On November 27, 2023, the U.S. Securities and Exchange Commission (SEC) issued a final rule (referred to herein as the final rule)1 that restricts securitization participants (defined to include placement agents, underwriters, initial purchasers, sponsors, and certain of their respective affiliates and subsidiaries) with respect to an asset-backed security (ABS) from engaging in conflicted transactions with respect to the ABS (generally meaning short sales, purchases of credit default swaps, or similar credit derivatives or their substantial economic equivalents) until the one-year anniversary of the first closing of the sale of the ABS. The final rule includes exceptions for risk-mitigating hedging activities, bona fide market-making activities and liquidity commitments, and a safe harbor for certain foreign transactions.
The final rule is effective February 5, 2024. Securitization participants must comply with the final rule’s prohibition with respect to any ABS the first closing of the sale of which occurs on or after June 9, 2025.2
The Dodd-Frank Wall Street Reform and Consumer Protection Act 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 20113 and a broader proposed rule on January 25, 2023 (the proposed rule).4
The final rule largely tracks the proposed rule but is significantly narrower in its scope. A chart explaining several key differences is attached as Appendix A, and a full redline of the text showing changes from the proposed rule is attached as Appendix B. Key differences:
- a narrower “catch-all” clause in the definition of “conflicted transaction"
- a narrower definition of “sponsor” that
- no longer includes persons who direct or cause the direction of the design of an ABS or the asset pool but lack a contractual right to do so
- excludes persons who act solely pursuant to their contractual rights as long investors
- adds protection for persons who perform only certain administrative, legal, due diligence, custodial, or ministerial acts in connection with the ongoing administration of the ABS
- affiliates and subsidiaries of securitization participants are only covered if they act in coordination with a securitization participant or have access to or receive information about the ABS or the asset pool prior to the first closing
- initial issuances of ABS can qualify as risk-mitigating hedging activity
- no sponsor exception for Fannie Mae and Freddie Mac while under conservatorship
- an anti-evasion provision relating only to the exceptions for hedging, liquidity commitments, and market-making replaces the anti-circumvention provision
- a new safe harbor for foreign transactions
The Final Rule, Generally
The final rule prohibits 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.
The Final Rule — Who, What, and When
(1) Securitization Participants
The “securitization participants” covered by the final rule include (a) placement agents, underwriters and initial purchasers, (b) sponsors and (c) certain affiliates and subsidiaries of the foregoing.
(a) Placement Agents, Underwriters, and Initial Purchasers
The final rule defines placement agents, underwriters, and initial purchasers consistent with their commonly understood meanings under the federal securities laws.
The final 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” generally follows the Volcker Rule and Regulation M, except that — unlike the Volcker Rule — it applies only to persons who have agreed with an issuer or a selling security holder to perform such functions.5 The final rule does not capture selling group members that have no agreement with an issuer or a selling security holder.6
The final rule’s definition of “initial purchaser” 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.”
The final rule captures placement agents, underwriters, and initial purchasers regardless of whether they were involved in structuring the ABS transaction or in selecting the underlying assets.7
For purposes of the final rule, “sponsor” is defined more broadly than the organizer-initiator meaning in Regulation AB and also captures any person “with a contractual right to direct or cause the direction of the structure, design, or assembly of an [ABS] or the composition of assets underlying or referenced by the [ABS], other than a person who acts solely pursuant to such person’s contractual rights as a holder of a long position in the asset-backed security.” A person may fall within this definition of “sponsor” even if that person does not exercise the applicable contractual right.8
The exclusion of persons who act solely pursuant to their contractual rights as holders of long positions in the ABS from the definition of sponsor is a change made in the final rule in response to feedback on the proposed rules. However, in its commentary, the SEC emphasized that only investors who act solely pursuant to their contractual rights as holders of long positions in the ABS will enjoy this exclusion from the rule.9
The final rule’s “sponsor” definition contains two additional exceptions.
The first exception covers persons that perform “only administrative, legal, due diligence, custodial, or ministerial acts related to the structure, design, assembly, or ongoing administration of an asset-backed security or the composition of the pool of assets underlying or referenced by the asset-backed security.” Significantly, the final rule adds a carveout for acts related to “ongoing administration,” by which the SEC means (as it explained in its commentary) “the types of activities typically performed by servicers, trustees, custodians, paying agents, calculation agents, and other contractual service providers pursuant to their contractual obligations in a securitization transaction over the life of the ABS.”10 However, in its commentary, the SEC made clear that “ongoing administration” does not include “active portfolio management or other such activity that would be subject to the ‘sponsor’ definition.”11 Furthermore, the SEC reiterated that this exception applies only to persons that perform only (not primarily) administrative, legal, due diligence, custodial, or ministerial acts related to the structure, design, assembly, or ongoing administration of an ABS or the composition of the pool of assets underlying or referenced by the ABS.
