February 1, 2023 - Last week, the SEC reproposed a Dodd-Frank era rule they initially proposed in 2011 in the wake of the Great Financial Crisis. The proposed 189-page rule, the “Prohibition Against Conflicts of Interest in Certain Securitizations Rule (the “Proposed Rule”) would prohibit a “securitization participant” from directly or indirectly engaging in any transaction that would result in a material conflict of interest between the securitization participant and an investor. Importantly, whereas it was unclear whether the 2011 proposal covered CLOs, the reproposed rule clearly does (as well as CLO managers, arrangers and underwriters). The Proposed Rule is significantly more prescriptive than the 2011 proposal but there remains much ambiguity and the Proposed Rule is quite concerning. If approved in its current form, the Proposed Rule could present serious challenges for the ABS market, including the CLO market.
Following, we present an initial, high-level summary of the Proposed Rule and identify some of its ambiguities and challenges. We will have more to say as we dig deeper and continue to assess the Proposed Rule’s implications for the CLO market. In the meantime, we refer you to comprehensive and helpful memos from Mayer Brown and Morgan Lewis on the Proposed Rule as it pertains to securitizations generally.
Why now? Good question. Like proposed Rule 9j-1 (which we addressed early last year), the original rule was proposed as a part of the 2010 Dodd-Frank Act, a sweeping financial reform law that was driven by the abuses that contributed to the Great Financial Crisis. As Morgan Lewis notes, the “scope of, and difficulty of compliance with, the original proposal generated a number of critical comments from industry participants [including the LSTA’s ]. The SEC did not take any further action on the original proposal.” As with Rule 9j-1, which was proposed in 2010, the reproposal came as a bit of a surprise. Morgan Lewis further notes, the “SEC’s expressed intent behind the renewed rulemaking is to fulfill a long-outstanding congressional mandate to address one of the perceived roots of the financial crisis.” Oddly, the SEC is moving forward even though they acknowledge that “[s]ecuritization markets have undergone various changes since that time, including as a result of other rules that regulate securitization activity,” and that it “do[es] not have data on the extent of such conduct following the financial crisis of 2007-2009,”.
Who is covered by the Proposed Rule? The Proposed Rule applies to “securitization participants”, including underwriters, placement agents, initial purchasers or sponsors of asset backed securities (“ABS”) as well as any affiliate or subsidiary of a securitization participant, including foreign affiliates and subsidiaries. Importantly, the definition of “sponsor” has been expanded form the 2011 proposal and now clearly covers CLO managers. Notably, the SEC does not permit the use of information walls to protect affiliates or subsidiaries (although it seeks comment on scenarios in which information walls would be respected). It is difficult to imagine how firms, especially large entities with many affiliates and subsidiaries and multiple strategies, could comply with the Proposed Rule without the ability to rely on information walls. Also noteworthy, the SEC leaves no room for disclosure and informed consent as avenues for curing potential conflicts.
What is covered by the Proposed Rule? ABS, including publicly registered and unregistered private offerings such as those issued under Rule 144A, such as CLOs.
What is a “conflicted transaction”? The Proposed Rule prohibits a securitization participant from engaging in any conflicted transaction. This includes any of the following transactions with respect to which there is a substantial likelihood that a reasonable investor would consider the transaction important to the investor’s investment decision, including the investor’s decision to retain the ABS: (i) a short sale of the ABS; (ii) the purchase of a CDS or other derivative that would benefit from the occurrence of a credit event in respect of an ABS; and (iii) the purchase or sale of any instrument, or the entry into any transaction, through which the securitization would benefit from the actual or potential adverse performance of the asset pool supporting the ABS; loss of principal monetary default or early amortization of the relevant ABS; or decline in market value of the relevant ABS. As Mayer Brown notes, this last part, a so-called “catch-all” provision, is very vague and open-ended and introduces a great deal of uncertainty. Similarly, determining what a “reasonable investor” considers material under the circumstances, coupled with inability of a securitization participant from protecting itself through disclosure, is daunting.
Exceptions. There are several exceptions built into the Proposed Rule including for risk-mitigating hedging activities, bona-fide market making and liquidity commitments. A discussion of the exceptions is beyond the scope of this article but is covered in the memos referred to above.
The Anti-circumvention clause. The Proposed Rule includes an anti-circumvention provision that is meant to capture any transactions that go against the spirit, if not the letter, of the Proposed Rule. This provision targets transactions that may technically fall outside the definition of conflicted transaction but are economically equivalent. This clause, too, injects a significant amount of ambiguity, cost and uncertainty into the Proposed Rule and puts an additional burden on securitization participants to determine whether transactions not covered within the four walls of the Proposed Rule are nevertheless in scope.
Conclusion. The Proposed Rule is very prescriptive, does not recognize basic, time-tested protective tools such as disclosure and information walls, yet includes a great deal of ambiguity and uncertainty. Moreover, its application to CLOs, a long-only product whose incentive structure is driven by the success of their portfolios, is questionable. The SEC seeks comment from interested parties yet, unreasonably, provides only 30 days from publication in the Federal Register to do so.
What’s Next? The LSTA continues to review the Proposed Rule and analyze its specific implications for CLOs and will report our findings soon. We will also consult with our members and consider submitting a comment letter by the deadline. For further information, please reach out to Elliot Ganz.