July 17, 2017 - Last week, the LSTA filed its Reply Brief in its lawsuit against the Federal Reserve Board and the Securities and Exchange Commission on the issue of the application to CLO managers of the Dodd-Frank risk retention rules.  The Reply Brief is available here.  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 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 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 final stage of this litigation saga by submitting its opening brief to the DC Circuit Court of Appeals on April 19th and the agencies responded with a brief of their own on June 7th.  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 statutory argument, the LSTA reiterates that the agencies’ construction of “transferring” disregards the plain meaning of that term as it is used in the statute.  The statute clearly describes a two-sided financial transaction involving a securitizer and an issuer whereby the issuer obtains assets.  Since the CLO manager is the agent for the issuer and the issuer (as everyone agrees) is the transferee of loan assets, the CLO manager cannot be on the other side of that transaction, i.e., the transferor.

The LSTA then asserts that the agencies’ failure to tailor the rule to the appropriate levels of credit risk was arbitrary and capricious.  In their order the agencies themselves concluded that requiring 5% credit risk is suuficient to protect investors and that requiring more would harm borrowers, investors, consumers and the markets.  But the final rule did none of this.  Instead, by tying the horizontal retention piece to 5% of the fair value, they required 9 times more retention than was necessary.

The LSTA also pushes back on the agencies’ assertion that so long as they provided an option that is equal to 5% of the credit risk (the vertical option) they have done enough.  Instead, the LSTA contends that these arguments “disregard the agencies’ own findings that supplementing the vertical element with the horizontal element was necessary and that many securitizers have no choice but to hold risk in a horizontal form.”

Finally the LSTA reiterates its position that the agencies’ failure to provide reasoned responses to comments raised during the rulemaking process “is itself a reason to vacate” the risk-retention rule.  For example, both the LSTA’s proposal of a “qualified CLO” that would require retention equal to 5% of the equity, and SFIG’s suggestions of 1% of the fair value, were rejected without any adequate explanation.

The filing of the reply brief concludes the briefing and the parties now await the scheduling of oral arguments which will probably take place in the fall.  Once oral arguments are heard, a final decision by the Court would likely follow a few months later.

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