Document ID: SEC-2011-1447-0001
Agency: sec
Document Type: Proposed Rule
Title: Prohibition against Conflicts of Interest in Certain Securitizations
Posted Date: 2011-09-28T04:00Z

[Federal Register Volume 76, Number 188 (Wednesday, September 28, 2011)]
[Proposed Rules]
[Pages 60320-60350]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-24404]

[[Page 60319]]

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 rule-comments@sec.gov. 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 (202) 551-5720, and David Beaning, Special Counsel and 
Katherine Hsu, Chief, Office of Structured Finance, Division of 
Corporation Finance, at (202) 551-3850, 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

[[Page 60321]]

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

[[Page 60322]]

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

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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

[[Page 60324]]

```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\
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    \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'').
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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).
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    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.

[[Page 60325]]

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.
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    \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.
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    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.
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    \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

[[Page 60326]]

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

[[Page 60327]]

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

[[Page 60328]]

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).
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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\
---------------------------------------------------------------------------

    \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.

[[Page 60329]]

    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

[[Page 60330]]

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

[[Page 60331]]

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

[[Page 60332]]

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)).
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    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.
---------------------------------------------------------------------------

    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

[[Page 60333]]

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.
---------------------------------------------------------------------------

    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

[[Page 60334]]

formed. This type of activity would fall within the proposed exception.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

    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 
connection with market-making to the extent it relates to positions 
taken in connection with the permitted activity.
    \87\ See, e.g., FSOC Study at p. 30 (``hedging activity should 
adjust over time'').
    \88\ See, e.g., id. at p. 20 (hedging ``presents a potential 
avenue to evade the proprietary trading prohibition if hedges do not 
correlate with owned assets or if a banking entity seeks an 
independent return through the application of the hedge'') (emphasis 
added).
    \89\ See, e.g., William L. Silber, On the Nature of Trading: Do 
Speculators Leave Footprints?, 29 Journal of Portfolio Management 4, 
64 (Summer 2003) (``Silber'') (describing speculation as trading in 
anticipation of future prices and taking on the risk of 
unanticipated equilibrium price movements in order to earn profits). 
In addition, we note that these statements are only intended to 
describe trading that may not qualify for the proposed exception. 
These statements are not intended to opine on the permissibility of 
speculative trading in other contexts.
---------------------------------------------------------------------------

    Material changes in risk should generate a corresponding change in 
risk-mitigating hedging.\90\ Moreover, a risk-mitigating hedge 
generally should unwind as exposure is reduced. Over-hedged exposure 
may be indicative of a proprietary position rather than a risk-
mitigating hedge. Intermittent activity (hedging only when one chooses 
to act) or activity that is inconsistent with a hedging policy is also 
indicative of proprietary trading. Typically, the hedge should not be 
significantly greater than actual exposure to the underlying assets. 
The hedge (e.g., the notional amount under the hedge) should be 
correlated so that losses (gains) on the position being hedged are 
offset by gains (losses) on the hedge without appreciable differences. 
The Commission preliminarily believes that activity would not qualify 
as a risk-mitigating hedge for purposes of the proposed rule if the 
predicted performance of the hedge throughout the length of time that 
the hedge and the related position were held, resulted in a situation 
in which incrementally poor performance of an ABS or its underlying 
assets would result in a securitization participant earning appreciably 
more profits on the hedge than the losses incurred from their ABS 
exposure.
---------------------------------------------------------------------------

    \90\ Risk-mitigating hedging indicia are considered in 
connection with the Volcker Rule. ``Hedging activity should be 
designed to reduce the key risk factors in the banking entities' 
existing exposure, and should offset gains or losses that would 
arise from those exposures. Hedging activity should adjust over time 
based on changes in a banking entity's underlying exposures. Hedging 
activity should adjust over time if market conditions alter the 
effectiveness of the hedge even if the underlying positions remain 
unchanged. Material changes in risk should generate a corresponding 
change in hedging activity and should be consistent with the desk's 
hedging policy.'' FSOC Study, at p. 30.
---------------------------------------------------------------------------

    We seek comment on the application of the proposed exception to 
``mitigating'' the consequences of a risk as intended by Congress.
Request for Comments Regarding Risk-Mitigating Hedging Activities
    47. It has been argued that firms must hedge actual risks created 
by actual positions that left them with actual exposures.\91\ Please 
discuss how such exposures arise and how they might be defined. Section 
27B uses only the terms ``positions or holdings.'' Please discuss 
application of Section 27B and the proposed rule to exposures. Is there 
any difference between ``positions or holdings'' and ``actual risks 
created by actual positions'' and ``actual exposures''? If yes, please 
discuss the application of the proposed rule in light of such 
difference.
---------------------------------------------------------------------------

    \91\ See, e.g., Jeff Merkley, U.S. Senator and Carl Levin, U.S. 
Senator, Making the Dodd-Frank Act Restrictions On Proprietary 
Trading & Conflicts of Interest Work, available at http://www.rooseveltinstitute.org/%5Bmenu-trail-parents-raw%5D/making-dodd-frank-act-restrictions-proprietary-trading-and-conflicts-intere#.
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    48. Please discuss whether clarifying interpretations concerning 
the terms ``mitigate'' and ``exposures'' would be consistent with 
prohibiting material conflicts of interest. Please discuss whether such 
interpretations would narrow or broaden the exception in a manner that 
is inconsistent with the purpose of Section 27B. Please discuss whether 
additional interpretations would be needed.
