The Securities and Exchange Commission's reintroduction of a 2011-era rule proposal to ban conflicts of interest for sponsors of asset-backed securities could have wide implications for conduit borrowers and could raise borrowing and compliance costs for underwriters, municipal advisors and conduit issuers alike.
The proposed rule would stop participants involved in securitization transactions from shorting the securitizations they design. Since the definition of ABS as set forth in Section 3 of the Exchange Act is so broad, the proposal would encompass a significant portion of munis that are backed by loans, leases or mortgages. The proposal would be particularly acute for conduit bond issuers, according to Municipal Market Analytics, but the true impacts on that side of the market are still being assessed.
"We are taking a close look at it to see what its potential impact would be," said Chuck Samuels, a member at Mintz Levin and counsel to the National Association of Health & Educational Facilities Finance Authorities, which represents conduit issuers. "We are grateful that the SEC suggests that maybe municipal securities should be exempt from this regulation and that probably is a position that we will support. If the type of transactions that they are concerned about do not exist or are infrequent in the municipal bonds arena then there is no good reason to impose new obligations on participants in our sector."
The proposal would prohibit a securitization participant from engaging in any other transactions that would result in a conflict of interest for a year following an asset-backed security transaction and would include any transaction that is a bet against the performance of an ABS that the individual sold or created, all short sales as well as the purchase of a credit default swap where the participant would benefit from an adverse event on the ABS. Certain allowances are pointed out for hedging activities, market-making activities and liquidity commitments.
But according to Lisa Washburn, managing director for Municipal Market Analytics, in order to take advantage of these, one would be required to establish a particular compliance program with written policies and procedures and would have the largest effect on municipal advisors and underwriters.
"It's administrative and compliance costs that would drive up the cost of doing your transaction for an affected party and that could be passed on to borrowers," Washburn said. "If certain entities either can't or decide that the cost of complying or monitoring is too much, you could see a shrinking of some small MAs that think the cost is just too much to be in that type of market, or to do those types of transactions."
The SEC estimates that there are 478 unique municipal entities that sponsor ABS, with 104 underwriters and 112 municipal advisors, but the agency acknowledged there is some overlap between MAs and underwriters. The SEC also estimates that in 2021, municipal issuance defined under the rule as ABS was $104 billion, or 20-25% of par issued, of the 1,928 transactions.
The Commission is particularly attuned to the fact that this proposal may adversely affect large swaths of the municipal securities market, highlighted in their own assertion that the municipal market be exempt entirely and asks respondents to lay out clearly why that should be the case.
But as the Commission points out, municipal entities do not typically issue ABS directly and even if munis were completely exempt from the proposal, it's not entirely clear that it wouldn't touch munis in some capacity.
"It seems to me that conduit financing, where you've got a hospital borrowing through a conduit issuer and supported by a loan agreement, is a very different animal and a very different type of transaction than one that's backed by a pool of self liquidating assets," Washburn said.
The Commission also points out in its proposal that the muni market is already subject to rules adopted under the Dodd-Frank Act and that the ABS definition should be somewhat familiar based on existing regulation.
"In this regard, we believe that market participants are familiar with analyzing whether such a security meets the Exchange Act ABS definition as the Commission has adopted other rules and regulations under the Securities Act and the Exchange Act that ABS definition or a substantially similar definition," the proposal said.
But the Commission also is forthright in its questions as to whether certain definitions are sufficient.
"Should we clarify in rule text or through guidance the types of municipal securitizations that would be covered by the re-proposed rule?," the SEC asked. "If so, please identify those types of municipal securitizations that you believe require clarification and explain why."
The SEC is accepting comments on the re-proposed rule until March 27.
