On November 27, 2023, the Securities and Exchange Commission (the "Commission") adopted Rule 192 under the Securities Act of 1933 (the "Securities Act"), a rule that is designed to prohibit "material conflicts of interest" in certain securitizations.1 Rule 192 implements Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"),2 which was codified as Section 27B ("Section 27B")3 of the Securities Act. Subject to certain exceptions, Section 27B prohibits certain participants in asset-backed securities ("ABS")4 securitization transactions from engaging in transactions within a designated time period that would involve or result in any "material conflict of interest." Section 27B directed the Commission to issue rules implementing this prohibition no later than 270 days after the enactment of Dodd-Frank (i.e., within 270 days of July 21, 2010).5

After originally proposing Rule 127B in September of 2011,6 in response to the Section 27B mandate, but taking no further action on that proposed rule for nearly 12 years, the Commission proposed Rule 192 on January 25, 2023 (the "Re-Proposal")7 to supersede proposed Rule 127B. While proposed Rule 127B largely tracked the text of Section 27B, the Re-Proposal asserted that Rule 192 is designed to "provide greater clarity regarding the scope of prohibited and permitted conduct."8

Rule 192 will become effective 60 days after its publication in the Federal Register; and compliance with Rule 192 will be required with respect to any ABS "the first closing of the sale of which" occurs 18 months after such publication date. The text of Rule 192 is set forth in Appendix A hereto.

BRIEF OVERVIEW

  1. SCOPE and PROHIBITION

Rule 192 prohibits:

  • an underwriter, placement agent, initial purchaser or sponsor of an ABS, as well as certain affiliates or subsidiaries of such an entity (collectively, "Securitization Participants");
  • for a period commencing on the date on which a person "has reached an agreement that such person will become a Securitization Participant with respect to an ABS" and ending on the date that is one year after the date of the first closing of the sale of such ABS;
  • from directly or indirectly engaging in any transaction that would involve or result in a "material conflict of interest" between the securitization participant and an investor in such ABS (e., a "Conflicted Transaction").
  1. EXCEPTED ACTIVITIES

As provided in Section 27B, the following three categories of activities are excluded from the prohibition in Rule 192:

  • risk-mitigating hedging transactions designed to reduce specific, identifiable risks to a Securitization Participant in connection with, and related to, positions, contracts or other holdings of the Securitization Participant;
  • purchases or sales made pursuant to commitments of Securitization Participants to provide liquidity for the ABS; and
  • purchases or sales made pursuant to bona fide market-making in the ABS, the underlying assets of the ABS or financial instruments that reference the ABS.
  1. KEY DIFFERENCES from PROPOSED RULE 192

Rule 192 largely retains the contours of the rule as proposed in the Re-Proposal. However, it narrows the sweep of proposed Rule 192 in several key respects:

  • narrowing the affiliates and subsidiaries that would be captured by the Securitization Participant definition to those that act "in coordination with" a Securitization Participant or receive or have access to pre-closing information regarding an ABS, without incorporating a formal, prescriptive "information barrier" exclusion;
  • allowing the initial distribution of an ABS to fall within the risk-mitigating hedging exception, thereby permitting synthetic ABS that perform a risk-mitigating function to be issued;
  • including a "safe harbor" for ABS issued by non-US persons and offered and sold in compliance with Regulation S under the Securities Act;
  • removing the "start-date" reference to having "taken substantial steps" to reach an agreement to become a Securitization Participant, but still leaving some ambiguity as to the "start-date";
  • clarifying that a person acting "solely pursuant to [its] contractual rights as a holder of a long position" in the applicable ABS is not a "sponsor" and therefore not included in the definition of Securitization Participant;
  • removing the proposed exclusion from "sponsor" status for Fannie Mae and Freddie Mac while they remain in the conservatorship, but making clear that the synthetic credit risk transfer transactions in which they engage are not prohibited, even if they exit conservatorship;
  • removing from the "sponsor" definition persons that have the non-contractual ability to direct the structure, design or assembly of an ABS; and
  • clarifying that the term "sponsor" does not include a person that is solely responsible for "ongoing administration" of an ABS, including servicers, but noting that the status of special servicers is subject to a "facts and circumstances" analysis.

