May 14, 2018 - Can you picture what will be? So limitless and free.

At midnight on May 10th, the last opportunity for the government to file a petition for certiorari to the United States Supreme Court in its risk retention litigation with the LSTA expired, with the agencies choosing not to pursue further action. Thus ends a judicial process initiated by the LSTA on November 10, 2014, exactly three and a half years ago.  While much is very clear (managers of pure open market CLOs are exempt from risk retention), other market questions persist (e.g., what about hybrids or EU originator CLOs?).  After a quick review of the most recent events, we will take a deeper dive into how to think about these open issues.

As readers recall, on February 9, 2018, the United States Court of Appeals for the District of Columbia Circuit (the Circuit Court) ruled in favor of the LSTA in its lawsuit against the SEC and Federal Reserve Board.  The ruling reversed a December 2016 decision by the DC District Court and held that the risk retention rules promulgated under section 941 of the Dodd-Frank Act cannot be applied to open market CLO managers.  The court’s ruling constituted an important victory for the CLO market.  (The LSTA’s in- depth analysis of the opinion and what it meant can be found here).  The agencies decided not to appeal for en banc review to the Circuit Court (where the deadline was March 26th), the Circuit Court issued its mandate to the District Court on April 3rd, and the DC District Court, on April 5th, ordered that i) summary judgment is granted in favor of the LSTA regarding the application of risk retention to open-market CLO managers, ii) summary judgement is vacated on the issue of how to calculate the five percent risk retention under the Credit Risk Retention Rule, and iii) the Credit Risk Retention Rule is vacated insofar as it applies to investment managers of open-market collateralized loan obligations.  With the passing of the deadline for appeal to the Supreme Court, that order cannot be reversed.

Now that it is clear how true open market CLOs are treated, how should the market be thinking about other risk retention situations?  Some are easy, others not so much.  For example, it is quite clear that a true balance sheet CLOs, where a bank originates all the loans and then sells them to a CLO, remains subject to risk retention even after the court decision since the bank is originating and initiating the CLO by selling or transferring assets.  What about a transaction where a direct lender creates a CLO ten or 20 percent of whose assets it originated with the balance of the assets purchased in the open market?  What is the status of a CLO that is compliant with EU risk retention rules because the manager purchases 5% of the assets and holds them on its balance sheet for 15 days?  What about a non-loan securitization that purchases all its assets in the open market (even if those assets might be considered very risky)?  As the LSTA’s lead litigation lawyer, Richard Klingler of Sidley, pointed out in a recent webinar (available here), all of these questions must be viewed through the prism of the Circuit Court’s opinion in the LSTA case, specifically, how would courts apply the LSTA decision and view of “transferor” and “organizer/initiator”.  Moreover, it is important to “think like a litigator” in deciding when it might be useful to go to the SEC for clarity regarding its enforcement policy and when it is acceptable to go without obtaining their views.  We expect market participants to grapple with these issues over the coming weeks and months and the LSTA looks forward to engaging with the market.

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