New SEC Rule 193 Adds Muscle to Issuer Disclosure Process

Another important ruling by the SEC this past week should significantly tighten up issuer disclosure related to the review of asset pools pledged to new securitizations.

A particularly sticky wicket in the unraveling of what might have gone wrong along the path to placing so many “toxic” assets in sub-prime mortgage and other asset-backed structures has been the inability to pin the responsibility for shoddy due diligence or portfolio reviews on any particular party in the “issuance chain” including, the issuers, underwriters, rating agencies, accountants and law firms.

Over the past few years, it has been clear to even the casual industry observer that while the industry (in the form of the same parties mentioned above) had for years been saying one thing (i.e. the collateral pools had been put through rigorous review and testing), in too many cases, it had been doing quite another (i.e. totally inadequate due diligence).

Once again, we think that SEC has gotten it right with the issuance of new Rule 193 of the Securities Act of 1933.  The rule does two important things:

1) It begins to set some standards for the level of review that an issuer should undertake in connection with a new securitization.  While leaving ample room for interpretation to exactly how detailed a review should be completed on an asset by asset class basis (e.g. perhaps a 100% review for a CMBS securitization and something more like a sample in the case of a credit card transaction), the Rule makes it clear that the collateral review should “provide reasonable assurance that the disclosure in the prospectus regarding the assets is accurate in all material respects”.

2) Rule 193 makes it much clearer that the issuer or a third-party that might have been relied upon to perform the collateral review shall be accountable for the quality of the review.  In fact, the Rule will require an issuer that has relied on a third-party firm to conduct the review to disclose the name of that firm in the registration statement, thereby exposing that third-party firm to liability as an “expert” under the Securities Act of 1933.

We believe that these measures are both necessary and appropriate.  We can so no reason why an issuer should be opposed to fulfilling the requirement of providing “reasonable assurance” to their investors that the particulars of the collateral pool are consistent with the representations described in the registration statement.

As you might imagine the requirement for third-party reviewers to “step up and be counted” has not been met with cheers by some in  the industry, most notably the firms that provide third-party due diligence and surveillance services.  It is certainly easy to appreciate that these companies would be very concerned about the costs associated with the liability that goes along with being labeled an “expert”, even if it is just the cost of additional insurance that they may have to carry.

We find these grievances to be just a bit hollow.  Hasn’t it been these same firms that for many years have touted their “expertise” and “experience” in this field; offering issuers a “better solution” for due diligence and surveillance, particularly in high volume asset classes (e.g. RMBS)?  We find the cry of additional cost to be a little bit too much to take, particularly when it might appear to some that these firms were paid for many years to deliver a level of quality that they clearly did not come close to achieving.   Even today, one can simply view some of the websites for these third-party providers and see words like “expertise” and “experience” thrown around quite liberally.  Seems to us that these firms should be willing to live up to their advertising. 

Some in the industry have also indicated that the costs associated with this additional liability may drive some of these third-party providers out of business.  We would again argue that this doesn’t hold water because, without changes like this (where issuers and their agents are willing to step up and be counted), there will be no resurgence in the securitization markets.  So on that basis, if they won’t step up, they need not worry, since there won’t be a market anyway.

We are also hearing that many third-party providers will be unwilling to have their names disclosed in a registration statement.  Cleary, the issuer will have to decide if they intend to rely on a third-party review or not.  If a third-party firm refuses to have their name disclosed, then it will be up to the issuer to take responsibility for the review.  Of course, we would hope that under such circumstances, issuers would receive the benefits of those third-party services at  pricing levels which are commensurate with the level of responsibility that their vendor is willing to assume.  Somehow, we imagine that market dynamics will kick-in along the way and one or more third-party providers will see the advantages associated with doing their job correctly and in demonstrating a willingness to stand behind it.

We also think that third-party providers who think they won’t have liability for their work under the new standard, if their name is not disclosed in the registration statement, are probably kidding themselves.  We would expect that any issuer with proper legal representation will require the third-party firm to stand behind their review in their contract, thereby giving the issuer the necessary level of comfort to make the required representations about such collateral review in the registration statement.  Either way, we see these third-party firms being on the hook.

It is our view that the SEC continues to make great strides in providing pragmatic revisions to securitization market practices.  Taken with the recent rulings related to disclosure of Repurchase History, we believe that Rule 193 will have a lasting positive effect on the resurrection of the securitization markets.

About markferraris
Managing Principal Orchard Street Partners LLC

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