BACKGROUND

Section 27B was enacted to prohibit underwriters, sponsors and others who assemble and sell ABS from profiting from the securities' failure.9 The Adopting Release characterizes this objective as prohibiting "transactions that effectively represent a "bet" against the performance of an ABS...."10 Although the Re-Proposal acknowledged that the securitization markets have undergone various changes since Section 27B was enacted and that the Commission does "not have data on the [current] extent of" the conduct that gave rise to that provision,11 the contours of Rule 192 as adopted, remain very similar to those of the proposed rule (except as noted above). In that regard, Commissioner Peirce – the lone dissenting Commissioner – expressed the view that although the rule is an improvement over the Re-Proposal, it nevertheless contains "lingering ambiguities" and continues to be characterized by "over-breadth."12 She expressed concern as to whether the rule successfully "stops the types of conflicted transactions that plagued financial crisis era securitizations without placing undue burdens on ordinary course transactions."13

KEY COMPONENTS OF THE PROHIBITION

Consistent with Section 27B, Rule 192 applies (unless an exception is available) when a transaction: (1) involves an asset-backed security; (2) is effected by a covered person (i.e., a Securitization Participant); (3) is deemed to involve a "conflict of interest" that is "material"; and (4) is effected during a covered timeframe. Rule 192 attempts to bring clarity with respect to each of those concepts.

  1. COVERED PERSONS

Rule 192(c) includes specific definitions for the terms underwriter, placement agent, initial purchaser and sponsor; and it defines the terms "affiliate" and "subsidiary" by reference to the definitions in Rule 405 under the Securities Act.

"Underwriter," "Placement Agent" and "Initial Purchaser" Definitions

The terms "underwriter" and "placement agent" are unchanged from those in the Re-Proposal. Rule 192 identically defines those terms as a person who has agreed with an issuer or selling security holder to: (1) purchase securities from the issuer or selling security holder for distribution; (2) engage in a distribution for or on behalf of the issuer or selling security holder; or (3) manage or supervise a distribution for or on behalf of such issuer or selling security holder. The term "distribution" (which also is unchanged from the Re-Proposal) is, in turn, defined to mean: (1) "an offering of securities, whether or not registered under the Securities Act, that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods"; and (2) an offering of securities made pursuant to an effective Securities Act registration statement. The Adopting Release notes that the focus on "special selling efforts and selling methods" is designed to distinguish an ABS offering from secondary trading and that indicia of those efforts and methods include greater than normal sales compensation, delivering a sales document and conducting road shows.14

The term "initial purchaser" is separately defined in Rule 192(c), to capture a person that has agreed with an issuer to purchase securities from the issuer for resale to other purchasers in transactions that are not required to be registered under the Securities Act in reliance upon Rule 144A under the Securities Act or because they do not involve any public offering. That term also is unchanged from the proposed rule.

The Adopting Release notes that the foregoing definitions are based on the function a person has agreed to perform, rather than the person's title,15 and that "no factual determination" as to whether that person had direct involvement in the structure or design of the ABS is required.16 The Adopting Release expresses the view that a person that has an agreement with the issuer to perform the enumerated functions "would likely be privy to information about the ABS or underlying assets, giving them the opportunity to influence the structure of the relevant ABS and engage in a bet against it."17 The Adopting Release clarifies, however, that selling group members that do not have a direct relationship with the issuer are not underwriters, placement agents or initial purchasers for purposes of Rule 192.18

"Sponsor" Definition

With respect to the term "sponsor," subparagraph (i) of the Rule 192(c) definition essentially incorporates the Regulation AB definition of that term, defining a "sponsor" as: "any person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the entity that issues the asset-backed security."

