
sponsor, among other things, might potentially engage in intentional
misvaluation of assets or in a form of ``dumping'' by transferring
assets insufficient to produce the cash flow needed to meet the
issuer's obligations to its securities holders, contrary to
representations made to investors. In addition, once the securities are
issued, any person involved in the operation of the issuer potentially
might engage in activities that could adversely affect payment of the
outstanding fixed-income securities. Such activities might include, for
example, substituting assets in the pool after the time of
securitization with lower quality assets, investing the issuer's cash
flow in a speculative manner, or other activities that present
potential conflicts of interest.
---------------------------------------------------------------------------
\63\ See e.g., supra notes 19-24 and accompanying text.
\64\ See Proposing Release, supra note 15, at nn. 69 and 70 and
accompanying text.
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There are various approaches that the Commission could take to
address these types of concerns in Rule 3a-7. The rule could impose
specific requirements or limitations on the structure and operations of
an asset-backed issuer relying on the rule in order to prevent these
potential types of abuses from occurring. For example, the rule could
specify the particular manner in which the issuer's assets should be
selected and valued to avoid potential ``dumping'' of assets and
misvaluation. The rule also could specify the particular manner in
which the issuer's depositor and sponsor may structure the issuer to
help guard against self-dealing and overreaching by these insiders. The
rule further could prohibit any person involved in the operation of the
issuer from engaging in specific activities that may adversely affect
payment of the fixed-income securities consistent with their terms.
Alternatively, the rule could take a principles-based approach that
would be less prescriptive. For example, among other things, the rule
could require that the parameters of the issuer's organization and
operations be set forth in its organizational documents, with the goal
of mitigating potential opportunities for self-dealing and overreaching
on the part of the issuer and any person involved in the organization
or operation of the issuer. To this end, the rule could require that
the issuer's organizational documents set forth: (i) The specific roles
and responsibilities of any person involved in the organization or
operation of the issuer; (ii) the specific terms and conditions
pursuant to which the issuer may acquire or dispose of eligible assets;
and (iii) policies and procedures that are reasonably designed to
prevent insiders from engaging in activities that may adversely affect
payment of the fixed-income securities after the securities are sold.
We understand that the current industry practice of publicly-offered
asset-backed issuers is to set forth the parameters of the issuer's
organization and operations in the issuer's organizational
documents,\65\ with varying degrees of specificity.\66\
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\65\ An issuer's organizational documents must be filed as
exhibits to the registration statement. See Item 60 of Regulation S-
K [17 CFR 229.60].
\66\ We note, for example, that Regulation AB generally requires
asset-backed issuers to describe much of this information in their
registration statements, although perhaps not with the same degree
of specificity that could be required under this approach. See,
e.g., Item 1104(d) (requiring a description of the sponsor's
material roles and responsibilities in its securitization program);
Item 1107(b) (requiring a description of the permissible activities
of the issuer); Item 1108(a)(1) (requiring a description of the
roles, responsibilities and oversight requirements of the servicers
involved in a transaction) [17 CFR 229.1104(d), 1107(b),
1108(a)(1)]. In addition, as discussed previously, under current
Rule 3a-7, an issuer generally may acquire additional eligible
assets or dispose of such assets only if that action complies with
the terms and conditions set forth in the issuer's organizational
documents . See supra note 45 and accompanying text.
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The Commission requests comment on the types of conditions that may
be appropriate for Rule 3a-7 to provide structural and operational
safeguards for
[[Page 55314]]
asset-backed issuers that seek to rely on the rule.
Is one of the possible approaches discussed above more
consistent with investor protection than, or otherwise preferable to,
the other? If so, which one and why? What would be the impact of such
an approach on capital formation?
What would be the potential economic impact of the
approaches discussed above?
If the rule were to impose specific requirements or
limitations on the structure and operations of an asset-backed issuer
relying on the rule, what should those requirements or limitations be,
and what would be the likely benefits and costs of such requirements or
limitations?
Should the rule require an issuer's organizational
documents to set forth the types of information suggested above? How
would such a requirement change current practice?
Rule 3a-7(a)(3)(i) currently provides that an issuer
generally may acquire additional eligible assets or dispose of eligible
assets only in accordance with the specific terms and conditions of the
issuer's organizational documents. Should that condition be expanded to
cover the initial transfer of eligible assets to the issuer at the time
of securitization, in order to mitigate opportunities for dumping and
other potential abuses by insiders that exist both at the time of the
initial transfer of the assets to the issuer and over the course of the
operation of the issuer? If the condition were so expanded, would it
help mitigate such potential abuses?
Are there other approaches that the Commission should
consider that would adequately address Investment Company Act-related
concerns such as self-dealing and overreaching, misvaluation, and
inadequate asset coverage? \67\ If so, what types of approaches, why
and with what economic impact? We ask commenters to fully explain their
views and, if appropriate, provide rule text and supporting data.
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\67\ One approach to addressing these concerns might be to
include a condition in Rule 3a-7 that provides for an independent
third party review of the issuer's structure and intended
operations. We discuss such a condition in the next section. See
infra section III.A.2.b.
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Are there other Investment Company Act-related concerns
that Rule 3a-7 should address besides self-dealing, misvaluation and
inadequate asset coverage? If so, what are those concerns and how
should the rule address them? For example, one of the Investment
Company Act-related concerns is the pyramiding of investment
companies.\68\ Should Rule 3a-7 address this concern? \69\ If so, why
and how should the rule address it? Should the rule restrict the
ability of an issuer relying on the rule to invest in other asset-
backed issuers? If so, what restrictions should the rule impose?
---------------------------------------------------------------------------
\68\ See Section 1(b)(4) of the Investment Company Act. Cf. Fund
of Funds Investments, Investment Company Act Release No. 26198 (Oct.
1, 2003) (``The complex structures that resulted from pyramiding
created additional problems for shareholders. These structures
permitted acquiring funds to circumvent investment restrictions and
limitations, and made it impossible for shareholders to understand
who really controlled the fund or the true value of their
investments.'').
\69\ We note, for example, that the Financial Crisis Inquiry
Commission found that investments by issuers of collateralized debt
obligations (``CDOs) in other CDOs magnified total leverage and
increased exposure to loss. Financial Crisis Inquiry Commission, The
Financial Crisis Inquiry Report (Jan. 2011) at 132-134, 155. See
also The Report of the Counterparty Risk Management Policy Group
III, Containing Systemic Risk: The Road to Reform (Aug. 6, 2008) at
55 (discussing CDOs that invested in other CDOs).
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b. Independent Review
The concept of independent oversight or independent review is
fundamental to the regulatory framework of the Investment Company
Act.\70\ Registered investment companies typically rely for their
structure and operations on third parties that have their own financial
interests separate and distinct from those of the investment companies
and their shareholders, presenting potential conflicts of interest that
require independent oversight. The independent oversight in the case of
registered management investment companies is provided by the company's
board of directors, and in particular the independent board members, as
required by the Act.\71\
---------------------------------------------------------------------------
\70\ See generally Section 1(b) of the Investment Company Act.
