SEC Proposes Rule Regarding Prohibition Against Conflicts of Interest in Certain Securitizations

The Securities and Exchange Commission (the “SEC”) has proposed a new rule (the “Proposing Release”)¹ under the Securities Act of 1933, as amended (the “Securities Act”), prohibiting material conflicts of interest in asset-backed securitizations, as required by Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).² Proposed Rule 127B would prohibit certain persons who create and distribute an asset-backed security, including a synthetic asset-backed security, from engaging in transactions or benefitting from facilitating a third party’s engaging in transactions, up to one year after the date of the first closing of the sale of the asset-backed security, that would involve or result in a material conflict of interest with respect to any investor in the asset-backed security. The proposed rule also would provide exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making.

The SEC has approached this rulemaking by proposing a broad rule that follows the language of the Dodd-Frank Act, and then by providing extensive interpretative guidance. As noted by the SEC, “Section 27B(a) is not effective until the adoption of final rules issued by the Commission….The proposed interpretations and related examples discussed in this proposing release therefore will have no force or effect except to the extent they are incorporated into any final Commission release adopting rules under Section 27B.”³

The Structure of the Proposed Rule and Its Proposed Interpretations

The text of the proposed Rule 127B is brief and closely follows the language of Section 27B of the Securities Act, as added by Section 621 of the Dodd-Frank Act:

An underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (. . .which for the purposes of this rule shall include a synthetic asset-backed security), shall not, at any time for a period ending on the date that is one year after the date of the first closing of the sale of the asset-backed security, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity. . . .[However,] the following activities shall not be prohibited:. . .(1). . .[r]isk-mitigating hedging activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an asset-backed security, provided that such activities are designed to reduce the specific risks to the underwriter, placement agent, initial purchaser, or sponsor associated with such positions or holdings;. . .(2). . .[p]urchases or sales of asset-backed securities made pursuant to and consistent with commitments of the underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, to provide liquidity for the asset-backed security; or (3). . .[p]urchases or sales of asset-backed securities made pursuant to and consistent with bona fide market-making in the asset-backed security.

Interpretative Guidance on the Proposed Rule

The Proposing Release, however, features a substantial effort by the SEC to provide interpretative guidance with respect to the proposed rule. The SEC states that its goal was “to strike an appropriate balance between prohibiting the specific type of conduct at which Section 27B is aimed without restricting other securitization activities.”⁴ The SEC’s interpretative guidance discusses: first, the scope and conditions required for the application of the rule (that is, persons, products, timeframes and conflicts that potentially fall within the rule); second, exceptions relating to risk-mitigating hedging activities, liquidity commitments and bona fide market-making; and third, examples of activities that are prohibited or permitted under the proposed rule.

According to the Proposing Release, there are five key conditions that a securitization transaction must satisfy in order to trigger the prohibition under the proposed rule.

Covered Persons

The proposed rule would apply to “securitization participants” such as underwriters, placement agents, initial purchasers or sponsors, or any affiliate or subsidiary thereof, of an asset-backed security (“ABS”), all of which have substantial roles in the structuring and sale of ABS. The SEC has not attempted to define terms such as “initial purchaser” and “placement agent,” on the premise that they are sufficiently well-understood in the ABS market. Further, the SEC preliminarily believes that the collateral manager of an ABS should also be subject to the proposed rule based on its role in structuring and selecting assets of an ABS.

Covered Products

The proposed rule would apply to any “asset-backed security,” as newly and broadly defined by Section 3(a)(77) of the Securities Exchange Act of 1934, which was added by the Dodd-Frank Act. In addition, for purposes of the proposed rule, ABS would specifically include any “synthetic ABS” (although the SEC proposes not to define this term based on its understanding that the term is commonly used and understood by ABS market participants). The proposed rule would apply to all ABS, whether offered and sold in registered offerings or offerings that are exempt from registration.

Covered Timeframe

The proposed rule would apply to transactions by a securitization participant for a period ending on the first anniversary of the first closing of the sale of the ABS. As Section 27B of the Securities Act does not specify the commencement point of the covered timeframe, the Proposing Release notes the SEC’s belief that it is appropriate not to propose a commencement point, meaning that the proposed rule would apply to transactions that occurred before the first closing of the sale of ABS. In the SEC’s view, securitization participants may have entered into pre-closing transactions involving material conflicts of interest that are difficult to distinguish from similar transactions entered into during the one-year post-closing period.

