SEC Proposes Expansive Conflict Of Interest Rules

Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act")1 was a reaction to securitizations structured such that the parties involved in arranging and marketing the transaction could profit from circumstances that might result in losses to the investors in the transaction. Section 621 prohibits certain persons who create and distribute asset-backed securities ("ABS") from engaging in transactions during a period of one year following the initial closing of the sale of such ABS that would involve or result in material conflicts of interest with respect to any investor in the ABS. On September 19, 2011, the Commissioners of the Securities and Exchange Commission (the "Commission" or the "SEC") voted unanimously at an open meeting to approve a notice of proposed rulemaking ("NPR") to implement this prohibition.2 In the press release accompanying the NPR, the Commission reiterated that proposed Rule 127B was designed to prohibit abusive structures and was not "intended to prohibit traditional securitization practices."3 However, the proposed rule itself is broadly worded, employs a number of abstract and vaguely defined concepts and relies heavily on interpretive guidance and illustrative examples in an effort to outline the rule's coverage. The result is a rule with the potential to reach the traditional securitization practices stated to be outside its purview. Possibly reflecting the Commission's concern with the potentially expansive coverage of the rule, the NPR includes a large number of requests for comments (over 100) for a single rule. Responses to these requests are due by December 19, 2011. This DechertOnPoint summarizes the proposed rule as presented in the NPR.

In the NPR, the Commission rarely strays far from the language of Section 621. In outlining the proposed rule, the SEC identifies the five conditions required for its application to an ABS transaction in terms that echo the terms of Section 621. These conditions are: the involvement of (1) covered persons and (2) covered products, (3) during the covered timeframe, resulting in (4) covered conflicts of interest that are (5) material.4 The NPR also reiterates the exceptions provided by Section 621 to this general prohibition, which are intended to permit hedging, liquidity commitment and market making activities customary in securitization transactions. A brief outline of each of these factors is warranted, focusing, as does the NPR, on the determination of covered conflicts and the assessment of their materiality.

Covered Persons

Section 621 indicates that its conflict of interest prohibition applies to any underwriter, placement agent, initial purchaser or sponsor (along with any affiliate or subsidiary thereof) with respect to an asset-backed security (collectively, "securitization participants"). Proposed Rule 127B adopts this language as well, providing the rationale that securitization participants are the parties who typically structure ABS and control the securitization process and are therefore in positions with the greatest potential for engaging in the activities sought to be prevented by the proposed rule.5 The Commission declined at this stage to further define the terms employed to identify the covered persons in the proposed rule...