\71\ See Section 10 of the Investment Company Act governing the
composition of a registered investment company's board of directors.
---------------------------------------------------------------------------
Asset-backed issuers are similar to registered investment companies
in that they also typically rely for their structure and operations on
third parties that have their own financial interests separate and
distinct from those of the asset-backed issuers and their fixed-income
securities holders.\72\ We are considering whether to replace the
rating condition currently contained in Rule 3a-7, in part, with a
condition that would provide for an independent review of the asset-
backed issuer and its intended operations prior to the sale of the
fixed-income securities. Such a condition could require the asset-
backed issuer to obtain an opinion from an independent evaluator that
the independent evaluator reasonably believes, based on information
available at the time the fixed-income securities are first sold and
taking into account the characteristics of the securitized assets
underlying the offering, that the asset-backed issuer is structured and
would be operated in a manner such that the expected cash flow
generated from the underlying assets, would likely allow the asset-
backed issuer to have the cash flow at times and in amounts sufficient
to service expected payments on the fixed-income securities. Such an
opinion would not serve as a guarantee that the securitization will
produce such cash flow. Alternatively, the rule could require the
issuer itself to provide a similar certification in its offering
documents, but to do so only after considering the views of an
independent evaluator that has reviewed the structure and the intended
operations of the issuer. For purposes of such a condition, potentially
any independent person, including an NRSRO, that has the expertise and
experience in the structuring or evaluating of asset-backed issuers and
their securities, could serve as the independent evaluator.
---------------------------------------------------------------------------
\72\ See supra note 25 and accompanying text.
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We note that, in the 2011 ABS Re-proposal, we proposed replacing
the investment grade ratings criterion for shelf eligibility for asset-
backed securities offerings with a requirement that a certification be
provided by either the chief executive officer of the depositor or the
executive officer in charge of securitization of the depositor.\73\ As
we stated in the 2011 ABS Re-proposal, such a certification may cause
these officials to review more carefully the disclosure and the
transaction, and to participate more extensively in the oversight of
the transaction. In the 2011 ABS Re-proposal, we also requested comment
on whether an asset-backed issuer should have the flexibility to engage
an independent evaluator to perform the review necessary to give the
certification, and the type of opinion that the independent evaluator
would provide.\74\
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\73\ As proposed, such certification would state, among other
things, that based on the officer's knowledge, ``taking into account
the characteristics of the securitized assets underlying the
offering, the structure of the securitization, including internal
credit enhancements, and any other material features of the
transaction, in each instance, as described in the prospectus, the
securitization is designed to produce, but is not guaranteed by this
certification to produce, cash flows at times and in amounts
sufficient to service expected payments on the asset-backed
securities offered and sold pursuant to the registration
statement.'' See 2011ABS Re-proposal, supra note 13 at proposed Item
601(b)(36) of Regulation AB.
\74\ See 2011 ABS Re-proposal, supra note 13 at text following
n. 58.
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[[Page 55315]]
If Rule 3a-7 were to be amended to include a condition requiring
independent review, the amendment would be premised on the need to
address concerns arising under the Investment Company Act about self-
dealing and overreaching by insiders.\75\ Thus, the purpose of the
independent review under Rule 3a-7 would be different from that which
might be performed in connection with the certification requirement
proposed in the 2011 ABS Re-proposal. Nevertheless, the scope of the
review under any independent review provisions in the shelf eligibility
conditions and those in Rule 3a-7 could be consistent so that one
review could satisfy both purposes.\76\
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\75\ As discussed above, within the framework of the Investment
Company Act, these concerns are addressed through independent
review. See supra note 70 and accompanying text.
\76\ See also infra section III.A.2.d.
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We request comment on whether Rule 3a-7 should require an
independent review of the structure and intended operations of the
asset-backed issuer.
Would such a review serve to address Investment Company
Act-related concerns?
What should be the scope of the independent review under
Rule 3a-7? What should be the standard(s) for the conclusion(s) reached
by the independent evaluator for purposes of Rule 3a-7?
What should be the independence requirements for an entity
to serve as an independent evaluator for purposes of Rule 3a-7? We note
that the 2011 ABS Re-proposal requests comment on certain potential
independence requirements for an independent evaluator, such as
prohibitions on affiliation with the issuer or any person involved in
the organization or operation of the issuer, on ownership of the
issuer's securities or underlying assets, and on certain material
business relationships.\77\ Would similar requirements be appropriate
in the context of Rule 3a-7?
---------------------------------------------------------------------------
\77\ 2011 ABS Re-proposal, supra note 13 at nn.60-61 and
accompanying text.
---------------------------------------------------------------------------
The 2011 ABS Re-proposal also requests comment on whether
it would be appropriate to define an independent evaluator as a person
that has the expertise and experience in the structuring or evaluating
of asset-backed securities. Would this be an appropriate definition of
an independent evaluator for purposes of Rule 3a-7?
Should we impose any additional or different requirements
on an independent evaluator? For example, should consideration be given
to whether the independent evaluator is subject to Federal regulation
or how the independent evaluator is regulated?
What steps should the asset-backed issuer be required to
take to determine whether a prospective independent evaluator meets the
qualifications to serve as an independent evaluator under Rule 3a-7?
Should the asset-backed issuer be able to rely on a statement of the
prospective independent evaluator, for example, that the prospective
independent evaluator has the required expertise and experience? Should
the asset-backed issuer perform some level of due diligence?
What types of entities may likely serve as independent
evaluators under
Rule 3a-7? We are interested in particular in hearing from
commenters that may meet the possible independent evaluator
qualifications discussed above whether they might be interested in
serving as independent evaluators if such a condition were to be
included in Rule 3a-7, and if not, why not.
Should rating agencies be allowed to serve as independent
evaluators under Rule 3a-7? Why or why not?
If an independent evaluator condition were to be included
in Rule 3a-7, should the rule also require the asset-backed issuer to
include the independent evaluator's opinion as an exhibit to its
registration statement thereby requiring the independent evaluator to
consent to being named as an ``expert'' in the registration statement
and being subject to potential liability under Section 11 of the
Securities Act?
What would be the economic impact of including an
independent evaluator condition in Rule 3a-7 and what would be the
factors affecting the economic impact? Would the economic impact depend
on whether the independent evaluator is subject to expert liability? If
so, how? How may the risk of expert liability affect the willingness of
an entity to serve as an independent evaluator and the price it may
charge for its services?
Is the alternative that the asset-backed issuer itself
must provide a certification about its structure and intended
operations, but only after considering the views of an independent
evaluator, preferable? Why or why not?
If Rule 3a-7 were to include an independent evaluator
condition, would there be circumstances in which compliance with such
condition may not be necessary for investor protection? For example,
should such a condition not apply with respect to an asset-backed
issuer that offers and sells its securities solely to investors that
meet certain objective standards, such as being ``qualified
institutional buyers'' within the meaning of Rule 144A under the
Securities Act? If such a condition should not apply to certain asset-
backed issuers, should such issuers be required to disclose in their
offering documents that they are not complying with the independent
evaluator condition and explain why? Should such issuers be subject to
other, alternative conditions under Rule 3a-7 that would address
Investment Company Act-related concerns, including self-dealing and
overreaching by insiders?
