Key Benefits of Using Trusts in Mortgage Loan Financing

1. Titling Trusts for Mortgage Loans: A Titling Trust holds the legal title to mortgage loans while allowing the beneficial interest in the loans to be financed, including being packaged into securities. This eliminates the need to retitle the loans when beneficial ownership changes, offering significant administrative efficiencies.
   • Example: A mortgage lender sets up a Titling Trust to hold the legal title to a pool of mortgage loans. As ownership of the loans transfers to investors, the legal title remains with the trust, and only the beneficial interests are given as collateral security for a financing facility or sold as securities, avoiding the need to retitle each loan.
2. Delaware Statutory Trusts (DSTs): A DST is a popular legal structure in mortgage loan securitization. It is easy to set up, providing flexibility in managing mortgage assets while ensuring asset protection. The DST holds the legal title, while the investors hold the economic beneficial interest.
   • Example: A mortgage lender forms a DST to pool multiple mortgage loans. The DST can grant a security interest in some or all the beneficial ownership interest in the mortgage loans or issue mortgage-backed securities (MBS), enabling investors to buy shares of the mortgage pool while the legal title remains with the DST.
3. Series Trusts for Mortgage Loan Pools: A Series Trust allows assets to be divided into Special Units of Beneficial Interest (SUBI). For example, different mortgage loan pools can be allocated into separate SUBIs, each representing a specific pool of loans. This segmentation reduces risk exposure and simplifies asset management. The Delaware statute governing DSTs provides that assets allocated to a SUBI are not subject to the claims of other Trust stakeholders including other SUBI holders. 
   • Example: A lender sets up a Series Trust with multiple SUBIs, each holding a distinct pool of mortgages (e.g., residential, commercial). Each SUBI is independently managed, and its assets are protected from creditors with interests in other mortgage loan pools.

Risks and Considerations

• Jurisdictional Limitations: DSTs including Series Trusts may not be recognized in all states, which could impact their use in certain jurisdictions.
• Bankruptcy Concerns: While trusts may provide protection from creditors of the beneficial holders, the structure’s bankruptcy risks, including possibly fraudulent conveyance risks, have not been fully tested.

Conclusion

Using trusts, especially DSTs and Series Trusts, offers significant benefits for structuring mortgage loan financings. These vehicles provide flexibility, asset protection, and administrative efficiencies, making them ideal for pooling and financing mortgage loans. However, it’s essential to consider the risks, particularly related to jurisdiction and bankruptcy, when setting up these structures. 

In an 8-1 decision, the Court found that when Congress abrogates tribal sovereign immunity, it must do so through a clear statement of congressional intent. Lac du Flambeau Band of Lake Superior Chippewa Indians, et al. v. Coughlin, Case No. 22-227, slip op. at 4 (June 15, 2023) (“Coughlin”). While this is a demanding standard, the Court held that the rule is not a “magic-words” requirement. Id. The Court found the standard was met in part based upon the specific text and structure of the definition of “governmental unit” in the Bankruptcy Code (the “Code”). Id. at 5.

At issue in the case was whether a debtor in bankruptcy, Brian Coughlin, can enforce the Code’s automatic stay protections against a short-term lending company wholly owned by a Wisconsin tribe to prevent alleged collection efforts by the tribal company. In reaching its decision, the Court settled a split among the Courts of Appeals for the Ninth and First Circuits on the one hand and the Court of Appeals for the Sixth Circuit on the other hand, siding with the Ninth and First Circuits that 11 U.S.C. § 106(a) of the Code abrogates the sovereign immunity of federally recognized Indian tribes and subjects tribes to certain bankruptcy proceedings specified in the Code. Prior to the Court’s Coughlin decision, in a case where a bankruptcy trustee sought to recover alleged fraudulent transfers by a bankrupt commercial casino on behalf of and to a federally recognized tribe, the Court of Appeals for the Sixth Circuit determined that the Code did not abrogate tribal sovereign immunity. See In re Greektown Holdings, LLC, 917 F.3d 451 (6th Cir. 2019).

