The United States Court of Appeals for the D.C. Circuit issued an important decision on February 9, 2018 that will have significant implications for CLO managers, investors and other securitization market participants. The D.C. Circuit's decision vacates a federal district court decision upholding a federal rule that construed open market CLO managers as "securitizers" and required them to retain 5% of the credit risk of assets held by a CLO even though they only selected the loans to be acquired by the CLO. The decision can be found here. The case was brought by the Loan Syndications and Trading Association, the lead advocate for participants in the U.S. syndicated loan market.
BRIEF SUMMARY OF THE DECISION
The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") requires that securitizers of asset-backed securities "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." Section 941 of Dodd-Frank defines a "securitizer" 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 .... "
The SEC and the Federal Reserve Board of Governors took the position that open market CLO managers fall within the scope of the definition of "securitizer", even though they only select loans to be acquired by a CLO and never hold the loans themselves, because they cause the transfer of the loans to the issuer. Accordingly, since December 2016, open market CLO managers have been required to retain 5% of the credit risk of CLOs.
The D.C. Circuit squarely rejected this interpretation and concluded that the statutory language makes clear that the agencies overstepped. An open market CLO manager, arranging for the purchase of loans by the CLO in arms-length transactions from third parties, cannot be said to have "transferred" loans it has never possessed or controlled. Therefore, it cannot be required to "retain" some credit risk of the loans. In effect, what the rule impermissibly required, the D.C. Circuit held, was that open market CLO managers had to "'obtain' a credit risk" they never owned. That went too far.
KEY QUESTIONS AND ANSWERS
Q: I currently manage or am about to launch an open market CLO. Do I need to comply with the credit risk retention rule?
A: For the time being, yes.
Q: Why is that?
A: The rule itself hasn't formally been vacated yet. The agencies have until March 26, 2018 to petition the D.C. Circuit for an en bane rehearing before a panel of all eleven judges on the court (the decision was issued unanimously by a panel of three of them). If the agencies don't seek rehearing before the full circuit court by March 26, 2018, the circuit court will issue its mandate within about a week directing the district court to vacate the rule, and the district court will proceed to do so. Once that happens, open market CLO managers will no longer be required to comply with the rule.
Q: And what happens if the agencies seek rehearing before the entire circuit court?
A: The court can either entertain the request and rehear the case or reject the rehearing request. If the former, the rule will remain in effect until the issue is further adjudicated. If the latter, the rule will be vacated, but precisely when will remain to be seen. Full en banc hearings are only rarely granted and it's unclear whether the Trump administration, which has recommended an exemption from the risk retention requirements for CLO managers, will pursue an appeal.
Q: Can the agencies seek review by the Supreme Court?
A: Yes, they have until May 10, 2018 (90 days from the date of the decision) if they don't seek a rehearing before the entire circuit court. If they do seek a rehearing from the full circuit court and the request is denied, the agencies will then have 90 days from such denial to seek Supreme Court review. Given that there is currently no split among the circuits on the issue, it appears unlikely that any Supreme Court petition would be successful.
Q: Can the agencies formulate a new rule addressing risk retention for open market CLOs?
A: Yes, though not directed at CLO managers and not for quite some time. Agency rulemaking is a lengthy process subject to public comment and review and typically takes a year or more. Given the circuit court ruling, the agencies would need to identify another party to be responsible for risk retention of open market CLO's and it's unclear who could fulfill such a role.
Q: When can a CLO manager sell the 5% risk it has been retaining?
A: Definitely not until the rule is vacated. And even then it will depend on what the deal documents provide for; CLO managers and other parties should carefully review the indenture and other agreements to see what contractual obligations may exist with respect to risk retention.
Q: Does this decision apply to all CLO managers?
A: No. So-called "balance sheet CLO managers" those which originate loans and hold those loans prior to transferring the loans to a CLO issuer-are still subject to the risk retention rule.
Q: What about CLO managers which comply with EU risk retention requirements using an originator/manager model in which some portion of the loans are acquired and sold by the manager?
A: It is an open question whether such CLO managers still need to comply with the U.S. risk retention rule, but such an arrangement is not squarely covered by the court decision.
Q: What does the ruling mean for the CLO market going forward, assuming it takes effect?
A: Institutional investors in the CLO market have broadly supported risk retention efforts by CLO managers and may exert a de facto requirement for some form of retention going forward, despite the court decision. Indeed, many managers have invested considerable time and cost to develop a risk retention compliant infrastructure and may look to continue to retain credit risk in some manner in an effort to differentiate themselves from other managers. For new and smaller managers, who may not have had as ready access to capital to permit risk retention, the decision should allow for more transactions. It is possible that managers eventually adopt a "risk retention-lite" approach in which they voluntarily continue to hold credit risk of deals, but without all of the formal disclosure and accounting requirements of the current rule.