# Prohibition Against Conflicts of Interest in Certain Securitizations > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2011-24404 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** September 28, 2011 - **Citation:** 76 FR 60320 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 230 [Release No. 34-65355; File No. S7-38-11] RIN 3235-AL04 Prohibition Against Conflicts of Interest in Certain Securitizations AGENCY: Securities and Exchange Commission. ACTION: Proposed rule. SUMMARY: The Securities and Exchange Commission (“Commission”) is proposing for comment a new rule under the Securities Act of 1933 (“Securities Act”) to implement the prohibition under Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) on material conflicts of interest in connection with certain securitizations. Proposed Rule 127B under the Securities Act would prohibit certain persons who create and distribute an asset-backed security, including a synthetic asset-backed security, from engaging 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 proposed rule also would provide exceptions from this prohibition for certain risk-mitigating hedging activities, liquidity commitments, and bona fide market-making. DATES: Comments should be received on or before December 19, 2011. ADDRESSES: Comments may be submitted by any of the following methods: Electronic Comments • Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed .shtml ); or • Send an e-mail to rule-comments@sec.gov. Please include File Number S7-38-11 on the subject line; or • Use the Federal eRulemaking Portal ( http://http://www.regulations.gov ). Follow the instructions for submitting comments. Paper Comments • Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549. All submissions should refer to File Number S7-38-11. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Web site ( http://www.sec.gov /rules/proposed.shtml ). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: Elizabeth Sandoe, Senior Special Counsel, David Bloom, Branch Chief, Anthony Kelly, Special Counsel, Barry O'Connell, Attorney Advisor, Office of Trading Practices and Processing and Jack I. Habert, Attorney Fellow, Division of Trading and Markets, at (202) 551-5720, and David Beaning, Special Counsel and Katherine Hsu, Chief, Office of Structured Finance, Division of Corporation Finance, at (202) 551-3850, at the Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549. SUPPLEMENTARY INFORMATION: The Commission is requesting public comment on proposed Rule 127B under the Securities Act. I. Introduction Section 621 of the Dodd-Frank Act adds new Section 27B to the Securities Act. 1 This new Section of the Securities Act prohibits an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity (collectively “securitization participants”), of an asset-backed security (“ABS”), including a synthetic ABS, from engaging in a transaction that would involve or result in certain material conflicts of interest. 2 The prohibition under Securities Act Section 27B applies to both registered and unregistered offerings of ABS. 3 This prohibition applies during the period ending on the date that is one year after the date of the first closing of the sale of the ABS. Section 27B provides exceptions from the prohibition described above for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making. 4 1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, § 621, 124 Stat. 1376, 1632 (2010). 2 Section 27B(a) of the Securities Act states that an “underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (as such term is defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c), which for the purposes of this section shall include a synthetic asset-backed security), shall not, 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 asset-backed security, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity.” 15 U.S.C. 77z-2a(a). 3 See infra Section IIIA(ii). 4 Section 27B(c) of the Securities Act excepts the following activity from the prohibition under Section 27B(a) of the Securities Act: “(1) Risk-mitigating hedging activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an asset-backed security, provided that such activities are designed to reduce the specific risks to the underwriter, placement agent, initial purchaser, or sponsor associated with positions or holdings arising out of such underwriting, placement, initial purchase, or sponsorship; or (2) purchases or sales of asset-backed securities made pursuant to and consistent with—(A) Commitments of the underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, to provide liquidity for the asset-backed security, or (B) bona fide market-making in the asset-backed security.” 15 U.S.C. 77z-2a(c). Section 27B of the Securities Act further requires the Commission to issue rules for the purpose of implementing the new Section's prohibition. 5 To meet this statutory requirement, we are proposing new Rule 127B under the Securities Act to make 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. 6 Consistent with Securities Act Section 27B(c), the proposed rule excepts from the prohibition certain risk-mitigating hedging activities, liquidity commitments, and bona fide market-making. We discuss proposed Rule 127B in more detail below and offer a number of examples of how the proposed rule would apply to particular fact patterns. We also seek commenter input regarding whether information barriers or disclosure would be relevant and appropriate in managing and mitigating conflicts of interest or permitting certain transactions that might otherwise be prohibited by the proposed rule. 5 Section 27B(b) of the Securities Act. 15 U.S.C. 77z-2a(b). 6 We note that Section 27B(a) is not effective until the adoption of final rules issued by the Commission. Section 621(b) of the Dodd-Frank Act states that “Section 27B of the Securities Act of 1933 * * * shall take effect on the effective date of final rules issued by the Commission under section (b) of such section 27B * * *.” The proposed interpretations and related examples discussed in this proposing release therefore will have no force or effect except to the extent they are incorporated into any final Commission release adopting rules under Section 27B. In crafting our proposed rule, we have primarily incorporated the text of Section 27B of the Securities Act. This release also sets forth below certain proposed clarifying interpretations of that text and a number of questions for public comment, all of which take into account comments we have received to date regarding the implementation of Section 621 of the Dodd-Frank Act. 7 7 As of August 24, 2011, the Commission had received eight comment letters addressing new Section 27B of the Securities Act. All the comment letters regarding new Section 27B of the Securities Act are available on the Commission's Web site at http://www.sec.gov/comments/df-title-vi/conflicts-of-interest/conflicts-of-interest.shtml. II. Background A. Securitization Securitization is a mechanism for pooling certain financial assets that have payment streams and credit exposures associated with them and effectively converting the pool into a new financial instrument—an ABS—that is “backed” by the pool of assets and offered and sold to investors. More specifically, a financial institution or other entity, commonly known as a sponsor, first originates or acquires a pool of financial assets, such as mortgage loans, credit card receivables, auto loans or student loans. The sponsor then sells the financial assets, directly or through an affiliate, to a special purpose entity (“SPE”). The SPE issues the securities supported or “backed” by the financial assets. These securities are sold to investors in either a public offering subject to an effective registration statement filed with the Commission or an offering exempt from registration. As described by the Commission: Securitization generally is a financing technique in which financial assets, in many cases illiquid, are pooled and converted into instruments that are offered and sold in the capital markets as securities. This financing technique makes it easier for lenders to exchange payment streams coming from the loans [or other pooled assets] for cash so that they can make additional loans or credit available to a wide range of borrowers and companies seeking financing. Some of the types of assets that are financed today through securitization include residential and commercial mortgages, agricultural equipment leases, automobile loans and leases, student loans and credit card receivables. 8 8 Asset-Backed Securities, Release No. 33-9117 (Apr. 7, 2010), 75 FR 23328, 23329 (May 3, 2010) (“Release 33-9117”). As a result of the securitization, the credit and other risks associated with the pooled assets is transferred away from the sponsor's balance sheet to investors in the ABS. 9 9 One type of ABS is a collateralized debt obligation (“CDO”). In a CDO structure, a sponsor may sell to an SPE an asset pool that holds fixed income products, such as loans, mortgage-backed securities or corporate bonds. The SPE then issues debt securities collateralized or “backed” by this asset pool. ABS investors are generally interested in the experience of the collateral manager and the “quality of the underlying assets, the standards for their servicing, the timing and receipt of cash flows from those assets and the structure for distribution of those cash flows.” 10 With respect to the structure for cash flow distributions, some ABS transactions are structured to provide cash flow distribution through “pass-through certificates representing a pro rata share of the cash flows from the underlying asset pool”. 11 Other ABS transactions offer a range of risk exposures and yields to investors. This is accomplished through the SPE issuing different classes of securities, commonly referred to as tranches. 12 Transaction agreements typically specify the structure of an ABS transaction and detail how cash flows generated by the asset pool will be divided among tranches. This division of cash flows is often referred to as the “flow of funds” or “waterfall.” 13 10 Asset-Backed Securities, Release No. 33-8518 (Dec. 22, 2004), 70 FR 1506, 1511 (Jan. 7, 2005) (“Release 33-8518”). 11 Id. 12 Id. (“ABS transactions often involve multiple classes of securities, or tranches, with complex formulas for the calculation and distribution of the cash flows. In addition to creating internal credit enhancement or support for more senior classes, these structures allow the cash flows from the asset pool to be packaged into securities designed to provide returns with specific risk and timing characteristics.”). 13 Id. (“The flow of funds specifies the allocation and order of cash flows, including interest, principal and other payments on the various classes of securities, as well as any fees and expenses, such as servicing fees, trustee fees or amounts to maintain credit enhancement or other support.”). The securitization process developed in the 1970s and subsequently has experienced significant growth and evolved dramatically. 14 With this evolution, the investor base has broadened and the ABS themselves have become more complex. There are, for example, now synthetic ABS in which investors in securities issued by SPEs acquire credit exposure to a portfolio of fixed income assets without the SPE owning these assets. Rather, the investors gain this exposure because the SPE has entered into derivatives transactions, such as credit default swaps (“CDS”) that reference particular assets. 15 The counterparty to the CDS may be the sponsor who originated or selected the underlying portfolio. The SPE, as seller of protection under the CDS, is in effect long the credit exposure on those assets as if it had purchased them. 14 See, e.g., Sylvain Raynes & Ann Rutledge, The Analysis of Structured Securities: Precise Risk Measurement and Capital Allocation 3 (2003); see also Release No. 33-9117, 75 FR at 23330, (“[a]t the end of 2007, there were * * * nearly $2.5 trillion of asset-backed securities outstanding”). Securities Industry and Financial Markets Association, Global CDO Issuance—Quarterly Data from 2000 to Q1 2011 (updated 4/1/11), available at http://www.sifma.org/research/statistics.aspx (reporting a doubling in the volume of synthetic CDO issuances between 2005 and 2007). In recent years, the market for securitization has declined. See, e.g., David Adler, A Flat Dow for 10 Years? Why it Could Happen, BARRONS (Dec. 28, 2009). 15 The protection sold by the SPE under a CDS may reference a portfolio of assets, a single asset, or an index. For example, a bank that maintains fixed income assets on its balance sheet may protect itself against default of those assets by purchasing a CDS from the SPE that references the same or similar types of assets. In other cases, a person may desire to purchase CDS protection even though such person does not own the reference assets underlying the CDS sold by the SPE. In both of the above cases, the SPE, as seller of the CDS protection, takes on the risk of default on the reference assets underlying the CDS (and the consequent obligation to make a payment to the CDS counterparty as a result of such default) in exchange for ongoing payments from the purchaser of the CDS protection. In addition, in both scenarios any payments the SPE is required to make under the CDS will be funded from amounts received by the SPE from the investors in the ABS issued by the SPE. Thus, the proceeds of the SPE's issuance of securities typically are not used to purchase loans, receivables or other investment assets, but instead are typically used to purchase highly creditworthy collateral 16 to support (i) The SPE's contingent obligation to pay the purchaser of the CDS in the event of one or more defaults with respect to the reference assets underlying the CDS (the synthetic reference pool of assets), and (ii) to the extent not used for payments to the CDS purchaser, the SPE's obligations to investors in the SPE's issued securities. 