Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-34
Involving Bear, Stearns & Co. Inc., Prudential Securities Incorporated,
et al., (D-10829); Notice [Notices] [08/23/2000]
Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-34
Involving Bear, Stearns & Co. Inc., Prudential Securities Incorporated,
et al., (D-10829); Notice [08/23/2000]
Volume 65, Number 164, Page 51453-51494
[[Page 51453]]
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Part III
Department of Labor
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Pension and Welfare Benefits Administration
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Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-34
Involving Bear, Stearns & Co. Inc., Prudential Securities Incorporated,
et al., (D-10829); Notice
[[Page 51454]]
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DEPARTMENT OF LABOR
Pension and Welfare Benefits Administration
Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-
34 Involving Bear, Stearns & Co. Inc., Prudential Securities
Incorporated, et al., (D-10829)
AGENCY: Pension and Welfare Benefits Administration, Department of
Labor.
ACTION: Notice of a proposed amendment to the Underwriter
Exemptions.\1\
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\1\ The term ``Underwriter Exemptions'' refers to the following
individual Prohibited Transaction Exemptions (PTEs): PTE 89-88, 54
FR 42582 (October 17, 1989); PTE 89-89, 54 FR 42569 (October 17,
1989); PTE 89-90, 54 FR 42597 (October 17, 1989); PTE 90-22, 55 FR
20542 (May 17, 1990); PTE 90-23, 55 FR 20545 (May 17, 1990); PTE 90-
24, 55 FR 20548 (May 17, 1990); PTE 90-28, 55 FR 21456 (May 24,
1990); PTE 90-29, 55 FR 21459 (May 24, 1990); PTE 90-30, 55 FR 21461
(May 24, 1990); PTE 90-31, 55 FR 23144 (June 6, 1990); PTE 90-32, 55
FR 23147 (June 6, 1990); PTE 90-33, 55 FR 23151 (June 6, 1990); PTE
90-36, 55 FR 25903 (June 25, 1990); PTE 90-39, 55 FR 27713 (July 5,
1990); PTE 90-59, 55 FR 36724 (September 6, 1990); PTE 90-83, 55 FR
50250 (December 5, 1990); PTE 90-84, 55 FR 50252 (December 5, 1990);
PTE 90-88, 55 FR 52899 (December 24, 1990); PTE 91-14, 55 FR 48178
(February 22, 1991); PTE 91-22, 56 FR 03277 (April 18, 1991); PTE
91-23, 56 FR 15936 (April 18, 1991); PTE 91-30, 56 FR 22452 (May 15,
1991); PTE 91-62, 56 FR 51406 (October 11, 1991); PTE 93-31, 58 FR
28620 (May 5, 1993); PTE 93-32, 58 FR 28623 (May 14, 1993); PTE 94-
29, 59 FR 14675 (March 29, 1994); PTE 94-64, 59 FR 42312 (August 17,
1994); PTE 94-70, 59 FR 50014 (September 30, 1994); PTE 94-73, 59 FR
51213 (October 7, 1994); PTE 94-84, 59 FR 65400 (December 19, 1994);
PTE 95-26, 60 FR 17586 (April 6, 1995); PTE 95-59, 60 FR 35938 (July
12, 1995); PTE 95-89, 60 FR 49011 (September 21, 1995); PTE 96-22,
61 FR 14828 (April 3, 1996); PTE 96-84, 61 FR 58234 (November 13,
1996); PTE 96-92, 61 FR 66334 (December 17, 1996); PTE 96-94, 61 FR
68787 (December 30, 1996); PTE 97-05, 62 FR 1926 (January 14, 1997);
PTE 97-28, 62 FR 28515 (May 23, 1997); PTE 97-34, 62 FR 39021 (July
21, 1997); PTE 98-08, 63 FR 8498 (February 19, 1998); PTE 99-11, 64
FR 11046 (March 8, 1999); PTE 2000-19, 65 FR 25950 (May 4, 2000);
PTE 2000-33, 65 FR 37171 (June 13, 2000); and PTE 2000-41, First
Tennessee National Corporation (August, 2000).
In addition, the Department notes that it is also proposing
individual exemptive relief for: Deutsche Bank AG, New York Branch
and Deutsche Morgan Grenfell/C.J. Lawrence Inc., Final Authorization
Number (FAN) 97-03E (December 9, 1996); Credit Lyonnais Securities
(USA) Inc., FAN 97-21E (September 10, 1997); ABN AMRO Inc., FAN 98-
08E (April 27, 1998); and Ironwood Capital Partners Ltd., FAN 99-31E
(December 20, 1999), which received the approval of the Department
to engage in transactions substantially similar to the transactions
described in the Underwriter Exemptions pursuant to PTE 96-62.
Finally, the Department notes that it is proposing relief for
Countrywide Securities Corporation (Application No. D-10863).
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SUMMARY: This document contains a notice of pendency before the
Department of Labor (the Department) of a proposed amendment to the
Underwriter Exemptions. The Underwriter Exemptions are individual
exemptions that provide relief for the origination and operation of
certain asset pool investment trusts and the acquisition, holding and
disposition of certain asset-backed pass-through certificates
representing undivided interests in those investment trusts. The
proposed amendment, if granted, would: (1) Permit, for certain
categories of transactions, the offering of ``investment grade''
mortgage-backed securities and asset-backed securities which are either
senior or subordinated; (2) permit the use of eligible interest rate
swaps (both ratings dependent and non-ratings dependent) under
circumstances described in this proposal; (3) permit the use of yield
supplement agreements which involve notional principal amounts; and (4)
make certain changes to the Underwriter Exemptions that would reflect
the Department's current interpretation of the Underwriter Exemptions.
Finally, the proposed amendment, if granted, would provide
exemptive relief for transactions involving: (1) an Issuer of mortgage-
backed securities or asset-backed securities which is a trust
(including a grantor or owner trust), REMIC, FASIT, special purpose
corporation, limited liability company or partnership and (2) mortgage-
backed securities or asset-backed securities issued which are either
debt or equity investments.
DATES: Written comments and/or requests for a public hearing should be
received by October 10, 2000.
Effective Date: If granted, the proposed amendment to the
Underwriter Exemptions would be effective for transactions occurring on
or after the date of publication of this notice in the Federal
Register, except as otherwise provided in sections I.C., II.A.(4)(b),
and III.JJ. of the proposed amendment to the Underwriter Exemptions.
ADDRESSES: All written comments and requests for a hearing (preferably
at least three copies) should be sent to: Office of Exemption
Determinations, Pension and Welfare Benefits Administration, Room N-
5649, Department of Labor, 200 Constitution Avenue, N.W., Washington,
D.C. 20210, Attn: Proposed Amendment to the Underwriter Exemptions. The
application pertaining to the amendment proposed herein and the
comments received will be available for public inspection in the Public
Documents Room of the Pension and Welfare Administration, U.S.
Department of Labor, Room N-5638, 200 Constitution Avenue, N.W.,
Washington, D.C. 20210.
FOR FURTHER INFORMATION CONTACT: Wendy McColough of the Department,
telephone (202) 219-8971. (This is not a toll-free number).
SUPPLEMENTARY INFORMATION: Notice is hereby given of the pendency
before the Department of a proposed exemption to amend PTE 97-34, 62 FR
39021 (July 21, 1997) (the 1997 Amendment). PTE 97-34 amended over
forty individual Underwriter Exemptions. The Underwriter Exemptions
provide substantially identical relief for the operation of certain
asset pool investment trusts and the acquisition and holding by plans
of certain asset-backed pass-through certificates representing
interests in those trusts. These exemptions provide relief from certain
of the restrictions of sections 406(a), 406(b) and 407(a) of the Act
and from the taxes imposed by section 4975(a) and (b) of the Code, by
reason of certain provisions of section 4975(c)(1) of the Code.
I. Introduction
The proposed amendment was requested by application dated October
22, 1999, and as restated in later submissions on behalf of Morgan
Stanley & Co. Incorporated.\2\ (the Applicant). In preparing the
application, the Applicant received input from members of The Bond
Market Association (TBMA).
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\2\ PTE 90-24, 55 FR 20548 (May 17, 1990). Morgan Stanley & Co.
Incorporated (Morgan Stanley) is an international securities firm
providing through its affiliates a wide range of financial and
securities services on a global basis to a large and diversified
group of clients and customers, including corporations, governments,
financial institutions and individuals. The businesses of Morgan
Stanley and its affiliates include securities underwriting,
distribution and trading; merger, acquisition, restructuring, real
estate, project finance and other corporate finance advisory
activities; asset management; private equity and other principal
investment activities; brokerage and research services; and the
trading of foreign exchange and commodities as well as derivatives
on a broad range of asset categories, rates and indices. Affiliates
of Morgan Stanley also provide credit and transaction services,
including the operation of the Discover/Novus (trademark symbol)
Network, a proprietary network of merchant and cash access
locations, and the issuance of proprietary general purpose credit
cards.
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The Department is proposing the amendment to this individual
exemption pursuant to section 408(a) of the Act and section 4975(c)(2)
of the Code, and in accordance with the procedures set forth in 29 CFR
Part 2570 (Subpart B) 55 FR 32836, 32847(August 10, 1990).\3\ In
addition, the Department
[[Page 51455]]
is proposing to provide the same relief on its own motion pursuant to
the authority described above for many of the other Underwriter
Exemptions which have substantially similar terms and conditions.\4\
The Department notes that it is also proposing individual exemptive
relief for: Deutsche Bank AG, New York Branch and Deutsche Morgan
Grenfell/C.J. Lawrence Inc., FAN 97-03E (December 9, 1996); Credit
Lyonnais Securities (USA) Inc., FAN 97-21E (September 10, 1997); ABN
AMRO Inc., FAN 98-08E (April 27, 1998); and Ironwood Capital Partners
Ltd., FAN 99-31E (December 20, 1999), which received the approval of
the Department to engage in transactions substantially similar to the
transactions described in the Underwriter Exemptions pursuant to PTE
96-62. Finally, the Department notes that it is proposing relief for
Countrywide Securities Corporation (Application No. D-10863).
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\3\ Section 102 of Reorganization Plan No. 4 of 1978 (43 FR
47713, October 17, 1978, 5 U.S.C. App. 1 [1995]) generally
transferred the authority of the Secretary of the Treasury to issue
exemptions under section 4975(c)(2) of the Code to the Secretary of
Labor. In the discussion of the exemption, references to sections
406 and 408 of the Act should be read to refer as well to the
corresponding provisions of section 4975 of the Code.
\4\ In this regard, the entities who received the other
Underwriter Exemptions were contacted concerning their participation
in this amendment process.
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A. The Underwriter Exemptions
The original Underwriter Exemptions permit plans to invest in pass-
through certificates representing undivided interests in the following
categories of trusts: \5\ (1) Single and multi-family residential or
commercial mortgage investment trusts; \6\ (2) motor vehicle
receivables investment trusts; (3) consumer or commercial receivables
investment trusts; and (4) guaranteed governmental mortgage pool
certificate investment trusts.\7\ Residential and commercial mortgage
investment trusts may include mortgages on ground leases of real
property. The terms of the ground leases pledged to secure leasehold
mortgages will in all cases be at least ten years longer than the terms
of such mortgages.\8\
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\5\ The Department stated in the 1997 Proposed Amendment to the
Underwriter Exemptions, 62 FR 28502 (May 23, 1997), that a given
trust may include receivables of the type described in one or more
of the categories under the definition of Trust.
\6\ The Department noted that PTE 83-1, 48 FR 895 (January 7,
1983), a class exemption for mortgage pool investment trusts, would
generally apply to trusts containing single-family residential
mortgages, provided that the applicable conditions of PTE 83-1 are
met. The Underwriter Exemptions provide relief for single-family
residential mortgages because the applicants preferred one exemption
for all trusts of similar structure. However, the applicants have
stated that they may still avail themselves of the exemptive relief
provided by PTE 83-1.
