PRIVILEGED AND CONFIDENTIAL — ATTORNEY WORK PRODUCT
CALDERWOOD & HARKNESS LLP 450 Park Avenue New York, NY 10022
INTERNAL MEMORANDUM
May 18, 2023
To: Samuel Eklund, Responsible Partner; Linda Osei, Billing Partner
From: Sylvia Hartwell, Specialist Partner, Tax; Hannah Brinkley, Lead Associate
Re: Tax and Structural Issues — Driftwood CLO 2023-I
Matter No.: 1024-00004
Billing Code: DARF-CLO-2023I
Client: Driftwood Absolute Return Fund Ltd.
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I. Executive Summary
Calderwood & Harkness LLP has been engaged by Driftwood Absolute Return Fund Ltd. ("Driftwood" or "DARF"), a Cayman Islands–domiciled hedge fund with approximately $6.8 billion in assets under management as of the first quarter of 2023, to structure and close a $400,000,000 broadly-syndicated cash-flow collateralized loan obligation designated Driftwood CLO 2023-I (the "Transaction"). This memorandum sets forth the principal tax and structural considerations arising from the proposed Transaction and provides our recommendations with respect to each material issue.
The client principals are Marcus Sorensen (Founder and Chief Investment Officer), Elena Voss (President and Chief Operating Officer), and David Hwan (Managing Director, Structured Credit), who serves as the portfolio manager for the CLO platform. Day-to-day management of the collateral portfolio will be conducted by Driftwood Credit Management LLC ("DCM"), a Delaware limited liability company and wholly owned subsidiary of DARF. DCM is an SEC-registered investment adviser (CRD #182447) with its principal office located at 200 Brickell Avenue, Suite 3100, Miami, Florida 33131.
This memorandum analyzes the following principal tax and structural considerations for the proposed Transaction:
(a) the two-tier offshore issuer / domestic co-issuer structure and the rationale for the dual-entity arrangement;
(b) U.S. federal income tax classification of each entity in the structure (the Issuer, the Co-Issuer, and DCM) and the characterization of the notes as debt or equity;
(c) avoidance of U.S. trade or business treatment for the Cayman issuer under the securities trading safe harbor of IRC § 864(b)(2)(A), including the open question of whether broadly syndicated leveraged loans constitute "securities" within the meaning of that provision;
(d) FATCA and CRS compliance obligations applicable to the Issuer as a Cayman Islands–domiciled Foreign Financial Institution;
(e) ERISA eligibility of the various note tranches, with particular focus on the plan asset rules applicable to the subordinated notes; and
(f) the management fee waterfall and the tax treatment of fees payable to DCM.
The capital structure comprises six tranches totaling $400,000,000 in aggregate principal amount. The reference tranche (Class A-2 Notes) is expected to price at a spread of SOFR + 190 basis points, and the blended weighted-average spread on all rated notes is approximately 195.49 basis points. The collateral pool will consist of broadly syndicated first-lien senior secured leveraged loans, primarily issued by U.S. obligors, with a target portfolio par of $400,000,000.
Pre-closing ramp-up of the collateral pool will be funded by a $250,000,000 warehouse credit facility from Havenwood Bank, N.A. (SOFR + 150 basis points; 85% advance rate), which is expected to be executed on or about May 22, 2023. The warehouse facility will be taken out in full on the Closing Date from proceeds of the note issuance.
The engagement was opened on May 15, 2023. The parties anticipate signing in late August 2023, with pricing and closing expected in September 2023. This memorandum is intended to serve as a working document for the Calderwood & Harkness deal team and will be supplemented as open issues are resolved and as the Transaction progresses toward signing and closing.
II. Proposed Transaction Structure
A. Overview of the Dual-Issuer Structure
The Transaction will employ a two-tier issuer structure consisting of a Cayman Islands–domiciled issuer and a Delaware–domiciled co-issuer, as is market standard for broadly syndicated CLO transactions marketed to U.S. institutional investors.
Driftwood CLO 2023-I, Ltd. (the "Issuer") will be formed as a Cayman Islands exempted company with limited liability. The Issuer's registered office will be located at PO Box 4927, Windward House, 3rd Floor, George Town, Grand Cayman KY1-1306, Cayman Islands. The Issuer's Cayman registration number is EX-382916. The Issuer will be the primary obligor on the notes and will hold all collateral assets pledged under the Indenture. The Issuer will be wholly owned by DARF.
Driftwood CLO 2023-I, LLC (the "Co-Issuer") will be formed as a Delaware limited liability company. The Co-Issuer's registered agent will be National Registered Agents Inc., 1209 Orange Street, Wilmington, Delaware 19801. The Delaware file number for the Co-Issuer is 7429831. The Co-Issuer's sole member will be the Issuer.
The Issuer and the Co-Issuer will jointly issue the secured notes pursuant to an Indenture to be dated as of the Closing Date (the "Indenture"). The Cayman Issuer will be the primary obligor on all notes, while the Co-Issuer will serve as co-issuer for purposes of the offering. The Co-Issuer's role exists primarily for U.S. regulatory and tax structuring purposes, and in particular to facilitate the placement of the notes with U.S. institutional investors under Rule 144A of the Securities Act of 1933, as amended (the "Securities Act").
The rationale for the dual-issuer structure is as follows:
(i) The use of a Cayman exempted company as the primary issuer satisfies the Cayman Islands regulatory framework and permits the Issuer to benefit from the absence of Cayman income, capital gains, and withholding taxes, as well as from the availability of a long-term tax exemption undertaking from the Cayman government.
(ii) The Delaware Co-Issuer, as the sole member of which is the Cayman Issuer, will be treated as a disregarded entity for U.S. federal income tax purposes, meaning that its activities and assets will be attributed to the Issuer and it will have no separate taxable existence. This structure avoids the creation of an additional taxable entity while permitting the issuance of notes that are registered and cleared through U.S. clearing systems.
(iii) The Co-Issuer facilitates the issuance of notes that are eligible for clearance through The Depository Trust Company ("DTC") (DTC Participant No. 2176 via Ironclad Trust Company, N.A. as trustee and custodian), which is essential for settlement and secondary market trading by U.S. investors.
