November 13, 2023 - The SEC is expected to finalize its proposed Conflicts of Interest in Securitizations Rule relatively soon. As written, the proposed Rule could be quite disruptive to the CLO market. To refresh members’ memories, we are providing a brief update on the proposal and the three letters we submitted.
There are a number of pitfalls in the proposed rule, but the most critical is the language that would prohibit a CLO arranger or manager from engaging in “Conflicted Transactions.” These include:
(i) A short sale of the relevant ABS (i.e., the CLO note arranged by the arranger or managed by the manager);
(ii) The purchase of a CDS or other credit derivative through which the manager or arranger would receive payments upon the default (or another credit event) of the ABS; or
(iii) The purchase or sale of any financial instrument (other than the ABS) or entry into a transaction through which the CLO manager or arranger would benefit from the:
(a) Adverse performance of the asset pool
(b) Loss of principal, default or early amortization event of the ABS
(c) Decline in market value of the ABS
Prong iii is especially problematic because – unlike most ABS – individual leveraged loans trade actively and are frequently amended. Thus, regular-way loan trading – such as a dealer selling a loan to a CLO manager and then sourcing the loan later – could be captured in Prong iii if the loan declined in value in the interim. Likewise, amendments and refinancings could be perceived as accelerating the amortization of a CLO. This alone is problematic, but what is worse is that affiliates and subsidiaries of CLO managers and arrangers are also prohibited from engaging in Conflicted Transactions.
To address these problems, the LSTA submitted three comment letters. The first, dated March 27, 2023, discussed the negative implications of the proposed rule on CLOs and the underlying loan market. The second, dated May 2, 2023, supported the general recommendations of a letter submitted by SIFMA, SIFMA AMG and BPI (SIFMA I). The third letter, dated Oct 30, 2023, supported specific language changes to the rule as recommended by SIFMA, SIFMA AMG and BPI in their second letter (SIFMA II) that also would help address problems for CLOs. While there are a number of areas where the LSTA supported the SIFMA II letter – such as affiliate language, risk-mitigating hedging, protection of pre-securitization hedging and more – we believe their most critical recommendation was a fix to Prong iii of the Conflicted Transaction language. Specifically, the SIFMA II letter recommended changing Prong iii to:
(i) The purchase or sale of any financial instrument (other than the relevant ABS) or entry into a transaction that substantially replicates one or both types of transactions set forth in clause (i) or (ii) above by means of the securitization participant’s shorting or buying protection on the asset pool underlying or referenced by the relevant ABS.
This language narrows the SEC’s very broad language to merely replicating the actions of Prongs (i) and (ii) through the activities in the underlying asset pool. Thus, SIFMA II’s revised language Prong iii language would remove the threat that individual loan trading or amendment activity could inadvertently land managers or arrangers in a Conflicted Transaction.
We may see in the coming weeks whether the SEC also arrived at such a commonsense solution.