Certain Consequences of Proposed Rule 127B on US Structured Products
As if current economic conditions weren't enough to stifle new issuances of synthetic structured securities, the Securities and Exchange Commission (the Commission) is proposing to hammer another nail in the coffin of the market for asset-backed securities (ABS). In connection with the implementation of Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act1 (the Dodd-Frank Act), the Commission has proposed new Rule 127B under the Securities Act of 1933 (the Proposed Rule). The Proposed Rule, a mere four short paragraphs long, adheres faithfully to the legislative text of Section 621 of the Dodd-Frank Act. 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) of an ABS (a Securitization Participant) from engaging in any transaction 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 three exceptions. The remaining 116 pages of the Commission's detailed commentary to accompany the Proposed Rule include no fewer than 120 questions and requests for further comment. It is perhaps not surprising therefore that the Proposed Rule sometimes raises more questions that it answers. We consider here the implications of the Proposed Rule on synthetic ABS, a product that is expressly included within the ambit of the Proposed Rule.2 There are a number of other interesting questions that Section 621 and the Proposed Rule present with respect to the purchase by a Securitization Participant of credit protection linked to ABS created by such Securitization Participant. We intend to address these questions in a separate client bulletin.
Background to Section 621 and the Proposed Rule
After a series of hearings by the United States Senate Homeland Security Permanent Subcommittee on Investigations (the PSI) in early 2010 examining the multiple roles played by financial institutions in the development, marketing and trading of ABS and credit default swaps, Senator Carl Levin (D-MI) and Senator Jeff Merkley (D-OR) proposed Section 621 of the Dodd-Frank Act to reduce perceived conflicts of interest in connection with the issuance of ABS.
Section 621 is rooted in findings by the PSI which, according to Senator Levin, "dramatically showed how some firms were creating financial products, selling those products to their customers, and betting against those same products."3 The politicians who drafted Section 621 were concerned that underwriters and sponsors "are the parties who select and understand the underlying assets, and who are best positioned to design [an ABS] to succeed or fail."4 The political motivations behind Section 621 were to prevent underwriters and sponsors from "securing handsome rewards for designing and selling malfunctioning [ABS] that undermine the [ABS] markets."5
What are the consequences of Section 621 and the Proposed Rule on Synthetic ABS?
Synthetic ABS structures typically involve the issuer of the ABS obtaining exposure to one or more underlying assets by selling protection to a buyer of protection under a credit default swap that references such assets (the Relevant CDS). Would the Relevant CDS constitute a prohibited transaction under Section 621 and the Proposed Rule? Would the Relevant CDS "involve or result in any material conflict of interest with respect to any investor in" the synthetic ABS if protection under the Relevant CDS is sold by the issuer of the ABS and purchased by the Securitization Participant of such ABS prior to the date that is one year after the date of the first closing of the sale of the ABS?
The approach of the Commission in response to these questions is somewhat mixed. In its commentary to the Proposed Rule, the Commission sets out a series of fact patterns with the purpose of providing clarity on the types of activity that may be caught by the Proposed Rule.
If the Securitization Participant is not also an investor in the ABS and does not have any form of exposure to the underlying assets other than by means of its short position as buyer of protection under the Relevant CDS, then the Commission believes that the Relevant CDS would result in a material conflict of interest and would be prohibited by the Proposed Rule.
If the Securitization Participant has an existing exposure to the underlying assets and subsequently synthetically transfers that exposure to the issuer of the ABS by entering into the Relevant CDS as buyer of protection, the Commission believes the Securitization Participant will be in a position to benefit from a decline in the ABS at the expense of the ABS investors who now have exposure to the underlying assets, engendering a material conflict of interest. The Securitization Participant's long exposure to the underlying assets and its short position under the Relevant CDS would offset each other, thereby raising the question of whether the exemption for risk-mitigating hedging activities from proposed Rule 127B(b)(1) would apply. Proposed Rule 127B(b)(1) provides an exemption for "[r]isk-mitigating activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an asset-backed security." However, the Commission clarifies that the Relevant CDS in this Example B is providing a hedge to an existing long investment position, rather than a hedge for "positions or holdings arising out of" the Securitization Participant's role in the ABS. Therefore the "hedging activity" exemption is not available to the Securitization Participant and the Relevant CDS would be a prohibited transaction under the Proposed Rule.
