This rule represents the culmination of the efforts of the Securities and Exchange Commission (“SEC”) to adopt a rule on conflicts of interest relating to securitization (“Rule 192”) to implement Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This Rule 192 prohibits securitization participants from engaging in any transactions involving an asset-backed security (“ABS”) that would involve or result in any material conflict of interest between such securitization participant and an investor in such ABS.  The rule has had an unconventional history. In response to the enactment of Section 621 of the Dodd-Frank Act, the SEC in 2011 presented a proposed rule to provide regulatory guidance. However, the process would languish until January 25, 2023, when the SEC provided a revised proposed rule. Over 900 comments thereto were received. The SEC finalized the rule upon review of the responses provided.

Rule 192 is set forth at 17 C.F.R. § 230.192 and adopted pursuant to SEC Release No. 33-11254 (Nov. 27, 2023), published as 88 FR 85396 with a publication date of December 7, 2023 (the “Adopting Release”).  Compliance with Rule 192 will be required for securitization participants for any ABS with respect to the closing of the first sale which occurs on or after June 9, 2025. However, such future reference date for covered ABS should not be confused with the effective date of Rule 192 itself, as it became effective on February 5, 2024. Thus, potential agreements creating conflicts of interest with ABS to be issued after June 9, 2025 are covered by Rule 192 now.

Rule 192 introduces the following obligations:

Prohibition

A securitization participant shall not, for a period commencing on the date on which such person has reached an agreement that such person will become a securitization participant with respect to an ABS and ending on the date that is one year after the date of the first closing of the sale of such ABS, directly or indirectly engage in any transaction that would involve or result in any material conflict of interest between the securitization participant and an investor in such ABS. 

Material Conflict of Interest

Engaging in any transaction that would involve or result in a material conflict of interest between a securitization participant for an ABS and an investor in such ABS if such a transaction is a conflicted transaction.

Conflicted Transaction

A conflicted transaction means any of the following transactions with respect to which there is a substantial likelihood that a reasonable investor would consider the transaction important to the investor's investment decision, including a decision whether to retain the ABS:

(i) A short sale of the relevant ABS;

(ii) The purchase of a credit default swap or other credit derivative pursuant to which the securitization participant would be entitled to receive payments upon the occurrence of specified credit events in respect of the relevant ABS; or

(iii) The purchase or sale of any financial instrument (other than the relevant ABS) or entry into a transaction that is substantially the economic equivalent of a transaction described in paragraphs (i) or (ii) above, other than, for the avoidance of doubt, any transaction that only hedges general interest rate or currency exchange risk.

Excepted Activity

The following activities are not prohibited under the heading Prohibition above:

(1) Risk-mitigating hedging activities

(i) Permitted risk-mitigating hedging activities. Risk-mitigating hedging activities of a securitization participant conducted in accordance with this paragraph (1) in connection with and related to individual or aggregated positions, contracts, or other holdings of the securitization participant, including those arising out of its securitization activities, such as the origination or acquisition of assets that it securitizes.

(ii) Conditions. Risk-mitigating hedging activities are permitted under paragraph (1) of this section only if:

(A) At the inception of the hedging activity and at the time of any adjustments to the hedging activity, the risk-mitigating hedging activity is designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks arising in connection with and related to identified positions, contracts, or other holdings of the securitization participant, based upon the facts and circumstances of the identified underlying and hedging positions, contracts or other holdings and the risks and liquidity thereof;

(B) The risk-mitigating hedging activity is subject, as appropriate, to ongoing recalibration by the securitization participant to ensure that the hedging activity satisfies the requirements set out in paragraph (1) of this section and does not facilitate or create an opportunity to materially benefit from a conflicted transaction other than through risk-reduction; and

(C) The securitization participant has established, and implements, maintains, and enforces, an internal compliance program that is reasonably designed to ensure the securitization participant's compliance with the requirements set out in paragraph (1) of this section, including reasonably designed written policies and procedures regarding the risk-mitigating hedging activities that provide for the specific risk and risk-mitigating hedging activity to be identified, documented, and monitored.

(2) Liquidity commitments

Purchases or sales of the ABS made pursuant to, and consistent with, commitments of the securitization participant to provide liquidity for the ABS.

(3) Bona fide market-making activities

(i) Permitted bona fide market-making activities. Bona fide market-making activities, including market-making related hedging, of the securitization participant conducted in accordance with this paragraph (3) in connection with and related to ABS with respect to which the prohibition under the heading Prohibition above applies, the assets underlying such ABS, or financial instruments that reference such ABS or underlying assets or with respect to which the prohibition under the heading Prohibition above otherwise applies, except that the initial distribution of an ABS is not bona fide market-making activity for purposes of paragraph (3) of this section.

