January 18, 2024 - In an environment where regulatory shifts are happening at a frustratingly rapid clip, 2023 was a gratifyingly positive year for the corporate loan market and its participants. Will 2024 see that trend continue? It remains to be seen.
Certainly 2024 will be busy on the policy front. We await final rulemakings by the SEC in important areas such as liquidity risk management for open end loan funds, outsourcing by investment advisers, custody/safeguarding of loan assets, conflicts in the use of predictive data analytics, ESG disclosures for funds and RIAs, and further word from IOSCO on leveraged lending and CLOs. Not to mention the compliance questions that market participants will be working through in preparation for the implementation of the SEC’s prohibition on conflicts of interest in securitizations rulemaking as well as potential considerations for private funds (other than CLOs) in preparation for the SEC’s Private Fund Advisers Rule coming online (more on that here). The hard work continues for the LSTA and its members; still, it is important to recognize our market’s “wins.” Below is a high-level summary of last year’s near misses.
The Kirschner case: Loans are not securities
Easily the issue that dominated conversations in the loan market for most of the year – the loan market faced the final showdown on its most existential question – are term loan Bs (TLBs) subject to the federal securities laws. In August the Second Circuit said “No,” affirming the district court’s decision in Kirschner v. JPM that TLBs are not subject to the federal securities laws. Both courts recognized that (at least) three out of the four Reves factors weighed in favor of treating TLBs as distinct from securities. To wit, TLBs are not offered or sold to a broad segment of the public, lenders could not have a reasonable belief that loans are securities, and the application of the securities laws is unnecessary in light of TLBs being secured and subject to prudential regulator oversight.
It was not always clear that the loan market would see this result, however, after the Second Circuit threw a curve ball in March. Shortly after hearing oral arguments the Second Circuit asked the SEC to weigh in “with any views it wishes to share” on whether the loans in the Kirschner case are securities under the Reves test. Fearing that the SEC may see this invitation as an opportunity to draw loans into their fold, the LSTA actively engaged with the SEC and the banking agencies to impress upon them the legal reality and congressional intent that loans are distinct from securities and, importantly, any view to the contrary would be massively disruptive to a decades-old market. Ultimately, despite having kept everyone in suspense for months, the SEC declined to weigh in.
The Kirschner decision now serves as a roadmap for maintaining the distinction between TLBs and securities and favorably (and appropriately) answers a question that had not been asked in 30 years. We note that Kirschner filed a petition for certiorari to the Supreme Court this week (and also note that this case presents no federal circuit split, the SEC did not take a position, and the decision affirms relevant case law).
Private Fund Advisers Rule: CLOs exempted
The SEC adopted final Private Fund Advisers Rule in August – finalizing a rulemaking that was extremely contentious and, as demonstrated by our lawsuit, in our opinion wholly unauthorized. The rulemaking represents an important step in the SEC’s quest to impose additional disclosure by and restrictions on private funds. Because CLOs are private funds, the proposed rule would have required CLOs to undertake massive additional and unnecessary reporting and prohibit or limit standard practices in the CLO market. In response, the LSTA engaged with the SEC extensively on this issue – through its comment letter (including an economic analysis report) and directly with SEC staff. The LSTA was gratified that our recommendation was adopted in the final rulemaking:The SEC recognized that the rule simply did not suit asset securitization funds, like CLOs, and exempted these funds from all of the rules other than the single requirement of all RIAs to review and document compliance reviews in writing at least once a year. With respect to all other private funds, the final rules represented an improvement from the proposed rules, but still would require significant compliance burden, negatively impact how GPs and LPs face each other, and, most importantly, do not fall within the SEC’s statutory authority.
Shortly after the final rules were adopted the LSTA together with five other trade associations sued the SEC in connection with that action arguing that the SEC exceeded its statutory authority and acted arbitrarily and capriciously in adopting the final rules. Never a decision that is taken lightly, the LSTA believes it important that the court defines the scope of the SEC’s authority now while several other open proposals rely on the same authority. While in no way certain, there is reason to hope that the Fifth Circuit may issue its opinion by the end of May.
