There are three regulations that are causing a hullabaloo among CLO market participants.
The first two were drafted by the Financial Accounting Standards Board (FASB) while the third is the Foreign Account Tax Compliance Act (FATCA) of 2009.
Of particular concern to CLO market participants are the two FASB rules — a new rule that FASB has drafted altering how banks record leveraged loans and an existing FASB rule called SFAS 167 requiring fund managers to consolidate CLO information on financial statements.
The FASB has drafted a new rule that would alter how banks record leveraged loans, requiring them to use fair value treatments on all loans on their balance sheets and to recognize loan commitments with fair value treatments on the commitment date.
This rule would have a dramatic impact on the CLO market, market participants said, because CLOs are all marked to market.
This rule is currently just a draft proposal and “won’t likely be implemented for two or three years,” the banker said. “This is all down the road. There are a lot of comments coming in right now in terms of how this is being treated.”
Meanwhile, CLO managers already have to contend with SFAS 167, which mandates consolidation of CLO information on financial statements.
There are two questions this rule requires the fund manager to answer. The first: Do you direct the activity of an entity? If you are a CLO manager, then the answer is yes. The second question is: Does that entity generate a significant variable interest for you—a subordinated fee, an equity fee, a senior fee, an equity fee, etc.? If the answer is yes to both of those questions, then you would have to consolidate CLO financial statements.
One of the biggest problems is that no one knows what “significant variable interest” means. “No one knows what the denominator is,” said a Boston-based investor.
The last rule that is scaring market participants like a horror movie on Halloween is part of the Foreign Account Tax Compliance Act of 2009.
The intent of this rule is to require foreign institutions, such as hedge funds and pension funds, to identify U.S. account holders, i.e. U.S. investors, so that the U.S. government can make sure said investors aren’t hiding money in foreign vehicles. If the foreign institution doesn’t comply, it will get hit with a 30% tax.
This presents a potentially huge problem for CLOs because the string of investors can be quite long. The conundrum is: How far up the chain do you have to go?
“It’s difficult enough to find direct investors,” said the market analyst. “So just multiply that. … We see CLOs between a rock and a hard place. The rock is that the CLO doesn’t know who their investors are because the chain could be infinite. And the CLO can’t make its investors reveal their info.”
New CLOs could be an exception because they could have mechanisms built into them that track the holders, making them compliant with the new rule.
FATCA was passed last year and is scheduled to go into effect Jan. 1, 2013. However, “based on past experiences, and what some of my tax colleagues say, it takes forever to get something implemented on the tax side,” said the market analyst.
This tax rule has been identified as a big enough issue that the Loan Syndications and Trading Association (LSTA) has created a sub committee within its CLO working group to engage the IRS and make sure that CLOs don’t get swept up.
The LSTA has prepared a comment letter to send to the Internal Revenue Service.