On January 25, 2023, the Securities and Exchange Commission (SEC) published proposed Rule 192 pursuant to Section 27B of the Securities Act of 1933 (the Securities Act). Section 27B, as introduced by the Dodd Frank Act, requires the SEC to issue rules to implement the prohibition set forth in such Section against “securitization participants” betting against the asset-back securities (ABS) that they distribute, purchase and resell or sponsor. Comments on the proposed rule are due by March 27, 2023, a tight deadline considering the impact the Rule may have on the securitization industry.
Proposed Rule 192 is the second attempt by the SEC to issue rules implementing Section 27B of the Securities Act. The previous attempt dates back to 2011, when the SEC offered a longer comment period and received over 40 comment letters and had multiple meetings on the proposal, which was ultimately shelved.
Rule 192, if adopted as proposed, would prevent a securitization participant from directly or indirectly engaging in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in the relevant asset-backed security. Under the proposed Rule, engaging in any conflicted transaction would involve or result in a material conflict of interest between a securitization participant for an asset-backed security and an investor in such asset-backed security.
The conflicted transactions that are considered as betting against the relevant asset-backed security or its underlying assets are (1) the short sale of the relevant asset-backed security, (2) the purchase of a credit default swap or other credit derivative that would entitle the securitization participant to receive payments due to the occurrence of credit events in respect of the asset-backed security and (3) the purchase or sale of any financial instrument (other than the relevant asset-backed security) or entry into a transaction through which the securitization participant would benefit from the adverse performance or decline in value of the asset-backed security or the underlying asset pool.
The general prohibition outlined above is subject to exceptions for (a) risk-mitigating hedging activities, (b) liquidity commitments and (c) bona fide market making activities, in each case, subject to specific conditions.
Finally, proposed Rule 192 includes a broad “anti-circumvention” provision that prohibits a securitization participant from engaging in any other transaction that circumvents the prohibition set forth under the Rule.
The scope of the prohibition is broad in terms of the targets to which it would apply, the types of transactions that it would cover, the duration of the prohibition and the potential for extraterritorial application.
The targets to which the Rule would apply
“Securitization participant” is defined an underwriter, placement agent, initial purchaser, or sponsor of an asset-backed security or affiliate or subsidiary of any such entity. Notably, the definition of sponsor in Rule 192 is broader than the definition set forth in the US Risk Retention Rules. In fact, sponsor is defined to cover, in addition to a sponsor that would qualify as such under the US Risk Retention Rules, any person who has a contractual right to direct or cause the direction of, or that directs or causes the direction of, the structure, design, or assembly of an asset-backed security or the composition of the pool of underlying assets.
The Transactions to which the Rule would apply
The definition of “asset-backed securities” covers securities falling under the definition of asset-backed securities under the US Risk Retention Rules (see Section 3(a)(79) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(79)), “The term “asset-backed security” means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset […].”) as well as synthetic asset-backed securities and hybrid cash and synthetic asset-backed securities. Despite these terms not being defined in Rule 192, the SEC release clarifies that, in the past, the SEC has used the term “synthetic asset-backed securities” to refer to securitizations that are designated to create exposure to an asset that is not included in the asset pool. With respect to “cash asset-backed securities” the release clarifies that the term is used to refer to asset-backed securities where the underlying pool consists of one or more financial assets. The SEC further clarified that the term “hybrid cash and synthetic asset-backed securities” refers to asset-backed securities where the underlying pool consists of one or more financial assets as well as synthetic exposure to other assets. Further, the prohibition would apply to both registered and unregistered offerings of such asset-backed securities.
The duration of the prohibition
The prohibition established by proposed Rule 192 would run from the date on which a person reaches, or has taken substantial steps to reach, an agreement to become a securitization participant with respect to an asset-backed security until one year after closing of the asset-backed securities sale. This definition does not address the element of the definition of “sponsor” that does not require a contractual agreement. The proposed Rule does not identify specific activities that would constitute “substantial steps” to becoming a securitization participant. However, the SEC, in the request for comments, asked interested parties to weigh in on whether such activities should be identified. Such a broadly defined starting point is likely to capture warehouse activities that precede asset-backed securities offerings and potentially other activities depending on specific facts and circumstances, and could mean that the proposed Rule is triggered a long time prior to the closing of the asset-backed securities sale. Further clarity would need to be provided by the SEC in relation to the specific activities constituting “substantial steps” and the time horizon in which these would be expected to occur.
The extraterritorial reach
The potential effects of the Rule on foreign transactions and/or foreign issuers (together, Non-US Transactions) are not yet known in full. Currently, the Rule offers no safe harbor for foreign transactions, and its broad scope of application could well mean that non-US securitizations could be impacted even though there is no US nexus.
It remains to be seen whether there could be issues arising for non-US securitisations if (even where there is no US nexus) a securitisation participant who is a non-US affiliate of a US entity and/or somehow has any contractual rights to determine the structure of the transaction is involved. This would be of particular relevance for securitisation participants who are a part of large groups, especially given that an information barrier exception was not included in the proposed Rule (although it would appear that this will be a topic subject to discussion between the industry and the SEC). It is also unclear whether certain credit risk mitigation strategies undertaken outside the US by a non-US entity within a group including US entities could be considered a conflicted transaction and/or otherwise be captured under the Rule’s catch-all and anti-circumvention provisions.
Another key question posed by the proposed Rule is the ability of the SEC to monitor and take enforcement action for non-compliance of the Rule in relation to Non-US Transactions, as the lack of US nexus would likely make this quite challenging.
Given the intense lobbying activity of some industry associations and their vocal participation in the SEC public consultation process, it is expected that the topic of extraterritoriality will somehow be addressed by the SEC and that some form of US nexus will be required for the Rule to apply to Non-US Transactions (such as is the case, for instance, in Section 15G).