Are there other considerations that should factor into the
Commission's determinations on the appropriateness and the details of
an independent review in the context of Rule 3a-7? We ask commenters to
fully explain their views and provide supporting data, if appropriate.
c. Preservation and Safekeeping of Eligible Assets and Cash Flow
Like registered investment companies, asset-backed issuers are
pools of financial assets that are subject to the risk of
misappropriation. In addition, unless the asset-backed issuer is
structured appropriately, its assets and cash flow might not be
insulated in the event of the sponsor's or depositor's bankruptcy or
insolvency. The issuer's assets and cash flow also might be endangered
if the servicer or trustee commingles them with its own assets. The
availability of the issuer's cash flow to the fixed-income securities
holders also could be endangered if the cash flow is invested in a
speculative manner.
Rule 3a-7 contains several conditions designed to address the
safekeeping of the issuer's eligible assets and the cash flow derived
from such assets. Under the rule, the issuer must take reasonable steps
to cause an independent trustee to have a perfected security interest
or ownership valid against third parties in the eligible assets.\78\
The rule also provides for the cash flow from such assets to be
deposited periodically in a segregated account maintained or controlled
by the independent trustee ``consistent with the rating of the
outstanding securities.'' \79\ In addition, the rule's condition that
the issuer's fixed-income securities generally receive a rating in one
of the four highest rating categories also touches on concerns relating
to the safekeeping of the issuer's assets and cash flow. For example,
we understand that asset-backed securities often could not achieve an
investment grade rating unless the issuer was structured in such
[[Page 55316]]
a manner that the assets and cash flow are insulated in the event of
the sponsor's or depositor's bankruptcy or insolvency.\80\
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\78\ Rule 3a-7(a)(4)(ii).
\79\ Rule 3a-7(a)(4)(iii).
\80\ See, e.g., Proposing Release, supra note 15 at n.33 and
accompanying text.
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We ask for comment on whether Rule 3a-7 should be amended to
strengthen the provisions relating to the preservation and safekeeping
of the asset-backed issuer's assets and cash flow. For example, the
current rule does not limit the practice of servicers commingling the
cash flow of asset-backed issuers with their own assets for periods of
time prior to transferring it to the trustee.\81\ We ask for comment on
whether such practice may be unnecessarily putting the cash flow at
risk. The current rule also does not address the treatment of the cash
flow when there is a timing mismatch between the receipt of collections
from the eligible assets and the distributions to the fixed-income
securities holders. Are there other aspects of the rule we should
consider amending in order to help preserve and protect the asset-
backed issuer's assets and cash flow? If so, please provide specific
suggestions for such amendments, including, where possible, suggested
rule text.
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\81\ Current Rule 3a-7(a)(4) differs significantly from the
condition that was initially proposed. The Commission proposed that
the cash flow derived from the eligible assets be transferred to the
trustee within a reasonable period from the time of receipt. See
Proposing Release, supra note 15 at nn.90-92 and accompanying text.
The Commission explained that the proposed provision was intended to
prohibit a servicer from commingling the cash flow with its own
assets, arguing that ``investor protection concerns outweigh any
benefit resulting from the commingling of a servicer's assets with
those of the issuer.'' Id. at text following n.92. Commenters argued
that transferring the cash flow ``within a reasonable period of
time'' was inconsistent with industry practice and that whether a
servicer commingled the cash flow with its own assets, and if so,
for how long, depended on the type of assets being securitized and
the capabilities of the servicer's computer systems to track the
cash flow. See Adopting Release, supra note 4 at n.77 and
accompanying text.
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We also note the irregularities that had recently surfaced that
have caused difficulties in determining the ownership of certain
mortgages that had been securitized.\82\ As discussed, under Rule 3a-7,
the issuer must take reasonable steps to cause an independent trustee
to have a perfected security interest or ownership valid against third
parties in the eligible assets.\83\ We ask for comment on whether and
how this requirement in Rule 3a-7 should be strengthened in light of
these events.
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\82\ See, e.g., November Oversight Report--Examining the
Consequences of Mortgage Irregularities for Financial Stability and
Foreclosure Mitigation, Congressional Oversight Panel 19 (Nov. 16,
2010) (``Various commentators have begun to ask whether the poor
recordkeeping and error-filled work exhibited in foreclosure
proceedings, described above, is likely to have marked earlier
stages of the process as well. If so, the effect could be that
rights were not properly transferred during the securitization
process such that title to the mortgage and the note might rest with
another party in the process other than the trust.'')
\83\ Rule 3a-7(a)(4)(ii).
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We invite commenters to provide us with information about current
practices with respect to the safekeeping of eligible assets under Rule
3a-7.
Does the current rule contain safeguards that adequately
protect the eligible assets?
Should stronger safeguards be adopted with respect to
these assets? If so, what should these safeguards be?
We also invite commenters to provide us with information about
current practices under Rule 3a-7 with respect to the management of the
cash flow that is derived from an asset-backed issuer's eligible
assets.
How long do servicers typically hold the cash flow prior
to transferring the cash flow to the trustee? What are the benefits, if
any, to servicers from holding the cash flow? What are the benefits and
risks to asset-backed issuers from servicers holding the cash flow?
We note that the rule does not specify that the servicer
must keep the cash flow in a segregated account prior to transferring
the cash flow to the trustee. Should such a condition be included in
the rule and what would be its economic impact if included? Is the
answer dependent on the time period that the servicer has, under the
asset-backed issuer's organizational documents or otherwise, in which
to transfer the cash flow to the trustee?
Should the rule be amended to prescribe a time period in
which the servicer must transfer the cash flow to the trustee and what
would be the economic impact of such a provision? If so, what should
that time period be? Commenters suggesting specific time periods should
address the costs and benefits associated with their suggestions.
Regulation AB requires that servicers provide an annual
assessment of compliance with servicing criteria enumerated in Item
1121(d) of Regulation AB, so that investors may identify those aspects
of standard servicing criteria that are in material compliance in order
to better evaluate servicing responsibilities and performance and
reliability of the information they receive.\84\ In particular,
servicers must assess compliance with the servicing criterion that
payments on pool assets are deposited into the appropriate custodial
bank accounts and related bank clearing accounts within no more than
two business days of receipt, or such other number of days as specified
in the transaction agreements.\85\ Consistent with this provision,
should the time period set forth in Rule 3a-7 be no more than two
business days of receipt? Why or why not? What would be the effect if
the time period were greater than or less than two business days?
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\84\ 17 CFR 229.1122(d).
\85\ See Item 1122(d)(2)(i) of Regulation AB [17 CFR
229.1122(d)(2)(i)].
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We are also interested in obtaining information about how the cash
flow is invested under Rule 3a-7 and who receives the returns from such
an investment.
