In connection with the implementation of Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which added Section 27B to the Securities Act of 1933, as amended (the Securities Act), the Securities and Exchange Commission (the Commission) has proposed new Rule 127B (the Proposed Rule) under the Securities Act. The Proposed Rule tracks the text of Section 621 of the Dodd-Frank Act and raises concerns for Securitization Participants about the potential breadth of the text. Both Section 621 and the Proposed Rule prohibit any underwriter, placement agent, initial purchaser or sponsor (or any affiliate and subsidiary of any such entity) (a Securitization Participant) of an asset-backed security (as defined under the Securities Exchange Act of 1934, as amended (the Exchange Act)) (ABS), including synthetic ABS, from engaging in any transaction at any time prior to the date that is one year after the date of the first closing of the sale of the ABS that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity, subject to exceptions for risk-mitigating hedging activities, liquidity commitments and bona fide market-making. As drafted, the Proposed Rule looks to the participants and not the ABS issuance, thus bringing within its scope both publicly registered offerings and private placements. And, unlike the proposed risk retention rules (which we discussed in a prior eAlert), the Proposed Rule would apply to synthetic ABS.
The Commission's detailed commentary accompanying the Proposed Rule acknowledges that certain conflicts are inherent to the securitization process and, therefore, Section 27B of the Exchange Act and the Proposed Rule "should be construed in a manner that does not unnecessarily prohibit or restrict the structuring and offering of an ABS." To provide guidance as to how the Proposed Rule should be construed, the Commission describes activities which the Commission believes would and would not be prohibited under the Proposed Rule. Included among more than 120 questions and requests for further comment are questions asking: whether investors understood which conflicts were inherent in the securitization process; whether the Commission should use its exemptive authority to provide exemptions for certain material conflicts which are disclosed; and what role information barriers play in the conflicts. As is often the case with a notice of proposed rulemaking, the Proposed Rule seems to be raising more questions among securitization participants and investors than it answers.
The Commission's commentary sets forth five conditions determining the applicability of the Proposed Rule:
The Proposed Rule applies to Securitization Participants such as underwriters, placement agents, initial purchasers and sponsors (and any of their respective affiliates and subsidiaries). The Commission notes that the Regulation AB definition of "sponsor" may not be broad enough to identify all persons involved in the structure and sale of an ABS transaction who may have the opportunity to engage in activities that the Proposed rule is intended to prevent. Similar to its controversial commentary with respect to the proposed risk retention rules, the Commission again preliminarily believes that the term "sponsor" should include a collateral manager in the context of the Proposed Rule.
Securitization Participants should carefully consider the implications of the inclusion of affiliates and subsidiaries within the scope of covered persons. Information barriers which have been implemented for other regulatory reasons may prevent Securitization Participants from knowing what transactions their respective affiliates and subsidiaries have entered into; however, the Proposed Rule does not provide an exemption relating to information barriers. The Commission is aware of the issue and has requested comments on the point.
The Proposed Rule would apply to asset-backed securities as defined in the Exchange Act (which definition was amended by the Dodd-Frank Act and is broader than the Regulation AB definition of asset-backed securities). Unlike the proposed risk retention rules, the Proposed Rule would capture synthetic ABS, which the Commission proposes not to define since it believes the term is commonly used and understood by ABS market participants. The Proposed Rule would apply to both public offerings and private placements of ABS.
Any transactions entered into at any time prior to the date that is one year after the date of the first closing of the sale of the ABS would be within the covered timeframe. The Commission purposely included only an end date for the covered timeframe. The Commission was concerned that the inclusion of a start date might result in the Proposed Rule being under-inclusive. Therefore, transactions entered into prior to the date of first closing of the ABS would be prohibited if they result in a material conflict of interest, unless an exemption applies.
Covered Conflicts of Interest
The Commission's commentary clarifies that, while the Proposed Rule would cover material conflicts of interest between Securitization Participants on the one hand and investors on the other hand, it would not cover conflicts:
- Solely among Securitization Participants or solely among investors. A covered conflict would involve a Securitization Participant and an investor in the ABS, whether or not the investor acquired the ABS from the Securitization Participant. Conflicts inherent in a multi-tranche structure would not be covered by the Proposed Rule.
