In this alert, we present the key lessons to be learned from the U.S. Securities and Exchange Commission’s (the SEC) settlement with Sound Point Capital Management, LP (Sound Point), and discuss whether a similar enforcement action would be possible under the EU and UK market abuse regimes. Fund managers trading in collateralized loan obligations (CLOs) should take note of the SEC’s decision, review their material nonpublic information (MNPI) policies, and closely monitor the SEC’s increased focus on transparency in private credit markets.

Settlement

On August 26, 2024, the SEC announced settled charges against a New York-based investment adviser, Sound Point, for failing to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of MNPI concerning its trading in CLOs. The settlement follows a similar enforcement action brought by the SEC against another investment adviser in 2020.

CLOs and Sound Point

CLOs are securities that typically consist of a series of bonds collateralized by a pool of corporate loans, loan participations, or credit default swaps tied to corporate liabilities. The bonds differ in terms of subordination or, in other words, the priority for receiving cash flow distributions from the underlying loans. The most junior tranche (also called the equity tranche) is subordinate to the remaining tranches and, as a result, is the first to absorb losses if any of the loans default.

Sound Point is an SEC-registered investment adviser that manages its own CLOs and CLOs issued by third parties. In addition, Sound Point often participates in ad hoc lender groups or creditors’ committees, where it explores potential debt restructuring opportunities with companies on the edge of bankruptcy filings or restructuring.

Sound Point and MNPI about Company A

According to the SEC, in June 2019, as a member of such an ad hoc group of lenders, Sound Point became aware of the likely need for rescue financing of a media services company (Company A) – information which constituted MNPI about that company. Given that Sound Point owned and managed CLOs collateralized by loans issued to Company A, it began to explore the possibility of reducing its exposure to such CLOs. Sound Point decided to sell portions of its equity tranches several weeks later, and its compliance department approved the sale despite being aware of MNPI about Company A.

When MNPI concerning Company A became public the day following the sale, the prices of loans issued to Company A immediately dropped by more than 50%, with the value of the tranches sold by Sound Point declining by approximately 11%, or $685,000.

SEC’s Charges

Although Sound Point had in place a general MNPI policy, it did not require Sound Point’s compliance personnel to consider the impact of MNPI relating to a corporate borrower on the value of a CLO tranche containing a loan to that borrower, when evaluating a proposed sale of that tranche.

In the SEC’s view, this gap constituted a violation of Sections 204A and 206(4) of the Investment Advisers Act of 1940 (the Advisers Act) and Rule 206(4)-7 promulgated thereunder, which require investment advisers to, among other things, “establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent […] the misuse of material, nonpublic information” and have “policies and procedures reasonably designed to prevent” violations of the Advisers Act.

After accounting for the subsequent reviews and investigations conducted by Sound Point, as well as the implementation of the revised MNPI policies in 2022 and 2024, the SEC accepted Sound Point’s offer to settle for $1.8 million in a civil penalty. (Sound Point neither admitted nor denied the SEC’s findings.) The SEC did not, however, charge Sound Point with violating SEC Rule 10b-5 relating to trading in securities based on MNPI.

Lessons for Fund Managers

The Sound Point enforcement action demonstrates the SEC’s increased focus on the activities of fund managers in the context of insider trading and the specificity of written policies and procedures.

The Sound Point enforcement action is not the first action brought by the SEC against a fund manager in relation to MNPI. In 2020, the SEC settled charges with another private equity adviser for the lack of sufficient policies and procedures to prevent the misuse of MNPI obtained through employees who had been appointed to the boards of portfolio companies. Although the firm had a general MNPI policy, the SEC concluded that the policy was not specific enough to account for the types of MNPI obtained in the context of the firm’s unique business lines.

Both settlements clearly signal the need for fund managers to review their MNPI policies and update them accordingly. When managers deal with complex derivative products, they should consider whether their policies accurately reflect the MNPI risks related to these products, including loans behind them. Generally restricting trades on the basis of MNPI may not be sufficient, and fund managers should holistically address exposure of their business operations to MNPI, and actively maintain and enforce their policies.

BROADER CONTEXT

Could a similar action be brought on the other side of the Atlantic? The European MNPI regime is based on EU Regulation 596/2014 on market abuse (MAR) that applies directly in every EU Member State. The UK decided to retain the provisions of MAR following Brexit with very limited amendments.

Competent authorities of the EU Member States and, in the UK, the Financial Conduct Authority (the FCA) have broad powers to investigate infringements of MAR, including infringements of its Article 16(2), which requires any person professionally arranging or executing transactions to “establish and maintain effective arrangements, systems and procedures to detect and report suspicious orders and transactions” involving insider dealing and market manipulation.

To date, the FCA has published three enforcement actions for violations of this provision (see here, here, and here). The last enforcement, published in August 2022, imposed a financial penalty of £12,533,800 on an international broker-dealer, part of one of the world’s largest banks, for failures in control systems resulting in a number of erroneous orders being executed across various European exchanges.

However, unlike the SEC, the FCA has not published the results of any investigation into MAR policies of fund managers operating in the UK, nor has it announced any specific focus on this type of enforcement action.