[1] Proposed Rule 192 would prohibit any "securitization participant" (a Securitization Participant) delineated under the rule from engaging in transactions that would involve or result in any "material conflict of interest" with respect to any investor in the applicable ABS transaction with respect to which the Securitization Participant is acting.
Scope of the rule: securitization participants
Proposed Rule 192 would apply to Securitization Participants involved in an ABS transaction, which includes (1) underwriters; (2) placement agents and initial purchasers; (3) securitization sponsors; and (4) any affiliate or subsidiary of any of the foregoing. The table below sets forth the definition applicable to such entities under the proposed rule, along with certain key items of interest in relation thereto.
Securitization participant
Key points
Placement agent or underwriter
Proposed definition: Proposed Rule 192 would define a "placement agent" or "underwriter" as "a person who has agreed with an issuer or selling security holder to:
- Purchase securities from the issuer or selling security holder for distribution;
- Engage in a distribution for or on behalf of such issuer or selling security holder; or
- Manage or supervise a distribution for or on behalf of such issuer or selling security holder."[2]
Key considerations:
- Prong 3 of the proposed definition would capture entities merely managing or supervising a "distribution" of ABS, meaning it not be necessary for the placement agent or underwriter to actually acquire the ABS and on-sell them. This, in turn, implicates placement agents (and their affiliates and subsidiaries) in Section 4(a)(2) private placements in Proposed Rule 192’s prohibitions.
- "Distribution" would have the same definition as under the Volcker Rule, focusing on either (i) the presence of "special selling efforts" and "selling methods" or (ii) the offering of ABS pursuant to an effective registration statement.
Initial purchaser
Proposed definition: Proposed Rule 192 would define "initial purchaser" as "a person who has agreed with an issuer to purchase a security from the issuer for resale to other purchasers in transactions that are not required to be registered under the Securities Act in reliance upon Rule 144A or that are otherwise not required to be registered because they do not involve any public offering."[3]
Key considerations:
- The definition of "initial purchaser" is consistent with the SEC's prior use of the term in the context of ABS.
Securitization sponsors
Proposed definition: Proposed Rule 192 would, subject to certain exceptions, define the term "sponsor" as:
- "Any person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the entity that issues the asset-backed security; or
- Any person:
- with a contractual right to direct or cause the direction of the structure, design, or assembly of an asset-backed security or the composition of the pool of assets underlying the asset-backed security; or
- that directs or causes the direction of the structure, design, or assembly of an asset-backed security or the composition of the pool of assets underlying the asset-backed security."[4]
Key considerations:
- The definition of "sponsor" under the proposed rule not only includes the Exchange Act definition of "sponsor" (familiar to market participants in the context of U.S. risk retention), but is broader than that definition in its inclusion of persons who either directs or has contractual rights to direct the ABS transaction. It is also broader than the Regulation AB definition of "sponsor".
- Staff commentary explicitly lists, among others, CLO managers as "sponsors" subject to the proposed rule (a difference in treatment for such managers vs. the U.S. risk retention context in light of the 2018 LSTA v. SEC decision).[5] Explicitly excluded from the proposed definition of "sponsor" are those entities who perform purely "administrative, legal, due diligence, custodial or ministerial" acts (such as, presumably, trustees, rating agencies, collateral agents, etc.).
- Sponsors need not have a contractual right to structure the deal or direct asset acquisition; mere factual circumstances evidencing that a party did so are sufficient to trigger the prohibitions of Proposed Rule 192.[6] This would encompass as a sponsor any party that participates in the asset selection process, though the Staff is careful to note that Proposed Rule 192 aims to distinguish ultimate investors seeking to hold long positions in the relevant ABS and who weigh in regarding the assets.[7]
Affiliate and subsidiary
Proposed definition: Proposed Rule 192 would define (i) an "affiliate" of a specified person as "a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified" and (ii) a "subsidiary" of a specified person as "an affiliate controlled by such person directly, or indirectly through one or more intermediaries."
"Control" would be defined "to mean the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise."[8]
Key considerations:
- "Affiliate" and "Subsidiary" would have the same meaning under Proposed Rule 192 as each respectively does for purposes of Regulation S.
- These definitions are broad, and capture indirect and intermediary control, as well as entities that are subject to common control by another entity. In the case of "subsidiaries", majority owned subsidiaries, significant subsidiaries, totally held subsidiaries and wholly owned subsidiaries would all be included under the proposed rule.
