COVID-19 and US Securitization Impacts

On March 11, 2020, the World Health Organization officially characterized COVID-19 as a pandemic, raising the health emergency to its highest level.  To date, a number of governmental programs have been enacted in response to the hardships created by the pandemic, including:

• On March 13, 2020, President Trump declared a national emergency under the National Emergencies Act and an emergency under the Robert T. Stafford Disaster Relief and the Emergency Assistance Act. 
• On March 15, 2020, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) announced it would drop interest rates to zero and buy at least $700 billion in government and mortgage-related bonds as part of a wide-ranging emergency action to protect the economy.  
• On March 16, 2020, the US Securities and Exchange Commission (“SEC”) announced that it will not take final action before April 24, 2020, regarding certain proposed actions that have comment periods expiring in March, to allow commenters additional time to submit comments.  
• On March 17, 2020, the Division of Swap Dealer and Intermediary Oversight of the Commodity Futures Trading Commission (“CFTC”) issued five letters providing temporary regulatory relief to certain categories of market participants with respect to COVID-19.
• On March 17, 2020, the Federal Reserve re-started the Primary Dealer Credit Facility and the Commercial Paper Funding Facility, each of which originally came about during the 2008 financial crisis in an effort to support the flow of credit to American households and businesses.
• On March 18, 2020, President Trump signed into law the Families First Coronavirus Response Act. This bill provides for paid sick leave and free COVID-19 testing, expands unemployment benefits and food assistance, and requires employers to provide additional protections for healthcare workers.  
• On March 18, 2020, the Federal Reserve established the Money Market Mutual Fund Liquidity Facility that will provide liquidity to certain types of money market mutual funds (“MMFs”) by making secured loans to financial institutions that purchase certain assets from MMFs. 
• On March 20, 2020, the Internal Revenue Service (“IRS”) released Notice 2020-18, which postpones the due date for making federal income tax payments (including payments of tax on self-employment income) for the 2019 taxable year due April 15, 2020, to a new due date of July 15, 2020.
• On March 23, 2020, the Federal Reserve re-started the Term Asset-Backed Securities Loan Facility, which originally came about during the 2008 financial crisis in an effort to ease liquidity concerns and generally stimulate deal flow. 
• On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act, or the “CARES Act”. This bill provides economic stimulus, including (1) direct financial help to Americans, (2) loans and benefits for businesses, (3) loans for directly impacted industries such as air carriers, and (4) assistance for healthcare.

The situation currently appears ominous as the number of cases of the virus has increased exponentially globally, with many countries severely impacted economically as well as socially. 

In addition to a host of general business concerns, such as stock price, revenues, supply chain and employee and community health and welfare, the novel coronavirus, COVID-19, has raised a number of issues in the securitization markets both domestically and offshore.  In this article, we will focus on the following issues—

1. SEC disclosures and related requirements;
2. Term Asset-Backed Securities Loan Facility;
3. Servicing modifications;
4. Servicing and labor disruptions;
5. Force majeure provisions and material adverse change clauses; and
6. Exacerbation of LIBOR issues.

SEC Disclosures and Related Requirements

To a large degree, SEC disclosure requirements are principles-based.  Applying the concept of materiality to the impact of COVID-19, there are many areas where existing SEC rules, while not expressly mentioning pandemics, could require disclosure.  Such disclosure considerations could arise in the context of a regularly scheduled periodic report, such as an annual or quarterly report.  Or, there could be an issue that requires more immediate disclosure through a current report on Form 8-K or Form 6-K or a press release.  For transactions currently being contemplated, we also anticipate that securitizers will make disclosures in risk factors regarding the impact of the pandemic on their business and the transaction generally. 

In addition to more general risks, with the impact from COVID-19 growing rapidly, companies may become increasingly aware of additional ways in which the pandemic is posing specific risks to their operations that warrant disclosure as much of their workforce transitions to working from home and/or production facilities are forced to close. Due to these rapidly evolving changes to operations, companies will likely find it useful to begin drafting more detailed risk factors relating to COVID-19 for inclusion in their next SEC filing that requires risk factor disclosure.  It will also be important for securitizers to make appropriate disclosures in offering documents to set forth risks that are specific to the asset-class and business as well as to the transaction as a whole.  We expect to see fulsome risk factors covering COVID-19 in offering documents as well as due diligence questions related thereto for purposes of underwriter and initial purchaser diligence. 

