Delayed Rules on Conflict of Interest Bound to Face More Conflict

Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) as a direct response to the 2008 Financial Crisis when millions of Americans lost homes due to foreclosure. (SEC). Among myriad findings, a final report on the 2008 Financial Crisis stated that investment transactions with conflicts of interest contributed to the crisis. (Financial Crisis Inquiry Commission). For example, the commission found that financial firms marketed an investment and profited off that investment product’s decline. Id. Dodd-Frank mandated that the Securities and Exchange Commission (“SEC”) create rules within 270 days of the Act’s passage to prohibit transactions with “certain material conflicts of interest” for asset-backed securities (“ABS”). (SEC). Over a decade and one failed attempt later, the SEC re-proposed Rule 192 to address Dodd-Frank’s conflict of interest requirement. (Jessica Corso, Law360).

The SEC focused Proposed Rule 192 on the type self-transacting that created conflicts of interest within ABS investments because of their outsized contribution to the 2008 Financial Crisis[BS1] . (SEC). Even today, ABS investments continue to play a significant role in the securitization market because ABS lending allows borrowers to access lending at cheaper rates by spreading the risk of long-term loans to multiple investors. (Bill Conerly, Forbes). Proposed Rule 192 prohibits anyone involved in the creation of an ABS investment from then entering into other transactions, like shorting, that would create material conflicts of interest in that ABS investment (called “conflicted transactions.”) (SEC). Shorting is making a bet against a security assuming that the security’s price will drop, and then collecting on that bet when the price drops. Id. The proposed rule’s scope seeks to prohibit conflicted transactions (like shorting) by anyone who has taken a “substantial step” in the “design, creation, marketing, and/or sale of an ABS” (called “securitization participants.”) Id. The proposed rule would prohibit a conflicted transaction within one year after the first sale of the ABS investment. Id. The proposed rule does include narrow exceptions for risk-mitigating activities (like shorting as a hedge), liquidity commitments, and bona fide market marketing activities. Id.

The SEC addressed comments from its 2011 attempted rule throughout the new proposed rule. Id. The scope of securitization participants (who and how firms identify securitization participants) and the scope of what makes a transaction prohibited are the sections in the proposed rule that received the most comments. (SEC). The SEC opened the comment period for sixty days, which Commissioner Peirce and industry participants criticized as too short given the rule’s complexity and how long implementation from Dodd-Frank’s mandate has already taken. (SEC; SEC).

The SEC’s questions highlight the difficulty the SEC continues to face in finding a “workable rule” that balances the need to regulate conflicts of interest with the need for risk mitigation. (Daniel Meade and Philipp von Pelser Berensber, Cadwalader). Commissioner Uyeda emphasizes the gravity of prohibiting a transaction rather than adding a disclosure requirement—a more common regulatory tool for securities. (SEC). As such, Commissioner Uyeda is not confident that the proposed rule balances prohibiting a transaction versus allowing the market to engage in other market activities outside of the narrow exceptions proposed within the rule. Id. Commission Uyeda urges for clearer definitions on what “substantial steps” makes a firm a securitization participant for purposes of this rule. Id. Commissioner Peirce echoes Commissioner Uyeda’s concerns. For example, Commissioner Peirce expressed that the definition of “sponsor” is too broad because the rule would prevent collateral managers, who do not play a role in structuring an ABS investment, from engaging in the prohibited transactions. (SEC). This broad interpretation could hurt the securitization market overall if implemented as is. Id.

The SEC anticipated Commissioners Peirce and Uyeda’s concern about scope by requesting comments on information barriers for subsidiaries and affiliates of securitization participants. (SEC). Information barriers are a set of policies and procedures used as a tool to control how information flows between distinct groups within a firm. (SEC). The SEC is interested in whether information barriers could allow flexibility for subsidiaries of securitization participants to engage in activities like shorting without violating the proposed rule. (SEC). Commissioner Crenshaw wants more feedback on information barriers because she is concerned whether firms can effectively implement information barriers to mitigate conflicts of interest within subsidiaries and affiliates. (SEC).

Some industry insiders support the rule because the rule would eliminate the incentive to self-deal. (ASF Senate Banking Testimony). Industry insiders generally believe that Proposed Rule 192 could work so long as the SEC narrowly limits the scope of “sponsor.” Id. Yet critics raise the possibility of whether a disclosure requirement could achieve the results of Dodd-Frank instead. (Cadwalader). In a case about ABS self-benefitting deals, SEC v. Tourre, the court held that Section 17(a) of the Securities Act of 1933 covers undisclosed conflicts of interest. (4 F. Supp. 3d 579 (S.D.N.Y. 2014)). Extending this premise: if a securitization participant engaged in a transaction prohibited by Proposed Rule 192, that firm creates an undisclosed conflict of interest—the same violation under Section 17(a). Thus, violating Proposed Rule 192 appears the same as violating Section 17(a), and creates the question of whether Proposed Rule 192 is necessary?

Proposed Rule 192 tackles this question head-on by creating bright lines and closing the loop mandated by Dodd-Frank. (Cadwalader). Although a court could construe a violation of Proposed Rule 192 as a Section 17(a) violation, Proposed Rule 192 sets more guidelines and stronger rules rather than relying on case law alone.