\7\ Guaranteed governmental mortgage pool certificates are
mortgage-backed securities with respect to which interest and
principal payable is guaranteed by the Government National Mortgage
Association (GNMA), the Federal Home Loan Mortgage Corporation
(FHLMC), or the Federal National Mortgage Association (FNMA). The
Department's regulation relating to the definition of plan assets
(29 CFR 2510.3-101(i)) provides that where a plan acquires a
guaranteed governmental mortgage pool certificate, the plan's assets
include the certificate and all of its rights with respect to such
certificate under applicable law, but do not, solely by reason of
the plan's holding of such certificate, include any of the mortgages
underlying such certificate. Exemptive relief for trusts containing
guaranteed governmental mortgage pool certificates was provided
previously because the certificates in the trusts may be plan
assets.
\8\ The Department previously noted that Trust assets may also
include obligations that are secured by leasehold interests on
residential real property. See PTE 90-32 (involving Prudential-Bache
Securities, Inc.) 55 FR 23147, at 23150 (June 6, 1990).
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Each trust is established under a pooling and servicing agreement
or an equivalent agreement among a sponsor, a servicer, and a trustee.
Prior to the closing date under the pooling and servicing agreement,
the sponsor and/or the servicer selects receivables from the classes of
assets described in section III.B.(1)(a)-(f) of the original
Underwriter Exemptions to be included in a trust, establishes the trust
and designates an independent entity as trustee for the trust.
Typically, on or prior to the closing date, the sponsor acquires legal
title to all assets selected for the trust. In some cases, legal title
to some or all of such assets continues to be held by the originator of
the receivables until the closing date. On the closing date, the
sponsor and/or the originator conveys to the trust legal title to the
assets, and the trustee issued certificates representing fractional
undivided interests in the trust assets.
Since the receivables to be held in the trust were all transferred
as of the Closing Date, no exemptive relief was requested under the
Underwriter Exemptions for the trust to hold any cash, or temporary
investments made therewith, other than cash representing undistributed
proceeds from payments of principal and interest by obligors under the
receivables. However, over time, the transactions relating to the
funding of the trust changed. The 1997 Amendment to the Underwriter
Exemptions: (1) Modified the definition of ``Trust'' to include a
``pre-funding account'' (PFA) and a ``capitalized interest account''
(CIA) as part of the corpus of the trust; (2) provided retroactive
relief for transactions involving asset pool investment trusts
containing PFAs which have occurred on or after January 1, 1992; (3)
included in the definition of ``Certificate'' a debt instrument that
represents an interest in a Financial Asset Securitization Investment
Trust (FASIT); and (4) made certain changes to the Underwriter
Exemptions that reflected the Department's current interpretation of
the Underwriter Exemptions.
Under the Underwriter Exemptions as amended in 1997: (1) The rights
and interests evidenced by certificates acquired by plans may not be
subordinated to the rights and interests evidenced by other
certificates of the same trust; (2) the certificates acquired by the
plan must have received a rating from a Rating Agency at the time of
such acquisition that is in one of the three highest generic rating
categories; (3) the assets held by the trust must consist solely of
receivables, obligations or credit instruments which are ``secured,''
(4) no interest rate swaps and no yield supplement agreements or
similar yield maintenance agreements involving swap agreements or other
notional principal contracts may be held by the trust and (5) the
certificates must represent a beneficial ownership interest in the
assets of a trust or a debt instrument issued by a REMIC or a FASIT
which is a trust.
B. Proposed Amendment to the Exemptions
The proposed amendment to the Underwriter Exemptions (the Proposed
Amendment) is requested in order to permit plans to invest in
investment-grade \9\ mortgage-backed securities (MBS) and asset-backed
securities (ABS) (collectively, Securities) involving categories of
transactions which are either senior or subordinated, and/or in certain
cases, permit the entity issuing such Securities (Issuer) to hold
receivables with loan-to-value property ratios (HLTV ratios) in excess
of 100%. Specifically, the requested amendment would exempt
transactions involving senior or subordinated Securities rated ``AAA,''
``AA,'' ``A'' or ``BBB'' issued by Issuers whose assets are comprised
of the following categories of receivables: (1) Automobile and other
motor vehicle loans, (2) residential and home equity loans which may
have HLTV ratios in excess of 100%, (3) manufactured housing loans and
(4) commercial
[[Page 51456]]
mortgages (the Designated Transactions).
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\9\ The term ``investment grade'' refers to Securities which are
rated at the time of issuance in one of the four highest generic
rating categories by at least one Rating Agency. The designations
``AAA,'' ``AA,'' ``A'' and ``BBB'' are used herein to refer to the
generic rating categories used by Standard & Poor's Ratings
Services, a division of The McGraw-Hill Companies Inc., Fitch ICBA,
Inc., and Duff & Phelps Credit Rating Co. and are deemed to include
the equivalent generic category rating designations ``Aaa'' ``Aa,''
``A'' and ``Baa'' used by Moody's Investors Service, Inc.
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The Applicant requests that the relief the Department granted to
MBNA America Bank National Association (MBNA) in Prohibited Transaction
Exemption 98-13, 63 FR 4038 (April 7, 1998) (PTE 98-13) and to Citibank
South Dakota, N.A., Citibank (Nevada), N.A. and affiliates (Citibank)
in Prohibited Transaction Exemption 98-14, 63 FR 4052 (April 7, 1998)
(PTE 98-14) with respect to the use of Eligible Swaps (both Ratings
Dependent and Non-Ratings Dependent) be extended to all securitizations
which otherwise meet the conditions of the Underwriter Exemptions,
provided that the swap transaction meets the requirements set forth in
the requested amendment. As a corollary to such request, the Applicant
also requests that yield supplement agreements which involve notional
principal amounts be permitted.
Finally, the Applicant is requesting that exemptive relief also be
extended to all securitization transactions which otherwise meet the
conditions of the Underwriter Exemptions notwithstanding that: (1) The
Issuer of the Securities is a trust (including a grantor or owner
trust), REMIC, FASIT, special purpose corporation, limited liability
company or partnership or that (2) the Securities issued are either
debt or equity investments.\10\
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\10\ The Department notes that this exemption request will not
preclude the Applicant (or any other parties which have previously,
or may in the future, request an Underwriter Exemption) from
requesting additional exemptive relief from the Department in future
applications with respect to other issues relating to the
Underwriter Exemptions.
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The proposed amendment to the Underwriter Exemptions specifically
will modify the relief previously provided in the following respects:
(i) The rights and interests evidenced by securities acquired by
plans in the Designated Transactions (i.e., motor vehicle,
residential/home equity, manufactured housing and commercial
mortgage ABS/MBS transactions) described in this application may be
subordinated to the rights and interests evidenced by other
securities of the same Issuer.
(ii) Securities acquired by a plan in a Designated Transaction
may receive a rating from a Rating Agency at the time of such
acquisition that is in one of the four highest generic rating
categories.
(iii) The corpus of the Issuer in residential and home equity
Designated Transactions may include mortgage loans with HLTV ratios
in excess of 100%.
(iv) Eligible interest rate swaps (both ratings dependent and
non-ratings dependent) and yield supplement arrangements with
notional principal amounts may be included.
(v) The securitization vehicle can also be an owner trust,
special purpose corporation, limited partnership or limited
liability company.
(vi) The security may be either an equity or debt interest
issued by any permissible type of Issuer.
The Applicant represents that the transactions associated with
subordinated and/or ``BBB'' rated debt and equity ABS/MBS, issued by a
variety of special purpose vehicles which may be funded with collateral
with HLTV ratios in excess of 100% and may use interest rate swaps or
yield supplement agreements with notional principal amounts, have been
customary in the financial marketplace for many years, and all of these
features and security types are taken into consideration by the Rating
Agencies when they rate the securities issued by such entities. If
these securities can not be sold to plans, investing plans will lose an
opportunity to achieve a current market return through investment in
securities that have received a rating from a Rating Agency which is as
high or higher than that of comparable instruments in which such plans
are clearly permitted to invest. In addition, thesetransactions are
backed by diverse varieties of individual assets that a plan would be
reluctant to purchase on its own, if for no other reason than the
necessity to perform its own asset-by-asset credit analysis and
servicing functions.
The Applicant notes that the requested relief is administratively
feasible since it substantially incorporates the provisions of the
Underwriter Exemptions which have already proven in practice to be
administratively feasible. To the extent that the requested amendment
permits additional types of securitization vehicles and the use of
yield supplement arrangements with notional principal balances and
interest rate swaps, the additional safeguards the Department has
required can be accommodated by market practices and do not require any
further action by the Department. The Applicant states that all of the
features included in the amendment request are also acceptable to the
Rating Agencies. The Applicant believes that the amendment is in the
interest of plan participants and beneficiaries because it provides
greater opportunities for plans to invest in a more diverse range of
liquid, extremely creditworthy securities. Lastly, the Applicant notes
that the requested amendment is protective of the rights of
participants and beneficiaries of affected plans because securities
with the features proposed in the request for amended relief have
experienced almost no defaults in their entire market history.
II. Request for Additional Types of Issuers
A. The Applicant's Request
The Applicant is requesting that the Underwriter Exemptions be
amended to expand the permissible types of securitization vehicles that
may be used to offer securities to include special purpose
corporations, limited partnerships and limited liability companies and
owner trusts, in addition to grantor trusts, REMICs and FASITs. It is
also requesting that the securities eligible for relief include those
issued by all such entities whether they are debt or equity.
When the original Underwriter Exemptions were granted, relief was
only requested for ABS/MBS issued by grantor trusts and REMICs since,
at that time, these were the principal securitization vehicles used for
asset-backed transactions. FASITs were included under PTE 97-34 in
response to legislation that had been enacted during the time period
when the relief requested under PTE 97-34 was being considered by the
Department. Currently, ABS/MBS securitizations are structured with a
variety of types of special purpose vehicles which issue both debt and
equity securities. The permissible types of Issuers used to offer
Securities include trusts (including grantor and owner trusts), special
purpose corporations, limited partnerships and limited liability
companies and may also be REMICs or FASITs. The Applicant asserts that
each of these different types of securitization entities provides
virtually the same legal protections to investors. At the request of
the Department, the Applicant provided the following discussion that
describes the legal structure, bankruptcy status and taxation of each
securitization vehicle. It also explains why debt is issued in certain
transactions instead of equity and the relative rights of both types of
securities.
The principal factors in the choice of securitization vehicle and
whether equity or debt securities are issued by the securitization
vehicle are not economic but involve a combination of tax, accounting
and ERISA considerations. In this regard, the Applicant notes that
where the Issuer is not a Trust, equity will not be sold to plans
pursuant to this exemption, if granted. In the final analysis, the
choice of securitization entity or type of security does not
significantly affect plan investors either from a legal rights,
[[Page 51457]]
credit risk or tax perspective, but it significantly affects ERISA
eligibility. Accordingly, transactions are restructured solely because
of ERISA considerations which have no relationship to the safety of the
securities for plan investors.
Securitizations transactions are structured with a variety of types
of Issuers which are special purpose vehicles which issue both debt
\11\ and equity Securities. Each of the different types of
securitization entities provides virtually the same legal protections
to investors.
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\ 11\ The Department notes that PTE 84-14, 49 FR 9494 (March 13,
1984) (as corrected at 50 FR 41430 (Oct. 10, 1985), relating to
transactions determined by independent qualified professional asset
managers; PTE 90-1, 55 FR 2891 (Jan. 29, 1990), relating to certain
transactions involving insurance company pooled separate accounts;
PTE 91-38, 56 FR 31966 (July 12, 1991) (as corrected at 56 FR 59299
(Nov. 25, 1991), relating to certain transactions involving bank
collective trust funds; PTE 95-60, 60 FR 35925 (July 12, 1995),
relating to certain transactions involving insurance company general
accounts and PTE 96-23, 61 FR 15975 (Apr. 10, 1996), relating to
transactions determined by in-house asset managers collectively
(Investor-Based Exemptions), may apply to the acquisition or
disposition of debt securities by plans. The Applicant requests
relief for transactions meeting the conditions of the Underwriter
Exemptions because it would prefer one Exemption for all Issuers of
similar structures. However, the Applicant has stated that Issuers
may still issue debt securities pursuant to the Investor-Based
Exemptions.
