September 22, 2011

 

SEC Proposes Rule To Prohibit Conflicts Of Interest In Asset-Backed Securities

The provisions of Section 27B of the Securities Act of 1933, as amended (the "Securities Act"), which were included in the Dodd–Frank Wall Street Reform and Consumer Protection Act enacted in 2010, prohibit an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity (collectively "securitization participants") of an asset-backed security ("ABS"), including a synthetic ABS, from engaging in a transaction that would involve or result in certain material conflicts of interest for one year following the date of the closing of the ABS. Section 27B provides exceptions from the prohibition described above for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making.

 

In connection with this new Section 27B of the Securities Act, on September 19, 2011, the Securities and Exchange Commission (the "SEC") issued a release (the "Release") proposing a new rule (the ‘Proposed Rule") intended to meet this statutory requirement and requested public comment on the Proposed Rule. Comments should be submitted to the SEC on or before December 19, 2011.

 

Conditions Required For Application Of The Proposed Rule

In the Release, the SEC listed the elements of an ABS transaction which, if satisfied, may result in the Proposed Rule prohibiting material conflicts of interest in the securitization process of the ABS. These elements include 1) covered persons, 2) covered products, 3) a covered time frame, 4) covered conflicts and 5) a "material conflict of interest.

 

1. Covered Persons:

The Proposed Rule applies to underwriters, placement agents, initial purchasers, or sponsors, or any affiliate of such an entity, of an ABS. The SEC states that these parties typically have substantial roles in the assembly, packaging and sale of an ABS.

 

An ABS is defined in the Release as:

(A) a fixed income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a security or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flows from the asset, including – 

  1. a collateralized mortgage obligation;
  2. a collateralized debt obligation;
  3. a collateralized bond obligation;
  4. a collateralized debt obligation of asset-backed securities;
  5. a collateralized debt obligation of collateralized debt obligations; and
  6. a security that the SEC, by rule, determines to be an asset-backed security;

 

(B) does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.

 

If a transaction occurs in the period prior to one year after the date of the first closing of the sale of the ABS, the ABS would be subject to the Proposed Rule.

 

A conflict of interest regarding an ABS would not be subject to the Proposed Rule if the conflict in question (a) arose exclusively between securitization participants or exclusively between investors; (b) did not arise as a result of or in connection with the related ABS transaction; or (c) did not arise as a result of or in connection with "engag[ing] in any transaction."

 

While the Proposed Rule does not define "material conflict of interest", the Release seeks to clarify the scope of conflicts of interest that are material through interpretative guidance. The SEC states that, for the purposes of the Proposed Rule, a material conflict of interest would result in an ABS transaction between a securitization participant and an investor if:

 

(A) Either:

1) the securitization participant would benefit directly or indirectly from the actual, anticipated or potential (a) adverse performance of the asset pool supporting or referenced by the relevant ABS, (b) loss of principal, monetary default or early amortization event on the ABS, or (c) decline in the market value of the relevant ABS (where these are discussed below, any such transaction will be referred to as a "short transaction"); or

 

2) the securitization participant, who directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS, would benefit directly or indirectly from fees or other forms of remuneration, or the promise of future business, fees, or other forms of remuneration, as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction as described above;

 

and

 

(B) There is a "substantial likelihood" that a "reasonable" investor would consider the conflict important to his or her investment decision (including a decision whether to retain the security or not).

 

In the Release, the SEC requests public comment to a number of issues related to each of these five elements.

 

The Proposed Rule also carves out exceptions to certain ABS transactions including those related to a) risk-mitigating hedging activities, b) liquidity commitments and c) bona-fide market-making exceptions. The Release also requests public comments to a number of issues related to these exceptions.

 

A copy of the Release can be found via the following link: Prohibition against Conflicts of Interest in Certain Securitizations

 

If you have any questions regarding the Proposed Rule or the Release, please contact Orical LLP at 212-705-4285 or visit our website at www.orical.org.

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