Securitizing Without Conflicts – Proposed SEC Rulemaking
On January 25, 2023, the SEC reproposed its 2011 proposed rule to prohibit certain securitization participants from engaging in transactions that present conflicts of interest vis-à-vis ABS investors. This note answers a number of important threshold questions you may have if you transact in the “securitization” market.
The proposed rule (available here) aims to implement Section 27B of the Securities Act of 1933 (the “Securities Act”), which was added by Section 621 of the Dodd-Frank Act. The statute calls for rulemaking to prohibit securitization participants from engaging in certain transactions that could incentivize that securitization participant to structure an ABS in a way that would put the securitization participant’s interests ahead of, and conflict with, those of ABS investors.
Which ABS Transactions Are Covered by the Proposed Rule?
The securitization landscape is vast and comprises a wide variety of underlying assets, structures and participants. The Securities Exchange Act of 1934 (the “Exchange Act”), the Dodd-Frank Act and its promulgating rules, however, do not treat as “securitizations” all transactions that are colloquially referred to by that term.
Unless the issued securities are “asset-backed securities” as defined in Section 3 of the Exchange Act, the proposed rule, like the U.S. Risk Retention Rules,1 will not apply. The SEC itself states that it believes that “market participants are familiar with analyzing whether such a security meets the Exchange Act ABS definition, and the Commission has adopted other rules and regulations under the Securities Act and the Exchange Act that use the Exchange Act ABS definition or a substantially similar definition.”
For instance, market participants have reached the conclusion that indenture-style cell tower and aircraft “securitizations” do not involve the issuance of “asset-backed securities” as defined in the Exchange Act because the assets securing the issued securities are not “self-liquidating financial assets.” As a result, these transactions fall outside of the scope of U.S. Risk Retention Rules. While such a consensus has not yet developed for oil & gas well “securitizations,” a growing number of market participants are reaching the same conclusion for these transactions. By contrast, CLOs and mortgage-backed securitizations fall squarely within the scope of the proposed rule, as do “synthetic ABS” that use derivatives such as credit default swaps or total return swaps. Moreover, the SEC specifically included “synthetic ABS” in the scope of the proposed rule and appears unconvinced by 2011 comment letters advocating for a synthetic ABS exception from the proposed prohibition to allow ordinary course balance sheet and risk management.
Relying on the same analysis, the proposed rule therefore does not apply to transactions that fall outside of the scope of U.S. Risk Retention Rules because they do not involve the issuance of “asset-backed securities.”
Which Securitization Participants Are Covered by the Proposed Rule?
The proposed rule only restricts behavior by underwriters, placement agents, initial purchasers and sponsors, and by their affiliates and subsidiaries. The SEC sought to adopt “functional definitions” that capture parties serving in roles that are generally associated with these terms — a substance over form approach.
Underwriter and placement agent, for instance, share the same definition. It captures parties who have agreed with the issuer, or selling security holder, to purchase for distribution, distribute, or manage the distribution of securities. Initial purchaser is similarly defined as a person who has agreed with the issuer to acquire securities from the issuer for resale pursuant to Rule 144A or another registration exemption. Importantly, an underwriter, placement agent, or initial purchaser who had no role in structuring the transaction will still be subject to the proposed rule if that party fits the definition.
Sponsor is defined more broadly than in other contexts, such as Regulation AB. The definition includes not only a person who organizes or initiates the securitization by transferring assets to the issuer, but also anyone who does (or has the contractual right to) direct or cause the direction of the ABS structure, design, or assembly or the composition of the asset pool. This second prong is meant to apply to certain portfolio selection agents in CDOs, collateral managers in CLOs and fund managers so long as they do or can shape the ABS transaction. The analysis will be inherently fact-based, and parties who would not otherwise consider themselves sponsors will need to determine whether the proposed rule applies to them.
The inclusion of affiliates and subsidiaries is meant to prevent circumvention of the proposed rule, but it does raise potential compliance issues for large financial institutions, as it does not exclude affiliates or subsidiaries that are screened from the securitization participant by information barriers. In its proposing release, the SEC does entertain arguments for an information barrier-based exception if certain conditions are satisfied — namely compliance monitoring, auditing and personnel separation.
What Activities Are Prohibited?
Covered securitization participants must not engage, directly or indirectly, in transactions that would involve or result in any material conflict of interest between them and an investor in the securitization. The proposed rule provides further guidance, but it deserves mention that the proposing release repeatedly takes aim at transactions that amount to “a bet against the securitization.”