However, subparagraphs (ii)(A) and (ii)(B) of the definition significantly expand upon the Regulation AB definition by including "any person with a contractual right to direct or cause the direction of the structure, design, or assembly of an asset-backed security or the composition of the pool of assets underlying or referenced by the asset-backed security," other than "a person who acts solely pursuant to such person's contractual rights as a holder of a long position in the asset-backed security."19 The Adopting Release expresses the view that the scope of the definition "is necessary to capture the relevant securitization participants that would have the incentive and ability to engage in conflicted transactions as a result of their ability to structure, design, or assemble an ABS or its underlying or referenced asset pool."20 However, the release explains that a person can be a contractual rights sponsor even if it does not actually exercise that right because it would have access to information regarding the ABS prior to their sale "and would therefore have the opportunity to use that information to engage in a conflicted transaction."21

The newly-added express exclusion for persons who act "solely pursuant to" their contractual rights as holders of long positions will be helpful for ABS investors, such as "B-piece buyers" in CMBS issuances. However, the inclusion of the word "solely" makes the availability of this carve-out subject to a facts and circumstances analysis, including with respect to any other roles the investor may have in the transaction (e.g., acting as special servicer) and any affiliation it may have with the special servicer or another transaction participant.22

In another potentially helpful change, the Commission eliminated from the definition of "sponsor" a person that has the non-contractual ability to influence the asset selection process. This deletion was made partly to ensure that ABS investors would not be deemed to be "sponsors" merely because they engage in an iterative negotiation process with deal participants.23

Persons that perform "only administrative, legal, due diligence, custodial, or ministerial acts related to the structure, design, or assembly, or ongoing administration" of an ABS are excluded from the Rule 192(c) sponsor definition. The "ongoing administration" concept is a newly-added clarification and encompasses servicers.24 However, the Adopting Release indicates that the status of a special servicer should be determined on a "facts and circumstances" basis.25 The Adopting Release notes that "the ability to determine whether (and when) to negotiate a work-out of a loan, take possession of the property collateralizing the loan, and purchase the loan out of the securitization at a discount" may not be consistent with the types of administrative or ministerial functions eligible for the "ongoing administration" exclusion.26 Of course, this fails to take into account the fact that transactions without a special servicer require the servicer to undertake activities to address troubled assets.

Certain Persons Included in and Excluded from the Sponsor Definition

The Adopting Release notes that sponsors could include, among others, collateral managers for collateralized loan obligations ("CLOs") and municipal advisors.27

Although Commissioner Peirce commented, in the context of the Re-Proposal, that "municipal entities are unlikely to engage in conflicted transactions" and therefore suggested that consideration should be given to exempting those entities from the prohibition altogether and other commenters echoed this view,28 the rule, as adopted, does not exclude municipal issuers from the "sponsor" definition.29

Rule 192(c) excludes from the definition of "sponsor" "the United States or an agency of the United States with respect to any ABS that is fully insured or fully guaranteed as to the timely payment of principal and interest by the United States."30 However, any other Securitization Participants involved in such an ABS transaction. Such transactions, such as ABS guaranteed by the Government National Mortgage Association (i.e., "Ginnie Mae"), would be subject to Rule 192, including Ginnie Mae issuers.31

The Re-Proposal had contained an exclusion from the "sponsor" definition for Fannie Mae and Freddie Mac with respect to securities that are fully insured or fully guaranteed by them as to the timely payment of principal or interest, but only for so long as they are operating under the conservatorship or receivership of the Federal Housing Finance Agency. However, this exclusion was not included in Rule 192, as adopted.32

The Adopting Release emphasizes that warehouse financing is "a routine activity to finance the purchase of assets by a securitization participant in furtherance of the issuance of an ABS" and that "a lender's right to determine which assets it is or is not willing to finance pursuant to its underwriting standards, does not meet the definition of "sponsor.""33 However, as is the case with any entity, affiliation with a Securitization Participant could potentially create Securitization Participant status.34 The Adopting Release also indicates that third-party asset sellers do not become "sponsors" purely by virtue of originating and selling assets to the ABS sponsor.35

"Affiliate" and "Subsidiary" Definitions; No Explicit Use of Information Barriers

The Re-Proposal defined the terms "affiliate" and "subsidiary" solely by reference to Rule 405 under the Securities Act, which would have caused those terms to sweep very broadly.36 However, in response to commenter concerns, the rule now limits those terms to affiliates and subsidiaries, as each defined in Rule 405, that: (1) act "in coordination with" an underwriter, placement agent, initial purchaser, or sponsor; or (2) have access to or receive information about the relevant ABS or the asset pool underlying the relevant ABS prior to the first closing of the sale of the relevant ABS.

