connection with market-making to the extent it relates to positions
taken in connection with the permitted activity.
    \87\ See, e.g., FSOC Study at p. 30 (``hedging activity should
adjust over time'').
    \88\ See, e.g., id. at p. 20 (hedging ``presents a potential
avenue to evade the proprietary trading prohibition if hedges do not
correlate with owned assets or if a banking entity seeks an
independent return through the application of the hedge'') (emphasis
added).
    \89\ See, e.g., William L. Silber, On the Nature of Trading: Do
Speculators Leave Footprints?, 29 Journal of Portfolio Management 4,
64 (Summer 2003) (``Silber'') (describing speculation as trading in
anticipation of future prices and taking on the risk of
unanticipated equilibrium price movements in order to earn profits).
In addition, we note that these statements are only intended to
describe trading that may not qualify for the proposed exception.
These statements are not intended to opine on the permissibility of
speculative trading in other contexts.
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    Material changes in risk should generate a corresponding change in
risk-mitigating hedging.\90\ Moreover, a risk-mitigating hedge
generally should unwind as exposure is reduced. Over-hedged exposure
may be indicative of a proprietary position rather than a risk-
mitigating hedge. Intermittent activity (hedging only when one chooses
to act) or activity that is inconsistent with a hedging policy is also
indicative of proprietary trading. Typically, the hedge should not be
significantly greater than actual exposure to the underlying assets.
The hedge (e.g., the notional amount under the hedge) should be
correlated so that losses (gains) on the position being hedged are
offset by gains (losses) on the hedge without appreciable differences.
The Commission preliminarily believes that activity would not qualify
as a risk-mitigating hedge for purposes of the proposed rule if the
predicted performance of the hedge throughout the length of time that
the hedge and the related position were held, resulted in a situation
in which incrementally poor performance of an ABS or its underlying
assets would result in a securitization participant earning appreciably
more profits on the hedge than the losses incurred from their ABS
exposure.
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    \90\ Risk-mitigating hedging indicia are considered in
connection with the Volcker Rule. ``Hedging activity should be
designed to reduce the key risk factors in the banking entities'
existing exposure, and should offset gains or losses that would
arise from those exposures. Hedging activity should adjust over time
based on changes in a banking entity's underlying exposures. Hedging
activity should adjust over time if market conditions alter the
effectiveness of the hedge even if the underlying positions remain
unchanged. Material changes in risk should generate a corresponding
change in hedging activity and should be consistent with the desk's
hedging policy.'' FSOC Study, at p. 30.
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    We seek comment on the application of the proposed exception to
``mitigating'' the consequences of a risk as intended by Congress.
Request for Comments Regarding Risk-Mitigating Hedging Activities
    47. It has been argued that firms must hedge actual risks created
by actual positions that left them with actual exposures.\91\ Please
discuss how such exposures arise and how they might be defined. Section
27B uses only the terms ``positions or holdings.'' Please discuss
application of Section 27B and the proposed rule to exposures. Is there
any difference between ``positions or holdings'' and ``actual risks
created by actual positions'' and ``actual exposures''? If yes, please
discuss the application of the proposed rule in light of such
difference.
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    \91\ See, e.g., Jeff Merkley, U.S. Senator and Carl Levin, U.S.
Senator, Making the Dodd-Frank Act Restrictions On Proprietary
Trading & Conflicts of Interest Work, available at http://www.rooseveltinstitute.org/%5Bmenu-trail-parents-raw%5D/making-dodd-frank-act-restrictions-proprietary-trading-and-conflicts-intere#.
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    48. Please discuss whether clarifying interpretations concerning
the terms ``mitigate'' and ``exposures'' would be consistent with
prohibiting material conflicts of interest. Please discuss whether such
interpretations would narrow or broaden the exception in a manner that
is inconsistent with the purpose of Section 27B. Please discuss whether
additional interpretations would be needed.
    49. We seek comment regarding whether or not there are concerns
about the level of transparency for risk-mitigating hedging activities
and whether there are ways to assure the transparency of risk-
mitigating hedging, such as through the use of standardized
instruments.
    50. Please describe whether, and if so, how firms engaging in
securitization transactions currently distinguish risk-mitigating
hedging from other activity.
    51. We seek comment concerning the type of activity that would fall
within the proposed exception under the proposed rule. Please discuss
how firms currently identify risks associated with securitization
transactions. Please discuss how firms currently hedge such risks
(e.g., currency hedges, interest rate hedges, index hedges, credit
derivatives). What policies or procedures are used to control, monitor,
or manage those hedges? Should it be a condition to relying on the
exception that the hedge was consistent with written, reasonably
designed policies and procedures regarding risk-mitigating hedging
activities? What types of instruments are used to hedge specific risks?
When would securitization participants typically engage in risk-
mitigating hedging activities pursuant to the proposed

exception? Are these activities continuous? Is there a time when risk-
mitigating hedging activities in connection with an underwriting,
placement, initial purchase or sponsorship would typically cease?
Please discuss whether and why a firm may either fully hedge a risk or
partially hedge a risk in connection with activities designed to reduce
specific risks arising out of an underwriting, placement, initial
purchase or sponsorship. Does risk-mitigating hedging differ among the
various securitization participants? If yes, please explain.
    52. We seek comment regarding how the proposed exception might
affect principal trading (other than market-making) as well as examples
of principal trading that you believe could or could not qualify for
the exception. Please explain why.
    53. We seek commenter input regarding any principal trading that
would be prohibited by the proposed rule and that would not qualify for
the proposed risk-mitigating hedging activities exception or the
proposed bona fide market-making exception discussed below. Please
discuss any positive and negative consequences of any such prohibition
of principal trading.
    54. Please discuss hedging that occurs during the ``warehouse
period'' as assets are accumulated and held prior to securitization.
Please comment upon the types of risk that are hedged during the
warehouse period (e.g., credit risk, basis risk, default risk, etc.) as
well as the types of instruments used to hedge (e.g., index products,
derivatives, etc.) and who undertakes the hedging. Please discuss
whether and how the securitization participant conducting the hedging
distinguishes such hedging from other trading. Please comment upon
whether and how such hedging is separated from other trading (e.g.,
different accounts, separate profit and loss treatment, etc.). Please
discuss how such hedging should be treated under the proposed new rule.
Commenters should explain their recommendations.
    55. We seek comment concerning the type of activities that should
or should not qualify for the proposed exception.
    56. We seek comment concerning indicators of speculative or other
trading masked as risk-mitigating hedging activity.
    57. We seek comment as to whether modifications should be made to
the proposed risk-mitigating hedging exception in order to reduce any
inappropriate adverse impact on investors.
    58. We seek comment as to whether modifications should be made to
the proposed risk-mitigating hedging exception in order to clarify its
scope for those who may seek to avail themselves of the exception.
    59. Should the term ``risk-mitigating hedging activities'' be
defined? If yes, please explain and provide a suggested definition. If
no, please explain.
    60. We seek comment concerning which department(s) of a
securitization participant (e.g., an underwriter) typically effect
risk-mitigating hedging.
    61. Should the exception be conditioned on the maintenance by the
securitization participant of books and records that would demonstrate
that the activity in question fell within the exception? If so, what
types of records should the securitization participant be required to
maintain?
    62. Should disclosure be a pre-requisite for relying on the
exception? Please explain.
ii. Liquidity Commitments
    Pursuant to the proposal, the following shall not be prohibited by
paragraph (a) of the proposed new rule:

    Purchases or sales of asset-backed securities made pursuant to
and consistent with commitments of the underwriter, placement agent,
initial purchaser, or sponsor, or any affiliate or subsidiary of
such entity, to provide liquidity for the asset-backed security.

    The exception would permit securitization participants (including
affiliates and subsidiaries of an underwriter, placement agent, initial
purchaser, or sponsor of an ABS) to provide liquidity pursuant to a
commitment. While the statutory language specifically refers to
``purchases or sales of asset-backed securities,'' generally, we
understand that commitments to provide liquidity may be viewed by some
market participants as encompassing a variety of activities. For
example, we understand that a liquidity commitment may be viewed as a
way to promote full and timely interest payments to ABS investors. In
addition, we understand that a securitization participant may provide
financing to accommodate for differences in the maturity dates between
asset-backed commercial paper and the underlying assets. For example, a
sponsor of asset-backed commercial paper may provide a liquidity
facility if a tranche of $3 million of the asset-backed commercial
paper matures on the 30th day of the month, yet only $2 million of the
underlying receivables match that maturity. If there is an inability to
repay the $1 million shortfall by issuing new commercial paper, the
sponsor may provide a loan secured by the receivables to provide for
the $1 million shortfall. By way of another example, a liquidity
commitment could be an agreement by a securitization participant, such
as an underwriter, to purchase an ABS from its customer in a repo
transaction consistent with applicable limitations on such
transactions.\92\ While we understand that these are some of the ways
that liquidity commitments are often understood by market participants,
we ask commenters to identify other examples of liquidity commitments
and to discuss the application of the exception to such activities as
consistent with Securities Act Section 27B.
---------------------------------------------------------------------------

    \92\ See, e.g., 15 U.S.C. 78k(d).
---------------------------------------------------------------------------

Request for Comments Regarding Liquidity Commitments
    63. Are modifications to the proposed Rule 127B(b)(2) exception
necessary or are there interpretations that the Commission should
provide in order for the exception to work as intended? If yes, please
explain why.
    64. Are there transactions that involve material conflicts of
interest related to a liquidity commitment that should qualify for this
exception? Please explain why or why not.
    65. Should the proposed exception be interpreted to cover only
purchases and sales of the ABS? Please explain why such interpretation
would or would not be consistent with the statute.
    66. Is liquidity provided through means other than purchases and
sales of the ABS? If yes, please describe all additional means of
providing liquidity.
    67. Should the proposed exception cover engaging in any
transactions involved in warehousing the underlying assets? If yes,
please explain, including why this would be consistent with the intent
of the exception.
    68. We seek comment concerning the current scope of liquidity
commitments by each type of securitization participant. How do such
entities currently supply liquidity? When does this activity commence
and terminate?
    69. Please discuss the impact of the proposed exception on
liquidity, especially for less liquid securities held by investors.
    70. How do firms currently distinguish commitments to provide
liquidity from bona fide market-making? Please include a discussion of
the use of inventory of the ABS and the underlying securities and the
method for setting prices.
    71. Please discuss how the various securitization participants
provide

liquidity commitments. For example, please identify specific ways that
a sponsor provides liquidity versus an underwriter.
    72. Should the exception be conditioned on the maintenance, by some
or all of the securitization participants, of the books and records
that would demonstrate that the activity in question fell within the
exception? If so, what types of records should the securitization
participant be required to maintain?
    73. Should disclosure be a pre-requisite for relying on the
exception? Please explain.
iii. Bona Fide Market-Making Exception
    The following activities would not be prohibited by paragraph (a)
of proposed Rule 127B under the Securities Act:

    Purchases or sales of asset-backed securities made pursuant to
and consistent with bona fide market-making in the asset-backed
security.