Should the rule contain a condition that restricts the
manner in which the cash flow may be invested? If so, what should this
condition provide?
Should the rule limit who may receive the benefit of the
returns of such investment? Why or why not? What economic benefits and
costs would be associated with such a limitation?
As discussed previously, we understand that asset-backed securities
often could not achieve an investment grade rating unless the issuer
was structured in such a manner that the assets and cash flow are
insulated in the event of the bankruptcy or insolvency of the sponsor
or depositor.\86\
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\86\ See supra note 80.
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Does our understanding hold true?
Should the rule include a condition specifying that the
eligible assets and the cash flow generated from such assets be
available to pay the fixed-income securities consistent with their
terms, notwithstanding the bankruptcy or insolvency of the sponsor or
depositor? Should any such condition also extend to the
bankruptcy of the servicer? Does the answer depend on whether the
servicer needs to hold the eligible assets for servicing purposes and
is not required to transfer the cash flow to the independent trustee
immediately upon receipt? What would be the potential economic impact
of so extending the condition?
The Commission also requests comment on any other concerns relating
to the safekeeping of the issuer's assets and cash flow that we have
not contemplated under Rule 3a-7.
If there are such concerns, what are they and how should
the rule address them?
Does the asset-backed market generally impose safeguards
that are intended to ensure the safety of the issuer's eligible assets
and cash flow? Should the rule reflect these safeguards?
[[Page 55317]]
If so, what are the safeguards, how should they be reflected, and what
would be the economic impact of reflecting them in the rule?
d. Other Possible Investor Protections
The exclusion from the definition of investment company provided by
Rule 3a-7 is one of many regulations under the Federal securities laws
addressing asset-backed issuers. Asset-backed issuers also are subject
to various regulations under the Securities Act and the Exchange Act.
We recognize that there may be existing or proposed provisions under
these other Federal securities laws applicable to asset-backed issuers
which, although intended for different purposes, also may help mitigate
potential Investment Company Act-related concerns. Such provisions
could be considered for inclusion in Rule 3a-7 in lieu of the rating
condition.\87\
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\87\ We note that not all asset-backed issuers that rely on Rule
3a-7 are subject to the same provisions under the Federal securities
laws. For example, asset-backed issuers that rely on Rule 3a-7 may
include those issuers that offer and sell their securities under an
exemption from registration under the Securities Act or that are not
subject to the Exchange Act reporting requirements. Therefore, if we
determine that certain existing or proposed provisions under the
Federal securities laws help mitigate potential Investment Company
Act-related concerns, such provisions may need to be included as
conditions in Rule 3a-7 to ensure that all asset-backed issuers
relying on the rule are subject to the same conditions, regardless
of their status under the other Federal securities laws.
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i. Other Commission Rules
For example, Rule 193 under the Securities Act generally requires
an asset-backed issuer to perform a review of the assets underlying any
asset-backed securities that will be registered under the Securities
Act that, at a minimum, provides reasonable assurance that the
disclosure in the issuer's prospectus regarding the assets is accurate
in all material respects.\88\ Section 945 of the Dodd-Frank Act
directed the Commission to enact Rule 193 so that due diligence was
``re-introduced'' into the offering process.\89\ This provision, if
included in Rule 3a-7, might help mitigate some of the concerns
underlying the Investment Company Act, such as the ``dumping'' of
assets and the potential opportunities for overreaching and self-
dealing.
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\88\ 17 CFR 230.193.
\89\ See Section 943 Release, supra note 9.
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Similarly, as part of the 2011 ABS Re-proposal, we proposed to
include, as part of the shelf eligibility requirements for asset-backed
issuers, a requirement that the issuer's underlying transaction
agreements provide for a ``credit risk manager'' to review the
underlying assets in specified circumstances.\90\ That proposal
addresses concerns about enforceability of representations and
warranties regarding the assets, but such a requirement also might
serve to mitigate potential Investment Company Act abuses relating to
misvaluation of assets and inadequate asset coverage for asset-backed
securities and therefore could be considered for inclusion in Rule 3a-
7.
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\90\ See 2011 ABS Re-proposal, supra note 13 at section
II.B.1.b.
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As another example, we note that the Dodd-Frank Act added Section
27B to the Securities Act generally to prohibit an underwriter,
placement agent, initial purchaser, sponsor, or any affiliate or
subsidiary of any such entity, of an asset-backed security, as defined
in the Exchange Act, from engaging in any transaction that would
involve or result in any material conflict of interest with respect to
any investor in a transaction arising out of such activity for a period
of one year after the date of the first closing of the sale of the
asset-backed security.\91\ This provision ``prohibits firms from
packaging and selling asset-backed securities to their clients and then
engaging in transactions that create conflicts of interest between them
and their clients.'' \92\ To the extent that this provision also may
help guard against certain of the Investment Company Act-related
concerns, such as the potential for self-dealing and overreaching by
insiders, it could be considered for incorporation into Rule 3a-7.
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\91\ Section 621 of Dodd-Frank Act. The Dodd-Frank Act also
directed the Commission to issue rules for the purpose of
implementing this provision, and the prohibition described above
takes effect only upon the effective date of such rules. Id.
\92\ Letter from Senators Jeffrey Merkley and Carl Levin to
Commission Chairman Mary Schapiro, et al. (Aug. 3, 2010) (``Merkley-
Levin Letter'') at p. 1, available at http://www.sec.gov/comments/df-title-vi/conflicts-of-interest/conflictsofinterest-2.pdf.
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Yet another example of requirements under the Federal securities
laws concerning certain asset-backed issuers that may be considered for
inclusion in Rule 3a-7 are the risk retention requirements for sponsors
of asset-backed issuers, such as the requirements recently proposed by
the Commission in a joint rulemaking with other Federal regulators.\93\
These requirements may be appropriate as conditions for issuers that
wish to rely on Rule 3a-7, if they serve to mitigate the Investment
Company Act-related concerns about self-dealing by insiders,
misvaluation of assets, and the safekeeping of assets and cash flow.
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\93\ Credit Risk Retention, Securities Exchange Act Release No.
64148 (Mar. 30, 2011) [76 FR 24090 (Apr. 29, 2011)].
