Feeling conflicted: SEC Rule 192 and you

¹ Proposed Rule 192 would prohibit any "securitization participant" (a Securitization Participant) delineated under the rule from engaging in transactions that would involve or result in any "material conflict of interest" with respect to any investor in the applicable ABS transaction with respect to which the Securitization Participant is acting.

Scope of the rule: securitization participants

Proposed Rule 192 would apply to Securitization Participants involved in an ABS transaction, which includes (1) underwriters; (2) placement agents and initial purchasers; (3) securitization sponsors; and (4) any affiliate or subsidiary of any of the foregoing. The table below sets forth the definition applicable to such entities under the proposed rule, along with certain key items of interest in relation thereto.

Securitization participant

Key points

Placement agent or underwriter

Proposed definition: Proposed Rule 192 would define a "placement agent" or "underwriter" as "a person who has agreed with an issuer or selling security holder to:

• Purchase securities from the issuer or selling security holder for distribution;
• Engage in a distribution for or on behalf of such issuer or selling security holder; or
• Manage or supervise a distribution for or on behalf of such issuer or selling security holder."²

Key considerations:

• Prong 3 of the proposed definition would capture entities merely managing or supervising a "distribution" of ABS, meaning it not be necessary for the placement agent or underwriter to actually acquire the ABS and on-sell them. This, in turn, implicates placement agents (and their affiliates and subsidiaries) in Section 4(a)(2) private placements in Proposed Rule 192’s prohibitions.
• "Distribution" would have the same definition as under the Volcker Rule, focusing on either (i) the presence of "special selling efforts" and "selling methods" or (ii) the offering of ABS pursuant to an effective registration statement.

Initial purchaser

Proposed definition: Proposed Rule 192 would define "initial purchaser" as "a person who has agreed with an issuer to purchase a security 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 or that are otherwise not required to be registered because they do not involve any public offering."³

Key considerations:

• The definition of "initial purchaser" is consistent with the SEC's prior use of the term in the context of ABS.

Securitization sponsors

Proposed definition: Proposed Rule 192 would, subject to certain exceptions, define the term "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; or
• 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 the asset-backed security; or
• that directs or causes the direction of the structure, design, or assembly of an asset-backed security or the composition of the pool of assets underlying the asset-backed security."⁴

Key considerations:

• The definition of "sponsor" under the proposed rule not only includes the Exchange Act definition of "sponsor" (familiar to market participants in the context of U.S. risk retention), but is broader than that definition in its inclusion of persons who either directs or has contractual rights to direct the ABS transaction. It is also broader than the Regulation AB definition of "sponsor".
• Staff commentary explicitly lists, among others, CLO managers as "sponsors" subject to the proposed rule (a difference in treatment for such managers vs. the U.S. risk retention context in light of the 2018 LSTA v. SEC decision).⁵ Explicitly excluded from the proposed definition of "sponsor" are those entities who perform purely "administrative, legal, due diligence, custodial or ministerial" acts (such as, presumably, trustees, rating agencies, collateral agents, etc.).
• Sponsors need not have a contractual right to structure the deal or direct asset acquisition; mere factual circumstances evidencing that a party did so are sufficient to trigger the prohibitions of Proposed Rule 192.⁶ This would encompass as a sponsor any party that participates in the asset selection process, though the Staff is careful to note that Proposed Rule 192 aims to distinguish ultimate investors seeking to hold long positions in the relevant ABS and who weigh in regarding the assets.⁷

Affiliate and subsidiary

Proposed definition: Proposed Rule 192 would define (i) an "affiliate" of a specified person as "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" and (ii) a "subsidiary" of a specified person as "an affiliate controlled by such person directly, or indirectly through one or more intermediaries."

"Control" would be defined "to mean 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."⁸

Key considerations:

• "Affiliate" and "Subsidiary" would have the same meaning under Proposed Rule 192 as each respectively does for purposes of Regulation S.
• These definitions are broad, and capture indirect and intermediary control, as well as entities that are subject to common control by another entity. In the case of "subsidiaries", majority owned subsidiaries, significant subsidiaries, totally held subsidiaries and wholly owned subsidiaries would all be included under the proposed rule.
• In addition, the Proposing Release notes that information barriers between Affiliates, Subsidiaries and their related Securitization Participant(s) would not exempt the related entities from prohibition set out in Proposed Rule 192⁹ However, the Staff seeks comment on whether or not an exemption for such information barriers would be appropriate, which may suggest openness to the idea (in the commentary to Proposed Rule 192, the Staff suggests four possible conditions for such exemption).¹⁰

Prohibition

As noted above, Proposed Rule 192 would prohibit Securitization Participants from, directly or indirectly, engaging in any transaction that would involve or result in any "material conflict of interest" with respect to any investor in the ABS deal in connection with which the Securitization Participant is acting. This prohibition would apply not only to general ABS transactions, but to synthetic transactions as well,¹¹ and would begin on the date on which the Securitization Participation "has reached, or has taken substantial steps to reach" an agreement regarding that entity's participation in the ABS and end on the date that is one year following the first closing of the sale of the ABS.