Prohibition on Conflicts of Interest in Securitizations Rule: It could have been (much) worse…
In an unwelcome blast from the past, 2023 started with CLO participants (and other ABS participants) facing the SEC’s resurrection of Rule 192 – the prohibition on conflicts of interest in securitizations – after nearly a decade. For context, Rule 192 was one of the few rules implementing the Dodd-Frank Act that had never been finalized and was intended to prevent “structured to fail” securitizations in the wake of the Global Financial Crisis. However, markets change over 10 years. There is no evidence that there are “structured to fail” ABS transactions and, more to the point, there have never been “structured to fail” CLOs. Indeed, CLOs are very much structured to succeed.
Be that as it may, the SEC’s proposal clearly captures CLOs and the sheer breadth and vagueness of what qualified as a conflicted transaction and the inability for market participants to rely on information barriers to address conflicts would have ushered in chaos for ABS transactions. The challenges would have been most acute for CLOs, because a CLOs’ underlying assets trade actively and leveraged loans are at the center of many banking activities. In light of the potential adverse impact for CLOs, the LSTA submitted three comment letters to the SEC identifying the CLO-relevant issues and proposing solutions.
The SEC’s final rulemaking positively addressed many of the most challenging aspects of the proposal. However, market participants active in the CLO space will need to carefully consider the new rules and, in some cases, will need to institute new or modified compliance programs for CLO transactions. It remains early days for market participants to think through the practical implications so more will be revealed, but a recent LSTA webcast has started that conversation.
Rule 15c2-11: Relief for private placements
At long last the SEC resolved a question that had been hanging over private placements in recent years – whether the SEC would apply Rule 15c-2-11 to 144A securities. As we have previously explained, for 70 years Rule 15c-2-11 had only been applied to equities but in 2021 the SEC proposed to extend the Rule to fixed income securities, including CLOs. Under the Rule, broker-dealers would have had to obtain and review public and current information about issuers, such as their earnings statements, before they could begin or maintain a secondary market in fixed-income securities. In the context of CLO securities, application of the rule would require that dealers validate a CLO’s extensive reporting before quoting those CLO securities on a “quotation medium.” This likely would have reduced liquidity for existing holders of CLO securities and could also have negatively impacted the ability of managers to efficiently issue CLO notes in the future.
In response to a request for exemptive relief by the National Association of Manufacturers, the SEC issued an exemptive order which effectively preserves the ability of CLO issuers to access the 144A market without needless burdens and expenses and relieves broker-dealers from additional compliance burdens and costs. This order is consistent with the SEC’s deferral of application of Rule 15c-2-11 to 144A securities in December 2022 (a result pushed for by the LSTA in partnership with SIFMA) and puts this issue to bed, likely for good.
Bye Bye, LIBOR!
The day for which loan market participants had been actively preparing for five years came about in 2023. A day both longed for and feared – the cessation of panel LIBOR. Much like the oft-given analogy of Y2K – June 30th’s final LIBOR publication proved mercifully anticlimactic. There had been a material ramp up in LIBOR transition amendments between May and June, with LevFin Insights, a Fitch Solutions Company, tracking more than 300 amendments completed in that time. That last flurry of amendments together with hardwired fallback amendments saw the share of loans referencing SOFR jump in July. According to JP Morgan research, the share of SOFR loans in CLOs hit 63% by early July, up from 41% a month earlier.
That is not to say that all the work was behind us. In the weeks that followed, amendments to LIBOR credit agreements continued where the borrower had locked in a LIBOR rate before the end of June. Momentum continued and, come autumn, 76% of the loans in the JP Morgan loan index referenced SOFR. In the CLO space, JP Morgan research recorded 99% of floating rate CLO liabilities referencing SOFR.
To cap off the successful transition,* the Alternative Reference Rates Committee (ARRC), which had been at the helm of the transition for cash products since 2018, dissolved at the end of last year. In doing so, the ARRC released its final reflections memorializing the hard won knowledge and incredible efforts of the thousands of individuals and organizations that delivered an orderly transition. Let us all hope it is knowledge that is never called upon again!
* It is true that some loans continue to reference “LIBOR” – synthetic LIBOR – per the terms of their credit agreements. These loans will need to be remediated in one way or another before October, when synthetic LIBOR settings are set to cease.