17 The SPE makes payments to investors based on cash flows and proceeds from the CDS and the collateral pool. 16 The term “collateral,” when used in connection with a synthetic ABS, has a different meaning than the term “collateral” in a non-synthetic ABS. In a non-synthetic ABS the collateral is the pool of underlying assets ( e.g., a pool of student loans). In a synthetic ABS, the collateral is often U.S. Treasury securities or other securities used as credit support for the SPE's potential payment obligations under a CDS that references an underlying asset pool. 17 The assets or types of assets on which the SPE will sell protection would typically be disclosed to investors upfront and they would invest in the SPE's securities based on the anticipated risk of default on those assets and income received by the SPE from selling protection via CDS that reference those assets. The SPE would in effect have a synthetic reference pool of assets created by the SPE's long exposure to the assets underlying the CDS that it sold. Therefore, in both the non-synthetic ABS and the synthetic ABS, the SPE and the investors in the SPE have an ongoing long exposure to each instrument in a reference pool of assets— i.e., assets held directly by the SPE, in the case of a non-synthetic transaction, or assets referenced in a CDS under which the SPE has sold protection to a counterparty, in the case of a synthetic transaction. The transactions differ, however, in that the synthetic transaction inherently involves a party—the counterparty to the CDS—that has purchased CDS protection on the same reference pool of assets and thus has an ongoing short exposure to those assets. This purchaser of CDS protection may be a securitization participant (such as the bank sponsoring the synthetic ABS). In these cases—and considering the CDS in isolation—the securitization participant would be taking an investment position that is directionally opposite to that taken by the investors in the synthetic ABS, as is generally the case in any transaction through which a buyer is able to acquire and a seller is able to dispose of a particular financial exposure in pursuit of their respective investment objectives. If the referenced assets default, the securitization participant receives a payment from the SPE pursuant to the CDS and the investors in the SPE ultimately suffer a loss on their investment. 18 If the referenced assets do not default, the investors would have benefited from payments from the CDS counterparty while the SPE would not have any payment obligations to the CDS counterparty. 18 As further discussed below, the securitization participant's short exposure may itself be hedged—by entering into an offsetting CDS transaction, or otherwise—such that in terms of its overall risk profile the securitization participant does not retain exposures directionally opposite to those taken by investors in the synthetic ABS. Request for Comments Regarding the Description of the Securitization Process 1. Are there any other key features of the securitization process that need to be highlighted in considering the scope of Securities Act Section 27B? If so, which features, and why? 2. We seek commenter input regarding the reasons why market participants enter into synthetic ABS transactions instead of non-synthetic ABS transactions. What relative economic or other benefits do synthetic ABS transactions offer to investors and securitization participants? Under what circumstances are such transactions more or less beneficial for each type of market participant? What economic, market or other considerations affect the determination by investors and securitization participants to enter into such transactions? 3. We ask that commenters estimate the volume of synthetic ABS transactions on an annual basis in terms of size and dollar value over the last ten years and to supplement those estimates with data where possible. We would also appreciate comparative estimates of synthetic and non-synthetic ABS transaction volume during this same period. 4. We ask that commenters describe the impact on the market, and in particular on investors, if securitization participants refrained from structuring and selling any particular types of synthetic ABS. Please include a discussion of all advantages and disadvantages as well as any effects on investor protection, liquidity, capital formation, the maintenance of fair, orderly and efficient markets and the availability of credit to borrowers. 5. Do synthetic ABS transactions involving other synthetic ABS, CDOs of CDOs or other transactions involving multiple layers of ABS exposures raise additional or heightened conflict of interest concerns? If so, why and how should these factors be reflected in our proposed rule? 6. What are the key features of the securitization process that bear on the existence or significance of conflicts of interest between participants in that process and investors in the ABS? How has the securitization process changed in recent years, and how have those changes exacerbated or mitigated any potential conflicts of interest? Are the potential conflicts of interest in this process different in kind, degree or with respect to transparency than the conflicts that may arise in connection with creating and offering other credit products, such as corporate debt? 7. Are certain types of ABS more susceptible to conflicts of interest? Are certain parties in the securitization process more likely to have a conflict of interest with investors than others? Are there transactions inherent in the structure of a synthetic ABS that raise special or heightened conflict of interest concerns relative to other ABS transactions or otherwise? 8. Are the conflicts of interest that may arise during the securitization process different in kind or degree than those that may arise after the securitization process? How should the Commission interpret issues related to pre- and post-offering conflicts of interest for purposes of Securities Act Section 27B? 9. We request commenters' views concerning conflicts that may arise from the multi-tranche structure, including where securitization participants retain part or all of a particular tranche. 19 19 We note that other provisions of the Dodd-Frank Act seek to align the interests of ABS investors with securitizers. See, e.g., Section 941 of the Dodd-Frank Act. The proposed rule is not intended to prohibit risk retention as required by Section 941. See Credit Risk Retention, Release No. 34-64148 (March 30, 2011), 76 FR 24090 (April 29, 2011) (Commission proposing rules jointly with the Office of the Comptroller of the Currency, Treasury, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency and the Department of Housing and Urban Development to implement the credit risk retention requirements of section 15G of the Securities Exchange Act of 1934 (15 U.S.C. 78o-11), as added by Section 941 of the Dodd-Frank Act) (“Release 34-64148”). B. Initial Comments Received Regarding the Implementation of Section 27B Shortly after the passage of the Dodd-Frank Act, the Commission provided the public with the opportunity to express views on the various Dodd-Frank Act provisions that the Commission is required to implement, including Section 27B of the Securities Act, as added by Section 621 of the Dodd-Frank Act. 20 As noted above, we received eight initial comment letters regarding our implementation of Section 27B. One letter was written by the sponsors of Section 621 of the Dodd-Frank Act, who urged the Commission and other federal financial regulators, among other things, to “fully and faithfully” implement the Dodd-Frank Act, including Section 27B of the Securities Act. 21 This letter noted that a central purpose of Securities Act Section 27B is to prohibit “firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients.” 22 Further, it noted that a Permanent Subcommittee on Investigations hearing that addressed issues related to The Goldman Sachs Group, Inc. “highlighted a blatant example of this practice: The firm assembled asset-backed securities, sold those securities to clients, bet against them, and then profited from the failures.” 23 These commenters included in their letter excerpts from the Congressional Record providing further background as to the purpose of Section 621, including the following statement: “[t]he intent of section 621 is to prohibit underwriters, sponsors and others who assemble asset-backed securities, from packaging and selling those securities and profiting from the securities' failures.” 24 20 Public Comments on SEC Regulatory Initiatives under the Dodd-Frank Act, available at http://sec.gov/spotlight/regreformcomments.shtml. 21 Letter from Senators Jeffrey Merkley and Carl Levin to Commission Chairman Mary Schapiro, et al. (Aug. 3, 2010) (“Merkley-Levin Letter”) at p. 1, available at http://www.sec.gov/comments/df-title-vi/conflicts-of-interest/conflictsofinterest-2.pdf. 22 Id. at p. 5. 23 Id. 24 Id. (citing 156 Cong. Rec. S5899 (daily ed. July 15, 2010) (statement of Sen. Carl Levin)). Other commenters were industry associations and representatives of market participants who expressed their views on the implementation of Section 27B both in general and in the context of specific situations, and who highlighted their concerns about an overly broad application of Securities Act Section 27B. For example, one comment letter supported the prohibition on material conflicts of interest but also urged that certain activities should not be prohibited regardless of whether they result in potential or actual conflicts of interest. 25 Two other commenters cautioned against a broad interpretation of the term “material conflicts of interest” for purposes of Section 27B of the Securities Act. 26 These commenters noted, for example, that the relationship between securitization participants, on the one hand, and investors, on the other hand, can in certain respects be viewed as fundamentally conflicted in the simple sense that a buyer and seller of assets always have opposing interests, as to price, asset quality and other terms and conditions. 27 These commenters asserted that Section 27B was not intended to eliminate this type of conflict. 25 Letter from the Securities Industry and Financial Markets Association (Dec. 10, 2010) (“SIFMA Letter”) at pp. 4 and 12 (SIFMA “generally support[s] the prohibition of material conflicts of interest” but “enumerates certain natural and expected conflicts which may arise in ABS transactions but do not constitute the type of `material conflicts' intended to be regulated by Section 621”). 26 Letters from the American Securitization Forum (Oct. 21, 2010) (“ASF Letter”) at p. 3 and the Committee on Federal Regulation of Securities and the Committee on Securitization and Structured Finance of the Section of Business Law of the American Bar Association (Oct. 29, 2010) (“ABA Letter”) at p. 2. 27 ABA Letter at p. 3 (“The relationship between an ABS sponsor and ABS investors is inherently conflicted, in that the ABS sponsor is seeking funding and the ABS investors are providing that funding on negotiated terms. Pool selection may also involve conflicts * * * We believe that conflicts of this type, relating to the terms and nature of the security, exist in any ABS transaction and cannot be eliminated.”). Commenters suggested different tests for assessing whether a transaction involves or results in a material conflict of interest prohibited by Section 27B. One commenter suggested that a transaction or activity should not be prohibited under Section 27B if “(i) Such transaction or activity represents an overall alignment of risk to the ABS or underlying assets similar to that borne by investors of the ABS, (ii) such transaction or activity is unrelated to the [securitization participant's] role in the specific ABS, (iii) disclosure of the transaction or activity of the [securitization participant] adequately mitigates the risk posed by the potential or actual conflict with respect to any investors in the ABS or (iv) another regulatory regime applies with respect to the potential or actual conflict of interest.” 28 28 SIFMA Letter at p. 3. Another commenter asserted the proposal should prohibit: “(a) ABS transactions in which the adverse performance of the pool assets would directly benefit an identified party or sponsor (or any affiliate of any such entity) of the applicable ABS transaction; (b) ABS transactions in which a loss of principal, monetary default or early amortization event on the ABS would directly benefit an identified party or sponsor (or any affiliate); and (c) ABS transactions in which an insolvency event related to the issuing entity of the ABS would directly benefit an identified party or sponsor (or any affiliate).” 29 This commenter believed that most ordinary course business transactions concerning securitization participants do not have these characteristics and should be permitted. 30 29 ABA Letter at p. 3. 30 Id. A third commenter suggested that the proposal should “prohibit transactions that create a material incentive to intentionally design asset-backed securities to fail or default.” 31 The commenter further proposed that a material conflict of interest would exist if “(i) A [securitization participant] participates in the issuance of an asset-backed security that is created primarily to enable such [securitization participant] to profit from a related or subsequent transaction as a direct consequence of the adverse credit performance of such asset-backed security and (ii) within one year following the issuance of such asset-backed security, the [securitization participant] enters into such related or subsequent transaction.” 32 31 ASF Letter at p. 4. 32 ASF Letter at p. 5. Commenters provided examples of a number of conflicts of interest that they view as inherent in, and indeed essential to, the securitization process and that in their opinion should not be prohibited by Section 27B. 33 In fact, one commenter listed more than twenty categories of potential conflicts of interest that, in its view, are inherent in the ordinary course of securitization but should not be prohibited by Section 27B: (1) The basic risk transfer that occurs in structuring a securitization; (2) the tranching of debt; (3) holding differing classes of securities in an asset-backed transaction; (4) risk retention; (5) retaining the right to receive excess spread or cash flows; (6) failure to provide funding under a liquidity facility; (7) failure to provide a credit enhancement; (8) control rights ( e.g., “the contractual right to remove the servicer, appoint a special servicer, exercise a clean-up call or instruct a trustee or servicer to take certain actions with respect to the collateral underlying the ABS or against an issuer or other transaction party” and “voting rights as a security holder or in another capacity in a transaction”); (9) hedging activities unrelated to a securitization; (10) providing financing ( e.g., a warehouse line or financing investors to purchase an ABS); (11) servicer conduct ( e.g., servicer interactions with obligors including loan modifications and adjustments to loan terms); (12) collateral manager conduct ( e.g., the collateral manager acquiring assets for itself or others but not making the assets available to the asset-backed issuer, engaging “in `agency cross' transactions in which the collateral manager or an affiliate thereof acts as a broker for compensation for both the issuer and the other party to the transaction” and “`client cross' transactions in which the collateral manager or an affiliate thereof causes a transaction between a securitization issuer and another client of the collateral manager without the collateral manager or its affiliates receiving compensation”); (13) conduct in connection with a trustee ( e.g., a sponsor “may want to acquire a trustee or the trust business from the trustee”); (14) transactions in swaps and caps; (15) transactions in CDS and other derivatives; (16) receipt of payments for performing a role in a securitization prior to payments made to investors; (17) paying an entity for a rating or to provide due diligence; (18) market research; (19) entering into a merger, acquisition, or restructuring that could be adverse to the securitization activities; (20) a bank affiliate of an underwriter making a loan to the sponsor; (21) an underwriter acting as underwriter or placement agent in connection with securities issued by a competitor of a sponsor; and (22) an underwriter hedging market-making activity. 34 Other commenters echoed the view that there are many activities that involve or result in potential conflicts of interest in connection with a securitization that should not be prohibited by Section 27B. 35 33 See, e.g., ABA Letter at p. 2 (“We believe rules implementing this provision should give appropriate weight to Congressional intent while permitting a broad range of common activities that are essential to the functioning of the securitization market.”); see also SIFMA Letter at pp. 2 and 5 (“The goal of the letter is to provide the Commission with some representative examples of potential conflicts of interest that may arise as part of an ABS transaction but that should not be expressly prohibited under Section 621”; “conflicts of interest are inherent in securitization * * * These conflicts should be disclosed to investors and other transaction parties to the extent they are material, but should otherwise be permitted * * * conflicts created in the normal course of a securitization are sufficiently known by, or disclosed to, investors and do not fall under the intended scope of Section 621.”). 34 SIFMA Letter at p. 5 through 11. 35 See, e.g., ABA Letter at pp. 2-4. The ABA Letter sets forth a more limited list of activities that occur in the ordinary course of a securitization, some of which overlap with the SIFMA Letter, that mainly occur either as part of structuring the ABS or in connection with a securitization, and which the ABA believes should not be prohibited by the proposed rule. With respect to conduct that is related to structuring the ABS, the ABA identifies: (1) A securitization participant seeking funding that is provided by the investor in the securitization; (2) pool selection; (3) risk retention; and (4) subordinated tranches. The ABA Letter also highlights the following conduct customarily effected in connection with securitization: (1) “Dealing with delinquent assets ( e.g., whether and to what extent to modify an obligation or to foreclose on underlying collateral)”; (2) originating or acquiring second lien loans on mortgaged properties; (3) providing a warehouse loan or other loan to be repaid from the proceeds of ABS issuance; (4) loans to servicers or credit enhancers; (5) loans to an investor secured by ABS ( e.g., an investor margin account or repo facility); (6) “sales by an identified party of ABS which it originally placed or sales of other debt or equity securities of an ABS issuer or of debt of an entity included in a CDO or CLO;” and (7) the exercise of remedies upon a loan default. Similarly, the ASF Letter identifies activities that are routinely undertaken in connection with securitization, which in its view should not be prohibited by the proposed rule, including (1) “Short-term funding facilities such as `warehouse' lines, variable funding notes and asset-backed commercial paper, whereby the underwriter or its affiliate provides financing to the sponsor to fund asset originations or purchases,” (2) the pursuit of customary servicing activities such as loan modifications, short sales and short refinances; (3) tranche structure; (4) risk retention; and (5) providing best execution in interest rate and currency swaps to obtain interest rates or currencies that differ from the underlying assets. ASF Letter at p. 3. Three other commenters offered their views on topics including the elimination of conflicts of interest, costs associated with regulation, and disclosure requirements. 36 A sponsor of tax lien-backed securities suggested that “municipally-sponsored [sic] tax lien securitization programs should be exempt from the rules promulgated pursuant to Section 621 of the [Dodd-Frank] Act.” 37 36 See Letters from Robin McLeish (July 28, 2010) (“People should not be allowed [to engage in] any conflict of interest.”), Timothy Hogan (Sept. 15, 2010) (“Underwriters * * * should disclose whether they are advocating for the Issuer or the Investor or both * * * This requirement should apply regardless of whether the securities are registered or exempt from registration.”), and Robert O.L. Lynn (Oct. 6, 2010) (“Redistributing compliance risk toward the individual-employee level could yield cost-efficient enforcement by increasing the downside risk to anyone attempting to disguise conflicts of interest—without requiring additional taxpayer resources.”). 37 See Letter from Mark Page, Director of Management and Budget, The City of New York (Nov. 12, 2010) at p. 5 (“City of New York Letter”). III. Discussion of Proposed Rule Pursuant to Section 27B(b) of the Securities Act, the Commission proposes Rule 127B under the Securities Act to address material conflicts of interest that arise in connection with a securitization. As the securitization process has grown more complex, securitization participants may in some circumstances engage in a range of different activities and transactions that give rise to potential conflicts of interest, and the existence and potential effects of conflicts of interest in that process have received increased attention. 38 38 See, e.g., Staff of S. Comm. On Homeland Security and Governmental Affairs, Sub. Comm. On Investigations, 112th Cong., Wall Street and the Financial Crisis: Anatomy of a Financial Collapse (Comm. Print 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf (hereinafter “ Senate Subcommittee Report: Anatomy of a Financial Collapse” ). See also, Staff of S. Comm. on Homeland Security and Governmental Affairs, Sub. Comm. on Investigations, 111th Cong., wall street and The Financial Crisis: The Role of Investment Banks (Comm. Print 2010) (Exhibit 1a), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/042710Exhibits.pdf (hereinafter “ Senate Subcommittee Report: The Role of Investment Banks” ); The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, available at http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_full.pdf (hereinafter, “ The Financial Crisis Inquiry Report” ); Consent and Final Judgment as to the Defendant J.P. Morgan Securities LLC in SEC v J.P. Morgan Securities LLC (f/k/a/J.P. Morgan Securities Inc.), 11 CV 4206 (S.D.N.Y 2011); Litigation Release No. 22008 (June 21, 2011); and Consent and Final Judgment as to Defendant Goldman, Sachs & Co. in SEC v Goldman, Sachs & Co. and Fabrice Tourre, 10 CV 3229 (S.D.N.Y. 2010); Litigation Release No. 21592 (July 15, 2010), 2010 WL 2799362 (July 15, 2010). The proposed rule is designed to implement Section 27B of the Securities Act. As noted above, the text of proposed Rule 127B is based substantially on the text of Section 27B. As described below, the Commission is proposing for comment guidance to market participants as to the nature and scope of conduct that would be prohibited under the proposed rule. The Commission has received a number of initial comments regarding the breadth of any proposed definition of material conflict of interest, and we have sought to strike an appropriate balance between prohibiting the specific type of conduct at which Section 27B is aimed without restricting other securitization activities. 39 We preliminarily believe that the proposed rule strikes that balance, but we seek comment on all aspects of proposed Rule 127B and of our proposed interpretations of its scope and requirements. It is important to note that although the proposed rule would prohibit certain transactions that would involve or result in certain material conflicts of interest, it would in no way limit or restrict the applicability of the general antifraud provisions of the federal securities laws to conduct arising before or after the proposed rule becomes effective. Thus, all conduct in connection with a securitization, whether or not effected in compliance with Section 27B and proposed Rule 127B, would remain subject to these and other relevant provisions of the securities laws. 39 See Section IIID of the Release. The discussion of the proposed rule set forth below is divided into three parts. First, we describe certain conditions that, under Section 27B, must be present for the proposed rule to apply. In particular, we discuss the persons, products, timeframes, and conflicts that potentially fall within the scope of the proposed rule, and we propose a standard for determining whether a “material conflict of interest” exists for purposes of the proposed rule. Second, we discuss three categories of activities—risk-mitigating hedging activities, liquidity commitments, and bona fide market-making—that are excepted from the scope of the proposed rule, as provided in Section 27B. Third, we provide examples of selected securitization transactions and describe how our proposed test for determining whether or not a transaction involves or results in a “material conflict of interest” prohibited by proposed Rule 127B would apply to such examples. Though in a number of examples particular reference is made to synthetic ABS for the purpose of furthering the discussion or providing clarification, we are seeking to apply the same general principles and guidance to both synthetic ABS and non-synthetic ABS. We note that in analyzing whether a particular activity is prohibited by the proposed rule, market participants would be permitted to consider each of the conditions and exceptions discussed below independently. Thus, they could conclude that the activity is not prohibited by the proposed rule if: (1) The activity is outside the scope of the proposed rule (because, for example, it does not involve a covered person or product, or does not entail a material conflict of interest), or (2) the activity falls within a permitted exception to the rule. We seek comment on all aspects of proposed Rule 127B and of our proposed interpretations of its scope and requirements. A. Conditions Required for Application of the Proposed Rule There are five key conditions, each of which is discussed below, that define the circumstances in which the proposed rule might prohibit material conflicts of interest in the securitization process. In particular, in order for the proposed rule to apply, the relevant transaction must involve (1) Covered persons, (2) covered products, (3) a covered timeframe, (4) covered conflicts, and (5) a “material conflict of interest”. Each of these conditions must be present in order for the prohibition under the proposed rule to apply. i. Covered Persons The proposed rule would apply to an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, of an ABS. These persons are specified in Section 27B(a) of the Securities Act and typically have substantial roles in the assembly, packaging and sale of ABS. They structure the product and control the securitization process, and thus they may have the opportunity to engage in activities that the proposed rule and Section 27B of the Securities Act are intended to prevent. The term “underwriter” is defined in Section 2(a)(11) of the Securities Act. The Securities Act, however, does not define for purposes of Section 27B of the Securities Act the terms “placement agent,” “initial purchaser,” “sponsor,” “affiliate” or “subsidiary.” We do not propose to define these terms for purposes of the proposed rule at this time. Although the term “sponsor” is defined in connection with Regulation AB's disclosure regime and the second prong of the definition of the term “securitizer” in Section 15G of the Securities Exchange Act of 1934 (“Exchange Act”) is substantially identical to the Regulation AB definition of sponsor, the Regulation AB definition might not identify all persons involved in the structure and sale of, for example, a synthetic ABS transaction, who may have the opportunity to engage in activities that the proposed rule is intended to prevent. 40 We note that synthetic ABS are not included within the scope of Regulation AB. 41 Neither the Commission nor our staff has interpreted the Regulation AB definition in the context of synthetic ABS transactions. We preliminarily believe that the Regulation AB definition of sponsor might be under-inclusive or confusing in the context of the proposed rule. Furthermore, we preliminarily believe that a collateral manager should be subject to the proposed rule, based on such entity's role in structuring the transaction and selecting assets. 40 The Regulation AB definition of sponsor is found at 17 CFR 229.1101( l ); see also Release No. 34-64148. 