Seven months after our initial note on the subject, the United States Securities and Exchange Commission (the SEC) on November 27, 2023 adopted Rule 192 (Rule 192 or the Final Rule)1 pursuant to Section 27B of the Securities Act of 1933, as amended.
The rulemaking process for Rule 192, which is aimed at preventing material conflicts of interest in the context of asset-backed securities (ABS) transactions, drew immense industry interest, with the SEC receiving over 900 comment letters.
The primary details can be found in our initial client alert, but generally, Rule 192 prohibits any "securitization participant" (a Securitization Participant)—which includes placement agents, underwriters, initial purchasers, sponsors and certain subsidiaries and affiliates of the foregoing—from engaging in transactions that would involve or result in any "material conflict of interest" with respect to any investor in the applicable ABS transaction with respect to which the Securitization Participant is acting. Notably, the Final Rule applies not only in the context of general ABS deals, but also in the context of synthetic and hybrid transactions.
However, while the fundamentals of the rule have not changed, other aspects of Rule 192 have been revised as between the initial proposal (the Proposed Rule) and the rule as formally adopted. Most notable are the following differences, some of which address certain issues identified by market participants in the Proposed Rule:
Time of application
Unlike the Proposed Rule, the Final Rule applies only from and after the time a Securitization Participant reaches an agreement to act in such capacity. This reflects the removal of the “substantial steps” language found in the Proposed Rule, which many commenters, including SIFMA and the LSTA, objected to.2
Scope of conflicted transactions
Where the Proposed Rule provided that “conflicted transactions” would encompass (i) short sales, (ii) the purchase of a CDS or other credit derivative entitling its holder to payments upon the occurrence of credit events on the underlying ABS and (iii) the purchase or sale of any financial instrument (other than the ABS itself) or entry into a transaction pursuant to which the Securitization Participant would benefit from any actual, anticipated or potential adverse performance or losses on the ABS or underlying assets. By contrast, the Final Rule removes the third prong and replaces it with reference to any transaction that is “substantially the economic equivalent of”3 a transaction described under the first two prongs. This narrowing of the catch-all provision also reflects the urgings of market participants such as the LSTA and SIFMA.4 In addition, the Staff confirmed in the Adopting Release that they do not view “[t]ransactions unrelated to the idiosyncratic credit performance of the ABS”, such as interest rate and foreign exchange risk hedging, provision of warehouse financing or the transfer of assets to a securitization vehicle as constituting conflicted transactions.5 This should provide reassurance to those in the market who feared that, if the Proposed Rule were adopted as drafted, ordinary course securitization-adjacent activities like interest rate and currency hedging would be caught and effectively prohibited to Securitization Participants.
Captured Securitization Participants
Several changes are notable with respect to the definition of “Securitization Participant” in the Final Rule.
Sponsors
First, where the Proposed Rule captured as a sponsor any party that in practice “directs or causes the direction of the structure” or the composition of the asset pool, this provision has been removed from the text of the Final Rule. Moreover, what the Adopting Release refers to as “Contractual Rights Sponsors”6 have been clarified to exclude any person acting “solely” pursuant to such person’s rights as the holder of a long-position in the relevant ABS. Accordingly, long-holding investors are no longer in danger of being considered “sponsors” for purposes of Rule 192. Second, servicers have been given some relief in that the third prong of the “Sponsor” definition, which provides for a carve-out from “Sponsor” status, now includes explicit reference to persons performing only “ongoing administration” of an ABS or the composition of the relevant asset pool.7
Affiliates and subsidiaries
While “affiliate” and “subsidiary” have the same definition in the Final Rule as they did in the Proposed Rule, the Final Rule clarifies that such entities are only caught by Rule 192’s prohibition where either (A) such entity “acts in coordination with” the direct Securitization Participant, or (B) such entity has “access to or receives information about” the relevant ABS or asset pool prior to first closing of the sale of the ABS.8 Accordingly, while information barriers between affiliates and subsidiaries would not absolve an entity from Rule 192 to the extent of direct coordination, it does allow such entities to avoid capture under prong (B) of the affiliate/subsidiary provision. While this does not go as far as many commenters requested, it does represent a positive change from the Proposed Rule.
Risk-mitigating hedging activities
Three changes from the Proposed Rule are notable.
