O’Melveny & Myers LLP: CLO Update

April 18, 2011

The sweeping financial reform measures passed under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), signed into law by President Obama on July 21, 2010, have begun to take shape as federal regulators chart new territory through rulemaking proposals and required studies and reports are released.

At the time of Dodd-Frank’s enactment, it was unclear whether Congress intended several aspects of the new regulatory framework to apply to collateralized loan obligation transactions (CLOs). Excluding CLOs from the coverage of many aspects of Dodd-Frank was and is widely considered by economists and respected trade associations and industry participants to be sensible considering their vital role in commercial credit generation and promotion of secondary market liquidity, and the fact that CLOs performed well throughout the financial crisis that began in 2007. Indeed, CLO performance results stand in stark contrast to those of subprime mortgage-backed securities and other consumer loan-backed securitizations, which failed as a result of asset-level underwriting deficiencies.

In this edition of CLO Update, we describe ways in which preliminary rulemaking proposals and the contents of studies required under Dodd-Frank suggest that CLOs will be swept up into many aspects of Dodd-Frank that were designed to target securitizations of significantly different and less stable asset classes than commercial loans. We also summarize new and proposed SEC rules that will require more CLO managers to register with the SEC under the Investment Advisers Act of 1940 (the Advisers Act) and consider the impact the Foreign Account Tax Compliance Act of 2009 (FATCA) may have on CLOs.

I. Risk Retention Requirements

The joint notice of proposed rulemaking (NPR) issued by the SEC and several federal banking agencies to implement the credit risk retention requirements of Section 15G of the Securities Exchange Act of 1934, as added by section 941 of Dodd-Frank, presages dramatic shifts in the U.S. CLO industry. If adopted in their proposed form, the rules would significantly narrow the field of eligible CLO sponsors to include only those with the financial ability to retain at least 5% of credit risk of the assets securitized in each CLO.

Generally, as proposed under the NPR, Section 15G would require a “sponsor” to retain, for the life of the CLO, at least 5% of the credit risk of any asset that the sponsor transfers, sells, or conveys to a third party through the issuance of an asset-backed security (ABS). The NPR defines a “sponsor” (consistent with the definition of such term under Regulation AB) as “a person who organizes and initiates a securitization transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuing entity.” The NPR suggests a particularly narrow interpretation of “sponsor” in the context of CLOs by stating in a footnote that “the CLO manager generally acts as the sponsor by selecting the commercial loans to be purchased by an agent bank for inclusion in the CLO collateral pool.” [1] While this sweeping assumption fails to explicitly describe participants other than CLO managers that may constitute “sponsors” as defined in the NPR, including banks that securitize static pools of loans from their balance sheets or other market participants that initiate CLOs by transferring assets from their balance sheets to issuers managed by affiliated advisers, such entities presumably would also be considered “sponsors” for purposes of the final rules. In any event, there is no support in the NPR for excluding such entities from the scope of the rule’s coverage.

The NPR offers CLO sponsors multiple options for satisfying the risk retention requirement, including:

1. Vertical Risk Retention: The sponsor can retain at least 5% of each issued class of CLO notes. Without specifying a method for measuring the sponsor’s 5% interest, the NPR requires simply that the amount retained should equal at least 5% of the par value, fair value, and number of shares or units of each class of notes issued.

2. Horizontal Risk Retention: The sponsor can retain a portion of the most subordinate, “equity” tranche of CLO notes in an amount equal to at least 5% of the par value of all of the CLO’s notes. To comply with this option, the sponsor would need to forego receiving any principal payments on its subordinated notes from principal prepayments or sale proceeds received on the CLO’s underlying assets. This form of retention therefore would not be a viable option for sponsors seeking to offer “turbo” payments or principal proceeds-sharing benefits to the holders of the CLO’s subordinated notes.

A CLO sponsor can also comply with the horizontal risk retention option by funding a cash reserve account, at the closing of the CLO, in an amount equal to 5% of the par value of all of the CLO’s notes. The CLO sponsor would be prohibited from withdrawing any amounts from the reserve account over the life of the CLO except for its pro rata portion of scheduled principal payments distributed to all holders of the CLO’s notes and interest accrued on the cash and cash equivalents held in the reserve account.

