The SEC adopts Final Rule 192 Preventing Securitization Participants from entering into “Conflicted Transactions”

As reported in our previous post, on January 25, 2023 the Securities and Exchange Commission (SEC) published proposed Rule 192 (the Proposal) pursuant to Section 27B of the Securities Act of 1933 (the Securities Act). The Proposal was intended to prohibit (the Prohibition) a securitization participant in an offering and sale of asset-backed securities (ABS) from engaging in transactions that would involve or result in a material conflict of interest between the securitization participant and an investor in the relevant ABS.

On November 27, 2023, the SEC adopted the final version of Rule 192 (Final Rule 192) following a comment period. Final Rule 192 departs from the initial proposal in certain key aspects, which we have summarized below. 

Conflicted transaction definition

The definition of “conflicted transactions” considered tantamount to a bet against the relevant ABS or its underlying assets is materially improved in Final Rule 192, as compared to the Proposal. In particular, the SEC removed what was a broad and concerning catch-all description in prong (iii) of the proposed definition that included “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 actual, anticipated or potential (A) [a]dverse performance of the asset pool supporting or referenced by the relevant asset-backed security; (B) [l]oss of principal, monetary default, or early amortization event on the relevant asset-backed security; or (C) [d]ecline in the market value of the relevant asset-backed security”[1] replacing it with significantly narrower language. 

In Final Rule 192, the term “conflicted transactions” is defined to mean: 

1. the short sale of the relevant asset-backed security (or of the ABS pool); 
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 ABS) or entry into a transaction that is substantially the economic equivalent of a transaction described in (1) or (2) above (other than hedges or general interest rate or currency exchange risk). 

The narrower scope of the definition will be welcomed by market participants because it addresses the concerns raised by key industry associations like AFME, SIFMA and LSTA, which advocated for the removal of the broad third prong of the definition during the comment period. 

While this third prong was not entirely removed, the final version significantly reduces the potential reach of the Prohibition by offering clearer boundaries as to the third type of conflicted transaction. Importantly, in the release, the SEC, addressing comments received by market participants, stressed that pre-securitization activities such as the provision of warehouse financing or the transfer of assets into an SPV securitization vehicle do not constitute conflicted transactions – as had been initially feared. 

Further, the SEC confirmed that the Prohibition applies to transaction entered into in connection with synthetic ABS.  However Final Rule 192 does not include a definition of synthetic ABS. 

Securitization participant definition

The definition of “securitization participant” identifies the entities that are prevented from entering into conflicted transactions. With respect to this definition, Final Rule 192 removes the sweeping inclusion of all affiliates of an underwriter, placement agent, initial purchaser, or sponsor of an ABS that had caused concern at the Proposal stage. 

Under Final Rule 192, affiliates of the above-mentioned entities are only captured by the Prohibition if they: 

1. act in coordination with such entities; or 
2. have access to, or receive information on, the ABS or the underlying assets prior to the ABS issuance. 

This substantially lessens the risk that separate desks within a financial institution will inadvertently violate Final Rule 192.

Sponsor definition

As noted in our previous post, the definition of “sponsor” in the Proposal was particularly broad and notably broader than the definition set forth in the US Risk Retention Rules. This aspect did not change in Final Rule 192, which continues to include, 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 the structure, design, or assembly of an asset-backed security or the composition of the pool of underlying assets. 

However, Final Rule 192 clarifies that this definition does not include any entity or person that does so only by virtue of the rights it has as a holder of a long position in the ABS. The SEC explained that Final Rule 192 is not designated to impair ABS investors’ ability to negotiate for, or exercise, contractual rights typically granted to holders. It remains to be seen how the scope of typical holders’ rights can be defined in practice. Further, to address the concerns of service provides involved in the administration of ABS structures, Final Rule 192 expressly carves out from the definition of sponsor entities involved in the “ongoing administration” of the ABS or the underlying assets. 

Prohibition time frame

Final Rule 192 refers to the prohibition period commencing on the date on which an agreement has been reached that a person will become a securitization participant with respect to an ABS, rather than on the date on which “substantial steps” had been taken to reach such an agreement, as initially proposed. 