A transaction would be subject to the prohibition if it is a "conflicted transaction" (a Conflicted Transaction), which under the proposed rule includes any of the following types of transactions, where there is a substantial likelihood that a reasonable investor would consider the transaction important to the investor's investment decision, including a decision whether to retain the ABS:

• (1) a short-sale of the ABS;
• (2) a purchase of a credit default swap or other credit directive entitling the Securitization Participant to payments on the occurrence of specified credit events under the ABS; or
• (3) the purchase or sale of any financial instrument (other than the ABS itself) or entry into a transaction pursuant to which the Securitization Participant would benefit from any actual, anticipated or potential (i) adverse performance of the underlying ABS portfolio, (ii) losses, early amortization or monetary defaults on the ABS or (iii) a decline in the market value of the ABS.

The proposed rule also contains an anti-circumvention prong intended to capture any transaction which, even if not of a type described above, would violate the spirit of Proposed Rule 192 by being "economically equivalent" to one of the three prohibited transaction types.¹² Notably, this means that market participants would, if rule takes effect as proposed, be required to evaluate any tangential activity undertaken by themselves or their affiliates and subsidiaries on an ongoing basis for economic equivalency as described above. This would add further compliance burdens and uncertainty to an already complex and wide-reaching rule.

Excepted activities

However, there are three activities that are excluded from the definition of a Conflicted Transaction under the proposed rule: certain risk-mitigating hedging (RMH) activities, liquidity commitments and bona fide market-making (BFMM) activities.

1. Risk-mitigating hedging activities

First, the prohibition under the proposed rule would not apply to certain RMH activities of a Securitization Participant in connection with and related to individual or aggregated positions, contracts, or other holdings of the Securitization Participant arising out of its securitization activities. However, such RMH activities must be: (A) at the time of inception (or adjustment, as applicable), designed to reduce or "significantly" mitigate "one or more specific, identifiable risks" arising with respect to such positions, contracts or other holdings, (B) be subject to "ongoing recalibration" by the Securitization Participant to ensure the activity does not facilitate or create an opportunity for actual benefit by the participant (rather than mere risk reduction) and (C) the Securitization Participant must implement, maintain and enforce written internal policies to ensure the foregoing requirements are observed. Notably, "specific" and "identifiable" are not defined by the Proposing Release, though the Staff seek comment as to whether such terms should be defined (and if so, how).

2. Liquidity commitments

Second, the prohibition would not apply to purchases or sales of the ABS made pursuant to, and consistent with, commitments of the Securitization Participant to provide liquidity for the ABS.

3. Bona fide market-making activities

Third, the prohibition would not apply to certain BFMM activities in connection with and related to the ABS, their underlying assets or financial instruments referencing either of the foregoing (any such financial instruments, Relevant Instruments). BFMM activities are only permitted, however, where: (A) the Securitization Participant "routinely stands ready" to purchase and sell one or more types of the Relevant Instruments, and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in the same in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity and depth of the market for the relevant types of financial instruments; (B) the Securitization Participant's BFMM activities are designed not to exceed ongoing "reasonably expected near term demands" for the Relevant Instruments; (C) the compensation arrangements for such BFMM are not designed to reward or incentivize Conflicted Transactions; (D) the Securitization Participant is licensed or registered to engage in such BFMM; and (E) the Securitization Participant implements, maintains and enforces written internal policies to ensure the above.

4. Un-exempted Activity

Notably, as currently drafted, Proposed Rule 192 features neither a disclosure exemption (marking a departure from positions taken by the Staff in connection with Reg AB in respect of conflict-of-interest disclosures) nor an exemption for offshore transactions and/or non-U.S. Securitization Participants (whether or not the Securitization Participation is located in the United States, and whether or not the ABS transaction otherwise has a U.S. nexus or is marketed to U.S. investors). In addition to raising questions about the SEC’s jurisdictional reach over offshore entities and transactions, the absence of an extraterritoriality exemption may cause confusion and uncertainty in the global securitization markets if it comes into effect in its current form, as well as vastly increasing the compliance complexity for those Securitization Participants whose affiliates and subsidiaries are overseas entities or act in non-U.S. markets.

