The current administration’s legislative initiatives are largely bottled up in a split Congress, so the path toward achieving the White House’s policy priorities runs almost exclusively through the executive order and rule-making process and boy, have they worked it hard. 

But Santa is coming down the chimney delivering lumps of coal so often these days, his knickers are smoldering (I hope they do).  The pace of regulatory initiatives from the White House, the Department of Labor, the FTC, the CFPB, from the Fed banking regulators and the SEC has been blistering and shows no signs of abating.  Comments are due March 27, 2023.

This newest initiative (though God knows, something else may pop up before I’ve finished writing this) is the SEC’s reproposed “Prohibition Against Conflicts of Interest in Certain Securitizations” or “Rule 192” (the banality of numerosity).  This Rule, casting an extraordinarily wide net, purports to stipulate that all “sponsors” and other “securitization participants,” and their subsidiaries and affiliates, cannot engage in a transaction constituting a material conflict of interest with an investor in any securitization in which such sponsor or securitization participant was involved.  The prohibition begins when the sponsor or the securitization participant first takes “substantial steps” to become a securitization participant (not clear when “fixin’ to securitize,” as they say down South, is deemed to begin) and ends one year after the first closing of the sale of the security. 

A material conflict of interest in this missive includes any of the following: 

  • a short sale,
  • the purchase of a credit default swap or other credit derivative tied to the relevant ABS, or
  • the purchase or sale of any financial instrument or entry into any transaction through which the securitization participant would benefit from the actual anticipated or potential occurrence of specified events, such as adverse performance of the asset pool or loss of principal, monetary default or decline of the market value of the ABS;

provided, only if there is a “substantial likelihood” that a “reasonable investor” would consider the transaction important to their investment decisions (or the SEC thinks they would). 

Not to bury the lede; but this is a bad idea.  It will impair capital formation.  It will impair the efficient operation of debt securities markets, impair the ability of market participants to manage risk, and deliver very little real benefit.  Another example of virtue signaling as opposed to a serious pursuit of serious policy. 

This is a re-proposal.  The SEC tried this one on for size a dozen years ago, as it was directed to do under the Dodd-Frank Act, but abandoned it after it was excoriated throughout the comment period.  It’s back.

Dodd-Frank mandated regulatory implementation of the legislative bar on an underwriter, placement agent, initial purchaser, or sponsor engaging in a transaction causing or resulting in a material conflict of interest with respect to any investor in a related securitization.  The law directed rulemaking within 270 days after its enactment on July 21, 2010.  Oops, sort of missed that deadline, didn’t we? 

Why do we have to deal with this more than a decade after its unlamented internment?  Certainly a surprise, this Frankenstein monster reanimation.  The answer might be that the SEC has concluded that it had to regulate because the law required it.  Maybe.  Hmm, it feels more like an excuse to deepen the engagement of the administrative state in our markets; the leitmotif of the SEC these days.  We all know the Dodd-Frank Act was a bit of a dumpster fire, another example of a “we have to pass the law to know it” sort of thing.  Dodd-Frank mandated the SEC to issue a number of regulations that have never seen the light of day, notably a requirement that the SEC revamp the entire NRSRO ratings process.  These elisions occurred, obviously, because, upon reflection, the proposed regulatory initiative was impractical, ill-suited to purpose or just plain damn silly.  Apparently, those are not good reasons to stop this initiative now. 

Other sleeping dogs have been let to lie, and clearly, this one should have been, too.  A solution in search of a problem.  (Please see the Dechert OnPoint published recently, and linked here, for what’s probably a more balanced and less exercised commentary on the Rule). 

We are 12 years out of the Great Recession, and, to my knowledge, the sort of conflict being singled out here has never been a subject around which the investor community has had very much energy.  Moreover, Dodd-Frank profoundly changed the contours of our market.  It’s not 2007 anymore!  If the SEC had proposed a rule which was rightsized to the scale of the actual problem, it would be tolerable, perhaps even constructive, but, of course, that’s not what we have.  Just to be clear, the problem which was apparently on our legislators’ minds (or at least that tiny handful of our gloriously elected clerisy that actually wrote the Dodd-Frank Act) was the need to stop a truly nefarious actor from engineering a securitization designed to fail while simultaneously betting against it to make an outsized profit.  That’s pretty bad behavior.  It should not be tolerated, but instead of a rifle shot on a very discrete problem, the SEC just carpet bombed the industry. 

