SEC proposes rules to prohibit conflict of interest in ABS transactions

3rd December, 2011: Emerging from the skin in game debate on securitization that we have witnessed in during the recent financial crisis, the Securities and Exchange Commission has proposed rules (Rules 127B) under Securities Act, 1933 to address the material conflicts of interest issue in connection with certain securitizations. The intent of the proposed rule is to prohibit material conflict of interest between those who package and sell asset-backed securities (ABS) and those who invest in them. 

The genesis of the rule lies in Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) which inserted Section 27B to the Securities Act. Under this section certain securitization participants such as underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity will be prohibited from engaging in a transaction that would involve or result in ‘material conflict of interest’.  

The prohibition under the newly inserted section is applicable on asset backed securities (ABS), including synthetic ABS, whether registered or unregistered. The proposed rule 127B prohibits securitization participants to engage in transactions within one year after the date of the first closing of the sale of the asset-backed security that would involve or result in a material conflict of interest with respect to any investor in the asset-backed security. The conditions for the prohibition to apply are that the transaction must involve, covered persons, covered product, covered timeframe, covered conflicts and material conflict of interest. The rule broadly prohibits securitization participants from benefiting from the failure of financial instruments that they help structure, offer and sell to investors, even if that securitization participant did not intentionally cause, or increase the likelihood of, such decline. 

The proposed rules also lay down two tests for material conflict of interest which includes 1) in case the securitization participant benefits directly or indirectly from the actual, anticipated or potential adverse performance of the underlying pool of assets, decline in market value of ABS, loss of principal, monetary default or early amortization event on the ABS or the securitization participant would structure the ABS in such a way that he would benefit from the decline in the ABS or underlying securities in the ABS and 2) there is a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision. 

The proposed rule also provides for exceptions to the prohibitions for certain risk-mitigating hedging activities, liquidity commitments and bona-fide market making. However the exceptions to the rules are only available where the activities mitigate the risks of the parties, limit the consequences of risks, and however would not permit speculative trading in the mask of hedging activities or to meet the liquidity commitments of these participants or for “bonafide” market making requirements.

The proposed rules are open for public comments on or before 19^th December, 2011. The text of the proposed rules can be seen here.   

[Reported by: Nidhi Bothra]

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