We have designed a flowchart to assist in determining whether an exemption may apply to your specific set of circumstances.

Questions and concerns

Given the complexity and ambiguities present in Proposed Rule 192, market participants will want to consider the following, both for internal purposes and as points upon which they may wish to base their comment submissions to the SEC.

Timing

To what extent are Securitization Participants constrained during the pre-deal phase, as well as during marketing prior to the issuance of the applicable ABS? Staff commentary suggests that the SEC wishes to avoid a situation where a Securitization Participant could enter into a Conflicted Transaction prior to issuance of the relevant ABS.¹³ However, the language of the proposed rule undercuts this given it captures merely taking "substantial steps to reach" (rather than, e.g., actual entrance into) an agreement as the commencement point of a Conflicted Transaction.

• Moreover, the Staff has indicated Proposed Rule 192 is not intended to constrain the activities of someone who either (i) takes substantial steps to reach an agreement to participate, but who ends up not doing so due to commercial breakdown or other reasons or (ii) someone who participates in a failed ABS deal where no ABS is actually ever issued (since in such case, there would be no investors).¹⁴
• On the other hand, the Staff suggests that someone who entered into a Conflicted Transaction prior to being engaged in the securitization would be violating Proposed Rule 192. In such a case, the Staff suggests that the person should withdraw rather than being part of the securitization.¹⁵
• Taken together, the above suggest an unusual degree of retroactive determination for the proposed rule. In other words, in the case of a failed securitization, an action undertaken that would otherwise be a Conflicted Transaction would pose no issues under Proposed Rule 192. However, that same action undertaken prior to closing of the securitization would be seen by the Staff as a rules violation where the transaction successfully results in the issuance of ABS.

Sponsorship

As noted above, the Staff seeks to ensure that an investor "acquiring a long position in the relevant ABS"¹⁶ (emphasis added) who provides input with respect to the structure of the ABS in which they are investing would not be regarded as a "sponsor" for purposes of Proposed Rule 192. More ambiguous, however, is a fact pattern where an investor seeks to hold the ABS only for a moment in time, yet nonetheless provides stipulations with respect to their investment that result in changes being made to the deal structure.

• Does the Staff intend for such entities to be captured as "sponsors"? Logic would suggest this cannot have been the intention, but absent guidance to the contrary, this ambiguity could chill participation in the market by those participants who wish to only hold the ABS position for a limited period of time (whether days, weeks or months, but in any case well before ultimate maturity of the ABS).

Affiliate and Subsidiary Relationships

Absent an information barriers exemption or other safe harbor, the breadth of the definitions for "Affiliate" and "Subsidiary" are such as would likely make compliance very complicated, particularly for large and multi-jurisdictional Securitization Participants, who may have a large number of entities in their corporate families who might end up subject to the Conflicted Transaction prohibition.

• This could pose serious compliance concerns; consider for example the complexity of determining whether a related entity (even one in another country with no direct contact with the Securitization Participant) is entering into a Conflicted Transaction, or alternatively, the complexity in ensuring that all of a Securitization Participant’s related entities are informed about the underlying ABS—with respect to which they are now barred from entering into a Conflicted Transaction—both reliably and promptly. Additionally, existing rules and regulations on information barriers that market participants are subject to may also hinder compliance efforts.
• Moreover, given that "subsidiaries" and "affiliates" are captured by the same prohibition applicable to Securitization Participants, how would JV or other joint-ownership structures be treated? If a JV or other joint-ownership entity could be captured, this would mean that independent third-parties otherwise uninvolved in the ABS transaction (but which nonetheless wish to engage in an activity that, if engaged in by a Securitization Participant of such ABS transaction) would find their own activities limited due to no fault of their own.

Asset Short Sales

The Staff commentary notes that a derivative which references underlying asset performance—and which provides a benefit to the Securitization Participant in the event of the poor performance thereof—would fall within the ambit of Proposed Rule 192.¹⁷ Does this, however, also mean that short sales of individual (or multiple) assets in the underlying pool by any Securitization Participant are considered Conflicted Transactions, even if the portion of the portfolio being shorted is de minimis or below a materiality threshold?