Under section 106(a) of the Code, Congress abrogated the sovereign immunity of “governmental units” for more than 50 Code provisions, including the automatic stay intended to stop debt collection while a bankruptcy case proceeds. The term “governmental unit” is defined in section 101(27) of the Code as the:

United States; State; Commonwealth; District; Territory; municipality; foreign state; department, agency, or instrumentality of the United States (but not a United States trustee while serving as a trustee in a case under this title), a State, a Commonwealth, a District, a Territory, a municipality, or a foreign state; or other foreign or domestic government.

­The Court interpreted this definition of “governmental unit” and especially the “catchall” phrase of “foreign or domestic government” as evidence of Congress’ intent to broadly waive the sovereign immunity of any government with respect to the proceedings and actions identified in section 106(a). Id. at 6. The Court also found that the Code’s policy goal of providing a comprehensive and orderly system of debt relief is better served by avoiding a carve-out of tribal governments from the comprehensive definition of section 101(a). Id. at 8.

Now that the Court has settled the prior split among the various U.S. Courts of Appeal by holding that the Code unequivocally abrogates the sovereign immunity of tribes, the Coughlin decision means that tribes can be compelled to appear and participate in bankruptcy proceedings as a third party, be targeted by a trustee seeking to recover money paid to the tribe by a debtor, be prohibited from evicting a lessee of tribal lands due to the automatic stay, or be subject to a debtor’s confirmed bankruptcy plan, including terms of a plan that might negatively impact a tribe’s rights under a lease. As governments subject to budgetary limitations and restraints, the possibility that a bankruptcy trustee can compel a tribe to return money or assets to a bankruptcy estate will have far-reaching financial implications for a tribe.

Tribes located within the jurisdiction of the Court of Appeals for the Ninth Circuit have been addressing the real life implications of the issues addressed in the Court’s Coughlin decision since the Krystal Energy decision in 2004. Parties can look to the experiences of tribes, debtors and creditors in bankruptcy proceedings in the U.S. Bankruptcy Courts for the districts within the Ninth Circuit to better understand the types of bankruptcy proceedings into which tribes should now expect to be subject. To prepare for the impact of the Court’s Coughlin decision, tribes nationwide will be well served to consider including additional funds and reserves in their budgets to address the litigation costs of potential bankruptcy proceedings and to invest resources in training and educational programs to comprehensively understand how to legally prepare for potential bankruptcy related litigation.

The Court’s decision did not address the eligibility of tribes to file for bankruptcy as debtors, as that question was not before the Court. Governmental units (other than some municipalities) may not be debtors eligible for bankruptcy protections because they are excluded from the definition of “person” under the Code, except under several limited exceptions. See 11 U.S.C. § 109 (only a “person” or “municipality” may be a debtor under the Bankruptcy Code); 11 U.S.C. § 101(41). Consequently, the Court’s holding that federally recognized Indian tribes are “governmental units” supports the presumption that a tribe itself is ineligible to file for debt relief under the Code. Such a presumption limits the ability of tribes to reorganize their commercial operations through an established regime that is open to other commercial enterprises. Non-tribal commercial entities in a Chapter 11 reorganization have the ability to obtain some level of debt relief and certainty. Instead, financially distressed tribes and their creditors often have to engage in complicated, costly and time-consuming out-of-court restructurings, without any of the protections or rules afforded debtors under the Code. Moreover, uncertainty remains for businesses wholly owned by tribes and organized under tribal law. 