41 Synthetic ABS do not fit within the more narrow definition of ABS included in Regulation AB because payments on synthetic ABS are based primarily on the performance of reference assets and not the performance of a discrete pool of financial assets that by their terms covert into cash and are transferred to a separate entity. See generally Release 33-8518. We preliminarily believe that terms such as placement agent and initial purchaser are sufficiently well understood in the context of the market for ABS, given that securitization developed in the 1970s and market participants frequently identify the various participants in the securitization process using these terms (for example, by specifying the placement agent, initial purchaser, and sponsor in offering documents). 42 We also recognize that many of these terms, however, are defined or used in other provisions of the federal securities laws and rules adopted thereunder. 43 While certain specific definitions used in other areas of the federal securities laws and rules may be workable in this context, others may be over- or under-inclusive. For example, we seek commenter input concerning whether the term “sponsor” in this context should include the collateral manager or others who for a fee, or some other benefit, play a substantial role in the creation of an ABS, or managing or servicing the assets underlying an ABS. Although as noted above we do not preliminarily believe definitions are warranted in the proposed rule text, we seek commenters' views on this issue. 42 ABA Letter at page 6 (“Section 27B also uses the term `sponsor', which is not currently defined in the Securities Act of 1933. However, the term sponsor has been defined in Regulation AB, and the definition there is virtually identical to clause (B) of the definition of “securitizer” that is added to the Securities Exchange Act of 1934 by virtue of Section 941 of the Dodd-Frank Act. We recommend that the Commission utilize the definition of `sponsor' in Regulation AB for purposes of Section 27B”). While the ABA Letter suggested using the Regulation AB definition of the term sponsor, others did not make such a suggestion. 43 See, e.g., infra notes 44 through 51. Request for Comments Regarding Covered Persons 10. Should we provide definitions for the terms “placement agent,” “initial purchaser,” “sponsor,” “affiliate” or “subsidiary”? One commenter suggested that we adopt definitions for the terms “initial purchaser” and “sponsor” but not for other covered persons. 44 Should we adopt this commenter's approach? We seek comment concerning whether certain terms should or should not be defined, and the rationale supporting such distinctions. Specifically, we seek comment as to whether definitions of these terms in other provisions of the federal securities laws and rules would be necessary and workable in this area, whether existing definitions should be tailored specifically for this rule proposal, or whether new definitions would be necessary to achieve the purpose of the proposal. 44 See ABA Letter at p. 6 (suggesting “the Commission clarify that the term `initial purchaser' as used in Section 27B refers to a broker-dealer functioning in a role equivalent to that of an underwriter or placement agent in a Rule 144A transaction” and “that the Commission utilize the definition of `sponsor' in Regulation AB for purposes of Section 27B.”). 11. Should the term “sponsor” have the same meaning as defined in Regulation AB? 45 Please explain why or why not. Would such definition be workable or would it be over- or under-inclusive in this context? 45 17 CFR 229.1101( l ) (“Sponsor means the 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 issuing entity.”). 12. For purposes of proposed Rule 127B, should the term “sponsor” be defined to specifically include a collateral manager or any other person ( e.g., servicers, custodians, etc. ) who, for a fee or some other benefit, has a substantial role in the creation of the ABS? We seek commenter input regarding whether such definition would be appropriate or over- or under-inclusive. If you believe such a definition would be over- or under-inclusive, please provide examples of how such definition would be over- or under-inclusive. Would clarification or more specificity be needed if we were to use such a definition of “sponsor”? If so, please explain what would be needed and why. Alternatively, should the term “sponsor” be defined to specifically include a collateral manager or any other person ( e.g., servicer, custodian, etc. ) who, for a fee or some other benefit, participates in the creation of the ABS? We seek commenter input regarding whether or not this alternative definition would be more appropriate. If commenters believe that definitions of a particular covered person are necessary but that existing definitions from other areas of the federal securities laws and rules or other sources are not workable in this context, please suggest an alternative definition(s). Commenters should explain why their suggested definition(s) better identifies persons intended to be covered by Section 27B. 13. Should proposed Rule 127B provide that an “affiliate” of, or a person “affiliated” with, 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? Such terms are defined similarly in Section 16 of the Securities Act, Rule 405 under the Securities Act, and Rule 12b-2 under the Exchange Act. 46 Would such a definition be workable or would it be over- or under-inclusive in this context? Please discuss whether or not a servicer would typically be an affiliate of an underwriter, placement agent, initial purchaser, or sponsor, under such a definition. 46 See 15 U.S.C. 77p(f)(1); 17 CFR 230.405; and 17 CFR 240.12b-2, respectively. 14. Should the definition of the term “subsidiary” be the same as the definition of subsidiary found in Exchange Act Rule 12b-2? 47 Please explain why or why not. Would such definition be workable or would it be over or under-inclusive in this context? 47 See 17 CFR 240.12b-2 (“A `subsidiary' of a specified person is an affiliate controlled by such person directly, or indirectly through one or more intermediaries.”). 15. Should the term “underwriter” in the context of Securities Act Section 27B have the same meaning as the definition in Section 2(a)(11) of the Securities Act? 48 We note that Section 2 of the Securities Act states that terms used in the Securities Act have the meanings assigned to them in that section “unless the context provides otherwise.” Is the context in Section 27B of the Securities Act, and proposed Rule 127B thereunder, such that the term “underwriter” should not have the meaning in Section 2(a)(11)? Would that definition be workable or over- or under-inclusive, in this context? Should we define the term “underwriter” instead to have the same meaning as the definition in Rule 100 of Regulation M under the Exchange Act? 49 Please explain why or why not. Would such definition be workable or over- or under-inclusive in this context? 48 15 U.S.C. 77b(a)(11). 49 17 CFR 242.100 (“Underwriter means a person who has agreed with an issuer or selling security holder: (1) To purchase securities for distribution; or (2) to distribute securities for or on behalf of such issuer or selling security holder; or (3) to manage or supervise a distribution of securities for or on behalf of such issuer or selling security holder.”). 16. Should definitions for each type of covered person be the same as or consistent with Regulation AB? Should “underwriter,” “placement agent,” “initial purchaser” and “sponsor” have the same meaning as either defined by Regulation AB or, if undefined, as understood in Regulation AB ( e.g., underwriter or initial purchaser)? Would these terms need to be defined differently than defined or understood, if undefined, in Regulation AB in order to fulfill the intent of Section 27B of the Securities Act, particularly in connection with synthetic ABS? Please explain. Alternatively, please explain why consistent treatment would be appropriate. 17. For purposes of Rule 127B, should we define “initial purchaser” to mean a broker-dealer functioning in a role equivalent to that of an underwriter or placement agent who purchases the ABS pursuant to an agreement that contemplates the resale of those securities to other purchasers in transactions that are not required to be registered under the Securities Act in reliance upon Rule 144A 50 or that are otherwise not required to be registered because they do not involve any public offering? 51 Would this language adequately describe the types of unregistered transactions in which an initial purchaser might participate ( i.e., Rule 144A transactions and private resales made in reliance on the so-called Section “4(1- 1/2 )” exemption)? Should the definition of “initial purchaser” incorporate different or other concepts? Are there persons that should be subject to this provision in addition to broker-dealers that act as initial purchasers? 50 17 CFR 230.144A. 51 See ABA Letter at p. 6 (suggesting that the Commission “clarify that the term `initial purchaser' as used in Section 27B refers to a broker-dealer functioning in a role equivalent to that of an underwriter or placement agent in a Rule 144A transaction.”). ii. Covered Products Proposed Rule 127B(a), like Section 27B under the Securities Act, applies with respect to any “asset-backed security (as such term is defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c), which for purposes of this rule shall include a synthetic asset-backed security)”. Section 941(a) of the Dodd-Frank Act added Section 3(a)(77) to the Exchange Act to provide that the term “asset-backed security”: (A) means a fixed income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a security or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flows from the asset, including— (i) A collateralized mortgage obligation; (ii) A collateralized debt obligation; (iii) A collateralized bond obligation; (iv) A collateralized debt obligation of asset-backed securities; (v) A collateralized debt obligation of collateralized debt obligations; and (vi) A security that the Commission, by rule, determines to be an asset-backed security for purposes of this section; and (B) Does not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company. 52 1890-91. 52 Public Law 111-203, 941, 124 Stat. 1376, 1890-91. The proposed rule, like Securities Act Section 27B, incorporates this definition and specifically includes synthetic ABS in describing the scope of the prohibition on certain material conflicts of interests. We are not proposing to define the term “synthetic asset-backed security” for purposes of proposed Rule 127B, because we understand that this term is commonly used and understood by market participants. 53 However, we seek comment on whether this understanding is correct and whether we should provide a definition of this term to facilitate implementation of the proposed rule. 53 We note that the definition of ABS in Securities Act Regulation AB does not include a synthetic ABS. See Release 33-8518, 70 FR at 1514 and Item 1101(c) of Regulation AB (17 CFR 229.1101(c)). However, the prohibition in Section 27B of the Securities Act applies both to an ABS as defined in Section 3 of the Exchange Act, and to a synthetic ABS. Synthetic securitizations “create exposure to an asset that is not transferred to or otherwise part of the asset pool. These synthetic transactions are generally effectuated through the use of derivatives such as a credit default swap or total return swap. The assets that are to constitute the actual `pool' under which the return on the ABS is primarily based are only referenced through the credit derivative.” Release 33-8518, 70 FR at 1514. We also note that the definition of an ABS in Section 3(a)(77) of the Exchange Act (an “Exchange Act-ABS”) is much broader than the definition of an ABS in Securities Act Regulation AB. The definition of an Exchange Act-ABS includes securities that are typically sold in transactions that are exempt from registration under the Securities Act, such as CDOs, and that are not necessarily backed by a discrete pool of assets. Neither Section 27B nor proposed Rule 127B distinguishes between ABS that are sold in an offering registered with the Commission or in an offering that is exempt from registration. Accordingly, our proposal would apply to ABS in both such circumstances. We recognize that Section 27B, and our proposed rule, refer to an underwriter, a term that, in the Securities Act, is typically, but not exclusively, used in the context of registered offerings. Section 27B, however, also applies to placement agents and initial purchasers, which are parties that perform functions similar to an underwriter in unregistered offerings. Moreover, as noted above, the definition of Exchange Act-ABS includes ABS typically offered and sold in unregistered transactions. Request for Comments Regarding Covered Products 18. Should we define or interpret the term “synthetic asset-backed securities” and if so, how? Please explain why or why not. Please provide a suggested definition and the rationale for why the suggested definition is appropriate. Should any such definition or interpretation be limited to ABS for which the credit exposure for the asset pool from which payments are derived consists substantially of swaps, security-based swaps or other derivatives (and the collateral held by the SPE)? 19. Should any such definition or interpretation of “synthetic ABS” include any combination of securities that produces an economic result equivalent to an ABS, whether or not collateralized or having features meeting the specific requirements of the definition of ABS? If we were to define the term, should we define “synthetic ABS” as securitizations designed to create exposure to an asset that is not transferred to or otherwise part of the asset pool, including transactions effectuated through the use of derivatives such as a CDS or total return swap, and for which the assets that are to constitute the actual “pool” under which the return on the ABS is primarily based are for the most part referenced through the derivative? 54 54 See Section IIIA(2)(a) of Release 33-8518, 70 FR at 1513-1515. 