All collateral assets will be held by Ironclad Trust Company, N.A. (100 Wall Street, Suite 1650, New York, New York 10005; contact: Catherine Nowak, Vice President, Corporate Trust) in its capacity as trustee, paying agent, note registrar, and custodian under the Indenture. Ironclad Trust Company is a national banking association chartered under the laws of the United States and is widely used as trustee in broadly syndicated CLO transactions.
B. Capital Structure
The proposed capital structure of Driftwood CLO 2023-I consists of six tranches totaling $400,000,000 in aggregate principal amount, as set forth in the table below:
The total principal amount of rated notes is $364,000,000 (i.e., $400,000,000 less the $36,000,000 of unrated subordinated notes). The notes will be dual-rated by Brindoval Analytical Services Inc. ("Brindoval" or "CAS") and Ridgeline Credit Ratings LLC ("Ridgeline" or "RCR"), both of which are nationally recognized statistical rating organizations ("NRSROs").
All notes bear a floating rate of interest linked to Compounded SOFR, with the 26253 fallback convention applicable in the event of a SOFR disruption. The day count convention for all notes is Actual/360. The subordinated notes do not bear a stated rate of interest but instead receive residual cash flows from the collateral portfolio after all senior obligations (including trustee fees, collateral management fees, and interest on the rated notes) have been satisfied.
The weighted-average spread on the rated notes is computed as follows:
(256,000,000 × 155) + (40,000,000 × 190) + (28,000,000 × 230) + (24,000,000 × 310) + (16,000,000 × 625) = 39,680,000,000 + 7,600,000,000 + 6,440,000,000 + 7,440,000,000 + 10,000,000,000 = 71,160,000,000
71,160,000,000 ÷ 364,000,000 ≈ 195.49 basis points
The reference spread for the Transaction is 190 basis points, corresponding to the spread on the Class A-2 Notes, which serves as the reference tranche for deal-term negotiations and pricing discussions with the placement agent and investors.
C. Subordination Levels
The Indenture will provide the following subordination levels for each class of rated notes, expressed as the percentage of the collateral portfolio par that is junior to each such class:
• Class A-1 Notes: 36.00% subordination
• Class A-2 Notes: 26.00% subordination
• Class B Notes: 19.00% subordination
• Class C Notes: 13.00% subordination
• Class D Notes: 9.00% subordination
These subordination levels represent the collateral cushion below each tranche, which supports the target ratings from Brindoval and Ridgeline. The subordination levels have been established based on rating agency criteria and the anticipated credit quality of the collateral portfolio, including the target weighted-average rating factor, weighted-average spread, and diversity score. The subordination structure is designed to provide sufficient credit enhancement to each rated tranche to achieve the target ratings while maximizing the residual return to the subordinated noteholders.
D. Key Structural Parameters
The principal structural parameters of the Transaction are as follows:
Offering Exemption. The notes will be offered and sold in reliance on the exemption from registration provided by Rule 144A under the Securities Act (to qualified institutional buyers within the United States) and Regulation S under the Securities Act (to persons outside the United States in offshore transactions).
Minimum Denomination. The rated notes will be issued in minimum denominations of $250,000, with integral multiples of $1,000 in excess thereof. The subordinated notes will be issued in minimum denominations of $250,000, with integral multiples of $1 in excess thereof.
Payment Date Frequency. Interest and principal payments on the notes will be made quarterly on each Payment Date, which shall be the 15th day of January, April, July, and October of each year, commencing January 15, 2024. The first Payment Date is expected to be January 15, 2024.
Record Date. The record date for each Payment Date shall be the 15th calendar day preceding such Payment Date.
Non-Call Period. The notes will be subject to a non-call period of two years from the Closing Date, expected to end on September 12, 2025. During the non-call period, the Issuer may not optionally redeem the notes.
Reinvestment Period. The reinvestment period shall be five years from the Closing Date, expected to end on September 12, 2028. During the reinvestment period, the Issuer (acting through DCM as collateral manager) may reinvest principal proceeds from the collateral portfolio in additional eligible collateral obligations in accordance with the eligibility criteria set forth in the Indenture. Following the expiration of the reinvestment period, principal proceeds will be applied to amortize the notes in accordance with the priority of payments.
Stated Maturity. The stated maturity of the notes will be October 15, 2036.
Effective Date Deadline. The effective date deadline — by which the collateral portfolio must satisfy certain effective date conditions (including minimum par, diversity, and coverage test compliance) — is 90 days following the pricing date, expected to be December 12, 2023.
III. U.S. Federal Income Tax Analysis
A. Classification of the Issuer (Driftwood CLO 2023-I, Ltd.)
The Issuer is a Cayman Islands exempted company with limited liability. Under the entity classification rules set forth in Treasury Regulations §§ 301.7701-2 and 301.7701-3 (commonly referred to as the "check-the-box" regulations), a foreign entity that is not listed as a per se corporation in Treas. Reg. § 301.7701-2(b)(8) may elect its classification for U.S. federal income tax purposes. Cayman Islands exempted companies are not included on the per se corporation list and are therefore "eligible entities" that may elect to be treated as either a corporation or a partnership (or, if they have a single owner, as a disregarded entity).
As a newly formed entity with a single owner (DARF), the Issuer, absent an affirmative election, would default to disregarded entity status under Treas. Reg. § 301.7701-3(b)(2)(i)(C). However, this default classification is not appropriate for a CLO issuer for several reasons. First, if the Issuer were treated as a disregarded entity, all of its income, gains, losses, and deductions would be attributed directly to DARF, potentially creating complex reporting obligations and unintended tax consequences for DARF and its investors. Second, the Issuer will issue multiple classes of notes, some of which will be treated as equity (the subordinated notes) and others as debt (the rated notes), and the corporate classification facilitates the proper characterization of these instruments.
Recommendation. The Issuer should affirmatively file IRS Form 8832 (Entity Classification Election) to elect to be treated as a corporation for U.S. federal income tax purposes. This election should be effective as of the date of the Issuer's formation, and in all events prior to any taxable transaction (including the first collateral purchase under the warehouse facility).
Rationale. Corporate classification is the market-standard approach for CLO issuers. It achieves three critical objectives: (i) it avoids flow-through taxation of the Issuer's income to noteholders or to DARF; (ii) it facilitates the debt/equity characterization of the various note tranches by establishing the Issuer as a separate taxable entity; and (iii) it simplifies the tax reporting obligations of the Issuer and its noteholders. As a foreign corporation, the Issuer will not be subject to U.S. federal income tax provided it is not engaged in a U.S. trade or business within the meaning of IRC § 864(b), as discussed in Section III.C below.
