[Federal Register Volume 76, Number 188 (Wednesday, September 28, 2011)]
[Proposed Rules]
[Pages 60320-60350]
[FR Doc No: 2011-24404]

Vol. 76

Wednesday,

No. 188

September 28, 2011

Part III

Securities and Exchange Commission

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17 CFR Part 230

Prohibition Against Conflicts of Interest in Certain Securitizations;
Proposed Rule

Federal Register / Vol. 76 , No. 188 / Wednesday, September 28, 2011
/ Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 230

[Release No. 34-65355; File No. S7-38-11]
RIN 3235-AL04

Prohibition Against Conflicts of Interest in Certain
Securitizations

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing for comment a new rule under the Securities Act of 1933
(``Securities Act'') to implement the prohibition under Section 621 of
the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(``Dodd-Frank Act'') on material conflicts of interest in connection
with certain securitizations. Proposed Rule 127B under the Securities
Act would prohibit certain persons who create and distribute an asset-
backed security, including a synthetic asset-backed security, from
engaging in transactions, within one year after the date of the first
closing of the sale of the asset-backed security, that would involve or
result in a material conflict of interest with respect to any investor
in the asset-backed security. The proposed rule also would provide
exceptions from this prohibition for certain risk-mitigating hedging
activities, liquidity commitments, and bona fide market-making.

DATES: Comments should be received on or before December 19, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-38-11 on the subject line; or
     Use the Federal eRulemaking Portal (http://http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549.

All submissions should refer to File Number S7-38-11. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's Web
site (http://www.sec.gov/rules/proposed.shtml). Comments are also
available for Web site viewing and printing in the Commission's Public
Reference Room, 100 F Street, NE., Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. All comments
received will be posted without change; we do not edit personal
identifying information from submissions. You should submit only
information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Elizabeth Sandoe, Senior Special
Counsel, David Bloom, Branch Chief, Anthony Kelly, Special Counsel,
Barry O'Connell, Attorney Advisor, Office of Trading Practices and
Processing and Jack I. Habert, Attorney Fellow, Division of Trading and
Markets, at<PHONE_NUMBER>, and David Beaning, Special Counsel and
Katherine Hsu, Chief, Office of Structured Finance, Division of
Corporation Finance, at<PHONE_NUMBER>, at the Securities and Exchange
Commission, 100 F Street, NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment
on proposed Rule 127B under the Securities Act.

I. Introduction

    Section 621 of the Dodd-Frank Act adds new Section 27B to the
Securities Act.\1\ This new Section of the Securities Act prohibits an
underwriter, placement agent, initial purchaser, or sponsor, or any
affiliate or subsidiary of any such entity (collectively
``securitization participants''), of an asset-backed security
(``ABS''), including a synthetic ABS, from engaging in a transaction
that would involve or result in certain material conflicts of
interest.\2\ The prohibition under Securities Act Section 27B applies
to both registered and unregistered offerings of ABS.\3\ This
prohibition applies during the period ending on the date that is one
year after the date of the first closing of the sale of the ABS.
Section 27B provides exceptions from the prohibition described above
for certain risk-mitigating hedging activities, liquidity commitments
and bona fide market-making.\4\
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    \1\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, Sec.  621, 124 Stat. 1376, 1632 (2010).
    \2\ Section 27B(a) of the Securities Act states that an
``underwriter, placement agent, initial purchaser, or sponsor, or
any affiliate or subsidiary of any such entity, of an asset-backed
security (as such term is defined in section 3 of the Securities
Exchange Act of 1934 (15 U.S.C. 78c), which for the purposes of this
section shall include a synthetic asset-backed security), shall not,
at any time for a period ending on the date that is one year after
the date of the first closing of the sale of the asset-backed
security, engage in any transaction that would involve or result in
any material conflict of interest with respect to any investor in a
transaction arising out of such activity.'' 15 U.S.C. 77z-2a(a).
    \3\ See infra Section IIIA(ii).
    \4\ Section 27B(c) of the Securities Act excepts the following
activity from the prohibition under Section 27B(a) of the Securities
Act: ``(1) Risk-mitigating hedging activities in connection with
positions or holdings arising out of the underwriting, placement,
initial purchase, or sponsorship of an asset-backed security,
provided that such activities are designed to reduce the specific
risks to the underwriter, placement agent, initial purchaser, or
sponsor associated with positions or holdings arising out of such
underwriting, placement, initial purchase, or sponsorship; or (2)
purchases or sales of asset-backed securities made pursuant to and
consistent with--(A) Commitments of the underwriter, placement
agent, initial purchaser, or sponsor, or any affiliate or subsidiary
of any such entity, to provide liquidity for the asset-backed
security, or (B) bona fide market-making in the asset-backed
security.''
    15 U.S.C. 77z-2a(c).
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    Section 27B of the Securities Act further requires the Commission
to issue rules for the purpose of implementing the new Section's
prohibition.\5\ To meet this statutory requirement, we are proposing
new Rule 127B under the Securities Act to make it unlawful for a
securitization participant to engage in any transaction that would
involve or result in any material conflict of interest between the
securitization participant and any investor in an ABS that the
securitization participant created or sold at any time for a period
ending on the date that is one year after the date of the first closing
of the sale of the ABS.\6\ Consistent with Securities Act Section
27B(c), the proposed rule excepts from the prohibition certain risk-
mitigating hedging activities, liquidity commitments, and bona fide
market-making. We discuss proposed Rule 127B in more detail below and
offer a number of examples of how the proposed rule would apply to
particular fact patterns. We also seek commenter input regarding
whether information barriers or disclosure would be relevant and

appropriate in managing and mitigating conflicts of interest or
permitting certain transactions that might otherwise be prohibited by
the proposed rule.
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    \5\ Section 27B(b) of the Securities Act. 15 U.S.C. 77z-2a(b).
    \6\ We note that Section 27B(a) is not effective until the
adoption of final rules issued by the Commission. Section 621(b) of
the Dodd-Frank Act states that ``Section 27B of the Securities Act
of 1933 * * * shall take effect on the effective date of final rules
issued by the Commission under section (b) of such section 27B * *
*.'' The proposed interpretations and related examples discussed in
this proposing release therefore will have no force or effect except
to the extent they are incorporated into any final Commission
release adopting rules under Section 27B.
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    In crafting our proposed rule, we have primarily incorporated the
text of Section 27B of the Securities Act. This release also sets forth
below certain proposed clarifying interpretations of that text and a
number of questions for public comment, all of which take into account
comments we have received to date regarding the implementation of
Section 621 of the Dodd-Frank Act.\7\
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    \7\ As of August 24, 2011, the Commission had received eight
comment letters addressing new Section 27B of the Securities Act.
All the comment letters regarding new Section 27B of the Securities
Act are available on the Commission's Web site at http://www.sec.gov/comments/df-title-vi/conflicts-of-interest/conflicts-of-interest.shtml.
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II. Background

A. Securitization

    Securitization is a mechanism for pooling certain financial assets
that have payment streams and credit exposures associated with them and
effectively converting the pool into a new financial instrument--an
ABS--that is ``backed'' by the pool of assets and offered and sold to
investors. More specifically, a financial institution or other entity,
commonly known as a sponsor, first originates or acquires a pool of
financial assets, such as mortgage loans, credit card receivables, auto
loans or student loans. The sponsor then sells the financial assets,
directly or through an affiliate, to a special purpose entity
(``SPE''). The SPE issues the securities supported or ``backed'' by the
financial assets. These securities are sold to investors in either a
public offering subject to an effective registration statement filed
with the Commission or an offering exempt from registration. As
described by the Commission:
    Securitization generally is a financing technique in which
financial assets, in many cases illiquid, are pooled and converted
into instruments that are offered and sold in the capital markets as
securities. This financing technique makes it easier for lenders to
exchange payment streams coming from the loans [or other pooled
assets] for cash so that they can make additional loans or credit
available to a wide range of borrowers and companies seeking
financing. Some of the types of assets that are financed today
through securitization include residential and commercial mortgages,
agricultural equipment leases, automobile loans and leases, student
loans and credit card receivables.\8\
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    \8\ Asset-Backed Securities, Release No. 33-9117 (Apr. 7, 2010),
75 FR 23328, 23329 (May 3, 2010) (``Release 33-9117'').

    As a result of the securitization, the credit and other risks
associated with the pooled assets is transferred away from the
sponsor's balance sheet to investors in the ABS.\9\
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    \9\ One type of ABS is a collateralized debt obligation
(``CDO''). In a CDO structure, a sponsor may sell to an SPE an asset
pool that holds fixed income products, such as loans, mortgage-
backed securities or corporate bonds. The SPE then issues debt
securities collateralized or ``backed'' by this asset pool.
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    ABS investors are generally interested in the experience of the
collateral manager and the ``quality of the underlying assets, the
standards for their servicing, the timing and receipt of cash flows
from those assets and the structure for distribution of those cash
flows.'' \10\ With respect to the structure for cash flow
distributions, some ABS transactions are structured to provide cash
flow distribution through ``pass-through certificates representing a
pro rata share of the cash flows from the underlying asset pool''.\11\
Other ABS transactions offer a range of risk exposures and yields to
investors. This is accomplished through the SPE issuing different
classes of securities, commonly referred to as tranches.\12\
Transaction agreements typically specify the structure of an ABS
transaction and detail how cash flows generated by the asset pool will
be divided among tranches. This division of cash flows is often
referred to as the ``flow of funds'' or ``waterfall.'' \13\
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    \10\ Asset-Backed Securities, Release No. 33-8518 (Dec. 22,
2004), 70 FR 1506, 1511 (Jan. 7, 2005) (``Release 33-8518'').
    \11\ Id.
    \12\ Id. (``ABS transactions often involve multiple classes of
securities, or tranches, with complex formulas for the calculation
and distribution of the cash flows. In addition to creating internal
credit enhancement or support for more senior classes, these
structures allow the cash flows from the asset pool to be packaged
into securities designed to provide returns with specific risk and
timing characteristics.'').
    \13\ Id. (``The flow of funds specifies the allocation and order
of cash flows, including interest, principal and other payments on
the various classes of securities, as well as any fees and expenses,
such as servicing fees, trustee fees or amounts to maintain credit
enhancement or other support.'').
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    The securitization process developed in the 1970s and subsequently
has experienced significant growth and evolved dramatically.\14\ With
this evolution, the investor base has broadened and the ABS themselves
have become more complex. There are, for example, now synthetic ABS in
which investors in securities issued by SPEs acquire credit exposure to
a portfolio of fixed income assets without the SPE owning these assets.
Rather, the investors gain this exposure because the SPE has entered
into derivatives transactions, such as credit default swaps (``CDS'')
that reference particular assets.\15\ The counterparty to the CDS may
be the sponsor who originated or selected the underlying portfolio. The
SPE, as seller of protection under the CDS, is in effect long the
credit exposure on those assets as if it had purchased them.
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    \14\ See, e.g., Sylvain Raynes & Ann Rutledge, The Analysis of
Structured Securities: Precise Risk Measurement and Capital
Allocation 3 (2003); see also Release No. 33-9117, 75 FR at 23330,
(``[a]t the end of 2007, there were * * * nearly $2.5 trillion of
asset-backed securities outstanding''). Securities Industry and
Financial Markets Association, Global CDO Issuance--Quarterly Data
from 2000 to Q1 2011 (updated 4/1/11), available at http://www.sifma.org/research/statistics.aspx (reporting a doubling in the
volume of synthetic CDO issuances between 2005 and 2007). In recent
years, the market for securitization has declined. See, e.g., David
Adler, A Flat Dow for 10 Years? Why it Could Happen, BARRONS (Dec.
28, 2009).
    \15\ The protection sold by the SPE under a CDS may reference a
portfolio of assets, a single asset, or an index.
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    For example, a bank that maintains fixed income assets on its
balance sheet may protect itself against default of those assets by
purchasing a CDS from the SPE that references the same or similar types
of assets. In other cases, a person may desire to purchase CDS
protection even though such person does not own the reference assets
underlying the CDS sold by the SPE. In both of the above cases, the
SPE, as seller of the CDS protection, takes on the risk of default on
the reference assets underlying the CDS (and the consequent obligation
to make a payment to the CDS counterparty as a result of such default)
in exchange for ongoing payments from the purchaser of the CDS
protection. In addition, in both scenarios any payments the SPE is
required to make under the CDS will be funded from amounts received by
the SPE from the investors in the ABS issued by the SPE. Thus, the
proceeds of the SPE's issuance of securities typically are not used to
purchase loans, receivables or other investment assets, but instead are
typically used to purchase highly creditworthy collateral \16\ to
support (i) The SPE's contingent obligation to pay the purchaser of the
CDS in the event of one or more defaults with respect to the reference
assets underlying the CDS (the synthetic reference pool of assets), and
(ii) to the extent not used for payments to the CDS purchaser, the
SPE's obligations to investors in the SPE's