    The exception would permit purchases or sales of ABS to be made
pursuant to and consistent with bona fide market-making in the ABS. The
exception would be available to all securitization participants
(including affiliates and subsidiaries of an underwriter, placement
agent, initial purchaser, or sponsor of an ABS) that qualify for it if
they engaged in bona fide market-making. We understand that the ABS
market is typically an over-the-counter market, and ABS are not broadly
distributed. We also understand that a few institutions may hold large
positions in an ABS.
    In determining if activities qualify as bona fide market-making for
purposes of proposed Rule 127B, we preliminarily believe that the
following principles are characteristics of bona fide market-making in
ABS:
     It includes purchasing and selling the ABS from or to
investors in the secondary market.
     It includes holding oneself out as willing and available
to provide liquidity on both sides of the market (i.e., regardless of
the direction of the transaction).
     It is driven by customer trading, customer liquidity
needs, customer investment needs, or risk management by customers or
market-makers.
     It generally is initiated by a counterparty and if a
customer initiated a customized transaction, it may include hedging if
there is no matching offset.
     It does not include activity that is related to
speculative selling strategies or investment purposes of a dealer, or
that is disproportionate to the usual market-making patterns or
practices of the dealer with respect to that ABS.
     Absent a change in a pattern of customer driven
transactions, it typically does not result in a number of open
positions that far exceed the open positions in the historical normal
course of business.
     It generally does not include actively accumulating a long
or short position other than to facilitate customer trading interest.
     It generally does not include accumulating positions that
remain open and exposed to gains or losses for a period of time instead
of being closed out promptly.\93\ In contrast, an aged open position
taken to facilitate customer trading interest would be hedged rather
than exposed to gains and losses for a period of time.\94\
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    \93\ Silber, supra note 90 (distinguishing market makers from
other traders, such as speculators, using the following market-maker
characteristics among others: (i) Customer-based traders who buy and
sell assets to accommodate customer purchase and sale orders, (ii)
earn money on the bid/ask spread without speculating on future
prices, (iii) tend to close out positions quickly and thus have
small losses on positions, (iv) reduce exposure to equilibrium price
movements by minimizing the length of time they hold assets, and (v)
avoid holding open positions).
    \94\ Similarly, indicia to be considered in connection with
permitted market-making in less liquid markets under the Volcker
Rule includes ``[p]urchasing or selling the financial instrument
from or to investors in the secondary market; [h]olding oneself out
as willing and available to provide liquidity on both sides of the
market (i.e., regardless of the direction of the transaction);
[t]ransaction volumes and risk proportionate to historical customer
liquidity and investment needs; and [g]enerally does not include
accumulating positions that remain open and exposed to gains or
losses for a period of time instead of being promptly closed out or
hedged out to the extent possible. For example, an aged open
position taken to facilitate customer trading interest would be
hedged rather than exposed to gains and losses for a period of
time.'' See, FSOC Study, p. 29. See infra Section IIIE (discussing
the potential interplay with the Volcker Rule).
---------------------------------------------------------------------------

    In addition, we note that the fact that trading is carried out in a
market-making account or on a market-making desk would not be
determinative of whether such trading is bona fide market-making in
ABS. The account type or desk would not govern the analysis, since
otherwise a market-making account or desk might be used in an attempt
to disguise proprietary trading as bona fide market-making.
    We seek comment as to whether the above principles accurately
identify the characteristics of bona fide market-making in ABS or
whether different or additional characteristics might better identify
this activity. We seek comment regarding how utilizing the principles
listed above in determining whether activity was bona fide market-
making in ABS would affect principal trading and the provision of
liquidity by market intermediaries. Please provide examples of
principal trading that would qualify for the exception as well as
principal trading that would not qualify for the exception.
    We note that the applicability of this proposed guidance concerning
bona fide market-making is specific to bona fide market-making in ABS
and may or may not be applicable in other areas of the federal
securities laws and rules, in self-regulatory organization (``SRO'')
rules or in connection with other provisions of the Dodd-Frank Act.\95\
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    \95\ Previously, we provided guidance that indicia of ``bona-
fide market making'' for equity securities includes maintaining
continuous two-sided quotes, among other things. See Release 34-
58775 (Oct. 14, 2008), 73 FR 61690, 61698 (Oct. 17, 2008). However,
different factors may apply to ABS, given the differences between
the markets in equities and ABS.
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    Depending on the facts and circumstances, bona fide market-making
that does not meet each of these principles may still be bona fide
market-making for purposes of the proposed exception. However, meeting
just one factor might or might not be sufficient to qualify for the
exception depending on the facts and circumstances.
    We preliminarily believe that these principles would be appropriate
as they are aimed at customer trading, customer liquidity needs,
customer investment interest, or risk management by customers or
market-makers. We also preliminarily believe that these principles
would be necessary in order to distinguish bona fide market-making with
respect to ABS that qualifies for the exception from other trading. We
recognize, however, that there could be additional principles that
would better identify bona fide market-making that is consistent with
the intent of the exception. We seek commenters' views on any such
principles.
Request for Comments Regarding Bona Fide Market-Making
    74. We seek comment concerning the proposed indicators of bona fide
market-making and any additional indicators of bona fide market-making
with respect to ABS. We also seek comment concerning additional
indicators of speculative or other trading masked as bona fide market-
making.
    75. Please provide specific, current examples of bona fide market-
making in connection with ABS and explain how such activity evidences
the proposed characteristics of bona fide market-making. Please discuss
activity that does not evidence the proposed characteristics of bona
fide market-making but that should qualify for the exception and why.
    76. Please discuss whether there are features of ABS market-making
that

differ from market-making in other types of securities. Please describe
the time period for which a market-making position in ABS is generally
held and any circumstances which would cause such a position to be held
longer.
    77. Do firms use derivatives in connection with bona fide market-
making with respect to ABS? If yes, how?
    78. Please describe whether firms currently identify bona fide
market-making in ABS. If so, how?
    79. Should we adopt a definition of the term ``bona fide market-
making'' for purposes of proposed Rule 127B? If yes, please provide a
suggested definition.
    80. Should the exception be conditioned on the maintenance, by some
or all of the securitization participants, of books and records that
would demonstrate that the activity in question fell within the
exception? If so, what types of records should the securitization
participant be required to maintain?
    81. Should disclosure be a pre-requisite for relying on the
exception? Please explain.
Request for Additional Comments Concerning the Exceptions
    82. Please discuss any activities that you believe would meet the
proposed exceptions for risk-mitigating hedging, liquidity commitments
and bona fide market-making but that could be viewed as a material
conflict of interest. Should the Commission expressly state its view
about why such activities would or would not be consistent with the
exceptions? Please explain why such activity should or should not be
interpreted as consistent with Securities Act Section 27B.
    83. Please discuss the ways in which securitization participants
might demonstrate compliance with the proposed exceptions for risk-
mitigating hedging, liquidity commitments and bona fide market-making.

C. Application of Material Conflict of Interest Test

    We set forth below examples of transactions that involve or that do
not involve, as the case may be, potential conflicts of interest and
describe how our proposed test for identifying material conflicts of
interest for purposes of Section 27B and our proposed rule would apply
to such transactions. We note that these examples are merely
illustrative, and even minor differences in the facts and circumstances
could change the analysis of these transactions. We further note that
the examples below are intended only to illustrate the application of
the proposed rule, and are not intended to address the application of
other laws, rules or regulations to the relevant transactions. The
conduct depicted in the examples might or might not violate provisions
of the securities laws or rules that are not discussed here.
    In the following examples, we focus primarily on items 1(A) and (B)
of the interpretation as to whether a transaction involves or results
in a material conflict of interest: First, whether under the
transaction the securitization participant ``would benefit directly or
indirectly from the actual, anticipated or potential (1) Adverse
performance of the asset pool supporting the relevant ABS, (2) loss of
principal, monetary default or early amortization event on the ABS, or
(3) decline in the market value of the relevant ABS''; or second,
whether under the transaction the securitization participant ``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.'' We assume for
purposes of discussion that, unless otherwise specified, the
materiality requirement for our proposed interpretation is satisfied--
i.e., there is a substantial likelihood that a reasonable investor
would consider the conflict important to his or her investment
decision. In addition, unless otherwise indicated in these examples, we
assume that the exceptions under the proposed rule (e.g., bona fide
market-making or risk-mitigation hedging activities) would not be
available.
Example 1--Securitization Participant Effecting a Short Transaction in
an ABS, or any of the Assets Underlying an ABS
    In Example 1, an ABS underwriter purchases CDS protection on the
securities offered in the relevant ABS three months after the date of
the first closing of the sale of the ABS. For these purposes, assume
that the ABS meets the definition of an asset-backed security in
Section 3(a)(77) of the Exchange Act and the underwriter's purchase of
CDS protection was made solely for its own proprietary investment
purposes and does not qualify for any exception in the proposed
rule.\96\
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    \96\ For example, the underwriter had no client that requested
the long CDS exposure such that the purchased CDS protection could
qualify for the bona fide market-making exception.
---------------------------------------------------------------------------

    The underwriter is a covered person as one of the enumerated
securitization participants in the proposed rule. The ABS is a covered
product because it meets the Section 3 definition of ABS in the
Exchange Act. The purchase of CDS protection is a transaction for
purposes of the proposal which occurred prior to one year after the
date of the first closing of the sale of the ABS. Therefore, the
transaction occurred within the covered timeframe.
    In this example, the purchase of the CDS protection by the
securitization participant is a short transaction within the covered
timeframe that is prohibited by the proposed rule.\97\ This short
transaction would involve a material conflict of interest between the
securitization participant and the ABS investors because the
securitization participant would profit from the adverse performance of
the ABS.\98\
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    \97\ Nothing in the proposed rule would prohibit the
securitization participant from purchasing the ABS or selling
protection on the ABS or the assets underlying the ABS.
    \98\ However, if the short transaction was executed in the
context of market-making by the securitization participant (e.g.,
the securitization participant purchases CDS protection from one
customer to offset its sale of CDS protection to another customer),
the exception under Rule 127B(b) would permit such market-making.
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Example 2--Securitization Participant Hedges Retained Investment in an
ABS
    In Example 2, an ABS underwriter purchases ABS that it distributed
and contemporaneously purchases CDS protection on the ABS. For these
purposes, assume that the ABS meets the definition of asset-backed
security in Section 3(a)(77) of the Exchange Act, and the underwriter
uses the CDS to hedge its ABS position on a delta neutral basis, such
that the potential gains on the hedged positions are not appreciably
larger than the potential losses on that portion of the ABS investment
that is being hedged at any point in the future.
    The underwriter is a covered person as one of the enumerated
securitization participants in the proposed rule. The ABS is a covered
product because it meets the Section 3 definition of ABS in the
Exchange Act. The purchase of CDS protection is a transaction, which
for purposes of the proposal occurred within the covered timeframe--
i.e., prior to one year after the date of the first closing of the sale
of the ABS.
    In this case, the proposed risk-mitigating hedging activities
exception could apply, because the securitization participant is
hedging a position arising out of the underwriting, placement,