Covered Conflicts of Interest

The Proposing Release provides very specific guidance as to the scope of “conflicts of interest” that would be covered by the proposed rule.

First, the proposed rule would cover only material conflicts arising between a securitization participant with respect to ABS and an investor in those ABS. Thus, any conflicts arising exclusively between securitization participants (for example, between a placement agent and a collateral manager) would not be covered by the proposed rule.

Second, conflicts of interest that arise solely among ABS investors (including a securitization participant in its capacity as an investor in such ABS) would not be covered by the proposed rule. Thus, the proposed rule would not prohibit multi-tranche structures, even though those structures may involve conflicts of interest between the holders of the various tranches.

Third, conflicts of interest between a securitization participant and an investor would be covered by the proposed rule only if they arise as a result of or in connection with the related ABS transaction. Thus, the proposed rule would not address conflicts of interest that are unrelated to the parties’ status as a securitization participant and an investor in the related ABS transaction.

Fourth, for the proposed rule to apply, the conflicts of interest would have to arise as a result of or in connection with engaging in a transaction, such as shorting the securities issued in the ABS or its underlying assets, or selecting assets (directly or indirectly) for the underlying ABS asset pool and selling those assets to the ABS issuer. However, the SEC recognizes that not every activity undertaken by a securitization participant would constitute engaging in a transaction for purposes of the proposed rule, citing as an example the issuance of investment or market research by a securitization participant.

Conflicts of Interest That are Material

Only conflicts of interest that are “material” would be subject to the prohibition of the proposed rule. Acknowledging the challenging nature of identifying conflicts of interest that are “material,” the SEC proposes not to define the term, fearing that any such definition might be both over-and-under-inclusive. Instead, the SEC proposes to clarify which conflicts of interest are “material” through an interpretative test.

Under the proposed test, a transaction would involve a material conflict of interest if a securitization participant would benefit directly or indirectly from the actual, anticipated or potential adverse performance of the asset pool; loss of principal, monetary default or early amortization event on the ABS; or decline in the market value of the ABS (i.e., a “short transaction”). Alternatively, a transaction would involve a material conflict of interest if a securitization participant, who directly or indirectly controls the structure of the ABS or the selection of its underlying assets, would benefit directly or indirectly from fees or other forms of remuneration (or the promise of future business, fees or other forms of remuneration) as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select its underlying assets in a way that allows the third party to benefit from a short transaction. In either case, there also would have to be a “substantial likelihood” that a “reasonable” investor would consider the conflict important to his or her investment decision (including a decision to retain the security or not).⁵

According to the SEC, the intent of a securitization participant in structuring an ABS to fail or default is not relevant to determining whether a transaction is a prohibited short transaction. It is sufficient to show that the securitization participant would benefit from the actual or potential decline of the market value of the ABS. In addition, no actual decline in market value of the ABS would be required to trigger the prohibition; rather, it would be sufficient that the securitization participant entered into a short transaction that would benefit it if the market value of the ABS were to decline. The SEC acknowledges that this part of the interpretation may restrict transactions where informed parties have different independent views regarding anticipated asset performance and would otherwise want to contract on that basis, thus having unintended effects such as potentially limiting investment opportunities for investors.

The SEC recognizes the practical difficulties of policing the behavior of a third party by a securitization participant of an ABS, and notes its preliminary belief that, where reasonable to do so, a securitization participant may rely on appropriate contractual covenants or representations from third parties that they would not engage in prohibited short transactions.

Finally, the SEC notes that potential implications of the relevant conflict must be sufficiently important in order to trigger the prohibition under the proposed rule. The SEC acknowledges that its proposed materiality formulation is also used under the federal securities laws to determine whether disclosure is necessary, but it cautions that this is not intended to suggest that an otherwise prohibited transaction under the proposed rule would be permitted if there were adequate disclosure.

Exceptions

As required by Section 621 of the Dodd-Frank Act, the proposed rule would provide three exceptions from the prohibition on material conflicts of interest.

Risk-Mitigating Hedging Activities

Risk-mitigating hedging activities would be permitted so long as they occur in connection with positions or holdings arising out of underwriting, placement, initial purchase or sponsoring of ABS and are designed to reduce or mitigate the risk to the securitization participant in connection with those activities. For instance, hedging by a securitization participant (or, the SEC preliminarily believes, its affiliates or subsidiaries) to protect against the risk of a price decline during the warehousing of the asset pool pending the closing of a securitization would not be prohibited. However, the SEC warns against speculative trading masked as risk-mitigating hedging activity. According to the SEC, the hedge should be correlated so that the losses (or gains) on the position hedged would be offset by the gains (or losses) on the hedge without any appreciable differences. A permitted hedge should unwind as exposure is reduced, whereas an over-hedged exposure could be indicative of proprietary trading for profit.

