My Crypto Lawyer
Jan. 25, 2023
The Commission is proposing to implement Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.[1] Even though it has been said frequently, I’d like to commend the work of so many tireless advocates, public servants, and elected officials in shepherding through a statute to protect American investors and their families, and to reduce the likelihood of a recurrence of the events that led up to the Global Financial Crisis of 2007-2008. And I also want to applaud the Commission staff for ensuring that Dodd-Frank, and all of our relevant statutes, are faithfully and meaningfully implemented.
Today’s re-proposal is designed to address certain conflicts of interest that may arise when assets, such as loan obligations in the form of mortgages or student debt, are pooled together and then effectively converted into a new financial instrument that is sold to investors as an asset backed security.[2] More specifically, Section 621 prohibits the sponsors and other entities involved in the creation and sale of asset backed securities from engaging in transactions that materially conflict with investors’ interests. [3] In 2011, when the Commission first proposed this rule, a commenter explained that asset backed securities offerings present a different set of considerations than when a public corporation issues equity or debt. With a publicly traded company there are current and periodic reporting requirements and the value of the transaction is measured in the context of an ongoing business.[4] While pieces of those elements may be present in a securitization, the key actors driving the structure of the transaction are financial intermediaries, who make money off of the securitization process itself. And, as we were all witness to in 2008, these intermediaries might be incentivized to, essentially, bet against the performance of an asset backed security that they created or sold.[5] Working in conjunction with other rules we have adopted to date, today’s re-proposal is an important limit on that kind of blatant conflict of interest.
But, as is the case with all of our rulemakings, how we define the scope translates into how meaningful and effective the rule will be in practice. In today’s re-proposal, the staff thoughtfully defined the scope of the entities involved that would be subject to the prohibition, the timeframe of the prohibition, what constitutes conflicted transactions, and provides statutorily required exceptions for hedging, liquidity, and market-making. I look forward to reviewing the comment file on all of these definitions.
That being said, I am particularly interested in feedback on the request for comment on the use of information barriers for entities involved in the securitization process, and whether information barriers can be effectively designed and implemented to eliminate potential conflicts of interest. Would these information barriers even faithfully implement the statute?[6] I am also curious whether the definition of market maker in the re-proposal is the right one to capture bona fide market-making activity.[7] Are the criteria used too broad? Should we consider a narrower definition?
I look forward to working with the public and the staff on adopting this important rule. As always, I have an open door and encourage investors, market participants, and all interested parties to come and speak to me about their comment letters and views on the re-proposal.
I also want to thank all of the staff who have worked on this, including Ben Meeks and Rolaine Bancroft for their engagement with my team along with all others in the Division of Corporation Finance, the Office of the General Counsel, the Division of Economic and Risk Analysis, Office of Municipal Securities, and my fellow Commissioners and their staff.
[1] The rulemaking was originally proposed in 2011. Today, the Commission is re-proposing that rule. The 2011 proposal can be found here. And the comment file can be found here.
[3] § 621 of the Dodd-Frank Act added Section 27B to the Securities Act. § 27B(a) provides that “[a]n underwriter, placement agent, initial purchaser, or sponsor, or any affiliate or subsidiary of any such entity, of an asset-backed security (as such term is defined in section 3 of the Securities and Exchange Act of 1934 (15 U.S.C. 78c), which for the purposes of this section shall include a synthetic asset-backed security), shall not, at any time for a period ending on the date that is one year after the date of the first closing of the sale of the asset-backed security, engage in any transaction that would involve or result in any material conflict of interest with respect to any investor in a transaction arising out of such activity. 15 U.S.C. 77z-2a(a). Subsection (c) provides exceptions for bona-fide hedging, market-making, or liquidity. See 15 U.S.C. 77z-2a(c).