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We ask for comment on whether these or any other existing or
proposed provisions under other Federal securities laws applicable to
asset-backed issuers also may help mitigate potential Investment
Company Act-related concerns and could serve, in whole or in part, as
substitutes for the references to ratings in Rule 3a-7. Commenters
should be specific in identifying the relevant provision and the
Investment Company Act-related concern, and explaining how the
provision may help mitigate the Investment Company Act-related concern.
ii. Eligibility to Use Rule 3a-7
Currently, any issuer generally may rely on Rule 3a-7 provided that
it is in the business of purchasing or otherwise acquiring and holding
``eligible assets,'' issues securities which entitle their holders to
receive payments that depend primarily on the cash flow from the
eligible assets, and meets the other conditions of the rule. When the
Commission adopted Rule 3a-7, the Commission stated that the definition
of ``eligible assets'' in Rule 3a-7--in part, ``financial assets,
either fixed or revolving, that by their terms convert into cash within
a finite time period''--was based on the definition of ``asset-backed
security'' under the Securities Act.\94\ We understand that asset-
backed commercial paper programs that issue securities in reliance on
an exemption from registration under the Securities Act, and other
asset-backed issuers that offer and sell their securities in reliance
[[Page 55318]]
on an exemption from registration under the Securities Act, often rely
on Rule 3a-7 to be excluded from regulation under the Investment
Company Act. Conversely, an asset-backed issuer that cannot meet the
conditions of Rule 3a-7 (and is unable to qualify for any other
exclusion from regulation under the Investment Company Act, such as
Section 3(c)(5), or register under the Act) generally may not register
the issuance of its securities even if the issuer and its securities
meet the other offering requirements under the Securities Act.
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\94\ See Adopting Release, supra note 4 at n.12 and accompanying
text. Regulation AB generally defines ``asset-backed security'' as
``a security that is primarily serviced by the cash flows of a
discrete pool of receivables or other financial assets, either fixed
or revolving, that by their terms convert into cash within a finite
time period, plus any rights or other assets designed to assure the
servicing or timely distributions of proceeds to the security
holders; provided that in the case of financial assets that are
leases, those assets may convert to cash partially by the cash
proceeds from the disposition of the physical property underlying
such leases.'' See Item 1101(c)(1) of Regulation AB. Regulation AB
considers certain types of master-trusts and issuers with prefunding
periods and revolving accounts to be discrete pools of assets. See
Item 1101(c)(3) of Regulation AB. In the 2010 April ABS Proposal,
the Commission proposed to restrict the use of Regulation AB by
master trust issuers backed by non-revolving assets, limit the
number of years for revolving periods of non-revolving accounts from
three years to one year, and decrease the limit on the amount of
prefunding permitted by the prefunding exception from 50% to 10%.
See 2010 ABS Proposing Release, supra note 10 at section IV. The
definition of ``asset-backed security'' in Regulation AB also
contains limits on the amounts of delinquent and non-performing
assets in the asset pool. See Item 1101(c)(2). The shelf eligibility
requirements on Form S-3 further limits the amount of delinquent
assets and certain leases that may be held in the asset pool. See
Form S-3.
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We request comment on whether the requirements of
Regulation AB or the shelf eligibility requirements may serve, in whole
or in part, to address the Investment Company Act concerns underlying
Rule 3a-7 and therefore be a basis for meeting some or all of the
rule's conditions, including the rating condition and any conditions
that may replace it. Should the conditions of Rule 3a-7 distinguish
between issuers that meet the shelf eligibility requirements and those
that do not? If so, why and how should the conditions differ? We ask
commenters to be specific in their responses and to provide data and
statistics, if possible.
Would certain asset-backed issuers that currently are able
to publicly offer their securities no longer be able to do so if Rule
3a-7 were limited to issuers that meet the shelf eligibility
requirements? If so, please explain. With respect to such issuers,
commenters also should address any alternative exclusion(s) from
regulation under the Investment Company Act that may be available, and
the advantages and disadvantages of the issuers' using these exclusions
if Rule 3a-7 were not available to them. We ask commenters to provide
data in support of their responses, if possible.
Is our understanding correct that some asset-backed
issuers that privately offer their securities rely on Rule 3a-7? If so,
would certain of these issuers no longer be able to rely on Rule 3a-7
if the rule was limited in this manner? If not, why not? We also ask
commenters to provide similar information and data about asset-backed
issuers that rely on the private investment company exclusions from
regulation under the Investment Company Act, and any alternative
exclusion(s) from regulation under the Investment Company Act that may
be available, and the advantages and disadvantages of the issuers'
using these exclusions if Rule 3a-7 were not available to them. The
Commission also requests that commenters provide any available data
about the sizes and types of asset-backed issuers that privately offer
their securities that rely on Rule 3a-7.
What would be the effect on the asset-backed securities
market in general, on capital formation, and on investors if the
availability of Rule 3a-7 were limited to issuers of asset-backed
securities as defined in Regulation AB or included the further
limitations found in the shelf eligibility requirements?
Are there alternative approaches that the Commission
should consider to an issuer's eligibility to use Rule 3a-7 that would
address Investment Company Act-related concerns? Commenters that offer
alternative approaches should be as specific as possible in explaining
their approach and the effect such an approach would have on asset-
backed issuers, on the asset-backed securities market in general, on
capital formation, and on investors.
3. Standard for Acquisition and Disposition of Eligible Assets
With respect to the type and amount of activity related to the
acquisition and disposition of an issuer's eligible assets that may
take place under Rule 3a-7, the Commission has stated that Rule 3a-7
was intended to permit only those activities ``that do not in any sense
parallel typical `management' of registered investment company
portfolios.'' \95\ Thus, according to the Adopting Release, permitted
activities under the rule include selling or substituting eligible
assets when documentation is defective or for nonconformity with
representations or warranties, disposing of assets in default or in
imminent default, and removing excess credit support.\96\ We request
comment on the management activities of asset-backed issuers under Rule
3a-7.
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\95\ See supra note 44 and accompanying text.
\96\ See Adopting Release, supra note 4 at n.68 and accompanying
text.
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What changes, if any, should be made to the rule's
conditions addressing the acquisition and disposition of eligible
assets? What would be the economic impact of any such changes?
Does the current rule adequately preclude activities
``that do not in any sense parallel typical `management' of registered
investment company portfolios''? If not, should additional conditions
be added to the rule that would limit the acquisition and disposition
of the issuer's eligible assets, and if so, what types of conditions?
What would be the economic impact of such conditions?
B. The Effect of the Exclusion Provided by Rule 3a-7
Current Rule 3a-7 excludes from the definition of investment
company any issuer that meets the rule's conditions. The rule does not
address how a holder of securities of a Rule 3a-7 issuer should treat
those securities for purposes of determining the holder's own status
under the Investment Company Act. In light of certain developments in
the asset-backed securities markets in recent years, detailed below, we
request comment whether we should consider limiting or clarifying the
manner in which the exclusion provided by Rule 3a-7 may be used by
certain holders of securities issued by Rule 3a-7 issuers.
1. Holders of an Asset-Backed Issuer's Securities
As a general matter, the status of an issuer under the Investment
Company Act matters not only to the issuer itself, but also to the
holders of the issuer's securities. A holder's own status under the
Investment Company Act may depend on the investment company status of
the issuers of securities that it owns.\97\ When the Commission adopted
Rule 3a-7, the Commission focused on providing an exclusion from
regulation under the Act for the asset-backed issuer, and not on the
manner in which such an exclusion may affect a holder of the asset-
backed issuer's securities.
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\97\ For example, the holder may be an investment company under
Section 3(a)(1)(C) of the Investment Company if it owns or proposes
to acquire investment securities, which generally include, among
others, securities issued by an investment company, having a value
exceeding 40% of the value of the holder's total assets (exclusive
of Government securities and cash items) on an unconsolidated basis.