issued securities.\17\ The SPE makes payments to investors based on
cash flows and proceeds from the CDS and the collateral pool.
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    \16\ The term ``collateral,'' when used in connection with a
synthetic ABS, has a different meaning than the term ``collateral''
in a non-synthetic ABS. In a non-synthetic ABS the collateral is the
pool of underlying assets (e.g., a pool of student loans). In a
synthetic ABS, the collateral is often U.S. Treasury securities or
other securities used as credit support for the SPE's potential
payment obligations under a CDS that references an underlying asset
pool.
    \17\ The assets or types of assets on which the SPE will sell
protection would typically be disclosed to investors upfront and
they would invest in the SPE's securities based on the anticipated
risk of default on those assets and income received by the SPE from
selling protection via CDS that reference those assets. The SPE
would in effect have a synthetic reference pool of assets created by
the SPE's long exposure to the assets underlying the CDS that it
sold.
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    Therefore, in both the non-synthetic ABS and the synthetic ABS, the
SPE and the investors in the SPE have an ongoing long exposure to each
instrument in a reference pool of assets--i.e., assets held directly by
the SPE, in the case of a non-synthetic transaction, or assets
referenced in a CDS under which the SPE has sold protection to a
counterparty, in the case of a synthetic transaction. The transactions
differ, however, in that the synthetic transaction inherently involves
a party--the counterparty to the CDS--that has purchased CDS protection
on the same reference pool of assets and thus has an ongoing short
exposure to those assets. This purchaser of CDS protection may be a
securitization participant (such as the bank sponsoring the synthetic
ABS). In these cases--and considering the CDS in isolation--the
securitization participant would be taking an investment position that
is directionally opposite to that taken by the investors in the
synthetic ABS, as is generally the case in any transaction through
which a buyer is able to acquire and a seller is able to dispose of a
particular financial exposure in pursuit of their respective investment
objectives. If the referenced assets default, the securitization
participant receives a payment from the SPE pursuant to the CDS and the
investors in the SPE ultimately suffer a loss on their investment.\18\
If the referenced assets do not default, the investors would have
benefited from payments from the CDS counterparty while the SPE would
not have any payment obligations to the CDS counterparty.
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    \18\ As further discussed below, the securitization
participant's short exposure may itself be hedged--by entering into
an offsetting CDS transaction, or otherwise--such that in terms of
its overall risk profile the securitization participant does not
retain exposures directionally opposite to those taken by investors
in the synthetic ABS.
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Request for Comments Regarding the Description of the Securitization
Process
    1. Are there any other key features of the securitization process
that need to be highlighted in considering the scope of Securities Act
Section 27B? If so, which features, and why?
    2. We seek commenter input regarding the reasons why market
participants enter into synthetic ABS transactions instead of non-
synthetic ABS transactions. What relative economic or other benefits do
synthetic ABS transactions offer to investors and securitization
participants? Under what circumstances are such transactions more or
less beneficial for each type of market participant? What economic,
market or other considerations affect the determination by investors
and securitization participants to enter into such transactions?
    3. We ask that commenters estimate the volume of synthetic ABS
transactions on an annual basis in terms of size and dollar value over
the last ten years and to supplement those estimates with data where
possible. We would also appreciate comparative estimates of synthetic
and non-synthetic ABS transaction volume during this same period.
    4. We ask that commenters describe the impact on the market, and in
particular on investors, if securitization participants refrained from
structuring and selling any particular types of synthetic ABS. Please
include a discussion of all advantages and disadvantages as well as any
effects on investor protection, liquidity, capital formation, the
maintenance of fair, orderly and efficient markets and the availability
of credit to borrowers.
    5. Do synthetic ABS transactions involving other synthetic ABS,
CDOs of CDOs or other transactions involving multiple layers of ABS
exposures raise additional or heightened conflict of interest concerns?
If so, why and how should these factors be reflected in our proposed
rule?
    6. What are the key features of the securitization process that
bear on the existence or significance of conflicts of interest between
participants in that process and investors in the ABS? How has the
securitization process changed in recent years, and how have those
changes exacerbated or mitigated any potential conflicts of interest?
Are the potential conflicts of interest in this process different in
kind, degree or with respect to transparency than the conflicts that
may arise in connection with creating and offering other credit
products, such as corporate debt?
    7. Are certain types of ABS more susceptible to conflicts of
interest? Are certain parties in the securitization process more likely
to have a conflict of interest with investors than others? Are there
transactions inherent in the structure of a synthetic ABS that raise
special or heightened conflict of interest concerns relative to other
ABS transactions or otherwise?
    8. Are the conflicts of interest that may arise during the
securitization process different in kind or degree than those that may
arise after the securitization process? How should the Commission
interpret issues related to pre- and post-offering conflicts of
interest for purposes of Securities Act Section 27B?
    9. We request commenters' views concerning conflicts that may arise
from the multi-tranche structure, including where securitization
participants retain part or all of a particular tranche.\19\
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    \19\ We note that other provisions of the Dodd-Frank Act seek to
align the interests of ABS investors with securitizers. See, e.g.,
Section 941 of the Dodd-Frank Act. The proposed rule is not intended
to prohibit risk retention as required by Section 941. See Credit
Risk Retention, Release No. 34-64148 (March 30, 2011), 76 FR 24090
(April 29, 2011) (Commission proposing rules jointly with the Office
of the Comptroller of the Currency, Treasury, the Board of Governors
of the Federal Reserve System, the Federal Deposit Insurance
Corporation, the Federal Housing Finance Agency and the Department
of Housing and Urban Development to implement the credit risk
retention requirements of section 15G of the Securities Exchange Act
of 1934 (15 U.S.C. 78o-11), as added by Section 941 of the Dodd-
Frank Act) (``Release 34-64148'').
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B. Initial Comments Received Regarding the Implementation of Section
27B

    Shortly after the passage of the Dodd-Frank Act, the Commission
provided the public with the opportunity to express views on the
various Dodd-Frank Act provisions that the Commission is required to
implement, including Section 27B of the Securities Act, as added by
Section 621 of the Dodd-Frank Act.\20\ As noted above, we received
eight initial comment letters regarding our implementation of Section
27B. One letter was written by the sponsors of Section 621 of the Dodd-
Frank Act, who urged the Commission and other federal financial
regulators, among other things, to ``fully and faithfully'' implement
the Dodd-Frank Act, including Section 27B of the Securities Act.\21\
This letter noted that a central purpose of Securities Act Section 27B
is to prohibit ``firms from packaging and selling asset-backed
securities to their clients and then engaging in transactions that
create conflicts of interest between them and their clients.'' \22\
Further, it noted that a Permanent Subcommittee on

