March 15, 2023 - As discussed last month, in January the SEC reproposed its 2011 “Prohibition Against Conflicts of Interest in Certain Securitizations Rule (the “Proposed Rule”), which would prohibit a “securitization participant” from directly or indirectly engaging in any transaction that would result in a material conflict of interest between the securitization participant and an investor. In the past month, the LSTA has been working with members and other trade associations to develop a strategy to engage constructively on the Proposed Rule. However, the bottom line: The original proposed rule would not work and the new Proposed Rule may actually be worse. Below, we provide a brief English-language (and SEC-language) recap of the rule, as well as key issues that the LSTA is considering in its response.
Background on the Rule: – The rule is complex but, in an English-language nutshell, if you are a CLO manager or a CLO arranger, for one year after the closing of the sale of the CLO notes, you cannot have any cash or synthetic short position in the CLO notes OR purchase or sell any instrument that could benefit from loss or decline in value of the CLO notes or the adverse performance of the asset pool. While we believe that any adverse performance should reference the actual pool of assets in the CLO – and not similar assets or a portion of the asset pool – the rule does not explicitly define asset pool.
Scope: Glib answer? Everyone and all their relatives. The rule applies to all subsidiaries and affiliates of a CLO manager or arranger, both domestic and foreign, and, as currently written, cannot be solved by information walls. Moreover, parties cannot rely on “disclosure and consent” from investors, a classic approach for managing conflicts. So, if CLO managers or arrangers (or their affiliates/subsidiaries) have multiple strategies (some of which could be conflicted transactions) basically anywhere in their institution, they could fall afoul of the rule. (Switching to SEC-speak, here are the affiliate and subsidiary definitions in the Proposed Rule: “Under Securities Act Rule 405, an “affiliate” of a specified person is a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified, and a “subsidiary” of a specified person means an affiliate controlled by such person directly, or indirectly through one or more intermediaries. Also, under Securities Act Rule 405, the term “control” is defined to mean the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”)
Unique CLO Issues – While the Proposed Rule presents many challenges for all forms of securitizations, CLOs have some fairly unique challenges because the underlying collateral (the loans) are actively traded and, potentially, some trading activity might be perceived as running into the prohibition against taking adverse positions in the “asset pool”. For instance, to support their clients, banks routinely sell loans into CLO warehouses, which might (inaccurately) be construed as an adverse position to the asset pool. In addition, there are a number of bank loan ETFs (in which there can be short interest) as well as a developing class of CLO ETFs. While we are not aware of any trades that are structured as a bet against CLOs, we need to clarify that these benign activities should not interpreted as such by the SEC. The LSTA currently is running all these issues down with our working group.
And everything else… Even outside of the CLO specific issues, there are many things that do not work in the rule, including an inability to rely on disclosure and consent and no recognition of information barriers. These approaches have worked well in the years since Dodd-Frank (under which the Proposed Rule was issued), and there is no reason to jettison well-honed and well-working tools. We will continue to engage.