On January 25, 2023, the Securities and Exchange Commission (the Commission) voted unanimously to re-propose new Securities Act Rule 192. The proposed rule would prohibit securitization participants from engaging in asset-backed security (ABS) transactions that would represent a conflict of interest with ABS investors.[1] The proposed rule aims to protect the integrity of the securitization market by aligning the interest of investors and securitization participants.[2]

ABS are securities collateralized by a specified pool of underlying assets. In the 2007-2009 financial crisis, some institutions sold ABS that were collateralized by housing market assets, including residential mortgage backed securities (frequently referred to as RMBS), to investors while at the same time taking trading positions that would benefit from the failure of the underlying assets.[3] When the assets supporting ABS diminished in value substantially, both investors and the financial system as a whole were negatively impacted.

Congress in 2010 passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) to strengthen government oversight and regulation of the financial markets. Section 621 of the Dodd-Frank Act added Section 27B to the Securities Act (Section 27B) that requires the Commission to implement a rule prohibiting certain transactions of asset-backed securities that result in a material conflict of interest.[4] In 2011, the Commission proposed a new rule designed to implement Section 27B, which drew criticism regarding its potential limitation on financial institutions’ ability to manage risk.[5] The proposed rule was not adopted.

Although the securitization markets have undergone significant changes since 2010, there currently is no prohibition on conflicted transactions. In re-proposing Rule 192, Securities and Exchange Commission Chairman Gary Gensler stated that the Commission was “seek[ing] to address this unfinished step in Congress’s vision for financial reform.”[6]

The proposed rule would prohibit a “securitization participant” from engaging, directly or indirectly, in any transaction that would involve or result in a material conflict of interest between securitization participants and ABS investors, subject to certain exceptions. “Securitization participants” include the underwriter, placement agent, initial purchaser, and/or sponsor of an ABS, and affiliate or subsidiary of any such entity. A conflicted transaction is defined to include two main components. First, the transaction must be adverse to the interests of the ABS itself (e.g., a short sale of the ABS).  Second, there must be a substantial likelihood that a reasonable investor would consider the transaction to be important to the decision whether or not to retain the ABS.

Under the proposed rule, a securitization participant is prohibited from entering into a “conflicted transaction” beginning when a person has reached, or has taken substantial steps to reach, an agreement that such person will become a securitization participant with respect to an ABS. This prohibition will expire one year after the date of the first closing of the sale of the relevant ABS.  The rule would apply to both registered and unregistered ABS. Moreover, the proposed rule provides exceptions for and does not apply to: (1) risk-mitigating hedging activities; (2) bona fide market-making activities; and (3) liquidity commitments. The SEC is open to receive comments on whether to include an exception allowing the use of information barriers to exclude affiliates and subsidiaries to mitigate the proposed rule’s overinclusion of affiliates and subsidiaries in the definition of “securitization participant.”[7]

The proposed rule is open for public comment until March 27, 2023, which may be further extended. We will continue to monitor the proposed rule, and provide updates as appropriate.