Investigations hearing that addressed issues related to The Goldman
Sachs Group, Inc. ``highlighted a blatant example of this practice: The
firm assembled asset-backed securities, sold those securities to
clients, bet against them, and then profited from the failures.'' \23\
These commenters included in their letter excerpts from the
Congressional Record providing further background as to the purpose of
Section 621, including the following statement: ``[t]he intent of
section 621 is to prohibit underwriters, sponsors and others who
assemble asset-backed securities, from packaging and selling those
securities and profiting from the securities' failures.'' \24\
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    \20\ Public Comments on SEC Regulatory Initiatives under the
Dodd-Frank Act, available at http:[sol][sol]sec.gov/spotlight/
regreformcomments.shtml.
    \21\ Letter from Senators Jeffrey Merkley and Carl Levin to
Commission Chairman Mary Schapiro, et al. (Aug. 3, 2010) (``Merkley-
Levin Letter'') at p. 1, available at http:[sol][sol]www.sec.gov/
comments/df-title-vi/conflicts-of-interest/conflictsofinterest-
2.pdf.
    \22\ Id. at p. 5.
    \23\ Id.
    \24\ Id. (citing 156 Cong. Rec. S5899 (daily ed. July 15, 2010)
(statement of Sen. Carl Levin)).
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    Other commenters were industry associations and representatives of
market participants who expressed their views on the implementation of
Section 27B both in general and in the context of specific situations,
and who highlighted their concerns about an overly broad application of
Securities Act Section 27B. For example, one comment letter supported
the prohibition on material conflicts of interest but also urged that
certain activities should not be prohibited regardless of whether they
result in potential or actual conflicts of interest.\25\ Two other
commenters cautioned against a broad interpretation of the term
``material conflicts of interest'' for purposes of Section 27B of the
Securities Act.\26\ These commenters noted, for example, that the
relationship between securitization participants, on the one hand, and
investors, on the other hand, can in certain respects be viewed as
fundamentally conflicted in the simple sense that a buyer and seller of
assets always have opposing interests, as to price, asset quality and
other terms and conditions.\27\ These commenters asserted that Section
27B was not intended to eliminate this type of conflict.
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    \25\ Letter from the Securities Industry and Financial Markets
Association (Dec. 10, 2010) (``SIFMA Letter'') at pp. 4 and 12
(SIFMA ``generally support[s] the prohibition of material conflicts
of interest'' but ``enumerates certain natural and expected
conflicts which may arise in ABS transactions but do not constitute
the type of `material conflicts' intended to be regulated by Section
621'').
    \26\ Letters from the American Securitization Forum (Oct. 21,
2010) (``ASF Letter'') at p. 3 and the Committee on Federal
Regulation of Securities and the Committee on Securitization and
Structured Finance of the Section of Business Law of the American
Bar Association (Oct. 29, 2010) (``ABA Letter'') at p. 2.
    \27\ ABA Letter at p. 3 (``The relationship between an ABS
sponsor and ABS investors is inherently conflicted, in that the ABS
sponsor is seeking funding and the ABS investors are providing that
funding on negotiated terms. Pool selection may also involve
conflicts * * * We believe that conflicts of this type, relating to
the terms and nature of the security, exist in any ABS transaction
and cannot be eliminated.'').
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    Commenters suggested different tests for assessing whether a
transaction involves or results in a material conflict of interest
prohibited by Section 27B. One commenter suggested that a transaction
or activity should not be prohibited under Section 27B if ``(i) Such
transaction or activity represents an overall alignment of risk to the
ABS or underlying assets similar to that borne by investors of the ABS,
(ii) such transaction or activity is unrelated to the [securitization
participant's] role in the specific ABS, (iii) disclosure of the
transaction or activity of the [securitization participant] adequately
mitigates the risk posed by the potential or actual conflict with
respect to any investors in the ABS or (iv) another regulatory regime
applies with respect to the potential or actual conflict of interest.''
\28\
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    \28\ SIFMA Letter at p. 3.
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    Another commenter asserted the proposal should prohibit: ``(a) ABS
transactions in which the adverse performance of the pool assets would
directly benefit an identified party or sponsor (or any affiliate of
any such entity) of the applicable ABS transaction; (b) ABS
transactions in which a loss of principal, monetary default or early
amortization event on the ABS would directly benefit an identified
party or sponsor (or any affiliate); and (c) ABS transactions in which
an insolvency event related to the issuing entity of the ABS would
directly benefit an identified party or sponsor (or any affiliate).''
\29\ This commenter believed that most ordinary course business
transactions concerning securitization participants do not have these
characteristics and should be permitted.\30\
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    \29\ ABA Letter at p. 3.
    \30\ Id.
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    A third commenter suggested that the proposal should ``prohibit
transactions that create a material incentive to intentionally design
asset-backed securities to fail or default.'' \31\ The commenter
further proposed that a material conflict of interest would exist if
``(i) A [securitization participant] participates in the issuance of an
asset-backed security that is created primarily to enable such
[securitization participant] to profit from a related or subsequent
transaction as a direct consequence of the adverse credit performance
of such asset-backed security and (ii) within one year following the
issuance of such asset-backed security, the [securitization
participant] enters into such related or subsequent transaction.'' \32\
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    \31\ ASF Letter at p. 4.
    \32\ ASF Letter at p. 5.
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    Commenters provided examples of a number of conflicts of interest
that they view as inherent in, and indeed essential to, the
securitization process and that in their opinion should not be
prohibited by Section 27B.\33\ In fact, one commenter listed more than
twenty categories of potential conflicts of interest that, in its view,
are inherent in the ordinary course of securitization but should not be
prohibited by Section 27B: (1) The basic risk transfer that occurs in
structuring a securitization; (2) the tranching of debt; (3) holding
differing classes of securities in an asset-backed transaction; (4)
risk retention; (5) retaining the right to receive excess spread or
cash flows; (6) failure to provide funding under a liquidity facility;
(7) failure to provide a credit enhancement; (8) control rights (e.g.,
``the contractual right to remove the servicer, appoint a special
servicer, exercise a clean-up call or instruct a trustee or servicer to
take certain actions with respect to the collateral underlying the ABS
or against an issuer or other transaction party'' and ``voting rights
as a security holder or in another capacity in a transaction''); (9)
hedging activities unrelated to a securitization; (10) providing
financing (e.g., a warehouse line or financing investors to purchase an
ABS); (11) servicer conduct (e.g., servicer interactions with obligors
including loan modifications and adjustments to loan terms); (12)
collateral manager conduct (e.g., the collateral manager acquiring
assets for itself or others but not making the assets available to the
asset-backed issuer, engaging ``in `agency cross' transactions in which
the collateral manager or an affiliate thereof acts as a broker for
compensation for both the issuer and the other party to the
transaction'' and

```client cross' transactions in which the collateral manager or an
affiliate thereof causes a transaction between a securitization issuer
and another client of the collateral manager without the collateral
manager or its affiliates receiving compensation''); (13) conduct in
connection with a trustee (e.g., a sponsor ``may want to acquire a
trustee or the trust business from the trustee''); (14) transactions in
swaps and caps; (15) transactions in CDS and other derivatives; (16)
receipt of payments for performing a role in a securitization prior to
payments made to investors; (17) paying an entity for a rating or to
provide due diligence; (18) market research; (19) entering into a
merger, acquisition, or restructuring that could be adverse to the
securitization activities; (20) a bank affiliate of an underwriter
making a loan to the sponsor; (21) an underwriter acting as underwriter
or placement agent in connection with securities issued by a competitor
of a sponsor; and (22) an underwriter hedging market-making
activity.\34\ Other commenters echoed the view that there are many
activities that involve or result in potential conflicts of interest in
connection with a securitization that should not be prohibited by
Section 27B.\35\
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    \33\ See, e.g., ABA Letter at p. 2 (``We believe rules
implementing this provision should give appropriate weight to
Congressional intent while permitting a broad range of common
activities that are essential to the functioning of the
securitization market.''); see also SIFMA Letter at pp. 2 and 5
(``The goal of the letter is to provide the Commission with some
representative examples of potential conflicts of interest that may
arise as part of an ABS transaction but that should not be expressly
prohibited under Section 621''; ``conflicts of interest are inherent
in securitization * * * These conflicts should be disclosed to
investors and other transaction parties to the extent they are
material, but should otherwise be permitted * * * 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.'').
    \34\ SIFMA Letter at p. 5 through 11.
    \35\ See, e.g., ABA Letter at pp. 2-4. The ABA Letter sets forth
a more limited list of activities that occur in the ordinary course
of a securitization, some of which overlap with the SIFMA Letter,
that mainly occur either as part of structuring the ABS or in
connection with a securitization, and which the ABA believes should
not be prohibited by the proposed rule. With respect to conduct that
is related to structuring the ABS, the ABA identifies: (1) A
securitization participant seeking funding that is provided by the
investor in the securitization; (2) pool selection; (3) risk
retention; and (4) subordinated tranches. The ABA Letter also
highlights the following conduct customarily effected in connection
with securitization: (1) ``Dealing with delinquent assets (e.g.,
whether and to what extent to modify an obligation or to foreclose
on underlying collateral)''; (2) originating or acquiring second
lien loans on mortgaged properties; (3) providing a warehouse loan
or other loan to be repaid from the proceeds of ABS issuance; (4)
loans to servicers or credit enhancers; (5) loans to an investor
secured by ABS (e.g., an investor margin account or repo facility);
(6) ``sales by an identified party of ABS which it originally placed
or sales of other debt or equity securities of an ABS issuer or of
debt of an entity included in a CDO or CLO;'' and (7) the exercise
of remedies upon a loan default.
    Similarly, the ASF Letter identifies activities that are
routinely undertaken in connection with securitization, which in its
view should not be prohibited by the proposed rule, including (1)
``Short-term funding facilities such as `warehouse' lines, variable
funding notes and asset-backed commercial paper, whereby the
underwriter or its affiliate provides financing to the sponsor to
fund asset originations or purchases,'' (2) the pursuit of customary
servicing activities such as loan modifications, short sales and
short refinances; (3) tranche structure; (4) risk retention; and (5)
providing best execution in interest rate and currency swaps to
obtain interest rates or currencies that differ from the underlying
assets. ASF Letter at p. 3.
---------------------------------------------------------------------------

    Three other commenters offered their views on topics including the
elimination of conflicts of interest, costs associated with regulation,
and disclosure requirements.\36\ A sponsor of tax lien-backed
securities suggested that ``municipally-sponsored [sic] tax lien
securitization programs should be exempt from the rules promulgated
pursuant to Section 621 of the [Dodd-Frank] Act.'' \37\
---------------------------------------------------------------------------

    \36\ See Letters from Robin McLeish (July 28, 2010) (``People
should not be allowed [to engage in] any conflict of interest.''),
Timothy Hogan (Sept. 15, 2010) (``Underwriters * * * should disclose
whether they are advocating for the Issuer or the Investor or both *
* * This requirement should apply regardless of whether the
securities are registered or exempt from registration.''), and
Robert O.L. Lynn (Oct. 6, 2010) (``Redistributing compliance risk
toward the individual-employee level could yield cost-efficient
enforcement by increasing the downside risk to anyone attempting to
disguise conflicts of interest--without requiring additional
taxpayer resources.'').
    \37\ See Letter from Mark Page, Director of Management and
Budget, The City of New York (Nov. 12, 2010) at p. 5 (``City of New
York Letter'').
---------------------------------------------------------------------------

III. Discussion of Proposed Rule

    Pursuant to Section 27B(b) of the Securities Act, the Commission
proposes Rule 127B under the Securities Act to address material
conflicts of interest that arise in connection with a securitization.
As the securitization process has grown more complex, securitization
participants may in some circumstances engage in a range of different
activities and transactions that give rise to potential conflicts of
interest, and the existence and potential effects of conflicts of
interest in that process have received increased attention.\38\
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    \38\ See, e.g., Staff of S. Comm. On Homeland Security and
Governmental Affairs, Sub. Comm. On Investigations, 112th Cong.,
Wall Street and the Financial Crisis: Anatomy of a Financial
Collapse (Comm. Print 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf
(hereinafter ``Senate Subcommittee Report: Anatomy of a Financial
Collapse''). See also, Staff of S. Comm. on Homeland Security and
Governmental Affairs, Sub. Comm. on Investigations, 111th Cong.,
wall street and The Financial Crisis: The Role of Investment Banks
(Comm. Print 2010) (Exhibit 1a), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/042710Exhibits.pdf
(hereinafter ``Senate Subcommittee Report: The Role of Investment
Banks''); The Financial Crisis Inquiry Report: Final Report of the
National Commission on the Causes of the Financial and Economic
Crisis in the United States, available at http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_full.pdf (hereinafter, ``The Financial Crisis Inquiry Report'');
Consent and Final Judgment as to the Defendant J.P. Morgan
Securities LLC in SEC v J.P. Morgan Securities LLC (f/k/a/J.P.
Morgan Securities Inc.), 11 CV 4206 (S.D.N.Y 2011); Litigation
Release No. 22008 (June 21, 2011); and Consent and Final Judgment as
to Defendant Goldman, Sachs & Co. in SEC v Goldman, Sachs & Co. and
Fabrice Tourre, 10 CV 3229 (S.D.N.Y. 2010); Litigation Release No.
21592 (July 15, 2010), 2010 WL 2799362 (July 15, 2010).
---------------------------------------------------------------------------

