On February 9, 2022, the United States Securities and Exchange Commission (SEC) released proposed rules (the “Proposed Rules”) for private fund advisers which, if adopted in their current form, could impose significant additional costs on secured loan obligation (CLO) operations and their makers. As further described in our Client Alert to Akin Gump_A Transformation in SEC Regulation of Private Fund Managers_February 2022, the proposed rules represent an aggressive and controversial potential expansion of private fund regulation by the SEC. Although the proposed rules primarily target traditional private equity and hedge funds, CLOs are also affected as most CLOs rely on Article 3(c)7 for their exemption from registration under the law. on investment companies of 1940, making them “private funds” and therefore covered by the proposed rules.

What’s at stake?

The proposed rules in their current form would require CLOs to comply with at least the following new obligations:

• Delivery of concise, plain language quarterly statements including specific new information regarding CLO manager compensation (both before and after any fee sharing or offsetting), other fees and expenses paid by the CLO, certain information about the CLO’s level of investment and standardized performance information (including the criteria used and the assumptions used to calculate this performance).[1]
• Annual audits of financial statements – a new requirement that would be based on and almost identical to Rule 206(4)-2 of the Advisers Act (the so-called “custody rule”).
• An independent fairness opinion for certain “advisor-led secondary transactions”, which could include transactions commonly referred to in the CLO market as “reissues” in which the assets of an existing CLO are sold to a new issue CLO managed by the same manager, where investors in the existing CLO have the option of either obtaining cash or transferring all or part of their investment into the new CLO vehicle.
• Prohibitions against charging fees and expenses (x) associated with reviews, investigations and regulatory or compliance matters, or (y) on a disproportionate basis for investments involving other clients advised by the CLO Manager.
• Prohibition of reimbursement, indemnification, exoneration or limitation of liability of a CLO manager for simple negligence, which are common features of existing CLO management agreements whose modification would require costly amendment processes .
• Prohibition on (x) selectively disclosing to certain investors only information about investments in a CLO or a “substantially similar pool of assets” (which could include another CLO) if the manager of the CLO reasonably expects to that the disclosure of the information would have a material adverse effect on other investors in this CLO or a “substantially similar pool of assets” and (y) grant any other preferential treatment to any investor unless the Manager of CLO discloses it to all “potential and actual” investors – a prohibition that would cover side letters relating to management fee-sharing agreements.
• Documentation of annual review of compliance policies and procedures and other record keeping requirements.

Who invests in CLOs?

CLOs primarily issue Rule 144A-qualifying securities which require buyers to be “qualified institutional buyers” for the purposes of this rule who are also “qualified buyers” for the purposes of Law 40, or non-U.S. investors pursuant to the S regulation: a basic investor of a very sophisticated nature; which includes investment banks, insurance companies, global asset managers and hedge funds; and who regularly and actively negotiates the material terms of CLO documents.

Would CLO investors materially benefit from these rules?

One of the areas of legitimate debate regarding the proposed rules, as they would impact the CLO market, is whether they would justify the significant additional burden of compliance costs given that their stated purposes – primarily (1) increased transparency and disclosure, (2) reduction of fraudulent behavior through accounting reviews, and (3) minimization of conflicts of interest – are arguably already achieved through applicable laws and regulations or best practices. established market. For example:

Transparency and Disclosure

• CLOs have independent trustees who, together with their affiliates, produce monthly reports and quarterly distribution reports for investors that outline key performance and compliance data regarding CLO assets which, although different from the specific reports that would be required under the Proposed Rules, are robust, based on a form that is often traded by investors and considered by CLO market participants to be the most relevant data regarding an investment in CLO notes. The format of these reports is similar for all CLOs in the market, making it easier for investors to make apples-to-apples comparisons between trades.
• Due in large part to the Rule 144A-eligible nature of CLO transactions, side letters are rare and, when executed, generally only affect management fee-sharing agreements which, to the extent where their nature is material, are generally disclosed in the relevant CLO’s offering circular for all investors. to have.

Independent accounting review

• The CLOs require annual “Agreed-Upon Procedures Reports” to be prepared by independent accountants who verify the calculations in the quarterly Investor Distribution Reports.
• Most CLO managers are not required to comply with the custodial rule because an independent trustee – not the CLO manager – is the only party to the transaction who can access cash in the CLO’s accounts, under strict restrictions and in accordance with the stated payment cascades. in CLO deeds and other operational transaction documents.

Disclosure and Conflict Mitigation

• CLO managers (as well as all private fund advisors more generally) are already subject to enforceable federal fiduciary duties under Section 206 of the Advisors Act (the so-called “anti-fraud provision”) and other federal securities laws designed to prevent fraud.
• The CLO offering circulars and management agreements describe in detail the potential conflicts of interest between the CLO manager and its affiliates, on the one hand, and the CLO issuer, on the other hand, and the the manager’s policies and procedures for managing such conflicts of interest, in accordance with laws and regulations.
• CLO management fees are calculated on the basis of assets under management; however, in most cases, the value of these assets is the full nominal amount of each loan held by the CLO, with limited input from the CLO manager, and therefore limited possibility of actions motivated by conflicts of interest between the CLO manager and the issuer to affect the manager’s fees.
• The types of costs that can be charged to a CLO are quite limited in nature, are only paid by the CLO’s trustees upon presentation of appropriate documentation, and are subject to an annual cap under the CLO’s trust deed.
• Investment grade securities of CLOs are rated by independent rating agencies that are subject to the requirements of Rule 17g-5 of the Securities Exchange Act, which requires the disclosure of material information for such ratings in a data room accessible by d ‘other rating agencies that may produce their own unsolicited ratings of the same securities (rule adopted to implement Section 943 of the Dodd-Frank Act, designed to reduce conflicts of interest in the third-party rating process ).

What is the timetable for the adoption of these rules?

The proposed rules are subject to an initial comment period expiring on April 25, 2022. As with all SEC proposals, the comment period may be extended and the proposals are subject to potential amendments and subsequent resubmission prior to publication. be adopted in their final form, if at all. CLO industry participants will recall that a protracted adoption process took place for the credit risk retention rules, originally proposed in April 2011 and not finalized until October 2014, with an effective date in force for two-year CLOs. After coming into effect for CLOs, these rules were then successfully challenged in court in 2018 as they purported to apply to “open market CLOs”. With regard to the rules proposed in this case, it is important to note that even their initial version indicates that they would not come into force until one year after the publication of the final rules in the Federal Register. That said, given the broad scope of the proposed rules and their significant potential impact on CLOs, industry groups and market participants are preparing comment letters and will continue to monitor this space closely for new developments.

¹ The type of performance information that would be required for CLOs is uncertain and depends on whether the CLOs will be considered “illiquid funds”, “liquid funds” or hybrids of the two. A careful reading of the proposed rules suggests that CLOs should be treated as liquid funds, which should disclose annual net total returns for each calendar year since inception, annual net total returns over the one-, five-, and 10-year periods and the cumulative net total return for the current calendar year at the end of the last calendar quarter covered by the quarterly statement.