US SEC re-proposes rule to prohibit conflicts of interest in certain securitizations

The Securities and Exchange Commission (SEC) unanimously voted on January 25, 2023 to re-propose a rule that would implement restrictions regarding conflicts of interest in certain securitization transactions (the Proposed Rule). The Proposed Rule is intended to supersede a similar rule proposed in September of 2011, and the SEC has stated that the re-proposal is aimed to provide greater clarity than the original rule with regard to prohibited conduct. The Proposed Rule would prohibit a "securitization participant" from engaging in a "conflicted transaction," which is a transaction which would effectively place the securitization participant's interest ahead of the underlying asset-backed security investor, for a one-year period following the closing of the ABS transaction. The restriction would exempt risk-mitigating hedges, liquidity commitments and bona fide market-making activities. As currently drafted, the Proposed Rule raises a number of issues for the securitization industry.

Overview

The Proposed Rule would prohibit a "securitization participant" or an underwriter, placement agent, initial purchaser or sponsor of an asset-backed security from entering into a "conflicted transaction" (i.e., betting against the performance of such asset-backed security). This prohibition on such adverse transactions would last for one year after the date of the first closing of the sale of the related asset-backed securities.

While some might argue that passive placement agents or underwriters on the lower right-hand side of an offering memorandum should not be included in the Proposed Rule’s definition of securitization participant, the SEC’s expanded definition of “sponsor” in the Proposed Rule is what most industry participants are concerned about.

The Proposed Rule also expands the definition of an "asset-backed security" in the Securities Exchange Act of 1934. The Proposed Rule's definition of "asset-backed security" includes synthetic asset-backed securities. The Proposed Rule, however, does not contain a definition of synthetic asset-backed securities as the SEC, apparently, does not think it is necessary to provide such a definition in the Proposed Rule. Given the potential breadth of the definition of "conflicted transaction," some market participants think a definition should be added to the Proposed Rule.

The final component of the Proposed Rule is the definition of "conflicted transaction." The definition of conflicted transaction has two components. The first two prongs of the first component are not controversial (e.g., short sales of the related asset-backed security or entering into a credit default swap with respect to the asset-backed security). The third prong is what has made market participants nervous in that it is potentially very broad. The third prong includes transactions that a reasonable investor might view as being material to his or her investment in the asset-backed security. It is worth noting that while the SEC has proposed this materiality standard it also states in the release for the Proposed Rule that disclosure is not a means of complying with the Proposed Rule.

Analysis

The release for the Proposed Rule contains 112 questions from the SEC which will take time for the securitization industry to answer adequately. The comment period currently expires at the end of March but the securitization industry is likely to ask for a 60-day extension of the comment period.

The SEC is likely to be more amenable to expanding the carveouts to conflicted transactions rather than re-issuing the Proposed Rule as a narrower rule focused on the intent of the parties given that, as the SEC states in the release for the Proposed Rule, intent is difficult to prove.

As noted above, the third prong of the first component of the definition of conflicted transaction is very broad. For example, if a bank is considering a securitization of a portfolio of loans, does the definition of conflicted transaction include short sales or credit default swaps with respect to individual loans in the underlying portfolio of loans being securitized? What if there is a credit default swap with respect to only one loan in the underlying portfolio of loans being securitized?

The second component of the definition of "conflicted transaction" contemplates a materiality standard that is based on Rule 10b-5 case law. Interestingly, as noted above, the SEC provides for this materiality concept even though it states elsewhere in the release for the Proposed Rule that disclosure is not a means for complying with the Proposed Rule. So even though the Proposed Rule is not a disclosure-based rule, a securitization participant would need to determine what would be material to a reasonable investor in the related asset-backed securities.

The Proposed Rule also expands the definition of "Sponsor" beyond that contained in US securities laws today. The existing definition of a sponsor is an entity that organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, to the entity that issues the asset-backed securities. The Proposed Rule expands this definition of sponsor to include "any person that directs or causes the direction of the structure, design or assembly of an ABS or the composition of the pool of assets underlying the ABS or has the contractual right to do so." For example, would an automobile manufacturer which has a captive finance subsidiary be deemed to be a sponsor since its treasury department presumably has a say in the securitization transactions conducted by its captive finance subsidiary? If so, would the automobile manufacturer be required to implement a compliance program for conflicted transactions.

Another example occurs in the context of commercial mortgage securitization transactions (CMBS). In the typical CMBS securitization, the special servicer gets paid a servicing fee to service distressed loans in the underlying portfolio of commercial real estate loans that have been securitized. The special servicer is often related to the B-piece buyer in a CMBS securitization and the B-piece buyer, in turn, normally has a say in which commercial real estate loans are selected for inclusion in a CMBS securitization.

Conclusion

The Proposed Rule raises several issues for the securitization industry. It will be interesting to see how flexible the SEC is in terms of accepting carveouts to the definition of conflicted transactions in the Proposed Rule. For a rule which has sat on the shelf for almost 12 years, the potential breadth of the Proposed Rule is striking.