The second exception covers 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. The second exception does not except the ABS transactions themselves from the scope of the final rule but only the aforementioned entities from the definition of “sponsor,” so other securitization participants in those ABS transactions will be covered by the final rule.
The SEC declined to make an exception for affiliates and subsidiaries that are already subject to fiduciary duties.12 Additionally, it declined to make an exception for entities that face overlapping duties, such as collateralized loan obligation (CLO) placement agents that are also administrative agents of a loan that underlies a CLO.13
The SEC clarified that unaffiliated originators are generally not sponsors14 and that warehouse lenders — who lend capital to sponsors so they can acquire and aggregate assets for securitization — are not covered by the rule unless they are otherwise covered by the rule as one of a securitization participant’s covered affiliates or subsidiaries, stating: “A warehouse lender whose role is to engage in such routine lending activity with respect to the ABS, including the lender’s right to determine which assets it is or is not willing to finance pursuant to its underwriting standards, does not meet the definition of ‘sponsor’ under the final rule.”15
(c) Affiliates and Subsidiaries
The definition of “securitization participant” includes an affiliate or subsidiary16 of an placement agent, underwriter, initial purchaser, or sponsor of an ABS only if it “acts in coordination with” such a person or “has access to or receives information about the relevant asset-backed security or the asset pool underlying or referenced by the asset-backed security prior to the first closing of the sale of the relevant asset-backed security.” Whether these conditions are met will depend on the facts and circumstances of the particular transaction.17 In its commentary, the SEC noted that securitization participants can use a variety of methods to “effectively prevent the affiliate or subsidiary from acting in coordination with the named securitization participant or from accessing or receiving information about the relevant ABS or the asset pool underlying or referenced by the relevant ABS.”18 The commentary provides examples of such methods, including the following:19
- implementing effective information barriers (including written policies and procedures, internal controls, and physical separation of personnel)
- maintaining separate trading accounts
- not having common officers (or persons performing similar functions) or employees (other than clerical, ministerial, or support personnel)
- being engaged in an unrelated business from the relevant affiliated entity and not, in fact, communicating with such relevant affiliated entity
- not permitting any persons having oversight or managerial responsibility over any shared accounts to have authority to execute trading in individual securities in the accounts or to have authority to pre-approve trading decisions for the accounts (and such persons do not, in fact, do either of these)
(2) Asset-Backed Security
The definition of “asset-backed security” includes ABS as defined under the Securities Exchange Act of 1934 (which includes both registered and unregistered offerings) and synthetic ABS and hybrid cash and synthetic ABS.20 The SEC did not define synthetic ABS and hybrid cash and synthetic ABS but stated in its commentary that a “synthetic ABS” generally means “a fixed income or other security issued by a special purpose entity that allows the holder of the security to receive payments that depend primarily on the performance of a reference self-liquidating financial asset or a reference pool of self-liquidating financial assets.”21
(3) Material Conflicts of Interest
The final rule prohibits 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 specified period of time. The final 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 that is substantially the economic equivalent of a transaction described in one of the two preceding bullets, other than, for the avoidance of doubt, any transaction that only hedges general interest rate or currency exchange risk.22
(4) Specified Period of Time
The prohibitions set forth in the final rule apply to any securitization participant during a period of time that
- starts on “the date on which such person has reached an agreement that such person will become a securitization participant” with respect to an ABS (which we refer to as the “starting date”)
- ends on “the date that is one year after the date of the first closing of the sale” of such ABS
Although this starting date may not reach as far back as the original proposal to commence the prohibition upon a securitization participant’s having taken “substantial steps” toward an agreement to become a securitization participant, the SEC commentary states that an agreement “refers to an agreement in principle (including oral agreements and facts and circumstances constituting an agreement).”23
The final rule contains the same three exceptions to the prohibitions on conflicted transactions as was contained in the proposed rule, with only minor changes:
- certain risk-mitigating hedging activities
- bona fide market-making activities
- liquidity commitments
The exception for liquidity commitments permits purchases or sales of the ABS made pursuant to, and consistent with, commitments of the securitization participant to provide liquidity for the ABS.
Safe Harbor for Certain Foreign Transactions
The final rule’s prohibition does not apply to an ABS that is not issued by a U.S. person and with respect to which the offer and sale are in compliance with Regulation S.