See supra note 30.
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We are interested in better understanding the manner in which the
exclusion provided by Rule 3a-7 affects the status under the Investment
Company Act of various types of holders of securities issued by Rule
3a-7 issuers. For example, in the last decade, many asset-backed
issuers that relied on Rule 3a-7 were established by companies that
sought to capture, by holding the equity or residual interest in these
issuers, the spread between the yield of the assets being securitized
and the financing cost of the fixed-income securities being issued.\98\
The potential
[[Page 55319]]
for returns on such investments led to companies being established
whose business focused on purchasing equity and residual interests in
collateralized loan obligations (``CLOs'') and CDOs of issuers that
relied on Rule 3a-7.\99\ The activities of some of these companies
suggest that they are in the business of investing in securities.\100\
However, because current Rule 3a-7 excludes issuers relying on the rule
from the definition of investment company, such companies that invest
in Rule 3a-7 issuers may not meet the definition of investment company
in the Investment Company Act.
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\98\ More generally, in 2007, for example, only approximately
11.5% of CDOs issued globally were issued to remove assets from the
balance sheet of the originator. The rest of the CDO market
consisted of arbitrage CDOs, which are CDOs that attempt to capture
the difference between the yield of its assets and the financing
costs of the CDO tranches. See, e.g., Securities Industry and
Financial Markets Association: Research at http://archives1.sifma.org/story.asp?id=2375 (``SIFMA'').
\99\ See, e.g., Jody Shenn, Bear Stearns Funds Own 67 Percent
Stake in Everquest (Update3), Bloomberg, May 11, 2007, http://www.bloomberg.com/apps/news?pid=newsarchive&sid= (describing various
investment vehicles formed to invest in residual interests of CDOs).
\100\ In contrast, when Rule 3a-7 was adopted, most private
sector sponsors of asset-backed issuers typically securitized
financial assets that they themselves had originated to facilitate
the financing and operation of their non-investment company
businesses. For example, some sponsors securitized their financial
assets in order to manage more effectively their loan portfolios
and, in turn, their balance sheets. In addition, securitization
allowed sponsors to gain access to alternative, usually cheaper,
funding sources. Commercial banks and savings and loan associations
also securitized financial assets to facilitate compliance with
regulatory capital requirements. As the Commission noted when
adopting Rule 3a-7, the purpose and operation of asset-backed
issuers therefore were fundamentally different from investment
companies. See Proposing Release, supra note 15 at n.18 and
accompanying text; Protecting Investors Report, supra note 4 at
nn.49-62 and accompanying text.
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Specifically, under the Investment Company Act, any company that
holds 50% or more of the outstanding voting securities of an issuer may
treat such issuer as its majority-owned subsidiary.\101\ Securities of
majority-owned subsidiaries that are not investment companies, in turn,
are not ``investment securities'' \102\ for purposes of determining
whether the parent meets the definition of investment company in
Section 3(a)(1)(C) of the Act. Since a Rule 3a-7 issuer is not an
investment company by virtue of the exclusion provided by the
rule,\103\ any company that holds 50% or more of the outstanding voting
securities of a Rule 3a-7 issuer may treat the Rule 3a-7 issuer as its
majority-owned subsidiary and is not required to treat any of the
securities issued by the Rule 3a-7 issuer as ``investment securities''
for purposes of determining the company's own status under Section
3(a)(1)(C) of the Investment Company Act. Such a company therefore may
have virtually all of its assets invested in securities of Rule 3a-7
majority-owned subsidiaries and not meet the definition of investment
company under Section 3(a)(1)(C).\104\
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\101\ Section 2(a)(24) of the Investment Company Act states that
a ``majority-owned subsidiary'' of a person ``means a company 50 per
centum or more of the outstanding voting securities of which are
owned by such person, or by a company which, within the meaning of
this paragraph, is a majority-owned subsidiary of such person.''
Section 2(a)(42) of the Act defines ``voting security,'' in relevant
part, to mean ``any security presently entitling the owner or holder
thereof to vote for the election of directors of a company.''
\102\ See supra note 18.
\103\ See Rule 3a-7(a) (``Notwithstanding section 3(a) of the
Act, any issuer who is engaged in the business of purchasing, or
otherwise acquiring, and holding eligible assets (and in activities
related or incidental thereto), and who does not issue redeemable
securities will not be deemed to be an investment company * * *'').
\104\ We note that, depending on the facts and circumstances,
some of these companies may meet the definition of investment
company in Section 3(a)(1)(A). See supra note 18. Companies that
meet the definition of investment company in Section 3(a)(1)(A) are
subject to the requirements of the Investment Company Act unless
they meet an exclusion or an exemption, even if they do not meet the
other definitions of investment company in Section 3(a)(1).
We also note that the idea of a company being in the business of
investing in securities, even though the securities the company
holds are those of its non-investment company majority-owned
subsidiaries, is not novel. We have concluded, for example, that a
company may be a ``special situation investment company'' that
should be regulated under the Investment Company Act, even though
the company holds securities of its majority-owned subsidiaries that
are not investment securities. See Certain Prima Facie Investment
Companies, Investment Company Act Release No. 10937 (Nov. 13, 1979)
[44 FR 66608 (Nov. 20, 1979)] at nn.18-20 and accompanying text. A
special situation investment company generally is a company that
secures control of other companies primarily for the purpose of
making a profit in the sale of the controlled companies' securities.
Id.
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If the exclusion provided by Rule 3a-7 specified that an issuer
relying on Rule 3a-7 would be deemed an investment company for the
limited purpose of the definition of ``investment securities'' in
Section 3(a)(2)(C)(i) of the Investment Company Act, any company that
holds 50% or more of the outstanding voting securities of a Rule 3a-7
issuer would be required to treat such securities, as well as any other
securities of that Rule 3a-7 issuer, as ``investment securities'' for
purposes of determining its own status under Section 3(a)(1)(C) of the
Investment Company Act.\105\ With respect to certain types of holders
of securities issued by Rule 3a-7 issuers, such as companies discussed
above whose business focused on establishing Rule 3a-7 subsidiaries to
capture the spread between the yield of the assets being securitized
and the financing cost of the fixed-income securities being issued, and
which may be engaged in the business of investing in securities, such
an approach may serve to more accurately reflect their status under
Section 3(a)(1)(C) of the Investment Company Act and afford their
investors the appropriate protections.
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\105\ See supra note 18. Under this approach, securities of a
majority-owned subsidiary relying on Rule 3a-7 would be treated in
the same manner as securities of a majority-owned subsidiary that is
an investment company or that relies on Section 3(c)(1) or Section
3(c)(7) of the Investment Company Act. See supra notes 18, 30.
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The Commission requests comment on the extent to which various
types of holders of securities of Rule 3a-7 issuers use the exclusion
to determine their own status under the Investment Company Act.
