The SEC’s Office of Structured Finance in the Division of Corporation Finance recently issued an interpretive guidance that agreed with Latham & Watkins’ request letter that fixed-income or other securities issued in data center securitizations of the type described in the request letter are not “asset-backed securities” within Section 3(a)(79) of the Securities Exchange Act of 1934.

Section 3(a)(79) defines an asset-backed security, in relevant part, as a fixed-income or other security collateralized by a self-liquidating financial asset (including a loan, lease, mortgage or receivable) that allows investors to receive payments depending primarily on cash flow from that asset.

For transactions that fall within the scope of the SEC interpretive guidance, some of the consequences are significant. Regulation RR regarding risk retention defines an “asset-backed security” by direct reference to Section 3(a)(79). Rule 192, regarding conflicts of interest relating to certain securitizations, does the same, with additional coverage in respect of synthetic ABS and hybrid cash and synthetic ABS. The absence of Exchange Act ABS status removes the federal risk-retention requirement and Rule 192, with respect to the transactions addressed in the SEC’s interpretive guidance.

Rules 15Ga-1 and 15Ga-2, relating respectively to repurchase-demand and third-party due diligence reporting, likewise operate by reference to Exchange Act ABS, subject in each case to additional conditions.

As a separate point, note, however, that the risk-based capital rules applicable to banks do not operate by reference to the Exchange Act ABS definition. Whether a bank’s credit exposure to a data center securitization is a “securitization exposure” turns instead on the definition of “traditional securitization” under the capital rules, which imposes its own conditions: tranching of credit risk into at least two levels of seniority, performance of the securitization exposures that depends on the performance of the underlying exposures, that all or substantially all of the underlying exposures be financial exposures, and that the underlying exposures are not owned by an operating company.

The same data center can produce different Section 3(a)(79) outcomes, depending on what the issuer actually owns.

In developing the ABS regulatory framework, the SEC described a self-liquidating asset as one that, by its terms, converts into cash within a finite period. The request letter argues that the data center securitizations described in its request operate differently. The issuer owns, directly or through asset entities, the data center facilities and associated infrastructure. Customer contracts and, in some cases, leases form part of the securitized assets and generate revenue. That revenue is reduced by the cost of operating the facilities, including electricity, insurance, repairs, maintenance and security. The operator or manager also performs an active role, including procuring customers, negotiating and renewing contracts, maintaining the facilities and managing expenses.

The request letter’s argument is that the securities finance an enduring operating asset, and that the cash ultimately available for debt service does not depend primarily on the liquidation of the customer contracts or other financial assets contained within the structure. The physical asset also survives the debt. After repayment of the securities, the issuer continues to own and operate the data center.

The comparison with single-asset, single-borrower CMBS is significant in that context. A conventional SASB CMBS issuer holds a mortgage loan secured by the underlying property. That loan is itself a financial asset. As the borrower repays it, the asset is extinguished. When the loan has been repaid in full, the securitization issuer no longer holds it.

The same operational characteristics supporting the argument that payments do not depend primarily on self-liquidating financial assets may also be relevant to the credit analysis. Where cash available for debt service depends in part on an operator controlling costs, maintaining infrastructure, procuring and renewing customers and managing the underlying facilities, investors are exposed to the performance of the operating business as well as the contractual revenues it generates.

Power availability and procurement, cooling requirements, water usage and availability, customer concentration, capital expenditure, technological change and recontracting can all affect the performance of a facility.

Accordingly, notwithstanding that certain ABS-specific regulatory requirements may no longer apply, investors may continue to require information regarding the operating risks relevant to the credit, including information that is not prescribed by the ABS regulatory framework.

Although Regulation RR’s 5% requirement does not apply to the securities described in the SEC response, the practical effect on sponsor economic exposure may be less significant than the removal of the requirement suggests. In a number of existing data center securitizations, the sponsor has satisfied Regulation RR through an eligible horizontal residual interest comprising 100% of the equity interests in the issuer, held through the guarantor, typically a direct wholly owned subsidiary of the parent. The fair value of that retained interest can substantially exceed the 5% regulatory minimum.

The ownership structure may also serve purposes independent of Regulation RR. In transactions containing this structure, the transaction documents may require the guarantor to continue to own 100% of the equity interests in the issuer, with a failure to maintain that ownership constituting an event of default. Removing Regulation RR therefore eliminates the regulatory requirements governing the form, valuation and treatment of the retained interest, but does not necessarily change the underlying structure and sponsor equity exposure.

More broadly, for almost the entire history of the product, market participants have structured transactions against uncertainty over Exchange Act ABS status and have generally complied with applicable requirements out of an abundance of caution. The removal of those requirements raises a broader question as to which protections will continue as a matter of contract or market practice. The absence of a Rule 15Ga-2 filing obligation, for example, does not eliminate an investor’s need for diligence or information. Similarly, whether contractual protections addressing conflicts of interest continue to appear will depend on investor requirements and the particular transaction.

