SEC Proposals For Private Fund Advisers Would Increase Costs For CLOs – Corporate/Commercial Law

On February 9, 2022, the U.S. Securities and Exchange Commission
(SEC) issued proposed rules (the “Proposed Rules”) for
private fund advisers that, if adopted in their current form, could
impose significant additional costs on collateralized loan
obligation (CLO) transactions and their managers. As described in
more detail in our client alert at Akin Gump_A Transformation in SEC Regulation of
Private Fund Managers_February 2022, the Proposed Rules
represent an aggressive and controversial potential expansion of
regulation of private funds by the SEC. While the Proposed Rules
primarily target traditional private equity and hedge funds, CLOs
are also in scope because most CLOs rely on Section 3(c)7 for their
exemption from registration under the Investment Company Act of
1940, rendering them “private funds” and therefore
covered by the Proposed Rules.

What is at stake?

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

• Delivery of plain English, concise quarterly statements that
  include specific new disclosures regarding CLO manager compensation
  (both before and after any fee sharing or offsets), other fees and
  expenses paid by the CLO, certain CLO investment-level information
  and standardized performance information (including the criteria
  used and assumptions made in calculating such
  performance).¹




• Annual financial statement audits-a new requirement that would
  be based on and nearly identical to Rule 206(4)-2 under the
  Advisers Act (the so-called “Custody Rule”).




• An independent fairness opinion for certain “adviser-led
  secondary transactions”, which could include transactions
  commonly known in the CLO market as “re-issues” in which
  an existing CLO’s assets are sold to a new issue CLO managed by
  the same manager, where the existing CLO’s investors have the
  option either to obtain liquidity or to roll all or a portion of
  their investment into the new CLO vehicle.




• Prohibitions on charging fees and expenses (x) associated with
  examinations, investigations, and regulatory or compliance matters,
  or (y) on a non-pro rata basis for investments in which other
  clients advised by the CLO manager are participating.




• Prohibition on a CLO manager’s reimbursement,
  indemnification, exculpation or limitation of its liability for
  mere negligence, which are common features of existing CLO
  management agreements that would require costly amendment processes
  to modify.




• Prohibition on (x) selectively disclosing to only certain
  investors information about investments in a CLO or in a
  “substantially similar pool of assets” (which could
  include another CLO) if the CLO manager reasonably expects that
  providing the information would have a material, negative effect on
  other investors in that CLO or in a “substantially similar
  pool of assets” and (y) providing any other preferential
  treatment to any investor unless the CLO manager discloses the same
  to all “prospective and current” investors-a prohibition
  that would cover side letters effecting management fee sharing
  arrangements.




• Documentation of annual review of compliance policies and
  procedures and other recordkeeping requirements.

Who invests in CLOs?

CLOs issue primarily Rule 144A-eligible securities that require
purchasers to be “qualified institutional buyers” for
purposes of that rule that are also “qualified
purchasers” for purposes of the ’40 Act, or non-U.S.
investors pursuant to Regulation S-an investor base that is very
sophisticated in nature; that includes investment banks, insurance
companies, global asset managers and hedge funds; and that
routinely and actively negotiates material terms of the CLO
documents.

Would CLO investors materially benefit from these rules?

One subject of legitimate debate concerning the Proposed Rules
as they would impact the CLO market is whether they would justify
the significant added compliance cost burden given that their
stated objectives-primarily (1) increased transparency and
disclosure, (2) reduced fraudulent conduct through independent
accountant review and (3) minimization of conflicts of interest-are
arguably already achieved through existing applicable law and
regulation or established market practice. For example:

Transparency & Disclosure

• CLOs have independent trustees that, together with their
  affiliates, produce monthly reports and quarterly distribution
  reports for investors that describe key performance and compliance
  data concerning the CLOs’ assets that-although different from
  the specific reporting that would be required under the Proposed
  Rules-are robust, based on a form that is often negotiated by
  investors and viewed by CLO market participants to be the most
  relevant data concerning an investment in the CLO notes. The format
  of these reports is similar across CLOs in the market, facilitating
  “apples to apples” comparisons by investors across
  deals.




• Due in large part to the Rule 144A-eligible nature of CLO
  transactions, side letters are rare and when executed usually only
  effect management fee sharing arrangements that, to the extent
  material in nature, are typically disclosed in the affected
  CLO’s offering circular for all investors to see.

Independent Accountant Review

• CLOs require annual “agreed upon procedures reports”
  to be prepared by independent accountants that back-test the
  calculations in quarterly investor distribution reports.




• Most CLO managers are not required to comply with the Custody
  Rule because an independent trustee-and not the CLO manager-is the
  only party in the transaction that can access cash in the CLO’s
  accounts, under strict restrictions and in accordance with payment
  waterfalls set forth in the CLOs’ indentures and other
  operative transaction documents.

 Conflicts Disclosure & Mitigation

• CLO managers (as well as all private fund advisers more
  generally) are already subject to federal fiduciary obligations
  enforceable through Section 206 of the Advisers Act (the so-called
  “anti-fraud provision”) and other federal securities laws
  designed to prevent fraud.




• CLO offering circulars and management agreements describe in
  detail potential conflicts of interest between the CLO manager and
  its affiliates, on the one hand, and the CLO issuer on the other,
  and the manager’s policies and procedures for managing such
  conflicts of interest as required by applicable law and
  regulation.




• CLO management fees are calculated based on assets under
  management; however, in most cases the value of those assets
  consists of the full par amount of each loan held by the CLO, with
  limited input from the CLO manager, and therefore limited
  opportunity for actions driven by potential 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 CLO trustees when appropriate
  documentation is presented and are subject to an annual cap under
  the CLO indenture.




• CLOs’ investment grade securities are rated by independent
  rating agencies that are subject to the requirements of Rule 17g-5
  of the Securities Exchange Act, which requires disclosure of
  information material to such ratings in a data room accessible by
  other rating agencies that may produce their own unsolicited
  ratings of the same securities (a rule adopted to implement Section
  943 of the Dodd-Frank Act, designed to reduce conflicts of interest
  in the third-party ratings process).

What is the timeline for adoption of these rules?

The Proposed Rules are subject to an initial comment period
expiring on April 25, 2022. As with any SEC proposals, the comment
period can be extended and the proposals are subject to potential
modification and subsequent re-proposal before being adopted in
final form, if at all. CLO industry participants will recall that a
protracted adoption process took place for the Credit Risk
Retention rules, which were initially proposed in April 2011 and
not finalized until October 2014, with an effective date for CLOs
of two years out. After coming into effect for CLOs, those rules
were then successfully challenged in court in 2018 insofar as they
would purport to apply to “open-market CLOs”. As for the
Proposed Rules in this case, it is important to note that even
their initial version indicates they would not take effect until a
year after 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 watch this space closely for further
developments.

footnote

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

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.