Liquidity Commitments

A securitization participant would be permitted to provide liquidity pursuant to a commitment with respect to the ABS. The SEC interprets the “purchases or sale of asset-backed securities” reference in the statutory exception to cover a range of activities, including the provision of financing to address maturity mismatches between ABS and their underlying assets, and commitments by a securitization participant to finance the purchase of an ABS pursuant to a repo transaction.

Bona Fide Market-Making

Purchases or sales of ABS would be permitted to be made pursuant to and consistent with bona fide market-making in the ABS. The SEC preliminarily believes that the following characteristics are indicative of bona fide market-making in ABS:

• It includes purchasing and selling the ABS from or to investors in the secondary market
• It includes holding oneself out as willing and available to provide liquidity on both sides of the market (i.e., regardless of the direction of the transaction)
• It is driven by customer trading, customer liquidity needs, customer investment needs, or risk management by customers or market-makers
• It generally is initiated by a counterparty and if a customer initiated a customized transaction, it may include hedging if there is no matching offset
• It does not include activity that is related to speculative selling strategies or investment purposes of a dealer, or that is disproportionate to the usual market-making patterns or practices of the dealer with respect to that ABS
• Absent a change in a pattern of customer-driven transactions, it typically does not result in a number of open positions that far exceed the open positions in the historical normal course of business
• It generally does not include actively accumulating a long or short position other than to facilitate customer trading interest
• It generally does not include accumulating positions that remain open and exposed to gains or losses for a period of time instead of being closed out promptly. In contrast, an aged open position taken to facilitate customer trading interest would be hedged rather than exposed to gains and losses for a period of time⁶

The SEC cautions that the account type or desk (that is, a market-making account or a market-making desk) is not determinative of whether trading constitutes bona fide market-making.

Examples of Application of Proposed Interpretations

The SEC provides a few examples of transactions that involve or do not involve, as applicable, potential conflicts of interest that are covered by the proposed rule. It, however, acknowledges that such examples are merely illustrative and that even minor changes in the facts and circumstances could change the analysis of the transactions.

Shorting ABS Exposures

If a securitization participant effects a short transaction on ABS, or on any of the assets underlying an ABS during the covered timeframe, the short transaction would involve a material conflict of interest between the securitization participant and the ABS investors because the securitization participant would profit from the adverse performance of the ABS.

Hedging Retained ABS Exposure

If a securitization participant purchases ABS and then hedges that position during the covered timeframe, this activity could fall under the risk-mitigating hedging activities exception, so long as it fits all of the prescribed parameters.

Synthetic ABS Transactions

The SEC discusses a variety of examples in which a securitization participant effects a short transaction by purchasing credit default swap (“CDS”) protection from the ABS issuer during the covered timeframe.

If the short transaction is the only exposure that the securitization participant has, then it would be prohibited under the proposed rule because the securitization participant would profit from the adverse performance of the ABS or the asset pool underlying the ABS.

If the short transaction is designed to hedge a pre-existing long position in the same assets underlying the ABS, the SEC still believes that the transaction would be prohibited by the proposed rule. The SEC preliminarily believes that the risk-mitigating hedging activities exception would not apply since the hedge is for an existing long investment position and not associated with underwriting activities relating to the ABS, though the SEC requests comment on this conclusion.

If the short transaction is designed to hedge long cash or derivative positions that are accumulated by the securitization participant solely in anticipation of creating and selling a synthetic ABS, then, assuming there was no significant net basis risk, the transaction would fall under the risk-mitigating hedging activities exception.

If contemporaneously with the entry into the short transaction with the ABS issuer the securitization participant enters into offsetting CDS trades with third-party market participants, the transaction would fall under the risk-mitigating hedging activities exception, so long as the three following conditions are met:

• The third parties did not have a role in selecting assets, or any influence on any aspect of the ABS transaction
• The securitization participant did not itself select assets biased to profit the market participants
• The offsetting CDS trades had no significant net basis risk

However, the exception would not apply if the short transaction with the ABS issuer is entered to offset pre-existing CDS exposures with third parties that were entered into for purposes unrelated to the ABS transaction.

