May 19, 2022 - The LSTA recently submitted a comment letter to the SEC on its proposed Private Funds Disclosure Rule and we have written extensively about the threat it poses to CLOs.  But another threat from the SEC looms which could also disrupt the CLO market.  The SEC issued a novel interpretation of a longstanding Rule that, in effect would require that CLO issuers publicly publish information about the structure and performance of their  vehicles and/or could constrain broker dealers from making markets in CLO notes. We highlight the issue below.

In December 2021 the SEC declared that Rule 15c2-11, originally adopted in 1971 to prevent “pump-and-dump” and similar schemes that defraud retail investors in the penny-stock world, would, starting in January 2023, be applied to fixed income securities.  According to that interpretation, the rule would cover asset-backed securities (ABS) issued under Rule 144A, including CLO liabilities.  Rule 15c2-11 will generally require a broker-dealer or a qualified interdealer quotation system to collect, record, and review for timeliness, accuracy, reliability, and public availability certain information related to securities before publishing a quotation, or submitting a quotation for publication, in any “quotation medium” for an OTC security, unless an exception exits.  The information requirements under 15c2-11 for ABS treats the servicer of the assets or trustee of the trust having title to the loans or other assets, acting on behalf of the trust or other legal entity, as the “issuer.” And, instead of the financial statements and other information required about issuers of more traditional securities, the SEC may interpret the information requirement to mandate provision of basic, material information concerning the structure of the securities and distributions thereon, the nature, performance and servicing of the assets supporting the securities, and any credit enhancement mechanism associated with the securities.

The SEC’s unusual interpretation of Rule 15c2-11 is in direct conflict with Rule 144A.  The SEC will now require Rule 144A issuers to publicly publish their information for dealers to be able to quote their securities, without regard for the fact that Rule 144A already provides for this disclosure to all investors eligible to invest in their securities. This could create significant consequences for issuers and investors, threatening capital formation and the healthy functioning of financial markets.  And, while the rule is unnecessary for fixed income securities generally, it is particularly inapposite for ABS liabilities and could materially reduce the liquidity of such securities and disrupt the market more generally.

What’s the problem?  CLO liabilities can only be purchased by sophisticated investors, and managers currently make extensive information available to those investors on a monthly and quarterly basis and to prospective investors on an “as requested” basis. No purpose is served by requiring such information to be publicly published and made available to retail investors who are not even eligible to purchase CLO securities.   Moreover, requiring dealers to validate that information before quoting the CLO securities could prevent dealers from publishing quotes on many CLO securities on any “quotation medium”.  This likely would reduce liquidity for existing holders of CLO securities and could also negatively impact the ability of managers to efficiently issue CLO notes in the future.  And, since CLOs currently purchase at least 65% of broadly syndicated loans, the impact of 15c2-11 could have serious negative ramifications for the underlying loan markets.

What can be done?  A number of trade associations, including the LSTA, are exploring possible solutions for the fixed income market generally and for ABS, including CLOs, specifically.  We will discuss some of those options in the coming weeks.

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