The Securities and Exchange Commission has picked up its pace of proposed rulemaking – “too much, too quickly,” Securities Industry and Financial Markets Association chief Kenneth Bentsen has complained – in areas ranging from cybersecurity to security-based swaps to asset management and fund disclosures. In the last category are changes that critics say could disrupt the collateralized loan obligation (CLO) market.
One proposal requires new disclosures by private-fund advisers to investors. Another amends an existing rule that may inhibit Wall Street’s ability to quote nonpublic fixed income securities. Together, the changes would affect a broad swath of financial instruments including CLOs, which purchase upwards of 70% of leveraged loans and so are a key funding source for those corporate borrowers.
An April comment letter from Structured Finance Association (SFA) president Kristi Leo said that in its current form, the disclosures rule “could have significant unintended and adverse consequences in the CLO and corporate lending markets.”
The 30-day comment period on the private-fund proposal expired April 25, 12 days after a submission from 47 Congress members said that the complexity of the rulemaking warranted a 90-day comment period. Other filers made a similar argument, with the SFA saying that it “and our members are still diligently working our way through the full proposal” and “we intend to supplement this preliminary submission, after we have completed our member assessment of the additional aspects of the proposal, within 30 days.”
The SEC on May 9 reopened the comment period on private-fund adviser compliance reviews for 30 more days.
In a May 6 speech, SEC Chair Gary Gensler stressed the importance of the agency’s “disclosure and transparency regimes” and how they are continually updated to keep pace with markets that “don’t stand still . . . We must always remain vigilant to opportunities to enhance transparency, which helps foster innovation and growth, and helps maintain our markets as the world’s gold standard.”
LSTA General Counsel Elliot Ganz
Missing the Target?
Both SFA and the Loan Syndications and Trading Association (LSTA) stated that the CLO market, and asset-backed securities (ABS) in general, already provide as much if not more disclosures than the proposal would require. They also argued that requirements such as annual finance audits are not material to CLO investors, and, SFA said, “performance of ABS depends primarily upon the cash flows generated by the underlying asset, rather than the issuer’s success as an operating company.”
The most problematic aspect of the proposal, wrote LSTA general counsel and co-head of public policy Elliot Ganz, is the lack of a grandfathering clause for existing CLOs. He said imposing the requirements retroactively could “not only harm CLO investors but could have material negative effects on the broader syndicated loan market and the U.S. economy.”
In an interview, Ganz explained, CLO structures differ significantly from hedge, private equity and venture capital funds. For example, CLOs have indentures setting out primary terms, including how payments are made and the appointment of trustees representing the investors. Those agreements are by design difficult to amend, specifically to protect investors. They can require unanimous consent of note holders who may be difficult to find.
Inability to amend the transactions could force managers’ resignations and, by terms of the indenture, dissolution of the fund or redemption by the equity noteholders.
“That could be incredibly disruptive to the underlying leveraged loan market, because if you’re going to be redeeming a lot of CLOs, there would suddenly be a lot of loans for sale,” Ganz said.
The LSTA counsel added that the proposal’s annual audits and new quarterly reporting requirements, on top of CLOs’ current disclosures including monthly and quarterly performance and cash flow information, would bring significant additional costs. Large asset managers such as Carlyle or Blackstone running numerous CLOs may digest those costs, Ganz said, but smaller players may be forced to consolidate or exit the business.
Also potentially raising costs for ABS transactions, and ultimately for consumer and business borrowers, are SEC’s expansion of Rule 15c2-11 to fixed income. The agency amended the longstanding rule in 2020 to modernize disclosures and investor protections in the over-the-counter market by ensuring that broker-dealers, as gatekeepers, only publish quotes for an issuer’s security when the current issuer information is publicly available. That effectively requires issuers to provide access to the required Rule 144A information via a public website.
The rule has technically always covered both OTC equities and bonds, but since it was passed in 1971 it has only been enforced with equities, where pump-and-dump schemes and other problematic practices are prevalent.
“Nobody’s calling to you to buy a bond from a nonexistent issuer,” said Chris Killian, managing director, securitization and corporate credit at SIFMA, so leading up to the amendment’s passage the industry largely assumed they would continue to apply just to equities.
As the September 26, 2021 effective date approached, Killian said, industry participants queried SEC staff to confirm that the rule did not apply to fixed income. An SEC no-action letter clarified that indeed it did but would not be enforced until January 2022.
Another letter December 16 said it would be enforced in stages. It will require quasi-private Rule 144A deals to have publicly available issuer information at the start of 2023 to be exempted from the rule’s quoting restrictions.
SFA President Kristi Leo
Published or On Request?
A large portion of the ABS market falls under Rule 144A, including all residential mortgage-backed securities (RMBS) deals, much of prime and subprime auto ABS, esoteric ABS, and most CLOs. The SFA’s Kristi Leo said the industry succeeded in persuading the SEC to make some adjustments appropriate for securitization. Balance-sheet and income-statement disclosures required for other fixed income and equity issues have thus been replaced with monthly cash flow statements.
“But what the SEC seems to be skirting is the whole concept of Rule 144A, which doesn’t require publicly available information, but just that it be made available on request,” Leo said.
One concern, she added, is that the rule applies to existing bonds, but 144A documents don’t contemplate a deal party providing this information publicly, and it is difficult to amend any deal when issuers may no longer exist. For example, Countrywide Financial, which once financed 20% of U.S. mortgages, was purchased by Bank of America in the wake of the housing crisis. Its RMBS remain in circulation, but there is no active issuer to post the information on a website.
Automate and Reduce Risk
“These deals are in a lot of folks’ portfolios, but it would be difficult for dealers to quote them because they don’t meet the letter of the rule,” Leo said.
So far, the SEC has shown little willingness to exempt fixed income from the amended rule to lessen the operational and technology burden on broker-dealers and issuers. Killian noted that unlike the thousands of OTC-equity CUSIP security identifiers, fixed income securities number in the millions to be filtered and handled appropriately by broker-dealers’ systems.
“There are several more possible exemptions, so broker-dealers are going to want to automate the process as much as possible to make it easier,” Killian said, “but also to reduce the risk of errors, which would prevent them from quoting the securities.”
He added that vendors are developing services to provide the necessary data, but it will be up to the intermediaries to develop comprehensive systems to process it, an effort likely to extend well into 2023.
In addition, private companies use the Rule 144A market specifically to avoid disclosures that the amended Rule 15c2-11 will require, including loan-level information that could reveal who their borrowers are. So they will have to decide whether to build the functionality to provide the public disclosures or avoid Rule 144A altogether and issue a privately placed bond or negotiated loans or other financings that are more private but also more expensive.
“The only direction this regulation goes in,” Killian said, “is toward lower liquidity, less efficient financing and less flexibility.”
That could impact major corporations that represent a significant chunk of the economy. Killian said the total number of 144A issuers is unclear, but at least 30 of the top 200 private companies issued Rule 144A debt over the last four years.
“We estimate just those 30 firms employ approximately one million people,” Killian said. “So it’s not some niche product.”