- Not arising as a result of or in connection with the related ABS transaction. A conflict of interest arising between parties that is unrelated to the ABS transaction that the parties are involved in would not be covered.
- Not arising as a result of or in connection with engaging in any transaction. Engaging in a transaction would include effecting a short sale or purchasing a CDS, but would not include issuing investment research.
Conflicts of Interest that are Material
In order to avoid being over-inclusive or under-inclusive, the Commission's commentary provides an interpretive test as to whether there is a material conflict of interest instead of defining materiality. The interpretive test consists of two parts.
The first part of the test examines whether a Securitization Participant would benefit, directly or indirectly, from either (i) the actual, anticipated or potential adverse performance of the underlying (or referenced) assets; loss of principal, monetary default or early amortization event on the ABS; or decline in the market value of the ABS or (ii) facilitating a third party in structuring the ABS or selecting the underlying assets in a manner that would allow such third party to benefit from a short transaction.
If the first part of the test is satisfied, the second part would examine whether there is a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision (including a decision to retain the security or not). Although this test is similar to the test used under U.S. federal securities laws to determine whether information should be disclosed in an offering document, the Commission notes that a transaction prohibited by the Proposed Rule would not be permitted merely because the conflict was disclosed. However, the Commission has requested comments regarding the role of disclosure in addressing certain conflicts of interest.
The Commission also notes that the intent to design a securitization to fail is not required in order to violate the Proposed Rule's prohibition. Moreover, an actual decline in the value of the ABS or adverse performance of the underlying assets would not be required to violate the Proposed Rule's prohibition. The act of engaging in the short transaction, even if it is not in the money, would be sufficient to violate the prohibition.
To help clarify the proposed interpretive test, the Commission includes in its commentary several examples which we discussed in a prior eAlert.
Exceptions under the Proposed Rule
The Proposed Rule provides three exceptions to the prohibition on engaging in any transaction that would "involve or result in any material conflict of interest with respect to any investor in" an asset-backed security. The exemptions for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making activities are modeled after the text of Section 621 of the Dodd-Frank Act.
Risk-Mitigating Hedging Activities
The Proposed Rule provides an exception for "[r]isk mitigating hedging activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an asset-backed security." The excepted activities must reduce the specific risks to the underwriter, placement agent, initial purchaser, or sponsor associated with such positions or holdings.
Purchases or sales of ABS made pursuant to and consistent with commitments of the underwriter, placement agent, initial purchaser, or sponsor or their respective affiliates or subsidiaries, to provide liquidity for the ABS would also be excepted from the Proposed Rule's prohibition.
Bona Fide Market-Making
Purchases or sales of ABS made pursuant to and consistent with bona fide market-making in the ABS would fall under the exception provided by the Proposed Rule. The Proposed Rule does not define "bona fide market-making," but the commentary does provide what the Commission believes to be characteristics of bona fide market-making in ABS. These characteristics presented by the Commission are not particularly surprising and include the market-maker's willingness to provide liquidity on both sides of the market, the proportionality of the market-maker's activity to its usual market-making patterns with respect to a particular ABS and that the market-making activity be driven by customer need. The Commission points out that, unless resulting from facilitation of customer interest, bona fide market-making activity does not typically result in open positions exceeding the open positions in the normal course of trading, actively accumulating long or short positions, or accumulating positions that remain open and exposed to gains rather than being promptly closed out.
Interaction with the Volcker Rule
Pursuant to Section 619 of the Dodd-Frank Act, commonly referred to as the Volcker Rule, which we discussed in a prior eAlert, four federal agencies (including the Commission) issued a notice of proposed rule making (the Proposed Volcker Rule), which would place certain prohibitions and restrictions on banking entities engaging in proprietary trading or sponsoring or investing in private equity and hedge funds. Like the Proposed Rule, the Proposed Volcker Rule provides exemptions for risk-mitigating hedging activities and for market-making related activities. While the Proposed Volcker Rule provides more detail regarding these terms than either the Proposed Rule or the corresponding commentary, the commentary to the Proposed Rule states that the exceptions for risk-mitigating hedging activities and bona fide market-making activities contained therein should be viewed "no less narrowly than the comparable exceptions for such activities under the Volcker Rule." The Commission seeks comment on the interplay between the two proposed rules and asks whether there are any reasons that the risk-mitigating hedging activities and bona fide market-making activities described in the Proposed Rule should be treated differently from the risk-mitigating hedging activities and permitted market-making activities under the Volcker Rule.
