February 16, 2022 - In Chapter 14 of the recently published Handbook on Loan Syndications and Trading, we noted that institutions that participate in the syndicated loan market are directly or indirectly subject to a series of laws and regulations that develop along three interrelated streams: legislative, regulatory, and judicial. Last week, a radical new 341-page rule proposal from the SEC and a new court brief filed in an ongoing case highlighted threats to the loan and CLO markets from two of those streams.
Kirschner v. JPM. Marc Kirschner, the litigation trustee for the Millennium Labs Litigation trust, filed a brief in his appeal of a 2020 decision by a New York District Court and a subsequent denial of his motion to amend his complaint. We have written extensively about this case and its importance to the loan market. In a nutshell, Kirschner asserts that the defaulted term loan B in Millennium Labs (which is structurally similar to all other term loan Bs in the market) is a security subject to state (and, by extension, federal) securities laws and that JPM violated those laws when it originated and distributed the loan to institutional lenders. In the appeal, Kirschner argues (pages 29-48) that the District Court misapplied New York and federal precedent in applying the four-pronged test for determining whether the Millennium loan was a security. He argues that (a) the buyers’ and sellers’ motivations show the loans were securities, (b) the extensive secondary trading of the loans evidences that they were securities, (c) the investors’ reasonable expectations support a finding that the notes are securities, and (d) the absence of a regulatory scheme to protect investors supports a conclusion that the loans were securities. On this last point, Kirschner argues that the mere existence of a bank regulatory scheme that covers these loans addresses bank safety rather than investor protection issues. JPM is expected to respond to the brief in mid-May and the LSTA anticipates filing an amicus brief supporting the proposition that term loan Bs are not securities shortly after that filing.
SEC Rule on Private Fund Investor Reporting/Fees/Compliance Reviews. In the past few weeks the SEC has proposed several sweeping rules relating to private funds. Proposed revisions to Rule PF significantly expand who must report under Form PF, what must be reported and accelerates the timing of event-driven reporting. Proposed cybersecurity risk management rules for private funds would require registered advisers and investment companies to adopt and implement policies and procedures designed to address cybersecurity risks and impose reporting requirements relating to significant cybersecurity incidents. But by far the most potentially impactful and disruptive proposal to many private funds generally and CLO managers specifically is the rule relating to investor transparency. The proposed rule would, among other things, require registered advisers to distribute to investors a quarterly report that would include a fund table, a portfolio investment table, and significant disclosure performance data. The rule would require the distribution to investors of audited financial statements in respect of each fund promptly after the completion of the annual audit. The proposal also includes an ”adviser-led secondaries rule” that would require a registered adviser to provide a fairness opinion from an independent provider in respect of any adviser-led secondary transaction. Remarkably, the rule would outright prohibit many types of sales practices, conflicts of interest and compensation arrangements which could not be remedied by disclosure and would prohibit private fund advisers from seeking indemnity for negligence. Under the proposed rule, advisers would also be required to document an annual review of their compliance policies and procedures. Finally, the rule prohibits advisers from offering side-letters providing preferential treatment to certain investors regarding redemption and other matters and would permit other preferential treatment only to the extent that the adviser discloses such preferences to current and prospective investors. (For a very comprehensive analysis of the proposed rule, see this update from Sidley).
Implications for CLO managers. A deep dive into the possible implications of the proposed rule is beyond the scope of this article (but we will be following up on this topic in future articles). For now, we can identify several potential areas of concern (although there are certainly others). (a) While current CLO disclosure is very extensive, it is not yet clear that current practice would comport with the technical requirements of the rule or what it would take to comply. (b) CLOs are not currently subject to annual audits and imposing that requirement would likely be very expensive. (c) Side-letters and fee arrangements are ubiquitous for CLOs so limitations and disclosure requirements could be difficult and burdensome. (d) Thinly capitalized CLO managers would be very challenged if they were unable to be indemnified for negligence.
What’s next? The SEC has imposed a very tight comment period in respect of this proposal; only 60 days from release of the proposed rule. The LSTA is in the process of carefully reviewing the proposed rule and intends to submit a comment letter by the deadline that will highlight the rule’s challenges and shortcomings as well as question whether the rule is appropriate at all for CLOs which are already extremely transparent and target very sophisticated investors.