A rule proposed late last January to prohibit conflicts of interest in securitizations drew significant concerns from across the industry, because it was considered too broad. After taking note, the Securities and Exchange Commission (SEC), worked closely with industry members, and released a final rule on October 27 that significantly reduces concerns.
The rule, Prohibition Against Conflicts of Interest In Certain Securitizations, stems from the Dodd-Frank Act and Congress's efforts to rein in problematic transactions. Compliance will be required 18 months after publication in the Federal Register.
"In essence, Congress wanted to make sure that so-called securitization participants cannot bet against the ABS that they underwrite, place, or sponsor," said SEC Chairman Gary Gensler in a written statement.
The original re-proposal was extremely broad and would have had a severe impact across the securitization market, said Charles Sweet, practice development leader of Morgan Lewis' structured transactions group. He added that the SEC acknowledged crafting provisions in the re-proposal broadly in an effort to facilitate enforcement, but closely monitored industry feedback.
"The SEC didn't take every suggestion from everybody into account, but it came up with something vastly more workable than the original rule," Sweet said.
For issuers, the new rule is an immense improvement over the previous iteration.
"The SEC is not only holding sponsors accountable, but also the initial purchasers [or underwriters] who frequently make markets in the issued securities and have historically taken positions with opposite interest to their clients and investors," Viktor Kuznetsov, managing director of Imperial Fund, a frequent RMBS sponsor, posted recently on social media in response.
A key change was narrowing the rule's scope. The proposed language could have prohibited virtually any transaction negatively correlated economically with the performance of the securitization or the underlying pool of assets, significantly impacting market participants hedging risks appropriately. Sweet said market participants generally recognized a credit-default swap or a direct short against a securitization as problematic, and the SEC narrowed the definition of problematic transactions to those and transactions that are "substantially the economic equivalent."
"There are terms in the final rule such as 'substantially the economic equivalent' that the SEC did not specifically define, but the industry will have more than 18 months to work through those issues before the compliance date," Sweet said.
Also, hedges such as an interest rate or currency swap are not conflicted transactions, and it permits, subject to certain conditions, the use of risk-management tools, Gensler said.
Another significant change, Sweet said, was narrowing the scope of who is impacted. Whereas before virtually any party affecting the structure of the ABS or asset pool could have been scoped in, the final version confines it to parties with a contractual right to impact the structure of the deal or its asset pool. In addition, the rule broadens exemptions to include parties performing administrative, legal and other support-type activities, such as loan servicing.
"Affiliates and subsidiaries of securitization participants are covered only if they act in coordination or have knowledge about the deal, and people can work to create compliance procedures to avoid that," Sweet said.
