Middle-Market Public Policy Roundup

In this week’s roundup, a spree of activity continued for the Securities and Exchange Commission. Last Thursday, witnesses provided testimony before the SEC’s Investor Advisory Committee to address the increased use of leveraged loans and the potential impact they could have on the broader economy. On Tuesday, the House Committee on Financial Services hosted a hearing attended by all five SEC commissioners for the first time in more than a decade.

Witnesses Give Leveraged Loan Outlook to SEC

The Securities and Exchange Commission’s Investor Advisory Committedivision held a hearing Thursday to gather information on the increased use of leveraged loans and the potential impact it could have on future regulatory efforts.

On Sept. 19, the IAC held a panel to discuss the benefits and risks associated with leveraged loans; the market for collateralized loan obligations, known as CLOs; and various factors leading to the leveraged lending boom.

Many of the panel’s witnesses pointed to the shift toward covenant-lite loans as a cause for concern. George Oldfield, principal emeritus at the Brattle Group, said proper due diligence at each step of the transaction—conducted by the sponsor, warehouse, rating entity, investors and underwriters—is essential to the success of the loan.

Elisabeth de Fontenay, a law professor at Duke University, attributed the loosening of lender protections—known as covenants—to nearly a decade of low interest rates from the Federal Reserve, the end of the Glass Steagall Act and the subsequent start of the “originate to distribute” model, and a push by academics extolling the benefits of debt to business operations.

Only Andrew O’Brien, head of global loan capital strategy and a managing director at JP Morgan, disagreed with his colleagues on the panel. O’Brien downplayed the risk of CLOs, saying they’re still secured by assets. “Covenant-lite does not mean no covenants,” he said.

Panelists also expressed concerns for the amount of liquidity CLO markets have. Erik Gerding, a professor of law and Wolf-Nichol Fellow at the University of Colorado Law School, pointed to a lack of centralized exchanges for CLOs as a cause for concern. Because there is no central exchange, there is a lack of price discovery mechanisms, making it impossible to track liquidity and price changes, he said. Gerding expressed concern that CLOs were being used as a form of regulatory arbitrage, rather than as a source of liquidity—many institutional investors are rewarded or mandated to have highly rated investments, but also seek high returns.

The “credit rating agency problem” was addressed as well. Witnesses discussed the difficulties of having objective ratings agencies, since credit rating agencies are paid by the fund whose CLO they are rating, CLO managers can “shop around” for loans, and CLO managers have been attempting to reverse engineer what rating agencies look for.

Policymakers Grill, Praise SEC Commissioners at Hearing

 For the first time in more than a decade, all five Securities and Exchange Commission leaders testified before a congressional committee, which lawmakers used both to praise and criticize the agency.

On Sept. 24, the House Financial Services Committee hosted a full committee hearing that included SEC Chairman Jay Clayton in addition to commissioners Robert Jackson, Hester Peirce, Elad Roisman and Allison Lee, who fielded questions posed by lawmakers.

In an opening statement, Rep. Maxine Waters, D-Calif. and chair of the Financial Services Committee, criticized the group for rolling back portions of the Volcker Rule and supporting the Regulation Best Interest rule, which Waters said fails to protect retirement savers from “unscrupulous financial advisers.”

“The SEC is not fulfilling its mission as Wall Street’s cop,” she said.

Ranking member of the committee Rep. Patrick McHenry, R-N.C., disagreed with that sentiment, using his alloted time to argue that additional regulations, such as mandatory disclosures, cost and weaken opportunities for investors.

“We need to focus on policies to incentivize companies to go public. We need to reexamine the private offering framework,” McHenry said.

Following opening statements, lawmakers began questioning the commissioners on topics that ranged from Facebook’s Libra cryptocurrency to Ponzi schemes and beyond.

Rep. Lacy Clay, D-Mo., asked commissioners if taxpayers and pensioners could be assured the SEC was doing enough to oversee private equity firms investing capital provided by pensions. Chairman Clayton said oversight of private equity firms and private markets in general is different from that of public ones, but private equity continues to be an enforcement focus of the agency.

The topic of leveraged lending was introduced by Rep. Andy Barr, R-Ky., who voiced the opinion that it did not pose a systemic risk to financial stability.

In response, Clayton said policymakers should recognize that the amount of credit from the banking sector has decreased while credit from the non-banking sector has increased, but he doesn’t see systemic risk.

“If I saw a systemic issue, I would be doing something about it,” he said.