So Loan-some I Could Cry: Adviser Settles Enforcement Action Related to Handling of Private-Side Loan Information
Executive Summary
On August 26, the SEC settled charges with an adviser alleging that the adviser did not have adequate policies and procedures to prevent the misuse material nonpublic information (MNPI) obtained in connection with its credit investments. The SEC’s order cites trading in loans that allowed the adviser to avoid significant losses related to its holdings in the equity tranches of two collateralized loan obligations (CLOs). The adviser agreed to pay a civil penalty of $1.8 million. The adviser also reimbursed a trading counterparty approximately $350,000 for losses the counterparty incurred after the MNPI became public.
The Facts of the Case
Because loans are not securities, advisers engaged in the business of private lending and/or that make direct investments in loans can (and often do) receive MNPI about borrowers as part of their investment process. This obviously creates risk as it relates to the adviser trading any public securities issued by the borrower. Perhaps less obvious, though, is the risk that the MNPI could impact the value of a CLO tranche that owns loans issued to the borrower. According to the SEC, while the adviser did have policies and procedures in place to address the former, they did not have policies and procedures in place that were reasonably designed to address the latter, which led to the violations alleged in the order.
A CLO tranche represents an interest in the cash flows generated by a pool of loans. Distributions are made using a “waterfall” method whereby the more senior (“debt”) tranches are paid out sequentially in order of seniority until each debt tranche receives its full distribution. At that point, if there is any residual cash, it will be paid out to the junior-most (“equity”) tranche. As a result, the equity tranche has more potential upside than the debt tranches (which, like traditional bonds, receive a fixed coupon payment), but it is also the first tranche to absorb losses in the event that any loans in the CLO portfolio decline in value or default.
The SEC’s order states that the adviser, through its CLOs and other vehicles, was one of the largest holders of term loans issued to a company and, as a result of its participation in an ad hoc lender group, came into possession of MNPI about the company that was expected to have a negative impact on the value of these loans. The order alleges that after receiving this MNPI, one of the adviser’s portfolio managers requested compliance approval to reduce exposure to the equity tranches of two CLOs that held loans in this company and that the trades were approved because the adviser did not have policies and procedures that required compliance personnel to consider the impact the MNPI could have on the value of the CLO tranches. The MNPI was publicly announced the day after the adviser sold down its interests in the two equity tranches and, according to the SEC, the value of the company’s loans dropped precipitously, which caused the value of the tranches sold by the adviser to decline by approximately 11%.
Key Takeaways
Advisers that make and/or invest in loans alongside managing and/or investing in CLOs may consider making the following enhancements to their compliance program:
Policies and Procedures: The adviser’s written policies and procedures should address the risk that MNPI about a borrower could impact the value of a CLO tranche if the CLO holds loans issued to the borrower.
Pre-Clearance: If the adviser invests in a CLO tranche that is exposed to loans where the adviser has MNPI about the borrower, the adviser should conduct pre-trade compliance reviews before proceeding with any transactions in the CLO tranche. These reviews may consider, for example, the nature of the information the adviser has about the borrower as well as the level of exposure the CLO has to the loans in question.
Information Barriers: If possible, the adviser should establish information barriers between personnel who are likely to receive MNPI about borrowers in connection with its credit investments and personnel who are involved in making decisions about trading in CLO tranches.
Creditor Committees / Ad Hoc Lender Groups: The compliance department should be involved in the process of approving adviser personnel to serve on a creditor committee or participate in an ad hoc lender group. As part of the decision-making process, the adviser should consider the potential impact of receiving MNPI about the borrower on its ability to trade CLOs that hold loans issued to the borrower.
Disclosure Documents: The adviser should ensure that it has adequately disclosed the risks associated with receiving MNPI about borrowers, including the risk that the adviser may be unable to trade certain CLO tranches owned by its clients while in possession of MNPI about a borrower whose loans are held by the CLO.
How Apogee Can Help
Apogee’s consultants have extensive experience working with advisers who invest in public and private credit and a deep understanding of the unique risks that can arise in this space. We can help with reviewing and updating your written policies and procedures, disclosure documents, and compliance monitoring and testing based on our observations of regulatory expectations and industry best practices. For more information, please contact us at info@apogeecomply.com.