If the Securitization Participant has a long exposure to the underlying assets that it has accumulated in anticipation of creating and selling a synthetic ABS – and not, as is the case in Example B above, with a view to taking an investment position in the underlying assets – the Relevant CDS may fall within the exception for risk-mitigating hedging activities, provided that there is no net basis risk between the Relevant CDS and the off-setting long exposure to the underlying assets. The long exposure may be obtained either by the Securitization Participant entering into separate credit default swaps as seller of protection with third party market participants who did not have any influence on any aspect of the ABS transaction or by the Securitization Participant acquiring the underlying physical assets themselves. In order to fall within the exception, the long exposure must not be acquired in the form of new positions designed to earn a profit. Furthermore, to the extent that the long positions are unwound, a corresponding portion of the Relevant CDS would similarly need to be unwound or new long positions established in order for the Relevant CDS to continue to benefit from the exception. The key distinction between Example B and Example C is whether the long exposure was previously held as an investment or whether the long exposure was accumulated for purposes of "warehousing" the risk until the ABS are issued.
Potential Unintended Consequences of Section 621
The Commission acknowledges that, from a practical perspective, it may not be possible to distinguish circumstances where the Securitization Participant's long position was originally acquired for investment purposes (Example B) from circumstances where the long position was acquired for purposes of creating the ABS (Example C). However, the Commission gives no guidance on how it will assess whether a long position was acquired for investment purposes or for purposes of building up exposure for purposes of the ABS issuance.
For example, will the Commission take into account the length of time that the risk has been held by the Securitization Participant prior to the first closing date of the ABS issuance? Where a Securitization Participant regularly trades an asset that is also to be included in an ABS, will the Commission be able to determine whether the Securitization Participant held the asset for investment purposes or whether it was held for purposes of creating the ABS? Will the Commission require Securitization Participants to record transactions in a particular way or flag them as transactions that are entered into for purposes of creating an ABS? If the positions established under Example C are unwound more than one year after the date of the first closing of the sale of the ABS, will the Relevant CDS still need to be unwound correspondingly?
The fact that a single structure may or may not be permitted under the Proposed Rule, depending upon certain complicated fact patterns, is not only confusing but could lead to arbitrary results which may have unintended consequences.
Section 621 and the Proposed Rule appear to be based on overly suspicious presumptions that (a) Securitization Participants are in the business of purposely structuring ABS to fail and (b) ABS investors are not sufficiently equipped to make their own assessments of the quality, price and performance associated with such ABS based on existing disclosure standards. Many markets are predicated on the fact that one side of the market has one view of an issue while the other side of the market has an opposite view of the same issue. Rather than any sinister activity on the part of the Securitization Participant seeking to offload exposure to an asset in which the Securitization Participant is an investor, the decision to reference a particular asset in an ABS may instead be motivated by positive sentiments among potential investors in the ABS regarding the price and quality of the asset, especially where the initial issuance of the asset may be oversubscribed or unique in nature.
In an attempt to cure Senator Levin of his distrust for "vague, technically worded, fine print disclosures", a criticism that arguably is not specific to the market for ABS, we would encourage the Commission, in its rule implementing Section 621, to permit exemptions to the requirements of Section 621 through enhanced disclosure standards for ABS and their underlying asset(s), creating reporting standards regarding hedge positions of the Securitization Participant with respect to the ABS and/or establishing heightened representations and warranties to be provided by investors in the ABS.
1 P.L. 111-203, H.R. 4173.
2 Notwithstanding that synthetic asset-backed securities are excluded from section 3 of the Securities Exchange Act of 1934, §230.127B(a) refers to "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 asset-backed security)" (emphasis added).
3 111 CONG. REC. S5901 (2010).
4 111 CONG. REC. S5899 (2010).