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B. Legal Protections and Structure of Issuers
A goal in every structured finance transaction is to remove the
assets being securitized from the estate of the Sponsor so that in the
event of a bankruptcy or insolvency of such Sponsor, its creditors (or
regulators in the case of entities such as banks that are not eligible
to be debtors under the Bankruptcy Code (11 U.S.C.)) will be unable to
claim those assets or delay payments therefrom. This allows potential
buyers of Securities to base their purchasing decisions solely on the
creditworthiness of the assets and not the Sponsor. This transfer of
assets is referred to as a ``true sale.''
The Applicant asserts that if the transfer of assets by the Sponsor
is not treated as a ``true sale,'' the transaction would be deemed a
borrowing by the Sponsor, with the assets serving as collateral for the
financing. In a typical financing transaction, if the Sponsor were to
become the subject of a proceeding under the Bankruptcy Code (or
comparable regulatory provisions for entities that are not eligible to
be debtors under the Bankruptcy Code), the assets may be deemed
property of the Sponsor's estate. Although a secured creditor should
eventually realize the benefits of its pledged collateral, several
provisions of the Bankruptcy Code or comparable regulatory provisions
may operate to delay payments, and such creditor may in some cases
receive less than the full value of the pledged collateral. First,
immediately upon filing of a bankruptcy petition, Section 362(a) of the
Bankruptcy Code imposes an automatic stay on the ability of all secured
creditors to exercise their rights against pledged collateral. Other
sections of the Bankruptcy Code allow a bankruptcy court to permit the
use of pledged collateral to aid in the debtor's reorganization
(Section 363), to provide ``super priority'' liens on such assets
(Section 364), or to require a secured creditor in possession of the
collateral to return it to the debtor (Section 542). Thus, in a loan
financing transaction, the creditworthiness of the Sponsor is a prime
factor in determining whether to extend credit, as well as the value of
the collateral.
Accordingly, the goal in a structured finance transaction is to
insulate the collateral from the Sponsor. The usual mechanism to
accomplish this goal is through the creation and use of a bankruptcy
remote Issuer which issues the Securities. The assets to be securitized
are transferred to the Issuer in a ``true sale'' transaction. The
Issuer either issues Securities backed by those assets or transfers the
Securities (in a second transaction) to a second Issuer, which then
issues the Securities backed by those assets. These are known as ``one-
tier'' or ``two-tier'' transactions, respectively.
An Issuer can be formed as a corporation, limited partnership,
limited liability corporation or trust. Regardless of legal structure,
many restrictions are placed on the Issuer's operations, including its
ability to file for bankruptcy protection (either voluntarily or
involuntarily). Examples of such prohibitions are severe restrictions
on the Issuer's ability to borrow money or issue debt, as well as
prohibitions on the Issuer's merging with another entity, reorganizing,
liquidating or selling assets (outside of the permitted securitization
transactions). In this regard, the Issuer can only borrow money or
issue debt in connection with the securitization.
The documents which create the Issuer (articles/certificates of
incorporation for corporations, deeds of partnership/partnership
agreements for limited partnerships, articles of organization for
limited liability corporations or deeds of trust/trust agreements for
trusts) contain restrictive clauses significantly limiting the
activities of the Issuer (usually to just activities relating to the
securitization transactions). They also provide for the election of one
or more independent directors/partners/members whose affirmative
consent is required before a voluntary bankruptcy petition can be filed
by the Issuer. Independent directors are generally individuals not
having significant interests in, or other relationships with, the
related Sponsor or any of its affiliates. The legal documentation
evidencing the securitization often contains covenants prohibiting all
parties thereto from filing an involuntary bankruptcy petition against
the Issuer or initiating any other form of insolvency proceeding. In
this way, the Issuer, Sponsor, Servicer, trustees and others are
contractually prohibited from seeking such actions against the Issuer.
Once the Issuer is formed, the Sponsor will transfer the assets to
the Issuer, typically in exchange for the cash (and possibly some
Securities) received from the securitization transaction. This
transaction will be evidenced by appropriate legal documentation. Also,
a ``true sale'' opinion from counsel is obtained for Issuers subject to
the Bankruptcy Code. For those Issuers not subject to the Bankruptcy
Code, an opinion is obtained from counsel to the effect that in the
event of insolvency or receivership of the Sponsor, the assets
transferred to the Issuer will not be part of the estate of the
Sponsor.
The Applicant explains that the above procedures are generally
perceived as effective in removing the assets from the Sponsor's
bankruptcy estate. However, if the Sponsor were to file for bankruptcy
protection, a bankruptcy court, under the provisions of Section 105 of
the Bankruptcy Code, could still gain jurisdiction over the securitized
assets if the Issuer could be ``substantively consolidated'' with the
Sponsor. Substantive consolidation permits the bankruptcy court to
treat separate but related legal entities as one and merge the assets
and liabilities of two or more entities as if they belonged to one
debtor. If a court determines that the Issuer has not acted as a
separate legal entity but merely exists as an ``alter-ego'' of another
entity, then the court may utilize the principles of ``piercing the
corporate veil'' or substantive consolidation to gain control of the
underlying assets even if a ``true sale'' of such assets from the
Issuer to the Sponsor exists.
To prevent a court from ordering a substantive consolidation, the
applicable Rating Agencies require that the organizing documents of the
Issuer
[[Page 51458]]
contain a variety of ``separateness'' covenants. These include, among
other things, requirements that the Issuer: Maintain fully separate
books and records, not commingle assets with any other entity, maintain
separate accounts, conduct business in its own name, prepare separate
financial statements, engage only in arm's-length transactions with
affiliates, pay its liabilities only from its own funds, observe all
trust, corporate or partnership formalities (as applicable), not
guarantee the debts or pledge its assets in support of another entity,
hold itself out to be a separate legal entity and maintain adequate
capital for its business operations. In certain transactions, legal
opinions are delivered to the effect that adherence to these covenants
would be sufficient to prevent a court from ordering the substantive
consolidation of the Issuer into a debtor-parent or affiliate. The
Applicant has suggested similar restrictions relating to the activities
of the Issuer and the parties to an ABS/MBS transaction that would
serve as conditions of the exemptive relief requested with respect to
non-Trust Issuers (see section II.A.(8) of the Proposed Amendment).
The Applicant states that whether an Issuer is structured as a
corporation, limited partnership, limited liability corporation or
trust will have little impact on the relevant bankruptcy or insolvency
protection features. They are merely different legal entities with
differing structures but will produce, in the aggregate, similar types
of protections for investors. A corporation will have shareholders (who
benefit from limited liability protections) and debt holders (who enjoy
a superior claim on assets to that of shareholders and are taxed
differently). A limited partnership will have general partners (who
operate the entity and are ultimately responsible for its debts) and
limited partners (who will receive investment earnings but are only
liable to the extent of their actual investment in the event of
losses). In a limited liability corporation, ``members'' (also the
holders of equity Securities) are given the limited liability
protections of a corporation's equity holders (much like limited
partners but with a greater degree of permitted active management
abilities). In an owner trust (which is also referred to as a business
trust), the trust itself is a separately existing entity that is under
the day-to-day control of its trustee but whose profits are
distributable to the beneficial owners. According to the Applicant, an
owner trust is essentially a Delaware business trust or similar entity
as organized under other local law. An owner trust may also issue debt
instruments. It can also declare bankruptcy (unlike a common law trust
which does not exist as a legal entity distinct and separate from its
creator). As previously indicated, the specific entity chosen for a
structured finance transaction is often motivated by tax considerations
and less so by any legal advantage of one structural form over another.
C. Rights of Equity and Debt Holders
Equity holders have an undivided beneficial ownership interest in
the issuer's assets. Debt holders do not beneficially own such assets
but have a security interest in such assets which has preference over
the rights of the equity holders to such collateral. The Applicant
believes that, since the Underwriter Exemptions currently allow equity
investments by plans, it is entirely appropriate for the Department to
also provide relief for debt instruments which give their holders
preferential rights to the collateral.
The equity holders, limited partners or other beneficial owners of
all types of Issuers are liable on the obligations of the entity only
to the extent of such holders' investment and are not personally liable
on any obligations in excess thereof. In general, each type of Issuer
may issue debt, and while debt holders (or note holders) of any of
these entities do not own an ownership interest in the assets of the
Issuer, they are entitled to preferential treatment over equity holders
(e.g., certificateholders) or limited partners with respect to rights
to collateral. To protect equity and debt holders further, the pooled
assets of any specific transaction will be placed under the control of
a trustee who is independent from the Sponsor and the Servicers. This
can be accomplished in different ways depending on the type of Issuer.
If the Issuer is a trust and only equity Securities are issued, then
the trustee of the trust would have control over the pooled assets. If
instead, debt Securities are issued by any type of Issuer (trust or
non-trust), then the Indenture Trustee would have control of the pooled
assets. Accordingly, any requirements under the Proposed Exemption
applying to the ``trustee'' will apply to both the trustee of any
Issuer which is a trust and to any Indenture Trustee (each a
``Trustee'' and any Issuer which is a trust, a ``Trust''). In any
transaction where debt Securities are issued, possession of the assets
by the Trustee or filing a security interest would serve to perfect the
debt holders' security interest in the pooled assets. In transactions
involving debt Securities, the Rating Agencies require perfected
security interest opinions. The Applicant agrees to make perfected
security interest opinions a condition of exemptive relief for those
securities issued which are debt instruments.
D. Choice of Issuer and Choice of Debt Versus Equity Securities
The principal determining factors for the choice of securitization
vehicle and whether equity or debt Securities are issued are tax and
accounting considerations which have no affect on plan investors as
they are tax exempt.\12\
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\12\ Although plans are subject to tax on their unrelated
business taxable income under sections 511-514 of the Internal
Revenue Code of 1986, as amended (UBTI), the kind of income produced
in securitization transactions does not generally trigger UBTI if
the plan investor holds a Security which is treated as a debt
instrument for tax purposes.
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Although the decision as to whether debt or equity Securities are
issued does not significantly affect the interests of the
securityholders, it does affect the Sponsor of an Issuer. A Sponsor may
want to be able to recognize the gain from the sale of the receivables
to the Issuer for accounting purposes but not have the sale trigger
gain for tax purposes. Under Statement of Financial Accounting
Standards No. 125 (FASB 125) issued by the Financial Accounting
Standards Board, generally a transfer of assets to an Issuer which
results in the Sponsor surrendering control of the transferred assets
will allow the Sponsor to book the gain for accounting purposes.
However, the tax treatment to a Sponsor can be greatly affected by
whether the Issuer issues debt or equity Securities. For example, if an
Issuer other than a REMIC or a FASIT issues debt, the Sponsor is
generally not taxed on the sale of the assets into the Trust (which is
treated instead as a financing) but will be taxed on the same
percentage of the economic gain on such sale as the proportion of
equity interest in the Issuer which is sold by the Sponsor. By way of
illustration, if an Issuer issues $100 of Securities, $6 of which are
equity and $94 are debt, and the Sponsor keeps 100% of the equity and
sells all of the debt, it will not be taxed on the gain from selling
the assets to the Trust. However, if the Sponsor issues $100 of equity
Securities and sells 94% of them, it will recognize gain of $94 on the
sale of the Securities. Accordingly, if a transaction does not qualify
under the REMIC or FASIT rules, the transaction may be structured to
issue debt instruments.
E. Effect of Tax Rules on Choice of Issuer and Securities
The Applicant notes that the choice of Issuer and whether the
Securities
[[Page 51459]]
offered are debt or equity is also greatly affected by the tax rules
governing each type of Issuer. The tax characterization of Issuers is
not necessarily the same as their characterization under local law. For
example, a Trust can be taxed as a trust, a partnership, a corporation
or be completely ignored for tax purposes. Conversely, any form of
Issuer can be treated as a REMIC or FASIT for tax purposes if it meets
the applicable requirements and so elects. However, regardless of the
tax characterizations, the transaction will be structured to avoid
double taxation; i.e., taxation at both the Issuer level and the
investor level (for investors who are tax-paying entities). The tax
treatment of each type of Issuer with respect to which exemptive relief
is requested is as follows.
1. Grantor Trust
Under the Federal tax rules which govern grantor trusts as set
forth in Treas. Reg. section 301.7701-4(c), a grantor Trust is
disregarded for tax purposes and the securityholders are generally
taxed on their ratable share of the income of the Trust. There is no
specific prohibition on a grantor Trust's ability to issue debt under
the tax rules. However, this is usually not done because if the debt
securities were ever recharacterized as equity for tax purposes, the
trust could be viewed as violating Treas. Reg. section 301.7701-4(c)
which generally prohibits multiple classes of equity from being issued.