    49. We seek comment regarding whether or not there are concerns 
about the level of transparency for risk-mitigating hedging activities 
and whether there are ways to assure the transparency of risk-
mitigating hedging, such as through the use of standardized 
instruments.
    50. Please describe whether, and if so, how firms engaging in 
securitization transactions currently distinguish risk-mitigating 
hedging from other activity.
    51. We seek comment concerning the type of activity that would fall 
within the proposed exception under the proposed rule. Please discuss 
how firms currently identify risks associated with securitization 
transactions. Please discuss how firms currently hedge such risks 
(e.g., currency hedges, interest rate hedges, index hedges, credit 
derivatives). What policies or procedures are used to control, monitor, 
or manage those hedges? Should it be a condition to relying on the 
exception that the hedge was consistent with written, reasonably 
designed policies and procedures regarding risk-mitigating hedging 
activities? What types of instruments are used to hedge specific risks? 
When would securitization participants typically engage in risk-
mitigating hedging activities pursuant to the proposed

[[Page 60335]]

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

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

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

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

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

[[Page 60336]]

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

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

    The exception would permit purchases or sales of ABS to be made 
pursuant to and consistent with bona fide market-making in the ABS. The 
exception would be available to all securitization participants 
(including affiliates and subsidiaries of an underwriter, placement 
agent, initial purchaser, or sponsor of an ABS) that qualify for it if 
they engaged in bona fide market-making. We understand that the ABS 
market is typically an over-the-counter market, and ABS are not broadly 
distributed. We also understand that a few institutions may hold large 
positions in an ABS.
    In determining if activities qualify as bona fide market-making for 
purposes of proposed Rule 127B, we preliminarily believe that the 
following principles are characteristics of bona fide market-making in 
ABS:
     It includes purchasing and selling the ABS from or to 
investors in the secondary market.
     It includes holding oneself out as willing and available 
to provide liquidity on both sides of the market (i.e., regardless of 
the direction of the transaction).
     It is driven by customer trading, customer liquidity 
needs, customer investment needs, or risk management by customers or 
market-makers.
     It generally is initiated by a counterparty and if a 
customer initiated a customized transaction, it may include hedging if 
there is no matching offset.
     It does not include activity that is related to 
speculative selling strategies or investment purposes of a dealer, or 
that is disproportionate to the usual market-making patterns or 
practices of the dealer with respect to that ABS.
     Absent a change in a pattern of customer driven 
transactions, it typically does not result in a number of open 
positions that far exceed the open positions in the historical normal 
course of business.
     It generally does not include actively accumulating a long 
or short position other than to facilitate customer trading interest.
     It generally does not include accumulating positions that 
remain open and exposed to gains or losses for a period of time instead 
of being closed out promptly.\93\ In contrast, an aged open position 
taken to facilitate customer trading interest would be hedged rather 
than exposed to gains and losses for a period of time.\94\
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    \93\ Silber, supra note 90 (distinguishing market makers from 
other traders, such as speculators, using the following market-maker 
characteristics among others: (i) Customer-based traders who buy and 
sell assets to accommodate customer purchase and sale orders, (ii) 
earn money on the bid/ask spread without speculating on future 
prices, (iii) tend to close out positions quickly and thus have 
small losses on positions, (iv) reduce exposure to equilibrium price 
movements by minimizing the length of time they hold assets, and (v) 
avoid holding open positions).
    \94\ Similarly, indicia to be considered in connection with 
permitted market-making in less liquid markets under the Volcker 
Rule includes ``[p]urchasing or selling the financial instrument 
from or to investors in the secondary market; [h]olding oneself out 
as willing and available to provide liquidity on both sides of the 
market (i.e., regardless of the direction of the transaction); 
[t]ransaction volumes and risk proportionate to historical customer 
liquidity and investment needs; and [g]enerally does not include 
accumulating positions that remain open and exposed to gains or 
losses for a period of time instead of being promptly closed out or 
hedged out to the extent possible. For example, an aged open 
position taken to facilitate customer trading interest would be 
hedged rather than exposed to gains and losses for a period of 
time.'' See, FSOC Study, p. 29. See infra Section IIIE (discussing 
the potential interplay with the Volcker Rule).
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    In addition, we note that the fact that trading is carried out in a 
market-making account or on a market-making desk would not be 
determinative of whether such trading is bona fide market-making in 
ABS. The account type or desk would not govern the analysis, since 
otherwise a market-making account or desk might be used in an attempt 
to disguise proprietary trading as bona fide market-making.
    We seek comment as to whether the above principles accurately 
identify the characteristics of bona fide market-making in ABS or 
whether different or additional characteristics might better identify 
this activity. We seek comment regarding how utilizing the principles 
listed above in determining whether activity was bona fide market-
making in ABS would affect principal trading and the provision of 
liquidity by market intermediaries. Please provide examples of 
principal trading that would qualify for the exception as well as 
principal trading that would not qualify for the exception.
    We note that the applicability of this proposed guidance concerning 
bona fide market-making is specific to bona fide market-making in ABS 
and may or may not be applicable in other areas of the federal 
securities laws and rules, in self-regulatory organization (``SRO'') 
rules or in connection with other provisions of the Dodd-Frank Act.\95\
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    \95\ Previously, we provided guidance that indicia of ``bona-
fide market making'' for equity securities includes maintaining 
continuous two-sided quotes, among other things. See Release 34-
58775 (Oct. 14, 2008), 73 FR 61690, 61698 (Oct. 17, 2008). However, 
different factors may apply to ABS, given the differences between 
the markets in equities and ABS.