Although the rule, as adopted, does not explicitly incorporate the use of information barriers, due to concerns that a prescriptive information barrier exception could be either too permissive for some market participants or too difficult for other participants to satisfy,37 the Adopting Release does note that information barriers can be central to assuring that an affiliate or subsidiary is not acting in coordination with a Securitization Participant and does not have access to or receive information about the applicable ABS or asset pool.38 The Adopting Release also discusses the criteria that can be used to identify the requisite "separateness."39

Therefore, Securitization Participants will be required to conduct factual assessments of their corporate structures to identify the affiliates and subsidiaries that could be deemed to be fall within the "sponsor" definition and, if necessary, implement measures to avoid that status or measures to assure compliance with Rule 192. In the case of Securitization Participants that are part of a large corporate family, this could be time-consuming and difficult process.

  1. COVERED ABS TRANSACTIONS

As required by Section 27B, Rule 192(c) applies to any asset-backed security, as that term is defined in Section 3(a)(79) of the Exchange Act, as well as to any synthetic ABS. Unlike proposed Rule 127B, Rule 192(c) also applies to any hybrid cash and synthetic ABS.40 The Adopting Release highlights the fact that the definition includes both ABS sold in registered and exempt offerings, making clear that both types of offerings could result in potential conflicts of interest.41

Synthetic CLOs and Other Synthetic ABS

Although the Re-Proposal could have been read to prohibit the issuance of synthetic balance sheet CLOs for risk management purposes, the Adopting Release makes clear that these transactions are not prohibited so long as they satisfy the risk-mitigating hedging exception described below.42

Although many commenters requested that the term "synthetic ABS" be defined and certain commenters offered proposed definitions,43 the rule, as adopted, does not do this. However, the Adopting Release notes that the Commission generally views a synthetic ABS "as a fixed income or other security issued by a special purpose entity that allows the holder ... to receive payments that depend primarily on the performance of a reference self-liquidating financial asset or a reference pool of self-liquidating financial assets."44

Transactions Not Included

Although the Re-Proposal requested comment regarding whether a catch-all provision should be added to the ABS definition to cover any product that functions as the equivalent of a cash ABS, synthetic ABS or a hybrid cash and synthetic ABS,45 the rule, as adopted, does not do this. Rather, the Adopting Release attempts to clarify that products that arguably could have been captured by this sort of broad catch-all are not subject to the rule.

In particular, the Adopting Release makes clear that mortgage insurance linked notes are not ABS, nor are corporate debt securities, even if they transfer risk regarding specific assets.46 The release also confirms that equity-linked or commodity-linked products are not ABS because they do not involve self-liquidating financial assets and that security-based swaps are not ABS because they are financial contracts between two counterparties that do not involve the issuance of a security from a special purpose entity.47

Exclusion for Foreign Securitizations

Unlike the proposed rule, Rule 192 includes an exclusion for securitizations effected by non-US issuers (as defined by reference to Regulation S under the Securities Act) and offered and sold in compliance with Regulation S.48 The Adopting Release notes that this exclusion is intended to parallel the exclusion under Rule 15Ga-2(e).49 However, the Adopting Release notes that, if there are ABS sales in the United States, the provisions of Rule 192 apply.50

Footnotes

1. See Prohibition against Conflicts of Interest in Certain Securitizations, SEC Release No. 33-11254; File No. s7-01-23; (Nov. 27, 2023) (the "Adopting Release"), available at https://www.sec.gov/files/rules/final/2023/33-11254.pdf.

2. Pub. L. 111-203, 124 Stat. 1376 (2010).

3. 15 U.S.C. 77z-2a.

