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News July 24, 2017 Issue

Protect Your Firm and Clients Against MNPI Risks in Bank Loan Investments

Some advisers are expressing interest in investing fund or other client assets in bank loans. Such loans may pay higher yields than other fixed income investments – but they also may carry higher risks, including exposure to material non-public information and potential insider trading issues. If you choose to invest in these loans, know the risks and the best practices to keep your clients and your firm safe.

Funds investing in bank loans should first make a point of learning the investment risks associated with this form of investment, which may involve a careful review of the loan documents as well as understanding the credit risk, said Morgan Lewis consultant Steven Hansen.

Aside from risks relating to the financial health of the borrower, investing in these loans may create compliance risks, he said. These include the possibility of receipt of MNPI. "If the borrower has issued publicly traded securities, including debt, the receipt of MNPI could preclude trading in those securities. If a fund, or a fund and an affiliated fund, own investments in different parts of the borrower’s capital structure, there also exists the possibility of conflicts."

Consider this scenario

Here’s a hypothetical situation showing how these problems might arise: A fund purchases an interest in a loan to ABC Corporation. Pursuant to the loan terms, it is now entitled to obtain information about ABC Corporation, and much of that information is confidential and some of it may be material.

As it turns out, the fund doesn’t just own that interest in the ABC loan. It also trades ABC Corporation stock on the open market.

Over time, ABC Corporation begins experiencing financial difficulties not yet fully reflected in public filings, but indicated in information provided to lenders to ABC. The fund manager now may well have MNPI, but it can’t tell its trading desk to start selling ABC Corporation stock, because that might be considered insider trading. "If the financial condition of ABC deteriorates and it files for bankruptcy, the fund manager could find itself with a conflict between the fund’s interest as a creditor and its interest as a holder of common stock," Hansen said. "Indeed, even prior to a filing, actions with respect to enforcing rights under the loan documentation could conflict with the fund’s or an affiliated fund’s interest as shareholders."

Mitigate the potential problem

Before investing in bank loans, consider the following best practices:

  • Disclose. Let investors know about the potential conflict of interest and what your firm’s practice will be when such conflicts arise, said Ropes & Gray partner Jason Brown. That practice may be letting the equity side know that your firm’s debt obligations will be favored . "We may be investing in equity and debt for the same company and, in certain situations, such as the underlying company coming under financial distress, our hands are going to be tied as to our course of action," is one concept you might need to convey, suggested Mayer Brown attorney Adam Kanter.
  • Create an information wall. Such a wall would separate the equity trading desk from the debt desk so that, should the bank loan borrower become financially distressed, each desk would make decisions independently. This would help protect the fund manager from charges of insider trading and/or conflict of interest, Brown suggested. Typically, larger advisory firms may already have such walls in place. Smaller firms could create "informal" walls to address the conflict of interest by, for instance, having separate portfolio managers for equity and debt, he said.
  • The debt side goes passive. A fund manager that has a conflict relating to clients holding debt and equity of a financially distressed corporation could mitigate the conflict of interest problem by simply having its debt desk take no action with respect to the corporation, Brown said. That would mean, for example, not holding a seat on the corporation’s creditors committee or other committees or voting in proportion to the other creditors. Of course, this practice would need to be disclosed to the other clients holding the debt, he said.
  • Waive receipt of future information from the underlying company. The initial MNPI that the fund manager receives will eventually grow old and not be considered MNPI, suggested Kanter. By waiving receipt of such future information, you can greatly reduce the chance that the fund manager will continue receiving MNPI, thereby mitigating the chances of these problems occurring.
  • Train staff to know when they have received MNPI. When staff reviews materials received, they should ask themselves whether the material is public or non-public, whether it provides information as to the value of the securities or the financial health of the underlying corporation, and/or whether it helps evaluate the value of the security purchased, Kanter said.
  • Report MNPI to the appropriate department. This is usually Compliance, Kanter said. The department will usually place that company on the fund manager’s restricted list, meaning that the firm cannot trade securities issued by it.