The Death of Synthetic ABS

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The Death of Synthetic ABS?

Certain Consequences of Proposed Rule127B on US Structured Products

Speed Read

As if current economic conditions weren't enough to stifle new issuances of synthetic structured

securities, the Securities and Exchange Commission (the Commission) is proposing to hammer

another nail in the coffin of the market for asset-backed securities (ABS). In connection with the

implementation of Section 621 of the Dodd-Frank Wall Street Reform and Consumer Protection

Act1 (the Dodd-Frank Act), the Commission has proposed new Rule 127B under the Securities

Act of 1933 (the Proposed Rule). The Proposed Rule, a mere four short paragraphs long,

adheres faithfully to the legislative text of Section 621 of the Dodd-Frank Act. Both Section 621

and the Proposed Rule prohibit any underwriter, placement agent, initial purchaser or sponsor

(or any affiliate and subsidiary of any such entity) of an ABS (a Securitization Participant) from

engaging in any transaction prior to the date that is one year after the date of the first closing of

the sale of the ABS that would involve or result in any material conflict of interest with respect to

any investor in a transaction arising out of such activity, subject to three exceptions. The

remaining 116 pages of the Commission's detailed commentary to accompany the Proposed

Rule include no fewer than 120 questions and requests for further comment. It is perhaps not

surprising therefore that the Proposed Rule sometimes raises more questions that it answers.

We consider here the implications of the Proposed Rule on syntheticABS, a product that is

expressly included within the ambit of the Proposed Rule.2 There are a number of other

interesting questions that Section 621 and the Proposed Rule present with respect to the

purchase by a Securitization Participant of credit protection linked to ABS created by such

Securitization Participant. We intend to address these questions in a separate client bulletin.

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Background to Section 621 and the Proposed Rule

After a series of hearings by the United States Senate Homeland Security Permanent

Subcommittee on Investigations (the PSI) in early 2010 examining the multiple roles played by

financial institutions in the development, marketing and trading of ABS and credit default swaps,

Senator Carl Levin (D-MI) and Senator Jeff Merkley (D-OR) proposed Section 621 of the Dodd-

Frank Act to reduce perceived conflicts of interest in connection with the issuance of ABS.

Section 621 is rooted in findings by the PSI which, according to Senator Levin, "dramatically

showed how some firms were creating financial products, selling those products to their

customers, and betting against those same products."3 The politicians who drafted Section 621

were concerned that underwriters and sponsors "are the parties who select and understand the

underlying assets, and who are best positioned to design [an ABS] to succeed or fail."4 The

political motivations behind Section 621 were to prevent underwriters and sponsors from

"securing handsome rewards for designing and selling malfunctioning [ABS] that undermine the

[ABS] markets."5

What are the consequences of Section 621 and the

Proposed Rule on Synthetic ABS?

Synthetic ABS structures typically involve the issuer of the ABS obtaining exposure to one or

more underlying assets by selling protection to a buyer of protection under a credit default swap

that references such assets (the Relevant CDS). Would the Relevant CDS constitute a

prohibited transaction under Section 621 and the Proposed Rule? Would the Relevant CDS

"involve or result in any material conflict of interest with respect to any investor in" the synthetic

ABS if protection under the Relevant CDS is sold by the issuer of the ABS and purchased by the

Securitization Participant of such ABS prior to the date that is one year after the date of the first

closing of the sale of the ABS?

The approach of the Commission in response to these questions is somewhat mixed. In its

commentary to the Proposed Rule, the Commission sets out a series of fact patterns with the

purpose of providing clarity on the types of activity that may be caught by the Proposed Rule.

Example A:

If the Securitization Participant is not also an investor in the ABS and does not have any form of

exposure to the underlying assets other than by means of its short position as buyer of

protection under the Relevant CDS, then the Commission believes that the Relevant CDS would

result in a material conflict of interest and would be prohibited by the Proposed Rule.

Example B:

If the Securitization Participant has an existing exposure to the underlying assets and

subsequently synthetically transfers that exposure to the issuer of the ABS by entering into the




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Relevant CDS as buyer of protection, the Commission believes the Securitization Participant will

be in a position to benefit from a decline in the ABS at the expense of the ABS investors who

now have exposure to the underlying assets, engendering a material conflict of interest. The

Securitization Participant's long exposure to the underlying assets and its short position under

the Relevant CDS would offset each other, thereby raising the question of whether the

exemption for risk-mitigating hedging activities from proposed Rule 127B(b)(1) would apply.Proposed Rule 127B(b)(1) provides an exemption for "[r]isk-mitigating activities in connection

with positions or holdings arising out of the underwriting, placement, initial purchase, or

sponsorship of an asset-backed security." However, the Commission clarifies that the Relevant

CDS in this Example B is providing a hedge to an existing long investment position, rather than a

hedge for "positions or holdings arising out of" the Securitization Participant's role in the ABS.