B. Classification of the Co-Issuer (Driftwood CLO 2023-I, LLC)
The Co-Issuer is a Delaware limited liability company with a single member — the Issuer. Under Treas. Reg. § 301.7701-3(b)(1)(ii), a domestic eligible entity with a single owner is, in the absence of an affirmative election to the contrary, classified as an entity that is disregarded as separate from its owner for U.S. federal income tax purposes.
Recommendation. The Co-Issuer should be treated as a disregarded entity for U.S. federal income tax purposes. Because the default classification under the check-the-box regulations for a domestic single-member LLC is disregarded entity status, no affirmative election (i.e., no Form 8832 filing) is required for the Co-Issuer.
Effect. As a disregarded entity, all activities and assets of the Co-Issuer will be treated as those of the Issuer (its sole member) for U.S. federal income tax purposes. The Co-Issuer will have no separate taxable existence. For all purposes relevant to this memorandum — including the analysis of U.S. trade or business status, withholding tax, and debt/equity classification — the Co-Issuer's activities, obligations, and assets are attributed to the Issuer as if the Co-Issuer did not exist.
No Form 8832 is required to be filed for the Co-Issuer unless the parties wish to affirmatively elect away from the default classification, which we do not recommend.
C. U.S. Trade or Business — Safe Harbor Analysis
Critical Tax Objective. The central tax structuring objective for the Issuer is to ensure that it is not treated as engaged in a U.S. trade or business within the meaning of IRC § 864(b). If the Issuer were treated as engaged in a U.S. trade or business, its income that is "effectively connected" with such trade or business would be subject to U.S. federal income tax at the applicable corporate rate (currently 21%) under IRC § 882(a), and the Issuer would also be subject to the branch profits tax under IRC § 884 (an additional 30% tax on the "dividend equivalent amount," subject to treaty reduction). The combined effective tax rate could be punitive and would fundamentally undermine the economics of the Transaction.
Securities Trading Safe Harbor — IRC § 864(b)(2)(A). The Issuer's activities will consist of purchasing, holding, and disposing of broadly syndicated leveraged loans, collecting interest and principal payments on those loans, and investing the proceeds of the notes in accordance with the Indenture and the Collateral Management Agreement (the "CMA"). The Issuer intends to rely on the "trading in stocks or securities" safe harbor set forth in IRC § 864(b)(2)(A)(ii). Under this provision, a foreign corporation is not treated as engaged in a U.S. trade or business solely by reason of trading in stocks, securities, or commodities for its own account, provided that such trading is conducted through a resident broker, commission agent, custodian, or other independent agent, and the foreign corporation does not have an office or other fixed place of business in the United States through which such trading is directed.
Application to Leveraged Loans. The safe harbor explicitly references "stocks or securities," and there is a threshold question as to whether broadly syndicated term loans constitute "securities" for purposes of § 864(b)(2). The term "securities" is not comprehensively defined in the statute for purposes of this provision. However, the weight of authority supports treating broadly syndicated leveraged loans as "securities" within the meaning of the safe harbor, particularly where — as is the case here — the loans are freely transferable on the secondary loan market, are assigned through standardized LSTA documentation, and trade on secondary markets with sufficient liquidity. This position is supported by IRS private letter rulings (which, while not precedential, are indicative of the IRS's position), legislative history, and the functional similarity between broadly syndicated loans and other instruments that are unambiguously "securities." Sylvia Hartwell will prepare a supplemental memorandum providing a detailed analysis of the loan-as-security question and any applicable IRS guidance, with a target completion date of June 1, 2023.
Independent Agent Requirement. DCM, as the collateral manager, will perform its portfolio management activities from Driftwood's Miami, Florida office located at 200 Brickell Avenue, Suite 3100. DCM's activities in the United States raise a question as to whether the Issuer could be treated as having an office or fixed place of business in the United States, or whether DCM's activities could be attributed to the Issuer in a manner that vitiates the safe harbor. However, DCM will act under the CMA as an independent contractor, not as an agent with authority to bind the Issuer in its own name. The CMA should include express provisions limiting DCM's authority and confirming that DCM does not have the power to conclude contracts in the name of, or otherwise bind, the Issuer. All trading in the secondary loan market should be executed through independent brokers/dealers, and DCM should not hold itself out as having general agency authority over the Issuer.
Recommendation. The Issuer's activities should be structured to fall within the § 864(b)(2) safe harbor. The following specific steps should be taken:
(i) The CMA should include standard representations and covenants limiting DCM's authority and confirming that DCM acts as an independent contractor, not as an agent with authority to bind the Issuer.
(ii) All collateral purchases and sales should be executed through independent brokers/dealers in the secondary loan market.
(iii) The Issuer should not maintain an office or fixed place of business in the United States. All Issuer-level decisions (other than investment decisions delegated to DCM under the CMA) should be made by the Issuer's Cayman-based directors.
(iv) The CMA should include a specific covenant that DCM will not take any action that would cause the Issuer to be treated as engaged in a U.S. trade or business or to have a U.S. permanent establishment.
Sylvia Hartwell will prepare a more detailed analysis of the loan-as-security question and will circulate the supplemental memorandum to the deal team for review.
D. Withholding Tax Considerations
Portfolio Interest Exemption — IRC § 881(c). Interest payments on the rated notes should qualify for the portfolio interest exemption from U.S. withholding tax under IRC § 881(c) (for foreign corporate payees) and IRC § 871(h) (for foreign individual payees). This exemption applies to interest on an obligation that is in "registered form" and that is paid to a foreign beneficial owner who is not one of the following:
(i) a 10-percent shareholder of the Issuer (within the meaning of IRC § 871(h)(3)(B));
(ii) a controlled foreign corporation related to the Issuer (within the meaning of IRC § 881(c)(3)(C)); or
(iii) a bank receiving interest described in IRC § 881(c)(3)(A) with respect to a loan agreement entered into in the ordinary course of its trade or business.
