July 25, 2023 - Rumors abound in Washington, D.C. that the 342-page Private Funds Disclosure Rule (the “Proposed Rule”) proposed by the SEC on February 9, 2022 will be up for a vote of the Commissioners in the coming weeks. As we explain in detail below, the Proposed Rule in its current form would impose significant reporting requirements on certain advisers, require advisers to obtain annual GAAP financial statement audit in respect of each private fund they advise, prohibit private fund advisers from engaging in certain sales practices, require advisers to disclose in detail any side letters they may have with investors, prohibit advisers from being indemnified by investors, and prohibit advisers from providing preferential treatment to certain investors (such as sharing information on a preferential basis). Finally, the Proposed Rule did not include a “grandfathering” clause meaning all existing funds would be subject to the Proposed Rule if finalized.
While the Proposed Rule appears to target Hedge and Private Equity Funds, CLO managers are in scope because of the way the SEC defined Private Funds. Notably, neither securitized asset funds generally, nor CLOs were meaningfully addressed by the SEC in its proposing release nor did they identify any problems or issues with CLOs.
We have previously summarized the Proposed Rule’s impact on CLOs here and here, have deconstructed its broader regulatory impact here, and have provided an economic analysis here and have addressed the issue of audits for securitized asset funds here.
The LSTA submitted a comment letter on April 25, 2022 in which we argued that CLO managers should be exempted from the Proposed Rule or, alternatively, should not be required to engage an auditor to perform annual GAAP audits, should not be required to provide investors with very prescriptive quarterly reports (on top of the extensive asset-level monthly and quarterly reports they currently provide), took issue with the need for the preferential treatment restrictions, and explained that the lack of grandfathering was unworkable.
While we are hopeful (but far from certain) that the audit and quarterly reporting requirements for CLO managers will be eliminated for CLO managers, we expect all the remaining provisions to be imposed on CLO managers in the final rule.
The following is a summary of our concerns with the Proposed Rule as initially released.
Prohibited Activities. The Proposed Rule prohibits several important and common CLO practices, the most critical of which is the ability to seek reimbursement, indemnification, exculpation, or limitation of liability for breach of duty, willful misfeasance, bad faith, recklessness or even negligence in providing services to the CLO. In addition, charging a CLO for examination fees and expenses, or certain non-pro-rata fees and allocations, would be prohibited.
Reporting and Compliance: The Proposed Rule would require CLO managers to prepare a quarterly statement for each CLO it manages. Although CLOs already disclose copious amounts of information to investors, the quarterly statement would also require very detailed accounts of adviser compensation and fees and other amounts allocated to the adviser, as well as fees and expenses paid by the fund. The manager would be required to report performance information based on whether it is a “liquid” or “illiquid” fund as defined under the rule but it’s not yet clear where CLOs fall. Moreover, if CLOs are considered liquid, performance reporting would be extremely onerous. The rule also requires consolidated reporting for substantially similar pools of assets managed by an adviser, and it is unclear how that requirement would apply to advisers that manage several CLOs. The Proposed Rule would also require the production of annual financial statements for each CLO, audited annually by independent public accountants in accordance with GAAP, something that would be very costly and is not current practice. Private funds would need to obtain third party “fairness opinions” in connection with “adviser-led secondary transactions”; while unclear, these might be deemed to include an issuer’s repurchase of CLO securities, re-issue transactions, and possibly re-pricing transactions. Under the proposed rules, registered investment advisers would also be required to document the annual review of their compliance policies and procedures.
Preferential Treatment Rule. CLO managers would be prohibited from providing preferential access to portfolio information to certain investors if that would have a material negative effect on other investors. Some CLO investors require deeper asset level information than others and it seems that this limitation would prohibit such uneven disclosures. This prohibition could have a chilling impact on the ability of managers to continue open dialogue with their investors regarding portfolio holdings. CLO managers would also have to disclose, with a high degree of specificity, if they have favorable “side-letter” fee arrangements with other investors in the CLO. The proposing release states that terms that are considered preferential depend on facts and circumstances.
Grandfathering. The Proposed Rule does not contain any grandfathering provision (but does contain a one-year transition period after which advisers would have to comply). This means that all existing CLOs would have to conform with the rule one year after its adoption even if they have indenture provisions or side-letters that are at odds with the rule.
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 get around to mentioning securitized asset funds until its economic analysis on page 210 and never meaningfully discusses 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.
We will continue to follow this Proposed Rule and will report to members if and when a final rule is approved by the SEC.