Although a grantor Trust is not permitted to issue multiple classes of
equity with disproportionate payments or fast-pay/slow-pay structures,
it may issue a senior class and a subordinated class, provided that
they each receive normal distributions pro rata. Because a grantor
Trust may not issue Securities with different maturity dates, real
estate related securitization transactions which are intended to have
these features are often structured as REMICs.
2. REMICs
REMICs can be formed as any type of Issuer; i.e., Trust,
corporation, partnership, limited liability company or even a
segregated pool of assets. A REMIC is permitted to issue both equity
and debt Securities but usually is set up as a Trust which issues
equity Securities. The REMIC itself does not pay tax, but the residual
equity holder instead is taxed on the REMIC's taxable income. REMIC
``regular'' interests are treated as debt instruments for tax purposes.
One of the principal advantages to using a REMIC structure is that the
transaction can use a fast-pay/slow-pay structure.
3. FASITs
FASITs can also be formed as any type of Issuer and can be a
segregated pool of assets. FASITs are a type of statutory entity
created by the Small Business Job Protection Act of 1996 (SBA) through
amendments to the Code effective on September 1, 1997.\13\ FASITs are
designed to facilitate the securitization \14\ of debt obligations,
such as credit card receivables, home equity loans and auto loans, and
thus allows certain features such as revolving pools of assets, Issuers
containing unsecured receivables and certain hedging types of
investments. A FASIT is permitted to issue both equity and debt
Securities. A FASIT is not a taxable entity and debt instruments issued
by such Issuers, which might otherwise be recharacterized as equity,
will be treated as debt in the hands of the holder for tax purposes.
The holder of the ownership interest (which may not be a pension plan)
is taxed on the FASIT income. FASIT ``regular interests'' are treated
as debt instruments.
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\13\ Section 1621 of the SBA added sections 860H, 860I, 860J,
860K and 860L to the Internal Revenue Code of 1986, as amended.
\14\ Securitization is the process of converting one type of
asset into another and generally involves the use of an entity
separate from the underlying assets. In the case of securitization
of debt instruments, the instruments created in the securitization
typically have different maturities and characteristics than the
debt instruments that are securitized.
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Although FASITs are permitted to have revolving pools of permitted
assets, exemptive relief is only currently available for FASITs that
are, in fact, passive in nature which would preclude (in the absence of
other exemptive relief) revolving asset pools. Thus, only FASITs with
assets which were comprised of secured debt and which did not allow
revolving pools of assets or hedging investments not otherwise
specifically authorized by the Underwriter Exemptions would be
permissible.
4. Owner Trusts
There are many situations where a securitization transaction wishes
to use a Trust as the Issuer but cannot qualify as a REMIC or a grantor
Trust. These include transactions that do not qualify as REMICs because
they either do not involve real estate assets (e.g., motor vehicle
transactions) or are real estate transactions where the REMIC rules are
not satisfied (e.g., the LTV ratios exceed the REMIC limits or the Pre-
Funding Period exceeds three months). If the parties wish to use the
type of tranching which uses a fast-pay/slow-pay structure, they also
cannot qualify as a grantor Trust. In such cases, the Issuer will be
set up as an owner Trust which is a business Trust. State statutory and
common law governs the formation and operation of owner trusts. An
owner Trust with more than one equity holder is treated as a
partnership with the same tax effects as the other types of Issuers
described above. The ``partnership'' is not taxed; its income is taxed
to its equity holders and any debt holders are taxed on the interest
income they receive. If the owner Trust is wholly owned, it is
disregarded for tax purposes.\15\ Whoever holds the equity in the owner
Trust is the beneficial owner of the trust assets. Therefore, if the
equity is sold to more than one entity it could have multiple
beneficial owners. The debt holder(s) would have a security interest in
the owner Trust assets.
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\15\ Whether an entity is wholly owned or owned by more than one
equity holder is determined under the tax rules.
---------------------------------------------------------------------------
5. Limited Liability Companies, Partnerships and Special Purpose
Corporations
Entities which are limited liability companies with more than one
equity holder or are partnerships under local law are taxed as
partnerships. If the limited liability company is wholly owned, it is
also disregarded for tax purposes.\16\ A special purpose corporation is
taxed on its income, but it receives a deduction for interest paid to
debt holders, so the tax result is similar to that of a partnership.
---------------------------------------------------------------------------
\16\ Id.
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While the permissible types of Issuers under the requested
exemption include Issuers which are not required under the tax rules to
be passive entities,\17\ in order for a transaction to qualify for
exemptive relief, each of the applicable requirements of the
Underwriter Exemptions as modified must be met. This would mean, for
example, that only transactions involving Issuers holding assets which
are comprised of secured debt (unless the assets are residential and
home equity loans in a Designated Transaction) and which do not allow
revolving pools of assets or hedging investments (unless specifically
authorized) are permissible under the requested relief. Specifically,
the Issuer must be maintained as an essentially passive entity, and,
therefore, both the Sponsor's discretion and the Servicer's discretion
with respect to assets included in an Issuer must be severely limited
both as to those assets transferred on the Closing Date and
[[Page 51460]]
those acquired during any Pre-Funding Period. Pooling and Servicing
Agreements provide for the substitution of Issuer receivables by the
Sponsor only in the event of breaches of representations and warranties
or defects in documentation discovered within a short time after the
issuance of Securities (within 120 days, except in the case of
obligations having an original term of 30 years, in which case the
period will not exceed two years). Any receivable so substituted is
required to have characteristics substantially similar to the replaced
receivable and will be at least as creditworthy as the replaced
receivable. In some cases, the affected receivable would be
repurchased, with the purchase price applied as a payment on the
affected receivable and passed through to securityholders.
---------------------------------------------------------------------------
\17\ Grantor trusts and REMICs are required under the tax rules
to be passive entities with limited asset substitution rights, but
other types of Issuers are not so restricted.
---------------------------------------------------------------------------
F. The Applicant's Arguments for Exemptive Relief for Different Types
of Issuers and Securities
Although, as previously noted, the choice of Issuer does not
significantly affect the rights of securityholders or the safety of the
investments, ERISA's prohibited transaction rules affect whether plan
investors can purchase these different forms of ABS/MBS. The plan asset
regulation set forth at 29 CFR Sec. 2510-3.101 (the Plan Asset
Regulation) was intended to prevent an employee benefit plan subject to
ERISA from retaining an asset manager indirectly through an equity
investment by the plan in an investment fund in order to avoid the
fiduciary responsibility and prohibited transaction provisions of
ERISA. The Department made a determination that debt instruments should
not be subject to the Plan Asset Regulations as they were not likely to
be vehicles for the indirect provision of investment management
services.\18\ As a consequence of this regulation, the treatment of
debt and the treatment of equity is very different under ERISA. Equity
investments in ABS/MBS not only can result in the purchase and sale of
the securities triggering prohibited transactions, but if the
underlying assets of the Trust are deemed to include plan assets, the
operation of the Trust and the servicing of its assets can also trigger
prohibited transactions.
---------------------------------------------------------------------------
\18\ See the preamble to the final Plan Asset Regulation, 51 FR
41280 (Nov. 13, 1986).
---------------------------------------------------------------------------
In contrast, investments in ABS/MBS which are debt securities avoid
any plan asset issues with respect to the operation of the Trust.
However, they can still result in one or more prohibited transactions.
This is because the acquisition or disposition of the debt security
itself may be a sale or exchange of property between a plan and a party
in interest and also an extension of credit between such entities. The
acquisition or disposition of the debt securities may be covered under
PTE 75-1. However, in many ABS/MBS transactions, the conditions of PTE
75-1 may not be met, i.e., where a broker-dealer is not selling the
securities but is instead acting as the placement agent for securities
which are being offered pursuant to a private placement exempt from
registration under the Securities Act of 1933. Similarly, if a plan
sold the ABS/MBS to a party in interest in the secondary market, Part V
of PTE 75-1 would not apply since it is limited to extensions of credit
to a plan in connection with the purchase or sale of securities (e.g.,
extensions of credits during the three-day settlement period).
When a plan purchases an ABS/MBS which is a debt security, it is
effectively viewed as an extension of credit to the Issuer for ERISA
purposes. While the Issuer, as a newly formed, special purpose entity,
would not be a party in interest with respect to such plan, if the
Issuer is deemed to be an affiliate of an existing party in interest,
this could create a prohibited extension of credit. Whenever ABS/MBS
are issued as debt, some other entity will own the equity of the
Issuer, either as a residual equity interest held by the Sponsor or all
or part of the equity could be sold to the public. If any equity holder
which owns a 50% or more interest in the Issuer is a party in interest
with respect to a plan holding the debt security, the Issuer will be
deemed a party in interest under 3(14)(G) of ERISA. This problem is
compounded by the fact that most publicly-offered securities are held
by the Depository Trust Company and Clearing Corporation so that the
identity of the public equity holders may not be known either at the
initial issuance of the securities or when a security is sold in the
secondary market. Accordingly, there is a need for the Underwriter
Exemptions to cover the acquisition, disposition and holding of debt
securities which is not met by PTE 75-1.
As debt securities generally are not eligible for relief under the
Underwriter Exemptions, an ABS/MBS which is a debt security may not be
purchased by a plan investor from a party in interest unless another
exemption is available. This is an anomalous result since the rights of
debt holders in ABS/MBS transactions are senior to those of
Certificateholders, and the decision to issue debt or equity ABS/MBS is
not dictated by the relative rights of the investor but is made based
on tax and accounting considerations which are not relevant to plan
investors. In fact, purchasers make the decision to invest in ABS/MBS
based on the projected return on the securities and the quality and
sufficiency of the underlying obligations in the pool without regard to
the characterization as debt or equity. According to the Applicant,
either type of security issued in an ABS/MBS transaction is viewed by
plan investment managers as a fixed income alternative to corporate
bonds. The fact that ABS/MBS pass-through Certificates are equity
interests under local law is completely disregarded by plan investors
except to the extent that the equity characterization negatively
impacts ERISA eligibility of those securities in the absence of an
exemption. Thus, the Applicant asserts that allowing debt securities
issued in ABS/MBS transactions to be eligible securities under the
Underwriter Exemptions is beneficial to such investors in their efforts
to diversify plan assets.
In this regard, the Applicant has submitted letters from the Rating
Agencies which state that the legal form of the issuer does not affect
the ratings given to comparable securities and that the Rating
Agencies' analysis takes into account the legal and structural risks of
each type of Issuer. Accordingly, the Applicant believes that, if a
particular transaction has sufficient substantive safeguards to protect
the interests of plan investors, the choice of Issuer or whether the
particular security is debt or equity should not be determinative of
whether they are eligible investments for ERISA plans.
Although the Applicant is requesting that the definition of
securitization vehicle be expanded to include special purpose
corporations, partnerships and limited liability companies, none of
which is a Trust, the Applicant believes that any and all requirements
under the Underwriter Exemptions which currently are applicable to the
``Trustee'' will continue to be applicable and are appropriate no
matter what type of Issuer is used. This is because, even in
transactions where the Issuer is not a Trust, ABS/MBS which are debt
securities will be issued pursuant to a Trust indenture, and there will
be an Indenture Trustee representing the interests of debt holders
which will be independent of the Sponsor and other members of the
Restricted Group. The Indenture Trustee is the trustee appointed
pursuant to an indenture which provides for the pledge of collateral to
secure the debt securities issued by the issuer pursuant to the
[[Page 51461]]
indenture and sets forth the rights of the debt holders. Accordingly,
the fact that an Issuer which is not a Trust does not have a Trustee
will not affect the existing requirement under the Underwriter
Exemptions relating to an independent Trustee that is not an affiliate
of any other member of the Restricted Group (see section III.M. of the
Proposed Amendment). Thus, there will always be an Independent Trustee
in transactions entered into pursuant to the requested exemption. The
Applicant notes that where the Issuer is not a Trust, equity will not
be sold to plans.
