Thursday, January 26, 2023

SEC re-proposes ABS conflicts of interest rule

By Rodney F. Tonkovic, J.D.

In its first open meeting of 2023, the SEC unanimously approved the re-proposal of a 2011 rule prohibiting certain conflicts of interest in the context of asset-backed securities. Proposed Rule 230.192 would implement Securities Act Section 27B and prohibit transactions involving or resulting in material conflicts of interest between a securitization participant and an investor in an asset-backed security. The rule would apply to the underwriter, placement agent, initial purchaser, or sponsor of an ABS and prohibits entering into certain conflicted transactions. Comments are due 30 days after publication in the Federal Register or March 27, 2023, whichever is later (Prohibition Against Conflicts of Interest in Certain Securitizations, Release No. 33-11151, January 25, 2023).

Section 27B. In the aftermath of the late-2000s financial crisis, the 2010 Dodd-Frank Act added Section 27B to the Securities Act. This section prohibits certain persons who create and distribute asset-backed securities ("ABS") from engaging in any transaction that would involve or result in a material conflict of interest with any investor within one year of the closing of the sale of the ABS. Section 27B is not effective until the Commission issues a final rule implementing this prohibition. To that end, in September 2011 the Commission proposed a new rule substantially incorporating the text of Section 27B while providing exceptions for certain activities. After two extensions, the comment period ended in February 2012. According to the Commission, the new proposal takes into account feedback on the earlier release and developments in the market since that time.

Proposed rule. The proposal would add new Securities Act Rule 192 to implement the prohibition outlined in Section 27B. The proposed rule would apply to an underwriter, placement agent, initial purchaser, or sponsor of an ABS. For the purposes of the rule, "asset-backed security" would have the same meaning as used in Section 3 of the Exchange Act (covering both registered and unregistered offerings) and would further encompass synthetic asset-backed securities and hybrid cash and synthetic asset-backed securities.

Chair Gensler said: "This re-proposed rule is designed to help address conflicts of interest arising with market participants taking positions against investors' interests. Further, as required by Section 621 of the Dodd-Frank Act, the re-proposed rule provides exceptions for risk-mitigating hedging activities, bona fide market making, and certain liquidity commitments. These changes, taken together, would benefit investors and our markets."

Conflicted transactions. At its core, the proposing release says, the rule is intended to "prevent the sale of ABS that are tainted by material conflicts of interest." The rule would prohibit a securitization participant from directly or indirectly entering into such a "conflicted transaction" for one year after the date of the first closing of the sale of the ABS. For the purposes of the rule, a "conflicted transaction" means:
  • A short sale of the ABS;
  • The purchase of a CDS or other credit derivative pursuant to which the securitization participant would be entitled to receive payments upon the occurrence of a specified adverse event with respect to the 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 asset pool supporting or referenced by the ABS; loss of principal, default, or early amortization event on the ABS; or decline in the market value of the ABS.
There is also a materiality component: there must be 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 ABS.

Exceptions. As set forth in Section 27B, the proposed rule carves out exceptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities. A securitization participant relying on these exceptions would be required to implement programs to ensure compliance with the requirements applicable to the exceptions, including written policies and procedures. In addition, proposed Rule 192(d) would provide that transactions designed to circumvent the prohibition will be deemed to violate the rule.

Departures. During the meeting, the Commissioners each took a moment to mark the departures of Renee Jones, the Director of the Division of Corporation Finance, and General Counsel Dan Berkovitz. Appointed Director in June 2021, Jones will depart on February 3, 2023, and return to her previous faculty position at Boston College Law School. Her replacement will be the Division's current Deputy Director, Erik Gerding. Berkovitz, who was appointed General Counsel in November 2021, is leaving the SEC on January 31, 2023, after over three decades in public service, including stints at the CFTC as Commissioner and as General Counsel. He will be replaced by Megan Barbero, currently SEC Principal Deputy General Counsel.

The release is No. 33-11151.