Description of Change
1. Narrowed the catch-all clause (iii) of the “conflicted transaction” definition
Any transaction where a securitization participation benefits from actual, anticipated, or potential (i) adverse performance of the asset pool, (ii) loss of principal, monetary default, or early amortization event on the ABS, or (iii) decline in market value of the ABS
Any transaction that is substantially the economic equivalent of a short sale, credit default swap, or other credit derivative entitling the holder to payments upon the occurrence of specified credit events in respect of the ABS
2. Narrowed the definition of “sponsor”
- Removed “Directing Sponsors”
Any person that directs or causes the direction of the design of an ABS or the pool of underlying assets
[Deleted in final rule]
- Added an exception for “Long-only Investors”
[Not present in proposed rule]
Any person who acts solely pursuant to its contractual rights as a holder of a long position in the ABS
- Added an exception for service providers
[Not present in proposed rule]
Any person that performs only certain administrative, legal, due diligence, custodial, or ministerial acts related to the ongoing administration of the ABS
3. Narrowed the definition of covered affiliates and subsidiaries
Any affiliate or subsidiary of a placement agent, underwriter, initial purchaser, or sponsor of an ABS
Any affiliate or subsidiary of the same that (i) acts in coordination with a securitization participant or (ii) has access to or receives information about the ABS or the asset pool prior to the first closing of the sale of the ABS
4. Clarified the starting date of the covered period
The date on which a securitization participant has taken substantial steps to reach an agreement to become a securitization participant
The date on which a securitization participant has reached an agreement to become a securitization participant
5. Risk-mitigating hedging activity expanded
Risk-mitigating hedging activity limited to individual or aggregated positions, contracts, or other holdings of the securitization participant arising out of its securitization activities
Risk-mitigating hedging activity not limited to hedging of exposures arising out of securitization activities and includes, e.g., hedging in the ordinary course of business
6. Removed the restriction on using initial issuance of ABS as risk-mitigating hedging activity
Initial distribution of an ABS is not risk-mitigating hedging activity
[Deleted in final rule]
7. Removed the exemption for Fannie Mae and Freddie Mac as sponsors
Fannie Mae and Freddie Mac, while operating under conservatorship, are not securitization participants with respect to ABS that are fully insured or fully guaranteed as to timely payment of principal and interest by such entity
[Deleted in final rule; however, see risk-mitigating hedging and other countervailing changes above]
8. Replaced the general anti-circumvention provision with a more specific anti-evasion provision applying only to the use of the final rule’s exceptions
Any transaction that circumvents the rule is prohibited
Any transaction structured in compliance with the risk-mitigating hedging activity, liquidity commitment, or bona fide market-making activity exceptions will violate the rule if it is part of a plan or scheme to evade the rule
9. Added a safe harbor for certain foreign transactions
[Not present in proposed rule]
ABS are exempted if (i) not issued by a U.S. person and (ii) offered and sold in compliance with Regulation S
1SEC Release No. 33-11254 (November 27, 2023). The final rule was published in the Federal Register on December 7, 2023, as 17 C.F.R. § 230.192. 88 Fed. Reg. 85396.
2 88 Fed. Reg. at 85,443.
3 SEC Release No. 34-65355 (September 19, 2011).
4 SEC Release No. 33-11151 (January 25, 2023).
5 12 C.F.R. § 248.4(a)(4) (Volcker Rule definition of “underwriter”); 17 C.F.R. § 242.100(b) (Regulation M definition of “underwriter”).
6 The final rule’s definition of “distribution” is identical to the definition of “distribution” in the Volcker Rule: “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. 12 C.F.R. § 248.4(a)(3).
7 88 Fed. Reg. at 85,405.
8 88 Fed. Reg. at 85,411.
16 “Affiliate” and “subsidiary” have the familiar (and broad) meanings of “affiliate” and “subsidiary” set forth in Rule 405 under the 1933 Act.
20 The Release indicates that municipal securitizations and single-asset conduit bonds, to the extent they meet the 1934 Act’s definition, and Section 4(a)(2) private placements are included. 88 Fed. Reg. at 85,407 (municipal securitizations and single-asset conduit bonds), 85,401 (Section 4(a)(2) private placements).
21 88 Fed. Reg. at 85,402.
22 The SEC noted in the Release that “[t]ransactions unrelated to the idiosyncratic credit performance of the ABS, such as reinsurance agreements, hedging of general market risk (such as interest rate and foreign exchange risks), or routine securitization activities (such as the provision of warehouse financing or the transfer of assets into a
securitization vehicle) are not ‘conflicted transactions’ as defined by the [final] rule, and thus are not subject to the
prohibition.” 88 Fed. Reg. at 85,398.
23 88 Fed. Reg. at 85,418.
Attorney Advertising—Sidley Austin LLP is a global law firm. Our addresses and contact information can be found at www.sidley.com/en/locations/offices.
Sidley provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from professional advisers. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer.
© Sidley Austin LLP