May 3, 2022 - On April 25th, the LSTA submitted a comment letter in response to the SEC’s Notice of Proposed Rulemaking (the “Proposed Rule”).   Previously, we analyzed the first part of the LSTA’s comment letter which explains how the structural requirements and protections of CLOs meet and exceed the SEC’s policy goals and argues that the SEC should exempt CLOs from the Proposed Rule, or, that in the absence of an exemption, the SEC should tailor it to the fit the realities of CLOs. Below, we break down the second part of our letter, describing our concerns with the SEC’s statutory authority to adopt the Proposed Rules and questioning whether, in proposing the rule, the SEC complied with the Administrative Procedure Act (“APA”).

The SEC’s Statutory Authority.  The LSTA’s letter questions whether the SEC exceeded its statutory authority in proposing the rule.  The SEC premises its authority on Sections 206 and 211 of the Investment Advisers Act of 1940 (“IAA”) but in doing so directly conflicts with the text and clear purpose of the Investment Company Act of 1940 (“ICA”), which was specifically designed to regulate pooled investments.  Congress in 1996 added Section 3(c)(7) to the ICA to exclude certain pooled investment vehicles from regulation under that Act.   Section 3(c)(7) funds must be “qualified purchasers” — intended to be institutions or wealthy individuals who are highly sophisticated in financial matters or who hire legal and financial advisers with those qualifications.   Congress adopted this new exception based in large part upon the recommendation of the staff of the SEC’s Division of Investment Management, which explained that “the new exception would be premised on the theory that ‘qualified purchasers’ do not need the [ICA’s] protections because they are able to monitor for themselves such matters as management fees, transactions with affiliates, corporate governance, and leverage”. The Staff also concluded that “no sufficiently useful governmental purpose is served by continuing to regulate funds owned exclusively by sophisticated investors.”  Furthermore, the legislative history of the bill that added Section 3(c)(7) to the ICA reflects Congress’s determination that financially sophisticated investors are capable of appreciating the risks associated with certain investment pools, that they do not need the protections of the ICA, and that the government’s regulatory apparatus is better directed elsewhere. 

Sections 206 and 211 of the IAA are now being used by the SEC to do precisely what Congress determined was unnecessary and precluded by statute.  As we note, “the Proposed Rules impose requirements and restrictions on the terms and operation of the very investment vehicles that Congress determined should not be so regulated. Characterizing these restrictions as regulation of the investment adviser to such funds does not change the reality that these provisions are inappropriately being used as a workaround by the Commission to regulate funds that have been expressly excluded from such regulation by Congress.”

We assert that the SEC lacks the authority to impose such drastic changes to the private fund regulatory framework without a mandate from, and in contravention of, Congress.

The Administrative Procedure Act.  The LSTA argues that a decision by the SEC to move forward with the Proposed Rules in their current form – including by applying the Proposed Rules to CLOs – would raise serious questions under the Administrative Procedure Act separate and apart from its statutory authority concerns.  The LSTA focuses on four elements of the APA: (i) is there a problem in the first place?: (ii) did the SEC properly assess the costs and benefits of its rule?; (iii).  Does the rule upset significant “reliance interests”; and (iv) did the SEC consider better alternatives?  First, the SEC has an obligation to “consider … important aspect[s] of the problem” but they failed to cite any concrete deficiencies or problems with respect to CLOs.  Indeed, the Proposed Rule does not even meaningfully discuss CLOs at all.  As the LSTA demonstrated in the first part of its comment letter, CLOs differ in fundamental, critical respects from other private funds that the SEC seeks to regulate. Whatever the purported justification for regulating those funds, there is no evidence whatsoever of a problem with CLOs that would justify the burdensome regulatory regime the SEC has proposed. By sweeping in CLOs with dissimilar private funds under a one-size-fits-all regulatory without addressing their critical differences, the SEC would not be engaging in “reasoned decision making”, as required under the APA.

Second, the LSTA argues that even if the SEC had reliable evidence of specific concerns with CLOs, the burdensome regulatory regime that it has proposed would do far more harm than good. The Supreme Court has explained that “reasonable regulation ordinarily requires paying attention to the advantages and the disadvantages of agency decisions” and the SEC faces a heightened obligation, as it is statutorily required to consider the economic implications of the Proposed Rule.  As we demonstrate in the first part of the letter, the Proposed Rule would burden CLOs with significant unnecessary costs and regulatory burdens that will reduce the supply, and potentially raise the cost, of capital for U.S. companies, with serious consequences for markets and the economy generally.  Furthermore, because the SEC appears to have given no consideration to CLOs in crafting the Proposed Rules, the LSTA submits that the SEC has no defensible cost-benefit basis for imposing significant new regulatory burdens on CLOs.

Third, the Supreme Court has made clear that a regulatory agency must “assess whether there were reliance interests, determine whether they were significant, and weigh any such interests against competing policy concerns.”  The LSTA argues that there is no basis for disrupting reliance interests on the regime in which CLOs have operated successfully for decades. This is especially true when it comes to the application of the Proposed Rule to existing CLOs.  The Supreme Court has also ruled that retroactivity is not favored in law and that, consequently, the SEC’s rulemaking authority should not “be understood to encompass the power to promulgate retroactive rules unless that power is conferred by Congress in express terms.”  Because the SEC has failed to give any meaningful consideration to the application of its proposed regulatory regime to CLOs specifically, it follows that the SEC has failed to justify the retroactive rewriting of existing CLO agreements.

Finally, the SEC is required to carefully consider alternatives to any regulations the agency ultimately adopts.  In the letter, the LSTA proposed two compelling alternatives: an exemption for CLOs or, at a minimum, a rule that is better tailored to CLOs.  If the SEC rejects these reasonable alternatives, the Proposed Rule will face significant legal risks under the APA.

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