Monday, January 16, 2012

Key Senators Suggest Enhancements to SEC Proposed Regulations on Securitization Conflicts of Interest

The Senate authors of the securitization conflict of interest provisions of the Dodd-Frank Act codified in Section 621 have suggested enhancements to the proposed SEC regulations implementing those provisions. In a letter to the SEC, Senators Carl Levin (D-MI) and Jeff Merkley (D-Ore) said that securitization transactions rife with conflicts of interest demonstrate not only the importance of investor safeguards, but also the need to strengthen aspects of the proposed regulations.

The proposed regulations would apply to an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, of an asset-backed security. While recognizing that such parties typically have substantial roles in the assembly, packaging and sale of asset-backed securities, the Senators noted that this language simply repeats the statutory terms without adding needed clarification to ensure that key asset-backed securities participants are prohibited from engaging in conflicts of interest damaging to the securitization markets.

The Senators said that the regulations should define the terms used to describe who is a covered person, and those persons should, in the aggregate, cover any party that has made a material contribution to the economic structure or composition of an asset-backed security, its management, or the sale of interests in the product to investors. The SEC should clarify that the test for whether a person is covered by the conflict of interest regulations will depend not just on the person's job title, but the party's economic involvement in the securitization transaction.

For example, collateral managers typically have significant influence in the structure, composition, and management of an asset-backed security, observed the Senators, adding that they are typically the main driver behind the selection and purchase price of the securitized assets. According to the Senators, to leave collateral managers out of a regulation intended to limit conflicts of interest in securitizations would make no sense in the context of industry norms and unduly restrict regulatory scope and impact.

The proposal suggests adopting the narrow definition of "sponsor" used in Regulation AB as a type of catchall phrase to encompass a variety of securitization participants. In the view of the Senators, adopting the Regulation AB definition of sponsor risks using a term that is both under-inclusive and confusing in the context of Section 621. A better approach, suggested the Senators, would be to define sponsor broadly for purposes of Section 621 to include any person (including a collateral manager, servicer, or custodian) who, for a fee or other remuneration or benefit, participates in the design, composition, assembly, sale, or management of the asset-backed security.

Similarly, in order to restore confidence in U.S. securitization markets, the proposed regulations must apply broadly to the wide variety of asset-back securities products that exist today as well as those that will be designed in the future. The proposal follows the statutory mandate that it cover asset-backed securities as that term is defined by Section 3(a)(77) of the Securities Exchange Act, as well as synthetic asset backed securities. In using the newly-created definition under Section 3(a), said the Senators, Congress explicitly rejected the more narrow definition used in Regulation AB.

Because the Section 3(a)(77) definition is so new, noted the Senators, its contours are still somewhat fluid. The success of the proposed regulations will thus partially rely on the Commission's interpretation of Section 3(a)(77). Since that definition explicitly applies to securities, including collateralized debt obligations, they observed, it already encompasses both registered and unregistered asset-backed securities products, which is important given that the collateralized debt obligations at the center of the financial crisis were unregistered securities.

The proposed regulations also encompass synthetic asset-backed securities products, a term that currently has no statutory definition. The proposal does not offer its own definition of synthetic asset-backed securities, instead noting that the term is commonly understood by market participants. While conceding that may be true, the Senators said that the regulations should not rely exclusively on the understandings of market participants, as those may vary and shift over time.

Instead, the Senators urged the SEC to provide a regulatory definition broad enough to cover any synthetic product that creates an economic exposure equivalent to one or more asset-backed securities. The lawmakers suggested that a possible definition in line with Section 3(a)(77) would be a fixed-income or other security that references any type of financial asset, including a loan, a lease, a mortgage, a secured or unsecured receivable, or index, and allows the holder of the security to receive payments that depend primarily on the value or performance of the referenced assets. The rule should also explicitly cover so-called hybrid products containing a mix of cash and synthetic assets.

In order to ensure that financial innovation does not render the definition under-inclusive, the SEC should add a catchall provision to its definition of covered products to ensure that the regulations will apply to any financial product that is the economic equivalent of a cash, synthetic, or hybrid asset-backed security. Without that added provision, cautioned the Senators, the regulations would not be able to restrain conflicts of interest affecting products important to the asset-backed securities markets.

Section 621 prohibits securitization participants from designing and selling asset-backed securities and then profiting from transactions in which the participants' interests materially conflict with the interests of persons being sold the securities. The proposal appropriately limits the scope of covered conflicts of interest to those arising out of transactions related to the asset-backed securities, said the Senators, and not unrelated activities.

Similarly, the proposed regulations wisely avoid a precise definition of material conflict of interest, which is a concept backed by years of administrative determinations and case law, and in which federal securities regulators already have significant expertise. Capturing that experience in a concise regulatory definition is neither feasible nor wise, reasoned the Senators, since the concept needs to remain flexible and adaptable to ensure its effectiveness.

In place of a precise definition, the proposal offers interpretive guidance to determine when a material conflict of interest exists. The guidance appears to prohibit securitization participants from engaging in a transaction through which they would have the potential to benefit if the related asset-backed securities perform poorly and there is a substantial likelihood that a reasonable investor would consider that fact important.

The Senators allowed that this approach seems to best capture the intent of Section 621. The guidance would also determine that a material conflict of interest exists when securitization participants benefit from allowing a third party to structure an asset-backed security in a way that permits a third party to benefit from a short transaction and there is a substantial likelihood that a reasonable investor would consider that fact important. Put simply, a securitization participant could not get paid for enabling a third party to engage in a conflicts-ridden transaction that the securitization participant itself could not.

The Senators urged the SEC to enhance the test by replacing ``structure an asset-backed security’’ with ``influence the structure of an asset-backed security.’’ They reasoned that it is more typical for third parties to "influence" rather than "structure" an asset-backed security.

Both conflict of interests tests would incorporate the well-established judicially-inspired standard of a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision. In other words, the conflict must be big enough for a reasonable investor to want to know about it before investing. While this standard is backed by a significant body of court interpretations, noted the Senators, the incredibly complex nature of asset-backed securities and the sheer number of roles that may be performed by various securitization participants may make its application difficult.

Thus, the Senators urged the SEC to make it explicit that the reasonable investor standard should be applied broadly to evaluate, not only obvious conflicts of interest arising from asset selection issues, but also hidden conflicts of interest that may arise from inappropriate fees, ministerial arrangements, or other actions taken by securitization participants. In addition, the regulations should clarify that application of the reasonable investor standard must assume that investors have all of the relevant facts to perform a fair evaluation of the securitization, including facts that may have actually been concealed from them at the time of the transaction.