In Item 1115 of the SEC's Regulation AB, published in final form in December 2004, the SEC took big strides in coming to grips with swap agreements. Reg AB establishes rules for the scope of disclosure of financial and other information about swap providers in offering documents for registered asset-backed securities. This article describes the basic operation of Item 1115. It then discusses the measurement dates on which the determination of the level of required disclosure needs to be made and some related market practices that have developed under it.

Item 1115, titled Certain derivatives instruments, relates to derivatives used to alter the payment characteristics of cashflows from the issuing entity, whose primary purpose is not to provide credit enhancement related to the pool assets or the asset-backed securities.

In all cases, the depositor will be required to disclose the name of the derivative counterparty, its organizational form, and the general character of its business. The operation and material terms of the derivative instrument, including any limits on the timing or amount of payments or any conditions to payments, must also be described, along with any material provisions regarding substitution of the derivative instrument. These disclosures are all items that were generally disclosed under market practice prior to adoption of Reg AB.

Significance percentage

In addition, the depositor might be required to disclose more, depending on the so-called "significance percentage" calculated under item 1115. The significance percentage will generally be equal to a fraction, expressed as a percentage, whose numerator is the "significance estimate" and whose denonominator is the aggregate principal balance of the pool assets. An exception to this rule exists if the derivative instrument relates only to certain classes of the asset-backed securities. In that case, the denominator of the fraction will be the aggregate principal balance of such classes instead. The significance estimate is the depositor's estimate of the maximum probable exposure, as described below.

If the significance percentage for a swap provider is less than 10%, the required disclosure will be essentially the same as what is currently disclosed as a matter of market practice. If the significance percentage for a swap provider is 10% or more, but less than 20%, the depositor will be required to provide the financial data for the swap provider required by Item 301 of Regulation S-K. This consists of selected financial data for at least the last five fiscal years of the swap counterparty in comparative columnar format.

If the significance percentage is 20% or more, the depositor must provide financial statements for the counterparty meeting the requirements of Regulation S-X, Items 1-01 through 12-29, except for Article 3-05 (financial statements of business acquired or to be acquired) and Article 11 (pro forma financial information) of Regulation S-X. In addition to being disclosed in the registration statement, the financial statements for the counterparty [as required under 240.14a-3(b)] must be filed with the SEC.

Calculated by depositor

The significance estimate of the derivative instrument is determined by a reasonable good-faith estimate of "maximum probable exposure", made in substantially the same manner as that used in the sponsor's internal risk management process in respect of similar instruments. Since the only party with access to the sponsor's internal risk management process is the depositor, not the derivatives counterparty, it follows that the estimate is required to be made and the significance percentage is therefore required to be calulated by the depositor. As a practical matter, some depositors will turn to the swap provider for assistance in modeling this risk, however, while retaining responsibility for the estimate.

Maximum probable exposure

The only thing left to explain is maximum probable exposure, a term not defined in Regulation AB. In fact, it is probably not possible to reliably interpret this phrase by reference to its plain meaning, or even by consulting the adopting release, SEC Release 33-3518. Upon reading a comment letter cited as a source in the Release, however, its meaning becomes clear. In the Release, the Commission referred to commenters that noted participants in the derivatives markets routinely evaluate their maximum probable exposure to a counterparty, to make a credit decision as to counterparty risk, in the case of an unsecured contract, or to set required collateral levels, in the case of a secured contract, for example. These commenters suggested that relying on maximum probable exposure would be more consistent with market practice.

In the comment letter submitted by the American Securitization Forum, it is stated that while the precise method for determining maximum probable exposure may vary among market participants, a typical approach would be to determine the maximum net amount that the counterparty might be required to pay under a statistical analysis using a range of scenarios that are within two or more standard deviations from the base case. Base case is also not defined, but presumably refers to the shape of the yield curve at the time the derivative was priced. Thus, in an interest-rate swap, the maximum probable exposure would refer to the net amount the counterparty would be required to pay to the issuing entity, if the actual changes in rates over the contract's term conformed to the least favourable rates scenario for the counterparty.