The Coughlin decision also has implications for the interpretation of other federal statutes. Although the Court was at pains to state that the standard to find a waiver of sovereign immunity was demanding, see, e.g. slip op.at 4, lower courts now have precedent to find other ways in which a federal statute that does not mention the word “tribe” could waive tribal sovereign immunity. For example, the Fair and Accurate Credit Transaction Act (“FACTA”) defines a person as “any individual, partnership, corporation, trust, estate, cooperative, association, government or governmental subdivision or agency, or other entity.” FACTA prohibits any “person” from printing certain credit card information on receipts provided to the cardholder at a point of the sale or transaction. In a FACTA class action case brought by a claimant against the Oneida Indian Tribe of Indians in Wisconsin, the Seventh Circuit upheld the Oneida Tribe’s defense of sovereign immunity holding that Congress did not unequivocally abrogate the sovereign immunity of tribes in FACTA, Meyers v. Oneida Tribe of Indians of Wisconsin, 836 F.3rd 818 (7th Cir. 2016). If a similar case were brought now against a tribe, a court could reach a different conclusion based on the Supreme Court’s decision, exposing tribal governments and their wholly owned tribal businesses to class action suits under FACTA.

Thus, the implications of the Coughlin decision are potentially far reaching and tribes will need to carefully consider the possible issues that will come up in the future in order to plan how to best protect their communities and governmental assets while also pursuing their economic development plans.

Any company regulated by the SEC and CFTC should prepare for significant possibility that they, too, will be contacted by regulators and required to conduct an off-channel communication investigation. For companies who have not already reviewed their policies and procedures related to communications, they should do so immediately. This blog post provides an overview of the pertinent rules and history of the off-channel communication sweep.

Rules

• Broker-Dealers: The rules adopted under Section 17(a)(1) of the Exchange Act, including Rule 17a-4(b)(4), require that broker-dealers preserve in an easily accessible place originals of all communications received and copies of all communications sent relating to the firm’s business as such.
• Investment Advisors: The rules adopted under Section 204 of the Advisers Act, including Advisers Act Rule 204-2(a)(7), require that investment advisers preserve in an easily accessible place originals of all communications received and copies of all written communications sent relating to, among other things, any investment advice given or proposed to be given.
• Swap Dealers/CFTC Registrants: Sections 4g and 4s of the Commodity Exchange Act, and the regulations implemented thereto, require that swap dealers and other CFTC registrants retain comprehensive records of their business-related communication.

Electronic communications include, but are not limited to, email, text messages, messaging apps, instant messages, Bloomberg messaging, and private messaging on social media sites.

History

The first major regulatory action based on off-channel communications was announced in December 2021, when the SEC and CFTC fined JP Morgan $200 million based on widespread off-channel communications. In September 2022, the SEC and CFTC fined eleven investment banks, which collectively paid $1.8 billion in fines and each agreed to certain compliance requirements, including hiring a compliance consultant and submitting to a one-year compliance evaluation. It has been publicly reported that, as part of these investigations, regulators have required a review of the personal devices for a sample pool of employees, the results of which showed that certain employees were engaging in off-channel business communications.

Putting It Into Practice

Following the settlement with the large banks, the regulators have moved to hedge funds, private equity firms, ratings agencies, online banks, and regional banks. Sheppard Mullin’s Governmental Practice team has experience handling this unique regulatory investigation, having represented over thirty employees of institutions involved in this enforcement initiative.

This off-channel sweep is a novel regulatory investigation for which there is little guidance. The process inevitably involves the highly sensitive process of obtaining personal cell phones from employees and reviewing their private communications to identify those that fall within the scope of the regulators’ requests. Our team understands how to handle this sensitive process in a manner that has facilitated productive outcomes.

The Proposed Rule, issued in January, resurrects a prior 2011 SEC proposal that lay dormant for over a decade after facing substantial pushback from industry participants. The re-proposal has revived this controversy, with critics arguing it is overly broad in scope and may create unintended consequences for the broader market.

Statutory Requirement and Proposed Rule

Section 27B of the Securities Act of 1933, which was added by Section 621 of the Dodd-Frank Act, prohibits underwriters, placement agents, initial purchasers and sponsors of ABS and their affiliates from engaging in “any transaction that would involve or result in a material conflict of interest with respect to any investor in a transaction arising out of such activity” for a period of one year after the date of the first closing of the ABS sale. 

