November 22, 2023 - The International Organization of Securities Commissions (IOSCO) has launched a consultation report Leveraged Loans and CLOs Good Practices for Consideration. Last week we looked at the consultation from a leveraged lending perspective, the focus of most of the proposed Good Practices. The consultation’s inclusion of CLO-targeted Good Practices is curious in that the supporting commentary makes clear that the current CLO structure, documentation and market practices already adequately address the risks the Good Practices seek to mitigate. Moreover, investors did not identify concerns or unaddressed risks in the industry roundtables (which included banks, rating agencies, managers, investors, academics and law firms) IOSCO held in developing the Good Practices. Below we focus on the two Good Practices for CLOs proposed in the consultation: “managing conflicts of interest in the management of CLOs” and “disclosure in CLOs”.
Managing Conflicts of Interest
Measure 10 provides that “potential conflicts of interest in the management of CLOs should be appropriately identified and managed.” The supporting commentary recognizes that alignment of manager and investor interest exists in several forms in a CLO – manager’s standard of care, fee structure and the waterfall. Measure 10 elaborates that “policies” governing the purchase of distressed assets, cross-sales and trading/valuation of CCC/Caa rated loans be clearly set out in a CLO indenture. Also, the trustee should report regularly on the trading activity and valuation of assets in the CLO. Finally, investors should be provided with sufficient opportunity to (i) conduct due diligence on the valuation methodology and results of the CLO manager and (ii) assess the strategy and rationale for asset management when performance tests are at risk of being breached. To the extent practicable, the CLO market already meets these standards. Moreover, to the extent there is any daylight at the margins, it is because investors have not made those requests – it may not be a priority or may be otherwise addressed, e.g., regulatory requirements on the CLO manager.
Second verse same as the first! The consultation recognizes the importance of investors receiving materially relevant information during the life of the CLO and the commentary goes on to detail that this already occurs. Measure 11 provides that “investors should be provided with all materially relevant information on the valuation, credit quality and performance of the CLO portfolio consistent with jurisdictional regulatory requirements. It is expected that such data is made available on a regular basis (e.g., monthly) to CLO investors in order for them to make an informed judgment of their investment decisions and that potential CLO investors be provided access to such information upon request.” Again, to the extent practicable, investors already receive this information in the reporting requirements that investors negotiate for when the CLO is being formed.
The fact that CLO practices already are “good” raises several questions about the Practices. On the one hand one may ask “what is the impact of these Good Practices?” IOSCO recognizes that “the good practices do not comprise either standards or recommendations as per IOSCO’s taxonomy;” rather they are designed to support market participants in their decision making when operating in the leveraged loan and CLO markets. Furthermore, the Good Practices appear to memorialize current disclosures and practices – disclosures and practices that investors have negotiated for on their own behalf. However, on the other hand one may ask “what is the need for or benefit of these Good Practices? The basic assumption of public sector involvement in financial markets must be that sophisticated market participants are able to freely transact as they see fit unless identified risks demand intervention. Otherwise, unnecessary costs and undue compliance burden weigh on the transaction, bringing inefficiency to the market. In IOSCO’s case, those identified risks must be consistent with its mandate: (i) protect investors, (ii) ensure markets are fair, efficient and transparent, and (iii) reduce systemic risk. In the case of the SEC (the regulator of US CLO managers), the mission is different: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. In neither case does it appear that CLO market practices conflict with these objectives.