Executive Summary

  • The SEC has issued proposed Rule 127B pursuant to Section 621 of the Dodd-Frank Act.
  • Rule 127B prohibits a securitization participant (i.e., an underwriter, placement agent, initial purchaser, sponsor or any affiliate or subsidiary of any such party) from engaging in a transaction that would result in a “material conflict of interest” with respect to an investor.
    • This prohibition is in effect for the period ending on the first anniversary of the first closing of the sale of the asset-backed security. However, Rule 127B does not specify the date on which the period begins.
    • Rule 127B covers transactions between a securitization participant and an investor. Rule 127B does not cover any transaction between investors or between securitization participants.
    • SEC commentary provides “interpretive guidance” on many aspects of Rule 127B, including the following two-part test for determining whether a material conflict of interest exists:
      • A securitization participant benefits directly or indirectly from a short transaction or from permitting a third party to structure the ABS or select the assets in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction; and
      • There is a substantial likelihood that a reasonable investor would consider the conflict important to its investment decision.
    • SEC commentary also provides several examples of the application of Rule 127B.
  • Rule 127B contains exceptions for risk-mitigating hedging activities, liquidity commitments and bona fide market making.
  • Rule 127B applies to “asset-backed securities” as defined by the Dodd-Frank Act (which, for purposes of Rule 127B, includes synthetic asset-backed securities).
  • Rule 127B applies to public and private offerings of asset-backed securities.
  • Rule 127B contains no safe harbor for foreign issuers or foreign transactions.
  • Compliance is required upon issuance of final Rule 127B, unless final Rule 127B contains a transition period.
  • Comments are due on December 19, 2011.

Introduction

On September 19, 2011, the US Securities and Exchange Commission (the “SEC”) issued proposed Securities Act Rule 127B (“Rule 127B”) prohibiting certain conflicts of interest in securitization transactions.1 Rule 127B implements Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) as codified in new Section 27B of the Securities Act of 1933 (the “Securities Act”).2

Rule 127B applies to transactions involving assetbacked securities (“ABS”), as that term is defined in Section 3(a)(77) of the Securities Exchange Act of 1934 (the “Exchange Act”).3 Rule 127B applies to registered public offerings of Exchange Act ABS as well as private offerings of Exchange Act ABS, regardless of whether such private offerings are conducted in reliance on Rule 144A, Regulation D or another safe harbor from the registration requirements of the Securities Act.

Deadline for Comments

Comments on the Proposed Rule are due on December 19, 2011.

Compliance Date

The Proposing Release does not specify a compliance date. Unless the adopting release provides otherwise, Rule 127B will become effective upon the issuance of final rule.

Overview of Rule 127B

Section 621 of the Dodd-Frank Act prohibits securitization participants from entering into “any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.” Section 621 is intended to “prohibit underwriters, sponsors and others who assemble asset-backed securities from packaging and selling those securities and profit from the securities’ failures.”4

Prior to undertaking its rulemaking under Section 621, the SEC invited comments regarding how it should craft a proposed conflicts-of-interest rule.5 During that prerulemaking comment process, market participants urged the SEC to tailor its conflictsof- interest rule in a way that satisfies the intent of Section 621, as described above, without causing unnecessary adverse impacts on the markets for ABS by inadvertently prohibiting otherwise normal and commonly accepted features of many ABS transactions.6

In proposing Rule 127B, the SEC chose to issue a rule that tracks almost identically the broad provisions of Section 621 of the Dodd-Frank Act. Rule 127B reads as follows:

§230.127B Conflicts of interest relating to certain securitizations.

  1. Unlawful activity. An underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (as such term is defined in section 3 of the Securities Exchange Act of 1934 ( 15 U.S.C. 78c), which for the purposes of this rule shall include a synthetic assetbacked security), shall not, at any time for a period ending on the date that is one year after the date of the first closing of the sale of the asset-backed security, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.
  2. Excepted activity. The following activities shall not be prohibited by paragraph (a) of this section:
    1. Risk-mitigating hedging activities. Risk-mitigating hedging activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an asset-backed security, provided that such activities are designed to reduce the specific risks to the underwriter, placement agent, initial purchaser, or sponsor associated with such positions or holdings; or
    2. Liquidity commitment. Purchases or sales of asset-backed securities made pursuant to and consistent with commitments of the underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, to provide liquidity for the asset-backed security; or
    3. Bona fide market-making. Purchases or sales of asset-backed securities made pursuant to and consistent with bona fide marketmaking in the asset-backed security.