3. L-Shaped Risk Retention: The sponsor can combine the vertical and horizontal risk retention options by retaining at least 2.5% of each tranche of CLO notes issued, plus an interest in the most subordinate “equity” tranche equal to at least 2.564% of the par value of all CLO notes issued (other than those interests required to be retained as part of the vertical component).

4. Representative Sample: The sponsor can retain an interest in a randomly selected representative sample of assets, drawn from a pool of at least 1,000 separate assets, that are equivalent in all material respects to the CLO’s assets and have an unpaid principal balance of at least 5% of the aggregate unpaid principal balance of all of the CLO assets “initially” identified for securitization.

If more than one entity qualifies as a CLO sponsor, only one of the sponsors is required to comply with the risk retention requirements under the proposed rules; however, each sponsor is required to ensure that at least one of the sponsors complies with the risk retention requirements.

A CLO sponsor that elects either the vertical or horizontal risk retention option can also allocate a portion of the risk it is required to retain to an “originator” that contributed at least 20% of the assets in the CLO’s portfolio. [2] At least 20% of a CLO sponsor’s retained risk can be allocated to an originator but the percentage allocated cannot exceed the percentage of assets the originator contributed to the CLO. The proposed rules also provide that an affiliate whose financial statements are consolidated with those of the CLO sponsor (consolidated affiliate) can satisfy the sponsor’s risk retention requirement [3].

Neither the CLO sponsor nor any consolidated affiliate can sell, transfer, or hedge any interest in the CLO retained to satisfy the risk retention requirement under the proposed rules. The CLO sponsor and any consolidated affiliate are also prohibited from pledging any interest retained to satisfy the risk retention requirement unless the obligation being secured is full recourse to the CLO sponsor or its consolidated affiliate.

While the proposed rules contain an exemption for CLOs collateralized exclusively by a static pool of qualifying commercial loans that satisfy very conservative underwriting standards, [4] most assets securitizing typical CLOs would not qualify. For example:

  • The originators of the commercial loans must (i) verify and document the financial condition of the borrower as of the end of the borrower’s two most recently completed fiscal years, (ii) conduct an analysis of the borrower’s ability to service its overall debt obligations during the next two years, based on reasonable projections, and (iii) determine that, during the borrower’s two most recently completed fiscal years and the two-year period after the closing of the commercial loan, the borrower had, or is expected to have: (1) a total liabilities ratio of 50% or less, (2) a leverage ratio of 3.0 or less and (3) a debt service coverage ratio of 1.5 or greater.
  • Based on a straight-line amortization of principal and interest, the commercial loan must be fully repaid within five years.
  • If the commercial loan is secured by collateral, the originator must obtain a first-lien security interest on the pledged property.
  • The CLO cannot have a reinvestment period.
  • The loan documentation must include covenants that prohibit the borrower form retaining or entering into a debt arrangement that permits in-kind payments, and place limitations on the transfer of any of the borrower’s assets and on the borrower’s ability to create other security interests with respect to any of its assets.

The deadline for submitting comments to the NPR is June 10, 2011. For CLOs, the risk retention requirement would become effective two years after final rules are published.

CLO sponsors structuring transactions that contemplate issuances of or transfers of notes to EU-regulated credit institutions must also comply with the risk retention requirements of article 122a of the EU Capital Requirements Directive, which imposes punitive capital charges on such investors if they invest in CLO notes in transactions in which the CLO sponsor does not retain a 5% economic interest. Although some overlap exists between the EU requirements and the NPR proposals, such as certain options for satisfying the 5% risk retention requirement, the two regimes are different and require separate compliance analyses. The EU rules took effect on January 1, 2011.

II. Update on the Volcker Rule

As we described in our Client Alert of July 21, 2010 (http://www.omm.com/obama-administration-enacts-sweeping-financial-regulatory-reform-07-21-2010/), Section 619 of Dodd-Frank, commonly referred to as the “Volcker Rule,” generally prohibits banks and bank holding companies with U.S. operations, their affiliates, and subsidiaries (collectively, banking entities) from (i) engaging in most proprietary trading activities and, (ii) with very limited exceptions, investing in or sponsoring private equity and hedge funds (collectively, private funds). The Volcker Rule broadly defines private funds to include any issuer that would be an investment company under the Investment Company Act of 1940 (the Investment Company Act) but for the exclusions provided under Sections 3(c)(1) or 3(c)(7) thereof. The Volcker Rule further provides that Federal banking agencies, the SEC and the Commodities Futures Trading Commission may, through rulemaking, expand the types of private funds covered to include any “similar funds” they deem appropriate.

