The Loan Syndications & Trading Association prevailed in its quest to eliminate credit risk retention requirements for open-market CLO managers, in a ruling that has other important implications.

Introduction

The US Court of Appeals for the DC Circuit (the Court) ruled on February 9 in favor of the Loan Syndications and Trading Association (LSTA) in its lawsuit against the US Securities and Exchange Commission (SEC) and the Board of Governors of the Federal Reserve (Federal Reserve Board),[1] concluding that managers of open-market collateralized loan obligations (CLOs) are not subject to the credit risk retention rules adopted[2] pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ( Dodd-Frank Act).[3] In its ruling (the Ruling), the Court directed the District Court to enter judgment in favor of the LSTA and to invalidate the credit risk retention rules as they relate to open-market CLOs.

Under the credit risk retention rules, a sponsor of a securitization generally is responsible for retaining not less than 5% of the credit risk of any asset that, through the issuance of asset-backed securities (ABS), is transferred, sold, or conveyed to a third party. Sponsors and other parties that retain ABS interests to satisfy the credit risk retention requirements generally are prohibited, for a specified period, from transferring the retained interests (other than to majority-owned affiliates), hedging the retained credit risk, or pledging the retained interests on other than a full recourse basis.[4]

The LSTA and other commenters on the rules were of the view that an open-market CLO manager is not a “sponsor” because it does not sell or transfer assets to the issuing entity. However, the Agencies rejected this interpretation, stating that a “CLO manager indirectly transfers the assets to the CLO issuing entity because the CLO manager has sole authority to select the commercial loans to be purchased by the CLO issuing entity for inclusion in the CLO collateral pool, directs the issuing entity to purchase such assets in accordance with investment guidelines, and manages the securitized assets once deposited in the CLO structure.”[5] The LSTA challenged the Agencies’ interpretation and appealed to the Court after the District Court decided in favor of the Agencies. The Ruling vindicates the views of the LSTA and those other commenters.

While the Ruling directly addresses only the need for open-market CLO managers to hold risk retention, its holdings may affect many other issues that have permeated risk retention analysis since adoption of the rules, including whether other structures also may be exempt from the credit risk retention requirements, and the identification of the appropriate sponsor that is required to hold risk retention.

CLOs Under the Risk Retention Rules

Section 15G of the Exchange Act imposes risk retention requirements on any “securitizer” of ABS. As defined, a “securitizer” includes “an issuer of an asset-backed security,” which the Agencies interpreted as referring to the ‘‘depositor’’ of the securitization transaction, as well as 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,” a phrase which is substantially identical to the definition of “sponsor” under Regulation AB. The Agencies generally applied the risk retention requirement to the sponsor, because of the active and direct role that a sponsor typically has in arranging a securitization transaction and selecting the assets to be securitized.

A CLO is a type of ABS that acquires and is typically collateralized by portions of tranches of senior, secured commercial loans of borrowers who are of lower credit quality or that do not have a third-party evaluation of the likelihood of timely payment of interest and repayment of principal. The LSTA case deals with a type of CLO known as an open-market CLO, which the Ruling described as CLOs that “acquire their assets from, as the name implies, arms-length negotiations and trading on an open market.”[6]

CLOs usually are organized and initiated by a CLO manager when the CLO manager engages an investment bank that, in addition to providing structuring and placement services, assists in financing asset purchases during the warehousing phase prior to the sale of the ABS in the capital markets. A special purpose CLO issuing entity is formed to warehouse the assets and issue ABS backed by commercial loans that the CLO manager has selected and directed the CLO issuing entity to purchase. After the terms of a CLO transaction, including investment guidelines, are agreed upon with key investors, and following the closing of the CLO transaction, the CLO manager usually has sole discretion to actively manage the asset portfolio (including conducting asset acquisitions and dispositions), in accordance with the agreed investment guidelines, and earns management and performance fees for management services provided.

For open-market CLOs, the Agencies required the CLO manager to satisfy the risk retention requirements. In their view, the CLO manager generally acts as the sponsor by selecting the commercial loans to be purchased by the issuing entity and managing the pool assets once deposited in the CLO structure. According to the Agencies, this constitutes an indirect transfer of the securitized assets.

The LSTA and other commenters on the rules disagreed, asserting that open-market CLO managers are not ‘‘securitizers’’ and are, therefore, not subject to Section 15G of the Exchange Act. According to these commenters, under plain language of Section 15G, open-market CLO managers cannot ‘‘sell’’ or ‘‘transfer’’ the assets securitized through the CLO because they do not own, possess, or control the assets. Additionally, commenters asserted that the open-market CLO manager acts as an agent to the CLO issuing entity in directing the purchase of assets, so it could not sell or transfer the assets to a third party to meet the definition, because it would be equivalent to selling or transferring the assets to itself. According to these arguments, the use of ‘‘indirectly’’ in the definition of “securitizer” was intended to prevent the party that originates a loan from avoiding risk retention obligations by passing the loan through an associated intermediary that organized and initiated the securitization.