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    Depending on the facts and circumstances, bona fide market-making 
that does not meet each of these principles may still be bona fide 
market-making for purposes of the proposed exception. However, meeting 
just one factor might or might not be sufficient to qualify for the 
exception depending on the facts and circumstances.
    We preliminarily believe that these principles would be appropriate 
as they are aimed at customer trading, customer liquidity needs, 
customer investment interest, or risk management by customers or 
market-makers. We also preliminarily believe that these principles 
would be necessary in order to distinguish bona fide market-making with 
respect to ABS that qualifies for the exception from other trading. We 
recognize, however, that there could be additional principles that 
would better identify bona fide market-making that is consistent with 
the intent of the exception. We seek commenters' views on any such 
principles.
Request for Comments Regarding Bona Fide Market-Making
    74. We seek comment concerning the proposed indicators of bona fide 
market-making and any additional indicators of bona fide market-making 
with respect to ABS. We also seek comment concerning additional 
indicators of speculative or other trading masked as bona fide market-
making.
    75. Please provide specific, current examples of bona fide market-
making in connection with ABS and explain how such activity evidences 
the proposed characteristics of bona fide market-making. Please discuss 
activity that does not evidence the proposed characteristics of bona 
fide market-making but that should qualify for the exception and why.
    76. Please discuss whether there are features of ABS market-making 
that

[[Page 60337]]

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

C. Application of Material Conflict of Interest Test

    We set forth below examples of transactions that involve or that do 
not involve, as the case may be, potential conflicts of interest and 
describe how our proposed test for identifying material conflicts of 
interest for purposes of Section 27B and our proposed rule would apply 
to such transactions. We note that these examples are merely 
illustrative, and even minor differences in the facts and circumstances 
could change the analysis of these transactions. We further note that 
the examples below are intended only to illustrate the application of 
the proposed rule, and are not intended to address the application of 
other laws, rules or regulations to the relevant transactions. The 
conduct depicted in the examples might or might not violate provisions 
of the securities laws or rules that are not discussed here.
    In the following examples, we focus primarily on items 1(A) and (B) 
of the interpretation as to whether a transaction involves or results 
in a material conflict of interest: First, whether under the 
transaction the securitization participant ``would benefit directly or 
indirectly from the actual, anticipated or potential (1) Adverse 
performance of the asset pool supporting the relevant ABS, (2) loss of 
principal, monetary default or early amortization event on the ABS, or 
(3) decline in the market value of the relevant ABS''; or second, 
whether under the transaction the securitization participant ``would 
benefit directly or indirectly from fees or other forms of 
remuneration, or the promise of future business, fees, or other forms 
of remuneration, as a result of allowing a third party, directly or 
indirectly, to structure the relevant ABS or select assets underlying 
the ABS in a way that facilitates or creates an opportunity for that 
third party to benefit from a short transaction.'' We assume for 
purposes of discussion that, unless otherwise specified, the 
materiality requirement for our proposed interpretation is satisfied--
i.e., there is a substantial likelihood that a reasonable investor 
would consider the conflict important to his or her investment 
decision. In addition, unless otherwise indicated in these examples, we 
assume that the exceptions under the proposed rule (e.g., bona fide 
market-making or risk-mitigation hedging activities) would not be 
available.
Example 1--Securitization Participant Effecting a Short Transaction in 
an ABS, or any of the Assets Underlying an ABS
    In Example 1, an ABS underwriter purchases CDS protection on the 
securities offered in the relevant ABS three months after the date of 
the first closing of the sale of the ABS. For these purposes, assume 
that the ABS meets the definition of an asset-backed security in 
Section 3(a)(77) of the Exchange Act and the underwriter's purchase of 
CDS protection was made solely for its own proprietary investment 
purposes and does not qualify for any exception in the proposed 
rule.\96\
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    \96\ For example, the underwriter had no client that requested 
the long CDS exposure such that the purchased CDS protection could 
qualify for the bona fide market-making exception.
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    The underwriter is a covered person as one of the enumerated 
securitization participants in the proposed rule. The ABS is a covered 
product because it meets the Section 3 definition of ABS in the 
Exchange Act. The purchase of CDS protection is a transaction for 
purposes of the proposal which occurred prior to one year after the 
date of the first closing of the sale of the ABS. Therefore, the 
transaction occurred within the covered timeframe.
    In this example, the purchase of the CDS protection by the 
securitization participant is a short transaction within the covered 
timeframe that is prohibited by the proposed rule.\97\ This short 
transaction would involve a material conflict of interest between the 
securitization participant and the ABS investors because the 
securitization participant would profit from the adverse performance of 
the ABS.\98\
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    \97\ Nothing in the proposed rule would prohibit the 
securitization participant from purchasing the ABS or selling 
protection on the ABS or the assets underlying the ABS.
    \98\ However, if the short transaction was executed in the 
context of market-making by the securitization participant (e.g., 
the securitization participant purchases CDS protection from one 
customer to offset its sale of CDS protection to another customer), 
the exception under Rule 127B(b) would permit such market-making.