initial purchase or sponsorship of an ABS. However, if, the CDS
transaction is structured such that under some circumstances, now or in
the future, the recovery on the CDS might be appreciably greater than
the exposure on the ABS, the risk-mitigating hedging exception would
not apply, because the securitization participant would profit from the
adverse performance of the ABS through a short transaction (the CDS).
In this case, the securitization participant would not be managing
risk, but instead would have a risk-taking position directionally
opposed to the ABS (in the amount of the CDS exposure that exceeds what
is necessary for a delta neutral hedge).\99\
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    \99\ Labels such as ``hedging'' would not permit what would
otherwise be prohibited conduct under the proposed rule. If a
securitization participant engaged in a transaction within one year
after the date of the first closing of the sale of the ABS that
involved or resulted in a material conflict of interest with respect
to investors in the ABS, that would be prohibited by proposed Rule
127B(a), even if it were referred to by the securitization
participant as ``hedging.''
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Example 3--Synthetic ABS Transaction
    Example 3 involves several variations on the role of a
securitization participant, in this case a sponsor, in a synthetic ABS
transaction. In each case, the securitization participant is a party to
the CDS contract with the SPE, and thus the securitization participant
is short the credit exposure of the reference portfolio underlying the
ABS transaction.
    In these scenarios, the sponsor is a covered person because it is
one of the enumerated securitization participants in the proposed rule,
and the ABS is a covered product because the proposal covers synthetic
ABS. For purposes of the proposal, the purchase of CDS protection is a
short transaction, which occurred prior to one year after the date of
the first closing of the sale of the ABS. Therefore, the transaction
occurred within the covered timeframe.
    In Example 3A, the securitization participant does not have any
exposure to the ABS or underlying assets other than its short position
through the CDS transaction. In this instance, entering into the CDS
with the issuer of the ABS would, by itself, generally involve or
result in a material conflict of interest between the securitization
participant and the ABS investors that would be prohibited by the
proposed rule.
    In Example 3B, the securitization participant's short exposure
under the CDS with the issuer offsets the securitization participant's
existing long exposure to the same assets underlying the ABS. For
instance, the securitization participant might be seeking to reduce its
long investment exposure to the relevant assets because it has come to
believe that the assets will perform poorly. If the firm accomplishes
this result by transferring the risk of its long positions to ABS
investors through a synthetic ABS--while marketing the ABS securities
to investors as a good investment opportunity--it could be viewed as
benefiting from a decline in the ABS at the expense of the ABS
investors, who now have the exposure to the underlying assets.\100\
Although the securitization participant's existing long exposure to
those assets and its short exposure under the CDS transaction may
offset each other, in this scenario the CDS transaction is providing a
hedge for an existing long investment position, rather than a hedge for
assets associated with underwriting activities, and thus the risk-
mitigating hedging exception would not be available.\101\
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    \100\ See 156 Cong. Rec. S2599 (daily ed. July 15, 2010)
(statement by Sen. Levin) (``But a firm that underwrites an asset-
backed security would run afoul of the provision if it also takes
the short position in a synthetic asset-backed security that
references the same assets it created.'').
    \101\ We note that that risk-mitigating hedging exception in
proposed Rule 127B(b)(1) is available only for hedging in connection
with positions or holdings arising out of underwriting, placement,
initial purchase or sponsorship of an ABS. In this scenario, the
securitization participant's position in the underlying assets was
acquired as an investment, and not for purposes of the initial
offering transaction, and therefore the exception would not apply.
---------------------------------------------------------------------------

    We preliminarily believe that in Example 3B and under our proposed
interpretation the securitization participant would be prohibited from
entering into the CDS transaction with the ABS issuer for the same
reason as in Example 3A--the securitization participant would benefit
through the CDS transaction from a potential decline in the ABS, and no
exception to the prohibition is available--but we request comment on
whether this result is appropriate in all circumstances.
    In Example 3C, the securitization participant has accumulated a
long cash or derivatives position in the underlying assets solely in
anticipation of creating and selling a synthetic ABS--and not with a
view to taking an investment position in those underlying assets. The
securitization participant might choose to use the synthetic
securitization structure rather than a traditional cash securitization
when that is a more efficient mechanism for providing particular
customers with exposure to the underlying assets. In this case the
securitization participant therefore enters into a CDS with the SPE as
part of a synthetic ABS transaction to offset the exposure to the
underlying reference portfolio that it in turn acquired for purposes of
effecting the ABS transaction.
    We preliminarily believe that in Example 3C the short CDS
transaction by the securitization participant would fall within the
exception for risk-mitigating hedging activities--provided that there
was no significant net basis risk, and that potential gains (or losses)
by the securitization participant from the CDS protection it purchased
from the issuer would be directly offset by losses (or gains) from the
long position accumulated to offset that exposure. We seek comment on
whether this interpretation would be appropriate. In addition, we seek
comment on whether as a practical matter it will be possible to
distinguish circumstances in which the securitization participant's
long position in the underlying assets was originally acquired for
investment purposes (i.e., Example 3B), from circumstances in which the
securitization participant's long position was acquired for purposes of
creating the ABS (i.e., Example 3C).
    In Example 3D, the securitization participant that has entered into
the short CDS transaction with the SPE contemporaneously enters into
one or more offsetting CDS transactions with other market participants
that did not play a role in selecting the reference assets of the ABS,
and did not have any influence on any aspect of the ABS transaction.
Provided that the securitization participant did not itself select
assets that were biased to facilitate the ability of these market
participants to profit from short transactions, and that the offsetting
CDS transactions had no significant net basis risk (i.e., potential
gains (or losses) by the securitization participant from the CDS
protection that it purchased from the issuer would be directly offset
by losses (or gains) from the CDS transactions with third parties), we
preliminarily believe that under the risk-mitigating hedging exception
the securitization participant would be permitted to enter into this
combination of the CDS transaction with the issuer of the ABS
securities and the offsetting transactions with third parties.\102\ The
CDS transaction with the SPE is itself a position or holding arising
out of the ABS transaction, and the securitization participant would
not profit from excess exposure directionally opposed to the

ABS because of the offset.\103\ In this sense, Example 3D is comparable
to Example 3C. However, if in Example 3D the securitization
participant's CDS with the issuer is entered into to offset pre-
existing CDS exposures to third parties that were entered into for
purposes unrelated to the ABS transaction, the scenario would be
comparable to Example 3B and the risk-mitigating hedging exception
would not apply. As above, we seek comment on whether as a practical
matter it will be possible to distinguish circumstances in which the
securitization participant's short transaction with the ABS issuer is
entered into to hedge an existing position (and is thus prohibited) or
to facilitate the ABS transaction (and thus permitted).
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    \102\ See 156 Cong. Rec. S2599 (daily ed. July 15, 2010)
(statement of Sen. Levin) (``Nor does it restrict a firm from
creating a synthetic asset-backed security, which inherently
contains both long and short positions with respect to securities it
previously created, so long as the firm does not take the short
position.'').
    \103\ Furthermore, since in this example there is no third party
that has influenced the asset selection or structure of the ABS, it
is unlikely that the ABS would have been structured in anticipation
of underperformance of the ABS or its reference portfolio.
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Example 4--Facilitation of Third Party Activities

    Example 4 involves variations on situations in which a
securitization participant, in this case a placement agent, benefits by
allowing an unaffiliated \104\ third party to select the composition of
the assets that underlie an ABS as defined in Section 3 of the Exchange
Act. In each case, the third party purchases CDS protection on the
relevant ABS prior to one year before the date of the first closing of
the sale of the ABS.\105\
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    \104\ ``Unaffiliated'' is used to describe the third party
because Section 27B of the Securities Act applies to (and proposed
Rule 127B would apply to) affiliates of a securitization
participant.
    \105\ Note that in order to fall within item 1(B), a third party
must both (i) Directly or indirectly structure the relevant ABS or
select assets underlying the ABS, and (ii) enter into a short
transaction. Thus, if in a synthetic ABS transaction a third party
purchases CDS protection on the relevant ABS from the SPE, but does
not structure the relevant ABS or select assets underlying the ABS,
the third party's activities would not fall within the scope of item
1(B).
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    In each of the examples below, assume that the placement agent is a
covered person as one of the enumerated securitization participants in
the proposed rule, and that, the ABS is a covered product because it
meets the Section 3 definition of ABS in the Exchange Act.
    In Example 4A, the securitization participant, for a fee,
facilitates the third party's entering into a short transaction, the
purchase of CDS protection on the ABS, with a party who is not a
securitization participant. Under item 1(B) of the interpretation of
material conflicts of interest, and as previously described in Section
III A(v)(b), by allowing the third party to select assets underlying
the ABS, and then facilitating the third party taking a short position
on the ABS or its underlying assets, the securitization participant has
engaged in a transaction that involves or results in a material
conflict of interest between the securitization participant and the ABS
investors, and such activity would be prohibited under the proposed
rule. The securitization participant creates the opportunity for the
third party to select riskier assets for the underlying asset pool so
that the anticipated poor performance of these assets would increase
the likelihood of a profitable short transaction. In return for
creating this opportunity for the third party, the securitization
participant receives compensation for facilitating the third party's
short transaction.
    In Example 4B, the third party again enters into the CDS
transaction but now with a party who is not a securitization
participant, so that in this case the securitization participant does
not facilitate that CDS transaction or receive a fee for doing so. As
in Example 4A, in Example 4B, the securitization participant creates
the opportunity for the third party to profit from its short
transaction by permitting it to select risky assets for the underlying
asset pool. We preliminarily believe that the securitization
participant's activities in Example 4B would be prohibited under our
proposed test. Although the securitization participant would not
receive direct compensation for facilitating the short transaction we
believe it would be appropriate to impute a benefit to the
securitization participant for creating the opportunity for the third
party to profit from its short transaction. For example, the
securitization participant may receive compensation from its role in
connection with the ABS or compensation from future business that the
third party promises to direct to the securitization participant. We
request comment on whether it is appropriate to treat the
securitization participant in Examples 4A and 4B in the same manner, or
whether the lack of direct compensation to the securitization
participant in Example 4B would justify a different result.
    In Example 4C, the third party who has selected assets in the ABS
also purchases one or more of the securities offered in the ABS
transaction. In this case, the third party's purchase of CDS protection
on the relevant ABS offsets its exposure to the ABS. In general, we
preliminarily believe that activities in which investors who purchase
one or more securities offered in an ABS transaction decide at that
time or later to reduce or hedge their exposure to these investments
through subsequent short transactions, such as purchasing CDS
protection, would qualify for the risk-mitigating hedging exception,
and that these activities do not involve or result in the types of
material conflicts of interest proposed Rule 127B is intended to
address. In Example 4C, the third party is in the same position as a
securitization participant who has selected the assets underlying the
ABS, purchases the ABS, and then seeks to hedge that ABS by buying CDS
protection (e.g., the securitization participant in Example 2). By
allowing the third party to select assets and then hedge a position in
ABS purchased in the offering, the securitization participant would not
be permitting the third party to do anything that the securitization
participant itself could not do under the proposed rule.
    In Example 4D, the same third party purchasing one or more
securities issued by the ABS also buys CDS protection on those same
securities or other securities in the offering (or their underlying
assets), but in this case does so in a manner such that the third party
will profit more from the short position than it will lose on the long
securities position. For example, the third party may have purchased
the equity tranche in order to influence the selection of riskier
assets and implement an arbitrage strategy in which it would gain more
on a CDS transaction on the issuer's securities than it would lose on
the equity tranche.\106\ This activity would no longer qualify for the
risk-mitigating hedging exception. As per item 1(B) of the test, by
allowing a third party to select assets underlying an ABS in a way that
facilitates that third party's ability to profit from a short position
on the ABS or its underlying assets, the securitization participant has
engaged in a transaction that involves or results in a material
conflict of interest between itself and investors in the ABS.
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    \106\ See e.g., Senate Subcommittee Report: Anatomy of a
Financial Collapse, supra n. 38, at 372 (describing a hedge fund's
investment strategy as ``purchas[ing] the riskiest portion of a
CDO--the equity--and, at the same time, to purchase short positions
on other tranches of the same CDO'').
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Request for Comments Regarding the Examples
    We request comment on whether these examples demonstrate engaging
in transactions that involve or result in material conflicts of
interest of a type that proposed Rule 127B should prohibit. We also
request that commenters provide descriptions of any