20. Please discuss any similarities or differences between security-based swap agreements in general and security-based swap agreements used in synthetic ABS that are relevant for purposes of proposed Rule 127B. Please discuss whether or not such similarities or differences should be addressed in a definition or interpretation of the term “synthetic ABS” for purposes of proposed Rule 127B, and why. 21. We seek comment on the application of proposed Rule 127B to municipal securities that are “asset-backed securities” within the meaning of Section 3(a)(77) of the Exchange Act as amended by the Dodd-Frank Act. 55 Please explain whether you believe there are any differences between the application of this provision to municipal securities that are ABS and its application to other types of ABS. Should there be an exemption under Securities Act Section 28 from proposed Rule 127B for decisions made in the exercise of the governmental function of a state or local government acting as a securitization participant? Please explain why or why not. Would other exceptions applicable to state and local government issuers or sponsors of ABS be appropriate? Please explain why or why not. If you believe exceptions should be included, please describe what such exceptions should be and why they would be appropriate. We seek specific comment about whether some or all varieties of municipally-sponsored tax lien securities should be exempt from the proposed rule and if so, why such an exemption would be appropriate for such tax-lien securities. 56 For example, we ask commenters to provide their reasoning as to whether or not the proposed rule should apply to a municipal tax lien securitization in which the tax liens arose by operation of law and were sold by a municipality through a tax lien securitization program in which all liens were securitized and the municipality had no role in the lien selection process. 57 55 The definition of an ABS within the meaning of Section 3(a)(77) of the Exchange Act as amended by the Dodd-Frank Act includes securities that are typically sold in transactions that are exempt from registration under the Securities Act. 56 See City of New York Letter at p. 5 (“Many actions that the City of New York takes in the exercise of its governmental powers pursuant to other statutes or regulations or to serve the public's interest and protect the health and safety of its residents could potentially be viewed as being in conflict with the interest of investors in the tax lien-backed securities. For example, the City could take an action that would adversely impact the value of one of the properties securing a tax lien or the value of other properties in that area, which could adversely impact the value of that property.”). 57 See id. iii. Covered Timeframe Proposed Rule 127B uses the Securities Act Section 27B language “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 asset-backed security.” It is during this time period, which extends for one year following the first closing of the sale of the security to the public, that no securitization participant could engage in a transaction giving rise to prohibited conduct. Accordingly, if a transaction occurs in the period prior to one year after the date of the first closing of the sale of the ABS, it is covered by the proposed rule. Securities Act Section 27B specifies the end of the covered timeframe—one year following the first closing of the sale of the security to the public. Section 27B, however, does not specify the commencement point for the covered timeframe and we are not proposing to do so at this time. As a result, the proposed rule would cover transactions effected prior to “the date of the first closing of the sale of the asset-backed security.” We preliminarily believe that this result may be appropriate because prior to the first closing securitization participants involved in structuring and marketing an ABS may engage in transactions involving or resulting in material conflicts of interest that in form or effect are, for purposes of the proposed rule, difficult to distinguish from similar transactions occurring after the first closing. Thus, using the sale date as a starting point for the covered timeframe might be under-inclusive. We request comment, however, on whether and how our proposed approach might be over-inclusive, as well as whether alternative approaches to defining the covered timeframe (such as treating the date of first sale as the beginning of the covered timeframe) might be appropriate. Request for Comments Regarding Covered Timeframe 22. Is there a point in time prior to “one year after the date of the first closing of the sale of the asset-backed security” at which the prohibition in Section 27B was not intended to apply? Please explain why or why not. 23. Should the proposed rule specify the commencement point for the covered timeframe? Please provide an explanation. In particular, please discuss whether or not the commencement point for the covered timeframe should be “the date of the first closing of the sale of the asset-backed security.” Please include a discussion of whether or not such commencement point for the covered timeframe would be appropriate, or whether it would be over- or under-inclusive. In addition, please discuss whether such approach would have any advantages or disadvantages. 24. Should the commencement point for the covered timeframe be tied to the point at which a person becomes a securitization participant? How would such a point in time be defined? Should the commencement point vary depending on which securitization participant role a person performs? Please provide an explanation. 25. Should the commencement point for the covered timeframe be tied to some other reference point prior to the first closing of the sale of the ABS to the public? Please provide an explanation. iv. Covered Conflicts of Interest The Commission also proposes to delineate the scope of “conflicts of interest” that would potentially be covered by the proposed rule. 58 Specifically, there would not be a covered conflict of interest involved if the conflict in question: (1) Arose exclusively between securitization participants or exclusively between investors; (2) did not arise as a result of or in connection with the related ABS transaction; or (3) did not arise as a result of or in connection with “engag[ing] in any transaction” (as more fully described below). 58 The proposed interpretations are not intended for broad application concerning the use of the term “material conflicts of interest” and would not apply in other areas of the federal securities laws and rules or SRO rules or in connection with other provisions of the Dodd-Frank Act. First, consistent with Securities Act Section 27B, we propose that the scope of the conflicts of interest covered by proposed Rule 127B(a) would be limited to material conflicts of interest between an entity that is a securitization participant with respect to an ABS and an investor in such ABS, whether or not such investor purchased the ABS from the securitization participant. This proposed interpretation is not intended to narrow or broaden the scope of the statutory language. Under this interpretation, however, if conflicts of interest were to arise solely among securitization participants, acting in their capacity as such in connection with the securitization process, they would not be subject to the proposed rule, given the focus of Section 27B on protecting investors ( e.g., conflicts of interests between a sponsor and a collateral manager of an ABS are not the focus of the proposal). 59 59 See Merkley-Levin Letter, at attachment (Cong. Rec. S5899 (daily ed. July 15, 2010) (statement of Sen. Carl Levin)) (“[Securitization participants], like the mechanic servicing a car, would know if the vehicle has been designed to fail. And so they must be prevented from securing handsome rewards for designing and selling malfunctioning vehicles that undermine the asset-backed securities markets. It is for that reason that we prohibit those entities from engaging in transactions that would involve or result in material conflicts of interest with the purchasers of their products.” ) (emphasis added). Second, conflicts of interest arising solely among investors in the ABS offering (where investors could include securitization participants, provided these conflicts arise only from their interests as an investor) would also not be covered by the proposed rule. 60 Thus, for example, the proposed rule is not intended to prohibit the multi-tranche structures commonly used in ABS offerings, even though those structures may involve conflicts between the interests of various classes of investors in the offering by virtue of the different risks and rewards associated with such tranches. 60 See supra note 19. Third, we propose that the prohibition under Rule 127B(a) would only apply to those conflicts of interest between a securitization participant and an investor that arise as a result of or in connection with the related ABS transaction. Our proposed rule, therefore, would not address other conflicts of interest that happen to arise between these same parties but that are unrelated to their status as a securitization participant and investor, respectively. 61 61 For example, the underwriter of an ABS may also be the underwriter in an unrelated common stock offering. One investor may purchase securities in both the ABS offering and the common stock offering. If the underwriter engaged in transactions that undermined the market value of the common stock offering, that activity (while potentially addressed by other provisions of the federal securities laws and rules thereunder, depending on the facts and circumstances) would not fall within the scope of Proposed Rule 127B even though one of the investors in the common stock offering is also an investor in the ABS offering. See ABA Letter at p. 5 (“The rules should clarify that the prohibition on material conflicts of interest does not extend to transactions unrelated to the relevant ABS transaction. The language of Section 27B referring to a `material conflict of interest with respect to any investor in a transaction arising out of such activity', creates some ambiguity as to whether the phrase `arising out of such activity' is intended to identify the investor, or the context in which the potential conflict may arise. Underwriters, placement agents, initial purchasers and sponsors, or their affiliates, may have a variety of relationships with investors who purchase ABS from or through them. We believe that the better reading of Section 27B is that the conflict of interest shall not arise in the context of the transaction with respect to which the investor acquired the ABS. This construction would help to assure the integrity of ABS offerings, while not imposing unreasonable restrictions on the overall relationships between the identified parties and sponsors, on the one hand, and ABS investors, on the other.”). Fourth, we propose that in order for the proposed rule to apply, the conflict of interest must arise as a result of or in connection with “engag[ing] in any transaction.” For example, engaging in any transaction would include, but not be limited to, effecting a short sale of, or purchasing CDS protection on, securities offered in the ABS transaction or its underlying assets. “Engag[ing] in any transaction” would also include the securitization participant selecting assets, directly or indirectly, for the underlying asset pool and selling those assets to the SPE. 62 62 Merely “engaging in any transaction” does not in and of itself trigger the prohibitions of the proposed rule. For example, the sale of underlying assets to the SPE must also involve or result in a material conflict of interest with ABS investors and all other conditions required for application of the proposed rule must be met. We recognize that not every activity undertaken by a securitization participant would be “engag[ing] in any transaction” for purposes of Securities Act Section 27B or the proposed rule. For example, the issuance of investment research by a securitization participant would not be “engag[ing] in any transaction” for purposes of the proposed rule. We request comment on whether there are other types of activities in which securitization participants may engage that should be specifically excluded from the scope of the phrase “engag[ing] in any transaction.” Request for Comment Regarding Covered Conflicts of Interest 26. Would the application of the proposed interpretation to conflicts of interest between securitization participants and investors in ABS be appropriate or could it be viewed as broadening or narrowing the scope of paragraph (a) of the proposed rule in a way that could prevent it from achieving its intended purpose? Please explain. Please describe any alternative interpretation that would better align the scope of the proposed rule with the conflicts that Section 27B is designed to address. 27. We seek commenter input regarding conflicts of interest that might arise between securitization participants, whether or not such conflicts impact ABS investors, and to what extent, if any, such conflicts are addressed under Securities Act Section 27B. 28. Should the phrase “engaging in any transaction” for these purposes be interpreted more broadly or narrowly? Please provide specific suggestions. 29. Are the examples noted above of activity that constitutes “engaging in any transaction” over-inclusive, under-inclusive or appropriate in the context of the proposed rule? Are there examples of “engaging in any transaction” in addition to effecting a short sale of securities offered in the ABS transaction or its underlying assets, or buying CDS protection on the relevant ABS or its underlying assets, that should be considered in this context? Please explain. Should the phrase “engaging in any transaction” include the asset-backed offering itself? 