A Material Sticking Point: What Constitutes Materiality in the SEC’s ABS Conflicts of Interest Proposal
On September 19th, the SEC published for comment a proposed rule that would implement Section 621 of the Dodd-Frank Act, which prohibits conflicts of interest in connection with asset-backed securities (“ABS”).
Overview. For the most part, the proposing release is straightforward. Proposed Securities Act Rule 127B would prohibit certain persons who create and distribute ABS from engaging in transactions, within one year after the date of the first closing of the sale of the ABS, that would involve or result in a material conflict of interest with respect to any investor in the ABS. The proposed rule provides exceptions from the prohibition for certain risk-mitigating hedging activities, liquidity commitments, and bona fide market-making.
In order for the proposed rule to apply, the relevant transaction must involve (1) covered persons, (2) covered products, (3) a covered timeframe, (4) covered conflicts, and (5) a “material conflict of interest.”
A covered person is an underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of such entity, of an ABS. Covered products are fixed income or other security collateralized by any type of self-liquidating financial asset that allows the holder of the security to receive payments that depend primarily on cash flows from the asset. Covered products do not include a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company. Synthetic ABS are included as covered products.
The covered timeframe extends for one year after the date of the first closing of the sale of the asset-backed security.
There would not be a covered conflict of interest involved if the conflict in question: (1) arose exclusively between securitization participants or exclusively between investors; or (2) did not arise as a result of or in connection with the related ABS transaction.
The rub. The proposal runs into trouble in trying to define what constitutes a material conflict of interest. Only material conflicts between an entity that is a securitization participant with respect to an ABS and an investor in such ABS are prohibited. But the proposal explicitly refrains from defining a “material conflict.” Instead, it relies on interpretive guidance that considers a material conflict of interest to be one in which a securitization participant engages in a transaction through which it benefits when the related ABS fails, or performs adversely, or has the potential to fail or perform adversely, and there is a substantial likelihood that a reasonable investor would consider the fact of such benefit important to his or her investment decision.
A material conflict could also arise if a securitization participant who controls the structure of the relevant ABS or the selection of assets underlying the ABS would benefit from fees or otherforms of remuneration, or the promise of future business or fees, as a result of allowing a third party to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction.
Explicating that guidance, the SEC notes that liability can attach even if the securitization participant did not act intentionally. Similarly, a conflict could be material even if the securitization participant’s actions only indirectly affect the price of the ABS. Moreover, disclosure of a material conflict would not necessarily immunize a securitization participant.
Comments should be submitted on or before December 19, 2011.