4. Proposed Rule 192(c) defines "ABS" to mean an asset-backed security as defined in Section 3(a)(79) of the Securities Exchange Act of 1934 (the "Exchange Act"), as well as synthetic asset-backed securities and hybrid cash and synthetic asset-backed securities.

5. 15 U.S.C. 77z-2a(b).

6. See Prohibition against Conflicts of Interest in Certain Securitizations, SEC Release No. 34-65355; File No. s7-38-11; (Sept. 19, 2011), 76 Fed. Reg. 60320 (Sept. 28, 2011) ( the "2011 Release"), available at http://www.sec.gov/rules/proposed/2011/34-65355fr.pdf.

7. See Prohibition against Conflicts of Interest in Certain Securitizations, SEC Release No. 33-11151; File No. s7-01-23; (Jan. 25, 2023), 88 Fed. Reg. 9678 (Feb. 14, 2023) (the "Re-Proposal"), available at https://www.govinfo.gov/content/pkg/FR-2023-02-14/pdf/2023-02003.pdf.

8. Re-Proposal, supra note 7, at 9679.

9. Congressional Record, S5899 (July 15, 2010) (statement of Sen. Carl Levin).

10. Adopting Release, supra note 1, at 9

11. Re-Proposal, supra note 7, at 9679.

12. Commissioner Hester M. Peirce, Statement on Adoption of Rule Prohibiting Conflicts of Interest in Certain Securitizations (Nov. 27, 2023).

13. Id.

14. Adopting Release, supra note 1, at 35 and footnote 137.

15. Id. at 35 and 39.

16. Id. at 37.

17. Id.

18. Id. at 36.

19. Text of proposed Rule 192, infra, Appendix A at § 230.192(c) (emphasis added).

20. Adopting Release, supra note 1, at 58–59.

21. Id. at 58.

22. Id. at 51–52.

23. Id. at 51.

24. Id. at 60–62.

25. Id. at 62.

26. Id.

27. Id. at 39 and 55.

28. See Commissioner Hester M. Peirce, Statement on Proposed Rule Prohibiting Conflicts of Interest in Certain Securitizations (Jan. 25, 2023) (noting that, in the event a municipal entity elects to establish compliance procedures as a defense against an enforcement investigation, it would incur "unnecessary costs").

29. Adopting Release, supra note 1, at 18. The Adopting Release notes that, even if municipal issuers might be subject to constraints that limit their ability to engage in conflicted transactions, underwriters and other Securitization Participants are not subject to those constraints.

30. Id. at 11 and 38.

31. Id. at 65.

32. Id. at 68.

33. Id. at 56–57.

34. Id. at 57.

35. Id. at 63–64.

36. Under Rule 405, an "affiliate" of a specified person is a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified. A "subsidiary" of a specified person is an affiliate controlled by such person directly, or indirectly through one or more intermediaries. "Control" means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise. See 17 C.F.R. 230.405.

37. Adopting Release, supra note 1, at 74.

38. Id. at 77.

39. Id. at 76–77. The Adopting Release notes that those include: (1) information barriers, including written procedures to prevent the flow of information between relevant entities, and physical separation of personnel; (2) separate trading accounts; (3) the absence of officer and employee interlocks; (4) involvement in unrelated businesses; or (5) the absence of trading authority or trade pre-approval authority on the part of any personnel with oversight or managerial responsibility.

40. See Id. at 15; Re-Proposal, supra note 7, at 9681 (noting that, given that the prohibition in Section 27B applies to both Exchange Act ABS and synthetic ABS, "it would be inconsistent for the rule not to apply to a hybrid ABS that has characteristics of both cash ABS and synthetic ABS.").

41. Adopting Release, supra note 1, at 20–21.

42. Id. at 225.

43. Id. at 14–15.

44. Id. at 24.

45. Re-Proposal, supra note 7, at 9682.

46. Adopting Release, supra note 1, at 21–22 and 24–25.

47. Id. at 25.

48. See Section (e) of Rule 192.

49. Adopting Release, supra note 1, at 29.

50. Id. at 27.

To view the full article click here

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.