What would be the potential economic impact if the
exclusion from the definition of investment company provided by Rule
3a-7 were modified so that it did not extend to the definition of
``investment securities'' in Section 3(c)(1)(C)(i)?
Would such a modification adversely affect those sponsors
that form Rule 3a-7 issuers to facilitate the operation of their non-
investment company business? Are such sponsors typically invested in
their Rule 3a-7 majority-owned subsidiaries to such an extent that this
approach would cause a sponsor to have more than 40% of its assets in
investment securities and therefore fall within the definition of
investment company in Section 3(a)(1)(C)? \106\
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\106\ Sponsors that are banks, bank holding companies, broker-
dealers, savings and loans and insurance companies are excluded from
the definition of the Investment Company Act by Section 3(c) of the
Investment Company Act and would be unaffected by a provision
narrowing the effect of the exclusion provided by Rule 3a-7. In
addition, other sponsors could conclude, based on an appropriate
analysis of their primary business, that they are not investment
companies pursuant to Section 3(b)(1) of the Investment Company Act
or seek a Commission order under Section 3(b)(2) of that Act.
Section 3(b)(1) of the Investment Company Act generally excludes an
issuer from the definition of investment company in Section
3(a)(1)(C) of the Act if it is primarily engaged, directly or
through wholly-owned subsidiaries, in a business other than
investing, reinvesting, owning, holding or trading securities.
Section 3(b)(2) of the Investment Company Act generally excludes
from the definition of investment company in Section 3(a)(1)(C) of
the Act any issuer which the Commission, upon application by the
issuer, finds and by order declares to be primarily engaged in a
business other than that of investing, reinvesting, owning, holding,
or trading in securities either directly or through majority-owned
subsidiaries or through controlled companies conducting similar type
of businesses.
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Rule 3a-7 alternatively could be recast such that a Rule
3a-7 issuer would be an investment company but would be exempted from
the Act's requirements, provided that the issuer meets the rule's
conditions. Under this approach, because the asset-backed issuer would
not be excluded from the definition of investment company, but
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exempted from the Investment Company Act, a holder of the issuer's
securities would be required to treat such securities as ``investment
securities'' for purposes of determining the holder's own status under
the Act, as under the approach discussed above. Is this approach
preferable? If so, why?
Are there reasons not to modify the exclusion provided by
Rule 3a-7 to address this issue? Please explain and, if possible,
provide data in support of your responses.
2. Eligible Portfolio Company
The Commission also has become aware of an interest among business
development companies (``BDCs'') to sponsor and invest in securities of
issuers relying on Rule 3a-7. Congress established BDCs in 1980 as a
type of closed-end investment company the primary purpose of which was
to make capital more readily available to small, developing and
financially troubled businesses.\107\ To accomplish this purpose,
Congress added a special set of provisions to the Investment Company
Act that govern closed-end investment companies that elect BDC
status.\108\ In amending the Investment Company Act, Congress
underscored that the new provisions would apply only to BDCs that are
operated for the purpose of investing in the securities of certain
issuers and that make available significant managerial assistance to
those issuers.\109\ Accordingly, the Investment Company Act generally
prohibits a BDC from making any investment unless, at the time of the
investment, at least 70% of the BDC's total assets (other than certain
specified non-investment assets) are invested in securities of certain
specified issuers (``70% basket'').\110\ The 70% basket includes, among
other things, certain securities of ``eligible portfolio companies,''
as defined by the Act.\111\ Among other criteria, issuers qualifying as
eligible portfolio companies must be organized under the laws of, and
have their principal place of business in, the United States,\112\ and
must not meet the definition of investment company in Section 3 of the
Investment Company Act or be excluded from the definition of investment
company under Section 3(c) of that Act.\113\
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\107\ Small Business Investment Incentive Act of 1980, Public
Law 96-477, 94 Stat. 2275 (1980) (codified at scattered sections of
the United States Code) (``SBIIA'').
\108\ See Sections 54-65 of the Investment Company Act.
\109\ See H.R. Rep. No. 1341, 96th Cong., 2d Sess. 22 (1980)
(``BDC House Report'').
\110\ Section 55(a) of the Investment Company Act. See BDC House
Report, supra note 109 at 23 (``The restrictions are designed to
assure that companies electing special treatment as [BDCs] are in
fact those that [the SBIIA] is intended to aid--companies providing
capital and assistance to small, developing or financially troubled
businesses that are seeking to expand, not passive investors in
large, well-established businesses.''). BDCs may invest in certain
other assets that would not count toward the 70% basket, provided
that such investments are consistent with the overall purpose behind
the BDC provisions of the Investment Company Act. Id. at 39-40.
\111\ Section 2(a)(46) of the Investment Company Act.
\112\ Section 2(a)(46)(A) of the Investment Company Act.
\113\ Section 2(a)(46)(B) of the Investment Company Act. Section
2(a)(46)(B) also includes as an eligible portfolio company a small
BDC which is licensed by the Small Business Administration and which
is a wholly-owned subsidiary of a BDC. In addition to meeting the
requirements set forth in Sections 2(a)(46)(A) and 2(a)(46)(B), a
company qualifying for eligible portfolio company status must also
meet one of the criteria set forth in Section 2(a)(46)(C) or in Rule
2a-46 under the Investment Company Act.
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By virtue of the exclusion from the definition of investment
company provided by Rule 3a-7, a BDC might seek to treat a Rule 3a-7
issuer as an eligible portfolio company, provided that certain other
criteria are met.\114\ As a general matter, the Commission presently
does not believe that Rule 3a-7 issuers are the type of small,
developing and financially troubled businesses in which Congress
intended BDCs primarily to invest. Accordingly, the Commission requests
comment on whether Rule 3a-7 should be amended to provide expressly
that an issuer relying on Rule 3a-7 is an investment company for
purposes of the definition of eligible portfolio company under the
Investment Company Act.
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\114\ See Section 55(a) of the Investment Company Act.
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What would be the effect on BDCs if Rule 3a-7 were amended
to expressly provide that an issuer relying on Rule 3a-7 is not an
eligible portfolio company?
What would be the effect on Rule 3a-7 issuers if Rule 3a-7
were amended to expressly provide that an issuer relying on Rule 3a-7
is not an eligible portfolio company?
We understand that BDCs that invest in Rule 3a-7 issuers
typically do not treat such issuers as eligible portfolio companies. Is
our understanding correct? If not, please explain.
C. Asset-Backed Issuers Relying on Section 3(c)(5)
As noted above, certain asset-backed issuers rely on the exclusion
from the definition of investment company in Section 3(c)(5) of the
Investment Company Act rather than on Rule 3a-7.\115\ Section 3(c)(5)
was intended to exclude from the definition of investment company
certain factoring, discounting and mortgage companies,\116\ and did not
specifically contemplate asset-backed issuers, which generally did not
exist at the time Congress adopted the Investment Company Act in
1940.\117\ Nevertheless, certain asset-backed issuers, including those
that securitize retail automobile installment contracts, credit card
receivables, trade receivables, boat loans or equipment leases, have
sought to rely on the provisions of Section 3(c)(5).\118\ In addition,
many issuers of mortgage-backed securities have sought to rely on
Section 3(c)(5). These asset-backed issuers include issuers of
securities backed by whole residential mortgage loans and home equity
loans (two of the most commonly securitized assets),\119\ whole
commercial mortgages, participated mortgage interests, and ``whole pool
certificates'' \120\ issued or
[[Page 55321]]
guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.