Therefore the "hedging activity" exemption is not available to the Securitization Participant and

the Relevant CDS would be a prohibited transaction under the Proposed Rule.

Example C:

If the Securitization Participant has a long exposure to the underlying assets that it has

accumulated in anticipation of creating and selling a synthetic ABS and not, as is the case in

Example B above, with a view to taking an investment position in the underlying assets the

Relevant CDS may fall within the exception for risk-mitigating hedging activities, provided that

there is no net basis risk between the Relevant CDS and the off-setting long exposure to the

underlying assets. The long exposure may be obtained either by the Securitization Participant

entering into separate credit default swaps as seller of protection with third party market

participants who did not have any influence on any aspect of the ABS transaction or by the

Securitization Participant acquiring the underlying physical assets themselves. In order to fall

within the exception, the long exposure must not be acquired in the form of new positionsdesigned to earn a profit. Furthermore, to the extent that the long positions are unwound, a

corresponding portion of the Relevant CDS would similarly need to be unwound or new long

positions established in order for the Relevant CDS to continue to benefit from the exception.

The key distinction between Example B and Example C is whether the long exposure was

previously held as an investment or whether the long exposure was accumulated for purposes of

"warehousing" the risk until the ABS are issued.

Potential Unintended Consequences of Section 621

The Commission acknowledges that, from a practical perspective, it may not be possible to

distinguish circumstances where the Securitization Participant's long position was originally

acquired for investment purposes (Example B) from circumstances where the long position was

acquired for purposes of creating the ABS (Example C). However, the Commission gives no

guidance on how it will assess whether a long position was acquired for investment purposes or

for purposes of building up exposure for purposes of the ABS issuance.

For example, will the Commission take into account the length of time that the risk has been held




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by the Securitization Participant prior to the first closing date of the ABS issuance? Where a

Securitization Participant regularly trades an asset that is also to be included in an ABS, will the

Commission be able to determine whether the Securitization Participant held the asset for

investment purposes or whether it was held for purposes of creating the ABS? Will the

Commission require Securitization Participants to record transactions in a particular way or flag

them as transactions that are entered into for purposes of creating an ABS? If the positionsestablished under Example C are unwound more than one year after the date of the first closing

of the sale of the ABS, will the Relevant CDS still need to be unwound correspondingly?

The fact that a single structure may or may not be permitted under the Proposed Rule,

depending upon certain complicated fact patterns, is not only confusing but could lead to

arbitrary results which may have unintended consequences.

Section 621 and the Proposed Rule appear to be based on overly suspicious presumptions that

(a) Securitization Participants are in the business of purposely structuring ABS to fail and (b)

ABS investors are not sufficiently equipped to make their own assessments of the quality, price

and performance associated with such ABS based on existing disclosure standards. Many

markets are predicated on the fact that one side of the market has one view of an issue while the

other side of the market has an opposite view of the same issue. Rather than any sinister activity

on the part of the Securitization Participant seeking to offload exposure to an asset in which the

Securitization Participant is an investor, the decision to reference a particular asset in an ABS

may instead be motivated by positive sentiments among potential investors in the ABS regarding

the price and quality of the asset, especially where the initial issuance of the asset may be

oversubscribed or unique in nature.

In an attempt to cure Senator Levin of his distrust for "vague, technically worded, fine print

disclosures", a criticism that arguably is not specific to the market for ABS, we would encourage

the Commission, in its rule implementing Section 621, to permit exemptions to the requirements

of Section 621 through enhanced disclosure standards for ABS and their underlying asset(s),

creating reporting standards regarding hedge positions of the Securitization Participant with

respect to the ABS and/or establishing heightened representations and warranties to be

provided by investors in the ABS.

It remains to be seen how these and other open issues will be addressed in the final rulemaking

and guidance provided by the Commission, however we are available to discuss any issues that

you might have in structuring new ABS and to assist in responding to the Commission's requestfor comment.

____________________________________________________________________

1 P.L. 111-203, H.R. 4173.

2 Notwithstanding that synthetic asset-backed securities are excluded from section 3 of the

Securities Exchange Act of 1934, 230.127B(a) refers to "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




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purposes of this rule shall include a synthetic asset-backed security)" (emphasis added).

3 111 CONG. REC. S5901 (2010).

4 111 CONG. REC. S5899 (2010).

5Id.

Contact information

David Lucking +1 212 756 1157

Partner, New York [email protected]

Lawton Camp +1 212 610 6309Partner, New York [email protected]

Deborah North +1 212 610 6408


John Williams +1 212 756 1131


John Hwang +1 212 610 6395Senior Counsel, New York [email protected]

This ePublication is for general guidance only and does not constitute definitive advice.

Allen & Overy 2011


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The Death of Synthetic ABS