To claim the portfolio interest exemption, the beneficial owner of the notes must provide the applicable withholding certificate — IRS Form W-8BEN (for individuals) or Form W-8BEN-E (for entities) — to the withholding agent (expected to be Ironclad Trust Company, N.A. as paying agent).
SOFR-Linked Payments. All rated notes bear floating-rate interest linked to Compounded SOFR. The interest payments on these notes constitute "portfolio interest" eligible for the exemption from U.S. withholding tax, provided the conditions described above are satisfied. There is no additional withholding tax concern arising from the SOFR-linked nature of the payments, as SOFR is a recognized and widely used reference rate.
Subordinated Notes. The subordinated notes will be treated as equity interests in the Issuer for U.S. federal income tax purposes, as discussed in Section III.E below. Distributions on the subordinated notes will not constitute "interest" and therefore will not be eligible for the portfolio interest exemption. However, because the Issuer is a foreign corporation that is not engaged in a U.S. trade or business (assuming the safe harbor analysis in Section III.C is satisfied), distributions on the subordinated notes should not be subject to U.S. federal withholding tax under IRC §§ 871(a) or 881(a). The withholding tax provisions of IRC §§ 871(a)(1)(A) and 881(a)(1) apply to "fixed or determinable annual or periodical" income from U.S. sources, including dividends. However, distributions by a foreign corporation are not U.S.-source income unless the foreign corporation derives a significant portion of its gross income from sources within the United States. While the Issuer's collateral portfolio will consist primarily of loans to U.S. obligors, the interest income on such loans, when received by the Issuer (a foreign corporation not engaged in a U.S. trade or business), is not effectively connected income and should not give rise to U.S.-source dividend treatment when distributed to the Issuer's equity holders. Additionally, the Issuer will not be treated as a U.S. real property holding corporation (as it holds no U.S. real property interests), and therefore the FIRPTA provisions of IRC § 897 will not apply.
E. Debt vs. Equity Classification of the Notes
Rated Notes (Class A-1, A-2, B, C, and D). The rated secured notes should be treated as indebtedness of the Issuer for U.S. federal income tax purposes. The determination of whether an instrument constitutes debt or equity for U.S. federal income tax purposes is based on the economic substance of the instrument, as evaluated under the multi-factor test derived from case law. The following factors support debt treatment for the rated notes:
(i) Unconditional obligation to pay. The Issuer has an unconditional obligation to pay interest and principal on the rated notes on each Payment Date, subject only to the availability of funds in the priority of payments waterfall. The obligation to pay is fixed and determinable, not contingent on the Issuer's profitability or the exercise of discretion.
(ii) Fixed maturity date. The rated notes have a stated maturity date of October 15, 2036, by which all principal must be repaid. The existence of a definite maturity date is a strong indicator of debt treatment.
(iii) Priority of payment. The rated notes are senior to the subordinated notes in the priority of payments waterfall. Each class of rated notes has a defined priority relative to other classes, and all rated notes are paid in full before any distributions are made to the subordinated noteholders (other than the senior collateral management fee and trustee fees, which are senior to all note interest payments).
(iv) No conversion features. The rated notes do not contain any conversion or exchange features that would give holders the right to convert their notes into equity of the Issuer or any other entity.
(v) Limited voting rights. Holders of the rated notes have no voting rights other than protective rights customary for secured debt obligations (e.g., consent rights with respect to amendments that adversely affect their interests, the right to direct the trustee in connection with an event of default).
(vi) Ratings. The rated notes will be rated by two NRSROs (Brindoval and Ridgeline), which is consistent with treatment as debt instruments. Rating agencies evaluate the notes as debt obligations and assess the creditworthiness of the Issuer's ability to make interest and principal payments.
Subordinated Notes. The subordinated notes should be treated as equity interests in the Issuer for U.S. federal income tax purposes. The following factors support equity treatment:
(i) No stated interest rate. The subordinated notes do not bear a stated rate of interest. Instead, holders of the subordinated notes are entitled to receive residual cash flows from the collateral portfolio after all senior obligations (including trustee fees, collateral management fees, administrative expenses, and interest and principal on the rated notes) have been satisfied. The return on the subordinated notes is entirely contingent on the performance of the collateral portfolio.
(ii) No fixed maturity for payment of principal. While the subordinated notes have a stated maturity date that coincides with the rated notes, there is no obligation to repay a fixed principal amount. The subordinated noteholders receive only the residual value of the collateral portfolio after all other obligations have been satisfied, which may be more or less than their original investment.
(iii) Subordination. The subordinated notes are the most junior obligation in the capital structure, subordinated to all rated tranches and to the collateral manager's senior and subordinate management fees.
(iv) No ratings. The subordinated notes are unrated (NR/NR), which is consistent with equity treatment and reflects the residual, first-loss nature of the investment.
(v) First-loss risk. Holders of the subordinated notes bear the first-loss economic risk with respect to the collateral portfolio. Any deterioration in the credit quality of the portfolio, including defaults, downgrades, or recoveries below par, will first reduce the value available to the subordinated noteholders before affecting the rated tranches.
(vi) Contingent distributions. Distributions on the subordinated notes are contingent on the availability of residual cash flow after payment of all senior obligations, and the amount and timing of such distributions are not fixed or determinable.
Tax Reporting for Subordinated Noteholders. Because the subordinated notes are treated as equity for U.S. federal income tax purposes and the Issuer is treated as a foreign corporation, the subordinated noteholders will be treated as shareholders of the Issuer. Holders will receive Schedule K-1 equivalent reporting reflecting their allocable share of the Issuer's income, gains, losses, and deductions, to the extent applicable. Calderwood & Harkness will coordinate with Greystone Audit Partners LLP (the Issuer's independent auditors; 345 Hudson Street, New York, New York 10014) to confirm the specific reporting mechanism and to ensure that the appropriate tax information is provided to subordinated noteholders on a timely basis.
IV. FATCA and CRS Compliance
A. FATCA (Foreign Account Tax Compliance Act)
The Foreign Account Tax Compliance Act ("FATCA"), codified at IRC §§ 1471–1474, imposes a 30% withholding tax on certain payments made to foreign financial institutions and other foreign entities that do not comply with specified identification and reporting requirements. The purpose of FATCA is to prevent U.S. taxpayers from using foreign accounts and entities to evade U.S. federal income tax.
