On January 25, 2023, the U.S. Securities and Exchange Commission (SEC) re-proposed rules1 (the "Proposed Rule") to implement Section 27B of the Securities Act of 1933, as amended ("Section 27B"), which was mandated by Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank").
The Proposed Rule, if adopted, would prohibit securitization participants (including collateralized loan obligation (CLO) managers) and their affiliates and subsidiaries from entering into certain transactions that effectively represent a bet against their own deals.2
What Types of Transactions Are Prohibited?
Section 621 of Dodd-Frank was enacted in the wake of the global financial crisis of 2008 to prohibit transactions such as the infamous Abacus 2007-AC1 synthetic collateralized debt obligation (CDO), which was designed to fail so that a particular hedge fund investor that had participated in selecting the CDO's referenced assets could short the CDO via a credit default swap.3 If the Proposed Rule merely sought to prevent a recurrence of the Abacus transaction, its sole impact would be akin to shutting the barn door long after the horse had bolted because such transactions have not seen the light of day since before Dodd-Frank was passed. Given that the Proposed Rule clarifies the scope of the prohibited conduct, the exceptions and the participants subject to the proposal, however, it merits closer attention, particularly by CLO managers that are part of a large diversified credit platform.
The Proposed Rule prohibits any underwriter, placement agent, initial purchaser or sponsor (including any CLO manager) of an asset-backed security (ABS) (including a CLO) or any affiliate or subsidiary of such entity (a "securitization participant") from engaging in any transaction that would involve or result in a material conflict of interest between the securitization participant and any investor in the ABS. The restriction is applicable for a period commencing on the date on which a person has reached, or has taken substantial steps to reach, an agreement that such entity will become a securitization participant and ending on the date that is one year after the date of the first closing of the sale of the ABS.
The Proposed Rule defines a material conflict of interest as a material conflict involving or resulting from any of the following transactions where there is a substantial likelihood that a reasonable investor in the ABS would consider the relevant transaction important to the investor's investment decision, including a decision whether to retain the ABS (such transactions, "conflicted transactions"):
- A short sale of the ABS.
- Purchase of a credit default swap or other credit derivative product where the securitization participant would be entitled to receive payments upon the occurrence of specified credit events in respect of the particular ABS.
- Purchase or sale of any financial instrument (other than the ABS) or entry into a transaction through which the securitization participant would benefit from the actual, anticipated or potential (a) adverse performance of the underlying asset pool for the ABS; (b) loss of principal, monetary default or early amortization of the ABS; or (c) decline in the market value of the ABS.
The Proposed Rule does not seek to restrict securitization participants from engaging in, subject to certain conditions, 1) risk mitigation hedging activities, 2) bona fide market-making activities and 3) purchases and sales of the ABS in connection with liquidity commitments.
How Are CLO Managers Impacted?
Securitization participants include CLO managers as well as their affiliates and subsidiaries. While CLO managers would not generally be expected to engage directly in conflicted transactions, if the Proposed Rule is adopted in its current form, CLO managers that form part of a diversified credit platform with numerous affiliates and subsidiaries around the globe will need to ensure that their internal policies and procedures address and prohibit conflicted transactions across their entire organizations.
Could Information Barriers Help?
The SEC staff acknowledged, both during the open meeting discussing the Proposed Rule and in the preamble to the Proposed Rule itself,4 that it is willing to consider including an additional exception to the Proposed Rule allowing the use of information barriers to mitigate the Proposed Rule's overinclusion of affiliates and subsidiaries. If this exception is included, CLO managers could utilize information barriers (whether pre-existing ones used to manage the potential use of material nonpublic information or new ones so long as they comply with any relevant conditions) as a safe harbor.
What Is the Comment Deadline for the Proposed Rule?
The initial comment period will expire the earlier of March 27, 2023, or 30 days following publication of the Proposed Rule in the Federal Register, whichever period is longer. Many of the SEC commissioners noted during the open meeting discussing the Proposed Rule that they were interested in hearing feedback during the comment period, including, among other things, on (i) the scope of the securitization participant definition, (ii) how the Proposed Rule would impact larger more diversified institutions, (iii) the applicable time period for the transaction prohibition and (iv) if an information barrier exception for affiliates and subsidiaries could be implemented in a way that would be consistent with Section 27B.
1 Proposed Rule: Prohibition Against Conflicts of Interest in Certain Securitizations.
2 In September 2011, the SEC had initially proposed for comment a new rule designed to implement Section 27B, but it was never adopted. This re-proposed rule takes into account comments received in response to the 2011 proposed rule.
3 See footnote 11 to the Proposed Rule, page 7.
4 See Section II.B.3. in the preamble of the Proposed Rule, pages 48-52 and Section III.F.2., pages 160-161.
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