Probable exposure distinguished

Note the maximum probable exposure cannot be the same thing as the probable exposure to the derivatives counterparty. To use a specific example, the maximum probable exposure to an interest-rate cap cannot be the cap purchase price. That amount only expresses the amount the cap provider expects to pay, plus a profit margin. But economic theory would indicate that the cap provider cannot charge a purchase price calculated on its maximum probable payment rather than its probable payment; if it did, competitors could come in at a lower price and still make a profit over time. This is unfortunate because the cap price is a contract term known to the sponsor without the requirement of undertaking additional modeling, and it will be lower than the maximum probable exposure, making it less likely that the derivative would hit the 10% or 20% threshold if the cap price were used.

Loss distinguished

The maximum probable exposure also cannot be the loss the issuing entity would suffer if the derivatives contract were terminated early. This number will also be smaller than maximum probable exposure.

On the other hand, the statistical approach embodied in the maximum probable exposure concept arguably comes closer to reflecting, on a conservative basis, the ABS investor's credit exposure to the derivatives counterparty during the term of the ABS securities than does using the cap purchase price.

The ASR comment letter contains an example that assumes a five-year interest-rate swap, with Libor exchanged for fixed-rate payments at a then current market rate, with a non-declining notional amount of S100 million. The letter notes that because the obligations of the floating rate paying counterparty are uncapped, under very extreme scenarios, the maximum possible exposure of the issuer to that counterparty could be in excess of even the notional amount.

As long as the maximum probable exposure to the counterparty for at-the-market interest-rate swap contracts supporting asset-backed securities remains below 10% of the aggregate principal balance of the pool assets or the classes of asset-backed securities to which the derivative relates, as applicable, Item 1115 will have a very modest effect on the scope of disclosure by providers of these contracts in ABS. In light of the difficulty that derivatives providers that are not US Exchange Act reporting companies would have in supplying the financial statement disclosure required by Item 1115, many market participants are probably counting on the 10% level never being hit.

As it happens, ABS are supported by currency swaps as well as interest rate swaps – think of US dollar-denominated Australian MBS backed by Australian dollar mortgage loans, or euro-denominated MBS backed by US dollar or sterling-denominated mortgages. For currency swaps, the maximum probable exposure may often exceed the 20% threshold. For this and other reasons, ISDA, The Bond Market Association and the American Securitization Forum have delivered a joint submission to the SEC containing interpretive suggestions to improve the workability of Reg AB's new financial information requirements for swap providers, smoothing the application of this important regulatory initiative.

Disclosure: whose responsibility?

A derivative counterparty that provides financial data or financial statements to an asset-backed security sponsor or depositor for inclusion in a prospectus supplement is not an issuer of the ABS and will not have an issuer's liability for material misstatements or omissions in the information that it provides. To protect themselves, sponsors have generally obtained indemnification from the derivative counterparty for any loss the sponsor or its affiliates suffer as a result of deficiencies in the counterparty's information, whether included in the prospectus supplement or in the Exchange Act filings of the depositor.

Updating required

Although, arguably, a depositor should have been required to measure maximum probable exposure only at the time of entering into the derivatives contract, because changes in the maximum probable exposure will only result from market-wide changes in interest rates and interest rate expectations, not changes specific to the swap provider, Reg AB doesn't take this approach. Instead, updated financial information complying with Item 1115(b) must be included under Form 10-D if maximum probable exposure has reached the 10% or 20% thresholds at the end of the distribution period for which the Form 10-D is filed, even if no such information was previously required to be included.

Sample of indemnification

A typical form of this indemnification would be as follows:

"Indemnity by Swap Counterparty. If, at any time during the term of the Derivative Transaction, (i) Swap Counterparty provides Issuer with financial information about Swap Counterparty pursuant to Item 1115(b) for the purpose of allowing Issuer to fulfill the Disclosure Obligations (the "Financial Information") and (ii) Issuer includes the Financial Information in its filings with the Commission in order to fulfill the Disclosure Obligations, then, from the date the Financial Information is so filed with the Commission (the "Filing Date"), Swap Counterparty shall indemnify and hold harmless Issuer and Sponsor, and the directors and officers of Issuer and Sponsor, and any person controlling Issuer or Sponsor, from any and all losses, claims, damages and liabilities (collectively, "Losses") caused by any untrue statement or alleged untrue statement of a material fact contained in the Financial Information or [PORTION RELATING TO ITEM 1115(a)(1)] (the "Item 1115(a)(1) Disclosure"), or caused by any omission or alleged omission to state a material fact that is required to be stated in the Financial Information or the Item 1115(a)(1) Disclosure, or is necessary to make the statements in the Financial Information or the Item 1115(a)(1) Disclosure, in light of the circumstances under which they were made, not misleading."

