This brief summary of the decision delivered on 9 February 2018 will be of interest to anyone involved in the CLO business in the United States.
In the wake of the 2008 financial crisis, Congress enacted the Dodd-Frank Act in July 2010 (the "Act").
In § 941 of the Act, the Securities and Exchange Commission ("SEC"), the Federal Reserve Board of Governors (the "Federal Reserve"), the Comptroller of the Currency and the Federal Deposit Insurance Corporation were directed to adopt regulations, which would require "any securitizer" of an asset-backed security to retain 5% of the credit risk for any asset that the securitizer "transfers, sells, or conveys" to a third party. The rationale for this requirement was that when securitizers retain a material amount of risk, they have “skin in the game”, aligning their economic interests with those of investors in asset-backed securities ("ABS").
The federal regulators adopted the final rules in October 2014 (Credit Risk Retention Rule, 79 Fed. Reg. 77, 601 (24 December 2014)), requiring all securitizers, including CLO asset managers, to retain 5% of the credit risk of securitized asset pools backing non-exempt asset-backed securities.
The Loan Syndications and Trading Association ("LSTA") filed a lawsuit against the Federal Reserve, the SEC and other federal regulators in November 2014 in response to this, where it challenged the inclusion of "open-market" CLO managers into the definition of "securitizers" and subjecting them to the risk retention rules. LSTA argued that the Act does not apply to CLO managers as their activity when managing CLOs does not involve “transferring, selling or conveying” any assets to any third party.
On 22 December 2016, Judge Reggie Walton from the U.S. District Court for the District of Columbia granted summary judgment for the defendants and found that CLO managers fell into the definition of "securitizers".
The LSTA appealed and after the hearing that took place in October 2017 the U.S. Court of Appeals for the District of Columbia Circuit delivered a unanimous judgement on 9 February 2018, where it found for the claimant and vacated the decision of the district court. Therefore, pursuant to this judgement, open-market CLO managers are excluded from the definition of "securitizers" and are not subject to the risk retention rules.
(1) Open-market CLO managers
Open-market CLOs securitize assets that are purchased on primary and secondary markets in accordance with the investment guidelines of the CLO.
The role of a CLO manager involves meeting potential investors and agreeing to the investment guidelines, as well as the risk profiles and tranche structures the CLO will ultimately take.
The manager then directs a Special Purpose Vehicle ("SPV") to issue notes in exchange for capital from the investors. The SPV uses the proceeds from the issuance of the notes or other securities to purchases the assets that will secure the SPV’s obligation to repay the notes. While doing this, the SPV operates at the recommendation of the manager, whose compensation and management fees are contingent on the performance of the asset pool over time.
Importantly, open-market CLO managers neither originate nor acquire assets nor hold them at any time.
(2) Decision of the district court
The LSTA claimed that the Dodd-Frank rules were misapplied and raised three arguments.
First, the LSTA claimed that treating managers of open-market CLOs as securitizers was "arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law".
Secondly, the LSTA claimed that the defendants acted in an arbitrary and capricious manner in using "fair value" as a metric to measure credit risk under the final rules.
Finally, the LSTA contended that the defendants failed to exempt or adjust the risk retention rules so that open-market CLO managers could manage their CLOs according to industry best practices without devoting excessive capital.
The defendants argued that the definition of a "securitizer" in the final risk retention rules (15 U.S.C § 78o-11(a)(3)(B)) was identical to the definition of "sponsor" under SEC regulations governing disclosure for ABS offerings under the Securities Act.
Therefore, it was argued that since CLO managers generally act as sponsors of securitization transactions, by selecting and managing the assets to be acquired, they should fall within the definition of a "securitizer" and should be subject to the retention requirements.
- Inclusion of CLO managers in the definition of "securitizer"
The district court referred to the "Chevron two-step" process (Chevron, U.S.A., Inc. v. NRDC, Inc. 467 U.S. 837(1984)) in order to test whether the defendants' actions were appropriate during the rulemaking process:
(i) If "Congress has directly spoken to the precise question at issue", then "the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress" (Chevron, 467 U.S. at 842-43).
