- Manager’s Discretionary Roles under the CLO Indenture
- November 25, 2013 | Authors: Grant E. Buerstetta; Jaiho Cho
- Law Firm: Blank Rome LLP - New York Office
While the primary duties of a manager in a collateralized loan obligation ("CLO") transaction are enshrined in the collateral manager agreement, the indenture also has numerous provisions that require the manager's direction or discretion. Managers must understand these responsibilities and the impact that they have on its day-to-day operations and other material periodic events, such as an early redemption of notes issued in the CLO transaction.
This article summarizes the most important roles and responsibilities set out in the indenture, although managers should be aware that there are many more provisions to be considered before launching a new CLO.
- A CLO manager should have a clear understanding of each and every responsibility it has under the indenture.
- The manager (or its counsel) should carefully review the indenture provisions to ensure that each assignment of responsibility to the manager is clear.
- The manager should understand the standard of care applied to each activity it agrees to perform.
Activities Related to Assets and Accounts
This category of activities encompasses the daily management of the assets in the CLO portfolio. This includes:
- Determining whether an asset is a credit improved or a credit risk obligation.
- Selecting various collateral quality test levels related to spread, recovery, and other portfolio characteristics.
- Determining the characteristics of discount obligations.
- Assigning the market value of certain assets that do not have readily available market prices.
- Directing sale and purchase of the assets.
In negotiating indenture provisions that impose discretion on it, a manager should seek to achieve an appropriate balance between flexibility and potential liability. Discretion may help the manager address issues arising in different market environments. There may also be certain actions and decisions requiring a degree of flexibility that cannot be performed efficiently by other parties. At the same time, discretionary powers may subject the manager to potential liability for matters that it has limited or no control over. For example, the manager should not agree to asset transactions on pre-established terms within a pre-determined period unless such activity is qualified by a clear standard, such as on a reasonable or "best efforts" basis. And the manager should avoid agreeing to broad, generic duties to use its discretion (e.g., "subject to the manager's discretion") in favor of clear, discrete obligations in taking action in the interest of the deal.
The indenture provides for the creation of numerous accounts and related accounting and reporting obligations. The manager's roles regarding the accounts are typically mechanical in nature, but the manager should carefully review the scope and the timing of duties in respect thereof (e.g., the instructions to be delivered to various agents responsible for the accounts). And the manager should consider how these responsibilities under the indenture coordinate with its internal operational platform. For example, the manager should have clear internal procedures dealing with any transfer of funds during the period between payment dates and that these procedures align with the permitted actions under the indenture. These intraperiod payments may be related to the funding of revolving assets, hedge payments, or administrative expense payments.
Activities Related to CLO Capital Structure
A majority of recent CLOs allow the CLO manager to change the CLO's capital structure as long as certain conditions are met. In that context, the collateral manager's decisions are often needed in connection with:
- Refinancing or issuance of additional notes.
- Re-pricing of notes.
- Optional redemption of notes.
In most CLO 2.0 transactions (a general reference to more recent (post-crisis) deals), the mechanics of the refinancing or the re-pricing have become fairly standardized. The important issues that should be addressed, however, are who has the right to initiate these changes to the capital structure and who, if anyone, has veto power. For example, the manager should consider the possibility that the economic interests of the manager and the equity investors may diverge over time or as the composition of the equity investors changes.
The manager should also consider the operational implications of these activities in order to create flexibility in order to enhance the ability to fulfill its obligations in varying market environments. For example, in connection with an optional redemption in full of the secured notes, there may be a very small window between the latest date on which the redemption notice can be delivered and the date by which the manager must deliver a certification to the effect that the expected sale proceeds (adjusted by advance rates) would exceed the amount to pay the secured notes and the expenses. Depending on prevailing market conditions, the manager may need a longer time period to fulfill its obligations.
As an agent of the issuer, the manager may have the right to remove and/or replace, or participate in the removal and replacement of the trustee, the calculation agent and the paying agent. The manager should review these provisions to ensure that its authority in these decisions do not impose conditions that may be practically impossible to satisfy.
The manager should consider whether it would prefer an explicit provision that gives it the interpretive powers of the document provisions. In certain instances, the trustee (and other agents and transaction parties) may look to the manager to make decisions and interpretations (particularly with respect to collateral assets) when ambiguity exists or multiple methods could be used in making necessary calculations. As a general matter, it may be useful to have explicit interpretive power vested in the manager. The corollary to this provision is that other transaction parties (e.g., the trustee) will generally have an "out," protecting those parties relying on, and leaving the manager as the only party to make, those interpretations.
In addition, the manager should have the power to act to maintain the tax and securities law status of the issuers. These typically include the ability to force non-qualifying noteholders (e.g., holders that are not qualified institutional buyers or qualified purchasers) to sell their notes or to cause the issuer to comply with any future tax and other regulations.
Continuing Evolution of CLOs
The specific terminology used in each CLO may vary from that used here. It is likely that, as the market continues to grow and evolve, other variations and terms may become more prevalent. As always, you should seek guidance from experienced counsel in negotiating all of the relevant terms of your CLOs.