30. Is the example noted above of an activity that does not constitute “engaging in any transaction” (the issuance of investment research) appropriate in assessing conflicts of interest? Are there other activities that should not be “engaging in any transaction” for these purposes? If so, which activities, and why? 31. Please identify situations, if any, in which a securitization participant has engaged in a transaction that conflicts with the interests of ABS investors as well as engaged in a transaction that is aligned with the interests of ABS investors. Please discuss whether and how you believe such situations should be addressed under the proposed rule. v. Conflicts of Interest That Are Material Perhaps the most challenging issue in implementing Section 27B is to identify those conflicts of interest involving securitization participants and investors that are “material” and intended to be prohibited under Section 27B and our proposed rule. If a conflict of interest is not a “material conflict of interest”, then it would not be covered by Section 27B and our proposed rule. The proposed rule does not define the term “material conflict of interest.” We preliminarily believe that any attempt to precisely define this term in the text of the proposed rule might be both over- and under-inclusive in terms of identifying those types of material conflicts of interest arising as a result of or in connection with a securitization transaction that Section 27B was intended to prohibit, especially given the complex and evolving nature of the securitization markets, the range of participants involved, and the various activities performed by those participants. Accordingly, we propose to clarify the scope of conflicts of interest that are material and intended to be prohibited under Section 27B and our proposed rule through interpretive guidance rather than through a detailed definition in the proposed rule. 63 63 See supra note 6. In considering how best to interpret the phrase “material conflict of interest” for these purposes, we note that on the one hand, in order to give full effect to Section 27B, this phrase should be interpreted sufficiently broadly so as to capture the full range of transactions by securitization participants that involve or result in a material conflict of interest between securitization participants and investors. If the phrase is construed too narrowly, the proposed rule could potentially permit certain securitization participants to take undue advantage of their role in the securitization process, in which case the proposed rule might fail to enhance the integrity of securitization practices as fully as intended. On the other hand, however, a number of commenters have argued that multiple conflicts of interest often arise between securitization participants and investors as an inherent part of the securitization process. Thus, they have cautioned, an overly broad interpretation may curtail the willingness of securitization participants to engage in securitization transactions, which ultimately could limit, increase the costs of, or effectively prohibit transactions that might benefit investors, efficiently redistribute risk, and support important segments of the economy. 64 64 See, e.g., SIFMA Letter at p. 3 (“If not focused on the transactions referenced by Senators Merkley and Levin, rules promulgated under Section 621 could restrict many standard industry practices which are vital to the functioning of the ABS markets and beneficial to investors.”). See also ASF Letter at p.3-4 (“Similarly, a broad interpretation of `material conflicts of interest' could prohibit servicers * * * who are affiliated with the sponsor of a transaction from pursuing customary servicing activities * * * This restriction would effectively prohibit sponsors and their affiliates from servicing the loans that they originate, requiring costly servicing transfers that will decrease efficiency and potentially lead to confusion for consumers and disruptions in the servicing of assets.”). We are not aware of any basis in the legislative history of Section 621 to conclude that this provision was expected to alter or curtail the legitimate functioning of the securitization markets, as opposed to targeting and eliminating specific types of improper conduct. Moreover, as a preliminary matter, we believe that certain conflicts of interest are inherent in the securitization process, and accordingly that Section 27B and our proposed rule should be construed in a manner that does not unnecessarily prohibit or restrict the structuring and offering of an ABS. We have considered the various tests suggested by commenters for identifying material conflicts of interest for purposes of Section 27B and our proposed rule. While mindful of these suggestions and of the analysis accompanying them, the Commission preliminarily believes that the appropriate balance would best be struck through an interpretation that, for purposes of the proposed rule, engaging in any transaction 65 would “involve or result in [a] material conflict of interest” between a securitization participant and investors in the relevant ABS if: 65 See supra Section IIIA(iv). Such a transaction would include effecting a short sale of securities offered in the ABS transaction or its underlying assets, or buying CDS protection on the relevant ABS or its underlying assets. (1) Either: (A) a securitization participant would benefit directly or indirectly from the actual, anticipated or potential (1) Adverse performance of the asset pool supporting or referenced by the relevant ABS, (2) loss of principal, monetary default or early amortization event on the ABS, or (3) decline in the market value of the relevant ABS (where these are discussed below, any such transaction will be referred to as a “short transaction”); or (B) a securitization participant, who directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS, would benefit directly or indirectly from fees or other forms of remuneration, or the promise of future business, fees, or other forms of remuneration, as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction as described above; and (2) there is a “substantial likelihood” that a “reasonable” investor would consider the conflict important to his or her investment decision (including a decision to retain the security or not). 66 66 See Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (citing TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). We preliminarily believe that this formulation of a conflict of interest that is material would directly address those types of activities that Section 27B was intended to prohibit— e.g., situations in which a securitization participant engages in a transaction through which it benefits when the related ABS fails or performs adversely or has the potential to fail or perform adversely and there is a substantial likelihood that a reasonable investor would consider the fact of such benefit important to his or her investment decision. 67 67 See 156 Cong. Rec. S5899 (daily ed. July 15, 2010) (statement of Sen. Levin) (“The intent of Section 621 is to prohibit underwriters, sponsors, and others who assemble asset-backed securities, from packaging and selling those securities and profiting from the securities' failures.”). Our proposed approach for identifying when a person engages in transactions that involve or result in material conflicts of interest is, in part, similar to the ABA's suggested focus for the proposed rule. See ABA Letter at p. 2 (“we believe the focus of the rulemaking should be on the following types of conflicts: (a) ABS transactions in which the adverse performance of the pool assets would directly benefit an identified party or sponsor (or any affiliate of any such entity) of the applicable ABS transaction; (b) ABS transactions in which a loss of principal, monetary default or early amortization event on the ABS would directly benefit an identified party or sponsor (or any affiliate); and (c) ABS transactions in which an insolvency event related to the issuing entity of the ABS would directly benefit an identified party or sponsor (or any affiliate).”). In addition, the ABA suggested that the “rules should clarify that the prohibition on material conflicts of interest does not extend to transactions unrelated to the relevant ABS transaction.” Id. at p. 5. a. Item 1(A) of “Material Conflict of Interest” Test Engaging in a transaction would “involve or result in [a] material conflict of interest” if as a result of such transaction the securitization participant would benefit from the actual, anticipated or potential poor performance of the ABS or the underlying assets. It would not be necessary for a securitization participant to intentionally design an ABS to fail or default in order to trigger the rule's prohibition. 68 We preliminarily interpret the intent of Section 27B more broadly—to prohibit securitization participants from benefiting from the failure of financial instruments that they help structure, offer and sell to investors. Thus, under the proposed rule a securitization participant would be prohibited from profiting from the decline of an ABS it helped to create (assuming that the conflict would be important to a reasonable investor), even if that securitization participant did not intentionally cause, or increase the likelihood of, such decline. For example, a securitization participant that engaged in a short sale of the relevant ABS four months following the first closing of sale of the ABS would meet item 1(A) of the material conflict of interest test. The securitization participant would be able to benefit from a decline in the market value of the ABS through the short sale even if the securitization participant did not design the ABS to fail. The analysis does not turn on whether the securitization participant intentionally designed the ABS to fail, but rather whether the securitization participant would benefit, through the actual, anticipated or potential decline in the market value of the ABS, in this case in the form of gains from the short sale. 68 See SIFMA Letter at p. 1 (“reforms may be necessary to ensure that securitization transaction parties are not creating and selling asset-backed securities (`ABS') that are intentionally designed to fail or default and profiting from the failure or default of such ABS.”). See also, ASF Letter at p. 5 (a material conflict exists if the ABS “is created primarily to enable such [securitization participant] to profit from a related or subsequent transaction as a direct consequence of the adverse credit performance of such asset-backed security.”). We highlight the reference in our proposed test to the requirement that a securitization participant would benefit directly or indirectly from the actual, anticipated or potential decline in the value of the ABS (or underlying assets). If a securitization participant effected a short transaction in the ABS, it would not be necessary for the market value of the ABS to actually decline in order for a “material conflict of interest” to arise. It would be sufficient that the securitization participant engaged in a transaction under which it would benefit if the market value of the ABS were to decline. 69 69 We also understand that a securitization participant may engage in a short transaction, for example, in the context of market-making or in the context of hedging assets being pooled to create an ABS. If such activities qualify for the proposed exceptions in the rule discussed below— i.e., the exceptions for bona fide market-making and risk-mitigating hedging—they would be permitted. We recognize that—like other prophylactic conflict of interest rules—the proposed rule and interpretation might limit certain investment activities that might otherwise be made for bona fide purposes. For example, it is possible for a securitization participant and investors in an ABS who have complete access to information regarding the underlying assets simply to have different views regarding the future prospects for those assets, based on their independent analysis of market and commercial trends or other factors. For example, an investor may believe that the assets will perform well, but the securitization participant may believe that the assets will perform poorly. In this case, restricting or prohibiting the securitization transaction would limit the ability of both the investor and the securitization participant to transact freely based on their respective views of the underlying assets (even though they might make the same investment choice if they were not involved in the securitization). We therefore acknowledge the concern that this proposal might have unintended effects, such as potentially limiting investment opportunities for investors if a securitization participant refrains from structuring and selling ABS in reaction to this proposal. We seek commenter input below concerning the extent to which such unintended effects might occur, and any potential impacts, including any impact on investors, investor protection, liquidity, capital formation, the maintenance of fair, orderly and efficient markets and the availability of credit to borrowers (through assets underlying an ABS). On the other hand, in the context of a securitization transaction, the securitization participant is generally seeking to sell to investors a particular investment view regarding the underlying assets, in the form of the ABS. In this sense, the proposed rule and interpretation would help prohibit the securitization participant from structuring and offering the ABS to investors on the premise that it will be a good investment when the securitization participant has either structured the transaction in a manner that is designed to fail or takes other actions ( i.e., entering into a short transaction) through which it will profit from such failure. Moreover, the proposed prohibition would be all the more important given that as a practical matter investors in the ABS may not have as much information regarding the underlying assets as the securitization participant, and may be drawing inferences regarding the quality of the assets based on the involvement and marketing efforts of the securitization participant in the transaction as well as any other information provided by the securitization participant. We seek commenter input regarding potential benefits, including benefits for investors, investor protection, liquidity, capital formation and the maintenance of fair, orderly and efficient markets that might ensue as a result of the proposed interpretation and how these potential benefits may impact any unintended consequences referenced above. Nothing in the proposed interpretation would prevent a securitization participant from taking positions in which its economic interests would be aligned with the investors in the ABS it has created and sold—such as by purchasing the ABS. 70 While the proposed interpretation would cover benefiting from the adverse performance of the asset pool supporting the ABS, we note that the proposed interpretation would not prevent a securitization participant's transactions in the securities of a lender whose mortgage pools are included or referenced in an ABS because the proposal is focused solely on the ABS and its underlying portfolio. 