Many CLOs rely on the Section 3(c)(7) exclusion. Those that do not ultimately could be covered by the rule as “similar funds” should regulators deem it appropriate. Pending further action by regulators, however, questions remain as to whether and how the proprietary trading, investment, and sponsorship restrictions contemplated by the Volcker Rule will apply to CLOs sponsored by banking entities.

In response to the Financial Stability Oversight Council’s (FSOC) solicitation for comments on implementation of the Volcker Rule, industry participants and trade associations, including the Loan Syndications and Trading Association (LSTA) and the Securities Industry and Financial Markets Association (SIFMA), advanced sound economic arguments for excluding secondary commercial loan trading from the scope of prohibited “proprietary trading activities.” These comment letters generally highlighted the essential market making role of banking entities as promoters of liquidity in many asset classes, including commercial loans, and as drivers of growth in the broader economy.

While the FSOC study, released on January 18, 2011, acknowledges the importance of market making and commercial lending, it makes no recommendation concerning whether the proprietary trading activities prohibition should extend to commercial loans or whether CLOs should fall within the definition of “private funds” covered by the Volcker Rule. Although the study further acknowledges that Congress never intended for the Volcker Rule’s restrictions to apply to the sale or securitization of loans, it recommends that regulators consider the scope of this exclusion to ensure that it cannot be used to undermine the Volcker Rule’s prohibitions on proprietary trading. In sum, the study leaves the door open for regulators to further consider whether and to what extent the Volcker Rule should regulate a banking entity’s activities with respect to CLOs.

Despite the present uncertainty surrounding applicability of the Volcker Rule to CLOs, such a result would seem to be contrary to Congress’s intent. Making and retaining commercial loans, whether they are retained in CLOs or otherwise, is an essential banking function. Moreover, prohibiting a banking entity from owning more than 3% of a CLO’s equity would directly conflict with the joint rulemaking proposal designed to codify the credit risk retention requirement of Section 15G of the Securities Exchange Act of 1934, as added by section 941 of Dodd-Frank, which expressly permits a CLO sponsor to satisfy its risk retention requirement through ownership of the most subordinate, “equity” tranche of a CLO’s notes in an aggregate amount equal to at least 5% of the par value of all of the CLO’s notes.

Regulators will have nine months from the release of the FSOC’s study to adopt final rules implementing the Volcker Rule. Banking entities in existence as of July 21, 2010 must conform their activities to the Volcker Rule within two years of the earlier of (a) 12 months following the date regulators issue final implementing rules, and (b) July 21, 2012, with the possibility of up to three one-year extensions if granted by regulators. A banking entity may apply for an additional 5-year extension for any one fund if the banking entity had a contractual obligation in effect on May 1, 2010 to invest in or provide capital to an “illiquid fund,” generally defined as private funds that invest in private equity, real estate, and venture capital investments. Any banking entity that came into existence after July 21, 2010 must conform its activities by the later of (x) the two-year period applicable to banking entities that were in existence prior to such date, and (y) two years following the date the entity was formed.

III. Foreign Account Tax Compliance Act of 2009

On March 18, 2010, President Obama signed the “Hiring Incentives to Restore Employment (HIRE) Act, which includes a revised version of a bill known as the “Foreign Account Tax Compliance Act of 2009” or “FATCA.” FATCA applies to any “withholdable payments” (described below) made on or after January 1, 2013 (though a grandfather rule generally exempts from FATCA payments obligations outstanding as of March 18, 2012). The goal of FATCA is to enhance the ability of the IRS to enforce US tax laws with respect to assets held abroad by US taxpayers through the generation of more information about the foreign assets of US taxpayers. FATCA effectively co-opts most foreign entities into collecting and providing the desired information by imposing onerous withholding taxes on those that do not cooperate.

