April 21, 2017 - In October 2014, the Securities and Exchange Commission, along with the Federal Reserve Board, the FDIC and the OCC, finalized risk retention rules under Section 941 of Dodd-Frank that imposed on CLO managers the requirement to purchase and retain 5% of the fair value of any CLO they initiate.  The LSTA almost immediately filed a lawsuit against the SEC and Federal Reserve asserting that the agencies lack statutory authority to impose risk retention on CLO manager at all and that, even if they had such authority, requiring a manager to hold a horizontal first-loss position in an amount equal to 5% of the fair value of a CLO (rather than 5% of the credit risk as required by the statute) was a misapplication of the statute.  The litigation journey has been long and arduous but on Wednesday the LSTA took the first step in the final stage of this litigation saga by submitting its opening brief to the DC Circuit Court of Appeals.  The LSTA seeks the reversal of a December 2016 decision by the DC District Court granting summary judgment to the federal agencies and requests that the court vacate the risk retention rules as applied to CLO managers.

On the issue of statutory authority, the LSTA argues that the Dodd-Frank Act does not apply to CLO managers because they do not initiate CLOs by selling assets to it as the statute, which targets “originate-to-distribute securitizations,  requires.  Instead, like other fund managers, CLO managers act on behalf of the CLOs by facilitating the purchase of the loans, never actually originating or owning any loans that they could sell or transfer.  On the issue of the appropriate measure of risk retention, the LSTA contends that the rule is “arbitrary and capricious” and violates the Administrative Procedures Act because the agencies disregarded the statutorily mandated “credit risk” standard and, instead, based risk retention on “fair value”, a standard that has no connection to credit risk.  The difference is profound.  Where 5% of the credit risk held as a horizontal first loss position would be equal to just over $2.5 million for a $500 million CLO (since most of the credit risk of a CLO is in the equity), the final rule requires CLO managers to purchase and retain almost ten times that amount, a challenging task for many thinly-capitalized asset managers.  The LSTA’s final challenge is that the agencies also acted in an arbitrary manner by failing to respond to comments and rejecting better alternatives (such as SFIG’s proposal of risk retention equal to 1% of the fair value of a CLO and the LSTA’s proposal of 5% of the equity for “qualified CLOs”) that would have achieved the agencies’ policy goals while still permitting a robust CLO market to continue to exist.

The agencies have until June 7th to respond and the LSTA’s reply brief is due on July 12th.  After all the briefs are filed, oral arguments will be scheduled for some time in the fall and a panel of three judges will be selected to consider and decide the case.  The LSTA’s opening brief is available here.

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