Additionally, the SEC has publicized its willingness to discuss on a case-by-case basis administrative difficulties in compliance with federal securities laws that may arise in connection with COVID-19.  The official beginning of the COVID-19 pandemic occurred in March, which is the same month that most periodic securitizers are obligated to file a Form 10-K. 

Term Asset-Backed Securities Loan Facility

The Term Asset-Backed Securities Loan Facility (“TALF”) was established by the Federal Reserve on March 23, 2020 to support the flow of credit to consumers and businesses. The Federal Reserve expects that the TALF will enable the issuance of asset-backed securities backed by underlying credit exposures in the following specified assets classes: student loans, auto loans and leases, commercial and consumer credit card receivables, equipment loans, floorplan loans, insurance premium finance loans, certain loans guaranteed by the Small Business Administration and eligible servicing advance receivables.  Under the TALF, the Federal Reserve Bank of New York will commit to lend to a special purpose vehicle and such special purpose vehicle will then make available up to $100 billion in non-recourse three-year loans to investors in asset-backed securities. The loans made to such investors will be secured by a pledge of the related asset-backed securities as collateral.  The pledged eligible collateral will be valued and assigned a haircut based on the asset class and the historical volatility and weighted average life of the pledged asset-backed securities.

Based on the TALF term sheet, to be eligible as collateral for the TALF, the asset-backed securities must: (1) have a credit rating in the highest investment grade category (long-term or short-term) from at least two rating agencies; and (2) be issued on or after March 23, 2020.  In addition, the credit exposures underlying such asset-backed securities must: (1) fall within one of the specified asset classes listed above; (2) all, or substantially all, have been originated by a U.S. company; and (3) all, or substantially all, have been newly issued.  Although investors in asset-backed securities will likely need to wait for the release of the more detailed terms and conditions to confirm eligibility, the Federal Reserve has indicated that such terms and conditions will be primarily based off of the terms and conditions used for the TALF established in 2008.

Servicing Modifications

The concept of permitted servicing modifications is prevalent in securitization transactions.  Most servicers are allowed to modify the terms of the underlying assets if the modification, among other things, would maximize collections or in the event of a national disaster.  Since President Trump declared a national emergency under the National Emergencies Act and an emergency under the Robert T. Stafford Disaster Relief and the Emergency Assistance Act on March 13, 2020, it is likely that we will see many servicers in securitizations granting payment extensions or deferrals to obligors.  The extent to which such modifications are permitted is governed by the servicing standard set forth in the related securitization documents. While these modifications will likely impact deal cash-flows in the short-term, these disruptions will likely only be temporary as servicers are not likely to grant long-term extensions and deferrals. 

Servicing and Labor Disruptions

As the outbreak of COVID-19 in China continues to spread to and within additional countries, including the United States, it has begun to disrupt business in the travel and hospitality industries, among others, and there is a risk that the outbreak will reduce general economic and commercial activity in the United States and offshore in a way that delays or reduces the origination of new assets.  Disruptions flowing from the outbreak will also have negative credit and cash-flow implications on transactions as borrower ability to pay will be stressed.

The continued spread of COVID-19 is starting to result in labor disruptions as manufacturing plants are closing and only essential businesses are permitted to remain open by decree of various state governmental officials.  Additionally, staffing problems are arising in various industries and businesses as staff members become ill or seek to avoid becoming ill.  Many businesses are reviewing and adjusting their business continuity plans to potentially change how and from where their staff members work in light of the outbreak, particularly with work from home policies.  Those staffing problems and adjustments could cause changes in obligor behavior and in the ability of servicers to seek timely payments on receivables and also result in delayed or reduced demand for loans.  It is also possible that the spread of COVID-19 could result in staffing problems at government offices (such as department of motor vehicles or UCC filing offices), the trustees and other deal parties, including financing sources, investors and prospective investors.  It is likely that the impact of the servicing and labor disruptions will be felt acutely in transactions.

Force Majeure Provisions and Material Adverse Change Clauses

Most securitization documents contain force majeure provisions.  Force majeure translates from French roughly as “a major force” and excuses a party, typically the securitization issuer, the servicer or their affiliates, from performance under the transaction documents.  While the concept of an excuse from performance of contractual obligations due to unexpected events is common to securitization transactions, there are differences in its scope and operation.  Business parties need to carefully consider the specific wording of force majeure clauses when they appear in a contract.

