What You Need to Know
- Key takeaway #1Investment advisers and CLO managers should tailor their MNPI policies to their unique operations, considering the loan exposure of both proprietary and third-party CLOs.
- Key takeaway #2Advisers should consult legal or compliance personnel before accessing confidential borrower information, especially as loan syndicate members or creditors committee members, as involvement in these committees poses increased risk of insider trading allegations.
- Key takeaway #3The characteristics of a CLO asset can significantly impact the materiality of non-public information. Equity tranche holders are the first to absorb losses, making confidential borrower information more likely to be material. Additionally, winding-down CLOs offer less diversification, increasing the potential materiality of information about underlying loans.
- Key takeaway #4The SEC continues to prioritize safeguarding MNPI in the credit markets as noted in its 2024 Examination Priorities Report.
- Key takeaway #5Advisers should routinely train their investment professionals on handling MNPI, regularly assess restricted lists and information barriers, and maintain proper documentation of MNPI handling and trading compliance. They must also adhere to confidentiality provisions in loan documents or NDAs, controlling individual access to MNPI.
On August 26, 2024, the U.S. Securities and Exchange Commission announced that it had settled charges with Sound Point Capital Management, LP, a New York-based registered investment adviser, for inadequate policies and procedures regarding its handling of material nonpublic information (“MNPI”) and related compliance deficiencies in its collateralized loan obligations (“CLOs”) trading activities. Sound Point agreed to pay a $1.8 million civil penalty in addition to other remedial measures. Notably, the SEC did not charge the investment adviser or its employees with violating SEC Rule 10b-5.
This enforcement action underscores the importance of tailoring a firm’s compliance policies and procedures to the unique risks associated with its business and specific asset classes. The need for tailored policies and procedures is especially pronounced when activities inherent to one business line result in the receipt of confidential information that may be relevant to a separate business of the same firm. It highlights the importance of understanding how firm personnel may come into possession of MNPI and the associated handling of that information.
Background
As part of its business activities, Sound Point actively manages several CLOs. These CLOs contain various underlying loans pooled together in a single CLO investment vehicle. Notes issued by the CLOs are divided into separate “tranches” based on a seniority waterfall. Generally, equity tranches are the least senior and are therefore the first to absorb any losses on the underlying pool of loans.
Like many CLO managers, Sound Point also operates a line of business (its “credit business”) in which it invests in individual leveraged loans. As part of that business, it sometimes gains access to confidential borrower information typically made available to all lenders in the loan syndicate. Additionally, from time to time, it joins ad hoc lender groups and creditors’ committees concerning insolvent or distressed borrowers, through which it may also gain access to confidential borrower information. It is well understood that when a lender engages in this activity, some portion of the information it receives may constitute MNPI of the relevant borrower, requiring the lender to become restricted from trading the securities of that borrower. The recent SEC Order makes it clear that MNPI received as a lender may, under certain circumstances, restrict trading not just in the securities of the relevant borrower but also in the notes issued by a CLO that holds the loan in its portfolio.
Findings
According to the SEC’s Order, by 2019, Sound Point, through its CLOs and hedge fund vehicles, had become one of the principal holders of term loans issued by a media services company (“Company A”). That same year, as part of its credit business, Sound Point joined an ad hoc lender group of Company A and allegedly received MNPI about Company A’s failed asset sale and need for rescue financing. The Order noted that Sound Point investment personnel communicated this MNPI to Sound Point’s compliance staff. In July 2019, a Sound Point employee responsible for CLO investments requested approval from compliance staff to sell portions of two equity tranches in a CLO containing loans made to Company A.
The SEC’s administrative action alleges that the firm violated Sections 204A and 206(4) of the Investment Advisers Act of 1940 due to insufficient policies and procedures to address the specific risk that MNPI obtained from the firm’s credit business could be misused in relation to CLOs managed by Sound Point. The Order also alleged that Sound Point lacked sufficient policies and procedures concerning its possession of MNPI related to loans held by its CLOs.
This recent settlement by the SEC is similar to the settled action brought against Ares Capital Management LLC in 2020, which alleged that Ares lacked sufficient policies and procedures to prevent the misuse of MNPI obtained by the firm through Ares’ employees that had been appointed to the boards of portfolio companies. The SEC also highlighted compliance issues, including the practice of having employees self-evaluate the materiality of particular information and the failure to document assessments of the extent to which Ares’ deal team members had obtained potential MNPI.
In both cases, the SEC found that these investment firms failed to pre-emptively design, implement, and enforce policies and procedures to prevent the misuse of MNPI obtained through their unique business lines. Both Sound Point and Ares had existing policies concerning the possession or use of MNPI, but in both instances, the SEC argued that a general MNPI policy was not sufficient to account for the types of MNPI obtained in those firms’ business activities.
The SEC’s Order pointed out that Company A’s loan value dropped by 50% and related CLO tranches by approximately 11% after news of a failed asset sale—suggesting that non-public information concerning this transaction was material. It’s important to note that most CLOs contain a large enough quantity of loans in their loan pool such that information related to a single loan in the pool would not normally be considered material to the value of any tranche of CLO notes. However, the SEC’s settlement suggests that there are indeed circumstances where underlying-loan information can constitute MNPI with respect to the CLO tranches. Given the uncertainty of “materiality” in this context, CLO managers should consider all of the characteristics of their CLOs, including (1) the CLO’s lifespan, (2) the number of loans remaining in the pool, and (3) whether the firm holds equity tranches of the CLO when evaluating the materiality of any MNPI related to loans held by the CLO.
For further information, please contact:
Paul B. Haskel, Partner, Crowell & Moring
phaskel@crowell.com