G. Classes of Securities
The Applicant notes that some of the Securities will be multi-class
Securities. The Applicant requests exemptive relief for two types of
multi-class Securities: ``strip'' Securities and ``fast-pay/slow-pay''
Securities. Strip Securities are a type of Security in which the stream
of interest payments on receivables is split from the flow of principal
payments and separate classes of Securities are established, each
representing rights to disproportionate payments of principal and
interest.\19\
---------------------------------------------------------------------------
\ 19\ It is the Department's understanding that where a plan
invests in REMIC ``residual'' interest Certificates to which this
Exemption applies, some of the income received by the plan as a
result of such investment may be considered unrelated business
taxable income to the plan, which is subject to income tax under the
Code. The Department emphasizes that the prudence requirement of
section 404(a)(1)(B) of the Act would require plan fiduciaries to
carefully consider this and other tax consequences prior to causing
plan assets to be invested in Certificates pursuant to this Proposed
Exemption.
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``Fast-pay/slow-pay'' Securities involve the issuance of classes of
Securities having different stated maturities or the same maturities
with different payment schedules. Interest and/or principal payments
received on the underlying Issuer's assets are distributed first to the
class of Securities having the earliest stated maturity of principal
and/or earlier payment schedule, and only when that class of Securities
has been paid in full (or has received a specified amount) will
distributions be made with respect to the second class of Securities.
Distributions on Securities having later stated maturities will proceed
in like manner until all the securityholders have been paid in full.
The only difference between this multi-class arrangement and a single-
class arrangement is the order in which distributions are made to
securityholders. In each case, securityholders will have a beneficial
ownership interest in the underlying Issuer's assets or a security
interest in the collateral securing such assets. Except as permitted in
a Designated Transaction, the rights of a plan purchasing Securities
will not be subordinated to the rights of another securityholder in the
event of default on any of the underlying obligations. In particular,
unless the Securities are issued in a Designated Transaction, if the
amount available for distribution to securityholders is less than the
amount required to be so distributed, all senior securityholders will
share in the amount distributed on a pro rata basis.\20\
---------------------------------------------------------------------------
\ 20\ If an Issuer issues subordinated Securities, holders of
such subordinated Securities may not share in the amount distributed
on a pro rata basis. The Department notes that the Proposed
Exemption does not provide relief for plan investment in such
subordinated Securities, unless the Securities are issued in a
Designated Transaction.
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III. Requested Modifications for Interest Rate Swap Agreements
A. Interest Rate Swaps
PTE 98-13 and PTE 98-14 provide exemptive relief for
securitizations featuring revolving pools of secured and unsecured
credit card receivables held in Trusts sponsored by MBNA and Citibank,
respectively, which Trusts may also hold simple interest rate swaps as
an asset. The granting of these exemptions involved extensive
discussions between the Department and representatives of MBNA and
Citibank as to the structure and operation of credit card
securitizations, including the use of interest rate swaps, and the
approach used by the Rating Agencies in rating these types of
securities where the rating given by the Rating Agency is dependent
upon the existence of an interest rate swap agreement.
Interest rate swaps are used in non-credit card securitization
transactions in the same manner that they are used in credit card
transactions; i.e., where the index used to calculate interest payments
on the receivables is different than the index used to calculate
interest payments on the securities issued by the Trust. For example,
many securities bear interest based upon the London Interbank Offered
Rate for dollar deposits of a specified maturity (LIBOR). However, the
assets being securitized often bear interest at fixed rates or rates
based upon U.S. Treasury securities, the prime rate or other indices
that may not move in tandem with LIBOR. The swap helps assure that the
Trust will have sufficient funds to make full payments of interest on
the securities.
The Applicant states that a class of Securities in a non-credit
card securitization may have the benefit of an interest rate swap
agreement entered into between the Issuer and a bank or other financial
institution acting as a swap counterparty. Pursuant to the swap
agreement, the swap counterparty would pay a certain rate of interest
to the Issuer in return for a payment of a rate of interest by the
Issuer, from collections allocable to the relevant class of Securities,
to the swap counterparty. The Applicant represents that the credit
rating provided to a particular class of Securities by the relevant
Rating Agency may or may not be dependent upon the existence of a swap
agreement. Thus, in some instances, the terms and conditions of the
swap agreements will not affect the credit rating of the class of
Securities to which the swap relates (i.e., a Non-Ratings Dependent
Swap).
The Applicant requests that the same exemptive relief which has
been provided to MBNA and Citibank with respect to interest rate swaps
be extended to all securitization transactions, otherwise meeting the
conditions of the requested amendment. Thus, the Applicant is
requesting relief for both ratings dependent and non-ratings dependent
swaps as described in PTE 98-13 and PTE 98-14 (the Credit Card
Exemptions), subject to the same terms and conditions regarding
interest rate swaps contained in those exemptions. Consistent with the
conditions of the Credit Card Exemptions, the Applicant has included
the swap counterparty as a member of the Restricted Group. However, two
revisions regarding interest rate swaps are necessary in order to make
the swap provisions compatible with fixed asset pool transactions.
First, the Credit Card Exemptions require that a ratings dependent
swap include as an early payout event the withdrawal or reduction by a
Rating Agency of the swap counterparty's credit rating where the
Servicer has failed to meet its obligations under the Pooling and
Servicing Agreement relating to obtaining a replacement swap agreement
or causing the swap counterparty to post collateral. The early payout
causes principal to be paid out for the benefit of securityholders
instead of being used to purchase additional credit card receivables.
In contrast, all principal and interest payments received by the Issuer
in non-revolving pool transactions are used to make payments to either
the securityholders, the swap counterparty or to pay servicing fees or
other expenses; none are used to purchase additional obligations for
deposit into the Issuer. Accordingly, the concept of an early payout
event is not relevant for
[[Page 51462]]
the non-revolving pools of assets which are covered under the
Underwriter Exemptions. Instead, the Applicant is proposing that if the
swap counterparty's rating is downgraded, and the Servicer fails to
obtain an acceptable replacement swap or to cause the swap counterparty
to post collateral or make other arrangements satisfactory to the
Rating Agency, the plan certificateholders would be notified in the
immediately following Trustee's periodic report and would have sixty
days thereafter to dispose of the Certificates before the exemptive
relief under section I.C. of the Underwriter Exemptions with respect to
the servicing, management and operation of the Issuer would
prospectively cease to be available. The party responsible for such
notification may be the Sponsor, the Trustee, a third-party
administrator or any other party designated in the pooling and
servicing agreement and/or servicing agreement to give periodic reports
to the securityholders.
Second, the Credit Card Exemptions use the term ``Excess Finance
Charge Collections'' which is not relevant to non-credit card ABS/MBS
transactions. Accordingly, the Applicant has substituted the term
``Excess Spread'' which is the functionally equivalent term and best
suited to the types of transactions covered by the Underwriter
Exemptions. The term ``excess spread'' applies to both ratings
dependent and non-ratings dependent swaps and is defined as the amount,
as of any given day funds are distributed from the issuer, by which the
interest allocated to the securities exceeds the amount necessary to
pay interest to the securityholders, servicing fees and issuer
expenses. This term is defined in section III.II. of the Proposed
Amendment.
The Applicant believes that allowing the use of interest rate swaps
is beneficial to plan investors as it helps to protect them from the
risk of interest rate fluctuations. The conditions the Department has
imposed in PTE 98-13 and PTE 98-14, which will be met with respect to
any interest rate swap used in transactions covered by the requested
exemption, will further protect the interest of plans. Accordingly, the
Applicant represents that whether or not the credit rating of a
particular class of Securities is dependent upon the terms and
conditions of one or more interest rate swap agreements entered into by
the Issuer (i.e., a ``Ratings Dependent Swap'' or a ``Non-Ratings
Dependent Swap''), each particular swap transaction will be an
``Eligible Swap'' as defined in the Proposed Amendment.
B. Conditions
In this regard, an Eligible Swap will be a swap transaction:
1. Which is denominated in U.S. Dollars;
2. Pursuant to which the Issuer pays or receives, on or immediately
prior to the respective payment or distribution date for the applicable
class of Securities, a fixed rate of interest or a floating rate of
interest based on a publicly available index (e.g. LIBOR or the U.S.
Federal Reserve's Cost of Funds Index (COFI)), with the Issuer
receiving such payments on at least a quarterly basis and being
obligated to make separate payments no more frequently than the
counterparty, with all simultaneous payments being netted;
3. Which has a notional amount that does not exceed either: (i) The
principal balance of the class of Securities to which the swap relates,
or (ii) the portion of the principal balance of such class represented
solely by those types of corpus or assets of the Issuer referred to in
subsections III.B. (1), (2) and (3) of the Proposed Amendment;
4. Which is not leveraged (i.e., payments are based on the
applicable notional amount, the day count fractions, the fixed or
floating rates designated in item (b) above and the difference between
the products thereof, calculated on a one-to-one ratio and not on a
multiplier of such difference);
5. Which has a final termination date that is the earlier of the
date on which the Issuer terminates or the related class of Securities
is fully repaid; and
6. Which does not incorporate any provision which could cause a
unilateral alteration in any provision described in items (1) through
(5) above without the consent of the Trustee.
In addition, any Eligible Swap entered into by the Issuer will be
with an ``Eligible Swap Counterparty,'' which will be a bank or other
financial institution with a rating at the date of issuance of the
Securities by the Issuer which is in one of the three highest long-term
credit rating categories, or one of the two highest short-term credit
rating categories, utilized by at least one of the Rating Agencies
rating the Securities; provided that, if a swap counterparty is relying
on its short-term rating to establish its eligibility, such
counterparty must either have a long-term rating in one of the three
highest long-term rating categories or not have a long-term rating from
the applicable Rating Agency, and provided further that if the class of
Securities with which the swap is associated has a final maturity date
of more than one year from the date of issuance of the Securities, and
such swap is a Ratings Dependent Swap, the swap counterparty is
required by the terms of the swap agreement to establish any
collateralization or other arrangement satisfactory to the Rating
Agencies in the event of a ratings downgrade of the swap counterparty.
Under any termination of a swap, the Issuer will not be required to
make any termination payments to the swap counterparty (other than a
currently scheduled payment under the swap agreement) except from
Excess Spread or other amounts that would otherwise be payable to the
Servicer or the Sponsor.
With respect to a Rating Dependent Swap, the Servicer shall either
cause the Eligible Counterparty to establish certain collateralization
or other arrangements satisfactory to the Rating Agencies in the event
of a rating downgrade of such swap counterparty below a level specified
by the Rating Agency (which will be no lower than the level which would
make such counterparty an Eligible Counterparty), or the Servicer shall
obtain a replacement swap with an Eligible Swap Counterparty acceptable
to the Rating Agencies with substantially similar terms. If the
Servicer fails to do so, the plan securityholders will be notified in
the immediately following Trustee's periodic report to securityholders
and will have a 60-day period thereafter to dispose of the Securities,
at the end of which period the exemptive relief provided under section
I.C. of the Underwriter Exemption (relating to the servicing,
management and operation of the Issuer) would prospectively cease to be
available. With respect to Non-Ratings Dependent Swaps, each Rating
Agency rating the Securities must confirm, as of the date of issuance
of the Securities by the Issuer, that entering into the swap
transactions with the Eligible Counterparty will not affect the rating
of the Securities, even if such counterparty is no longer an Eligible
Counterparty and the swap is terminated.\21\
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\21\ In the course of considering applications for exemptive
relief under PTE 98-13 and PTE 98-14, the Department received
representations from the Rating Agencies that certain classes of
Securities issued by an Issuer holding receivables will have
Securities ratings that are not dependent on the existence of a swap
transaction entered into by the Issuer. Therefore, a downgrade in
the swap counterparty's credit rating would not cause a downgrade in
the rating established by the Rating Agency for the Securities.
These Rating Agency representations stated that in such instances,
there will be more credit enhancements (e.g., ``excess spread,''
letters of credit, cash collateral accounts) for the class to
protect the securityholders than there would be in a comparable
class where the Issuer enters into a so-called Ratings Dependent
Swap. Non-Ratings Dependent Swaps are generally used as a
convenience to enable the Issuer to pay certain fixed interest rates
on a class of Securities. However, the receipt of such fixed rates
by the Issuer from the counterparty is not a necessity for the
Issuer to be able to make its fixed rate payments to the
securityholders.
