The Securities and Exchange Commission’s proposal to clamp down on conflicts of interest connected with the sale of asset- backed securities and certain other securitization transactions, as required by Dodd-Frank, should exempt municipal bonds as the proposal is unnecessarily broad and may negatively affect underwriters involved in certain transactions.
The proposed rule as part of Section 27B was originally floated in 2011 and the Commission re-proposed the rule in January.
“This re-proposed rule is designed to help address conflicts of interest arising with market participants taking positions against investors’ interests,” said SEC chairman Gary Gensler. “Further, as required by Section 621 of the Dodd-Frank Act, the re-proposed rule provides exceptions for risk-mitigating hedging activities, bona fide market making, and certain liquidity commitments. These changes, taken together, would benefit investors and our markets.”
The proposed rule garnered hundreds of comments detailing what many called the proposal’s “unnecessarily wide” scope, that its exceptions undermine the entire proposal and that the municipal bond market in particular should be exempt from any final rule.
“The SEC’s proposal shouldn’t disrupt well-functioning markets, disincentivize legitimate market activity or raise costs for investors,” American Securities Association general counsel Jessica Giroux wrote. “This proposal is unnecessarily broad and goes beyond the scope and intent of Section 621 in addressing betting against ‘designed to fail’ asset-backed securities. We remind the Commission that municipal bonds and their related securitizations were not the target of Congress when it drafted Section 621 of the Dodd-Frank Act, and for that reason they should be exempt from the final rules.”
Giroux also noted that as the Commission has noted in itsr proposal, risk retention rules under Section 941 of Dodd-Frank already apply to municipal securitizations, therefore, “participants in these offerings are already required to hold a specific amount of risk related to each securitization on their books,” and thus should be viewed very differently than traditional ABS.
Giroux also wrote that there is often trading of financial instruments connected to a certain ABS and for good reason, the underwriter who worked on the securitization can often be involved in the trading.
“These underwriters may enter into a swap to mitigate the risk associated with the security and should not be automatically perceived as ‘betting’ that the ABS will fail,” Giroux wrote. “The SEC should avoid prohibiting an initial purchaser of an ABS from trading in the market for that security, even if the purchaser acted as an underwriter. Under the current Proposal, every trade that an underwriting firm wished to enter into could be deemed a ‘conflict of interest’ and therefore prohibited.
As detailed in Section 27B of Dodd-Frank, the proposed rule provides exceptions for risk mitigating hedging activities, bona fide market making activities and liquidity commitments and would require any securitization participant to implement compliance programs applicable to those exceptions. But many say the exceptions give hedge funds and large institutional players with large hedging capabilities too much power to do what they want.
“These exceptions provide an out for the exact type of bad actors that this section is intending to stop since hedging, market making, and liquidity providing inherently run off of and make money from shady market actions constituting as conflicts of interest,” wrote J. Bradford DeLong, professor of Economic History at the University of California Berkeley. “Having these entities implement compliance programs is too loose of a restriction as well, as that is essentially asking them to police themselves, which they have no reason to, as it would impede their business.”
The SEC also received numerous comments from retail investors, some of whom expressed the belief that they’d be disproportionately harmed as a result of the exceptions.
“For true market fairness and maximum benefit to the average household investor, this rule should apply to all entities, regardless of their role in the market,” DeLong said.
But from others, the proposal does not go far enough to incentivize good behavior.
“The Commission should consider including additional mechanisms designed to promote the effectiveness of the policies and procedures,” said David Certner, legislative counsel and legislative policy director of government affairs at the AARP. “The SEC could provide increased incentives to identify relevant transactions by, for example, providing that transactions not properly identifies and documented were ineligible for the exception. The SEC could also require certification of the effectiveness of the policies and procedures by the chief compliance officer or other officer responsible for ensuring proper implementation.”