The effect of the SEC’s position may also differ between existing master trust platforms and newly established ones. For a new master trust falling within the fact pattern addressed by the SEC, the transaction can be structured from inception without requirements that apply solely by reason of Exchange Act ABS status. Existing master trusts present a different question. Where risk retention and other ABS-derived requirements have been hardwired into the transaction documents, the fact that the underlying regulatory requirement no longer applies does not itself remove the contractual provision.

That distinction may matter in a market built around repeat issuance. A new series issued from an existing master trust is not necessarily in the same position as an issuance from a newly established platform. If risk retention or other requirements operate at the platform level, an existing trust may remain subject to them unless its governing documents are amended, even though an otherwise identical new platform would not be required to include them. Whether sponsors seek those amendments will depend on the terms of the relevant documents, including applicable consent requirements, as well as the economic value of the change and the response of investors and rating agencies.

Legacy and new platforms may therefore operate under different structural conventions for some time, reflecting the regulatory assumptions against which the legacy platforms were documented.

Features of the existing data center securitization model that were included in response to ABS regulations may also serve independent structural or commercial purposes. Certain conventions may be phased out because their principal purpose was regulatory compliance, while others may persist because they are embedded in the ownership or structural architecture of the financing, or because investors or rating agencies regard them as useful for assessing or monitoring the credit. Yet other conventions may remain in legacy platforms simply because the benefit of removing them does not justify the amendment process.

The SEC’s response is concise. It does not set out an independent analysis and specifically avoids reciting the facts in the request letter. Instead, it concurs with the result on the basis of the facts and representations presented. The response is also explicit about its status. It reflects the views of Division staff, rather than constituting a rule, regulation or statement of the SEC. It has no legal force or effect, and different facts or conditions could require a different conclusion.

Data center financing structures are not homogeneous. A transaction in which the issuer owns physical data center assets that are actively managed, while customer contracts constitute only one element of the economics, may resemble the request letter’s fact pattern closely. A structure in which value and debt service depend principally on contractual receivables or leases may present a materially different question.

The number of customer contracts should not, by itself, determine the analysis. A colocation or edge platform may have thousands of customer contracts, but its ability to service debt may depend substantially on the operator’s continuing ability to acquire and retain customers, managing churn and pricing, and operate the underlying infrastructure. Conversely, a facility leased to a single hyperscale customer under a long-dated lease may derive a substantial portion of its cash flow, and potentially its value, from that contractual relationship.

Section 3(a)(79) asks what collateralizes the security and whether payments depend primarily on cash flows from self-liquidating financial assets. Future transactions would need to be tested against that language rather than against any industry label attached to them.

Traditional SASB CMBS provides a useful contrast to data center securitizations of the type described in the request letter, because a mortgage loan sits between the capital-markets investor and the underlying property. The securitization issuer owns that loan and the underlying borrower owns the real estate.

If the intervening mortgage loan is removed and the property-owning entity itself issues bonds, continues to own the property following repayment and services the debt from income generated through ownership and operation of that property, the issuer would not hold the intervening mortgage loan that constitutes the self-liquidating financial asset in the traditional SASB CMBS structure. If this structure is adopted, it remains to be seen what the market reaction would be to a non-typical structure for CMBS.

That does not mean that direct real estate issuance is categorically outside Section 3(a)(79). The SEC guidance has not addressed that proposition, and the answer would depend on the particular structure, collateral, and cash-flow mechanics. The fact that investors ultimately have exposure to the same real estate does not necessarily mean that the securities receive the same treatment under Section 3(a)(79). The analysis may differ, depending on whether the securities are backed by a mortgage loan secured by that real estate or are issued directly by the entity that owns the real estate. This may become more pertinent as real estate and infrastructure borrowers increasingly look to capital-markets structures outside conventional CMBS.

Although, like all no-action letters, the SEC’s response is strictly limited to the fact pattern presented to it, the letter may nonetheless also be useful in providing comfort on, or a useful framework about how to consider, structured financings that are dependent on operating assets for payment of their issued debt.

The data center securitization market has, since its inception, borrowed the architecture of ABS while financing assets whose economics increasingly resemble operating infrastructure. Following the SEC response, future structures may retain certain ABS-derived protections while dispensing with others, and may develop new disclosure and covenant conventions around operating risks that conventional ABS rules were not specifically designed to address.

It will be worth monitoring which features the market chooses to retain, how far the reasoning in the SEC’s position extends beyond the structures described in the request letter, and how the data center financing product evolves once it no longer needs to be structured on the assumption that it is an Exchange Act ABS.

Authored by Nika Silva.