Because reciprocity is of the essence of indemnification provisions, the above language generally begets the below language:

"Indemnity by Issuer and Sponsor. From the Filing Date (if it occurs) and simultaneously with any indemnity from Swap Counterparty that becomes effective pursuant to Section 2 above, Issuer and Sponsor shall jointly and severally indemnify and hold harmless Swap Counterparty, and the directors and officers of Swap Counterparty, and any person controlling Swap Counterparty, from any and all Losses caused by any untrue statement or alleged untrue statement of a material fact contained in the Prospectus Supplement (except for the Financial Information and the Item 1115(a)(1) Disclosure), or caused by any omission or alleged omission to state a material fact that is required to be stated in the Prospectus Supplement (except for the Financial Information and the Item 1115(a)(1) Disclosure) or is necessary to make the statements in the Prospectus Supplement (except for the Financial Information and the Item 1115(a)(1) Disclosure), in light of the circumstances under which they were made, not misleading."

Some swap providers may be unwilling or unable to provide the financial information required by Item 1115 when maximum probable exposure is 10% or more. For these providers, the sponsor or issuing entity may be willing to give the swap provider the choice of agreeing either to (1) provide the Item 1115 information when required, or (2) at its own expense, novating the transaction to a satisfactory counterparty who is able to provide the necessary financial information.

Which base case?

The requirement to periodically recalculate maximum probable exposure to determine if updated derivatives provider financial information must be filed on Form 10-D surfaces the question, which base case should be used in order to do the statistical scenario analysis which calculates the probable exposures to the swap provider over a two or more standard deviations range on either side of the base case. Presumably the base case to be used is the assumed yield curve used in pricing a hypothetical new interest rate swap entered into on an arm's length basis on the date of determination with a term equal to the remaining term of the derivatives contract. Needless to say, none of this is spelled out in Reg AB.

How long should indemnification survive?

Under the Securities Act, the statute of limitations for Section 11 liability for material misstatements or omissions in a registration statements is one year after the plaintiff discovers or reasonably should have discovered the misstatement or omission, but in any event no later than three years after the misstatement or omission was made. Thus, there is no need for a derivative provider's indemnity for information included in the prospectus supplement to survive longer than three years after the date that the prospectus supplement is first used. However, because derivatives provider information may be required to be filed with Form 10-D at a time in the future, sponsors generally obtain indemnification for longer periods (such as until the ABS have been paid full). Just as Item 1115 is not likely to actually cause swap counterparty financial disclosure to be increased because the maximum probable disclosure will generally be below 10% (at least for interest-rate swaps), the life-of-deal indemnification provisions will in reality have teeth for a much shorter time. Because Reg AB did away with the market making prospectus, the vast majority of ABS issuing entities will suspend Exchange Act reporting requirements each January as they will have fewer than 300 record holders of their securities, determined by the number of DTC direct participants holding positions. In theory, the issuing entity could again become subject to Exchange Act reporting if the number of record holders of its securities later climbed above 300, but the likelihood is very low.

Swaps outside the deal

In December 2000, the US Congress made it clear that swaps are not securities when it adopted the Commodity Futures Modernization Act. Thus, if an ABS investor purchases a capped floating rate ABS security and enters directly into a rate cap to hedge the risk of rising interest rates, writing the cap will have no Securities Act consequences for either the cap provider or the investor. In contrast, if the same instrument is embedded in an ABS security subject to Reg AB, the prospectus supplement or the depositor's Exchange Act filings may require the inclusion of significant financial disclosures about the cap provider, as discussed above.

Adam Glass is a partner at Linklaters in New York

The article first appeared in Derivatives Week, a publication of Euromoney Institutional Investor