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SEC Proposes ABS Conflict of Interest Prohibition under Dodd-Frank
Practical Law Legal Update 1-508-3141 (Approx. 5 pages)
SEC Proposes ABS Conflict of Interest Prohibition under Dodd-Frank
by PLC Finance and PLC Corporate & Securities
| Published on 21 Sep 2011 • USA (National/Federal) |
On September 19, 2011, the SEC proposed a rule under the Dodd-Frank Act that would prohibit underwriters, sponsors and other parties involved in the creation and distribution of asset-backed securites (ABS) from engaging in transactions that would create or result in a material conflict of interest with any investor in the ABS.
On September 19, 2011, the SEC issued a proposed rule under the Dodd-Frank Act that would prohibit certain parties involved in the creation and distribution of asset-backed securities (ABS) from engaging in any transaction that would create or result in a material conflict of interest with any investor in the ABS for one year after the date of the first closing of the sale of the securities.
Proposed Rule 127B under the Securities Act would apply to both registered and unregistered offerings of ABS. Certain risk mitigating hedging activities, liquidity commitments and bona fide market making activities would be exempted from the prohibition. A central purpose of the proposed rule is to prohibit underwriters, sponsors and others who assemble ABS from selling those securities to investors and later profiting from their failure.
Proposed Rule 127B is substantially similar to Section 27B of the Securities Act, which was added to the Securities Act by Section 621 of the Dodd-Frank Act.
Proposed Rule 127B
The SEC has proposed Rule 127B under the Securities Act, which would apply to transactions that involve a:
- "Covered person," which includes underwriters, placement agents, initial purchasers and sponsors of ABS, and any of their affiliates or subsidiaries (collectively, securitization participants).
- "Covered product," which includes ABS, as that term is defined in Section 3 of the Exchange Act, and synthetic ABS.
- "Covered timeframe," which ends one year after the date of the first closing of the sale of the ABS. The proposed rule does not propose any starting point for the covered timeframe, which permits regulators to look back to activities undertaken by covered persons during or even prior to the ABS assembly stages.
- "Covered conflict of interest," which includes conflicts between a securitization participant in an ABS transaction and an investor in those ABS, but does not include conflicts that:
- arise exclusively between securitization participants or exclusively between investors;
- do not arise as a result of or in connection with that ABS transaction; or
- do not arise as a result of or in connection with "engaging in any transaction." For example, engaging in any transaction would include but not be limited to effecting short sales of, or purchasing credit default swap (CDS) protection on, the offered ABS or its underlying assets.
- Material conflict of interest.
Material Conflict of Interest
For a covered conflict of interest to be deemed a material conflict of interest, it must meet two criteria.
First, either:
- A securitization participant would benefit directly or indirectly from the actual, anticipated or potential:
- adverse performance of the asset pool underlying or referenced by the ABS;
- loss of principal, monetary default or early amortization event on the ABS; or
- decline in the market value of the ABS.
- A securitization participant that controls the structure of the ABS or the assets underlying and collateralizing the ABS would benefit from fees or other forms of compensation, or the promise of future business, as a result of allowing a third party to structure the ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from the adverse performance, loss of principal or decline in market value of the ABS.
Second, there must also be a substantial likelihood that a reasonable investor would consider the conflict important to its investment decision.
For information on sponsors in ABS transactions, as well as the role of other parties to a securitization, see Practice Note Securitization: US Transaction Parties and Documents.
For information on synthetic ABS, see Practice Note, Securitization: US Overview: Synthetic Securitizations.
Relationship to the Volcker Rule
The Dodd-Frank Act's Volcker Rule generally prohibits certain banking entities and their affiliates and subsidiaries from:
- Engaging in proprietary trading.
- Acquiring or retaining any ownership interest in, or sponsoring, a hedge fund or a private equity fund.
Like proposed Rule 127B, the Volcker Rule:
- Is intended to curb conflicts of interest.
- Exempts certain risk mitigating hedging and market making activities.
Accordingly, the SEC is seeking public comment on the potential interplay between proposed Rule 127B and the Volcker Rule. For more on the Volcker Rule, see Practice Note, Summary of the Dodd-Frank Act: The Volcker Rule.
Information Barriers, Disclosure and Exemptions
Section 27B and proposed Rule 127B do not include conflict of interest exemptions based on a securitization participant's use of information barriers or disclosure to investors. The SEC is seeking public comment, however, on whether information barriers and disclosure could effectively mitigate potential conflicts of interest in connection with securitizations.
The SEC is accepting public comment on the proposed rule through December 19, 2011.
To learn more about securitization rulemaking under the Dodd-Frank Act, see Practice Notes, Summary of the Dodd-Frank Act: Securitization and Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: Securitization.