June 30, 1999
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Attention: Jonathan G. Katz, Secretary
Re: File No. S7-30-98 Ė The "Aircraft Carrier Release"
Residential Funding Corporation is delighted to have the opportunity to comment on your proposals for reforming the federal securities laws, contained in the Aircraft Carrier release (the "Release") issued in November 1998. We have a number of specific comments that relate to the potential application of the concepts in the Aircraft Carrier release to the SECís separate rulemaking project for asset-backed securities (as defined in the instructions to Form S-3, "ABS").
Residential Funding Corporation is the largest private issuer of mortgage-backed securities in the United States and one of the largest issuers of mortgage related asset-backed securities. As of June 1999, Residential Funding Corporation has brought to market over 400 public mortgage-related securitizations totaling over $115 billion.
Following are our specific comments.
1. ABS should have Form B equivalent treatment. All investment grade ABS are currently
eligible for short form registration on Form S-3. It is vitally important for the efficiency of the ABS market to maintain a similar status in connection with any regulatory reforms. Therefore, all ABS that would currently be eligible for Form S-3 should be eligible for short form registration under new Form B or a similar form, and should have the benefits given to securities filed on Form B.
Since each ABS issuance relates to a newly formed pool, and the "issuer" is generally a shell entity whose financial condition is irrelevant to the rating of the ABS, seasoning requirements cannot be made applicable to ABS in any meaningful way. Therefore, we advocate that there be no seasoning requirement for an ABS issuer, as is the case currently under Form S-3. Furthermore, we advocate that there be no pre-effectiveness review for an ABS registration statement, or, alternatively, that pre-effectiveness review be limited to first-time filers that are not under common control with another registrant that has an effective ABS registration statement.
A. ABS rated investment grade. We recommend that Form B equivalent treatment be provided for all ABS rated investment grade by at least one NRSRO at issuance. Additionally, the issuance of ABS should not be disqualified from being offered on Form B solely because those ABS have received a non-investment grade rating from another NRSRO. The latter rating would most likely be an unsolicited rating based on incomplete information.
B. ABS offered to QIBs and IAIs. In the Release, Form B eligibility would also be extended to securities sold only to qualified institutional buyers. Under current market practices, non-investment grade ABS are typically restricted to QIBs and institutional "accredited investors" or IAIs (as defined in Rule 501(a)(1), (2), (3) and (7)). This universe of buyers also forms the basis for the exemption from the Investment Company Act of 1940, as amended, contained in Rule 3a-7 promulgated under that act. The utility of Rule 3a-7 to ABS issuers would be greatly undermined if Form B were restricted to QIBs only. Therefore, we recommend broadening the scope of permitted offerees under Form B to include IAIs.
C. Safe harbor guidelines for restricted offerings. As set forth in the Release, the proposal to allow Form B to be used in an offering to QIBs is conditioned upon that offering actually being made to QIBs only. Without express aftermarket trading restrictions, and with offering information and free writings generally available in the post-Release marketplace, difficult fact issues could arise. Accordingly, the Release should be modified to include a "safe harbor" set of procedures, which if followed would (i) be deemed to satisfy the requirements for Form B eligibility and (ii) eliminate any need to register secondary sales. We recommend that the following set of procedures be adopted:
D. Retail Investors in the ABS Market. As you commence drafting rules for the ABS market, we understand the SECís sensitivity to balancing rules designed to foster effective disclosure for a predominantly institutional investor market, while also protecting the limited number of individual investors that may purchase ABS. We believe that these interests can be effectively balanced by building upon the proposal to permit the use of Form B for offerings of investment grade rated debt securities. Specifically, we recommend that Form B could be used in connection with offerings of ABS to retail investors if:
In this manner, the offering as a whole would be effectively "policed" by two rating agencies and the institutional investors that would be purchasing the majority of the offering, thereby effectively protecting the material interests of retail investors.
2. Term sheet prospectus - delivery and filing requirements. The Release introduces the concept of the term sheet prospectus, which would have to be (a) provided to any investor prior to making its investment decision and (b) filed before the first sale is made. Delivery of the term sheet prospectus would obviate the need for the issuer or an underwriter to physically deliver the final prospectus. We believe that this is a sound concept, and is preferable to the alternative proposal set forth in the Release that would mandate delivery of a full preliminary prospectus. Preliminary prospectuses are generally not used in connection with offerings of ABS, due to the difficulty in assembling a nearly final prospectus by the time when a preliminary usually would be sent.