As flagged by commentators, the reference to any “substantial steps” included in the Proposal would have created considerable uncertainty around the time for commencement of the prohibition. Although certain commenters have suggested that the Prohibition commencement point should be tied to a specific date (e.g., the commencement of marketing or pricing of the ABS, 30 days prior to the first sale of the ABS or of the date of the first closing of the sale of the ABS, just to name a few), the SEC opted not to follow this approach on the basis that it would be underinclusive and capable of easy circumvention.

Hedging exemption

As provided under the Proposal, risk-mitigating hedging activities, liquidity commitments and bona fide market making activities, in each case, subject to specific conditions, are excluded from the prohibition in Final Rule 192. With respect to hedging activities, Final Rule 192 broadens the scope of the exemption by no longer limiting such activities to those “arising out of securitization activity”. Now those are included among the permitted hedging activities but are not the only carved out hedging activities. 

In this way, the SEC explained, the exemption will cover not only the hedging of ABS positions but also the hedging of exposures arising out of the assets that are originated or acquired by the securitization participant in connection with warehousing assets in advance of an ABS issuance. Further, in a departure from the Proposal, the initial issuance of a synthetic ABS will be eligible for the risk-mitigating hedging activities exception. It shall be noted, however, that in order to benefit from this exemption, securitization participants need to have an internal compliance program in place including written policies and procedures aimed at ensuring the hedging activities are performed in compliance with the exemption.

The hedging activities carve out is in addition to the clarification, added to Final Rule 192, that transactions that only hedge general interest rate or currency exchange risk do not qualify as conflicted transactions.

Anti-evasion

The anti-circumvention provision included in the Proposal has been replaced by an anti-evasion provision covering “a transaction or a series of related transactions that, although in technical compliance with [the prohibition in Final Rule 192], is part of a plan or scheme to evade the prohibition”. The concept of a series of related transactions part of a deliberate scheme was not in the Proposal. This revised concept adds an element of intentionality that helps narrowing the scope of the transactions that may be considered as aimed at circumventing the Prohibition. 

Foreign transaction safe harbor

Final Rule 192 provides for a safe harbor for certain foreign transactions, whereby the prohibition on a securitization participant of engaging in certain transactions that would involve or result in any material conflict of interest between the securitization participant and an investor in the relevant ABS will not apply: 

1. if the relevant ABS is not issued by a U.S. person (as defined in Rule 902(k) of Regulation S); and 
2. the offer and sale of such ABS is made in compliance with Regulation S.

The introduction of a safe harbor, which was not included in the Proposal, will certainly be welcomed by the industry. This was one of the key requests submitted by commenters to the Proposal and is seen by the industry at large as essential in providing clarity with respect to the cross-border application of Final Rule 192 and reduce compliance burden and costs. 

The SEC has confirmed that it shares the view of commenters that the inclusion of a safe harbor for foreign transactions would be consistent with other SEC rules applicable to securitizations that were promulgated under the Securities Act. The safe harbor is also a pragmatic solution to address issues relating to the ability of the SEC to monitor and take enforcement action for non-compliance with the Rule in relation transactions without a US nexus. However, it should be noted that the SEC advised that, notwithstanding the existence of a safe harbor, the SEC would still retain broad cross-border antifraud powers which could be used to deter participants from engaging in fraudulent or manipulative conduct with sufficient nexus to the United States. 

Despite industry feedback, the SEC has elected not to depart from the Proposal in relation to the other aspects of Final Rule 192, including as it relates to the existence of information barriers and disclosures. In line with what would be expected, an information barrier exception was not included in Final 192 Rule as the SEC did not believe that an information barrier exception would be appropriate in this context, had the potential to become a tick-box exercise and would be extremely difficult to legislate for in a meaningful and proportionate manner given the heterogeneous nature of industry participants. 

The SEC has further advised that, in light of the revisions to the definition of “securitization participant”, there would be no need for a prescriptive information barrier exception (which would entail an additional compliance burden and costs). Additionally, given the introduction of a foreign transaction safe harbor, the relevance of this measure is considerably diminished for securitization participants which are a part of large groups and engage in securitization activities through a non-US affiliate of a US entity.

The final version of Rule 192 is available on the SEC website and will become effective 60 days after publication in the Federal Register. The compliance date for Final Rule 192 will be the date falling 18 months after the date of publication of Rule 192 in the Federal Register (likely in mid-2025).

Please stay tuned to our transactions blog for more insights on evolving regulation. 

[1] See 88 FR 9678, page 9726.