Critics are warning that the SEC’s recently proposed rule (the “Proposed Rule”) prohibiting conflicts of interest in asset-backed securities (ABS) transactions may impede the ability of financial institutions, broker-dealers and others to enter into interest rate hedges and other risk-mitigating transactions.
The Proposed Rule, issued in January, resurrects a prior 2011 SEC proposal that lay dormant for over a decade after facing substantial pushback from industry participants. The re-proposal has revived this controversy, with critics arguing it is overly broad in scope and may create unintended consequences for the broader market.
Statutory Requirement and Proposed Rule
Section 27B of the Securities Act of 1933, which was added by Section 621 of the Dodd-Frank Act, prohibits underwriters, placement agents, initial purchasers and sponsors of ABS and their affiliates from engaging in “any transaction that would involve or result in a material conflict of interest with respect to any investor in a transaction arising out of such activity” for a period of one year after the date of the first closing of the ABS sale.
The statute requires the SEC to issue rules implementing this prohibition, subject to exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making.
The Proposed Rule implements the statute by prohibiting such “securitization participants” and their affiliates from directly or indirectly engaging in any such conflicted transaction during the one-year period. In addition to certain specified transactions that are per se “conflicted transactions” (e.g., short sales of the ABS, purchases of certain CDS referencing the ABS), the Proposed Rule includes an anti-evasion clause covering any “economically equivalent” transaction.
Exception for Risk-Mitigating Hedging
Consistent with the statute, the Proposed Rule provides an exception from the prohibition for certain risk-mitigating hedging activities arising out of the securitization activities.
As proposed, however, this exception would be available only where the following conditions are met:
- at inception and at the time of any subsequent adjustment, the hedging activity is “designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks arising in connection with identified positions, contracts or other holdings of the securitization participant”;
- the hedging activity is subject to “ongoing recalibration” to ensure its remains permissible and “does not facilitate or create an opportunity to benefit from a conflicted transaction other than through risk-reduction”; and
- the securitization participant has implemented an internal compliance program reasonably designed to ensure it engages only in permitted hedging activities.
Possible Unintended Consequences
Commenters argue that the first condition—in particular, the requirement that the hedging activities must arise out of the securitization activities and relate to one or more “identified positions, contracts, or other holdings”—may unduly limit the scope of the exception by excluding, for instance, certain portfolio hedges or hedges tied to indices, where it is not clear that the underlying exposure arises in connection with the securitization.
As proposed, even run-of-the-mill interest rate swaps entered into by a securitization participant (or its affiliates) may not be eligible for the exception if they are not materially related to the credit risk of the relevant ABS or the underlying asset pool. Absent a clear exception for such interest rate hedges, they may constitute “conflicted transactions” to the extent they increase in value when the ABS decreases in value, such as when interest rates rise.
In addition to concerns around scope, commenters have also expressed concerns with the “ongoing recalibration” and compliance program requirements, arguing that they would place unnecessary restrictions on the manner in which market participants manage their hedges and impose excessive compliance costs on a broad range of ABS participants, including banks and non-banks alike.
While recent events in the banking sector highlight the importance of avoiding any obstacles to banks’ and other financial institutions’ ability to mitigate interest rate and other risks, it remains to be seen how the SEC will respond to these concerns and whether the Proposed Rule will survive or will suffer the same fate as its 2011 predecessor.