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Example 2--Securitization Participant Hedges Retained Investment in an 
ABS
    In Example 2, an ABS underwriter purchases ABS that it distributed 
and contemporaneously purchases CDS protection on the ABS. For these 
purposes, assume that the ABS meets the definition of asset-backed 
security in Section 3(a)(77) of the Exchange Act, and the underwriter 
uses the CDS to hedge its ABS position on a delta neutral basis, such 
that the potential gains on the hedged positions are not appreciably 
larger than the potential losses on that portion of the ABS investment 
that is being hedged at any point in the future.
    The underwriter is a covered person as one of the enumerated 
securitization participants in the proposed rule. The ABS is a covered 
product because it meets the Section 3 definition of ABS in the 
Exchange Act. The purchase of CDS protection is a transaction, which 
for purposes of the proposal occurred within the covered timeframe--
i.e., prior to one year after the date of the first closing of the sale 
of the ABS.
    In this case, the proposed risk-mitigating hedging activities 
exception could apply, because the securitization participant is 
hedging a position arising out of the underwriting, placement,

[[Page 60338]]

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

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

[[Page 60339]]

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

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

[[Page 60340]]

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

D. Application of the Proposed Rule to Other Activities

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

    We believe that activities associated with the typical structuring 
of a non-synthetic ABS would not be prohibited by the proposed rule. 
For example, the basic transfer of risk in a non-synthetic ABS in which 
a securitization participant who is long the underlying assets sells 
them to an SPE is typical of most ABS structures and would not 
constitute a prohibited transaction, because after such sale the 
securitization participant would not benefit from the subsequent 
decline in the value of the ABS or the underlying assets. Additionally, 
the proposed rule would not prohibit the multi-tranche structure 
commonly used in securitization transactions. While investors in 
different tranches may have interests that conflict with each other, 
such conflicts would fall outside the scope of the proposed rule, which 
is focused on conflicts of interest between securitization participants 
and ABS investors. In addition, mere ownership by a securitization 
participant of the ABS would not constitute a material conflict of 
interest under the proposed rule, because such ownership by itself 
would not cause the securitization participant to benefit from the 
adverse performance of the asset-pool or the ABS; instead, the 
securitization participant would benefit from the positive performance 
of these assets.\108\
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    \108\ For this reason, we believe the proposed rule would not 
prohibit risk retention as required by Dodd-Frank Act Section 941. 
See supra note 19.
---------------------------------------------------------------------------

    Commenters stressed the importance of the ``material'' aspect of 
the phrase ``material conflict of interest'' in Section 27B and 
suggested that activities inherent in the securitization process 
evidence ``expected conflicts * * * but do not constitute the type of 
`material conflicts' intended to be regulated by Section 621.'' \109\ 
We preliminarily believe that many activities that these commenters 
identified as being inherent to the securitization process would not be 
prohibited by the proposed rule because they would not fall within its 
scope or would fall within one of the exceptions to the 
prohibition.\110\ Thus, we preliminarily agree that most activities 
undertaken in connection with the securitization process would not be 
prohibited by the proposed rule, including but not limited to: 
Providing financing to a securitization participant, deciding not to 
provide financing, conducting servicing activities, conducting 
collateral management activities, conducting underwriting activities, 
employing a rating agency, receiving payments for performing a role in 
the securitization, receiving payments for performing a role in the 
securitization ahead of investors, exercising remedies in the event of 
a loan default, exercising the contractual right to remove a servicer 
or appoint a special servicer, providing credit enhancement through a 
letter of credit, and structuring the right to receive excess spreads 
or equity cashflows.
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    \109\ SIFMA Letter at p. 4.
    \110\ See, e.g., SIFMA Letter.
---------------------------------------------------------------------------

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

[[Page 60341]]

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

E. Relationship to Volcker Rule

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

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

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

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

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

IV. Information Barriers, Disclosure, and Exemptions

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

A. Information Barriers

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

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

[[Page 60342]]

violation of Regulation M.\122\ In order for an affiliate to avail 
itself of the exception it must also obtain an annual, independent 
assessment of the operation of such policies and procedures.\123\ Like 
Rule 14e-5, it contains a restriction on common officers and 
employees.\124\
---------------------------------------------------------------------------

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

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

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

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

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

[[Page 60343]]

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

B. Disclosure

    While Securities Act Section 27B does not contain a disclosure 
provision, commenters discussed the extent to which disclosure might 
mitigate potential conflicts of interest in this context.\127\ 
Commenters stated that while there can be many potential conflicts of 
interest that arise in connection with securitization, most are not the 
type of material conflict of interest intended to be prohibited by 
Securities Act Section 27B.\128\ Commenters stated that many conflicts 
of interest that arise in the normal course of a securitization are 
often contemplated by investors and indeed may be disclosed to 
investors.\129\
---------------------------------------------------------------------------

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

    We seek comment concerning the role of disclosure in the context of 
Securities Act Section 27B and the proposed rule. Securitization 
participants typically provide various disclosures to investors in ABS, 
which generally should include appropriate disclosure as to conflicts 
of interest between investors and the securitization participant that 
would be material to investors.\130\ While we have not identified all 
circumstances in which a transaction potentially could be characterized 
as involving or resulting in material conflicts of interest within the 
meaning of the proposed rule and Securities Act Section 27B, we seek 
comment on whether certain types of conflicts relating to an investor 
could be managed through disclosure. We seek comment about the value of 
disclosure as a means to manage conflicts of interest, while keeping in 
mind the limits of disclosure.\131\ Various provisions of the federal 
securities rules and laws address actual and potential conflicts of 
interest in a variety of ways, including through the use of disclosure. 
