On February 9, 2018, the D.C. Court of Appeals ruled that treating managers of open-market CLOs as "securitizers" subject to the risk retention rules exceeded the statutory authority to promulgate rules to implement the risk retention requirements under Section 941 of the Dodd-Frank Act.1 In so doing, the Court agreed with the argument made by the Loan Syndications and Trading Association (LSTA) that under the statute, "securitizers" applies only to those parties that initiate securitizations by selling or transferring assets to securitization vehicles, and not to CLO managers who purchase assets in the CLO entity on behalf of investors. As noted by the Court, "[t]he agencies' interpretation seems to stretch the statute beyond the natural meaning of what Congress wrote; it turns 'retain' a credit risk into 'obtain' a credit risk. Even under Chevron, after all, agencies only 'possess whatever degree of discretion [an] ambiguity allows.'"2
Section 941 of the Dodd-Frank Act directs the Securities and Exchange Commission, the Board of Governors of the Federal Reserve System and certain other regulatory agencies (the "Agencies") to prescribe regulations to require any securitizer of an asset-backed security (ABS) to retain a portion of the credit risk for any asset that the securitizer "transfers, sells, or conveys" to a third party, specifically "not less than 5 percent of the credit risk for any asset." The risk retention requirement was intended to redress the complexity and opacity of securitizations that Congress viewed as preventing investors from adequately assessing risks in a securitized portfolio; the reasoning behind the risk retention requirement was that if securitizers were to retain a material amount of risk, they would have "skin in the game," and their economic interests would be aligned with those of the investors in ABSs.3
The Agencies adopted the risk retention rules on October 22, 2014, and, about a month later, on November 24, 2014, the LSTA announced that it had brought suit against the Agencies, challenging, among other things, their decision to apply the rule to CLO managers on the grounds that the plain language of Section 941 does not encompass the activities of managers of open-market CLOs. The District Court granted summary judgment in favor of the Agencies, finding that Section 941 could be reasonably read to capture CLO managers by virtue of clause (B) of the definition of "securitizer," which captures "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...".4
The Court of Appeals for the D.C. Circuit disagreed, noting that "[t]he two key words in determining whether § 941 can be reasonably read to encompass CLO managers are 'transfer' and 'retain'."5
The Court first noted the importance of the concepts of "retain" and "transfer" in the portion of the statute mandating the rule-making: "[t]he 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) (emphasis added).
The Court further noted the prominence of "transfer" in the definition of "securitizer," defined by Congress 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 ...". Id. § 78o-11(a)(3) (emphasis added).
The Court found that the plain language of Section 941 "refers to an entity that at some point possesses or owns the assets it is securitizing and can therefore continue to hold some portion of those assets or the credit risk those assets represent" (emphasis in original).6 In order to be covered by the Section, the Court held a party must actually be a transferor, relinquishing ownership or control of assets to an issuer.7 Because the manager for an open-market CLO neither originates the loans underlying CLOs nor at any point holds them as assets (instead, such CLO manager gives direction to the CLO issuer, in return for compensation and management fees contingent on performance of the asset pool), a CLO manager is not a transferor under Section 941.8 Turning next to the meaning of "retain," the Court held that the Agencies exceeded their authority when interpreting the requirement to "retain" a credit risk permitted the Agencies to require CLO managers to "obtain" a credit risk position—practically speaking, by requiring open-market CLO managers to go into the marketplace and buy an asset they never before held.9
The Court considered the policy concerns raised by the Agencies, but did not find such concerns to be sufficiently compelling to cause a redrafting of the statutory boundaries of Section 941. To the contrary, the Court noted that the manager in an open-market CLO was acting on behalf of its investors, and stated that "Congress in its statutory scheme seems to be trying to achieve through regulation the incentives and transparency that the CLO market achieved through its business model;" aspects of such model including that the compensation dependency already gives CLO managers "skin in the game" and that the activities of CLO managers present a much weaker version of the opacity that Congress sought to rectify in other ABS markets through Dodd-Frank.10
Reversing the judgment of the District Court, the Court of Appeals remanded the case with instructions to (i) grant summary judgment to the LSTA on whether application of the rule to CLO managers is valid under the Section, (ii) vacate summary judgment on an issue which was litigated and decided at the district court level but which was not reached by the Court of Appeals in light of their decision in (i) above (how to calculate the 5 percent risk retention), and (iii) vacate the risk retention rule insofar as it applies to managers of open-market CLOs.11
The Agencies have 45 days to seek en banc review by the Circuit Court and 90 days to seek judicial review by the Supreme Court. However, in light of the Treasury's Capital Markets Report of October 2017 where they recommended that the Agencies should "right size" the risk retention requirement applicable to CLO managers, it is not clear whether the agencies will appeal. The Treasury report recommends some risk retention depending on the quality of the securitized loans which may be difficult to achieve under the Circuit Court's ruling. On the other hand, the Treasury Report recommends significant exemptions for CLO managers' risk retention which may indicate that the Agencies may have limited interest in pursuing an appeal.
What Does The Decision Mean in Practice?
The court decision was narrowly circumscribed to only apply to true "open-market CLOs." Consequently, it will be important as an initial step to distinguish "true" open-market CLOs from other securitizations that employ a third-party manager. Based on the Court's reasoning, it appears that appointment and control over CLO managers will be the key distinguishing factors: "where the actual organizer is the institution that holds the assets and 'pre-approve[s]' the selections of a 'third-party' manager, then both the rule and the statute logically apply" (citing 79 Fed. Reg. 77,655/1). The Court further noted that "[t]he bank or financial institution that is actually calling the shots is organizing the securitization 'by transferring' its assets and can be required to retain credit risks that it is already holding."12
The Court noted that a securitization that was sponsored by indirect transfer through agents and intermediaries was distinct from securitizations where CLO managers act as independent contractors with investors rather than as agents of an originating financial institution.
In a true open-market securitization where there is no transferor of assets that has initiated the securitization, it is likely that there will be no securitizer to retain the risk in light of the Agencies' current interpretation of who qualifies as an "issuer" for purposes of clause (A) of the securitizer definition in Section 941. It is also possible that the Agencies will go back to the drawing board to fashion a risk retention rule for open-market CLOs that conforms with the statutory mandate, for example by having the securitization entity itself retain the relevant risk, a structure the Court indicated would be permissible under the plain reading of the definition.
CLO managers of CLO issuers with European financial investors will potentially have limited benefits from the Court's decision, because under the European risk retention regime, those financial institutions may determine that they will be subject to punitive capital requirements unless the European risk retention rules have been complied with. Unlike the U.S. rules which place the risk of compliance on the securitizer, the European risk retention rules place the onus to confirm compliance with the risk retention requirement on the investing financial institution.
1 The Loan Syndications & Trading Ass'n v. SEC and Bd. of Governors of the Fed. Reserve Sys., No. 17-5004, slip op. at 3 (D.C. Cir. Feb. 9, 2018). https://www.cadc.uscourts.gov/internet/opinions.nsf/871D769D4527442A8525822F0052E1E9/$file/17-5004-1717230.pdf
2 Id. at 7.
3 Id. at 2-3.
4 Id. at 3-5.
5 Id. at 5.
6 Id. at 5.
7 Id. at 10.
8 Id. at 6.
9 Id. at 7, 10.
10 Id. at 16-17.
11 Id. at 17.
12 Id. at 15.
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