Sunday, November 28, 2010

ABA Asks SEC to Follow Legislative History When Adopting Securitization Conflict of Interest Regulations

In a joint comment letter to the SEC, the American Bar Association Committees on Federal Securities Regulation and Securitization ask the Commission to permit a broad range of common activities that they believe are essential to the functioning of securitization when adopting regulations dealing with conflicts of interest in securitization as commanded by Section 621 of the Dodd-Frank Act. According to the ABA, the legislative history of Section 621 indicates that the statutory intent was to address blatant conflicts of interest in which an underwriter or sponsor creates an asset-backed security that is designed to fail and then profits by betting against it, by means of short sales or otherwise.

The legislative history further provides that changes in market conditions may lead an underwriter to wish to sell the securities it holds. That is also not likely to pose a conflict. Although the legislative history indicates a focused intent, noted the ABA, the language of Section 621 is significantly broader. The ABA groups request that the SEC, in adopting rules implementing this provision, should give appropriate weight to Congressional intent while permitting a broad range of common activities essential to the functioning of the securitization markets. Ordinary course business transactions do not involve the types of material conflicts contemplated by Congress and should be permitted under the rules. Instead, the SEC regulations implementing Section 621 should focus on the asset-backed securities transactions in which the adverse performance of the pool assets would directly benefit an identified party or sponsor of the applicable securitized transaction, as well as those transactions in which a loss of principal, monetary default or early amortization event on the asset-backed security would directly benefit an identified party or sponsor.

The implied conflicts in most ordinary course transactions involving underwriters, placement agents, initial purchasers and sponsors of ABS do not have the above characteristics, said the ABA, and indeed, these transaction parties generally have a strong interest in the positive performance of the assets and the transaction. The ABA believes that the relationship between an asset-backed security sponsor and investors in such instruments is inherently conflicted. The sponsor is seeking funding and the investors in the securitization are providing that funding on negotiated terms. Pool selection also may involve conflicts, and risk retention itself may create conflicts with some classes of investors. Conflicts of this type relating to the terms and nature of the security exist in any ABS transaction, posited the ABA, and cannot be eliminated. Similarly, many potential conflicts of interest are an unavoidable byproduct of the of the securitization process or arise from transaction features that on the whole are beneficial to investors. For example, subordinate tranches act as credit enhancement for the more senior
tranches and are frequently required by the rating agencies and investors.

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