    The proposed rule is designed to implement Section 27B of the
Securities Act. As noted above, the text of proposed Rule 127B is based
substantially on the text of Section 27B. As described below, the
Commission is proposing for comment guidance to market participants as
to the nature and scope of conduct that would be prohibited under the
proposed rule. The Commission has received a number of initial comments
regarding the breadth of any proposed definition of material conflict
of interest, and we have sought to strike an appropriate balance
between prohibiting the specific type of conduct at which Section 27B
is aimed without restricting other securitization activities.\39\ We
preliminarily believe that the proposed rule strikes that balance, but
we seek comment on all aspects of proposed Rule 127B and of our
proposed interpretations of its scope and requirements. It is important
to note that although the proposed rule would prohibit certain
transactions that would involve or result in certain material conflicts
of interest, it would in no way limit or restrict the applicability of
the general antifraud provisions of the federal securities laws to
conduct arising before or after the proposed rule becomes effective.
Thus, all conduct in connection with a securitization, whether or not
effected in compliance with Section 27B and proposed Rule 127B, would
remain subject to these and other relevant provisions of the securities
laws.
---------------------------------------------------------------------------

    \39\ See Section IIID of the Release.
---------------------------------------------------------------------------

    The discussion of the proposed rule set forth below is divided into
three parts. First, we describe certain conditions that, under Section
27B, must be present for the proposed rule to apply. In particular, we
discuss the persons, products, timeframes, and conflicts that
potentially fall within the scope of the proposed rule, and we propose
a standard for determining whether a ``material conflict of interest''
exists for purposes of the proposed rule. Second, we discuss three
categories of activities--risk-mitigating hedging activities, liquidity
commitments, and bona fide market-making--that are excepted from the
scope of the proposed rule, as provided in Section 27B. Third, we
provide examples of selected securitization transactions and describe
how our proposed test for determining whether or not a transaction
involves or results in a ``material conflict of interest'' prohibited
by proposed Rule 127B would apply to such examples.

Though in a number of examples particular reference is made to
synthetic ABS for the purpose of furthering the discussion or providing
clarification, we are seeking to apply the same general principles and
guidance to both synthetic ABS and non-synthetic ABS.
    We note that in analyzing whether a particular activity is
prohibited by the proposed rule, market participants would be permitted
to consider each of the conditions and exceptions discussed below
independently. Thus, they could conclude that the activity is not
prohibited by the proposed rule if: (1) The activity is outside the
scope of the proposed rule (because, for example, it does not involve a
covered person or product, or does not entail a material conflict of
interest), or (2) the activity falls within a permitted exception to
the rule. We seek comment on all aspects of proposed Rule 127B and of
our proposed interpretations of its scope and requirements.

A. Conditions Required for Application of the Proposed Rule

    There are five key conditions, each of which is discussed below,
that define the circumstances in which the proposed rule might prohibit
material conflicts of interest in the securitization process. In
particular, in order for the proposed rule to apply, the relevant
transaction must involve (1) Covered persons, (2) covered products, (3)
a covered timeframe, (4) covered conflicts, and (5) a ``material
conflict of interest''. Each of these conditions must be present in
order for the prohibition under the proposed rule to apply.
i. Covered Persons
    The proposed rule would apply to an underwriter, placement agent,
initial purchaser, or sponsor, or any affiliate or subsidiary of such
entity, of an ABS. These persons are specified in Section 27B(a) of the
Securities Act and typically have substantial roles in the assembly,
packaging and sale of ABS. They structure the product and control the
securitization process, and thus they may have the opportunity to
engage in activities that the proposed rule and Section 27B of the
Securities Act are intended to prevent.
    The term ``underwriter'' is defined in Section 2(a)(11) of the
Securities Act. The Securities Act, however, does not define for
purposes of Section 27B of the Securities Act the terms ``placement
agent,'' ``initial purchaser,'' ``sponsor,'' ``affiliate'' or
``subsidiary.'' We do not propose to define these terms for purposes of
the proposed rule at this time. Although the term ``sponsor'' is
defined in connection with Regulation AB's disclosure regime and the
second prong of the definition of the term ``securitizer'' in Section
15G of the Securities Exchange Act of 1934 (``Exchange Act'') is
substantially identical to the Regulation AB definition of sponsor, the
Regulation AB definition might not identify all persons involved in the
structure and sale of, for example, a synthetic ABS transaction, who
may have the opportunity to engage in activities that the proposed rule
is intended to prevent.\40\ We note that synthetic ABS are not included
within the scope of Regulation AB.\41\ Neither the Commission nor our
staff has interpreted the Regulation AB definition in the context of
synthetic ABS transactions. We preliminarily believe that the
Regulation AB definition of sponsor might be under-inclusive or
confusing in the context of the proposed rule. Furthermore, we
preliminarily believe that a collateral manager should be subject to
the proposed rule, based on such entity's role in structuring the
transaction and selecting assets.
---------------------------------------------------------------------------

    \40\ The Regulation AB definition of sponsor is found at 17 CFR
229.1101(l); see also Release No. 34-64148.
    \41\ Synthetic ABS do not fit within the more narrow definition
of ABS included in Regulation AB because payments on synthetic ABS
are based primarily on the performance of reference assets and not
the performance of a discrete pool of financial assets that by their
terms covert into cash and are transferred to a separate entity. See
generally Release 33-8518.
---------------------------------------------------------------------------

    We preliminarily believe that terms such as placement agent and
initial purchaser are sufficiently well understood in the context of
the market for ABS, given that securitization developed in the 1970s
and market participants frequently identify the various participants in
the securitization process using these terms (for example, by
specifying the placement agent, initial purchaser, and sponsor in
offering documents).\42\ We also recognize that many of these terms,
however, are defined or used in other provisions of the federal
securities laws and rules adopted thereunder.\43\ While certain
specific definitions used in other areas of the federal securities laws
and rules may be workable in this context, others may be over- or
under-inclusive. For example, we seek commenter input concerning
whether the term ``sponsor'' in this context should include the
collateral manager or others who for a fee, or some other benefit, play
a substantial role in the creation of an ABS, or managing or servicing
the assets underlying an ABS. Although as noted above we do not
preliminarily believe definitions are warranted in the proposed rule
text, we seek commenters' views on this issue.
---------------------------------------------------------------------------

    \42\ ABA Letter at page 6 (``Section 27B also uses the term
`sponsor', which is not currently defined in the Securities Act of
1933. However, the term sponsor has been defined in Regulation AB,
and the definition there is virtually identical to clause (B) of the
definition of ``securitizer'' that is added to the Securities
Exchange Act of 1934 by virtue of Section 941 of the Dodd-Frank Act.
We recommend that the Commission utilize the definition of `sponsor'
in Regulation AB for purposes of Section 27B''). While the ABA
Letter suggested using the Regulation AB definition of the term
sponsor, others did not make such a suggestion.
    \43\ See, e.g., infra notes 44 through 51.
---------------------------------------------------------------------------

Request for Comments Regarding Covered Persons
    10. Should we provide definitions for the terms ``placement
agent,'' ``initial purchaser,'' ``sponsor,'' ``affiliate'' or
``subsidiary''? One commenter suggested that we adopt definitions for
the terms ``initial purchaser'' and ``sponsor'' but not for other
covered persons.\44\ Should we adopt this commenter's approach? We seek
comment concerning whether certain terms should or should not be
defined, and the rationale supporting such distinctions. Specifically,
we seek comment as to whether definitions of these terms in other
provisions of the federal securities laws and rules would be necessary
and workable in this area, whether existing definitions should be
tailored specifically for this rule proposal, or whether new
definitions would be necessary to achieve the purpose of the proposal.
---------------------------------------------------------------------------

    \44\ See ABA Letter at p. 6 (suggesting ``the Commission clarify
that the term `initial purchaser' as used in Section 27B refers to a
broker-dealer functioning in a role equivalent to that of an
underwriter or placement agent in a Rule 144A transaction'' and
``that the Commission utilize the definition of `sponsor' in
Regulation AB for purposes of Section 27B.'').
---------------------------------------------------------------------------

    11. Should the term ``sponsor'' have the same meaning as defined in
Regulation AB? \45\ Please explain why or why not. Would such
definition be workable or would it be over- or under-inclusive in this
context?
---------------------------------------------------------------------------

    \45\ 17 CFR 229.1101(l) (``Sponsor means the person who
organizes and initiates an asset-backed securities transaction by
selling or transferring assets, either directly or indirectly,
including through an affiliate, to the issuing entity.'').
---------------------------------------------------------------------------

    12. For purposes of proposed Rule 127B, should the term ``sponsor''
be defined to specifically include a collateral manager or any other
person (e.g., servicers, custodians, etc.) who, for a fee or some other
benefit, has a substantial role in the creation of the ABS? We seek
commenter input regarding whether such definition would be appropriate
or over- or under-inclusive. If you believe such a definition would be
over- or under-inclusive, please provide examples of how such
definition would be over- or

under-inclusive. Would clarification or more specificity be needed if
we were to use such a definition of ``sponsor''? If so, please explain
what would be needed and why. Alternatively, should the term
``sponsor'' be defined to specifically include a collateral manager or
any other person (e.g., servicer, custodian, etc.) who, for a fee or
some other benefit, participates in the creation of the ABS? We seek
commenter input regarding whether or not this alternative definition
would be more appropriate. If commenters believe that definitions of a
particular covered person are necessary but that existing definitions
from other areas of the federal securities laws and rules or other
sources are not workable in this context, please suggest an alternative
definition(s). Commenters should explain why their suggested
definition(s) better identifies persons intended to be covered by
Section 27B.
    13. Should proposed Rule 127B provide that an ``affiliate'' of, or
a person ``affiliated'' with, a specified person is a person that
directly, or indirectly through one or more intermediaries, controls,
or is controlled by, or is under common control with, the person
specified? Such terms are defined similarly in Section 16 of the
Securities Act, Rule 405 under the Securities Act, and Rule 12b-2 under
the Exchange Act.\46\ Would such a definition be workable or would it
be over- or under-inclusive in this context? Please discuss whether or
not a servicer would typically be an affiliate of an underwriter,
placement agent, initial purchaser, or sponsor, under such a
definition.
---------------------------------------------------------------------------

    \46\ See 15 U.S.C. 77p(f)(1); 17 CFR 230.405; and 17 CFR
240.12b-2, respectively.
---------------------------------------------------------------------------

    14. Should the definition of the term ``subsidiary'' be the same as
the definition of subsidiary found in Exchange Act Rule 12b-2? \47\
Please explain why or why not. Would such definition be workable or
would it be over or under-inclusive in this context?
---------------------------------------------------------------------------

    \47\ See 17 CFR 240.12b-2 (``A `subsidiary' of a specified
person is an affiliate controlled by such person directly, or
indirectly through one or more intermediaries.'').
---------------------------------------------------------------------------

    15. Should the term ``underwriter'' in the context of Securities
Act Section 27B have the same meaning as the definition in Section
2(a)(11) of the Securities Act? \48\ We note that Section 2 of the
Securities Act states that terms used in the Securities Act have the
meanings assigned to them in that section ``unless the context provides
otherwise.'' Is the context in Section 27B of the Securities Act, and
proposed Rule 127B thereunder, such that the term ``underwriter''
should not have the meaning in Section 2(a)(11)? Would that definition
be workable or over- or under-inclusive, in this context? Should we
define the term ``underwriter'' instead to have the same meaning as the
definition in Rule 100 of Regulation M under the Exchange Act? \49\
Please explain why or why not. Would such definition be workable or
over- or under-inclusive in this context?
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 77b(a)(11).
    \49\ 17 CFR 242.100 (``Underwriter means a person who has agreed
with an issuer or selling security holder: (1) To purchase
securities for distribution; or (2) to distribute securities for or
on behalf of such issuer or selling security holder; or (3) to
manage or supervise a distribution of securities for or on behalf of
such issuer or selling security holder.'').
---------------------------------------------------------------------------

    16. Should definitions for each type of covered person be the same
as or consistent with Regulation AB? Should ``underwriter,''
``placement agent,'' ``initial purchaser'' and ``sponsor'' have the
same meaning as either defined by Regulation AB or, if undefined, as
understood in Regulation AB (e.g., underwriter or initial purchaser)?
Would these terms need to be defined differently than defined or
understood, if undefined, in Regulation AB in order to fulfill the
intent of Section 27B of the Securities Act, particularly in connection
with synthetic ABS? Please explain. Alternatively, please explain why
consistent treatment would be appropriate.
    17. For purposes of Rule 127B, should we define ``initial
purchaser'' to mean a broker-dealer functioning in a role equivalent to
that of an underwriter or placement agent who purchases the ABS
pursuant to an agreement that contemplates the resale of those
securities to other purchasers in transactions that are not required to
be registered under the Securities Act in reliance upon Rule 144A \50\
or that are otherwise not required to be registered because they do not
involve any public offering? \51\ Would this language adequately
describe the types of unregistered transactions in which an initial