In the Proposing Release, the SEC acknowledges the concerns of ABS market participants that the rule not be overly broad, but chose to address those concerns by issuing, and requesting comment on, “interpretive guidance” in the Proposing Release.7 The following is a discussion of Rule 127B, as supplemented by the interpretive guidance provided by the SEC.

FIVE CONDITIONS REQUIRED IN ORDER FOR RULE 127B TO APPLY

The Proposing Release describes five conditions that must be present in order for Rule 127B’s prohibition on conflicts of interest to apply to a particular transaction. Click here to see those five conditions summarized in a chart.

TWO-PART TEST FOR IDENTIFYING MATERIAL CONFLICTS OF INTEREST

The Proposing Release contains a two-part test for identifying “material conflicts of interest.” This test is included in the Proposing Release as an interpretation and is not included within the text of Rule 127B itself.

The SEC noted the difficulty in avoiding an interpretation that construes material conflicts of interest either too narrowly (thus failing to capture the full range of transactions that involve the types of conflicts that the Dodd-Frank Act was intended to prevent) or too broadly (thus curtailing the willingness of securitization participants to engage in securitization transactions).10 In examining the legislative history of Section 621 of the Dodd-Frank Act, the SEC concluded that Section 621 was not intended to curtail the legitimate function of the securitization markets, but, rather, was intended to target and eliminate specific types of improper conduct.11 Thus, in the view of the SEC, the “activities associated with the typical structuring of a non-synthetic ABS would not be prohibited by the proposed rule.”12

The SEC’s two-part test is discussed in the chart which can be viewed here. In order for the test to be met, either Prong 1(A) or Prong 1(B) must be met and Prong 2 must be met.

EXCEPTIONS FOR HEDGING, LIQUIDITY COMMITMENTS AND MARKET MAKING

Description of the Exceptions

The exceptions contained in Rule 127B are modeled on the exceptions contained in Section 621 of the Dodd-Frank Act. These exceptions are discussed in the chart which can be viewed here.

Scope of the Exceptions and the Volcker Rule

In the Proposing Release, the SEC notes that Section 619 of the Dodd-Frank Act (the “Volcker Rule”) contains exceptions for market-making activities19 and risk-mitigating hedging.20 In the SEC’s view, the Volcker Rule is intended to address conflicts of interest stemming from proprietary trading by banks and non-bank financial firms. In light of the common purpose of the Volcker Rule and Rule 127B:

  • The SEC “may consider whether aspects of the rules adopted to implement [the Volcker Rule] should be applied to [Rule 127B] in the future”21 and
  • The SEC’s “preliminary belief is that the exceptions for risk-mitigating activities and bona fide market-making activities for purposes of proposed Rule 127B should be viewed no less narrowly than the comparable exceptions for such activities under the Volcker Rule.”22

Extraterritorial Application of Rule 127B

The provisions of Section 621 and Rule 127B (including the definition of “asset-backed security” as used therein) do not contain any limitations on the jurisdictional reach of those provisions. Unlike the risk retention rules, for example, Rule 127B contains no safe harbor for foreign issuers or foreign transactions. Many market participants are likely to be very concerned about the potentially broad jurisdictional reach of Rule 127B, especially in light of the fact that the securitization participants covered by Rule 127B include affiliates and subsidiaries of the entities that are directly involved in the securitization transaction.  

Conclusion

The very broad scope of Section 621 of the Dodd- Frank Act caused concern among many market participants that the SEC would propose a conflicts-of-interest rule that prohibits many common practices in ABS transactions. Although several aspects of Rule 127B are likely to draw heavy comment, Rule 127B and the related interpretive guidance indicate a clear intention on the part of the SEC to craft a rule that is narrowly tailored and designed to prohibit only those types of conflicts that are of particular concern to the SEC.