The Securities and Exchange Commission (SEC) re-proposed a rule on January 25 that aims to prohibit key participants in securitizations from betting against transactions, reviving concerns that that the prohibition may end up being too broad and adversely impact asset-backed securities (ABS) offerings.
The rule, Prohibitions Against Conflicts of Interest in Certain Securitizations, was first proposed in 2011 to implement a Dodd-Frank-Act provision prohibiting key participants creating and managing ABS deals—or their affiliates or subsidiaries—from engaging in transactions resulting in conflicts of interest. The re-proposed rule would also apply to synthetic ABS, which use credit derivatives to reference a pool of assets and achieve the same credit-risk transfer as conventional ABS.
The proposal points to transactions that regulatory and Congressional investigations cited as examples of ABS-related misconduct leading up to the 2008-2009 financial crisis (GFC). For example, it notes that Goldman Sachs used net short positions to benefit from the downturn in the mortgage market, and it "designed, marketed and sold collateralized debt obligation (CDO) securities in ways that created conflicts of interest with the firm's clients."
Market participants have since steered away from such problematic transactions, according to Michael Mitchell, a partner at Orrick, Herrington & Sutcliffe, who authored a comment letter on the original proposal for the American Securitization Forum, the predecessor to the Structured Finance Association (SFA).
Once bitten, twice gun shy
The ABS market has avoided conflicting transactions partly due to other rules stemming from Dodd-Frank that have been in place several years already, including the multi-agency credit risk retention rule requiring deal sponsors to retain 5% unhedged exposure to the securitized pool of assets, aligning their interests with investors'.
The re-proposed rule, for which comments are due on or about March 27, would prohibit securitization participants from entering into a "conflicted transaction" for one year after an ABS transaction's closing. Those participants are the deal's underwriter, placement agent or initial purchaser, and its sponsor, and their affiliates or subsidiaries.
The conflicted transactions include a short sale of the ABS—the purchase of a credit default swap or other credit derivative that rewards the participant if the ABS performs poorly—or the purchase or sale of a separate financial instrument that would benefit if the ABS deals perform poorly. In addition, Mitchell said, a "reasonable investor" must consider the conflicted transaction to be important to his or her investment decision, including whether to retain the ABS deal.
Exceptions to the rule?
The proposal does provide exceptions for risk-mitigating hedging activities, bona fide market-making activities, and liquidity commitments. Nevertheless, securitizations and especially collateralized loan obligations (CLOs) have numerous components handled by different participants whose actions, in the normal course of creating and managing ABS, could appear conflicting.
"A prevalent industry concern," Mitchell said, "is whether the text of the proposed rule is sufficiently ambiguous that the SEC could apply the prohibition too broadly."
A broad application could adversely impact routine securitization activity. For example, an investment bank may have an affiliate that provides financing to a borrower to "warehouse" loans until the borrower can pool them, issue ABS, and use the proceeds to pay down the warehouse facility, which an ABS investor could characterize as conflicting if the transaction performs poorly. Or a CLO collateral manager may decide to sell an asset, a move an investor later experiencing losses could second guess, especially since CLOs usually prioritize the fees they pay to collateral managers.
Mitchell said that if the SEC addresses the concerns of applying the rule too broadly and so avoids impacting the normal securitization activities, then the rule is less likely to cause a big ripple in the market, since the conflicted transactions it intends to address—bets against a transaction—are viewed today as problematic.
