Funds Talk: June 2018
Topics covered in this issue include:
- A New Legislative Framework for ICOs in France The focus on virtual currency offerings continues as French market regulators develop a framework that seeks to balance the risks and the rewards of ICOs.
- The EU Commission’s Proposal for a Directive on the Protection of Whistleblowers A proposed directive would represent a broad expansion of whistleblower regulations across EU member states, offering protections for those reporting violations in areas including anti-money laundering rules, financial services legislation and corporate tax rules.
- Three Asset-Based Financing Options for Private Funds: Total Return Swaps, Structured Repos and SPV Financing Private funds are increasingly seeking bespoke financing arrangements. But these highly specialized products often offer different features and certain structures are better suited to specific asset classes or objectives, making choosing the right option a complex but important decision.
- Open Market CLO Managers Are Not ‘Securitizers’ After a recent D.C. Circuit ruling settled a long-standing debate related to the Dodd-Frank Act’s Credit Risk Retention Rule, what’s next for CLO managers who are no longer covered by the regulation?
- Fabien Carruzzo and Steven Zide Unravel Hovnanian Kerfuffle Corporate partner Fabien Carruzzo and Bankruptcy and Restructuring partner Stephen D. Zide recently joined Debtwire's Richard Goldman for a podcast discussion about Hovnanian Enterprises’ “failure to pay” credit event and ensuing litigation.
A New Legislative Framework for ICOs in France
The regulatory focus on initial coin offerings (ICOs) in France continues unabated, with the French Treasury proposing a new legislative framework, yet to be officially adopted, that aims to balance the development of ICO transactions with the protection of purchasers wishing to participate in ICOs.
The French Financial Markets Authority, or AMF, recently proposed the development of an ad hoc legal framework for ICOs rather than promotion of a best practices guide, without amending existing legislation or extending to ICOs the scope of existing provisions regulating public offerings of securities.
The AMF had previously identified the absence of clear ICO regulation as an inherent risk factor of ICOs, together with the absence of disclosure documents, possibility of loss of capital, volatility or lack of liquidity on the secondary market, money laundering and terrorist financing scams, and concerns about the viability of the underlying projects that the ICO seeks to finance.
The New Legislative Framework
The proposed legislation would introduce a new chapter to Book V, Title V of the French Monetary and Financial Code, or CMF, which will be renamed “Intermediaries in Miscellaneous Property and Token Issuers.” Chapter 2 of Title V will be titled “Token Issuers” and will detail the rules applicable to ICOs in articles L. 550-6 et seq.
Chapter 2 provides a definition of tokens, indicating that a token is intangible property representing, in numerical form, one or more rights that can be issued, registered, conserved or transferred using a shared electronic registration mechanism that facilitates the identification, directly or indirectly, of the owner of said property. It also defines an ICO as any offer to the public, in any shape or form, to purchase tokens. However, it excludes offers made to a small number of buyers. Under the proposed legislation, the issuer should notify token buyers of the status of the project the ICO funds were used to finance, and of the establishment of any secondary market for the tokens.
Chapter 2 then specifies that the rules it sets forth do not apply to tokens that share the same characteristics as financial instruments; these token offerings will have to comply with the regulations applicable to public offerings of securities. Any token issuers will be obligated to comply with the conditions and requirements set out in article L. 550-8, which discusses the role of the AMF, notably when the issuer chooses to request an approval for its ICO (aka an AMF visa).
The AMF’s Role Within This Framework
Under the proposed legislation, the AMF is required to provide additional guidance regarding the law’s provisions in its General Regulation (RG AMF). Moreover, the AMF will be authorized to approve ICOs. It is interesting to note that the legislation opted not to make securing AMF authorization mandatory for issuers. Instead, the issuers were provided with the right to submit a disclosure document to the AMF, allowing buyers to make an informed decision regarding the ICO. The AMF would then:
- Examine the disclosure document and any promotional or advertising material published and circulated by the issuer. The contents of the disclosure document and promotional material should be (i) accurate, (ii) clear, (iii) devoid of misleading information and (iv) detailed as to the risks faced by investors when buying tokens.
- Verify that the issuer adopted adequate procedures to track and safeguard the funds raised in the ICO.
- Ensure that the activities of the issuer of the ICO conform to the content of the disclosure document and comply with the applicable regulation. In case of a violation, the AMF can compel the issuer to cease offering and selling tokens as well as terminate any promotional campaign. The AMF can also withdraw its approval.
- Verify that the issuer is a legal entity organized under French law and registered in France. Indeed, the AMF will only issue visas for French issuers, excluding foreign corporations and entities with the objective of attracting ICOs to the French market.