We ask that commenters consider the use of the disclosure in the 
federal securities laws and rules or other areas, such as SRO rules, 
and reference those laws or rules and their experiences with those laws 
or rules in their responses to the questions below where applicable.
---------------------------------------------------------------------------

    \130\ We are not addressing the quality or adequacy of typical 
disclosures in ABS offerings, but are simply noting that such 
disclosure typically does occur in connection with such offerings.
    \131\ 156 Cong. Rec. S5899 (daily ed. July 15, 2010) (statement 
of Sen. Levin). In addition, we note that disclosure that is made 
subsequent to an ABS transaction would not be appropriate in 
managing conflicts of interests because an investor would have 
already made an investment decision regarding whether or not to 
purchase the ABS.
---------------------------------------------------------------------------

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

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

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

[[Page 60344]]

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

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

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

C. Exemptive Authority

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

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

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

[[Page 60345]]

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

V. General Request for Comment

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

VI. Paperwork Reduction Act

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

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

A. Summary of Collections of Information

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

B. Proposed Uses of Information

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

C. Respondents

    According to issuance data from Asset-Backed Alert, supplemented 
with data from Securities Data Corporation (``SDC''), from 2005 through 
2010, there were approximately 751 registered asset-backed transactions 
yearly. Therefore, the Commission preliminarily estimates that there 
are approximately 751 securitization participant respondents that might 
enter into contractual covenants concerning the involvement of a third 
party in the transaction.\136\
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    \136\ We note that the actual number of respondents could be 
less than 751 as some respondents may be involved in more than one 
asset-backed transaction.
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    The Commission seeks comment as to the accuracy of the above 
estimates and all other estimates in this section. The Commission also 
seeks data regarding the yearly estimated number of unregistered asset-
backed transactions.

D. Total Annual Reporting and Recordkeeping Burdens

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

[[Page 60346]]

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

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

    To the extent there are not existing contracts in place between the 
securitization participants and third parties, we believe the proposed 
rule would impose more significant burdens and estimate that it would 
take approximately 20 internal hours and 20 external hours at a cost of 
$8,000 (using the estimated $400 per hour cost for outside legal 
services noted above) per contract to draft and negotiate the 
contractual covenant. In this instance, we estimate that the total 
annual burden would be approximately 7,500 internal burden hours (20 
hours x 375 contracts) and approximately $3.0 million ($8,000 per 
contract x 375 contracts) in external costs.
    In summary, we estimate that the collection of information would 
require an annual burden of 11,260 internal hours and $4.5 million in 
external costs.\138\
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    \138\ These costs are all monetized in the cost-benefit analysis 
section of this release. The estimated dollar costs for the internal 
hours are $3.6 million ($320 per hour x 11,260 hours), where the 
$320 per hour figure for a compliance attorney is from SIFMA's 
Management and Professional Earnings in the Securities Industry 
2010, modified by Commission staff to account for an 1800-hour work-
year and multiplied by 5.35 to account for bonuses, firm size, 
employee benefits and overhead. The total annual monetized PRA cost 
for the cost-benefit analysis is therefore $8.1 million ($3.6 
million in monetized internal costs + $4.5 million in external 
costs).
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E. Collection of Information Is Mandatory

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

F. Confidentiality

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

G. Request for Comment

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

VII. Economic Analysis

A. Introduction

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

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

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

B. Benefits

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

[[Page 60347]]

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

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

C. Costs

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

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

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

[[Page 60348]]

participate in a particular investment opportunity that it desires. A 
broad interpretation by market participants of the term ``material 
conflict of interest'' in the rule could therefore cause the 
securitization participant to lose profits or fees that would have 
resulted from the client's business with respect to the conflicting 
transaction and, potentially, future profits and fees if the client 
determines to take some of its future business to other firms, or might 
cause investors to lose investment opportunities they might otherwise 
have. We recognize that firms expend considerable time and resources to 
cultivate relationships with their clients and, thus, if the proposed 
rule were to diminish (beyond the statutory mandate in Securities Act 
Section 27B) existing relationships or impede the formulation of new 
relationships, the impacts of the proposed rule could be significant to 
firms and the broader marketplace.
    In addition, clients also could bear undesirable costs by losing 
the ability to utilize firms with particular expertise or 
specialization in certain areas due to real or perceived material 
conflicts of interest. Clients might also incur costs in searching for 
a different firm to consummate a transaction, where they have a 
preexisting relationship that they too have invested resources into 
developing. In addition, to retain their ability to utilize specific 
firms for non-ABS related transactions, some potential clients might 
choose to forego the ABS investment. We recognize that if the proposed 
rule were to cause an investor to forego an ABS investment entirely, 
there could be costs incurred by the investor in terms of seeking out 
alternative investments as well as the loss of return from the ABS 
investment. We seek commenter input regarding other costs that might be 
incurred by investors from foregoing an ABS transaction entirely.
