SEC Issues Interpretive Letter on Proposed Applicable Margin Reset Mechanism

September 07, 2016

The staff of the Division of Corporate Finance (the “Staff”) of the U.S. Securities and Exchange Commission issued an interpretive letter (the “Interpretive Letter”) to Sancus Capital Management LP and its affiliates (“Sancus Capital”) in response to a letter from Dechert LLP on behalf of Sancus Capital (the “Request Letter”) on September 1, 2016. In the Request Letter, Dechert and Sancus Capital proposed an applicable margin reset (“AMR”) procedure through which interest rates payable to the senior securities (the “CLO Securities”) in a collateralized loan obligation transaction (a “CLO”) are periodically reset at predetermined intervals pursuant to an auction mechanism. The AMR procedures were modeled after the mechanics used widely across the auction rate securities market, which under prior Staff no-action guidance were found to be in the nature of secondary market transactions between investors rather than an “offer and sale” by an issuing entity. The Request Letter requested confirmation from the Staff, and the Staff (in consultation with the staffs of the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation) confirmed in the Interpretive Letter, that the application of the AMR procedures would not constitute an “offer and sale of asset-backed securities by an issuing entity,” and therefore would not trigger application of the risk retention requirements of Section 15G of the Securities Exchange Act (the “Final Rule”). 

The overwhelming majority of CLOs contain a refinancing and/or repricing mechanism to reduce the interest paid on one or more senior tranches of CLO Securities to then-current market rates (a “Re-Pricing”). While CLOs that close prior to December 24, 2016 (the “Effective Date”) are exempt from the retention provisions of the Final Rule, uncertainty remains as to whether a Re-Pricing constitutes an “offer and sale of asset-backed securities by an issuing entity” and whether a “grandfathered” CLO that undergoes a Re-Pricing after the Effective Date will be required to come into compliance with the risk retention provisions. Since pursuant to the Interpretative Letter, the resetting of interest rates on CLO Securities through an AMR procedure will not be deemed to be an “offer and sale of asset-backed securities by an issuing entity”, the use of the AMR procedure following the Effective Date will not cause a previously exempted CLO to lose its grandfathered status and become subject to the retention requirements of the Final Rule. Furthermore, because the retention and disclosure requirements of the Final Rule apply each time there is an “offer and sale,” a CLO that originally closes after the Effective Date (and complies with the retention and disclosure requirements of the Final Rule at the time of its initial closing) would not need to satisfy the retention and disclosure requirements anew if its CLO Securities undergo the AMR procedure at a later date. 

The AMR procedure described in the Request Letter provides for the reset of interest rates of through a reverse Dutch auction occurring at predetermined dates after the CLO closing (each an “AMR Date”), which will be subject to certain objective conditions precedent and not subject to the discretion of the CLO issuer, CLO manager, or holders of any CLO Securities. Each auction will be facilitated by an auction services provider (the “Auction Services Provider”) that provides a platform on which broker-dealers submit bids for CLO Securities subject to the auction, and a settlement agent (the “Settlement Agent”) that solicits pre-approved broker-dealers to participate in the auction and then facilitates settlement between buyers and seller of CLO Securities. All AMR procedures must be outlined in the offering document and indenture at the time of closing, including the initial schedule of AMR Dates, the conditions necessary for an AMR Date to occur, and the mechanics of the bidding process. 

Prior to each AMR Date, the trustee will provide notice specifying the AMR Date, auction procedures and transfer price to the Settlement Agent and holders of CLO Securities. The Settlement Agent will solicit confidential bids, each representing a commitment to purchase up to a stated principal balance of CLO Securities of a particular class (any class of CLO Securities subject to the AMR procedures being an “AMR Class”) if the rate determined at auction is not lower than a margin specified in the Bid, from pre-approved broker-dealers on behalf of existing holders of CLO Securities, third party investors or on the broker-dealer’s own behalf (each, a “Bid”). For CLOs in which a retention holder affiliated with the Sponsor or Originator is holding a vertical interest in the CLO, the retention holder may submit a retention order (a “Retention Order”) evidencing a commitment to retain a given principal balance of CLO Securities of any designated class, which CLO Securities then will not be included in the AMR procedure (but which will have their applicable interest rates or margins reset to the rate determined by the AMR); otherwise, neither the retention holder, the manager or their affiliates may submit bids in the AMR. The lowest applicable margin at which there are sufficient Bids and Retention Orders to account for all of the notes in such class is the “Clearing Rate” for such class. 

If there are sufficient bids to establish a Clearing Rate for any AMR Class not higher than the specified maximum margin, the Clearing Rate will become the applicable margin applied to all notes in the AMR Class (including any notes subject to a Retention Order) until the next AMR Date. The notes of each AMR Class will be tendered through a mandatory call mechanism to the Settlement Agent, who will immediately re-sell them to the winning bidders without obtaining a new CUSIP, re-registering the notes with the relevant securities depositary, or cancelling the existing CLO Securities. The end result is a transfer of CLO Securities from the existing holders to the winning bidders, in exchange for a transfer price based on par plus accrued interest. If there are not enough Bids to purchase all available notes in particular AMR Class, the AMR mechanism will fail and the current holders will continue to hold their CLO Securities at the existing margin until a new AMR Date is held and a successful auction occurs. 

The AMR mechanic differs from the Re-Pricing mechanic included in existing CLOs in several important ways. First, the AMR Dates occur automatically (upon the satisfaction of the conditions precedent) at stated intervals, while a Re-Pricing must be called by the CLO manager, the holders of the subordinated tranche of interests in the CLO, or both. Second, unlike in a Re-Pricing, no consent of the holders of any class of CLO Securities is necessary for an AMR to occur: as long as sufficient Bids and Retention Orders are received, the AMR will be successful and the margin applicable to the related AMR Class will be reset to the related Clearing Rate. However, in both cases of a Re-Pricing or an AMR, the underlying policy goals of the Final Rule are not implicated, because neither mechanism results in new money from investors being paid to the CLO and used to purchase new securitized assets. 

Read the Interpretive Letter »