The holiday season did not deliver for open market collateralized loan obligations (CLOs). On Dec. 22, 2016, the United States District Court for the District of Columbia released its decision in The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System, No. 16-652 (D.D.C. Dec. 22, 2016). The Loan Syndications and Trading Association (LSTA), representing members participating in the syndicated corporate loan market, brought an action against the defendants challenging the applicability to open market CLOs of the final credit risk retention rules adopted by the defendants pursuant to Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The court concluded that “the agencies did not act arbitrarily, capriciously, or otherwise unlawfully in declining to provide an exemption or adjustment to the credit risk retention rules for open market CLOs.”
A CLO is a type of securitization backed by loans made to corporate borrowers. Balance sheet CLOs are typically sponsored by large institutions, securitizing loans originated by such institutions. In contrast, in an open market CLO, a collateral manager directs the purchase of loans through a special purpose vehicle in the open market, and these loans meet certain investment guidelines. After loans are selected for the CLO, the collateral manager operates and manages the loan portfolio.
The defendants, along with other relevant agencies, issued a joint notice of proposed rule-making and solicited comments on the Dodd-Frank Act’s credit risk retention provisions. Under the proposed rules, a “securitizer” is required to retain at least 5% of the credit risk of the securitized assets. The proposed rules generated thousands of comments. Open market CLO market participants expressed concern with the application of the credit risk retention rules to a CLO manager who is unaffiliated with the origination of the loans and purchases loans on the open market. In adopting the final credit risk retention rule, the agencies reaffirmed their determination that the term “securitizer” (which includes 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) covered CLO managers.
The Arguments and the Court’s Analysis
The plaintiffs argued that the agencies violated the Administrative Procedure Act (APA) by arbitrarily and capriciously construing the term “securitizer” to include open market CLO managers and declining to provide an exemption or adjustment to the credit risk retention rules for open market CLOs. In the context of reviewing a violation of the APA based on the reasonableness of the construction of the Dodd-Frank Act, the court determined that the two-step test set forth in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) was the proper framework to govern the court’s analysis. The two-step analysis in Chevron requires a court to consider “whether Congress has directly spoken to the precise question at issue,” and “[i]f the intent of Congress is clear, that is the end of the matter,” but “if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute” (Chevron at 842, 843). Application of the Chevron two-step test provides great deference toward the agencies’ interpretation of the statutes. Under this test, the plaintiffs were unable to prevail.
The LSTA announced that it will appeal the decision to the U.S. Court of Appeals for the D.C. Circuit. During the appeal, the credit risk retention rules as they apply to open market CLOs will remain in effect and open market CLO collateral managers will be required to retain credit risk in CLO securitizations. Unless and until the LSTA has a successful appeal or the incoming administration repeals and/or amends all or a portion of the Dodd-Frank Act, specifically the credit risk retention rules, the CLO industry will have to operate within the confines of the credit risk retention rules. Creative structures have been discussed among market participants to enable securitizers to leverage their retained piece of the CLO structure. All securitization transactions issued on or after Dec. 24, 2016, must comply with the credit risk retention rules, so investment managers seeking to manage open market CLOs should consider alternative structures to mitigate the cost of compliance.