On September 19, 2011, the Securities and Exchange Commission (SEC) released its proposed rule to prevent conflicts of interest in certain asset-backed securities (ABS) transactions (securitizations). The proposal comes just a week after news reports that the SEC widened its investigation into securitizations in which the underwriter or sponsor of the deal, or a third party hedge fund with influence over selecting the assets underlying the securitization, took a short position such that it stood to gain if the deal's investors lost. In case there was any doubt that the proposal was motivated to prohibit transactions such as the now notorious Abacus 2007-AC1 synthetic collateralized debt obligation (CDO) sponsored by Goldman Sachs at the behest of hedge manager John Paulson, the proposal expressly cites to such deals as indicative of "the existence and potential effects of conflicts of interest" in securitizations.
This post summarizes the SEC's 118-page proposed rule and makes some preliminary observations.
The SEC's proposed Securities Act Rule 127B is mandated by Section 27B of the Dodd-Frank Act, which prohibits material conflicts of interest between securitization investors and any "securitization participant," that is, any securitization underwriter, placement agent, initial purchaser, or sponsor. The proposal
make[s] it unlawful for a securitization participant to engage in any transaction that would involve or result in any material conflict of interest between the securitization participant and any investor in an ABS that the securitization participant created or sold at any time for a period ending on the date that is one year after the date of the first closing of the sale of the ABS.
The SEC expressly recognizes that there are benefits from securitization and that conflicts of interest are inherent to the process. Accordingly, in implementing its Dodd-Frank mandate, the SEC does not seek to prohibit all conflicts of interest outright but rather "to strike an appropriate balance between prohibiting the specific type of conduct at which Section 27B is aimed without restricting other securitization activities."
As a threshold matter, the proposed rule only applies to "(1) covered persons, (2) covered products, (3) a covered timeframe, (4) covered conflicts and (5) a material conflict of interest."
Covered persons are securitization participants other than investors--those having primary control in the securitization process, that is, any underwriter, placement agent, initial purchaser, or sponsor, or any of their affiliates or subsidiaries. Covered products include any cash or synthetic asset-backed security. The covered time frame extends from the initiation of the transaction up to one year after the sale of the asset-backed securities in any particular deal. The types of conflicts of interest the proposal seeks to prohibit are those between investors and covered persons, and not conflicts among securitization participants or among investors.
The proposal does not define material conflict of interest. However, using a two-part test the proposal identifies a conflicted transaction as one in which a securitization participant takes a short position that a reasonable investor would consider important. Taking a short position means that the securitization participant would benefit from a loss or decline in value of the issued securities, or is paid by a third party itself taking such a short position. The proposal seeks to prohibit an ABS from being sold "on the premise that it will be a good investment" when it is actually "designed to fail." The proposal also is motivated by the SEC's view that investors in ABS often do not know as much about the underlying securities as securitization participants and rely on the participants to asses their quality.
The proposal provides three exemptions: for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making. An otherwise prohibited conflicted transaction would not be probhitied if it qualifies under any of the three exemptions. The Volcker Rule contains comparable exemptions for risk-mitigating hedging activities and bona fide market-making activities, and the SEC noted that its exemptions should not be viewed any less narrowly.
Participants in a securitization necessarily expose themselves to risks while the deal is being undertaken and before the securities are sold to investors. The proposal therefore exempts risk-mitigation hedging activities that are designed to reduce the specific risks to securitization participants from an existing position or one about to be taken in connection with the securitization. Exempted hedging activities do not include "speculative trading masked as risk-mitigating hedging activities" such as trading to establish new positions or over-hedging positions. Hedging also does not include positions that would result in net profits to the securitization participant from a loss or decline in value of the issued securities. Hedging activities must also be reduced in proportion to a participant's risk exposures.
Securitization participants may also provide liquidity enhancements to ensure that investors properly receive their expected principal and interest payments. Liquidity enchantments may be necessary to cover any cash flow shortfalls from the assets underlying the securitization or temporal mismatches between the assets' cash flows and those required to be paid to investors, which often have a shorter maturity or more frequent payment schedule. The proposal exempts such liquidity commitments from the prohibition on conflicts.