We recommend the following modifications to the term sheet prospectus proposal:
3. Exception to term sheet prospectus delivery requirement. Given the unique way in which ABS offerings are structured and sold, it will not always be possible to deliver to an investor a term sheet prospectus that summarizes the entire ABS structure and final collateral prior to that investor making an investment decision with respect to a particular class of offered securities.
In a typical multiple class ABS offering under a shelf registration, pre-marketing activities may commence after the asset pool has been substantially finalized and the preliminary structure has been determined. Marketing communications may be made either orally, or by using computational materials, structural term sheets or collateral term sheets as contemplated in the SECís relevant no-action letters. Some investors may agree to purchase some of the classes as contemplated in the preliminary structure. Other prospective investors may agree to purchase the remaining classes, but only if the terms of those classes are modified to suit the investment objectives of those investors. These changes could be made to the structure, as long as the changes did not materially affect the financial characteristics and material terms of the classes that the first investors agreed to purchase. Structure changes may continue in this fashion through a number of different iterations, until investors have agreed to purchase all or substantially all of the classes.
Thus, because of the unique manner in which ABS offerings are tailored to meet the specific demands of investors, a term sheet prospectus containing a final structure cannot be delivered to each investor prior to making their individual investment decision. Institutional investors have come to expect the ability to fashion classes of ABS to meet their specific requirements. If the delivery requirements for term sheet prospectuses as currently embodied in the Release were applied to the ABS market, issuers would be required to fashion "take-it-or-leave-it" structures Ė which would not be beneficial to investors or issuers.
In order to accommodate the need to pre-market offerings of ABS while the structure is being finalized, we recommend that the requirement to deliver the final term sheet prospectus prior to the investor making its investment decision would not apply if:
4. Free Writings and the Definition of "Offering Material". One of the primary goals of the Release is to encourage an increased flow of information to investors by attempting to de-regulate the treatment of "free writing" material under the federal securities laws. While we applaud this objective, we strongly encourage the Commission to fully consider the nature of and source of free-writing material when deciding whether that information should be filed and what level of liability should be associated with that material.
In similarity to many private offerings of securities, institutional investors in the ABS market often request certain business documentation regarding the assets and/or servicing, in addition to receiving the prospectus. Such requests are made despite the fact that the requested business documentation will have been described in the prospectus to the extent material to the ABS offering. Under the current federal securities laws, requests by investors for additional business information usually go unfulfilled because of the potential for violating Section 5, or the threat of liability for that information under Section 12(2).
As discussed below, we believe that free writing material used in connection with ABS offerings fall into one of two categories Ė free writing material that because of their content can be legitimately termed offering information, and free writing material that cannot. We have made this distinction by assessing whether the free writing material was generated to serve a legitimate business purpose that is unrelated to any specific offering of ABS. We strongly believe that if such a distinction is not made in the treatment of free writing material, and liability standards consistent with such distinction are not applied, adoption of the Release will have a chilling effect on the release of information to the capital markets. Furthermore, if the SEC were ever to mandate the availability to investors of certain free writing material without adopting appropriate standards of liability, we believe that many issuers would opt to make their offerings in the private market.
A. Free writings that are offering communications Ė argument for no Section 12(2) liability.
The Release effectively takes the view that all communications by the issuer during the offering period are free writings, and can be regulated as communications to offer the securities with the same liability as a prospectus (and in some cases a filing requirement), with limited exceptions. The principal exception is for "factual business communications" that are not made to offer the securities; these are not required to be filed and are not subject to Section 12(2) liability. We believe that this approach goes far beyond the intent of the 1933 Act.
Under the 1933 Act, a written communication that offers the securities is excluded from the definition of prospectus, if it is accompanied or preceded by the final prospectus. The term "free writings" traditionally refers to a communication that is not a formal prospectus but purports to offer the securities, and usually consists of supplemental sales literature. The 1933 Act does not impose a filing requirement on non-prospectus offering materials, if given with or after the prospectus. However, the effect of the 1933 Act is to ban outright the use of these materials prior to the delivery of the final prospectus, because that use of these materials would create a Section 5 prospectus delivery violation.
The 1933 Act is ambiguous on the question of whether non-prospectus offering materials delivered with or after the prospectus are subject to liability under Section 12(2). A strict reading of the Actís provisions would support the view that there is no such liability. Moreover, the Supreme Courtís decision in Gustafson can be read to support this view. Applying the Gustafson rationale, since a free writing delivered with or after the prospectus is not required to comply with the requirements under Section 10 applicable to a prospectus, it is therefore not a prospectus for purposes of either Section 10 or Section 12(2). However, this question remains unsettled.
