On January 25, 2023, the U.S. Securities and Exchange Commission (SEC) issued a proposed rule that would prohibit certain conflicts of interest in securitization transactions.1 The proposed rule would restrict securitization participants (defined to include placement agents, underwriters, initial purchasers, and broadly defined “sponsors” and their respective affiliates and subsidiaries) with respect to an asset-backed security (ABS) from engaging in conflicted transactions with respect to the ABS (including but not limited to short sales and purchases of credit default swaps) until the one-year anniversary of the first closing of the sale of the ABS. The proposed rule includes exceptions for risk-mitigating hedging activities, bona fide market-making activities, and liquidity commitments but imposes conditions on the first two of those. Comments are due 30 days after publication in the Federal Register or March 27, 2023, whichever is later.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted in 2010, added new Section 27B to the Securities Act of 1933 (the 1933 Act) to address certain conflicts of interest in securitization transactions and required the SEC to promulgate rules addressing such conflicts of interest. The SEC issued a proposed rule in 20112 (Rule 127B, which we refer to as the “2011 proposed rule”) that largely restated the text of Section 27B, but the SEC did not issue a final rule. The current proposed rule (Rule 192) (which we refer to as the “proposed rule”), however, is more expansive than the 2011 proposed rule, particularly in its broad definition of sponsor and its imposition of conditions on exceptions to prohibited transactions.
The proposed rule would prohibit
- a securitization participant with respect to
- an ABS
- from directly or indirectly engaging in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in the ABS
- during a specified period of time.
This Sidley Update walks through each of these elements before turning to the exceptions included in the proposed rule where the prohibition would not apply.
(1) Securitization Participants
The “securitization participants” covered by the proposed rule include (a) placement agents, underwriters and initial purchasers, (b) sponsors, and (c) affiliates and subsidiaries of the foregoing. While the proposed rule would generally follow established definitions, its expanded definition of “sponsor” warrants special attention.
(a) Placement Agents, Underwriters, and Initial Purchasers
The proposed rule defines placement agents, underwriters and initial purchasers consistent with their commonly-understood meanings under the federal securities laws.
The proposed rule defines each of “placement agent” and “underwriter” as “a person who has agreed with an issuer or selling security holder” to “purchase securities from the issuer or selling security holder for distribution” or to “engage in,” “manage,” or “supervise” a “distribution for or on behalf of such issuer or selling security holder.” The definition of underwriter thus follows the Volcker Rule and Regulation M, except that — unlike the Volcker Rule — it would apply only to persons who have agreed with an issuer or a selling security holder to perform such functions. The proposed rule would not capture mere selling group members that have no agreement with an issuer or a selling security holder.3
The proposed rule’s definition of “initial purchaser,” meanwhile, follows the SEC’s and the industry’s use of the term in securitization transactions that are not registered under the 1933 Act by defining the term as any “person who has agreed with an issuer to purchase a security from the issuer for resale to other purchasers” either in transactions exempt from registration in reliance on Rule 144A “or that are otherwise not required to be registered because they do not involve any public offering.”
Notably, the proposed rule would capture underwriters, placement agents, and initial purchasers regardless of whether they were involved in structuring the ABS transaction or in selecting the underlying assets.
For purposes of the proposed rule, “sponsor” is defined more broadly than the organizer-initiator meaning in Regulation AB to capture any person who “directs or causes the direction of the structure, design, or assembly of an asset-backed security or the composition of the pool of assets underlying the asset-backed security” or who has a contractual right to do so (even if that person does not exercise such contractual right). The SEC refers to these “sponsors” as “directing sponsors” and “contractual rights sponsors,” respectively.4 Whether a person would qualify as a “directing sponsor” would be based on the specific facts and circumstances, but the SEC indicates in its commentary that the expanded definition of “sponsor” would encompass portfolio selection agents and collateral managers.
The proposed rule contains two exceptions to the “sponsor” definition.
