October 20, 2022 - On November 4th, a revised Marketing Rule promulgated by the SEC goes into effect. The Rule (which was described in detail in an LSTA webinar in May 2021) impacts most Registered Investment Advisers (RIAs), and CLO managers are no exception. Complicating matters, the Rule implicates the relationship between CLO managers (who are all RIAs) and the arrangers that arrange and place the CLOs on behalf of managers. On the one hand, compliance with the Rule falls on the managers. On the other, arrangers, who interact with prospective CLO investors but are not directly subject to the Rule, will necessarily be part of the process. Determining how to thread the needle on how to allocate responsibilities has been the subject of many recent conversations among lawyers who represent managers and/or arrangers. Below we lay out what the Rule requires and describe some of the pressures facing market participants in arriving at a sensible solution.
Background. The Rule regulates “Advertisements” which include compensated third-party solicitations of prospective investors in private funds. For the purposes of the Rule, private funds include virtually all CLOs and certain “third-party communications” of the CLO arranger on behalf of a manager would be captured under the Rule as “endorsements or testimonials” for which an RIA provides direct or indirect compensation. It is beyond the scope of this note to describe in detail what is considered an endorsement or many of the intricacies of, and exemptions from, the Rule, but we will highlight several key points. (Milbank has recently published a comprehensive summary of the Rule and it’s impact on CLO managers and arrangers, available here).
Importantly, the Rule does not exempt oral or one-on-one communications. The SEC has made it clear that “these types of communications are precisely what” the Rule intends to capture. Thus, as Milbank notes, any form of statement by an arranger to a prospective investor could potentially be viewed as an endorsement “if it is considered a solicitation or referral to invest in CLO securities or indicates approval, support, or recommendation of the collateral manager or its personnel.” Consequently, at least a portion of an arranger’s communications with prospective investors would be considered endorsements.
What requirements are applicable to endorsements? The manager must disclose or reasonably believe that the person giving the endorsement discloses, at the time of the endorsement, (i) that the endorsement was given by a person other than a current client or investor, (ii) that cash or non-cash compensation was provided for the endorsement, and (iii) a brief statement of any material conflicts of interest on the part of the person giving the endorsement resulting from the manager’s relationship with the such person. The manager must reasonably believe that arrangers working on their behalf are providing those disclosures.
Adviser Oversight. The Rule requires that RIAs oversee compliance by any person compensated to provide endorsements. The RIA must have (i) a reasonable basis for believing that the endorsement complies with the requirements of the Rule, and (ii) a written agreement with any person giving an endorsement that describes the scope of the agreed-upon activities and the terms of compensation for those activities. Importantly, the Commission does not require explicit undertakings; instead, it is left to the RIAs to determine whether and how to address disclosure and other requirements. Similarly, the Rule does not proscribe the steps an adviser must take to establish a reasonable basis for believing an arranger’s endorsements are compliant.
And Therein Lies the (Market) Rub. The written agreement referred to in the preceding paragraph would generally be satisfied by the engagement letter between a manager and an arranger. However, there is apparently no consensus, and, indeed, a significant gap, between arrangers and managers as to what terms should be included in the agreement. Nevertheless, the Rule is coming very soon and managers will be required to comply in order to issue new CLOs. Accordingly, the LSTA, working through its CLO Committee, is facilitating a conversation among members of the CLO community in the hopes of arriving at a workable resolution for the market. We will continue to communicate with our members as the process plays out.