The Loan Ranger Rides Again: SEC Lassos Sound Point in MNPI Roundup
Two Kinds of Investment Advisers
Some investment advisers are relatively simple. You ask them for advice and they say, “Oh, invest in this, don’t invest in that. Allocate here, keep some in cash, maybe not too much, blah blah blah.” Many of their regulatory requirements will be relatively simple. It won’t be that hard to manage whatever material, nonpublic information they have about publicly traded issuers because they might not have that much.
Some are complex! Sound Point Capital Management is one of those. Sound Point is a hedge fund that does “investment strategies concentrated on performing credit and CLOs, opportunistic credit, structured credit, specialty finance and marketplace lending, and commercial real estate credit.”
Things Sound Point Did
Two of these things it did from May 2018 to June 2024 and are at issue for this post and the administrative order it agreed to with the SEC earlier this week.
Thing 1
First, Sound Point participated in lender groups “to explore potential favorable debt restructuring opportunities” for companies just before those companies filed for bankruptcy or did a similar restructuring. Maybe the interest rates are high in those situations? I imagine they are. Importantly for today’s purposes, participating in these groups often put Sound Point in a position to know if a company was about to go into bankruptcy or its ilk.
Thing 2
Second, Sound Point managed collateralized loan obligations (CLOs) and traded tranches of them. You have to call them “tranches”, not “sections” or “pieces” or anything else. CLOs are created by packaging a diverse set of corporate loans into a single security. These loans are typically issued to companies that have a lot of debt or lower credit ratings, just like the ones Sound Point sometimes loaned money to as part of its lender groups. The pooled loans, the CLOs, are then divided into different tranches, each with its own risk profile and corresponding yield. The tranches are usually structured in a hierarchy, with senior tranches being the safest and junior equity tranches being the riskiest.
Company A
By 2019, Sound Point was doing these things with ‘Company A’. Early that year under Thing 1, “Sound Point became a member of an ad hoc lender group to Company A (the ‘ad hoc group’).” At the same time under Thing 2, “through its CLOs and hedge fund vehicles, Sound Point was one of the largest holders of term loans issued to Company A.”
On June 27th, through its role as a member of the ad hoc group, some Sound Point personnel learned “of the likely failure of an expected major asset sale by Company A and Company A’s need for rescue financing.” The market did not know about this situation. On July 30th, “after several weeks exploring the possibility of reducing Sound Point’s exposure to Sound Point CLO equity tranches, a Sound Point co-portfolio manager for its CLO investments emailed [its] compliance department to request approval to sell portions of two equity tranches of Sound Point CLOs that contained loans by Company A.”
I guess they got approval because later that day Sound Point “sold portions of these two CLO equity tranches to two counterparties on July 30, 2019 . . . .” On July 31st, “when the MNPI concerning Company A became public, the prices of Company A’s loans immediately dropped by more than 50% and thus the value of the two CLO tranches Sound Point had sold the previous day declined in value by approximately 11% or $685,000.”
You can read that the bottom of page 4 of the SEC’s order. In my margin notes, I wrote, “I would be mad about that.” And on page 5 we learn that one of the counterparties was mad! One of them “contacted Sound Point and demanded either rescission of the sale or a reduction in the purchase price equal to the decline in the value of the CLO tranches in response to the Company A MNPI becoming public (approximately $350,000) and threatened litigation. Sound Point paid the amount requested by the counterparty in full.” The order doesn’t include the word “wisely” before paid in that last sentence, but it could have.
I sort of wonder how it was clear to this counterparty that Sound Point knew about Company A’s problems before they became public. We don’t work at a hedge fund and maybe this world is so small it was obvious. But . . . how excited would you have been to make that phone call? Would you put your phone on speaker and gather your neighbors around to listen? I would pay $10 to listen to a recording of it.
What Sound Point Should Have Done
Advisers Act Section 204A and Rule 206(4)-7 require investment advisers to have written policies and procedures reasonably designed, taking into consideration the nature of the adviser’s business, to prevent the misuse of material, nonpublic information (“MNPI”). Sound Point wasn’t completely derelict here. They did have an insider trading policy and maintained a restricted list containing the names of securities that were out of bounds.
But the policy “did not contain any prohibitions on trading a CLO tranche while in possession of MNPI about the underlying loans in that CLO.” You have to do that! If your business is as complex as Sound Point’s is, your policies and procedures have to take into account what your traders are actually doing. Did their compliance department read the email they got from the portfolio manager on July 30th? Did they know all the information about Company A’s problems that their traders knew? This information had been within Sound Point’s walls for over a month. It seems weird that compliance wouldn’t have been aware of it. But if they did know about it, did they tell the portfolio manager, “Sure, bombs away”?
Also, once this blew up, it took Sound Point three years to write better policies and procedures that did incorporate the firm’s actual business. I think it doesn’t take that long?
Anyway, this isn’t a disaster for Sound Point. They pay a $1.8 million penalty and move on. In March they reported having $38.3 billion in assets under management. They’ll be fine.