September 14, 2017 - More than seven years after the passage of the Dodd-Frank Act, some of the resulting regulations imposed on CLOs are still being hotly contested. Indeed, just this week the LSTA learned the identities of the three judges from the D.C. Circuit Court of Appeals that will constitute the panel presiding over the three-year old lawsuit against the SEC and Federal Reserve Board on the issue of risk retention. Also this week, in response to the OCC’s request for comment on revising the Volcker Rule, the LSTA filed a comment letter addressing the prohibition on banks owning debt securities of CLOs that hold any amount of bonds.
First up: Risk Retention. As we noted in April, the SEC, Fed, FDIC and OCC, in October 2014 finalized risk retention rules under Section 941 of Dodd-Frank that required CLO managers 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 Fed asserting that the agencies lacked 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 LSTA took the first step in the most recent (and final) stage of this litigation saga by submitting its opening brief to the DC Circuit Court of Appeals on April 19, 2017; the agencies responded with a brief of their own on June 7, 2017 and the LSTA finished the briefing with its reply brief filed in mid-July. 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.
Oral arguments for the case are scheduled for October 10, 2017 and on Monday, September 11th a panel of three judges was randomly selected to consider the case. Interestingly, only one of the judges, Judge Brett Kavanaugh, is a full-time member of the court, while two, Judge Stephen Williams and Judge Douglas Ginsburg, have senior status. Even more notably, despite the fact that seven of the 11 full-status judges on the court were appointed by Democrat presidents, all three of the panelists in this case were appointed by Republican presidents. While some have suggested this is a favorable panel, it is important to remember that most judges on this court, both Democrat and Republican, still generally give great deference to the government’s interpretation of its own regulations in cases like ours brought under the Administrative Procedure Act. A final decision by the panel will likely come within a few months after oral argument.
Next up: Volcker. The LSTA also this week submitted a comment letter to the Office of the Comptroller of the Currency in response to its request for comment on revising the Volcker Rule. The Volcker Rule and the regulations promulgated thereunder generally prohibit banks from proprietary trading and from investing in the equity of hedge funds and private equity funds. The impact of the Volcker Rule has been widespread and profound and many lawmakers, market participants and even regulators believe it goes too far and needs to be better tailored. However, proprietary trading of loans is not prohibited and the effect of the Volcker Rule on the loan market has been somewhat limited. Consequently, the LSTA letter focused on the ban on banks’ investment in the notes of certain CLOs.
The Volcker Rule was intended to limit banks’ investments in the equity of PE and hedge funds (“covered funds”). But, because the definition of covered funds was very broadly drafted, the effect was to pick up many types of securitizations, including CLOs that are not “loan-only” vehicles (which are specifically carved out of the Volcker Rule). Moreover, the agencies oddly ruled that even the most senior debt securities of CLOs that have even a small bucket for bonds are considered “ownership interests”, the equivalent of equity and forbidden to banks. The LSTA’s comment letter explains why both these positions are incorrect and urges the OCC to revise them. The LSTA notes that even the Financial Stability Oversight Council (“FSOC”) agreed that the definition of covered fund was far too broad and urged the regulators to limit it to its intended targets, i.e., hedge funds and PE funds, and not extend it to securitizations at all. And, just like any corporate capital structure, the senior securities of a CLO also do not resemble equity notwithstanding that in the case of CLOs those securities come with the right to remove and replace a manager for cause. The LSTA argues that prohibiting banks from investing in these notes furthers no policy goal and needlessly reduces the ability of CLO managers to diversify their portfolios by investing a small portion of their portfolios in bonds when market circumstances are favorable. It is important to note that since the Volcker rulemaking involved all of the banking agencies, the OCC will not be able to act on the recommendations of commenters without agreement from the Federal Reserve and the FDIC.