Wednesday, November 29, 2023

SEC adopts new ABS conflicts of interest rule

By Rodney F. Tonkovic, J.D.

The SEC adopted a rule prohibiting conflicts of interest in certain securitizations. Securities Act Rule 230.192 will implement Securities Act Section 27B and bar transactions in asset-backed securities that involve or result in material conflicts of interest. For one year after closing, specified securitization participants will be barred from engaging in certain transactions where there is a conflict between the participant and an investor in that asset-backed security. The rule is effective 60 days after publication in the Federal Register, and compliance will be required for sales closing 18 months after that date (Prohibition Against Conflicts of Interest in Certain Securitizations, Release No. 33-11254, November 28, 2023).

Dodd-Frank implemented. The new rule will implement Securities Act Section 27B, which was added in 2010 by the Dodd-Frank Act. The 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, however, mandates Commission rulemaking implementing this prohibition. A new rule incorporating the section's text was proposed in 2011, but the proposal lay dormant until it was unanimously re-proposed during the Commission's first open meeting of 2023.

SEC Chair Gary Gensler said that he was pleased to support the rule: "As directed by Congress, today's rule prohibits securitization participants—including those who sell or facilitate the sale of an asset-backed security—from engaging in transactions that involve or result in any material conflict of interest with investors in that ABS. Further, as required by Section 621 of the Dodd-Frank Act, the final rule provides exceptions for risk-mitigating hedging activities, bona fide market making, and certain liquidity commitments. Such a rule benefits investors and issuers alike."

Rule 192. The heart of new Rule 192 is the prevention of ABS sales that are tainted by material conflicts of interest. The rule provides strong investor protections against transactions that are effectively a "bet" against the ABS's performance while leaving routine transactions unhindered, the release says. To that end, the rule prohibits entering into 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 credit default swap entitling the securitization participant 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 that is substantially the economic equivalent of a short sale or credit derivative, other than, for the avoidance of doubt, any transaction that only hedges general interest rate or currency exchange risk.
There is also a materiality standard: 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. Rule 192 also puts into effect the exceptions outlined in Section 27B for risk-mitigating hedging activities, bona fide market-making activities, and liquidity commitments. The exception for hedging activities and bona fide market-making activities are accompanied by specified conditions, including the establishment and enforcement of an internal compliance program including reasonably designed written policies and procedures. The release notes that the Commission believes that no additional exceptions are necessary in order to implement Section 27B and that there is no need to include a mechanism to provide additional exceptions in the future.

The final rule also addresses evasion of the exceptions. A securitization participant may not engage in a transaction that is in technical compliance with the exceptions while being part of a scheme to evade the prohibition on conflicts. In addition, there is a safe harbor for certain foreign transactions.

Peirce objects. Commissioner Peirce was the sole vote against the new rule. While Peirce supported the rule as proposed, she did so with reservations. Peirce would prefer that the rule be re-proposed to allow public comment on substantial revisions made after the comment period closed. She observed that the Commission has a "troubling recent pattern" of releasing unworkable rules with numerous questions and then substantially revising a rule after the comment period closes. Overall, the commissioner believes that the rule is broader than necessary and fails to implement the Dodd-Frank mandate in a way that would stop conflicted transactions.

The release is No. 33-11254.