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[[Page 51463]]
Any class of Securities to which one or more swap agreements
entered into by the Issuer applies will be acquired or held only by
Qualified Plan Investors. Qualified Plan Investors will be plan
investors represented by an appropriate independent fiduciary that is
qualified to analyze and understand the terms and conditions of any
swap transaction relating to the class of Securities to be purchased
and the effect such swap would have upon the credit rating of the
Securities to which the swap relates.
For purposes of the Underwriter Exemptions, such a qualified
independent fiduciary will be either:
(a) A ``qualified professional asset manager'' (i.e., QPAM), as
defined under Part V(a) of PTE 84-14;
(b) An ``in-house asset manager'' (i.e., INHAM), as defined under
Part IV(a) of PTE 96-23; or
(c) A plan fiduciary with total assets under management of at least
$100 million at the time of the acquisition of such Securities.
C. Yield Supplement Agreements
A yield supplement agreement is a contract under which the issuer
makes a single cash payment to the contract provider in return for the
contract provider promising to make certain payments to the issuer in
the event of market fluctuations in interest rates. For example, if a
class of securities promises an interest rate which is the greater of
7% or LIBOR and LIBOR increases significantly, the yield supplement
agreement might obligate the contract provider pay to the issuer the
excess of LIBOR over 7%. In some circumstances, the contract provider's
obligation may be capped at a certain aggregate maximum dollar
liability under the contract. Alternatively, a cap could be placed on
the supplemental interest that would be paid to a securityholder from
monies paid under the yield supplement agreement. For example, the
yield supplement agreement would provide the difference between LIBOR
and 7% but only to the extent that the securityholder would be paid a
total of 9%. The interest to be paid by the contract provider to the
issuer under the yield supplement agreement is usually calculated based
on a notional principal balance which may mirror the principal balances
of those classes of securities to which the yield supplement agreement
relates or some other fixed amount. This notional amount will not
exceed either: (i) The principal balance of the class of Securities to
which such agreement or arrangement relates, or (ii) the portion of the
principal balance of such class represented solely by those types of
corpus or assets of the Issuer referred to in subsections III.B. (1),
(2) and (3) of the Proposed Amendment. In all cases, the issuer makes
no payments other than the fixed purchase price for the yield
supplement agreement and may, therefore, be distinguished from an
interest rate swap agreement, notwithstanding that both types of
agreements may use an ISDA form of contract. The 1997 Amendment
includes within the definition of ``Trust'' cash or investments made
therewith which are credited to an account to provide payments to
certificateholders pursuant to any yield supplement agreement or
similar yield maintenance arrangement provided that such arrangements
do not involve swap agreements or other notional principal contracts.
However, the Applicant notes that the Credit Card Exemptions (PTE 98-13
and PTE 98-14) permit interest rate swaps which clearly feature
notional principal amounts. In addition to requesting exemptive relief
for ``plain vanilla'' interest rate swaps, the Applicant also requests
relief for yield supplement arrangements that do not involve interest
rate payments by the Trustee, even if they have a notional principal
amount.
Accordingly, the Applicant is requesting that yield supplement
agreements with notional principal amounts be permitted retroactively
to April 7, 1998, which is the date that PTE 98-13 and PTE 98-14 were
issued as final exemptions. The Applicant's request for relief covers
only the type of interest rate cap agreements which are currently
covered under the Underwriter Exemptions. The only change being
requested is to clarify that agreements which have a notional principal
balance and/or are set forth on International Swaps and Derivatives
Association, Inc. (``ISDA'') forms will be permitted.
The Applicant notes that no ``plan assets'' within the meaning of
the Plan Asset Regulation (under 29 CFR 2510-3-101) are utilized in the
purchase of the cap agreement, as the Sponsor or some other third party
funds such arrangement with an up-front single-sum payment. The
Issuer's only obligation is to receive payments from the counterparty
if interest rate fluctuations require them under the terms of the
contract and to pass them through to securityholders. The Rating
Agencies examine the creditworthiness of the counterparty in a ratings
dependent yield supplement agreement. The Applicant suggests that the
relief for yield supplement agreements should be subject to the same
conditions as for interest rate swaps found in the Credit Card
Exemptions ( PTE 98-13 and PTE 98-14), to the extent relevant. These
conditions would include that the yield supplement agreement must be
denominated in U.S. dollars, the agreement must not be leveraged, any
changes in these conditions must be subject to the consent of the
Trustee, and the counterparty must be subject to the same eligibility
requirements as an interest rate swap counterparty.
IV. Other Features of Securitizations
A. Formation of the Issuer
Each Issuer is established under a Pooling and Servicing Agreement
or equivalent agreement between a Sponsor, a Servicer and a Trustee.
Prior to the Closing Date under the Pooling and Servicing Agreement,
the Sponsor and/or Servicer selects receivables from the classes of
assets described in section III.B.(1)(a)-(f) of the Underwriter
Exemptions to be included in the Issuer, establishes the Issuer and
designates an independent entity as Trustee. Typically, on or prior to
the Closing Date, the Sponsor acquires legal title to all assets
selected for the Issuer. In some cases, legal title to some or all of
such assets continue to be held by the originator until the Closing
Date. On the Closing Date, the Sponsor and/or the originator conveys to
the Issuer legal title to the assets, and the Issuer issues Securities
representing fractional undivided interests in the Issuer's assets and/
or debt obligations of the Issuer.
B. Pre-Funding Accounts
While in many cases all of the receivables to be held in the Issuer
are transferred to the Issuer on or prior to the Closing Date,\22\ it
is also common for other transactions to be structured using a Pre-
Funding Account and/or a Capitalized Interest Account as described
below. If pre-funding is used, some portion of the receivables will be
transferred after the Closing Date during an interim Pre-Funding
Period. The Pre-Funding Period for any Issuer will be
[[Page 51464]]
defined as the period beginning on the Closing Date and ending on the
earliest to occur of: (i) The date on which the amount on deposit in
the Pre-Funding Account is less than a specified dollar amount, (ii)
the date on which an event of default occurs under the related Pooling
and Servicing Agreement \23\ or (iii) the date which is the later of
three months or ninety days after the Closing Date. If pre-funding is
used, cash sufficient to purchase the receivables to be transferred
after the Closing Date will be transferred to the Issuer by the Sponsor
or originator on the Closing Date. During the Pre-Funding Period, such
cash and temporary investments, if any, made therewith will be held in
a Pre-Funding Account and used to purchase the additional receivables,
the characteristics of which will be substantially similar to the
characteristics of the receivables transferred to the Issuer on the
Closing Date. Certain specificity and monitoring requirements described
below will be met which will be disclosed in the Pooling and Servicing
Agreement and/or the prospectus \24\ or private placement memorandum.
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\22\ The Department is of the view that the term ``Issuer''
under the Underwriter Exemptions would include an Issuer: (a) The
assets of which, although all specifically identified by the Sponsor
or originator as of the Closing Date, are not all transferred to the
Issuer on the Closing Date for administrative or other reasons but
will be transferred to the Issuer shortly after the Closing Date, or
(b) with respect to which Securities are not purchased by plans
until after the end of the Pre-Funding Period at which time all
receivables are contained in the Issuer.
\23\ The minimum dollar amount is generally the dollar amount
below which it becomes too uneconomical to administer the Pre-
Funding Account. An event of default under the Pooling and Servicing
Agreement generally occurs when: (i) A breach of a covenant or a
breach of a representation and warranty concerning the Sponsor, the
Servicer or certain other parties occurs which is not cured, (ii)
there occurs a failure to make required payments to securityholders
or (iii) the Servicer becomes insolvent.
\24\ References to the term ``prospectus'' herein shall include
any related prospectus supplement thereto, pursuant to which
Securities are offered to investors.
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For a transaction involving an Issuer using pre-funding, on the
Closing Date, a portion of the offering proceeds will be allocated to
the Pre-Funding Account generally in an amount equal to the excess of:
(i) The principal amount of Securities being issued over (ii) the
principal balance of the receivables being transferred to the Issuer on
such Closing Date. In certain transactions, the aggregate principal
balance of the receivables intended to be transferred to the Issuer may
be larger than the total principal balance of the Securities being
issued. In these cases, the cash deposited in the Pre-Funding Account
will equal the excess of the principal balance of the total receivables
intended to be transferred to the Issuer over the principal balance of
the receivables being transferred on the Closing Date.
On the Closing Date, the Sponsor transfers the receivables to the
Issuer in exchange for the Securities. The Securities are then sold to
an Underwriter for cash or to the securityholders directly if the
Securities are sold through a placement agent. The cash received by the
Sponsor from the securityholders (or the Underwriter) from the sale of
the Securities issued by the Issuer in excess of the purchase price for
the receivables and certain other Issuer expenses, such as underwriting
or placement agent fees and legal and accounting fees, constitutes the
cash to be deposited in the Pre-Funding Account. Such funds are either
held in the Issuer and accounted for separately, or are held in a sub-
account or sub-trust. In either event, these funds are not part of
assets of the Sponsor.
Generally, the receivables are transferred at par value, unless the
interest rate payable on the receivables is not sufficient to service
both the interest rates to be paid on the Securities and the
transaction fees (i.e., servicing fees, Trustee fees and fees to credit
support providers). In such cases, the receivables are sold to the
Issuer at a discount, based on an objective, written, mechanical
formula which is set forth in the Pooling and Servicing Agreement and
agreed upon in advance between the Sponsor, the Rating Agency and any
credit support provider or other Insurer. The proceeds payable to the
Sponsor from the sale of the receivables transferred to the Issuer may
also be reduced to the extent they are used to pay transaction costs.
In addition, in certain cases, the Sponsor may be required by the
Rating Agencies or credit support providers to set up Issuer reserve
accounts to protect the securityholders against credit losses.
The exemptive relief provided under the 1997 Amendment for pre-
funding is limited so that the percentage or ratio of the amount
allocated to the Pre-Funding Account, as compared to the total
principal amount of the Securities being offered (the Pre-Funding
Limit), does not exceed 25% effective for transactions occurring on or
after May 23, 1997 and did not exceed 40% effective for transactions
occurring on or after January 1, 1992, but prior to May 23, 1997. The
Pre-Funding Limit (which may be expressed as a ratio or as a stated
percentage or as a combination thereof) will be specified in the
prospectus or the private placement memorandum.
Any amounts paid out of the Pre-Funding Account are used solely to
purchase receivables and to support the interest rate payable on the
Securities (as explained below). Amounts used to support the interest
rate are payable only from investment earnings and are not payable from
principal. However, in the event that, after all of the requisite
receivables have been transferred into the Issuer, any funds remain in
the Pre-Funding Account, such funds will be paid to the securityholders
as principal prepayments. Upon termination of the Issuer, if no
receivables remain in the Issuer and all amounts payable to the
securityholders have been distributed, any amounts remaining in the
Issuer would be returned to the Sponsor.
A dramatic change in interest rates on the receivables held in an
Issuer using a Pre-Funding Account would be handled as follows. If the
receivables (other than those with adjustable or variable rates) had
already been originated prior to the Closing Date, no action would be
required as the fluctuations in market interest rates would not affect
the receivables transferred to the Issuer after the Closing Date. In
contrast, if interest rates fall after the Closing Date, receivables
originated after the Closing Date will tend to be originated at lower
rates, with the possible result that the receivables will not support
the interest rate payable on the Securities. In such situations, the
Sponsor could sell the receivables into the Issuer at a discount and
more receivables will be used to fund the Issuer in order to support
the interest rate. In a situation where interest rates drop
dramatically and the Sponsor is unable to provide sufficient loans at
the requisite interest rates, the pool of receivables would be closed.
In this latter event, under the terms of the Pooling and Servicing
Agreement, the securityholders would receive a repayment of principal
from the unused cash held in the Pre-Funding Account. In transactions
where the interest rates payable on the Securities are variable or
adjustable, the effects of market interest rate fluctuations are
mitigated. In no event will fluctuations in interest rates payable on
the receivables affect the interest rate payable on fixed rate
Securities.