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\115\ See supra note 30 discussing the 3(c)(5)(C) Concept
Release. Section 3(c)(5) excludes from the definition of investment
company ``[a]ny person who is not engaged in the business of issuing
redeemable securities, face-amount certificates of the installment
type or periodic payment plan certificates, and who is primarily
engaged in one or more of the following businesses: (A) Purchasing
or otherwise acquiring notes, drafts, acceptances, open accounts
receivable, and other obligations representing part or all of the
sales price of merchandise, insurance, and services; (B) making
loans to manufacturers, wholesalers and retailers of, and to
prospective purchasers of, specified merchandise, insurance, and
services; and (C) purchasing or otherwise acquiring mortgages and
other liens on and interests in real estate.''
\116\ S. Rep. No. 1775, 76th Cong. 3d. 13 (1940); H.R. Rep. No.
2639, 76th Cong., 3d Sess. 12 (1940); S. Rep. No. 184, 91st Cong.,
1st Sess. 37 (1969); H.R. Rep. No. 1382, 91st Cong., 2d Sess. 17
(1970). See Proposing Release, supra note 15 at text following n.5
(``section 3(c)(5)] * * * originally was intended to exclude issuers
engaged in the commercial finance and mortgage banking
industries.''). See also Section 3(c)(5)(C) Concept Release, supra
note 30.
\117\ See Kravitt, supra note 15 at 12.03[G][4] (``The
exceptions stated in Section 3(c)(5) predate by many years the
securitization industry. The `original intent' of the drafters of
Section 3(c)(5) could not possibly have anticipated financial
products such as collateralized mortgage obligations and
receivables-backed securities. As with many of the Section 3
exceptions, issuers that do not, or arguably do not, fall within the
original intent of the provisions have attempted to rely on the * *
* exception.'')
\118\ See Kravitt, supra note 15 at 12.03[G]; Protecting
Investors Report, supra note 4 at n.261 and accompanying text. Note,
however, that an asset-backed issuer that securitizes these types of
assets may be unable to rely on these exclusions if the issuer's
structure allows for the holding of cash or similar instruments in
such amounts that the issuer may not be ``primarily engaged'' in
holding the asset being securitized. See Kravitt, supra note 15 at
12.03[G].
\119\ See Kravitt, supra note 15 at 12.03[G].
\120\ A whole pool certificate is a security that represents the
entire ownership interest in a particular pool of mortgage loans.
See Protecting Investors Report, supra note 4 at n.267.
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Unlike the exclusion provided by Rule 3a-7, the exclusion provided
by Section 3(c)(5) is not subject to any conditions specifically
addressing the Investment Company Act-related concerns presented by
asset-backed issuers.\121\ Whether an asset-backed issuer has the
option of relying on Section 3(c)(5) as an alternative to Rule 3a-7
generally depends on whether the issuer is primarily engaged in
purchasing or otherwise acquiring a particular type of financial
assets.\122\ Rule 3a-7, in contrast, was generally designed to
encompass any asset-backed issuer that meets the rule's conditions,
regardless of the type of financial assets that it holds.
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\121\ See supra section III.A. See also supra note 115.
\122\ See supra note 115.
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When first considering Rule 3a-7 in 1992, the Commission noted
that, absent a statutory amendment precluding asset-backed issuers from
relying on Section 3(c)(5), asset-backed issuers that rely on that
section and those that rely on Rule 3a-7 would be subject to somewhat
disparate treatment based solely on the type of the financial assets
that they held. Accordingly, when the Commission proposed Rule 3a-7 in
1992, it also requested comment on, among other things, whether it
should seek statutory amendments to Section 3(c)(5) that would preclude
asset-backed issuers from continuing to rely on the Section.\123\ Most
commenters then argued that it would be inappropriate to narrow the
scope of Section 3(c)(5), at least until both the market and the
Commission gained experience with Rule 3a-7.\124\ In response to
commenters' concerns, the Commission decided not to pursue any
regulatory changes with respect to Section 3(c)(5) at that time.\125\
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\123\ Proposing Release, supra note 15 at section II.B.
\124\ Adopting Release, supra note 4 at n.88 and accompanying
text.
\125\ Id. at text following n.89.
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Now that the market and the Commission have gained almost twenty
years of experience with Rule 3a-7, we believe that it is appropriate
to revisit this issue as part of our review of the rule. We also
believe that revisiting the ability of asset-backed issuers to rely on
the exclusion provided by Section 3(c)(5) is appropriate in the
aftermath of the recent financial crisis and the role that issuers of
mortgage-backed securities have played in that crisis.\126\
Accordingly, the Commission once again is seeking comment on whether
Section 3(c)(5) should be amended to limit the ability of asset-backed
issuers to rely on Section 3(c)(5).\127\ The Commission also requests
comment on whether it should engage in any rulemaking, consistent with
Section 3(c)(5), that would define terms used in that section so as to
limit its availability to those companies that are intended to be
encompassed by the statutory exclusion. We also seek comment on whether
there are any structural or operational reasons that make it necessary
for certain asset-backed issuers to rely on Section 3(c)(5) rather than
Rule 3a-7.
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\126\ See generally 2010 ABS Proposing Release, supra note 10.
\127\ See also Section 3(c)(5)(C) Concept Release, supra note
30; 2011 ABS Re-proposal, supra note 13 at n.110 and accompanying
text (requesting comment on whether compliance with Rule 3a-7 should
be one of the shelf eligibility requirements).
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If there are such structural or operational reasons, what
are they?
What types of asset-backed issuers rely on Section
3(c)(5)?
What would be the effect on asset-backed issuers, the
securitization market and on capital formation if asset-backed issuers
could no longer rely on Section 3(c)(5)?
Are there revisions to Rule 3a-7 that could be made to
better facilitate asset-backed issuers' reliance on the rule rather
than on Section 3(c)(5) and what would be the economic impact of such
revisions?
Commenters also are requested to provide any other observations,
suggestions and data on the interplay between Rule 3a-7 and Section
3(c)(5) today and as the asset-backed securities markets may develop in
the future.
IV. General Request for Comment
In addition to the issues raised in this release, the Commission
requests and encourages all interested persons to submit their views on
any issues relating to the treatment of asset-backed issuers under the
Investment Company Act. This release is not intended in any way to
limit the scope of comments, views, issues or approaches to be
considered. The Commission particularly welcomes statistical,
empirical, and other data from commenters that may support their views
and/or support or refute the views or issues raised in this release.
Dated: August 31, 2011.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-22772 Filed 9-6-11; 8:45 am]
BILLING CODE 8011-01-P