    All securitization participants are subject to the proposed rule's 
prohibition on material conflicts of interest. Thus, although the 
inability to conduct a transaction that would result in a material 
conflict of interest between the securitization participant and 
investors in the ABS might have a negative impact on certain client 
relations and could require the client to go elsewhere to conduct the 
requested transaction, presumably all securitization participants and 
their clients would potentially encounter similar issues. As a result, 
while a securitization participant could lose the business of one 
client due to the proposed rule, in some cases it also could gain the 
business of another securitization participant's client, where that 
securitization participant could not conduct the transaction due to a 
material conflict of interest. Collectively, based upon the analysis 
above related to firm-client relationships, we acknowledge that the 
potential loss of customers could be more costly to firms than the 
potential gain of other clients.\142\ In turn, clients could incur 
costs in having to seek out new firms rather than utilizing firms with 
which they have preexisting, preferred business relationships. In sum, 
we recognize that both firms and clients could bear costs that may, in 
turn, impact the broader market, and we seek comment regarding these 
costs of the Commission's proposed rule.
---------------------------------------------------------------------------

    \142\ See, e.g., Myron B. Slovin, Marie E. Sushka & John A. 
Polonchek, The Value of Bank Durability: Borrowers as Bank 
Stakeholders, 48 J. Fin. 247 (1993); Mitchell A. Petersen & Raghuram 
G. Rajan, The Benefits of Firm-Creditor Relationships: Evidence from 
Small Business Data, 49 J. Fin. 3 (1994); Sreedhar Bharath, Sandeep 
Dahiya, Anthony Saunders & Anand Srinivasan, So What Do I Get? The 
Bank's View of Lending Relationships, 85 J. Fin. Econ. 368 (2007).
---------------------------------------------------------------------------

    Further, we recognize that there could be some instances in which 
the inability of a securitization participant to conduct a transaction 
that would result in a material conflict of interest could adversely 
affect the price of the ABS. Consistent with Section 27B, the proposed 
rule provides exceptions for risk-mitigating hedging activity, 
liquidity commitments, and bona fide market-making. A proposed 
transaction that results in a prohibited material conflict of interest, 
however, might not fit into one of these exceptions and, thus, would be 
subject to the general prohibition in the proposed rule. Although the 
transaction, if executed, could ultimately have a positive impact on 
the ABS, it would not be permitted to be undertaken under the proposed 
rule. This could impose costs both on the securitization participant 
and on investors in the ABS resulting from a decline (or foregone 
increase) in the value of the ABS. We seek comment on these pricing-
related costs of the proposed rule.
    The proposed rule could impose certain costs upon departments 
within a firm not directly involved with the securitization process by 
impacting their ability to conduct transactions that could result in a 
material conflict of interest with investors in an ABS for which the 
firm is a securitization participant. The scope of the proposed rule 
could require monitoring for potential material conflicts of interest 
within all or many departments of the firm. If any department's 
proposed transaction were determined to raise a potential material 
conflict of interest, that department could have to abandon the 
proposed transaction or wait until the proposed rule's prohibition 
period ended. We seek comment concerning any costs that could be 
incurred with respect to the various activities among different 
departments within one firm. We also seek comment concerning whether 
the operation of information barriers within firms might suggest the 
need for the Commission to provide interpretations to the proposed rule 
to exclude activity that should not be captured.
    As required by Securities Act Section 27B, the scope of 
securitization participants in the proposed rule includes affiliates 
and subsidiaries of underwriters, placement agents, initial purchasers, 
and sponsors. In some instances, the activities of an affiliate or 
subsidiary may not be known to the underwriter, placement agent, 
initial purchaser, or sponsor, and could, inadvertently, involve or 
result in a material conflict of interest with the investors in the 
ABS. Monitoring the activities of the affiliate or subsidiary for 
conflicts could be difficult, especially when there are existing 
information barriers between the entities, and could impose costs. For 
this reason, we seek comment concerning any costs that could be 
incurred by affiliates and subsidiaries.\143\
---------------------------------------------------------------------------

    \143\ See supra Section IV (noting the recognition of 
information barriers in Section 15(g) of the Exchange Act, Exchange 
Act Rule 14e-5, and Regulation M under the Exchange Act).
---------------------------------------------------------------------------

    We recognize the statutory prohibition and thus the proposed rule 
may have significant costs with respect to how firms and clients 
establish, maintain, and benefit from relationships. For instance, 
because larger financial entities tend to form in an effort to achieve 
synergies and economies of scope in combining and offering multiple 
services, restrictions on such activities could lead to changes to 
their business activities that could reduce firm earnings. In part 
because of the breadth of the statutory provision and, thus, the 
proposed rule, these potential changes could have some disruptive 
effect on the firms, their clients, and the broader marketplace, 
reducing current efficiencies that may exist. Restricting the ability 
of securitization participants to maintain relationships that service 
multiple objectives could ultimately impact negatively both financial 
firms and their clients' ability to conduct economically efficient 
activities. In addition, firms with particular specialization in given 
areas that were precluded from providing such expertise due to

[[Page 60349]]

perceived material conflicts could disadvantage clients.
    While not required by the proposed rule, we recognize that one way 
that securitization participants might seek to facilitate their 
compliance with the proposed rule is through contractual 
assurances.\144\ The costs associated with such assurances could be 
minimal if contracts are currently utilized and could be easily 
modified to reflect the assurances (e.g., standardized industry 
agreements, purchase and sale agreements, and confidentiality 
agreements). However, in circumstances where there are no agreements in 
place, there could be more significant costs for parties to negotiate a 
new agreement in its entirety. Other costs may or may not ensue if a 
tool other than a contractual assurance were used to manage compliance 
with the proposed rule. We seek commenter input regarding whether and 
how behaviors could change as a result of the use of contractual 
assurances that might increase or decrease costs.