The first exception covers persons that perform “only administrative, legal, due diligence, custodial, or ministerial” acts related to the structure, design, or assembly of an ABS or the composition of the underlying asset pool. Whether other parties to a securitization transaction, such as servicers, would qualify as “sponsors” would be based on a facts-and-circumstances analysis of their roles, including whether the acts they perform in the transaction fall within the exception. Activities customarily performed by accountants, attorneys, and credit rating agencies with respect to the creation and sale of an ABS, and the activities customarily performed by trustees, custodians, paying agents, calculation agents, and other contractual service providers relating to the ongoing management and administration of the entity that issues the ABS, are in the SEC’s view the sorts of activities that would typically be excluded from the proposed definition of “sponsor.”
The second exception covers (a) the United States and agencies thereof (such as Ginnie Mae) with respect to ABS that are fully insured or fully guaranteed as to the timely payment of principal and interest by the United States and (b) Fannie Mae and Freddie Mac operating under the conservatorship of the Federal Housing Finance Agency with capital support from the United States (or any limited-life regulated entity succeeding to the charter of either, provided such entity is also operating with capital support from the United States) with respect to ABS that are fully insured or fully guaranteed as to the timely payment of principal and interest by such entity. Notably, the second exception does not except the ABS transactions themselves from the scope of the proposed rule but only the aforementioned entities from the definition of a sponsor, so other securitization participants in those ABS transactions would be covered by the proposed rule.
(c) Affiliates and Subsidiaries
For purposes of the proposed rule, the terms “affiliate” and “subsidiary” have the familiar (and broad) meanings of “affiliate” and “subsidiary” set forth in Rule 405 under the 1933 Act. Accordingly, entities that might not be perceived to have much (if any) involvement in the structuring of an ABS or the selection of an asset pool for a securitization would nevertheless be considered securitization participants by virtue of their relationship to a placement agent, underwriter, initial purchaser, or sponsor for an ABS transaction.
The SEC declined to include an “information barriers” exception for affiliates and subsidiaries, but it did request comment as to whether the rule should include such an exception. Appendix A to this Sidley Update describes the SEC’s proposed conditions for such an exception.
(2) Asset-Backed Security
For purposes of the proposed rule, “asset-backed security” captures not only ABS as defined under the Securities Exchange Act of 1934 (which includes both registered and unregistered offerings) but also synthetic ABS and hybrid cash and synthetic ABS.5 The SEC declined to define “synthetic ABS” but noted that it has previously described such securitizations as those “designed to create exposure to an asset that is not transferred to or otherwise part of the asset pool,” generally through the use of certain derivatives, total return swaps, or similar structures. The SEC rejected a suggestion, made by certain portfolio managers and investors in collateralized loan obligations (CLOs) in their comments to the 2011 proposed rule, to exempt from coverage certain synthetic balance sheet CLOs used for risk management purposes, but the SEC did request comment on whether such an exception should be included.
(3) Material Conflicts of Interest
The proposed rule would prohibit securitization participants from directly or indirectly engaging in “any transaction that would involve or result in any material conflict of interest” between the securitization participant and an investor in the ABS within the relevant timeframe. The proposed rule refers to such transactions as “conflicted transactions” and defines them to include any of the following transactions “with respect to which there is a substantial likelihood that a reasonable investor would consider the transaction important to the investor’s investment decision, including a decision whether to retain the asset-backed security”:
- a short sale of the relevant ABS,
- the purchase of a credit default swap or other credit derivative pursuant to which the securitization participant would be entitled to receive payments upon the occurrence of specified credit events in respect of the relevant ABS, or
- the purchase or sale of any financial instrument (other than the relevant ABS) or entry into a transaction through which the securitization participant would benefit from the actual, anticipated, or potential:
- adverse performance of the underlying or referenced asset pool;
- loss of principal, monetary default, or early amortization event on the relevant ABS; or
- decline in the market value of the relevant ABS.
Such “conflicted transactions” are intended to capture any material transaction that represents a “bet” against the ABS that the securitization participant created and/or sold to investors, encompassing both actual “bets” against the ABS and the economic equivalent of such “bets.” Notably, the securitization participant need not actually profit from the transaction and the ABS need not actually decline in value for the transaction to be prohibited.