The Issuer, as a Cayman Islands entity that holds financial assets and pays income thereon to noteholders, will be classified as a Foreign Financial Institution ("FFI") under FATCA. As an FFI, the Issuer is subject to FATCA's identification and reporting requirements.
The Cayman Islands has entered into a Model 1 intergovernmental agreement ("IGA") with the United States, which provides a framework for FATCA compliance by Cayman-domiciled FFIs. Under the Model 1 IGA, Cayman FFIs do not enter into FFI agreements directly with the IRS. Instead, they register with the IRS to obtain a Global Intermediary Identification Number ("GIIN") and report information about their U.S. account holders to the Cayman Tax Information Authority (the "TIA"), which in turn exchanges such information with the IRS on an annual basis.
Recommendation. The Issuer should be registered as a Reporting Foreign Financial Institution with the Cayman TIA and should obtain a GIIN prior to the Closing Date. The FATCA classification and GIIN should be disclosed in the Offering Memorandum. Registration should be completed well in advance of closing to allow sufficient time for IRS processing and to ensure that the GIIN is available for inclusion in the Offering Memorandum (which is expected to be finalized on or about August 18, 2023).
DCM, as collateral manager, should implement due diligence procedures consistent with the requirements of the Model 1 IGA to identify U.S. account holders among the noteholders and to provide the required FATCA reporting through the Cayman TIA. The Offering Memorandum and the subscription documents should require each noteholder to provide a completed IRS Form W-8BEN, W-8BEN-E, W-9, or other applicable withholding certificate, as well as any additional documentation required for FATCA compliance.
Failure to comply with FATCA could result in 30% withholding on "withholdable payments" made to the Issuer, which includes payments of U.S.-source interest and, beginning after the later of December 31, 2026 or the date of publication of applicable final regulations, gross proceeds from the sale or other disposition of debt instruments that produce U.S.-source interest. Such withholding would significantly impair the Issuer's ability to satisfy its obligations under the Indenture and would reduce returns to noteholders.
B. CRS (Common Reporting Standard)
The Cayman Islands has adopted the OECD Common Reporting Standard ("CRS"), which is an international standard for the automatic exchange of financial account information between tax authorities. The CRS is similar in concept to FATCA but applies on a multilateral basis among participating jurisdictions.
The Issuer, as a Cayman-domiciled "Financial Institution" within the meaning of the CRS, will be required to identify and report to the Cayman TIA the tax residence and account information of noteholders who are residents of CRS-participating jurisdictions. The Cayman TIA will then exchange this information with the tax authorities of the relevant participating jurisdictions.
Recommendation. The CMA and the Offering Memorandum should include noteholder consent provisions and information-gathering mechanisms to ensure CRS compliance. Specifically, the subscription documents should require each noteholder to provide a self-certification of its tax residence status and to consent to the reporting of its account information to the Cayman TIA and, through the TIA, to the tax authority of the noteholder's jurisdiction of tax residence. The Offering Memorandum should contain disclosure regarding the Issuer's CRS obligations and the potential consequences of a noteholder's failure to provide the required information.
V. ERISA Analysis
A. Plan Asset Rules and ERISA Eligibility
The Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and Section 4975 of the Internal Revenue Code impose significant restrictions on transactions involving the "plan assets" of employee benefit plans subject to Title I of ERISA and plans subject to Section 4975 of the Code (including individual retirement accounts). If the Issuer's underlying assets were treated as "plan assets" of an investing benefit plan, then each transaction involving the collateral portfolio — including the purchase and sale of loans, the payment of management fees to DCM, and the execution of trades through broker-dealers — could constitute a prohibited transaction under ERISA § 406 or IRC § 4975(c), exposing the parties to excise taxes, potential plan disqualification, and other penalties.
Under Department of Labor Regulation § 2510.3-101, as modified by Section 3(42) of ERISA, an entity's underlying assets will generally be treated as plan assets if benefit plan investors hold, in the aggregate, 25% or more of any class of equity interests in the entity. For this purpose, "benefit plan investors" include employee benefit plans subject to Title I of ERISA, plans subject to Section 4975 of the Code, and entities whose underlying assets include plan assets by reason of a plan's investment in such entity.
The characterization of the notes as "debt" or "equity" is therefore of critical importance for the ERISA plan asset analysis. If the rated notes are treated as debt, the acquisition of rated notes by a benefit plan investor would not constitute the acquisition of an "equity interest" in the Issuer and would not trigger the 25% threshold test. Conversely, if the subordinated notes are treated as equity, holdings of subordinated notes by benefit plan investors must be monitored to ensure that the 25% threshold is not breached.
Subordinated Notes. As discussed in Section III.E above, the subordinated notes will be treated as equity interests in the Issuer for U.S. federal income tax purposes. They should likewise be treated as equity interests for purposes of the ERISA plan asset analysis. Therefore, the aggregate holdings of benefit plan investors in the subordinated notes must not exceed 25% of the total subordinated notes outstanding at any time. The offering documents should include transfer restrictions designed to prevent benefit plan investors from acquiring subordinated notes in excess of this threshold.
As an alternative structural approach, the Transaction could be structured to qualify for one of the regulatory exemptions from the plan asset rules, such as the venture capital operating company ("VCOC") exemption or the real property operating company ("REOC") exemption under DOL Reg. § 2510.3-101(d) and (e). However, a CLO issuer is unlikely to satisfy the VCOC criteria, which require that the entity obtain management rights with respect to the operating companies in which it invests and exercise such rights with respect to at least one such company within 90 days of its initial investment. A CLO issuer that holds broadly syndicated loans does not obtain management rights in its borrowers. The REOC exemption is similarly inapplicable to a CLO.
A more potentially applicable exemption is the prohibited transaction class exemption available under PTCE 96-23 (which permits certain transactions by plans managed by "in-house asset managers") or the securitization safe harbor. The deal team should evaluate whether any class exemption provides additional flexibility, though the most straightforward approach remains the 25% limitation on benefit plan investor holdings of the subordinated notes.
B. Rated Notes — ERISA Eligibility
The rated notes (Class A-1, A-2, B, C, and D) should be treated as debt instruments, not equity interests, for ERISA plan asset purposes. This treatment is consistent with the U.S. federal income tax analysis set forth in Section III.E above. Accordingly, the acquisition of rated notes by a benefit plan investor should not cause the Issuer's underlying assets to be treated as plan assets, and the 25% test described above applies only to the subordinated notes (which are the only equity interests in the Issuer).