 The AMF is the authorized governmental authority to draft the relevant ICO regulation to complement the law, to enforce this regulation and to sanction potential violations. See articles L. 621-7. I bis, L. 621-9. I al. 2 and L. 621-15. II e.
The EU Commission’s Proposal for a Directive on the Protection of Whistleblowers
On April 23 2018, the European Commission published a proposal for a Directive (the proposal or the Directive) on whistleblower protections in response to a request from the European Parliament, thereby promoting a significant mechanism for both fighting corruption and protecting individuals, employees or others against abuses (e.g., retaliation or sexual harassment). Whistleblower protections have already made a notable entry into Union law, most recently in the trade secrets Directive, which precludes whistleblowers from liability for reporting misconduct or illegal activity, even if it involves the disclosure of trade secrets. However, the latest Directive is significantly more ambitious. Beyond merely reaffirming the legal protections granted to whistleblowers, it will create a genuine whistleblowing system within the Union, because a Directive implies that the EU Member States will adapt their legislation within a specified time to meet its aims and requirements.
1. A particularly broad scope of application
As suggested by its name, the purpose of this Directive is to protect those reporting violations of Union law, which undoubtedly falls within the Union's powers. The whistleblowing systems to be implemented under the Directive broadly cover illegal activities or abuses of rights — real or potential — which contravene public procurement rules, competition rules, legislation on financial services, money laundering and terrorist financing, safety of products placed on the Union internal market, food safety, transport safety, nuclear and radiation safety, protection of the environment, animal health and welfare, public health and consumer protection, protection of privacy and personal data, and security of networks and information systems.
The proposal would also protect whistleblowing involving breaches of corporate tax rules and arrangements that aim at obtaining a tax advantage and evading legal obligations, insofar as they are likely to harm the proper functioning of the Union internal market through “unfair tax competition” and “extensive tax evasion.”
As for whistleblowers, their status is based on the freedom of speech enshrined in Article 11 of the Charter of Fundamental Rights of the European Union (the Charter) and Article 10 of the European Convention on Human Rights (ECHR). Whistleblowers are those who, in one capacity or another (employees, trainees, volunteers, persons working under the supervision and direction of contractors, subcontractors, suppliers, etc.), report or disclose information on breaches they have learned about in the course of their professional activities, whether in the public or private sector.
Further, there are very limited exceptions to implementing a whistleblowing system.
In the private sector, only entities employing fewer than 50 persons and those having an annual turnover or a balance sheet of less than EUR 10 million are exempted (unless their activities give rise to specific risks). Since there are around 25 million SMEs (defined as employing fewer than 250 employees) in the Union, this Directive intends to apply to tens of millions of economic players. Moreover, no exemption is provided for the financial services sector, or for companies “vulnerable to money laundering or terrorist financing.” Setting up an internal whistleblowing system therefore seems to have become a European norm.
In the public sector, all state, regional and departmental administrations; municipalities with more than 10,000 inhabitants; and “other entities governed by public law” (which may include local authorities, public state establishments and territorial cooperation establishments, as to be specified by the French law implementing the Directive) are affected by the implementation of such a mechanism.
2. A confidential formalized procedure
The proposal distinguishes between internal and external alert systems, but the conditions governing them are similar.
Both systems provide for the reporting of whistleblower alerts in diverse forms: written alerts in electronic or paper form; oral alerts by telephone, recorded or not; or meetings with the person or the service designated to receive the alerts.
Further, they guarantee the following protections:
- Safeguarding the confidentiality of the identity of the whistleblowers
- Restricting access to the information sent to the only persons authorized to have access to it
- Giving feedback to the whistleblowers within a maximum period of three months (which may be extended to six months when the alert is received externally)
In response to the reports received internally, the entity should provide “clear and easily accessible information regarding the procedures and information on how and under what conditions reports can be made externally to competent authorities,” whether administrative or judicial. When they receive a report and have duly processed it, these authorities “communicate to the reporting person the final outcome of the investigations.” Moreover, any authority that receives a report but is not competent to address the reported breach should transmit the report to a competent authority and inform the reporting person thereof.
In addition, competent authorities will have to dedicate a separate, easily identifiable and accessible section on their website, notably informing the public on communication channels, the confidentiality regime applicable to reports, the conditions that must be fulfilled by whistleblowers in order to be protected, and the remedies and procedures available against retaliation. Further, “a statement clearly explaining that persons making information available to the competent authority in accordance with this Directive are not considered to be infringing any restriction on disclosure of information imposed by contract or by any legislative, regulatory or administrative provision, and are not to be involved in liability of any kind related to such disclosure” must be made. Competent authorities should also update their alert systems at least once every two years, keep a record of all alerts received, and allow the whistleblowers to check, rectify and agree to the transcription or reporting of their alerts.