Prohibited transactions, called “conflicted transactions,” are defined as (i) short sales of the ABS, (ii) purchases of derivatives that pay out if certain adverse events occur with respect to the ABS or (iii) transactions through which the securitization participant benefits (actually or potentially) from (A) adverse performance of the ABS asset pool, (B) loss of principal, monetary default, or early amortization of the ABS or (C) decline in market value of the ABS.
A conflict of interest is material if there is a substantial likelihood that a reasonable investor would consider the transaction important to the investor’s investment decision, including whether to retain the asset-backed security. Without further discussion, the SEC release simply notes the similarity to the reasonable investor standard established in Basic v. Levinson.2
The proposed rule does not allow securitization participants to cure a conflict by disclosing it to investors or obtaining investor consent to the asset pool. Nor does the proposed rule contain a safe harbor whereby securitization participants could rely on a process for determining that no prohibited conflict exists.
The restriction falls away one (1) year after the date of the first closing of the sale of the asset-backed securities.
What Activities Are Not Prohibited?
Purchases of the asset-backed securities themselves are excluded from the prohibition. Some transactions organically fall outside of the prohibition’s scope, and others may fit one of three exceptions contained in the rule, for (i) risk-mitigating hedging activities, (ii) liquidity commitments and (iii) bona fide market-making activities, all of which are limited in scope.
Integral hedging transactions, such as commodity price hedging by an affiliate of the placement agent in an oil & gas well ABS, should not come within the prohibition. The hedge provider (like the issuer and its investors) would benefit if prices rise, meaning the asset pool outperforms — if commodity prices decline, the hedge provider pays the issuer and benefits investors. Furthermore, such hedging is a fundamental element of the transaction that mitigates investors’ risk.
The hedging exception further permits securitization participants to hedge their positions in the ABS to the extent those positions arose out of the participant’s role in the ABS, e.g., the underwriting, placement, initial purchase or sponsorship. The securitization participant could hedge retained ABS positions and assets warehoused pre-ABS, but would in all instances need to comply with three conditions. First, whenever the hedge is struck or adjusted, it must be designed to hedge against a specific and identifiable risk tied to the ABS position — overhedging that would result in a short position is not permitted. Second, the hedge position needs to be recalibrated on an ongoing basis to maintain compliance with the first condition, e.g., by avoiding an overhedge. Third, the securitization participant must implement a compliance program to ensure its hedging activity meets the other conditions of the exception.
Many liquidity commitments also fall beyond the scope of the prohibitions, even if the provider may recoup its liquidity injections, with interest, ahead of investors. The SEC’s proposing release expressly states that “an extension of credit by a securitization participant . . . functions to support the performance of the securitization” and thus is not prohibited by the proposed rule.
The liquidity commitment exception permits securitization participants to sell or purchase ABS securities consistent with liquidity commitments to the ABS. Limited to sales and purchases of the asset-backed securities, this exception is quite narrowly defined and excludes a variety of liquidity support structures utilized in securitizations, such as liquidity facilities, that may nevertheless be permitted because they are not prohibited in the first place.
The third exception permits bona fide market-making activities by licensed or registered entities. To avail themselves of the exception, securitization participants need to comply with five conditions. First, the participant must routinely stand ready to purchase and sell, quote, and enter into long or short positions of the relevant financial instruments as merited by the liquidity, maturity, and depth of the market therefor. Second, the market-making activities must be proportional to the reasonably expected near-term demands in light of liquidity, maturity, and depth of the market for the relevant financial instrument. Third, compensation for the market-making activities cannot incentivize conflicted transactions. Fourth, the market maker must be licensed or registered to conduct such activities. Fifth, the market maker must maintain compliance programs to ensure its activities comport with the other conditions of this exception. Potential market makers in asset-backed securities would be well advised to carefully examine this exception and consider its impact on their ordinary course activities. This is another aspect of the proposed rule, where we see potential for thoughtful comments to lead to improved implementation in practice.
If I Do Not Like the Proposed Rule, How Much Time Do I Have to Submit Comments?
Securitization participants are advised to carefully review the proposed rule in its entirety and submit comments to the SEC. Such comments may cover parts of the proposed rule or the whole proposed rule. All comments to the proposed rule must be submitted by the later of (i) thirty (30) days after the date of publication in the federal register and (ii) March 27, 2023 (sixty (60) days after issuance). As with other proposed SEC rules of late, time is of the essence.
1 17 C.F.R. Part 246.
2 Basic v. Levinson, 485 U.S. 224, 231-32 (1998).
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.