‘Re-proposed’ 2011 rule bans conflicts of interest at core of 2008 crisis

Effort to stamp out ABS conflicts of interest is one of the few big Dodd-Frank requirements not yet in force

The SEC voted Jan. 25 to “re-propose” regulations that would fulfill a 12-year-old Congressional mandate to ban the investment scam most emblematic of the 2008 U.S. financial crisis.

If it is eventually passed, Securities Act Rule 192 will ban the issuance of asset-backed securities (ABS) structured in ways that would allow issuers to put their own interests ahead of those of investors, according to a Jan. 25 SEC announcement.

The rule is designed to prohibit abuses documented following the financial crisis of banks and investment firms that “sold securitized assets to investors while simultaneously taking large positions against those assets – in essence selling a product and then betting against their clients,” SEC chair Gary Gensler said during the meeting during which all five commissioners voted in favor of the proposal. “These market participants put their own interests ahead of that of investors, to profit at the investors’ expense.”

The best-known example was the $550 million the SEC charged Goldman Sachs Group, Inc. in 2010 to settle civil fraud charges related to an ABS made up largely of subprime mortgage bonds Goldman sold to investors based on its potential for growth without revealing that hedge funds also involved in development of the ABS were short-selling it on the assumption that the high-risk debt included would cause the investment to go south.

The rule applies to any underwriter, placement agent, initial purchaser or sponsor of an ABS or any of their affiliates and subsidiaries, , according to a fact sheet posted by the SEC.

It also bans the creation of an ABS based on credit-default swaps or other credit derivatives by companies that would receive payment every time there is a credit event related to debt included in the ABS.

The current version if the proposal includes exceptions that would allow a certain amount of risk-mitigating hedging by firms involved with the ABS and bona-fide market-making activities and efforts to maintain liquidity commitments.

The “re-proposed” rule, which came out in 2011 but was never finalized, “would provide an important safeguard against some of the misconduct that led up to the 2007 to 2009 financial crisis” by extending existing anti-fraud and anti-manipulation laws by prohibiting for a year the involvement in a new ABS of companies whose own interests conflict materially with those of investors, according to Renee Jones, director of the SEC’s Division of Corporation Finance, who will leave the SEC Feb. 3 to return to an earlier post as a professor at Boston College School of Law.

Previous failures to confirm the rule represent “an unfinished step in Congress’ vision for financial reform,” Gensler said.

Commissioner Hester Peirce – who opposes most regulations proposed by the Gensler-led commission – supported the proposal, but objected to the 60-day period set aside for public comment as too short, and suggested that a rule created during 2011 to ban a specific type of abuse may be irrelevant in a market in which that particular abuse has become much less common.

The SEC doesn’t have solid, recent data defining how frequently such conflicts occur, but did modify the language to take into account ways investors and participants operate within the market now as well as with research done before the 2011 that laid out regulations based on the mechanics of how those conflicts are likely to happen, Jones said in defending the relevancy and applicability of the rule.

The Division of Corporation Finance put the proposal together “out of an abundance of caution” and to respond to a specific mandate from Congress “to provide as extensive an investor protection as possible,” Jones said.

The public comment period for the rule will be open for 60 days following publication on the SEC website. More detail on the history of the rule proposal is available from the Federal Register summary posted Jan. 3, 2012, and the SEC’s regulatory agenda notice.

Previous public comments, which include a July, 2014 letter to then-SEC chair Mary Jo White from 11 U.S. Senators asking why the SEC had not yet enacted regulations as required by Congress – are available here.