Recommendation. The rated notes should be designated as "ERISA eligible" in the Offering Memorandum. This designation is market standard for rated CLO notes and permits benefit plan investors to acquire and hold rated notes without restriction. The Offering Memorandum should include appropriate disclosure regarding the basis for the ERISA eligibility determination, including a summary of the plan asset rules and the treatment of the rated notes as debt instruments.
C. Subordinated Notes — ERISA Restriction
Because the subordinated notes are equity interests for both tax and ERISA purposes, the offering documents should include transfer restrictions providing that either (a) subordinated notes may only be held by non-benefit plan investors, or (b) benefit plan investors may not hold more than 25% of the subordinated notes outstanding at any time.
Recommendation. The following steps should be taken with respect to the subordinated notes:
(i) The Indenture and the Offering Memorandum should include transfer restriction provisions prohibiting the transfer of subordinated notes to benefit plan investors in excess of the 25% threshold, together with representations by each purchaser as to its status (or non-status) as a benefit plan investor.
(ii) Appropriate ERISA legends should be affixed to the subordinated notes (or included in the global note representing the subordinated notes) and in the Offering Memorandum.
(iii) The note registrar (Ironclad Trust Company, N.A.) should be instructed to refuse to register any transfer of subordinated notes that would cause the aggregate holdings of benefit plan investors to exceed 25% of the subordinated notes outstanding.
Given the anticipated investor base for the subordinated notes, particular care is warranted with respect to Stonehill Public Employees' Retirement System ("Stonehill PERS"), a public pension fund whose Director of Fixed Income, James Whitaker, has expressed interest in the subordinated tranche. Stonehill PERS may qualify as a "governmental plan" within the meaning of ERISA § 3(32) and IRC § 414(d). Governmental plans are generally exempt from Title I of ERISA and are not subject to IRC § 4975. However, governmental plans may be subject to analogous restrictions under applicable state law. Hannah Brinkley and Patrick Gallagher should conduct a governmental plan analysis for Stonehill PERS and should review the applicable state-law restrictions before permitting Stonehill PERS to acquire subordinated notes. The other anticipated investors — Marlowe Asset Management Peak Institutional Credit Fund LP and Blackpine Insurance Holdings Ltd. — should also be analyzed for their ERISA status as part of the investor qualification process.
VI. Cayman Islands Tax Considerations
A. Cayman Tax Exemption
The Cayman Islands does not currently impose any income tax, capital gains tax, withholding tax, or other direct tax on the Issuer or on payments by the Issuer to noteholders. The Cayman Islands is widely recognized as a tax-neutral jurisdiction, and its zero-tax regime is a principal reason for the domiciliation of CLO issuers in the Cayman Islands.
To provide long-term certainty regarding the Cayman tax regime, the Issuer should obtain a tax exemption undertaking from the Cayman Islands government under the Tax Concessions Act (as revised). The tax exemption undertaking provides that, for a period of at least 20 years from the date of the undertaking (and potentially up to 30 years), no law enacted in the Cayman Islands imposing any tax on profits, income, gains, or appreciation shall apply to the Issuer, and no such tax shall be levied on the Issuer or on the profits, income, gains, or appreciation of the Issuer. The undertaking also covers payments by the Issuer to its creditors and shareholders and provides that no estate, inheritance, succession, or gift tax shall be payable with respect to any interests in the Issuer.
Applegategate Offshore Services Ltd. (contact: Nigel Pemberton, Partner; Windward House, 4th Floor, George Town, Grand Cayman, Cayman Islands) has been engaged to prepare the application for the tax exemption undertaking and to provide a Cayman tax opinion at closing confirming the availability of the exemption and the absence of Cayman taxation on the Issuer and its noteholders.
B. Economic Substance
The Cayman Islands International Tax Co-operation (Economic Substance) Act (as revised) (the "ES Act") requires certain Cayman entities that conduct "relevant activities" to maintain adequate economic substance in the Cayman Islands. The relevant activities enumerated in the ES Act include banking, insurance, fund management, financing and leasing, headquartering, shipping, distribution and service centers, intellectual property business, and holding company activities.
A CLO issuer that is a "pure equity holding company" or an "investment fund" and does not conduct any other relevant activity is generally not required to meet the full economic substance requirements (which include maintaining adequate employees, physical offices, and expenditures in the Cayman Islands). However, even entities that are not subject to the full economic substance requirements must file an annual economic substance notification with the Cayman Registrar of Companies, confirming their categorization and the basis for any applicable exemption or reduced requirements.
Recommendation. Counsel should confirm with Applegategate Offshore Services Ltd. that the Issuer is properly categorized under the ES Act — either as an "investment fund" (if the Issuer is regulated or registered under the Cayman Mutual Funds Act or Private Funds Act) or as an entity that is not conducting a relevant activity. In either case, the annual economic substance notification must be filed. DARF, as the parent entity (CIMA Registration No. MC-2017-02834), should coordinate with Applegategate on this filing and should ensure that the notification is submitted within the prescribed statutory deadline following the end of each financial year of the Issuer.
VII. Investment Company Act Analysis
A. Rule 3a-7 Exemption
The Issuer must be structured to avoid the requirement to register as an "investment company" under the Investment Company Act of 1940, as amended (the "1940 Act"). Registration as an investment company would impose substantive regulatory requirements — including limitations on capital structure, leverage, and transactions with affiliates — that are incompatible with the operation of a CLO.
The primary exemption upon which the Issuer will rely is Rule 3a-7 under the 1940 Act. Rule 3a-7 provides that an issuer is not an "investment company" (as defined in Section 3(a) of the 1940 Act) if the following conditions are satisfied:
(i) The issuer issues "fixed-income securities" or other securities that entitle their holders to receive payments that are dependent primarily on the cash flow from "eligible assets" (as defined in the rule);
(ii) A "fixed-income security" issued by the issuer does not bear a rate of interest that is determined by reference to the financial condition or the operating results of the issuer (or any affiliate of the issuer);
(iii) The issuer has a "trustee" (within the meaning of the rule) or an independent person who, among other things, has the power to effect the replacement of the issuer's servicer or collateral manager under specified circumstances; and
(iv) The issuer does not acquire or dispose of eligible assets for the primary purpose of recognizing gains or decreasing losses resulting from market value changes.