Finally, although ABS are not widely traded in secondary markets, some securitization participants, or their dealer affiliates or subsidiaries, may nonetheless attempt to make markets in ABS. Bona-fide market-making qualifies for an exemption under the proposal and, under the principles identified in the proposal, generally consist of secondary market trading and customer driven transactions. Bona-fide market making does not include speculation- or investment-related dealer activities or activities that result in historically disproportionate open positions or those that expose dealers to substantial risk from changes in the market prices of ABS.
To better clarify the application of the rule, the proposal provides several categories of examples of transactions that do or do not involve prohibited conflicts. Example transactions involving prohibited conflicts by definition do not fall under any of the three statutory exemptions.
Shorting by an Underwriter
One category of prohibited transactions involve securitization participants, such as the underwriter, short selling either the ABS securities sold to investors or the securitization's assets. The proposed rules do, however, permit as an exempted hedging activity an underwriter to purchase CDS protection on the ABS it purchased and that it also distributed to investors.
Another category of prohibited transactions are certain synthetic ABS transactions. These transactions involve a securitization sponsor taking a short position in the securitization's assets by puchasing CDS from the issuer (a special purpose entity). One type of prohibited transaction is a synthetic ABS is where the sponsor does not have any exposure to the ABS or underlying assets other than its short position through the CDS referencing the assets. This example seems to target transactions such as the Goldman Sachs Abacus synthetic CDO program where Goldman was the protection buyer (Financial Crisis Inquiry Comission (FCIC) Report pages 143-145). Presumably, a bank or financial institution with credit assets on its balance sheet that purchases CDS protection from an issuer in a synthetic ABS (as discussed on page 7 of the proposal) would not fall within this prohibition.
A second type of prohibited synthetic ABS includes a sponsor, purportedly marketing ABS as a good investment, transferring the risk of its investment in the assets underlying a securitization through a synthetic ABS because it developed a negative view of the assets. Importantly, the proposal notes that offsetting a long exposure to underlying assets does not qualify under the hedging exemption because what is being hedged is an existing exposure to assets underlying a completed securitization deal with ABS outstanding, as opposed to the risks of assets associated with (or arising out of) the underwriting of a securitization while it is still in the process of being structured and sold to investors. This example seems to prohibit the types of synthetic CDO transactions undertaken by commercial and investment banks that ultimately resulted in the risk of super senior tranches backed by subprime mortgage-backed securities being transferred to AIG (FCIC Report page 140).
The proposal also gives two examples of transactions involving a securitization participant purchasing CDS protection from an issuer that are not prohibited. One is where a securitization participant has accumulated a long cash or derivatives position in the underlying assets solely in anticipation of creating and selling a synthetic ABS. Another type of permitted synthetic ABS transaction is where a securitization participant that purchased a CDS from the issuer simultaneously sells offsetting protection to a market participant having no role in the ABS transactions (i.e., that had no role in selecting the securitization's assets).
Placement Agents Facilitating Third Party Shorts
A final category of sample transaction involves a securitization placement agent benefiting from allowing a third party taking a short position in the ABS (third party short) to select the assets in a securitization. A third party short would likely be a hedge fund or other asset management firm seeking to select risky securitization assets to make the short position more valuable. The placement agent may directly facilitate the third party short's position and get paid a fee, or not facilitate the short position and only indirectly benefit by, for example, obtaining future business referred by the third party. Either way, the proposed rules prohibit such activities.
The proposal does, however, permit placement agents to allow third parties that purchased ABS to select the securitization's assets and take a short position. However, the proposal prohibits such a third party to purchase CDS on the ABS so that it would gain more from a decline in their value than it would lose on its long position. This rule would effectively prohibit "correlation trades" of the type undertaken by hedge fund Magnetar.
The SEC's proposed rule is open for a 90-day comment period. Given the proposal's length, complexity, and relevance to the future of U.S. capital markets, undoubtedly numerous market participants and their representatives will file comments in response to the SEC's request for them.