The statute requires the SEC to issue rules implementing this prohibition, subject to exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making.

The Proposed Rule implements the statute by prohibiting such “securitization participants” and their affiliates from directly or indirectly engaging in any such conflicted transaction during the one-year period. In addition to certain specified transactions that are per se “conflicted transactions” (e.g., short sales of the ABS, purchases of certain CDS referencing the ABS), the Proposed Rule includes an anti-evasion clause covering any “economically equivalent” transaction.

Exception for Risk-Mitigating Hedging

Consistent with the statute, the Proposed Rule provides an exception from the prohibition for certain risk-mitigating hedging activities arising out of the securitization activities.

As proposed, however, this exception would be available only where the following conditions are met:

• at inception and at the time of any subsequent adjustment, the hedging activity is “designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks arising in connection with identified positions, contracts or other holdings of the securitization participant”;
• the hedging activity is subject to “ongoing recalibration” to ensure its remains permissible and “does not facilitate or create an opportunity to benefit from a conflicted transaction other than through risk-reduction”; and
• the securitization participant has implemented an internal compliance program reasonably designed to ensure it engages only in permitted hedging activities.

Possible Unintended Consequences

Commenters argue that the first condition—in particular, the requirement that the hedging activities must arise out of the securitization activities and relate to one or more “identified positions, contracts, or other holdings”—may unduly limit the scope of the exception by excluding, for instance, certain portfolio hedges or hedges tied to indices, where it is not clear that the underlying exposure arises in connection with the securitization.

As proposed, even run-of-the-mill interest rate swaps entered into by a securitization participant (or its affiliates) may not be eligible for the exception if they are not materially related to the credit risk of the relevant ABS or the underlying asset pool. Absent a clear exception for such interest rate hedges, they may constitute “conflicted transactions” to the extent they increase in value when the ABS decreases in value, such as when interest rates rise.

In addition to concerns around scope, commenters have also expressed concerns with the “ongoing recalibration” and compliance program requirements, arguing that they would place unnecessary restrictions on the manner in which market participants manage their hedges and impose excessive compliance costs on a broad range of ABS participants, including banks and non-banks alike.

While recent events in the banking sector highlight the importance of avoiding any obstacles to banks’ and other financial institutions’ ability to mitigate interest rate and other risks, it remains to be seen how the SEC will respond to these concerns and whether the Proposed Rule will survive or will suffer the same fate as its 2011 predecessor.

Although the Federal Reserve Board’s recent regulations implementing the LIBOR Act (available here) (the “FRB regulations”) aim to address these concerns, they acknowledge that many LIBOR legacy contracts (i.e., those that identify a specific benchmark replacement) fall outside the scope of the Act and its regulatory authority. 

Background

On November 23, 2022, the FCA announced a proposal to require ICE Benchmark Administration (“IBA”), the administrator for LIBOR[1], to continue to publish the 1-, 3- and 6-month settings of US dollar LIBOR[2] under a non-representative, “synthetic” methodology until end-September 2024.

The FCA proposal on US dollar LIBOR follows prior mandates to IBA to continue to publish, on a synthetic basis:

• 1-, 3- and 6- month yen LIBOR to the end of 2022;
• 1- and 6- month sterling LIBOR until the end of March 2023; and
• 3-month sterling LIBOR until the end of March 2024.

FCA’s recent proposal aims to smooth the market transition away from LIBOR and seeks feedback on whether to:

• require publication of USD LIBOR for 1-, 3- and 6-month settings beyond the end-June 2023 deadline until the end of September 2024, using a synthetic methodology based on the sum of the CME’s Term SOFR Reference Rate plus the relevant ISDA spread adjustment; and
• permit use of these synthetic USD LIBOR settings in all legacy contracts except for cleared derivatives (consistent with prior synthetic LIBOR rates).[3] 

Compelled publication of synthetic USD LIBOR would be intended for use only in legacy (not newly entered) contracts and would be accompanied by an FCA announcement that the synthetic rates are not “representative” of the markets that the original LIBOR setting were intended to measure. The FCA also stressed that synthetic USD LIBOR settings would be “only a bridge to appropriate alternative risk-free rates, not a permanent solution”, and thus market participants should prioritize active transition and focus on converting their legacy contracts to risk-free rates as soon as possible.

