A three-judge panel of the U.S. Court of Appeals for the D.C. Circuit ("D.C. Circuit") issued a unanimous decision1 on Friday, February 9, 2018 holding that the final rules implementing the requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Risk Retention Rules" or the "Rule") do not apply to "open-market CLO" managers. Before the issuance of the D.C. Circuit's decision, the market was adjusting to the Rule's requirement that a CLO manager, as "sponsor" of a CLO, retain or cause to be retained by a "majority-owned affiliate" at least five percent of the securities issued in the CLO transaction.2 The D.C. Circuit ruled that the federal agencies implementing the Rule (collectively, the "agencies")3 incorrectly characterized open-market CLO managers as "securitizers" required to retain the requisite credit risk because such managers have no "relationship to the assets such that one can reasonably say that they 'transfer' the assets and could be required to 'retain' a portion of the assets' risk."4 While the D.C. Circuit's decision is expected to be, over the long term, a shot in the arm to an already robust CLO market, there may be some pause in the market for pricings of some new CLOs and CLO resets and refinancings, in particular in such transactions that had contemplated retention financings, pending possible appeal (or passage of the time period for appeal) of the decision.
II. APPLICATION OF THE RULE PENDING POSSIBLE APPEAL
The agencies have 45 days to petition for rehearing en banc by a full panel of judges on the D.C. Circuit. In the absence of a successful challenge by the agencies, the D.C. Circuit's mandate will generally be implemented as follows: if the agencies do not petition for rehearing, within seven days after expiration of the 45-day period (i.e., by April 2, 2018); or if the agencies do petition for rehearing, within seven days after the petition is denied or, if granted, when the appeal proceeding ends and the decision is upheld.5 The D.C. Circuit also can exercise discretion to shorten such periods.6 The agencies also could file a petition for a writ of certiorari in the United States Supreme Court (and move to stay the mandate pending certiorari) without first filing a petition for rehearing with the D.C. Circuit or after a petition for rehearing is denied.7
Petitions for rehearing or for a writ of certiorari are neither favored nor granted as a matter of right.8 Moreover, given the current political landscape and the October 6, 2017 Treasury Report recommending a qualified exemption from risk retention for CLOs, an appeal by the agencies may be unlikely.
CLO managers are required to comply with the Risk Retention Rules until the mandate is issued. Once the D.C. Circuit's mandate is effective, the Risk Retention Rules will not apply to managers of existing or future open-market CLOs.
III. SCOPE OF THE D.C. CIRCUIT'S DECISION
The D.C. Circuit determined that the agencies' decision to apply credit risk retention requirements to managers of open-market CLOs represented an unreasonable interpretation of the authorizing statute, which calls for the agencies to adopt regulations requiring any "securitizer" to retain a portion of the credit risk for any asset the securitizer transfers or sells through the issuance of an asset-backed security.9 The court relied on the plain reading of the text of the statute in concluding that "transfer" is a key element of the definition of "securitizer" and that, because they do not transfer assets, managers of open-market CLOs are not "securitizers" required to retain any credit risk. The D.C. Circuit's decision draws a distinction between open-market CLOs and balance sheet CLOs (which include most middle-market CLOs):
[O]pen-market CLOs acquire their assets from . . . arms-length negotiations and trading on an open market. Balance sheet CLOs (sometimes called middle-market CLOs) are usually created, directly or indirectly, by the originators or original holders of the underlying loans to transfer the loans off their balance sheets and into a securitization vehicle. Only [open-market CLOs] are governed by the rule at issue in this case . . . . (emphasis added)
Given the D.C. Circuit's focus on the word "transfer" and its view that open-market CLOs are CLOs in which the entity initiating the securitization transaction did not own or possess the securitized assets prior to such assets being securitized, it is an open question whether a CLO that holds even a de minimis amount of balance sheet assets would qualify for the relief from the Rule that the court's decision would provide.
IV. WHAT ABOUT STRUCTURES OTHER THAN OPEN-MARKET CLOs?
It remains to be seen to what extent the D.C. Circuit's decision will impact risk retention as applied to asset-backed securitization transactions other than open-market CLOs.
Might there be an impact on CDOs and CBOs where the manager acts in a manner consistent with that of an open-market CLO manager? Much of the reasoning in the decision would support a conclusion that the Rule generally should not apply to any securitization, whether or not a CLO, "in which those 'organizing and initiating' the securitization do not do so by 'transferring' the securitized 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."10 To the extent this results in a "loophole," the opinion states, "it is one that the statute itself creates, and not one that the agencies may close with an unreasonable distortion of the text's ordinary meaning."11 The court also questions whether such a "loophole" would in fact be cause for concern, as the open-market business model mitigates the problems that the regulators were concerned about with the originate-to-distribute model.12
How is the Rule to be interpreted in the case of an external manager of a fund that transfers assets on the balance sheet of the fund to a securitization issuer (the structure commonly used in many middle-market CLOs)? An argument could be made that such an external manager would not be a "securitizer" under the D.C. Circuit's reasoning because it would not itself possess the transferred assets at any point; requiring it to hold the retention interest would "turn 'retain' a credit risk into 'obtain' a credit risk"13 which, the opinion states, goes beyond the authorized scope of the Rule as it applies to open-market CLOs. If the D.C. Circuit's reasoning is taken to its logical conclusion, arguably, the externally managed fund as prior owner of the transferred assets would appear to be the only party that potentially satisfies the "securitizer" definition. Yet there is tension in coming to this conclusion, as the preamble to the Rule suggests that the agencies have concerns about allowing an externally managed vehicle to be a retention holder, and the policy considerations that underlie exempting open-market CLO managers from the Rule may not fully apply to middle-market CLO managers. Because these concerns were not presented in the case (among other reasons), it is difficult to say exactly how the decision will affect the application of the Rule to many middle-market CLOs.
