SEC Proposes Rule 127B to Implement Section 621 of the Dodd-Frank Act

Giovanni Prezioso is a partner focused on securities and corporate law matters at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Raymond B. Check, Michael A. Mazzuchi, and Joyce E. McCarty.

The SEC recently proposed Rule 127B to implement the prohibition under Section 621 of the Dodd-Frank Act on material conflicts of interest between securitization participants of an ABS and any investor in the ABS. The proposed rule includes exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making. The proposed rule is available here.

Key provisions of the rule include:

Conditions Required for Application of the Proposed Rule

    • Covered Persons. The proposed rule would apply to an underwriter, placement agent, initial purchaser or sponsor, or any affiliate or subsidiary of such entity, of an ABS.
    • Covered Products. The proposed rule would apply to any ABS, as such term is defined in section 3 of the Exchange Act, including, for the purpose of the rule, synthetic ABS. The definition of ABS provided in the Exchange Act is much broader than the definition of ABS in the Securities Act Regulation AB. Both registered offerings and private placements would be covered by the proposed rule.

  • Covered Timeframe. The proposed rule would generally apply to any transaction giving rise to the prohibited conduct that occurs prior to the one year anniversary of the first closing of the sale of the ABS.
  • Covered Conflicts of Interest. The proposed rule would apply to “material conflicts of interest between an entity that is a securitization participant with respect to an ABS and an investor in such ABS, whether or not such investor purchased the ABS from the securitization participant.” Not covered would be (i) conflicts exclusively between securitization participants or between investors; (ii) conflicts that did not arise as a result of or in connection with the related ABS transaction; or (iii) conflicts that did not arise as a result of or in connection with engaging in any transaction, including short sales of, or purchasing CDS protection on, securities offered in the ABS transaction or its underlying assets and a securitization participant selecting assets, directly or indirectly, for the underlying asset pool and selling those assets to the special purpose entity used in the transaction.
  • Conflicts of Interest that are Material. The proposed rule does not define “material conflict of interest,” but offers some guidance on what would qualify:

    1. Either:

    A) a securitization participant would benefit directly or indirectly from the actual, anticipated or potential (i) adverse performance of the asset pool supporting or referenced by the relevant ABS, (ii) loss of principal, monetary default or early amortization event on the ABS or (iii) decline in the market value of the relevant ABS (each a “short transaction”); or

    B) a securitization participant, who directly or indirectly controls the structure of the relevant ABS or the selection of assets underlying the ABS, would benefit directly or indirectly from fees or other forms of remuneration, or the promise of future business, fees or other forms of remuneration, as a result of allowing a third party, directly or indirectly, to structure the relevant ABS or select assets underlying the ABS in a way that facilitates or creates an opportunity for that third party to benefit from a short transaction; and

    2. there is a substantial likelihood that a reasonable investor would consider the conflict important to his or her investment decision (including a decision to retain the security or not).

Statutory Exceptions

Risk-mitigating hedging activities, providing liquidity commitments and engaging in bona fide market-making would be exempt.

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