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SEC Issues Controversial Rule Regulating Asset-Backed Securities

The SEC will soon put the finishing touches on a rule stemming from one of the most infamous cases of fraud from the 2007-08 financial crisis. The new rule prohibits certain material conflicts of interest between those who create or distribute asset-backed securities (ABS), including synthetic ABS, and the investors in the ABS. This proposal takes direct aim at a transaction that, within the securities industry, has become a symbol of greed and profiteering: Goldman Sachs’s Abacus transaction.

Abacus 2007-AC1 (“Abacus 2007” or “Abacus”) was an investment vehicle designed to fail. It was created in February 2007 at the request of John Paulson, the hedge fund manager who made billions of dollars during the recession by shorting subprime mortgage-backed securities (MBS). Paulson selected the pieces of toxic subprime MBS that he wanted to short which were then packaged together and sold by Goldman to its clients, including German bank IKB and Dutch bank ABN Amro. The buyers were not aware that Paulson selected Abacus’s underlying portfolio; in fact, these banks were led to believe that an independent third party selected the mortgages. The Abacus 2007 transaction resulted in massive losses for IKB and ABN Amro, while Paulsen profited from the investment vehicle’s demise to the tune of over $1 billion.

Though Paulson never faced charges for his involvement with Abacus 2007, the SEC took action against Goldman Sachs for facilitating the sale of the Abacus investment. The case eventually resulted in the largest settlement ever with the SEC. Goldman paid a record $550 million to settle charges stemming from Abacus 2007.

The SEC’s case centered on Goldman’s fraudulent misrepresentation. However, the conflict of interest in the Abacus deal did not itself equate to legal foul play. Dodd-Frank sought to correct this. At the end of 2011, the SEC proposed a new rule banning material conflicts of interest between those who create or distribute ABS and the investors of those ABS. The rule states that an underwriter (or similar entity) shall not engage, within one year of the issuance of an ABS, in any transaction that would “involve or result in any material conflict of interest with respect to any investor” of that ABS transaction.

Some commentators believe this rule effectively and efficiently prevents “firms from packaging and selling asset-backed securities to their clients and then engaging in transactions that create conflicts of interest between them and their clients.” However, Susan M. Curtis, a structured finance partner at Skadden, and a team of her colleagues believe this rule proposal raises questions about some typical securitization activities. Detractors have highlighted concerns about an overly broad application, urging that certain hedging activities should not be prohibited regardless of whether they result in potential or actual conflicts of interest. Others cautioned against a broad interpretation of the term “material conflicts of interest” noting that the rule treads on certain fundamental premises that are the essence of sophisticated financial transactions. For example, the relationship of securitization participants versus investors can be viewed as fundamentally conflicted since a buyer and seller of assets always have opposing interests, as to price, asset quality and other terms and conditions. These critics hold the viewpoint that sophisticated parties should be allowed to operate relatively unfettered, however some academics and financial professionals attribute such transactions between sophisticated parties as having played a major role in causing the recent recession.

Though the SEC does not usually extend the comment period for proposed rules, the final implementation of this controversial rule has been postponed to allow for more public commentary. The Commission is expected to close the comment period on February 13, 2012 and to issue its final ABS conflicts of interest rule thereafter.

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