---------------------------------------------------------------------------

    \144\ See supra Section IIIA(v)(b).
---------------------------------------------------------------------------

    We also note that there are potential costs associated with a 
clarification we propose to one of the exceptions under the proposed 
rule.\145\ The proposed rule provides exceptions for risk-mitigating 
hedging activities, liquidity commitments, and bona fide market-making, 
which are consistent with Securities Act Section 27B. We seek comment 
on the scope of the risk-mitigating hedging exception in the proposed 
rule in a manner that we believe is consistent with the intent of the 
legislation, but which could help securitization participants and other 
industry participants better understand whether an activity qualifies 
under the exception. In the proposed rule, we seek comment on the 
application of the proposed exception for risk-mitigating hedging 
activity to ``mitigating'' the consequences of a risk. We believe that 
risk mitigation would permit a securitization participant to limit the 
consequences of a risk, which could facilitate investor protection. We 
also seek comment on how ``exposures'' arise and whether the risk-
mitigating hedging exception should apply to exposures as well as 
positions and holdings. Although we believe that such clarification 
would allow firms to better reduce and mitigate specific risks that 
arise out of underwriting, placement, initial purchase, or sponsorship 
of an ABS, we recognize that securitization participants would bear an 
additional cost in dedicating resources to determine whether their 
activities fall within this exception as interpreted beyond any cost 
they already would bear due to the existence of the statutory 
exception. Similar to the costs that could be incurred for compliance 
with the proposed rule, securitization participants could also face 
costs in their assessment of whether their activities qualify for the 
risk-mitigating hedging exception. We seek comment with respect to all 
aspects of the proposed risk-mitigating hedging exception.
---------------------------------------------------------------------------

    \145\ See supra Section IIIB(i).
---------------------------------------------------------------------------

D. Related Considerations

    The coverage of Securities Act Section 27B and, thus the proposed 
rule which tracks the statute, could negatively impact economic 
efficiency both from the point of view of the securitizations 
participants, and sometimes also from the point of view of investors 
who seek to invest in the pools that back the ABS if certain ABS 
transactions did not get consummated because of the scope of the 
proposed rule.
    The scope of activities under the proposed rule that could 
constitute potential conflicts of interest could potentially impact 
competition among asset-backed securitization market participants. For 
instance, larger entities with multiple business lines could have, as a 
result of their structure, unavoidable material conflicts of interest. 
An investor that utilizes such entities for multiple services could 
have to switch to competitors, or depending on the structure of ABS, 
forego the ABS transaction. Under these circumstances, the investor 
could incur additional search costs and find its business processes 
less efficient due to the loss of relationships.\146\ The 
securitization participant could also potentially lose any profits or 
fees that would have resulted from the investor's business with respect 
to the conflicting transaction and, potentially, future profits and 
fees if the investor takes future business to another firm. In 
addition, investors and financial firms could both lose the financial 
benefits gained from established, cultivated relationships with 
securitization participants. This could be potentially costly to both 
investors that have established relationships with firms and, 
ultimately, to investors in the broader marketplace as a contraction in 
the securitization process could ensue. As firm-investor relationships 
are costly to develop, but valuable to maintain, firms and such 
investors might find application of the proposed rule to be disruptive 
in some circumstances and, thus, the broader marketplace could 
experience some inefficiency, as well as unintended impacts on capital 
formation.
---------------------------------------------------------------------------

    \146\ See, e.g., Myron B. Slovin, Marie E. Sushka & John A. 
Polonchek, The Value of Bank Durability: Borrowers as Bank 
Stakeholders, 48 J. Fin. 247 (1993).
---------------------------------------------------------------------------

    In addition, given that the ABS offering process can involve 
multiple lead underwriters and an underwriting syndicate with several 
members, the proposed rule could have a multiplicative effect by 
conflicting out several unaffiliated financial institutions. If an 
attempt to limit this multiplicative effect through reducing the number 
of parties involved in a securitization negatively affects the manner 
in which ABS are structured and underwritten, this might have a 
negative impact on the efficiency of the securitization process. As 
previously noted, the scope of the statutory prohibition could amplify 
the inability of departments within a securitization participant to 
conduct business as they have in the past, which could increase 
financial costs, as well as heighten market inefficiency. These 
inefficiencies could ultimately negatively impact investors in ABS, as 
well as the consumers whose loans back the ABS.
Request for Comments Regarding the Economic Analysis
    We seek comments and empirical data on all aspects of this Benefit-
Cost Analysis, including identification and quantification of any 
additional benefits and costs. Specifically, we ask the following:
    112. Are there any additional benefits that may arise from the 
proposed rule? Or, are there benefits described above that would not be 
likely to result from the proposed rule? If so, please explain these 
benefits or lack of benefits in detail.
    113. Are there any additional costs that may arise from the 
proposed rule? Or, are there costs described above that would not be 
likely to result from the proposed rule? If so, please explain these 
costs or lack of costs in detail.
    114. Do the types, or extent, of any benefits or costs from the 
proposed rule differ between certain securitization participants? For 
example, do potential benefits or costs differ in their application to 
underwriters as opposed to placement agents? Please explain.
    115. Do the types, or extent, of any benefits or costs from the 
proposed rule differ between certain kinds of asset-backed 
securitizations? For example, do any benefits or costs differ between 
ABS and synthetic ABS? If so, how do the benefits or costs differ?