It is noteworthy that, in any case, whistleblowers — as well as concerned persons — should be protected in terms of data protection by the European General Data Protection Regulation, in addition to any other applicable national laws as in France, where the French Data Protection Statute has been amended in order to comply therewith.
Further, the proposal does not provide for anonymity of reports, thus leaving Member States to decide on that point.
3. What protection is to be granted to the whistleblowers and persons affected by the reports?
In order to benefit from the protection offered by the Directive, whistleblowers must fulfill two critical conditions:
- Good faith: At the time of the alert, they should have reasonable grounds to believe in the veracity of the information and not act maliciously.
- Following a graduated procedure under the rules laid down by the European Court of Human Rights (ECtHR): They should first make an internal report. If the report is met with no response, they can report externally, but should be able to (a) justify that there is an imminent or manifest danger for the public interest, (b) demonstrate the particular circumstances of the case, and (c) demonstrate that there is a risk of irreversible damage.
Upon fulfilling these conditions, whistleblowers shall be afforded a legal protection against any form of direct or indirect retaliation, including suspension, dismissal (or equivalent), layoff, demotion or denial of promotion, disciplinary measures, harassment and intimidation, reputational damage, blacklisting, discrimination, disadvantage, unfair treatment, etc. In accordance with national laws, whistleblowers may also obtain compensation where such measures have been taken against them.
Moreover, advice on existing procedures and remedies; public, free, comprehensive, independent information; and assistance from the competent authorities should be provided to the whistleblowers. The Directive also states that “in addition to providing legal aid to reporting persons in criminal and in cross-border civil proceedings in accordance with Directive (EU) 2016/1919 and Directive 2008/52/EC of the European Parliament and of the Council, and in accordance with national law, Member States may provide for further measures of legal and financial assistance and support for reporting persons in the framework of legal proceedings.”
Whistleblowers should also be able to disclose the content of an alert in the context of legal proceedings for defamation, violation of copyright, violation of secrecy, or compensation requests based on private, public or collective labor law.
The proposal also imposes “effective, proportionate and dissuasive” penalties, notably in cases of retaliation, breach of confidentiality of the alert.
Regarding the protection of the persons affected by the alert, the proposal provides them with the right to an effective remedy and to a fair trial, presumption of innocence and the rights of defense, including the right to be heard and to have access to the file on the proceedings brought under the Charter. In addition, competent authorities should ensure that affected persons’ identities are protected throughout the ongoing investigation.
Finally, effective, proportionate and dissuasive penalties to sanction malicious or abusive alerts, as well as measures aiming to compensate the losses of the persons affected by such alerts, should also be provided for.
4. What room for maneuvering do Member States have?
Once the Directive is adopted, Member States will have until May 15, 2021, at the latest, to implement the Directive, which gives them time to consider any related modalities. However, as often occurs, the principles set forth in this Directive will undoubtedly be taken into account by national courts in the event of litigation, or even by the Union judge when it comes, for example, to assessing the protection granted to whistleblowers and the persons concerned by the alerts revealing trade secrets (with regard to the provisions of the “trade secrets” Directive transposed into French law).
It should also be noted that the Directive will only partially harmonize the related regimes applicable in the Union, given that Member States may introduce or keep more favorable provisions.
This Directive is not “the end of a story” for whistleblowers and is evolutionary in nature. Significantly, the Directive requires the European Commission to submit, six years after its transposition, a report assessing the impact of national laws in order to consider making further changes.
 Proposal for a Directive on the protection of persons reporting on breaches of Union law, 23 April 2018.
 Directive on the protection of undisclosed know-how and business information (trade secrets) against their unlawful acquisition, use and disclosure, 8 June 2016.
 Nevertheless, this protection remains at the very heart of reporting by a whistleblower, as shown by the Antoine Deltour case. Deltour had reported in 2014 the large-scale optimization practices of several multinationals in Luxemburg. The case for stealing documents is currently being retried (following the judgment of the Supreme Court of the Grand Duchy of Luxembourg, 11 January 2018, No. 3912) by a Luxembourgish court of appeal.
 It is clearly stated that the Directive “should be without prejudice to the protection of national security.”
 There were over 23.8 million SMEs in 2017: http://ec.europa.eu/eurostat/statistics explained/index.php/Structural_business_statistics_overview/fr#Couverture.2C_unit.C3.A9s_et_nomenclatures.