- In addition, the Proposing Release notes that information barriers between Affiliates, Subsidiaries and their related Securitization Participant(s) would not exempt the related entities from prohibition set out in Proposed Rule 192[9] However, the Staff seeks comment on whether or not an exemption for such information barriers would be appropriate, which may suggest openness to the idea (in the commentary to Proposed Rule 192, the Staff suggests four possible conditions for such exemption).[10]
Prohibition
As noted above, Proposed Rule 192 would prohibit Securitization Participants from, directly or indirectly, engaging in any transaction that would involve or result in any "material conflict of interest" with respect to any investor in the ABS deal in connection with which the Securitization Participant is acting. This prohibition would apply not only to general ABS transactions, but to synthetic transactions as well,[11] and would begin on the date on which the Securitization Participation "has reached, or has taken substantial steps to reach" an agreement regarding that entity's participation in the ABS and end on the date that is one year following the first closing of the sale of the ABS.
A transaction would be subject to the prohibition if it is a "conflicted transaction" (a Conflicted Transaction), which under the proposed rule includes any of the following types of transactions, where there is a substantial likelihood that a reasonable investor would consider the transaction important to the investor's investment decision, including a decision whether to retain the ABS:
- (1) a short-sale of the ABS;
- (2) a purchase of a credit default swap or other credit directive entitling the Securitization Participant to payments on the occurrence of specified credit events under the ABS; or
- (3) the purchase or sale of any financial instrument (other than the ABS itself) or entry into a transaction pursuant to which the Securitization Participant would benefit from any actual, anticipated or potential (i) adverse performance of the underlying ABS portfolio, (ii) losses, early amortization or monetary defaults on the ABS or (iii) a decline in the market value of the ABS.
The proposed rule also contains an anti-circumvention prong intended to capture any transaction which, even if not of a type described above, would violate the spirit of Proposed Rule 192 by being "economically equivalent" to one of the three prohibited transaction types.[12] Notably, this means that market participants would, if rule takes effect as proposed, be required to evaluate any tangential activity undertaken by themselves or their affiliates and subsidiaries on an ongoing basis for economic equivalency as described above. This would add further compliance burdens and uncertainty to an already complex and wide-reaching rule.
Excepted activities
However, there are three activities that are excluded from the definition of a Conflicted Transaction under the proposed rule: certain risk-mitigating hedging (RMH) activities, liquidity commitments and bona fide market-making (BFMM) activities.
1. Risk-mitigating hedging activities
First, the prohibition under the proposed rule would not apply to certain RMH activities of a Securitization Participant in connection with and related to individual or aggregated positions, contracts, or other holdings of the Securitization Participant arising out of its securitization activities. However, such RMH activities must be: (A) at the time of inception (or adjustment, as applicable), designed to reduce or "significantly" mitigate "one or more specific, identifiable risks" arising with respect to such positions, contracts or other holdings, (B) be subject to "ongoing recalibration" by the Securitization Participant to ensure the activity does not facilitate or create an opportunity for actual benefit by the participant (rather than mere risk reduction) and (C) the Securitization Participant must implement, maintain and enforce written internal policies to ensure the foregoing requirements are observed. Notably, "specific" and "identifiable" are not defined by the Proposing Release, though the Staff seek comment as to whether such terms should be defined (and if so, how).
2. Liquidity commitments
Second, the prohibition would not apply to purchases or sales of the ABS made pursuant to, and consistent with, commitments of the Securitization Participant to provide liquidity for the ABS.
3. Bona fide market-making activities
Third, the prohibition would not apply to certain BFMM activities in connection with and related to the ABS, their underlying assets or financial instruments referencing either of the foregoing (any such financial instruments, Relevant Instruments). BFMM activities are only permitted, however, where: (A) the Securitization Participant "routinely stands ready" to purchase and sell one or more types of the Relevant Instruments, and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in the same in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity and depth of the market for the relevant types of financial instruments; (B) the Securitization Participant's BFMM activities are designed not to exceed ongoing "reasonably expected near term demands" for the Relevant Instruments; (C) the compensation arrangements for such BFMM are not designed to reward or incentivize Conflicted Transactions; (D) the Securitization Participant is licensed or registered to engage in such BFMM; and (E) the Securitization Participant implements, maintains and enforces written internal policies to ensure the above.
4. Un-exempted Activity
Notably, as currently drafted, Proposed Rule 192 features neither a disclosure exemption (marking a departure from positions taken by the Staff in connection with Reg AB in respect of conflict-of-interest disclosures) nor an exemption for offshore transactions and/or non-U.S. Securitization Participants (whether or not the Securitization Participation is located in the United States, and whether or not the ABS transaction otherwise has a U.S. nexus or is marketed to U.S. investors). In addition to raising questions about the SEC’s jurisdictional reach over offshore entities and transactions, the absence of an extraterritoriality exemption may cause confusion and uncertainty in the global securitization markets if it comes into effect in its current form, as well as vastly increasing the compliance complexity for those Securitization Participants whose affiliates and subsidiaries are overseas entities or act in non-U.S. markets.
We have designed a flowchart to assist in determining whether an exemption may apply to your specific set of circumstances.