Application to the Transaction. The CLO's rated notes are fixed-income securities with interest rates tied to Compounded SOFR (an external reference rate), not to the financial condition or operating results of the Issuer. The collateral pool will consist of broadly syndicated first-lien senior secured leveraged loans — which constitute "eligible assets" under Rule 3a-7, as they are self-liquidating financial assets that generate cash flows from interest and principal payments. Ironclad Trust Company, N.A. will serve as trustee under the Indenture and will have the powers required by Rule 3a-7, including the ability to replace the collateral manager upon the occurrence of certain events of default.
Subordinated Notes. The characterization of the subordinated notes under Rule 3a-7 requires careful analysis. Rule 3a-7 contemplates that the issuer may issue "fixed-income securities" and "other securities" that entitle their holders to receive payments dependent on the cash flow from eligible assets. Market practice supports treating unrated residual tranches (such as the subordinated notes) as securities that entitle their holders to receive payments dependent on the cash flow from eligible assets, even though such payments are residual in nature and are not "fixed-income" in the traditional sense. The subordinated notes do not bear a rate of interest determined by reference to the Issuer's financial condition; rather, they entitle their holders to a residual interest in the cash flows from the collateral portfolio. Accordingly, the issuance of the subordinated notes should not defeat the Rule 3a-7 exemption, provided the notes are structured consistently with prevailing market practice and SEC staff interpretations.
B. Section 3(c)(7) Backup Exemption
As a backup exemption, the Issuer may also rely on the exemption from 1940 Act registration provided by Section 3(c)(7) of the 1940 Act. Section 3(c)(7) exempts from the definition of "investment company" any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition, are "qualified purchasers" within the meaning of Section 2(a)(51) of the 1940 Act, and that is not making and does not at the time propose to make a public offering of its securities.
The Section 3(c)(7) exemption provides an independent basis for the Issuer to avoid 1940 Act registration, even if the Rule 3a-7 exemption were determined not to be available. However, reliance on Section 3(c)(7) requires ongoing compliance with the "qualified purchaser" requirement, including transfer restrictions to ensure that notes are not transferred to persons who are not qualified purchasers.
Recommendation. The Transaction should be structured to rely primarily on Rule 3a-7, with Section 3(c)(7) available as a fallback. The Offering Memorandum should contain transfer restrictions requiring that each purchaser of notes (and particularly subordinated notes) represent that it is a "qualified purchaser" within the meaning of Section 2(a)(51) of the 1940 Act. This dual-exemption approach is market standard for broadly syndicated CLO transactions and provides maximum structural flexibility.
VIII. Collateral Management Fee Waterfall
A. Fee Structure
DCM will serve as collateral manager under the CMA and will be compensated through a three-component fee structure consisting of a senior collateral management fee, a subordinate collateral management fee, and an incentive management fee.
Senior Collateral Management Fee. DCM will receive a senior collateral management fee equal to 0.15% per annum of the aggregate principal balance of the collateral portfolio. Based on the target portfolio par of $400,000,000, the senior collateral management fee is expected to be $600,000 per year ($150,000 per quarter). The senior collateral management fee is payable quarterly on each Payment Date and is senior in the priority of payments waterfall, ranking ahead of interest payments on the rated notes to the extent customary and as defined in the Indenture. The seniority of this fee ensures that DCM receives a minimum level of compensation for ongoing portfolio management regardless of the CLO's performance.
Subordinate Collateral Management Fee. DCM will receive a subordinate collateral management fee equal to 0.35% per annum of the aggregate principal balance of the collateral portfolio. Based on the target portfolio par of $400,000,000, the subordinate collateral management fee is expected to be $1,400,000 per year ($350,000 per quarter). The subordinate collateral management fee is payable quarterly on each Payment Date and is junior in the priority of payments waterfall — it is payable only after all Class D Note interest and all other senior expenses and obligations have been paid in full. The subordination of this fee component aligns DCM's interests with those of the noteholders by ensuring that the fee is paid only to the extent the CLO generates sufficient cash flow to service all of its debt obligations.
Incentive Management Fee. DCM will also be entitled to an incentive management fee equal to 20% of excess residual interest proceeds, payable only after a 12% internal rate of return ("IRR") hurdle has been met with respect to the subordinated noteholders. The incentive management fee is designed to align the collateral manager's economic incentive with the performance of the subordinated notes, rewarding DCM for superior portfolio management that generates above-target returns for the equity investors.
Total Base Management Fees. The aggregate base management fees (senior plus subordinate) are $600,000 + $1,400,000 = $2,000,000 per year, representing 0.50% per annum of the target portfolio par. This aggregate fee level is consistent with market norms for broadly syndicated CLO transactions.
B. Tax Treatment of Management Fees
The management fees payable to DCM will be U.S.-source income to DCM. DCM is a Delaware limited liability company with its principal office at 200 Brickell Avenue, Suite 3100, Miami, Florida 33131. DCM is a disregarded entity for U.S. federal income tax purposes, with DARF (a Cayman entity) as its sole member. However, because DCM conducts its investment advisory activities in the United States — including portfolio management, credit analysis, and trade execution — the management fees constitute income that is effectively connected with the conduct of a U.S. trade or business and are taxable under IRC § 882. If DCM is treated as a disregarded entity, the management fees are attributed to DARF but are nevertheless effectively connected income because they arise from activities conducted in the United States. If DCM is treated as a regarded entity (for example, if it were to elect corporate classification), the fees would be taxable to DCM directly.
DCM is an SEC-registered investment adviser (CRD #182447). The management fees should be reported on DCM's U.S. federal tax returns (or, if DCM is a disregarded entity, on DARF's U.S. federal tax return for its effectively connected income). The senior collateral management fee, the subordinate collateral management fee, and the incentive management fee are each treated as ordinary income for U.S. federal income tax purposes.
The incentive management fee is subject to the same analysis and is treated as ordinary income. As discussed in Section XIV below, the incentive fee structure should be reviewed to confirm that it does not create adverse carried-interest treatment under IRC § 1061 for DCM or its principals.