(ii) Conditions. Bona fide market-making activities are permitted under paragraph (3) of this section only if:

(A) The securitization participant routinely stands ready to purchase and sell one or more types of the financial instruments described in paragraph (3)(i) of this section as a part of its market-making related activities in such financial instruments, and is willing and available to quote, purchase and sell, or otherwise enter into long and short positions in those types of financial instruments, in commercially reasonable amounts and throughout market cycles on a basis appropriate for the liquidity, maturity, and depth of the market for the relevant types of financial instruments;

(B) The securitization participant's market-making related activities are designed not to exceed, on an ongoing basis, the reasonably expected near term demands of clients, customers, or counterparties, taking into account the liquidity, maturity, and depth of the market for the relevant types of financial instruments described in paragraph (3)(i) of this section;

(C) The compensation arrangements of persons performing the foregoing activity are designed not to reward or incentivize conflicted transactions;

(D) The securitization participant is licensed or registered, if required, to engage in the activity described in paragraph (3) of this section in accordance with applicable law and self-regulatory organization rules; and

(E) The securitization participant has established, and implements, maintains, and enforces, an internal compliance program that is reasonably designed to ensure the securitization participant's compliance with the requirements of paragraph (3) of this section, including reasonably designed written policies and procedures that demonstrate a process for prompt mitigation of the risks of its market-making positions and holdings.

Definitions

For purposes of this section:

Asset-backed security has the same meaning as in section 3(a)(79) of the Securities Exchange Act of 1934, and also includes a synthetic ABS and a hybrid cash and synthetic ABS.

Distribution means:

(i) An offering of securities, whether or not subject to registration under the Securities Act of 1933, that is distinguished from ordinary trading transactions by the presence of special selling efforts and selling methods; or

(ii) An offering of securities made pursuant to an effective registration statement under the Securities Act of 1933.

Initial purchaser means a person who has agreed with an issuer to purchase a security from the issuer for resale to other purchasers in transactions that are not required to be registered under the Securities Act in reliance upon Rule 144A or that are otherwise not required to be registered because they do not involve any public offering.

Placement agent and underwriter each mean a person who has agreed with an issuer or selling security holder to:

(i) Purchase securities from the issuer or selling security holder for distribution;

(ii) Engage in a distribution for or on behalf of such issuer or selling security holder; or

(iii) Manage or supervise a distribution for or on behalf of such issuer or selling security holder.

Securitization participant means:

(i) An underwriter, placement agent, initial purchaser, or sponsor of an ABS; or

(ii) Any affiliate or subsidiary of a person described in paragraph (i) of this definition if the affiliate or subsidiary:

(A) Acts in coordination with a person described in paragraph (i) of this definition; or

(B) Has access to or receives information about the relevant ABS or the asset pool underlying or referenced by the relevant ABS prior to the first closing of the sale of the relevant ABS.

Sponsor means:

(i) Any person who organizes and initiates an ABS transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the entity that issues the ABS; or

(ii) Any person with a contractual right to direct or cause the direction of the structure, design, or assembly of an ABS or the composition of the pool of assets underlying or referenced by the ABS, other than a person who acts solely pursuant to such person's contractual rights as a holder of a long position in the ABS.

(iii) Notwithstanding paragraph (ii) of this definition, a person that performs only administrative, legal, due diligence, custodial, or ministerial acts related to the structure, design, assembly, or ongoing administration of an ABS or the composition of the pool of assets underlying or referenced by the ABS will not be a sponsor for purposes of this rule.

(iv) Notwithstanding paragraphs (i) and (ii) of this definition, the United States or an agency of the United States will not be a sponsor for purposes of this rule with respect to an ABS that is fully insured or fully guaranteed as to the timely payment of principal and interest by the United States.

Anti-Evasion

If a securitization participant engages in a transaction or a series of related transactions that, although in technical compliance with the provisions under the heading Excepted Activity above, is part of a plan or scheme to evade the prohibition under the heading Prohibition above, that transaction or series of related transactions will be deemed to violate the provisions under the heading Prohibition above.

Safe Harbor for Certain Foreign Transactions

The prohibition under the heading Prohibition above shall not apply to any ABS for which all of the following conditions are met:

(1) The ABS is not issued by a U.S. person; and

(2) The offer and sale of the ABS is in compliance with Regulation S.

Further Guidance

The Adopting Release provides guidance that:

(i) the definition “sponsor” is functional in nature which will apply regardless of a person’s title, based upon the specific facts and circumstances¹; and

(ii) transactions unrelated to the idiosyncratic credit performance of the ABS such as reinsurance agreements, hedging of general market risks or routine securitization activities (such as the provision of warehouse financings or the transfer of assets into a securitization vehicle) are not conflicted transactions.²

Steps to Consider

Enterprises which undertake activities which may fall within the ambit of Rule 192 should carefully review its terms and evaluate the scope of their activities in light of its provisions and should consider the following steps:

• Ensure there is clarity as to the commencement date of any agreement, particularly as there is no specific requirement that any agreement should be in writing.
• Evaluate the categories of one’s activities and those of related parties which may constitute the actions of a securitization participant. 
• Evaluate those categories of such activities which may constitute conflicted transactions under Rule 192.  Parties will need to consider carefully, for example, what constitutes a “substantially” economically equivalent transaction.
• Assess the applicability of exceptions for certain of those categories of activities under Rule 192.
• Develop procedures and policies to assure compliance with Rule 192 requirement, as applicable, across the enterprise, including transaction review and approved procedures.  This could include for example considering information barriers between affiliates or subsidiaries. 
• Develop enterprise-wide training for Rule 192 compliance and procedure and policy implementation.
• Develop practices for monitoring and evaluating ongoing compliance with Rule 192 requirements and enterprise policies.

This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation.

Please contact any of the Hogan Lovells lawyers listed herein with any questions or concerns regarding the developments or any other sanctions compliance issues.

Authored by Russell Slanover