June 21, 2023 - This week the LSTA submitted its comment letter on the SEC’s 432-page proposed rule on Safeguarding Advisory Client Assets, a/k/a the Custody Rule (the “Proposed Rule”).  As we noted previously and as discussed below, the Proposed Rule in its current form is extremely challenging for managers of loan assets.  It would, at a minimum, impose a requirement to arrange for an annual surprise audit, and would completely alter advisers’ relationships with custodians.   A worse outcome would require managers to engage an independent accountant to monitor every loan trade and report discrepancies to the SEC in near-real time.

What does the Proposed Rule say?  The Proposed Rule’s requirements attach to advisers that have “custody” of client assets.  “Custody” is defined to include any arrangement where an adviser maintains “discretionary authority” over a client’s assets (i.e., “the authority to decide which assets to purchase and sell for the client”).  Among other things, the Proposed Rule would require that a qualified custodian maintain possession or control of client’s assets pursuant to a written agreement between the adviser and the qualified custodian.  The Proposed Rule would define “possession or control” as:[H]olding assets such that the qualified custodian is required to participate in any change in beneficial ownership of those assets, the qualified custodian’s participation would effectuate the transaction involved in the change in beneficial ownership, and the qualified custodian’s involvement is a condition precedent to the change in beneficial ownership.”  Importantly, for assets that cannot be maintained in the “possession and control” of a qualified custodian, the Proposed Rule would impose on advisers a trade-by-trade verification requirement, performed by an independent public accountant.

Why could this be a problem for loan managers?  We have significant concerns regarding the definition of “possession or control,” both because the definition itself is very vague, and, more troubling, because the Commission appears to believe that Loan Interests fail the test.  Indeed, the Commission states that loan participation interests, “may not currently involve a qualified custodian.” This conclusion ignores the multi-faceted and well documented trade and settlement process where more than one third party – independent of the adviser – verifies trade information, records changes in beneficial ownership, and reconciles the receipt of interest payments and Loan Interest proceeds. The controls and processes in place in the trading and settlement of loans are more than adequate to protect clients from theft, loss, and misappropriation.

The Loan Trading and Settlement Process.  Section III of the LSTA comment letter explains in great detail how the controls and processes in place in the loan market protect clients from misappropriation.  A discussion of those controls is beyond the scope of this note and we refer you to the comment letter itself.

The Proposed Rule’s trade-by-trade accountant verification requirement is unnecessary and superfluous.  We conclude the comment letter by asserting that the proposed verification requirement would not add any protection regarding the transfer of loan interests above and beyond the robust protections already in place.  The Administrative Agent, the settlement platform, and the collateral/fund administrator each plays a significant role in ensuring integrity and accuracy in the settlement process, and collectively perform the same trade verification function contemplated by the Proposed Rule.  The electronic settlement platform captures and stores transaction records and provides them, as well as the underlying documents, to custodians and trustees, serving as another control against theft, loss, or misappropriation. The transaction process for Loan Interests already incorporates robust independent checks and controls against accidental and deliberate misdirection of client assets.  Moreover, the settlement process for the transfer of Loan Interests includes extensive documentation and the involvement of several outside parties, all of which serve to place checks on the adviser’s activities and mitigate the risk of an adviser’s misappropriation (as well as inadvertent errors that could harm clients).  Therefore, we urge the Commission to recognize that the process for trading and settling Loan Interests incorporates robust controls and, in conjunction with the role of service providers, provides sufficient protection of client assets without additional verification of each trade by an independent public accountant.

Next steps.  In the coming weeks, we expect to meet with members of the Commission staff to respond to explain our views and respond to their questions.

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