Holdings of the Ruling in the LSTA Case

In the LSTA case, the LSTA continued to press the arguments that it and other commenters made during the comment process for the credit risk retention rules. The District Court granted summary judgment in the Agencies’ favor, finding that they could reasonably read Section 15G to treat open-market CLO managers as “securitizers.”[7] The Court disagreed and reversed.

According to the Court, the credit risk retention rules turned the statutory obligation to “retain” a credit risk, at least in the case of open-market CLO managers, into the obligation to “obtain” a credit risk. In order to be deemed to “transfer” (and “retain”) assets, one must first have possession or control over them. A party, such as an open-market CLO manager, cannot “transfer” assets if it simply causes them to be transferred between two other independent parties. As the Court stated, “[t]he language does not seem to apply to a person or firm that causes an SPV, whose value belongs to the investors, to make an open-market purchase from wholly independent third parties.”[8] Open-market CLO managers neither originate the loans nor hold them at any point. The issuing entity, using the investors’ money and operating at the manager’s recommendation, purchases the loans in order to securitize them. Like mutual fund or other asset managers, open-market CLO managers only give directions to the issuing entity and receive compensation and management fees contingent on the performance of the asset pool.

The Court noted that, in addition to ”revers[ing] the apparent flow of the ‘transfer’,” the agencies’ disregard of context leads them to embrace a reading of ‘transfer’ that would include any third party who exerts some causal influence over a transaction.”[9] The fact that the Agencies’ interpretation would sweep in obviously inapplicable parties such as brokers, lawyers, and non-CLO investment managers, reinforced the Court’s view of the inappropriateness of the Agencies’ position.

The Court quoted prior case law to the effect that the words “directly” and “indirectly” can modify the word “retain,” but not completely erase its meaning. According to the Court:

[These] adverbs were meant to assure that, despite the often complicated array of affiliates, depositors and SPVs that financial institutions use to create and sell asset-backed securities, the credit retention rule would reach a transferor no matter how many intermediaries it used. But to be covered…, the party must actually be a transferor, relinquishing ownership or control of assets to an issuer.[10]

The Court noted that by interpreting “retain” as “obtain,” the Agencies required open-market CLO managers to actually acquire investments that they had not acquired before, “necessitating significant amounts of capital that they may neither have nor have access to.”[11] This result “seems too large a surprise to have been intended.”[12]

The Court also discussed the Agencies’ concern that “any securitizer could ‘evade risk retention by hiring a third-party manager to ‘select’ assets for purchase by the issuing entity that have been pre-approved by the sponsor.”[13] This would entail the employment by an institution of a putatively third-party “manager” to sponsor a securitization without transferring assets, thus “creating ‘a situation in which no party to a securitization can be found to be a ‘securitizer’ because the party that organizes the transaction and has the most influence over the quality of the securitized assets could avoid legally owning or possessing the assets.”[14]

According to the Court, if the third-party manager in this example is effectively acting as an agent of the owner of the assets, then the owner is simply transferring “through agents and intermediaries”[15] risk that it is already holding, and it is subject to the credit risk retention rules. That is not the case with open-market CLO managers, which “act as independent contractors with investors rather than as agents of an originating financial institution.”[16]

The Court acknowledged that there may be other cases where “those ‘organizing and initiating’ the securitization do not do so ‘by transferring’ the assets to the issuer, while those that do transfer the assets are not the entities who organize or initiate the securitization in any meaningful way.”[17] However, the Court characterized this as a legislative gap, not susceptible to being closed by regulatory action. The Agencies simply were not justified in stretching the definition of “sponsor” to include “those who do not. . .have a relationship to the assets such that one can reasonably say they ‘transfer’ the assets or could be required to ‘retain’ a portion of the assets’ risk.”[18]

The Court also acknowledged that the Ruling may result in the CLO structure becoming more widespread in the structured finance industry, but concluded that “it is highly doubtful that their falling outside the reasonable coverage of the statute need be a cause of concern.”[19] The Court accepted the LSTA’s position that open-market CLO managers have “skin in the game” because of their compensation structure, that the purchase of pool assets in arms’ length transactions means that the assets are likely less risk than those originated in an “originate to distribute” model, and the “superior incentives and relative transparency” reduce the risk that CLOs will generate the kind of decline in underwriting standards that characterized the recent financial crisis.[20]

The Finality of the Ruling

The Court remanded the case to the District Court with instructions to grant summary judgment to the LSTA on whether application of the rule to open-market CLO managers is valid, and to vacate the credit risk retention rules insofar as they apply to open-market CLO managers. The Ruling will not become the law of the land until the District Court enters the order, and at that time open-market CLO managers will not be required by law to hold risk retention.