The FATCA rules will affect most non-US entities, including most CLOs, that hold or may in the future hold most types of US investments. For foreign entities that are “foreign financial institutions” (which includes CLOs), FATCA compliance generally will require entrance into agreements with the IRS that will require them to follow certain due diligence procedures, collect information about direct and indirect “account holders” (which would generally include a CLO’s noteholders and their direct and indirect owners), and report certain information about account holders that are US persons. The precise details of these requirements are not yet known; Treasury has issued only limited preliminary guidance at this time, and is expected to issue additional guidance prior to 2013. Failure to comply with the terms of the above-described agreement will result in the imposition of a 30% withholding tax on “withholdable payments”― payments of US source income, including but not limited to interest and dividends, as well as gross proceeds from the sale of securities that can produce US source dividend or interest income (e.g., US stocks, bonds and notes). Because the definition includes gross proceeds, withholding may be required even where a CLO disposes of investments at a loss.

In order to avoid FATCA withholding, CLOs with an investment period that extends past March 18, 2012 must either comply with the diligence, information gathering, and reporting requirements or avoid making any new US investments after that date. Additionally, loans that are modified may be deemed to be reissued for tax purposes. The IRS has taken the preliminary position that such a deemed reissuance occurring after March 18, 2012 would throw the modified obligation out of grandfathered status. Although transaction documents governing recently formed CLOs may include provisions designed to address FATCA requirements, addressing these issues may be complicated for pre-existing CLOs because the transaction documents do not give service providers the authority to comply with FATCA or to incur the necessary compliance expenses. Industry associations such as SIFMA and LSTA have sought an exemption from these rules for existing CLOs, but as of the date of this publication, Treasury has granted no such exemption.

FATCA becomes effective on January 1, 2013, and will impact any CLO that makes or modifies obligations of U.S. borrowers after March 18, 2012. On the assumption that Treasury does not create an exemption to FATCA for CLOs, withholding agents for CLOs would be well advised to communicate with CLO noteholders about FATCA compliance prior to FATCA’s effective date, which may include sending a notice to CLO noteholders that would: (i) provide general information about FATCA, (ii) describe the CLO’s compliance obligations thereunder, (iii) inform noteholders that, in order to comply with FATCA, the CLO likely will be required to request information from them and/or financial institutions or other persons through which they hold their notes, (iv) explain that information collected from noteholders whose notes constitute “U.S. accounts” (as defined under FATCA) must be reported to the U.S. Internal Revenue Service, (v) warn noteholders that (1) a failure by the CLO to satisfy its compliance obligations under FATCA will result in the imposition of the 30% FATCA withholding tax with respect to all “withholdable payments” made to the CLO and (2) a failure by a noteholder to provide information requested by the CLO may cause the CLO (or its withholding agent) to be required to deduct the 30% FACTA withholding tax from its payments to the noteholder, and (vi) advise noteholders to promptly consult with their tax advisers about how FATCA may impact their investment in the CLO’s notes. By communicating with CLO noteholders about FATCA compliance early on, withholding agents for CLOs may be able to maximize the number of noteholders that ultimately comply with FATCA-related information requests.

IV. New Rules Regarding Registration under the Investment Advisers Act of 1940

Due to recent amendments to the Advisers Act and a series of proposed rules issued by the SEC, CLO managers that have not registered with the SEC in reliance upon the “private adviser exemption” provided by Section 203(b)(3) of the Advisers Act will be required to register with the SEC.

As we described in our Client Alert of July 21, 2010 (http://www.omm.com/obama-administration-enacts-sweeping-financial-regulatory-reform-07-21-2010/), Dodd-Frank eliminated the “private adviser exemption” [5] upon which many CLO managers (including CLO managers based outside of the U.S.) had relied in order to avoid registration as investment advisers with the SEC under the Advisers Act. In place of the private adviser exemption, Dodd-Frank authorized the SEC to tailor alternative registration exemptions for certain investment advisers that do not pose systemic risk to the financial markets. On November 19, 2010, the SEC proposed rules that provide the following limited exemptions from registration for advisers to private funds: [6]