Even in the absence of a contractual force majeure provision, common law principles of impracticability, frustration of purpose, or prevention by government regulation are available in most states and are incorporated into the Restatement (2d) of Contracts, which is followed in most state jurisdictions.  Under the doctrine of impracticability, a party’s contractual obligations may be discharged if, after the contract is made, the party’s performance becomes impracticable due to the occurrence of an event that is:

• outside of a party’s control; and
• a basic assumption on which the contract was made (Restatement (2d) Contracts § 261).

Similarly, under the doctrine of “frustration” of contract, a party’s contractual obligations may be discharged if, after the contract is made, the party’s principal purpose is substantially frustrated:

• without the party’s fault; and
• where the occurrence or non-occurrence of an event was a basic assumption on which the contract was made (Restatement (2d) Contracts § 265).

The party asserting the existence of the force majeure event will bear the burden of demonstrating the existence of such event.  Whether events related to COVID-19 will constitute force majeure will turn on the language used in the agreement, the specific events that are being referenced, and the extent to which those events were foreseeable or under a party’s control.  For example, if an agreement defines a force majeure as an “Act of God,” and the event triggering the force majeure is a voluntary directive to work from home, such directive may not sufficiently fall within the definition of force majeure.  Similarly, in the event of a government-mandated business shut down, a party’s right to discharge its contractual obligation may be more naturally adjudicated under the doctrine of impracticability due to government regulation, rather than under a force majeure clause.  On the other hand, if a force majeure provision specifically includes a pandemic, parties may have a better argument for relying on such provisions to excuse their contractual obligations. 

In addition to the above, material adverse change (“MAC”) clauses are a common feature in most securitization documents and most frequently, although not exclusively, relate to events that have a material adverse impact on the securitizer’s, servicer’s or a related party’s capacity to perform under the securitization documents or that otherwise have a material adverse impact on noteholders. Similar to a force majeure event, the party asserting a breach of a MAC clause will bear the burden of demonstrating the existence of such event. However, in contrast to a force majeure event, in the case of securitizations, the party invoking a MAC clause is more likely to be an investor, rather than the securitizer, servicer or one of their respective affiliates. With respect to COVID-19, assuming the invoking party can show that COVID-19 has or will have a substantial adverse impact on the securitizer’s, servicer’s or other party’s capacity to perform under a securitization agreement, on the noteholders or on any other covenant containing a MAC clause, the primary question may be whether COVID-19, and the harm it has caused, will persist for a significant period of time. To the extent the harm caused by COVID-19 persists, and economic dislocation increases in severity and duration, the argument that a MAC clause has been triggered may well grow stronger. How severity and duration are measured and evaluated at any point in time remains to be seen, and these questions will need to be carefully considered in interpreting a MAC clause.

Parties considering exercising their force majeure rights should carefully review the contract’s language to determine if a force majeure event (or non-occurrence thereof) is a condition to contracting, an excuse from performing certain obligations, or creates a mutual right for both parties to terminate their obligations.  Further, parties should note the procedural requirements to exercising the force majeure rights, as most courts will require rigid adherence to such procedural mechanisms. In addition, securitizers should carefully review any MAC clauses in their securitization documents and consider whether they will arguably breach any of these covenants based on the effects COVID-19 may have on their operations or their ability to timely pay interest and principal on their securities.  

Exacerbation of LIBOR issues

In May 2019, the Alternative Reference Rates Committee (“ARRC”) published “ARRC Recommendations Regarding More Robust Fallback Language for New Issuances of LIBOR Securitizations” (“ARRC Recommendations”).  While the ARRC Recommendations included a definition of what constitutes a cessation of LIBOR and provided a “waterfall” of replacement rates to be used when LIBOR is no longer published or is no longer representative, the securitization industry has been hesitant to adopt the ARRC Recommendations.  Instead, we have seen some securitization sponsors adopting a modified ARRC approach or not adopting the ARRC Recommendations at all.  The time and attention that securitizers would have spent developing LIBOR transition plans has now been diverted to more pressing needs caused by the pandemic.

While the disruption of LIBOR would pose some issues in a normally functioning financial market, the COVID-19 outbreak has exacerbated any such LIBOR disruption issues.  Specifically, with the Federal Reserve setting interest rates at zero, it is possible that certain securities indexed to LIBOR could be in the odd position of bearing a negative interest rate whereby the investors would theoretically have to pay the securitization issuer interest.  While many deals set a LIBOR indexed floor of zero in transactions, most older transactions do not have this feature.  Although this anomaly may benefit buyers of the equity portions of the capital stack in a transaction, most transactions are simply not legally or operationally equipped to handle a reversal in cash-flow.