V. IMPLICATIONS FOR DUAL U.S./EU RISK RETENTION COMPLIANT CLOs
Many CLO managers that manage dual U.S./EU risk retention compliant deals utilize so-called "limb b" origination whereby a portion of the portfolio is acquired in the open market by the retention holder and later "transferred" to (and often directly settled with) the CLO issuer. This raises the question whether such a transfer of only a minor portion of assets by an originator-manager (in many cases, as little as 5% of the assets measured as of the closing date) could taint its treatment as an "open-market CLO." While time will tell if the market will view this component of a transaction as rendering such transaction outside of the scope of the D.C. Circuit's decision, it may be argued that this type of "origination" activity would not render an otherwise open-market CLO a balance sheet CLO since such "origination" is not necessary for purposes of securitizing the assets but is done solely for purposes of complying with the EU risk retention rules and the portfolio of assets was sourced by the CLO manager from third-party sellers in the open market. As a practical matter, this question may have little impact on the market, as a deal that is compliant with the EU risk retention rules (via the use of an originator-manager) may be made compliant with the Rule by virtue of, in the case of horizontal retention, proper measurement and sizing of, and disclosure with respect to, the eligible horizontal residual interest, and in the case of vertical retention, proper disclosure with respect to the eligible vertical interest. However, we expect that the number of U.S. open-market CLOs that are EU risk retention compliant will be reduced by the D.C. Circuit's decision.
VI. WHAT'S NEXT?
The D.C. Circuit's decision marks the latest twist in a regulatory saga impacting the CLO industry dating back to 2010. Although this development is undeniably positive, the market will again need to adjust to achieve an understanding of which CLOs may fall outside of the scope of the decision and of the various implications of the decision on existing and future transactions (e.g., the impact on transfers of assets from warehouse vehicles, reset transactions and reissue transactions). Market participants that previously acquired risk retention stakes—particularly "vertical strips"—may decide to sell once the mandate is effective, to the extent no contractual obligation prevents them from doing so. CLO managers that had been working with third parties to establish risk retention funding partnerships may find themselves with more negotiating leverage given that the imperative for accumulating such capital may soon be greatly reduced. It also remains to be seen how many managers will continue to retain interests in their transactions and whether there will be any pricing benefit to those who do. These are only a few of the trends we may see moving forward.
1 Loan Syndications & Trading Ass'n v. SEC, No. 17-5004 (D.C. Cir. Feb. 9, 2018). The D.C. Circuit's decision reverses the district court's decision in Loan Syndications & Trading Ass'n v. SEC, 223 F. Supp. 3d 37 (D.D.C. 2016), and remands the case with instructions that the district court (among other things) vacate the rule insofar as it applies to open-market CLO managers.
2 The required five percent can take the following forms: (1) an eligible vertical interest ("EVI") equal to five percent of the face value (i.e., par value) of each class of CLO securities issued in the transaction, (2) an eligible horizontal residual interest ("EHRI") comprised of the first loss interest (i.e., in the most subordinated class or classes of securities of the CLO) having a fair value of not less than five percent of the fair value of all securities issued by the CLO, determined under GAAP or (3) an "L-shaped interest" whereby the percentage of the fair value of the EHRI and the percentage of the face value of the EVI (by class) must equal at least five percent.
3 The Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Department of Housing and Urban Development, Federal Housing Finance Agency, Office of the Comptroller of the Currency, and Securities and Exchange Commission were jointly responsible for implementing the Risk Retention Rules. Only the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System codified the Risk Retention Rules as applied to open-market CLOs, and thus only these agencies were named in the lawsuit.
4 Loan Syndications & Trading Ass'n v. SEC, No. 17-5004, at *14.
5 See Fed. R. App. P. 41(b) ("The court's mandate must issue 7 days after the time to file a petition for rehearing expires, or 7 days after entry of an order denying a timely petition for panel rehearing, petition for rehearing en banc, or motion for stay of mandate, whichever is later.").
After the D.C. Circuit issues its mandate, the district court will have to enter an order formally vacating the rule, which is a ministerial matter.
6 A party may move the D.C. Circuit for expedited issuance of the mandate.
7 A party that obtains a stay of the mandate (normally limited to 90 days) can seek an extended stay pending resolution of the petition for writ of certiorari if the petition is filed within the period of the stay. See Supreme Court Rule 10; see also Fed. R. App. P. 41(d)(2)(B).
8 "An en banc hearing or rehearing is not favored and ordinarily will not be ordered unless: (1) en banc consideration is necessary to secure or maintain uniformity of the court's decisions; or (2) the proceeding involves a question of exceptional importance." Fed. R. App. P. 35.
"Review on a writ of certiorari is not a matter of right, but of judicial discretion. A petition for a writ of certiorari will be granted only for compelling reasons." Supreme Court Rule 10.
9 Section 941(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
10 Loan Syndications & Trading Ass'n v. SEC, No. 17-5004, at *12.
12 Id. at *16.
13 Id. at *7.
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