  • Venture Capital Exemption: Provides a limited exemption from registration for investment advisers that solely advise “venture capital funds,” a term that is defined narrowly by the SEC and would exclude CLOs.
  • Foreign Private Adviser Exemption: Provides a complete exemption from registration requirements for foreign private advisers. A foreign private adviser is any investment adviser that (i) has no place of business in the U.S.; (ii) has, in total, fewer than 15 clients in the U.S. and investors in the U.S. in private funds advised by the investment adviser; (iii) has aggregate assets under management attributable to such U.S. clients and investors of less than $25 million; and (iv) does not generally hold itself out to the public in the U.S. as an investment adviser [7].
  • Private Fund Adviser Exemption: Provides a limited exemption from registration for both U.S. advisers and non-U.S. advisers (i.e., investment advisers whose principal office and principal place of business is outside the U.S.). This exemption would be available to (i) a U.S. adviser that acts solely as an adviser to one more qualifying private funds [8] whose aggregate private fund assets are less than $150 million, and (ii) a non-U.S. adviser whose advisory activities in the U.S. are limited solely to managing qualifying private funds; provided, that, if the non-U.S. adviser has a place of business in the U.S., it manages in the aggregate less than $150 million in private fund assets from such U.S. place of business.

Generally, the “foreign private adviser exemption” and “private fund adviser exemption” will apply to far fewer CLO managers than the private adviser exemption. As a result, many CLO managers who were previously exempt from registration under the private adviser exemption will now be required to register with the SEC. Further, CLO managers who are eligible to rely on the “private fund adviser exemption” will be subject to SEC examination and certain reporting and record-keeping requirements. Foreign private advisers would be exempt from all requirements of the Advisers Act other than the general anti-fraud provision of Section 206 of the Advisers Act.

While Dodd-Frank originally required that all advisers required to register thereunder complete their SEC registration by July 21, 2011, the SEC staff has indicated that it is considering extending the compliance date for investment adviser registration for currently unregistered advisers until the first quarter of 2012.

Registering with the SEC under the Advisers Act can be accomplished through the preparation of Part 1 and Part 2A of Form ADV. The investment adviser is required to hire a Chief Compliance Officer who is competent and knowledgeable regarding the Advisers Act and develop a written supervisory procedures manual and a code of ethics reasonably designed to prevent violations of the Advisers Act. The registered adviser will also be required to comply with the rules and regulations promulgated under the Advisers Act, including rules pertaining to advertising and marketing, custody of client assets, books and records, cross trades and principal trades, and client solicitations, among other requirements.

[1] NPR, footnote 42.
[2] An “originator” is a person who, through the extension of credit or otherwise, creates a financial asset that collateralizes an ABS; and who sells an asset directly or indirectly to a sponsor. The NPR notes that the definition refers only to a person who “creates” a loan; thus, only the original creditor--and not any intermediate purchasers of the loan--would be deemed an originator for purposes of the proposed rules.
[3] The proposed rules specify that the CLO issuer does not qualify as a consolidated affiliate even if its financial statements are consolidated with the CLO sponsor. The stated purpose of this distinction is to permit the CLO issuer to hedge its obligations without violating the proposed rules so long as the hedge does not cover any CLO notes retained by the CLO sponsor or its consolidated affiliates in satisfaction of the risk retention requirement.
[4] The proposed rules define a commercial loan as “any secured or unsecured loan to a company or an individual for business purposes, other than a loan to purchase or refinance a one-to-four family residential property, a loan for the purpose of financing agricultural production, or a loan for which the primary source of repayment is expected to be derived from rents collected from persons or entities that are not affiliates of the borrower.”
[5] The private adviser exemption provided that if an adviser (i) had less than 15 clients during the preceding 12 months and (ii) did not hold itself out to the public as an investment adviser, the adviser would be exempt from registration under the Advisers Act.
[6] Section 202(a) of the Advisers Act, as amended by Dodd-Frank, defines a private fund as a fund that would be an investment company under the Investment Company Act but for the exceptions set forth in Section 3(c)(1) or Section 3(c)(7) thereof.
[7] For purposes of determining (i) the number of an adviser’s clients and investors in the United States, (ii) the adviser’s place of business, and (iii) whether the adviser holds itself out to the public in the United States, the SEC has proposed to adopt the definitions of “US Person” and “United States” promulgated under Regulation S of the Securities Act of 1933. In certain cases, an adviser may be required to look through an investor for purposes of counting the number of investors in the private fund and determining whether the adviser has less than 15 clients or investors in the U.S.
[8] A qualifying private fund means any private fund that is not registered under Section 8 of the Investment Company Act and has not elected to be treated as a business development company pursuant to Section 54 of the Investment Company Act.