The flaws of this Rule are legion.  We’ll begin with who is subject to this Rule.  The guardrails as to who is in and who is out are not clear.  It surely includes the “sponsor” as we’ve come to understand that term in the securities law writ large, but it is clearly more than that in this case.  Is it every co-manager in a bank syndicate, whether they have actual input into the structure of the securitization or merely what amounts to a stuffie?  It certainly is a mortgage loan seller who had some input into the tape.  How about special servicers?  How about B-buyers and control class representatives who are entitled to take action for their own account without regard to the interest of other investors?  (With a delightful bit of sensible clarity, the lawyers who work on the deal are out!) 

For a world-girding bank or other large enterprise, one needs to worry not only about the desk or business unit that securitized the loan, but business units all over the institution around the world who might engage in hedging or market-making activities completely distant and separate from the securitization and virtually certainly without any knowledge of it.  The Rule applies to all affiliates of sponsors and securitization participants, and hence includes enterprises that are merely under common control with the business unit that engineered a securitization.  This will apply the Rule to business units that have little or nothing to do with the securitization business.  

The first two prongs of the prohibition, short sales and credit derivatives are at least largely understandable.  The third prong is a puzzle.  It’s written so broadly that one wonders which type of transaction the staff had in mind (and which they did not).  Would it apply to a follow-on securitization that competes with a prior securitization?  If the co-manager (earning very modest compensation) becomes lead left on a subsequent securitization and earns significantly more, do we have a conflict if the follow-on securitization allegedly suppressed demand for the prior one?  Have we then fallen into the scope of the Rule?  I don’t know. 

Oh, there are exceptions, the statute requires them.  There are three.  Providing liquidity, pursuant to a commitment; engaging in customary market-making activity; and engaging in customary risk mitigating hedging. 

Liquidity should be, but is not, straightforward.  According to the commentary, the liquidity exception captures commitments to promote timely principal/interest payments, and commitments to provide financing to accommodate differences between bond-level and asset-level payment dates.  Huh?  Is that it?  Is it a repo with a high default interest rate or an exit fee just acceptable liquidity, or could it be seen as a bet against the deal?  Not addressed in the commentary. 

Market-making?  We already have market-making restrictions in Dodd-Frank.  That all seems to work.  Why do we need additional guardrails around the core business of market-making?  Bona fide market-making will be in the eye of the beholder and as the beholder will be the SEC collecting points; that’s a little scary. 

How about hedging?  Can a securitization participant hedge with CMBX?  What happens if a prior securitization is included in the next index?  Is that now prohibited?  The hedging exemption also requires the hedging party not to make a profit (gasp).  How can a hedging position that subsequently (subsequently!) becomes profitable be a problem?  It strikes me that avoiding the possibility that a hedge position morphs into a profitable hedge could be a daunting task. 

One thing that is particularly worthy of note is the obligation to establish, implement and maintain an internal compliance program that is reasonably designed to ensure securitization participants’ compliance.  The staff comments suggests that EVERY securitization participant should have to have policies and procedures regardless of whether they are currently relying on the exemption.  Essentially then, this would become a rule for every enterprise which would itself, or through an affiliate or a subsidiary, might become a securitization participant, now or in the future. 

This is noteworthy because this obligation to maintain policies and procedures is an independent obligation from the fundamental obligation not to engage in conflicted transactions.  Caesar’s wife on conflicts but, in the staff’s determination, inadequate policies and procedures makes one a rulebreaker.  Another trap for the unwary.

The two obvious bright lines which should have been incorporated into this Rule are intent and knowledge firewalls.  Neither has and moreover, the SEC’s commentary suggests neither should. 

