February 12, 2018 - Last week, 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, concluding that the risk retention rules promulgated under section 941 of the Dodd-Frank Act cannot be applied to CLO managers. Although this decision is subject to appeal, the court’s ruling constitutes a huge victory for the LSTA and the CLO market. This article will examine how we got here, what the court’s ruling said, what happens next, the scope of the decision, and what it means for the CLO market.
In July 2010, Congress passed, and President Obama signed into law, the Dodd-Frank Act, representing sweeping financial regulatory reform. Included in Dodd-Frank was Section 941 which required any “securitizer” of a securitization to retain and hold 5% of the credit risk associated with any such securitization, commonly known as risk retention. Section 941 delegated to the SEC and banking agencies the joint responsibility of issuing rules implementing risk retention. In October 2014, after a three-year rule-making process, the agencies concluded that CLO managers were the “securitizers” in respect of CLOs and required each manager to purchase and retain 5% of the fair value of the securitization it originates. Thus, for a $500 million CLO, a manager would be required to retain $25 million. Retention could be in the form of a vertical strip of 5% of all liabilities, a horizontal, first-loss strip of the equity or an “L-shaped” combination of vertical and horizontal strips adding up to 5% of the fair value. The retained piece could not be sold or hedged but could be held by a “majority-owned affiliate” and financed with recourse. Throughout the rulemaking process the LSTA and others attempted to persuade the agencies that (a) the plain language of the statute did not authorize the agencies to require CLO managers to retain risk, and (b) as a policy matter, the agencies should not require managers to retain so much risk because (i) CLOs performed very well through the financial crisis and (ii) the structure of CLOs already builds in the types of “skin-in-the-game” features that the rules were meant to enforce. Indeed, the LSTA filed six comment letters and met with the agencies numerous times, all to no avail.
The LSTA files suit.
Given the potential negative consequences to the CLO and loan markets, the LSTA filed a lawsuit against the SEC and the Federal Reserve Board in November 2014, almost immediately after the agencies approved the final risk retention rules for CLOs. The complaint asserted that the agencies lacked statutory authority to impose risk retention on CLO managers 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. On the issue of statutory authority, the LSTA argued 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, and never actually originate or own any loans that they could sell or transfer. On the issue of the appropriate measure of risk retention, the LSTA contended that the rule is “arbitrary and capricious” and violates the Administrative Procedure 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 required CLO managers to purchase and retain almost 10 times that amount, a challenging task for many thinly capitalized asset managers. The LSTA’s final challenge was 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 “QCLOs that would have achieved the agencies’ policy goals without imposing burdensome and unnecessary restrictions.”)
For jurisdictional reasons, the case was transferred to the US District Court for the DC District in March 2016 and, in late December 2016, Judge Reggie Walton ruled in favor of the agencies. The LSTA quickly appealed back to the DC Circuit Court.
Almost three years from the day it initially filed its lawsuit, the LSTA got its “day in court.” On Oct. 10, 2017, a three-judge panel of the DC Circuit Court heard oral arguments from LSTA’s counsel, Richard Klingler of Sidley Austin, and Joshua Chadwick representing the federal agencies.
The Court Rules.
On February 9, 2018, the Circuit Court published a unanimous 17-page decision reversing the District Court’s decision on the statutory argument and instructing the court to enter judgment for the LSTA and vacate the risk retention rule as it is applied to CLO managers. Because it ruled that risk retention does not apply to CLO managers, the Circuit Court did not consider the issue of the proper measure of credit risk. (Nevertheless, the Circuit Court did vacate the District Court’s adverse ruling on credit risk, leaving that issue open to dispute if it arises in this or any other context in the future).
What Does the Decision Say?
The Circuit Court focused on two things: the statutory language and policy arguments. First, it closely analyzed the statutory language and concluded that to be a securitizer for purposes of Section 941 “a party must actually be a transferor, relinquishing ownership or control of assets to an issuer” of the securitization notes. They did not accept the agencies’ argument that a manager is a securitizer because it causes other parties to transfer assets to the securitization. The Circuit Court also observed that the statute requires securitizers to “retain” credit risk and pointed out that one cannot retain that which it has never owned or controlled.
After dismissing the agencies’ statutory arguments the Circuit Court pivoted to the agencies’ argument that if CLO managers are not covered by Section 941, it “would do violence to the statutory scheme” and “creat[e] a loophole that would allow securitizers of other types of transactions to structure around their risk retention obligation.” The Court was not persuaded and explained in detail why the agencies “overstate the supposed loophole” which, in any event, was largely of their own making. Finally, the Circuit Court noted that no matter the policy arguments, they “cannot compel us to redraft the statutory boundaries set by Congress. Our commentary on those concerns only reinforces the reasoning that the ordinary meaning of § 941 does not extend to CLO managers.”
What Happens Next?
The Circuit Court’s decision is not yet final. The agencies have 45 days from the day of the decision to request en banc review (i.e., review by the entire DC Circuit Court).
The Scope of the Decision
Once finalized, the decision will apply to all US open market CLOs, whether new or existing, and all other securitizations that are similarly structured. (Thus, subject to the terms of its own indenture and other relevant documentation, an existing securitization that is risk retention compliant would be able to become non-compliant). The decision does not apply to so-called “balance sheet” CLOs or any other securitization in which a party that organizes or initiates a securitization does so by selling or transferring assets to the securitization. Finally, the decision does not impact whatsoever EU risk retention rules.
Are CLOs Subject to Risk Retention in Any Other Way?
No. It is important to note what the decision does and what it doesn’t do. The Circuit Court has vacated the rule as it applies to CLO managers. It does not impose risk retention on any other party or identify any other securitizer associated with a CLO. Since Section 941 of Dodd-Frank does not by its terms identify any specific party as a securitizer but, rather, delegates that authority to the regulatory agencies, a formal joint rulemaking among the SEC, the Federal Reserve Board, the OCC and the FDIC (including a comment period) would be required, which rulemaking would have to be consistent with the statutory language of Section 941 as interpreted by the Circuit Court’s ruling, for any other party to a CLO to be tagged as securitizer.
After grappling with risk retention for almost eight years, submitting six comment letters to regulatory agencies, testifying at four Congressional hearings, supporting risk retention reform legislation in two separate Congressional sessions, attending countless meetings with regulators, legislative staffers and members of Congress, filing seven legal briefs, presenting two oral arguments, and enduring an adverse decision by the District Court, the LSTA has finally prevailed in its efforts to obtain relief for CLO managers from the risk retention rules. This ruling vindicates the LSTA’s long-held analysis of the clear statutory language and reflects the reality that CLOs have performed very well for over 20 years, including through the recent financial crisis.