Potential Impact on Certain U.S. Law Contracts

In its November proposal, the FCA cited a substantial number of non-U.S. cash market contracts that would benefit from a 15-month extension. The 15-month extension is intended to address this set of international “tough legacy” contracts not covered by the existing US legislative fix in the LIBOR Act, while balancing the interests of market participants whose contractual fallbacks will be delayed by publication of a synthetic USD LIBOR. 

However, some are warning of collateral consequences for US law governed contracts that either identify a specific benchmark replacement or determining person or opt out of the LIBOR Act, and thus are not covered by the US legislative fallback to the SOFR replacement rate. Specifically, for any such contracts containing fallbacks that are not expressly triggered unless USD LIBOR becomes “unavailable”, the continued publication of a synthetic USD LIBOR that, although non-representative, arguably remains “available” may raise questions as to whether the LIBOR Act’s safe harbor for such excluded contracts applies.

In the adopting release accompanying the FRB regulations, the FRB seeks to resolve this ambiguity with respect to a subset of contracts that (a) authorize a party or person to select a benchmark replacement when USD LIBOR becomes unavailable (without identifying a specific benchmark) and (b) do not expressly authorize such selection when USD LIBOR ceases to be representative. Specifically, the FRB regulations clarify that, notwithstanding the lack of an express non-representativeness trigger, such contracts will fall back to the SOFR replacement rate if the determining person does not select another benchmark replacement by the LIBOR replacement date (i.e., June 30, 2023).

The FRB declined, however, to extend this interpretation to contracts that identify a specific benchmark replacement (but lack a non-representativeness trigger), as the FRB has concluded such contracts are outside the scope of the LIBOR Act.

Although publication of synthetic USD LIBOR should not affect loan agreements with fallbacks based on LSTA-recommended language (as such fallbacks apply if USD LIBOR becomes non-representative), it may raise issues for a set of legacy contracts that specify a benchmark replacement but lack such a non-representativeness trigger.

Comments on the FCA proposal are due by January 6, 2023 and a final announcement is expected by the end of the first quarter or early in the second quarter of 2023.

FOOTNOTES

[1] The FCA is the regulatory supervisor for IBA.

[2] The announcement has no effect on the publication of other remaining USD LIBOR settings (i.e., overnight and 12-month), which will cease permanently after June 30, 2023.

[3] The expectation is that, for derivatives used to hedge cash products (e.g., bonds), synthetic USD LIBOR would be permitted for such hedges if it is permitted in such cash products.

1. Revised Net Worth Requirements

Effective September 30, 2023, the minimum Net Worth requirement for all institutions seeking approval as Ginnie Mae single-family Issuers (“SF Applicants”) will be $2.5mm “plus 0.25% (25 basis points) of the applicant’s total Government-Sponsored Enterprise (“GSE” or “Enterprise”) single-family outstanding servicing portfolio, plus 0.25% (25 basis points) of the applicant’s total non-agency single-family servicing portfolio”.

2. Revised Liquidity Requirements

I. Eligible Assets

Effective September 30, 2023, for SF Applicants and SF Issuers, the list of liquid assets that are eligible to meet Ginnie Mae’s liquidity requirement will be expanded to include GSE obligations (marked to market), GSE MBS (marked to market), and the following advances made as reflected in total assets reported on the balance sheet: advances made to cover principal and interest payments, taxes and insurance payments, and foreclosure advances relating to loans serviced on behalf of mortgagors and mortgage investors.

