New SEC Rule Targets Securitization Market Conflicts of Interest

On January 25, 2023, by a unanimous vote, the SEC  issued a proposed rule to implement Section 27B of the Securities Act of 1933,  to reduce conflicts of interest in certain securitization transactions…

On January 25, 2023, by a unanimous vote, the Securities and Exchange Commission’s (SEC)  issued a proposed rule to implement Section 27B of the Securities Act of 1933,  to reduce conflicts of interest in certain securitization transactions. As proposed, Securities Act Rule 192 would prohibit securitization participants from engaging in certain transactions that could incentivize a securitization participant to structure an asset-backed security (ABS) in a way that would put the securitization participant’s interests ahead of those of ABS investors.

History of Rule New Securities Act Rule 192

Securities Act Rule 192 was authorized under Section 27B of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in response to conflicts of interests in the securitization market, which contributed to the 2008 financial crisis. The SEC originally proposed  Rule 127B to implement Section 27B in September 2011. As set forth in the rule proposal, “The re-proposed rule targets transactions that effectively represent a bet against a securitization and focuses on the types of transactions that were the subject of regulatory and Congressional investigations and were among the most widely cited examples of ABS-related misconduct during the lead up to the financial crisis of 2007-2009.”

Prohibition on Conflicted Transactions Under Securities Act Rule 192

Securities Act Rule 192 would prohibit an underwriter, placement agent, initial purchaser, or sponsor of an ABS, including affiliates or subsidiaries of those entities, from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in such ABS. Such transactions would be deemed “conflicted transactions.”

Under the new rule, a “conflicted transaction” is defined to include two main components. As set forth in a fact sheet provided by the SEC, the first component is whether the transaction is:

• 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.

The second component centers on materiality. The key question is whether there is a substantial likelihood that a reasonable investor would consider the relevant transaction important to the investor’s investment decision, including a decision whether to retain the ABS.

Under the proposed rule, the prohibition on conflicted transactions would commence on the date on which a person has reached, or has taken substantial steps to reach, an agreement that such person will become a securitization participant with respect to an ABS. It would terminate one year after the date of the first closing of the sale of the relevant ABS.

Three Exceptions Under Securities Act Rule 192

Proposed Securities Act Rule 192would provide three exceptions, all of which are contingent upon participants satisfying certain conditions set forth in the rule. The exceptions are:

• Risk-mitigating hedging activities: The prohibition would not apply when a securitization participant engages, subject to certain conditions, in risk-mitigating hedging activities in connection with its securitization activities.
• Bona fide market-making activities: The proposed exception would apply to bona fide market-making activity, including market-making related hedging, of a securitization participant conducted in connection with and related to an (i) ABS, (ii) the assets underlying such ABS, or (iii) financial instruments that reference such ABS or underlying assets.
• Liquidity commitments: The prohibition would not apply when a securitization participant engages in purchases or sales of ABS made pursuant to, and consistent with, commitments of the securitization participant to provide liquidity for the relevant ABS.

Compliance Program Required

Notably, the proposed rule would require a securitization participant relying on any of the exceptions to implement compliance programs reasonably designed to ensure the securitization participant’s compliance with the conditions applicable to those exceptions, including reasonably designed written policies and procedures.

Proposed Definitional Details

Rule 192 includes significant and broad definitional details of:

• Securitization Participant
• Sponsor – although defined in the Proposing Release as used in Regulation AB of Dodd-Frank Act, Regulation AB and Regulation RR, the SEC does not limit the proposed definition to Regulation AB.
• Affiliates, subsidiaries and no exceptions for Information Barriers
• Material Conflict of Interest back on transaction type
• ABS defined by 3(a)(79) of Exchange Act, including synthetic and hybrid cash, synthetic ABS
• Exclusions, Exemptions and Related Conditions
• Conflicted Transaction – “substantial likelihood that a reasonable investor would consider the transaction important to the investors investment decision . . .”

What’s Next?

The SEC’s public comment period  ends on March 27, 2023 or 30 days following the publication of the proposing release in the Federal Register, whichever period is longer.

Absent details in the adopting Release, Rule 192 becomes effective upon issuance of Final Rule.  Expect substantial comments focused on defined terms, exemptions, and other features that remove ambiguities and overly general provisions. To determine how you may be impacted by the SEC’s proposed rule, we encourage you to consult with  Paul A. Lieberman or other member of Scarinci Hollenbeck’s Financial Services and Regulatory Practice Group. Our experienced team routinely advises broker-dealers, investment advisers, insurance companies, hedge funds, and other regulated entities, providing cost-effective, practical advice on how to meet the requirements of new laws, rules and regulations.

If you have questions, please contact us

If you have any questions or if you would like to discuss these issues further,
please contact Paul A. Lieberman or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.