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SEC Rule 192 — Prevention of Conflicts in Securitizations
Summary:
- On November 27, 2023, the Securities and Exchange Commission adopted its long-awaited rules on conflicts of interest relating to securitizations. The rule is required under Section 621 of the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 which was, in part, in response to the enforcement actions brought by the SEC in connection with the Abacus transactions.
- The rule prohibits certain transaction participants in a securitization, underwriter, placement agent or Sponsor of an ABS or, subject to certain exceptions, any of their affiliates, from engaging in certain types of transactions (mostly shorting either the ABS to be issued or the underlying pool) for a year after the issuance date of the ABS.
Effective Date:
- The rule will become effective for any ABS issued after 18 months from the effective date of the rule which is 60 days after it is published in Federal Register or approximately in the third quarter of 2025.
Rule Provisions:
- Rule prohibits any Securitization Participant from entering into any transaction, which a reasonable investor would consider important in making its investment decision, and involving:
1. The short sale of the related ABS
2. The purchase of a credit default swap or other derivative on the ABS
3. Any other purchase of a financial instrument or entering into a transaction that is the substantial economic equivalent of 1 and 2 above. - Activity excepted from the rule:
- Risk mitigating hedging activities:
- Hedging activity is designed to reduce identifiable risks.
- Must be recalibrated so it only acts as a hedge.
- An internal compliance program relating to the hedging program has been established.
- Liquidity commitments
- Bona Fide market-making activities:
- Participant routinely stands ready to purchase and sell related ABS.
- Market making activity designed not to exceed reasonably expected near term demand.
- Compensation is not designed to incentivize conflicted transactions.
- Participant is properly licensed or registered.
- A compliance policy relating to these activities has been implemented.
- Risk mitigating hedging activities:
- The above prohibition lasts from the time a securitization participant has reached an agreement to become a securitization participant and one year after the closing of the ABS.
- The rule does not apply to foreign ABS transactions that meet the following criteria.
- Not issued by a US person
- Offer and sale in compliance with Reg S
Other Considerations:
- Information Barriers Can Be An Effective Way to Ensure Inadvertent Rule Triggering at Large Managers:
- Affiliates and subsidiaries of a securitization participant will be subject to the rule for any ABS unless they do not have access to or receive information about the underlying collateral. The SEC suggested the following ways to ensure separation:
- Informational barriers
- Separate trading accounts
- Do not have common officers.
- Engaged in unrelated business and does not communicate with the securitization participant.
- Has oversight over an account but does not have authority to execute trades in the account of the affiliate.
Managers will need to conduct a review of their internal structures of different groups/trading desks/divisions in order to make a determination whether those entities have enough attributes of separation.
- Affiliates and subsidiaries of a securitization participant will be subject to the rule for any ABS unless they do not have access to or receive information about the underlying collateral. The SEC suggested the following ways to ensure separation:
- Economic Equivalence May Cause Inadvertent Violations:
- The rule contains a “substantial economic equivalent” for violative transactions that may cause managers to inadvertently trigger the rule. Economic equivalence is a facts and circumstances determination however, the SEC stated that:
- A short or its equivalent on a non-sizable portion of the underlying assets would likely not be a “substantial economical equivalent”.
- A short on a large portion of the assets of the underlying pool (even if this short position is maintained through a short on an index) could considered a “substantial economic equivalent.”
- The rule contains a “substantial economic equivalent” for violative transactions that may cause managers to inadvertently trigger the rule. Economic equivalence is a facts and circumstances determination however, the SEC stated that:
- Warehousing Period Should Be Closely Monitored To Avoid Being Deemed a Securitization Participant:
- Securitization Participants includes any person who has the contractual right to direct or assemble the underlying assets. Although there is a carve out for participants who have a contractual right as a holder of a long position in ABS, managers must pay particular attention to any control rights they may have over an ABS particularly during any warehousing period or as a subordinate bond holder.
Key Definitions:
- Asset-backed security has the same meaning as in Section 3(a) (79) of the Exchange Act; a very broad definition which includes CLOs.
- Securitization Participant
- underwriter, placement agent, initial purchaser or sponsor of an asset backed security.
- any affiliate or subsidiary of the above who:
- acts in coordination with one of the above listed participants; or
- has access to or receives information about the ABS or the underlying assets prior to the first closing.
- Sponsor includes any person who initiates an ABS or who has a contractual right to direct the structure or assemble the underlying assets.
- Important exceptions:
- Other than a person who has contractual rights solely as a holder of a long position in the ABS.
- Those persons who only perform administrative functions.
- Important exceptions: