April 28, 2022 - On April 25th, the LSTA submitted a comment letter in response to the SEC’s Notice of Proposed Rulemaking for Private Funds (the “Proposed Rule”). As we’ve previously noted, the Proposed Rule mainly targets private equity, hedge funds and venture capital funds but clearly encompasses CLOs as well. Below, we analyze the first part of the LSTA’s comment letter which (i) explains how the structural requirements and protections of CLOs meet and exceed the policy goals of the SEC, (ii) addresses the specific provisions of the Proposed Rule and (iii) argues that CLOs should either be exempt from the Proposed Rule, or, in the absence of an exemption, the SEC should tailor it to the fit the realities of CLOs. In coming articles we will (i) decode the Regulatory Impact Analysis commissioned by the LSTA and submitted along with the comment letter, which demonstrates that the SEC materially understated the costs imposed by the Proposed Rule, (ii) break down the second part of our letter, where we describe our concerns with the SEC’s statutory authority to adopt the Proposed Rules and whether, in proposing the rule, they complied with the Administrative Procedure Act (APA), and (iii) summarize a whitepaper providing additional information about the CLO market and the history of CLOs that we produced and submitted to the SEC.
The comment letter calls for an exemption from the Proposed Rule for CLOs because they are structured products that are already subject to strong governance, structural protections, and transparency requirements that effectively achieve or exceed the purported goals of the Proposed Rule. Among those protections are the roles played by the trustee, collateral administrator and other third parties who are all independent of the CLO manager and thereby mitigate potential conflicts of interest and protect the interests of investors. For example, the trustee works closely with a collateral administrator who acts as the CLO’s bookkeeper, generating and posting periodic reports for investors and rating agencies. Importantly, the trustee and the collateral administrator control all cash and collateral assets from the closing date to the date that the CLO is liquidated, including the disbursement of fees and expenses to the CLO manager. Also critical is the role played by accountants who perform services known as “agreed upon procedures”, or “AUPs” that are designed to prevent errors as well as check any potential overreach or abuse by the CLO manager. CLO management fees, most of which can only be paid if the CLO is performing well, are set and described clearly and transparently in the indenture. Moreover, administrative fees are also transparent and capped. This is different from the way fees are calculated and paid in typical private funds. Finally, CLO investors already receive extremely detailed monthly and quarterly reports that include information on the CLO’s entire portfolio holdings and performance. Notably, and in contrast to other private fund advisers, the CLO manager has no role in the preparation of asset and performance reports, and, except in very limited circumstances, no role in the valuation of the portfolio assets for the purpose of these reports. Thus, the SEC’s concern that private fund advisers could manipulate performance figures to improve their track record for future fundraising is unfounded with respect to CLOs. Similarly, the SEC’s concern that investors do not receive sufficiently detailed information about private fund investments, fees and expenses, and performance does not apply to CLOs.
The letter next proposes that if the SEC determines not to exempt CLOs, it should tailor the Proposed Rules to recognize the substantial structural protections provided to CLO investors and the limited role of the CLO manager. With respect to quarterly reports, we ask the SEC to (i) provide flexibility regarding the form and content of the quarterly reports to allow CLO investors to continue to receive their information in a form that reflects their preferences and priorities (essentially, what they receive now through monthly and quarterly reports), and (ii) clarify that the Proposed Rule’s consolidated reporting requirements should not apply to CLOs.
Regarding the requirement for annual financial statement audits, we note that GAAP audits would be misleading and unhelpful in the context of cash flow CLOs and would be significantly more costly than estimated by the SEC’s economic analysis. We urge the SEC to exempt CLOs from the requirement to obtain annual GAAP audits, or, alternatively, to expressly allow the AUP process described in the letter to satisfy the audit requirement for CLOs.
Next, we address “prohibited activities” under the Proposed Rule, including (i) charging a private fund for fees or expenses associated with a governmental examination or investigation of the adviser; (ii) charging a private fund for any regulatory or compliance fees or expenses of the adviser or its related persons; or (iii) seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund. The Proposed Rule would prohibit these practices even if the adviser has fully and fairly disclosed such practices to investors and, for existing CLOs, even after investors have agreed to them after full and fair disclosure. We explain that contractual provisions that allow a CLO manager to limit liability in the case of ordinary negligence and to charge CLO clients for certain regulatory or compliance fees or expenses of the adviser (and, in some cases, fees or expenses associated with an examination or investigation of the adviser) are fully transparent practices that are priced into the economics of the CLO. These provisions are willingly accepted and agreed to by sophisticated investors and we question whether the proposed prohibitions of common contractual provisions are beyond the scope of the SEC’s authority.
Finally, we turn to the Proposed Rule’s prohibition of certain types of “preferential treatment” by investment advisers. This section would prohibit investment advisers from granting an investor the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in the private fund or in a substantially similar pool of assets. Because this provision of the rule is vague, it could be interpreted to prohibit the repayment of principal to a waterfall structure (!) which would make it impossible to operate CLOs. We ask the SEC to clarify that repayment of principal to a waterfall structure is not a prohibited preferential redemption. Further, the preferential treatment provision would require an investment adviser to provide to each prospective investor in a private fund a written notice that identifies specific information regarding any preferential treatment the adviser or its related persons provide to other investors in the same private fund. We note that CLO investors are empowered to negotiate and require terms and protections in the indenture with respect to their rights and the characteristics of specific CLO tranches. We note further that the CLO market is also extremely competitive, and investors have the ability to negotiate the terms they are willing to accept. Thus, we do not believe it is necessary or appropriate for the SEC to interfere with individually negotiated terms by requiring advanced disclosure to all investors and prospective investors of preferential terms.
The last, but by no means least, important issue we address in the comment letter is “grandfathering” (or the lack thereof) for existing CLOs. We note that CLO indentures are heavily negotiated and, by design, extremely difficult to amend, typically requiring consent of 100% of noteholders in each tranche for many types of amendments. Moreover, under the Proposed Rule the CLO manager would be the party subject to the SEC’s requirements and the sole party bearing the risk of adverse regulatory action for non-compliance. Given the standard consent requirements for indenture amendments, the CLO manager would be put in an untenable position, facing the near impossible task of obtaining all the necessary consents or be forced to resign to avoid violating the new rules. We assert that application of the Proposed Rule by the Commission retroactively would significantly disrupt the CLO market and the underlying leveraged loan market, and harm existing CLO investors and urge the SEC to refrain from doing so. We will continue our investigation into the SEC’s statutory authority and compliance with the Administrative Procedure Act (APA) in an upcoming missive.