The Volcker Rule and Conflict-of-Interest Rulemaking:
Will Traditional Securitization Survive?

Abstract

While many reforms in Dodd–Frank are aimed at the securitization market, the proposed rules to implement Sections 619 and 621 may fundamentally limit traditional securitization practices that are vital to the consumer economy. Section 619 and the related proposed rule, otherwise known as the Volcker Rule, are intended to prohibit banks from engaging in proprietary trading and sponsoring, owning, or having certain relationships with hedge funds and private equity funds. Many securitizations are brought within the scope of the rule because they rely on the same exemptions from the Investment Company Act, namely Section 3(c)(1) or 3(c)(7), as do traditional hedge funds and private equity funds. However, there is ample evidence that the Volcker Rule is intended to address concerns that have nothing to do with the securitization markets, including the securitization exemption language in Dodd–Frank that explicitly states, “[n]othing in [the Volcker Rule] shall be construed to limit or restrict the ability of a banking entity … to sell or securitize loans.” For this reason, industry participants believe that Congress intended the Volcker Rule to fully exempt securitizations from its prohibitions. If a broad exclusion is not granted, other provisions of the rule must be modified to accommodate securitization, such as the “Super 23A” provisions that prohibit banking entities from engaging in certain “covered transactions” with securitization entities that are often integral to the securitization process.

Section 621 and the related proposed rule, otherwise known as the conflict-of-interest rule, prohibit certain persons who create and distribute an asset-backed security (ABS) from engaging in transactions within one year after the date of the first sale of the ABS that would result in certain material conflicts of interest. The purpose of this prohibition is to eliminate incentives for market participants to intentionally design ABS to fail or default. Although the proposed rule does provide exceptions to the prohibition for risk-mitigating hedging activities, liquidity commitments, and bona fide market making, it is critical that the U.S. Securities and Exchange Commission (SEC) clarify which activities, including those inherent to the securitization process, would or would not be prohibited by the rule. Additionally, it remains to be seen the extent to which meaningful disclosure may be used as a tool to manage conflicts of interest that would otherwise be prohibited under the proposed rule. By revising the proposed Volcker Rule and conflict-of-interest rule to preserve traditional securitization activities, these rules can effectively achieve their intended goals without impeding the recovery of the securitization market.