The Release would invite issuers to use written non-prospectus offering materials prior to the delivery of the final prospectus by eliminating the threat of a Section 5 violation, as long as those materials are filed (although factual business communications are not required to be filed, even if made to offer the securities). However, the Release would impose Section 12(2) liability on those materials, even though there may be no such liability under the current federal securities laws if they were delivered with or after the final prospectus.
We believe that non-prospectus offering materials should not be subject to Section 12(2) liability. As an example, consider structural term sheets and collateral term sheets, as described in SECís no-action letters. These materials include summary information about the most important terms of an ABS offeringís structure and underlying assets. These materials typically state that they will be superseded in their entirety by the final prospectus. If used alone, without being followed up by the final prospectus, these materials would not contain sufficient information to meet the completeness standards of Section 12(2). Only the final prospectus contains sufficient information about the assets, structure, operative agreements, servicing agreements, legal considerations (including tax), and risk factors to meet the standards of Section 12(2).
Although the "bespeaks caution" doctrine would suggest that the ABS term sheets should be viewed together with the final prospectus to determine whether they satisfy Section 12(2), we do not believe that this approach alone provides the issuer with adequate protection. To the extent that the final prospectus completely restates the content of the ABS term sheet, as it should, there should be no possibility that Section 12(2) recission liability might arise from an error in the ABS term sheet that is corrected in the final prospectus, or from an omission that is completed in the final prospectus. Rather, the only question should be whether an erroneous or incomplete ABS term sheet is used in a manner that could reasonably be expected to mislead investors.
We believe that Rule 10b-5 provides an appropriate standard and remedy for non-prospectus offering materials such as ABS term sheets. For example, if an issuer uses a term sheet that includes an error about a material term of the securities, and the investor purchases in reliance on that error without being given a corrected term sheet or a correct prospectus prior to purchase or otherwise being alerted to the error, the investor can bring a claim for damages under Rule 10b-5. Furthermore, we recommend that offering communications other than the prospectus (including any term sheet prospectus) should not be subject to any filing requirement.
B. Limitation on free writings that may be subject to Section 12(2) liability. If, however, the SEC decides to apply Section 12(2) liability to non-prospectus offering materials, we believe that the category of materials subject to that level of liability in the ABS context or to any filing requirement should be limited to written materials that:
This category would therefore include structural and collateral term sheets as described in the no-action letter referenced above, as well as preliminary versions of the term sheet prospectus. Examples of free writing materials that should not be included in this category are described in C below.
C. Free writings that are not offering communications. Written communications made by the
issuer, even during the offering period, that do not "offer the securities" are not prospectuses as defined under the 1933 Act, and are not regulated under the 1933 Act. There is no statutory basis for regulating communications that do not actually offer the securities. The Release purports to regulate all communications by the issuer during the offering period, including communications that do not offer securities, unless the communications fall within a narrowly drawn list of exceptions (including factual business communications not made to offer the securities). In addition to Section 12(2) liability, the Release would also impose filing requirements on regulated free-writing material, except for factual business communications.
We believe that the Release casts far too wide a net, and in practice would do as much to stifle the free flow of information as does current law. As noted above, it is essential to distinguish between:
Material that is prepared for use in connection with an offering of securities is reviewed for accuracy by the issuer and its advisors. In contrast, material generated to serve a legitimate business purpose unrelated to an offering of securities would not have received this level of scrutiny. While this information may be of interest to investors Ė it simply was not prepared with a view toward incurring potential liability under Section 12(2). For example, a select few investors in an initial public offering by a start-up automobile company might find it of interest to review the companyís assembly line manual and perhaps even the manuals and sales literature related to the companyís cars. These materials would be considered to be "factual business communications" under the Release, and therefore would not have to be filed. However, if the issuer were to distribute such materials during the offering period to prospective investors to facilitate the offering, the Release would cause the manuals and automobile brochure to be subject to Section 12(2) liability. It seems unjust, and unwarranted under the 1933 Act, to force issuers to assume Section 12(2) liability merely because certain investors may find such material to be of interest. Rather than allow such a result to occur, we believe that issuers will choose to refrain from distributing any free writing material, which would frustrate one of the primary goals of the Release.