II. Required Liquidity

Effective September 30, 2023, SF Applicants[3] will be required to have and maintain liquid assets equal to the greater of:

“$1,000,000, or the sum of:

(i) 0.035% (3.5 basis points) of the applicant’s outstanding GSE single-family servicing Unpaid Principal Balance (“UPB”), if the applicants remits (or the Enterprise draws) the principal and interest only as actually collected from the borrower, plus

(ii) 0.07% (7 basis points) of the applicant’s outstanding GSE single-family servicing UPB, if the applicant remits (or the Enterprise draws) the principal or interest, or both, as scheduled, regardless of whether principal or interest has been collected from the borrower, plus

(iii) 0.035% (3.5 basis points) of the applicant’s outstanding non-agency single-family UPB.”

Effective December 31, 2023, SF Applicants that originated more than one billion in UPB of residential mortgages in the most recent four-quarter period must have assets equal to the greater of $1,000,000 or the sum of (i)-(iii) listed immediately above, and

(iv) 0.10% (10 basis points) of the Issuer’s outstanding Ginnie Mae single-family servicing UPB, plus

(v) 0.5% (50 basis points) of the sum of the applicant’s total Loans Held For Sale (“HFS”), plus

(vi) 0.5% (50 basis points) of the applicant’s UPB of Interest Rate Lock Commitments (“IRLCs”) after fallout adjustments. UPB of IRLCs after fallout adjustments is UPB of IRLCs after making adjustments for estimated fallout (i.e., excluding part of the balance because some locks are not expected to close).

3. Risk Based Capital Ratio

Scheduled to take effect December 31, 2024, SF Issuers and SF Applicants that are not financial institutions must maintain a Risk-Based Capital Ratio (“RBCR”) of a minimum of 6%.[4] The Risk Based Capital Ratio is the most controversial part of the new financial requirements not only because it imposes a new financial requirement on a cohort that currently has no RBCR (unlike banks that are regulated and take customer deposits) but also because it isn’t seen as being properly calibrated to address the risks. 

RBCR equals Adjusted Net Worth (as currently defined in the Ginnie Mae MBS, effectively, Equity) minus Excess Mortgage Servicing Rights (“MSRs”) divided by total Risk Weighted Assets. Total Risk Weighted Assets equals the sum of total assets calculated on a risk weighted basis according to the following schedule: 

Risk Weighting         Asset Type

0%                             Cash and Cash Equivalents

0%                             Reverse Mortgages Held for Investment (non-true sale)

0%                             Ginnie Mae Loans Eligible for Repurchase, if included in                                    total assets

20%                           Government Loans HFS

50%                           Conforming and Other Loans HFS

250%                         Total MSRs (not to exceed Adjusted Net Worth)

100%                          All other assets not included above

While it is perfectly logical for Ginnie Mae to seek to ensure that non-bank SF Issuers have the financial strength to withstand adverse market conditions, there is strong opposition to the manner in which they have chosen to address it. Although Ginnie Mae takes the position that the new requirements were designed taking into account the “unique attributes of independent mortgage banks”, it appears that Ginnie Mae missed the mark …by a lot. For example, it is a well-known in the industry that the balance sheets of many independent mortgage banks include MSRs and government loans on the asset side, each of which receives punitive treatment under the new requirements, particularly the MSRs. 

Ginnie Mae’s rationale in devising a Risk Based Capital requirement that takes aim at its own MSR asset is being questioned. So is the fact that, by all accounts, such treatment is more likely than not going to have a detrimental effect on the MSR market. A number of well-regarded market observers disagree with Ginnie Mae’s claims that if the new capital requirements were in effect today, “95% of our issuers (by count) would be compliant”. Many market observers have serious concerns as to the effect the RBCR will have on independent mortgage banks and the segments of the mortgage market they serve which tend to be the first-time homebuyers, low- and moderate-income borrowers, rural home borrowers, tribal home borrowers and veteran home borrowers across the country. Assuming such issuers find themselves unable to make the business adjustments necessary to comply with the RBCR, they will have no choice but to sell MSRs. Assuming the prognosticators are correct and a number of MSR sellers suddenly find themselves in the market looking for buyers, the price of such MSRs is sure to erode. 