other examples of material conflicts of interest that the proposed rule
should prohibit, and address whether our proposed materiality test
appropriately captures such conflicts of interest.
    84. Please identify activity that would constitute selecting assets
underlying the asset pool or structuring the ABS transaction as
discussed in the examples above. Should such activity include
establishing criteria for asset selection, selecting names from a list
of potential reference assets provided by a securitization participant
or other activities? Should the number or percentage of assets selected
as collateral be a factor in determining whether or not a person played
a role in selecting assets? Should there be some level of activity that
should not be considered selecting the assets or structuring the ABS?
Please explain why or why not.
    85. In connection with Example 3D above, please describe any
circumstances in which a securitization participant may not be able to
offset its CDS exposure, or can only partially offset its CDS exposure
by entering into one or more offsetting transactions with other market
participants. We seek commenter input regarding any specific
consequences of prohibiting the activity described in Example 3D if the
securitization participant cannot fully offset its CDS exposure.
    86. We seek commenter input regarding the rationale applied in each
of the scenarios in Example 4.
    87. Are there additional factors that would better identify
material conflicts of interest, especially in the context of evaluating
the examples above? Please explain. For example, should we consider any
factors not discussed in Example 4B when the unaffiliated third party
may purchase CDS protection from another entity? How should such
factors be considered in determining whether a transaction involves or
results in a material conflict of interest?
    88. Are there examples not listed above that occur frequently for
which further guidance is needed? Please describe.
    89. In Examples 1, 2, 3A, 3B, 4A, 4B, 4D, we illustrate activities
that would be prohibited under the proposed interpretation discussed in
the release. For each of these examples, we seek commenter input
regarding how frequently the transactions described in the examples
occur in connection with ABS and synthetic ABS as well as the potential
positive and negative consequences of prohibiting such transactions.
Please also include a discussion regarding any potential impacts,
including any positive or negative impact, on investors, investor
protection, liquidity, capital formation and the maintenance of fair,
orderly and efficient markets if securitization participants refrained
from creating and selling certain ABS and synthetic ABS to avoid the
activities described in the examples above as a result of the proposed
rule.
    90. Example 3B describes a securitization participant transferring
the risk of its long positions to ABS investors through a synthetic
ABS. We seek commenter input regarding how frequently or infrequently
this occurs and the consequences that might result from transferring
such risk to ABS investors through a synthetic ABS. We also seek
commenter input regarding the reasons why a securitization participant
might or might not prefer to transfer such risk using a synthetic ABS
instead of a non-synthetic ABS.

D. Application of the Proposed Rule to Other Activities

    Initial commenters identified many activities that they believed
could be implicated by Section 27B and the proposed rule. These
activities include: (1) Activities that are routinely part of the
securitization process that may be effected in connection with
structuring an ABS; and (2) activities undertaken by securitization
participants that are unrelated to the securitization.\107\
---------------------------------------------------------------------------

    \107\ See supra Section IIB.
---------------------------------------------------------------------------

    We believe that activities associated with the typical structuring
of a non-synthetic ABS would not be prohibited by the proposed rule.
For example, the basic transfer of risk in a non-synthetic ABS in which
a securitization participant who is long the underlying assets sells
them to an SPE is typical of most ABS structures and would not
constitute a prohibited transaction, because after such sale the
securitization participant would not benefit from the subsequent
decline in the value of the ABS or the underlying assets. Additionally,
the proposed rule would not prohibit the multi-tranche structure
commonly used in securitization transactions. While investors in
different tranches may have interests that conflict with each other,
such conflicts would fall outside the scope of the proposed rule, which
is focused on conflicts of interest between securitization participants
and ABS investors. In addition, mere ownership by a securitization
participant of the ABS would not constitute a material conflict of
interest under the proposed rule, because such ownership by itself
would not cause the securitization participant to benefit from the
adverse performance of the asset-pool or the ABS; instead, the
securitization participant would benefit from the positive performance
of these assets.\108\
---------------------------------------------------------------------------

    \108\ For this reason, we believe the proposed rule would not
prohibit risk retention as required by Dodd-Frank Act Section 941.
See supra note 19.
---------------------------------------------------------------------------

    Commenters stressed the importance of the ``material'' aspect of
the phrase ``material conflict of interest'' in Section 27B and
suggested that activities inherent in the securitization process
evidence ``expected conflicts * * * but do not constitute the type of
`material conflicts' intended to be regulated by Section 621.'' \109\
We preliminarily believe that many activities that these commenters
identified as being inherent to the securitization process would not be
prohibited by the proposed rule because they would not fall within its
scope or would fall within one of the exceptions to the
prohibition.\110\ Thus, we preliminarily agree that most activities
undertaken in connection with the securitization process would not be
prohibited by the proposed rule, including but not limited to:
Providing financing to a securitization participant, deciding not to
provide financing, conducting servicing activities, conducting
collateral management activities, conducting underwriting activities,
employing a rating agency, receiving payments for performing a role in
the securitization, receiving payments for performing a role in the
securitization ahead of investors, exercising remedies in the event of
a loan default, exercising the contractual right to remove a servicer
or appoint a special servicer, providing credit enhancement through a
letter of credit, and structuring the right to receive excess spreads
or equity cashflows.
---------------------------------------------------------------------------

    \109\ SIFMA Letter at p. 4.
    \110\ See, e.g., SIFMA Letter.
---------------------------------------------------------------------------

    Commenters also suggested that certain transactions in swaps, caps,
CDS and derivatives should fall outside the proposed rule's
prohibition. We invite commenters to analyze any such transactions with
our proposed framework. In addition, commenters highlighted activities
that are unrelated to a particular securitization (such as underwriting
another ABS transaction for another issuer) and suggested that they
should not be prohibited. We generally agree that many such activities
would not be prohibited by the proposed rule, including underwriting an
ABS for a different issuer. These activities generally could be
undertaken absent additional facts indicating otherwise, such as facts
indicating a securitization participant engaged in a proprietary trade
that would profit from

a directionally opposite view of the ABS.
    Other activities unrelated to the securitization, such as market
research, could be undertaken by a securitization participant. As
mentioned earlier, the issuance of research would not be engaging in a
transaction for purposes of the proposed rule and as such would not be
prohibited.
    We ask that commenters analyze these and other activities, using
the proposed framework set forth above, including the use of the
derivatives and the activities of servicers and collateral managers.

E. Relationship to Volcker Rule

    Section 619 of the Dodd-Frank Act,\111\ commonly referred to as
``the Volcker Rule,'' amends the Bank Holding Company Act to add new
Section 13, Prohibitions on Proprietary Trading and Certain
Relationships with Hedge Funds and Private Equity Funds. The Volcker
Rule includes (1) General prohibitions and restrictions on certain
financial entities--including certain broker-dealers--engaging in
proprietary trading or sponsoring or investing in a hedge fund or
private equity fund, (2) certain exceptions to these prohibitions and
restrictions (referred to as ``permitted activities''), and (3)
limitations on permitted activities.
---------------------------------------------------------------------------

    \111\ Dodd-Frank Act, Public Law 111-203, 619, 124 Stat. 1376,
1620 (2010).
---------------------------------------------------------------------------

    Like Section 621, the Volcker Rule is concerned with conflicts of
interest. For example, the Volcker Rule is concerned with conflicts of
interest that stem from proprietary trading at banking and non-bank
financial firms. In addition, the Volcker Rule, like Section 621,
includes the concepts of certain permitted activities concerning
market-making related activities and risk-mitigating hedging
activities.\112\ Given the similarities between these two sections of
the Dodd-Frank Act, the Commission may consider whether aspects of the
rules adopted to implement Section 619 should be applied to this
proposed rule in the future.\113\ Our preliminary belief is that the
exceptions for risk-mitigating hedging activities and bona fide market-
making activities for purposes of proposed Rule 127B should be viewed
no less narrowly than the comparable exceptions for such activities
under the Volcker Rule.
---------------------------------------------------------------------------

    \112\ See Sections 619(d)(1)(B) and (C) of the Dodd-Frank Act,
Public Law 111-203, 619(d)(1)(B) and (C), 124 Stat. 1376, 1624
(2010).
    \113\ The Commission must adopt rules not later than nine months
after completion of the Financial Stability Oversight Council's
study on the Volcker provisions. The study, see supra note 85, was
issued on January 18, 2011.
---------------------------------------------------------------------------

Request for Comments Regarding Relationship to Volcker Rule
    94. Please discuss any potential interplay of the ``Volcker Rule''
of Section 619 of the Dodd-Frank Act with Section 27B and proposed Rule
127B. In particular, we seek commenter input regarding whether or not
the treatment of risk-mitigating hedging activities and bona fide
market-making exceptions in Proposed Rule 127B(1) and (3) should be
consistent with Section 13(d)(1)(B) and (C) of the Bank Holding Company
Act concerning permitted market-making related activities and risk-
mitigating hedging activities or whether there are reasons that
necessitate different treatment. Please explain.
    95. We ask that commenters describe any potential consequences if
risk-mitigating hedging and market-making were treated differently
under Proposed Rule 127B and the Volcker Rule.
    96. We seek commenter input regarding any costs that may be
incurred by securitizations participants, ABS investors and others if
the exceptions in Proposed Rule 127B(b)(1) and (3) are interpreted
differently than Sections 13(d)(1)(B) and (C) of the Bank Holding
Company Act.

IV. Information Barriers, Disclosure, and Exemptions

    Information barriers and disclosure are often used as tools to
manage conflicts of interest in other areas of the federal securities
laws. While Securities Act Section 27B does not explicitly provide for
specific exceptions concerning information barriers or disclosure, we
believe it would be useful to explore whether these tools might permit
the proposed rule to better achieve its policy objectives without
unnecessarily restricting beneficial market activities.

A. Information Barriers

    Commenters suggested the Commission consider potential burdens
triggered by Securities Act Section 27B on securitization participant's
affiliates and the use of existing mechanisms to manage conflicts of
interests, including in particular information barriers.\114\
Commenters stated that securitization participants may have a large
number of affiliates that engage in ordinary course activity that is
both ``walled-off'' from other areas of the securitization participant
and effected for purposes unrelated to any particular ABS transaction.
Commenters asked that the Commission be mindful of potential
``unintended effects on everyday operations'' of securitization
participant affiliates.\115\
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    \114\ See discussion infra at note 126. See, e.g., SIFMA Letter
at p. 7 (``Financial institutions engage in hedging activities in
many contexts and at many levels throughout an organization
comprised of many business units, offices, trading desks and funds,
each of which may be engaged in separate transactions that, in some
cases, are walled off from other parts of the financial institution
and may otherwise be transacted for purposes other than betting
against the specific ABS that is sponsored or underwritten by that
financial institution or its affiliate. Curtailing such hedging
activities--which are unrelated to the actual ABS sponsored or
underwritten by financial institutions and their affiliates and are
entered into as part of their risk management practices and not as a
bet against that ABS--would have adverse and unintended effects on
everyday operations and risk management practices of financial
institutions and their affiliates.'').
    \115\ SIFMA Letter at p. 8.
---------------------------------------------------------------------------