The cash deposited into the Issuer and allocated to the Pre-Funding
Account is invested in certain permitted investments (see below), which
may be commingled with other accounts of the Issuer. The allocation of
investment earnings to each Issuer account is made periodically as
earned in proportion to each account's allocable share of the
investment returns. As Pre-Funding Account investment earnings are
required to be used to support (to the extent authorized in the
particular transaction) the amounts of interest payable to the
securityholders with respect to a periodic distribution date, the
Trustee is necessarily required to make periodic, separate allocations
of
[[Page 51465]]
the Issuer's earnings to each Issuer account, thus ensuring that all
allocable commingled investment earnings are properly credited to the
Pre-Funding Account on a timely basis.
C. The Capitalized Interest Account
In certain transactions where a Pre-Funding Account is used, the
Sponsor and/or originator may also transfer to the Issuer additional
cash on the Closing Date, which is deposited in a Capitalized Interest
Account and used during the Pre-Funding Period to compensate the
securityholders for any shortfall between the investment earnings on
the Pre-Funding Account and the interest rate payable on the
Securities.
The Capitalized Interest Account is needed in certain transactions
since the Securities are supported by the receivables and the earnings
on the Pre-Funding Account, and it is unlikely that the investment
earnings on the Pre-Funding Account will equal the interest rates
payable on the Securities (although such investment earnings will be
available to pay interest on the Securities). The Capitalized Interest
Account funds are paid out periodically to the securityholders as
needed on distribution dates to support the interest rate. In addition,
a portion of such funds may be returned to the Sponsor from time to
time as the receivables are transferred into the Issuer and the need
for the Capitalized Interest Account diminishes. Any amounts held in
the Capitalized Interest Account generally will be returned to the
Sponsor and/or originator either at the end of the Pre-Funding Period
or periodically as receivables are transferred and the proportionate
amount of funds in the Capitalized Interest Account can be reduced.
Generally, the Capitalized Interest Account terminates no later than
the end of the Pre-Funding Period. However, there may be some cases
where the Capitalized Interest Account remains open until the first
date distributions are made to securityholders following the end of the
Pre-Funding Period.
In other transactions, a Capitalized Interest Account is not
necessary because the interest paid on the receivables exceeds the
interest payable on the Securities at the applicable interest rate and
the fees payable by the Issuer. Such excess is sufficient to make up
any shortfall resulting from the Pre-Funding Account earning less than
the interest rate payable on the Securities. In certain of these
transactions, this occurs because the aggregate principal amount of
receivables exceeds the aggregate principal amount of Securities.
D. Pre-Funding Account and Capitalized Interest Account Payments and
Investments
Pending the acquisition of additional receivables during the Pre-
Funding Period, it is expected that amounts in the Pre-Funding Account
and the Capitalized Interest Account will be invested in certain
permitted investments or will be held uninvested. Pursuant to the
Pooling and Servicing Agreement, all permitted investments must mature
prior to the date the actual funds are needed. The permitted types of
investments in the Pre-Funding Account and Capitalized Interest Account
are investments which are either: (i) Direct obligations of, or
obligations fully guaranteed as to timely payment of principal and
interest by, the United States or any agency or instrumentality
thereof, provided that such obligations are backed by the full faith
and credit of the United States or (ii) have been rated (or the Obligor
on the investment has been rated) in one of the three highest generic
rating categories by Standard & Poor's Ratings Services, a division of
The McGraw-Hill Companies Inc., (S&P's), Moody's Investors Service,
Inc. (Moody's), Duff & Phelps Credit Rating Co. (D&P), Fitch ICBA, Inc.
(Fitch) or any successors thereto (each a Rating Agency or
collectively, the Rating Agencies) as set forth in the Pooling and
Servicing Agreement and as required by the Rating Agencies. The credit
grade quality of the permitted investments is generally no lower than
that of the Securities. The types of permitted investments will be
described in the Pooling and Servicing Agreement.
The ordering of interest payments to be made from the Pre-Funding
Account and Capitalized Interest Accounts is pre-established and set
forth in the Pooling and Servicing Agreement. The only principal
payments which will be made from the Pre-Funding Account are those made
to acquire the receivables during the Pre-Funding Period and those
distributed to the securityholders in the event that the entire amount
in the Pre-Funding Account is not used to acquire receivables. The only
principal payments which will be made from the Capitalized Interest
Account are those made to securityholders if necessary to support the
Security interest rate or those made to the Sponsor either periodically
as they are no longer needed or at the end of the Pre-Funding Period
when the Capitalized Interest Account is no longer necessary.
E. The Characteristics of the Receivables Transferred During the Pre-
Funding Period
In order to ensure that there is sufficient specificity as to the
representations and warranties of the Sponsor regarding the
characteristics of the receivables to be transferred after the Closing
Date during the Pre-Funding Period:
1. All such receivables will meet the same terms and conditions for
eligibility as those of the original receivables used to create the
Issuer (as described in the prospectus or private placement memorandum
and/or Pooling and Servicing Agreement for such Securities), which
terms and conditions have been approved by a Rating Agency. However,
the terms and conditions for determining the eligibility of a
receivable may be changed if such changes receive prior approval either
by a majority vote of the outstanding securityholders or by a Rating
Agency; \25\
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\25\ In some transactions, the Insurer and/or credit support
provider may have the right to veto the inclusion of receivables,
even if such receivables otherwise satisfy the underwriting
criteria. This right usually takes the form of a requirement that
the Sponsor obtain the consent of these parties before the
receivables can be included in the Issuer. The Insurer and/or credit
support provider may, therefore, reject certain receivables or
require that the Sponsor establish certain Issuer reserve accounts
as a condition of including these receivables. Virtually all Issuers
which have Insurers or other credit support providers are structured
to give such veto rights to these parties. The percentage of Issuers
that have Insurers and/or credit support providers, and accordingly
feature such veto rights, varies.
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2. The transfer of the receivables acquired during the Pre-Funding
Period will not result in the Securities receiving a lower credit
rating from the Rating Agency upon termination of the Pre-Funding
Period than the rating that was obtained at the time of the initial
issuance of the Securities by the Issuer;
3. The weighted average annual percentage interest rate (the
average interest rate) for all of the receivables in the Issuer at the
end of the Pre-Funding Period will not be more than 100 basis points
(``bps'') lower than the average interest rate for the receivables
which were transferred to the Issuer on the Closing Date;
4. The Trustee of the Trust (or any agent with which the Trustee
contracts to provide trust services) will be a substantial financial
institution or trust company experienced in Issuer activities and
familiar with its duties, responsibilities and liabilities as a
fiduciary under the Act. The Trustee, as the legal owner of the
receivables in the Issuer or the holder of a security interest in the
receivables, will enforce all the
[[Page 51466]]
rights created in favor of securityholders of the Issuer, including
employee benefit plans subject to the Act.
In order to ensure that the characteristics of the receivables
actually acquired during the Pre-Funding Period are substantially
similar to receivables that were acquired as of the Closing Date, the
Applicant represents that for transactions occurring on or after May
23, 1997,\26\ the characteristics of the subsequently acquired
receivables will either be monitored by a credit support provider or
other insurance provider which is independent of the Sponsor or an
independent accountant retained by the Sponsor will provide the Sponsor
with a letter (with copies provided to the Rating Agencies, the
Underwriter and the Trustee) stating whether or not the characteristics
of the additional receivables acquired after the Closing Date conform
to the characteristics of the receivables described in the prospectus,
private placement memorandum and/or Pooling and Servicing Agreement. In
preparing such letter, the independent accountant will use the same
type of procedures as were applicable to the receivables which were
transferred as of the Closing Date.
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\26\ May 23, 1997, was the date the proposed 1997 Amendment to
the Underwriter Exemption was published in the Federal Register.
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Each prospectus, private placement memorandum and/or Pooling and
Servicing Agreement will set forth the terms and conditions for
eligibility of the receivables to be held by the Issuer as of the
related Closing Date, as well as those to be acquired during the Pre-
Funding Period, which terms and conditions will have been agreed to by
the Rating Agencies which are rating the applicable Securities as of
the Closing Date. Also included among these conditions is the
requirement that the Trustee be given prior notice of the receivables
to be transferred, along with such information concerning those
receivables as may be requested. Each prospectus or private placement
memorandum will describe the amount to be deposited in, and the
mechanics of, the Pre-Funding Account and will describe the Pre-Funding
Period for the Issuer.
F. Parties to Transactions
The originator of a receivable is the entity that initially lends
money to a borrower (Obligor), such as a homeowner or automobile
purchaser, or leases property to a lessee. The originator may either
retain a receivable in its portfolio or sell it to a purchaser, such as
a Sponsor.
Originators of receivables held by the Issuer will be entities that
originate receivables in the ordinary course of their business
including finance companies for whom such origination constitutes the
bulk of their operations, financial institutions for whom such
origination constitutes a substantial part of their operations, and any
kind of manufacturer, merchant, or service enterprise for whom such
origination is an incidental part of its operations. Each Issuer may
hold assets of one or more originators. The originator of the
receivables may also function as the Sponsor or Servicer.
The Sponsor will be one of three entities: (i) A special-purpose or
other corporation unaffiliated with the Servicer, (ii) a special-
purpose or other corporation affiliated with the Servicer, or (iii) the
Servicer itself. Where the Sponsor is not also the Servicer, the
Sponsor's role will generally be limited to acquiring the receivables
to be held by the Issuer, establishing the Issuer, designating the
Trustee, and assigning the receivables to the Issuer.
The Trustee of a Trust (or the Issuer, if it is not a Trust) is the
legal owner of the obligations held by the Issuer and would hold a
security interest in the collateral securing such obligations. The
Trustee is also a party to or beneficiary of all the documents and
instruments transferred to the Issuer, and as such, has both the
authority to, and the responsibility for, enforcing all the rights
created thereby in favor of securityholders, including those rights
arising in the event of default by the servicer.
The Trustee will be an independent entity, and therefore will be
unrelated to the Underwriter, the Sponsor or the Servicer or any other
member of the Restricted Group. The Applicant represents that the
Trustee will be a substantial financial institution or trust company
experienced in trust activities. The Trustee receives a fee for its
services, which will be paid by the Servicer, Sponsor or out of the
Issuer's assets. The method of compensating the Trustee will be
specified in the Pooling and Servicing Agreement and disclosed in the
prospectus or private placement memorandum relating to the offering of
the Securities.
The rights and obligations of the Indenture Trustee are no
different than those of the Trustee of an Issuer which is a Trust. The
Indenture Trustee is obligated to oversee and administer the activities
of all of the ongoing parties to the transaction and possesses the
authority to replace those entities, sue them, liquidate the collateral
and perform all necessary acts to protect the interests of the debt
holders. If debt is issued in a transaction, there may not be a pooling
and servicing agreement. Instead, there is a sales agreement and
servicing agreement (or these two agreements are sometimes combined
into a single agreement). The agreement(s) set(s) forth, among other
things, the duties and responsibilities of the parties to the
transaction relating to the administration of the Issuer. The Indenture
Trustee is often a party to these agreements. At a minimum, the
Indenture Trustee acknowledges its rights and responsibilities in these
agreements or they are contractually set forth in the indenture
agreement pursuant to which the Indenture Trustee is appointed.
The Servicer of an Issuer administers the receivables on behalf of
the securityholders. The Servicer's functions typically involve, among
other things, notifying borrowers of amounts due on receivables,
maintaining records of payments received on receivables and instituting
foreclosure or similar proceedings in the event of default. In cases
where a pool of receivables has been purchased from a number of
different originators and transferred to an Issuer, it is common for
the receivables to be ``subserviced'' by their respective originators
and for a single entity to ``master service'' the pool of receivables
on behalf of the owners of the related series of Securities. Where this
arrangement is adopted, a receivable continues to be serviced from the
perspective of the borrower by the local Subservicer, while the
investor's perspective is that the entire pool of receivables is
serviced by a single, central Master Servicer who collects payments
from the local Subservicers and pays them to securityholders.
A Servicer's default is treated in the same manner whether or not
the Issuer is a Trust. The original Servicer is replaced. The entity
replacing the Servicer varies from transaction to transaction. In
certain cases, it may be the Trustee (or Indenture Trustee if the
Issuer is not a Trust) or may be a third party satisfactory to the
Rating Agencies. In addition, there are transactions where the Trustee
or Indenture Trustee will assume the Servicer's responsibilities on a
temporary basis until the permanent replacement takes over. In all
cases, the replacement entity must be capable of satisfying all of the
duties and responsibilities of the original Servicer and must be an
entity that is satisfactory to the Rating Agencies.