The proposed rule also includes an “anti-circumvention” clause designed to capture any other attempts to evade the prohibitions established by the proposed rule, such as by routing funds through multiple entities or multiple transactions.
(4) Specified Period of Time
The prohibitions set forth in the proposed rule would apply to any securitization participant during a period of time that
- starts on “the date on which [such] person has reached, or has taken substantial steps to reach, an agreement that such person will become a securitization participant” with respect to an ABS (which we refer to as the “commencement date”) and
- ends on “the date that is one year after the date of the first closing of the sale” of such ABS.
The SEC intends the proposed commencement date to capture the earliest point at which securitization participants would be able and incentivized to engage in conflicted transactions. The commentary also observes that securitization participants’ agreement (or the substantial steps they take toward one) triggering the commencement date could be merely oral or based on facts and circumstances. The SEC declined to peg the commencement date to certain other specific dates, such as the date of the first marketing of the ABS or the date of the offering materials for the ABS, stating that securitization participants could engage in conflicted transactions that Section 27B was intended to prevent prior to such events. Recognizing the need for greater certainty around the commencement date, the SEC has requested comments on indicia of whether a person has reached an agreement to become a securitization participant or has taken substantial steps to reach such an agreement.
The proposed rule would establish three exceptions to the prohibitions on conflicted transactions:
- certain risk-mitigating hedging activities
- bona fide market-making activities
- liquidity commitments
We describe each of these exceptions in greater detail below.
The SEC did not provide an exception based on disclosure to investors or investor consent.
(1) Certain Risk-Mitigating Hedging Activities
The proposed rule permits “[r]isk-mitigating hedging activities of a securitization participant ... in connection with and related to individual or aggregated positions, contracts, or other holdings of the securitization participant arising out of its securitization activities, including the origination or acquisition of assets that it securitizes.” The initial distribution of an ABS is not considered a risk-mitigating hedging activity, however. In addition, a securitization participant would have to satisfy certain conditions to engage in hedging activities, as described on Appendix B to this Sidley Update.
(2) Bona Fide Market-Making Activities
The proposed rule also permits “[b]ona fide market-making activities, including market-making related hedging, of the securitization participant” in connection with and related to ABS with respect to which the prohibition on conflicted transactions applies, the underlying assets, or financial instruments that reference such ABS or underlying assets. However, as with permitted risk-mitigating hedging activity, the initial distribution of an ABS is not considered bona fide market-making activity. In addition, a securitization participant would have to satisfy certain conditions to engage in market-making activities, as described on Appendix C to this Sidley Update.
(3) Liquidity Commitments
The exception for liquidity commitments would permit purchases or sales of the ABS made pursuant to, and consistent with, commitments of the securitization participant to provide liquidity for the ABS.
The proposed rule includes requests for comments on many issues. In addition to the request for comment on proposed “information barriers” discussed above, other issues include the following:
- How could disclosure or investor approvals be used to manage potential conflicts of interest, and how would it be consistent with Section 27B?
- Should the definition of “securitization participant” be modified?
- Should the definition of “sponsor” be expanded or narrowed?
- Should the definition of “conflicted transaction” exclude the issuance of synthetic ABS where a securitization participant takes the short side of a transaction with the issuing entity?
Comments are due 30 days after publication in the Federal Register or March 27, 2023, whichever is later.
1 SEC Release No. 33-11151 (January 25, 2023). If adopted, the new rule would be published in the Federal Register as 17 C.F.R. § 230.192.
2 SEC Release No. 34-65355 (September 19, 2011).
3 The proposed rule’s definition of “distribution” is consistent with the Volcker Rule as well. It is defined to mean “an offering of securities, whether or not subject to registration under the [1933 Act], that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods” or “an offering of securities made pursuant to an effective registration statement” under the 1933 Act.
4 These terms appear in the SEC commentary contained in the Release but not in the text of the proposed rule.
5 The Release indicates that municipal securitizations, to the extent they meet the 1934 Act’s definition, would also be included.
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