    Information barriers, in the form of written, reasonably designed
policies and procedures, have been recognized in other areas of the
federal securities laws and rules as a means to address or mitigate
potential conflicts of interest or other inappropriate activities. For
example, Section 15(g) of the Exchange Act recognizes that information
barriers may be used to effectively manage the potential misuse of
material, non-public information.\116\ Exchange Act Rule 14e-5
prohibits certain purchases of securities outside of tender
offers,\117\ but contains an exception for purchases or arrangements to
purchase by an affiliate of a dealer-manager.\118\ The exception
requires, among other things, that the dealer-manager maintains and
enforces written policies and procedures reasonably designed to prevent
the flow of information to or from the affiliate.\119\ It also requires
that the dealer-manager be a registered broker-dealer and that the
affiliate have no officers (or persons performing similar functions) or
employees (other than clerical, ministerial or support personnel) in
common with the dealer-manager that direct, effect, or recommend
securities transactions.\120\ Likewise, Regulation M, the set of anti-
manipulation rules concerning securities offerings, contains an
exception for certain persons based on information barriers.\121\
Affiliated purchasers are excepted if, among other things, the
affiliate maintains and enforces written policies and procedures
reasonably designed to prevent the flow of information to or from the
affiliate that might result in a

violation of Regulation M.\122\ In order for an affiliate to avail
itself of the exception it must also obtain an annual, independent
assessment of the operation of such policies and procedures.\123\ Like
Rule 14e-5, it contains a restriction on common officers and
employees.\124\
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    \116\ Formerly Section 15(f) of the Exchange Act but
redesignated by the Dodd-Frank Act. 15 U.S.C. 78o(g).
    \117\ 17 CFR 240.14e-5.
    \118\ 17 CFR 240.14e-5(b)(8).
    \119\ 17 CFR 240.14e-5(b)(8)(i).
    \120\ 17 CFR 240.14e-5(b)(8)(ii and iii).
    \121\ 17 CFR 242.100-105.
    \122\ 17 CFR 242.100(b).
    \123\ Id.
    \124\ Id.
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    The concept of independent units (including affiliated entities)
within multi-service firms has been recognized in discrete areas of the
securities laws for those multi-service firms with units that function
separately and independently.\125\ We preliminarily believe it may be
appropriate to consider the issue of independent units within a multi-
service firm in the context of the proposed rule. Certain firms
involved in securitization may undertake a wide range of activities in
connection with multiple and different business lines, underwriting and
trading ABS among them. We seek comment below concerning the extent of
the restrictions that the proposed rule would place on firm-wide
activities. We seek commenter input regarding whether firm-wide
restrictions would be necessary to achieve the objectives of the
statute or whether firm-wide restrictions would be unwarranted if
transactions were independent of the creation and distribution of an
ABS.
---------------------------------------------------------------------------

    \125\ See e.g., 17 CFR 200(f) (allowing multi-service broker-
dealers to aggregate positions within defined trading units if a
registered broker-dealer meets the following requirements ``(1) The
broker or dealer has a written plan of organization that identifies
each aggregation unit, specifies its trading objective(s), and
supports its independent identity; (2) Each aggregation unit within
the firm determines, at the time of each sale, its net position for
every security that its trades; (3) All traders in an aggregation
unit pursue only the particular trading objective(s) or strategy(s)
of that aggregation unit and do not coordinate that strategy with
any other aggregation unit; and (4) Individual traders are assigned
to only one aggregation unit an any time.'').
---------------------------------------------------------------------------

Request for Comments Regarding Information Barriers
    91. We seek comment concerning the operation of information
barriers and whether or not the use of information barriers to address
conflicts of interest in connection with securitization transactions
might be consistent with Securities Act Section 27B. In particular, the
Commission seeks comment concerning whether this would be appropriate
for certain affiliates and subsidiaries of securitization participants
that may operate separately and independently.\126\
---------------------------------------------------------------------------

    \126\ See ABA Letter at p. 5 (``Section 27B applies to all
affiliates of underwriters and placement agents, which could include
banks, broker-dealers, asset managers and ERISA fiduciaries. Banks
and their affiliates are already subject to statutory and regulatory
provisions designed to prevent conflicts of interest and prevent the
use of material nonpublic information, and these provisions may
require the establishment of information walls between affiliated
entities or between different departments of a bank. Additionally,
entities which are fiduciaries are obligated to act for the benefit
of their beneficiaries and must be permitted to sell securities and
enforce loans based on the best interests of beneficiaries.
Underwriters and placement agents subject to Section 27B may have a
large number of affiliates, which may result in significant
administrative difficulties in applying the rule to all related
entities. We ask the Commission to be mindful, when preparing its
rules, of these existing obligations of transaction parties and
their affiliates and of the compliance burdens which may result.'').
---------------------------------------------------------------------------

    92. Should we consider the imposition of information barriers or
other means of managing potential conflicts of interest? If so, what
specific means should be considered (e.g., physical separation?) How
effective are any such alternative methods as currently used? Can such
methods be circumvented? If so, in what ways? We seek commenter input
regarding any limitations related to the use of information barriers in
the context of managing potential material conflicts of interest under
Section 27B?
    93. We seek comment concerning whether ordinary business functions
of affiliates and subsidiaries of underwriters, placement agents,
initial purchasers, and sponsors are sufficiently separated from the
process of creating and marketing ABS so as not to create material
conflicts of interest that the proposed rule is designed to address.
For example, consider application of the proposed rule to an affiliate
of a securitization participant that manages a fund and such fund
purchases a CDS referencing securities issued in the ABS transaction.
Should this type of activity be permitted, and if so, under what
conditions? Discuss whether this scenario might form the basis of a
clarifying interpretation or an exemptive rule. Please include in the
discussion your views about possible forms of, and utility of,
disclosure regarding the fund's CDS purchase. Please provide an
explanation concerning any current separation between the
securitization participant and/or its affiliates and subsidiaries, and
whether the separation is mandated by existing rules and regulation.
Please describe in detail how such separation is implemented,
maintained and enforced by a firm. Please discuss whether information
barriers, with respect to affiliates or subsidiaries, could result in a
conflict of interest not being material, and/or whether, where
consistent with Commission authority, the use of information barriers
should be conditioned on certain requirements (e.g., restrictions on
common officers and employees, annual assessments of policies and
procedures, being regulated by the Commission, entities providing
certification to the Commission or other persons that activities have
not involved or resulted in material conflicts of interest). We seek
comment concerning whether such separation can meaningfully protect
against material conflicts of interest in this context.
    94. If consistent with Securities Act Section 27B, should one unit
of a firm be able to effect (or be restricted from effecting) a
transaction that involves a directionally opposed view of the ABS or
its reference portfolio if that unit is separated by information
barriers from another unit in the same firm that created and
distributed the ABS? Is there any reason why information barriers would
not be effective in this context? We seek comment on circumstances in
which departments within one firm may be sufficiently separated so as
not to create a material conflict of interest that the proposed rule is
designed to address. Please identify all such departments and the
activities in which they may engage that could result in the
application of the prohibition in proposed Rule 127B, but may not raise
the concerns designed to be addressed by Securities Act Section 27B.
Discuss whether this scenario might form the basis of a clarifying
interpretation or an exemptive rule. Please include in the discussion
your views about possible forms of, and utility of, disclosure. Please
provide an explanation of the separation between departments and
whether it is mandated by existing rules and regulations. Please
describe how such separation is implemented, maintained and enforced by
the firm. We seek comment concerning whether such separation can
meaningfully protect against material conflicts of interest in this
context.
    95. If a separate, independent unit concept were to be applied in
connection with the proposed rule, what conditions would be appropriate
to maintain the integrity of the independence between the separate
units within a multiservice firm to permit transactions in one unit
that are truly independent from the creation and distribution of an ABS
in another unit (e.g., (1) A written plan of organization to identify
each unit, support its objective, and support its independent identity;
(2) individual employees assigned to only one unit at any time; (3)
compliance and internal audit routines; (4) written records; (5)
separate management structure, location,

business purpose and profit and loss treatment; and (6) other
conditions).

B. Disclosure

    While Securities Act Section 27B does not contain a disclosure
provision, commenters discussed the extent to which disclosure might
mitigate potential conflicts of interest in this context.\127\
Commenters stated that while there can be many potential conflicts of
interest that arise in connection with securitization, most are not the
type of material conflict of interest intended to be prohibited by
Securities Act Section 27B.\128\ Commenters stated that many conflicts
of interest that arise in the normal course of a securitization are
often contemplated by investors and indeed may be disclosed to
investors.\129\
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    \127\ See, e.g., Merkley-Levin Letter (``Further, the utility of
disclosures must be carefully examined and not be seen as a cure for
the conflicts. We provided the Securities and Exchange Commission
with sufficient authority to define the contours of the rule in such
a way as to remove conflicts of interest from these transactions,
while also protecting the healthy functioning of our capital
markets.''); see infra note 129.
    \128\ See, e.g., ABA Letter at p. 4 (``In view of the many
potential conflicts of interest that may arise between participants
and investors in ABS * * * and in view of the legislative history
and the statutory use of the term `material conflict of interest,'
we believe the rules issued by the Commission should focus on
prohibiting the type of blatant conflict of interest described in
the legislative history, while permitting other types of conflicts
to exist subject to appropriate disclosure requirements * * *
Potential conflicts of the type described above that either exist,
or are contemplated, at the time of an ABS transaction are
customarily disclosed in offering materials. Although the
legislative history is clear that disclosure is not necessarily a
cure for a conflict of interest arising out of profiting from a
`designed to fail' transaction, we believe adequate disclosure
should suffice to address these ordinary course conflicts.''); see
also SIFMA Letter at p. 5 (``In contrast to the material conflicts
of interest created in the `designed to fail' transactions cited by
Senators Merkley and Levin, many other potential conflicts of
interest are inherent in securitizations. These conflicts should be
disclosed to investors and other transaction parties to the extent
they are material, but should otherwise be permitted to fall outside
the scope of Section 621. While Senators Merkley and Levin assert
that disclosure alone may not eliminate the problematic nature of
certain conflicts, SIFMA believes that conflicts created in the
normal course of a securitization are sufficiently known by, or
disclosed to, investors and do not fall under the intended scope of
Section 621.''); ASF Letter at note 11 (``We note that Senator Levin
believes that disclosure alone may not cure material conflicts of
interest in all cases, such as in situations where `disclosures
cannot be made to the appropriate party or because the disclosure is
not sufficiently meaningful.' We further note that Senator Levin
does not believe that disclosing that the underwriter of an ABS `has
or might in the future bet against the security' will cure the
conflict of interest arising if the underwriter takes a short
position in a synthetic transaction that references the ABS.
However, in situations that are clearly not instances of an asset-
backed security being designed to fail, ASF believes that effective
disclosure would remedy perceived conflicts.'').
    \129\ See, e.g., SIFMA Letter at p. 5 (``SIFMA believes that
conflicts created in the normal course of a securitization are
sufficiently known by, or disclosed to, investors and do not fall
under the intended scope of Section 621.'').
---------------------------------------------------------------------------

    We seek comment concerning the role of disclosure in the context of
Securities Act Section 27B and the proposed rule. Securitization
participants typically provide various disclosures to investors in ABS,
which generally should include appropriate disclosure as to conflicts
of interest between investors and the securitization participant that
would be material to investors.\130\ While we have not identified all
circumstances in which a transaction potentially could be characterized
as involving or resulting in material conflicts of interest within the
meaning of the proposed rule and Securities Act Section 27B, we seek
comment on whether certain types of conflicts relating to an investor
could be managed through disclosure. We seek comment about the value of
disclosure as a means to manage conflicts of interest, while keeping in
mind the limits of disclosure.\131\ Various provisions of the federal
securities rules and laws address actual and potential conflicts of
interest in a variety of ways, including through the use of disclosure.
We ask that commenters consider the use of the disclosure in the
federal securities laws and rules or other areas, such as SRO rules,
and reference those laws or rules and their experiences with those laws
or rules in their responses to the questions below where applicable.
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    \130\ We are not addressing the quality or adequacy of typical
disclosures in ABS offerings, but are simply noting that such
disclosure typically does occur in connection with such offerings.
    \131\ 156 Cong. Rec. S5899 (daily ed. July 15, 2010) (statement
of Sen. Levin). In addition, we note that disclosure that is made
subsequent to an ABS transaction would not be appropriate in
managing conflicts of interests because an investor would have
already made an investment decision regarding whether or not to
purchase the ABS.
---------------------------------------------------------------------------

