In a case of first impression, the D.C. Circuit Court struck down the Dodd-Frank-mandated risk retention requirements for managers of open market collateralized loan obligations (CLOs). In its Feb. 9 opinion in Loan Syndication & Trade Association v. SEC, the court found that CLO managers do not originate or hold assets, and are therefore not “transferors” of assets or “securitizers” under section 941 of the Dodd-Frank Act. As a result, CLO managers will no longer be required to maintain sufficient capital to retain the risk of the open market CLOs they manage.
In an open market CLO, the assets of the CLO are typically not originated by the CLO’s investment manager and are purchased by the CLO from third parties. This investment manager, however, was required to hold or retain an equity interest in the CLO equal to 5 percent of the fair value of the CLO under the risk retention rule. The Loan Syndication and Trade Association (LSTA) sued the SEC and the Federal Reserve Board of Governors (the agencies that entered the risk retention rule into the Federal Register), claiming that the rule deviated from the statutory requirement laid out in the Dodd-Frank Act. The district court upheld the rule, and the LSTA appealed to the D.C. Circuit (read more on the background of the rule and the district court’s opinion here.)
Circuit Court Strikes Risk Retention Rule
The LSTA litigated on two main claims: (1) that Dodd-Frank section 941 did not apply to managers of open market CLOs and (2) that even if it did, the risk retention rule did not correctly determine the amount of risk that needed to be retained.
The LSTA argued that under section 941, the 5 percent risk retention requirement only applied to “securitizers.” The underlying policy for the risk retention rule was to ensure that the individuals who created securities would have “skin in the game” so that they would not create unduly risky securities to be repackaged as part of a securitization offering. LSTA argued that open market CLO managers are only placing the CLOs in the market, and are not creating them, and are therefore not “securitizers.”
The Circuit Court agreed. It found that under the terms of section 941, “an entity which transfers assets to an issuer [must] retain a portion of the credit risk from the underlying assets that it transfers.” The court focused on the plain meaning of the statute, and found that “CLO managers do not hold the securitized loans at any point. Instead of being a financial institution originating or acquiring assets and then securitizing them, a CLO manager meets with potential investors and agrees to the terms of its performance as well as the risk profiles and tranche structures the CLO will ultimately take.” Therefore, the court found, an open market CLO manager was not a securitizer under section 941.
A key point in the court’s analysis is that open market CLO managers typically do not own the loans and never originate the loans. If, however, affiliates of a CLO manager were involved in the origination of loans that were purchased by a CLO, that CLO might not qualify as an open market CLO for purposes of this ruling.
Because the court struck the rule on LSTA’s first argument, it did not consider the association’s second argument.
While this case is a win for the CLO market, it would be premature for open market CLO managers to act on it. The SEC has 45 days in which to appeal, though it seems unlikely that it will do so. Generally, regulatory agencies appeal decisions related to politically divisive topics and those that rely on novel and unique statutory interpretations.
Even if the SEC does not appeal, the risk retention rule will not be vacated until seven days after the appeal period has expired. At that point, the credit risk retention requirement for open market CLO managers will still be “on the books,” but will practically be unenforceable, since any attempt to enforce it by the SEC would be challenged in court.
The D.C. Circuit’s decision, if it stands, also limits the need to rely on the July 17, 2015 Crescent no-action letter, since open market CLOs will not need to follow the credit risk retention requirements. As such, any refinancings of open market CLOs that were originally closed before December 24, 2014 do not need to be structured in accordance with the Crescent no-action letter in order to be exempt from the 5 percent risk retention requirement. Even so, many of the so-called “CLO 2.0” deals that have already been finalized include provisions related to risk retention, and those positions held by the manager may not be “dumped” without running afoul of the contractual requirements.
Additionally, balance sheet CLOs (sometimes called middle-market CLOs) — which are CLOs created by the originators or original holders of the underlying loans to transfer the loans off their balance sheets and into a securitization vehicle — would still need to follow the mandate of the Crescent no-action letter when refinancing since they must still adhere to the credit risk retention requirements.
Finally, federal regulators do have other means to “reinstate” the risk retention requirement for open market CLO managers. They could petition Congress to amend the relevant portions of the Dodd-Frank Act, or they could seek to adopt a new rule, which would need to follow the traditional rulemaking process requirements, including both the notice and public comment periods and Congressional Review Act (CRA) presentment to Congress (for more information on CRA and its role in overturning regulations, see our client alert here.)
It should be noted that the Circuit Court’s opinion is limited to open market CLO managers. Managers of middle-market CLOs are still subject to the rule.
The Crescent no-action letter is still relevant for middle-market CLOs because they must still abide by the risk retention requirements.
Managers of open market CLOs will no longer need to have access to capital to remain in the game because they will no longer need to buy pieces of the CLOs they manage to meet risk retention requirements. This should facilitate the ability of smaller managers to initiate or resume their CLO management activities since the equity requirements will be substantially less and will be driven by market forces rather than mandated regulatory requirements.
While the decision was limited to the application of risk retention requirements to managers of open market CLOs, the decision raises the prospect that similarly situated intermediaries in other CLO transactions could challenge the risk retention requirements.