    116. Can you quantify costs that might arise in relation to 
monitoring for

[[Page 60350]]

transactions that would result in a material conflict of interest 
between a securitization participant and investors in the ABS? Do 
securitization participants have existing procedures that might help 
mitigate potential costs?
    117. With respect to potential costs related to the proposed rule 
prohibiting transactions by affiliates, subsidiaries, or another 
department within the firm that would result in a material conflict of 
interest with investors in the ABS, is it possible to quantify the cost 
of not being permitted to undertake such transactions?
    118. Should the Commission consider interpretations that would be 
consistent with the goals of Section 27B and the proposed rule, but 
that would further reduce costs? If so, what areas of interpretation 
should the Commission explore?
    119. What costs would be incurred by securitization participants, 
investors and others if certain synthetic ABS (e.g., balance sheet 
CDOs) could no longer be created? We ask commenters to describe any 
resulting impacts on the ABS market and lending institutions if this 
were to occur, and provide supporting data if available.
    120. We solicit comment on the impact of the proposed rule on 
efficiency, competition, and capital formation. Commenters are 
requested to provide empirical data and other factual support for their 
views if possible.

VIII. Small Business Regulatory Enforcement Fairness Act

    Under the Small Business Regulatory Enforcement Fairness Act of 
1996,\147\ a rule is ``major'' if it has resulted, or is likely to 
result, in:
---------------------------------------------------------------------------

    \147\ Public Law 104-121, Title II, 110 Stat. 857 (1996).
---------------------------------------------------------------------------

     An annual effect on the U.S. economy of $100 million or 
more;
     A major increase in costs or prices for consumers or 
individual industries; or
     Significant adverse effects on competition, investment, or 
innovation.
    We request comment on whether our proposed rule would be a 
``major'' rule for purposes of the Small Business Regulatory 
Enforcement Fairness Act. In addition, we solicit comment and empirical 
data on:
     The potential effect on the U.S. economy on an annual 
basis;
     Any potential increase in costs or prices for consumer or 
individual industries; and
     Any potential effect on competition, investment, or 
innovation.

IX. Regulatory Flexibility Act Certification

    Pursuant to 5 U.S.C. 605(b), the Commission hereby certifies that 
the proposed rule, if adopted, would not have a significant economic 
impact on a substantial number of small entities. The proposed rule 
prohibits transactions by underwriters, placement agents, initial 
purchasers, or sponsors of an ABS, or any affiliate or subsidiary of 
such entities, that would involve or result in a material conflict of 
interest with investors in the ABS. Based on our current available 
data, we do not believe that a substantial number of underwriters of 
ABS would meet the definition of a small broker-dealer for purposes of 
the Regulatory Flexibility Act.\148\ In addition, we are aware of only 
one sponsor that would meet the definition of a small entity for 
purposes of the Regulatory Flexibility Act.\149\ Thus, the Commission 
does not believe the proposed rule, if adopted, would have a 
significant economic impact on a substantial number of small entities.
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    \148\ This is based on the ABS Database, which captures 
information on all asset-backed and mortgage-backed securitization 
issues sold worldwide. The database is compiled by the editors of 
Asset-Backed Alert. A detailed description of the database is 
provided at http://www.abalert.com/about_abs.php.
    \149\ This is based on data from the ABS Database.
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X. Statutory Authority and Text of Proposed Rule

    The Commission is proposing new rule 127B (17 CFR 230.127B) 
pursuant to authority set forth in Sections 10, 17(a), 19(a), 27B, and 
28 of the Securities Act.

List of Subjects in 17 CFR Part 230

    Advertising, Brokers, Reporting and recordkeeping requirements, 
Securities.

Text of the Proposed Rule

    For the reasons set out above, Title 17, chapter II of the Code of 
Federal Regulations is proposed to be amended as follows:

PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933

    1. The authority citation for Part 230 continues to read in part as 
follows:

    Authority:  15 U.S.C. 77b, 77c, 77d, 77f, 77g, 77h, 77j, 77r, 
77s, 77z-3, 77sss, 78c, 78d, 78j, 781, 78m, 78n, 78o, 78t, 78w, 
78ll(d), 78mm, 80a-8, 80a-24, 80a-28, 80a-29, 80a-30, 80a-37, and 
Pub. L. 111-203, Sec.  939A, 124 Stat. 1376, (2010) unless otherwise 
noted.
* * * * *
    2. Add Sec.  230.127B to read as follows:

Sec.  230.127B  Conflicts of interest relating to certain 
securitizations.

    (a) Unlawful activity. 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 rule 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.
    (b) Excepted activity. The following activities shall not be 
prohibited by paragraph (a) of this section:
    (1) Risk-mitigating hedging activities. 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; or
    (2) Liquidity commitment. Purchases or sales of asset-backed 
securities made pursuant to and consistent with commitments of the 
underwriter, placement agent, initial purchaser, or sponsor, or any 
affiliate or subsidiary of such entity, to provide liquidity for the 
asset-backed security; or
    (3) Bona fide market-making. Purchases or sales of asset-backed 
securities made pursuant to and consistent with bona fide market-making 
in the asset-backed security.

    By the Commission.

    Dated: September 19, 2011.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-24404 Filed 9-27-11; 8:45 am]
BILLING CODE 8011-01-P