The SEC and the Federal Reserve Board could seek en banc review by the Court within 45 days from the date of the Ruling. In our view, such a request is unlikely to be granted, but any such application would delay remand to the District Court and its issuance of summary judgment until the request for rehearing is resolved.

The SEC and the Federal Reserve Board also could seek review of the Ruling by the US Supreme Court. The time for filing a petition for certiorari is 90 days from the date of the panel’s opinion or the order denying a petition for rehearing, whichever is later. A petition for certiorari would not automatically stay the Court’s mandate, although the SEC and the Federal Reserve Board could seek a stay of the mandate pending Supreme Court review. The bar for such a stay would be quite high; in addition to the normal requirements for the stay of a judgment (e.g., irreparable harm, likelihood of success, and balance of equities), the proponents would have to show that it is more likely than not four justices would vote to grant certiorari.

The possibility of the SEC or the Federal Reserve Board taking any or all of these appellate options should be considered in light of the fact that the current administration has been skeptical of the value of at least some aspects of the credit risk retention rules, including their application to CLOs.[21]

Open-market CLO managers who wish to avail themselves of the Ruling should carefully consider all implications of ceasing to hold risk retention, including the effect of their existing risk retention disclosures and securitization agreements in existing transactions, as well as the possible market impact on both existing and future transactions.

Other Ramifications of the Ruling

As acknowledged by the Court, there may be other structures where those “organizing and initiating” the securitization do not do so by “transferring” the assets to the issuer, while those that do transfer the assets are not the entities who organize or initiate the securitization in any meaningful way. Under the rationale of the Ruling, these structures would not be subject to credit risk retention.

The universe of these structures, however, may be somewhat limited. In the case of an open-market CLO, the two parties to the asset transfer (the seller of assets and the purchaser, the special purpose issuing entity) are unrelated from the collateral manager that causes the transfer of the assets between those parties. In many other structures in which the sponsor is not directly in the chain of title to the pool assets, the sponsor owns the depositor, the equity in the issuing entity, the originator or seller of the assets, or some other entity that is in the chain of title. This may be sufficient to conclude that these entities “have a relationship to the assets such that one can reasonably say that they ‘transfer the assets or could be required to ‘retain’ a portion of the assets’ risk.”

The Ruling may also have implications for the identification of sponsors (or co-sponsors) in more complex structures. Based on the discussion by the Agencies, many industry participants have used a multifactor test to identify the sponsor. Active selection of the assets to be securitized generally has been considered to be the most important factor, along with undertaking all required organizational and initiation activities through the sponsor’s own employees, rather than at the direction of a third party or acting solely as a “rubber stamp.”[22] The requirement that the sponsor transfer the receivables to the issuing entity, directly or indirectly, has often taken somewhat of a back seat, based on the Agencies’ conclusion that it is not necessary for a CLO collateral manager ever to have legally owned or possessed the pool assets to be deemed to have “transferred” them to the issuing entity. After the Ruling, we expect that an entity’s connection with the pool assets will take on increased importance in the sponsorship analysis.

Conclusion

Once the District Court complies with the Court’s direction to grant summary judgment to the LSTA on whether application of the rule to open-market CLO managers is valid and to vacate the credit risk retention rules insofar as they apply to open-market CLO managers, the Ruling will become the law of the land, unless it is modified as a result of an appeal. At that time, open-market CLO managers will no longer be required to acquire and hold risk retention in open-market CLO transactions.

Open-market CLO managers who wish to avail themselves of the Ruling should carefully consider all implications of ceasing to hold risk retention, including the effect of their existing risk retention disclosures and securitization agreements in existing transactions, as well as the possible market impact on existing and future transactions.

Sponsors in other structures where those “organizing and initiating” the securitization do not do so by “transferring” the assets to the issuer, while those that do transfer the assets are not the entities who organize or initiate the securitization in any meaningful way, should consider carefully their next steps, including any steps needed to secure for themselves the benefits of the Ruling.

Sponsors and co-sponsors in current securitization structures that do not directly own or possess the pool assets should carefully consider the impact of the Ruling, but may not reach a different sponsorship conclusion, particularly if they have an ownership interest in and control over an entity (such as the depositor, the issuing entity, or the originator or seller of the assets) that is in the chain of title.