Risk-Mitigating Hedging

• The current proposed exception requires that the RMH activities be, at the time of their inception, designed to reduce or mitigate "one or more specific, identifiable risks" arising with respect to the relevant positions. However, "specific" and "identifiable" are not defined in the Proposing Release. This creates ambiguity for Securitization Participants and can make it difficult to achieve certainty with respect to exemption status. For example, would a risk be "specific" where a Securitization Participant enters into a hedge designed to hedge a portion of the names in, but not all the names in, an underlying portfolio of corporate loans? As to "identifiable", does the risk in question need to be objectively identifiable to anyone in the same position as the Securitization Participant, or is this standard subjective?
• Similarly, the current proposal requires that the RMH activities be subject to "ongoing recalibration" by the Securitization Participant to ensure the activity does not facilitate or create an opportunity for actual benefit by the participant (rather than mere risk reduction). How often does a Securitization Participant need to recalibrate to satisfy this requirement, and what constitutes "recalibration"? Likewise, if there is a possibility for benefit (i.e. an "opportunity"), however remote, but no benefit is ever actually received by the participant, would the RMH activity fall outside the as-drafted exemption? In terms of the "benefit", would this also capture intangible benefits (e.g. reputational) rather than purely monetary gain?

Please reach out to the A&O team if you have any further questions or would like to discuss.

Footnotes

1 Prohibition Against Conflicts of Interest in Certain Securitizations, Securities and Exchange Commission, Release No. 33-11151, available on the SEC website(hereinafter, the Proposing Release).
2 See Proposing Release, p. 21.
3 Proposing Release, pp. 23-24.
4 Proposing Release, pp. 26-27.
5 See Proposing Release, p. 27. The commentary specifically calls out as sponsors "a portfolio selection agent for a CDO transaction, a collateral manager for a CLO transaction with the contractual right to direct asset purchases or sales on behalf of the CLO, or a hedge fund manager or other private fund manager who directs the structure of the ABS or the composition of the pool of assets underlying the ABS as described in the definition."
6 The Staff notes that the rule is designed to capture situations like "certain well-known examples of synthetic CDOs that were issued in the lead up to the financial crisis of 2007-2009" in which hedge funds seeking to short the CDO effectively set up the structure to fail. See Proposing Release, p. 31.
7 The Staff is careful to note that "[a]n ABS investor that is acquiring a long position in the relevant ABS would be expected to provide input with respect to the structure of the ABS investment or the underlying pool of assets for the purpose of maximizing the expected value of its ABS investment," and would, accordingly, note be regarded as a "sponsor". See Proposing Release, p. 32. 8 Proposing Release, p. 47.
9 See Proposing Release, p. 50.
10 See Proposing Release, pp. 51-52. The hypothetical requirements suggested by the Staff include (i) physical separation of applicable personnel, (ii) the existence of a written, internal control structure to enforce such information barriers, (iii) a requirement that the Securitization Participant obtain an annual, independent assessment of its information barrier controls and (iv) a requirement that there be no shared personnel between the Securitization Participant and the Affiliate or Subsidiary in question.
11 See Proposing Release, p. 11.
12 See Proposing Release, p. 83. "We received comment on the 2011 proposed rule that the rule should address potential evasion of the rule’s prohibition on material conflicts of interest, and commenters noted a variety of ways in which a securitization participant might attempt to evade the re-proposed rule’s prohibition. We agree with such commenters that potential evasion of the re-proposed rule could weaken the re-proposed rule’s conflict of interest protection. Accordingly […] Proposed Rule 192(d) would address a securitization participant circumventing the re-proposed rule’s prohibition on material conflicts of interest by structuring one or more transactions to fall outside of the prohibition (including its permitted exceptions) while nonetheless engaging in a transaction that is economically equivalent to a type of transaction specified in the proposed definition of “conflicted transaction." (emphasis added)
13 See Proposing Release, p. 57. "The re-proposed rule’s approach to the commencement point is designed to reduce the circumstances in which a person could engage in prohibited conduct prior to the issuance of the relevant ABS."
14 See Proposing Release, pp. 57-58. The Staff notes that "under the re-proposed rule, the prohibition on material conflicts of interest would not apply to a person that never reaches an agreement to become an underwriter, placement agent, initial purchaser, or sponsor of an ABS, even if such person were to take substantial steps to reach such an agreement." (emphasis added).
15 See Proposing Release, p. 58.
16 See Proposing Release, p. 32.
17 See Proposing Release, p. 66. "[T]he financial instruments captured under proposed Rule 192(a)(3)(iii) would, for example, include entering into the short-side of a derivative (with the special purpose entity issuer of a synthetic CDO or otherwise) that references the performance of the pool of assets underlying the ABS with respect to which the person is a securitization participant under the reproposed rule and pursuant to which the securitization participant would benefit if the referenced asset pool performs adversely."