purchaser might participate (i.e., Rule 144A transactions and private
resales made in reliance on the so-called Section ``4(1-\1/2\)''
exemption)? Should the definition of ``initial purchaser'' incorporate
different or other concepts? Are there persons that should be subject
to this provision in addition to broker-dealers that act as initial
purchasers?
---------------------------------------------------------------------------

    \50\ 17 CFR 230.144A.
    \51\ See ABA Letter at p. 6 (suggesting that the Commission
``clarify that the term `initial purchaser' as used in Section 27B
refers to a broker-dealer functioning in a role equivalent to that
of an underwriter or placement agent in a Rule 144A transaction.'').
---------------------------------------------------------------------------

ii. Covered Products
    Proposed Rule 127B(a), like Section 27B under the Securities Act,
applies with respect to any ``asset-backed security (as such term is
defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C.
78c), which for purposes of this rule shall include a synthetic asset-
backed security)''. Section 941(a) of the Dodd-Frank Act added Section
3(a)(77) to the Exchange Act to provide that the term ``asset-backed
security'':

    (A) means a fixed income or other security collateralized by any
type of self-liquidating financial asset (including a loan, a lease,
a mortgage, or a security or unsecured receivable) that allows the
holder of the security to receive payments that depend primarily on
cash flows from the asset, including--

    (i) A collateralized mortgage obligation;
    (ii) A collateralized debt obligation;
    (iii) A collateralized bond obligation;
    (iv) A collateralized debt obligation of asset-backed
securities;
    (v) A collateralized debt obligation of collateralized debt
obligations; and
    (vi) A security that the Commission, by rule, determines to be
an asset-backed security for purposes of this section; and

    (B) Does not include a security issued by a finance subsidiary
held by the parent company or a company controlled by the parent
company, if none of the securities issued by the finance subsidiary
are held by an entity that is not controlled by the parent
company.\52\1890-91.

    \52\ Public Law 111-203, 941, 124 Stat. 1376, 1890-91.
---------------------------------------------------------------------------

The proposed rule, like Securities Act Section 27B, incorporates this
definition and specifically includes synthetic ABS in describing the
scope of the prohibition on certain material conflicts of interests.
    We are not proposing to define the term ``synthetic asset-backed
security'' for purposes of proposed Rule 127B, because we understand
that this term is commonly used and understood by market
participants.\53\ However, we seek comment on whether this
understanding is correct and whether we should provide a definition of
this

term to facilitate implementation of the proposed rule.
---------------------------------------------------------------------------

    \53\ We note that the definition of ABS in Securities Act
Regulation AB does not include a synthetic ABS. See Release 33-8518,
70 FR at 1514 and Item 1101(c) of Regulation AB (17 CFR
229.1101(c)). However, the prohibition in Section 27B of the
Securities Act applies both to an ABS as defined in Section 3 of the
Exchange Act, and to a synthetic ABS. Synthetic securitizations
``create exposure to an asset that is not transferred to or
otherwise part of the asset pool. These synthetic transactions are
generally effectuated through the use of derivatives such as a
credit default swap or total return swap. The assets that are to
constitute the actual `pool' under which the return on the ABS is
primarily based are only referenced through the credit derivative.''
Release 33-8518, 70 FR at 1514.
---------------------------------------------------------------------------

    We also note that the definition of an ABS in Section 3(a)(77) of
the Exchange Act (an ``Exchange Act-ABS'') is much broader than the
definition of an ABS in Securities Act Regulation AB. The definition of
an Exchange Act-ABS includes securities that are typically sold in
transactions that are exempt from registration under the Securities
Act, such as CDOs, and that are not necessarily backed by a discrete
pool of assets.
    Neither Section 27B nor proposed Rule 127B distinguishes between
ABS that are sold in an offering registered with the Commission or in
an offering that is exempt from registration. Accordingly, our proposal
would apply to ABS in both such circumstances. We recognize that
Section 27B, and our proposed rule, refer to an underwriter, a term
that, in the Securities Act, is typically, but not exclusively, used in
the context of registered offerings. Section 27B, however, also applies
to placement agents and initial purchasers, which are parties that
perform functions similar to an underwriter in unregistered offerings.
Moreover, as noted above, the definition of Exchange Act-ABS includes
ABS typically offered and sold in unregistered transactions.
Request for Comments Regarding Covered Products
    18. Should we define or interpret the term ``synthetic asset-backed
securities'' and if so, how? Please explain why or why not. Please
provide a suggested definition and the rationale for why the suggested
definition is appropriate. Should any such definition or interpretation
be limited to ABS for which the credit exposure for the asset pool from
which payments are derived consists substantially of swaps, security-
based swaps or other derivatives (and the collateral held by the SPE)?
    19. Should any such definition or interpretation of ``synthetic
ABS'' include any combination of securities that produces an economic
result equivalent to an ABS, whether or not collateralized or having
features meeting the specific requirements of the definition of ABS? If
we were to define the term, should we define ``synthetic ABS'' as
securitizations designed to create exposure to an asset that is not
transferred to or otherwise part of the asset pool, including
transactions effectuated through the use of derivatives such as a CDS
or total return swap, and for which the assets that are to constitute
the actual ``pool'' under which the return on the ABS is primarily
based are for the most part referenced through the derivative? \54\
---------------------------------------------------------------------------

    \54\ See Section IIIA(2)(a) of Release 33-8518, 70 FR at 1513-
1515.
---------------------------------------------------------------------------

    20. Please discuss any similarities or differences between
security-based swap agreements in general and security-based swap
agreements used in synthetic ABS that are relevant for purposes of
proposed Rule 127B. Please discuss whether or not such similarities or
differences should be addressed in a definition or interpretation of
the term ``synthetic ABS'' for purposes of proposed Rule 127B, and why.
    21. We seek comment on the application of proposed Rule 127B to
municipal securities that are ``asset-backed securities'' within the
meaning of Section 3(a)(77) of the Exchange Act as amended by the Dodd-
Frank Act.\55\ Please explain whether you believe there are any
differences between the application of this provision to municipal
securities that are ABS and its application to other types of ABS.
Should there be an exemption under Securities Act Section 28 from
proposed Rule 127B for decisions made in the exercise of the
governmental function of a state or local government acting as a
securitization participant? Please explain why or why not. Would other
exceptions applicable to state and local government issuers or sponsors
of ABS be appropriate? Please explain why or why not. If you believe
exceptions should be included, please describe what such exceptions
should be and why they would be appropriate. We seek specific comment
about whether some or all varieties of municipally-sponsored tax lien
securities should be exempt from the proposed rule and if so, why such
an exemption would be appropriate for such tax-lien securities.\56\ For
example, we ask commenters to provide their reasoning as to whether or
not the proposed rule should apply to a municipal tax lien
securitization in which the tax liens arose by operation of law and
were sold by a municipality through a tax lien securitization program
in which all liens were securitized and the municipality had no role in
the lien selection process.\57\
---------------------------------------------------------------------------

    \55\ The definition of an ABS within the meaning of Section
3(a)(77) of the Exchange Act as amended by the Dodd-Frank Act
includes securities that are typically sold in transactions that are
exempt from registration under the Securities Act.
    \56\ See City of New York Letter at p. 5 (``Many actions that
the City of New York takes in the exercise of its governmental
powers pursuant to other statutes or regulations or to serve the
public's interest and protect the health and safety of its residents
could potentially be viewed as being in conflict with the interest
of investors in the tax lien-backed securities. For example, the
City could take an action that would adversely impact the value of
one of the properties securing a tax lien or the value of other
properties in that area, which could adversely impact the value of
that property.'').
    \57\ See id.
---------------------------------------------------------------------------

iii. Covered Timeframe
    Proposed Rule 127B uses the Securities Act Section 27B language
``at any time for a period ending on the date that is one year after
the date of the first closing of the sale of the asset-backed
security.'' It is during this time period, which extends for one year
following the first closing of the sale of the security to the public,
that no securitization participant could engage in a transaction giving
rise to prohibited conduct. Accordingly, if a transaction occurs in the
period prior to one year after the date of the first closing of the
sale of the ABS, it is covered by the proposed rule.
    Securities Act Section 27B specifies the end of the covered
timeframe--one year following the first closing of the sale of the
security to the public. Section 27B, however, does not specify the
commencement point for the covered timeframe and we are not proposing
to do so at this time. As a result, the proposed rule would cover
transactions effected prior to ``the date of the first closing of the
sale of the asset-backed security.'' We preliminarily believe that this
result may be appropriate because prior to the first closing
securitization participants involved in structuring and marketing an
ABS may engage in transactions involving or resulting in material
conflicts of interest that in form or effect are, for purposes of the
proposed rule, difficult to distinguish from similar transactions
occurring after the first closing. Thus, using the sale date as a
starting point for the covered timeframe might be under-inclusive. We
request comment, however, on whether and how our proposed approach
might be over-inclusive, as well as whether alternative approaches to
defining the covered timeframe (such as treating the date of first sale
as the beginning of the covered timeframe) might be appropriate.
Request for Comments Regarding Covered Timeframe
    22. Is there a point in time prior to ``one year after the date of
the first closing of the sale of the asset-backed security'' at which
the prohibition in Section 27B was not intended to apply? Please
explain why or why not.
    23. Should the proposed rule specify the commencement point for the
covered timeframe? Please provide an explanation. In particular, please

discuss whether or not the commencement point for the covered timeframe
should be ``the date of the first closing of the sale of the asset-
backed security.'' Please include a discussion of whether or not such
commencement point for the covered timeframe would be appropriate, or
whether it would be over- or under-inclusive. In addition, please
discuss whether such approach would have any advantages or
disadvantages.
    24. Should the commencement point for the covered timeframe be tied
to the point at which a person becomes a securitization participant?
How would such a point in time be defined? Should the commencement
point vary depending on which securitization participant role a person
performs? Please provide an explanation.
    25. Should the commencement point for the covered timeframe be tied
to some other reference point prior to the first closing of the sale of
the ABS to the public? Please provide an explanation.
iv. Covered Conflicts of Interest
    The Commission also proposes to delineate the scope of ``conflicts
of interest'' that would potentially be covered by the proposed
rule.\58\ Specifically, there would not be a covered conflict of
interest involved if the conflict in question: (1) Arose exclusively
between securitization participants or exclusively between investors;
(2) did not arise as a result of or in connection with the related ABS
transaction; or (3) did not arise as a result of or in connection with
``engag[ing] in any transaction'' (as more fully described below).
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    \58\ The proposed interpretations are not intended for broad
application concerning the use of the term ``material conflicts of
interest'' and would not apply in other areas of the federal
securities laws and rules or SRO rules or in connection with other
provisions of the Dodd-Frank Act.
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    First, consistent with Securities Act Section 27B, we propose that
the scope of the conflicts of interest covered by proposed Rule 127B(a)
would be limited to material conflicts of interest between an entity
that is a securitization participant with respect to an ABS and an
investor in such ABS, whether or not such investor purchased the ABS
from the securitization participant. This proposed interpretation is
not intended to narrow or broaden the scope of the statutory language.
Under this interpretation, however, if conflicts of interest were to
arise solely among securitization participants, acting in their
capacity as such in connection with the securitization process, they
would not be subject to the proposed rule, given the focus of Section
27B on protecting investors (e.g., conflicts of interests between a
sponsor and a collateral manager of an ABS are not the focus of the
proposal).\59\
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    \59\ See Merkley-Levin Letter, at attachment (Cong. Rec. S5899
(daily ed. July 15, 2010) (statement of Sen. Carl Levin))
(``[Securitization participants], like the mechanic servicing a car,
would know if the vehicle has been designed to fail. And so they
must be prevented from securing handsome rewards for designing and
selling malfunctioning vehicles that undermine the asset-backed
securities markets. It is for that reason that we prohibit those
entities from engaging in transactions that would involve or result
in material conflicts of interest with the purchasers of their
products.'') (emphasis added).
---------------------------------------------------------------------------

    Second, conflicts of interest arising solely among investors in the
ABS offering (where investors could include securitization
participants, provided these conflicts arise only from their interests
as an investor) would also not be covered by the proposed rule.\60\
Thus, for example, the proposed rule is not intended to prohibit the
multi-tranche structures commonly used in ABS offerings, even though
those structures may involve conflicts between the interests of various
classes of investors in the offering by virtue of the different risks
and rewards associated with such tranches.
---------------------------------------------------------------------------

    \60\ See supra note 19.
---------------------------------------------------------------------------

    Third, we propose that the prohibition under Rule 127B(a) would