C. Waterfall Priority Impact
The bifurcation of the collateral management fee into senior and subordinate components is structurally significant from both a credit and a tax perspective. From a credit perspective, the bifurcation ensures that a minimum fee is available to DCM for ongoing portfolio management regardless of the CLO's performance (through the seniority of the $600,000 per annum senior fee), while aligning the larger portion of the fee ($1,400,000 per annum) with the interests of noteholders by subordinating it to interest payments on all rated tranches. This structure reduces the effective "leakage" from the waterfall under stress scenarios and increases the cash flow available to service the rated notes.
The placement agent, Meridian Atlantic Securities LLC (contact: Jonathan Halevy), and the rating agencies (Brindoval and Ridgeline) will analyze the fee waterfall as part of their financial modeling and rating analysis. The subordinate management fee's position in the waterfall affects the effective overcollateralization and interest coverage ratios, as the fee is paid only after all rated-note interest has been satisfied. From the perspective of the subordinated noteholders, the subordinate management fee reduces the residual cash flow available for distribution, and the incentive management fee further reduces equity returns above the 12% IRR hurdle. These dynamics will be modeled and disclosed in the Offering Memorandum.
IX. Other Structural Fees and Expenses
In addition to the collateral management fees described in Section VIII above, the Transaction will involve the following fees and expenses, each of which must be positioned appropriately in the priority of payments waterfall under the Indenture:
Trustee Fee. Ironclad Trust Company, N.A. will receive an annual trustee fee of $25,000, payable in equal quarterly installments on each Payment Date. The trustee fee is senior in the priority of payments waterfall, ranking ahead of collateral management fees and interest payments on the notes. The trustee fee compensates Ironclad Trust Company for its services as trustee, paying agent, note registrar, custodian, and collateral administrator under the Indenture.
Trustee Expense Cap. Ironclad Trust Company, N.A. will be entitled to reimbursement of its reasonable out-of-pocket expenses (including legal fees and expenses of counsel) incurred in connection with the administration of the Indenture, subject to a cap of $50,000 per Payment Date. Expenses in excess of this cap will be deferred and paid from available funds on subsequent Payment Dates, to the extent funds are available.
Placement Fee. Meridian Atlantic Securities LLC will receive a placement fee of 0.50% of the aggregate principal amount of the rated notes, calculated as follows: 0.005 × $364,000,000 = $1,820,000. The placement fee is payable at closing and compensates Meridian Atlantic for its services in structuring and placing the rated notes with institutional investors.
Co-Placement Fee. Northbridge Capital Markets Inc. will receive a co-placement fee of 0.25% of the aggregate principal amount of the subordinated notes, calculated as follows: 0.0025 × $36,000,000 = $90,000. The co-placement fee is payable at closing and compensates Northbridge for its services in placing the subordinated notes with equity investors.
The placement fees and the co-placement fee are one-time closing costs and are not recurring expenses in the waterfall. The trustee fee and trustee expense reimbursements are periodic expenses that recur on each Payment Date. The positioning of each fee in the priority of payments waterfall should be confirmed and reflected in the Indenture drafting to ensure consistency with rating agency criteria and investor expectations.
X. Overcollateralization and Interest Coverage Tests
The Indenture will include a series of overcollateralization ("O/C") and interest coverage ("I/C") tests, which are standard credit enhancement mechanisms in CLO transactions. These tests are designed to ensure that the collateral portfolio maintains a sufficient cushion of collateral value (for O/C tests) and interest income (for I/C tests) to support the rated notes. The tests will be calculated by Ironclad Trust Company, N.A. in its capacity as collateral administrator on each quarterly Determination Date (which is expected to be three business days prior to each Payment Date).
The following table sets forth the trigger levels for each O/C and I/C test:
If an O/C or I/C test fails at any level on a Determination Date, the priority of payments waterfall will be modified on the corresponding Payment Date to redirect cash flows to cure the deficiency. Specifically, available interest proceeds (and, if necessary, principal proceeds) will be applied to pay down the most senior class of notes outstanding until the applicable test is cured, before any distributions can be made to junior tranches or subordinated noteholders. This "turbo" mechanism operates as a self-correcting feature that reduces the outstanding principal of the senior notes and thereby restores the coverage ratios to levels at or above the trigger thresholds.
Tax Implications. From a tax perspective, the O/C and I/C cure mechanisms do not, in and of themselves, create taxable events for the Issuer. The reallocation of cash flows within the waterfall is a contractual priority of payments mechanism that affects the timing and amount of payments to different classes of noteholders but does not generate gain or loss at the Issuer level. However, the acceleration of principal payments to certain note classes as a result of a coverage test failure may affect the timing and character of income recognition for noteholders. For example, a holder of Class A-1 Notes that receives accelerated principal payments as a result of a turbo mechanism may realize ordinary income or capital gain (or loss) depending on whether the note was purchased at a premium or discount. The Offering Memorandum should include appropriate tax disclosure regarding the potential consequences of accelerated principal payments.
XI. Collateral Eligibility Criteria — Tax and Structural Implications
The Indenture will establish detailed eligibility criteria that the collateral portfolio must satisfy at all times during the reinvestment period. These criteria are designed to maintain the credit quality and diversity of the portfolio and to support the ratings assigned to the rated notes. The principal eligibility criteria are summarized below, together with a discussion of their tax and structural implications:
• Minimum weighted-average spread: 350 basis points
• Maximum weighted-average life: 7.5 years
• Minimum diversity score: 60
• Maximum CCC bucket: 7.5% of aggregate collateral par ($30,000,000)
• Maximum second-lien bucket: 5.0% of aggregate collateral par ($20,000,000)
• Maximum fixed-rate bucket: 10.0% of aggregate collateral par ($40,000,000)
• Minimum weighted-average recovery rate: 45.0%
• Minimum weighted-average rating factor (WARF): 2,850 (Brindoval scale)
Tax Relevance of the Fixed-Rate Bucket. To the extent the collateral portfolio includes fixed-rate assets that are funded by floating-rate notes, the Issuer will be exposed to basis risk — i.e., the risk that interest income on the fixed-rate assets does not increase in tandem with the Issuer's floating-rate interest expense during periods of rising interest rates. However, this basis risk does not create a tax mismatch for the Issuer if it is treated as a