February 24, 2022 - As we’ve noted, the SEC recently introduced a sweeping 341-page rule proposal that would significantly impact CLOs. Now we home in on the most problematic provisions of the rule for CLOs. We break down the analysis into three parts: Prohibited Activities Rules; Reporting and Compliance Rules; and Preferential Treatment Rules and end with notes about grandfathering (or lack thereof) and next steps.
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. Most CLO managers currently are indemnified for acts or omissions that result from negligence which would no longer be possible. 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 is not clear whether this limitation would prohibit such 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 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.
Next steps. Comments are due by April 11th and the LSTA is working expeditiously to comprehensively address the flaws in this proposed rule.