only apply to those conflicts of interest between a securitization
participant and an investor that arise as a result of or in connection
with the related ABS transaction. Our proposed rule, therefore, would
not address other conflicts of interest that happen to arise between
these same parties but that are unrelated to their status as a
securitization participant and investor, respectively.\61\
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    \61\ For example, the underwriter of an ABS may also be the
underwriter in an unrelated common stock offering. One investor may
purchase securities in both the ABS offering and the common stock
offering. If the underwriter engaged in transactions that undermined
the market value of the common stock offering, that activity (while
potentially addressed by other provisions of the federal securities
laws and rules thereunder, depending on the facts and circumstances)
would not fall within the scope of Proposed Rule 127B even though
one of the investors in the common stock offering is also an
investor in the ABS offering.
    See ABA Letter at p. 5 (``The rules should clarify that the
prohibition on material conflicts of interest does not extend to
transactions unrelated to the relevant ABS transaction. The language
of Section 27B referring to a `material conflict of interest with
respect to any investor in a transaction arising out of such
activity', creates some ambiguity as to whether the phrase `arising
out of such activity' is intended to identify the investor, or the
context in which the potential conflict may arise. Underwriters,
placement agents, initial purchasers and sponsors, or their
affiliates, may have a variety of relationships with investors who
purchase ABS from or through them. We believe that the better
reading of Section 27B is that the conflict of interest shall not
arise in the context of the transaction with respect to which the
investor acquired the ABS. This construction would help to assure
the integrity of ABS offerings, while not imposing unreasonable
restrictions on the overall relationships between the identified
parties and sponsors, on the one hand, and ABS investors, on the
other.'').
---------------------------------------------------------------------------

    Fourth, we propose that in order for the proposed rule to apply,
the conflict of interest must arise as a result of or in connection
with ``engag[ing] in any transaction.'' For example, engaging in any
transaction would include, but not be limited to, effecting a short
sale of, or purchasing CDS protection on, securities offered in the ABS
transaction or its underlying assets. ``Engag[ing] in any transaction''
would also include the securitization participant selecting assets,
directly or indirectly, for the underlying asset pool and selling those
assets to the SPE.\62\
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    \62\ Merely ``engaging in any transaction'' does not in and of
itself trigger the prohibitions of the proposed rule. For example,
the sale of underlying assets to the SPE must also involve or result
in a material conflict of interest with ABS investors and all other
conditions required for application of the proposed rule must be
met.
---------------------------------------------------------------------------

    We recognize that not every activity undertaken by a securitization
participant would be ``engag[ing] in any transaction'' for purposes of
Securities Act Section 27B or the proposed rule. For example, the
issuance of investment research by a securitization participant would
not be ``engag[ing] in any transaction'' for purposes of the proposed
rule. We request comment on whether there are other types of activities
in which securitization participants may engage that should be
specifically excluded from the scope of the phrase ``engag[ing] in any
transaction.''
Request for Comment Regarding Covered Conflicts of Interest
    26. Would the application of the proposed interpretation to
conflicts of interest between securitization participants and investors
in ABS be appropriate or could it be viewed as broadening or narrowing
the scope of paragraph (a) of the proposed rule in a way that could
prevent it from achieving its intended purpose? Please explain. Please
describe any alternative interpretation that would better align the
scope of the proposed rule with the conflicts that Section 27B is
designed to address.
    27. We seek commenter input regarding conflicts of interest that
might arise between securitization participants, whether or not such
conflicts impact ABS investors, and to what extent, if any, such
conflicts are addressed under Securities Act Section 27B.

    28. Should the phrase ``engaging in any transaction'' for these
purposes be interpreted more broadly or narrowly? Please provide
specific suggestions.
    29. Are the examples noted above of activity that constitutes
``engaging in any transaction'' over-inclusive, under-inclusive or
appropriate in the context of the proposed rule? Are there examples of
``engaging in any transaction'' in addition to effecting a short sale
of securities offered in the ABS transaction or its underlying assets,
or buying CDS protection on the relevant ABS or its underlying assets,
that should be considered in this context? Please explain. Should the
phrase ``engaging in any transaction'' include the asset-backed
offering itself?
    30. Is the example noted above of an activity that does not
constitute ``engaging in any transaction'' (the issuance of investment
research) appropriate in assessing conflicts of interest? Are there
other activities that should not be ``engaging in any transaction'' for
these purposes? If so, which activities, and why?
    31. Please identify situations, if any, in which a securitization
participant has engaged in a transaction that conflicts with the
interests of ABS investors as well as engaged in a transaction that is
aligned with the interests of ABS investors. Please discuss whether and
how you believe such situations should be addressed under the proposed
rule.
v. Conflicts of Interest That Are Material
    Perhaps the most challenging issue in implementing Section 27B is
to identify those conflicts of interest involving securitization
participants and investors that are ``material'' and intended to be
prohibited under Section 27B and our proposed rule. If a conflict of
interest is not a ``material conflict of interest'', then it would not
be covered by Section 27B and our proposed rule.
    The proposed rule does not define the term ``material conflict of
interest.'' We preliminarily believe that any attempt to precisely
define this term in the text of the proposed rule might be both over-
and under-inclusive in terms of identifying those types of material
conflicts of interest arising as a result of or in connection with a
securitization transaction that Section 27B was intended to prohibit,
especially given the complex and evolving nature of the securitization
markets, the range of participants involved, and the various activities
performed by those participants. Accordingly, we propose to clarify the
scope of conflicts of interest that are material and intended to be
prohibited under Section 27B and our proposed rule through interpretive
guidance rather than through a detailed definition in the proposed
rule.\63\
---------------------------------------------------------------------------

    \63\ See supra note 6.
---------------------------------------------------------------------------

    In considering how best to interpret the phrase ``material conflict
of interest'' for these purposes, we note that on the one hand, in
order to give full effect to Section 27B, this phrase should be
interpreted sufficiently broadly so as to capture the full range of
transactions by securitization participants that involve or result in a
material conflict of interest between securitization participants and
investors. If the phrase is construed too narrowly, the proposed rule
could potentially permit certain securitization participants to take
undue advantage of their role in the securitization process, in which
case the proposed rule might fail to enhance the integrity of
securitization practices as fully as intended.
    On the other hand, however, a number of commenters have argued that
multiple conflicts of interest often arise between securitization
participants and investors as an inherent part of the securitization
process. Thus, they have cautioned, an overly broad interpretation may
curtail the willingness of securitization participants to engage in
securitization transactions, which ultimately could limit, increase the
costs of, or effectively prohibit transactions that might benefit
investors, efficiently redistribute risk, and support important
segments of the economy.\64\
---------------------------------------------------------------------------

    \64\ See, e.g., SIFMA Letter at p. 3 (``If not focused on the
transactions referenced by Senators Merkley and Levin, rules
promulgated under Section 621 could restrict many standard industry
practices which are vital to the functioning of the ABS markets and
beneficial to investors.''). See also ASF Letter at p.3-4
(``Similarly, a broad interpretation of `material conflicts of
interest' could prohibit servicers * * * who are affiliated with the
sponsor of a transaction from pursuing customary servicing
activities * * * This restriction would effectively prohibit
sponsors and their affiliates from servicing the loans that they
originate, requiring costly servicing transfers that will decrease
efficiency and potentially lead to confusion for consumers and
disruptions in the servicing of assets.'').
---------------------------------------------------------------------------

    We are not aware of any basis in the legislative history of Section
621 to conclude that this provision was expected to alter or curtail
the legitimate functioning of the securitization markets, as opposed to
targeting and eliminating specific types of improper conduct. Moreover,
as a preliminary matter, we believe that certain conflicts of interest
are inherent in the securitization process, and accordingly that
Section 27B and our proposed rule should be construed in a manner that
does not unnecessarily prohibit or restrict the structuring and
offering of an ABS.
    We have considered the various tests suggested by commenters for
identifying material conflicts of interest for purposes of Section 27B
and our proposed rule. While mindful of these suggestions and of the
analysis accompanying them, the Commission preliminarily believes that
the appropriate balance would best be struck through an interpretation
that, for purposes of the proposed rule, engaging in any transaction
\65\ would ``involve or result in [a] material conflict of interest''
between a securitization participant and investors in the relevant ABS
if:
---------------------------------------------------------------------------

    \65\ See supra Section IIIA(iv). Such a transaction would
include effecting a short sale of securities offered in the ABS
transaction or its underlying assets, or buying CDS protection on
the relevant ABS or its underlying assets.
---------------------------------------------------------------------------

    (1) Either:
    (A) a securitization participant would benefit directly or
indirectly from the actual, anticipated or potential (1) Adverse
performance of the asset pool supporting or referenced by 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 (where these are discussed below, any such transaction will be
referred to as a ``short transaction''); or
    (B) a securitization participant, who directly or indirectly
controls the structure of the relevant ABS or the selection of assets
underlying the ABS, 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 as described
above; and
    (2) there is a ``substantial likelihood'' that a ``reasonable''
investor would consider the conflict important to his or her investment
decision (including a decision to retain the security or not).\66\
---------------------------------------------------------------------------

    \66\ See Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (citing
TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).
---------------------------------------------------------------------------

    We preliminarily believe that this formulation of a conflict of
interest that is material would directly address those types of
activities that Section 27B was intended to prohibit--e.g., situations
in which a securitization participant engages in a transaction through
which it benefits when the related ABS fails or performs adversely or
has the potential to fail or perform adversely and there is a
substantial likelihood that a reasonable investor would consider the

fact of such benefit important to his or her investment decision.\67\
---------------------------------------------------------------------------

    \67\ See 156 Cong. Rec. S5899 (daily ed. July 15, 2010)
(statement of Sen. Levin) (``The intent of Section 621 is to
prohibit underwriters, sponsors, and others who assemble asset-
backed securities, from packaging and selling those securities and
profiting from the securities' failures.'').
    Our proposed approach for identifying when a person engages in
transactions that involve or result in material conflicts of
interest is, in part, similar to the ABA's suggested focus for the
proposed rule. See ABA Letter at p. 2 (``we believe the focus of the
rulemaking should be on the following types of conflicts: (a) ABS
transactions in which the adverse performance of the pool assets
would directly benefit an identified party or sponsor (or any
affiliate of any such entity) of the applicable ABS transaction; (b)
ABS transactions in which a loss of principal, monetary default or
early amortization event on the ABS would directly benefit an
identified party or sponsor (or any affiliate); and (c) ABS
transactions in which an insolvency event related to the issuing
entity of the ABS would directly benefit an identified party or
sponsor (or any affiliate).''). In addition, the ABA suggested that
the ``rules should clarify that the prohibition on material
conflicts of interest does not extend to transactions unrelated to
the relevant ABS transaction.'' Id. at p. 5.
---------------------------------------------------------------------------

a. Item 1(A) of ``Material Conflict of Interest'' Test
    Engaging in a transaction would ``involve or result in [a] material
conflict of interest'' if as a result of such transaction the
securitization participant would benefit from the actual, anticipated
or potential poor performance of the ABS or the underlying assets. It
would not be necessary for a securitization participant to
intentionally design an ABS to fail or default in order to trigger the
rule's prohibition.\68\ We preliminarily interpret the intent of
Section 27B more broadly--to prohibit securitization participants from
benefiting from the failure of financial instruments that they help
structure, offer and sell to investors. Thus, under the proposed rule a
securitization participant would be prohibited from profiting from the
decline of an ABS it helped to create (assuming that the conflict would
be important to a reasonable investor), even if that securitization
participant did not intentionally cause, or increase the likelihood of,
such decline. For example, a securitization participant that engaged in
a short sale of the relevant ABS four months following the first
closing of sale of the ABS would meet item 1(A) of the material
conflict of interest test. The securitization participant would be able
to benefit from a decline in the market value of the ABS through the
short sale even if the securitization participant did not design the
ABS to fail. The analysis does not turn on whether the securitization
participant intentionally designed the ABS to fail, but rather whether
the securitization participant would benefit, through the actual,
anticipated or potential decline in the market value of the ABS, in
this case in the form of gains from the short sale.