As noted above, the Underwriter Exemptions currently require that
the Trustee not be an Affiliate of any
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member of the Restricted Group. Thus, if a Servicer of receivables held
by an Issuer which has issued Securities in reliance upon the
Underwriter Exemptions (or an Affiliate thereof) merges with or is
acquired by (or acquires) the Trustee of such Trust (or an Affiliate
thereof), exemptive relief would cease to be available under the
Underwriter Exemptions. The Applicant states that, as the result of
legal constraints applicable to such merger and acquisition
transactions (e.g., confidentiality requirements), the entities
involved in the transaction are unable before the transaction is
consummated to cross check all relationships between the often numerous
Affiliates of the entities involved in the transaction in order to
determine whether or not any of the new affiliations resulting from the
transaction will violate this non-affiliation condition of the
Underwriter Exemptions. In response to this issue, the Department
proposes to revise subsection II.A.(4) of the Underwriter Exemptions to
provide that this condition will not be considered to be violated for
transactions occurring on or after January 1, 1998, merely by reason of
a Servicer becoming an Affiliate of the Trustee as the result of a
merger or acquisition between or among the Trustee, such Servicer and/
or their Affiliates which occurs after the initial issuance of the
Securities, provided that: (i) Such Servicer ceases to be an Affiliate
of the Trustee no later than six months after the later of August 23,
2000, or the date such Servicer became an Affiliate of the Trustee; and
(ii) such Servicer did not breach any of its obligations under the
Pooling and Servicing Agreement, unless such breach was immaterial and
timely cured in accordance with the terms of such agreement, during the
period from the closing date of such merger or acquisition transaction
through the date the Servicer ceased to be an Affiliate of the Trustee.
The Department proposes to make this revision retroactive to January 1,
1998 in response to the Applicant's representations that recent merger
and acquisition transactions occurring within the financial services
industry have resulted in an unknown but potentially significant number
of inadvertent violations of this condition.
The Underwriter will be a registered broker-dealer that acts as
Underwriter or placement agent with respect to the sale of Securities.
Public offerings of Securities are generally made on a firm commitment
or agency basis. Private placement of Securities may be made on a firm
commitment or agency basis. It is anticipated that the lead or co-
managing Underwriters will make a market in Securities offered to the
public.
In some cases, the originator and Servicer of receivables to be
held by an Issuer and the Sponsor of the Issuer (though they themselves
may be related) will be unrelated to the Underwriter. In other cases
however, Affiliates of the Underwriter may originate or service
receivables held by an Issuer or may sponsor an Issuer.
G. Security Price, Interest Rate and Fees
In some cases, the Sponsor will obtain the receivables from various
originators or other secondary market participants pursuant to existing
contracts with such originators or other secondary market participants
under which the Sponsor continually buys receivables. In other cases,
the Sponsor will purchase the receivables at fair market value from the
originator or a third party pursuant to a purchase and sale agreement
related to the specific offering of Securities. In other cases, the
Sponsor will originate the receivables itself.
As compensation for the receivables transferred to the Issuer, the
Sponsor receives Securities representing the entire beneficial interest
in the Issuer and/or debt Securities representing the Issuer's
obligations to debt securityholders, or the cash proceeds of the sale
of such Securities. If the Sponsor receives Securities from the Issuer,
the Sponsor sells some or all of these Securities for cash to investors
or securities underwriters.
The price of the Securities, both in the initial offering and in
the secondary market, is affected by market forces including investor
demand, the interest rate payable on the Securities in relation to the
rate payable on investments of similar types and quality, expectations
as to the effect on yield resulting from prepayment of the underlying
receivables, and expectations as to the likelihood of timely payment.
The interest rate payable on the Securities is equal to the
interest rate on receivables included in the Issuer minus a specified
servicing fee.\27\ This rate is generally determined by the same market
forces that determine the price of a Security. The price of a Security
and its interest, or coupon, rate, together determine the yield to
investors. If an investor purchases a Security at less than par, that
discount augments the stated interest rate; conversely, a Security
purchased at a premium yields less than the stated coupon.
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\ 27\ The interest rate payable on Securities representing
interests in Issuers holding leases is determined by breaking down
lease payments into ``principal'' and ``interest'' components based
on an implicit interest rate.
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As compensation for performing its servicing duties, the Servicer
(who may also be the Sponsor or an Affiliate thereof, and receive fees
for acting as Sponsor) will retain the difference between payments
received on the receivables held by the Issuer and payments (payable at
the interest rate) to securityholders, except that in some cases a
portion of the payments on the receivables may be paid to a third
party, such as a fee paid to a provider of credit support. The Servicer
may receive additional compensation by having the use of the amounts
paid on the receivables between the time they are received by the
Servicer and the time they are due to the Issuer (which time is set
forth in the Pooling and Servicing Agreement). The Servicer typically
will be required to pay the administrative expenses of servicing the
Issuer, including in some cases the Trustee's fee, out of its servicing
compensation.
The Servicer is also compensated to the extent it may provide
credit enhancement to the Issuer or otherwise arrange to obtain credit
support from another party. This ``credit support fee'' may be
aggregated with other servicing fees, and is either paid out of the
income received on the receivables in the Issuer in excess of the
interest rate or paid in a lump sum at the time the Issuer is
established.
The Servicer may be entitled to retain certain administrative fees
paid by a third party, usually the Obligor. These administrative fees
fall into three categories: (a) Prepayment fees; (b) late payment and
payment extension fees; and (c) expenses, fees and charges associated
with foreclosure or repossession, or other conversion of a secured
position into cash proceeds, upon default of an obligation.
Compensation payable to the Servicer will be set forth or referred
to in the Pooling and Servicing Agreement and described in reasonable
detail in the prospectus or private placement memorandum relating to
the Securities.
Payments on receivables held by the Issuer may be made by Obligors
to the Servicer at various times during the period preceding any date
on which interest payments to the Issuer are due. In some cases, the
Pooling and Servicing Agreement may permit the Servicer to place these
payments in non-interest bearing accounts in itself or to commingle
such payments with its own funds prior to the distribution dates. In
these cases, the Servicer would be entitled to the benefit derived from
the use of the funds between the date of payment on a receivable and
the
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payment date on the Securities. Commingled payments may not be
protected from the creditors of the Servicer in the event of the
Servicer's bankruptcy or receivership. In those instances when payments
from receivables are held in non-interest bearing accounts or are
commingled with the Servicer's own funds, the Servicer is required to
deposit these payments by a date specified in the Pooling and Servicing
Agreement into an account from which the Issuer makes payments to
securityholders.
The Underwriter will receive a fee in connection with the
underwriting or private placement of Securities. In a firm commitment
underwriting, this fee would normally consist of the difference between
what the Underwriter receives for the Securities that it distributes
and what it pays the Sponsor for those Securities. In a private
placement, the fee normally takes the form of an agency commission paid
by the Sponsor. In a best efforts underwriting in which the Underwriter
would sell Securities in a public offering on an agency basis, the
Underwriter would receive an agency commission rather than a fee based
on the difference between the price at which the Securities are sold to
the public and what it pays the Sponsor. In some private placements,
the Underwriter may buy Securities as principal, in which case its
compensation would be the difference between what the Underwriter
receives for the Securities and what it pays the Sponsor for these
Securities.
H. Purchase of Receivables by the Servicer
The Applicant represents that as the principal amount of the
receivables held by an Issuer is reduced by payments, the cost of
administering the Issuer generally increases, making the servicing of
the receivables prohibitively expensive at some point. Consequently,
the Pooling and Servicing Agreement generally provides that the
Servicer may purchase the receivables remaining in the Issuer when the
aggregate unpaid balance payable on the receivables is reduced to a
specified percentage (usually between 5 and 10 percent) of the initial
aggregate unpaid balance.
The purchase price of a receivable is specified in the Pooling and
Servicing Agreement and will be at least equal to either: (1) The
unpaid principal balance on the receivable plus accrued interest, less
any unreimbursed advances of principal made by the Servicer, or (2) the
greater of the amount in (1) or (b) the fair market value of such
obligations in the case of a REMIC, or the fair market value of the
receivables in the case of an Issuer which is not a REMIC.
V. Requested Modifications for Motor Vehicles, Residential/Home
Equity, Manufactured Housing and Commercial Mortgage-Backed
Securities Transactions
A. The Applicant's Request
The Applicant requests an amendment to the 1997 Amendment to
provide relief for the offering of investment-grade mortgage-backed
securities (MBS) and asset-backed securities (ABS) which are either
senior or subordinated, and/or in certain cases, permit the Issuer to
hold receivables with loan-to-value property ratios (LTV ratios) in
excess of 100%. Specifically, this request relates to Securities issued
by Issuers for a limited number of asset categories: (1) Automobile and
other motor vehicle ABS which are senior or subordinated securities
rated ``AAA,'' ``AA,'' ``A'' or ``BBB''; (2) residential and home
equity ABS/MBS with senior or subordinated securities rated either
``AAA,'' ``AA,'' ``A'' or ``BBB,'' which are issued by Issuers whose
assets may include mortgage loans with LTV ratios in excess of 100%;
(3) manufactured housing ABS/MBS with senior or subordinated securities
rated either ``AAA,'' ``AA,'' ``A'' or ``BBB'' and (4) commercial
mortgage-backed securities (CMBS) which are senior or subordinated
securities rated ``AAA,'' ``AA,'' ``A'' or ``BBB.''
The Applicant requests that the Department include high LTV loans
as acceptable assets of the Issuer only in residential and/or home
equity transactions, as long as such loans are secured by collateral
whose fair market value on the Closing Date of the securitization
transaction is at least equal to 80% of the sum of the outstanding
principal balance due under the loan which is held as an asset of the
Issuer and that of other loans if any, of higher priority (whether or
not held by the Issuer) which are secured by the same collateral. This
modification would also address the situation where a residential or
home equity pool of assets contains a de minimis number of
undercollateralized loans. According to TBMA, a pool could have, for
example, 400 loans, 399 of which are fully secured and one of which is
99% secured, but the transaction would not qualify for the Underwriter
Exemptions. The situation cannot always be cured by removing even a
small number of loans from the pool because replacement loans may not
be available by closing, and pre-funding may not be feasible. The
Applicant has suggested as additional safeguards, that: (i) the rights
and interests evidenced by the Securities issued in such Designated
Transactions involving residential and/or home equity transactions with
high LTV loans are not subordinated to the rights and interests
evidenced by Securities of the same Issuer, and (ii) such Securities
acquired by the plan have received a rating from a Rating Agency at the
time of such acquisition that is in one of the two highest generic
rating categories.
The Applicant believes that it is appropriate for the Department to
provide relief for Designated Transactions for three principal reasons.
First, such ABS/MBS have proven to be extremely safe investments
with superior credit performance and investment return. Defaults on
investment-grade ABS/MBS have occurred in only isolated instances,
despite significant down-market cycles experienced during the financial
history of such securities. In addition, comparably rated corporate
bonds have historically experienced more downgrades and a much greater
number of defaults. Even during extreme credit market conditions, such
as those of the late summer and early fall of 1998 which put severe
cash flow stress on securitization Sponsors, ABS/MBS securitization
structures maintained their integrity and continued to perform in
accordance with their terms.
Second, allowing a broader range of ABS/MBS to be purchased by plan
investors as an alternative to corporate bonds is beneficial to plan
participants and their beneficiaries because it allows greater
diversification of investments by plans without sacrificing the safety
and credit quality of those investments. It also gives plan investors
the flexibility of being able to structure a portfolio of fixed income
securities with varying maturities and cash flow characteristics that
can be tailored to the unique requirements of each plan.
Third, most ABS/MBS, unlike corporate bonds whose performance is
dependent on the financial condition of one Obligor, constitute
interests in a discrete pool of financial assets which can be evaluated
by plan fiduciaries who have available to them a large body of
historical data as to the performance of various types of ABS/MBS
issued by many different issuer |