 Noëlle Lenoir, Hélène Bérion et Alizée Dill, « Alerte professionnelle et protection des données personnelles », JCP G, n° 19-20, 7 May 2018.
Open Market CLO Managers Are Not ‘Securitizers’
It is finally settled that the Credit Risk Retention Rule, adopted pursuant to Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, does not apply to open market CLO managers. On April 5, 2018, in accordance with the mandate issued by the District of Columbia Circuit on April 3, 2018, and the opinion of the D.C. Circuit issued on Feb. 9, 2018 (see 882 F.3d 220 (D.C. Cir. 2018), the U.S. District Court for the District of Columbia ordered that the Credit Risk Retention Rule be vacated insofar as it applies to open market CLO managers.
A CLO is a type of securitization backed by loans made to corporate borrowers. Balance sheet CLOs are typically sponsored by large institutions, securitizing loans originated by such institutions. In contrast, in an open market CLO, a collateral manager directs the purchase of loans through a special purpose vehicle in the open market, which loans meet certain investment guidelines. After loans are selected for the CLO, the collateral manager operates and manages the loan portfolio.
In 2011, the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System, along with other relevant agencies, issued a joint notice of proposed rule-making and solicited comments on the Dodd-Frank Act’s credit risk retention provisions. Under the proposed rules, a “securitizer” — defined as including a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer — would be required to retain at least 5% of the credit risk of the securitized assets. The proposed rules generated thousands of comments. Open market CLO participants expressed concern with the application of the Credit Risk Retention Rule to a CLO manager who is unaffiliated with the origination of the loans and purchases loans on the open market. Notwithstanding a raft of opposition, in adopting the final Credit Risk Retention Rule, the agencies reaffirmed their determination that the term “securitizer” covers CLO managers.
In 2016, the Loan Syndications and Trading Association (LSTA), representing members participating in the syndicated corporate loan market, brought an action against the SEC and the Fed challenging the applicability of the Credit Risk Retention Rule to open market CLOs.
The District Court granted summary judgment to the defendant agencies. The agencies successfully argued that “the agencies did not act arbitrarily, capriciously, or otherwise unlawfully in declining to provide an exemption or adjustment to the credit risk retention rules for open market CLOs.” See Loan Syndications & Trading Ass’n v. SEC, 223 F. Supp. 3d 37 (D.D.C. 2016). The Court of Appeals, ruling de novo, reversed.
The Court’s Analysis
On appeal, the LSTA renewed its argument that, given the nature of the transactions performed by open market CLO managers, the extension of the Credit Risk Retention Rule to open market CLOs lacked a statutory basis.
The Credit Risk Retention Rule requires a “securitizer” to retain an economic interest. The question is whether managers of open market CLOs are “securitizers,” as defined in the statute.
Section 941 of the Dodd Frank Act directs the agencies to issue regulations —
to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.
The statutory definition of “securitizer” reads in relevant part as follows:
(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.”
The two key words on which the D.C. Circuit focused in analyzing whether the Credit Risk Retention Rule can be reasonably read to encompass open market CLO managers were “transfer” and “retain.” The court observed that “[t]he two subsections quoted above have the effect of authorizing requirements that an entity which transfers assets to an issuer retain a portion of the credit risk from the underlying assets that it transfers.” To be a “securitizer” for purposes of the Credit Risk Retention Rule, “a party must actually be a transferor, relinquishing ownership or control of assets to an issuer,” such that it can retain a portion of what it transfers.
Open market CLO managers neither own nor control assets that are transferred to a CLO issuer, and thus there are no assets for them to transfer or to retain. As such, the appellate court concluded that open market CLO managers are not “securitizers” for purposes of the statute, and are therefore not subject to the risk retention requirements set forth in the Credit Risk Retention Rule.
It is now the law that open market CLO managers do not have to comply with the Credit Risk Retention Rule. Many CLO managers have invested a lot of time and money in creative structures to ensure compliance with the Credit Risk Retention Rule and to enable securitizers to leverage their retained piece of the CLO structure. It remains to be seen whether managers will abandon the new structures or whether they will use them as a selling point to distinguish themselves in the market. Deals may continue to be structured as risk retention compliant, but without the formal disclosure requirements and filings.
Also, smaller market participants that did not have the resources to comply with the Credit Risk Retention Rule, and therefore exited the business, may now re-enter the market, and new participants may enter as well.
Only time will tell how different managers, investors and the market react to the D.C. Circuit’s interpretation of Section 941, and the exclusion of open market CLOs from the Credit Risk Retention Rule.