---------------------------------------------------------------------------

    \68\ See SIFMA Letter at p. 1 (``reforms may be necessary to
ensure that securitization transaction parties are not creating and
selling asset-backed securities (`ABS') that are intentionally
designed to fail or default and profiting from the failure or
default of such ABS.''). See also, ASF Letter at p. 5 (a material
conflict exists if the ABS ``is created primarily to enable such
[securitization participant] to profit from a related or subsequent
transaction as a direct consequence of the adverse credit
performance of such asset-backed security.'').
---------------------------------------------------------------------------

    We highlight the reference in our proposed test to the requirement
that a securitization participant would benefit directly or indirectly
from the actual, anticipated or potential decline in the value of the
ABS (or underlying assets). If a securitization participant effected a
short transaction in the ABS, it would not be necessary for the market
value of the ABS to actually decline in order for a ``material conflict
of interest'' to arise. It would be sufficient that the securitization
participant engaged in a transaction under which it would benefit if
the market value of the ABS were to decline.\69\
---------------------------------------------------------------------------

    \69\ We also understand that a securitization participant may
engage in a short transaction, for example, in the context of
market-making or in the context of hedging assets being pooled to
create an ABS. If such activities qualify for the proposed
exceptions in the rule discussed below--i.e., the exceptions for
bona fide market-making and risk-mitigating hedging--they would be
permitted.
---------------------------------------------------------------------------

    We recognize that--like other prophylactic conflict of interest
rules--the proposed rule and interpretation might limit certain
investment activities that might otherwise be made for bona fide
purposes. For example, it is possible for a securitization participant
and investors in an ABS who have complete access to information
regarding the underlying assets simply to have different views
regarding the future prospects for those assets, based on their
independent analysis of market and commercial trends or other factors.
For example, an investor may believe that the assets will perform well,
but the securitization participant may believe that the assets will
perform poorly. In this case, restricting or prohibiting the
securitization transaction would limit the ability of both the investor
and the securitization participant to transact freely based on their
respective views of the underlying assets (even though they might make
the same investment choice if they were not involved in the
securitization). We therefore acknowledge the concern that this
proposal might have unintended effects, such as potentially limiting
investment opportunities for investors if a securitization participant
refrains from structuring and selling ABS in reaction to this proposal.
We seek commenter input below concerning the extent to which such
unintended effects might occur, and any potential impacts, including
any impact on investors, investor protection, liquidity, capital
formation, the maintenance of fair, orderly and efficient markets and
the availability of credit to borrowers (through assets underlying an
ABS).
    On the other hand, in the context of a securitization transaction,
the securitization participant is generally seeking to sell to
investors a particular investment view regarding the underlying assets,
in the form of the ABS. In this sense, the proposed rule and
interpretation would help prohibit the securitization participant from
structuring and offering the ABS to investors on the premise that it
will be a good investment when the securitization participant has
either structured the transaction in a manner that is designed to fail
or takes other actions (i.e., entering into a short transaction)
through which it will profit from such failure. Moreover, the proposed
prohibition would be all the more important given that as a practical
matter investors in the ABS may not have as much information regarding
the underlying assets as the securitization participant, and may be
drawing inferences regarding the quality of the assets based on the
involvement and marketing efforts of the securitization participant in
the transaction as well as any other information provided by the
securitization participant. We seek commenter input regarding potential
benefits, including benefits for investors, investor protection,
liquidity, capital formation and the maintenance of fair, orderly and
efficient markets that might ensue as a result of the proposed
interpretation and how these potential benefits may impact any
unintended consequences referenced above.
    Nothing in the proposed interpretation would prevent a
securitization participant from taking positions in which its economic
interests would be aligned with the investors in the ABS it has created
and sold--such as by purchasing the ABS.\70\ While the proposed
interpretation would cover benefiting from the adverse performance of
the asset pool supporting the ABS, we note that the proposed
interpretation would not

prevent a securitization participant's transactions in the securities
of a lender whose mortgage pools are included or referenced in an ABS
because the proposal is focused solely on the ABS and its underlying
portfolio.
---------------------------------------------------------------------------

    \70\ See SIFMA Letter at p. 3 (a transaction or activity should
not be prohibited under Securities Act Section 27B if ``such
transaction or activity represents an overall alignment of risk to
the ABS or underlying assets similar to that borne by investors of
the ABS'').
---------------------------------------------------------------------------

b. Item 1(B) of ``Material Conflict of Interest'' Test
    If a securitization participant would not benefit in the manner set
forth in item 1(A) of the material conflict of interest test, one must
determine whether the securitization participant would benefit in the
manner set forth under item 1(B) of that test. A benefit under either
item 1(A) or 1(B) would satisfy item 1 of the test.
    Engaging in a transaction would involve or result in a material
conflict of interest arising as a result of or in connection with a
transaction if a securitization participant who directly or indirectly
controls the structure of the relevant ABS or the selection of assets
underlying the ABS 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 as described
above.\71\
---------------------------------------------------------------------------

    \71\ For purposes of item 1(B), we interpret the statutory
reference to a securitization participant ``engaging in a
transaction'' to include circumstances where the securitization
participant, although not itself a party to a transaction as
contemplated by item 1(A), would benefit directly or indirectly 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.
---------------------------------------------------------------------------

    In certain circumstances, a third party might directly or
indirectly select assets underlying an ABS or structure the ABS
transaction through its relationship with a securitization participant.
In these situations, it is possible that the third party, rather than
the securitization participant, might enter into a short transaction of
a type that would be prohibited for the securitization participant
itself under our proposed rule and interpretation. For example, the
third party might select assets for the securitization transaction that
it anticipates will perform poorly, and then enter into a short
transaction on the ABS in order to benefit from the anticipated decline
in the market value of the ABS or its underlying assets.
    The securitization participant would not necessarily be a party to
the short transaction, and therefore might not directly profit from
that short transaction due to any future adverse performance of the ABS
or its underlying assets. However, the securitization participant may
be incentivized to leverage the role it plays in selecting assets
underlying the ABS to seek other benefits. For example, the
securitization participant might benefit (e.g., through compensation,
the promise of future business, or other forms of remuneration from
either the third party or the ABS) by allowing a third party to select
the assets in the manner described, and in so doing would effectively
benefit by having permitted the third party to potentially profit from
a related short transaction. This would result in a material conflict
of interest between the securitization participant and investors in the
ABS of the type that Section 27B is intended to prohibit. Item 1(B)
would apply because 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 item 1(B), a securitization participant could not create an
opportunity for a third party to engage in any transaction that the
securitization participant itself would not be permitted to engage in
under item 1(A) of the proposed interpretation.\72\
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    \72\ We note for clarity that in order for a transaction to be a
material conflict of interest under item 1(B), the third party would
actually need to effect a short transaction. Thus, with respect to
both items 1(A) and 1(B), the material conflict of interest test
contemplates the existence of a short transaction by the
securitization participant or the third party, as applicable.
---------------------------------------------------------------------------

    Given that Section 27B and our proposed rule apply to
securitization participants, the burden of compliance with these
requirements would fall on the securitization participant that directly
or indirectly controls the structure of the relevant ABS or the
selection of assets underlying the ABS and who then permits or
facilitates the involvement of a third party in those aspects of the
transaction. We recognize that in certain instances there might be
practical challenges for securitization participants seeking to
determine whether they are subject to this restriction, or whether the
involvement of third parties in a securitization transaction complied
with the proposed rule. For example, in certain cases there might be
practical difficulties for a securitization participant in determining
whether a third party that was involved in selecting the underlying
assets or the structuring of the ABS might also engage in prohibited
short transactions. While securitization participants could use
different tools to manage these practical difficulties, we
preliminarily believe that when reasonable to do so, securitization
participants could rely on appropriate contractual covenants or
representations, either between themselves or with the relevant third
parties, to determine compliance with our proposed rule. For example,
if a third party were involved in selecting the underlying assets or
structuring the ABS, where reasonable to do so a securitization
participant could 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 any short transactions that would be prohibited if engaged in by a
securitization participant in the relevant offering.
    Of course, it would not be necessary for a securitization
participant to obtain such contractual assurances--for example, in
circumstances where it did not have any reasonable basis to believe
that a third party would engage in a short transaction in a way that
would violate our proposed rule.
c. Item 2 of ``Material Conflict of Interest'' Test
    Item 2 of the proposed interpretation, which requires ``a
substantial likelihood that a reasonable investor would consider the
conflict important to his or her investment decision,'' is intended to
require that the potential implications of the relevant conflict be
sufficiently important as to warrant the prohibition imposed under the
proposed rule. We preliminarily do not believe it would be appropriate
to interpret the proposed rule so broadly as to prohibit all
transactions that give rise to any conflict of interest, even if the
potential benefits of such transactions for the securitization
participant were so minimal as to be unimportant to a reasonable
investor.
    We note that in considering whether there is a substantial
likelihood that a reasonable investor would consider the conflict
important to his or her investment decision, it is not possible to
designate in advance certain facts or occurrences as determinative in
every instance.\73\ Rather the proposed interpretation would require an
assessment of the inferences that a reasonable investor would draw from
a

given set of facts and circumstances.\74\ It would be appropriate,
however, to consider both the probability that the securitization
participant would receive a benefit and the magnitude of the
benefit.\75\ Thus, for example, it is possible that a securitization
participant might stand to benefit substantially from a decline in the
value of the ABS, but the probability of its receiving such benefit
under the circumstances might be so small that a reasonable investor
would not consider the conflict important to his or her investment
decision.
---------------------------------------------------------------------------

    \73\ Basic v. Levinson, 485 U.S. at 236 (``Any approach that
designates a single fact or occurrence as always determinative of an
inherently fact-specific finding such as materiality, must
necessarily be overinclusive or underinclusive.'').
    \74\ Id. (citing TSC Industries, Inc. v. Northway, Inc., 426
U.S. 438, 450 (1976)).
    \75\ Id. at 238 (citing SEC v. Texas Gulf Sulphur, Co., 401 F.2d
833, 849 (2d Cir. 1968) (en banc), cert. denied, sub nom Coates v.
SEC, 394 U.S. 976 (1969)).
---------------------------------------------------------------------------

    Although the proposed interpretation uses a materiality formulation
that is also used under the federal securities laws for determining
whether disclosure is necessary--i.e., whether there is a substantial
likelihood that a reasonable investor would consider the issue
important to his or her investment decision--the use of this phrase in
this context is not intended to suggest that a transaction otherwise
prohibited under the proposed rule would be permitted if there were
adequate disclosure by the securitization participant. We note in this
regard that there may be practical challenges in relying on disclosure
as a means to address all transactions involving a material conflict of
interest--including in particular certain transactions arising after
the offering documents have been disseminated but before the one-year
timeframe covered by the proposed rule has elapsed.\76\ Nevertheless,
we request comment as to whether and to what extent adequate disclosure
of a material conflict of interest should affect the treatment under
the proposed rule of an otherwise prohibited transaction.
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    \76\ See infra Question 98.
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Request for Comments Regarding Material Conflicts of Interest
    32. We seek comment regarding any potential consequences of not
defining the term ``material conflict of interest'' in the proposed
rule text and instead proposing an interpretation in the context of the
proposed rule. Please discuss whether or not there may be an unintended
chilling effect on securitization transactions resulting from potential
uncertainty associated with not defining material conflict of interest.
If you believe the Commission should define ``material conflict of
interest,'' please provide a suggested definition and the rationale as
to why such definition identifies the conflicts that the proposed rule
is intended to address.\77\ Is it likely or unlikely that such a
definition would be able to anticipate all future material conflicts of
interest? Would such a definition lead to unintended consequences, such