    As discussed in further detail below, Section 28 of the Securities
Act provides the Commission with authority to adopt conditional or
unconditional exemptive rules or regulations ``to the extent that such
exemption is necessary or appropriate in the public interest, and is
consistent with the protection of investors.'' \132\ We solicit comment
as to whether, in some circumstances, material conflicts of interest
that would be prohibited under Section 27B and the proposed rule could
be addressed sufficiently through a conditional exemption.
Specifically, provided the Commission were able to make the findings
required by Securities Act Section 28, the Commission could require
disclosure, as a condition to an exemption, to allow securitization
participants to engage in what otherwise would be prohibited behavior
under Section 27B and the proposed rule.
---------------------------------------------------------------------------

    \132\ 15 U.S.C. 77z-3. See infra note 135.
---------------------------------------------------------------------------

Request for Comments Regarding Disclosure
    96. We seek commenter input regarding whether or not disclosure
would be useful in this context and why. We seek commenter input
regarding whether or not disclosure would adequately improve the
alignment of the interests of securitization participants and investors
and whether utilizing disclosure in this manner would adequately
protect the public interest and the interests of investors. Please
provide specific examples (e.g., disclosure that a particular entity,
whether or not a securitization participant, directly or indirectly
selected the pool of assets or disclosure of other types of
information). If you believe that specific disclosure would be
appropriate, please explain under what circumstances and what level of
detail should be required.
    97. Are there conflicts of interest associated with specific types
of transactions or activities that should be or could be managed
through disclosure? \133\ How would such an approach be incorporated in
the context of the proposed rule? Should the use of disclosure in lieu
of a complete prohibition apply to specific conflicts and not others?
Which? What level of detail should any such disclosures include? Should
any such disclosures include details about specific transactions or
activities that the securitization participant plans to engage in, or
has engaged in, relating to

the ABS? Is a substantial level of detail effective or useful?
---------------------------------------------------------------------------

    \133\ See, e.g., SIFMA Letter at p. 4 through 11 (suggesting (i)
``To the extent the risk transfer dynamic between ABS sponsors and
asset originators and investors constitutes a conflict of interest,
this potential conflict is best addressed through disclosure,'' (ii)
``Potential conflicts arising in connection with these types of
liquidity facilities should be disclosed to investors and otherwise
permitted,'' (iii) ``Disclosure of the existence of control rights
and transaction parties entitled to exercise such rights should be
sufficient to inform investors of the possibility of such
conflicts,'' (iv) ``Potential conflicts of interest arising in a
transaction with an affiliated servicer should be disclosed to
investors and otherwise permitted under the scope of Section 621,''
(v) ``Potential conflicts arising in a transaction with an
affiliated trustee (to the extent permitted by existing law) should
be disclosed to investors and otherwise permitted under the scope of
Section 621,'' and (vi) ``Each securitization waterfall should
clearly set forth the priority of payments for investors, including
which payments are made prior to payments to investors, which
disclosure should be adequate to permit the continuance of these
arrangements.'').
---------------------------------------------------------------------------

    98. Are there circumstances in which any such disclosure might be
impracticable or ineffective? For example, if a securitization
participant desired to effect a transaction several months after the
closing, how might it be feasible for the securitization participant to
send disclosures at that time? Would the securitization participant be
able to identify all ABS investors to whom disclosures should be, or
would be required to be, sent? Would disclosure of transactions that
occurred long after the closing be useful, effective or appropriate?
    99. Should the use of disclosures in lieu of a complete prohibition
be limited to offerings involving certain types of ABS investors? If
yes, please specify which ABS investors and why. Why might disclosure
be adequate for some ABS investors but not others? What characteristics
should a securitization participant use in determining whether an ABS
investor needs particular disclosure? Are there some types of ABS
investors for which disclosure should never be sufficient in this
context? Should disclosures include risk disclosure statements for
certain types of ABS investors? If so, which ones? If not, why not?
    100. If disclosure were used in the context of proposed Rule 127B,
in what format or structure should such disclosure be made? What
information should be disclosed? Are there existing documents that
could be used to make disclosures to ABS investors? Please specify
which documents and explain why they would be appropriate. Conversely,
please identify existing documents that would not be appropriate
sources for disclosure. Please explain why.
    101. We seek commenter input regarding the manner in which
disclosure could be made so that it is timely, effective, and provides
a meaningful opportunity for ABS investors to evaluate the conflict of
interest. Please provide examples of disclosure that would be timely,
effective, and provide a meaningful opportunity for ABS investors to
evaluate a conflict of interest. Please provide examples of disclosures
that would not be timely, effective, or provide a meaningful
opportunity for ABS investors to mitigate the conflict of interest.
    102. In order for disclosure to be timely, is there a specific time
period prior to an ABS transaction in which disclosure should be made?
Please explain. Alternatively, should disclosure be made within a
reasonable time prior to an ABS transaction in order to permit an ABS
investor an opportunity to evaluate the conflict of interest?
Conversely, please discuss when disclosure might be made so far in
advance of an ABS transaction that it would not be useful.
    103. In order for disclosure to be effective, please discuss the
level of detail that would permit a reasonable ABS investor to
understand the conflict of interest. Please provide examples of
disclosure that would be effective as well as examples of generic
disclosures that would not be useful to ABS investors.
    104. We seek commenter input regarding what explicit disclosures
might be appropriate so that an ABS investor could meaningfully
understand a conflict of interest. We seek commenter input regarding
whether specific or enhanced disclosures should be made in connection
with more complex ABS. Please identify the type of ABS and discuss the
additional disclosures.
    105. If disclosure were used in the context of proposed Rule 127B,
should some or all of the securitization participants be required to
make and maintain records to document disclosure, or to document that
disclosure was made, to qualified customers? If so, what types of
records should the securitization participant be required to make and
maintain? We ask that commenters include in their response a
description of the manner in which they would demonstrate compliance
that disclosure was made to ABS investors.
    106. Are there additional steps that securitization participants
that seek to manage conflicts of interest through the use of disclosure
should be required to take with regard to disclosure, such as notifying
a regulator (e.g., a designated examining authority or other relevant
regulatory agency) of any failures to disclose, or ABS investor
complaints?
    107. Are there specific types of transactions or activities that
should or could be managed through consent? Should the use of consent
only apply to specific conflicts and not others? Which? Are there
circumstances in which obtaining consent might be impracticable or
ineffective? Should consent be limited to certain types of customers?
Would consent prior to the first sale in the offering (or a reasonable
time prior to first sale) provide adequate investor protection? Should
consents, if permitted, require customers to acknowledge receipt, or
acknowledge understanding of the matters to which they are consenting?
Should a securitization participant be required to obtain new consents
for each new transaction, or should securitization participants be
permitted to rely on consents indicating that the securitization
participant may also enter into transactions in the future that may
result from potential conflicts of interest? Would consents indicating
potential future transactions be useful or effective?
    108. Please discuss the benefits and costs if a disclosure-based
exemption were or were not adopted. In addition, please discuss any
positive or negative impact on investors of providing or not providing
a disclosure-based exemption. For example, would a disclosure-based
exemption avoid potential prohibitions or restrictions (or potential
chilling effects) on transactions that might otherwise arise under the
proposed rule and that might have the unintended consequence of
limiting investment opportunities that--if all the risks were fully
disclosed--investors would want to have? Would a disclosure-based
exemption adversely impact investor protection? If so, how? Similarly,
would a disclosure-based exemption alleviate or exacerbate any
unintended consequences of the proposed rule related to investors,
investor protection, liquidity, capital formation, the maintenance of
fair, orderly and efficient markets, and the availability of credit to
borrowers (through the assets underlying an ABS)?

C. Exemptive Authority

    While Section 27B of the Securities Act prohibits securitization
participants from engaging in transactions that involve or result in
material conflicts of interest, Section 28 of the Securities Act
provides the Commission with authority to adopt conditional or
unconditional exemptive rules or regulations.\134\ We seek comment on
whether and to what extent we should consider exemptive rules or
regulations for certain transactions or activities otherwise covered by
Section 27B, including conditional exemptions based on information
barriers or disclosure.
---------------------------------------------------------------------------

    \134\ Section 28 of the Securities Act provides that ``the
Commission, by rule or regulation, may conditionally or
unconditionally exempt any person, security, or transaction, or any
class or classes of persons, securities, or transactions, from any
provision or provisions of this title or of any rule or regulation
issued under this title, to the extent that such exemption is
necessary or appropriate in the public interest, and is consistent
with the protection of investors.'' 15 U.S.C. 77z-3.
---------------------------------------------------------------------------

    109. We ask for comment about any benefits or disadvantages of
using the general exemptive authority in Section 28 of the Securities
Act to address circumstances where commenters believe the application
of the

prohibition under Section 27B would not be consistent with prohibiting
material conflicts of interest. Are there any special considerations
relating to offshore sales of ABS that we should take into account in
the proposed rule?
    110. Are there other considerations related to cross-border sales
of ABS that should be contemplated in connection with the proposed rule
(e.g., securitizations by offshore affiliates of U.S. entities,
offshore securitizations sold to U.S. investors both in and outside of
the U.S.)? Please provide comments.
    111. Please discuss the ways in which the proposal, if adopted,
would affect the ABS market, ABS investors, underwriters, placement
agents, initial purchasers, or sponsors and the affiliates or
subsidiaries of such entities.

V. General Request for Comment

    The Commission seeks comment generally on all aspects of proposed
Rule 127B, including on our approach to the proposed rule and
implementation of Securities Act Section 27B as enacted by Section 621
of the Dodd-Frank Act. Are there other approaches that we should
consider? We seek commenter input regarding whether and how the
proposal might positively or negatively impact investor protection, the
maintenance of fair, orderly, and efficient markets (including, e.g.,
investment opportunities or liquidity), and capital formation.
Commenters are requested to provide empirical data or economic studies
to support their views and arguments related to the proposed rule. In
addition to the questions above, commenters are welcome to offer their
views on any other matter raised by the proposed rule. We note that
comments are of greatest assistance to our rulemaking initiative if
accompanied by supporting data and analysis of the issues addressed in
those comments and if accompanied by alternative suggestions to our
proposal where appropriate.

VI. Paperwork Reduction Act

    Certain provisions of the proposed rule would impose new
``collection of information'' requirements within the meaning of the
Paperwork Reduction Act of 1995 (``PRA'').\135\ The Commission is
submitting the proposed collections of information to the Office of
Management and Budget (``OMB'') for review in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. An agency may not conduct or sponsor, and a
person is not required to respond to, a collection of information
unless it displays a currently valid OMB control number. OMB has not
yet assigned a control number to the proposed collections of
information.
---------------------------------------------------------------------------

    \135\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------

A. Summary of Collections of Information

    Proposed Rule 127B might cause securitization participants to rely
on appropriate contractual covenants or representations--either between
other securitization participants or with relevant third parties--to
determine compliance with the rule. For example, if a third party was
directly or indirectly involved in structuring the ABS or selecting
assets underlying the ABS, a securitization participant might rely on
contractual assurances (from the third party or from another
securitization participant who had obtained such assurances from the
third party) that the third party would not engage in certain short
transactions. We expect that, to facilitate compliance with the
proposed rule, securitization participants might enter into new
contractual covenants.

B. Proposed Uses of Information

    Although proposed Rule 127B does not require that a securitization
participant enter into contractual covenants when it allows a third
party, directly or indirectly, to structure the ABS or select assets
underlying the ABS, the burden of compliance would fall on the
securitization participant. Accordingly, entering into such contractual
covenants might assist securitization participants in managing
compliance with the proposed rule. To the extent that a securitization
participant were a regulated entity, we anticipate that this collection
of information would be used by the Commission staff in its examination
and oversight program. Further, to the extent that a securitization
participant were a member of an SRO, we anticipate that this collection
of information would be used by the SRO staff in its examination and
oversight program.

