CLO Managers, Meet the CFTC

Managers of CLOs won a delay, but not necessarily an exemption, from a requirement to register with the U.S. Commodity Futures Trading Commission if they use swaps.

The new oversight is a result of rules mandated by the Dodd-Frank Act, which overhauled financial regulation in the wake of the 2008 financial crisis. In August of this year, the CFTC and the Securities and Exchange Commission jointly published rules subjecting a wide range of securitization transactions to regulation as commodity pools.

The rules, which went into effect Oct. 12, changed the definition of a ‘commodity pool operator’ from one that trades commodity futures and options on an exchange to one that specifically includes pools trading in swaps.

Collateralized loan obligations are special purpose vehicles that issue bonds backed by pools of below investment-grade corporate loans; most have the ability to use swaps to hedge these loans against fluctuations in interest rates or currencies, though not all of them do so.

CLO managers, along with the broader securitization industry, had lobbied the CFTC for an exemption. On Oct. 11, the regulator granted permanent relief to many types of asset-backed securities, but not CLOs.
Issuers must meet five criteria to be exempted from registration requirements; one of them is that they must not acquire additional assets or dispose of assets for the primary purpose of realizing gain or minimizing loss due to changing values of the vehicle’s assets, according to a client alert published Oct. 16 by law firm Dechert LLP.

That requirement trips up most U.S. cash flow CLOs, which are typically actively managed, at least during an initial reinvestment period.

The four other criteria issuers must meet to avoid registering with the CFTC are:

1. That they operate consistent with the conditions of SEC Regulation AB or SEC Rule 3a-7 of the Investment Company Act of 1940;

2. The entity’s activities are limited to passively owning or holding a pool of receivables or other financial assets that by their terms convert to cash within a finite period of time;

3. The entity’s use of derivatives is limited to the use of derivatives permitted under Regulation AB;

4. The issuer makes payments to securities holders only from cash flow generated by its pool assets and other assets, and not from changes to the value in the entity’s equity assets.

CLOs aren’t the only kinds of securitization that do not qualify for an exemption from registration requirements. Asset-backed commercial paper, collateralized debt obligations, and covered bonds also fail the meet the five criteria.

Dechert said CFTC staff have stated repeatedly that it would consider granting exemptions to such transactions if they use de minimis amounts of swaps, however.

The regulator did throw CLOs and other transactions that don’t qualify for an exemption a bone: they now have until Dec. 31 to comply with the rules, instead of Oct. 12.

Bram Smith, executive director of the Loan Syndication and Trading Association, issued a statement advising CLO market participants to consult with their counsel to determine whether they must register and seek an exemption for their vehicles.

In a client alert published last month, law firm Winston & Strawn said that if a CLO is not currently a party to a swap transaction, despite its ability to do so, then the CLO manager is not required to register or find an exemption from registration with the CFTC, but will be required to register or find an exemption from registration prior to the CLO entering into any swaps transactions.

The law firm said managers of CLOs that do engage in swap transactions must either provide a notice of exemption or register as CPOs or CTAs.

Pat Hardiman, partner and co-chair of Winston & Strawn’s corporate lending and debt capital markets practice groups, said that the firm has a significant number of  CLO manager clients, most of whom either do not use swaps in their CLOs or expect to qualify for an exemption from registering as a CPO under the de miminis tests found in Rule 4.13(a)(3).

Speaking in a telephone interview, Hardiman said many CLO managers that expect to qualify for the de minimis exemption have already started the process of applying for the exemption, which is a fairly streamlined process, and are waiting for the CFTC’s decision to pull the trigger.

Basil Godellas, a partner in Winston & Strawn’s corporate department and chair of the firm’s financial services practice group, said the CFTC’s decision not to provide explicit relief for CLOs has caused some anxiety in the industry because the CFTC’s regulatory regime isn’t designed for these kinds of vehicles.
“It’s like fitting a square peg in round hole,” Godellas said in the same telephone interview.

Other currently excluded securitization deals include synthetics as well as securitizations of tax liens; future flow deals; royalty payment streams; auto and equipment backed securities that rely on residuals; insurance-linked securities such as catastrophe bonds; container leases; time shares; whole business securitizations and possibly others, according to Dechert.

Dechert's report said the CFTC has also failed to address concerns that the new rule will interact with the so-calledVolker Rule, part of the Dodd-Frank Act that was designed as a ban against proprietary trading.