Given the exodus of Banks from the Ginnie Mae issuer market over the last several years due in part to the reduced regulatory cap on MSRs stemming from Basel III, it is hard to imagine why the powers that be at Ginnie Mae would think similar requirements would work for non-bank issuers. One industry commentator points to the failure of U.S. regulators to recognize the true value of the servicing asset: 

“The mortgage servicing asset, lest we forget, is not only a source of steady cash flow for issuers, but contains embedded optionality in terms of refinance opportunities that is arguably worth more than the fair value of the asset under GAAP. Prudential regulators don’t even recognize this extremely valuable optionality, one reason bank lending performance in 1-4s is so poor.”[5]

Notwithstanding the pushback Ginnie Mae has received on the RBCR from the MSR market, Ginnie Mae seems determined to have it take effect. Although Ginnie Mae did further delay implementation of the RBCR another year until the end of 2024, to date it hasn’t changed the policy. Only time will tell if Ginnie Mae can be convinced to turn away from the RBCR approach and develop a policy that deals with the real risks it perceives to be associated with its MSRs while at the same time leaving the mortgage industry intact.

FOOTNOTES

[1] Notably, the FHFA requirements do not include the Risk-Based Capital Requirements discussed below.

[2] The Net Worth requirements for Ginnie Mae single-family Issuers (“SF Issuers”) are identical to those for SF Applicants except that the percentage of the SF Issuers total GSE single-family outstanding servicing portfolio increases to 0.35% (35 basis points).

[3] SF Issuers have similar requirements but also include (vi) 0.10% (10 basis points) of the Issuer’s outstanding Ginnie Mae single-family servicing UPB.

[4] In addition to a Leverage Ratio of at least 6%.

[5] See Christopher Whalen “Ginnie Mae Issuer Rule Threatens Government Market”, 7/20/2021 Hedgeye (https://app.hedgeye.com/insights/102527-ginnie-mae-issuer-rule-threatens-government-market?with_category=17-insights).

The final rule updates the types of IRS required to be submitted to a registered derivatives clearing organization (“DCO”) for mandatory clearing by:

• eliminating the requirements to clear IRS referencing LIBOR and certain other interbank offered rates (“IBORs”); and
• introducing, in their place, new requirements to clear IRS referencing the relevant replacement risk-free rates, such as the Secured Overnight Financing Rate (“SOFR”) in the case of USD LIBOR.

CFTC Chairman Rostin Behnam called the final rule an “important milestone” in the transition away from LIBOR and other IBORs, noting the importance of legal certainty and regulatory transparency in promoting financial stability, mitigating systemic risk and ensuring cross border harmonization in the IRS market.

Background

Title VII of the Dodd-Frank Act amended the Commodity Exchange Act to require that a swap be cleared through a registered (or exempt) DCO if the CFTC has issued a determination that the swap (or relevant group, category, type or class of swaps) is required to be cleared. 

Since the enactment of the Dodd-Frank Act, the CFTC has issued clearing determinations with respect to IRS in four classes: fixed-to-floating swaps, basis swaps, forward rate agreements (FRAs) and overnight index swaps (OIS), including a number of IRS referencing LIBOR and other IBORs in various currencies.

In recent years, regulators and global standard-setting bodies have urged market participants to accelerate their adoption of USD SOFR and other replacement risk-free rates and to cease entering into new swaps referencing LIBOR and other IBORs. As this phaseout continues, liquidity has shifted away from IBOR swaps and into OIS referencing the risk-free rates.

In light of this shift, the CFTC has determined that the IRS clearing requirements must be modified to address the cessation (or loss of representativeness) of various IBORs that have been used as reference rates and the market’s adoption of swaps referencing the risk-free rates.