C. Respondents

    According to issuance data from Asset-Backed Alert, supplemented
with data from Securities Data Corporation (``SDC''), from 2005 through
2010, there were approximately 751 registered asset-backed transactions
yearly. Therefore, the Commission preliminarily estimates that there
are approximately 751 securitization participant respondents that might
enter into contractual covenants concerning the involvement of a third
party in the transaction.\136\
---------------------------------------------------------------------------

    \136\ We note that the actual number of respondents could be
less than 751 as some respondents may be involved in more than one
asset-backed transaction.
---------------------------------------------------------------------------

    The Commission seeks comment as to the accuracy of the above
estimates and all other estimates in this section. The Commission also
seeks data regarding the yearly estimated number of unregistered asset-
backed transactions.

D. Total Annual Reporting and Recordkeeping Burdens

    Proposed Rule 127B might cause securitization participants to rely
on appropriate contractual covenants or representations to determine
compliance with the rule. While the Commission does not have details
concerning the nature of the contractual relationships that exist among
and between securitization participants and third parties involved in
an asset-backed transaction, we expect that these parties typically
enter into contractual relationships to protect their interests. For
example, we believe that securitization participants likely enter into
confidentiality agreements with other parties concerning the
structuring of the transaction. We also understand that most asset-
backed transactions are conducted as private placements and that in
connection with each of these private placements there is a purchase
and sale agreement for the equity piece of the transaction. To the
extent that third parties and other securitization participants are
parties to these confidentiality agreements and purchase and sale
agreements, we believe the proposed rule would impose minimal
additional burdens on the securitization participants as it would
require only an additional covenant to existing contracts.
    Because the Commission expects that most securitization
participants already enter into some form of a contractual relationship
with other securitization participants and third parties involved in
the transaction, from discussions with industry experts we estimate
that, on average, it would take approximately 2 to 10 internal and 2 to
10 external hours to draft and negotiate a contractual covenant
assuring compliance with proposed Rule 127B into an existing contract.
For PRA purposes, we conservatively use the upper end of this range and
estimate 10 internal hours from a compliance attorney, and also 10
external hours for outside legal services that would cost $4,000 per
contract.\137\ Further, we

preliminarily estimate that only about half of all securitization
participants already have some type of existing contractual
arrangements. Accordingly, we estimate that the total annual burden of
those securitization participants who already have contractual
arrangements would be approximately 3,760 internal burden hours (10
hours x 376 contracts) and approximately $1.5 million ($4,000 per
contract x 376 contracts) in external costs.
---------------------------------------------------------------------------

    \137\ This is based on an estimated $400 per hour cost for
outside legal services. This is the same estimate used by the
Commission for these services in the proposed consolidated audit
trail rule: Exchange Act Release No. 62174 (May 26, 2010); 75 FR
32556 (June 8, 2010).
---------------------------------------------------------------------------

    To the extent there are not existing contracts in place between the
securitization participants and third parties, we believe the proposed
rule would impose more significant burdens and estimate that it would
take approximately 20 internal hours and 20 external hours at a cost of
$8,000 (using the estimated $400 per hour cost for outside legal
services noted above) per contract to draft and negotiate the
contractual covenant. In this instance, we estimate that the total
annual burden would be approximately 7,500 internal burden hours (20
hours x 375 contracts) and approximately $3.0 million ($8,000 per
contract x 375 contracts) in external costs.
    In summary, we estimate that the collection of information would
require an annual burden of 11,260 internal hours and $4.5 million in
external costs.\138\
---------------------------------------------------------------------------

    \138\ These costs are all monetized in the cost-benefit analysis
section of this release. The estimated dollar costs for the internal
hours are $3.6 million ($320 per hour x 11,260 hours), where the
$320 per hour figure for a compliance attorney is from SIFMA's
Management and Professional Earnings in the Securities Industry
2010, modified by Commission staff to account for an 1800-hour work-
year and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead. The total annual monetized PRA cost
for the cost-benefit analysis is therefore $8.1 million ($3.6
million in monetized internal costs + $4.5 million in external
costs).
---------------------------------------------------------------------------

E. Collection of Information Is Mandatory

    The collection of information is not mandatory, however, we
recognize that securitization participants may be likely to engage in
the collection of information to manage their compliance with the
proposed rule.

F. Confidentiality

    The collection of information is not required to be filed with the
Commission or otherwise made publicly available. However, as discussed
above, if a securitization participant were a regulated entity, we
anticipate that this collection of information would be used by the
Commission staff in its examination and oversight program. Further, as
discussed above, if a securitization participant were an SRO member, we
anticipate that this collection of information would be used by the SRO
staff in its examination and oversight program.

G. Request for Comment

    We invite comment on these estimates. Pursuant to 44 U.S.C.
3506(c)(2)(B), we request comment in order to:
     Evaluate whether the proposed collection of information is
necessary for the performance of our functions, including whether the
information will have practical utility;
     Evaluate the accuracy of our estimates of the burdens of
the proposed collections of information;
     Determine whether there are ways to enhance the quality,
utility and clarity of the information to be collected; and
     Evaluate whether there are ways to minimize the burden of
the collection of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
    Persons wishing to submit comments on the collection of information
requirements of the proposed rules should direct them to (1) The Office
of Management and Budget, Attention: Desk Officer for the Securities
and Exchange Commission, Office of Information and Regulatory Affairs,
Washington, DC 20503; and (2) Elizabeth M. Murphy, Secretary,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-1090, with reference to File No. S7-XX-XX. Requests for materials
submitted to OMB by the Commission with regard to this collection of
information should be in writing, with reference to File No. S7-XX-XX,
and be submitted to the Securities and Exchange Commission, Office of
Investor Education and Advocacy, 100 F Street, NE., Washington, DC
20549-0213. OMB is required to make a decision concerning the
collections of information between 30 and 60 days after publication, so
a comment to OMB is best assured of having its full effect if OMB
receives it within 30 days of publication.

VII. Economic Analysis

A. Introduction

    We are proposing Securities Act Rule 127B to implement the
requirements of new Section 27B of the Securities Act,\139\ as mandated
under the Dodd-Frank Act. The proposed rule would prohibit
securitization participants from engaging in transactions that would
involve or result in a material conflict of interest with respect to an
investor in such ABS. The proposed rule includes exceptions, as
established by Congress, from this prohibition for certain risk-
mitigating hedging activities, bona fide market-making, and liquidity
commitments.
---------------------------------------------------------------------------

    \139\ 15 U.S.C. 77z-2a.
---------------------------------------------------------------------------

    We are sensitive to the benefits and costs of our rules. Some of
those costs and benefits stem from statutory mandates, while others are
affected by the discretion we exercise in implementing those mandates.
We have endeavored to focus our economic analysis of the proposed rule
on the policy choices under the Commission's discretion, recognizing
that it may often be difficult to separate the discretionary aspects of
the rule from those elements required by statute. We request comment on
all aspects of the costs and benefits of the proposal, particularly any
effect our proposed rules may have on efficiency, competition, and
capital formation. We particularly appreciate comments that distinguish
between costs and benefits that are attributed to the statute itself
and costs and benefits that are a result of policy choices made by the
Commission in implementing the statutory requirements.

B. Benefits

    Consistent with the statute, the proposed rule is intended to
benefit investors by better aligning incentives of securitization
participants with those of investors in the ABS. For example, the
proposed rule would apply to an underwriter or sponsor effecting a
short transaction in an ABS within the prohibited time period. Although
the possibility of short selling the securities during any period of
time may create conflicting incentives for securitization participants,
the proposed rule is intended to prevent such conflicting incentives
during the prohibited time period as required under the statute.
    We believe that our decision not to define ``material conflict of
interest'' in the proposed rule would provide the benefit of better
investor protection. An inadvertently narrow definition of that term
could have the unintended consequence of excluding from the proposed
prohibition certain activities undertaken by securitization
participants that involve material conflicts of interest. Furthermore,
by not limiting the definition to a specific list of material conflicts
of interest, the

proposed rule may help prevent behavior involving material conflicts of
interest that have not come to the attention of investors or the
Commission, or that may develop in the future. The broad investor
protection provided by the proposed rule could alleviate investor
concerns that the securities they purchase might be tainted by
conflicts of interest. This would reduce adverse selection costs in the
ABS market and encourage investment in ABS to the extent that investors
consider material conflicts of interest important in their investment
decisions.
    As discussed above, one way in which securitization participants
might manage their compliance with the proposed rule given the
practical difficulties for a securitization participant in determining
third-party involvement in the securitization, is through contractual
assurances.\140\ Similarly, if a securitization participant were a
regulated entity, such assurance would be useful information for
Commission staff (and, in appropriate circumstances, SRO staff) in its
compliance and oversight program. We believe that the use of such
assurances would help to prevent transactions that result in a
misalignment of interests between securitization participants and ABS
investors. Similar or different benefits may or may not ensue if
different tools were used to manage compliance. We seek comment
regarding the benefits to investors, securitization participants, and
the marketplace stemming from the Commission's proposed rule.
---------------------------------------------------------------------------

    \140\ See supra Section IIIA(v)(b).
---------------------------------------------------------------------------

C. Costs

    We recognize that the proposed rule could impact the scope of some
current activities undertaken by underwriters, sponsors, and other
securitization participants, such as curtailment or cessation of
otherwise common activities which, in turn, could lead to potential
costs for such participants and the broader securitization market. As
will be described below, material conflicts of interest might only
arise between an investor and a particular securitization participant,
which might lead the investor to seek a relationship with another
securitization participant. However, as illustrated in some of the
examples in Section IIIC above, other material conflicts of interest
arise as a result of the nature or structure of the transaction as a
whole (without regard to the identity of the securitization
participants involved), such that these types of transactions might be
effectively prohibited. In such cases, there might be costs to the
marketplace as a whole as investors and securitization participants
seek alternative and potentially less efficient transaction structures
to effect a similar investment strategy in a way that would not result
in a material conflict of interest, or if investors and securitization
participants were unable to effect their investment strategies at all.
For example, a type of synthetic collateralized debt obligations
(CDOs)--balance sheet CDOs--would generally be prohibited under the
proposed rule (see Example 3B). Though securitization participants
might be able to effect similar types of transactions in the form of
non-synthetic ABS (which generally would not be prohibited by the above
interpretation of material conflict of interest), there may be reasons
why a synthetic form of a balance sheet CDO is a more efficient form of
the transaction from the standpoint of the issuer or investors. In
addition, this aspect of the proposed rule would limit the hedging
options available to a lender who originated assets without the intent
to securitize them.\141\ Such a lender would be able to sell or
securitize assets on its balance sheet, but not synthetically, even if
doing so is economically optimal. Thus, a prohibition on structuring
balance sheet CDOs might have a negative effect on efficiency and
capital formation.
---------------------------------------------------------------------------

    \141\ See supra note 100.
---------------------------------------------------------------------------

