May 3, 2023 - This week, the LSTA submitted its second comment letter on the SEC’s recent Conflict in Securitizations Rule Proposal (the “Proposal”). Given the unreasonably short comment period offered by the SEC, the LSTA decided to split its response into three parts. The first letter, summarized here, focused on the characteristics of the loan and CLO markets and addressed certain cost/benefit issues, was submitted on the March 27th deadline. The third letter, which we expect to submit in the coming weeks, will do a deep dive into the unique challenges, and possible solutions, relating specifically to CLOs and the underlying loan market. As we explain below, the second letter addresses the impact and weaknesses of the Proposal on the broader securitization markets.
The LSTA’s second comment letter was constructed by reference to, and in support of, the comprehensive comment letter (the “SIFMA Letter”) previously submitted by SIFMA, SIFMA AMG and the Bank Policy Institute (the “Associations”).
As a starting point, we expressed our agreement with the general observations in the Associations’ Executive Summary, including the proposition that the Proposal is significantly flawed and should not be adopted, and that the Commission should propose a revised, more tailored rule. The Proposal is vague and overly broad, goes far beyond the statutory mandate, and does not consider the vast changes that have taken place in the securitization market since the Dodd-Frank Act, which authorizes the Proposal, became law over 12 years ago. We also observed that the Commission ignores and fails to honor many of its own most basic, long-held interpretations and applications of fundamental securities law principles such as (1) the efficacy of disclosure and consent and information barriers and (2) the meaning of material conflict of interest. In the balance of this letter, we addressed several of the more critical issues raised by the Associations that would impact the securitization market generally and, in some cases, would be especially challenging for CLOs and the loan market.
We agreed with the Associations that the Proposal’s definition of “securitization participant” was far too broad and should be narrowed and clarified and is particularly challenging for CLOs because many of the legal entities that participate in that market are affiliated with, or subsidiaries of, many other entities (including international affiliates and subsidiaries) that play no substantive role in (i) structuring, creating, marketing, or selling CLOs, (ii) structuring, creating, marketing, or selling the underlying leverage loans or high yield bond assets of a CLO or (iii) selecting (initially or during the reinvestment period for CLOs) the assets backing the asset-backed securities. These “non-participating entities” are nevertheless caught up under the Proposal.
Relatedly, we addressed the SEC’s puzzling refusal to honor the use of information barriers as one of several methods that may be used to establish and demonstrate the separateness of non-participating entities and securitization participants. As the Associations noted, the Commission has long recognized the efficacy and importance of information barriers to manage the potential misuse of material non-public information among the most significant of all securities law concerns. And it is unclear why the Commission would take the position in the Proposed Rule that information barriers are insufficient to prevent conflicted transactions and why it would propose five unnecessary conditions for the use of information barriers.
We also supported the Associations’ view that the Proposal’s definition of “conflicted transaction” should be narrowed and clarified. Specifically, (a) the Proposal’s definition of “conflict of interest” does not reflect the ordinary and natural meaning of that term; (b) the “catchall” provision of the definition of “conflicted transaction” is much too broad and does not describe transactions that create material conflicts of interest; (c) pre-securitization transactions should be expressly carved out of the definition of “conflicted transaction”; and (d) while a short sale of ABS by a securitization participant may create a conflict of interest between that securitization participant and investors, a short position in an index that references the ABS should be expressly carved out of the definition of “conflicted transaction.”
The next issue we addressed was the Proposal’s failure to permit disclosure as a means of addressing material conflicts of interest. Under the securities laws, disclosure is the fundamental approach for addressing the risks faced by investors and that should be no different under the Proposal. It is unclear why the Commission fails to provide for a disclosure alternative to a prohibition of material conflicts of interest in the Proposal when the securities laws prescribe such an alternative in almost all other cases. We urge the SEC to recognize disclosure and consent as a viable alternative to the Proposal.
We then ask the Commission to refine the definition of “sponsor” in a way that is consistent with its ordinary and plain meaning, and not to include investors, rating agencies and third-party service providers. The LSTA agrees with the Associations that the definition of “sponsor” is “a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.” We agree also that clause (ii) of the definition extends far beyond its ordinary and natural meaning and that it is so wide-ranging that it threatens to capture many entities that are not involved in the organization and initiation of an ABS—even, incredibly, investors. At a minimum, credit rating agencies, investors in a long position in ABS, and third-party service providers, none of whom are involved in the organization or initiation of a securitization transaction, should be excluded from the definition of “sponsor.”
Another important issue we covered was the Proposal’s vague and expansive anti-circumvention provision. We call on the Commission to remove that provision and replace it with a narrower anti-evasion provision that applies only to the Proposal’s exceptions and safe harbors. The anti-circumvention provision goes beyond what is reasonable in this context and is not supported by the Proposal’s authorizing legislation, Section 621 of the Dodd-Frank Act. Instead, the provision should specify that an exception or safe harbor to the Proposal is not available with respect to any transaction or series of transactions that, although in technical compliance with that exception or safe harbor, is part of a plan or scheme to evade the general prohibition contained in the rule. As we discussed in our previous letter, the challenges presented by the breadth and vagueness of the term “conflicted transaction” are even more acute in the CLO and loan markets given the nature of the underlying loan assets, and so it follows that the broad and vague application of the anti-circumvention provision would be more problematic as well.
The LSTA’s second comment letter also addresses exemptions, the appropriate beginning of the compliance period for securitizations, the need for a reasonable transition period, and the weakness of the Commission’s economic analysis. The LSTA is currently working on the third and final comment letter with counsel, the CLO Committee and the conflicts rule working group and will summarize that letter when it is submitted.