- First, the Final Rule now specifies that the scope of risk-mitigating hedging activities is “including those” arising out of the Securitization Participant’s securitization activities rather than (as was previously the case) being limited only to such activities.9 Several commenters had expressed concern that such a formulation was unduly restrictive (preventing, for example, an affiliate or subsidiary from hedging exposures it originated in the ordinary course of its business unrelated to the Securitization Participant’s securitization activities), and the Staff acknowledged this change as being responsive to those concerns in the Adopting Release.10
- Second, the Final Rule removed language from the Proposed Rule that would have excluded the “initial distribution” of an asset-backed security from qualifying under the permitted risk-mitigating hedging activity exception. In explaining this change, the Staff indicated the new formulation was “intended to allow for the initial issuance of a synthetic ABS that the relevant securitization participant enters into and maintains as a hedge,” something that was the subject of comment by commenters, including e.g. SIFMA and AFME.11
- Finally, the Final Rule softens the ongoing recalibration requirement of the risk-mitigating hedging exception by including the word “materially” in sub-clause (B). Now, the Securitization Participant wishing to avail themselves of the exception is required to ensure that their hedging activity does not create an opportunity to materially benefit other than via risk reduction.
Foreign safe harbor
The SEC has included in the Final Rule foreign a safe harbor provision, exempting from Rule 192’s ambit any ABS transaction (i) issued by someone other than a “U.S. person” (as defined for purposes of Regulation S under the Securities Act (Reg S)) and (ii) offered and sold in compliance with Reg S.12 Accordingly, any Reg S-only issuance by a non-U.S. issuer will be outside the bounds of Rule 192. Note, however, that Rule 192 would still apply to Securitization Participants in e.g. a U.S. private placement transaction or a dual 144A/Reg S transaction, even if such entities are located outside the United States.
Anti-evasion
Many commenters noted that the Proposed Rule had an exceedingly broad anti-circumvention provision. The Final Rule instead includes an anti-evasion provision, which more narrowly captures transactions that are “part of a plan or scheme to evade” Rule 192’s prohibition on conflicted transaction.
The Final Rule represents an improvement over many aspects of the Proposed Rule, though compliance challenges remain. Compliance with Rule 192 is required for any asset-backed securities transaction which closes 18 months or more after the Final Rule’s date of publication in the Federal Register.
Footnotes
1. See the adopting release (the Adopting Release), available at https://www.sec.gov/files/rules/final/2023/33-11254.pdf
2. See e.g. p. 22 of the SIFMA Letter (available at https://www.sec.gov/comments/s7-01-23/s70123-20161806-330705.pdf) and p. 6 of the Second LSTA Letter (available at https://www.sec.gov/comments/s7-01-23/s70123-182539-335222.pdf).
3. §230.192(a)(3)(iii).
4. See e.g. p. 42 of the SIFMA Letter and p. 3 of the Second LSTA Letter.
5. Adopting Release, p. 10. “Transactions unrelated to the idiosyncratic credit performance of the ABS, such as reinsurance agreements, hedging of general market risk (such as interest rate and foreign exchange risks), or routine securitization activities (such as the provision of warehouse financing or the transfer of assets into a securitization vehicle) are not “conflicted transactions” as defined by the rule.”
6. See e.g. p. 38 of the Adopting Release.
7. Though note that if such person or entity also acted in other capacities with respect to the transaction, they may nonetheless constitute a Securitization Participant. This also would not stop such entity from being captured pursuant to the affiliate/subsidiary prong of the Securitization Participant definition.
8. §230.192(c).
9. The exception (though remaining subject to conditions specified in the Final Rule) now covers “[r]isk-mitigating hedging activities of a securitization participant conducted in accordance with this paragraph (b)(1) in connection with and related to individual or aggregated positions, contracts, or other holdings of the securitization participant, including those arising out of its securitization activities, such as the origination or acquisition of assets that it securitizes.” Emphasis added. The Proposed Rule instead read: “[r]isk-mitigating hedging activities of a securitization participant conducted in accordance with this paragraph (b)(1) in connection with and related to individual or aggregated positions, contracts, or other holdings of the securitization participant arising out of its securitization activities, including the the origination or acquisition of assets that it securitizes, except that the initial distribution of an asset-backed security is not risk-mitigating hedging activity for purposes of paragraph (b)(1) of this section.”
10. Adopting Release, p. 127.
11. Adopting Release, p. 125.
12. §230.192(e).
