November 23, 2004
By E-mail to: rule-comments@sec.gov
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549-0609
Attention: Jonathan G. Katz, Secretary
Re: Proposed Rule – Disclosure Requirement for Asset-Backed Securities (Regulation AB), File Number S7-21-04
Ladies and Gentlemen,
WestLB AG ("WestLB") is writing in response to the Securities and Exchange Commission's request for comment on proposed Regulation AB (17 C.F.R. 229.1100, et seq.), as set forth in Release Nos. 33-8419 and 34-49644 (May 13, 2004) (the "Proposed Rule"), dealing with new disclosure requirements for issuers of publicly-registered asset-backed securities ("ABS").
WestLB is an international bank which, as part of its commercial banking activities in the U.S., provides credit enhancement (as described in III(B)(7) of the Proposed Rule) to U.S. issuers of ABS.
We believe that certain sections of the Proposed Rule are in need of clarification, without which the Proposed Rule would make it difficult, if not impossible, for certain providers of ABS credit enhancement, such as WestLB, to comply with.
Our comments fall under the following three headings, each detailed below: (i) Thresholds for Additional Disclosures for Providers of Credit Enhancement; (ii) Clarification of Financial Disclosure Obligations; and (iii) Grandfathering.
Thresholds for Additional Disclosures for Providers of Credit Enhancement
The Proposed Rule would require issuers of ABS to provide disclosure related to credit enhancement of ABS. Section 229.1113 of the Proposed Rule defines "credit enhancement" to include "[a]ny derivatives . . . used to reduce or alter risk . . . such as interest rate or currency swaps." Additional disclosures are required to be provided for entities providing such "credit enhancement" to an issuer of ABS so long as a threshold test is met. The threshold test states that, "if any entity or group of affiliated entities that provided enhancement or other support for the asset-backed securities was liable or contingently liable to provide payment representing [10% or 20% as applicable] or more of the cash flow supporting any class of the asset-backed securities" additional disclosures are required. Further, the text of the Proposed Rule says that "[e]ven if a swap, such as an interest rate swap, was currently 'out of the money' and no payments were required, if the swap provider was contingently liable for more than 10% of the cash flow supporting a class (for example, if interest rates changed), disclosure would be required on the same basis as any other form of enhancement . . .". This seems overly burdensome since in, for example, a prepaid interest rate cap, a swap provider is at all times "contingently liable" to provide payment representing 10% or 20% of the cash flow to a particular class of securities. This is because, due to the interest rate sensitivity of a prepaid interest rate cap, a substantial enough movement in interest rates could in theory always result in provision of 10% or 20% of cash flow even for a swap that, initially, provides no cash flow or a much lower percentage of cash flow and, except for the most extreme interest rate assumptions, would be expected to continue to provide no cash flow or a much lower percentage of cash flow.1
We suggest that this threshold test relate only to potential liability as implied in the current market yield curve on the date the relevant derivative transaction is entered into and not to contingent liability.2
Clarification of Financial Disclosure Obligation
Under the Proposed Rule, a swap provider meeting the tests described under "Thresholds for Additional Disclosures for Providers of Credit Enhancement" above must provide audited financial statements meeting the requirements of Item 301 of Regulation S-K (at a 10% threshold) or Regulation S-X (at a 20% threshold). In particular, Regulation S-X permits foreign issuers to provide financial statements other than in accordance with US GAAP (Item 8 of Form 20-F). However, Item 8 of Form 20-F applies by its terms only to financial statements to be filed with a registration statement. We believe that the overall context of the Proposed Rule would permit a foreign swap provider to provide such alternate disclosure. However, we wanted to clarify that our understanding is correct as it would be extremely burdensome, if not practically impossible, for certain foreign derivative providers to provide financials in accordance with US GAAP.
Grandfathering
We strongly support explicit inclusion of "grandfathering" for providers of credit enhancement of the type described under "Thresholds for Additional Disclosures for Providers of Credit Enhancement" above. Depending on the scope of any obligation ultimately imposed in a final rule, it is not clear that all current market participants would be able to comply on a retroactive basis (for example, in the unlikely event that financials prepared in accordance with US GAAP must be provided). As a result, retroactive application of the final rule could have an unduly disruptive impact on the marketplace since it would potentially result in the removal of swap providers incapable of complying with the final rule.
We appreciate the opportunity to comment, and would be pleased to discuss further any questions that the Commission might have with respect to our comments and requests for clarification. Please feel free to telephone Gary E. Kalbaugh at (212) 852-6187 if you have any questions.
Gary E. Kalbaugh
Associate Director and Counsel
1 For example, if a $1,000,000 notional, 6-month duration prepaid interest rate cap paying any LIBOR in excess of 5% is entered into, the amount of cash flow contingently provided by the prepaid interest rate cap provider would, regardless of expected market movements, be unlimited since the interest rates could, theoretically, move substantially beyond market expectations (and, therefore, the threshold would be triggered, because the contingent cash flow provided would exceed the 10% and 20% thresholds for any sized related class of ABS). Total cash flow to the related class of ABS would be irrelevant as the threshold for additional disclosure obligations would always be triggered by a prepaid interest rate cap under the test in the Proposal no matter how miniscule the notional amount of the prepaid interest rate cap is.
2 For example, if a $1,000,000 notional 6-month duration prepaid interest rate cap paying any LIBOR in excess of 5% is entered into, and the market yield curve implies a LIBOR of 6.5% over the duration of the cap, then the amount of cash flow potentially provided by the prepaid interest rate cap provider would be deemed to be $7,500 (although, in fact, if interest rates moved higher than market expectations, the prepaid interest rate cap provider could be liable for substantially more). If the related class of ABS is receiving expected aggregate cash flow over the same period of more than $75,000, the threshold for additional disclosure obligations would not be triggered applying the above facts to the test we propose.