January 31, 2024 - Much ink has been spilled on the unprecedented number of proposed rulemakings that the SEC has issued under Chair Gensler. Now focus is turning to preparing for compliance with these new rules. One such rulemaking – Prohibition on Conflicts of Interest in Securitizations (“Final Rule”) adopted in November – is one such example. The Final Rule stems from the Dodd Frank Act and implements new Section 27B of the Securities Act, which is designed to prevent the “designed to fail” securitizations which preceded the Global Financial Crisis. When the rule was reproposed in January 2023 (10 years after the initial proposal), market participants were greatly concerned with the expansive scope of the rule. The key definitions of “securitization participant” and “conflicted transaction” were overly broad by their terms. That breadth was compounded by the fact that the prohibition does not require intent and no benefit needs to be realized. The LSTA and other industry bodies actively engaged with the SEC, including submitting multiple comment letters. In the end, as we previously reported, the Final Rule is better, but will still require affected market participants to augment and modify compliance programs.
Fortunately for LSTA members, compliance with the Final Rule was the subject of a recent webcast presented by Giles Kelly and Eno Usoro, partners at Sidley. Below is a high-level summary of the webcast, particularly focusing on considerations for CLOs.
What does the Final Rule do?
The Final Rule prohibits a “securitization participant” from engaging, directly or indirectly, in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in an asset-backed security (“ABS”). This prohibition applies until one year after the first closing of the sale of the ABS and starts on the date the “securitization participant” reaches an agreement that it will become a securitization participant with respect to that ABS. The Final Rule will only apply with respect to securitizations that have their first closing on or after June 9, 2025.
Who is a “securitization participant”?
There are three categories: the underwriter, placement agent, or initial purchase of an ABS, the “sponsor” of an ABS, e.g., CLO manager or sponsor of a balance sheet CLO, and certain of their affiliates and subsidiaries unless certain criteria are met. Whether those criteria are met is a facts and circumstances determination and one area of compliance focus. The Final Rule does include a service provider exclusion to the definition, but it is narrow and would not apply if the person has a role in portfolio management. (See replay starting at 26:00.)
What is a “conflicted transaction”?
The Final Rule defines “conflicted transaction” as (i) a short sale of the ABS, (ii) the purchase of certain credit default swaps or other credit derivatives, or (iii) the purchase or sale of any financial instrument or entry into a transaction that is “substantially the economic equivalent” of (i) or (ii), other than any transaction that only hedges general interest rate or currency exchange risk. The definition is supplemented by the anti-evasion provision which captures transactions that are technically compliant but in contravention of the spirit of the Final Rule.
There are three categories of transactions that are exceptions to the definition, but only if certain conditions are met: risk-mitigating hedging, liquidity commitments, and bona fide market-making activities. In many cases making a determination that the relevant conditions have been met is a facts and circumstances analysis. Compliance programs will need to address this and is a point of focus as market participants prepare.
What are key considerations for CLOs?
As discussed in the webcast, CLO managers will generally be contractual rights sponsors and therefore be subject to the prohibition as a securitization participant. Many of the exclusions that industry had pushed for were not adopted in the Final Rule, such as a carveout for loan administration or an exclusion where a party has a fiduciary duty or is advising a client. The Final Rule does have a narrower scope, and some of the concerns around these exclusions are addressed by that, but this is an area to pay attention to. (See replay starting at 53:00.) In designing compliance programs – which will take time – members need to be thinking about their business activities and where in the corporate structure those activities reside (or can reside) in light of the Final Rule. This is particularly true for multi strategy managers. Members also need to consult with their counsel and advisers to develop interpretations of vague language where there is not specific guidance in the Final Rule or related commentary.
The LSTA will continue to monitor implementation as the June 9, 2025 date draws near. If you are interested in being a part of those discussions, please email Tess Virmani.