    We recognize that by not defining the phrase ``material conflict of
interest'' for purposes of this particular proposal, the proposed rule
could create some regulatory uncertainty, which could lead to costs in
the asset-backed securitization process. Securitization participants
could avoid undertaking certain activities out of concern that the
proposed rule would apply to such activities, despite the
securitization participant's view that such activities did not create
or result in a material conflict of interest. In particular, larger
entities with multiple business lines could potentially have, as a
dynamic of their structure and relationships with customers (and
others), conflicts that--without sufficiently specific guidance--would
be perceived as material and unavoidable. Thus, we acknowledge that
many of the potential conflicts and costs discussed could
disproportionately impact larger, multi-faceted, and diversified firms
that offer a variety of services. Below, we identify a number of these
potential costs and seek comment on whether there are ways to mitigate
them.
    Generally, we recognize that securitization participants would
incur costs in updating or creating new procedures to monitor for
potential material conflicts of interest that would be prohibited under
the proposed rule. The magnitude of these potential costs could be more
pronounced because we have not proposed definitions of terms, including
a definition as to what is material or a conflict of interest. The
proposed rule may result in creating an environment in which even the
potential for relationships or transaction structures that would result
in a material conflict of interest would be reduced. For example, there
often may be several independent, unaffiliated parties under the
definition of a securitization participant (e.g., underwriters and
placement agents) for a given asset-backed securitization. If each such
participant in an asset-backed securitization were effectively
conflicted out of the process, the asset-backed securitization market
could in some situations cease to function efficiently. We recognize
that such a restriction on potential participants to an asset-backed
securitization could have costs, as well as potential unintended
consequences on the ability of market participants to structure asset-
backed products. We seek comment as to how the proposed rule might be
applied or modified to address such situations.
    Because we are not proposing to define the term ``material conflict
of interest'', the effect could amplify the potential costs from the
statutory prohibition on a securitization participant's existing and/or
potential future client relations. For example, if an existing or
potential client approached a firm to request that it undertake a
certain conflicted transaction, the firm might determine not to do so
because of the concern that the transaction could be viewed as a
material conflict of interest between the securitization participant
and investors in the ABS if one of the exceptions to the proposed rule
were not available. Under these circumstances, the client might need to
approach another financial firm to conduct the desired transaction. In
some cases, the financial firm might not be able to determine with a
sufficient level of certainty that a conflict of interest did not
exist. As described above, in certain circumstances, where the
transaction structure itself (without regard to the identity of the
parties) involved a conflict of interest, the investor might have to
forego the ABS investment entirely and thus might be unable to

participate in a particular investment opportunity that it desires. A
broad interpretation by market participants of the term ``material
conflict of interest'' in the rule could therefore cause the
securitization participant to lose profits or fees that would have
resulted from the client's business with respect to the conflicting
transaction and, potentially, future profits and fees if the client
determines to take some of its future business to other firms, or might
cause investors to lose investment opportunities they might otherwise
have. We recognize that firms expend considerable time and resources to
cultivate relationships with their clients and, thus, if the proposed
rule were to diminish (beyond the statutory mandate in Securities Act
Section 27B) existing relationships or impede the formulation of new
relationships, the impacts of the proposed rule could be significant to
firms and the broader marketplace.
    In addition, clients also could bear undesirable costs by losing
the ability to utilize firms with particular expertise or
specialization in certain areas due to real or perceived material
conflicts of interest. Clients might also incur costs in searching for
a different firm to consummate a transaction, where they have a
preexisting relationship that they too have invested resources into
developing. In addition, to retain their ability to utilize specific
firms for non-ABS related transactions, some potential clients might
choose to forego the ABS investment. We recognize that if the proposed
rule were to cause an investor to forego an ABS investment entirely,
there could be costs incurred by the investor in terms of seeking out
alternative investments as well as the loss of return from the ABS
investment. We seek commenter input regarding other costs that might be
incurred by investors from foregoing an ABS transaction entirely.
    All securitization participants are subject to the proposed rule's
prohibition on material conflicts of interest. Thus, although the
inability to conduct a transaction that would result in a material
conflict of interest between the securitization participant and
investors in the ABS might have a negative impact on certain client
relations and could require the client to go elsewhere to conduct the
requested transaction, presumably all securitization participants and
their clients would potentially encounter similar issues. As a result,
while a securitization participant could lose the business of one
client due to the proposed rule, in some cases it also could gain the
business of another securitization participant's client, where that
securitization participant could not conduct the transaction due to a
material conflict of interest. Collectively, based upon the analysis
above related to firm-client relationships, we acknowledge that the
potential loss of customers could be more costly to firms than the
potential gain of other clients.\142\ In turn, clients could incur
costs in having to seek out new firms rather than utilizing firms with
which they have preexisting, preferred business relationships. In sum,
we recognize that both firms and clients could bear costs that may, in
turn, impact the broader market, and we seek comment regarding these
costs of the Commission's proposed rule.
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    \142\ See, e.g., Myron B. Slovin, Marie E. Sushka & John A.
Polonchek, The Value of Bank Durability: Borrowers as Bank
Stakeholders, 48 J. Fin. 247 (1993); Mitchell A. Petersen & Raghuram
G. Rajan, The Benefits of Firm-Creditor Relationships: Evidence from
Small Business Data, 49 J. Fin. 3 (1994); Sreedhar Bharath, Sandeep
Dahiya, Anthony Saunders & Anand Srinivasan, So What Do I Get? The
Bank's View of Lending Relationships, 85 J. Fin. Econ. 368 (2007).
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    Further, we recognize that there could be some instances in which
the inability of a securitization participant to conduct a transaction
that would result in a material conflict of interest could adversely
affect the price of the ABS. Consistent with Section 27B, the proposed
rule provides exceptions for risk-mitigating hedging activity,
liquidity commitments, and bona fide market-making. A proposed
transaction that results in a prohibited material conflict of interest,
however, might not fit into one of these exceptions and, thus, would be
subject to the general prohibition in the proposed rule. Although the
transaction, if executed, could ultimately have a positive impact on
the ABS, it would not be permitted to be undertaken under the proposed
rule. This could impose costs both on the securitization participant
and on investors in the ABS resulting from a decline (or foregone
increase) in the value of the ABS. We seek comment on these pricing-
related costs of the proposed rule.
    The proposed rule could impose certain costs upon departments
within a firm not directly involved with the securitization process by
impacting their ability to conduct transactions that could result in a
material conflict of interest with investors in an ABS for which the
firm is a securitization participant. The scope of the proposed rule
could require monitoring for potential material conflicts of interest
within all or many departments of the firm. If any department's
proposed transaction were determined to raise a potential material
conflict of interest, that department could have to abandon the
proposed transaction or wait until the proposed rule's prohibition
period ended. We seek comment concerning any costs that could be
incurred with respect to the various activities among different
departments within one firm. We also seek comment concerning whether
the operation of information barriers within firms might suggest the
need for the Commission to provide interpretations to the proposed rule
to exclude activity that should not be captured.
    As required by Securities Act Section 27B, the scope of
securitization participants in the proposed rule includes affiliates
and subsidiaries of underwriters, placement agents, initial purchasers,
and sponsors. In some instances, the activities of an affiliate or
subsidiary may not be known to the underwriter, placement agent,
initial purchaser, or sponsor, and could, inadvertently, involve or
result in a material conflict of interest with the investors in the
ABS. Monitoring the activities of the affiliate or subsidiary for
conflicts could be difficult, especially when there are existing
information barriers between the entities, and could impose costs. For
this reason, we seek comment concerning any costs that could be
incurred by affiliates and subsidiaries.\143\
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    \143\ See supra Section IV (noting the recognition of
information barriers in Section 15(g) of the Exchange Act, Exchange
Act Rule 14e-5, and Regulation M under the Exchange Act).
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    We recognize the statutory prohibition and thus the proposed rule
may have significant costs with respect to how firms and clients
establish, maintain, and benefit from relationships. For instance,
because larger financial entities tend to form in an effort to achieve
synergies and economies of scope in combining and offering multiple
services, restrictions on such activities could lead to changes to
their business activities that could reduce firm earnings. In part
because of the breadth of the statutory provision and, thus, the
proposed rule, these potential changes could have some disruptive
effect on the firms, their clients, and the broader marketplace,
reducing current efficiencies that may exist. Restricting the ability
of securitization participants to maintain relationships that service
multiple objectives could ultimately impact negatively both financial
firms and their clients' ability to conduct economically efficient
activities. In addition, firms with particular specialization in given
areas that were precluded from providing such expertise due to

perceived material conflicts could disadvantage clients.
    While not required by the proposed rule, we recognize that one way
that securitization participants might seek to facilitate their
compliance with the proposed rule is through contractual
assurances.\144\ The costs associated with such assurances could be
minimal if contracts are currently utilized and could be easily
modified to reflect the assurances (e.g., standardized industry
agreements, purchase and sale agreements, and confidentiality
agreements). However, in circumstances where there are no agreements in
place, there could be more significant costs for parties to negotiate a
new agreement in its entirety. Other costs may or may not ensue if a
tool other than a contractual assurance were used to manage compliance
with the proposed rule. We seek commenter input regarding whether and
how behaviors could change as a result of the use of contractual
assurances that might increase or decrease costs.
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    \144\ See supra Section IIIA(v)(b).
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    We also note that there are potential costs associated with a
clarification we propose to one of the exceptions under the proposed
rule.\145\ The proposed rule provides exceptions for risk-mitigating
hedging activities, liquidity commitments, and bona fide market-making,
which are consistent with Securities Act Section 27B. We seek comment
on the scope of the risk-mitigating hedging exception in the proposed
rule in a manner that we believe is consistent with the intent of the
legislation, but which could help securitization participants and other
industry participants better understand whether an activity qualifies
under the exception. In the proposed rule, we seek comment on the
application of the proposed exception for risk-mitigating hedging
activity to ``mitigating'' the consequences of a risk. We believe that
risk mitigation would permit a securitization participant to limit the
consequences of a risk, which could facilitate investor protection. We
also seek comment on how ``exposures'' arise and whether the risk-
mitigating hedging exception should apply to exposures as well as
positions and holdings. Although we believe that such clarification
would allow firms to better reduce and mitigate specific risks that
arise out of underwriting, placement, initial purchase, or sponsorship
of an ABS, we recognize that securitization participants would bear an
additional cost in dedicating resources to determine whether their
activities fall within this exception as interpreted beyond any cost
they already would bear due to the existence of the statutory
exception. Similar to the costs that could be incurred for compliance
with the proposed rule, securitization participants could also face
costs in their assessment of whether their activities qualify for the
risk-mitigating hedging exception. We seek comment with respect to all
aspects of the proposed risk-mitigating hedging exception.
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    \145\ See supra Section IIIB(i).
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D. Related Considerations

    The coverage of Securities Act Section 27B and, thus the proposed
rule which tracks the statute, could negatively impact economic
efficiency both from the point of view of the securitizations
participants, and sometimes also from the point of view of investors
who seek to invest in the pools that back the ABS if certain ABS
transactions did not get consummated because of the scope of the
proposed rule.
    The scope of activities under the proposed rule that could
constitute potential conflicts of interest could potentially impact
competition among asset-backed securitization market participants. For
instance, larger entities with multiple business lines could have, as a
result of their structure, unavoidable material conflicts of interest.
An investor that utilizes such entities for multiple services could
have to switch to competitors, or depending on the structure of ABS,
forego the ABS transaction. Under these circumstances, the investor
could incur additional search costs and find its business processes
less efficient due to the loss of relationships.\146\ The
securitization participant could also potentially lose any profits or
fees that would have resulted from the investor's business with respect
to the conflicting transaction and, potentially, future profits and
fees if the investor takes future business to another firm. In
addition, investors and financial firms could both lose the financial
benefits gained from established, cultivated relationships with
securitization participants. This could be potentially costly to both
investors that have established relationships with firms and,
ultimately, to investors in the broader marketplace as a contraction in
the securitization process could ensue. As firm-investor relationships
are costly to develop, but valuable to maintain, firms and such
investors might find application of the proposed rule to be disruptive
in some circumstances and, thus, the broader marketplace could
experience some inefficiency, as well as unintended impacts on capital
formation.
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    \146\ See, e.g., Myron B. Slovin, Marie E. Sushka & John A.
Polonchek, The Value of Bank Durability: Borrowers as Bank
Stakeholders, 48 J. Fin. 247 (1993).
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    In addition, given that the ABS offering process can involve
multiple lead underwriters and an underwriting syndicate with several
members, the proposed rule could have a multiplicative effect by
conflicting out several unaffiliated financial institutions. If an