Facilitation of Third-Party Activities

This example involves variations on situations in which a securitization participant, in this case a placement agent, benefits by allowing an unaffiliated third party to select assets underlying an ABS. In each case, the third party purchases CDS protection on the relevant ABS during the covered timeframe.

If the securitization participant facilitates the third-party short transaction and allows the third party to select the assets, the transaction would be prohibited. The securitization participant, in exchange for compensation, would be creating an opportunity for the third party to select riskier assets so that it could benefit from poor performance of such assets.

If the securitization participant does not facilitate (and does not get paid for) the third-party short transaction with an unrelated party, but does permit the third party to select the riskier assets, the transaction would still be prohibited. The SEC believes that, even though there is no direct compensation, the securitization participant may be deriving other benefits such as the promise of future business from such third party.

If a third party selects assets, purchases one or more classes of ABS, and at that time or after decides to hedge its exposure by purchasing CDS protection on those ABS, the transaction would not be covered by the proposed rule. The SEC preliminarily believes that such investor activities do not involve or result in the types of the material conflicts of interest intended to be addressed by the proposed rule and would qualify for the risk-mitigating hedging exception. However, if the third party structures its transactions so that it would profit more from its short position than it would lose on its long ABS position, the transaction would no longer qualify for the risk-mitigating hedging exception.

Application of the Proposed Rule to Other Activities

The SEC believes that activities associated with the typical structuring of a non-synthetic ABS would not be prohibited by the proposed rule. Such activities would include “providing financing to a securitization participant, deciding not to provide financing, conducting servicing activities, conducting collateral management activities, conducting underwriting activities, employing a rating agency, receiving payments for performing a role in the securitization, receiving payments for performing a role in the securitization ahead of investors, exercising remedies in the event of a loan default, exercising the contractual right to remove a servicer or appoint a special servicer, providing credit enhancement through a letter of credit, and structuring the right to receive excess spreads or equity cashflows.”⁷ With regard to swaps, caps, CDS and derivatives transactions in non-synthetic ABS, the SEC requests comments analyzing these transactions within its proposed interpretive framework.

Interplay With Volcker Rule

Section 619 of the Dodd-Frank Act, commonly referred to as “the Volcker Rule,” contains general prohibitions and restrictions on certain financial entities — including certain broker-dealers — engaging in proprietary trading or sponsoring or investing in a hedge fund or private equity fund. The SEC notes that the Volcker Rule is concerned with conflicts of interest (for example, conflicts of interest stemming from proprietary trading at banking and non-bank financial firms). In addition, the SEC notes that the Volcker Rule, like Section 621 of the Dodd-Frank Act, incorporates certain exceptions concerning market-making-related activities and risk-mitigating hedging activities. Given the similarities between these two sections of the Dodd Frank Act, the SEC is seeking comment on whether the treatment of risk-mitigating hedging activities and bona fide market-making exceptions in the proposed rule should be consistent with the corresponding provisions in the Volcker Rule. The SEC preliminarily believes that the exceptions for risk-mitigating hedging activities and bona fide market-making activities for purposes of the proposed rule should be viewed no less narrowly than the comparable exceptions for such activities under the Volcker Rule.

Information Barriers, Disclosure and Exemptions

According to the Proposing Release, while Section 27B of the Securities Act does not explicitly provide for specific exceptions concerning information barriers or disclosure, the SEC believes it would be useful to explore whether these tools might permit the proposed rule to better achieve its policy objectives without unnecessarily restricting beneficial market activities.

The SEC recognizes that the concept of independent units (including affiliated entities) within multi-service firms has been recognized in discrete areas of the securities laws for those multi-service firms with units that function separately and independently. As such, the SEC preliminarily believes it may be appropriate to consider the issue of independent units within a multi-service firm in the context of the proposed rule. In addition, while recognizing that Section 27B does not contain a disclosure provision, the SEC seeks comment as to the value of disclosure as a means to manage conflicts of interest, while keeping in mind the limits of disclosure. Further, the SEC requests comments on whether and to what extent it should make use of its general exemptive authority to adopt exemptive rules or regulations for transactions or activities that otherwise would be covered by Section 27B, including conditional exemptions based on information barriers or disclosure.

The SEC seeks comment generally on all aspects of the proposed rule, including on its approach to the proposed rule and implementation of the statutory mandate of Section 621 of the Dodd-Frank Act.

Comments on the proposed rule will be due to the SEC 90 days after publication of the Proposing Release in the Federal Register.