[4] See Americans for Financial Reform, Comment Letter on Proposed Rule on Prohibition Against Conflicts of Interest in Certain Securitizations at 2 (Feb. 13, 2012) (“When corporations issue shares, there is a company with (hopefully) responsible managers to make final judgments regarding the underpinnings of an offering. Similarly, when governments offer their debt to the public, elected officials are ultimately responsible for the offering. In corporate and government offerings, the value of the transaction is measured in the context of an ongoing enterprise, introducing a longer-term perspective on the transaction. The balance of interests driving ABS transactions is quite different. Financial intermediaries drive the structuring of the issuer, a special purpose entity (‘SPE’), and its assets and cash flow. They benefit from the transaction, not the long term performance of the assets. If the financing can be successfully distributed to the public, many of the individuals in a position to evaluate the quality of the ABS will receive compensation at levels which are mind-boggling to the vast majority of people; and the consequences that they will suffer if the financings do not work out in the end are disproportionately small. That lesson was reinforced by the real-world experiences of the financial crisis.”)
[5] See Prohibition Against Conflicts of Interest in Certain Securitizations, Release No. 33-11151 at n. 11 (re-proposed Jan. 25, 2023) [hereinafter the Re-proposal] (citing Wall Street and The Financial Crisis: Anatomy of a Financial Collapse, Majority and Minority Staff Report, Permanent Subcommittee on Investigations, United States Senate (Apr. 13, 2011)). Also, Senators Levin’s and Merkley’s 2011 comment letter provides a concise summary of the subcommittee’s findings related to Abacus. “In Abacus 2007-AC1, Goldman allowed a favored hedge fund client to participate in the selection of the assets and then short the CDO without telling potential investors of the hedge fund ‘ s adverse interest. This transaction is a glaring example of the type of conflicts of interest Section 621 was intended to prohibit. Abacus 2007-ACI was one of a series of Abacus CDOs that, while synthetic, had complex structures different from a traditional synthetic asset-backed security. Although economically equivalent to a synthetic ABS, the counterparty’s investment was not necessarily collateralized by the mortgage-backed securities that were the economic substance of the transaction. Rather, cash was collateralized by one set of low-interest investments owned by the Abacus trust, and the true substance of the transaction was based on premiums or losses accrued to the investor based on the performance of a pool of mortgage-backed securities not owned by the trust. Although it appears the Abacus transactions as they existed before the financial crisis would be covered under the proposed rule, it is also conceivable that a bank could add additional layers of complexity to the structure and potentially avoid classification as an asset-backed security.” Senators Carl Levin & Jeff Merkley, Comment Letter on Proposed Rule on Prohibition Against Conflicts of Interest in Certain Securitizations at 5 (Jan. 12, 2012)
[6] As the Re-proposal puts it, certain “commenters opposed the use of information barriers to manage material conflicts of interest in connection with the 2011 proposed rule for reasons such as perceived permeability, limited utility, and difficulties associated with monitoring and enforcing information barriers in addition to their weakening impact on the prohibition set forth in Section 27B.” See Re-proposal at § II.B.3, n. 94 & accompanying text. The Re-proposal cites to the 2011 commenters that voiced opposition to information barriers. See Barnard, Comment Letter on Proposed Rule on Prohibition Against Conflicts of Interest in Certain Securitizations at 2 (Sept. 28, 2011) (stating that, although information barriers and disclosure may be useful to mitigate conflicts of interest, short transactions should be absolutely prohibited); Better Markets, Comment Letter on Proposed Rule on Prohibition Against Conflicts of Interest in Certain Securitizations at 9, n. 23 (stating that history had proved that information barriers are not reliable and are difficult for regulators to monitor and enforce); Public Citizen, Comment Letter on Proposed Rule on Prohibition Against Conflicts of Interest in Certain Securitizations at 1, 4-5 (Feb. 13, 2012) (stating that information barriers invite abuse and present major enforcement problems); Tewary, Comment Letter on Proposed Rule on Prohibition Against Conflicts of Interest in Certain Securitizations at 13-14 (Dec. 2, 2011) (stating that academic studies have found that, even where information barriers are erected, regulators are routinely unaware of when such barriers have been breached).
[7] See Re-proposal at § II.G. The Re-proposal notes that the conditions of the bona fide market making activities is draws from the concept of market-making in both the Volcker Rule and the definition of market maker in the Exchange Act. See id.
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