70 See SIFMA Letter at p. 3 (a transaction or activity should not be prohibited under Securities Act Section 27B if “such transaction or activity represents an overall alignment of risk to the ABS or underlying assets similar to that borne by investors of the ABS”). b. Item 1(B) of “Material Conflict of Interest” Test If a securitization participant would not benefit in the manner set forth in item 1(A) of the material conflict of interest test, one must determine whether the securitization participant would benefit in the manner set forth under item 1(B) of that test. A benefit under either item 1(A) or 1(B) would satisfy item 1 of the test. Engaging in a transaction would involve or result in a material conflict of interest arising as a result of or in connection with a transaction if a securitization participant who directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS would benefit directly or indirectly—from fees or other forms of remuneration, or the promise of future business, fees, or other forms of remuneration—as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction as described above. 71 71 For purposes of item 1(B), we interpret the statutory reference to a securitization participant “engaging in a transaction” to include circumstances where the securitization participant, although not itself a party to a transaction as contemplated by item 1(A), would benefit directly or indirectly as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction. In certain circumstances, a third party might directly or indirectly select assets underlying an ABS or structure the ABS transaction through its relationship with a securitization participant. In these situations, it is possible that the third party, rather than the securitization participant, might enter into a short transaction of a type that would be prohibited for the securitization participant itself under our proposed rule and interpretation. For example, the third party might select assets for the securitization transaction that it anticipates will perform poorly, and then enter into a short transaction on the ABS in order to benefit from the anticipated decline in the market value of the ABS or its underlying assets. The securitization participant would not necessarily be a party to the short transaction, and therefore might not directly profit from that short transaction due to any future adverse performance of the ABS or its underlying assets. However, the securitization participant may be incentivized to leverage the role it plays in selecting assets underlying the ABS to seek other benefits. For example, the securitization participant might benefit ( e.g., through compensation, the promise of future business, or other forms of remuneration from either the third party or the ABS) by allowing a third party to select the assets in the manner described, and in so doing would effectively benefit by having permitted the third party to potentially profit from a related short transaction. This would result in a material conflict of interest between the securitization participant and investors in the ABS of the type that Section 27B is intended to prohibit. Item 1(B) would apply because the securitization participant would benefit directly or indirectly from fees or other forms of remuneration, or the promise of future business, fees or other forms of remuneration. As a result of item 1(B), a securitization participant could not create an opportunity for a third party to engage in any transaction that the securitization participant itself would not be permitted to engage in under item 1(A) of the proposed interpretation. 72 72 We note for clarity that in order for a transaction to be a material conflict of interest under item 1(B), the third party would actually need to effect a short transaction. Thus, with respect to both items 1(A) and 1(B), the material conflict of interest test contemplates the existence of a short transaction by the securitization participant or the third party, as applicable. Given that Section 27B and our proposed rule apply to securitization participants, the burden of compliance with these requirements would fall on the securitization participant that directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS and who then permits or facilitates the involvement of a third party in those aspects of the transaction. We recognize that in certain instances there might be practical challenges for securitization participants seeking to determine whether they are subject to this restriction, or whether the involvement of third parties in a securitization transaction complied with the proposed rule. For example, in certain cases there might be practical difficulties for a securitization participant in determining whether a third party that was involved in selecting the underlying assets or the structuring of the ABS might also engage in prohibited short transactions. While securitization participants could use different tools to manage these practical difficulties, we preliminarily believe that when reasonable to do so, securitization participants could rely on appropriate contractual covenants or representations, either between themselves or with the relevant third parties, to determine compliance with our proposed rule. For example, if a third party were involved in selecting the underlying assets or structuring the ABS, where reasonable to do so a securitization participant could rely on contractual assurances (from the third party or from another securitization participant who had obtained such assurances from the third party) that the third party would not engage in any short transactions that would be prohibited if engaged in by a securitization participant in the relevant offering. Of course, it would not be necessary for a securitization participant to obtain such contractual assurances—for example, in circumstances where it did not have any reasonable basis to believe that a third party would engage in a short transaction in a way that would violate our proposed rule. c. Item 2 of “Material Conflict of Interest” Test Item 2 of the proposed interpretation, which requires “a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision,” is intended to require that the potential implications of the relevant conflict be sufficiently important as to warrant the prohibition imposed under the proposed rule. We preliminarily do not believe it would be appropriate to interpret the proposed rule so broadly as to prohibit all transactions that give rise to any conflict of interest, even if the potential benefits of such transactions for the securitization participant were so minimal as to be unimportant to a reasonable investor. We note that in considering whether there is a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision, it is not possible to designate in advance certain facts or occurrences as determinative in every instance. 73 Rather the proposed interpretation would require an assessment of the inferences that a reasonable investor would draw from a given set of facts and circumstances. 74 It would be appropriate, however, to consider both the probability that the securitization participant would receive a benefit and the magnitude of the benefit. 75 Thus, for example, it is possible that a securitization participant might stand to benefit substantially from a decline in the value of the ABS, but the probability of its receiving such benefit under the circumstances might be so small that a reasonable investor would not consider the conflict important to his or her investment decision. 73 Basic v. Levinson, 485 U.S. at 236 (“Any approach that designates a single fact or occurrence as always determinative of an inherently fact-specific finding such as materiality, must necessarily be overinclusive or underinclusive.”). 74 Id. (citing TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 450 (1976)). 75 Id. at 238 (citing SEC v. Texas Gulf Sulphur, Co., 401 F.2d 833, 849 (2d Cir. 1968) (en banc), cert. denied, sub nom Coates v. SEC, 394 U.S. 976 (1969)). Although the proposed interpretation uses a materiality formulation that is also used under the federal securities laws for determining whether disclosure is necessary— i.e., whether there is a substantial likelihood that a reasonable investor would consider the issue important to his or her investment decision—the use of this phrase in this context is not intended to suggest that a transaction otherwise prohibited under the proposed rule would be permitted if there were adequate disclosure by the securitization participant. We note in this regard that there may be practical challenges in relying on disclosure as a means to address all transactions involving a material conflict of interest—including in particular certain transactions arising after the offering documents have been disseminated but before the one-year timeframe covered by the proposed rule has elapsed. 76 Nevertheless, we request comment as to whether and to what extent adequate disclosure of a material conflict of interest should affect the treatment under the proposed rule of an otherwise prohibited transaction. 76 See infra Question 98. Request for Comments Regarding Material Conflicts of Interest 32. We seek comment regarding any potential consequences of not defining the term “material conflict of interest” in the proposed rule text and instead proposing an interpretation in the context of the proposed rule. Please discuss whether or not there may be an unintended chilling effect on securitization transactions resulting from potential uncertainty associated with not defining material conflict of interest. If you believe the Commission should define “material conflict of interest,” please provide a suggested definition and the rationale as to why such definition identifies the conflicts that the proposed rule is intended to address. 77 Is it likely or unlikely that such a definition would be able to anticipate all future material conflicts of interest? Would such a definition lead to unintended consequences, such as excluding from the proposed prohibition certain activities undertaken by securitization participants that involve material conflicts of interest? Or would such a definition be over-inclusive and encompass activities undertaken by securitization participants that do not involve material conflicts of interest? 77 See, e.g., ASF Letter at p. 5 (suggesting that a material conflict of interest “shall exist, if other than for hedging purposes or as permitted by Section 27B(c) of the Securities Act of 1933, (i) A [securitization participant] participates in the issuance of an asset-backed security that is created primarily to enable such [securitization participant] to profit from a related or subsequent transaction as a direct consequence of the adverse credit performance of such asset-backed security and (ii) within one year following the issuance of such asset-backed security, the [securitization participant] enters into such related or subsequent transaction.”). 33. Is the distinction suggested by commenters between conflicts that are inherent in the securitization process and those that are not a meaningful one? 78 Is this proposed distinction useful for purposes of defining the scope of Securities Act Section 27B? Are there other ways to distinguish between different conflicts of interest that the Commission should take into account in considering the scope of Section 27B? Would a reasonable investor understand the difference between conflicts of interest that are inherent in the offering process and those that are not? 79 Would the reasonable expectations of an investor in an ABS offering be a useful test for determining which conflicts of interest are material? 78 See supra Section IIB. 79 Id. 34. Is the proposed interpretation regarding what constitutes a material conflict of interest appropriate? Should the interpretation be broader or narrower? Please suggest alternative interpretations for what would constitute material conflicts of interest for purposes of the proposed rule and explain why such interpretations would better identify transactions that involve or result in material conflicts of interest. In addition to the magnitude of a benefit and the probability that it will occur, are there additional (or alternative) factors that should be considered in assessing whether there is a substantial likelihood that a reasonable investor would consider the conflict important to his or her decision to invest? 35. Should the proposed interpretation extend to indirect or unforeseeable benefits to a securitization participant? Please explain why or why not. How would a securitization participant determine that there was no such indirect or unforeseeable benefit? 36. Are there circumstances in which facilitating a third party to benefit from the adverse performance of the ABS or underlying assets would not be a material conflict of interest? Please explain. 37. We seek commenter input regarding the potential use of contractual provisions and covenants by securitization participants to manage their compliance with the proposed rule, as well as a discussion of how a securitization participant would determine that no contractual assurance was necessary. 38. As an alternative, would it be appropriate to prohibit a securitization participant from allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS (absent contractual provisions) if the involvement of the third party in the ABS transaction or the actions of the third party unrelated to the ABS transaction constituted a material conflict of interest with the investors in the ABS transaction (regardless of whether or not the securitization participant benefitted)? 39. Some commenters asserted that the prohibited conduct should be limited to creating and selling an ABS that is “intentionally designed to fail or default” 80 or creating and selling an “intentionally flawed” ABS so that a securitization participant can profit from a related or subsequent transaction. 81 As one commenter suggested, should the test focus on whether “(i) Such transaction or activity represents an overall alignment of the risk to the ABS or underlying assets similar to that borne by investors of the ABS, (ii) such transaction or activity is unrelated to the [securitization participant's] role in the specific ABS, (iii) disclosure of the transaction or activity of the [securitization participant] adequately mitigates the risk posed by the potential or actual conflict with respect to any investors in the ABS or (iv) another regulatory regime applies with respect to the potential or actual conflict of interest”? 