(ii) If "the statute is silent or ambiguous with respect to the specific issue", the court inquires "whether the agency's answer is based on a permissible construction of the statute" (Chevron, 467 U.S. at 843).
The district court concluded that Congress intended to "broadly delegate rulemaking authority to [defendants]". The court also found that Congress did not unambiguously intend to exclude open-market CLO managers from the "securitizer" definition because Congress chose to incorporate the defendants' definition of "sponsor" into the definition of "securitizer" in the risk retention rules.
Therefore, the district court found that the defendants' construction was reasonable.
- Measure of the credit risk
The LSTA argued that the adoption of "fair value" as the measure of the ABS interest to be retained by the defendants was not appropriate, as Congress did not provide a clear direction for the defendants to use fair value as a measure for retained risk.
The district court noted that Congress required defendants to promulgate rules to ensure that securitizers retain an economic interest in a portion of the credit risk of the transaction and that the retained economic interest should be at least 5%.
The district court was of the opinion that, because Congress did not define credit risk or expressly provide a methodology to be used in measuring the value of the retained interest, the defendants were provided with a broad mandate and were entitled to use fair value to measure risk retention. The court also concluded that such choice was appropriate, reasonable and supported in the explanatory text of the final rule.
- Exemptions for CLOs
The LSTA submitted that the defendants failed to grant exemptions or make appropriate adjustments so that open-market CLO managers could adhere to industry best practices for risk retention without having to commit excessive capital to do so.
The claimant also argued the defendants failed to "appropriately assess the costs and benefits associated while declining to grant [exemptions and] adjustments".
The district court concluded that agency decisions are "untouchable if [the agency] 'examine[d] the relevant data and articulated a satisfactory explanation for its action'" and that they were adequately reasoned in the explanatory text of the final rule.
(3) Decision of the court of appeals
The appeals court focussed on two specific points: (i) the provision of 15 U.S.C. § 78o-11(b)(1) specifying the scope of the mandate to regulate given to the agencies, and (ii) the wording of the definition of "securitizer".
- The scope of the mandate
The statute directs the agencies to issue regulations "to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party" (15 U.S.C. § 78o-11(b)(1)).
The appeals court noted that, based on the literal construction of the rule, the credit risk retention provisions should only be applied to an entity that transfers assets to an issuer. Therefore, the essence of the rule would be that the transferring entity would "retain" some interest in the associated risk by continuing to hold some portion of the assets.
The appeals court noted that nothing in the Act could be construed as requiring the transferring entity to acquire the assets but only to retain a portion of the existing interest.
The appeals court noted that the agencies' interpretation "[stretched] the statute beyond the natural meaning of what Congress wrote" and turned "'retain' a credit risk into 'obtain' a credit risk". Given that under Chevron the agencies only "possess whatever degree of discretion [an] ambiguity allows" (City of Arlington v. FCC, 569 U.S. 290, 296 (2013)), the defendants' actions failed to meet the Chevron test.
- The definition of "securitizer"
"Securitizer" is defined in the Act as: “(A) an issuer of an asset-backed security; or (B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer . . . .” (§ 78o-11(a)(3)).
The appeals court analysed clause (A) of the definition and noted that "issuer" under the rule "is not what an ordinary reader would think is an issuer", but is rather the "entity that transfers assets to the issuer".
Given that open-market CLO managers do not hold or transfer any of the securitised assets, the appeals court concluded that CLO managers are not covered by the definition of the "securitizer" and the credit retention rules shall not apply to open-market CLO managers.
Having resolved that the CLO managers need not retain any credit risk, the appeals court decided that there was no need to address the risk calculation issue.
The government has 45 days from the ruling in which to appeal the decision. The government has not yet indicated whether it intends to appeal the ruling.
Once finalised, the decision will apply to all existing and future open-market CLOs but in the interim, the current agency risk retention rules continue to apply to open-market CLO managers at least until the government’s intentions with regard to an appeal are made clear.