Incorporating an element of intent seems breathtakingly reasonable and obvious here.  If a party intends to create a bad deal in order to benefit from that construct, that’s obviously inappropriate and should be subject to censure.  But gotchas for trades not structured to conflict?  The SEC remains hostile to an intent analysis because they think the restrictions would provide cover for the nefarious.  Ok, so, while we’re at it, shall we get rid of the presumption of innocence, which we agree would make the criminal justice system way more efficient? 

The second thing which would have made the Rule more sensible is some notion of information firewalls.  If a desk thousands of miles away from New York (physically) and thousands of miles substantively away from any securitization (metaphorically), buys or sells a hedge, buys or sells a CDS or makes a market in a security, how could that be possibly be part of a scheme to stick a rod in the wheels of the initial securitization?  It’s just unreasonable to extend the ambit of the Rule that far. 

The Rule effectively makes everyone who directly or through an affiliate securitizes anything, a party who could very intentionally violate this Rule and the Rule’s inclusion of an independent obligation to build and maintain policies and procedures makes the Rule relevant and expensive to everyone, all the time. 

What about enforcement?  As with the risk retention rule, there’s essentially nothing about enforcement in the actual text of the Rule.  Would we expect SEC audits to determine whether policies and procedures are in place and robust enough in the staff’s judgment?  What about a private right of action?  It’s extremely unclear whether one exists, but it’s hard to dismiss the possibility.  That by itself raises the stakes of simply being a securitization participant and exposes all participants to the threat of litigation.  As my senior trial partner, Andy Levander, regularly says, “You may not do the time, but you certainly may take the ride.”

The obvious response to this republication is to make the case strongly that this is an undue burden on capital formation for little benefit.  We know who the bad guys are.  A rule could be crafted which would be very focused on bad guy behavior.  That’s not what’s been done here, and this proposed solution is disproportionate to the problem.  The SEC should be mindful of the impact this will have on capital formation and the efficient operation of markets, but is willfully dismissive. 

The economic analysis section of the Rule’s commentary suggests the staff is entirely uninterested in economic arguments here.  In the economic analysis, the staff blithely asserts that complying with the rule would cause very little change from current compliance regimes and therefore would not cause significant increase in compliance costs (a mere $27 million per year, according to them). That is surely not true.  The commentary then goes on to admit that the Rule will constrain the current activities of underwriters and other securitization participants and it could, or probably will, have an adverse impact upon securitization participants and, “taken together…will reduce the availability of investment opportunities and could ‘impact market efficiency, competition among asset-backed securitization market participants and capital formation by the ABS markets.’”  Such a terrific idea!  How does one make an economic impact argument when the SEC has already put the rabbit in the hat?  The staff seems to have already concluded that the pain is worth the candle.  It’s not. 

On to the barricades, folks.  This Rule will materially reduce competition, materially reduce access to capital, and vastly increase the cost of compliance for an industry already burdened by enormous regulatory burdens for very little benefit.  What could possibly go wrong? 

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Richard D. Jones (“Rick”), Rick Jones is a capital markets and securitization practitioner highly rated by both Chambers, USA  and Legal 500.

A leader in the industry, a recipient of both the CREFC Founders Award and the Distinguished Service Award from the…

Richard D. Jones (“Rick”), Rick Jones is a capital markets and securitization practitioner highly rated by both Chambers, USA  and Legal 500.

A leader in the industry, a recipient of both the CREFC Founders Award and the Distinguished Service Award from the Mortgage Bankers Association (MBA) for his leadership.  Rick publishes widely and speaks on a wide range of issues effecting the capital markets and mortgage finance.  He is a past president of the CRE Finance Council; a founder of the Commercial Real Estate Institute (CRI); a member and past governor of the American College of Real Estate Lawyers and a former chair of its Capital Markets Committee; and a member of the Commercial Mortgage Board of Governors (COMBOG) of the MBA. Mr. Jones is a member of the Real Estate Roundtable, serving on its Capital and Credit Policy Advisory Committee. He also serves as the chairman of CRE Finance Council’s PAC.