The Volcker Rule exempts hedging transactions made in connection with and related to individual or aggregate positions, contracts, or other holdings so long as the hedge is designed to reduce the specific risks in connection with those positions, contracts or holdings. To take advantage of this exemption, a banking entity subject to the Volcker Rule is required to have established an internal compliance program designed to ensure compliance with six additional criteria. These include, among other things, a requirement that the transaction be reasonably correlated to the risks that the transaction is intended to hedge, that the hedge at its inception not give rise to exposures to which the banking entity was not already exposed, and that the hedge be continually monitored to maintain a reasonable level of correlation and mitigate exposure arising from the hedge after inception. Even if a transaction is exempted from the Volcker Rule prohibitions, it will require several specific disclosures if it causes a "material conflict of interest" with a counterparty.
The exemption for permitted market-making activity under the Proposed Volcker Rule covers transactions that a covered banking entity made in connection with the covered banking entity's market-making-related activities. Appendix B to the Proposed Volcker Rule describes the features of permitted market-making activities, listing in part C thereof factors the Commission will use to distinguish permitted market-making activities from prohibited proprietary trading. According to the Appendix, the following would constitute prohibited proprietary trading rather than permitted market-making activity:
- Retaining risk in excess of the size and type required to provide intermediation services to customers.
- Trading activity in which a trading unit primarily generates revenue from price movements of retained principle positions and risks.
- Trading activity in which a trading unit generates very small or very large amounts of revenue per unit of risk taken, does not demonstrate profitability or demonstrates high earnings volatility.
- Trading activity in which a trading unit does not transact through a trading system that interacts with orders of others or primarily with customers of the banking entity's market-making desk to provide liquidity services, or retains principal positions and risks in excess of reasonably expected near-term customer demands.
- Trading activity in which a trading unit routinely pays rather than earns fees, commissions, or spreads.
- Trading activity of a trading unit that provides compensation incentives to employees that primarily reward proprietary risk-taking.
For each of the factors above, Appendix B lists explanatory facts that would move trading activity from the realm of prohibited proprietary trading. In addition to meeting the terms in Appendix B, transactions or activities for which a covered banking entity intends to rely on the market-making exemption must comply with seven criteria: (i) the banking entity must establish a comprehensive compliance program; (ii) the banking entity must hold itself out as willing to buy and sell, including entering into long and short positions in the covered financial position for its own account on a regular or continuous basis; (iii) the market-making activities must be designed not to exceed the reasonably expected near-term demands of customers, clients or counterparties; (iv) the banking entity must be appropriately registered as a dealer or be exempt from registration under applicable laws and a non-U.S. based banking entity for which no U.S. registration is required must be subject to substantive regulation of its dealing business in its local jurisdiction; (v) the market-making activities must be designed to generate revenues primarily from fees, commissions, bid/ask spreads or other income not attributable to appreciation in the value (or hedging) of the covered financial positions it holds in trading accounts; (vi) market-making activity should be consistent with the six principles proposed by the Agencies in Appendix B of the Proposed Rule to distinguish market-making related activities from prohibited proprietary trading; and (vii) compensation arrangements of persons performing market-making activity should be designed to not encourage or reward proprietary risk-taking. While the criteria that a banking activity must satisfy under the Proposed Volcker Rule and the factors in Appendix B do not conflict with the characteristics of bona fide market-making identified in the commentary to the Proposed Rule, the exemption in the Volcker Rule is far narrower than the plain text of the Proposed Rule.
It is unclear whether viewing the exceptions in the Proposed Rule as narrowly as the Volcker Rule exemption would require an entity to satisfy any additional criteria that do not relate directly to the interpretation of the terms "market-making" and "risk-mitigating hedging," such as the requirement to establish written policies and procedures. In other words, it is unclear whether the Commission is simply relying on the Volcker Rule to provide the definitions of "market-making" and "risk-mitigating hedging" or whether it is the Commission's intent that all of the same steps be taken to qualify for the exemptions under each proposed rule.