Final Rule

The final rule amends the clearing requirements in CFTC Regulation 50.4(a) as follows:

• Removing the requirement to clear IRS referencing USD, GBP, CHF and JPY LIBOR, Euro Overnight Index Average (EONIA) and SGD Swap Offer Rate (SOR-VWAP), in each of the fixed-to-floating swap, basis swap and forward rate agreement classes, as applicable; and
• Adding new requirements to clear the following classes of IRS:
  • USD-denominated IRS referencing SOFR with a stated termination date range of seven days to 50 years;
  • GBP-denominated IRS referencing the Sterling Overnight Index Average (SONIA) with a stated termination date range of seven days to 50 years;
  • JPY-denominated IRS referencing the Tokyo Overnight Average Rate (TONA) as a floating rate index with a stated termination date range of seven days to 30 years;
  • CHF-denominated IRS referencing the Swiss Average Rate Overnight (SARON) as a floating rate index with a stated termination date range of seven days to 30 years;
  • SGD-denominated IRS referencing the Singapore Overnight Rate Average (SORA) with a stated termination date range of seven days to 10 years; and
  • EUR-denominated IRS referencing the Euro Short-Term Rate (€STR) with a stated termination date range of seven days to three years.

Although these amendments will become effective 30 days after publication of the final rule in the Federal Register, in order to align with the anticipated timing for discontinuation of certain LIBORs and to harmonize with foreign regulatory timelines, special implementation dates will apply in the following cases:

• October 31, 2022 for the new requirements to clear OIS referencing SOFR and SGD SORA; and
• July 1, 2023 for the removal of the requirements to clear IRS referencing USD LIBOR and SGD SOR-VWAP.

Putting it Into Practice: Impacted companies offering should note that the final regulations do not provide a model disclosure form but provide fairly prescriptive rules regarding the content and format of the required disclosures. While similar regulations in New York are still pending (we discussed these regulations in a previous bog, here), Virginia regulation applicable to merchant cash advance companies is effective July 1, and Utah’s commercial financing disclosure regulations are effective Jan. 1, 2023. Commercial lenders and small business financers will likely need to prepare for additional disclosure laws being considered by legislatures in several other states, including in Connecticut, Maryland, Mississippi, Missouri, New Jersey, and North Carolina.

John has over thirty-five years of experience in the restructuring space. He has served on the board, or as part of the management of, some of the largest companies in the world, including as Special Committee Chairman of Purdue Pharma, CEO and CRO of SunEdison, CFO of Worldcom during its chapter 11 case, and as independent board member for Highland Capital Management, LP and WMC Mortgage, LLC. He is currently the CEO of Dubel & Associates, LLC.

For more on these issues, listen to Episode 7 of Restructure THIS! hosted by Sheppard Mullin partner Justin Bernbrock.

About Restructure THIS!

Sheppard Mullin’s Restructure This! podcast explores the latest trends and controversies in Chapter 11 bankruptcy, commercial insolvency and distressed investing. Join host Justin Bernbrock, partner in the firm’s Finance and Bankruptcy group, as he and his guests discuss popular, and sometimes not-so-popular, developments in the wild west of the bankruptcy legal world and high yield dealmaking.  Subscribe to the show to receive every new episode delivered straight to your podcast player on Apple Podcasts, Google Podcasts, Spotify, Amazon Music or Stitcher.

For more on this topic, listen to the Restructure THIS! Podcast Episode 6 hosted by Sheppard Mullin partner Justin Bernbrock, who interviews Sydney Isaacs and Dan Scorpio of the communications firm  Abernathy MacGregor.

About Restructure THIS!

Sheppard Mullin’s Restructure This! podcast explores the latest trends and controversies in Chapter 11 bankruptcy, commercial insolvency and distressed investing. Join host Justin Bernbrock, partner in the firm’s Finance and Bankruptcy group, as he and his guests discuss popular, and sometimes not-so-popular, developments in the wild west of the bankruptcy legal world and high yield dealmaking.  Subscribe to the show to receive every new episode delivered straight to your podcast player on Apple Podcasts, Google Podcasts, Spotify, Amazon Music or Stitcher.