as excluding from the proposed prohibition certain activities
undertaken by securitization participants that involve material
conflicts of interest? Or would such a definition be over-inclusive and
encompass activities undertaken by securitization participants that do
not involve material conflicts of interest?
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    \77\ See, e.g., ASF Letter at p. 5 (suggesting that a material
conflict of interest ``shall exist, if other than for hedging
purposes or as permitted by Section 27B(c) of the Securities Act of
1933, (i) A [securitization participant] participates in the
issuance of an asset-backed security that is created primarily to
enable such [securitization participant] to profit from a related or
subsequent transaction as a direct consequence of the adverse credit
performance of such asset-backed security and (ii) within one year
following the issuance of such asset-backed security, the
[securitization participant] enters into such related or subsequent
transaction.'').
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    33. Is the distinction suggested by commenters between conflicts
that are inherent in the securitization process and those that are not
a meaningful one? \78\ Is this proposed distinction useful for purposes
of defining the scope of Securities Act Section 27B? Are there other
ways to distinguish between different conflicts of interest that the
Commission should take into account in considering the scope of Section
27B? Would a reasonable investor understand the difference between
conflicts of interest that are inherent in the offering process and
those that are not? \79\ Would the reasonable expectations of an
investor in an ABS offering be a useful test for determining which
conflicts of interest are material?
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    \78\ See supra Section IIB.
    \79\ Id.
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    34. Is the proposed interpretation regarding what constitutes a
material conflict of interest appropriate? Should the interpretation be
broader or narrower? Please suggest alternative interpretations for
what would constitute material conflicts of interest for purposes of
the proposed rule and explain why such interpretations would better
identify transactions that involve or result in material conflicts of
interest. In addition to the magnitude of a benefit and the probability
that it will occur, are there additional (or alternative) factors that
should be considered in assessing whether there is a substantial
likelihood that a reasonable investor would consider the conflict
important to his or her decision to invest?
    35. Should the proposed interpretation extend to indirect or
unforeseeable benefits to a securitization participant? Please explain
why or why not. How would a securitization participant determine that
there was no such indirect or unforeseeable benefit?
    36. Are there circumstances in which facilitating a third party to
benefit from the adverse performance of the ABS or underlying assets
would not be a material conflict of interest? Please explain.
    37. We seek commenter input regarding the potential use of
contractual provisions and covenants by securitization participants to
manage their compliance with the proposed rule, as well as a discussion
of how a securitization participant would determine that no contractual
assurance was necessary.
    38. As an alternative, would it be appropriate to prohibit a
securitization participant from allowing a third party, directly or
indirectly, to structure the relevant ABS or select assets underlying
the ABS (absent contractual provisions) if the involvement of the third
party in the ABS transaction or the actions of the third party
unrelated to the ABS transaction constituted a material conflict of
interest with the investors in the ABS transaction (regardless of
whether or not the securitization participant benefitted)?
    39. Some commenters asserted that the prohibited conduct should be
limited to creating and selling an ABS that is ``intentionally designed
to fail or default'' \80\ or creating and selling an ``intentionally
flawed'' ABS so that a securitization participant can profit from a
related or subsequent transaction.\81\ As one commenter suggested,
should the test focus on whether ``(i) Such transaction or activity
represents an overall alignment of the risk to the ABS or underlying
assets similar to that borne by investors of the

ABS, (ii) such transaction or activity is unrelated to the
[securitization participant's] role in the specific ABS, (iii)
disclosure of the transaction or activity of the [securitization
participant] adequately mitigates the risk posed by the potential or
actual conflict with respect to any investors in the ABS or (iv)
another regulatory regime applies with respect to the potential or
actual conflict of interest''? \82\ Is such a formulation for the
proposed rule appropriate? Please explain. Would such a test be over-
inclusive and encompass activities that do not involve or result in
material conflicts of interest? Would such a test be under-inclusive
and fail to cover activities that are intended to be prohibited by
Section 27B and the proposed rule? What other approaches would provide
a substantially similar or higher level of investor protection as the
proposed rule?
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    \80\ See SIFMA Letter at p. 2.
    \81\ See ASF Letter at p. 5 (``the definition of `material
conflicts of interest' should prohibit those types of transactions
identified by Senators Merkley and Levin that create conflicts of
interest by creating intentionally flawed asset-backed securities.''
Specifically, the commenter suggested that a material conflict of
interest exists ``if, other than for hedging purposes or as
permitted by Section 27B(c) of the Securities Act of 1933, (i) A
[securitization participant] participates in the issuance of an
asset-backed security that is created primarily to enable such
[securitization participant] to profit from a related or subsequent
transaction as a direct consequence of the adverse credit
performance of such asset-backed security and (ii) within one year
following the issuance of such asset-backed security, the
[securitization participant] enters into such related or subsequent
transaction.'').
    \82\ SIFMA Letter at p. 3.
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    40. Are there transactions inherent in the securitization process
that would be material conflicts of interest under the proposed
interpretation that were not intended to be prohibited by Section 27B?
Or, are there transactions inherent in the securitization process that
would not fall within the proposed interpretation and the proposed rule
that should be prohibited under Section 27B and application of the
proposed rule? Please identify and provide an explanation of these
activities as well as an explanation of why they should or should not
be prohibited under Section 27B and the proposed rule. We ask that
commenters address each of the activities set forth in initial comment
letters as described in Section II.B as well as activities not
addressed by initial comment letters.
    41. Are modifications to the proposed rule or interpretation,
consistent with the statute, necessary or advisable to mitigate any
such unintended consequences?
    42. Is the phrase ``fees or other forms of remuneration, or the
promise of future business, fees or other forms of remuneration'' too
narrow or too broad, or is it appropriate? Are there benefits to the
securitization participant that would not be captured by this phrase?
Should the proposal specifically address the anticipation or
expectation of or attempts to induce such benefits? Please explain why
or why not.
    43. We ask commenters to discuss whether or not the proposal would
prohibit any person ``engag[ing] in any transaction'' that commenters
believe should be permitted under Section 27B of the Securities Act? If
such activity were prohibited, please discuss any potential impact,
including any impact on investors, investor protection, liquidity,
capital formation and the maintenance of fair, orderly and efficient
markets.
    44. We seek commenter input regarding whether the phrase used in
item 1(B) ``directly or indirectly controls the structure of the
relevant ABS or the selection of assets underlying the ABS'' is
appropriate, under- or over-inclusive. Please provide examples of
persons who would not be identified by this phrase that you believe
should be subject to the proposed rule. Please provide examples of
persons that would be identified using this phrase that you believe
should not be subject to the proposed rule. Would the phrase
``exercises control over the structure of the relevant ABS or the
selection of assets underlying the ABS'' be more appropriate? Please
explain why or why not. Would the phrase ``has substantial control over
the relevant ABS or the selection of assets underlying the ABS'' be
more appropriate? Please explain why or why not. Would the phrase
``influences the structure of the relevant ABS or the selection of
assets underlying the ABS'' be more appropriate? Please explain why or
why not. We seek commenter suggestions on alternative language and an
explanation of why it would be more appropriate in this context. Please
include in your responses a discussion of whether any alternative
option would be over- or under-inclusive and provide examples of
persons who would not be identified by the alternatives that you
believe should be subject to the proposed rule as well as examples of
persons who would be identified by alternatives but that you believe
should not be subject to the proposed rule.
    45. Is the proposed application of the prohibition under Section
27B to securitization participants if third parties, directly or
indirectly, structure the relevant ABS or select assets underlying the
ABS appropriate? Should the restrictions be placed on a broader
category of activities or a more delineated one? Should we define the
phrase ``directly or indirectly, to structure the relevant ABS or
select assets underlying the ABS'' used in item 1(B)? If yes, please
provide a suggested definition and the rationale as to why such
definition would be appropriate.
    46. We seek commenter input regarding whether the phrase used in
item 1(B) ``as a result of allowing a third party, directly or
indirectly, to structure the relevant ABS or select assets underlying
the ABS'' is appropriate, over- or under-inclusive. Please provide
examples of persons who would not be identified by this phrase that you
believe should be. Please provide examples of persons that would be
identified using this phrase that you believe should not be. Would the
phrase ``as a result of allowing a third party, directly or indirectly,
to influence the structure of the relevant ABS or the selection of
assets underlying the ABS'' be more appropriate? Please explain. Would
the phrase ``as a result of allowing a third party, directly or
indirectly, to substantially influence the structure of the relevant
ABS or the selection of assets underlying the ABS'' be more
appropriate? Please explain. We seek commenter suggestions on
alternative language and an explanation of why it would be more
appropriate in this context.

B. Statutory Exceptions

    Consistent with Securities Act Section 27B, proposed Rule 127B(b)
would provide exceptions to the prohibition in proposed Rule 127B(a)
for risk-mitigating hedging activities, liquidity commitments, and bona
fide market-making. We have modeled the proposed exceptions on the text
of Section 27B of the Securities Act.
i. Risk-Mitigating Hedging Activities
    Pursuant to the proposed rule, the following would not be
prohibited by paragraph (a) of the proposed rule:

    Risk-mitigating hedging activities in connection with positions
or holdings arising out of the underwriting, placement, initial
purchase, or sponsorship of an asset-backed security, provided that
such activities are designed to reduce the specific risks to the
underwriter, placement agent, initial purchaser, or sponsor
associated with such positions or holdings.

    The proposed exception for risk-mitigating hedging activities uses
the language set forth in Section 27B(c)(1).\83\ The goal of this
proposed exception is to allow certain hedging activities that are
designed to reduce or mitigate risk for the underwriter, placement
agent, initial purchaser, or sponsor, where risk mitigation refers to
the practice of limiting the consequences of a risk, without
necessarily reducing the probability of the risk occurring. For
example, firms engage in risk-mitigating hedging as they pool assets to
create ABS. The assets are assembled over time and firms hedge the
specific risk of a price decline of the assets being assembled for the
pool while the pool is

formed. This type of activity would fall within the proposed exception.
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    \83\ We did not incorporate the second use of the phrase
``arising out of such underwriting, placement, initial purchase or
sponsorship'' to streamline the proposed rule text, and intend no
substantive change from Section 27B(c)(1).
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    Although the exception in Section 27B(c)(1) by its terms does not
address affiliates and subsidiaries, the Commission preliminarily
believes that, since affiliates and subsidiaries of securitization
participants are included in the list of persons who are prohibited
from engaging in the type of activity specified in Section 27B they too
should have the benefit of the proposed exception for risk-mitigating
hedging activities. Therefore, the Commission would interpret the
exception as applying to affiliates and subsidiaries of securitization
participants.
    The proposed exception is not intended to permit speculative
trading masked as risk-mitigating hedging activities.\84\ Generally,
risk-mitigating hedging is effected to reduce risk from an existing
position or a position about to be taken.\85\ The risk-mitigating
hedging activities would be required to occur in connection with
positions or holdings arising out of the underwriting, placement,
initial purchase, or sponsorship of an ABS.\86\ In addition, the
activities would be required to be designed to reduce the specific risk
to the underwriter, placement agent, initial purchaser, or sponsor
associated with positions or holdings as mandated by Section 27B. Risk-
mitigating hedging may include a series of hedging transactions, based
on the price movements of the underlying assets, in order to remain
delta-neutral.\87\ Risk-mitigating hedging does not include trading to
establish new positions designed to earn a profit.\88\ That activity
might be an indicator of speculation.\89\
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    \84\ Similar concepts are used in proposed Exchange Act Rule
3a67-4 which defines the term ``hedging or mitigating commercial
risk.'' For example, Rule 3a67-4(b)(1) provides that ``[s]uch
position is: (i) [n]ot held for a purpose that is in the nature of
speculation, investing or trading'' Release No. 34-63452 (Dec. 7,
2010), 75 FR 80174, 80215 (Dec. 21, 2010).
    \85\ See infra Section IIIE (discussing the potential interplay
with the Volcker Rule). Similar concepts are used in connection with
risk-mitigating hedging with respect to the Section 619 of the Dodd-
Frank Act, commonly referred to as the Volcker Rule. ``Risk-
mitigating hedging is defined by two essential characteristics; (i)
The hedge is tied to a specific risk exposure, and (ii) there is a
documented correlation between the hedging instrument and the
exposure it is meant to hedge with a reasonable level of hedge
effectiveness at the time the hedge is put in place.'' Financial
Stability Oversight Council, Study & Recommendations on Prohibitions
on Proprietary Trading & Certain Relationships with Hedge Funds &
Private Equity Funds (Jan. 2011)(``FSOC Study''), at p. 30,
available at http://www.treasury.gov/initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.pdf.
    \86\ Risk-mitigating hedging would also be permitted in