The U.S. SEC’s recent amendments to Rule 506 regarding “bad actors” have caused undue alarm among CLO market participants. Perhaps CLO market participants are a bit on edge as of late, having come to expect nothing but the worst from any new regulatory proposals. In any event, some CLO market Cassandras have conjectured, since CLOs frequently include subordinated certificated securities that are placed with “accredited investors,” and Rule 506 applies to the offering and sale of securities to accredited investors, that CLOs must comply with the administrative burdens imposed by the new “bad actor” provisions of Rule 506. Our view, however, is that CLOs should not be impacted by this new rule (provided the CLOs do not use a general solicitation) for the simple reason that CLOs generally rely on a different exemption from registration. CLOs (like other asset-backed securitization transactions) are predominantly institutional offerings and, when they sell subordinated certificated securities to accredited investors, they generally do so pursuant to the statutory exemption from registration for private placements under Section 4(a)(2) of the Securities Act and the interpretive exemption for resales under so-called Section 4(a)(1½). Thus, the good news is that CLOs should not get entangled in the new “bad actors” requirements under Rule 506 since such provisions do not apply to private placements pursuant to Section 4(a)(2), resales pursuant to Section 4(a)(1½) and Rule 144A, and sales to non-U.S. persons in offshore transactions pursuant to Regulation S.
Section 926(1) of the Dodd-Frank Act required the Securities and Exchange Commission (“SEC”) to adopt rules that disqualify securities offerings involving certain felons and other “bad actors” from reliance on Rule 506 under Regulation D of the Securities Act of 1933 (“Securities Act”).1 Under new paragraph (d) of Rule 506 (“Bad Actor Provisions”), effective September 24, 2013, the participation of “bad actors” in a private offering could disqualify the offering from claiming the safe harbor exemption from registration under Rule 506.2 The Bad Actor Provisions impose an additional layer of diligence requirements on issuers involved in an offering that relies on Rule 506. Coincidentally, it is common for a CLO’s capital stack to include a relatively small portion of certificated subordinated securities intended only for institutional accredited investors (“IAIs”)3 or accredited investors (“AIs”),4 who might be qualified purchasers under Rule 506. Based on this overlap, many market participants have questioned whether the additional layer of diligence required by the Bad Actor Provisions could negatively impact CLO issuances. Our position is that they should not, as CLO issuances typically do not occur under Regulation D, and the provisions of Section 506(d) thereunder do not apply to such CLOs.
CLO Issuances and the Securities Act Exemptions on Which They Do and Do Not Rely
Section 5 of the Securities Act requires all offers and sales of securities to be registered with the SEC unless there is an available registration exemption.5 Not only is the registration of an offering a costly and burdensome process, but, perhaps more importantly, a registered prospectus must be publicly available on the SEC’s website, which destroys both transactional and party-specific confidentiality for a transaction.
CLOs have historically been undertaken in the U.S. as private offerings through the use of various exemptions. Typically, CLO securities are offered pursuant to the private offering exemption under Section 4(a)(2) of the Securities Act, with most CLO securities issued in global form to the underwriter or placement agent, which then resells such securities pursuant to Rule 144A under the Securities Act. In its simplest form and as applied to CLOs, Rule 144A permits unregistered private offerings when an underwriter or placement agent purchases securities at issuance from the CLO issuer and resells them to qualified institutional buyers (“QIBs”).6 CLO issuers also frequently issue one or more subordinated tranches of certificated securities directly to IAIs and to AIs that are either knowledgeable employees ("Knowledgeable Employees")7 or investors who are known by and have a pre-existing relationship with the underwriter or the CLO collateral manager ("Known Investors"), in reliance in either case on Section 4(a)(2) of the Securities Act or the Section 4(a)(1½) interpretative exemption. CLO securities are also offered to foreign investors pursuant to the Regulation S transactional exemption permitting offshore unregistered offerings.8
Section 4(a)(2) exempts any transaction by an issuer that does not involve a public offering or distribution. While the term “public offering” has been left undefined in the Securities Act, judicial and SEC guidance have focused on several factors when applying it, including, but not limited to, the following: (i) the type of investor to whom the securities are offered (e.g., sophisticated investors able to obtain information from the issuer and investors with a pre-existing relationship with or special knowledge about an issuer, each being deemed less likely to need the protection afforded by registration of the securities offering); (ii) the absence of general solicitation and general advertising in an offering; (iii) a limited number of investors; and (iv) transfer restrictions prohibiting the transfer of the covered securities except to similarly qualified investors. These restrictions, together with minimum denominations and investor representations and warranties and transfer restrictions in CLO transactional documents, have been carefully tailored by issuers in light of the case law and SEC publications to ensure that the offer and sale of CLOs qualify for the applicable Section 4(a)(2), Rule 144A and Regulation S exemptions. Thus, the sale of subordinated certificated securities in CLOs is limited to AIs who are Knowledgeable Employees or Known Investors, not to meet Rule 506 safe harbor requirements, but rather to serve as a screening mechanism which, when coupled with other factors, helps ensure that the offering is a private placement that meets the requirements of Section 4(a)(2) for sales or the Section 4(a)(1½) interpretative exemption for resales.
While some firms and market participants may believe that there are policy reasons for applying the Bad Actor Provisions to CLOs when sales are made to individuals who are AIs even when such CLOs do not rely on Rule 506 for exemption from registration, we believe that there is nothing in the securities laws requiring this and that the policy reasons for doing so are mitigated where the sales are to AIs who are either Knowledgeable Employees or Known Investors. In either such instance, the CLO issuer and the underwriter have knowledge of the sophistication of the purchaser. In addition, CLOs typically rely on high minimum denominations (typically around $250,000) for sales to AIs who are Known Investors. The SEC has placed particular emphasis on high minimum denominations as a means of identifying and restricting the offering and sale of securities to qualified investors.
Conclusion: Bigger Fish to Fry
Given the barrage of pessimism surrounding the potentially market-destroying risk retention rules that have been proposed, it is understandable that CLO market participants are leery of new regulatory proposals generally. However, the Bad Actor Provisions of new Rule 506 should be the least of a CLO issuer’s concerns since, as we explain above, they do not apply to CLOs.
It is possible that some CLO market participants will use new Rule 506 to support policies that restrict or prohibit sales to AIs. However one might feel about such an approach, it is not required by the securities laws or the new Rule 506 itself and therefore we do not believe this approach will be widely adopted in the CLO marketplace. At most, the following may possibly occur:
- Increased hesitation to sell to AIs outside of the Knowledgeable Employee and Known Investor universe. While rare, such sales do occur. In the future, we would expect such sales to be subject to rigorous scrutiny; and
- A push to maintain high minimum denominations in connection with sales to AIs as a method of further ensuring investor sophistication and wherewithal. While minimum denominations tend to ebb and flow, new Rule 506 will certainly be a reason to maintain high levels.