82 Is such a formulation for the proposed rule appropriate? Please explain. Would such a test be over-inclusive and encompass activities that do not involve or result in material conflicts of interest? Would such a test be under-inclusive and fail to cover activities that are intended to be prohibited by Section 27B and the proposed rule? What other approaches would provide a substantially similar or higher level of investor protection as the proposed rule? 80 See SIFMA Letter at p. 2. 81 See ASF Letter at p. 5 (“the definition of `material conflicts of interest' should prohibit those types of transactions identified by Senators Merkley and Levin that create conflicts of interest by creating intentionally flawed asset-backed securities.” Specifically, the commenter suggested that a material conflict of interest exists “if, other than for hedging purposes or as permitted by Section 27B(c) of the Securities Act of 1933, (i) A [securitization participant] participates in the issuance of an asset-backed security that is created primarily to enable such [securitization participant] to profit from a related or subsequent transaction as a direct consequence of the adverse credit performance of such asset-backed security and (ii) within one year following the issuance of such asset-backed security, the [securitization participant] enters into such related or subsequent transaction.”). 82 SIFMA Letter at p. 3. 40. Are there transactions inherent in the securitization process that would be material conflicts of interest under the proposed interpretation that were not intended to be prohibited by Section 27B? Or, are there transactions inherent in the securitization process that would not fall within the proposed interpretation and the proposed rule that should be prohibited under Section 27B and application of the proposed rule? Please identify and provide an explanation of these activities as well as an explanation of why they should or should not be prohibited under Section 27B and the proposed rule. We ask that commenters address each of the activities set forth in initial comment letters as described in Section II.B as well as activities not addressed by initial comment letters. 41. Are modifications to the proposed rule or interpretation, consistent with the statute, necessary or advisable to mitigate any such unintended consequences? 42. Is the phrase “fees or other forms of remuneration, or the promise of future business, fees or other forms of remuneration” too narrow or too broad, or is it appropriate? Are there benefits to the securitization participant that would not be captured by this phrase? Should the proposal specifically address the anticipation or expectation of or attempts to induce such benefits? Please explain why or why not. 43. We ask commenters to discuss whether or not the proposal would prohibit any person “engag[ing] in any transaction” that commenters believe should be permitted under Section 27B of the Securities Act? If such activity were prohibited, please discuss any potential impact, including any impact on investors, investor protection, liquidity, capital formation and the maintenance of fair, orderly and efficient markets. 44. We seek commenter input regarding whether the phrase used in item 1(B) “directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS” is appropriate, under- or over-inclusive. Please provide examples of persons who would not be identified by this phrase that you believe should be subject to the proposed rule. Please provide examples of persons that would be identified using this phrase that you believe should not be subject to the proposed rule. Would the phrase “exercises control over the structure of the relevant ABS or the selection of assets underlying the ABS” be more appropriate? Please explain why or why not. Would the phrase “has substantial control over the relevant ABS or the selection of assets underlying the ABS” be more appropriate? Please explain why or why not. Would the phrase “influences the structure of the relevant ABS or the selection of assets underlying the ABS” be more appropriate? Please explain why or why not. We seek commenter suggestions on alternative language and an explanation of why it would be more appropriate in this context. Please include in your responses a discussion of whether any alternative option would be over- or under-inclusive and provide examples of persons who would not be identified by the alternatives that you believe should be subject to the proposed rule as well as examples of persons who would be identified by alternatives but that you believe should not be subject to the proposed rule. 45. Is the proposed application of the prohibition under Section 27B to securitization participants if third parties, directly or indirectly, structure the relevant ABS or select assets underlying the ABS appropriate? Should the restrictions be placed on a broader category of activities or a more delineated one? Should we define the phrase “directly or indirectly, to structure the relevant ABS or select assets underlying the ABS” used in item 1(B)? If yes, please provide a suggested definition and the rationale as to why such definition would be appropriate. 46. We seek commenter input regarding whether the phrase used in item 1(B) “as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS” is appropriate, over- or under-inclusive. Please provide examples of persons who would not be identified by this phrase that you believe should be. Please provide examples of persons that would be identified using this phrase that you believe should not be. Would the phrase “as a result of allowing a third party, directly or indirectly, to influence the structure of the relevant ABS or the selection of assets underlying the ABS” be more appropriate? Please explain. Would the phrase “as a result of allowing a third party, directly or indirectly, to substantially influence the structure of the relevant ABS or the selection of assets underlying the ABS” be more appropriate? Please explain. We seek commenter suggestions on alternative language and an explanation of why it would be more appropriate in this context. B. Statutory Exceptions Consistent with Securities Act Section 27B, proposed Rule 127B(b) would provide exceptions to the prohibition in proposed Rule 127B(a) for risk-mitigating hedging activities, liquidity commitments, and bona fide market-making. We have modeled the proposed exceptions on the text of Section 27B of the Securities Act. i. Risk-Mitigating Hedging Activities Pursuant to the proposed rule, the following would not be prohibited by paragraph (a) of the proposed rule: Risk-mitigating hedging activities in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an asset-backed security, provided that such activities are designed to reduce the specific risks to the underwriter, placement agent, initial purchaser, or sponsor associated with such positions or holdings. The proposed exception for risk-mitigating hedging activities uses the language set forth in Section 27B(c)(1). 83 The goal of this proposed exception is to allow certain hedging activities that are designed to reduce or mitigate risk for the underwriter, placement agent, initial purchaser, or sponsor, where risk mitigation refers to the practice of limiting the consequences of a risk, without necessarily reducing the probability of the risk occurring. For example, firms engage in risk-mitigating hedging as they pool assets to create ABS. The assets are assembled over time and firms hedge the specific risk of a price decline of the assets being assembled for the pool while the pool is formed. This type of activity would fall within the proposed exception. 83 We did not incorporate the second use of the phrase “arising out of such underwriting, placement, initial purchase or sponsorship” to streamline the proposed rule text, and intend no substantive change from Section 27B(c)(1). Although the exception in Section 27B(c)(1) by its terms does not address affiliates and subsidiaries, the Commission preliminarily believes that, since affiliates and subsidiaries of securitization participants are included in the list of persons who are prohibited from engaging in the type of activity specified in Section 27B they too should have the benefit of the proposed exception for risk-mitigating hedging activities. Therefore, the Commission would interpret the exception as applying to affiliates and subsidiaries of securitization participants. The proposed exception is not intended to permit speculative trading masked as risk-mitigating hedging activities. 84 Generally, risk-mitigating hedging is effected to reduce risk from an existing position or a position about to be taken. 85 The risk-mitigating hedging activities would be required to occur in connection with positions or holdings arising out of the underwriting, placement, initial purchase, or sponsorship of an ABS. 86 In addition, the activities would be required to be designed to reduce the specific risk to the underwriter, placement agent, initial purchaser, or sponsor associated with positions or holdings as mandated by Section 27B. Risk-mitigating hedging may include a series of hedging transactions, based on the price movements of the underlying assets, in order to remain delta-neutral. 87 Risk-mitigating hedging does not include trading to establish new positions designed to earn a profit. 88 That activity might be an indicator of speculation. 89 84 Similar concepts are used in proposed Exchange Act Rule 3a67-4 which defines the term “hedging or mitigating commercial risk.” For example, Rule 3a67-4(b)(1) provides that “[s]uch position is: (i) [n]ot held for a purpose that is in the nature of speculation, investing or trading” Release No. 34-63452 (Dec. 7, 2010), 75 FR 80174, 80215 (Dec. 21, 2010). 85 See infra Section IIIE (discussing the potential interplay with the Volcker Rule). Similar concepts are used in connection with risk-mitigating hedging with respect to the Section 619 of the Dodd-Frank Act, commonly referred to as the Volcker Rule. “Risk-mitigating hedging is defined by two essential characteristics; (i) The hedge is tied to a specific risk exposure, and (ii) there is a documented correlation between the hedging instrument and the exposure it is meant to hedge with a reasonable level of hedge effectiveness at the time the hedge is put in place.” Financial Stability Oversight Council, Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds (Jan. 2011)(“FSOC Study”), at p. 30, available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.pdf . 86 Risk-mitigating hedging would also be permitted in connection with market-making to the extent it relates to positions taken in connection with the permitted activity. 87 See, e.g., FSOC Study at p. 30 (“hedging activity should adjust over time”). 88 See, e.g., id. at p. 20 (hedging “presents a potential avenue to evade the proprietary trading prohibition if hedges do not correlate with owned assets or if a banking entity seeks an independent return through the application of the hedge” ) (emphasis added). 89 See, e.g., William L. Silber, On the Nature of Trading: Do Speculators Leave Footprints ?, 29 Journal of Portfolio Management 4, 64 (Summer 2003) (“Silber”) (describing speculation as trading in anticipation of future prices and taking on the risk of unanticipated equilibrium price movements in order to earn profits). In addition, we note that these statements are only intended to describe trading that may not qualify for the proposed exception. These statements are not intended to opine on the permissibility of speculative trading in other contexts. Material changes in risk should generate a corresponding change in risk-mitigating hedging. 90 Moreover, a risk-mitigating hedge generally should unwind as exposure is reduced. Over-hedged exposure may be indicative of a proprietary position rather than a risk-mitigating hedge. Intermittent activity (hedging only when one chooses to act) or activity that is inconsistent with a hedging policy is also indicative of proprietary trading. Typically, the hedge should not be significantly greater than actual exposure to the underlying assets. The hedge ( e.g., the notional amount under the hedge) should be correlated so that losses (gains) on the position being hedged are offset by gains (losses) on the hedge without appreciable differences. The Commission preliminarily believes that activity would not qualify as a risk-mitigating hedge for purposes of the proposed rule if the predicted performance of the hedge throughout the length of time that the hedge and the related position were held, resulted in a situation in which incrementally poor performance of an ABS or its underlying assets would result in a securitization participant earning appreciably more profits on the hedge than the losses incurred from their ABS exposure. 90 Risk-mitigating hedging indicia are considered in connection with the Volcker Rule. “Hedging activity should be designed to reduce the key risk factors in the banking entities' existing exposure, and should offset gains or losses that would arise from those exposures. Hedging activity should adjust over time based on changes in a banking entity's underlying exposures. Hedging activity should adjust over time if market conditions alter the effectiveness of the hedge even if the underlying positions remain unchanged. Material changes in risk should generate a corresponding change in hedging activity and should be consistent with the desk's hedging policy.” FSOC Study, at p. 30. We seek comment on the application of the proposed exception to “mitigating” the consequences of a risk as intended by Congress. Request for Comments Regarding Risk-Mitigating Hedging Activities 47. It has been argued that firms must hedge actual risks created by actual positions that left them with actual exposures. 91 Please discuss how such exposures arise and how they might be defined. Section 27B uses only the terms “p [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2011-24404. Public record. Not legal advice.