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Senator Levin Explains Intent of Dodd-Frank Conflict of Interest Provision for Firms Profiting from Failure of Securities They Packaged

By Jim Hamilton

The intent of Section 621 of the Dodd-Frank Act is to prohibit underwriters, sponsors, and others who assemble asset-backed securities, from packaging and selling those securities and profiting from the securities? failures. Given the unique control that firms packaging and selling asset-backed securities have over transactions involving those securities, Section 621 of Dodd-Frank protects purchasers by prohibiting those firms from engaging in transactions involving or resulting in material conflicts of interest. The conflicts of interest provision under Section 621 arises directly from the hearings and findings of the Senate Permanent Subcommittee on Investigations, which dramatically showed how some firms were creating financial products, selling those products to their customers, and betting against those same products.

Senator Carl Levin, the principal author of Section 621, likened this practice to selling someone a car with no brakes and then taking out a life insurance policy on the purchaser. In the asset-backed securities context, the sponsors and underwriters of the asset-backed securities are the parties who select and understand the underlying assets, and who are best positioned to design a security to succeed or fail. They, like the mechanic servicing a car, would know if the vehicle has been designed to fail. And so they must be prevented from securing handsome rewards for designing and selling malfunctioning vehicles that undermine the asset-backed securities markets. It is for that reason that Congress prohibited those entities from engaging in transactions that would involve or result in material conflicts of interest with the purchasers of their products (Cong. Record, July 15, 2010, S5901)

However, Section 621 is not intended to limit the ability of an underwriter to support the value of a security in the aftermarket by providing liquidity and a ready two-sided market for it. Nor does it restrict a firm from creating a synthetic asset-backed security, which inherently contains both long and short positions with respect to securities it previously created, so long as the firm does not take the short position. But a firm that underwrites an asset-backed security would run afoul of the provision if it also takes the short position in a synthetic asset-backed security that references the same assets it created. In such an instance, noted Senator Levin, even a disclosure to the purchaser of the underlying asset-backed security that the underwriter has or might in the future bet against the security will not cure the material conflict of interest. (Cong. Record, July 15, 2010, S5899).

While a strong prohibition on material conflicts of interest is central to Section 621, Congress recognized that underwriters are often asked to support issuances of asset-backed securities in the aftermarket by providing liquidity to the initial purchasers, which may mean buying and selling the securities for some time. That activity is consistent with the goal of supporting the offering, is not likely to pose a material conflict, and thus Congress was comfortable in excluding it from the general prohibition. Similarly, market conditions change over time and may lead an underwriter to wish to sell the securities it holds. That is also not likely to pose a conflict. But Senator Levin cautioned federal regulators to act diligently to ensure that an underwriter is not making bets against the very financial products that it assembled and sold. (Cong. Record, July 15, 2010, S5901)

Disclosure has a role in relation to conflicts of interest. But in the view of Congress, disclosure alone may not cure these types of conflicts in all cases. Indeed, while a meaningful disclosure may alleviate the appearance of a material conflict of interest in some circumstances, in others, such as if the disclosures cannot be made to the appropriate party or because the disclosure is not sufficiently meaningful, disclosure is likely insufficient.

The intent of Congress is to provide regulators with the authority and strong directive to stop the egregious practices, and not to allow for regulators to enable them to continue behind the fig leaf of vague, technically worded, fine print disclosures. These provisions must be interpreted strictly, and regulators are directed to use their authority to act decisively to protect critical financial infrastructure from the risks and conflicts inherent in allowing banking entities and other large financial firms to engage in high risk proprietary trading and investing in hedge funds and private equity funds. (Cong. Record, July 15, 2010, S5901). In the end, Congress believes that the SEC has sufficient authority to define the contours of the rules in such a way as to remove the vast majority of conflicts of interest from these transactions, while also protecting the healthy functioning of the capital markets. (Cong. Record, July 15, 2010, S5899).

Full post as published by Jim Hamilton's World of Securities Regulation on August 16, 2010 (boomark / email).