In the ABS context, there are many examples of legitimate business information that further illustrate the distinction made above. These include:
Loan documents and underwriting files for the receivables;
Schedules showing loan level data about the receivables,
Information on the past performance of the receivables or of similar pools,
Underwriting guidelines and program descriptions applicable to the origination of the receivables; and
For commercial mortgage loans, appraisals, environmental reports and property statements of operation;
Much of the information described above is simply background data, corporate records and supporting material that were never prepared with the expectation that their content would be subject to the Section 12(2) standard of accuracy (example: underwriting guidelines). Also, much of this information is prepared by third parties who would not protect the issuer against claims (example: appraisals).
Under the Release, the information described above would be "factual business communications" and thus would not have to be filed, but only to the extent that they are "factual information about the issuer or some aspect of its business," and they do not contain "information about the registered offering." These standards are unclear at best. Much of the materials listed above is about persons other than the issuer or financial assets. In particular, the requirement that the materials cannot include "information about the registered offering" is unclear because information about the assets underlying an ABS may be considered to be about the offering.
It is simply unfair and unreasonable to hold the issuer to a Section 12(2) standard for the accuracy and completeness of legitimate business information. Section 12(2) imposes a recission claim against the seller if the "prospectus" includes a material error, and the defendant cannot sustain the burden of proof that he did not know, and could not have known with the exercise of reasonable care, of that error. Reliance by the plaintiff on the erroneous information, and causation of harm by the error, need not be shown. If the types of information described above are held to this standard, they will continue to be withheld from prospective investors. There is no valid public interest served by obstructing the free flow of this information. In essence, the Release merely substitutes one set of unreasonable restraints on free commercial speech for another. Only by fully de-regulating the free flow of legitimate business this type of information will the SEC achieve the goal of making more information available to investors.
Moreover, treating this information as offering information, and requiring it to be filed with the SEC, would be extremely burdensome on both the issuer and the SEC. In many cases, complying with a filing requirement would be impossible.
The ABS market would be greatly benefited if the types of information described above could be provided to investors without a filing requirement, the threat of Section 12(2) liability or a Section 5 violation. Of course, the distribution of such information during the offering period would still be subject to potential liability under Rule 10b-5.
For these reasons, we recommend that the SEC clarify by rulemaking that, in the ABS context, information released by the issuer at any time, and for any purpose, should not be subject to any filing requirement and should not be subject to Section 12(2) liability, as long as the information either:
The issuer typically has no involvement in the preparation of these materials. For example, the issuer would generally have no input as to the range of hypothetical scenarios depicted, the methodology used to generate the information, or the decision to use assumed rather than collateral characteristics. Nor does the issuer have any opportunity to review computational materials before they are distributed to potential investors.
Computational materials are customized reports that are prepared by the underwriter at the request of a specific prospective investor, and in most cases are based on assumptions about future interest rates, prepayment speeds and other parameters that are specified by the investor. As a result, the usefulness of any set of computational materials to any prospective investor other than the one who requested them is extremely limited. Any prospective investor that wanted computational materials would simply request them from the underwriter, rather than looking in the SECís files for copies of computational materials provided to others.
The ABS market has recognized that liability for computational material should not be placed on issuers by contractually shifting this liability in most instances to the underwriters. In the underwriting agreement for an ABS offering, the issuer and underwriter typically agree that the underwriter will indemnify the issuer for any errors in the computational material, except for errors caused by errors in the information about the collateral that is provided by the issuer. The computational materials themselves contain a legend to the effect that they are provided solely by the underwriter, and that the issuer makes no representation as to the accuracy of the materials.
Under these circumstances, it seems unfair that the issuer should have liability under the 1933 Act for computational materials. Therefore, we recommend that the SEC clarify by rulemaking that:
Under current law, publishing information on past transactions during an offering for similar, newly-issued securities may raise questions under the 1933 Act.
Proposal: In order to avoid any legal uncertainty, and to encourage the free flow of information, we recommend that the SEC clarify by rulemaking that:
The regular, periodic publication of information in the ordinary course of business about any series of ABS, for which the final prospectus has already been filed with the SEC, shall not be deemed to constitute an offer for that series of ABS or any other series of ABS.
* * *
We appreciate the opportunity to comment on the Release. We are available to discuss these comments with the Commission or the staff if so desired. Please feel free to call Ms. Teresa R. Farley, Managing Director of Residential Funding Corporation at (612) 832-7476 or Mr. David A. Marple, Associate Counsel of Residential Funding Corporation at (612) 857-6355 or Stephen S. Kudenholdt of Thacher Proffitt & Wood at (212) 912-7450.
/s/ Teresa R. Farley
Teresa R. Farley
/s/ David A. Marple
David A. Marple
cc: Mr. Stephen S. Kudenholdt
Mr. Richard Kent
Mr. Robert L. Schwartz